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Cross Posted at Blog For Arizona

Okay, this diary involves a trip through tax geekdom, so hang on and enjoy the ride, or at least try to stay awake.

There have been countless articles and blog posts regarding Mitt’s new tax plan, which he released to coincide with his appearance Friday at Ford Field, which was packed to 1/65th of its capacity. But precious little attention has been paid to one feature of the plan, which actually is unchanged from his previously released plan -- the exemption of dividends, capital gains, and interest income from tax for those with taxable income of under $200,000.

That’s too bad. As a tax lawyer, my take on that one provision is that, in concept, it is one of the most fertile areas for tax sheltering I’ve ever seen, will cost us hundreds of billions in revenue, will benefit mainly those who are just a notch below the super rich, and will lead to increased complexity in the tax code. Here’s why.

Tax planners make use of various techniques, but one they always will seize on is a distortion in the tax code. For example, the taxation of long-term capital gains at reduced rates is a distortion. If a planner can figure out how to “convert” income that otherwise would be ordinary income into capital gain income, he can shelter his client’s income from tax. Another is the “depreciation” deduction for real estate, which allows folks who own real estate for investment or in their business to reduce income that is taxed at relatively higher rates, then, upon sale of the real estate, “recapture” that income at a lower rate.

Mitt’s exemption for capital gains, dividends and interest income gives rise to unbelievable distortions that would easily be manipulated by tax planners into tax shelters for folks who, while not super rich, certainly qualify as highly affluent. Here are just a few of the examples of the distortions (think, sheltering opportunities) created by Mitt’s proposal:

The Corporate Rate / Individual Rate Distortion. I operate a business through a corporation that pays me a reasonable salary of $150,000 per year, and throws off an additional $50,000 of income annually. Currently, I have a subchapter S election in place, which makes the $50,000 per year of corporate income taxable to me and not the corporation. Most small business owners use the S election, because it allows them to avoid paying corporate tax, then paying tax again when cash is distributed as a dividend. But under Mitt’s proposal, I can terminate my subchapter S election and start paying tax at the lower corporate rate of 15% on the first $50,000 per year of corporate income. I can then distribute the $50,000 to myself as a dividend, and make use of Mitt’s new exemption to avoid further tax.

The Asymmetry of Deduction and Income Distortion. Interest expense generally is deductible unless the debt giving rise to it is personal debt. Mitt’s proposal allows planners to create situations where the payer of interest gets a deduction, giving rise to a tax benefit, while the recipient of the interest income does not pay tax. So, I own a growing business in which I typically reinvest the profits. Under Mitt’s proposal, I’ll distribute the profits and invest them personally, avoiding tax on the investment income I realize in my “personal column.” At the same time, I’ll have the business borrow the money it needs to grow, thereby garnering a tax deduction for the interest expense I pay on the borrowing.

Now, think of what this one distortion means at the macro level. Every time debt is created where the interest paid is subject to Mitt’s new exemption, federal revenue decreases. If you had 20 million taxpayers able to reduce their tax by $3000 each through Mitt’s exemption, the revenue loss would be $60 Billion.

The Interest Income / Rental Income Distortion.  For whatever reason, Mitt thought it wise to exclude from his proposal one significant type of investment income -- rental income -- while including the other three -- dividends, interest and capital gain. The distortion here stems from the reality that a real estate owner’s rental income will be greater or less depending on how much he borrows to purchase the property, because the interest expense on the borrowing reduces the net rental income. So, if I, an affluent but not super rich real estate investor, own an investment property free of debt, I could sell the property to my son, with payment in the form of a purchase money mortgage. I’ll now have interest income, free of tax, while my son will have the rental income I used to have, but reduced by the interest expense he pays on the mortgage. The actual economic effect of my “gift” is minimal, by the way, as the cash flow largely will remain with me. My son will receive the rent, but he’ll pay most of it to me in the form of mortgage payments.

The significance of this distortion on a macro level is that by giving interest income more favorable treatment than rental income, Mitt has favored investments that give rise to interest income (bonds) over those that give rise to rental income (real estate). Newsflash, Mitt. We’re in the middle of one of the worst real estate recessions in history, so your proposal in this regard lies somewhere between idiotic and moronic.

Beyond these distortions, it’s worth noting who benefits the most from Mitt’s proposal. It won’t be the average worker making $45,000 per year with precious little savings to invest. It won’t even be the professional making $175,000 with a modest investment portfolio. The real winners will be the slice of retirees with wealth somewhere between ordinary and super rich. An example would be a retired couple who own a $1 Million dollar home free and clear and have $4 Million in an investment account that gives rise to $200,000 of dividends, interest and capital gains. This lucky couple would save $40,000 or more in tax each year under Mitt’s proposal.

Lastly, consider what Mitt’s proposal would do to his oft stated goal of simplifying the tax code. When distortions are used by planners to create tax shelter opportunities, Congress responds by enacting “anti-abuse” provisions. Then, the planners up the ante by creating more sophisticated shelter opportunities. Then, more anti-abuse provisions, and so on.

Of course, precious few voters have the inclination or patience to sift through all this. In fact, precious few journalists do. So, Mitt and his ilk can make these sorts of proposals with impunity. Here’s hoping he’ll never have the chance to follow through.

Originally posted to Bob Lord on Sun Feb 26, 2012 at 10:39 AM PST.

Also republished by Community Spotlight.

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