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How One Learned to Stop Worrying and Love the US Legislative Process

 4 min read / 

There are at least seventeen Christmas tree organisations in the United States. Their lobbying efforts have been producing fruit for their members for over forty years and are instructive for anyone who wants to understand what is going on in Washington D.C. right now.

It is hard to imagine the amount of legislative language devoted to Christmas Trees or, as the Internal Revenue Code knows them, “evergreen trees which are more than six years old at the time severed from their roots and are sold for ornamental purposes.”

Since 1954, under IRC Section 631 (and before that, under a predecessor section 117 of the 1939 Code), taxpayers have been able to elect to treat the sale of Christmas trees as subject to the more favourable capital gains tax rates.

Until 1971, their supporters had been fighting court battles concerning the ability to deduct pruning and shearing expenses currently rather than being forced to capitalise these expenses until sale (six years later). In 1971, the IRS, having lost two court cases, decided to issue a revenue ruling permitting the deduction of these costs.

In 1986, in the Tax Reform Act of that year, Congress enacted Section 263A. This section sought to introduce a uniform methodology to the inclusion in inventory or capital account all costs incurred in the manufacturing, construction of production of real and personal property. The general rule was to capitalise so that the costs incurred would increase the capital basis in an asset and the benefit would accrue to the taxpayer in the form of reduced taxable income on sale.

The ’86 Act granted some exceptions to this and allowed expensing for certain trees cultivated in the business of farming, provided those trees did not bear fruit, nuts or other crops and were not ornamental (ineffective lobbying here). On its face, this was bad news for the for those Christmas tree growers benefitting under Section 631 and whose trees were “…sold for ornamental purposes”.

Fortunately, the trees that are considered ornamental for Section 631 purposes, due, no doubt, to the lobbying prowess of the Christmas Tree Associations, are specifically – under Section 263A(e)(4)(B)(ii) – carved out:

“For purposes of clause (ii), an evergreen tree which is more than six years old at the time severed from the roots shall not be treated as an ornamental tree.”

Well played.

Tax Reform 2017

The purpose of the Christmas tree story is simply to illustrate what is happening in the run-up to Christmas 2017.

Deals are being cut in Congress in both the House and Senate on the various provisions being discussed as part of tax reform. As recently discussed, the budget within which any legislation to be passed through the process of Reconciliation must fit is $1.5trn over the next ten years.

The Joint Committee on Taxation has scored the costs of the Senate bill as follows:

  • Reduction in individual tax rates: $1.17trn
  • Repeal of AMT: $769bn
  • Increase in standard deduction: $737bn
  • Modification of child credit: $584bn
  • Change in treatment of pass-through income: $362bn
  • Reduction in the corporate tax rate to 20% from 35% starting 1/1/2019: $1.33trn

In terms of revenue raisers, the big ‘pay fors’ are:

  • Repeal of itemised deductions: $978bn
  • Repeal of the individual mandate for healthcare: $318bn
  • Limit interest deductions: $308bn

Since the budget will not balance if the individual tax benefits continue beyond ten years, the ‘deal’ that has been cut in D.C. is to sunset those provisions on the assumption that Congress in 2027 will extend them.

The corporate tax breaks, however, are permanent because those are assumed to be essential for economic growth.

Who Is Lobbying for the Middle Classes?

Apparently, since the Democrats are not involved in the discussion and shaping of this legislation, the Republicans must be relied on to represent all taxpayers in this process. Corporations and, by extension, those for whom a substantial portion of their wealth flows from corporations in the form of dividends and capital gains, will do fine for the next ten years and beyond.

Christmas Tree growers do not seem likely to lose their benefits. The rest of the individual taxpayer universe, also known as the middle class, not so much.

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Featured Columnist

How Harm Reduction Policies for Substance Abuse Save Money and Lives

 6 min read / 

Harm Reduction

There is an aphorism often used in politics: Don’t let the perfect be the enemy of the good. Its roots go back at least as far as a 17th-century Italian phrase, later popularised by Voltaire, which translates as “the better is the enemy of the good.” In the United States, it is currently being invoked in defence of the Republican Senate’s proposed income tax reform, bipartisan efforts at health care reform, and even debates on whether to allow self-driving cars on the roads.

It also should be applied to alcohol and drug abuse treatment programs. The “perfect” would be that no one ever uses or becomes addicted to illegal and/or harmful substances, or that everybody who is so addicted wants and can find effective substance abuse treatment. The good would be that we minimise the harm to individuals and society of such addictions.

The argument against minimising harm is that harm discourages people from illicit drug use. One American politician argued that stigmatising illicit drug users would help “push” them into treatment. Others argue that such stigmatisation can cause them to delay acknowledgement or treatment of the substance use disorder.

Such stigmatisation can include incarceration, although an International Journal of Drug Policy paper, The Cost-Effectiveness of Harm Reduction, concluded that “compulsory detention” does not reduce drug dependency. A combination of harm reduction interventions can.

Harm Reduction

Harm reduction policies are based on evidence, not faith, prejudices or hope. Harm reduction recognises that people, having free will, engage in dangerous, harmful and illegal activities – usually though not exclusively related to drugs, alcohol and similar substances – despite the best intentions of family, friends, the government and society to discourage them. This harm also may envelop other people and property, so it is in the interest of society to seek to reduce the potential for harm.

Harm reduction can save money as well as lives, but some people worry, fear or declare that if society makes such behaviour less harmful, it is tantamount to encouraging it. The more harmful it is, the less likely people are to engage in it. The evidence does not support this viewpoint, but rather shows that drug use does not increase with harm reduction programmes, nor are treatment programmes undermined.

Twelve Steps vs. Evidence-Based Recovery

In many ways, harm reduction is the opposite of the 12-step programs epitomised by Alcoholics Anonymous, which involve a rigid set of acts or acknowledgements, including putting your fate in the hands of a higher power, i.e. God. AA stresses abstinence and fellowship, not science.

Although there are chapters of AA that do not emphasise faith, and it is possible to attend meetings and work the steps without faith, there also are non-faith-based alternative groups, such as SMART Recovery (Self-Management and Recovery Training). Founded in 1994, in a way, it is a bridge between Twelve Steps and traditional detox recovery.

SMART is all about harm reduction, according to an article on The Humanist, and one of the first programs to embrace the concept. It stresses free will and balance, not extremism or absolutism. It does not even necessarily call for abstinence, only moderation. SMART is an international organisation, with in-person meetings on every continent but Antarctica – as well as online meetings – and partnerships with many UK alcohol and drug treatment providers, including some prisons.

Safe Injection Site

One controversial form of harm reduction that is being tested around the world is the safe injection site. A report by the Johns Hopkins Bloomberg School of Public Health and the Clinton Foundation has recommended the establishment of such “safe consumption sites” – also known as fix rooms, drug consumption room (DCR), supervised injecting facilities and shooting galleries – to combat the public health emergency caused by the opioid epidemic. Even the American Medical Association supports the idea.

One of the most dangerous aspects of illegal drug use is that they are dangerous to use. Heroin may be adulterated with poison or cheaper, more powerful opioids and easier-to-obtain drugs such as fentanyl or carfentanil. Needles may be reused and contaminated. And if you do overdose, you may not have a friend who knows what to do or is willing to get you to a doctor and risk arrest.

A safe injection site is just that: a safe place to use. Their drugs can be tested for potency or contaminants – at one site, 80% of the street drugs contained Fentanyl – clean needles are provided and, in the event of an overdose, trained medical personnel are on hand. According to this article, 66 cities have supervised injection sites, some more than one, including Europe, Canada and Australia. Amongst all the safe injection sites that have been established around the world, no deaths have been reported, but no sites in the United States or the United Kingdom have opened so far, in part because of opposition from law enforcement and neighbourhood groups.

It also is less expensive than the cost of overdose deaths, HIV and Hepatitis C transmission and the associated medical care expenses. One recent study estimated that placing a supervised injection site in a US city would net cost savings of $3.5m (US) per year. Another study found that the city of Baltimore alone could save almost $6m with a safe injection site.

Needle Exchange

One form of harm reduction is needle exchange programmes where intravenous drug users are given clean needles so that they do not share them with other users, potentially spreading HIV or Hepatitis C. The Global Commission on Drug Policies found that such programmes in Australia have not encouraged users to start at an earlier age, use more frequently or continue using for a longer period than they would have otherwise, but have prevented transmission and resultant deaths.

They also have saved money. Each Australian dollar spent on the program is estimated to have saved four Australian dollars in healthcare costs and 27 Australian dollars in overall costs to the community, saving billions in just a few years. Maybe those potential monetary savings can overcome the restraints of politics and human nature that continue to fight harm reduction initiatives.

Keep reading |  6 min read

Cryptocurrencies

Why Buying Bitcoin Still Makes Sense in 2017: The Five Waves of Crypto

 6 min read / 

Buying Bitcoin

Even as bitcoin’s price surged within striking distance of $6,000 on October 15th experts are still considering it an ultra-high return investment. Many — notwithstanding Warren Buffet, Jamie Dimon, Paul Krugman and Alan Greenspan — believe it to be one of the most undervalued asset classes around. When asked how one values bitcoin in an interview with CNBC, author and CEO of Bank To The Future Simon Dixon replied that some people look at it taking a small percentage of each asset class: “Even if it takes just 5% of investments made in gold as a hedge against financial uncertainty then that would create a $25,000 bitcoin.” Billionaire private investor Mike Novogratz has also stated he would not be surprised to see the price of bitcoin hitting over $10,000 next year. Trace Mayer, an early evangelist of the cryptocurrency and host of the ‘Bitcoin Knowledge Podcast’ tweeted that bitcoin may well jump to $27,000 in just a few months time.

Is It a Bubble?

The question is irrelevant. Virtually every novel technology wave has its respective bubble as new capital looking to “make a killing” flows in. This is not necessarily a bad thing, as there are positive effects as well. The extra cash can spur innovation, accelerating the pace at which things move forward. Moreover, increased attention leads to more qualitative exposure which, in the case of exciting innovation such as decentralised payment networks, can only be a good thing as it leads to more enthusiastic followers.

In an interview with Business Insider, co-founder of Fundstrat Global Advisors Thomas Lee mentions how bitcoin has closely followed the behaviour of a social network. The more engagement there is, the more the value rises. Using Metcalfe’s law, which states that the value of a (telecommunications) network is proportional to the number of the of connected users in the system squared (n2), Lee built a short-term valuation model, valuing bitcoin as the square function of the number of users multiplied by the average price. This very simple equation explains 94% of bitcoin’s movements over the past four years.

Lately, the price has largely been driven by institutional investors stepping into the game and by growing interest from Asia, notably China, South Korea and Japan. Although China and South Korea have clamped down on the currency, investor interest is continuing to rise with some reports arguing that traders in both countries were purchasing bitcoins with premiums of up to $300 during the latest rally. So why would people do such a thing?

The Waves

Since bitcoin first came to the scene, there have been five notable waves. The first was the advent of the cryptocurrency itself. Bitcoin started getting traction because of its sound and decentralised monetary policy. It provided a store of value independent of any government or central bank, a great value proposition at the time considering the conjuncture of severe financial crisis.

Then there was the growing universe of altcoins where people tried to copy bitcoin by creating alternative versions, some of which stuck and delivered incredibly high returns. What followed suit was the emergence of billion-dollar unicorns such as Coinbase and Kraken (Coinbase currently has a post-money valuation of $1.6bn).

More recently, one witnessed the trend of ICO campaigns, with even celebrities like Floyd Mayweather, Paris Hilton and DJ Khaled trying to catch a piece of the pie by promoting specific coins. Hundreds of companies have now started creating and distributing virtual tokens in order to raise money for their venture, many of which have partnered up with celebrities to get the word out. Because so many people have made money in the sector, many are pumping their wealth into these projects in order to speculate (especially early bitcoin adopters who also do so to avoid taxes).

The latest and most remarkable wave is that of forks or splits which emerge out of disagreements on common rules regarding governance. Now that Bitcoin has reached its scale, developers are disagreeing about how the technology should move forward. When a blockchain diverges into two potential paths forward — e.g. with regard to a network’s transaction history or a new rule determining what makes a transaction valid — it splits into different communities which show support for one choice over the other.

Naturally, the value of both versions of a coin after a hard fork is determined based on user sentiment and demand/supply in the market. It is interesting because, essentially, these forks act as a sort of dividend for everyone holding bitcoin. The upcoming bitcoin hard fork on the 25th of October is known as Bitcoin Gold. This new would-be cryptocurrency’s community is defining it as “a community-activated hard fork to make mining decentralised again“. By changing bitcoin’s original protocol, Bitcoin Gold advocates aim to make a new democratised version which will be mineable by using cheap GPUs as opposed to the expensive ASIC miners, which have been acting as a strong barrier to entry for an average user. Their intention seems noble. Whatever the outcome the fact of the matter is that just as with Bitcoin Cash, free Bitcoin Gold coins will be airdropped to anyone owning bitcoin at the time of the fork.

Sky’s the Limit?

To conclude, one should consider that going from the current price of around $5,647 (October 19th 9:17 PM) to a $1m bitcoin would represent a relatively mild gain when compared to the gains bitcoin has made in the past seven years. In fact, $100 worth of bitcoin bought at the purchase price of approximately $0.003 seven years ago, would be equal to roughly $188m today, a gain of about 1,800,000%. Meanwhile, a jump from $5,647 to $1m would represent a gain of “only” 17,609%. Unfortunately, there are no time machines yet, but it is still affordable to invest in some bitcoin.

Keep reading |  6 min read

Companies

US Tax Reform: The Difference Between Corporations and Partnerships

 7 min read / 

US Tax Reform

Tax reform in the US is still being formed in the abattoir of Washington DC. Since the reform proposal has a lot to say about the relative roles and tax rates applied to corporations and partnerships, it is time to take a quick look at the history of these.

Corporations

The early years of corporate law in the United States suggest some mistrust of the role of corporations. Companies such as the Massachusetts Bay Company, the Hudson’s Bay Company and the East India Company had reputations for being corrupt, exploiting their workers and exerting excessive influence on government and politicians.

In the century after American independence was won, there was a keen focus on limiting the power of corporations. Corporate charters were granted by states for limited purposes and for a limited duration. The political goal of limited corporate power was undermined by the inexorable rise of business to accomplish societal needs such as railroads, the mining of natural resources and organized trade on an increasing scale. Those who provided the capital to finance these endeavours wanted limited liability and permanent capital vehicles to carry on trade for the long term in a predictable legal framework not subject to revocation at the whim of state politicians.

Corporations were the vehicle of choice. They offered limited liability, the ability to raise equity financing that could be traded and legal personality (the latter enshrined by the 1886 court case of Santa Clara County vs. Southern Pacific Railroad).

The rise of trade and commerce and, especially during the Civil War years, the dramatic rise of government spending in many areas of the economy, led to a familiar arc for corporations: accumulation of wealth and power for their managers and their shareholders; the tendency to become self-serving and the urge to use corporate resources to shape a favorable political landscape.

As corporations began to proliferate, individuals looked to corporations as a way to operate their businesses with limited personal liability. Unfortunately, the price of the corporate form was two layers of taxation. Corporations must first pay tax on their taxable income before distributing that income, net of tax, to their shareholders who must then pay tax on the dividends they receive – the so-called classical system of taxation.

Partnerships

Until 1958, the alternative form of business ownership – other than simply a sole proprietorship where individuals conducted business in their own names – was partnership.

The original partnership form involved two or more individuals acting together through a vehicle for which they had joint and several liability. It was a natural form of business and one consistent with aligning the responsibility of the individuals involved with the consequences of their business decisions by making them responsible for the liabilities they created.

In contrast to corporations, partnerships do not pay tax; rather they pass the tax liability through to their partners in proportion to the shares of profits and losses that the partners agree upon. When partners contribute capital to the partnership, they are given a capital account that keeps score of what the partners are owed by the partnership and how the profits and losses are divided at various points during the life of the partnership.

The partnership form evolved as a popular means of raising and deploying capital – the so-called capital-labour partnership on which the private equity business has been built. Typically, a general partner with unlimited liability raises capital from limited partners whose liability is limited to the amount of capital they contribute. The general partner runs the business and takes a management fee and a share of the profits.

General partners took steps to ensure their liability was limited by making sure that the general partner was a corporation. Eventually, corporate law developed the concept of a limited liability partnership where none of the partners, including those responsible for operating the business of the partnership, had unlimited liability.

Many states developed the concept of a limited liability company that had the characteristics of a partnership for tax purposes but still had limited liability. In 1997, the IRS passed regulations that permitted taxpayers, with certain limited exceptions (the PLC in the UK and the Inc in the US), to choose passthrough or entity level taxation by simply filing a form and making an election – widely referred to as the ‘check-the-box’ regulations.

The tax liability of partners is reported to them on Form K-1. This form appears as part of the partners’ individual tax Form 1040. It functions to report income earned at the partnership level as income of the individual taxpayer. K-1s are not always distributed to taxpayers in time for them to file their taxes by the April deadline and cause many partners to file for an automatic six-month extension.

Partners are liable for the tax on partnership income even if they receive no cash distributions from the partnership. This is one example of what is referred to as “phantom income”: tax must be paid but the taxpayer has received no cash with which to pay it and must meet the tax obligation from elsewhere.

Another problem for foreign partners in a US-based partnership is the possibility they may have to file a US tax return or suffer withholding of US tax by the partnership on distributions. This issue was discussed in an earlier article.

S Corporations

Before the development of LLCs and limited liability partnerships, individuals sought the benefit of corporate limited liability without suffering two levels of taxation. This led to the birth of the S corporation. S corporations have been described as a hybrid entity having some of the characteristics of corporations and some of the functionality of partnerships.

S corporations were breathed into life in 1958, twelve years after the Treasury Department proposed them as a solution to a couple of significant problems. The impetus to act was driven by political considerations: President Eisenhower was under pressure to curb the growing power of corporations and there was widespread scepticism about trickle-down economics. In 1958 there were only two ways in which entrepreneurs could set up a business: they could set up a corporation and suffer two layers of taxation, or they could set up as a sole proprietor or as a partnership, pay only one level of taxation but sacrifice the umbrella of corporate liability protection.

In 1958, the highest corporate tax rate was 52% and the highest individual tax rate was 91%, a combined rate of 96% for an individual doing business through a corporation. By doing business through an S corporation, individuals could enjoy limited liability and save 5% on their taxes. It was an attractive proposition.

S corporations were limited in some important ways. They are limited to 100 shareholders; the shareholders must, with limited exceptions, be individuals; those individuals must be US citizens or residents and there can only be one class of stock. Income, as it is for partnerships, is reported on Form K-1.

Absent some careful structuring for partnership distributions, S corporations can offer their shareholders an advantage on the self-employment taxes – FICA. Whereas partnership distributions are fully subject to FICA (maximum rate of 15.3%), FICA is only owed on wage distributions from an S corporation. Provided shareholders receive a “reasonable wage,” distributions beyond the wages are not subject to FICA. The IRS is aware of the potential for abuse and polices the concept of a reasonable wage.

S corporations have proven popular and, while arguably superseded by the development of the LLC together with the flexibility of the check-the-box regulations, there are approximately 4.6 million in existence – twice the number of C corporations.

Tax Reform

The business forms described above all have their unique tax custom and practice. They are taxed under separate subchapters (C, K and S) of the Internal Revenue Code. Each area has its specialist advisors. The proposal to impose tax at a separate rate on small businesses – sole proprietorships, partnerships and S corporations – is ill-considered. It is not clear under which subchapter such income would be taxable and, therefore, how it would be administered. This, however, is not the greatest of the problems the administration’s proposal presents. The rest of the year will be interesting.

Keep reading |  7 min read

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