Comments on Senate Finance Committee Paper on Anti-Deferral Accounting
Steve Wamhoff, Director for Federal Tax Policy, Institute on Taxation and Economic Policy
September 12, 2019
I appreciate the opportunity to comment on this paper describing anti-deferral accounting (ADA). The proposal seems like a good one in its overall direction. The proposal would sensibly target the very rich, those with incomes exceeding $1 million or assets exceeding $10 million over three consecutive years. Most of my comments are directed towards creating rules that apply widely with no or very few exceptions, that treat all types of assets the same way, and that treat taxpayers who have held an asset for a number of years the same way regardless of how exactly they dispose of that asset. I believe this approach would create the simplest and most efficient rules that prevent gaming and avoid distorting decision-making.
The Fewer Exceptions the Better
Of course, taxes are simpler and more efficient the fewer exceptions they have, meaning there are fewer opportunities for taxpayers to try to recharacterize income or assets to fit within exceptions. The paper describes several exceptions that could encourage wealthy taxpayers to do exactly that.
The first $2 million of value in a first and second personal residence, the first $5 million of value in family farms, and the first $3 million of value in tax-preferred savings accounts are exempt from the formula that determines whether or not someone is an applicable taxpayer (whether or not ADA applies to them generally).
The rationale for these exceptions is not clear. Simplification would be better achieved by using high overall thresholds for income and assets — which this proposal already does — and no exceptions for particular types of assets.
For applicable taxpayers with first and second personal residences or family farms, only the gains on value in excess of the thresholds are taxed on an ADA basis.
For tax-preferred savings accounts, the rule described in the paper is even more generous because they are never subject to ADA even if their value exceeds the $3 million threshold, which is only used to determine whether someone is an applicable taxpayer (whether someone is subject to ADA generally under the proposal).
A rule using high income and asset thresholds without exceptions would likely generate great public support because it would be easy for the public to understand. It would be very clear that it would not affect typical households. The rule proposed in the paper is that a taxpayer must have either income exceeding $1 million or assets exceeding $10 million for three consecutive years before ADA applies. The vast, vast majority of Americans are well aware that this would never apply to them.
Valuing Non-Tradable Assets for the Purposes of Determining Who Is an Applicable Taxpayer
The paper proposes to apply mark-to-market taxation to tradable assets, which is a viable approach because the value of these assets is readily determined. But for non-tradable assets the proposal allows taxpayers to continue to defer tax until realization, at which point a lookback rule would reduce the benefit of deferral. The point of treating non-tradable assets this way is to avoid the difficult valuations that would be necessary to truly mark them to market.
Some measure of value must be used for non-tradable assets in order to determine whether a taxpayer’s assets exceed the $10 million threshold and is, therefore, an applicable taxpayer (meaning ADA applies generally). But the measure used for this purpose can be relatively rough because it will not be used to calculate tax liability. The paper, therefore, sensibly lists several straightforward measures of an asset’s worth (such as the unadjusted basis, which is usually the purchase price paid by the taxpayer for the asset) and then proposes to use the greatest of those listed measures.
Repeal Existing Provisions that Reinforce the Benefit of Deferral
The paper asks for comments on how to coordinate this proposal with several existing provisions. Many of these provisions are clearly incompatible with the basic purpose of ADA. For example, like-kind exchanges allow gains on real estate to be deferred even more than gains on other types of assets by allowing investors to claim their property sale is simply a trade of similar properties that does not generate income.
The point of ADA is to remove the benefit of deferral, at least for the very wealthy. If, under ADA, like-kind exchanges continued to avoid treatment as a realization event, then investors would flock to them to avoid the intended effects of the proposal.
Several of the other provisions listed raise similar problems, like Opportunity Zones and the exclusion of gains on small business stock.
In many cases, the way to coordinate these provisions is to repeal them. ADA would probably be most effective and helpful if conceived as a major tax reform to simplify the tax system overall. Repealing provisions that compound the advantage of the deferral associated with capital gains would provide that simplification and would make the proposal more effective.
Gifts and Death Should Be Realization Events
ADA will work best if applicable taxpayers face the same consequences regardless of what they do with their assets. If a very wealthy person owns an asset for a given number of years, her ultimate position should be the same whether the asset is tradable or non-tradable, whether her ownership of the asset ended in a sale, a gift to a family member, a gift to charity, or a bequest. Under such rules, wealthy people would pay more taxes than they pay today, but the tax code would be neutral towards their decisions regarding how to invest and how to dispose of their assets.
Depending on how details are worked out, the proposal may strive to accomplish this for assets that are sold during the lifetime of the taxpayer. For example, imagine that two taxpayers both purchase an asset for the same purchase price. Both assets appreciate at the same rate for several years, and both are sold at the same time for the same price. One of those assets could be tradable, and the other could be non-tradable. If the proposal is structured well, both taxpayers would ultimately be in the same position. The tradable asset is taxed on a true mark-to-market basis throughout the holding period. The non-tradable asset is taxed only upon sale, but the lookback rule—if structured well—increases the income tax on the gain enough to put the second taxpayer in the same position as the first.
But ADA might break down if assets that are given to family, donated to charity, or passed to heirs are not treated the same way as assets that are sold. Applicable taxpayers would avoid the effects of the proposal. The rules would not be neutral towards investment decisions but would instead seem to favor non-tradable assets because it would be easier to avoid taxes by giving these assets away or leaving them to heirs.
The paper asks for comments on property transferred as a gift. Gifts should be treated as realization events. Applicable taxpayers should not be allowed to avoid ADA by simply giving assets to family members or others who are not applicable taxpayers. This is particularly important for non-tradable assets, because under this proposal, gains on these assets would still be deferred until a realization event, such as a sale of the asset. If sale of the asset is considered a realization event but gifting the asset is not, then applicable taxpayers will have a way to defer the tax, which defeats the purpose of ADA.
It may be sensible to treat gifts as realization events even when the donors are not applicable taxpayers under this proposal. Without such a rule, taxpayers who are nearing the asset threshold might give away both tradable and non-tradable assets to avoid being subject to ADA.
At a minimum, gifts should be treated as realization events for donors who are applicable taxpayers. Without such a rule, those who are already applicable taxpayers might give away non-tradable assets to avoid the taxation that would occur if they instead sold the asset. (This is less of an issue for tradable assets because applicable taxpayers would pay income tax on the gains on those assets annually until disposing of the asset.)
The paper asks for comments on the treatment of trusts. While trusts present complicated questions, part of the solution is to treat any contribution to a trust by an applicable taxpayer as a realization event, for the same reasons discussed above with regard to gifts.
Gifts to charity should also be realization events. The paper does not mention charitable giving. Current law already allows what is effectively a double deduction for capital gains on donated assets, and if not corrected, this problem would be compounded under ADA.
For example, under current law, if one taxpayer donates $20,000 of cash that she earned from work while another donates a $20,000 asset, both receive a deduction of $20,000. In the case of the donation of money that was earned, the taxpayer paid taxes on the income before donating it. But this is not necessarily true for the donated asset. The taxpayer may have spent only $10,000 to purchase the asset, assessed its value at $20,000 at the time it was donated and deducted the full $20,000.
This would no longer matter if the donation is treated as a realization event, meaning the $10,000 in appreciation will be taxed as a capital gain at the time the donation is made. Under such a rule, both taxpayers in this example would be treated the same because both would receive a deduction for donating what is effectively post-tax income. This would be even more important under ADA because wealthy taxpayers would have even more incentive to use any opportunity available to avoid taxes on capital gains.
The paper mentions that one of the special breaks for capital gains is the rule excluding gains on assets passed to heirs from taxable income. But the paper does not refer to this issue again. Death should be treated as a realization event, meaning gains on non-tradable assets would be taxed on the final tax return filed on behalf of the decedent. Without such a rule, the wealthy would have an incentive to hold onto assets for the rest of their lives even when that would not otherwise make sense economically. In other words, failure to tax gains at death in an ADA system would create an inefficient “lock-in” effect.
Rules Should Not Allow the Wealthy to Avoid Taxes by Manipulating Debt
The paper asks whether debt should reduce a taxpayer’s aggregate applicable assets to determine whether he is an applicable taxpayer under this proposal.
There is an argument for not considering debt at all for this purpose. The asset threshold is designed to identify taxpayers who are sufficiently sophisticated to bear the more complex reporting and rules that come with ADA. Anyone with $10 million in gross assets is likely to meet that description, even if they have debts that reduce their net worth to a lower amount.
If debt is allowed to reduce a taxpayer’s aggregate applicable assets to determine whether they exceed the threshold, then strict rules are needed to prevent abuses. For example, debt guaranteed by a third party should not be counted for this purpose. It would be too easy for taxpayers to arrange loans from related parties (even wealthy family members) who will almost certainly never demand payment and which pose no real risk to the taxpayer’s other assets.
Income tax on the gains accrued on non-tradable assets would still be deferred until the asset is disposed of but would be subject to a lookback rule to reduce the benefits of deferral. The most effective type of lookback rule would be based on the asset’s yield over the holding period, retrospectively imposing the tax that would have been paid had the asset been subject to true mark-to-market taxation. In other words, the best lookback rule would be one that places the owner of a non-tradable asset in the same position he would be in if the asset was a tradable one and therefore marked to market.
Probably no lookback rule can accomplish this perfectly and some amount of “rough justice” is necessary. For example, it may be necessary to assume that a non-tradable asset appreciated at a steady rate throughout its holding period, even if that is not always true.
But the goal nonetheless should be to place the owner of a non-tradable asset in the same position, to the extent possible, she would be in if the asset was tradable and therefore truly marked to market. Otherwise, the tax rules could make non-tradable assets more attractive than tradable ones, introducing distortions into investment decisions.
A lookback rule structured this way could avoid many problems. For example, the paper asks what rules are needed to prevent taxpayers from using C corporations (particularly privately held ones) to avoid the additional taxes imposed under this proposal. An individual could own a privately held C corporation that buys and sells non-tradable assets without being subject to the lookback rule that would apply if the individual had bought and sold those assets directly. The paper asks whether the C corporation itself should be subject to the proposal or whether more complicated anti-abuse rules are needed.
But none of that would matter if the lookback rule was strong enough to place the owners of non-tradable assets in the same position they would be in had their assets been tradable and marked to market. This would mean that the owner of a private C corporation in this example would eventually dispose of the corporation and be subject to the lookback rule that negates the benefits of deferring income tax on unrealized gains on assets held by the company.
When Individuals Are Applicable Taxpayers for Only Part of an Asset’s Holding Period
The paper asks how to treat non-tradable assets when the taxpayer was an applicable taxpayer for only part of the holding period. If the lookback rule retrospectively imposes tax that would have been paid under true mark-to-market taxation, then it could be relatively easy to impose that tax exclusively on the part of the holding period during which the taxpayer was an applicable taxpayer. If it is assumed that the asset appreciated at a steady rate throughout the holding period, a formula would apply the same charge to each year in the holding period, and the taxpayer would be liable only for charges for years when he was an applicable taxpayer.
Taxpayers Moving In and Out of the System
A perhaps even more important question is how to handle taxpayers who move in and out of the system frequently as their income and assets fluctuate. For example, consider a person who is an applicable taxpayer for decades and then, for some reason, his fortunes decline, and he no longer exceeds the asset threshold or income threshold. This must happen for three years before he is no longer an applicable taxpayer subject to ADA. During these three years he is probably happy to be subject to ADA because he likely has losses. Marking losses to market, or subjecting them to the lookback rule, increases the losses he can deduct (just as ADA increased the gains that were taxed during better times).
If he continues to remain below the asset and income thresholds for three years, he is no longer subject to ADA during the fourth year. What happens now? His position may have recovered and he may have non-tradable assets that never stopped appreciating. But he will not be an applicable taxpayer again for three years. If he sells assets now, would ADA not apply? Would this be true even if he was an applicable taxpayer for most of the time when he owned these assets? If so, a taxpayer who times the sale of assets in a particular way might avoid much of the intended impact of ADA.
One solution might be to impose the lookback rule in some cases even when a taxpayer no longer meets the definition of “applicable taxpayer” spelled out in the paper. For example, it might make sense to impose the lookback rule on the disposal of a non-tradable asset by a person who previously met that definition, if the majority of the holding period occurred when she was an applicable taxpayer. This could prevent taxpayers whose income and wealth hover right around the thresholds from gaming the rules.
A simpler solution might be to lengthen the number of years over which a person becomes or stops being an applicable taxpayer. The paper suggests three years – a person would be an applicable taxpayer if she exceeds the income or asset threshold for three consecutive years and she stops being an applicable taxpayer if she does not exceed either of those thresholds for three consecutive years. The rule could be increased from three years to a longer period of time, so that people are less likely to bounce in and out of the system frequently.
As with other parts of this proposal, the rules should be structured so that they reduce gaming that would allow wealthy people to avoid the proposal’s intended effects and avoid distorting investment decisions.