Congress Misfires on SUV Loophole

• Author: Andrew Pike
• Position: Professor Andrew D. Pike is Associate Dean for Academic Affairs and Professor of Law
• Pages: 07

Professor Andrew D. Pike is Associate Dean for Academic Affairs and Professor of Law at American University's Washington College of Law. Prior to his academic career, he served as Associate Tax Legislative Counsel in the Office of Tax Policy of the United States Department of the Treasury. He has been a consultant to the Internal Revenue Service, the Congressional Joint Committee on Taxation and the Congressional Research Service. In addition, Professor Pike has provided assistance to several of the republics of the former Soviet Union concerning the reform of the tax laws and the systems of tax administration in these countries. Professor Pike received his academic degrees from the University of Pennsylvania Law School and Swarthmore College.

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THE INTERNAL REVENUE CODE (IRC) provides special tax treatment for purchasers of gas-guzzling, jumbo Sports Utility Vehicles (SUVs). Congress had the opportunity to remedy this situation when it considered tax legislation in 2004, but it did not do so. Instead, it enacted a limited measure that retains excessive, (albeit reduced) tax benefits for the affluent few who feel the need to acquire a Hummer-class vehicle. Why would Congress create an incentive that is limited to some of the most luxurious, high-cost, and least fuel-efficient vehicles on the road? The simple answer is that Congress never enacted an IRC provision that either requires, or explicitly encourages, taxpayers to purchase these gas-guzzlers. Rather, it has enacted several sensible provisions which, when considered together, produce a seemingly incongruous set of incentives due to the complexities of the IRC and the interplay of unrelated provisions. This article discusses the creation of the SUV tax break and examines: (1) the special tax benefits available for motor vehicle purchasers, (2) the IRC's cost recovery provisions that govern the tax treatment of new equipment that is purchased for business use, (3) the limitations that Congress enacted to prevent what it perceived as excessive tax benefits claimed with respect to luxury automobiles, (4) the incentives that Congress created in 2003 to encourage small businesses to invest in new business equipment, (5) how the interaction of these provisions created the unanticipated SUV tax break, and (6) how Congress responded to the SUV loophole in the American Jobs Creation Act of 2004.¹

Special Tax Benefits Available for Motor Vehicle Purchasers

PRIOR TO THE ENACTMENT of the American Jobs Creation Act of 2004, purchasers of the least fuel-efficient SUVs could receive a tax deduction. However, this deduction was not available to all who purchased an SUV. Rather, only those who purchased a Hummerclass behemoth for use in a business could benefit. Thus, this tax benefit was available primarily to doctors, lawyers and small businesses owners -folks who receive a salary need not apply. Unlike the $2,000 deduction available to those who purchase hybrids,² the tax break for an SUV purchase may have equalled the full cost of the vehicle, up to a maximum of $100,000. The tax deduction for SUV purchasers is not explicitly stated; rather, it results from the interplay of several statutory provisions governing the tax treatment of equipment purchased for use in a business.

Tax Treatment of Equipment Purchased for Use in a Business

One of the cornerstone principles of the U.S. income tax system is that taxpayers must report their income on an annual basis.³ The IRC incorporates three broadly applicable principles that are fundamental to measuring income on an annual basis. First, a business' income for any given year should reflect all income generated during the year as well as the costs incurred in producing this income. This "matching principle" is reflected in numerous statutory provisions. For example, taxpayers must use a specific "method of accounting" that governs the timing of income and deductions.⁴ In addition, taxpayers are permitted to deduct an expense only in the year in which the expense is "paid or incurred."⁵

Second, the IRC generally provides that a business may not deduct any capital expenditure in the year in which the expenditure incurs. A capital expenditure represents the cost of acquiring an asset that will last substantially beyond the end of the taxable year.⁶ The capitalization requirement was created to prevent serious distortions in the calculation of a taxpayer's annual income. Absent this requirement, the cost of an asset would be treated as a cost of producing income in the year in which the taxpayer acquires an asset. A mismatching of income and costs results to the extent that the asset generates income in future years.

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Third, consistent with the matching principle, taxpayers are allowed depreciation deductions.⁷ Depreciation represents the decline in value of a business asset that takes place in any given year. This economic cost represents one of the costs that the taxpayer incurs to generate his income for that year. Although the depreciation deduction is an essential feature of an income tax, Congress has used the depreciation provisions of the IRC to provide economic subsidies for businesses. For many years, taxpayers have been allowed to claim depreciation on an accelerated basis. This acceleration generates a "time value of money" benefit for a business: the larger deductions in the first years in which an asset is owned reduces the business' tax liability in those years. Although this is offset by the effect of smaller depreciation deductions allowed in later years, the "time value of money" benefit is significant.

There are several distinct factors that contribute to the acceleration of depreciation deductions:

· Taxpayers may use short "useful lives" for purposes of depreciation. For example, the cost of a business asset that remains productive in a business for nine years may be fully deducted over a five-year period rather than over its nine-year economic lifespan.⁸

· Depreciation deductions are "front-loaded." Under the depreciation rules in effect since 1981, taxpayers may utilize accelerated methods of depreciation for assets other than real property.⁹ As a result, more than half of the cost of a business asset may be deducted as depreciation during the first half of the asset's useful life.¹⁰

· Congress enacted explicit front-loading provisions: In 2002 and 2003, Congress increased the extent to which depreciation deductions are front-loaded. For assets acquired after September 10, 2001, taxpayers were allowed to deduct 30 percent of an asset's cost in the year in which it was first used in business. In 2003, Congress increased the additional first-year depreciation deduction to 50 percent of an asset's cost.¹¹ An asset's remaining cost is depreciated under the general accelerated depreciation rules. The 50 percent first-year deduction applies to most tangible personal property acquired after May 5, 2003, and before January 1, 2005.

· Congress allowed "small businesses" to deduct the full

cost of business assets. In 1981, Congress enacted IRC...