Posts Tagged ‘deduction’

Covering President Obama’s recent tax proposals has given me a firm appreciation for what it must have been like to be a sports reporter during the latter stages of Brett Favre’s career, when journalists breathlessly covered whether he would retire or continue playing, despite the fact that everyone knew damn well Favre would show up to camp a week late and start another 16 games. And what I’ve learned is this: it’s a rather empty feeling to spend day after day analyzing a story the ending to which was preordained before it even began.

But that’s where we are with tax reform in this country. Everything is happening, but nothing’s happening. Last week the president unveiled his plans for individual tax reform, and today it’s corporate tax reform, but regardless of what’s said or written, we all know nothing will be passed unless the president wins re-election, and even then these proposals — as currently constructed — are a long-shot to ever become law.

Anyhoo, what follows is a summary of President Obama’s appeal for corporate tax reform, released today. And while the headlining proposal — the promise to reduce the maximum corporate tax rate to 28% —  is likely to win some appreciation from the Republican party, there are enough high-profile revenue raisers in the plan, such as the elimination of tax preferences for the oil and gas industry and the imposition of a “minimum tax” on a U.S. corporation’s worldwide profits, to guarantee that the president’s corporate proposals will be shelved right along with his plan for individual tax reform until after the election.

The president’s plan can be separated into three distinct categories: general corporate reform, manufacturing industry reform, and international reform.  

General Corporate Reform

While the president’s pitch to lower the maximum corporate tax rate from 35% to 28% is sure to get the most publicity, understand that the intention is for this lost revenue to be paid for by broadening the tax base, i.e.., eliminating deductions. The president (correctly) points out that our current tax system — replete with innumerable deductions, exclusions and preferences — benefits certain industries over others. Take a gander at the following table, which illustrates the effective tax rate paid by different industries in 2007 and 2008, even though they were all subject to the same 35% marginal rate:


The president believes that while eliminating deductions and preferences, care should be taken to equalize the benefits of the code across all industries.  To that end, he has placed a number of provisions on the chopping block, calling for the following changes:

  •  Elimination of “Last in first out” accounting. Under the “last-in, first-out” (LIFO) method of accounting for inventories, it is assumed that the cost of the items of inventory that are sold is equal to the cost of the items of inventory that were most recently purchased or produced. This allows some businesses to artificially lower their tax liability.
  • Elimination of oil and gas tax preferences. The president’s framework would repeal the expensing of intangible drilling costs, and percentage depletion for oil and natural gas wells. .
  • Reform treatment of insurance industry and products The president’s framework would close this loophole and not allow interest deductions allocable to life insurance policies unless the contract is on an officer, director, or employee who is at least a 20 percent owner of the business.  
  • Taxing carried (profits) interests as ordinary income. The framework would eliminate the loophole for managers in investment services partnerships and tax carried interest at ordinary income rates.
  • Eliminate special depreciation rules for corporate purchases of aircraft. This would eliminate the special depreciation rules that allow owners of non-commercial aircraft to depreciate their aircraft more quickly (over five years) than commercial aircraft (seven years).
  • Addressing depreciation schedules. Current depreciation schedules generally overstate the true economic depreciation of assets.
  • Reducing the bias toward debt financing. Reducing the deductibility of interest for corporations should be considered as part of a reform plan. This is because a tax system that is more neutral towards debt and equity will reduce incentives to overleverage and produce more stable business finances, especially in times of economic stress.

 Manufacturing Industry Reform

 While the president asserts that all industries should be treated equally, the plan then goes on to bestow certain preferences specifically on the manufacturers by proposing the following:

  •  Effectively cutting the top corporate tax rate on manufacturing income to 25 percent and to an even lower rate for income from advanced manufacturing activities by reforming the domestic production activities deduction. The president’s framework would focus the current I.R.C. § 199  deduction more on manufacturing activity, expand the deduction to 10.7 percent, and increase it even more for advanced manufacturing. This would effectively cut the top corporate tax rate for manufacturing income to 25 percent and even lower for advanced manufacturing.
  •   Expand, simplify and make permanent the R&D Tax Credit. The president’s framework would increase the rate of the alternative simplified  credit to 17 percent.  
  •  Extend, consolidate, and enhance key tax incentives to encourage investment in clean energy.

International Reform

It is in the international arena that the president’s proposals most deviate from those of his Republican counterparts. While Mitt Romney and Newt Gingrich have loudly called for a move to a “territorial” tax system, whereby U.S. corporations would only pay tax on U.S. income, leaving other nations to trust foreign profits, President Obama wants to expand the current corporate tax regime to tax profits earned by foreign affiliates of U.S. corporations before they are repatriated to the U.S. This is sure to be a sticking point in any future negotiations, as some powerful lobbies will not take kindly to the idea of a minimum international tax rate.

 The president’s proposals include the following:

  •  Require companies to pay a minimum tax on overseas profits. Specifically, under the President’s proposal, income earned by subsidiaries of U.S. corporations operating abroad must be subject to a minimum rate of tax. This would stop our tax system from generously rewarding companies for moving profits offshore. Thus, foreign income deferred in a low-tax jurisdiction would be subject to immediate U.S. taxation up to the minimum tax rate with a foreign tax credit allowed for income taxes on that income paid to the host country. This minimum tax would be designed to balance the need to stop rewarding tax havens and to prevent a race to the bottom with the goal of keeping U.S. companies on a level playing field with competitors when engaged in activities which, by necessity, must occur in a foreign country.
  • Remove tax deductions for moving productions overseas and provide new incentives for bringing production back to the United States. The President is proposing that companies will no longer be allowed to claim tax deductions for moving their operations abroad. At the same time, to help bring jobs home, the President is proposing to give a 20 percent income tax credit for the expenses of moving operations back into the United States.
  •  Other reforms to reduce incentives to shift income and assets overseas. The Framework would strengthen the international tax rules by taxing currently the excess profits associated with shifting intangibles to low tax jurisdictions. In addition, under current law, U.S. businesses that borrow money and invest overseas can claim the interest they pay as a business expense and take an immediate deduction to reduce their U.S. taxes, even if they pay little or no U.S. taxes on their overseas investment. The Framework would eliminate this tax advantage by requiring that the deduction for the interest expense attributable to overseas investment be delayed until the related income is taxed in the United States.

Of course, the chess match continues. In response to the president’s plan for corporate reform, the rise of Rick Santorum, and his recent slip in the polls, Mitt Romney changed his stance on the maximum individual tax rate today, proposing to reduce it to 28% (as part of a 20% cut of all rates across the board) as opposed to simply extending the Bush tax cuts (which contain a 35% maximum tax rate), as he’d proposed earlier in his campaign. Romney also went on to promise a free Chalupa to anyone who votes for him.* Desperation, as they say, is a stinky cologne.

*this may not have happened

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Double-dipping is more than just a faux pas committed by fat toddlers at Super Bowl parties; it’s also an undeserved tax benefit that much of the language in the Code is designed to safeguard against. The prohibition on double-dipping is why taxpayers generally can’t take a tax deduction and credit on the same expense, or why an asset’s depreciable basis must be reduced by any first-year “bonus” depreciation. Or, in the case of Judith Gaerttner (Gaerttner), why she couldn’t take a medical expense deduction for amounts reimbursed by insurance.

In 2002,  Gaerttner was involved in an automobile accident. She underwent treatment for her related injuries through 2004, but did not pay out-of-pocket for any of the medical expenses. Instead, she signed a waiver requesting that her doctors bill her attorney. In late 2004, Gaerttner received a $20,000 insurance settlement and ordered her attorney to pay $11,000 worth of accrued medical bills.

On her tax return, Gerttner excluded the $20,000 of settlement proceeds[i] from income and claimed $20,915 of medical expenses as itemized deductions on Schedule A.[ii]

The IRS audited Gaerttner’s tax return and disallowed half of her medical expenses. Gaerttner responded by arguing that the expenses were attributable to her 2002 automobile accident.

The Tax Court sided with the IRS and disallowed the medical expenses.

In general, I.R.C. § 213(a) provides that expenses paid during the taxable year for medical care of the taxpayer, not compensated for by insurance or otherwise, shall be allowed as a deduction to the extent that such expenses exceed 7.5% of adjusted gross income. The regulations reinforce the language emphasized above, stating that in order for medical expenses to be deductible, the expenses must not be “compensated for by insurance or otherwise.”[iii]  This made for an easy decision by the Tax Court:

Ms. Gaerttner was compensated by insurance for medical expenses related to her 2002 automobile accident. The record confirms that Ms. Gaerttner’s attorney paid her accumulated medical bills in 2004 when he received the insurance settlement

[i] The IRS had no issue with Gaerttner’s exclusion of the settlement proceeds, as settlement amounts paid on account of a physical personal injury are generally excluded from the taxpayer’s income under I.R.C. § 104(a)(2).

[ii] For whatever reason, Gaerttner actually deducted the medical expenses on her 2005 tax return, as opposed to the 2004 return, but it’s not germane to this discussion.

[iii] Treas. Reg. § 1.213-1(a)(3)(i).

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In perhaps the most senseless legal proceeding since my brother Mike’s false-advertising claim against the film “The Neverending Story,” an Alabama man attempted to convince the Tax Court that the repayment of a $1,000,000 loan should give rise to a tax deduction.

Sam Johnson (Johnson) and his father owned Johnson & Associates Mortgage Co, Inc., a full-service mortgage company. To stay afloat during its formative years, the company entered into a $1,000,000 line of credit with a local bank. In addition to the corporation, Johnson and his father were also listed as borrowers on the note in their individual capacities.  

In 2003,  half of the line of credit was repaid using life insurance proceeds paid upon the death of Johnson’s father. The repaid balance was promptly replaced with a new $500,000 note, which again was entered into by both the corporation and Johnson in his individual capacity.

This replacement note was subsequently repaid from Johnson’s personal account in 2004. On his 2003 individual tax return, Johnson claimed a $1,000,000 bad debt deduction related to his payments on the line of credit.[i]

Johnson argued that he was permitted the deduction because he had personally guaranteed the corporate liabilities in that amount. Presumably, Johnson believed that because he paid the notes in his individual capacity, he was entitled to repayment from the corporation, and the failure of the corporation to “make him whole” entitled him to a bad debt deduction pursuant to I.R.C. § 166.

Needless to say, the Tax Court disagreed, holding that because Johnson was listed as a separate borrower on the corporate notes, he did not make payment as a guarantor, but rather as a primary obligor. Citing prior case history — as well as common sense — the court held that Johnson’s repayment of a loan on which he was primarily responsible did not give rise to a tax deduction.[ii]

Of course, the most notable aspect of this case is that it ever managed to find its way onto the court’s docket to begin with. With so many legitimate tax issues of first impression yet to find their way into judicial precedent, it’s fascinating that such a well-established and fundamental tax concept was actually tried in front of the Tax Court. It would appear Judge Dean felt the same sense of frustration, as he was quick to slap Johnson with an accuracy related penalty.

[i] Good luck working through the math here, as only $500,000 of the debt was repaid in 2003 by Johnson personally. The other $500,000 was paid by his father’s life-insurance company upon his death in 2003. Presumably, Johnson was the beneficiary on the policy so he felt he “paid” this portion of the note.

[ii] See Brenner v. Commissioner, 62 T.C. 878 (1974).

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