COMPLEXITY IN THE TAX LAWS AND TAX REFORM

> Prepared Statement of Peter L. Faber to the\
> Senate Finance Committee, March 19, 1976

My name is Peter L. Faber and I am a partner in the law firm of Harter,
Secrest & Emery in Rochester, New York. I am the Chairman of the Tax
Section of the New York State Bar Association and appear before you
today on behalf of the Section. The Section has over 1900 members, all
of whom are lawyers with a special interest in taxation. Our members
include practicing lawyers, teachers, corporate counsel, and employees
of government agencies including the Internal Revenue Service.

The fact that so many people make their living explaining the tax laws
to private citizens and businesses is itself a sad commentary on the
complexity with which our tax system is afflicted. It is that
complexity, and the extent to which it may be aggravated by proposed tax
legislation, that I would like to discuss today.[^1]

It is appropriate to deal with the subject of complexity at this time of
year, when millions of taxpayers throughout the country are struggling
with the 15,000 words of Internal Revenue Service instructions to form
1040. Despite valiant efforts by the Service to simplify both the forms
and the instructions, it is clear that they are just too much for the
great majority of taxpayers.

Almost four years ago, the Section's Committee on Tax Policy prepared A
Report On Complexity And the Income Tax which called attention to the
problem, analyzed its causes, and recommended solutions.[^2] The
Committee did not attempt to blame the situation on any one source,
finding that Congress, the courts, administrative agencies, and, in
fact, the tax bar, all had a measure of responsibility. Unfortunately,
although the report was widely praised, it was just as widely ignored.
The last few years have seen the enactment of several pieces of tax
legislation that have substantially aggravated the problem.

What are the effects of complexity?

One result that is hard to quantify is the lack of confidence in the
fairness of the tax system that it fosters among individuals. People are
suspicious of that which they do not understand. In a tax system which
depends as heavily as ours on the honesty of taxpayers who compute their
own tax liability, the creation of such suspicion can have unfortunate
results.

The complexity of tax laws applicable to business makes it impossible
for the small businessman lacking access to sophisticated tax advisors
to predict the tax consequences of a transaction with any degree of
assurance. Most small businessmen are represented by lawyers and
accountants in general practice who do not have the time or familiarity
with the tax system to master all its nooks and crannies. Moreover, even
the small businessmen who do have sophisticated advisors often cannot
afford to pay them for the time necessary to do an adequate research
job.

The complexity of the tax laws makes it harder for the Internal Revenue
Service to perform its functions. Laws that are unduly complicated
cannot be applied by revenue agents on audit and cannot be explained to
taxpayers by the Service's taxpayer assistance staff. A recent survey
showed that advice given to taxpayers by the taxpayer assistance
personnel of the Service was wrong 25% of the time. When one considers
that questions addressed to the taxpayer assistance staff are likely to
be basic ones, the result of the survey becomes truly frightening.

By diluting the effectiveness of the Internal Revenue Service's audit
procedures, complexity in the tax law encourages taxpayers to take
positions with little or no basis, hoping that they will not be audited
or that, if they are, the revenue agents will not pick up the point.

Complicated tax laws that are hard to understand and comply with can
have consequences going far beyond the immediate impact on tax
determination and collection. For over thirty years, the federal income
tax laws have provided direct incentives to employers to establish
retirement plans for their employees, thus encouraging private business
to assume a social role that otherwise would be performed by the
government. The Employee Retirement Income Security Act of 1974 (ERISA),
although enacted by Congress with the best of intentions in order to
strengthen the private pension system, has proved to be so hard to
understand and administer that many people feel it has had just the
opposite result. It has been stated that the number of plan terminations
since ERISA's enactment his been substantially greater than expected. I
can testify from personal experience that many of those terminations
have been a direct result of the law's complexity, not of added costs
posed by expanded coverage, vesting, and funding requirements.

Is this much complexity really necessary?

It has been argued that the complexity of our tax laws results from the
complexity of our society and is necessary if equity is to be done. A
simplified tax structure would inevitably have the effect of applying
the same rules to taxpayers in different positions who, arguably, should
receive different tax treatment. The question that must be asked in each
instance is whether the added equity resulting from different tax rules
is really important and, if it is, whether it is worth the additional
layers of complexity that result. In many cases, the balancing of
interests will lead to a conclusion that the added equity is in fact
worth the additional complexity. All I ask of you today is that this
balancing of interests occur. All too often, it does not, and the
complexity side of the equation is totally ignored.

It has been suggested that simplicity in tax statutes simply leads to
complexity in administrative regulations and court decisions. Section
482 of the Internal Revenue Code, giving the Commissioner of Internal
Revenue the power to allocate tax attributes among controlled taxpayers
in order to reflect fairly the income earned by each, is an example of a
statutory provision of less than 100 words that has been expanded into
several thousand words of regulations. While this may be true in some
cases, the problem is that a complicated statute does not provide any
guidance as to its basic meaning. A lawyer in general practice reading
§482 will understand the basic principles involved and will realize that
the Commissioner has the power to readjust income where related parties
do not deal with each other at arms length. Can a lawyer in general
practice whose client asks for advice about depreciation recapture get
the same general message from the statute? I doubt it.

It is not a defense that complexity in the tax law applies primarily to
wealthy taxpayers who can afford to pay sophisticated advisors to
interpret the laws for them. In fact, some of the most complicated
provisions (e.g. IRC §341, dealing with collapsible corporations) apply
primarily to small businesses and individuals. Even the rich cannot
always cope with complexity. All too often, a wealthy taxpayer's
highly-paid advisors come to him and report that their hours of diligent
research have failed to produce a clear answer to his problem. If, as is
often the case, pressures of time (and the Freedom of Information Act)
make seeking a private ruling impractical, the wealthy taxpayer may be
in exactly the same position with respect to a proposed transaction as
his less affluent brother, except that he has paid his lawyers several
thousand dollars to find this out. The rich may not enter the Kingdom of
Heaven, but surely they are entitled to some certainty in their lives.

With this as background, let me discuss some provisions of the Tax
Reform Bill and their effect on the complexity of the tax laws.

Let me begin on a positive note by applauding the expansion of the use
of tax tables embodied in Tax Reform Bill §501(a). This will help many
individual taxpayers to accurately compute their tax liability.

One unfortunate tendency in the Bill is the excessive length of many of
its provisions. It may well be laudatory to expand the retirement income
credit and provide a child care credit, but couldn't these be done in
less than 1,000 words? Most of us, I am sure, endorse the idea embodied
in Tax Reform Bill §1502 of allowing an individual covered by a
qualified retirement plan to deduct contributions to an individual
retirement account, but must the provisions which enable him to do this
really be as long as the Constitution of the United States?

In addition to the sheer volume of statutory language, the Bill reflects
a recent tendency of Congress to clutter up the Code and tax forms with
additional deductions and credits that serve no purpose other than to
confuse people. A case in point is the credit for home garden tools that
would be added by Tax Reform Bill §1801. Does anyone seriously believe
that the addition to the Code of such a credit (the maximum tax savings
in any one year would be \$7) will result in the creation of one single
home garden that otherwise would not exist? I think it can be said with
confidence that the only results of this provision will be to cost the
federal government some money (some of which will undoubtedly go to
owners of flower gardens who don't read the instructions carefully) and
confuse a few more hapless taxpayers.

One perversity that recurs in the draftsmen of Internal Revenue Code
provisions is their fondness for cross-references. The limitation on
artificial loss provisions (Bill §§101, 102) read like a parody of this
tendency. It may be instructive to trace the steps that would be
necessary to research a problem arising under this part of the Bill.

Let us assume that we are in the office of a lawyer in general practice
who receives a telephone call from a client asking what the new rules
are respecting the extent to which losses from a proposed investment in
rental real estate can be used to offset his other income. The lawyer,
being conscientious and disdainful of secondary sources, tells his
client that he will look the answer up and call him right back.

Knowing that the principal component of the tax losses will be
depreciation deductions, he turns first to §167 and is somewhat put out
to find that there is no reference whatsoever to any limitation on the
use of depreciation deductions to shelter other income. He then thumbs
through the index of his copy of the Internal Revenue Code and comes
across a reference to "limitation on artificial losses" in subpart D of
Part II of chapter 1 of the Code. The titles of the sections under that
subpart seem vaguely related to depreciation deductions and, taking a
chance, he turns to §466, which he is delighted to find is indeed the
applicable provision. Section 466(a)(1) seems to have the answer,
providing:

> Except as otherwise provided in this subpart, in the case of any
> taxpayer subject to this subpart, accelerated deductions which are
> attributable to a class of LAL property and which (but for this
> section) would be allowable for the taxable year shall not be allowed
> for such year to the extent that such deductions exceed the net
> related income for such year from such class of property.

A few of the terms used in this sentence are not entirely clear but our
lawyer friend is confident that explanations will be offered. Before
moving on, however, he notes a reference in §466(a)(3) to an exception
"for certain accrual taxpayers engaged in farming." He knows that his
client has a few farm properties and decides he had better check this
out. The exception refers to "property described in section 467(a)(3) if
the taxpayer "uses an accrual method of accounting with respect to such
property and capitalizes preproductive period expenses described in
section 468(c)(1)." He dutifully turns to §467(a)(3) which describes the
property in question as being property used in farming or property
"described in section 122l(1) and held in connection with the trade or
business of farming." He turns to §1221(l) which seems simple enough and
he concludes that this particular provision may apply. Turning back to
§468(c)(1), he wonders why the language from §1221(l) couldn't have been
put directly into §467(a)(3).

Section 468(c)(1) indicates that the expenses in question are those used
with respect to a "class of property described in section 467(a)(3)." He
turns back to that section, remembers he has just looked at it, and
returns to §468(c)(1) which, mercifully, seems clearly not to apply.

Concluding that the exception for farming operations in §466(a)(3) does
not affect his client, the lawyer turns back to §466(a)(1).

The provision applies only to taxpayers "subject to this subpart" and
fortunately those taxpayers are described immediately below in
§466(a)(2). Subparagraph (a) clearly seems to apply to his client, who
is an individual. Noting the cross references to §§1371(b) and 447(a) in
the case of corporate taxpayers, the lawyer congratulates himself on his
foresight in talking his client out of forming a personal holding
company for his investments the year before.

The next expression used is "accelerated deductions" and, turning ahead
in the Code, he finds a definition in §468(a). Although the definition
seems simple enough, he notes that it applies only to "a class of
property described in section 467(a)(1)" so he turns back to that
provision. Property in that section is described as property which is
"or will be" property "described in section 1221(l)" or property held
for rental. Fortunately, he remembers from an earlier stage in his
research what §1221(l) is all about. Unfortunately, the definition goes
on to say that §467(a)(1) property does not include "any section 1245
property (as defined in section 1245(a)(3)) which is leased or held for
leasing." Turning wearily ahead to §1245(a)(3), he finds that it applies
generally to property which is or has been "of a character subject to
the allowance for depreciation provided in section 167 (or subject to
the allowance of amortization provided in section 185)." Fortunately, he
remembers that the property is in fact depreciable and that §167 is the
section authorizing the depreciation deduction, so he need not turn to
that provision. Since his client has indicated that the proposed
investment is in real estate, he concludes that subsections (A), (B),
and (C) do not apply. Subsection (D) looks disturbing, however, because
it applies to real property "which has an adjusted basis in which there
are reflected adjustments for amortization under section 169, 185, or
188." Turning to these sections, he finds that they deal with the
amortization of pollution control facilities, railroad grading and
tunnel bores, and expenditures for on‑the‑job training and child care
facilities. Common sense tells him that none of those sections apply to
his client's situation and, without reading them carefully, he turns
back to the definition of "accelerated deduction" in §468(a)(1). The
definition of "accelerated depreciation" in §468(a)(2) refers to
deductions "allowable under this chapter" and he checks the table of
contents of the Code to make sure that the coverage of the word
"chapter" is sufficiently broad. Then, he notices a few pages ahead that
§470 seems to have definitions of terms used in subpart D and, sure
enough, he sees definitions for "construct" and "construction period."
He reviews these to make sure how they apply to his client's situation.

Feeling confident that he has established the meaning of the expression
"accelerated deductions", he turns back to §466(a)(1) and sees that it
applies only to deductions attributable to a "class of LAL property."
This strikes him as an expression that could not possibly have a useful
meaning outside the Internal Revenue Code and he turns the page, hoping
to find a definition. He almost does. Although there is no definition of
"class of LAL property," §467(a) defines "LAL property" and the word
"class" as applied to different types of LAL property is explained in
subsections (b)-(g). With some trepidation, he decides to apply logic
and common sense and concludes that, for purposes of his client's
problem, the definition of "classes of LAL real property" in §467(b) is
the one he must deal with.

Turning back to §466(a)(1), our attorney finds that his client's
accelerated deductions will not be allowed to the extent that they
exceed the "net related income" for the year from the class of property.
This, too, looks like an expression that must be defined somewhere, and
he turns ahead to §468, which includes the phrase in its title. Sure
enough, it is defined in §468(g). He shakes his head, wondering why
Congress could not have put all these definitions in one place instead
of spreading them throughout subpart D. He decides that, like Li'l
Abner, he loves and respects the U.S. Congress and if they did it this
way they must have had a reason.

The basic definition in §468(g)(l) seems simple enough, but
unfortunately subsection (2) is entitled "special rules" and our friend
knows that this means trouble. He is right. The special rules indicate
that net operating loss deductions under section 172 shall not be taken
into account. This is a phrase that he has not run across in his
practice and he turns to the section to see what it means. It seems to
be concerned primarily with active businesses and, after looking at it
carefully for a while, he decides that it does not apply to his client's
case. Another special rule relates to capital gain deductions under
§1202 and capital loss carrybacks or carryovers under §1212. Knowing
that his client has from time to time bought and sold real estate, he
checks these out as well. Section 1202 seems familiar and he does not
dwell on it. Section 1212, unfortunately refers to §172 again. Not
wanting to reenter that particular thicket, he decides to take his
chances that this provision does not apply.

Our attorney has now concluded that the deferral of accelerated
deductions will indeed be a problem for his client. The next stop is to
find out exactly how it will work and whether he will ever get some tax
benefit from them. Unfortunately, it is late in the day and all hopes of
getting in a set of tennis before dinner have vanished. He calls his
client and tells him that the research is taking more time than he had
hoped and that he will call him tomorrow. He then goes home and has two
martinis with his wife before dinner.

The next day, suitably refreshed, he arrives at the office a bit early
and gets back to §466. He finds, in subsection (b), that the deferred
deductions are placed in a "deferred deduction account." Subsection (c)
indicates that these deferred deductions will be allowed in later years
if the income from the same class of property exceeds the accelerated
deductions attributable to the class of property for the later year. It
seems simple enough.

A thought then strikes him. He knows that depreciation deductions reduce
the basis of property for purposes of determining gain on later sales.
He wonders whether the basis will not be reduced if deductions are not
allowed under §466. Knowing that the basis adjustment provisions appear
in §1016 of the Code, he turns to that section and finds that it reads
the same way it always did. This seems to indicate that there is no
basis reduction since the deferred deductions are neither allowed nor
allowable. Turning back to subpart D, however, he finds in §470(d)(1)
that a deduction not allowed under §466(a) will be treated as "allowed"
for purposes of §1016.

Our lawyer notices that §469 deals with the consequences of
"dispositions" of property. Section 469(a) indicates that, if any LAL
disposition class is sold during the year, any amount remaining in the
deferred deduction account is deductible in that year. This seems to say
that all of the client's investment real estate must be sold in order to
get this deduction. Reading on, however, he finds in §469(b)(2) that in
the case of property described in §467(a)(1) this rule applies where any
item of property is transferred. Turning back to §467(a)(1), he finds
that he has already reviewed this definition and, looking at his
research notes from the day before, he satisfies himself that it does in
fact apply. It occurs to him that it might not be illogical (although it
certainly would be confusing) to provide that the deduction under
§469(a) might be limited by the property's depreciation recapture
potential (or the depreciation recapture potential the property would
have had if accelerated deductions had been claimed). He can find no
reference to this in §1250 and decides that he may or may not mention it
to his client, depending on how confused the client seems to be when he
tells him everything else.

Finally, he remembers that accelerated depreciation is subject to the
minimum tax on tax preferences and decides that he had better review the
application of the minimum tax in years in which amounts are placed in
the deferred deduction account and the year in which the property is
sold. He finds in §57(e) that an amount placed in a deferred deduction
account under §466(b) is not a tax preference. The law does not
indicate, however, whether the deduction resulting under §469(a) when he
sells the property is a tax preference item in the year of sale.

Having (he hopes) completed his research, he calls up his client and
tells him that he is not absolutely sure but that he thinks there may be
a problem. He discusses some of the principles involved, including
additional record keeping expenses, at which point his client cuts in
with an exasperated tone and says "look, I don't care about all these
fancy rules, should I buy that property or shouldn't I?" At this, the
lawyer shouts into the telephone "how should I know, ask your
Congressman! " and hangs up in disgust.

This scenario points out some of the complexities of the drafting of the
LAL provisions. I might add that the LAL concept is inherently complex.
The Tax Section will submit a detailed report on LAL in the next few
weeks.

Let me close with some thoughts for those of you who will be drafting
and voting on tax reform legislation during this session of Congress and
those to follow.

In drafting, consider who will be reading and interpreting tax statutes.
Will the average attorney in general practice who is conscientious and
doesn't want to rely on secondary sources be able to advise his client?
Will the Internal Revenue Service be able to design a 1040 form that
accommodates new deductions and credits clearly, and will it be able to
explain them to taxpayers? It is not sufficient to make a policy
decision, instruct the drafting personnel of the appropriate committees
to prepare legislation, and vote for it without reading carefully the
draftsmen's work product.[^3] Remember that you are the generalists. You
represent the people who will have to live with new tax legislation.

Don't try to solve every conceivable problem and treat specially every
possible factual variation. Instead, enact generalized statutes that
clearly indicate their purpose.

A further element of complexity arises from the uncertainty as to what
the tax laws will contain. This results from what I can only describe as
a continual tampering with the tax laws. Just about every year since the
Tax Reform Act of 1969, new proposals to curb so-called tax shelters
have been seriously advanced in Congress. Since these proposals
typically have retroactive effect, the complexity and uncertainty
already written into the tax laws are compounded by apprehensions as to
what complexities and uncertainties may be added retroactively. Sensible
planning is impossible in this kind of atmosphere. If you conclude that
reform is needed in a particular area of the tax law, by all means do
something about it (hopefully in a simple manner). Once you do, forget
about it for a few years.

This will give the taxpayers and the Internal Revenue Service a chance
to live with the legislation for a while and will not force them to
conduct their affairs in an atmosphere of continual change.

We in the Tax Section are mindful of the pushes and pulls of the
legislative process. Many people will appear before you in these
hearings asking for special rules and exceptions for one group or
another. Many groups will have special problems and appeals for special
treatment will sound attractive to you. We urge you to think hard about
whether the alleged equity resulting front each new exception is really
worth the added complexity and confusion.

Finally, let me make a plea for clarity of literary style. Tax lawyers
are not noted for their conciseness of expression, but to some extent
our literary style is tarnished by that of the materials we are forced
to read every day. The Internal Revenue Code already contains a single
sentence that is almost twice as long as Lincoln's Gettysburg
Address.[^4] The Tax Reform Bill proposes to give us several more of
similar length. Complex concepts are troublesome enough, but when they
are expressed in complex language the felony is compounded.

I realize that general testimony of the type I have just presented may
not appear as directly pertinent to the work before you as the more
detailed and specific comments that will be submitted later by other
committees of the Tax Section and by other speakers at those hearings. I
submit to you, however, that this message is, in the long run, more
important than whether a category of deduction is limited by or freed
from the LAL provisions. I hope that this issue of complexity will be
given more attention than it has in the past. I sincerely believe that
the viability of our income tax laws depends upon recognition of the
adverse effects complexity has on our self-assessment system.

NYK 617441-2.009900.0021

[^1]: ^\*^ Committees of the Section are reviewing the various
    provisions of H.R. 10612 (referred to in this statement as the Tax
    Reform Bill) and will submit detailed written comments during the
    next month.

[^2]: ^\*^ 27 Tax Law Review 325 (Spring 1972)

[^3]: ^\*^ This is what happened with ERISA. The Pension Reform Bill
    passed by the Senate by a vote of 93-0 obviously had not been read
    in its entirety by anyone. The draftsmen had to work under time
    pressure and last-minute floor amendments did not integrate with the
    rest of the statute. Policy aside, and without regard to complexity,
    it was internally inconsistent.

[^4]: ^\*^ IRC §341(e)(1).