Hot Topics September 1995

The Flat Tax Reconsidered

In the March edition of my Hot Topics page, I wrote about Congressman Richard Armey's flat tax proposal. In July, I participated as a panelist on a cable television show called "Newstalk TV." The producer was cruising the net, used the search engine "Infoseek," typed in the words "flat tax," and -- voila!-- found my article. The program was similar to "Larry King Live." There was a moderator, panelists and people calling in with questions.

The first caller made the following statement, "Almost everybody here at work is for the flat tax since it will get rid of the tax lawyers and accountants, and will get rid of the IRS." Of course, this is a myth which many frustrated Americans share. My response was that the flat tax should be renamed "The Tax Attorneys and Accountants Full Employment Act" since if enacted, tax experts would be busy restructuring transactions for the foreseeable future.

Also, despite the caller's wishful thinking, the IRS would still be auditing tax returns and striking terror in the citizenry. Flat tax audits, however, would involve "characterization of income" issues, since, only some types of income will be fully taxable. For this month's Hot Topic, I will elaborate on the flat tax and explain some of its pitfalls.

Contrary to Belief, There will be a Whole Lot of Work for Tax Attorneys and Accountants

The flat tax will apply to wages and rents, but not to sales of investment property ("capital gains" transactions), dividends and interest. This disparity will create a huge incentive to restructure transactions ("recharacterize" income) to fall within the non-tax provisions of the flat tax.

The battle over what constitutes capital gains has been fought throughout the history of the tax code and both the taxpayers and the IRS have had their share of victories. One of the main reasons for enacting the Tax Reform Act of 1986 was to eliminate the distinction between capital gains and ordinary income and thereby avoid this confrontation. Under the flat tax, this issue will once again take center stage. Winning this battle will mean the difference between a 20% flat tax and no tax; consequently, tax attorneys and accountants will be extremely busy and creative --pulling out all the old techniques for converting ordinary income into capital gains -- so their clients will pay no tax.

While capital gains conversions would be the primary target, restructuring payments to workers in closely held companies from wages to tax-free dividends or interest will also occur. We will also see complicated arrangements to convert rental income into tax-free dividends and interest. For instance, owners of rental property will transfer title to corporations to take advantage of the tax-free provisions for interest and dividends paid to shareholders.

Example: Assume a rental property has a tax basis of $200,000 and produces $20,000 in rents. Assume there is $10,000 in expenses and depreciation so the net profit is $10,000. Currently, the owner is taxed on $10,000 as ordinary income. Assume there is a flat tax in which the rental income will be taxed at 20%. The owner can convert the income into tax-free interest as follows: The owner forms a corporation and transfers the property to the corporation. He receives stock of $100,000 and debt of $100,000 at 10% interest. The transaction is considered a sale producing capital gains since the owner is receiving both stock and debt. But capital gains would no longer be a taxable transaction. The corporation receives a net of $10,000 in profits, but it will have an off-setting deduction (either an interest deduction or a large depreciation deduction - if the corporate interest deduction is eliminated under the flat tax proposal); consequently, there will be little or no corporate tax. The shareholder has interest income of $10,000, but under the flat tax, interest is not taxable. The end result is a conversion of taxable rents into tax-free interest.

If the interest deduction is eliminated for corporations, the taxpayer could use a limited liability company or other pass-through entity to accomplish the same result (an installment sale to a friend or relative could also work).

Of course, this example can be replicated or modified to meet all types of transactions. The basic technique to accomplish the conversion involves triggering a tax-free capital gain and then converting the proceeds into a tax-free stream of income. Use of installment sales, where a highly-appreciated asset (such as real estate) is sold for a promissory note paying principal and interest over a long period of time, will now be a completely tax-free event. Therefore, taxpayers could sell such assets to entities in which they control and receive a tax-free income stream. By raising the interest rate or using a participation percentage (such as a 50% of the profits) as interest, one can virtually strip-out all the taxable profits from the entity that now holds the asset.

In conclusion, the incentive to recharacterize income as tax-free will be irresistible and the flat tax will be quickly overwhelmed by creative and aggressive taxpayers and their advisors.

Audits are Still Necessary

The flat tax's promise of a "post-card" sized tax return will not eliminate the IRS or record keeping. The IRS will continue to ensure compliance with the tax law, and that means audits. The focus of IRS audits will shift from verifying the deductions to characterization of income issues, such as the conversion from taxable income into tax-free income. Remember, if someone is paid $1.00, the economic substance of the transaction is that one person received a dollar and one person paid a dollar. If the transaction can be restructured so that the person receiving the dollar receives it tax-free, then the parties will have a direct economic incentive to restructure the transaction. The government must continue to audit transactions to prevent massive fraud and a loss of tax revenue to the government. Wishful thinking aside, it is clear that the government will do whatever is necessary to secure its proper share of revenues under a flat tax, your revenue-hungry politicians will demand it.

The Flat Tax Could Cause an Economic Disaster

If one were forming a new country and devising an ideal tax system, the flat tax might merit consideration. Unfortunately, in the real world we are dealing with an economy that is a tightly-woven and inter-related set of billions of on-going transactions. Changing the rules in the middle of such an economy will invite disaster.

As discussed in the April edition of Hot Topics, the flat tax will eliminate the mortgage interest deduction for the family home. This alone will cause the interest portion of mortgage payments to increase by 25%. (At a 20% flat tax, an interest payment of $1,000 would require earning $1,250; a tax of 20% on $1,250 = $250, leaving $1,000 for the interest payment). That, in turn, will decrease the value of housing since the cost of maintaining a home will have increased 25%. While some would argue that a decrease in the housing market will enable first-time home buyers to purchase a house, their monthly payments now will be 25% higher which might make it harder (or impossible) for them to qualify for a loan. Also, with the tax incentive for owing a home gone, rents will increase and could drive those renters who cannot afford the higher rents into the street. Higher monthly mortgage payments could also trigger numerous defaults on mortgage loans and a collapse in the housing market. Banks and Savings and Loans who have loaned large amounts to the housing market could fail if their borrowers default in large numbers. And so on.

Actually, this scenario occurred after the Tax Reform Act of 1986. The collapse of the Savings and Loan industry occurred, in large part, because many of the major construction projects they were financing could not be sold. The target purchasers for many projects were limited partnerships which took advantage of the tax breaks offered for real estate investments. But the Tax Reform Act eliminated those tax breaks and all of a sudden, there were no buyers for these real estate projects. The lesson is clear, massive tax reform can have sudden, unforeseen and ruinous consequences.

Also, under the flat tax, corporations would not be able to deduct health care payments or any other non-taxable fringe benefits now provided to their workers. Guess what -- corporations will eliminate those payments and suddenly workers will have to scramble to pay for their own health care and other fringe benefits; again, with after-tax dollars. This is another example of a hidden tax lurking in the flat tax proposal.

The Flat Tax is an Absolute Gift to the Rich

Finally, stripped of all its pretense, the flat tax is really a reward to the very rich; those people to whom the Washington politicians grovel for campaign financing. Consider this actual example: In 1994, a taxpayer received salary, dividends, interest and sold some assets for a profit. His income was $1,100,000 and his federal income tax was approximately $300,000. Under the flat tax, his income tax will fall to $17,000! This example makes crystal clear who benefits from a flat tax. Another example: Assume Bill Gates has $5 billion of Microsoft stock and receives dividend payments of 5% on that stock. Under the flat tax, he will receive $250,000,000 in tax-free dividend income and will pay less tax than a family of four earning $50,000!

The flat tax rewards those who clip interest coupons and receive dividends from their investments and punishes those who work to support themselves and their families. Under a flat tax, one is far better off inheriting wealth rather than working for a living. Instead of surgeons performing operations and paying tax on their earnings, they will become real estate speculators engaging in tax-free capital gain transactions. This is precisely what happened when capital gains were taxed at a maximum of 20% compared to a 50% tax for personal service income. These priorities are perverse and certainly go directly against the very "work ethic" that its anti-government promoters constantly espouse.

You Can't Fix the System Until You Know Why It's Broken

While everyone agrees that our current tax system is a convoluted mess, the flat tax or any other quick fix will never work until we deal with the causes of the tax system's complexity. First, the code is complex because the economy itself is complicated, diverse and complex. The same tax code taxes an individual with $10,000 of income and General Motors with over a $10,000,000,000 of income. There is no reason why a single tax code should attempt to tax every transaction in our economy. Second, the code attempts to levy the tax burden in a fair manner - those with large incomes should pay their fair share of taxes and should not be able to subvert their duty though clever manipulations of the code. Consequently, there are many "defensive" provisions in the code to close loopholes and ensure that people pay their fair share of taxes.

More importantly, the tax code has been usurped by the Washington politicians as a tool to finance their re-election campaigns. They have rewarded their special interest contributors with loopholes and tax breaks. The relationship between the special interests and the legislators is symbiotic: the politicians threaten tax reform and the elimination of loopholes in order to garner campaign contributions from the special interests in return for preserving the status quo, just as the special interests lobby for increased tax breaks in the first place. The end result: campaign funds for the politicians, tax breaks for special interests, and a tax code that is incomprehensible.

The influence of special interests works two ways: First, they want loopholes and are willing to contribute heavily to the campaign coffers of politicians on the tax-writing committees to get those favors. Secondly, Congress has decreed that for each tax decrease, there must be an offsetting tax increase. The combination of these two facts means that special interests are adding complexity to the code by first giving themselves loopholes, and then raising taxes to off-set the loophole created. Since Congress will not raise taxes directly, the special interests tinker with the accounting provisions or penalty provisions in the code to raise the funds for their tax breaks. But those provisions burden all taxpayers and the cumulative effect of this procedure has made the tax code unworkable.

The failure of Congress to level with the American people when its raises tax indirectly also contributes to the current level of complexity. Congress relies on the Treasury Department and the IRS to issue regulations and rulings that protect the tax revenue base, rather than raise taxes directly. So instead of a straight-forward tax increase which the American people see, the Treasury Department and the IRS crank out thousands of pages of complex regulations and rulings which accomplish the same task; confusing the public with complexity, then punishing them with tax penalties for "misinterpreting" the tax law. Also, the tax-writing committee staffs have jobs to protect -- and complexity is a bureaucrat's security blanket.

Until campaign reform is enacted, special interests will continue to rule the day in Washington. Their efforts to secure tax breaks, while simultaneously skewering the rest of the taxpaying public by providing complex tax provisions that raise taxes to off-set their tax breaks will continue, despite passing a flat tax or any other tax measure. Just wait. Next year, the special interests will be back in force, undermining whatever tax proposal passed the year before. And so it goes....

| Home Page | Search | E-mail Form | Firm Profile |

**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**