Last month, ProPublica, aided by a trove of tax information on the richest Americans delivered by an anonymous whistleblower, began a series of reports on the staggeringly low to nonexistent tax bills paid by specific billionaires and the tactics they use to achieve that end.
In its most recent release, ProPublica detailed PayPal co-founder Peter Thiel’s use of a Roth IRA, a specialized retirement account in which contributors pay taxes up front but not on distributions, to shelter billions in investment income gains. This involved questionable valuations and other strategies that are either explicitly or implicitly illegal.
ProPublica’s blockbuster reports have prompted a number of congressional inquiries into how to fix the tax system to ensure the wealthy pay the taxes they owe. After the Thiel story, for instance, Sen. Ron Wyden announced he’d renew his efforts to create a legislative fix for the abuse of Roth IRAs as tax shelters.
But the emphasis on legislative solutions implicitly assumes that the wealthy are merely doing what the tax code allows them to do, that the fault for this specific problem lies entirely with a broken tax system, rather than with rich tax cheats stretching the law beyond its bounds. That simply isn’t true. Instead, the wealthy have gotten away with zero-dollar tax bills not because that is their true tax liability but largely because of poor enforcement of a little-known component of our tax code called the “economic substance doctrine.”
The economic substance doctrine disallows tax benefits to any “trade or business” (two terms not defined in this section of the tax code) based on any transaction (again, not explicitly defined) that lacks a concrete purpose beyond reduction of tax liability. The doctrine is intended to allow the IRS to charge the wealthy with their proper tax liability, regardless of whatever sophisticated tax planning and arbitrage they undertake. While the economic substance doctrine generally doesn’t apply to individuals, it does apply to any transactions undertaken by individuals who are “in connection with a trade or business or an activity engaged in for the production of income.”
Under the doctrine, an activity is said to have economic substance when:
a) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and
b) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction. (26 U.S.C. § 7701(o)1)
The term “economic position” also isn’t defined in the tax code. This means that the IRS has an enormous amount of leeway in whether and how it applies the doctrine. Arguably, if fully enforced, the doctrine would completely eliminate the distinction between explicitly illegal tax evasion—things like misreporting one’s income as a much lower sum—and dubiously legal tax avoidance strategies, which generally have little economic purpose beyond reducing tax liability.
Thiel’s use of a Roth IRA is very clearly tax avoidance but not necessarily tax evasion (although Thiel’s purchase of undervalued shares is suspicious). ProPublica’s initial story, which examined how billionaires like George Soros, Warren Buffett, Elon Musk, and Jeff Bezos end up paying little to the federal government, characterized their behavior as legal tax avoidance.
We don’t have enough information to determine whether that’s truly all their behavior consists of, but the economic substance doctrine largely makes even this assessment unnecessary. This would spell trouble particularly for Thiel, whose purposeful utilization of a Roth IRA to purchase shares well below their value and shield the massive investment income gains from taxes appears to have no substantive purpose outside of lowering his tax liability. In contrast, Bezos, Soros, and Buffett’s tiny tax bills are attributable to massive investment income losses, which could be legitimate (although they could also be illegitimate products of strategies like tax-loss harvesting).
By collapsing distinctions made between tax avoidance and tax evasion, the economic substance doctrine is supposed to preemptively cut off sophisticated strategies to deprive the government of revenue. Under the accepted definitions, because tax avoidance operates by exploiting legal loopholes, its solution requires legislative fixes to close those loopholes, while tax evasion requires additional enforcement of existing laws.
But legislation moves slowly, and trying to close loopholes will always be a game of catch-up. Moreover, by forefronting the need for legislative fixes, we concede that the use of loopholes is legal, depriving the IRS of its full authority to make the rich pay. Congress and the IRS will always be at a disadvantage in preventing tax avoidance; it is simply impossible to predict all potential strategies to twist the laws to negate tax liability, and wealthy taxpayers have every incentive to utilize the most complex strategies to do so. Loopholes exist in tax laws primarily because they are unforeseen, not because they were intentionally placed there. The economic substance doctrine is a tool against even those unforeseen strategies.
It’s no wonder that the IRS has for the most part stopped enforcing the doctrine. As I and many others have written previously, the IRS has lost significant amounts of funding since 2010, particularly for its enforcement budget, leaving it massively outgunned in efforts to get the wealthy to pay their fair share.
The consequences from an insufficient IRS budget are only getting more dire; IRS Commissioner Charles Rettig estimated that the tax gap, the amount of revenue lost to tax evasion, is now about $1 trillion each year, a significant increase from Treasury’s $630 billion estimate in 2019. And, because the tax gap only accounts for tax evasion and not tax avoidance, the true amount of lost revenue is likely far higher.
Legislative fixes to the tax code are absolutely necessary. Until the federal money printer is permanently set to 11, to fully fund (or offset demand from) major popular programs like Social Security and Medicare and to create new ones like the expanded Child Tax Credit, the federal government will need to collect more revenue in a fair and equitable way. And tax policy on its own terms can be a powerful spur to reduce the soaring inequality we’ve seen over the past several decades.
That makes it essential to increase tax rates on the wealthy and big corporations and fill crucial tax positions like assistant secretary for tax policy at Treasury and assistant attorney general of the Department of Justice’s Tax Division. But it also means using all available tools to crack down on tax avoidance and rejecting wholesale the vehement protests from the wealthy that they are simply following the law.
As bipartisan infrastructure talks whittle away at some of President Biden’s more ambitious tax plans, the future grows dimmer for a truly equitable tax system in the near future. But even if Biden does succeed in raising corporate income tax rates and the top marginal income tax rates, the wealthy will still be able to use complex financial strategies to dodge taxes unless the IRS is prepared to stop them. Independent of Congress, the Biden administration must make use of its existing powers to prevent tax avoidance and ensure that the existing tax code is properly and equitably administered.