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Recently, the written supervisory approval requirement of Section 6751(b) has been one of the primary issues in Tax Court litigation concerning penalties that the IRS has asserted against taxpayers. The focus of this litigation is the effect of Section 6751(b) and its interplay with the Commissioner’s burden of production as to penalties in court proceedings under Section 7491(c). In Dynamo Holdings v. Commissioner, 150 T.C. No. 10 (May 7, 2018), the Tax Court addressed these issues in a partnership-level proceeding.

Section 6751(b)(1) provides that “[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination…” (note that Section 6751(b)(2) provides certain exceptions to this general rule).

Section 7491(c) provides that the IRS “shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty, addition to tax, or additional amount imposed by this title.”

Until the Chai and Graev III opinions, there had been little litigation over the effect of Section 6751(b).

In Chai v. Commissioner, 851 F.3d 190 (2nd Cir. 2017), the taxpayer argued in his post-trial brief that compliance with the written-approval requirement in Section 6751(b)(1) is an element of the Commissioner’s claim for penalties and is therefore part of the Commissioner’s burden of production under Section 7491(c). The Second Circuit Court of Appeals agreed, holding that Section 6751(b)(1) requires written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty. Chai held that Section 6751(b) is part of the Commissioner’s burden or production in a deficiency case in which a penalty is asserted.

In Graev v. Commissioner (Graev III), 149 T.C. No. 23 (Dec. 20, 2017), the Tax Court held that the Commissioner’s burden of production under Section 7491(c) includes establishing compliance with the written supervisory approval requirement of Section 6751(b). Thus, in a deficiency case in which a penalty is asserted, it is the IRS’s burden to introduce sufficient evidence establishing compliance with the supervisor approval requirement.

In Dynamo Holdings, the Tax Court addressed the interplay between the supervisor approval requirement and the IRS’s burden of production in a partnership-level proceeding. The Court held that the IRS does not bear the burden of production with respect to penalties under Section 7491(c) in a partnership-level proceeding. The Court reasoned that Section 7491(c) provides that the IRS has the burden of production “with respect to the liability of any individual for any penalty…” Because partnership-level proceedings do not determine liabilities and are not with respect to individuals, the IRS does not bear the burden of production as to penalties. In a similar vein, the IRS does not bear the burden of production with respect to penalties asserted against corporations.

The Court further held that where the IRS does not bear the burden of production as to penalties, the lack of supervisory approval of penalties may be raised as a defense to those penalties. However, taxpayers should note that they must affirmatively argue that the IRS failed to comply with the supervisory approval requirements of Section 6751. Failure to make such an argument can be costly, as the taxpayer will be deemed to have waived the defense.

United States v. Gerard, a recent case from the Northern District of Indiana, demonstrates how a tax lien, once attached, can stay with property even after the property is conveyed to someone other than the taxpayer.  In 1990, a husband and wife named Robert and Cynthia Gerard bought a residence as tenants by the entirety.  Although the Gerards bought the residence together, Robert paid at least 90% of the purchase price.  Between 2003 and 2008, Cynthia owned a business with outstanding employment and unemployment taxes.  The Gerards and the government generally agreed that the assessments for these tax liabilities attached to Cynthia’s interest in the property.  As time went on, Robert and Cynthia decided to convey the property solely to Robert.  The deed stated that the conveyance was “by way of gift and without any consideration other than for love and affection.”

The government, however, still wished to enforce the liens.  Litigation ensued, and the government moved for summary judgment.  The key issue was whether the liens that were attached to Cynthia’s interest in the property survived the severance of the tenancy by the entirety.  Section 6323 provides that a lien is not valid against a purchaser until the IRS files proper notice.  Thus, according to the court, Robert would not be liable for Cynthia’s outstanding tax balance if Robert was a “purchaser.”  A “purchaser” is “[a] person who, for adequate and full consideration in money or monies worth, acquires an interest (other than a lien or security interest) in property which is valid under local law against a subsequent purchaser without actual notice.”  IRC § 6323(h)(6).  “Adequate and full consideration in money or money’s worth” is “a consideration in money or money’s worth having a reasonable relationship to the true value of the interest in property acquired.”  Treas. Reg. § 301.6323(h)-1(f)(3).

The Gerards argued that Robert was a purchaser because Cynthia used marital assets to pay her business’s expenses and then transferred her interest in the property in repayment of those debts.  The government, however, pointed out that the deed specifically stated that the transfer was made “by way of gift and without any consideration other than for love and affection,” and that any consideration would have been past consideration, which was insufficient.

The court was not concerned that the deed stated that the property was a gift.  It noted that “[i]t is a well-known fact that often a conveyance recites a nominal consideration whereas the true consideration is not nominal.  It is therefore never certain that the recited consideration is the true consideration.”  Clark v. CSX Transp., Inc., 737 N.E.2d 752, 759 (Ind. Ct. App. 2000).  The court was, however, concerned with the fact that the parties agreed that the use of marital assets to pay Cynthia’s business expenses was “past consideration.”  Under the regulations, “adequate and full consideration” includes past consideration only if, “under local law, past consideration is sufficient to support an agreement giving rise to a security interest. . .”  Treas. Reg. § 301.6323(h)-1(a)(3); (f)(3).  Accordingly, the court turned to Indiana law to determine whether past consideration could create a security interest.

The Gerards could not cite any Indiana authority indicating that past consideration gives rise to a security interest.  Also, other federal courts hold that past consideration does not make a party a “purchaser” under section 6323(a).  See, e.g., United States v. Register, 727 F. Supp. 2d 517, 526 (E.D. Va. 2010).  Thus, the court concluded that Robert was not a purchaser under section 6323(a) and that the liens attached to Cynthia’s interest in the property survived the conveyance.

The parties still disputed the extent to which the liens attached to the property.  The government argued that the liens remained attached to a one-half interest in the property.  The Gerards, however, argued that Cynthia’s actual interest was worth less than one-half of the property when it was conveyed, so the liens only attached to something less than a one-half interest.  Here again, the court found that Indiana law did not support the Gerards’ argument.  For example, in Radabaugh v. Radabaugh, the court held that the trial court erred by “conclud[ing] that appellee was the owner of less than an undivided one-half interest in the mortgage loan” for real estate owned by a husband and wife as tenant by the entirety.  35 N.E.2d 114, 115-16 (Ind. Ct. App. 1941).  Thus, the court concluded that the liens were still attached to one-half of Robert’s interest in the property, even after the conveyance.

 

The Internal Revenue Code requires employers to withhold certain taxes in “a special fund in trust for the United States” (sec. 7501(a)). IRS regulations require employers to pay these trust fund taxes to the IRS quarterly. Employers who fail to pay withheld taxes to the government are personally liable for the taxes under section 6672 of the Code. In general, the government can recover unpaid taxes if (1) the employer is responsible for collecting and paying withholding taxes, and (2) the individual willfully failed to collect and pay the withholding taxes. What is key is that the IRS can recover from any responsible person, not necessarily the most responsible person.

The trust fund recovery penalty is often a trap for the unwary, including for partners and shareholders of law firms, as illustrated by Spizz v. United States, 120 A.F.T.R. 2d 2017-6719 (S.D.N.Y. Dec. 4, 2017). Spizz and Todtman were shareholders of the law firm Todtman, Nachamie, Spizz & Johns, P.C., from 2009 through September 2012. The court in Spizz held that the government could hold Spizz and Todtman personally liable for the trust fund taxes the firm failed to pay between 2009 and 2012. Despite the fact that the firm was going through serious financial difficulty, the court held that both shareholders were personally liable for the trust fund taxes.

Responsible Persons

The court first turned to whether Todtman and Spizz were “responsible persons” for the firm’s payment of trust fund taxes. The court stated that the payment issue depended on whether, given the individual’s authority over the company’s financial operations, the individual could have prevented the tax delinquency.

The court found that both Todtman and Spizz were responsible persons. Todtman founded the firm, served as its president while holding one-third ownership during the relevant periods and exercised authority over the firm’s finances. Although Spizz did not make financial decisions to the same extent as Todtman, the court stated that the “inquiry focuses on whether an individual could have exerted influence” to avoid tax delinquency. The court found that Spizz was also a responsible person because he held one-third of the firm’s shares and was its vice president.

Willfulness

The second element of tax payment liability under section 6672 is willfulness. A person willfully fails to pay withholding taxes if payment is made to other creditors while knowing that withholding taxes are due. The court found that Todtman was aware of the firm’s responsibility to pay trust fund taxes, and that the firm was paying other creditors before the IRS. While the trust fund taxes were still due, Todtman signed checks on behalf of the firm to disburse funds for payroll and payments to creditors.

The court also held that Spizz willfully failed to remit trust fund taxes. Although he did not learn of the firm’s tax liability until June 2010, he failed to apply the firm’s unencumbered assets to the firm’s tax liability when he found out about it. The court held that this was sufficient to establish willfulness for the pre-June 2010 period. After June 2010, when Spizz became aware of the firm’s tax liability, the court held that he could no longer maintain a reasonable belief that other members of the firm would timely pay its trust fund taxes. Thus, Spizz could not claim that he did not willfully withhold trust fund taxes.

Our colleague Tiana R. Seymore has authored a client alert addressing several provisions in the Tax Cuts and Jobs Act which directly impact the workplace, including one that gives some employers a credit for providing paid family and medical leave if they meet specific requirements and another that eliminates certain tax deductions in sexual harassment and sexual abuse cases.  You can read Tiana’s alert here.

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The Internal Revenue Service advised tax professionals and taxpayers today that pre-paying 2018 state and local real property taxes in 2017 may be tax deductible under certain circumstances.

The IRS has received a number of questions from the tax community concerning the deductibility of prepaid real property taxes. In general, whether a taxpayer is allowed a deduction for the prepayment of state or local real property taxes in 2017 depends on whether the taxpayer makes the payment in 2017 and the real property taxes are assessed prior to 2018.  A prepayment of anticipated real property taxes that have not been assessed prior to 2018 are not deductible in 2017.  State or local law determines whether and when a property tax is assessed, which is generally when the taxpayer becomes liable for the property tax imposed.

The following examples illustrate these points.

Example 1:  Assume County A assesses property tax on July 1, 2017 for the period July 1, 2017 – June 30, 2018.  On July 31, 2017, County A sends notices to residents notifying them of the assessment and billing the property tax in two installments with the first installment due Sept. 30, 2017 and the second installment due Jan. 31, 2018.   Assuming taxpayer has paid the first installment in 2017, the taxpayer may choose to pay the second installment on Dec. 31, 2017, and may claim a deduction for this prepayment on the taxpayer’s 2017 return.

Example 2:  County B also assesses and bills its residents for property taxes on July 1, 2017, for the period July 1, 2017 – June 30, 2018.  County B intends to make the usual assessment in July 2018 for the period July 1, 2018 – June 30, 2019.  However, because county residents wish to prepay their 2018-2019 property taxes in 2017, County B has revised its computer systems to accept prepayment of property taxes for the 2018-2019 property tax year.  Taxpayers who prepay their 2018-2019 property taxes in 2017 will not be allowed to deduct the prepayment on their federal tax returns because the county will not assess the property tax for the 2018-2019 tax year until July 1, 2018.

The IRS reminds taxpayers that a number of provisions remain available this week that could affect 2017 tax bills. Time remains to make charitable donations. See IR-17-191 for more information. The deadline to make contributions for individual retirement accounts – which can be used by some taxpayers on 2017 tax returns – is the April 2018 tax deadline.

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Our colleagues Stanley Barsky, Michael S. Bookbinder, and Eric J. Michaels have published an article about several provisions in the Tax Cuts and Jobs Act — signed into law by the president today — that significantly affect the federal income tax consequences of structures often used in domestic M&A transactions.  While some are taxpayer-favorable, others are unfavorable, as compared with prior law.  Buyers and sellers should carefully plan any acquisition or disposition of assets or equity interests to maximize the impact of the favorable provisions and mitigate the impact of the unfavorable provisions.  You can read their article by clicking here.

For more up-to-date coverage from Tax Controversy Sentinel, please subscribe by clicking here.

We have all heard the old proverb “if it’s too good to be true, then it probably is.” In the tax world, this proverb might as well be referred to as the economic substance doctrine. Generally, taxpayers are free to structure their business transactions in a manner of their choosing. However, the economic substance doctrine permits a court to disregard a transaction for Federal income tax purposes if the transaction has no effect other than generating an income tax loss.  In the case of Smith v. Commissioner, T.C. Memo. 2017-218, the taxpayers violated this doctrine by trying to transform cash and securities into a loss through a series of transfers involving an S corporation and a limited partnership.

The Plan

In Smith v. Commissioner, Mr. Smith retired from National Coupling in 2009. Upon retirement, he received a bonus and total employee compensation of approximately $664,000. Mr. Smith’s financial adviser referred him to a tax and estate planning attorney (who was also a CPA) for tax planning services. With the intention of offsetting the compensation income Mr. Smith received from National Coupling, the attorney recommended the following tax planning structure:

  • In 2009, Mr. Smith and his wife (the “taxpayers”) would create an S corporation (wholly owned by the taxpayers) and a family limited partnership.
  • The S corporation (along with a management company) would own the family limited partnership.
  • The taxpayers would transfer cash and marketable securities to the S corporation. The S corporation, in turn, would immediately transfer the cash and marketable securities to the family limited partnership.
  • The S corporation would dissolve in 2009 (the same year it was created). Upon dissolution, the S corporation would distribute limited partnership interests in the family limited partnership to the taxpayers.
  • The fair market value of the distributed partnership interests would be discounted for lack of marketability and lack of control, generating a tax loss equal to the difference between the fair market value of the discounted partnership interests that were distributed over the cash and marketable securities the S corporation transferred to the family limited partnership.

The taxpayers agreed to the structure, and in 2009 they transferred a total of approximately $1.8 million in cash and marketable securities to a newly formed S corporation. The S corporation transferred an approximately equal amount to the newly created family limited partnership. At the end of 2009, the taxpayers and the attorney dissolved the S corporation. In the dissolution, the S corporation transferred a 49% limited partnership interest to each Mr. and Mrs. Smith. The attorney determined that the fair market value of the distributed partnership interests were approximately $1.1 million after discounting the value for lack of marketability and lack of control. The S corporation reported a loss of approximately $700,000 ($1.1 million in gross receipts (equal to the discounted value of the distributed partnership interests) less $1.8 million cost of goods sold (equal to the cash and marketable securities transferred to the family limited partnership)).

The Problem

The S corporation did not have any business activity whatsoever. It did not have a bank account, did not issue stock certificates, did not keep minutes of meetings, and did not follow corporate formalities. The S corporation existed solely to generate an artificial tax loss to offset Mr. Smith’s income. Consequently, the Court determined that the economic substance doctrine prevented the taxpayers from claiming the loss.

The Kicker

The IRS also asserted that the taxpayers were liable for a $125,000 accuracy-related penalty for a substantial understatement of tax. Taxpayers have a defense to accuracy-related penalties for reasonable reliance on the advice of a tax professional if they can prove three elements: (1) the taxpayer reasonably believed that the professional was a competent adviser with sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment. Further, due care does not require that the taxpayer challenge his or her attorney’s advice or independently investigate its propriety. Surely, the taxpayers would be able to establish that they reasonably relied on the faulty advice of their attorney, right? The Court determined that the taxpayers proved the first two elements of the defense, but not the third. What was the taxpayers’ fatal flaw? The Court thought they lied during trial. In the Court’s own words:

“They understood, early in the process, that [the S corporation] would be organized and dissolved in 2009 but continued to represent, even at trial, that [the S corporation] had a business purpose. This is not acting in good faith. They knew from the beginning that [the S corporation] would not last past 2009, it did not have a genuine business purpose, and its sole purpose was tax avoidance. That knowledge alone negates a reliance defense.”

Consequently, the Court determined that the taxpayers were liable for the accuracy-related penalty.

We highly recommend that taxpayers understand every aspect of transactions they enter into, especially when targeted to tax planning.  If a proposal seems too complicated or if you can’t make sense of something, get a second opinion, or…RUN!

On Thursday, November 2, the House Ways and Means Committee released the proposed Tax Cuts and Jobs Act, which proposes significant revisions to the Internal Revenue Code. According to Fox Rothschild tax partner Jennifer Benda, “my sense after reading the Bill is that most taxpayers’ tax liabilities will roughly remain the same.” The Tax Policy Center agrees with this general view.

A broad overview of several different parts of the Bill are discussed below.

Individuals

  • The Bill reduces the number of individual income tax brackets from seven to four. In general, rates are lowered.
  • The Bill provides for an increased standard deduction (nearly double the current deduction amount). The intent behind the increased standard deduction is to achieve simplification by reducing the number of filers who itemize deductions from approximately 33% currently to less than 10%. To accomplish this objective, the Bill repeals or reduces many deductions (such as deductions for personal exemptions, moving expenses, tax preparation expenses, medical expenses, and personal casualty losses, among others).
  • The Bill reduces the mortgage interest deduction. Under current law, taxpayers are allowed to deduct $1 million for acquisition indebtedness and $100,000 for home equity indebtedness. The Bill reduces the deduction for acquisition indebtedness from $1 million to $500,000, and interest is deductible only on the taxpayer’s principal residence (under current law, the deduction is available for interest paid on a principal residence and one other residence). Interest on home equity indebtedness will no longer be deductible.
  • The Bill modifies the exclusion of gain from the sale of a principal residence. Under current law, a taxpayer may exclude $250,000 ($500,000 if married filing jointly) on gain of the sale of a principal residence if the property was owned and used as a principal residence for two of the previous five years. The Bill modifies the exclusion to require the taxpayer to own and use the home as a principal residence for five of the previous eight years, and the exclusion if phased out one dollar for every dollar by which the taxpayer’s adjusted gross income exceeds $250,000 ($500,000 if married filing jointly).
  • The Bill narrows property that is eligible for like-kind exchange treatment. Current law allows like-kind exchange treatment for real property and personal property if certain conditions are met. The Bill allows for like-kind exchange treatment only for real property. However, the Bill provides for a transition rule to allow exchanges of personal property to be completed if the taxpayer has either disposed of the relinquished property or acquired the replacement property on or before December 31, 2017.
  • The Bill increases the Child Tax Credit from $1,000 per child to $1,600, and increases the threshold at which the credit is phased out. The Bill also provides for a new family flexibility credit, which is non-refundable and subject to a phase out.
  • The Bill consolidates the current American Opportunity Credit, Hope Scholarship Credit, and Lifetime Learning Credit into a single education credit. The Bill also repeals the deduction for student loan interest and qualified tuition and related expenses.
  • Family law attorneys will want to note that the Bill provides that alimony payments are not deductible by the payor or included in income of the payee.

Repeal of Alternative Minimum Tax

  • The Bill repeals the AMT, effective for tax years beginning after 2017. If a taxpayer has an AMT credit carryforward, the taxpayer can claim a refund of 50 percent of the remaining credits in tax years beginning in 2019, 2020, and 2021, and taxpayers can claim a refund of all remaining credits beginning in tax year 2022.

Estate Tax, Gift Tax, Generation Skipping Transfer Taxes

  • The Bill doubles the basic exclusion amount from $5 million under current law to $10 million (indexed for inflation).
  • The Bill repeals the estate and generation skipping transfer taxes beginning after 2023.
  • The Bill lowers the gift tax rate to a top rate of 35% (currently 40%) and retains an annual exclusion of $14,000 (indexed for inflation).

Pass-Through Entities

  • The Bill introduces an option for individual owners or shareholders of pass-through entities to treat a portion of pass-through entity net income distributions as “business income” that would be taxed at a maximum 25% rate. The remaining income would be taxed at the owner or shareholder’s individual income tax rates. Under current law, owners of pass-through entities are taxed on their share of business income at their respective individual income tax rates (i.e., there is currently no option to treat a portion of income as business income that would be taxed at a reduced rate).
  • The proposal offers two different ways to determine business income: (1) a set capital percentage of 30% of the net business income derived from active business activities (treated as business income subject to the 25% rate, and the remaining 70% is taxed at the owner or shareholder’s individual income tax rate), or (2) apply a formula to determine the exact capital percentage. Professional service partnerships are not eligible for the 70/30 rule. If the alternative method is chosen (option 2), the election would be binding for a five-year period. The Bill distinguishes between passive and active activities, to be determined pursuant to already-existing regulations.
  • The Bill repeals the current technical termination rule related to partnerships. Under current law, a partnership terminates if within a 12 month period there is a sale or exchange of 50% or more of the total interests in partnership capital and profits. The Bill repeals the technical termination rule, meaning the partnership would be treated as continuing and new elections that are currently required in the event of a technical termination would not be required or permitted.

Corporations

  • The Bill provides for a flat 20% corporate tax rate (25% for personal service corporations), eliminating the current marginal tax rate structure.
  • The Bill provides for enhanced cost recovery deductions and expands section 179 expensing. Under current law, taxpayers may take additional depreciation deductions when it places qualified property in service through 2019. The additional depreciation is limited to 50% of the cost of the property, at most. The Bill allows taxpayers to fully and immediately expense 100% of the cost of qualified property acquired and placed in service after September 7, 2017 and before January 1, 2023, and expands property that is eligible.
  • The Bill modifies the accounting method rules. Under current law, corporations with average gross receipts exceeding $5 million typically must use the accrual method of accounting. The Bill allows more corporations and partnerships with corporate partners to be eligible for the cash method of accounting by increasing the $5 million threshold to $25 million.
  • The Bill also allows more taxpayers to be eligible to use the completed contract method of accounting for long-term contracts (as opposed to the percentage of completion method) by increasing the threshold amount from $5 million to $25 million. The completed contract method allows eligible taxpayers to deduct costs associated with construction when they are paid and recognize income when the contract is completed.
  • The Bill modifies or repeals several business-related deductions. The Bill provides for interest deduction limitations (although the limitations do not apply to businesses with average gross receipts of $25 million or less), which disallows a deduction for net interest expense in excess of 30 percent of the business’s adjusted taxable income. The Bill also modifies the net operating loss deduction and nonrecognition for like-kind exchanges (discussed above – limited to exchanges of real property under the Bill), among other deductions. The Bill repeals deductions for local lobbying expenses and domestic production activities (DPAD).
  • The Bill repeals a number of business credits.

Tax Controversy

  • From a tax controversy perspective, the Bill does not modify any existing procedural rules for dealing with the IRS or provide for additional penalties.

This article touches on only a few topics addressed in the Bill. The Bill also revises taxation of foreign income and foreign persons, multi-national businesses, and exempt entities. You can read the Ways and Means Committee’s section-by-section summary of the Bill here.

The White House, Washington, D.C.On October 16, 2017, the White House released the Council of Economic Advisers’ Report, entitled Corporate Tax Reform and Wages: Theory and Evidence.  The Report comes in the wake of the current administration’s push for major tax reform.  With $299 billion in corporate profits abroad in 2016, the focus of the Report is to make the U.S. corporate tax rate more competitive in a global market.  The ultimate goal is for the benefits of the competitive U.S. corporate tax rate to trickle down to an increase in wages.  The Report reaches the conclusion that decreasing the U.S. corporate tax rate from the current thirty five percent to twenty percent will increase the average household income by $4,000 up to $9,000 annually.

Theory

The Report is rooted in the economic theory that there is a correlation between corporate tax rates and labor wages.  The Report states that U.S. companies move capital abroad to take advantage of lower capital tax rates in other countries.  It offers data showing that U.S. corporate profits have soared while wage growth has stagnated.  Over the past eight years, U.S. corporate profits increased at an average rate of eleven percent, but the average household income only increased at a rate of 1.1 percent.

The Report states that lowering the U.S. corporate tax rate to a more global competitive rate would not only bring profits back to the U.S., but also create an incentive for companies to invest the extra capital domestically.  It cites to research suggesting that increased domestic capital investments increases the demand for labor.  An increased demand for labor would theoretically create jobs and raise the price for labor, or workers’ wages.  Under this theoretical basis, the Report uses empirical data gathered from various sources to calculate an estimated dollar amount of the average wage benefits to the proposed lower corporate tax.

Empirical Evidence

The Report relies on different sources that use economic models to predict how a country’s corporate tax rate affects labor.  First, the Report cites to different sources that each offer a percentage of how much workers’ wages bear the burden of corporate tax in order to support the theory that wages bear most of the burden of corporate tax.  The percentages offered in the Report range from twenty-one to ninety-one percent, depending on the specifications used in the economic model.  This means that there are sources cited in the Report that calculated that workers’ wages bear the burden of only twenty-one percent of corporate tax, while other sources cited calculated that workers’ wages bear the burden of ninety-one percent of corporate tax.  The Report concludes that the disparity among the percentages depends on how much the economic model accounted for the flow of corporate capital to other countries, expressing the notion that workers’ wages bear more corporate tax burden as more corporate capital moves abroad.

Next, the Report cites to sources that used economic models to measure the direct relationship between corporate tax and workers’ wages to determine the elasticity of average wages, which is how much wages change when the corporate tax rate changes.  Each economic model cited in the Report offers a different elasticity, meaning that each economic model produced a different result as to how much a one percent change in the corporate tax rate affects workers’ wages.  This is because each model used slightly different variables.  The Report uses results from these different economic models to conclude that for every one percent increase in U.S. corporate tax, workers’ wages decrease by about 0.3 percent.  Using these figures, the Report concludes that these various economic models suggest that decreasing the current corporate tax rate by fifteen percent will raise the average household income annually by, conservatively, $4,000, and up to $9,000, using the higher range of the figures.

Lastly, the Report states that data from the Bureau of Economic Analysis shows that increasing the U.S. corporate tax rate by one percent results in 2.25 percent higher corporate profit shifting to lower tax jurisdictions.  The Report suggests that reducing the U.S. corporate tax rate by fifteen percent would reduce corporate profit shifting to lower tax jurisdictions and result in $140 billion of repatriated profit, based on the figures from 2016.

Review of Sources Cited

A review of the sources cited to in the Report highlight that the disagreement among economic theorists depends on the variables used in the economic model.  First, an economic model can be based on either a closed or open economy.  In a closed economy model, the supply of capital and labor are restricted to that country’s economy.  A closed economy model results in the owners of the capital bearing the burden of the corporate tax.  See Harberger, A.C., The Incidence of the Corporate Income Tax, Journal of Political Economy (1962).  The closed economy model is found more often in older economic literature, as the modern U.S. economy is more global.  In an open economy model, the capital is mobile, meaning that the supply of capital can move to different countries, but the labor remains immobile.  The open economy model shifts the corporate tax burden onto workers’ wages.  Although the Report ultimately uses figures from open economy models to reach its conclusion, this consistency among economic models does not necessarily decrease the variability in results.

Even among economic models that use an open economy, there is drastic variability in results.  Sophisticated economic models based on an open economy can take many forms, such as analyzing data across countries or restricting the model to data from only one country.  For example, the Report used a combination of results from economic models that analyzed data across countries and from economic models that analyzed data across states within the U.S. to calculate the figure for elasticity of wages.

Each open economy model can also account for a different rate of openness, or capital mobility.  The economic models that found that workers’ wages bear a lower percentage of the burden of corporate tax used moderate estimates of capital flow overseas.  On the other hand, economic models that found that workers’ wages bear a high percentage of the burden of corporate tax used figures to account for a free flow of capital abroad.  The differences in percentages cited in the Report show the drastic effect on results when an economic model adjusts figures for just one variable: openness.

Within these sophisticated economic models, there are assumptions and variables that are manipulated.  For example, two sources cited in the Report note the differences in outcomes when an open economic model does not assume that domestic and foreign products are perfect substitutes.  See Felix, R.A. Passing the Burden: Corporate Tax Incidence in Open Economies, LIS Working Paper Series (2007; see also Gravelle, Jane and Smetters, Kent, Does the Open Economy Assumption Really Mean that Labor Bears the Burden of Capital Income Tax?, B.E. Journal of Economic Analysis & Policy, (2006).  This variability is also seen in the conclusions drawn in the Report, as it notes that the estimated $4,000 annual increase to the average household income was calculated based on economic models that used countries and time periods that have less foreign corporate profit activity than the U.S. and less corporate profits held abroad.

Conclusion

Overall, the Report offers a conclusion that is supported by modern economic theorists and empirical data; a sophisticated economic model using an open economy can show that workers’ wages bear most of the burden of corporate tax, and a decrease in corporate tax may increase workers’ wages.  Importantly, the Report’s estimated effects of lowering the corporate tax rate in the U.S. suffer the same uncertainty as the results from any sophisticated economic model.  Adjustments to even one variable can create significantly different results.  Although sophisticated economic models offer valuable insight, it is crucial to investigate the information used in order to gain a clear picture of the basis of economic predictions, which in turn become the basis of major tax reform.