An Extremely Simple Tax Proposal

Introduction

The frantic April 15th tax-filing ritual is over, restaurants and businesses are advertising bargains to cash-strapped taxpayers and once again, we wonder, isn’t there a better way?

Everyone claims to want a simpler, fairer and loophole-free tax system, so here’s a solution so simple that, for most taxpayers, return preparation and filing could be completed in less than one minute – that’s it!

Broaden the Tax Base, Lower the Tax Rate

As Emperor of America, charged with the task of making the income tax system simple, straightforward, with no loopholes, here’s my approach.  It terminates tax-driven businesses, including the tax preparation industry (goodbye CPAs, Turbo-tax and scheming tax lawyers) – and all that waste of time and money.

Individuals

Taxpayers receive a large front-loaded exemption along with drastically lower tax rates, in exchange for eliminating all deductions:

  • From $0 to 50,000 = no tax
  • From $50,000 to $100,000 =10%
  • Thus, the first $100,000 of income is taxed at no more than 5% ($5,000 maximum)

  •  From $100,000 to $250,000= 20%
  •  From $250,000 to $500,000 = 25%
  •  Over $500,000 = 30%

That’s it, a major reduction in the current tax rates, which range as high as 39.6% for taxable incomes exceeding $400,000 for joint filers.

No Write-Offs

Oh by the way, there are no deductions, exemptions or credits whatsoever. Seriously, no deductions for mortgage interest, charitable donations, state, local, sales or property taxes, alimony, retirement contributions or medical expenses.  The first $50,000 you earn is tax free (you pay only 5% on the first $100,000) and replaces all deductions.  Also, all income is taxed at the new rates, thereby eliminating capital gains (a major cause of complexity and abusive tax planning) and other preferential tax rates; in addition the alternative minimum tax is tossed out (another huge source of mind-boggling complexity and unfairness).

Filing

Since IRS directly receives information concerning wages and compensation, interest, dividends, royalties and other reportable payments, it can compute your taxes instantly.  Consequently, for the vast majority of taxpayers, returns can be prepared and submitted on-line in less than a minute.  With all deductions eliminated, the tax calculation is simple.

For those with business and investment income and expenses, the process is slightly more complicated.

Business and Investment Deductions

Business and investment income is taxed differently because legitimate deductions are incurred in the production of that income.  However, I would eliminate all deductions except for directly-related and essential expenses actually incurred (costs of purchasing raw materials, labor, rent, direct overhead) and not subject to accounting manipulations.

No Interest Deductions

There would be no interest deductions, since they distort our tax system by favoring borrowed funds (debt) over direct investments (equity).  Eliminating the interest deduction should collapse deals whose economic survival depends on writing-off interest expenses, such as leveraged buyouts and leveraged real estate deals, tax shelters and securities speculations.

Limited Depreciation Deductions

There would be no deductions for depreciation on real estate, no oil or gas depletion allowance, no amortization for intellectual property or goodwill; only business assets that actually wear out within seven years will have a depreciation allowance.  Eliminated are deductions for entertainment, meals and perks for execs, such as automobiles and club memberships, although a straight mileage allowance for vehicles actually used in  business would be permitted.

“Tax-free” exchanges of real estate would no longer exist (the transaction would be immediately taxable) and reorganizations (mergers, acquisitions and alike) would be subject to a flat tax of 2% on the gross value of the transaction.

The upshot:  businesses and investments would have to stand on their economic merit, rather than on tax loopholes and accounting shenanigans.

World-Wide Income

Individuals and entities would be taxed on their world-wide income, whether or not the income, whether or not the funds were repatriated to the U.S.  The current gimmicks used by Apple, Google, Marriott and others to escape U.S. taxation by transferring intellectual property to foreign subsidiaries would be stopped.

Entity Tax Rates

Entities will pay 5% tax on the first $100,000 of gross income, then 15% to $5.0 million, then  25% over that amount. Note: the current corporate tax rate is generally 35% on income over $100,000.  Current flow-through entities (partnerships, LLCs and S-corporations) would be taxed as entities.  As with individuals, the reduced rate up to $5.0 million compensates entities for the loss of deductions.

Minimum tax

Individuals with gross receipts of more than $100,000 will pay a minimum tax of 2%. Entities with gross receipts of more than $25 million a will pay a minimum of 4%.   This will eliminate accounting tricks and gimmicks.  These minimums will apply each year, carryover losses will not reduce the minimum tax – every individual and entity will pay at least the minimum tax – no exceptions.

Example: An individual earns $1.0 million in real estate income, but claims $1.2 million in deductions. Even so, the individual pays 2% on the million or $20,000 at a minimum.

Example: Assume GE has $150 billion of gross income but currently pays no income taxes.  Under the minimum tax, it pays $6.0 billion.  Thus, GE, even with its army of 375 tax lawyers, will not escape the minimum tax.

Audit Risk

If an entity is caught under-reporting taxes by more than 10%, the minimum tax doubles to 8% for the next three years.  This should deter companies that hire boatloads of accountants and attorneys to finagle their taxes.

Conclusion

This drastically simplifies our current tax code by eliminating loopholes and special interest deductions that have created such a mess.  It is simple, fair, and causes every individual and entity to pay taxes.

The reduction of billions of hours of wasted time and dollars spent on dealing with the current law will boost our economy, but the most important result is that businesses and investments will once again base their decisions on economic merit, rather than on gaming the tax system.

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Fiscal Cliff Deal

Congress dove off the fiscal cliff at midnight, December 31st, but then quickly passed legislation preserving the Bush tax cuts for all but the highest income earners.  The full text of the legislation is contained in H.R. 8.

Individuals

Despite President Obama’s insistence that those earning more than $250,000 pay higher taxes, the final amount was almost doubled to $400,000 for single files and $450,000 for married couples. (“new ceiling”).

Income exceeding the new ceiling is taxed as follows (i) capital gains and dividends at 20%; and (ii) ordinary income (compensation, retirement distribution, rents, interest, royalties) at 39.6%, the rate under President Clinton.  The alternative minimum tax exemptions were increased to $50,600 for individuals ($78,750 for joint filers) and indexed for inflation.

Deductions and Credits

Itemized deductions remain subject the phase-out rules, but the thresholds have been raised to $250,000 for individuals and $300,000 for married couples.  Tax credits have been continued for five years, including the earned income credit, educational credits and the child care credit.

 New Obamacare Tax

Starting in 2013, investment income 1 is subject to an additional 3.8% tax to pay for Obamacare and applies to income in excess of $200,000 for individuals and $250,000 for married couples.

 Estate and Gift Tax

The 2012 estate and gift tax rules will continue with one minor modification.  The unified estate and gift exemption remains at $5 million per individual ($10 million for a couple) and is indexed for inflation ($5,120,000 in 2013), but the tax rate is increased to 40%.

 Payroll Tax and Unemployment Benefits

The 2% break for payroll taxes on the first $113,000 of compensation will expire, thus raising taxes for almost all wage earners; however, long-term unemployment benefits are extended for another year.

 S Corporations

The 10-year waiting period for built-in gains (gains taxed at the corporate rate of 35%) has been slashed to 5 years, so small corporations with built-in gains may want to convert to S corporation status.  After the five-year period, those gains will be taxed at individual capital gains rates (15% for those under the ceiling).

 Miscellaneous Provisions

The rules regarding income from the discharge of indebtedness involving a principal residence were continued through 2013.  Research and development credits were extended, as well as the 50% bonus first year depreciation tax break.

Footnotes

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The Bain Files – The Fee Waiver Ploy

Introduction

On August 23, 2012, the Gawker website released more than 950 pages of confidential Bain Company documents, illustrating how Mitt Romney’s former company games the tax system.  When Gawker released the documents, Forbes magazine smugly announced that it had the same documents and they were “worthless.” Oh, really?

Transformation

Catching the attention of tax professionals was $1.0 billion in professional fees, usually taxed as ordinary income (maximum federal rate 35%), that were magically and improperly transformed into long-term capital gains (15% federal tax rate), thereby saving $200 million in taxes.  The tax ploy has been questioned by Victor Fleischer, a noted expert on fee waivers. 1

Fee Waiver

The Bain fee conversion tax-dodge rests on the dubious premise that partners providing services to a partnership can choose whether to receive compensation income earned and owed to them or waive it, thereby transforming the fees into additional partnership equity taxed as capital gains.

Carried Interest

The Bain technique involves a distortion of the “carried interest” rule, currently under fire in Congress as an abuse.  The carried interest concept is derived from a quirk in partnership law.  Partners are considered co-owners, not employees, of the partnership, although they provide personal services indistinguishable from any other employment relationship.

Thus, partners who commute full-time to the same office, work 60-80 hours a week under the direct supervision and control of their supervisors, and receive compensation for personal services, are not considered employees of the partnership.  As owners, they may receive a profits interest (the “carried interest”) in the partnership in exchange for rendering personal services without immediate taxation. 2

Fee Waivers

However, there is nothing in the carried interest exception that suggests a voluntary waiver of fees already earned and owed is permissible.  In fact, IRC Section 707(a)(2)(A) was enacted to disallow transactions that lacked economic risk.

Because the Bain partnerships were earning income or were profitable, there was little or no actual risk economic risk to the partners who waived their fees; therefore,  the attempted fee waiver failed and the partners were immediately taxable at ordinary income rates on the fees.

 Conclusion

Bain’s fee-waiver gambit was invalid and its partners owe an additional $200 million in federal income taxes on the $1 billion in fees they received. 3

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