The University of Chicago Law School Faculty Blog

The Twilight of Tax Sunsets?

Assistant Professor Daniel Hemel on the rise and fall of temporary tax laws:

Since the early 2000s, Congress has filled the Internal Revenue Code with numerous sunset provisions. These provisions by their terms apply for a limited period, although Congress regularly renews them through annual “extenders” legislation. Examples have included the tax credit for research and experimentation expenses, the Subpart F exception for active financing, the deduction for state and local sales taxes, and the American Opportunity Tax Credit for the first four years of postsecondary education. Interest groups have devoted significant resources toward ensuring that members of Congress extend these tax breaks from year to year. Tax law scholars, in turn, have channeled considerable energy toward explaining the prevalence of sunset provisions in tax law.

A leading explanation of the “sunset” phenomenon is that lawmakers use temporary tax legislation to extract rents from interest groups. Rebecca Kysar writes that “the continuous threat of expiration allows Congress to extract more rents from interest groups through the use of sunset provisions that require those groups repeatedly to return to the congressional floor to achieve their goals.” Edward McCaffery and Linda Cohen likewise hypothesize that lawmakers will maximize rents through a “stringing-along” strategy, using extenders bills to get “multiple bites at the apple.” Others have offered similar accounts.

The rent-extraction hypothesis might lead one to expect that temporary tax breaks will be a permanent feature of the Code, as lawmakers have little incentive to relinquish the rents they derive from the extenders game. But that prediction has proven wrong: earlier this month, Congress voted to make 22 once-temporary tax breaks permanent, including all four provisions mentioned above. Congress’s recent action gives rise to a puzzle: If temporary legislation allows lawmakers to maximize the rents they can extract from interest groups, why did Congress allow these tax breaks to become permanent? Did DC suffer a sudden outbreak of public spiritedness this holiday season? Or does the rent-extraction hypothesis need updating?

I imagine that others will weigh in on this question in the coming weeks and months. My initial take, though, is that this month’s permanent extensions actually serve as evidence in favor of the rent-extraction hypothesis. This is because the rent-extraction hypothesis hinges upon the existence of campaign finance laws that limit transfers from interest groups to lawmakers in a given election cycle. Recent election law developments effectively lifted some of those limits. As a result, lawmakers can now extract rents from interest groups without using the device of temporary legislation.

In a world without campaign finance laws, the rent-extraction hypothesis would not be terribly compelling. Interest groups presumably assign a higher value to permanent legislation than to temporary legislation, and so would be willing to pay a higher price for permanent provisions. Think of temporary legislation like a lease and permanent legislation like a sale. It’s not immediately obvious why lawmakers will be able to extract more rents by “leasing” tax breaks than by “selling” them. If anything, one might think that selling would be a superior strategy because interest groups value certainty (e.g., corporations want to be able to plan multi-year R&D efforts with the assurance that the research tax credit will remain available throughout), and so may be willing to pay extra for the added certainty that comes with a permanent provision. (To be sure, even a permanent provision doesn’t lead to 100% certainty because of the possibility—however remote—of repeal; however, the costs borne by an interest group in preventing repeal are likely lower than the price of serial extensions, because the legislative coalition necessary to prevent repeal is smaller than the coalition needed to secure an extension.)

This is where campaign finance laws come into the picture. Campaign finance laws impose a cap on the rents that lawmakers can extract from interest groups in any given election cycle. Temporary legislation offers a way for lawmakers and interest groups to circumvent the cap. A stylized example serves to illustrate: Imagine that an interest group is represented by a single political action committee, and that a single lawmaker (we’ll call her Congresswoman X) is the pivotal player in deciding whether a tax break benefitting the interest group is enacted (perhaps she is the chairwoman of the House Ways and Means Committee). Let’s say, moreover, that the interest group is willing to pay $5,000 to Congresswoman X (or to her PAC) for each year in which the tax break is in place. Assume a 10% discount rate on both sides; thus, the interest group and Congresswoman X are indifferent between (a) an arrangement in which the interest group pays $5,000 each year to Congresswoman X’s PAC in exchange for Congresswoman X’s support of a one-year extension of the tax break, and (b) a deal in which the interest group makes a one-time payment of $50,000 to Congresswoman X in exchange for Congresswoman X pushing a permanent provision through.

Federal campaign finance law precludes the interest group and Congresswoman X from selecting option (b). The maximum contribution from one PAC to another is $5,000 per year. So instead of supporting permanent legislation in exchange for a one-time transfer of $50,000, Congressman X will support a temporary tax break (extended each year) in exchange for annual transfers of $5,000. Congressman X might support permanent legislation now if the interest group could guarantee that it would continue to make annual contributions of $5,000 in perpetuity, but such a deal would be unenforceable, and so the interest group and Congressman X settle on the temporary legislation/annual contribution pattern.

Or, at least, that was the status quo until 2010, the year of the Supreme Court’s decision in Citizens United v. FEC and the DC Circuit’s decision in SpeechNow v. FEC. As a consequence of those court decisions, corporations, unions, and individuals can make unlimited contributions to “independent expenditure only committees,” or so-called “super PACs.” Super PACs cannot coordinate expenditures with candidates; however, many lawmakers have strong links to particular super PACs. Four years later, in McCutcheon v. FEC, the Supreme Court struck down limits on the aggregate amount that an individual could donate to all candidates, parties, and PACs in a given election cycle. And in December 2014, Congress passed a provision that effectively increased the amount that a donor can give to a national political party from $129,600 per year to $777,600 per year.

The net effect of these developments is that binding limits on the amount that lawmakers can extract in rents from interest groups in any given election cycle are much less binding now than they were six years ago. And if those campaign finance limits were what stood in the way of interest groups making lump-sum payments to lawmakers in exchange for permanent tax breaks, then we might expect that the weakening of campaign finance laws would result in a shift from temporary tax provisions to permanent legislation. That is exactly what has happened. At the time that Citizens United was handed down, the Joint Committee on Taxation counted 201 temporary tax provisions set to expire in the next decade, up from 44 in the year before the McCain-Feingold campaign finance reform legislation. By January 2015, that figure had fallen to 70. And that count came before Congress made 22 more provisions permanent in this month’s omnibus bill.

It is still too early to declare the death of tax sunsets. Several significant tax provisions are set to expire next year, such as the exclusion for cancelled home mortgage debt, the deductibility of mortgage insurance premiums, and the $4,000 above-the-line deduction for qualified tuition. Still others are set to expire in 2019, including the New Markets Tax Credit, the Work Opportunity Tax Credit, the $500,000 bonus depreciation allowance, and the Subpart F “look-thru” rule. And while the developments described above have relaxed the restrictions on rent extraction in any given election cycle, important limits remain: an individual cannot donate more than $2,700 to a candidate committee per election, and a PAC still cannot donate more than $5,000. Moreover, factors other than campaign finance limits may make temporary legislation attractive under certain circumstances. For example, interest groups and lawmakers may settle on a temporary legislation/annual contribution arrangement if the interest group’s discount rate is higher than the lawmaker’s. And Congress still may use temporary tax breaks for short-term stimulus purposes during downturns.

In sum, it’s still premature for a postmortem. But it does appear that sunset provisions have reached something of a twilight phase. And while no doubt there are multiple reasons why this is so, recent court decisions and legislative changes relaxing campaign finance restrictions appear to be at least part of the story.

 

An Alaska Tax Puzzle

Assistant Professor Daniel Hemel on the Alaska governor’s plan for a state income tax: 

Alaska Governor Bill Walker wants to institute a state income tax and reduce the dividend that state residents receive each year from the Alaska Permanent Fund. As the New York Times explains:

Mr. Walker’s recovery plan would take more from residents through the income tax and would give them less as well, by changing the formula under which the dividend is paid. The income tax would be 6 percent of the amount an Alaskan currently pays in federal taxes, so a person who owed $10,000 to the Internal Revenue Service would also need to write a $600 check to Alaska. Dividend payments would be tied directly to royalties that decrease or increase with oil production. Because oil production is down, next year’s payout would be cut by roughly half under the proposal, to about $1,000 a person.

On first glance, Walker’s plan seems like a rational response to the worldwide drop in petroleum prices, which has reduced revenues for the oil-dependent state. But when one considers the federal income tax consequences of Walker’s proposal, the logic becomes less clear.

Start with the way that federal tax law will treat the amount Alaska residents pay in state income tax. That amount is deductible from taxable income under section 164 of the Internal Revenue Code. Not all Alaska residents will benefit from the section 164 deduction though. Roughly two-thirds of taxpayers (primarily in the lower and middle income brackets) claim the standard deduction instead of itemizing; for them, the section 164 deduction is worthless. Some higher-income taxpayers are subject to the alternative minimum tax (AMT); those taxpayers also don’t benefit from section 164 because state taxes aren’t deductible from AMT income. And even for taxpayers who itemize and who aren’t hit by the AMT, the value of the deduction may be limited by various other features of tax law. For example, state taxes are included in adjusted gross income for purposes of the 2% floor on miscellaneous itemized deductions, the Pease limitation, and the personal exemption phaseout (PEP). The section 164 deduction is not one of the miscellaneous itemized deductions limited by the 2% floor, but the value of the deduction is reduced by the Pease provision for some taxpayers.

Next, consider the fact that dividends from the Permanent Fund are treated as ordinary income for federal tax purposes. This means that many Alaska residents will pay federal income tax on their $1,000 dividend but won’t be able to deduct the amount they pay in state income tax. So say that an Alaskan resident in the 25% federal income tax bracket claims the standard deduction and pays $16,667 in federal income tax. She will then owe $1,000 in state income tax (6% of $16,667) and will receive a $1,000 dividend from the Permanent Fund. She won’t benefit from the section 164 deduction for the $1,000 she pays in state income tax, but she will be liable for $250 in federal income tax due to the dividend she receives from the Permanent Fund. In other words, even though her tax payment to the state exactly equals the dividend she receives from the state, she is $250 worse off after factoring in the federal income tax consequences.

What is especially curious about this result is how easily Alaska can avoid it. Consider an alternative in which Alaska imposes a state income tax on residents equal to 6% of federal income tax due, while also eliminating the Permanent Fund dividend and replacing it with a $1,000 refundable tax credit. Thus, an Alaska resident who owes nothing in federal income tax would receive a $1,000 check from the state; a resident who owes $16,667 in federal income tax would receive nothing from the state and would owe nothing to the state; and an Alaska resident who owes $200,000 in federal income tax would have her $12,000 state income tax bill reduced to $11,000 by virtue of the $1,000 tax credit.

On a pre-federal tax basis, this alternative arrangement is identical to Governor Walker’s plan. Factoring in federal taxes, however, the alternative would seem to be much better from the perspective of Alaska residents. A U.S. Tax Court decision this spring, Maines v. Commissioner, addressed the federal tax treatment of refundable state tax credits. A state tax refund is taxable income for federal tax purposes under certain circumstances; however, “the amount of a state-tax credit that reduces a tax liability is not an accession to wealth under section 61,” and is thus not included in taxable income. So an Alaska resident who pays zero federal income tax and receives a $1,000 refund under my alternative would be no better off than under the Walker plan—but no worse off either. And most other Alaska residents would be better off under my alternative than under the Walker proposal.

To get a sense of just how much better off Alaska residents would be under my alternative, consider a few hypothetical cases. I’ve already discussed the example of an Alaska resident in the 25% bracket who claims the standard deduction and owes $16,667 in federal income tax. She is $250 better off under my alternative than under the Walker plan, because her $1,000 credit would not be federal taxable income but her $1,000 dividend would be. Next, consider an Alaska resident subject to the federal AMT and in the 28% AMT bracket who pays more than $16,667 in federal income tax (i.e., more than $1,000 in state income tax under the Walker plan). She is $280 better off under my alternative—again because the tax credit is excluded from AMT income. Finally, consider an itemizing couple in the 33% bracket whose income is above the Pease limitation and within the personal exemption phaseout range. Under the Walker plan, the $2,000 dividend ($1,000 for each member of the couple) decreases the couple's itemized deductions by $60 because of Pease, reduces their personal exemption by roughly $128 because of PEP, and raises the floor on their miscellaneous itemized deductions by $40. While they can claim the section 164 deduction for state tax, their taxable income is still $228 higher (and they pay roughly $75 more) under the Walker plan than under my alternative.

My point is not to criticize Walker for putting forward his plan rather than mine. Those of us outside Alaska should be quite pleased that Governor Walker structured his plan in a way that results in Alaska residents paying more in federal income taxes. As compared to my alternative, Walker’s plan effectively amounts to a transfer of wealth from Alaskans to the rest of us. So on behalf of everyone in the other 49 states: Thank you.

The puzzle is why Governor Walker opted for this path. In other words: Why would Walker choose the combination of a state income tax and a Permanent Fund dividend when an otherwise equivalent approach, involving a state income tax and a refundable credit, would lead to lower federal income taxes for many Alaska residents without resulting in higher federal income taxes for any Alaska residents? I see no easy answer. Perhaps Walker thinks that from a political perspective, it’s easier to sell a plan that reduces the Permanent Fund dividend than to sell a plan that eliminates the Permanent Fund dividend and replaces it with a refundable tax credit. This strikes me as a questionable strategy. Walker is up for reelection next in November 2018, by which point Alaska residents will have two tax seasons of experience under his plan. By then, at least some voters will have come to recognize the disadvantage of the dividend-plus-state-income-tax combination. And Walker’s Republican and Democratic challengers (Walker is an independent) will have an incentive to point out that the governor’s plan has cost the state millions of dollars. (According to the IRS, nearly 358,000 Alaskans filed individual income tax returns in 2014. If the average Alaska taxpayer would be $100 better off under my alternative than under the Walker plan, that amounts to $35.8 million flowing out of Alaska each year.)

Alaska is unique insofar as it has a Permanent Fund that pays a dividend to state residents. But the mystery of the Walker plan has analogs in other tax puzzles. Most states have state income taxes and state sales taxes, even though section 164 only allows taxpayers to deduct one or the other. One would think that itemizing taxpayers in dual-tax states would be better off from a federal tax perspective if the state imposed only an income tax or only a sales tax (in which case all state taxes would be deductible under section 164). Nonetheless, 39 states have opted for a dual income-plus-sales tax structure, despite the federal tax drawback. Meanwhile, the vast majority of S&P 500 companies (424 of 500) pay dividends, even though share buybacks are a more efficient way to return profits to shareholders from a federal tax perspective. In this respect, Governor Walker’s plan resembles the payout policies of the largest publicly traded companies; although tax-sensitive investors would be better off if these payments did not take the form of dividends, the prevalence of dividends persists.

In sum, Governor Walker’s plan presents a puzzle, but it’s a puzzle not limited to the Last Frontier. Like other states, Alaska is structuring its tax and transfer system in a way that fails to minimize its residents’ federal tax liabilities. And like other dividend payers, the Alaska Permanent Fund is returning profits to stakeholders in a tax-inefficient manner. The Walker plan might seem illogical in this respect, but the illogic is widely shared.

Vanguard Fund Fees To "Quadruple"? (Not So Fast)

Assistant Professor Daniel Hemel on the Vanguard Group’s potential tax liabilities:

CBS News posted a story on its website last week headlined, “Vanguard investors, your fund fees could quadruple.” The report follows a Newsweek article earlier this month asserting that Vanguard may have to quadruple its average fee in response to claims that the mutual fund company has been avoiding taxes. The University of Chicago, like nearly 2,000 other employers, offers retirement plans to its employees through Vanguard, so the subject is of more than academic interest here. Could it really be that Vanguard will have to quadruple its expense ratio in order to cover its tax liabilities?

In a word: No. There is no plausible scenario in which tax law would require Vanguard to quadruple its fees. If the IRS chooses to enforce transfer pricing rules against Vanguard, the mutual fund company may have to increase its fees modestly—but nowhere close to the “quadrupling” suggested by media reports.

First, a bit of background on Vanguard’s structure: Vanguard Group, Inc. (VGI) is a corporation headquartered in Pennsylvania and chartered in Delaware that provides investment management and administrative services to various Vanguard mutual funds. VGI is a C corporation for federal tax purposes; the mutual funds are regulated investment companies, or “RICs.” VGI must pay corporate income tax just like any other C corporation; the mutual funds generally are not taxed as long as they distribute at least 90% of their income to investors. The mutual funds technically own VGI—an arrangement described in more detail by John Morley in this excellent Yale Law Journal article.

The Vanguard mutual funds pay VGI for the services that VGI provides. As Reuven Avi-Yonah explains in a recent Tax Notes article, VGI is a “controlled” taxpayer in relation to the mutual funds for purposes of the transfer pricing rules because the mutual funds own VGI. Transfer pricing rules require VGI to report income based on the price that it would have received from each mutual fund in an “arm’s length” transaction. So if a Vanguard mutual fund pays VGI $5 for services that would have been priced at $10 in an arm’s length transaction, VGI must pay taxes as if it had received $10 from the mutual fund, even though it actually received only $5.

VGI charges the mutual funds “at cost,” without any markup. The problem with this approach from a tax perspective is that service providers generally don’t price their services at cost; they try to earn a profit. According to former Vanguard tax attorney-turned-whistleblower David Danon, VGI is underreporting its taxable income because it doesn’t account for the markup it would receive if it dealt with the mutual funds at arm’s length. Vanguard has an obvious incentive to report lower income for VGI and (correspondingly) higher income for the mutual funds because VGI is taxable at a 35% corporate rate while the mutual funds generally pay no tax. (Investors in the mutual funds may be liable for tax, but many of Vanguard’s customers hold their mutual fund shares through IRAs, 401(k) plans, and other vehicles that are effectively tax-exempt.)

Professor Avi-Yonah expands on this argument in his article and in an expert report submitted to the IRS and SEC in connection with Danon’s whistleblower submission. Avi-Yonah’s basic logic strikes me as sound. VGI should be reporting income as if it were receiving arm’s length prices from Vanguard mutual funds. If it’s not, then VGI is underpaying the IRS and state tax authorities.

The harder question is: by how much is Vanguard underreporting its taxable income? Professor Avi-Yonah pegs the arm’s length price of VGI’s services at 71 to 82 basis points (0.71% to 0.82%), a figure based on average expense ratios for all mutual funds from 2007 through 2014 as reported by Morningstar. Avi-Yonah compares this to Vanguard’s average expense ratio of 18 to 21 basis points over the same period. Avi-Yonah notes that “average fees reported by Morningstar understate the true arm’s-length price because the average includes Vanguard’s non-market fees.”

Significantly, though, Morningstar’s industry-wide average includes actively managed funds as well as index funds, while assets under management at Vanguard are predominantly in index funds. Active management and index fund management are very different services that command very different prices in arm’s length transactions. So comparing Vanguard (predominantly index funds) to the industry-wide average (actively managed and index funds) is like comparing apples to oranges—or, perhaps more precisely, comparing a basket of apples to a basket that includes both apples and oranges. The apples-to-apples comparison would be Vanguard index funds versus non-Vanguard index funds.

Fortunately, Morningstar’s data allows us to make apples-to-apples comparisons. Vanguard’s most popular products are its large cap blend index funds, including its Total Stock Market Index Fund and the S&P-tracking Vanguard 500 Index Fund. In 2013, the average asset-weighted expense ratio for Vanguard’s large blend index funds was 13 basis points below the asset-weighted average for non-Vanguard large blend index funds. In some other sectors, the cost difference was wider (48 basis points for large growth index funds); in still other sectors the gap was narrower (8 basis points for foreign large blend index funds, 12 basis points for intermediate bond index funds). Note that after the large blend category, assets in index funds are concentrated in the foreign large blend and intermediate bond categories—the segments for which the cost difference between Vanguard and non-Vanguard funds is the smallest. And the cost difference is even narrower for some categories of exchange-traded funds (e.g., 4 basis points for large blend ETFs). 

To get a better sense of just how much Vanguard might owe in back taxes, I reconstructed Avi-Yonah’s calculations, but instead of using the difference between Vanguard’s average expense ratio and the industry-wide average for actively managed funds and index funds, I relied on an apples-to-apples comparison between the average expense ratios for Vanguard large blend index funds and non-Vanguard large blend index funds. This comparison is admittedly suboptimal: ideally one would run the comparison across all fund categories with appropriate adjustments for asset weights. But the available Morningstar data isn’t detailed enough to allow for the ideal comparison. And using the gap between expense ratios for Vanguard and non-Vanguard large blend index funds strikes me as quite a bit better than an apples-to-oranges comparison between Vanguard funds and the industry-wide (actively managed plus index) average. (One of the many admirable aspects of Avi-Yonah’s expert report is that he is crystal clear about his assumptions, making it easy for others to reconstruct his calculations while tweaking those assumptions.)

Morningstar’s data on expense ratios for Vanguard and non-Vanguard large blend index funds goes through 2013; lacking 2014 data, I assumed that the 13 basis point differential in 2013 remained constant over the next year. On those assumptions, Vanguard’s estimated underreported income for 2007 through 2014 is $18.6 billion, compared to Avi-Yonah’s estimate of $70.6 billion. Factoring in a 40% penalty plus interest (as Avi-Yonah does), the sum total for taxes and penalties due to the IRS comes to $9.9 billion—well below Avi-Yonah’s estimate of $34.6 billion.

I acknowledge that this estimate is quite rough (and I look forward to hearing suggestions as to how it might be made more precise). I think it’s at least in the right ballpark though. Note that $9.9 billion is equal to about 0.32% of Vanguard’s assets under management (i.e., 32 basis points). If Vanguard spreads that cost across all of its funds, investors would face a significant one-time charge—but 32 basis points on top of an existing average expense ratio of 18 basis points is not a “quadrupling” by any measure.

So far, I’ve only addressed Vanguard’s potential liability for back taxes. What about for future years? Even if VGI has to add 13 basis points to the price it charges the mutual funds for tax purposes, that doesn’t mean VGI actually has to collect an additional 13 basis points from the funds. Rather, it has to calculate taxable income as if it were charging the arm’s length rate. The federal corporate income tax rate tops out at 35%; the top tax rate on corporate net income in Pennsylvania is 9.99%; and when one factors in the federal deduction for state income taxes, Vanguard’s rate comes out to 41.5%. (This is an overestimate because some of Vanguard’s income would be apportioned to Arizona and North Carolina, where corporate tax rates are lower than in Pennsylvania.) Multiply 41.5% by 13 basis points and you get roughly 5.4 basis points—which is to say, Vanguard funds would have to pay an extra 5 or so basis points to VGI in order to compensate VGI for its additional federal and state corporate income tax liabilities.

The bottom line is that if the IRS enforces transfer pricing rules against Vanguard, investors might face a one-time charge of roughly 30 basis points and a recurring charge of roughly 5 basis points per year, on top of average fees today of approximately 18 basis points across Vanguard funds. These amounts aren’t insignificant; an individual who opens an IRA with Vanguard and holds it for several decades may see the ultimate value of the funds in her account reduced by more than a full percentage point as a result. Even so, you’re still a lot better off over the long term in the Vanguard 500 than, say, a JPMorgan index fund tracking the S&P 500 with an expense ratio of 45 basis points.

All of this assumes that the IRS chooses to go after Vanguard on transfer pricing. And it very well might not. For an agency already under fire, pursuing a transfer pricing case against a popular mutual fund company does not seem like a politically savvy move—especially when that mutual fund company manages the retirement savings of millions of Americans. This is not to say that the IRS shouldn’t go after Vanguard, but I’d be surprised if it did. Professor Avi-Yonah asks whether Vanguard is “too big to tax”; perhaps the question is whether it’s too beloved.

A "Duty" to Minimize Taxes?

Assistant Professor Daniel Hemel on the “duty” of CEOs to minimize corporate taxes:

CNBC’s Jim Cramer came to the defense of Apple CEO Tim Cook yesterday, arguing that Apple’s CEO has a duty to minimize the company’s corporate tax liabilities. Cramer said on CNBC’s “Squawk on the Street”:

“One of the things I did take seriously when I was in law school was taxes. The main thing you learn is that tax avoidance is everybody’s . . . duty. You’re supposed to try to avoid.”

Cramer graduated from Harvard Law School in 1984, and it’s perhaps unfair to hold him at fault for misremembering what he learned in a tax course more than 30 years ago. But Cramer seems to be confusing “right” and “duty” here. Justice Sutherland famously said in Gregory v. Helvering that “[t]he legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.” 293 U.S. 465, 469 (1935). The claim that directors and officers have a “duty” to minimize a corporation’s taxes, though, can indeed be doubted. In fact, the Delaware Chancery Court recently rejected such a claim.

The question whether corporate directors and officers have a duty to minimize taxes arose in a 2012 case, Freedman v. Adams. That case concerned an executive compensation plan approved by the board of XTO Energy, Inc., a publicly traded company. Section 162(m) of the Internal Revenue Code generally prevents a publicly traded corporation from claiming a tax deduction for compensation to a CEO or other top executive in excess of $1 million a year. Section 162(m) allows a deduction, however, for payments made pursuant to a shareholder-approved plan and tied to “the attainment of one or more performance goals” (known as a “§ 162(m) plan”).

The plaintiff in Freedman argued that the XTO board “had a duty to adopt a § 162(m) plan” so that payments to top executives in excess of $1 million would be tax-deductible. The Delaware Chancery Court disagreed. As Vice Chancellor John Noble wrote:

The Plaintiff does not cite any case law of this Court or the Delaware Supreme Court directly supporting the purported fiduciary duty to minimize taxes. . . . For reasons that are both numerous and obvious, this Court is not convinced that it should endorse this proposed new duty. Tax strategy is a complex, dynamic area of corporate decision-making that affects and is affected by many other aspects of a company. . . . Minimizing taxes can also require large expenditures for legal and accounting services and may entail some level of legal risk. As such, decisions regarding a company’s tax policy are not well-suited to after-the-fact review by courts and typify an area of corporate decision-making best left to management's business judgment, so long as it is exercised in an appropriate fashion. This Court rejects the notion that there is a broadly applicable fiduciary duty to minimize taxes . . . .

Freedman v. Adams, 2012 Del. Ch. LEXIS 74, at *45-46 (Del. Ch. Mar. 30, 2012), aff’d on other grounds, 58 A.3d 414 (Del. 2013). (The Chancery Court reached a similar result three months later in Seinfeld v. Slager, 2012 Del. Ch. LEXIS 139 (Del. Ch. June 29, 2012), in which Vice Chancellor Sam Glasscock hewed closely to the reasoning in Freedman. For more on Seinfeld, see Stephen Bainbridge’s blog.)

Freedman might seem inconsistent with Cramer’s claim. But before dismissing Cramer’s assertion entirely, a few qualifications are in order:

First, Freedman is a Delaware case, and Apple is a California corporation. I am not aware of any California case directly addressing the duties of directors and officers to minimize corporate taxes. California courts often look to Delaware corporate law for guidance, though, so Freedman is at least suggestive as to how a California court would rule. See, e.g., Potter v. Hughes, 546 F.3d 1051, 1057 (9th Cir. 2008).

Second, Freedman is a decision of the Delaware Chancery Court, which is subordinate to the Delaware Supreme Court. The Delaware Supreme Court has yet to address this issue, and it would be free to go the other way. (The fact that Freedman is unpublished, however, doesn’t deprive it of precedential force, as “unpublished decisions have precedential value” in Delaware. See Case Financial, Inc. v. Alden, 2009 Del. Ch. LEXIS 153, *21 n.39 (Del. Ch. Aug. 21, 2009).)

Third, the Chancery Court in Freedman acknowledged that “under certain circumstances overpayment of taxes or a poor tax strategy might . . . result from breaches of the fiduciary duties of care or loyalty or constitute waste.” Freedman, 2012 Del. Ch. LEXIS 74, at *45 n.14. The court mentioned the case of Dodge v. Woolsey, 59 U.S. 331 (1855), in which the plaintiff argued that an Ohio bank had violated its charter by paying an unconstitutional tax. Perhaps Apple’s CEO would have a legal duty to minimize taxes if the corporation’s governing documents imposed such a duty. (This is all hypothetical, though, as no such provision appears in Apple’s charter or bylaws.)

Finally, the analysis above has all been about what the law is, not what the law should be. As a normative matter, the rule in Freedman strikes me as the right one. A fiduciary duty to minimize taxes would force directors and officers to navigate between the Scylla of tax law and the Charybdis of D&O liability: a tax strategy that’s too aggressive might trigger penalties, while a tax strategy that’s not aggressive enough might give rise to shareholder lawsuits. If shareholders think that courts are competent to engage in after-the-fact review of managers’ tax-related decisions, they can seek to insert provisions in corporate charters imposing a duty to minimize taxes on managers. Perhaps some courts would say such provisions are unenforceable on grounds of public policy. More likely, shareholders will decide that it’s not in their best interest to try.

Tinkering with the Tax Court

Assistant Professor Daniel Hemel on a new bill that could affect the constitutional status of the U.S. Tax Court:

The House of Representatives voted 318-109 on Thursday to approve a package of tax breaks that will cost an estimated $680 billion over the next decade. The big-ticket items in the package include permanent extensions of the business research credit and the child tax credit, as well as a two-year delay of the controversial “Cadillac” tax on expensive employer-sponsored health insurance plans. Meanwhile, one provision in the package that has drawn little attention so far could have significant implications for the United States Tax Court. The provision, buried on page 231 of the 233-page bill, puts the 19-member court in a state of constitutional limbo.

The provision is entitled “Clarification Relating to United States Tax Court,” and it amends the Internal Revenue Code to add the following language:

The Tax Court is not an agency of, and shall be independent of, the executive branch of the Government.

The provision appears to have been added in response to the D.C. Circuit’s 2014 decision in Kuretski v. Commissioner. That case involved a couple, Peter and Kathleen Kuretski, who went to Tax Court to challenge an IRS levy on their Staten Island home. After the Tax Court ruled against them, the Kuretskis launched an attack on the court’s constitutional structure. The D.C. Circuit summarized the Kuretskis’ core argument as follows:

The Kuretskis now contend that the Tax Court judge may have been biased in favor of the IRS in a manner that infringes the constitutional separation of powers. They point to 26 U.S.C. § 7443(f), which enables the President to remove Tax Court judges on grounds of “inefficiency, neglect of duty, or malfeasance in office.” According to the Kuretskis, Tax Court judges exercise the judicial power of the United States under Article III of the Constitution, and it violates the constitutional separation of powers to subject any person clothed with Article III authority to “interbranch” removal at the hands of the President. The Kuretskis thus ask us to strike down 26 U.S.C. § 7443(f), vacate the Tax Court's decision, and remand their case for re-decision by a Tax Court judge free from the threat of presidential removal and hence free from alleged bias in favor of the Executive Branch.

The D.C. Circuit rejected the Kuretskis’ claim. It assumed, arguendo, that “‘interbranch’ removal of a Tax Court judge would raise a constitutional concern.” But it found “no cause for concern in fact.” According to the D.C. Circuit, the Tax Court “exercises Executive authority as part of the Executive Branch,” and “[p]residential removal of a Tax Court judge thus would constitute an intra—not inter—branch removal.” (No Tax Court judge has ever actually been removed by the President.)

This holding evidently unnerved Senator Orrin Hatch, who chairs the tax writing committee in the upper chamber. Senator Hatch introduced a bill this past April with language identical to the “clarification” found in the extenders package. The accompanying report explained:

The Committee is concerned that statements in Kuretski v. Commissioner may lead the public to question the independence of the Tax Court, especially in relation to the Department of Treasury or the Internal Revenue Service. The Committee wishes to remove any uncertainty caused by Kuretski v. Commissioner, and to ensure that there is no appearance of institutional bias.  

This “clarification” seems to be motivated by entirely noble sentiments. But it has the potential to cause much more confusion than it resolves. If the Tax Court isn’t inside the Executive Branch, then where exactly is it? And if the Hatch provision becomes law, how would a federal court of appeals handle a future challenge to the Tax Court’s constitutional structure?

A few possibilities (with thanks to my colleague Will Baude for helping me think through the permutations):

First, the court of appeals might say that the Tax Court is part of the Legislative Branch. The D.C. Circuit considered this possibility in Kuretski but rejected it. According to the D.C. Circuit, “[t]he Tax Court is in the business of interpreting and applying the internal revenue laws . . . , not in the business of making those laws.” (Some Legislative Branch officials aren’t in the lawmaking business either—for example, the House and Senate Chaplains. Would the court of appeals say that Tax Court judges fall into the same category?)

Second, the court of appeals might say that the Tax Court is part of the Judicial Branch. Yet that possibility raises two immediate red flags. For one, Tax Court judges don’t have life tenure. To be sure, bankruptcy judges don’t have life tenure either, but bankruptcy judges “constitute a unit of the district court”: each district court can decide which cases will be “referred” to bankruptcy judges, and the district court can withdraw the reference at any time. The Tax Court is subject to no such supervision by Article III judges.

Another red flag arises from the fact that Tax Court judges, as the Kuretskis emphasized, are removable by the President for cause. The Supreme Court held in Mistretta v. United States that the President may exercise removal power over Judicial Branch officials under “limited circumstances”: specifically, “Congress may vest in the President the power to remove for good cause an Article III judge from a nonadjudicatory independent agency placed within the Judicial Branch.” Yet Mistretta does not allay the constitutional concern here, because the Tax Court is most certainly “adjudicatory.” That fact doesn’t make it part of the Judicial Branch: as the D.C. Circuit emphasized in Kuretski, Executive Branch agencies can perform adjudicative functions too. But it does suggest that if the Tax Court is part of the Judicial Branch, presidential removal of Tax Court judges raises constitutional questions distinct from Mistretta.

A third possibility is that the court of appeals might say the Tax Court lies off in constitutional no-man’s land, apart from all three branches. The Supreme Court has said that the Constitution “disperses the federal power among the three branches—the Legislative, the Executive, and the Judicial,” but maybe it didn’t really mean that? (Senator Hatch, for his part, wrote in the Washington Post this past March that the Supreme Court should “protect the delicate balance of powers between the three branches of government”; would he now want a federal court to legitimate an adjudicative body that’s in no branch at all?) Perhaps the federal courts should acknowledge that a complex modern state may include governmental bodies that don’t fall neatly into a single branch. But given the formalistic trend in the Supreme Court’s recent separation-of-powers jurisprudence, I find it hard to believe that such an outcome is likely.

A fourth possibility is that the court of appeals might say that the “clarification” in the extenders package is itself a nullity. Congress could, hypothetically, pass a statute saying that the Department of the Treasury “is not an agency of, and shall be independent of, the executive branch”; just because Congress said it wouldn’t make it so. A similar issue arose in Department of Transportation v. Association of American Railroads, a case decided by the Supreme Court this past term. Congress had enacted a statute saying that Amtrak “is not a department, agency, or instrumentality of the United States Government”; the Supreme Court looked at that statute in Association of American Railroads and essentially said it was hogwash. As the Supreme Court put it: “Congressional pronouncements, though instructive as to matters within Congress’ authority to address . . . , are not dispositive of Amtrak’s status as a governmental entity for purposes of separation of powers analysis under the Constitution.” A court might look at the language addressing the Tax Court’s status in the extenders package and say the same thing.

But if the court of appeals does take Congress at its word, then the issue becomes a trickier one. The court might say that an adjudicative body whose members are removable by the President can comfortably lie outside the Executive Branch. Or it might say that if the Tax Court isn’t part of the Executive Branch, then the Tax Court’s structure is constitutionally unsound. If the latter, then presumably the Supreme Court would take up the matter. And at that point, the ultimate outcome is anyone’s guess.

I doubt I’ve thought through all the possibilities. I doubt that members of Congress have either. The hasty addition of the “clarifying” provision to the end-of-year extenders package means that there is little time for lawmakers to debate the measure. Yet it may take courts quite a bit of time to sort through the provision’s potential implications.

And for what? Say the Kuretskis are correct that the Tax Court judge in their case may have been biased in favor of the IRS because he was subject to presidential removal. A congressional declaration that the Tax Court is “independent” of the Executive Branch doesn’t change that: it’s the removal provision that the Kuretskis say is the source of the bias, and the extenders package leaves the removal provision in place. Congress cannot wave a magic wand and make the “appearance of institutional bias” go away. What it can do is create a constitutional quandary for the Tax Court—and an entirely unnecessary one at that.

CNN now reports that the Senate will vote on the extenders package as early as this afternoon. The smart money says that the package will pass. In all likelihood the Tax Court “clarification” will make it into the final version. After that, all bets are off.

[Update (2:12pm CT): The Senate passed the package today by a 65-33 vote. The bill now heads to the desk of President Obama, who says he will sign it.]

An Exam-Grading Hypothetical for Affirmative Action's Supreme Court Test

Assistant Professor Daniel Hemel on tomorrow’s Supreme Court oral argument in Fisher v. University of Texas:

It’s the end of the fall term on university campuses across the country, and so professors are gearing up to grade final exams. Meanwhile, the Supreme Court is gearing up for oral arguments this Wednesday in a case brought by Abigail Fisher, a white student who claims that the University of Texas at Austin’s race-based affirmative action program is unconstitutional. End-of-term exam grading gives rise to a thought experiment with potential implications for Fisher’s case—a case likely to be among the most consequential of this Supreme Court term.

Imagine that a professor keeps a Microsoft Excel spreadsheet with all his students’ names, as well as demographic information (race, gender, etc.) and the students’ scores on the midterm and final exams. The professor doesn’t intend to use the demographic information in the grading process; he just wants to be able to know at the end of the term whether there are substantial racial or gender disparities in students’ scores. But there’s a snag in his plan: Unfortunately, the professor makes a mistake in writing the Excel formula that will spit out final grades. The professor meant for the formula to spit out the weighted average of midterm and final exam scores, but absentmindedly and accidentally, he subtracted 10 points from the grades of all the female students in the class.

We might forgive the absentminded professor for his error. Anyone who uses Excel often enough has probably made the mistake of adding the wrong columns at one point or another. But all would agree that the error should be corrected. The professor should add 10 points back to the women’s scores so that the final grades reflect each student’s actual performance in the class.

Might the male students in the class argue that the professor improperly engaged in gender-based affirmative action? I doubt it. I think we would all say that once the professor recognized his unfortunate error, the right thing for him to do was to correct it. Perhaps some would say that the professor shouldn’t have been tracking gender in the first place, though we can also imagine good reasons why the professor would want to know whether men had systematically outperformed women in his class or vice versa. (Maybe the data might lead him to adjust his teaching style or his exam questions next term.) In any event, we wouldn’t say that the 10-point correction reflected a “preference” for female students. Rather, adding 10 points back to the women’s scores made the grading system more meritocratic.

The Excel example is only hypothetical; the possibility of educators accidentally subtracting points from students of a specific demographic group is not. Indeed, we have reason to believe that educators across the country are making a mistake similar to the absentminded professor’s formula-writing error. Some of the strongest evidence comes from the Implicit Association Test, pioneered by psychologists Mahzarin Banaji and Anthony Greenwald. One version of the test asks subjects to classify children’s faces as “African American” or “European American” and to classify words as “pleasant” or “unpleasant.” In some stages of the test, subjects are asked to press the “e” key when they see an unpleasant word (such as “disaster” or “agony”) or an African-American child’s face, and to press the “i" key when they see a pleasant word (“smile,” “honest”) or a white child’s face. In other stages, subjects are asked to associate the “e” key with unpleasant words and white children’s faces, and the “i” key with pleasant words and African-American children’s faces. Researchers repeatedly find that white adults more quickly associate pleasant words with white faces than with African-American ones. (Evidence of an implicit in-group preference among African-American adults is much weaker.)

If white adults are more likely to link pleasant words with white children’s faces, then that might lead us to suspect that white teachers are more likely to associate positive feelings with white students. And that, in turn, might lead white teachers to assign higher grades to white students than to students of color. This isn’t to suggest that white teachers are closet racists: they might be unaware of their implicit bias, and might strive to correct their own bias if made aware. Here at UChicago Law, professors blind-grade exams in part so that we can prevent implicit biases from affecting the results. But students applying for undergraduate admission to the University of Texas most likely were not blind-graded throughout high school, and so there is good cause to believe that implicit bias has affected their grades and class rank.

Banaji and law professor Jerry Kang have previously argued that implicit bias findings strengthen the case for affirmative action in general, but the findings are especially relevant to the particular facts of the Fisher case. In 1996, the University of Texas at Austin introduced a new undergraduate admissions program that guarantees spots for Texas high school students who finish in the top 10% of their graduating class. More than half of Latino students in Texas and 40% of African-American students attend high schools with minority enrollment of 90% or more; this de facto segregation makes it a mathematical certainty that the top 10% at those high schools will include minorities. Indeed, more than half of African-American and Latino students admitted under the Top 10% Plan hail from high schools with minority enrollment of 90% or higher. One of the reasons why University of Texas says it wants to use race-based affirmative action is so that it can assure that African-American and Latino students from racially diverse high schools are represented on campus too. (Since Fisher’s lawsuit was filed, Texas has amended the plan so that only the top 7% to 8% of students in each high school graduating class are guaranteed admission, but otherwise the details remain essentially the same.)

Abigail Fisher’s lawyers say that the University of Texas has no good reason for “favoring” minority students who have been educated at racially integrated high schools. In Fisher’s view, the set-aside for the top students from each high school already assures that minority students from predominantly minority high schools will be represented on the UT Austin campus, and the university has no additional interest in ensuring that minority students from integrated high schools will be represented as well. But the results of the implicit bias research suggest otherwise. For an African-American student at a high school that is virtually all black, implicit bias is unlikely to affect class rank; the student is being compared to classmates of the same race. But for African-American students at mixed-race high schools, the effect of implicit bias is potentially more pernicious. If white teachers unconsciously favor white students when grading, then an African-American student’s class rank at an integrated high school won’t be an accurate measure of the student’s performance. Rather, the African-American student will find himself in the same position as the female students in the Excel hypothetical who had points arbitrarily deducted from their score.

If you thought the professor should add back 10 points to the female students’ grades in the Excel hypothetical, and if you accept the overwhelming weight of the implicit bias research, then you should probably support the University of Texas policy as well. An admissions preference for minority students from integrated high schools is a way for the university to add back points incorrectly deducted by earlier graders—that is, by the white high school teachers who gave grades reflecting this own implicit bias. In other words, giving a preference to minority students from integrated high schools is a way to measure merit more accurately—which is to say, it’s not a “preference” at all.

Not everyone will be convinced by this argument. Perhaps some students in integrated high schools didn’t have white teachers (though that seems unlikely—65% of public school teachers in Texas are white, despite the overall student body being majority minority). Not all white adults exhibit a pro-white implicit bias (though in some studies, more than three-quarters do). And it is difficult to know whether implicit bias bleeds over into grading (though there is evidence that it affects trial judges as well as employers evaluating resumes). Moreover, the affirmative action policy at the University of Texas gives a boost to Latino students as well as African-Americans, whereas the implicit bias findings are strongest with respect to anti-black bias (though there is evidence of an anti-Latino bias too). And unlike the Excel hypothetical, where it was clear how many points the female students lost due to the spreadsheet error, it’s harder to know how many GPA points to add back for minority high school students.

So a closer hypothetical might be as follows: Let’s say that the absentminded professor can’t be sure whether he accidentally deducted 10 points from all the female students’ scores. He strongly suspects that he did, but he has deleted the spreadsheet and lost the original exams. Should the professor add 10 points to the female students’ scores based on the belief that he probably (but not certainly) subtracted those points by accident? In other words, should the professor take a step that will probably (but not certainly) make the final outcome more meritocratic? That, in a nutshell, is the quandary facing the University of Texas. The university wants to add those points back. The question now is whether the Supreme Court will let it.