Tuesday, August 28, 2018

A New Angle in the Trump Scandals

by Neil H. Buchanan

When commentators review the litany of, shall we say, the problematic aspects of the emergence of Donald Trump as a political force, the list almost always includes Trump's absolute refusal to release his tax returns.  That refusal, we now know, was only the leading edge of examples of "rules of the game" that Trump would ignore, proving again and again how often we have relied on voluntary (or merely reputationally enforced) rules that truly matter but that never needed to be formally enacted into law.

I am hardly the only tax scholar who is of mixed feelings about that particular Trumpian refusal.  On the one hand, I most definitely understand the importance of norms, and seeing a candidate's or president's tax returns gives citizens the ability to get a sense of that person's honesty and integrity.  That is surely why, for example, Elizabeth Warren recently put ten years of her tax returns up for public inspection on a website.  And good for her, both in terms of politics and simple decency.

Despite its importance, however, the controversy over Trump's tax secrecy has always been accompanied by an overblown sense of what we would learn if or when his returns finally become public.  No, we will not be able to figure out whether he is truly a billionaire, for example, and unless his people are even more shockingly incompetent than they seem to be, the tax returns will not include items with notations like: "Deduction for payment to secret Putin account -- Thanks for the collusion!"

Even when tax issues have come up during Trump's time in office, claims that "we now really need to see his taxes" were only partly persuasive.  After all, people could say that 2017's changes in partnership tax law and all but gutting the estate tax were not just terrible policy but were especially generous to people like Trump precisely because of what we already know about Trump.  Details can be interesting, but we knew all along that he is lining his pockets and that Republicans are happy to help him do it (as long as they and their owners get a big slice, too).

At long last, however, we now have a situation in which seeing Trump's tax returns would be indispensable in determining a specific (and otherwise nearly impossible to verify) crime or set of crimes.  As so often happens with questions of tax law, the details are perversely fascinating.

After Trump's "terrible Tuesday" last week, when Paul Manafort was convicted of eight felony counts and Michael Cohen pled guilty to eight counts of his own, a Washington Post article that explained why we can now definitively call some of Trump's statements "lies" (even under the most generous definition of that word) included this nugget:
"Court filings showed that the [Trump Organization] 'grossed up' the [hush money reimbursement] payments to cover Cohen’s taxes and also added a bonus, for a total of $420,000 in payments, according to the criminal information.”
My eyebrows shot up.  "Grossed up"?!  Where did this come from?  In my Federal Income Taxation class, I always take a few minutes early in the semester to discuss the concept of grossing up.  I will explain what that means momentarily, but I should start by saying that the concept typically seems so odd to students that I often have a difficult time trying to convince them that it has real-world relevance.  For at least the next few semesters, that problem is solved.

So what is grossing up?  Suppose you are only willing to take on a task (either at your current job or as a side gig, it does not matter) if you net $1000 from doing so.  You are offered $1000, so you of course refuse, because you know that you will have to pay taxes on your income.  If your marginal tax rate was 33.3%, you would demand $1500.  It your rate was 20%, you would demand $1250.

There is a simple equation that solves this question under any tax rate: Gross Pay = Desired Net Pay / (1 - marginal tax rate).  That becomes mildly complicated when the grossed-up amount moves the earner into a higher tax bracket, but we live in a world where the solution to that problem is built into all kinds of basic software. The computation is trivial.

Who normally grosses up?  Essentially, the more bargaining power the earner has, the more able she is to shift her tax payments onto the entity that wants to hire her.  I have a friend who, before same-sex marriage became legal everywhere, was considering working for a state university that was prohibited by law from providing spousal benefits to same-sex couples.  "Fine," my friend told the dean, "just adjust my salary to cover my extra expenses" -- what we might call the Bigotry Penalty -- "and I will tell you what the grossed-up total will be."  The particulars or that situation were somewhat rare, but as a matter of course, many sought-after earners can demand gross-ups.

What makes the Cohen gross-up so interesting is that it was part of his reimbursement for the hush money payments that he was making to deal with the Clifford and McDougal situations for Trump.  Either Cohen asked for, or the Trump Organization simply included as a matter of course, a larger payment in anticipation of the tax consequences for Cohen.

This provides evidence of "corrupt intent" on both sides of the transaction, because no matter who brought up the grossing-up question, no one could reasonably imagine that the explicit inclusion of a gross-up was somehow accidental.  More to the point, the gross-up also provides direct evidence that the payments to Cohen were not intended to be treated for tax purposes as normal business expenses, and that is a big deal.

Before I explain why, however, I want to emphasize a point out that I think John Oliver recently made, although I might not be remembering the source correctly.  That is, the $420,000 payment to Cohen was evidently to be made over a six-year period.  Question: What kind of billionaire weenies out hush-money payments on an installment basis?  Answer: Either a fake billionaire or one who decides to screw people over even as he is paying them for their loyalty.  It seems more likely to be the former, but in any case this kind of thing might be better evidence for the "Trump is not actually all that rich" theory than we would likely find on his tax returns.

But to return to what I described above as "a big deal," what would be the normal tax treatment of a payment made by a lawyer for which he is reimbursed by a client?  In an interesting piece late last week, Post columnist Catherine Rampell did a nice job of summarizing the story (and adding a few extra morsels about other Trump tax troubles).  The bottom line is that this smells very, very bad.

Why?  Imagine that a lawyer makes a payment on his client's behalf, and the client later reimburses him.  For example, the lawyer might have an account from which he pays the client's contractors (assuming that, unlike Trump, the client actually pays his contractors), and the client then makes the lawyer whole.

Not only is that arrangement fully legitimate, but it also makes the lawyer's participation irrelevant as an income tax matter.  Receiving $130,000 after paying $130,000 would simply mean that the lawyer was acting as a legitimate intermediary.  The lawyer would have no income to tax as a result of this situation.

What about the client's taxes?  If I run a business, and I (through my lawyer, but ultimately from my business's funds) hire a contractor to do business-related tasks for me, that is (absent special circumstances) an "ordinary and necessary expense" that I can deduct under section 162 of the Internal Revenue Code.  If, however, I make my lawyer whole for a payment that is not a legitimate business expense, then (even if I make the payment from a business account) there can be no deduction.

As Rampell points out, neither of the possible explanations for the payments to Clifford and McDougal -- that they amounted to illegal campaign contributions, or Trumpland's rationalization that they were paid to protect Trump's wife and children from embarrassment -- would qualify the payments as deductible business expenses.

Because Trump's taxes are still secret, we do not know whether Trump illegally deducted those payments.  What we do know is that Cohen was paid in the way that assumes that he is going to have to include the payments in his taxable income.  After all, if Cohen were simply doing what lawyers normally do, he would not have tax liabilities that need to be grossed up.  Saying, "Here, you pay the money to these two women, and we'll pay you enough to cover your taxes, too," is an outright admission that they wanted Cohen to treat the payments as his own income.

That, as I said, smells very, very bad.  If Trump actually took the tax deductions, that is a crime.

Trump's enablers, of course, are now claiming that none of these are "real crimes," even claiming that Cohen pleaded guilty to crimes that are not crimes.  Perhaps they are intuiting the classic distinction between "mala in se" and "mala prohibitum," which are the fancy criminal law terms used to distinguish crimes that are "simply wrong, and everyone knows it" (like murder) from crimes that are not obviously crimes but are prohibited as a matter of law (like, say, not allowing lawyers to commingle funds, or specific legal limits on campaign contributions).

During a presidential debate in 2016, Trump said that minimizing his taxes "makes me smart."  The most generous reading of that statement was that Trump was saying that he merely engaged in tax avoidance (legally minimizing his tax payments by taking advantage of all available legal provisions), not tax evasion.

If it turns out that Trump actually engaged in criminal tax evasion, I have no doubt that he and his people would call tax crimes merely mala prohibitum.  You know, crimes are not crimes merely because they are legally defined as crimes.  They are only crimes if we think they are serious enough to make us turn against Trump.

And we already know that there are no such crimes.  Republicans at long last seem to agree with Richard Nixon that it is not a crime if the president does it.  Heaven help us.

5 comments:

NFJ said...

Neil, only you can make taxes this sexy. I really enjoyed today's article. Moving forward in a post Trump political epoch do you think liberals should continue to play by the rules of transparency or should the next generations of liberals play by the new set of Republican rules? (Not releasing tax returns, refusal to divest in owned investments)

David Ricardo said...

This is an excellent post, and one can see how Mr. Buchanan does a great job in teaching tax.

There are a couple of points though that I think need clarification regarding the tax treatment of the $420,000 payment to Cohen to 'reimburse' him for the payment to Stormy Daniels.

1. The payment was made in 2017, which means that with the likely extensions the tax return that would have the payment has not been finalized yet. So it is unlikely illegal tax evasion has taken place, but only because the opportunity to do so has not yet occurred.

2. From published reports it appears the payments were made by the Trump organization and not Trump himself (despite his claims that "I paid him back".

3. So the tax treatment depends upon what type of organization, C Corp, S Corp, LP,GP, LLC with multiple members, LLC with a single member or Sched C business the entity is that made the payment.

4. Since as Mr. Buchanan pointed out the payment cannot have been a legitimate business expense it must be treated as a distribution to Mr. Trump. How that is treated is dependent on point 3 above.

So at the end of the day the Cohen payment, like much of Trump's financial manipulations are a mystery, because he will not make his finances public. Occam's Razor here, if you act guilty you are guilty.

Joe said...

The last comment highlights the importance of disclosure, sunlight as they say often the best disinfectant. One thing Congress could do is allow Trump to profit from his businesses even if foreign princes and the like are involved but require full disclosure of his finances.

The Foreign Emoluments Clause appears to leave open up such a rule.

The Domestic Emoluments Clause is more absolute: "The President shall, at stated Times, receive for his Services, a Compensation, which shall neither be increased nor diminished during the Period for which he shall have been elected, and he shall not receive within that Period any other Emolument from the United States, or any of them."

In general, congressional regulation of various things also provides room for disclosure requirements. Citizens United also upheld disclosure requirements.

Shag from Brookline said...

I'm not familiar with NYC and NY State income tax rates, but the gross-up would include such potential taxes.

Also, to what extent might criminal conspiracy federal and state laws come into play regarding federal, state and municipal tax laws? It is my understanding that a lawyer and a client are not immune from criminal conspiracy charges.

Neil H. Buchanan said...

Many thanks for the gratifying reactions and interesting comments by all. In response to NFJ’s question: “... [D]o you think liberals should continue to play by the rules of transparency or should the next generations of liberals play by the new set of Republican rules?” It is emphatically the case that transparency is both right and a winner politically. In fact, becoming the anti-corruption party might be Democrats’ most promising strategy. Thanks for the idea for a follow-up column.