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COPYRIGHT 2007 Stanford Law School
INTRODUCTION
I. PARALLELISM AND TAX POLICY A. Horizontal Equity and Parallelism B. Exclusions and Deductions: Where's the Equivalency? C. The Importance of Enforceability to Tax Policy II. PLAYING FAVORITES: THE CRITICAL ROLE OF THIRD PARTIES A. Clark v. Commissioner: A Tax Refund by Any Other Name B. Excludible Personal Receipts C. Excludible Employment-Related Receipts 2. The self-employment comparison 3. Moving expenses III. WHEN ARE THIRD PARTIES HELPFUL AND WHEN ARE THEY HARMFUL? A. The Zero-Sum Constraint and the Unselfish Exception B. Manufactured Surplus Minimized: The Example of Wages C. Identifying Accommodation and Cooperating Parties 1. Tax-indifferent parties 2. Familiar parties 3. Soliciting parties 4. Parties playing two roles CONCLUSION
INTRODUCTION
Numerous laws prohibit and punish behavior the government seeks to prevent, such as running red lights or driving faster than the posted speed limit. However, recent legal and economic scholarship has recognized that the government has an important alternative mechanism it can use to reduce prohibited behavior: "structural" systems. (1) Structural systems either facilitate enforcement, as red light cameras do, (2) or actually help constrain behavior. For example, if the government seeks to reduce speeding in a residential neighborhood, instead of (or in addition to) imposing fines and ticketing speeders, it can construct roads in ways that help reduce speeding, (3) such as making them narrow or winding, or including speed bumps. The structure of the road can thus actually help prevent the behavior the government seeks to reduce.
This insight can apply in an array of areas in addition to traffic laws. For example, why people pay taxes is sometimes described as a puzzle. (4) From an economic perspective, it appears that penalties and enforcement rates are too low to deter cheating with respect to such taxes as the federal income tax in the United States. (5) Yet, the federal government estimates that 84% of federal income taxes due are timely and voluntarily paid. (6) An essential missing piece of this seeming puzzle is that the federal income tax law benefits from structural mechanisms that constrain payment with respect to the major sources of income for many people, including wages and salaries. (7)
The structural mechanisms the federal income tax uses, unlike red light cameras and speed bumps, make use of third parties to the taxpayer/government relationship. As is well known, in a variety of situations, the federal government requires third parties to report to the government, with a copy to the taxpayer, amounts the payor transferred to the taxpayer. (8) This "information reporting," like red light cameras, provides information to the government, and it is information that the taxpayer knows the government is receiving. (9) Moreover, in some situations, the payor, such as an employer, must also withhold taxes from the payment and remit those taxes to the government. Withholding taxes, like speed bumps, constrain compliance with the law. However, unlike speed bumps, withholding taxes are effective largely because they essentially make a third party responsible for paying the taxpayer's taxes. (10)
Information reporting and withholding extend to a variety of types of income in the U.S, and are highly successful at securing compliance. (11) A comparison of the estimated "voluntary compliance" rates under the federal income tax with respect to various types of income suggests just how effective these systems are. (12)
Amounts subject to withholding (e.g., wages and salaries) have a net misreporting percentage of only 1.2 percent. Amounts subject to third party information reporting, but not to withholding (e.g., interest and dividend income) have a slightly higher net misreporting percentage of 4.5 percent. Amounts subject to partial third-party reporting (e.g., capital gains) have a still higher net misreporting percentage of 8.6 percent. Amounts not subject to withholding or other information reporting (e.g., Schedule C income or other income) are the least visible, with a much higher net misreporting percentage of 53.9 percent. (13)
Structural systems that engage third parties to help facilitate compliance with the federal income tax are thus highly successful. (14) The use of such mechanisms need not necessarily be limited to tax administration, however. Substantive tax law could incorporate structural systems that benefit from the use of third parties. In fact, although it has gone unnoticed until now, federal income tax law already implicitly takes account of the structural benefit arm's length third parties can offer. Specifically, as discussed below, the tax law often fails to extend the favorable tax treatment afforded particular reimbursed expenses or losses to similar but unreimbursed items. (15) This distinction does not reflect different tax treatment of equivalent events, as prior scholarship suggests. (16) Instead, it reflects the enforcement benefits that a reimbursement provides--including the presence of a third party who implicitly has "vouched" for the bona tides of the taxpayer's claim. (17) In fact, the more favorable tax treatment of amounts verified by third parties is not only rational, it is consistent with the important tax policy goal of an administrable tax system. (18)
Although third parties can thus provide a type of "friction" that reduces tax avoidance, (19) they do not do so in all contexts. In fact, transaction counterparties have also been known to participate in abusive tax-reduction strategies in return for a portion of the tax savings generated. (20) The government thus needs to be able to identify the types of situations in which counterparties will tend to act as verifiers of taxpayers' claims, as well as those in which they are more likely to collude in noncompliance. Aspects of the structure of each situation can help the government make this distinction. It then generally can "free ride" in situations in which third parties perform a verification function while scrutinizing more closely other transactions. Moreover, the government can consciously seek to use legislation to create more of the beneficial structures and reduce the number of structures that lend themselves to exploitation.
In elaborating on these distinct but connected points relating to the bridge that third parties provide between substantive income tax laws and enforcement of those laws, this Article proceeds in three major parts. Part I develops the insight of this Article that the substantive role third parties play in federal income tax law helps explain numerous instances in which an exclusion of a reimbursed or compensated expense or loss is not matched by a deduction in full of a comparable but uncompensated expense or loss. It first discusses the concept of "parallelism," which Professor Jeffrey Kahn describes in a recent article as a concept related to but narrower than horizontal equity, the concept that similarly situated taxpayers should be similarly taxed. (21) This Part then demonstrates that the exclusion of a reimbursement is not economically equivalent to the deduction of an unreimbursed amount. Finally, it connects the economic distinction between reimbursed and unreimbursed amounts to the important tax policy principle of administrability of the tax system.
In Part II, the Article explores the use of third parties as a compliance tool, as currently reflected in substantive federal income tax law. It discusses several situations in which more favorable tax treatment is accorded to a transaction that involves an arm's length third party than to an otherwise similar transaction that does not involve a third party, and argues that the distinct treatment is justified by the policy considerations discussed in Part I.
Because third parties are not a panacea for tax compliance, Part III of the Article explores how the government can distinguish contexts in which third parties tend to foster compliance from settings in which they may tend to undermine it. This Part first discusses the underlying economic distinction between contexts in which third parties, in acting out of their own self-interest, will verify the taxpayer's claim, and situations in which third parties' self-interest will instead incline them to collude with the taxpayer to exploit the tax system. Next, it examines these issues in the context of employers' payments of wages to employees. Finally, the Article identifies four types of transaction counterparties for whom the government should be watchful because transactions in which they are involved provide opportunities for collaboration in abusive tax-minimization strategies.
I. PARALLELISM AND TAX POLICY
A. Horizontal Equity and Parallelism
Equity in a tax system is an important tax policy consideration. (22) "[H]orizontal equity," which "demands that similarly situated individuals face similar tax burdens[,] ... is universally accepted as one of the more significant criteria of a 'good tax.'" (23) Horizontal equity implicitly refers to taxpayers' overall tax burdens. (24) In a recent article, Professor Jeffrey Kahn discussed a related, narrower principle, which he terms "parallelism"--the notion that "the same or equivalent receipts, expenditures or losses should be treated the same by the tax law." (25)
The focus of Professor Kahn's analysis "is the notion that if the reimbursement of an expenditure or loss is excluded from the recipient's income, the same type of expenditure or loss that is not reimbursed should be fully deductible." (26) His analysis rests on the principle, discussed further below, that an exclusion is mathematically equivalent to an inclusion coupled with a deduction. (27) Professor Kahn argues:
Since the exclusion and deduction approaches generally are identical for tax purposes, one might expect there to be parallel treatment of reimbursed and unreimbursed expenditures and losses. That is, one might expect a taxpayer who incurs an expenditure or loss to be treated the same by the tax law whether the item is reimbursed or not. (28)
Yet, as Professor Kahn explains, there are numerous examples in which the federal income tax law allows an exclusion for a reimbursed or compensated expense or loss but disallows or limits any deduction for a similar but unreimbursed, uncompensated item. (29) Professor Kahn discusses seven examples of this phenomenon, arising in the following general contexts: (1) damage to property; (2) personal injury damages; (3) forgone or unavailable tax refunds; (4) employee business expenses; (5) life insurance proceeds; (6) employee meals and lodging; and (7) job interview expenses. (30)
The following frequently discussed example, which involves the tax treatment of victims of personal injuries, is illustrative of the phenomenon in the federal income tax of allowing an exclusion for a compensated loss but no deduction for an uncompensated one. (31) Assume that Ann and Bob are identically situated, and each is identically physically injured by different tortfeasors. Ann was injured by a wealthy tortfeasor and receives a large sum in settlement of a personal injury suit--say $2 million. Bob, by contrast, was injured by a poor, unidentifiable, or judgment-proof tortfeasor and receives nothing.
Under current law, Ann can exclude the damages she received, (32) but Bob cannot claim a deduction comparable to the amount Ann excluded from income. (33) Ann will thus exclude the $2 million from income, while Bob gets no such tax benefit. As a result, assuming that their tax profiles are otherwise the same, Ann and Bob will pay the same amount of tax despite Ann's additional $2 million receipt. (34) This result appears troubling. (35) In fact, not only does it appear that Bob is treated worse than Ann, but Bob seems to be the one more in need of a tax benefit, as he did not receive anything from the tortfeasor. (36)
Professor Kahn's article does not seek to resolve the seeming puzzle of this and the six other examples he discusses of lack of parallelism between exclusions and tax deductions. (37) Instead, his article focuses on the role of parallelism as a policy principle. Thus, he takes a case-by-case approach to each of his examples, arguing that "[e]ach instance of nonparallel treatment of the tax law should be examined separately to determine whether there are competing principles that outweigh the goal for parallel treatment." (38) Accordingly, Professor Kahn's article generally analyzes the rationales supporting each exclusion and those in favor of disallowing or limiting a corresponding deduction, and also considers the role, if any, that parallelism should play.
Professor Kahn's approach has the virtue of examining, in several distinct areas of federal income tax law, whether an existing exclusion is justified; some of them, though well-entrenched, may not be. (39) It also draws valuable attention to a number of areas in which the tax law does not treat reimbursed and unreimbursed amounts alike. Yet, his approach ignores two important issues that allow development of a larger framework that resolves the seemingly puzzling inconsistency that Professor Kahn highlights.
First, as further explained below, although every exclusion from income implicitly contains a deduction in full, such an implicit deduction inherently is paired with an implicit inclusion in income in the same amount; it is the combination of inclusion and deduction that is equivalent to an exclusion. (40) The inclusion is not only critical, it generally does not occur in the absence of a receipt. Second, as a matter of tax policy, the substantive distinction between reimbursed and unreimbursed amounts is actually highly meaningful, although the literature previously has not recognized this fact. Thus, it is not the case, as Professor Kahn's analysis suggests, that because there is a deduction implicit in an exclusion of a reimbursed amount, economic equivalency calls for a deduction of a comparable, unreimbursed amount (41) that should be allowed unless situation-specific policies triumph. (42) These points are discussed in the next two Sections.
B. Exclusions and Deductions: Where's the Equivalency?
The federal income tax is imposed on "taxable income." (43) Taxable income generally means "gross income" minus deductions, except that, for individuals, deductions are separated into categories, with only "above-the-line" deductions--those taken off the top--being fully deductible. (44) Thus, in isolation, an inclusion in gross income increases taxable income and thereby increases tax liability. Conversely, a deduction, if not disallowed, reduces taxable income, and thus generally reduces taxation.
Because taxable income reflects both gross income and deductions, a receipt constituting gross income that is paired with an offsetting deduction (one in the same amount as the receipt, and deductible in full) is equivalent to exclusion of the receipt from gross income and no deduction. (45) For example, assume that Carla, a corporate employee, purchases office supplies for use this year in her job, at a cost of $100, and her employer reimburses her. (46) The supplies are a business expense, so Carla can deduct them. (47) Assuming that Carla's employer has an appropriate reimbursement arrangement, the deduction is above the line, (48) so the full $100 is deductible. (49) If Carla deducts the cost of the supplies, she then takes the $100 receipt into gross income. (50) Her taxable income from the transaction would be as follows:
$100 gross income
above-the-line deduction
==
$0 taxable income.
This result is equivalent for federal income tax purposes to allowing Carla to exclude the $100 receipt from gross income but not take a deduction for the expense; she simply would have no gross income from the transaction, no deduction, and thus no taxable income from it. In fact, unlike the Internal Revenue Code (Code), which provides for an inclusion in gross income coupled with an above-the-line deduction, (51) Treasury regulations take this simplified approach. (52)
Note that the equivalency holds only if the deduction is allowed in full. If a portion of the deduction is disallowed or not usable, exclusion is more beneficial than the receipt coupled with the deduction because an exclusion does not give rise to taxable income. (53) An individual's deduction may be unusable, in whole or in part, if it is an "itemized deduction." To use an itemized deduction, an individual must elect to itemize in lieu of taking the standard deduction, so itemized deductions, in the aggregate, must exceed the standard deduction in order for that election to be warranted. (54) In addition, some itemized deductions are "miscellaneous itemized deductions" that only are included as itemized deductions to the extent that, in the aggregate, they exceed two percent of the taxpayer's adjusted gross income. (55) Furthermore, there is an overall limitation on itemized deductions for higher-income individuals. (56)
Where the deduction is allowed in full, however, it fully offsets the receipt, as shown above, and thus is equivalent to an exclusion. Accordingly, an exclusion is equivalent to an inclusion coupled with a full deduction for the same amount. (57) Federal income tax law contains a number of exclusions from income, such as the exclusion for life insurance proceeds received by reason of the death of the insured, (58) personal physical injury damages, (59) and qualified scholarships. (60) The equivalency principle means, for example, that no change in federal income tax would result to a taxpayer who, instead of excluding personal physical injury damages from gross income, as provided by current law, (61) took the receipt into income but took an above-the-line deduction for that amount. The mechanics in this example would be somewhat odd--the taxpayer would be taking a deduction not based on an expense or tax loss--but the economic result would be the same as the exclusion. (62)
By contrast, an exclusion of a personal physical injury damages receipt and the deduction of uncompensated personal physical injury damages do not have the same effect on tax liability. For example, assume that taxable income is taxed at a flat rate of 20%. If Dan has $100,000 of taxable income apart from $70,000 of excludible personal physical injury damages he received, his tax liability is $20,00063 because of the exclusion of the $70,000 in damages. If Dan instead had no such receipt but were allowed to deduct $70,000 worth of uncompensated personal injuries, rather than facing a $20,000 tax liability, the deduction would shelter $70,000 of income, lowering his taxable income to $30,000 and thereby reducing his federal income tax liability to $6,000. (64)
Thus, in the example above involving Ann and Bob, (65) Ann's exclusion of her personal injury damages receipt is economically equivalent to a deduction in full for her loss coupled with inclusion of the damages she received. There is no such equivalency for Bob because, unlike Ann, he received nothing from the tortfeasor. A deduction for Bob would actually offset other income, such as salary, whereas a deduction for Ann would only shelter the related receipt. (66) Exclusions thus implicitly have built-in "basketing" (67) in that reconceiving the exclusion as a deduction would allow the hypothetical deduction only in the presence of the hypothetical gross income that necessarily accompanies it. (68) By contrast, a deduction without an inclusion shelters other, otherwise-taxed amounts--actually lowering tax liability rather than keeping it the same.
This reality raises important compliance issues that would arise were uncompensated personal injuries allowed to be deducted. Under current law, a taxpayer has no tax incentive to fabricate the receipt of a personal injury damages payment because such a receipt, even if it is excludible from income, would not reduce her taxes (it would merely keep them from increasing). Ann, accordingly, has no incentive to lie to the federal government about the existence or magnitude of her injuries or about the amount of damages she received for those injuries. (69) Moreover, the payment to Ann means that the government can have confidence in the magnitude and value of her injuries. The tortfeasor who pays $2 million in damages has no self-interest in disgorging funds, so the bona tides of the transaction generally can be respected. (70) That is, the payment by the tortfeasor eliminates questions about the existence of the injury and the magnitude of the damage. (71)
There is no such structural constraint on Bob. Because a deduction can offset other income, if the value of uncompensated personal injuries were deductible, taxpayers would have an incentive to exaggerate the extent of personal injuries on their tax returns (72)--and even to fabricate them entirely, because deductions actually reduce tax liability. (73) Accordingly, a deduction for uncompensated personal injuries, particularly one not limited by the amount of actual medical expenses, (74) would amount to an invitation to commit tax evasion. Without a requirement of the receipt of funds as a prerequisite to a tax benefit, a taxpayer could fabricate an injury or exaggerate the consequences of an injury in order to reduce tax liability and gamble on the small chance of losing the "audit lottery." (75) Moreover, if such a taxpayer were audited, his claim of uncompensated injury would be hard for the government to counter. (76) He could claim that the tortfeasor injured him in a hit-and-run accident, for example, so that even the identity of the supposed tortfeasor was unknown.
Thus, when Congress enacts an exclusion for a reimbursed item, whether or not the exclusion is justifiable from a tax policy perspective, the cost of the provision to the federal government--aside from issues of misallocation of receipts to the excludible category, which are discussed below (77)--will be limited to the forgone tax revenue from those entitled to benefit from the exclusion. However, if Congress enacts a deduction for a similar but unreimbursed item, the likely costs will include not only the forgone tax revenue from those entitled to the deduction but also the forgone tax revenue from those who falsely claim the deduction but escape detection.
C. The Importance of Enforceability to Tax Policy
When the appropriateness of a tax proposal or provision is evaluated as a policy matter, the concerns usually referenced are efficiency, equity, and "simplicity" or "administrability." (78) The simplicity or administrability of a tax system has two major components: the ease of government enforcement and the ease of taxpayer compliance. Administrability may appear comparatively superficial or more concerned with form than efficiency and equity do, which resonate as matters of substance. A simple or easily administered tax may even seem like a luxury if those values are in tension with the efficiency and/or equity of the tax system. Yet, administrability of a tax is key to its effectiveness; "[t]he best tax policy in the world is worth little if it cannot be implemented effectively." (79) In fact, Milka Casanegra de Jantscher famously stated that "tax administration is tax policy." (80)
Similarly, in 1965, when Judge Joseph Sneed developed a list of seven attributes that have shaped the federal income tax, he included "[p]racticality," which he defined as "a practical and workable tax system." (81) Included in Judge Sneed's concept of practicality is the government's ease of collection of the tax. (82) Although he ranked practicality and equity (83) as the most important of his seven criteria, he noted that practicality generally is given the most weight. (84)
In part, the importance of the administrability or practicality of a tax system reflects the notion that a tax system that appears equitable is not so if it is not enforceable in a manner that reaches equitable results. (85) For example, assume that, in a two-person economy populated by Ellen and Fred, the most equitable tax system designed to raise $100 needed by the government would tax Ellen somewhat more than Fred. Tax A, which would tax Ellen $60 and Fred $40, is the best such tax the government can design. Unfortunately, the structure of the tax is such that Ellen can easily evade it and pay nothing. The government then faces the possibility of collecting only $40 (from Fred), which is insufficient; to meet its revenue needs, it would have to raise tax rates so as to collect $100 from Fred (Tax A'), a very inequitable result in that it actually taxes Fred much more than Ellen (who is not taxed).
Assume that the government could instead impose a different tax (Tax B) that will tax Ellen and Fred in the amount of $50 each, and that this tax is designed to be easily enforced,...
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