Originally published on Forbes.com.
A couple of thousand news cycles ago (July 30, 2018), a story broke about Treasury Secretary Steven Mnuchin indicating that the Treasury might allow taxpayers to consider inflation in computing capital gains, without actually, you know, asking Congress to amend the Internal Revenue Code. I’ll refer you to Trump Administration Mulls a Unilateral Tax Cut for the Rich by Alan Rappeport and Jim Tankersly.
The White Collar Jobs Program
The notion had me quite excited. What a lot of people don’t realize is that the main purpose of the Internal Revenue Code is to serve as a white-collar jobs program for people not quite smart enough to be engineers or not quite competitive enough to succeed in academic careers. I sometimes try to exercise my senior citizen sovereignty by giving sage advice to young men. What I tell them is that in order to make their way in the world, they need to either be entrepreneurial or gain a credential and not just any credential. Here is one of many options.
When the prospect of being a waiter/uber driver with a part-time position as an adjunct professor in art history begins to pale, consider becoming a CPA and focusing on tax. You may have seen reports about there being 70,000 pages of material you have to be familiar like that is a big deal. That is a distortion, as I explain here. Nonetheless, I don’t think a historian or a literary scholar would find 70,000 pages very intimidating. As far as math goes, you learned pretty much everything you need by the fourth grade, although some of your high school math can come in handy once in a while. Pretty much just the algebra and you can really get by without it.
What creates the opportunity is not that the work is that intellectually challenging. It is just more intellectually challenging than maybe 90% of the population cares to deal with. There are some people for whom being a tax accountant is a calling and I admire them, but I prefer to hang out with the types like myself who fell into it, because they realized that they needed to do something to feed their families.
Back To 1984
Asset indexing would be a great boon for tax accountants. That is what excites me about it. I first encountered the notion while reading Tax Reform For Fairness, Simplicity, And Economic Growth – The Treasury Department Report to The President which was issued in 1984. Here are links to Volume 1 and Volume 2. Much of what was in the report would be incorporated into the Tax Reform Act of 1986 in Here is the rationale for basis indexing included in the report:
During inflationary times, taxes are collected on totally fictitious income. Capital gains taxes are paid when the prices of assets merely rise with inflation. Business firms are not allowed tax-free recovery of their real capital investments in inventories and depreciable assets. Moreover, high interest rates that merely reflect expected inflation overstate the real income of recipients of interest and inflate deductions for real interest expense.
The interaction of inflation and taxes creates further inequities and distortions. The overstatement of real interest income and deductions arbitrarily increases the tax burden on savers and rewards borrowers. Resource allocation is distorted by effective tax rates on some types of capital income that can easily exceed 100 percent. During the 1970s, the combination of high rates of inflation and a tax system that was not inflation-proof caused an increase in the tax induced bias in favor of investment in owner-occupied housing; this probably aggravated the shortage of funds for business capital formation.
Note the “during inflationary times”. Inflation was 4% or more from 1973 to 1981 going to double digits in 1974, 1979 and 1980. The peak was 13.29% in 1979. In more recent times, it sneaked over 4% in 2007 (4.08%). Other than that you have to go back to 1990. Economist Arthur Okun created an economic indicator called the “misery index” which is the unemployment rate added to the inflation rate. Frankly, I don’t think it is mathematically sound, but it was definitely a thing in the seventies and eighties. The misery index was double digits during every presidential administration from Richard Nixon to George H.W. Bush.
The Devilish Details
The most interesting detail of the indexing system proposed by Treasury in 1984 was indexing of the depreciation deduction.
RCRS would adjust depreciation allowances for inflation by means of a basis adjustment. Under ACRS, only the unadjusted original cost basis of an asset is recovered over the class recovery period. Under RCRS, the remaining unrecovered basis of an asset would be increased each year by the inflation rate and the fixed depreciation rate applicable to the asset’s class would be applied against the resulting adjusted basis. The basis of depreciable property not subject to RCRS would be indexed for inflation in a similar manner.
If an asset’s basis were adjusted each year for inflation, applying a fixed depreciation rate of less than 100 percent to the adjusted basis would never fully recover such basis. To simplify accounting, RCRS would allow a taxpayer to close out its depreciation account for any asset in a particular class after a specified period of years.
Indexing applied to loans could have even been more challenging, but they decided they would hold back a little.
Perfect adjustment of debt or interest for inflation would require that lenders receive an annual deduction for each outstanding loan equal to the product of the inflation rate and the principal of the loan; borrowers would report an offsetting amount of taxable income on each loan. Such an approach would be extremely complicated, and thus is not recommended. The Treasury Department does, however, propose a rough surrogate for an exact inflation adjustment. Under this proposal a given fraction of interest income will be excluded from tax, and the deduction of interest expense (in excess of the sum of mortgage interest attributable to the principal residence of an individual taxpayer and $5,000) will be reduced by the same fraction. Corporations will also exclude this fraction of interest income or expense.
Indexing the basis of assets that are sold is a piece of cake compared to that stuff. I won’t even get into inventories. Indexed FIFO was going to be optional.
Can It Be Done Without Congress?
Whether Treasury could implement this change without Congress is an interesting question. I batted it around a bit with David G. Shapiro of Saul Ewing Arnstein & Lehr. He started me out with Code Section 1012 which defines basis ( a very important tax concept) as generally being “cost.” (Let’s stay in the general area). He also indicated that there are other areas of the tax law where Congress has used in inflation indexing (some exclusions for example). So Congress knows about indexing, could have used it for cost and therefore implicitly decided not to index cost. Regulations cannot contradict the statute, therefore Treasury can’t implement indexing on its own.
It’s a good argument, but here is a different one. “Income” has never been defined by statute, although the courts have not had any problem tackling it as Dan Evans notes in his Tax Protester FAQ (a handy resource when somebody sidles up to you in the coffee shop with a loose-leaf notebook that “proves” that the income tax is voluntary).
The United States Supreme Court has not hesitated to interpret the word “income,” and has stated that Congress intended to impose the income tax on “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion,” with no restriction as to “source.” Commissioner v. Glenshaw GlassCo., 348 U.S. 426, 431 (1955).
Remember when the income tax was first implemented the country was on the gold standard. ( How we went on and off that is a story too complicated for this post). At any rate, if during the gold standard days you bought something for twenty dollars, you might hand somebody a twenty-dollar gold piece. If you sold it for $40 a few years later, you would get two $20 gold pieces. You could go make change for the second one and use some of that to pay taxes and you are clearly ahead.
Off the gold standard, it is a different story. Suppose you bought a vacant lot for $10,000 in 1980 and sell it for $20,000 next week. Is that extra $10,000 an “undeniable accession to wealth”? Well maybe not. According to this handy calculator, $10,000 “1980 dollars”, which is what you paid are equal to $32,912.52 “2018 dollars. There is a common expression “today’s dollars”. You paid over $30,000 in today’s dollars for the lot and are only getting $20,000 in today’s dollars. So indexed gains are a reasonable interpretation of the word “income”, which was not defined because everybody knew what it meant and they were on the gold standard when it went into law.
Mr. Shapiro thinks that argument might have some merit, although I can’t rule out that he was just being polite.
But Does It Get To Be Argued?
I read a lot of tax decisions. I generally read them with the view of a tax-focused CPA. While planning and preparing returns with the Learned Hand motto in mind – “there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right”, I don’t ever want a return or plan I am involved with to be the subject of litigation and the decisions provide valuable lessons in how to have your returns never turn into cases. And if I catch the agent from hell and AFH pressures counsel into fighting, I want the IRS to be embarrassed by the Tax Court judge and ordered to pay attorneys fees. And back in the chief counsel’s office, they will be saying, “That return was signed by Peter J. Reilly, CPA. What were we thinking?” Well, I can dream.
That focus means that I don’t pay too much attention to the procedural and purely legal aspects of the litigation. You need to read Procedurally Taxing or Taishoff Law to learn about that stuff. There is one lawyerly concept that I have latched onto, though, mainly through following the fight about the dubious constitutionality of Code Section 107(2), the parsonage exclusion which allows “ministers of the gospel” to exclude cash housing allowances in unlimited dollar amounts from their income.
The concept is standing. You can’t get a court to look at whether this or that law or regulation is wrong or unfair or unconstitutional, just because that is what you think. You need to show that you have skin in the game.
In Lujan v. Defenders of Wildlife (90-1424), 504 U.S. 555 (1992), the Supreme Court created a three-part test to determine whether a party has standing to sue:
The plaintiff must have suffered an “injury in fact,” meaning that the injury is of a legally protected interest which is (a) concrete and particularized and (b) actual or imminent. There must be a causal connection between the injury and the conduct brought before the court. It must be likely, rather than speculative, that a favorable decision by the court will redress the injury
Things that might be affecting you in a general way like wasteful government spending or televangelists affording private jets in part due to an unconstitutional tax provision are not things you should take to court. You can, but you will be quickly knocked out on standing. And if you keep it up, you might get into trouble for wasting the court’s time.
Who Has Standing On The Indexing Issue?
Thanks to my ruminations about standing, the one sentence that really piqued my interest in the Times story was “The move would face a near-certain court challenge. ” When it comes to New York Times tax coverage, don’t get me started. But in this case, they were on the ball. The article addresses the standing issue and points to an article. The False Promise of Presidential Indexation by Daniel Jacob Hemel of the University of Chicago and David Kamin of NYU (Download).
Professors Hemel and Kamin suggest three possible litigants who might have standing. “Members of Congress might challenge an indexing regulation on the grounds that Treasury has deprived lawmakers of a vote on whether to adjust basis for inflation”. Mr. Shapiro and I had thought that was a non-starter, since presumably, Congress should deal with the issue by passing a law. Well Daniel Hemel is a law professor at the University of Chicago and I flunked out of the University of Chicago, so I guess I should revisit that. Nonetheless. even the professors don’t think that one is too likely – “Finally, note that the analysis in this section assumes that a majority in either the House or the Senate would vote to authorize a lawsuit to stop presidential indexation.”
Then there are the states.
Most states tie their definition of income for state income tax purposes to the federal definition. Indexing basis for inflation via regulation would reduce the federal adjusted gross income and taxable income of taxpayers with capital gains, and so would reduce the amount those taxpayers pay to their states as well. As a result, presidential indexation would lead to revenue losses for the states.
What pops into my head is like yeah, but nobody is making them do that. They don’t have to follow federal if they don’t want to. Think about New Hampshire. Don’t get me started. Anyway, there is a really lengthy analysis on that argument which concludes that the states might have standing because the change fouls things up for them so much. People want their federal numbers to just drop onto the state return rather than elaborately reworking them. There is solid support for state standing, but maybe not a slam dunk.
Then there are charitable organizations. “Can a charity go to court to challenge a regulation that does not raise the charity’s tax bill but makes contributions to the charity less attractive? ” The professors end up with that one giving the charities a “plausible claim to standing”.
Well. All that makes me rather pleased that I think I have come up with a slam-dunk standing scenario to challenge Treasury capital gain indexing. And Mr. Shapiro thought it had merit.
The Slam Dunk Standing Argument
I came up with this, because I do planning for individual tax and prepare and review returns. Complicated returns. With lots of bells and whistles and moving parts. This experience is what is behind Reilly’s Sixth Law of Tax Planning – Don’t do the math in your head. Have you ever run a return and then added a gain transaction to it and had the tax go down? Here is an example of that from a pretty well worked out scenario involving Warren Buffett.
I came up with another scenario for this example. My made-up client is a plastic surgeon. She earns $1,000.000 a year modifying some body part or other. Her mother had given her a 100 acres of land which her grandfather had given to her. The basis of $100,000 goes back to 1949. She also owns a couple of shopping centers, one of which sits on the ancestral 100 acres. She had a terrible financial adviser so she has $1,000,000 in capital loss carryovers. And then there are the passive activity loss carryovers from the shopping centers – another million.
So she sells the shopping center that was on the old homestead for a million-dollar gain. What does that do to her 2018 tax liability? It goes down by $370,000 (more or less). The gain from the passive activity releases suspended losses, but it does not in itself increase AGI because of the capital loss carryover. A million-dollar gain makes her taxable income go down by a million dollars.
But then comes basis indexing. The $100,000 in 1947 is $1,10,000 in today’s dollars. There is no gain (and to you nitpickers out there the suspended passive losses are associated with the other shopping centers).
So what do we do? We file a return using the 1947 basis which gives us the gain which saves us money. We attach Form 8275-R to let them know we are challenging their stinking indexing regulations. After a bit of process we will have a statutory notice of deficiency, the ninety-day letter, that is your ticket to Tax Court. And we’ve got standing.
If Treasury is cagey, it might make the indexing elective, but that might create all sorts of other problems.
I reached out to the professors and Professor Hemel got back to me asking me to explain the hypothetical a little better. Just as I was about to press publish, I heard back from him.
It’s a clever point. And I see the charitable contribution carryover application too. I have $100x of ordinary income and we’ll make the math easy by saying that my rate on ordinary income is 40% and my rate on long term capital gains is 20%. I have essentially infinite capacity and desire to give to charity. Let’s say I exhaust my maxima with $30x of stock and $30x of cash, so I pay tax on $40x x 40% = $16x.
Let’s say I want to give away another $10x of zero-basis stock. My best bet is to sell the stock and pay $2x in tax. My maxima are now $33x and $66x. My taxable income is $44x but $10x of that is long-term capital gain. My tax on ordinary income is 40% x $34x = $13.6x. My total tax bill is $15.6x.
That made my day.
Is It Over?
Apparently this discussion still has life in it. There is something in Tax Policy Center by C. Eugen Steurele – Indexing Capital Gains For Inflation Addresses A Real Problem But Ignores Existing Law. Nonetheless, according to this report in Business Insider, the administration has moved on.