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Tax Accounting by Businesses

Questioning Conventional Tax Planning

Fair Tax or Flat Tax

Charities You Support

Tax Accounting by Businesses

An interesting suggestion was recently made in an editorial in The Wall Street Journal that companies should be required to report income taxes on the basis of accounting income. The reason for this suggestion was that doing so would curtail funny accounting practices such as applied by Enron, Global Crossing and some other companies.

Take a look at the tax footnote in the financial statements for a publicly-held company. This footnote is usually fairly substantial and concerns primarily the timing difference between income and deductions reported for tax purposes and income and deductions reported for book purposes. The difference in the tax and book accounting practices can have a company show a current income and taxes for income statement purposes without having to pay the income taxes which are booked. Thus, a company may end up with a better looking income statement without having to pay out any cash for the taxes which are booked.

While the suggestion was made for the purpose of improving financial statement reliability for the securities markets, the suggestion is one which I have made in Let's Really Change Taxes because it makes tax sense as well. The only real difference in tax accounting treatment and book accounting treatment is timing. Ultimately, if a business is successful, taxes will be paid. If a business is not successful taxes will not be paid. The proof that the difference is merely a timing difference which does not make sense can be found in the alternative minimum tax provisions for corporations. If a corporation does not pay enough in taxes, either as determined regularly or for alternative minimum taxes, then a special alternative minimum tax is computed using essentially the income for book accounting purposes. (Return to top of page.)

Questioning Conventional Tax Planning

There are conventional precepts followed in most tax planning. The general effort is to avoid paying taxes whenever possible or at least to delay paying taxes. I have no problem with avoiding paying taxes using proper legal means. However, often when efforts are directed toward delaying paying taxes, other opportunities are passed up. It is never good to make a bad decision because too much focus is maintained on taxes. Much of tax savings is based upon timing, and the long-term savings may not be realized because of assumptions which do not occur.

Following are some separate commentaries about some conventional techniques for delaying taxes which you should consider when making decisions:

Like-Kind Exchanges

Use of Tax Deferred Investments

Retirement Planning

Like-Kind Exchanges. Like-kind exchanges are used by many people to keep from paying taxes when switching real estate investments. The rules are very formal, but can normally be met fairly easily. However, a like-kind exchange is not always the best thing to do.

While current cash flow can be improved because taxes are deferred, long term tax savings can be lost. If the property being sold has been held for a substantial period of time, the gain may be taxed at lower capital gains rates. If the property being acquired is subject to depreciation, the deduction offsets ordinary income usually at higher rates. Therefore, by deferring a lower capital gains tax, you lose out on greater tax savings from higher depreciation deductions.

Another potential problem with focusing just on deferring taxes is a loss of flexibility in investment planning. The investment opportunities available may be better in property that is not of the same kind as that being sold. If a person is not willing to pay the taxes, then potentially better investment choices may be lost.

Finally, investing in real estate can involve spending time on investments which you may not have to spend.

In short, do not look just at the immediate tax deferral when making a decision whether to use a like-kind exchange. Such a transaction is not always the best choice.

Tax Deferred Investments. Tax-deferred investments can be very popular. However, the apparent benefits in the long run may not be as great as they seem.

The real benefit of tax-deferred investments is realized if the payout is at a lower tax rate than would otherwise be applicable during the period that the money is being saved. While income and gains can be realized during the period of investment, withdrawals are at the ordinary income tax rates applicable at the time. Most of the gain during the deferral period would be taxed at lower long-term capital gain rates if realized in an ordinary investment. Thus, what would have been a capital gain taxed at a lower rate becomes ordinary income taxed at a higher rate at the time of withdrawal.

If the rate of growth in two investments and the applicable tax rates for ordinary income are the same at the time of withdrawal as during the period of investment, then you may actually lose money by using tax-deferred investments and passing up the chance of having gains taxed at lower rates.

Retirement Planning. Retirement plans are wonderful vehicles for saving money for retirement that one might not otherwise save. However, such plans suffer from the same problem as other tax-deferred investments, namely potentially turning gains taxed at lower rates into ordinary income taxed at higher rates.

In addition, retirement plans cause you to lose flexibility in use of your money and in some investments that you may find more attractive. There are limitations upon the types of transactions that can be undertaken with retirement funds. Retirement funds also are subject to restrictions on withdrawals, as well as mandatory withdrawals after a certain age.

Because of the often illusory tax savings, I generally recommend that use of qualified retirement plans be limited to Roth IRA's and contributions to 401(k) plans only to the extent needed to get the maximum employer match. A plan provided by an employer to which an employee makes no contribution is beneficial if you would not otherwise get the money going into the plan.

Saving current taxes is not always the best choice. (Return to top of page.)

Fair Tax or Flat Tax

Introduction. One of the objectives President Bush hopes to achieve in his second term is fundamental tax reform. Others have given lip service to this goal in the past. Congress even held hearings on fundamental tax reform several years ago. Various taxpayer groups have sought fundamental tax reform. Different proposals have been advanced from time to time. The two most mentioned in the last several years are the flat tax and the "Fair Tax." The Fair Tax, as it is called, is a high percentage national sales and services tax.

There are now two different bills which have been proposed in Congress for reforming our current tax system, the Fair Tax (HR 25) introduced by Congressman Linder from Georgia and the Freedom Flat Tax (HR 1040) introduced by Congressman Burgess from Texas. If you wish to read either of the bills, you will need to go to the website for the House of Representatives. Both proposals offer some interesting alternatives to our current system of taxation. No system is perfect. Each of the bills has some positive aspects, but each also has some significant flaws which are being downplayed.

 I have written a simplified tax code and included it in a book (Let's REALLY Change Taxes) which is available from this website as a free PDF download. My proposed code is only 30 sections long and is based primarily on the concept of a flat income tax using a rate of only 10%. There are also reduced payroll taxes and a low level sales and services tax of 2.5%. After having looked at the two proposals now before Congress, I still prefer a flat low rate income tax with a modest sales and services tax for several reasons.

I cite seven principles to be followed in simplifying the tax code: (1) the law should be reasonably understandable; (2) the law should be economically neutral; (3) the law should have minimal administrative requirements; (4) there should be a reasonable allocation of the burden of taxation; (5) the focus should be upon raising money for government; (6) individuals should be taxed whenever reasonably possible; and (7) for a flat rate income tax, all income should be taxed the same. The seventh principle would not apply to the national sales tax. Therefore, that item should not be considered in comparing that proposal to what I propose. However, the other concepts are properly considered when comparing the two proposals now before Congress and what I have proposed.

Following is a brief description of the strengths and weaknesses of the Fair Tax and Freedom Flat Tax proposals and a comparison to what is proposed in Let's REALLY Change Taxes.

Fair Tax. The website www.fairtax.org has information about the Fair Tax proposal, but does not contain the actual statute. Congressman Linder notes on his website that the legislation is only 132 pages long. There are several  benefits to the proposal. It is much simpler than our current tax system. The complex income, estate, gift and employment taxes provisions are either eliminated. The tax cost of government is obvious to all since the sales tax is separately stated on the receipt provided with each sale. Since the tax is imposed only on sales in the United States, our exports will be more competitive. Savings will be encouraged since income from investments will not be taxed.

However, there are many problems with the proposal.

Income Tax Return. Some have stated that there is no income tax return, but effectively there is. The proposal provides for a rebate to certain low income people based upon the poverty level. The rebate will vary depending upon the income of the persons seeking the rebate and the number of dependents in the family of such persons. Income and dependents are the two key elements of income tax returns for individuals. Therefore, any person who would qualify for the rebate will have to file an income tax return. True, the return is voluntary and is not filed with the Internal Revenue Service. However, it still is an income tax return and must be filed to receive the benefits. In addition, the filing of such a return is somewhat more complicated by the need to file amended information when there is a change in circumstances. Therefore, there could be multiple tax returns required in a given year for persons seeking the rebate.

System Shock. One of the big concerns I have is the shock to the system with a 23% sales tax. It is true that, as many have touted, Federal Reserve Board Chairman Greenspan did make some positive statements about a consumption tax. However, those statements were guardedly positive. Chairman Greenspan specifically mentioned that he thought there would be some potential problems in the transition period. The problems could be very significant. High sales taxes tend to suppress sales. This fact can be seen in New York where retail sales generally tend to lag neighboring areas because of high sales taxes, but have boomed during short periods when sales taxes have temporarily been suspended.

Another potential problem with a high sales tax is the encouragement of a black market economy. Cost of goods will supposedly be reduced thus causing a boom, which is supposed to overcome the potential problems created by applying a high sales tax. First, as noted below, I doubt that the promised reductions will be forthcoming as quickly as indicated, if ever. A delay in the supposed positive impact will itself cause some transition problems. Second, if the supposed benefits do appear quickly, the high tax will still be an encouragement to cheat. The IRS today is bemoaning the complexity and rates of our current tax system and blaming such for much of the uncollected taxes we supposedly have now. Finally, even if the transition does occur and, after it occurs people are not inclined to cheat, undoing the black market which might arise in the interim will be difficult and take time.

Continuing Complexities. The proposed Fair Tax legislation still contains many complexities which I believe a simplified tax systems should eliminate. There are many complexities which are removed, but some remain. Much of the administrative framework still seems to be in place. For instance, there will still be a Tax Court, which should not be needed with a simplified tax system.

Most of the excise taxes remain. Excise taxes are special sales taxes. Why should special sales taxes stay in place, if there is to be a general sales tax? Another aspect of our current excise tax system is that some programs are rung through that system which should not be. For instance, the Railroad Retirement System and the Black Lung Trust system are run through the excise tax system. These should be private funds. The Railroad Retirement System is nothing more than an industry-wide pension plan. Such plans are routinely private plans negotiated with unions. The Black Lung Trust system is an industry-wide disability system, which also should be run privately. Such plans can be run privately much more effectively than through a public government system. At the very least, they have no place in our basic tax system.

The proposed Fair Tax also has a system of different credits. There are substantially fewer credits than in the current system, and the credits are reasonable given what is being proposed. However, starting out with credit procedures merely adds a level of complexity which encourages future complexity. Further, credits which never appear on the budget are really a means of budget shifting which hides the true potential cost of government. While some would argue that credits for charities is worthwhile, the effective impact is for some who do not want to support such charities in fact end up doing so by paying higher taxes to make up for charities not paying taxes.

Finally, the proposed Fair Tax plan hides the problems with Social Security and Medicare. The proposal eliminates employment taxes and substitutes an allocation formula to be sure the trust fund remains solvent. While I think there are good arguments for doing away with such payroll taxes, they should be tied to doing away with or substantially reforming the support systems which such taxes fund. As long as the support systems are not changed, then the taxes funding them should be explicit in order for people to see what is needed in the future if such systems are not changed. Eliminating the taxes and providing an allocation system for these two trust funds, as well as other trust funds, allows the problems with these systems to go undetected while constantly eating up more of the taxes collected and putting pressure upon raising such taxes.

Lack of Some Promised Improvements. I have heard and read many supposed promised improvements in our economy which would come from such a system. For instance, the cost of goods will supposedly decrease. Further, some have suggested that there will be increases in discretionary incomes of individuals of 15.3% upon the elimination of the Social Security and Medicare taxes. However, all of these supposed improvements will come only if behavior is changed.

Cost of goods may at some point decrease relatively to nominal incomes because of inflation adding to incomes. However, such is something which would occur only in the short run because of businesses decreasing the prices of their goods and services to account for the decrease in their costs. Often businesses merely accept the benefit of reduced costs without it along very quickly to consumers. The funds may be used for other purposes, such as deferred investments, but the cost of the goods may not decrease, though economic activity might very well increase.

There will not be an immediate 15.3% increase in personal incomes. Half of this tax is paid by the employer. Therefore, the employer would have to make a decision to increase the incomes of employees by the amount of taxes saved. Such will not necessarily be the case.

Elimination of Tax Burden. The Fair Tax proposal has a further potential problem of eliminating a large group of citizens from any responsibility for supporting government. Rebates to poor people and elimination of payroll taxes for Social Security and Medicare may well effectively remove a large portion of our population from paying any Federal taxes. When such is done, the only interest such people have in government is what they can get from government. These aspect creates a built in class conflict which can be exploited for inappropriate political gain.

We do not need to eliminate people from the tax roles. If anything, all people should have some funding stake in government. We also do not need to provide a means of further encouraging political rhetoric which only hides the ability to have meaningful discussion of issues.

Sixteenth Amendment Still Present. The Sixteenth Amendment to the Constitution is not eliminated as a part of this proposal. Given the propensity of Congress to seek money wherever it can be found, switching to a national sales and services tax without eliminating the Sixteenth Amendment is dangerous.

Freedom Flat Tax. The Freedom Flat Tax is very short and simple. There are only three principal sections for imposition of the tax. There are some other sections concerning modest administrative changes and elimination of the estate and gift taxes. For those who chose the flat tax, completing and filing an income tax return will be quite simple. Many of the current complications will be eliminated, and some forms of income will not be taxed. One very positive aspect of this proposal is the requirement of a supermajority to change the law once it is implemented. This provision may not be constitutional, but still it will be written into law.

This proposal, however, also has several shortcomings.

Elective Provision. The Freedom Flat Tax is not a general simplification of the income tax, but is purely elective. Once a person elects to be taxed in this manner, the election is irrevocable. In most instances the election will make sense because of the elimination of tax on some types of income, such as investment income and capital gains, the effective elimination of various complicated accounting rules and the elimination of the alternative minimum tax. However, it would still be preferable to have the new law be a change to the current system rather than an elective replacement.

Possible Higher Tax Burden. Depending upon a person's situation, the actual taxes to be paid may be increased by choosing the flat tax. For instance, if a person is self-employed and has no investment income, then there is some chance that the combination of income taxes and self-employment taxes will cause the total tax cost to be greater than under the current system. Thus, for some the introduction of the flat tax may really add another layer of complexity to an already overly complicated tax system.

Continued Complexity. All of the current administrative provisions, employment tax provisions and excise tax provisions remain in the law. Therefore, there is substantial continuing complexity.

Let's REALLY Change Taxes. The proposed code in my book has some benefits over both of these proposals. The nominal rates of all taxes are much lower, thus providing less shock to the system.

All forms of income are taxed in exactly the same manner.

Since the national sales and services tax does not have a rebate provision, all persons will be on the tax roles to some extent and, thus, will have some interest in government efficiency.

Administration is greatly simplified.

Summary. It is good to see some serious thought being given to tax simplification. Both proposals now before Congress have positive and negative aspects to them. What I have proposed has some of the benefits of each proposal. None of the three proposals is perfect, but it appears that we may finally be on track to have some positive reforms in our tax system. (Return to top of page.)

Charities You Support (Whether or not You Want to)

Making gifts to charities at the end of the year is a typical practice of many people. Various charities, such as the Salvation Army and many churches which collect food stuffs for the needy, run extra campaigns during this time. Other charities, such as the United Way,  typically run their campaigns towards the end of the year when individuals are making gifts and business are budgeting for the next year. Some of the provisions of the tax law, however, have all of us supporting charities which we might not want to support and underwriting some businesses which have specific tax breaks that give them competitive advantages over other businesses which we may prefer. This problem is one of many which I address in the simplified tax code included in Let's REALLY Change Taxes.

Contributing for Charities You Don't Support. My idea of a charity has always been something which helps those people who are needy. However, the concept of charity in our tax code is not limited in that manner. For example, if you are a liberal who disagrees with the efforts of the Cato Institute or the Heritage Foundation or  a conservative who disagrees with the American Civil Liberties Union, you support the efforts of such entities whether you want to or not. If you are neither liberal nor conservative, but just do not want to support these sorts of groups, you still do. The charitable contribution deduction in our current tax code has you supporting these organizations even if you do not contribute to them. There are two different ways our current tax cods has you supporting these groups.

The first means of support comes from making for charitable contributions deductions. The Heritage Foundation and the Cato Institute are both considered to be charities to which you can make tax deductible contributions. The ACLU has a separate foundation which supports its litigation and education efforts, and contributions to the foundation are tax deductible.

Whenever anyone makes a charitable contribution for which the person is given a tax deduction, others have to make up the difference, since the government always believes that it needs to replace money which it would otherwise get if there were not these deductions. Therefore, even if you do not make contributions directly to these organizations, you support them through the taxes you pay to replace taxes their contributors do not pay.

The reason for this anomaly is the loose definition of charity. A charity includes educational institutions, which can be very broadly defined. A charity also includes certain public interest activities, such as public interest law firms. These provisions allow for the above treatment of Cato, Heritage and the ACLU Foundation. The provisions also allow for the formation of essentially private businesses that take advantage of these tax benefits, such as local children's theaters and dance schools. The list of charities to which deductible contributions can be made is overwhelming. In my law practice, I do much work in the charitable area, and I know firsthand how easy it is to qualify an organization as a charity contributions to which are deductible.

The second way you support these organizations is by their tax exempt status.

Tax-Exempt Entities. Any entity which does not have to pay taxes is supported by you because of the taxes you have to make up for the untaxed income made by these entities. (As mentioned above, this effect comes from the determination by Congress that no deduction is allowed without some corresponding income.) Tax exemption is the second way in which you support entities such as Cato, Heritage and the ACLU. However, there are other businesses which are essentially profit-making or support profitable efforts which are tax-exempt and, thus, are supported by you whether you want to or not. The two examples which I believe to be most striking are credit unions and professional football leagues.

Credit unions are no longer the means of providing savings and personal loans to individuals who have a "common bond." The supposed common bond anymore can be something as simple as serving only a limited geographic area. Such is the case with a local credit union in my city, the University of Virginia Credit Union. This company makes loans to and provides deposit services for anyone, including businesses with no connection to the University, has a means of providing trust services and provides other services which have historically never been associated with credit unions. Yet this company pays no income taxes. All taxpayers throughout the United States provide support for this entity indirectly by paying taxes which this entity would otherwise pay. Yet the entity is just a typical local bank.

You underwrite the educational efforts of essentially every professional group which has a requirement for continuing education. For instance, the Virginia Continuing Legal Education is tax-exempt. Yet its only substantial function is to provide educational materials and classes to Virginia lawyers.

Recommended Changes. Charities and other non-profits are addressed in three different ways in my proposed tax codes. First, there would be no charitable contribution deduction, including for businesses. Second, true charities, that is, organizations which help the poor, would be provided a substantial exemption over and above the deductions which they would be entitled to take against income. This substantial exemption would allow such charities actually to set some money aside for emergency needs of such entities. Third, other entities which truly are not-for-profit, but which are not formed for helping the poor, would still be entitled to be taxed as businesses. The benefit of this treatment is that, even though such entities did not make a profit, they would be able to deduct the expenditures made to support their "business" purpose.

Cumulative Impact of Changes. The above changes to the treatment of charities and contributions constitute a small part of the overall changes in the tax code I propose. There are many potential objections to such changes, but the logic of such changes and the benefits of all such changes are addressed in detail in Let's REALLY Change Taxes. The potential simplicity is tremendous, and the savings generated by such simplicity will be in addition to the decrease in taxes most of us will enjoy. A simple scoring of the proposed code indicates that we could have reduced employment taxes, a single income tax rate of 10% and a national sales and services tax of 2.5%. Implementing the proposed simplified code or something substantially less cumbersome than the current code will be an enormous benefit to all of us.