TO SECTION 302 (ALLOCATION OF DEDUCTIONS) INTRODUCTION Section 302 of the Tax Reform Bill of 1959 (proposed Code Section 277) is designed to require pro-rata allocation of so-called "personal" deductions between taxable and exempt income and deny a deduction for the portion thereof allocated to exempt income and tax preferences. In spite of the farreaching impact of this provision, it has received very little attention or publicity,-probably because there is no single large business or other organized group which would be peculiarly or particularly adversely affected by this Section. Section 302 was intended as a companion to Section 301, which establishes a 50% of income limit on certain exempt income and preferences. Section 302 relates to exempt income and tax preferences from the same sources as those described in Section 301 (plus certain others). However, while Section 301 would apply only to those exceedingly rare individuals over half of whose income is from such exempt or preferential sources, Section 302 on the other hand would apply to every taxpayer who in any year has more than $10,000 of income or deductions from the exempt or preferential sources in question. Thus nearly every individual real estate investor with substantial accelerated depreciation of one or more buildings or investor with substantial gross income from oil and gas or individual with a substantial total capital gain (or unrealized appreciation from a charitable donation in kind) for any given year would be subject to the adjustments of Section 302 regardless of the relative or absolute size of his total income on which he is paying taxes. 1. SINCE MOST OF THE "TAX PREFERENCE" ITEMS TO WHICH SECTION The basic rationale of Section 302 is that non-business or personal deductions should be allocated pro-rata between exempt and taxable income and that those thus allocated to exempt income should be disallowed as deductions on account of representing payments arising out of the production of exempt income or paid out of the proceeds of exempt income. The most fundamental defect in this approach is the fact that most of the classes of tax preferences covered by Section 302 do not constitute cash or property received at all and therefore personal deductions could never have been paid out of such tax preferences, -for example, (a) farm losses to the extent attributable to failure to use the inventory method of accounting or failure to capitalize capital expenditures, (b) intangible drilling expenses and percentage depletion to the extent that they exceed what would have been allowed if a taxpayer had capitalized such expenses and recovered the same by cost depletion and depreciation, and (c) accelerated depreciation of buildings to the extent that it exceeds straight line depreciation. Depreciation, acquisition of farm inventory or capital assets, and intangible drilling expenses never represent dollars or income received (taxable or exempt) but rather represent money paid out or spent (though in the case of depreciation it may have been paid out in a prior year). One might well argue that such payments should be treated as capital expenses (to be deducted gradually over the years by way of depreciation or depletion rather than all at once when incurred) but to prevent part of them from ever being deducted at all at any time would be grossly unfair. In any event it is clear that to the extent that during the year a taxpayer spends money on intangible drilling costs of oil and gas wells (or buys a depreciable asset for his farm not required to be capitalized under his method of accounting) resulting in a deduction of such costs in full when spent, he receives no net cash realization from such expenditure such as might be regarded even in part as the source of any of his payments resulting in personal deductions. 2. PERSONAL DEDUCTIONS SHOULD NOT BE DISALLOWED EXCEPT TO THE EXTENT ACTUALLY ATTRIBUTABLE TO TAX EXEMPT INCOME OR PREFERENCES. Certainly nobody can fairly object to denying a personal deduction for any expenditure actually attributable to or incurred in the production of tax-exempt income or preferences. The existing law already recognizes this, however, and denies, for example, a deduction of interest paid on money borrowed to pay the premium on a single premium annuity or insurance policy (IRC Section 264), interest paid on any debt incurred or continued to acquire taxexempt state or municipal bonds (IRC Section 265(2)), and expenses incurred in the production of tax-free income (IRC Section 265(1)), such as trustee's fees and other investment expenses attributable to tax-exempt state or municipal bonds. If there are other examples of personal deductions which may with any frequency be in fact attributable to the receipt of tax-exempt income or tax preferences (though I believe there are none), then IRS Sections 254 and 265 should be expanded to deny such deductions. But where the payments giving rise to personal deductions are not in fact attributable to any item of exempt income or tax preference (as is, in the nature of things, never the case with respect, for example, to the payment of a medical or dental expense) there can be no reason at all for making an arbitrary assumption to the contrary, on a pro-rata basis or otherwise, by constructively attributing or ascribing a portion of all personal deductions to exempt income or tax preferences. After all, the inherent nature of personal deductions is such that in an economic sense they are almost never traceable or related in any way to exempt income or preferences. Thus they become "personal" deductions by virtue of not being business-related. -2 The proponents of Section 302 may reply that even if a personal deduction cannot be identified as being attributable to or incurred in connection with the production of exempt income, it may still in economic effect be deemed pro-rata to have been paid out of such exempt income. This "source-of-payment" argument and its arbitrary pro-rata approach is, I submit, wholly fallacious. Thus a change might logically be made in the law to provide that personal deductions are only to be allowed to the extent that they are paid out of taxable income, but Section 302 is not predicated on that rationale. Thus payments made out of capital or principal (as opposed to exempt income or tax preferences) would of course remain allowable as personal deductions notwithstanding Section 302. For example, if in a given year a taxpayer has $50,000 of ordinary income and sells capital assets for $40,000 resulting in $25,000 of long term capital gain (since the property cost him only $15,000 many years earlier), I fail to see why he should have any more charitable contributions and other personal deductions disallowed than an identical taxpayer with the same $50,000 of ordinary income but whose sale of the same property for the same $40,000 resulted in no capital gain (since his original cost was $40,000 or more). It may be perfectly true that in both cases the proceeds of sale of a capital asset may be said at least theoretically to constitute the source or subject matter of a pro rata part of the payment of a charitable contribution or other personal deduction, but what possible reason can there be for making the availability and amount of the deduction depend on the matter of how much of such sale proceeds happen to constitute capital gain rather than a return of capital costs? It may be further noted that since personal deductions (unlike net operating losses) cannot be carried forward or backward to a different year (with a minor exception as to charitable deductions), no tax benefit can ever be had from any personal deduction in excess of what otherwise would be the taxpayer's taxable income for the year. That is to say, even under the present law personal deductions are in effect not allowable unless they at least could have been made from taxable (as opposed to tax-exempt) income. The theoretical pro-rata source of payment approach of Section 302 also ignores the situation often prevailing as to personal deductions that are specifically attributable to or paid out of identifiable items of taxable income; for example, interest on money borrowed for the specific purpose of investing in (taxable) interest or dividend producing assets, or property taxes or mortgage interest paid on rental property held as an investment. Such interest and taxes, though incurred in connection with the maintenance of property held for the production of income (and not constituting purely personal expenses) would of course be allowed to an individual only as personal deductions if not incurred in a "trade or business". But Section 302 makes no provision for excluding such identifiable personal deductions from the items subject to the artificial proration called for by that section. -3 3. IF THE TAX PREFERENCES IN QUESTION SHOULD BE ELIMINATED OR If a taxpayer who has tax-exempt income or preferences should as a policy matter be required to pay additional income taxes as a result of same, this should be provided for either by eliminating the tax exemption feature or preference or a portion thereof directly (such as the House Bill has already done by narrowing the definition of long term capital gains and removing the 25% tax ceiling on same) or by directly taxing otherwise exempt income at some lower rate, -and not by the "back-door" method of penalizing the recipients of such income or preferences by disallowing perfectly legitimate deductions (for charitable contributions, interest and taxes paid, medical and dental expenses, etc.) which are allowed in full to other taxpayers who don't happen to also have that particular type of preferential income. Direct taxation of exempt income or direct disallowance of a deduction of tax preferences would also have the advantage of treating in identical fashion different taxpayers with the same amount of exempt income or tax preferences, whereas the Section 302 approach differentiates between them by making the amount of the (indirect) tax on such exempt income or preferences depend instead on the amount of the taxpayer's personal deductions. I submit that if two taxpayers, one using the standard deduction and the other having substantial itemized personal deductions, have an identical amount of taxable income and also an identical amount of exempt income and tax preferences, there is no resaon why one of them should pay no additional tax on such exempt income and preferences (because of using the standard deduction in lieu of itemizing his personal deductions) whereas the other one must pay a substantial tax penalty as a result of having such exempt income or tax preferences. If only such a direct approach could be employed, I am confident that Congress would, for example, not even consider taxing interest received on state or municipal bonds heretofore issued and which were bought at a price and with an interest rate entirely predicated on the assumption of their being exempt. Many also question whether Congress could constitutionally do so. I submit that if it would be unfair to tax directly such state or municipal bond interest, it would be even more unfair to attempt to tax it through the indirect method prescribed by Section 302. Furthermore, the uncertain, unequal and unmeasurable effect of Section 302 on different taxpayers (or on the same taxpayer in different years, depending on the varying amount of his personal deductions) might seriously disrupt or disturb the municipal bond market and thus substantially increase the future cost of state and municipal borrowing. 4. SECTION 302 DISCRIMINATES BETWEEN DIFFERENT CLASSES OF TAXPAYERS Section 302 is worded so as not to apply to corporations. Thus under the House Bill a corporation would continue to be entitled -4 to deductions for all charitable contributions paid (subject only to the applicable percentage of income limitations), all interest paid, and all property, sales, gasoline, state and local income taxes paid,-cven though unrelated to its trade or business and therefore constituting items which an individual could only take as "personal" deductions. The fact that such corporation also has exempt income or tax preferences of the type to which Section 302 applies will not cause it to be deprived under Section 302 of any part of its deductions for charitable contributions, interest and taxes paid. Other forms of discrimination as between otherwise identical taxpayers would also result from Section 302. For example, accelerated depreciation of buildings in excess of straight line depreciation in any year is treated as a tax preference requiring allocation of personal deductions under Section 302. However, accelerated depreciation in a given year can only mean that in certain subsequent years during the life of the depreciable asset in question the taxpayer's depreciation will be less than what would have been allowed if the asset had been depreciated on a straight line basis throughout its life. But Section 302 proposes no adjustment in any subsequent year to allow for such reverse preference", even though it in effect constitutes in economic effect a partial repayment of a preceding year's tax preference. Thus two identically situated taxpayers, one using the sum-of-the digits method of depreciation and the other using the straight line method, will each have the same amount of aggregate depreciation deductions during the full life of a given asset. Yet the one using the sumof-the-digits method will be required to make a Section 302 adjustment on account of the same during certain years while the one using the straight line method will never be required to make any Section 302 allocation on account thereof. Similar examples of unequal treatment of identical taxpayers could be demonstrated for the Section 302 adjustments called for as a result of failure to capitalize intangible drilling costs and certain farm expenses. 5. SECTION 302 WOULD HAVE A SERIOUS ADVERSE EFFECT ON CHARITABLE While other types of personal deductions represent for the most part involuntary payments and the amount thereof should accordingly not be appreciably affected by the enactment into law of Section 302, charitable contributions on the other hand are in their very nature voluntary. An independent school which I represent advises me that well over 90% of the dollar value of all gifts to it consists of gifts of $100 or more each. The amount of charitable giving by most donors above approximately this $100 level depends in large part on the tax effect of such giving. Recognition of this fact and the impact of same on hospitals, private colleges, universities, etc. resulted in the House's narrowing the scope of Section 201 (c) and (d) of H. R. 13270 (taxing the unrealized gain from appreciated property given to charitable organizations) to the point where it will only apply to a very small percentage of such contributions. But the House then proceeded to do under -5 |