Friday, March 23, 2012

You Can Make a Billion Dollars and Never Pay Taxes!!

-- Posted by Neil H. Buchanan

Each time I teach the basic Federal Income Taxation course, I have the mixed pleasure of teaching the famous case of Eisner v. Macomber. The 1920 case is included in nearly every tax law casebook, although it is not clear why. Our income tax system includes something called the "realization doctrine" (which I will explain momentarily), and Macomber is a foundational case in that area of law. Even so, the Supreme Court's reasoning in Macomber is so muddled -- one might even say, so ridiculous -- that the case is arguably more trouble than it is worth, in the context of trying to teach tax law. (The case is bad on tax, and simply embarrassing on constitutional law.)

Why do I continue to teach the case, as I did again just this week? In part, I do so because everyone else does so. Macomber is one of those cases that should be part of the shared knowledge of everyone who has studied the income tax. That might not be a good thing, but I am in no position to change that reality. Given the frustratingly daffy reasoning of the case, however, every professor who teaches it has to come up with some way to make it more than merely another exercise in laughing at the Supreme Court.

Many cases are difficult to teach because the facts are so idiosyncratic. Especially with older cases, the likelihood is that the technologies and social norms that drove the parties' actions are, at best, quaint. In such cases, the best pedagogical choice is to soft-pedal the facts and focus on the legal rule that emerges. In Macomber, by contrast, the facts are so current and so relevant to today's policy debates, that the case can motivate students to think about current legal debates more productively.

First, however, it is best to return to the realization doctrine. The U.S. income tax includes a rule that says that increases in the value of property -- even though they are clearly income, because they make a person richer -- are not taxed until they are "realized." Setting aside huge complications, that means that you do not pay tax on your gains until you sell the property for cash. So, if I own a piece of land, and it starts to rise in value because the local government re-zones the area for residential development, I do not have to pay tax on the gains until -- that is, unless -- I sell the land. Similarly, if I bought shares in Apple a generation ago, I do not have to pay income tax on the gain unless I sell the shares.

But I will have to sell the shares some day, because I need money to live, right? Not necessarily. If I know that I will pay tax on any realized gains, it will usually be better to borrow against the value of my property (at very low interest rates, because the loans will be backed by rock-solid collateral). It is, therefore, possible to put off paying tax on any gains on my property holdings, essentially forever. By contrast, I can avail myself of the tax advantage of losses by selling any property that has gone down in value at any time, reducing my taxable income.

When I explain this to my students, it becomes necessary to explain why dealings in property -- which are, of course, almost entirely matters that affect only high-income people -- are so tax-favored. Beyond the cynical explanations, the textbook justifications for the realization requirement are: (1) It is often difficult to put a value on property, in the absence of a sale, (2) It is often difficult for a taxpayer to raise the funds necessary to pay their tax bill, without selling the property itself that gave rise to the tax liability; and sometimes that property is difficult to sell, or is indivisible, and (3) property that has gone up in value might later go down in value, making it arguably wasteful to tax people this year and then give them refunds next year.

All of which are very plausible explanations, depending on the facts on the ground. Which is why Macomber's facts are so useful, even though the case is almost a century old. There, the taxpayer was holding shares of Standard Oil of California stock, which were traded on the New York Stock Exchange. The total value of the shares was $800,000, which is in the $10-$20 million range in today's dollars (depending on how one chooses to account for inflation and economic changes).

This makes the taxpayer in that case, Myrtle Macomber, the anti-poster child for realization. It is easy to determine the value of the shares, even if she never sells them, because they are traded on one of the most transparent markets in the world. If her tax bill were to force her to sell some of the property to raise cash, she could easily sell a fraction of her shares. Finally, if her remaining shares go down in value, then she could take a deduction for the losses in subsequent years.

All of which makes Macomber still fun to teach. Even so, it has always seemed odd to then say, "But, the realization doctrine still applies to people like Macomber, apparently because other kinds of property transactions justify the realization doctrine. Macomber and people like her essentially get a tax break, because we refuse to notice that their property transactions do not match up with the policy justifications of the realization doctrine."

Until now. Last month, someone finally declared that the emperor was naked. A tax lawyer named David S. Miller, writing in The New York Times, proposed a "Zuckerberg Tax," which would be called the "Myrtle Macomber Tax," if tax nerds ruled the world. Miller's op-ed precisely tracked the mismatch between the justifications of the realization doctrine and holders of big chunks of widely-traded stock, like Myrtle Macomber and Mark Zuckerberg (and Warren Buffett, and so on).

While much is being made of Zuckerberg's wealth, due to the first-time sale of FaceBook shares to the public, the op-ed points out that Zuckerberg is completely in charge of his tax fate. He apparently plans to sell $5 billion of his stock in the company, which will result in tax liability of roughly $2 billion. He will pay the taxes from the proceeds of the stock sale, leaving him a paltry $3 billion in after-tax cash. Lest we think that Mr. Z is being taxed at "Buffett Tax" rates or above, the op-ed reminds us that Zuckerberg has another $23 billion in shares on which he will pay zero tax. He has been accumulating this wealth for the past decade or so, paying no tax in any year. That he will pay any tax at all is his choice.

Moreover, anyone who dies with unrealized gains on their property can pass the property to his heirs, income-tax free. If Zuckerberg's heirs were to receive his $23 billion in FaceBook stock, they could sell those shares the next day under rules that would allow them to say that they had received no income from the deal. This is, among other things, one of the poorly understood justifications for the estate tax. The realization doctrine thus allows income from property to be shielded from income tax for decades, at which point the estate tax is the only thing that keeps the gains from being entirely exempt from taxation.

There is, in the current political environment, no traction for the Zuckerberg/Macomber tax. For that matter, there is no traction for anything that would collect more tax revenue. Even so, Miller's proposal reminds us that we have, for the last century, been giving a pass to a group of taxpayers who never should have been able to take advantage of the realization doctrine. If equity means anything in tax law, this is an area that is ripe for fundamental change.

8 comments:

David Ricardo said...

As a person who practices in both the tax and valuation areas your comments are interesting, provocative and generally valid, but the principle against taxing unrealized gains is largely supported by the practicalities of not doing so. Even for assets for which there is a readily attainable market value it does not mean that a person’s holdings can be sold at that value.

For assets that do not have a readily attainable market value, the practicalities are enormous. Anyone familiar with the difficulties in valuing options, FLP’s, minority interests etc for example, is well aware of this.

The argument against taxing the unrealized value is that the owner does not have benefit until the asset is liquidated and converted to cash. You cannot buy things or pay bills with stocks, bonds or deeds, you have to use cash.

On the other hand, your argument that by borrowing against the value of the assets the person can enjoy the economic benefit of increased value without realization is correct. But if you want to put that into the tax equation we need a practical method to do so. I don’t know of one, unless the borrowing could be treated as a deemed sale. But then what happens if the borrowings are repaid?

Finally the comments on the estate tax and step up basis for assets conveyed to heirs are correct, and this is one place where the system can be more fair. An estate tax, combined with carry over basis would be the correct way to deal with this issue. The estate tax is essentially a transfer tax, taxing the right to transfer assets and as such is a valid tax. Applying capital gains when the assets are sold even after an estate tax is paid is justified by the excellent points made in the this Post.

LucienNicholson said...

I am taking Income Taxation I and we discussed both Zuckerberg and, of course, Macomber.

I genuinely see no equitable problem with not taxing unrealized gains, even if wealthy individuals do take loans against their property. I could take a HELOC against my house and as far as I know, I won't pay income tax on that.

Zuckerberg, according to you article, paid 2 billion dollars in income tax. That is more than I will ever pay, or probably even earn, in my life. He did so creating immense value for the US economy.

As I am fairly new to tax law, what are the equitable principles guiding the decision to tax unrealized gains?

David Ricardo said...

Lucien

Equity, like beauty and good BBQ is in the eye of the beholder.

The equitable rationale for taxing unrealized gains is that the holder somehow enjoys economic benefit, value and utility from unrealized gains. For example, a person with large unrealized gains in real estate can re-mortgage that real estate at a higher value and use the funds for economic enjoyment.

The problems are, of course, the fact that the borrowing in this case creates a liability equal to the asset. And even more important, developing a practical manner to tax unrealized gains is probably impossible.

I think the question is not over taxing unrealized gains, but whether or not gains are ultimately taxed. Under our current system if a person dies with unrealized gains, the basis is stepped up at transfer to heirs, so the gain is never taxed. For high net worth taxpayers some of this is captured with the estate tax. Of course, with proposals to abolish the estate tax and reduce or abolish the tax on capital gains we could be moving to a system where some, if not all gains are never taxed.

That is the future if Conservative tax policy is ever implemented.

Neil H. Buchanan said...

Thanks to both TDPE and LucienNicholson for their comments. I find their insights and questions intriguing, and I will return to this subject in my post this Friday, addressing the equity question in particular.

Anonymous said...

With respect to your articles penultimate paragraph:

If Mr. Zukerberg's estate were valued at $23 billion, his estate would file U.S. tax form 706 and include a check for $8 billion,($23 billion x 35% estate tax rate).

Assuming the $8 billion is obtained by selling stock,Zukerbergs heirs would receive $15 billion, not the $23 billion your article implied.

The above comments assume Zukerberg is a single man with no bequests to charity.

Your comments would be appreciated.

W. C. Boller

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