A roadmap to certain perceived “loopholes” in the Tax Code may be considered currently available through a bit of reverse engineering. Specifically, a review of the Treasury Department’s “General Explanations of the Administration’s Fiscal Year 2017 Revenue Proposals” (this year’s so-called “Green Book”) points to certain tax advantages that are considered loopholes and, therefore, implicitly, are considered currently available (or at least open to interpretation).
Any particular “loophole closer” may, of course, be in the eyes of the beholder. As a result, the use of any identified “loophole” by Congress, either as a revenue offset or directly in legislation to close a particular abuse, remains speculative. It should also be noted that many of the “loopholes” mentioned in the current Green Book have been mentioned in past budgets. In any event, any provision that does pass likely will do so with only prospective application.
This year’s Green Book carves out an entire section for “Loophole Closers.” In the aggregate, they are projected to cost the government almost $2.2 billion in 2017 if not closed.
- Accrued market discount. Market discount generated by a change in interest rates, or by a decrease in an issuer’s creditworthiness, is similar to original issue discount. However, unlike OID, taxpayers are not required to take accrued market discount into income currently, as with OID.
- “Specific identification” method in disposing of stock. Investors remain able, in the words of the Green Book, to “manipulate” the gain or loss recognized on the disposition of stock by choosing among identical shares of stock with different cost bases. The proposal would require the use of average basis for all identical shares held by a taxpayer that have a long-term holding period.
- Carried interest. Carried interest may be structured under current law to avoid ordinary income for services. Certain partners may receive partnership interests, typically interests in future profits (“profits interests” or “carried interests”), in exchange for services. If and to the extent a partnership recognizes long-term capital gain, the partners, including partners who provide services, reflect their shares of long-term gain as long-term capital gain. They may also avoid self-employment taxes on that income. Under various proposals, a service provider’s share of the income of a partnership attributable to a carried interest would be taxed as ordinary income and subject to self-employment tax under the argument that such income is derived from the performance of services.
- IRAs beneficiaries. For non-spouse beneficiaries and heirs, the administration proposes minimum distributions to be based on a five-year payout. This would prevent a current situation under which some much younger, non-spouse beneficiaries are enjoying tax-favored accumulation of earnings over long periods of time.
- Accrual of tax-favored retirement benefits. The administration believes that tighter restrictions on retirement contributions and benefits need to be imposed on accumulating large amounts of wealth, far in excess of retirement needs, through the use of multiple plans. It proposes a limit on current contributions by taxpayers who have already accumulated “very large amounts” within the tax-favored retirement system.
Avoidance of NII and employment taxes. The Net Investment Income Tax and the Self-Employment Contributions Act Tax treat active owners of pass-through businesses differently according to the legal form of their ownership and the legal form of the payment that they receive. Under certain structures currently in play, the distributive shares of S corporation owner-employees and similar payments to certain LLC members and limited partners avoid employment taxes and may also not be subject to the NII Tax.
The administration proposes to revise the definition of net investment income to include gross income and gain from any trades or businesses of an individual that is not otherwise subject to employment taxes. Among other things, it would also subject to employment taxes limited partners and members of LLCs or other entities taxed as partnerships who materially participate in their firms but who claim the limited partner exclusion from SECA. It would include all nonwage earnings of high-income S corporation owner-employees, as well as sales of business property by active partners and S corporation shareholders.
- Limitations on Roth conversions. Some taxpayers who are not eligible to make contributions to Roth IRAs because their modified AGI exceeds the limit for such contributions have indirectly made contributions to a Roth IRA by making nondeductible contributions to a traditional IRA and then converting the traditional IRA to a Roth IRA. The administration proposes that the Roth conversion be effective only to the extent a distribution of those amounts would be includable in income if they were not rolled over.
- ESOP benefits. The dividends paid with respect to employer stock held by an ESOP that is sponsored by a publicly traded corporation would largely be repealed, if the administration had its way. In addition, the administration would repeal the exclusion of net unrealized appreciation in employer stock in the year of a distribution for participants in tax-qualified retirement plans (but with an age 50 cutoff).
- College sports tickets. Donors to colleges and universities who receive in exchange for their contributions the right to purchase tickets for seating at an athletic event currently may deduct 80 percent of the contribution. The administration would deny any charitable contribution, claiming that the value of the right to purchase tickets often far exceeds 20 percent of the contributed amount.
Other existing tax benefits are also identified within the Green Book as loopholes, independent of their designation within the “Loophole Closers” section. Among others, these include the following:
- Loopholes under Subpart F. The existing categories of Subpart F income, and the threshold requirements for applying Subpart F, rely on technical distinctions that the administration points out may be manipulated or circumvented contrary to Subpart F’s policy of requiring current U.S. taxation of passive and other highly mobile income earned by foreign corporations controlled by U.S. taxpayers. In addition, taxpayers manipulate a so-called 30-day rule by intentionally generating significant Subpart F income during short tax years of fewer than 30 days (for example, through a Sec. 338(g) election).
- Lower-of-cost-or-market inventory method. The allowance of inventory write-downs under the LCM and subnormal goods provisions, as an exception from the realization principle, is described by the Treasury as “essentially a one-way mark-to-market regime that understates taxable income.” Elaborating on this one-way street, the Green Book explains that a taxpayer is able to obtain a larger cost-of-goods-sold deduction by writing down an inventory item if its replacement cost is lower than its historical cost, but need not do the opposite — increase an item’s inventory value — if its replacement cost increases above historical cost.
- Like-kind exchange rules. The Treasury considers use of a Code Sec. 1031 like-kind exchange as a giveaway that has outlived the reason for its initial use — an inability generally to value old and replacement property for an equitable outcome. Rather than repeal Sec. 1031 entirely, however, the Treasury in effect admits that tax-deferred exchanges (which, in some cases, have been structured to extend almost indefinitely) are ingrained into the economic fabric of small business. As a result, it would not repeal but rather would limit the amount of capital gain deferred under Sec. 1031 to $1 million (indexed for inflation) per taxpayer per taxable year. It also would exclude art and collectibles from any use of the like-kind exchange provisions.
- Corporate jets. Corporate jets, compared to commercial passenger airplanes, now receive a shorter recovery period for depreciating airplanes not used in commercial passenger operations. “Their recovery periods should be harmonized,” according to the Green Book.
- Partnership built-in loss. Although amendments to Sec. 743 in 2004 prevent the duplication of losses where a partnership has a substantial built-in loss in its assets, it does not prevent the duplication of losses where the transferee partner is allocated a net loss in excess of $250,000 in situations where the partnership sells all its assets in a fully taxable transaction for cash equal to the fair market value, but the partnership itself does not have a substantial built-in loss in its assets. The Green Book proposes ending this.
- Nondeductible partnership expenditures. Even though a partner’s distributive share of nondeductible expenditures on the partnership level reduces their basis in its partnership interest, such items are not subject to Code Sec. 704(d), and the partner may deduct or credit them currently even if the partner’s basis in its partnership interest is zero. The Treasury recommends allowing a partner’s distributive share of expenditures not deductible in computing the partnership’s taxable income and not properly chargeable to capital account only to the extent of the partner’s adjusted basis in its partnership interest at the end of the partnership year in which such expenditure occurred.
- Corporate ownership control. By strategically allocating voting power among the shares of a corporation, the Green Book reports that taxpayers can manipulate the control test in order to qualify or not qualify, as desired, a transaction as tax-free. In addition, the absence of a value component allows corporations to retain control of a corporation but to “sell” a significant amount of the value of the corporation tax-free. The proposal would conform the control test under Sec. 368 with the affiliation test under Sec. 1504.
- Lowering E&P to reduce dividend income. The Green Book complains that corporations can enter into preparatory transactions to eliminate a corporation’s earnings and profits or shift the corporation’s E&P to a prior or subsequent tax year to transform dividends from ordinary income to capital gain or return of basis. It also cites “leveraged distributions” in which a corporation with E&P provides funds (for example, through a loan) to a related corporation with no or little E&P, but in which the distributee shareholder has high stock basis.
- Stepped-up/carryover basis. The administration is proposing that transfers of appreciated property by a donor or deceased owner generally would be treated as a sale of the property in which capital gain would be realized at the time the asset is given or bequeathed to another. A $100,000 exclusion would apply.
- Education credits taken by children. Some high-income families are benefitting from a loophole in current law that allows their children, even if dependents, to claim a nonrefundable American Opportunity Tax Credit if the parents do not claim them on their tax return, thus avoiding the AOTC’s income limits.
A review of provisions designated as “loopholes” within the Treasury’s latest Green Book may assist in exposing a number of current, still-viable tax strategies. Although some may be challenged under existing law without the need for enabling legislation, the majority appear to be airtight until Congress acts.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at Wolters Kluwer US, Tax & Accounting.
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