During the first week of teaching federal income tax I give a homework assignment where I ask students to compare the 2011 tax returns of Mitt Romney and Hillary Clinton. Students must decide who had the heavier tax burden. You can find these returns (and many more) on the Tax Analyst Tax History website. Here’s what we usually come up with in class:
||% of Total Inc.
||% of Taxable Inc.
My students are surprised by this result. Although they had similar total incomes, Romney and Clinton paid hugely different amounts and percentages of taxes no matter how you measure tax burden. But there is nothing nefarious about it. It simply reflects Congressional choice to tax capital gains at a lower rate than ordinary income.
To get the lower tax rate the gain must come from a sale or exchange of something called a “capital asset” that has been held for more than one year. Romney’s income came mostly from sales or exchanges of capital assets while Clinton’s came mostly from her labor. That difference in source made the difference in tax. Whatever one thinks about Clinton’s speaking fees, they still resulted from her labor and so were taxed at significantly higher rates than Romney’s capital gain income, even though dollars derived from labor have the same purchasing power as dollars derived from capital.
This preferential tax treatment for capital gains over labor income is a subsidy whereby Congress shifts dollars from one set of taxpayers (those like Clinton) to another set of taxpayers (those like Romney). It’s a subsidy just like the Earned Income Tax Credit (EITC) except that the EITC shifts dollars from higher earning taxpayers to lower earning taxpayers. So who does Uncle Sugar love more? Why, folks like Romney!! In 2016 the federal government spent about $106 billion to subsidize taxpayers who, like Romney, received income from capital sales or exchanges. In comparison, it spent $63 billion on the EITC subsidy. You can see these figures in the JCT’s latest Estimates of Federal Tax Expenditures.
Congress does put some restrictions on this rate subsidy. For example, §1211 generally prevents taxpayers from deducting capital losses against ordinary income. After all, if a gain from the sale or exchange of a capital asset gets a lower rate, then a resulting loss should not be able to shelter otherwise higher taxed gain but only similarly taxed gains.
So when taxpayers have gain from the sale of some kind of property held for more than one year, they really want that lower tax rate. They want their gains to be from the sale of a capital asset. Contrariwise, when taxpayers have losses from the sale of some kind of property, taxpayers would really like to deduct those losses from their ordinary income, the kind that gets taxed at a higher rate. They want those losses to be from the same of property that is not a capital asset.
So what the heck is a “capital asset”? That is the lesson in Sugar Land Ranch Development, LLC, Sugar Land Advisors, LLC, Tax Matters Partner v. Commissioner, T.C. Memo 2018-21 (February 22, 2018). There, the taxpayers were able to transform properties that did not qualify as capital assets before 2008 into properties that did qualify as capital assets when they sold the properties for a net gain in 2012. So they got the rate subsidy. How’d they do that? Details below the fold, along with the Tax Lawyer’s Wedding Toast.
March 5, 2018 in Bryan Camp, New Cases, Tax | Permalink
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