American Jobs, Closing Tax Loopholes and Preventing Outsourcing Act of 2010

by Linda Beale

Extension Bill and Carried Interest: American Jobs, Closing Tax Loopholes and Preventing Outsourcing Act of 2010 [Ataxingmatter is back online after a break for the Chicago Law and Society Conference]

Last Friday, the House passed the extenders bill, HR 4213, the American Jobs, Closing Tax Loopholes and Preventing Outsourcing Act of 2010, by a 215 to 204 vote. The bill includes only tax and revenue provisions, extending various business and individual tax breaks and paying for those with a number of controversial revenue raisers. The Joint Committee on Taxation’s “estimated revenue effects” (JCX-30-10, May 28, 2010) for the bill is here. The JCT “Technical Explanation” (JCX-29-10, May 28, 2010) is here.

The extenders include various energy incentives including benefits for energy and oil companies (e.g., suspending the limitation on percentage depletion for oil and gas from marginal wells, which allows independent producers and royalty owners to deduct 15% of their gross income up front, even if that amount exceeds 100% of their net income; allowing mine companies to expense safety equipment), a number of ongoing tax expenditures for business (treating timber sales by REITs as not inventory; the research credit, the new markets tax credit, accelerated depreciation for certain farming equipment and restaurant improvements and “motorsports entertainment complexes, and of course the banks’ favorite–the subpart F exception for active financing income ) and a number of individual provisions (e.g., the above-the-line deduction for teachers for up to $250 of expenses for various supplies and equipment). Most of these business extenders make no sense–e.g., why should there be a tax subsidy via accelerated depreciation (expensing) for sports facilities, thus making wealthy sports franchise owners even wealthier? As we move towards a resource-restricted future, we should attune our tax code to supporting sustainability, not to the centuries’ old view that resources are there to be used up. The most egregious of all, in light of the way that financial institutions have benefited–and continue to benefit in terms of lower cost of funds–from government support, is the active financing exception: this provision essentially permits banks to keep their overseas investment profits without paying tax currently as other multinationals are required to do.

The revenue raisers are always controversial, because they generally end a loophole that some group has enjoyed for some period of time and feels entitled to continue to enjoy. Funny, though, the Wall Street Journal seldom runs an editorial or Op-Ed noting that entitlements are problematic and therefore ending these types of entitlements is a good thing. Compare that to the Journal’s typical slant on any “entitlements” that tend to go to ordinary taxpayers, such as union-negotiated pensions, union-negotiated health insurance provisions, Social Security, Medicare, Medicaid.

There are three areas of revenue raisers for which the House deserves credit, even though the bill’s provisions are, as always, a compromise that falls short of the best approach to the issue.

1) Carried interest

The House bill includes a provision to tax most carried interest as ordinary income, but because of a huge lobbying effort by the fund industry, the bill gave managers a break that ordinary taxpayers don’t get. After the provision comes into full force after the delayed effective date, managerse who earn a share of the profits of the partnership they manage will be able to treat 25% of their compensation as though it were a capital gain (even though they have no capital invested), while now treating 75% of those profits as ordinary income like every other person who pays taxes on compensation. The lobbyists now will focus their attention on the Senate, where they hope to get this modification altered even more, so that perhaps only 60% or 50% of their compensation income will be treated as compensation income and taxed at the ordinary rate.

The bill also taxes dispositions of the partnership interest attributable to carried interest as ordinary income and recognizes that income nothwithstanding other rules that might provide nonrecognition or deferral.

It would be nice if the Senate got some spine and changed the provision in the other direction, taxing all of the profits share at the ordinary income rate. Managers are earning their compensation as a partnership profits share, and there is really no justification for the 75-25 split. Shame on the House for caving in this way to the wealthy fund managers’ lobby.

2) S corporations

For a long time, S corporations have been treated as the way around payroll tax obligations. John Edwards is the poster-boy for this problem, in that he created an S corporation that received his services income, then claimed that he was paid a “salary” from the S corporation that should be subject to payroll taxes, but claimed the rest of his services income was a pass-through of S corporation profits, so not subject to payroll taxation. Clearly, all of the profits were services income attributable to his personal efforts, and all of the pass-through should have been subject to payroll taxation.

The House bill addresses this issue, but applies it only to S corporations with three or fewer shareholder/service provides upon whose reputations the S corporation’s profits hinge. A major step in addressing the problem, even if not perfect.

3) international tax provisions

The US has a “worldwide taxation” schema, meaning that we tax income from all sources, not just income from within the territory of the US. Many of the provisions have been changed in recent years to be too taxpayer-friendly, such as the reduction of foreign tax credit “baskets” that essentially permits taxpayers to “cross-credit” taxes, thus reducing US taxes too much for taxes paid on foreign income.

The extenders bill provides rules preventing taxpayers from splitting foreign tax credits from the income to which they relate, and denying foreign tax credits for income not subject to US taxation because of certain asset acquisition provisions (e.g., section 338 elections, section 754 elections, check-the-box liquidations). A significant development is the rule requiring separate application of the foreign tax credit limitation to items re-sourced under tax treaties, and a new source rule for income on guarantees.