November 22, 2017 The Honorable Kevin Brady The Honorable Orrin ...

Section of Taxation Suite 400 1050 Connecticut Avenue, NW Washington, DC 20036 202-662-8670 FAX: 202-662-8682 E-mail: [email protected] OFFICERS Chair Karen L. Hawkins Yachats, OR Chair-Elect Eric Solomon Washington, DC Vice Chairs Administration Charles P. Rettig Beverly Hills, CA Committee Operations Scott D. Michel Washington, DC Continuing Legal Education Fred F. Murray Gainesville, FL Government Relations Julian Y. Kim Washington, DC Pro Bono and Outreach Bahar A. Schippel Phoenix, AZ Publications Julie A. Divola San Francisco, CA Secretary Katherine E. David San Antonio, TX Assistant Secretary Robb A. Longman Bethesda, MD COUNCIL Section Delegates to the House of Delegates Richard M. Lipton Chicago, IL Armando Gomez Washington, DC Last Retiring Chair William H. Caudill Houston, TX Members John F. Bergner Dallas, TX Thomas D. Greenaway Boston, MA Roberta F. Mann Eugene, OR Carol P. Tello Washington, DC Gary B. Wilcox Washington, DC Adam M. Cohen Denver, CO Sheri A. Dillon Washington, DC Ronald A. Levitt Birmingham, AL Christopher S. Rizek Washington, DC Melissa Wiley Washington, DC Gregg D. Barton Seattle, WA Michael J. Desmond Santa Barbara, CA Catherine B. Engell New York, NY Peter A. Lowy Houston, TX R. David Wheat Dallas, TX LIAISONS Board of Governors Allen C. Goolsby Richmond, VA Young Lawyers Division Vlad Frants New York, NY Law Student Division Scott Woody University Park, NM DIRECTOR John A. Thorner Washington, DC

November 22, 2017

The Honorable Kevin Brady Chairman House Committee on Ways and Means 1102 Longworth House Office Building Washington, D.C. 20515

The Honorable Orrin G. Hatch Chairman Senate Committee on Finance 219 Dirksen Senate Office Building Washington, D.C. 20510

The Honorable Richard E. Neal Ranking Member House Committee on Ways and Means 1102 Longworth House Office Building Washington, D.C. 20515

The Honorable Ron Wyden Ranking Member Senate Committee on Finance 219 Dirksen Senate Office Building Washington, D.C. 20510

Re:

Deductibility of Expenses For Tax Code Compliance

Dear Chairmen Brady and Hatch, and Ranking Members Neal and Wyden: The views expressed below regarding the elimination of deductibility for tax code compliance are presented on behalf of the Section of Taxation. They have not been approved by the House of Delegates or the Board of Governors of the American Bar Association and, accordingly, should be construed as representing the position of the Section and not the Association. Section 212 paragraph (3) of the Internal Revenue Code (“section 212(3)”) allows for a deduction from income for the costs connected with the determination, collection, or refund of any tax.1 Section 212(3) applies to all taxpayers and does not require the expense to be incurred for the production of income. The current tax reform bills pending before the House of Representatives and the Senate would amend Section 212 to eliminate the ability of individual taxpayers to deduct expenses incurred in connection with complying with the tax code, unless the expenses are for the production of income. The Section of Taxation of the American Bar Association (the “Section”) submits this letter to respectfully request that Congress reconsider the proposed repeal of section 212(3), a provision that has been part of the tax laws for 1

References to a “section” are to a section of the Internal Revenue Code of 1986, as amended (the “Code”), unless otherwise indicated.

Hon. Kevin Brady Hon. Richard E. Neal Hon. Orrin G. Hatch Hon. Ron Wyden November 22, 2017 Page 2 of 4

over 60 years, and for good reason. Income taxes are not optional, but the U.S. system is one that relies on voluntary compliance. The Section recognizes Congress’ goal of simplifying the Code, but believes that increasing the cost of complying with the tax laws will undermine voluntary compliance. Section 212(3) was enacted as part of the Internal Revenue Code of 1954. Prior to 1954, section 23, the predecessor to section 212, allowed deductions for expenses for the production of income and the preservation of capital, but not for expenses incurred determining the correct amount of tax. The addition of the deduction for costs in connection with the determination, collection or refund of any tax was a response to the Supreme Court decision in Lykes v United States 343 U.S. 118 (1952). Mr. Lykes sued the U.S. over the denial of deductions for legal costs incurred in defending the assessment of gift tax based upon transfers of closely held stock to relatives who also served on the company board of directors. In a 6-3 decision the Court held that the legal fees were not deductible because they were only tangentially related to the production of income. It was the dissent, however, that truly impacted tax policy. In his dissent, Justice Robert H. Jackson, wrote: The Treasury may feel that it is good public policy to discourage taxpayers from contesting its unjustified demands for taxes and thus justify penalizing resistance. It is hard to imagine any instance in which the Treasury could have a stronger self-interest in its regulation…. I think Congress allows a taxpayer to protect his estate, even against the Treasury. It seems to me a tacit slander of the Nation's credit that need for money should drive us to such casuistry as this. The drafters of the Internal Revenue Code of 1954 took notice of this reasoning, and when the first modern tax code was passed, it included section 212(3). Section 212(3) allows for a broad deduction of costs incurred to determine, contest collection of, or seek a refund of any tax. The deduction for costs in connection with a tax include tax preparation fees, costs associated with defending an audit, tax litigation, and the costs associated with contesting a collection action or submitting a claim for a refund. These costs extend to those incurred with respect to any governmental taxing authority. The Importance of Section 212(3) in Determining the Correct Amount of Tax Due Every U.S. citizen must comply with their legal obligation to file and pay taxes. Due to the complexity of the tax laws, compliance often requires payment for the use of software or of hiring a tax professional to determine the correct amount of tax and to file the return. Since the U.S. tax system relies on voluntary assessment, these efforts and expenses of its citizens are necessary for efficient tax administration.


Elimination of one of the incentives to spend the time and resources to determine the correct amount of tax due by repealing section 212(3) reduces the likelihood that taxpayers will seek the correct answer. Instead of spending money on tax professionals or high-quality software, the Section believes taxpayers will seek a less costly alternative to determining their tax liability, possibly not seeking assistance at all, potentially leading to higher error rates. The higher the error rates, the less tax will be collected through the voluntary system. The less effective the voluntary system, the more resources tax authorities will have to use auditing and making liability determinations. Additionally, deficiencies imposed by a taxing authority have a lower collection rate than self-determined deficiencies. The result is less total revenue and a higher cost per dollar of revenue collected. The Importance of Section 212(3) in the Litigation, Collection, and Refund Stages The less accurate our voluntary reporting system becomes, the more the Service and other taxing authorities will be forced to rely on audits and collection actions. Tax law often is unsettled or heavily fact dependent. Resolving tax issues requires time and effort on both sides. It is not uncommon for taxpayers to spend significant resources only for the Service to conclude that the tax return was correct, and no changes are required. Eliminating the deduction for expenses incurred for defending an audit could result in fewer taxpayers willing to fight an improper determination because the after-tax cost of the defense would increase. A taxpayer who decides to pay, without objection, a proposed deficiency based solely on a cost-benefit analysis is not a taxpayer who has been treated fairly by tax administration. Section 212(3) permits deductions for expenses incurred during tax litigation. Tax litigation is an essential component of our tax administration system. It is through case law that ambiguities in the tax code are resolved, and certainty is created. Discouraging the volume of legitimate tax disputes litigated by raising the after-tax costs also will have the unintended, and undesirable effect, of increasing statutory uncertainty. Eliminating section 212(3) is also a direct affront to constitutional tax due process in the context of the government’s taking of its citizen’s property. The tax collection process, as well as the tax refund process, give every taxpayer who disagrees with the amount she or he may owe the fisc a chance to challenge the Service’s determination and to have that challenge heard by an impartial third party. These procedural safeguards exist to protect a taxpayer from forced collection actions, such as a lien or a levy, without an opportunity to be heard. Existing collection due process protections are used overwhelmingly by individual taxpayers to defend against the Service taking their property without an opportunity to be heard. Repealing section 212(3) and thereby raising the costs of hiring a tax professional to assert constitutional due process rights, will deprive taxpayers of an important due process right. The Cost of Repealing Section 212(3) Compared to the Revenue Benefits Currently costs covered by section 212(3) are expensed as an itemized deduction. Roughly 30% of taxpayers itemize, which means 70% of taxpayers receive no benefit from the


deduction. Of the 30% of the taxpayers who itemize, the vast majority have minimal costs which are limited to preparation costs. The revenue impact from repealing section 212(3) are not readily available from the revenue estimates issued by the Joint Committee on Taxation because they are combined in the overall revenue estimate from eliminating most itemized deductions. However, the cost to our voluntary compliance system of repealing section 212(3) are easy to foresee, even if they may not be easily quantifiable. In a voluntary compliance system, the perception of unfairness for a single year can impact a number of future tax years. Increasing the cost of defending against a perceived unfair tax assessment can lead to increased feelings of victimization and unfair treatment. Taxpayers who feel they are being forced to pay an unjustified assessment because the cost to defend it is too high are not likely to be inclined to “volunteer” their self-assessments in future years, resulting in lower revenues collected and increased enforcement costs incurred by the Service. These costs, plus the damage to efficient tax administration are real costs that cannot be captured in the revenue scoring tables. *

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Although determining and reporting the correct amount of tax due is a civil (and legal) obligation, the Section believes that section 212(3) appropriately incentivizes taxpayers to undertake the effort required to comply with the tax laws. Most U.S. taxpayers are not tax professionals. For them the tax laws always will remain a challenge to understand and follow. As Justice Jackson wrote in his dissent in Lykes, Congress should allow a “taxpayer to protect his estate, even against the Treasury,” and section 212(3) is one way Congress has protected against a government taking of property without an opportunity to dispute the legitimacy of the action. The rationale of section 212(3) remains as strong in 2017 as when it was enacted in 1954. We thank you for your time and attention to this important matter affecting taxpayers of all types and would look forward to meeting with you and your staffs to discuss these issues further. Sincerely,

Karen L. Hawkins Chair, Section of Taxation cc:

Hon. Steven T. Mnuchin, Secretary, Department of the Treasury David J. Kautter, Assistant Secretary Tax Policy, Department of the Treasury David J. Kautter, Acting Commissioner, Internal Revenue Service William M. Paul, Acting Chief Counsel, Internal Revenue Service