TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Friday, October 23, 2009

Tax Prof Presentations at Central States Law Schools Association Annual Conference

Here are the Tax Prof presentations at the two-day 2009 Central States Law Schools Association Annual Conference in Columbus, Ohio at Capital University School of Law:

For several years, a debate has swirled around the taxation of hedge fund managers’ compensation. Because it is structured as a type of partnership interest in the hedge fund, hedge fund managers may be eligible to pay taxes at lower capital gains rates on a large percentage of their income from the fund, which seems intuitively unfair. Until now, the debate has generally revolved around whether this compensation, called “carried interest,” is more like compensation, taxable at a 35% rate, or is more like an investment return, taxable at a 15% rate. And, because strong arguments support analogizing carried interest to both compensation and investment income, there is no clear resolution to the debate.

This Article argues that asking what carried interest most resembles is the wrong question. Instead, it asks whether the policy considerations employed to justify taxing capital gains at lower rates apply equally to carried interest. Because those policy considerations do not strongly support taxing carried interest at lower rates, it is not necessary to determine what carried interest most resembles. Moreover, taxing hedge fund managers’ receipt of carried interest using a simplified mark-to-market approach better solves the problems that weakly justify taxing carried interest at lower rates better than the lower rates solve the problems.

Mark-to-market taxation provides the best representation of economic income. Because of liquidity and valuation concerns, however, the tax law generally requires realization before imposing tax. Carried interest does not present these liquidity or valuation problems, however, and can and should be taxable on a mark-to-market basis.

During the Presidential administrations of William J. Clinton and George W. Bush changes in the political climate made politics increasingly visible in judicial appointments. Not surprisingly, politics were also very visible with respect to President Barack Obama’s first judicial appointments. Most of the public attention with regard to judicial appointments is focused on nominees to serve as judges on the Article III courts: the United States District Courts, United States Courts of Appeals, and the United States Supreme Court. However, other courts are affected by this trend, specifically, the courts created by legislative enactment pursuant to Article I of the Constitution, like the United States Tax Court.

As an Article I court, the Tax Court has a number of differences from Article III courts, including different the protections afforded to Tax Court judges following their appointment to the bench. Under current law, Tax Court judges are appointed by the President, with the advice and consent of the Senate to serve 15 year terms, and judges may be reappointed.

The majority of civil tax litigation goes through the Tax Court, and the Tax Court’s decisions play an important role in the economic life and health of all taxpayers. As a consequence, the effect of the Tax Court’s decisions is very far reaching. Thus, the appointments and reappointments to the Tax Court should be of great concern to all.

This Article explores the appointment of Tax Court judges and the reappointment of Tax Court judges. In exploring these issues, this Article focuses particularly on the processes historically used, and the impact that changes delays experienced during the two most recently past presidential administrations have had on the efficient and effective disposition of justice to taxpayers.

This Article concludes that a politicizing the selection of Tax Court judges, or the conditions under which a Tax Court judge will be reappointed, would weaken the legitimacy of the Tax Court, however, in this context, politics are only a symptom. Nonetheless, recent experience demonstrates that the appointment process is working well to ensure that Tax Court judges are well qualified, as demonstrated by the nomination and subsequent withdrawal of unqualified candidates during the Bush Administration. This Article also demonstrates that the reappointment process, as recent Administrations have used it, weakens the Tax Court by reducing the availability of experienced, established, well qualified Presidentially appointed Tax Court judges. A rebuttable presumption of timely reappointment should exist among sitting Tax Court judges who receive favorable ratings from the American Bar Association Section on Taxation Judicial Appointments Committee, can complete at least two-thirds of a full term without reaching the mandatory age for judicial retirement, and make a timely expression of willingness to be reappointed to the President, to remove political considerations that may override considerations of merit during the reappointment process. In instances where these presumptions are not satisfied, reappointment should remain entirely at the discretion of the President.

In an income tax system comporting with the Haig-Simons norm, deductible expenses would be deductible from all income regardless of source. For example, a taxpayer would be able to deduct investment expenses from business income or personal income, not just from investment income. A true Haig-Simons income tax system thus would not take the schedular approach of sorting different types of expenses and losses into distinct conceptual “baskets” containing corresponding types of income.

Practical realities often require departing from the Haig-Simons norm, however. The U.S. federal income tax system does require individuals to basket a number of types of expenses and losses. For example, individuals’ investment interest expense can only be deducted from net investment income. Similarly, individuals’ passive activity losses can only be deducted from passive income gains. These particular basketing requirements are anti-tax shelter devices; they prohibit “investment” expenses and losses from being deducted from income from other sources (such as the salary of a high-income doctor or lawyer).

Oddly, corporations taxed under Subchapter C of the Internal Revenue Code (Code) generally are not subject to many of the basketing restrictions that apply to individuals. Thus, corporations generally can deduct their passive investment expenses and losses from their active business income. That ability allowed infamous tax strategies such as the FLIP/OPIS basisshifting shelter and the CINS contingent installment sale shelter to be developed.

The article examines the concept of tax basketing and proposes extending the passive/active distinction that already exists for individuals to the domestic corporate context. If corporations’ passive-source expenses and losses were required to be basketed with their passive income (such as income from interest; dividends; and rents and royalties, other than those produced by an active business), most abusive tax shelters involving financial products would not work. Thus, if adopted, the proposal would limit the prospects of future cloned tax shelters.

The paper also discusses possible objections to the proposal, including the complexity entailed in separating corporations’ active business income and losses from passive income and losses. Multi-national corporations are already required to do that sorting for several purposes. For example, the Passive Foreign Investment Company (PFIC) regime requires identification of a foreign corporation’s passive and active income (and assets) in order to determine whether the corporation is a PFIC, which subjects U.S. shareholders to anti-deferral tax rules. The distinction made by this and other regimes that draw on the same definitional Code section could readily be extended to the domestic context. The proposal thus would impose the minimum additional costs needed to eliminate the effectiveness of the most common and costly type of corporate tax shelter activity.

The United States is one of the last remaining countries that use the joint return for tax filing; most other countries have adopted individual filing. In 1990, the United Kingdom transitioned from a tax system that required husbands and wives to file as a marital unit to one that requires individual filing, and so it has almost two decades experience with the new regime. Although the U.K. ought to be a natural example for the U.S. if the U.S. government decided to change its filing requirements, little research that is available to American scholars has been done on the British transition. Looking first at the origins of the mandatory joint return requirement, this paper will then examine the forces that drove the change to individual filing, the groups that advocated and opposed it, and, perhaps most importantly, the consequences of this shift in British law. Evaluating the change in the U.K., including the changed situation of wives and the potential for tax avoidance, this paper will then explore its implications as a model for the U.S. In doing so, it will use a comparative approach to assess the potential costs and benefits of changing tax units.

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