The U.S.Tax System
Little Know Fact
Something very few people realize, the 16th amendment to the constitution created two tax systems, one for individuals and and one for businesses. And there’s a world of difference between them.
After proposing the new amendment, Congress began to worry that the amendment wouldn’t be ratified by the states. The issue was the way it was worded.
“The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.”
The specific language causing the concern was, “collect taxes on incomes from whatever source derived.” The concern was, the way it was written included money borrowed & the proceeds when selling at at loss in income subject to taxation. Obviously, Congress had a good reason to be worried. So at the last moment, Congress took out ads in newspapers all over the country promising to ‘tax only profits’.
That relieved an uneasy electorate and the amendment passed unanimously among all the states that voted. Voters weren’t opposed to income tax, they were opposed to an unreasonable tax.
The 16th amendment was subsequently ratified by the Supreme Court in ‘Glenshaw Glass’ and added to the tax code in section 162 of the 1954 tax code. In their deliberations, both the Supreme Court & Congress considered those ads as ‘legislative intent’. Courts have subsequently looked back at those ads to determine Congress’ intent. Intent is crucial to determining how the law will be interpreted and enforced.
In the final analysis, this created to tax systems, which I will explain in my next post.
The upshot is this. Wage earners with no business income have a only handful of tax deductions allowed by Congress; mortgage interest, contributions, etc. Every one of them is a gift from Congress and can be revoked at any time.
On the other hand, businesses can deduct anything & everything. There are no limitations on what a business can deduct. Over the decades since 1913 when the 19th amendment was passed, the requirements for a business deductions into these five requirements.
- Economic substance
- Valid business purpose.
Plus, the IRS does not make those decisions, the business or its owner makes them. If the IRS disagrees, it has to prove the deduction doesn’t meet these requirements.
Since 1913, 90% of tax law, in one way or another, has been written in an attempt to get around the 16th amendment.
According to the constitution & the Supreme Court, before the 16th amendment was added to the Constitution in 1913, it was illegal for Congress to levy tax directly. Congress’ taxing authority was limited to taxing the states, who could raise the money anyway they wished. Never-the-less, Congress actively taxed people off and on until 1895, when the Supreme Court finally took the matter up & decided a direct income tax was un constitutional.
The U.S. Tax System is Brilliant by Mistake.
In the right hands, the tax code is a powerful force for good. It’s size, duration, & complexity create an environment where a good tax professional can mine the complexities, anomalies, differences and conflicts for tax savings.
I am a big fan of the U.S. tax code and the entirety of U.S. tax law. I think it’s a veritable playground of tax saving opportunities that most tax professionals never discover. Throw in 50 states and it gets better. Throw in 171 countries and tax law becomes the perfect playground for tax cutting strategies. Apple built itself in this playground.
The tax code may be an integral part of America’s economic prowess. I believe it is. It opened the door for innovative companies to use unique tax approaches to save taxes. That’s what we do. Every dollar saved drops straight to the bottom line as another dollar of cash, working capital, profits & competitive advantage.
Nowhere in tax are you standing on solid ground.
The tax code is always moving under your feet. There are 54 different individual codes in the United States Code. The Internal Revenue Code is the 26th of 54 titles in the . Other codes include Armed Forces, Bankruptcy & Banking. The 53 other codes are relatively stable & unchanging.
Tax Law is a constantly evolving matrix composed of the code itself, IRS Regulations, litigation results, Revenue Proclamations, private letter rulings, interpretations, etc. Each of these define the way the law is interpreted or enforced. And each of them change regularly as developments occur, especially when the law is new. And none of those are reflected in the original statute or the code itself. So just looking up the tax code is not enough. My research is not complete until I read articles about that specific tax law.
The Tax Code
Prior to 1874, U.S. statutes were not codified. That is, the acts of Congress were not separately organized and published in separate volumes based on the subject matter (such as taxation, bankruptcy, etc.). The first attempt to codify the Tax Code was in the Revenue Act of 1861. Codifications of statutes, including tax statutes, undertaken in 1873 resulted in the Revised Statutes of the United States, approved June 22, 1874, effective for the laws in force as of December 1, 1873. Title 35 of the Revised Statutes was the Internal revenue title. Another codification was undertaken in 1878.
- Revenue Act of 1861
- 1873 tax code
- 1878 tax code
- 1939 tax code
- 1954 tax code
- 1986 tax code
- 2017 tax code
In 1954 all the various tax laws that had ever been passed were codified into the 54 tax code, even preceding the 16th amendment, which became law in 1913. This code was referred to as the 54 code. This basic structure of the tax code has been identical ever since. Tax laws, which are passed every year, are simply hung like Christmas Tree ornaments on the 54 code. Few tax laws are ever repealed. Instead they are superseded. But, if they are never superseded they last forever. In 1986, during the Reagan administration, a big batch of new bills were passed as a reform package. This included ‘at risk’ provisions and ‘passive activities’ to kill a burgeoning tax shelter industry. ‘Economic Substance’ and ‘Valid Business Purpose’ arose separately as tax doctrines with the force of law. They were used to attack tax frauds such as ‘Boss’ & ‘Son Of Boss’. People began calling it the 86 code, but the basic 54 Code structure is still the basic structure of the code and remains unchanged. Many unsupervised tax laws remain fully functional although little used. 2017 tax reform will undoubtedly come be called the 2018 tax code.
So, for the entire time since 1863, Congress has been adding to to tax law, known since 1883 as the U.S. tax code. It started at 400 pages in 1913, the size of a decent book. In 26 years it grew only to 504 pages. Today it’s more than 77,000 pages long. (An entire library of 400 page books.)
This creates a bizarre matrix of anomalies, inconsistencies, differences, conflicting individual laws, that are tied together by invisible threads. This is today’s tax code.
The Tax Code Was Brilliant By Design …
… but the brilliant result was unforeseen. As I’ve already said, the 16th amendment created two separate tax systems. One for business & one for wage earners. That’s because wages are considered profits, which excludes wage earners from deducting ordinary, necessary & reasonable expenses. Businesses & their owners have the full benefit of the 16th amendment.
The Way It Works Is Brilliant By Mistake.
Overwhelming Size & Complexity. The tax code is reportedly 77,000 pages long. Add in Regs, Rev Procs and litigated results, and you’re up to 240,000 pages. Add in 50 states and 172 countries and you are dealing with 25 million to 53 million pages.
Somewhere in that conglomeration, the average tax preparer is completely left behind. Our genius intellect, 4+ decades experience and deep domain expertise sets us apart from the average tax preparers who were left behind after a few thousand pages.
Inevitably in anything as complex and enormous as the tax codes, there are hundreds of thousands of unintended discrepancies, differences, anomalies, inconsistencies, etc. that are breeding grounds for legal tax savings. In addition, in some instances, such as international taxation, when you’re determining which countries to run revenues through, your data base includes the 25 to 53 million pages. There are discrepancies, differences, anomalies, inconsistencies between countries as well as within individual tax codes that can play off each other to save tax legally. This is breeding ground for tax strategy.
Facts & Circumstances
Here is the pecking order of the entire body of tax law. From most important to least important. The bottom of the list reflects the language passed into law. Emphasis moves up the list as government decides how to administer and enforce it legislation & litigated results.
- Facts & Circumstances. (Most important.)
- Revenue Procedures
- IRS Regulations
- Everything else like private letter rulings.
- Tax code.
- Individual tax acts like the Tax Cut & Jobs Act. (Least important.)
- Private Letter Rulings
The tax code is unique in all the world. As soon as it hits the internet, the law begins morphing as the IRS, the courts & taxpayers begin attacking it determining how the act will be administered & enforced. Unique among the worlds’ tax codes, U.S. tax law, not the code, is a living law, constantly growing & changing. No other law in the world is anything like it.
We are unique, and this ubiquity, and all the other iniquities about the U.S., add to to the powerful uniqueness of our country? Especially our economies muscle.
No other country in the world holds a candle to us.
Tax law is available to everyone in the country. It’s identical for everyone. Taxpayers with identical earnings should get identical results. Bit they don’t because Facts & Circumstances change, & also because of widespread incompetence throughout the professions. When facts & circumstances are introduced into that particular mix, the door opens to niche opportunities to save tax legally based on facts & circumstances. That is the brilliance of the U.S. tax system.
That’s why we have a tax industry in the U.S. The distinguishing factor between companies that are successful long term in blending talent with tax law. Most of the Global 500 have people who can blend them together well. See here for a discussion of tax talent. Private companies generally don’t.
The difference in talent is severe. That’s why the GAO reported large companies pay less tax at lower rates than privately owned companies. Both have access to the same tax code, but vastly different talent. Top notch talent is simply not widely available to private companies. Most tax professionals avoid the talent issue altogether by filing tax on the SALY (same as last year) method.
Key Tax Doctrines
The entire tax code rests on two doctrines which, technically, are not in the tax code per se, but which for all intents and purposes provide the foundation the entire tax code was based on – Economic substance & valid business purpose. Every time I think about this I am reminded of the parable about building your house on solid rock instead of shifting sand. The entire tax code was built on shifting sand. It took a Supreme Court decision, Glenshaw Glass, to place the cornerstone. We introduced them above, but these two precepts lurk in the background of every tax controversy. So you need to be aware of them.
Economic substance is a doctrine in the tax law of the which a transaction must have both a substantial purpose aside from reduction of tax liability and an economic effect aside from the tax effect in order to be considered valid. It isn’t valid to pursue a course of action if saving taxes is the only reason you do it. Every transaction must have an economic substance aside from avoiding taxes in order to be valid. Just satisfying the technical requirements of the code, isn’t enough. You also have to pass the test of economic substance. If it doesn’t, it’s considered abusive. Economic substance made its way into the tax code for the first and only time in in 2010 in ACA.
Valid Business Purpose.
Valid business purpose raises the issue of motive on federal income tax liability. Tax avoidance “by means which the law permits” traditionally has been viewed as a legal right. Justice Learned Hand of the New York Court of Appeals, made the famous statement, “It is perfectly legal to so arrange your affairs to pay the least income tax.” However, for forty-five years, the Commissioner of Internal Revenue (Commissioner) has been probing taxpayers’ business motives, generally with the blessing of courts. This has led to the development of the business purpose doctrine, which permits the Commissioner to reverse tax benefits for certain transactions motivated by tax avoidance or non-business purposes. Although the doctrine arose in the context of reorganizations, it was extended rapidly to other areas.- Recently, it has been discussed as a “pervasive judicial doctrine” in tax law. When and how the doctrine should be applied, however, is still the subject of controversy … because it has never been codified by adding it to the tax code.
These concepts developed organically in the courts because they were necessary to hold the tax code together. As people with uncommon abilities began working in the tax code on behalf of their clients to avoid income tax, some very bright people discovered ways to work in the seams of the tax code to follow the letter of the law but cut taxes to nothing. (This is what we do at Ellis.) That’s still possible. But today you have to be aware of these two foundational precepts. People have overlooked them & gone to prison for their oversight.
In today’s world, there are three kind of tax professionals. Education based, preparation based & strategy based. The education based suffered severe devaluation when Google put everything on your phone. Today, I personally do a large part of my research on Google.
Preparation based prepare returns by plunking your numbers on tax forms. This is by far the vast majority of American tax professionals.
Tax strategists make the world go around by devising means to save tax that you would otherwise pay.
In its ultimate simplicity, if you’re doing everything else right, there are only three ways to save tax; move income to lower tax jurisdictions, convert personal, non-deductible expenditures into legitimate tax deductions, or convert taxable income into nontaxable income. The hated fourth way that targets you specifically or as part of a protected group from the maximum tax rates. For instance, Carried Interest that allows specific individuals to pay capital gains rates on ordinary income.
The fifth way which is generally considered folk lore, tax strategy. Tax strategy can’t be learned in college. You can’t learn it from a book or osmosis. Not everyone has a strategic viewpoint. And not everyone is creative. There is only one way to learn tax strategy … by actually doing it over a long period of time. A few years won’t do it. A couple decades may not be enough. Today, I’m now more than four decades into tax strategy. Do the math. As far as I know, I’m the only tax strategist working with private businesses.
Here’s how we do it.
First we listen & learn. Then we mix & match. Tax law with circumstances. The result is tax strategy custom designed specifically for you. Which is exactly what Apple’s tax strategist did for them, and we’ve had similar success. In the last decade, we’ve saved millions of dollars for hundreds of businesses using this process. We are successful 99% of the time. Because these savings repeat themselves year after, it’s nearly impossible to estimate the total tax we saved.
There 28 million privately owned business & their owners, but there’s only one of us. You need us worse than we need you. We’re the prize.
If your tax preparers aren’t saving you tax, what good are they?
Quote from a frustrated physician … “Despite hiring a local CPA, I was paying excessive amounts of taxes. Even worse, every time I suggested a way to reduce my tax burden it was rejected off hand. Taxes were easily my biggest expense and I had a sinking feeling that I was overpaying. When I discussed the topic with my colleagues, they were in the same boat.” Read this to understand why.