Tax Law Isn’t Fair. In Other News, Fire is Really, Really Hot
To illustrate a basic principle of tax law, allow me to borrow from the most successful sitcom in TV history:
Cosmo Kramer once coined Jerry Seinfeld “Even Steven” due to the uncanny manner in which every bad moment in Jerry’s life was inevitably countered by an offsetting good moment. In furtherance of this hypothesis, Elaine grabbed a twenty from Jerry’s wallet and tossed it out the window. As anticipated, hours later Jerry found $20 in an old jacket, proving that everything in his life neatly balances out.
Tax law does not make for prime comedic fodder, however, so the episode failed to address the fact that the IRS would likely not view Jerry’s lost and found twenty as offsetting. Instead, the Service would require the found $20 to be included in taxable income as an accretion to wealth or “treasure trove,” while the twenty tossed out the window would represent a nondeductible personal expense. The net result being an increase to Jerry’s taxable income.
While this may seem like an incongruous result — as Jerry was left no wealthier at the conclusion of the episode — the takeaway lesson is that when enacting law, Congress is not always concerned with the economic effect of a transaction; instead, tax policy considerations often rule the day.
For an illustration of this point that doesn’t involve fictional characters, take a gander at Brown v. Commissioner. [i]
Brown sold stock at a gain, and reported the gain on his federal and South Carolina tax returns. Several years later, the state of New York contacted Brown and argued that the gain was properly sourced to NY, rather than South Carolina. As a result, Brown had to do two things to remedy the problem:
1. He amended his South Carolina return to remove the gain, and in 2008 received a refund of the tax previously paid as well as $4,000 of interest income.
2. He filed a NY return reflecting the gain, paying tax and $8,000 of interest expense to the State, also in 2008.
On his 2008 federal tax return, Brown failed to report the $4,000 of interest income received from South Carolina, prompting the IRS to assess a deficiency of $1,500. Brown — quite logically — argued that he shouldn’t recognize any taxable income as a result of the two transactions, because the income received from South Carolina was more than offset by the interest expense paid to New York.
While the Tax Court agreed that economically Brown ended up no better off after shifting the gain from South Carolina to New York, there remained tax policy considerations to be dealt with.
First, the court cited both the statute [ii] and judicial precedent, [iii] which require interest income resulting from a tax refund to be included in taxable income.
In addressing the interest expense, the court — while recognizing and appreciating the asymmetry of the treatment — noted that the statute and judicial precedent specifically bar a deduction for Brown’s payment of interest to NY resulting from his individual tax deficiency:
Nondeductible “personal interest” is defined broadly in section 163(h)(2) with exceptions that do not include the Browns’ payments to the State of New York.See Alfaro v. Commissioner, T.C. Memo. 2002-309, aff’d, 349 F.3d 225 (5th Cir. 2003) (holding that interest paid on individual tax deficiencies is nondeductible personal interest). The Code does not allow the Browns to deduct their interest paid on their State tax underpayments, so there is no valid mechanism for the “setoff” that they assert.
The lesson? This likely goes without saying, but tax law is not guided by what we perceive to be “fair.” While this can be difficult to convey and explain to clients, tax policy may not reflect the underlying economic effect of a given transaction.
