Section 382, tax breaks for bailed out banks, and changing tax law by memo

A remarkable Washington Post story on how long-standing tax policy was changed by administrative notice hit the wires last Sunday.

It’s not every day that a popular press story deals with an obscure section of the tax code. But these aren’t regular times. Amit R. Paley does a good job explaining how, in the heat of financial chaos and the clamoring to do something, a tax policy of some 22 years was quietly reversed by a mere memo published by the Treasury Department.

In a nutshell, Congress passed Section 382 in the 1980s to attack certain kinds of tax shelters. The code had allowed corporations to buy companies that had a “net operating loss” or “built in loss” and then apply that loss to their books to reduce taxable income. The loss companies had no real value except for the tax benefit. Section 382 drastically limited the types and amounts of loss that the buying company could write off.

Although many business-oriented economists and tax policy experts (certainly not all) argued that the rule was too heavy-handed, Congress steadfastly refused to change it. This is consistent with Congress’s general power to set tax and fiscal policy.

Until Treasury, in the heat of the financial meltdown, decided to do away with it by an administrative notice.

The notice essentially does away with the limitations for institutions that participate in the “Capital Purchase Program (CPP) implemented by Treasury under the authority of the “Emergency Economic Stabilization Act of 2008 (aka Bailout Bill). The idea was to ease the tax consequences of bank mergers. The Washington Post article points out:

The Treasury notice suddenly made it much more attractive to acquire distressed banks, and Wells Fargo, which had been an earlier suitor for Wachovia, made a new and ultimately successful play to take it over.

But, apparently, Congress was surprised and not happy about what has come to be called “the Wells Fargo Ruling.” According to the article, estimates of the hit to federal revenue range from $105 billion to $140 billion.

Some commentators are very surprised as well. From the article:

"Did the Treasury Department have the authority to do this? I think almost every tax expert would agree that the answer is no," said George K. Yin, the former chief of staff of the Joint Committee on Taxation, the nonpartisan congressional authority on taxes. "They basically repealed a 22-year-old law that Congress passed as a backdoor way of providing aid to banks."

Reading the Notice, I can see why he said this. It is only 2 ½ pages long. The memo is written in technical terms that are incomprehensible to anyone not familiar with the operations of Section 382. However, under the “Background” header is a paragraph that insouciantly states the authority for the action:

Section 101(c)(5) of the Act provides that the Secretary is authorized to issue such regulations and other guidance as may be necessary or appropriate to carry out the purposes of the Act. Section 382(m) of the Code provides that the Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of sections 382 and 383.

Parse that a little. The first sentence says that “the Act” (aka Bailout Bill) gives the Treasury Secretary authority to issue regulations for the purpose of carrying out “the Act” (aka Bailout Bill). OK, nothing very controversial about that.

The next sentence says something similar about Section 382 of “the Code” (in Treasury lingo, this means the “Tax Code”). The Treasury Secretary is authorized to issue regulations “to carry out the purposes of section 382. . . .”

The problem is obvious. The “purposes of section 382” has nothing to do with the Bailout Bill. The purpose of 382 is to stop a certain kind of tax shelter.

And, as far as I know, the Bailout Bill did not grant the Treasury Secretary authority to amend the Tax Code. The Bailout Bill did deal with the tax code in three separate areas: capital gains, executive compensation, and help for homeowners. It does not give the Treasury Secretary authority to amend the Tax Code. (The Bailout Bill is a mere 451 pages long, maybe you can find something in there I have missed, but I doubt it.)

Yet the Secretary of Treasury did amend the tax code because, apparently, it seemed like a good idea. Certainly the merging banks are getting a huge break. And maybe it is a good idea, but this sort of sweeping change to tax policy, under cover of administrative ruling and in the heat of confusion, is decidedly unusual and ominous.

BTW, don't expect this change in the law to benefit any small companies that might want to buy out other struggling companies. It's only for the big kids, the "too big to fail finance companies," who have been able to sell their smoldering and nearly worthless instruments to the government.

Tax Plans are not patentable

One of the weirder discussions in the tax world has been the question of whether a fancy tax plan, devised by lawyers and accountants, could be patentable. Stories abounded regarding whether such authors (inventors?) could sue other practitioners for patent infringement for using similar strategies. It was all potentially lucrative for those holding patent rights.

The idea was based on a view that certain business ideas are patentable. However, that view has taken a serious hit in the Federal Circuit Court of Appeals.

As background, 35 U.S.C. 101 states that a "new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof" are patentable. The Supreme Court has held that the scope of the statute is very broad, but that "laws of nature, natural phenomena, and abstract ideas" are not patentable.

However, in 1998, State Street Bank & Trust Co. v. Signature Financial Group, Inc. 149 F.3d 1369, opened the door to allowing the patenting of business processes. This led to the idea that tax planning processes could be patentable as well.

But State Street has been overruled. In the Bilski case, just decided, the Court of Appeals held that a method of hedging risk in the field of commodities trading is not patentable. In essence, the method was too abstract:

We hold that the Applicants' process as claimed does not transform any article to a different state or thing. Purported transformations or manipulations simply of public or private legal obligations or relationships, business risks, or other such abstractions cannot meet the test because they are not physical objects or substances, and they are not representative of physical objects or substances.

This language seems to effectively prevent any sort of legal strategy from being patented.

Student Loan Consolidation Incentive Deemed Income

Some student loan companies offer incentives for consolidating various student loans into one loan. In one case, a consolidation loan offered to forgive a portion of the loan if 36 consecutive payments were made. The IRS called that forgiven amount income, and the Tax Court agreed.

Dollars to Saturn

The latest national debt figure as of as of October 29, 2008 at 02:58:51 AM GMT (check often, it goes up) is $10,529,390,498,011.35.

Let’s round that to a nice easy number: 10.53 X 10^12.

Of course, this doesn’t even include the bailouts, which are heading toward 2 trillion dollars.

So I was wondering how far a trillion dollar bills laid end to end would reach. I grabbed a tape measure and found that a typical dollar is about 6 and an eighth inch long. So, as a public service, I set out the calculations using scientific notation, which is apparently a necessity these days when talking about politics.

6.125 inches X 10^12 (this is a one followed by 12 zeros, aka trillion) divided by 12 inches per foot = 5.104 X 10^11 feet. Divide that by 5280 feet per mile and you get 9.67 X 10^7 miles.

Which is the same as 96.7 million miles. The earth is about 24,000 miles in circumference, so I figure that’s a bit over 4029 times around the world. It’s also a little more than the distance from the earth to the sun.

And that’s only a trillion dollars. Multiply by, say 12 (current debt plus the bailout), and you’re out past Saturn.

Somebody, quick, shut the Minneapolis Fed up

The Federal Reserve Bank of Minneapolis recently issued a white paper titled Facts and Myths about the Financial Crisis of 2008. It is only six pages of text followed by a bunch of graphs. Here are the "Myths":

1. Bank lending to nonfinancial corporations and individuals has declined sharply.

2. Interbank lending is essentially nonexistent.

3. Commercial paper issuance by nonfinancial corporations has declined sharply, and rates have risen to unprecedented levels.

4. Banks play a large role in channelling funds from savers to borrowers.

The authors of the report, V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe, review aggregate financial data compiled by the Federal Reserve and conclude that none of the above statements is true. In other words, there is lending going on between banks, to businesses and individuals, and that businesses do have other available means of credit.

Of course, the authors acknowledge that "[t]he United States is indisputably undergoing a financial crisis." But they are questioning the "bold action" that is being pushed. Their conclusion, set out in as blunt language as you are likely to see from a Federal Reserve Bank, is this:

Our analysis has raised questions about the claims made for the mechanism whereby the financial crisis is affecting the overall economy. We emphasize that we do not dispute that the United States is undergoing a financial crisis and that the United States economy may be in a recession or may experience one in the near future. Our analysis is based on publicly available data. Policymakers have access to other sources of data as well. Policymakers could well believe that bold action is necessary based on data that are different from that considred here. If so, responsible policymaking requires that they share both the data and the analysis that underlies the need for bold policy with the public.

(Emphasis added)

What interested me was that, from a big picture standpoint, lending is going on quite well during this crisis. It struck me that the only institutions that were having trouble getting financing were the big banks holding suspect assets. Regional and smaller banks are doing fine. (Which answers my late recurring question: if there is no money to lend, why are we still subjected to all these advertisements for refinancing?)

So what is the bailout all about? I think it has to do with helping Wall Street (and big Wall Street at that), rather than Main Street. That's just what the pitchfork people who wrote their representatives at the first vote thought all along. In any event, the Minneapolis Federal Reserve Bank is obviously not playing the same tune as the world fixers.

More commentary here.

Riddle me this, Batman

From an editorial in Barron's, regarding Congress's failure to pass the bailout bill:

HOW DO YOU TURN $700 billion into $1 trillion in a matter of hours?

Simple, by voting down the proposed rescue plan in a fit of either principle or pique.

The $700 billion, of course, was the size of the plan that would authorize the Treasury to purchase impaired mortgage assets. The $1 trillion was the amount that was erased from the value of the U.S. stock market.

Specifically, the DJ Wilshire 5000 -- the broadest measure of the American equity market -- plunged 1,024.27, or over 8%, to 11,322.76. Since every point on the DJ Wilshire is worth $1 billion, those thousand-plus points of fright were worth over $1 trillion.

Does anybody see a fallacy here? I mean, really, do the smart people on Wall Street think that a taxpayer financed injection of $700 billion to support prices at the margin is a fair comparison to the paper loss of financial institutions? After all, the money didn't actually go anywhere (except that those who sold put the money in their own accounts). But the bailout bill would have put real people on the hook for money from their real pockets.

If the Wall Street whizzes really wanted a stock market rally, they should just hope that the US government starts buying stock. That would probably be cheaper than buying the smoldering assets in the basement. Now that would be a plan. Governmental day-trading may be the best way out yet.

Finally the script gets interesting

Just when I thought the fix was in, that the Treasury and the Federal Reserve had pummelled Congress into committing $700 billion plus dollars for the magic experiment in emergency finance, things got interesting. A Federal Reserve Governor has essentially publicly told Fed Reserve Chairman Bernanke to take a hike.

Fed's Fisher Says Rescue Would Increase Fiscal Burden.

This is nigh unto unprecedented. I'm thinking the bailout scheme is in tatters, and ole Ben's days are numbered.

Now, I'm not happy about any of this, but I'm not at all impressed with the ideas coming from the top.

"One of the biggest challenges facing both John McCain and Barack Obama in their commitment to provide tax relief to working-class Americans is the simple fact that millions of them already pay no personal income taxes."

This is the opening sentence of a recent article from Tax Foundation. (H/T to TaxProf Blog.)

Already about 33% of all tax filers pay no income tax. Under the Obama plan, the number is projected to reach 44% and under the McCain plan it is projected to reach 43%.

The article contains this interesting chart showing how the percentage of non-payers has been going up:

I have mixed feelings about this. When the income tax first was implemented, it was designed to affect the highest earners. Most normal workers didn't even notice it.

But now, at least until recently, the requirement of paying at least some income tax was fairly pervasive.

My paleo instincts might suggest to me that it is not such a bad thing to narrow the tax base (in terms of population). But the fly in the ointment is that the government is now the big provider of all sorts of things that cost money. And the budget lately has been growing by the day.

From a policy perspective, however, I wonder what the effect will be on government spending if nearly half of the potential beneficiaries do not have to pay taxes?

A quote by John Adams comes to mind:

The moment the idea is admitted into society, that property is not as sacred as the laws of God, and that there is not a force of law and public justice to protect it, anarchy and tyranny commence. If "Thou shalt not covet," and "Thou shalt not steal," were not commandments of Heaven, they must be made inviolable precepts in every society, before it can be civilized or made free.

John Adams, Defence of the Constitutions of Government of the United States, Works 6:9 (1789)

As I've hinted at before, I think neither of the candidates' policies will ever see the light of day. $700 billion, as a starter bailout, is around $2,300 for every human person gracing the face of our fair country, working or not. I expect in the end that pragmatism will overwhelm theory.

No one knows what to do

A confidence building statement from our Senate Majority Leader regarding the late financial crisis showed up in a Bloomberg article today:

Sept. 17 (Bloomberg) -- The U.S. Congress is unlikely to pass new legislation to overhaul financial regulations this year because “no one knows what to do,” Senate Majority Leader Harry Reid said today.

“We are in new territory, this is a different game,” Reid said at a briefing in Washington. Neither Federal Reserve Chairman Ben Bernanke nor Treasury Secretary Henry Paulson “know what to do but they are trying to come up with ideas,” Reid said.

Mish is thankful that Congress thinks it's too late to do anything before the end of the year anyway.

But I suspect that the Obama vs. McCain tax plan debate is pretty much out the window. Whatever the economic scene looks like in two months, we can be pretty sure that the funding the federal budget will take on even greater urgency. Neither plan contemplated the vast expenditures put out the past couple of weeks.

Sorting through candidate's tax plans

Specifics are hard to come by, but Senator Obama's speech last night reminded me that tax policy will be a big issue in the next couple of months. Both candidates are promising tax cuts for the middle class. Sounds appealling and wonderful, almost as nice as free hot fudge sundaes every week.

Tax Prof Blog has an interesting comparison of the tax "breaks" here. It includes a link to the remarkable Obama Tax Cut Calculator.

I plugged in a single married wage earner with no children earning $100,000 per year and got this:

"Your Obama Tax Cut is: $920.73
John McCain would tax you $289.59 MORE than Barack Obama."

So John McCain has a tax cut too, just not as big.

The key, according to the methodolgy section, is that Obama is mostly going to tax the upper 1% more heavily. But here is the interesting word play:

"Obama will only increase taxes for the top 1% of incomes; and this isn't really an increase: he's simply going to let the Bush tax cuts expire."

There's a lot of missing context and history as to why the Bush tax cuts are set to expire, but it is fairly plain that allowing them to expire is in fact an increase.

One major problem with either plan is that they both look to run up the government debt even more. From the executive summary provided by the Tax Policy Center:

"Both candidates prefer to compare their plans to the “current policy” baseline, which would extend the 2001 and 2003 tax cuts and indefinitely extend an indexed
AMT “patch”—and collect nearly $3.6 trillion less than under current law over the coming decade. Against that baseline, Obama would raise revenues by about $600 billion over the decade, while McCain would lose $600 billion. But choice of baseline doesn’t change how the proposals would affect the budget picture; without substantial cuts in government spending, both plans would sharply increase the national debt. Including interest costs, Obama’s tax plan would boost the debt by $3.5 trillion by 2018. McCain’s plan would increase the debt by $5 trillion."

I'm starting to hear echos of "read my lips. . . ."

Decoding Party Platforms

Michael Kinsley, in an August 9, 2008, N.Y. Times column on the Democratic Party Platform, noted this in passing:

Translating the document is no simple task. First, an alarmist note. Democrats favor “tough, practical and humane immigration reform.” And, “We will provide immediate relief to working people who have lost their jobs, families who have lost their homes and people who have lost their way.” It’s not clear what that third item refers to. Tax credits for G.P.S. devices? Presumably,“people who have lost their way” doesn’t mean illegal immigrants trying to find the border.

I like the idea. If we stick only to G.P.S. devices, we might be able to afford this plan.

Update on US v. Stein et al.

The 2nd Circuit Court of Appeals affirmed the dismissal of the charges against the KPMG defendants:

We affirm the district court’s ruling that the government deprived Defendants-Appellees of their right to counsel under the Sixth Amendment by causing KPMG to place conditions on the advancement of legal fees to Defendants-Appellees, and to cap the fees and ultimately end them. Because the government failed to cure the Sixth Amendment violation, and because no other remedy will return Defendants-Appellees to the status quo ante, we affirm the dismissal of the indictment.

Opinion.


In the big KPMG tax shelter case, back in June 2006, Federal District Judge Kaplan ruled that the prosecutors violated the Fifth and Sixth Amendment rights of KPMG Defendants because it was demonstrated that the government had interfered with KPMG's practice of paying legal expenses for cases involving their work with the firm. The government's activity stemmed from the Thompson memorandum, which essentially said that if KPMG paid defense fees of its employees, that would be used as evidence against KPMG itself.

Note that the Thompson memorandum has since been supplanted by the McNulty memorandum as this short Wall Street Journal article points out. Under the new memo, paying your employees attorney's fees is still a factor in deciding whether to prosecute a company.

It looks like, under this opinion, paying your employee's attorney's fees cannot be used as a factor to decide to prosecute so long as your company has had an established policy of doing so and does not implement such a policy for the purpose of impeding an investigation.

Some tax lawyer out there is likely heading for trouble

From today's page of the U.S. Tax Court:

NOTICE: The United States Tax Court has received many telephone calls regarding an e-mail which purports to originate from the Court being sent by a member of the Tax Court's practitioner bar. This message is an example of "Spear Phishing", which is an e-mail spoofing attempt that targets a specific organization. The Tax Court is not disseminating any e-mail notice to anyone who currently has a case before this Court. If you receive an e-mail with a subject line that includes the text, "Notice of Deficiency #" followed by a series of numbers or "US Tax Petition", along with a malformed docket number following the format #000-000, and a sender address of noreply@ustaxcourt.org, complaints@ustaxcourt.org, or notice@ustaxcourt.org, please ignore/delete the e-mail and do not click any link within the e-mail message.

I don't know how the Court knows it is a member of the Tax Court bar, but if it knows, no doubt so does the Justice Department.

Nonprofits and charitable orgs take note

They IRS has just issued a new form 990 to be used for 2008. Instructions and form at the IRS website:

http://www.irs.gov/charities/article/0,,id=185561,00.html: