Statutory speed bumps: the roles third parties play in tax compliance.

• Author: Lederman, Leandra

INTRODUCTION I. PARALLELISM AND TAX POLICY A. Horizontal Equity and Parallelism B. Exclusions and Deductions: Where's the Equivalency? C. The Importance of Enforceability to Tax Policy II. PLAYING FAVORITES: THE CRITICAL ROLE OF THIRD PARTIES A. Clark v. Commissioner: A Tax Refund by Any Other Name B. Excludible Personal Receipts C. Excludible Employment-Related Receipts 2. The self-employment comparison 3. Moving expenses III. WHEN ARE THIRD PARTIES HELPFUL AND WHEN ARE THEY HARMFUL? A. The Zero-Sum Constraint and the Unselfish Exception B. Manufactured Surplus Minimized: The Example of Wages C. Identifying Accommodation and Cooperating Parties 1. Tax-indifferent parties 2. Familiar parties 3. Soliciting parties 4. Parties playing two roles CONCLUSION INTRODUCTION

Numerous laws prohibit and punish behavior the government seeks to prevent, such as running red lights or driving faster than the posted speed limit. However, recent legal and economic scholarship has recognized that the government has an important alternative mechanism it can use to reduce prohibited behavior: "structural" systems. (1) Structural systems either facilitate enforcement, as red light cameras do, (2) or actually help constrain behavior. For example, if the government seeks to reduce speeding in a residential neighborhood, instead of (or in addition to) imposing fines and ticketing speeders, it can construct roads in ways that help reduce speeding, (3) such as making them narrow or winding, or including speed bumps. The structure of the road can thus actually help prevent the behavior the government seeks to reduce.

This insight can apply in an array of areas in addition to traffic laws. For example, why people pay taxes is sometimes described as a puzzle. (4) From an economic perspective, it appears that penalties and enforcement rates are too low to deter cheating with respect to such taxes as the federal income tax in the United States. (5) Yet, the federal government estimates that 84% of federal income taxes due are timely and voluntarily paid. (6) An essential missing piece of this seeming puzzle is that the federal income tax law benefits from structural mechanisms that constrain payment with respect to the major sources of income for many people, including wages and salaries. (7)

The structural mechanisms the federal income tax uses, unlike red light cameras and speed bumps, make use of third parties to the taxpayer/government relationship. As is well known, in a variety of situations, the federal government requires third parties to report to the government, with a copy to the taxpayer, amounts the payor transferred to the taxpayer. (8) This "information reporting," like red light cameras, provides information to the government, and it is information that the taxpayer knows the government is receiving. (9) Moreover, in some situations, the payor, such as an employer, must also withhold taxes from the payment and remit those taxes to the government. Withholding taxes, like speed bumps, constrain compliance with the law. However, unlike speed bumps, withholding taxes are effective largely because they essentially make a third party responsible for paying the taxpayer's taxes. (10)

Information reporting and withholding extend to a variety of types of income in the U.S, and are highly successful at securing compliance. (11) A comparison of the estimated "voluntary compliance" rates under the federal income tax with respect to various types of income suggests just how effective these systems are. (12)

Amounts subject to withholding (e.g., wages and salaries) have a net misreporting percentage of only 1.2 percent. Amounts subject to third party information reporting, but not to withholding (e.g., interest and dividend income) have a slightly higher net misreporting percentage of 4.5 percent. Amounts subject to partial third-party reporting (e.g., capital gains) have a still higher net misreporting percentage of 8.6 percent. Amounts not subject to withholding or other information reporting (e.g., Schedule C income or other income) are the least visible, with a much higher net misreporting percentage of 53.9 percent. (13) Structural systems that engage third parties to help facilitate compliance with the federal income tax are thus highly successful. (14) The use of such mechanisms need not necessarily be limited to tax administration, however. Substantive tax law could incorporate structural systems that benefit from the use of third parties. In fact, although it has gone unnoticed until now, federal income tax law already implicitly takes account of the structural benefit arm's length third parties can offer. Specifically, as discussed below, the tax law often fails to extend the favorable tax treatment afforded particular reimbursed expenses or losses to similar but unreimbursed items. (15) This distinction does not reflect different tax treatment of equivalent events, as prior scholarship suggests. (16) Instead, it reflects the enforcement benefits that a reimbursement provides--including the presence of a third party who implicitly has "vouched" for the bona tides of the taxpayer's claim. (17) In fact, the more favorable tax treatment of amounts verified by third parties is not only rational, it is consistent with the important tax policy goal of an administrable tax system. (18)

Although third parties can thus provide a type of "friction" that reduces tax avoidance, (19) they do not do so in all contexts. In fact, transaction counterparties have also been known to participate in abusive tax-reduction strategies in return for a portion of the tax savings generated. (20) The government thus needs to be able to identify the types of situations in which counterparties will tend to act as verifiers of taxpayers' claims, as well as those in which they are more likely to collude in noncompliance. Aspects of the structure of each situation can help the government make this distinction. It then generally can "free ride" in situations in which third parties perform a verification function while scrutinizing more closely other transactions. Moreover, the government can consciously seek to use legislation to create more of the beneficial structures and reduce the number of structures that lend themselves to exploitation.

In elaborating on these distinct but connected points relating to the bridge that third parties provide between substantive income tax laws and enforcement of those laws, this Article proceeds in three major parts. Part I develops the insight of this Article that the substantive role third parties play in federal income tax law helps explain numerous instances in which an exclusion of a reimbursed or compensated expense or loss is not matched by a deduction in full of a comparable but uncompensated expense or loss. It first discusses the concept of "parallelism," which Professor Jeffrey Kahn describes in a recent article as a concept related to but narrower than horizontal equity, the concept that similarly situated taxpayers should be similarly taxed. (21) This Part then demonstrates that the exclusion of a reimbursement is not economically equivalent to the deduction of an unreimbursed amount. Finally, it connects the economic distinction between reimbursed and unreimbursed amounts to the important tax policy principle of administrability of the tax system.

In Part II, the Article explores the use of third parties as a compliance tool, as currently reflected in substantive federal income tax law. It discusses several situations in which more favorable tax treatment is accorded to a transaction that involves an arm's length third party than to an otherwise similar transaction that does not involve a third party, and argues that the distinct treatment is justified by the policy considerations discussed in Part I.

Because third parties are not a panacea for tax compliance, Part III of the Article explores how the government can distinguish contexts in which third parties tend to foster compliance from settings in which they may tend to undermine it. This Part first discusses the underlying economic distinction between contexts in which third parties, in acting out of their own self-interest, will verify the taxpayer's claim, and situations in which third parties' self-interest will instead incline them to collude with the taxpayer to exploit the tax system. Next, it examines these issues in the context of employers' payments of wages to employees. Finally, the Article identifies four types of transaction counterparties for whom the government should be watchful because transactions in which they are involved provide opportunities for collaboration in abusive tax-minimization strategies.

1. PARALLELISM AND TAX POLICY

   1. Horizontal Equity and Parallelism

      Equity in a tax system is an important tax policy consideration. (22) "[H]orizontal equity," which "demands that similarly situated individuals face similar tax burdens[,] ... is universally accepted as one of the more significant criteria of a 'good tax.'" (23) Horizontal equity implicitly refers to taxpayers' overall tax burdens. (24) In a recent article, Professor Jeffrey Kahn discussed a related, narrower principle, which he terms "parallelism"--the notion that "the same or equivalent receipts, expenditures or losses should be treated the same by the tax law." (25)

      The focus of Professor Kahn's analysis "is the notion that if the reimbursement of an expenditure or loss is excluded from the recipient's income, the same type of expenditure or loss that is not reimbursed should be fully deductible." (26) His analysis rests on the principle, discussed further below, that an exclusion is mathematically equivalent to an inclusion coupled with a deduction. (27) Professor Kahn argues:

      Since the exclusion and deduction approaches generally are identical for tax purposes, one might expect there to be parallel treatment of reimbursed and unreimbursed expenditures and...