Is Talk Of Executive Action On Tax Loopholes Political Theater?

Living in Central Massachusetts, had I the vision of Sarah Palin, who can see Russia from her home in Alaska, I could look north and see New Hampshire on the right and Vermont on the left. It is perhaps an apt metaphor. New Hampshire with its “Live Free Or Die” license plate, apparently made by prisoners, go figure, has an overrated reputation as a tax haven, thanks to the lack of income tax on wages. More to the point, there is the Free State Project that promises to turn New Hampshire into a libertarian paradise with a little bit of help from the Koch brothers. Vermont, on the other hand, has Bernie Sanders, who calls himself a socialist. Anyway, Bernie Sanders has started a bit of flap by with a letter recommending that the President take executive action to raise taxes by closing loopholes.

A Letter And A Press Conference

Robert Wood wrote about the press conference where the Press Secretary Josh Earnest indicated that the President was “very interested” in the option. Republican leaders have now written to the President that it would be a very bad idea for him to take executive action on the “loopholes” since they were so looking forward to working with the President on tax reform and this would just spoil it. I think that buried in there somewhere is the notion that if you close a “loophole’ with legislation you can use the projected revenue to open another loophole someplace else or lower rates.

Bernie Sanders had six items that he thought the President should pay particular attention to. Three of them involve the overseas games that multi-nationals play to avoid corporate tax. That stuff give me a headache and I don’t have a lot of practical insight into it. Another corporate tax “loophole” Sanders wants to attack involves REITs (real estate investment trusts).

Corporations can elect REIT status becoming flow through entities of a sort if the bulk of their income is from real estate. Some real estate intensive companies, like private prisons and nursing homes will try to transform much of their income into “rent” in order to qualify for REIT status.

Not Just Corporate Loopholes

I am pretty familiar and have written about the two provisions that affect individuals. One is an estate and gift tax maneuver. You take assets, possibly a business, maybe some real estate or even just securities and put them in a limited partnership. Then you make gifts of the limited partnership interests. Because of lack of marketability and control a limited partnership interest of say 10% might be valued as worth say 7% of the aggregate value of the underlying assets. Intellectually, it seems like this should not work. Why would smart business people take their assets and make it so the sum of the parts is worth less than the whole? It often does work. Whether these plans, sometimes called family limited partnerships, work or not turns almost entirely on how well executed they are. The case law in this area is a good illustration of Reilly’s Fourth Law of Tax Planning – “Execution isn’t everything, but it’s a lot”.

Carried Interest

Finally there is “carried interest”. This is a partnership concept. It is pretty arcane. The problem with closing the “carried interest” loophole is that it is not really a loophole, it is an application of fundamental principles of partnership taxation. A partnership pays no taxes, but is considered to be a “taxpayer”, with its own accounting methods and determinations about the nature of income. So if a partnership has a capital gain, capital gain income is what is allocated to the partners, even partners who have not put in capital. This allows venture capitalists and hedge fund managers to structure some of their service income as capital gain.

During the last year Presidential election carried interest was in the fore, because it was something that Mitt Romney had used to keep his taxes low. The discussion about attacking carried interest with regulation was a staple of my blog during that period, as I considered the President kind of hypocritical for not doing that and also thought that the proposed legislation to address the issue was really awful. At any rate here is how carried interest could be easily addressed by regulation.

There is, however, an approach that could end the benefit without adding three thousand words to the Code. It does not require the cooperation of Congress. There is a regulation 1.701-2 that governs using the partnership form in a way that is inconsistent with its purpose to:

“permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax”

The regulation goes on to list good and bad reasons for using the partnership form. Venture capital funds and hedge funds do not have to be organized as partnerships in order to do what they do. You could have some sort of co-ownership. Frequently people prefer co-ownerships, since they can often be simpler. Why do venture capital funds and hedge funds organize as partnerships ? Well one reason is so that the managers can get captial gains treatment on their incentive compensation. If that is not a good reason, the IRS can add it to the “bad partnership” list and it is done.

This Might All Be Good

I like to be optimistic, when I can and I think there might be reason to be optimistic about this current drama. Tax reform would probably be a good thing, but the ideological divide makes it very challenging. Each side has to cater to its own base. The threat of executive action on these particular goodies might give Congress the cover it needs to address them. If done by Congress, the largely hypothetical additional revenue can be used to lower rates.