The second-largest tax break in the massive CARES Act – $135 billion – applied to a relatively small number of taxpayers. The Joint Committee on Taxation indicated that over 80% of the benefit went to 43,000 returns with income over a million dollars.
Not For The Little People
The break was the push back of the effective date of the limitation on excess business losses – Code Section 461(l). You probably don’t know what that means. That’s OK. Neither do most tax professionals and certainly very few of the congresspeople who voted on it. There was another provision about farm losses also affected, but it is pretty clear that fooling with 461(l) was generating the bulk of the $135 billion revenue loss.
The coverage on this move, which apparently was a fast one in that the voting came before the scoring, has been negative. There is a lonely voice out there crying that rather than fooling with the effective date, 461(l) should have been retroactively repealed as it is poor tax policy and unfair.
A Pillar Of The Tax Blogosphere
The lonely voice is Joe Kristan, one of the longest-running tax bloggers who is back from a break dictated by the demands of an upstream merger on a new platform.
Here is the essence of what Joe wrote me.
“Peter, you have asked for a “sympathetic” example of why Sec. 461(l), limiting business losses to a fixed dollar amount, is bad policy. My short answer is that it is a classic “heads they win, tails you lose” provision. If you have a good year, the government has no problem taxing all of your income, but if you have a bad year, somehow it’s abusive to deduct your entire loss.
A lot of the commentary on this provision talks about how it disproportionately benefits “millionaires.” This glides over how most businesses are taxed on 1040s in recent decades. If a business has a good year, the owner can be a “millionaire” on his 1040, even if all the earnings go back into the business. If the business has an awful year and wipes out accumulated prior year income, it means a “millionaire” gets a tax break. Somehow that’s a bad thing, even though that “millionaire” is getting hammered economically.”
A Hypothetical Example
Joe put together an example, but I had too many nits to pick with it, so I will give you my own. It is very loosely based on a case I wrote about many years ago. Charley is a software engineer in his thirties. He was one of the founders of a company that was acquired in an upstream merger with a major publicly-traded company. He decided to just hang onto the stock that he received.
So Charley owned $3 million worth of stock in a publicly-traded company, but did not have much else going on and was at loose ends. He lives pretty simply. Being a software engineer he is a lot smarter than CPAs so he does his own tax planning.
Shake That Guy’s Hand
Charley decided to found company to create a new app. It is called “Hand Shake”. You ever hear the expression “I’d like to shake his hand”. You know – after somebody does something great. Well, maybe there is somebody who wants to shake your hand for something you’ve done.
He knew that he was going to run losses for the first couple of years. He started out by borrowing on margin and pouring the money into the new company, but you know how that can go. And the losses are worse than he thought. Towards the end of the year he sold half his stock in the public company. That was back in December.
Surprise!
He is just so busy, that he decided to have a CPA do his return. It’s pretty simple. A $1.5 million loss from his S Corporation and a $1.5 million gain from the stock sale. So it comes as a real shock when he learns that he can only use $250,000 of the loss and he owes a few hundred thousand dollars in tax. And now with the pandemic and all an app to facilitate hand shaking seems a little questionable.
Charley is pretty philosophical about it. He grew up in very modest circumstances. He considers himself lucky, but of course there is this odd thing about how the harder you work the luckier you seem to get.
It just bugged the heck out of him that he owed a few hundred thousand dollars in tax and all he had to show for it was a net operating loss that will take him years to work off if he goes back to working for a salary. The CARES Act provision was a big relief.
I think Charley is much more sympathetic than the real estate billionaire I highlighted in this piece.
Not Just Charley
Joe Kristan tells me that there are a number of people he knows in the agriculture sector who were hurt by 461(l). He reminded me of some things that I sometimes forget when I have my commentator hat on.
“Another awful part of the commentary is the implication that all of these business losses are “paper losses,” and deducting them is somehow abusive. You know well the many obstacles to deducting “paper” losses in the tax law, from basis limits to the at-risk rules to the passive loss rules – not to mention form v. substance doctrines, accounting method limitations, and so on. Even in years where the economy is doing well, there are businesses that actually lose money. That’s especially true in businesses dependent on volatile commodities – agriculture, many manufacturers, and extractive businesses.”
The history of tax legislation since at least 1969 is in part a war against tax sheltering. The system that has been created is a series of hoops that have to be jumped through to post a negative number to Form 1040. As in many wars, there is a lot of collateral damage. People who are not really trying to get away with anything dastardly end up stepping on mines that were meant for the scoundrels.
The positive side of it is that it gives people work. I sometimes think that the whole system is a sort of white-collar jobs program for college graduates who are not quite smart enough to be engineers.
More to the point in any given year some of the people with seven-figure adjusted gross income are having a once in a lifetime experience and given the way income tax realization fails to align with cash flow, they might not be in such great financial shape.
Where We Agree And Disagree
Joe mentions the short history of 461(l), by my reckoning the sixth hoop that you need to jump through.
“Incidentally, it’s not as though Sec. 461(l) is a long-standing pillar of tax law. It’s a kludge improvised to improve the revenue projections of TCJA, which itself is a grab bag of bad tax policy. I hope this makes it easier to understand why I believe the loss limits are unfair and poor policy.”
I agree with Joe on that comment but have a different view. The worst piece of bad tax policy in TCJA was to create a whole new class of income that favored the owners of businesses, whether they worked or not, over people who work. 461(l) was dreamed up to offset some of the revenue lost by that and other provisions.
There is a good argument that 461(l) should go, but not as an emergency response to the pandemic. There needs to be a round of balanced tax reform, but right now we have a pandemic on.
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