The 16th Amendment: How the U.S. Federal Income Tax Became D.C.'s Favorite Political Weapon - Part 2
Come Tax Day, many Americans receive money back after paying excess taxes all year, so they’re left feeling like they’ve been given the gift of free money. Sounds too good to be true, right? Skeptics have every reason to question the euphoria certain Americans display on April 15th. In reality, the government is actually forcing taxpayers to loan it money to finance lavish programs, with zero interest.
Ironically enough, withholding wasn’t an original feature of the income tax. It wasn’t until World War II that the practice of tax withholding was standardized through the Current Tax Payment Act of 1943. Withholding would later become a permanent feature of the current tax code, despite its original intentions of being a temporary wartime measure.
Sales Tax Deductions vs. Income Tax Deductions
Though the income tax is a convoluted maze that creates headaches for business owners and individual taxpayers alike, there are certain features in the current tax code that can be used to help taxpayers reduce their overall tax burden and make their tax filing experience more comfortable. Tax deductions are just one of these features.
Taxpayers have the choice of opting for a standard deduction or they can itemize their deductions. If an individual decides to itemize, one of the deductions they’re allowed to take is on various taxes at the state and local level. These deductions are called SALT deductions. Taking a sales tax deduction is a legitimate way to recoup an individual’s local and state sales tax obligations
For 2018, the standard tax deduction was $12,000 for individuals, $18,000 for heads of household, and $24,000 for married couples filing together. Itemizing is a reasonable route to go if an individual's itemized deductions are larger than the allowed standard deduction. Individuals can’t deduct all state and local taxes, however. They have to choose between deducting state sales taxes or state income taxes, but they can’t deduct both. That being said, taxpayers can deduct state and local property taxes irrespective of the options they choose.
It should be noted that this deduction strategy is not necessarily a one-way ticket to lower taxes. In the case that itemizing deductions gives an individual a lower income tax burden than a standard deduction, the sales tax deduction is worth looking into. It makes sense for individuals who have realized major purchases, thus paying a considerable amount in sales taxes, or for those living in states with no income tax, to include the sales tax in their list of itemized deductions.
Bear in mind that certain things have changed since the 2017 tax reforms. The Trump administration’s tax reforms have capped how much individuals can deduct from federal income taxes for state and local income, property, and sales taxes. Under the 2017 Tax Cuts and Jobs Act, taxpayers can only deduct a maximum of $10,000 in state income taxes and property taxes combined.
The IRS Sales Tax Deduction Calculator
For those who proceed to file a Form 1040 and itemize deductions on Schedule A, they have the option of choosing between claiming state and local income taxes or state and local sales taxes.
If an individual is planning to claim sales taxes paid in order to lower their federal income tax burden, they should first go to the IRS’ Sales Tax Deduction Calculator page. This way they can better estimate their itemized SALT tax savings versus taking the standard deduction.
The IRS’ Sales Tax Deduction Calculator is a handy tool for helping individuals figure out the amount of state and local sales tax one can claim. This is true even if the individual’s state and local sales tax rates changed during the year (e.g., because the rates changed or because you moved your personal residence). Be sure and have your Form 1040 draft in-hand when you are ready to calculate.
GILTI: The Global Intangible Low-Taxed Income Provision
Apart from lowering certain taxes, the 2017 Trump tax reforms came with a series of changes with global implications to the U.S. tax code. One that stands out in particular is the introduction of “The Global Intangible Low-Taxed Income” (which is subversively-nicknamed “GILTI”). GILTI is a new tax provision that specifically targets U.S. corporations that own Controlled Foreign Companies (CFCs) for U.S. tax purposes.
Prior to GILTI, U.S. corporations with a CFC could defer U.S. taxes on the earnings of their CFCs until the CFC distributed those earnings to the parent U.S. corporation. (This is how a U.S.-based multinational like Apple Inc. came to have close to a quarter trillion dollars of foreign cash on-hand, and subsequently had to explain American tax law to U.S. Senators who couldn’t understand what Apple was in fact legally doing.) Post-GILTI, U.S. corporations are taxed at a rate of 10.5% on the earnings of their CFCs regardless of whether the earnings are distributed or not.
To address this transition, the U.S. made two important changes. First, the law authorized the IRS to impose a Section 965 transition tax (also called “The Mandatory Repatriation Tax”) on the accumulated earnings of CFCs through the end of 2017. And second, the law authorized the IRS to impose on CFCs the aforementioned GILTI tax on all future (i.e., post-2017) foreign earnings.
In practice, here’s how the GILTI tax works: Assume you have a CFC owned by a U.S. C corporation (like Apple Inc.) with $1,000 in earnings for 2019. Also assume it has tangible assets with a tax basis of $2,000. You would subtract $200 (10% of $2,000 tangible assets) from the $1,000 in earnings, leaving you with $800 to which a 10.5% tax rate is applied – and you’d get a GILTI tax due of $84.
Amongst Constitutional scholars, the Section 965 transition tax has raised 5th Amendment due process concerns because it authorizes the IRS to impose a retroactive tax on foreign earnings nearly three decades after the fact. To comply with this change, companies have the option to pay in installments over eight years – but they still owe back taxes worth 15.5% on overseas profits computed under U.S. tax principles represented by cash and liquid assets, and 8% on profits represented by illiquid assets.
To address this transition, the U.S. made two important changes. First, the law authorized the IRS to impose a Section 965 transition tax (also called “The Mandatory Repatriation Tax”) on the accumulated earnings of CFCs through the end of 2017. And second, the law authorized the IRS to impose on CFCs the aforementioned GILTI tax on all future (i.e., post-2017) foreign earnings.
In practice, here’s how the GILTI tax works: Assume you have a CFC owned by a U.S. C corporation (like Apple Inc.) with $1,000 in earnings for 2019. Also assume it has tangible assets with a tax basis of $2,000. You would subtract $200 (10% of $2,000 tangible assets) from the $1,000 in earnings, leaving you with $800 to which a 10.5% tax rate is applied – and you’d get a GILTI tax due of $84.
Amongst Constitutional scholars, the Section 965 transition tax has raised 5th Amendment due process concerns because it authorizes the IRS to impose a retroactive tax on foreign earnings nearly three decades after the fact. To comply with this change, companies have the option to pay in installments over eight years – but they still owe back taxes worth 15.5% on overseas profits computed under U.S. tax principles represented by cash and liquid assets, and 8% on profits represented by illiquid assets.
It is this illiquid asset provision which is ensnaring some expected U.S. companies like Kansas City Southern and Tupperware (hardly Silicon Valley darlings like Apple Inc.), and causing them to pay taxes above the new statutory corporate rate of 21%. And in other cases, business owners must resort to becoming residents of the foreign country their multinational is operating in as a means of lowering their tax burden. This is on display when people consider establishing their residency in Puerto Rico, as will be discussed below.
Tax Reformers Still Have Work to Do
The 16th Amendment: How the U.S. Federal Income Tax Went From Temporary to Political WeaponDespite the marketing campaign that initially sold the income tax as a straightforward measure to finance government, it has morphed into a legal maze that keeps tax lawyers gainfully employed. After more than a century in existence, the income tax may no longer be worth the headache that millions of Americans must cope with every year on April 15th.
Although the last few decades have witnessed politicians reducing income taxes at reasonable rates, fiscal irresponsibility and a lopsided tax burden remain lingering problems.
As of 2018, the U.S. has been running a fiscal deficit of $778 billion, in a year when unemployment has reached historical lows. One can only imagine how deep those deficits will go under less favorable economic circumstances. A report from the Wall Street Journal also indicates that the U.S. income tax system remains very progressive, with the top 20 percent of taxpayers paying 87 percent of total income tax revenue.
Tax cuts are not bad in of themselves. The great Libertarian economist Milton Friedman was in “favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it’s possible.” The real problem at hand is the political class’s insistence on maintaining unsustainable levels of spending
In a tragic twist of fate, these deficits will negate all of the positive effects of the original tax cuts. As debt accumulates, future generations will be stuck with a hefty tax bill. Not only that, but big spending crowds out private-sector investment, thus creating a capital-starved future economy. History has shown, in such cases of fiscal irresponsibility, that governments will either raise taxes exorbitantly or turn to the printing presses to debase the currency.
Alternative Tax Models to Consider
For many Americans today, the idea of a world without income taxes seems almost absurd. Income tax has become a presence like furniture in the living room – a baseline they’ve been so used to that they no longer even notice it. But for many business owners, the income tax is a very real part of everyday life that must be dealt with, lest they want to suffer legal penalties.
In the frustrated business owner’s eyes, any type of reform to simplify the tax code would be a release from the current income tax quagmire. The good news is that business owners no longer have to figure out alternatives to the present tax code. There are numerous individuals who have stepped up to plate and put forward reasonable alternatives to the current system.
Several proposals to reform the income tax have come in the form of a national sales tax or a flat tax. Both of these taxes are preferable to the income tax status quo. A flat tax entails having a single tax that taxes every American at one rate. Additionally, the flat tax treats all taxpayers and income equally, in stark contrast to the current tax model.
On the other hand, the national sales tax would repeal the current income tax code and replace it with a tax on the final sale of all goods and services to consumers. Although the most notable difference between the national sales and flat tax is the collection point, they are actually quite similar when it comes to how income is treated.
Economist Dan Mitchell breaks down some of the similarities between the flat tax and a national sales tax:
“No bias against savings and investment. Implementing either the flat tax or a national sales tax would eliminate the current tax code’s bias against capital formation by ensuring that no income is taxed more than one time. Because double taxation of capital income is a pervasive problem in the current law, going to the flat tax or a national sales tax would stimulate higher incomes and faster growth by minimizing the tax penalties on savings and investment.”
“Equality. Adoption of the flat tax or a national sales tax also would end the discriminatory treatment caused by a tax code that grants preferences or imposes penalties on certain behaviors and activities. Either reform would change the code so that all taxpayers – and all income – are treated the same under the law.”
In the same token, income taxes do have a social engineering function that encourages certain types of behavior and favors certain interest groups over others. For example, on the class warrior side of the aisle, the earned-income tax credit effectively subsidizes low-income tax filers. Other uses of the tax code to socially engineer desired results include sweetheart tax breaks for the solar industry or making childcare costs deductible.
All in all, a switch to either a national sales tax or a flat tax would lead to a simpler tax system that no longer incentivizes interest group politicking or places a disproportionate tax burden on a certain class of taxpayers. Instead, they would encourage productive activities like entrepreneurship, saving, and investment.
Puerto Rico: Tax Incentives For Americans
Due to GILTI and other questionable features of the U.S. tax code, Americans have looked for ways to move abroad so as to lighten their tax burden. The U.S. is unique in its approach to taxing worldwide income, which makes it very difficult for Americans to substantially reduce the amount of taxes they are paying to the U.S. government, even if they live abroad.
With the recent Trump tax reforms, it has become more difficult for U.S. citizens to lower their global tax burden, however, there are still ways around this. One of these strategies has been to move to U.S. territories, which are not subject to the U.S. income tax.
One of the more popular destinations for Americans looking for favorable tax advantages is Puerto Rico. Provided that they they do their homework, Americans could potentially enjoy federal income tax exemptions and see their taxes drop by 90%.
Two programs that the Puerto Rican government offers are Act 20 and Act 22, which are the island’s two major tax incentives.
Here is a brief summary of what these programs entail:
Act 20: The Export Services Act
Act 20 targets certain types of qualifying businesses, like consulting or financial services, by offering incentives such as 4% corporate income tax rates. This is available to corporations who relocate to Puerto Rico and meet the following requirements:
- Become a bona fide resident. In other words, an individual must relocate their center of life to the island and spend at least half the year (183 days) in Puerto Rico.
- Set up a Puerto Rican company.
- Establish an office in the country.
Act 22: Individual Investor Act
Act 22, the Individual Investors Act, gives investors the ability to pay 0% tax on interest, dividends, and capital gains while living in Puerto Rico as a certified resident. Like Act 20, the taxpayer must be a bona fide resident who has relocated their life to Puerto Rico and must spend at least half the year (183 days) on the island.
This program is especially attractive to traders and crypto-investors, or any individual with a large amount of passive income or capital gains from any source.
A Cause for Hope
The tedious process of filing tax returns is a common pain point for millions of Americans on April 15th. After more than a century’s existence, the income tax has become a political baseline, which many Americans take as a given.
Make no mistake about it, the income tax is no mundane feature of the American political economy. In fact, it’s one of the largest enablers of government growth. To genuinely reduce the size of the American state in economic affairs, the abolition of the income tax – or at the very least, a gradual phase-out – would be solid steps in bringing fiscal sanity.
Thanks to a few high-profile political campaigns over the last decade, the desire to get rid of the income tax is no fringe idea, and is starting to gain momentum in Conservative and Libertarian circles.
Since 2008, each presidential cycle has featured candidates on the Republican side of the aisle with campaigns to abolish the IRS. Ron Paul did so in 2008 and 2012, whereas candidates like Paul’s son Rand Paul and Senator Ted Cruz followed in the retired Congressman’s footsteps during the 2016 Republican primaries.
Should the Overton window of public opinion shift toward limited government, the days of Americans having to deal with the IRS may soon come to an end.
After all, tax rebellions are in the American people’s DNA. And with the U.S.’s fiscal situation deteriorating annually, bold measures will need to be taken.
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Part 2 of this article by Ammo.com was submitted by Alex Horsman to the ARRA News Service.
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