There are numerous laws that prohibit and punish behavior the government seeks to prevent. However, recent legal and economic scholarship has recognized that an important alternative mechanism the government can use to prevent or reduce certain behavior is “structural” systems. The federal tax system already uses structural mechanisms to reduce tax evasion and thus foster compliance. The well-known structural mechanisms of withholding and information reporting constrain payment with respect to many people’s major sources of income, including wages and salaries. They do so by making use of third parties to the taxpayergovernment relationship. The success of these mechanisms explains, in no small part, the standard economic puzzle of why people pay taxes.
The use of structural systems to reduce tax evasion need not be limited to tax administration, however. The thesis of this article is that substantive federal income tax law can—and in many contexts does—rely on the structural incentives of third parties to foster compliance. Although this phenomenon apparently has gone unnoticed, third parties are routinely implicitly used by the government to verify, for tax purposes, the bona fides of the taxpayer’s claim in diverse contexts involving reimbursed amounts or other receipts. That is, amounts that, in effect, have been vouched for by a third party are excludible, while the deduction of unverified amounts is restricted. Specific contexts in which third party involvement results in more favorable tax treatment include reimbursed employee business expenses, medical expense reimbursements from “flexible spending accounts,” damages payments by tortfeasors to victims of physical personal injuries, and certain payments from negligent tax-preparers. The insight that third parties play an important verification function helps explain an otherwise puzzling lack of parallelism in the tax law—the fact that many economically equivalent expenses or losses receive a tax benefit only when reimbursed.
Third parties do not always behave in ways that are helpful for the federal fisc, however. They certainly can also facilitate tax avoidance or evasion, as the phenomenon of corporate tax shelters vividly demonstrates. To use third parties successfully, the government therefore must distinguish between situations in which, by virtue of the structural context, third parties have the incentive to act as verifiers or enforcers, and those in which their structural incentive is complicity in tax avoidance. To do so requires identification of situations in which the third party’s incentive is to act independently from the taxpayer. Situations in which the third party is related to the taxpayer; has a relationship with the taxpayer outside of the transaction; is taxindifferent, either in the transaction or more generally; or is playing two roles in the transaction are all situations in which the third party does not have the structural incentive to act completely at arm’s length. Those contexts, accordingly, are ones that the government needs to scrutinize. In other contexts, the government can afford to free ride on the incentives of the third party, which, by protecting its own interests, will implicitly be acting to protect the federal fisc.