Missing Billions? Potential Problems Of Omitting Tax Expenditures

Robert Goulder of Tax Notes and Don Susswein, Tony Coughlan, and Kyle Brown of RSM US LLP discuss the exclusion of deferred capital gains as tax expenditures and why it could be a problem.

This transcript has been edited for length and clarity.

Robert Goulder: Hello, I’m Bob Goulder, a contributing editor with Tax Notes. Welcome to the latest edition of In the Pages, where we take a closer look at some of the commentary from our print and online publications.

Our featured article for the month looks at the thorny issue of economic subsidies embedded in the tax code. And yes, my goodness, there are a lot of them there to be found. So we are talking about tax expenditures — which provisions in the tax code represent a deviation from a normative income tax and which are just part of a normal and fair standardized tax base? It’s really hard to answer those questions. There can be a subjective element to the determinations, and frankly, some of the nation’s leading tax experts for generations have struggled over this and come to different conclusions.

You might say the tax expenditure analysis is a little bit like beauty in that the answer lies in the eyes of the beholder. Well, fortunately, we have some pretty astute sets of eyes to help guide us through this process. The featured article is titled “Are We Missing Billions in Hidden Corporate Tax Subsidies?” and the authors are Don Susswein, Kyle Brown, and Tony Coughlan, all of whom are with the Washington National Tax office of RSM US. We’re delighted to have all three of the authors on the program.

Don, Kyle, and Tony, welcome to In the Pages.

Don Susswein: Thank you, Robert.

Kyle Brown: Thank you.

J. Anthony Coughlan: Thank you.

Robert Goulder: So I really enjoyed this article. You mentioned the concept of a tax expenditure budget and then you invoke it to help address this question that is implied by the title of your article, are we missing billions in subsidies? My first question concerns the definition of what is a tax expenditure and why we should pay attention. Why is this so important?

Don Susswein: Well, Bob, that’s a great place to start. And I will say that when we chose the title “billions,” we did have several other options. We were thinking gazillions or something larger, but billions seem to be about right without being accused of exaggeration.

As far as the definition is concerned, we actually were very surprised because, like you, we’re aware of the long-standing academic disputes about what does it mean? Is it subjective? What’s a normal tax? And when we took a close look at [it] — for reasons which we’ll get into — we were very surprised that it’s not unclear at all. The definition is very, very clear. There are some issues about whether tax rates should be considered tax expenditures or foreign issues. Those are kind of complicated. But if it comes to the basic definition of what’s in and what’s out, there is a very, very crystal clear standard.

And the Joint Committee on Taxation and Treasury since around ’90s — in the early days it wasn’t unclear — but by the ’90s, they had decided that it’s Haig-Simons income, very traditional academic concept, except for what they said were items very, very infeasible to tax, difficult or infeasible to tax, like unrealized capital gains was one and imputed income on owner-occupied housing. And they just said, “Well, that’s just impossible. We’re never going to be able to tax either of those, so let’s not bother.” But everything else, any other deviation from that standard, is supposed to be listed.

And we then saw that they had a specific example. The Joint Committee in particular, they said, “For example, we don’t treat an unrealized gain as income or as a deviation from the rule if we don’t tax it. But any deferral of tax after the gain has been realized is a tax expenditure.” You don’t get much more of a direct statement than that. And so we thought the definition was very, very objective.

The problem we saw, and we were quite surprised, is that we — Kyle and I work in the partnership area, so we work in [section] 721, but most tax practitioners work mostly with [sections] 351 and 368, reorgs. And we said, “Where are the reorganization provisions?” By definition, those provisions are there to defer the realization, the recognition, not the realization, of realized gains. My God, we were very surprised. So that’s where this all began.

As to why it’s important, let me ask Tony. Tony, I was on the Hill many years ago. Tony was on the Senate Finance Committee staff much more recently, worked on the 2017 [Tax Cuts and Jobs] Act very intensely. And maybe, Tony, you can tell us from the standpoint of a recent émigré from Capitol Hill, why it matters. Does it matter?

J. Anthony Coughlan: Sure, it matters a lot. It’s something that tax staffers, congressional tax staffers, look at the list of tax expenditures a lot when trying to reflect on how the code perhaps should change. Or if we want to pull down tax rates, well, how are we going to pay for that? Certainly, a first spot to look is going to be the list of tax expenditures that come out from the JCT — also from the Treasury, but congressional staffers are more likely to look at the JCT list.

So it’s a really big deal in that that’s where we look. That’s where congressional tax staffers are going to look in large part in reflecting on these issues. And it’s kind of a list of, “Maybe these are things we should get rid of, or at least reflect on that.”

Robert Goulder: Kyle, anything to add to that?

Kyle Brown: No, I mean, I think everybody’s pretty much nailed it. I agree. When Don and I looked at the definition originally and looked at the example that was provided, it seemed pretty clear that there was something missing when you applied that what seemed to be [a] fairly objective definition to these nonrecognition provisions. And that just sparks some question as to number one, why they’re not there and maybe what that entails and why that would matter.

Robert Goulder: I want to take a look here at section 368, and whenever something comes up, I think back to my time in the LLM program and the professors putting it all up on the board, and you’re thinking, “This is just magic,” because you have what is really a realized gain, but we’re not recognizing it. The gain is preserved through basis adjustments and so forth. But it is a gain; we’re just not recognizing it. It’s sort of like tax magic. Should [section] 368 be off-limits?

Don Susswein: No, but I wouldn’t necessarily say that they shouldn’t. We’re not suggesting — first of all, we have no problem policywise with any of these provisions. We’re not taking a position on that, and I’m certainly not suggesting that the Congressional Budget Office’s next options pamphlet includes [section] 368 or 351 or whatever. But if you’re engaging people in thought about tax policy, it’s very, very important that you see what the tax policy is so that, for example, and this is really — in the original tax expenditure budget, I mean [Stanley S.] Surrey’s original, we haven’t actually found them, but we’ve seen secondary sources and things like that.

And the Joint Committee in ’74 says, “Well, we’re listing anything. The first budget, anything that anybody in the world had ever called a tax expenditure, we’re putting it on the list.” They didn’t want to choose favorites. And these were not on the list. And that was one of the things Boris Bittker made a big deal about in his commentary. He says, “Well, how did you decide not to put this in? What did you say you like it?” He was very critical of Surrey.

But the other thing that wasn’t on there was like-kind exchanges. And like-kind exchanges are very similar. There’s no business entity, but it’s as you say, it’s tax magic. You’ve swapped one piece of property, real estate now, for another. You’re holding something totally different, and you don’t have to pay tax. You don’t get step-up, but you don’t have to pay tax. Well, in fact, [section] 1031 was the origin of [section] 351. [Section] 1031 came first in the ’20s or something, and then they said, “Well, we’re going to break off.” It was the grandfather, or the grandmother, of all the rest of them.

And so if somebody says, “Well, gee, I think [section] 1031 is a special tax provision because it is tax magic,” as you said. The logical question is, well, what’s different about Steve Jobs taking Apple Computer public or whatever or merging into IBM? He didn’t merge into IBM. Or Google is a better example. What’s different about YouTube merging into Google? If YouTube had a Chicago office building and they swapped it for a New York office building, we’d say, “Oh, that’s a tax expenditure.” But if the whole company gets merged into Google for Google stock, “Eh, it’s OK.” It just doesn’t make sense.

I mean, Kyle, I think your feeling throughout this — Tony and I are probably more into the policy, but I think you have some feelings about just the notion of consistency, which is important.

Kyle Brown: Absolutely. Consistency in the application of the rule I think is really key. If you have consistent application, then I think you can use it to measure various things, which I think in some cases is what the tax expenditure budget does. And if you have, as Don mentioned, a provision that operates almost identically to another and one is on the list and the other’s off, both arguably meet the definition to be on the list, then you wind up with what seems like an inconsistent application of the rule. And anytime you have inconsistency, at least for me, it makes application, or it makes the use of that particular tool, to be more difficult, turns it into something maybe more subjective and not as objective.

And I think that was a big piece. And something that you had mentioned earlier, I think when you first posed the question as well, was that I think part of what makes all of this so surprising is that the nonrecognition provisions seem to be so fundamental to everybody’s thinking about how the code works, that they’re not really viewed potentially as an exception to the rule. They’re more viewed as the rule.

But the reality I think is indeed all of them are exceptions. It’s just that they’re so prevalent and long-standing that perhaps the viewpoint is that, well, they’re not really exceptions to the rule, they are the rule. So over time, perhaps that’s become the rule.

And that to me was one of the things that made this discussion so interesting and kind of this thought so surprising was that it seemed like the viewpoint in a lot of cases was that the exception potentially had become the rule or become the norm. And to suggest that “well, perhaps no, we have to continue to view those as exceptions” was a little bit surprising. But maybe that explains why some of this can be as surprising as it is or why people would think, “Well, I’m not sure why that would be so different than the normal income tax.” That exception has maybe become the norm over time.

Robert Goulder: Yeah, very well said. And you get a sense of that, reading your article and going through your hypotheticals. There’s this portion in the middle of the article where you have, I think, seven hypotheticals in all. And we don’t have time in this episode to go through all of them, but you’re talking about special deferral rules and this idea of a reinvested capital gain. Is that philosophically a legitimate basis for saying, “We’re not going to tax this now. We’re going to wait and tax it later depending on what happens because it’s being reinvested.” And is that a fair outcome? I mean, what do you see as the takeaway from those seven hypotheticals that you had in the piece?

Don Susswein: Well, once again, Bob, I hate to say it and I hate to contradict Kyle, fairness has nothing to do with it. It certainly has nothing to do with what we’re talking about. Consistency, yes. But the point — we were shocked actually. We weren’t just shocked when we saw the omission. And we couldn’t believe our eyes. I mean, we can’t tell you who we spoke to, but we asked a number of people and said, “Are we missing something? Is it there? Is it hidden some place? Is there some footnote?” And nobody could find it.

The point is it’s an issue. And you could argue that “no, there should be no savings incentives; there should be no deferral,” or you could argue that “it’s fine; it’s a wonderful thing.” What we were surprised at, and look, I don’t practice in the subsidy area. I think neither did Kyle, neither did Tony. And I have the highest respect. That is a very, very complicated area. Billions of dollars, gazillions. The guys and gals who can work their way through those provisions deserve an award in my opinion.

However, if it’s a simple case, this is the insight that we drew at it — if it’s just the case where you’re selling your company and you’re not going to cash out and the buyer truly wants your company and they’re not going to sell it in two years — if it’s a simple case, this is as easy as pie. The norm is tax deferral. That’s not the exception. That’s the point that we came away. It is amazingly simple. And when we created those seven examples, I think a lot of practitioners are going to be surprised, maybe not if they play in the field, but because they’re always focusing on the quirky case, the exception. “Well, we have this special subsidiary over here and we have three Jamaican entities over there, and we’ve got a little [earnings and profits] problem,” or whatever.

And they’re wonderful, and they’re great at what they do, but if you take it down to its bare essential, I mean, nobody said this to me in tax class. I remember taking tax class in law school, and this was very complicated. But Bittker and [Marvin] Chirelstein both, they said, “It’s really very simple. Is it a sale or is it not a sale?” Whatever. But the point is it is incredibly easy to defer. That’s what was the takeaway. Not that it’s good or bad — other people are going to have to make that decision — but we’re just saying it’s blatant, it’s obvious, it’s normal. It’s not an exception. How can you say that the norm is something that’s the general rule? It’s a contradiction of the English language. The norm is deferral.

Robert Goulder: Tony, anything to add there?

J. Anthony Coughlan: Well, Bob, you said a few minutes ago, you said, “Well, should [section] 368 be off-limits?” I mean, we’re just saying, I think the big message we have is if part of the definition of tax expenditure is, “Well, if there’s a realization, but deferral of recognition, that qualifies as a tax expenditure.” Well, [section] 368 is an enormous case of exactly that. So we’re not proposing legislation in that area. We’re saying it seems like it fits the definition. So it either ought to be on the list or somehow the definition, there’s something that we need to reflect on about the definition.

Robert Goulder: Well, I’m glad you brought up the subject of unrealized gains because, of course, that has been in the news these days. You’ve got the [Biden] administration talking about a billionaire income tax and so forth. Could you have a wealth tax? Could you base it on some sort of a mark-to-market mechanism?

What you’ve done in your article can help us think about the propriety of that kind of a proposal. And this is a quote I’d like to mention from your article, you write as follows: “If the government’s top tax experts believe that it’s perfectly normal not to tax a realized gain because it’s reinvested, then it’s hard to see any policy case for changing the treatment of unrealized gains where the built-in gain never leaves the business entity, not even for a moment.”

So I mean, that’s a great observation. Should we even be talking about taxing unrealized gains if we’re saying we’re not even going to tax the ones that are realized?

Don Susswein: I think what we’re getting at is the following. If you look at it from a tax policy view, the way an economist or a tax economist ought to look at it, I think, you’re asking the question that the White House is asking, which is, “What is income?” And if somebody invests in a corporation or a partnership or anything else and they hold it for 30 years and they pay tax in the meantime on all the income in between, taking a snapshot of what it was worth to the market on one day, that doesn’t make any sense. Realization is a great technical rule for having a tax system, but for analyzing economics, doesn’t mean anything.

And what the Joint Committee and others who — first of all, it’s possible they’ll just read our article; first of all, it’s possible they’ll ignore it, but it’s possible they’ll read it and say, “Well, thank you for bringing this to our attention. We’re going to add those provisions.” But if they don’t, we think that some people are saying it doesn’t feel like a tax expenditure. It doesn’t feel like it’s altering the lifelong income of the investor. And that’s the question.

Taking into account not just one snapshot, but the entire 30-year or 10-year, whatever the holding period is. What if it goes down in value? What if it goes up in value? We use the example of Apple. Apple had an IPO; they were worth $1.8 billion. Steve Jobs became an instant megamillionaire. He didn’t have very much cash, but on paper, adjusted for inflation, he had $2 billion, then it was a little bit less. But guess what? Apple went bankrupt in 1997 or just about, became worthless. And I was looking at the dividend history. I don’t think they paid much in dividends. All of that gain, that just disappeared.

So to say, “Oh, he should have paid a $100 million tax when they took the IPO public.” Yeah. But it was nothing. It was at nothing. And I think that’s part of what somebody may be thinking when they say, “Well, they’re realization events, but not really because the guy didn’t really get the cash and spend it. He kept it. He changed the company a little bit. You know, YouTube merging into Google, it stayed in the business or in a business.” And if that’s the philosophy, then obviously you’re right, Bob, it applies to unrealized and realized alike.

Robert Goulder: Kyle, anything to add on that last issue we talked about?

Kyle Brown: Yeah, to me it’s all about consistency, as Don mentioned. You could have a policy that does or does not tax unrealized gain. That’s outside the purview of a tax question. But if you’re going to pursue that kind of policy, then it seems that you would want to address all of the arguments associated with making that policy. And obviously one of them is going to be, well, if you pursue that to tax unrealized gains, then you have to discuss the argument that, well, even realized gains in a lot of cases aren’t taxed.

So what’s the jump? How do you get from that argument to a final proposal or final policy argument going through the fact that you still have realized gains that are untaxed? And it’s not to say it can’t be done or that it’s one way or the other, but if you’re going to craft an argument and go down that road, then I think you do have to acknowledge all of the various aspects. And one of the big things to acknowledge to me is that realized gains in some cases aren’t even afforded the same treatment that would be afforded to, afforded is the wrong word, but subject to attacks on unrealized gains.

So I think you have to deconflict. If it’s a policy choice, then you have to be able to deconflict that policy choice with other policy choices that are being made. And there may be a valid way to deconflict it, but it’s something I think that you still have to bring up and still has to be discussed and deconflicted.

Robert Goulder: That is it for now. Again, the title of the article is “Are We Missing Billions in Hidden Corporate Tax Subsidies?” The three authors are Don Susswein, Kyle Brown, and Tony Coughlan, all with the Washington National Tax office of RSM US. Gentlemen, thank you for being on In the Pages.

Don Susswein: Thank you, Robert.

J. Anthony Coughlan: Thanks for having us, Bob.