The sections of the Internal Revenue Code known as Subchapter D (those in the Subtitle A, Chapter 1 neighborhood) give us the rules for qualified retirement plans and other deferred compensation arrangements. Those of us on the tax and regulatory side of the compensation and benefits consulting practice are fond of Subchapter D. We tend to think our mere willingness to step into that labyrinth — to follow those twisted, dimly lit passages — somehow distinguishes us from our tax department colleagues. More important, we approach our work with the faith that the Subchapter D maze will miraculously keep the nation's private retirement savings system on the straight and narrow path toward retirement security.
Two recent events, however, cause me to question that faith. Just last month we welcomed the long-awaited release of Rev. Proc. 2013-12, expanding and improving the Employee Plans Compliance Resolution System (EPCRS), a program the IRS launched in 1998 to allow taxpayers to correct compliance failures made in their qualified retirement plans. This month we celebrate the 100th anniversary of the 16th Amendment to the Constitution, the birth (or rebirth) of the income tax. Taken together, those two events invite us to reflect on the federal income tax itself and its troublesome, some say illegitimate, offspring: the tax expenditure, including the tax expenditure for pension benefits authorized by Subchapter D.
Consider first the 16th Amendment: "The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration." Just 30 words. Impressive. More impressive still, the measure passed the Senate 77–0 and the House 318–14; was supported by Taft, Wilson and Roosevelt (all running for president in 1913–14); and was eventually ratified by 42 of the 46 state legislatures. No one would suggest that ratification was easy or the income tax was ever actually popular, but there can be little argument today that the income tax was not an improvement over the inherently regressive system of tariffs that was the largest source of federal revenue from 1790 to 1913.
100 years and a galaxy away
2013 is 100 years and a galaxy away from that short, simple and "fairer" income tax. CCH, a leading publisher of tax information, reports, "The text of the Sixteenth Amendment, combined with the text of the United States Revenue Act of 1913, is generally considered to be the original tax code. Combined, these documents were approximately 27 pages in length..." The 2011 CCH Winter Edition of the Internal Revenue Code was 5,296 pages. The thousands of additional pages were not for clarification. The 2012 National Taxpayer Advocate Annual Report to Congress identified the complexity of the tax code as the most serious problem facing taxpayers, "a significant, even unconscionable burden on taxpayers."
Nina E. Olson, the IRS's National Taxpayer Advocate, wrote:
The existing tax code makes compliance difficult, requiring taxpayers to devote excessive time to preparing and filing their returns. It obscures comprehension, leaving many taxpayers unaware how their taxes are computed and what rate of tax they pay; it facilitates tax avoidance by enabling sophisticated taxpayers to reduce their tax liabilities and provides criminals with opportunities to commit tax fraud; and it undermines trust in the system by creating an impression that many taxpayers are not compliant, thereby reducing the incentives that honest taxpayers feel to comply.
After immigrating to the United States, Albert Einstein said, "The hardest thing in the world to understand is the income tax."
Of course, the staggering complexity of the income tax is not news. The 100th anniversary simply invites us to give a second thought to something we've taken for granted — the efficacy of that piece of the income tax system that creates tax-favored, employer-provided retirement benefits. Does Subchapter D do its job well? The American Institute of CPAs (AICPA) developed a framework of 10 guiding principles of good tax policy, among them certainty, economy of calculation and simplicity. The AICPA explains that "certainty may be viewed as the level of confidence a person has that a tax is being calculated correctly." Economy of calculation embodies the concept that the costs to collect a tax should be kept minimal for both the government and the taxpayer. As for simplicity, Einstein should be able to figure it out.
We evaluate Subchapter D in light of the AICPA standards by considering the EPCRS. Like its predecessors, the 2013 revenue procedure guides plan sponsors and their advisers step by step through the process of correcting their qualified retirement plans and 403(b) plans when they find themselves out of compliance with Subchapter D. The system permits a plan sponsor to self-correct certain plan failures without contacting the IRS and to correct most plan failures with IRS approval and payment of a fee. The system even permits a plan sponsor to correct a plan failure while the plan is under audit, although that course involves paying a sanction in addition to correcting the plan failure. We recognize that the expanded and improved EPCRS demonstrates the IRS's continuing commitment to help plan sponsors comply with the law. At the same time, by its very existence, EPCRS is the IRS's tacit acknowledgement that a great part of Subchapter D is incomprehensible. It simply defies compliance. We may have to admit Subchapter D is part of the "unconscionable burden."
How did it happen? 100 years of legislation is one easy answer. The Farmers' Almanac observed, "If Patrick Henry thought that taxation without representation was bad, he should see how bad it is with representation." Shortly after ratification of the 16th Amendment, our representatives discovered the "tax expenditure," conveniently located at the intersection of social policy and the tax system. The revenue acts of 1921 and 1926 codified what had been an informal allowance of a deduction for employer contributions to employee retirement plans as long as the expense was ordinary and necessary. Exclusion of retirement plan contributions was intended to encourage Americans to save for retirement, justifying the tax expenditure — that is, the employer's deduction, together with the deferral of trust earnings and wage income for employees.
From that mustard seed grew current retirement provisions. National Taxpayer Advocate Olson reported to Congress in 2011, "The tax code contains at least 12 separate incentives to encourage taxpayers to save for retirement. These incentives are subject to different sets of rules governing eligibility, contribution limits, taxation of contributions and distributions, withdrawals, availability of loans and portability." Moreover, the tax expenditure is no small-ticket item. The Office of Management and Budget estimates the 2013 tax expenditures for pension benefits at $192.2 billion, second only to employer contributions for medical insurance premiums and medical expenses, and half as large as the mortgage interest deduction, the third-ranking tax expenditure.
The use of the tax code to implement social policy, however desirable, inevitably complicates the business of raising revenue. A more egregious cause of the "unconscionable burden," however, may be the ever-escalating tension between the quest for fairness and what some observers call the "sporting theory of taxation." From the outset, tax-favored treatment for employer-sponsored retirement savings plans has been conditioned on those plans' covering a broad cross-section of employees, not just owners and highly compensated employees. Congress and regulators have mustered considerable determination in pursuit of that objective. In turn, those in control of designing qualified retirement plans have matched that determination with equal measures of ingenuity and industriousness in pursuit of a different objective: maximizing contributions and deductions for owners and highly compensated employees.
As a nation, we seem to be fairly accepting of that tension. Judge Learned Hand's dicta in Gregory v. Helvering (2d Cir. 1934) is sometimes credited with inspiring the sporting theory of taxation. He wrote:
Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern that best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike, and all do right, for nobody owes any public duty to pay more than the law demands.
Nearly 100 years of some taxpayers "so arranging affairs" as to keep excludable contributions high (thus, taxes low) for key employees, countered by legislators and regulators so arranging what the law demands as to thwart them, has produced such a truly byzantine set of laws, regulations, rulings and cases that it is hard to remember the simple goal of promoting private retirement savings.
The goal of promoting private retirement savings is this tax expenditure's reason for being. It justifies its part of the "unconscionable burden" on employers, individuals and taxpayers. Does it succeed in its mission? On that point we can offer only a few observations. Clearly, retirement plan assets compose a significant part of household wealth, despite the great recession. Yet the role of tax policy in that reality is unclear. The Federal Reserve Board has reported a steady decline in personal savings from 1980 to the beginning of the great recession. The Tax Policy Center offers a stunning observation to explain that trend: The tax subsidy for pension benefits does not subsidize savings; it merely subsidizes deposits to tax-favored accounts. To the extent individuals divert other household savings or increase personal debt, the subsidy may have no net effect on household savings. Thus, whether tax policy promotes personal savings remains a question to ponder over the next 100 years.
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