I Grew Up With The Internal Revenue Code of 1986 – Will We Retire Together ?

When I was growing up I was more of a DC kid than a Marvel kid.  I liked Sgt Fury and His Howling Commandos, but when it came to superheroes, it was Superman and Green Lantern not Spiderman and the Hulk for me.  I lost interest in comic books for quite a while, but then in 1985 after nearly 50 years DC did something amazing.  Their “universe” had built up all sorts of contradictions because editors and writers had not paid attention to “continuity”.  So they scrapped it all and started over again.  The funny thing is just last month they went and did it again.  I actually went out and bought 52 first issues as the DC superheroes are once again rebooted.  The Internal Revenue Code is a little like that.  It is constantly tinkered with but once in a very great while, there is a reboot.  The last one was in 1986.

Lu Gauthier, whose Boston Tax Institute provides the best tax CPE value in New England if not the world, once remarked that the Tax Reform Act of 1969 cut the value of his LLM in taxation in half.  Before 1969 you could have great fun with C corporations.  The first $50,000 of corporate income was taxed at a much lower rate than individuals paid.  So the more corporations you had, the better.  Lu told us about a guy who had figured out how to make 23 corporations out of a single camera shop.  Rules in the 1969 Act  limiting “multiple surtax exemptions” took a lot of the fun out of that.  You could still, however, build up value in a coproration, then sell the assets without recognizing corporate gain if you liquidated within a year.  There were all sorts of other neat tricks.  Of course with individual rates as high as 70%, you needed neat tricks, like tax shelters.  Oil and gas,equipment leasing.  My particular specialty was low income housing.  Highly leveraged building has rehab costs written off over five years.  At some point the principal amortization is greater than the depreciation.  Phantom income.  No problem.  Sell to new investors and get capital gains income.   Since Congress was encouraging low income housing, Section 183 did not apply.  The amount you paid in each year was equal or less than your tax benefit.  When it turned around the phantom income was a capital gain.  Deferral and conversion.

In the early eighties they talked about simplifying.  To hedge my bets I got a Masters in Applied Mathematics rather than a Masters in Taxation.  I also deeply studied the Treasury II proposals.  The essence of the proposals was to tax real income.  Part of the proposals, which did not pass, would have tried to not tax any income that was actually not economic gain, but rather a byproduct of inflation.  So if a bank charged 12% for a loan andinflation was 8% (You think I am making these numbers up ?  Well I am, but they are realistic.  I remember prime being as high as 20% and the yield curve being inverted.) – only 4% would be taxable to the bank and deductible to the borrower.  The basis of assets would be indexed for inflation, which would make for really entertaining depreciation computations.  They did not go that far with the actual act, but they went pretty far.  In the first classes that Lu Gauthier taught on the Act, he handed out applications to tractor trailer driving school, because he thought some of his students would want to be looking at new trades.

The act came at an ideal time for me.  I was a manager in a large local firm – Joseph B. Cohan and Associates in Worcester Massachusetts.  Since I had the Treasury II proposals umpteen times, nothing in the Act surprised me (I later came to regret my intense study of Treasury II, because I would sometimes get confused about what did and did not get into the Act), I played a big role in planning the transition for our clients.  My biggest concern was with the repeal of the General Utilities doctrine.  A corporation could no longer liquidate or make distribution of property to shareholders  without recognizing gain at the corporate level.  I insisted that we look at every corporation and explain why it was that it was not making an S election.  There was urgency, because General Utilities repeal was backed up by an entirely new tax, the built-in gains tax, which applies to S corporations for 10 years after conversion.  BIG did not apply to corporations that made S elections before 12/31/1986.  The following year the Omnibus Budget Reconciliation Act of 1987 would create requirements that forced most S corporations and professional service corporation on to a December year end.  The industry already had a work load compression problem but making the default entity choice an S corporation with a December year end made the problem intractable.

The other huge game changer was the passive activitiy loss rules.  This was what killed classic tax shetlers.  People in the middle of them were in a particular pickle.  Their benfits were not worth as much and the back end would be more expensive.  On top of that there would be no new group of investors to help bail them out since the game changed.  A low income housing dealing would typically become ripe for resyndication after 10 years.  I was working on a fairly big one just as the act passed.  It is still around.  The fast write-off was replaced with the low income housing credits which required re-engineering of deal structures.  Now inner city housing would be renovated with syndication proceeds from large C corporations rather than a collection of dentists.  It was a little crazy but as my elders who vividly remembered the depression used to say – It gave people work.

I think what people fail to realize is the amount of transition confusion that is caused by reboots.  The Tax Reform Act of 1986 did have a consensus principle behind it.  Tax real economic income.  People who designed tax shelters had a hard time believing that they could not be made to work anymore.  Inside the national firms there were bands of true believers like Japanese soldier on isolated islands who just could not believe that it was over. They were rooted out not by new legislation but by regulations and aggressive auditing.  The litigation is still going on.  The most extreme example of how long things linger that I have noted is the case of Stan Lee’s friend Harry Stonehill,  The Ninth Circuit just rendered an opinion concerning assessments of taxes for the years 1958 to 1961.  So I can be confident that knowledge of the Internal Revenue Code of 1986 will continue to have some value somewhere for the rest of my life.  At a less extreme level the transition issues created by a hypothetical Internal Revenue Code of 2013 will keep me occupied until my normal retirement age in 2018.

At Joseph B. Cohan and Associates we used to have a lot of sayings.  Most of them would violate the contributor guidelines, but there is one that doesn’t.  “It is better to be lucky than good.”  That is how I feel about the intersection of the Tax Reform Act of 1986 with my career.