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How Now, Sacred Cow? Tax Rules To Beef About

Finding goofy rules in the tax code is a game everyone can play. Sure, there are plenty of ways the government sticks it to unwary taxpayers. We listed some in our last issue (“Ten Tax Rules Guaranteed to Drive You Crazy”, Sentinel May 1997). But lots of other provisions let taxpayers with the right political demographics off the hook when broader policy needs might argue otherwise.

Is it fair to call these animals sacred cows? Decide for yourself, but you can be sure that if anyone tries to send these critters to the slaughterhouse, clerical collars will come out and mooing will commence before you can say “Elsie.”

Death as tax shelter, Part 1. Backers of the estate and gift tax have one good argument in defense of that awful second- or third-level levy on wealth (which applies only after personal and, often, corporate income taxes have been paid). This argument is that the estate tax catches income that otherwise goes untouched when an individual dies while holding assets that have increased in value. Unlike the estate tax, the income tax on those assets is forgiven by creating a new, fictitious “cost” equal to the value of the assets at the owner’s death. Since this “stepped-up basis” means that cost is now deemed to be equal to the value, there is no gain left to be subject to income tax.

Why not just eliminate the estate tax and apply income tax at death to the increased value of the deceased’s assets? Canada did this 25 years ago. Here in the U.S., however, the estate tax applies only to a small, relatively wealthy minority, while many middle-class families benefit from the basis step-up. So a common-sense move that would make the tax system vastly simpler and fairer is too easily portrayed as a sop to the rich to have much chance of passing.

Blood and guts time. [Parents, this tax issue is not for the young or the squeamish.] Suppose you removed an arm or a kidney and sold it to a willing buyer. The income you received would be taxable. But if you lose that arm or kidney in an industrial accident, the compensation you receive is exempt because it is on account of “personal physical injury.” Congress last year imposed the requirement that injuries be “physical” after endless taxpayer-IRS arguments over the extent of the prior “personal injury” exclusion.

Now we will have new arguments. Payments for emotional distress are taxable — unless the distress arises from a physical injury, such as watching your boss’s machine cut off your arm. Punitive damages are always taxable under the new rules, which gives taxpayers a reason to inflate their injury settlements rather than litigate over punitive damages that the government would share. Meanwhile, most businesses will still be able to deduct the cost of the settlements they make even when the recipients pay no tax on what they receive, which shifts a significant share of settlement cost from the defendant to the government.

The simple and fair approach: Declare that settlement and litigation proceeds are tax-exempt only to the extent of the owner’s cost of damaged property; otherwise, make everything taxable. Our litigation flood might recede if Uncle Sam stops picking up a good share of the cost.

Remove the cap, uncover the truth. Social Security has always been a welfare scheme to transfer money from relatively young workers to older retirees, but the scheme is packaged as a fiction in which an individual “earns” his own benefits. A big part of the fiction is the cap on the portion of earnings, $65,400 in 1997, that is subject to Social Security tax. A bizarre, unintended and inevitable result: taxes on moderate-income workers can be much higher than on those with more income. In 1997, a married, self-employed architect with $50,000 of taxable income pays a marginal federal rate of 28% for ordinary taxes and 15.3% for Social Security and Medicare, or a total rate of 43.3%. However, with $99,000 of taxable income this individual would pay the same 28% ordinary tax rate but only 2.9% in uncapped Medicare taxes, for a tax rate of 30.9%. We can fix this anomaly only when we stop lying to ourselves about the nature of Social Security.

Who pays for health care? Most workers these days find themselves in managed care plans for which they personally shoulder a good deal of the cost, with little or no benefit on their tax returns. But a lucky few receive elaborate, first-dollar coverage from their employers, paying no tax on either the cost of the insurance or on any of the benefits they receive. Even self-employed individuals now can deduct a portion of their insurance costs. Fairness demands that either everyone can deduct all of their health insurance and health care costs, or nobody can.

Incentives to do what? Incentive stock options, or ISOs, were popular in the days before tax reform because they allow employees to defer tax from the time they exercise their options until the time they sell the stock, and then to pay the tax at favorable capital gains rates. These options virtually disappeared when the 1986 tax law eliminated the preferential rate for capital gains. Guess what has come back along with the return of a capital gains preference? We might ask ourselves what companies were doing in the decade or so that ISOs were invisible. Well, they found lots of other ways to compensate and motivate executives, which leads one to wonder, what policy problem do ISOs help us solve today?

Bail out! The Employee Stock Ownership Plan was invented three decades ago amid claims that widespread worker ownership would revitalize American industry. ESOPs seem to have had no measurable impact on our economy, but they sure offer some nice opportunities to cash out a business owner’s stock. A business owner selling shares to an ESOP generally has a 15-month window in which to reinvest in other U.S. corporate shares without paying capital gains tax. We financial planners love this opportunity to diversify the investments of a retiring owner or his estate. We do not love this idea so much from the employee standpoint, however, since the ESOP is a retirement plan whose undiversified holdings in employer stock can make the employee dangerously dependent on one company for current and future security.

A match made in Washington. In a flock of 8,000 mutual funds, how do you make your turkey stand out? With a tax break, of course. Variable annuities are the much-flogged way of getting assets locked into a particular group of funds, often upon pain of stiff surrender charges and with high annual costs and mediocre performance to boot. But not to worry, say backers, because the growth in the investment can go untaxed for decades until it is withdrawn. Many of these products require more than a decade of investment before the tax benefits outweigh the additional costs to consumers. Most of the tax subsidy essentially goes to the variable annuity sponsors, which, of course, means the insurance and money management industries.

Better to give than to receive. Veteran Sentinel readers know that I am not a fan long-term care insurance, more accurately described as inheritance insurance for parents who are loathe to spend their children’s prospective fortune on their own maintenance. Congress, however, has been sold on this vehicle — so much so that, beginning this year, you can get a deduction, within limits, for your premium payments and exclude from taxable income any benefits your receive. This makes no sense. The Treasury gives up money today, then never receives any of the proceeds of that money later. Contrast the treatment of life and disability insurance (premiums never deductible by the insured and benefits, accordingly, not taxed), or retirement plans (deduction up front balanced by tax upon eventual payment). This something-for-nothing treatment is an honest-to-goodness tax miracle: The incorporation of the Golden Rule, right there in the Internal Revenue Code.

Death as tax shelter, Part 2. The death of a 30-year-old breadwinner is rare and disastrous, a risk that ought to be insured. The death of a 90-year-old retiree may be sad, but it is neither tragic nor, ordinarily, a financial calamity. Why insure the 90-year-old’s life? There is no reason except for a tax quirk that makes virtually all life insurance death benefits tax-free. This converts life insurance from a simple risk-spreading mechanism to a tax-exempt long-term investment. Naturally, the tax benefit helps insurers sell much more coverage than people actually need for risk protection, which is exactly why industry lobbyists are paid to protect the present rule. It would not be difficult to limit the tax exemption to the portion of the insurance proceeds representing the real actuarial risk of the insured’s death, so that the exemption would gradually diminish as the insured gets older. Given the strength of the insurance lobby, this change will occur when all the sacred cows come home.