Frictions as a Constraint on Tax Planning

Abstract

David Schizer, Frictions as a Constraint on Tax Planning In recent years, the government has enacted a series of narrow tax reforms targeting specific planning strategies. Sometimes these reforms stop the targeted planning, but sometimes they merely prompt a new, more wasteful variation. The difference often lies in so-called frictions, which are constraints on tax planning other than the tax law, such as fees, accounting or regulatory treatment, credit risk, and the like. While frictions are important, reformers often lack key information, and legal academics should help provide it. This Article offers general observations about frictions that deter end runs. Most promising are strong “discontinuous” frictions that impose significant costs when taxpayers depart, even in subtle ways, from the transaction covered by the reform. Costs of relying on frictions are also considered, including information costs and distributional effects. Two case studies also are offered involving taxmotivated use of derivative financial securities. These reforms use essentially the same statutory language, but taxpayers have responded differently – and frictions explain this difference. The first reform, the “constructive sale” rule of Section 1259, targets use of derivatives in effect to sell an appreciated asset without paying tax. The second, the “constructive ownership” rule of Section 1260, targets use of derivatives in effect to invest in a hedge fund (or other pass-through entity) without the usual adverse tax consequences (i.e., less deferral and a higher tax rate). Theoretically, taxpayers can avoid either rule through relatively modest changes in the derivative’s economic return. This strategy is commonly used to avoid Section 1259, a reality that was understood by government and taxpayers alike when the measure was enacted. In contrast, this strategy is not commonly used to avoid Section 1260. The difference, which was not well understood by Section 1260’s drafters, is that securities dealers cannot supply the derivative that theoretically avoids the rule. For years, the tax system has wrestled with the problem of wasteful tax planning. Because the tax law often treats similar transactions differently, restructuring can significantly reduce the tax burden. Aggressive planning is pervasive not only in so-called tax shelters, which are not the focus of this Article, but also in real business deals such as sale of an asset or financing of a venture. Ambitious reforms, such as mark to market accounting or a consumption tax, could eliminate many discontinuities in the tax law and associated planning opportunities. But these steps are politically unattainable, at least for now. Instead, in recent years the government has Under mark-to-market accounting, investment returns are taxed annually based on changes in the asset’s fair market value, regardless of whether the property has been sold. See, e.g., David Shakow, Taxation Without Realization: A Proposal for Accrual Taxation, 134 U. Pa. L. Rev. 1111 (1986) (proposing broader use of mark-tomarket taxation). Under a consumption tax, investment returns generally would not be taxed. See, e.g., William D. Andrews, A Consumption-Type or Cash Flow Personal Income Tax, 87 Harv. L. Rev. 1113 (1974). Political Schizer, Frictions as a Constraint on Tax Planning Page 2 used a less satisfying strategy: narrow reforms that target specific planning strategies. In these transactional responses, as they are called here, the tax treatment of a particular transaction is modified to restore the customary result. This Article emphasizes that, in crafting transactional responses, reformers must consider constraints on tax planning other than the tax law. Even if a tax planning strategy is legally permissible, taxpayers may still abandon it as practically unworkable. Transaction costs may be too high, financial accounting or regulatory treatment may be unappealing, and the like. Borrowing from the economics literature, and specifically from Professors Scholes and Wolfson, this Article uses the term “frictions” to describe constraints on tax planning other than the tax law. An understanding of these nonlegal constraints reveals which tax planning merits an immediate legal response – and thus a commitment of administrative resources and political capital – and which planning is theoretical only. If a legal response is needed, frictions inform how broad the legal rule must be to actually stop the planning, instead of merely spawning a new