A tisket, a tasket: basketing and corporate tax shelters.

• Author: Lederman, Leandra

TABLE OF CONTENTS INTRODUCTION I. TAX BASKETING IN THEORY AND IN PRACTICE A. The Mechanics of Basketing B. Examples of Basketing Rules for Individuals 1. The Limitation on the Deduction of Investment Interest 2. The Passive Activity Loss Rules 3. The Limitation on Capital Losses 4. Hobby Losses 5. Gambling Losses II. A PROPOSAL FOR DOMESTIC CORPORATE BASKETING A. The Proposal 1. Threshold Applicability 2. Identifying Passive Items a. The Passive Activity Loss Rules and the Unrelated Business Income Tax b. Section 954(c) c. Applying the Section 954(c) Definition 3. Ordering Rules 581 B. Limiting Passive Deductions: Effects on Tax Shelters 1. Inflated-Basis Strategies a. Basis-Shifting Strategies i. Basis Shifting Across Time: CINS (ACM Partnership) ii. Basis Shifting Between Parties: FLIP/OPIS b. Strategies Involving Offsetting Transfers i. Contingent Liabilities ii. Son-of-BOSS 2. Cross-Border Dividend-Stripping Transactions 3. One-Off Tax Strategies III. ANTICIPATING OBJECTIONS TO THE PROPOSAL A. The Underinclusiveness Objection B. The Overinclusiveness Objection. 1. Limiting Overinclusiveness 2. A Possible Alternative C. The Complexity Objection: Segregating Corporations' Passive and Active Items CONCLUSION INTRODUCTION

How should expenses and losses in profit-seeking activities be taxed? Most people would probably answer that they should be deductible. The federal income tax generally does allow deductions related to business and investment activities. (1) However, it limits some deductions more than others. In a tax system that comported with the economic, or Haig-Simons, definition of income, all expenses and losses connected with profit-seeking activities would be fully deductible, regardless of their source. (2) The federal income tax frequently deviates from that norm for both policy reasons and practical reasons that include administrative difficulties and efforts to close loopholes.

One type of deviation from the Haig-Simons norm involves what is often termed "basketing," whereby particular types of deductions are grouped with the same type of income and are only allowed to be deducted to the extent of that income. For example, a taxpayer's capital losses can only be deducted to the extent of capital gains (plus, in the case of an individual, up to $3,000 of ordinary income). (3) Basketing generally restricts individuals' ability to deduct passive or investment-type expenses and losses from active-type income, but not vice versa. For example, individuals can deduct investment-related interest expense (such as interest paid with respect to investments in portfolio stock) only from net investment income. (4) Similarly, they can deduct so-called "passive activity losses" only from passive income gains, not from other income (such as salary). (5)

The last restriction was enacted as part of an effort to halt the tax shelter activity of high-income individuals in the 1970s and 1980s. (6) The hallmark of many of these old-style tax shelters was an "investment" in an asset or in an activity run by someone other than the taxpayer that produced expenses (such as for interest and depreciation) or net losses, giving rise to deductions that the taxpayer used to lower tax on other income (typically portfolio or employment income). (7) The 1970s and 1980s tax shelter investors generally were individuals, so it is not surprising that responsive statutes exempted most corporations from their ambit. (8)

The 1990s saw a new breed of tax shelter, the corporate tax shelter. The new shelters were much more complex than the earlier ones, but many shelters were easily replicated once developed. (9) The newer shelters also shared with the older shelters the feature of using an "investment" to produce losses for tax purposes that would shelter the corporation's other income, such as income from its business activities. (10) As discussed below in Part II.B, had the Internal Revenue Code (Code) required basketing of corporations' passive-source expenses and losses with their passive-source income, many of these strategies would not have worked and therefore likely would not have been developed.

Instead, the government unleashed an expensive, multi-pronged attack on corporate tax shelters that included significant litigation, specifying "listed transactions" that are subject to special rules, such as enhanced disclosure requirements, and increased penalties. (11) The government seems to have prevailed, at least for the moment. (12) In part, most companies have a lot less income to try to shelter given the current state of the economy. (13) However, tax shelters are a recurring problem. (14) It is not safe to assume that if the government has won the battle, the war is over. Requiring corporations to basket passive expenses and losses with passive income would help prevent a resurgence of corporate tax abuses by precluding the deduction of passive losses from active income.

This Article therefore proposes the extension of tax basketing to corporations in the domestic context. Part I explores the current uses of basketing domestically in the federal income tax. This part shows that basketing is often used to prevent what Congress considers to be abuse of the tax laws, and is primarily applied to individuals' passive expenses and losses, as well as to certain personal expenses and losses of individuals.

Part II of the Article proposes the extension of basketing to corporations' passive items. It describes the details of the proposal, including a definition of passive items that would rely on a section already used by three regimes applicable to multinational corporations--Subpart F, the Passive Foreign Investment Company regime, and the foreign tax credit--and argues that the distinction made by all three of these regimes could readily be extended to the domestic context. Part II also discusses the effect the proposal would have on tax shelters, applying it to specific tax shelters that would not have worked had the proposed provision existed at the time.

Part III considers possible objections to the proposal. First, it considers the argument that basketing is underinclusive (not addressing all tax sheltering). In this regard, it both (1) draws on the analysis in Part II, which shows that the proposal targets the shelters that are most easily replicated, and (2) considers possible ploys to avoid the impact of the proposal. Second, Part III addresses the point that basketing inevitably is overinclusive, throwing out some wheat with the chaff. Finally, this Part considers the issue of complexity and, in particular, the possible objection that it is simply too difficult for corporations to separate their passive and active items. However, as discussed in Part II, multinational corporations are already required to do that sorting for several other purposes. The Article therefore concludes that extending basketing to corporations in the domestic context would give rise to substantial benefits that likely would justify its costs.

1. TAX BASKETING IN THEORY AND IN PRACTICE

   The tax base of the federal income tax is "taxable income." (15) Taxable income generally is comprised of gross income less deductions, though the calculation differs somewhat for individuals depending on whether they itemize their deductions or simply claim the standard deduction. (16) Most deductions can be claimed without basketing. (17) Therefore, the federal income tax generally is not what is termed a "schedular" system, under which income is routinely sorted by type. (18) However, some provisions do limit certain deductions by requiring basketing. (19) This Part discusses the mechanics of basketing, as well as several major basketing provisions and the rationales behind them.

   1. The Mechanics of Basketing

      Basketing involves the grouping together of related income and deductions, and is an exception to the general rule under the federal income tax system of allowing deductions to be taken from income of any type. (20) To understand the mechanics of basketing, first consider a situation without basketing in which the taxpayer has income of $100,000 from an investment and a business-related loss of $20,000. The tax treatment of just those two items (that is, ignoring deductions available to individuals, such as the standard deduction (21) and personal exemption (22)) is as follows:

      Gross income $100,000

      Deduction /

      Taxable income $80,000

      That example does not involve basketing; a deduction of one type (business) was allowed against income of another type (investment). Now consider an example involving basketing. Imagine that the taxpayer has $100,000 of business income and $20,000 of investment interest expense. As discussed below, (23) the taxpayer can only deduct the investment interest to the extent of net investment income, (24) and the taxpayer has no investment income in this example. The taxpayer therefore cannot take the investment interest expense as a deduction this year. Accordingly, the taxpayer's tax treatment of these two transactions is as follows:

      Gross income $100,000

      Deduction /

      Taxable income $100,000

      Note that the deduction in this example was disallowed because of the absence of income of the same type. The converse is not true, however. That is, income inclusion is not limited by basketing--only deductions are. (25) Thus, in the first example, the investment income was included in gross income despite the absence of any investment expenses.

      Another illustration of this principle involves the limitation on capital losses, also discussed below. (26) Capital losses are deductible only from capital gains, plus, for noncorporate taxpayers, up to $3,000 of ordinary income. (27) It is only capital losses, not gains, that are subject to the limitation; (28) regardless of the presence of capital losses, capital gains constitute gross income. (29) For example, if a taxpayer has $100,000 of capital gains for the year, all $100,000...