If you’ve ever wondered how the Internal Revenue Code grew to 70,000 pages, allow me to borrow a parable from TV’s favorite family:
On an otherwise lazy day in Springfield, a lone brown bear emerged from the woods and stumbled into town, terrifying the townspeople:
Despite the fact that this was the first bear spotted on Springfield’s streets in decades, the town viewed this isolated occurrence as evidence that constant bear attacks would soon threaten their way of life, eating the town’s children and scaring away its salmon. An angry mob immediately confronted Mayor Quimby, demanding that something be done to protect them. The Mayor satiated their concerns with a swift and decisive overreaction, instituting a daily Bear Patrol complete with ground troops and helicopter surveillance.
Silly as it sounds, the exact same thing happens in the tax world. A code or regulation section can exist for decades without creating a kerfuffle, but as soon as one high-profile fact pattern gives rise to an anomalous result, the outcry for change begins, often resulting in a completely unnecessary amendment that further complicates the statute.
To wit: as we discussed a month ago, the Facebook IPO contained a rather interesting bit of information:
Despite recognizing $1.7 billion in pre-tax book income in 2011, Facebook anticipates that it will generate a net operating loss (NOL) in 2012. How is that possible? Through its employees’ exercise of nonqualified stock options, that’s how.
After the IPO, hundreds of millions of shares of NQ options previously granted to employees are expected to be exercised. As a reminder, these forms of compensation are generally not taxable under I.R.C. § 83 until exercise …[but] upon exercise the employee must recognize income equal to the excess of the FMV of the stock over the exercise price, with the employer getting a corresponding deduction.
Here’s the thing: Section 83 has existed in the Code since 1969, and I.R.C. § 83(h) – which allows for the corporate level deduction highlighted in the underlined text — was incorporated into the statute to achieve a rather logical result: if an employee is required to recognize compensation income upon exercising stock options or receiving property from a corporation in exchange for services provided, then the corporation should receive an offsetting deduction, since they are the ones providing the compensation.
It’s an equitable provision, and one that has existed free from controversy for over 50 years. In light of the enormous one-time compensation deduction Facebook is set to receive upon the exercise of its options, however, Senator Carl Levin, a Democrat from Michigan, has made it his own personal crusade to wipe I.R.C. § 83(h) from the code, decrying it as a “loophole.”
As proof of the “loophole,” Levin repeatedly points out the lost tax revenue resulting from Facebook’s stock-based compensation deduction, while failing to mention that those who exercised the nonqualified options are recognizing compensation income in the exact same amount, and thus will be paying tax at the same 35% that the corporation would have paid had the options not been exercised.
Of course, the facts should never get in the way of a good filibuster, so Levin is moving forward with his plans. He’s proposing to limit the corporation’s deduction to the amount it deducts on the financial statements (which is typically significantly less), or alternatively, to cap the deduction at the $1 million per employee limitation currently applied to regular executive compensation under I.R.C. § 162(m). So to clarify, he wants the employees to recognize income to the full extent, but for the corporation to lose or limit the corresponding deduction.
Others are taking an even more extreme approach. In this op-ed published in the New York Times titled “The Zuckerberg Tax,” a tax attorney recommended taxing the super-rich each year on the growth in value of their publicly-traded stock, even if it is not sold:
For individuals and married couples who earn, say, more than $2.2 million in income, or own $5.7 million or more in publicly-traded securities (representing the top 0.1 percent of families), the appreciation in their publicly-traded stock and securities would be “marked to market” and taxed annually as if they had sold their positions at year’s end, regardless of whether the securities were actually sold. The tax could be imposed at long-term capital gains rates so tax rates would stay as they were.
As an example, if Bill Gates saw his publicly-traded portfolio grow by $1 billion in 2012, he would be on the hook for $150 million in tax, even if he didn’t sell a single share.
Ignoring the countless real-world economic hazards of instituting such a proposal, consider the many changes to the Code that would be necessary for its implementation. A mark-to-market system would drastically alter the landscape of the statute, just as the overwhelming majority of the nation has been united in its agreement that the Code needs to be simplified.
Of course, these types of needless proposals do sometimes become law, which is precisely how we’ve come to be saddled with the convoluted, overly complicated statute that exists today. It is exactly this type of reactionary response to an isolated, extreme example that left Springfield with a pricy Bear Patrol, and the U.S. with a 70,000-page Internal Revenue Code.
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