Fairness, Exceptions, and Exceptional Unfairness

-- Posted by Neil H. Buchanan

Two weeks ago, in "You Can Make a Billion Dollars and Never Pay Taxes!!" I endorsed the so-called Zuckerberg Tax. The idea behind that tax is to end a well-hidden tax benefit (a benefit that overwhelmingly helps the wealthy) that delays -- and in many cases ultimately eliminates -- taxation on gains from holding property. The idea for this tax was floated in response to news that Mark Zuckerberg, the founder of FaceBook, will pay tax on only $5 billion of the $28 billion in wealth that he has accumulated in his firm, which is becoming a publicly-traded company.

Moreover, the only reason that Zuckerberg is even paying taxes on the $5 billion is because he is choosing to do so. That is, he would be able, if he wanted, not to sell any of his shares in FaceBook; and because we only tax the income from appreciated property when it is "realized" (that is, when the property is sold, leaving aside some irrelevant complications), this would allow him to shield all of his wealth from taxation for as long as he chose. And if he died without selling his shares, the gains would never be taxed as income at all, because his heirs would able to sell any appreciated shares without incurring income tax liability of their own.

My discussion in the previous post focused on the disjuncture between the original arguments for adopting this realization requirement and the situation of someone like Mr. Zuckerberg. Comparing his situation to the classic Macomber case that appears in all of the tax law casebooks, I noted that people whose property consists of publicly-traded stocks are especially bad exemplars of people who need the protection of the realization requirement: (1) Their property (unlike, say, a remote cabin, or a rarely-traded antiquity) is very easy to value, because up-to-the-minute price updates are available for stocks traded on the New York Stock Exchange and similar stock markets, (2) It would be easy for the holder of several million shares of a NYSE-listed stock to sell a fraction of those shares, if necessary, to pay her tax bill, and (3) It is relatively easy to set up a system in which losses on traded stocks can result in tax refunds, just as increases in the values of stocks should result in tax liability.

As so often happens on Dorf on Law, the comment board brought useful comments from some readers. One reader's comments were almost entirely supportive, either agreeing directly with what I had written or offering what amount to "friendly amendments" to my analysis (describing , for example, the practical reasons that other types of property should continue to be taxed only upon realization). He or she did, however, raise one issue that I thought I might discuss here. The second comment was from a current law student who said that he did not see the inequity in the realization requirement, noting that non-rich people can take out home equity loans (just as rich people can borrow against the value of their appreciated shares of stock). The question then arises: If the benefits of realization are available to rich and non-rich alike, where is the unfairness? And besides, the commenter noted, Zuckerberg is paying a lot of money in tax, anyway.

The first commenter wrote: "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." This observation captures the idea that a large enough holder of a company's stock could inadvertently push down the price of the stock by dumping too many shares on the market at once. Surely, Zuckerberg could not really raise $28 billion in cash tomorrow by selling all of his shares! This is why securities laws prevent large cash-outs in most cases, forcing holders of large chunks of a company's shares who wish to liquidate their holdings to do so in an orderly fashion.

Although all of this is true, it is not fatal to the proposed Zuckerberg Tax. It is, after all, not going to apply to someone like Mrs. Macomber, who held several hundred thousand dollars worth of shares ($10 million or so in today's dollars) in Standard Oil of California -- a tiny fraction of the overall value of the company. Even if she had liquidated all of her shares, the needle on the stock would have barely moved. For most people subject to a Zuckerberg Tax -- that is, a tax on the unrealized appreciated value of shares of publicly-traded companies -- that will be true. Even large holders of shares of stock will generally not be large enough to move the market. In that case, it really is true that they could sell their shares for the current market price, today. (Moreover, the tax owed will be much less than the value of the shares, making a complete cash-out unnecessary.)

For the rare (or even not-so-rare) cases of actual Zuckerbergs, who hold market-moving fractions of a company's shares, we could simply track the Zuckerberg Tax to the rules on how many shares could legally be sold in a given year. The taxpayer's basis in those shares could then rise, and the process could repeat each year as needed, until all income has been taxed. Yes, this is a bit more complicated, but it is child's play compared to most of the issues raised on the tax returns of such taxpayers.

(And it is certainly better, as the commenter notes, than trying to figure out how to tax loan proceeds when a person borrows against her shares. We are not trying to tax loan proceeds, after all. We are simply pointing out that the taxpayer is able to enjoy the benefits of her gains, even without cashing out. We are taxing income, not cash-flow. People like Macomber receive economic benefit from both realized and unrealized income.)

The second commenter, by contrast, wondered about the basic equity question. Fairness is a subjective matter, but that does not mean that we cannot discuss it, to find common ground.

It is true that Zuckerberg will pay more in tax on his $5 billion realization than most of us combined will ever pay. As a matter of equity, however, that strikes me as simply not the point. He has become $28 billion richer, and (by his choice) he is paying perhaps $2 billion in taxes on his $5 billion realization. That is a 7.14% tax rate. This makes Mitt Romney and Warren Buffett look heavily taxed! (Romney and Buffett, themselves, of course, have much lower tax rates than advertised, for exactly this reason. Both, like Zuckerberg, are sitting on huge unrealized gains.)

More to the point, Zuckerberg will have $3 billion left in cash, which is also more after-tax money than the rest of us combined are likely ever to see, to say nothing of the $23 billion that he is sitting on. If tax fairness means anything, I think it means that if people who earn $70,000 in salary every year have to pay taxes on that income in the year earned, then people who receive $700,000 or $700 million in gain on their stocks and bonds should have to pay taxes on that income in that year as well.

The more interesting question is embedded in the second commenter's observation that middle-class people can borrow against the value of their homes, and those funds are not taxed. This raises the question of why I think it is so unfair to allow the Macombers and Zuckerbergs of the world not to pay tax on gains against which they, too, can borrow. (I will set aside for now the fact that there are many people in the country who have no home against which to borrow, either because they do not own their own home, or they are underwater, or they cannot qualify for a home-equity loan. The people who can get home-equity loans are not Zuckerbergs, of course, but they are among the more fortunate in our society.)

This is a fascinating observation, because it demonstrates the danger of granting exceptions to any general rule. The reason that there is an issue here at all is that we have carved out the realization requirement as an exception to the fundamental premise of an annual income tax, which is that all income earned in a year is taxable in that year. That requirement, as noted above, is based essentially on the non-marketability (and indivisibility) of things like one's home. It is one thing to tell Myrtle Macomber to sell a few shares of SoCal stock; it is another to tell a homeowner to sell her house to pay income tax on the appreciated value of that house!

Once the exception (increases in the value of a home are not taxable, now or -- in most cases -- ever) is in place, then other people want to get in on it. Noticing that some homeowners can take out home-equity lines, the Macombers say, "That makes them no different from me. And if they don't deserve to be taxed until realization, neither do I!" This is simply, therefore, yet another example of the problem with defining what it means to be similarly situated.

As a matter of fairness, I think the much more relevant comparison group for Macombers and Zuckerbergs is wage and salary earners, who pay taxes when they earn income, than homeowners who take home equity loans. It is true that we could also exempt wage and salary earners from paying taxes until several years after the money was earned, but all that does is wipe out your tax base. If we are going to grant exceptions, therefore, we have to remember why we created the exceptions in the first place. The realization requirement has a good policy justification when applied to the single-family home. That is an exception to the general rule. It should not open the floodgates to grant exceptions to people who are really nothing like Joe and Jane Homeowner.

As a matter of equity, I doubt that most people would feel that Macomber or Zuckerberg were being cheated, simply because they had to pay taxes on their income from owning shares of stock, while owners of homes were granted the right to wait to pay income tax on the increased values of their homes. Again, notions of fairness can differ. Still, if we are to cabin exceptions as carefully as possible, we cannot allow the exceptions to justify their own expansion.