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Media Reporting on the American Tax System - Don't Believe What You Hear

10/02/16

With the recent revelation of parts of Donald Trump's 1995 tax returns, the media and some other commentators seem to be up in arms about his over $900 million in business losses being some kind of "loophole." Folks - that is not a loophole. Mr. Trump received approximately $450 million in tax savings over an 18-ish-year period for a $900 million immediate outlay - he'd rather have his $900 million back in his pocket (in 1995), I assure you. The net operating loss rules - which, by the way, can be found in Section 172 of the Internal Revenue Code - will be used to the advantage of millions of businesses, large and small alike, this year and for many years to come.

I'm not here to endorse or criticize Mr. Trump or any other political candidate - I'm here to say that the popular press has an extraordinarily poor understanding of how the American tax system really works. To the detriment of the American public, many politicians and legislative staff also share that extraordinarily poor understanding, which is doubly unfortunate because many of them actually pass the tax laws that us practitioners must then digest in order to advise our clients.

For most taxpayers, the American tax system is already quite manageable. Taxpayers even have a choice to file a Form 1040EZ every year, which will make filing a breeze as long as the taxpayer does not care much about itemizing deductions. You may be surprised to learn that much of the lobbying against making the tax system even easier for everyday people comes from companies like Jackson Hewitt and H&R Block, but when you think about what's at stake for those companies, the notion begins to make much more sense. For everyday taxpayers who do wish to itemize deductions, paying a skilled CPA to prepare a federal income tax return will run between $250-$500. Compared to the cost of self-preparation programs like TurboTax, which I would strongly discourage any human being alive from actually using, the fees CPAs charge are quite reasonable considering the difference between their work and your crappy attempt to do it yourself will almost certainly result in more money in your pocket. Seriously - 90+% of the time, a skilled CPA will pay for herself and then some. Savvy taxpayers already know this.

Where the American media loves to sensationalize tax stories (which usually takes quite a bit of skill considering how boring most people find the subject), they usually focus on ways the wealthy can take advantage of the system. Therefore, any instance of a person of Mr. Trump's purported net worth paying a lower effective income tax rate than a Starbucks barista will always make for good clickbait - even if the method of achieving that end does not actually expose any inherent problems with the system itself. The reason why it's very, very hard to write a story accurately describing some of the many ways the wealthy can take advantage of the system is because the story would be horribly lengthy and convoluted. The closest I've seen someone come to accomplishing the goal is David Cay Johnston's book Perfectly Legal.

A couple of core concepts about the American tax system should be made clear, considering apparently nobody else will give the public the straight dope.

  1. Some tax techniques the wealthy use are, in fact, abusive and illegal - and I'm not just talking about people straight-up hiding their money in Panama or Switzerland or the Cayman Islands. Promoted tax shelters are a cottage industry - these first became an enormous problem in the 1970s and 1980s before the Tax Reform Act of 1986 shut many of them down through legislative change. When accountants and lawyers became more clever about designing them, Congress passed the reportable transaction rules and the IRS beefed up standards of practice under Circular 230. Even after all these measures, though, promoted tax shelters still exist today. I can name four of them currently being used across the country but will not do so in this forum because the repercussions are simply not worth the trouble. As far as the ones the IRS and the Department of Justice have already exposed, here's a short and fun list: Son of BOSS nearly sank the entire firm of KPMG, and a lawyer from Sidley Austin went to federal prison (his collaborators at KPMG would have joined him in jumpsuits, but for a technicality); CHIPS and TRIPS, which the geniuses at Long-Term Capital Management thought would work and later added insult to injury when the Northern District of Connecticut excoriated them for doing it long after their bailout was already over; Midco, which is still being litigated to this day and resulted in wealthy taxpayers forking over billions in the aggregate as part of a Global Settlement Initiative; Basket Option Transactions, which was the first technique in almost a decade to be labeled a promoted tax shelter by the IRS in 2015; 419A(f)(6) plans, which contributed to the end of at least one lawyer's career; charitable split-dollar life insurance and private reverse split-dollar life insurance, both of which were legal until Congress caught wind of them and actually changed the law to make them illegal... you get the idea. The IRS is understaffed and underfunded, so it is very difficult for them to (1) evaluate what's out there, (2) determine whether these highly complex techniques are abusive, and (3) take the enforcement actions necessary to dismantle them and bring the offenders to justice. That being said, I have great respect for the Service and do believe that they eventually find and punish all of the promoters of these abusive vehicles and the taxpayers who use them. It's good for every law-abiding citizen, however, to have a stronger IRS. Strength comes in the form of funding and manpower - it's an investment Congress ought to make regardless of who is President.
  2. The system is really, really hard to change - rule of thumb: do not pay attention to any promises a candidate makes about overhauling the tax system. Examples: Gary Johnson and Bill Weld support the FairTax, which would nuke the Internal Revenue Code and start all over again with a consumption-based tax; Ted Cruz supposedly wants to abolish the IRS for reasons I never bothered investigating because it will never happen; and Herman Cain proposed a 9/9/9 plan in the 2012 Republican primary cycle. These are all well and good, but there are two primary reasons why the Internal Revenue Code is here to stay. The first is because the American tax system is mostly fine and does not need sweeping changes for the reasons I detailed above - it's manageable already and is quite fair for everyone except the mega-wealthy. The second is because remedying the IRC to not favor the wealthy - or in any way at all, really - is too difficult to accomplish logistically and politically. From a logistical standpoint, too many changes would negatively affect regular Americans or some politician's precious constituency (choose your adventure - energy, real estate, banking, agriculture, insurance, pharmaceutical, tech, government contractors, health care, small business owners, homeowners, the retirement planning industry, importers, exporters - the fun never ends!), thereby throwing out the proverbial baby with the bathwater. From a political standpoint, you'll never be able to get both sides to agree to anything major in this climate. During the Obama administration, the closest Congress came to making the tax system a bit tougher on the super-rich was the Net Investment Income Tax used to fund the Obamacare initiative and the corresponding addition of a new capital gains tax bracket. It was a decent start, but there's room to do a fair bit more - and this new tax ended up impacting some everyday Americans in select circumstances. No matter what politicians do (within the realm of realistic possibility), they'll also never be able to get rid of people like me and the other professionals whose sole occupational task is to put clients in a better tax situation by using the existing tax laws in legitimate (i.e., legal and above-board) ways. There are other substantive reasons why the Code is almost impossible to significantly alter and why the Code is intentionally designed to skew benefits toward large businesses and the very wealthiest individuals, but I don't want to belabor the point - reforming the Code is so hard that even Bernie Sanders limited his platform to raising marginal rates and imposing a new tax on financial speculation (both of which would not go very far in solving the core problem).
  3. Everyday people, including small business owners, don't use the various tax loopholes already available to them - oh, and there are plenty. Certain business owners can form Subchapter S corporations and pocket a few thousand dollars in payroll tax savings every year. If you're a rank-and-file employee and your employer offers a qualified retirement plan, you're a fool if you don't contribute, and that goes double if your employer matches a certain amount of contributions. Speaking of which, if you haven't contributed to an IRA, you're missing out on very favorable tax leverage. If you're a small business owner and you haven't consulted an actuary about implementing a qualified retirement plan, you're potentially overpaying your taxes by many thousands of dollars. If you haven't looked into a Health Savings Account or a Flexible Spending Account, see whether those arrangements could put you ahead a few hundred or perhaps even more than a thousand dollars every year. If you're currently renting, evaluate whether you can use the same monthly payment to own a home, which allows you to deduct mortgage interest and state/local taxes. If you're investing money, your returns from certain municipal bonds are totally tax free. If you're looking to protect your family while diversifying your savings and investment vehicles, whole life insurance is nifty - a permanent death benefit (paid completely free of income taxes to your beneficiary of choice) with a tax-advantaged bucket of money paying a decent dividend in case a rainy day comes.

Are these loopholes as powerful as some of those available to only the mega-rich? No, but they'll work pretty well for almost every hard-working American taxpayer. How can you find out more? If you haven't already, engage a skilled CPA and consult an independent financial advisor. Anyone complaining about the impact of income taxes can easily afford both. Knowing these techniques is part of their job description. Not all tax loopholes are reserved for the ultra-wealthy -- Congress has passed some favorable tax laws available to everybody, but knowledge is power... and your tax or financial professional's knowledge is well worth paying for.

Unlike the inaccurate reporting of the American media - which applies to every topic, not just taxation - I hope my thoughts were useful and informative for you.

The foregoing is not intended to be attorney advertising.


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