(This is the first installment of a two-part feature by J. Michael Pusey, CPA.)
Our topic is not so much the type of discussion that makes the newscasts – tax rate progressiveness or lack thereof and whether the group benefiting from this or that is big or small, or whether donations to the politicians seem to correlate with a particular tax break.
My background includes many years of watching legislative developments, and practicing as a CPA, and I don’t recall studying a major tax bill and having an impression of it being inherently unfair in many respects. That was until recent months with study of the Tax Cuts and Jobs Act enacted in late December, 2017. ((References herein to Conf. Rep. are to the Tax Cuts and Jobs Act, Conference Report to Accompany H.R. 1, 115th Cong., 1st Sess., House Report 115-466, December 15, 2017.))
Introduction and Scope
We will lay out our scope but we note that early in the process, the author set out to find a suitable definition of “fairness” when the focus is paying for the government. It might take an article to explain why he soon abandoned that approach.
The Act defies simple summarization, but there were in the Act significant cuts in tax rates, particularly corporate tax rates, enhanced ability to deduct immediately costs that would otherwise be depreciated over long periods, and increases in the standard deduction. For singles, the standard deduction went from $6,350 in 2017 to $12,000 in 2018. For married couples, the standard deduction was $12,700 in 2017 and it increased to $24,000 in 2018.
The details within the Act for paying for the tax-reducing aspects of the law took a multitude of different approaches.
For example, with respect to the ability under the old law to deduct miscellaneous itemized deductions, those in excess of 2% of adjusted gross income, these were simply declared nondeductible for a time, whether small or large and regardless of the taxpayer’s income.
We discuss below the new rule that non-corporate business losses above certain levels become currently nondeductible and instead become contingent future deductions as part of the net operating loss carryover.
Within the sphere of writing off capital costs, the limitation under Section 179 was increased from $500,000 to $1,000,000, but this benefit is phased out for “bigger taxpayers.” The approach here is not income but rather the amount of capital expenditures. The benefit begins to phase out as capital expenditures exceed $2,500,000. So there is a basic concept of not allowing this benefit to bigger taxpayers, but the definition focuses on capital expenditures, not sales or taxable income. Is it fair to discriminate in favor of only the smaller taxpayer when it comes to writing off capital costs?
Within the new 20% of business income deduction concept, there are particular details within the rules that may turn on the level of income. The rules become much more complex with higher-income taxpayers.
The approach to generating more taxes is sometimes to just limit a particular deduction. One of the provisions in the Act, often discussed in a fairness context, is the de facto limitation on the deductibility of state income taxes in high-tax states, particularly California, New York and Massachusetts. After 2017, the new law limits the itemized deductions for the sum of the state income tax and property tax on the residence to $10,000. The limitation is long-term but barring further changes, it goes away after 2025. The same rule applies in all the states. It is just that taxpayers in high-tax states get hurt, often rather severely. Is it fair to allow some taxpayers full deductions for their (more limited) state income taxes and not allow full deductibility to other taxpayers? It is in the basic nature of capping certain deductions that some taxpayers get hurt. The author believes it would be fairer to mitigate multiple taxes on the same income by allowing a full deduction for state income taxes on the federal return. We note the federal context is to generally mitigate double taxation when it arises from payments to a foreign country, but less so, when payments go to a state. Even states normally mitigate double taxation. A Philadelphia resident earning a living in New York may qualify for a Pennsylvania credit. But even mitigating double taxation as an element of fairness isn’t our main focus here.
What approach do we choose in focusing on “fairness”?
Deductions are, famously, a matter of legislative grace. ((See New Colonial Ice, 292 U.S. 435, 440 (1934) and other case citations in Chief Counsel Memorandum 201319010, December 28, 2012; https://www.irs.gov/pub/irs-wd/1319010.pdf.)) But we believe that our basic tax system focuses on a measurement of income on a net basis. One would be aghast to contemplate a business reported on Form 1040 with a net income of $ 1 million on sales of $10 million and the owner basically had to pay tax at our income tax rates on gross income. The result would be to convert a profitable business into a loss business, after taxes. We might call the tax confiscatory. “Confiscatory” might well arise in describing the effects of the 2017 tax law changes as they apply in certain circumstances. Our focus is aimed at particular provisions. We don’t address the Act’s overall fairness, or even provisions that might be said to achieve fairness.
The basic concept of allowing losses and related deductions to offset the income seems to be deteriorating. This is our major focus – the deterioration of the most basic concept of allowing related expenses to be deducted in the measurement of income given our structure is obviously not one of a gross receipts tax. We argue that it is generally unfair to disallow related expenses and losses when the basic nature of the tax relates to income.
We will also address in the employees-parking-at-the-charity discussion one instance of mischaracterization of the basic nature of the matter; i.e., “taxation without representation” of anything resembling the actual facts. Basically, the legislators take an expense and call it income so as to subject it to an income tax. Can they do that?
Eliminating Related Expense Deductions and Loss Disallowance Generally
Eliminating Net Operating Loss Carrybacks
The tax rules have for a very long time mitigated the sometimes rather arbitrary results of annual accounting by allowing losses to be carried back, as well as forward if necessary. Most recently the carryback rules were two or three years if a small business. There was significant mitigation of the unfairness that often results from our annual accounting approach. ((Section 172.))
One taxpayer could make $1 million in year one and lose $1 million in year two, and the result under the post-2017 Tax Act law is the taxpayer pays tax on essentially $1 million over the two years, despite breaking even over those years. You could press this to a two-day example – cash-method taxpayer gets $1 million on December 31st and while TV-watching the football games, pays out $1 million in expenses on January 1st. The taxpayer who happens to lose $1 million in year one and make $1 million in year two has the markedly different result of breaking even over the two years due to the ability to carryover the year one loss.
One of the year-end tax planning considerations here is whether the taxpayer refrains from paying some expenses, leaving an estimated amount of income in the current year at lower tax rates when paying the expenses in the following year may ultimately be nondeductible if it is a year of net operating loss.
“Repealing the net operating loss carryback should be opposed because it is fundamentally unfair.” ((See generally “Net Operating Loss Carryback Repeal Isn’t Getting the Attention It Deserves,” Robert L. Rojas, Rojascpa.com, April 22, 2017; National Real Estate Investor, Robert L. Rojas, August 8, 2017, https://www.nreionline.com/finance-investment/nol-carryback-repeal-isn-t-getting-attention-it-deserves.))
It’s an income tax, not a gross receipts tax, but this is among myriad moves to limit offset.
Larger Business Losses May Not Be Deducted Currently
For taxable years beginning after December 31, 2017, non-corporate taxpayers are limited in so far as offsetting non-business income with business losses. When such losses exceed $250,000 or $500,000 on a joint return, the losses just skip the current year’s return and go straight to net operating loss carryover, where they are a contingent future benefit. The passive loss rules apply prior to these rules. ((Sec. 461 (l); Conf. Rep. p. 238, 239.))
The legislative history just basically says, “Here’s what we’re going to do.” I don’t read a whisper of justification.
Note that the topic is also not necessarily limited to the large taxpayer. The taxpayer could run into this situation when after a long period of tax-profitable years, there is a large Section 1231 loss on the sale of a business asset or a large business casualty loss (e.g., the recent California fires).
The rule can seemingly arise with that last little bit of deduction; e.g., a dollar expense can potentially destroy the current deductibility of a large amount of losses.
The practitioner and taxpayer may run into situations where just not deducting that $250 business trip expense translates effectively into incremental current deductions of almost $250,000 or $500,000. Could we run into a strange new world where not deducting something even raises issues of major penalties? For example, if the applicability of this new rule is close and the taxpayer tears up the support for the $250 business trip so he or she can argue the business trip is nondeductible and this translates into freeing up almost $250,000 or $500,000 of additional losses, could this even be fraught with penalties?
This is a strange new world with myriad issues of just how the rules are to be applied and interpreted.
It’s an income tax, not a gross receipts tax, but this is another instance of basically not allowing offset.
(Look forward to the next installment in December.)
About the Author
J. Michael Pusey, CPA, MSA, is a National Tax Director with Rojas and Associates, CPAs, Los Angeles. He has over forty years experience in tax and finance. Mr. Pusey has written or contributed to four tax books, including an AICPA Tax Study, and a finance book. Mr. Pusey began his career with KPMG before working nine years in “national tax” for Laventhol & Horwath and Grant Thornton. He was V.P., Assistant Tax Director, Manager of Research and Planning for a NYSE financial institution prior to beginning his practice, then joining Rojas and Associates.