During the recent election campaign, one heard about how President-Elect Trump has made use of the tax code to avoid federal income tax for up to 18 years. There was not much detail given: just a screen shot of a page in his tax return. There are many ways this could have been accomplished but, absent better information, any explanation is speculative.
The larger point is that losses are a good thing: making lemonade out of lemons. The tax codes in most jurisdictions allow expenses incurred in the production of business income to be deducted in arriving at taxable income. Wages and rent are great examples as is the cost of goods sold. Startup companies may incur expenses in excess of income for some time before eventually turning a profit.
The tax code considers it only fair to permit net losses from operations (NOLs) to be carried forward to a future period of profitability and then deducted (a recent article “Why Trump’s Proposed Tax Rate Reduction is Bad for Banks” discusses the idea of deferral of NOLs). At some point, however, the tax code says enough is enough, and the losses expire. For NOLs, that period is currently 20 years.
It is worth stating that if Donald Trump legitimately incurred $900m of NOLs, he was entitled to offset these losses to shelter future income. It may not have taken 18 years. If he had generated $900m of income in the following year, those NOLs would have been used up.
A Macroeconomic View Of Losses
In a report by the Inspector General of the Treasury, the reported NOLs carried forward for the tax year 2012 were $1.96trn. The losses arising from the Great Recession in 2007-2009 peaked in 2010 at $722bn. In discussing the context of NOLs, the report documents how the current tax policy can provide some economic stimulus to promote investment and risk taking and some economic relief during an economic downturn.
By allowing NOLs to be carried back (currently allowed for two years), the taxpayer is offered some relief during a downturn by allowing NOLs to be carried back to generate a tax refund that may help soften the blow when profits are down. By allowing NOLs to be carried forward, as in the example of startups mentioned above, the government in effect becomes a ‘partner’ in providing risk capital to businesses: forbearance from taxation when the business is growing and not generating profits and, when the business begins to generate profits, a ‘forgiveness’ from immediate taxation to allow the company to build some reserves.
All good and many countries do the same thing. It makes sense.
Potential For Abuse
The report also notes that there is the potential for abuse. There are many forms this could take: duplication of losses by careful structuring or manufacturing losses ‘from thin air’ by use of clever schemes exploiting the rules. Not a lot to argue about here. The grey area, however, is where the government discusses the potential for shifting losses between companies where one company believes that its losses may expire before it uses them and therefore enters into a transaction with another company that is profitable.
The government does not like this and constrains it in some very obvious ways. It makes it difficult for profitable companies to buy companies that have no assets other than their NOLs. It is possible that many NOLs can expire before utilisation. This is not a good thing.
Lemonade Vs Wasted Lemons
If total taxable income in an economy is seen as a measure of the productive economic behaviour of corporate taxpayers, and the government is anticipating taking a share of this in the form of taxation, then creating tax policy that causes NOLs to expire unused is not productive.
If the $1.96trn of NOLs referenced above expired unused, the government would have taxed $1.96trn more income than had actually been productively produced in the economy. That is not good tax policy.
A Better Way
Administration of NOL carry-forwards is costly and time-consuming both for the government and the taxpayer. A more efficient approach would be to allow taxpayers to trade their NOLs on an exchange. The market would clear quickly.
Those with losses which they thought they would never use could receive an upfront cash benefit and decide whether they wanted to remain in business or return the money to their shareholders. Those with profits could determine what price made sense to pay for the tax shelter and move forward without uncertainty regarding whether or not the NOLs would be challenged.
What do you say, Mr Trump?