Deficit report may force consideration of vital reforms

December 13, 2010
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Since the mid-term elections, Washington, D.C., is busy with activity. On Dec. 1, the bi-partisan Deficit Commission (otherwise known as the National Commission on Fiscal Responsibility and Reform) released its report. Much awaited in some circles, it had no easy cures for the ills we face in our current economic and fiscal situation.

Most of the issues and solutions are long term and can’t be changed in a short-time horizon or without a major overhaul of many of the ways the U.S. spends funds and raises revenue. At the same time, the extension of the Bush-era tax cuts also has been hotly debated, and resolution of the issue is hopefully near.

Tax policy has been debated in many circles. Recently, there have been reports on certain tax strategies undertaken by some large corporations. Some of the planning gets tagged with some memorable names that aren’t necessarily associated with taxes. “Double Irish” and “Dutch Sandwich” are not the latest offerings at your favorite fast-food restaurant. Other names sound more like a science fiction movie sequel such as “Killer B” and “Deadly D.”

All of these terms describe some global tax planning that has been reported in the media. As world business has gone global, so has the tax planning. Tax planning is often not one dimensional. It has gone three dimensional in many regards: federal, foreign and state.

Tax planning occurs in many ways that we often take for granted and in some ways is more generic than a fancy term associated with a particular tax strategy. The choice of whether to operate as a “C” corporation or an “S” corporation or partnership/LLC has significant tax consequences for the owners of the business entities.

The current debate in Washington on the Bush-era tax cuts is evidence of this, as any change in individual ordinary and qualified dividend tax rates will impact the tax consequence of operating in a particular entity format. Operating as a “C” corporation will likely become more expensive from a tax view if the rates for qualified dividends are increased. Increases in ordinary tax rates for individuals will impact the amount of tax business owners operating as S corporations or partnerships/LLCs or sole proprietorships will pay on any business profits that may be earned.

Whether a business is on Wall Street or Main Street, tax policy (including tax rates) impacts behavior, and therefore investment and hiring decisions. A day hardly passes without us reading about a package of state and local tax incentives either retaining a business in Michigan or enticing a business to relocate or expand in another state. Many countries have development authorities that do the same on a larger scale to attract business to a specific geographic and jurisdictional location.

As mentioned earlier, the Deficit Commission issued its report Dec. 1 and in the report were included many recommended changes with respect to income taxes. To summarize some of the recommendations, which offer no real surprise: simplify the tax code, reduce tax rates, reduce the types of deductions and expand the tax base of income on which to levy an income tax and reduce the number of tax credits that are now embedded in the Internal Revenue Code.

This is not the first time we have heard such recommendations. The Tax Reform Act of 1986 moved us in a similar direction when it reduced the individual tax rates to two brackets: 15 percent and 28 percent. The corporate rate was reduced from 46 percent to 35 percent. The 1986 reforms also sought to broaden the tax base by eliminating certain deductions, and at the same time it eliminated some tax credits such as the investment tax credit for equipment investment. Also in 1986, the alternative minimum tax was revamped to provide for a 28 percent tax  rate for individuals and 20 percent tax rate  for C corporations with certain adjustments to the regular income tax base. The AMT was intended to ensure that an appropriate rate of tax was borne by all taxpayers.

In the intervening years since 1986, Congress and the various administrations have tinkered and complicated the tax code in some respects, with new deductions, new exclusions, new tax credits and phase-outs that  have resulted in a very complex set of rules.

It is a given today that nearly all taxpayers need the assistance of tax software or a professional tax preparer to complete and file a tax return. If you don’t believe this, try to calculate by hand an individual’s tax liability using the schedule on page 2 of schedule D. This is the schedule that computes tax for a taxpayer with qualified dividends or capital gains income. That task will send your mind spinning faster than the Mad Tea Party ride at Disney World’s Magic Kingdom.

In addition, as a result of the complexity, we are left nearly each year-end with the need for a patch for AMT so taxpayers who were never intended to pay AMT, don’t pay AMT. The IRS form creators are left in a holding pattern regarding whether Congress will pass a patch for AMT. The Deficit Commission did recommend that AMT be permanently repealed.

It is interesting that the Deficit Commission report also did make a recommendation that the U.S. consider moving to an exemption system from a credit system with respect to foreign active business income. Most of the trading partners the U.S. deals with have moved to such a system. The U.K. is the most recent. Canada, France and Germany have been using some form of an exemption system for many years. The exemption system generally does not tax earnings that have otherwise already been taxed in another jurisdiction, albeit at a lower rate than the corporate tax rate in the parent country jurisdiction. The commission also recommended a reduction in corporate tax rates to a level similar to a level of our trading partners.

The Deficit Commission report may soon gather dust as it lays out some politically difficult decisions that need to be undertaken. It does highlight long-term planning and reform of how we operate from both a spending and revenue-raising perspective and suggests how some real progress can occur. At some point, we cannot continue bad habits by shifting the debt burden from the current generation to our children and grandchildren and future generations.

As financial talk show host Dave Ramsey often states, one needs to change spending and savings habits and live on rice and beans for awhile so one can begin to attack the debt load. Change can’t happen until habits are changed. There is the saying that insanity is repeating the same action and expecting a different result. The Deficit Commission report may bring back some sanity and help start some serious dialogue about where this nation is headed and the tough decisions for tax policy and budget policy that need to occur. This may be its lasting mark.

William F. Roth III is a tax partner with BDO USA LLP. The views expressed above are those of the author and not necessarily those of BDO USA LLP. The comments are general in nature and are not to be considered as any specific tax or accounting advice and cannot be relied upon for the purpose of avoiding penalties. Readers are urged to consult with their professional advisers before acting on items discussed herein.

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