(Bloomberg View) The details of Donald Trump’s taxes are a bit of a mystery, even with the unauthorized release of a single tax return from 1995. Still, the evidence suggests that the real-estate magnate and presidential candidate may have used a staggering loss of $916 million to avoid paying income taxes for many years afterward.
As plenty of tax authorities have pointed out, this gambit is perfectly legal. The Internal Revenue Service calls it a “net operating loss carry-forward,” which can run as long as 20 years. (That includes a “carry-backward” provision that allows deductions of losses over two previous years.)
Trump’s use of this provision is certainly worth discussing. But it’s also worth contemplating where the idea of “carrying” losses came from in the first place. It’s a tangled tale indeed.
The U.S. didn’t get a modern income tax until the passage of the 16th Amendment to the Constitution gave Congress the power to tax incomes “from whatever source derived.” This paved the way for the Revenue Act of 1913, which hit select citizens and corporations with the new income tax.
Under the original Revenue Act, taxpayers who sustained a loss could use it to offset profits made in other ventures the same year. But they could not carry these losses forward or backward to offset taxes in more profitable years.
Then came World War I. The U.S. entered the conflict in 1917, and taxes went up to pay for the war effort. Congress instituted an “excess-profits tax,” which aimed to prevent profiteering from a national emergency. It remained in place when the war ended just a year later.
In the fall of 1918, Congress sought to reform the tax code to address simmering complaints about inequities inherited from the war. It was from these deliberations that the idea of time-traveling losses was born.
Here’s how a Senate Committee drafting the legislation framed the matter: “Taxes which can easily be borne amid the feverish activity and patriotic fervor of war times, are neither so welcome nor so easily sustained amid the uncertainties, the depreciating inventories, and the falling markets which are apt to mark the approach of peace.”
In testimony before Congress, business leaders echoed this assessment, claiming that the aggressive taxes on profits reported in 1917 and 1918 were unfair, given that the end of hostilities would saddle them with losses on inventories no longer needed for the war effort.
Reformers in Congress agreed. In a House of Representatives report drafted to accompany a new revenue bill, the legislation’s sponsors admitted that one of “the most important provisions inserted by the committee is quite new to our tax laws.” At that time, the committee noted, “no recognition is given to net losses.” Taxpayers who took a huge profit one year and a huge loss the next could not use the one to offset the other. This, the committee believed, “does not adequately recognize the exigencies of business, and, under our present high rates of taxation, may result in grave injustice.”
The end result was a bill that enabled individual and corporate taxpayers to carry losses backward or forward by one year. This aroused intense opposition from both Republicans and Democrats who argued that it subsidized bad business practices.
Republican Senator Irvine Lenroot of Wisconsin was especially vocal, arguing that it was unfair to “demand of a business which is properly run that it pay into the Treasury, while other businesses, mismanaged, are allowed to make up their losses and deprive the government of a just tax in doing it.” Lenroot suggested that the provision would benefit businesses built on ill-advised speculation.
In the end, these and other arguments failed and Congress instituted the first net-loss provision in the tax code. It was meant to deal with the aftermath of the war, but like many additions to the tax code, it proved difficult to dislodge.
In 1920, as the expiration of the net-loss carryover provision drew near, Congress enlarged it and made it permanent, enabling businesses to spread losses over three years. This was done against the backdrop of a painful recession. Robert Reed, president of the Investment Bankers Association of America, testified before Congress that carryover of net losses would “prevent the gross injustices that have resulted from the accidents of business and inventory profits and taxable periods.”
Congress agreed, and in 1921 a law permitting carryovers over a three-year period went into effect.
It’s worth noting that the ostensible reason for allowing the original carryovers—the excess-profits tax instituted during wartime— was repealed at this time as well. Rather imperceptibly, the rationale for carryovers had shifted. What had begun as a wartime exigency now became the basis for a new philosophy of taxation.
In 1932, Congress contemplated repealing the net-loss carryover provision, but resistance to the idea was strong. A congressional report on a revenue bill that year noted that this mechanism offered business “essential protection against excessive hardships inherent in a tax based on arbitrary annual accounting.” Nonetheless, Congress rolled back the carryover to a single year.
Then, in June 1933, Congress summoned J.P. Morgan Jr., son of U.S. history’s most famous financier, to testify before a Senate committee investigating causes of the 1929 stock market crash. While Wall Street was the focus, much of the inquiry focused on the banking scion’s taxes: Neither Morgan nor his partners had paid income taxes in 1931 and 1932, thanks to their ability to spread losses across multiple years.
The outrage was immediate, and in the fall of 1933, Congress eliminated loss carryovers as part of the New Deal’s signature legislation, the National Industrial Recovery Act. For the next five years, neither individual nor corporate taxpayers could offset profits with losses unless they were incurred in the same year.
As the New Deal lost its more radical edge, the carryover provisions crept back. Beginning in 1938 and then in subsequent revisions, individuals and businesses regained their ability to spread out losses over ever-greater lengths of time. By the time Trump took his alleged $916 million loss, he could offset his profits two years in the past and 18 years into the future.
Revelations of this entirely legal tactic has sparked the same kind of outrage that greeted Morgan back in 1933. Perhaps Congress, once the election is over, will once again revisit this little-understood bit of the tax code. Stranger things have happened.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners, or of Accounting Today.
