Tax Reform: Who Pays, Who Profits : Would Pay : Large Write-Offs, Capital Gains at Risk in Proposal

“When there is an income tax,” Plato said, “the just man will pay more and the unjust less on the same amount of income.”

Twenty-three centuries later, the Treasury Department has concluded much the same. It doesn’t buy the Greek philosopher’s premise that income taxes and justice are mutually exclusive, of course.

But in its mission of tax reform, the Treasury has acknowledged that injustice runs deep in the tax laws and must be routed out. On the other hand, many taxpayers would pay a heavy price for the reforms.

To translate the Treasury’s theories to real-world cases, The Times examined how the taxes of three individuals and two companies would be affected if the agency’s tax-simplification proposal were enacted in full. Tax calculations were performed by the Los Angeles office of the Price Waterhouse accounting firm.

The analysis relies on several assumptions: All provisions have been phased in; inflation is at 4%; and the proposed depreciation method was in effect when assets were acquired. To calculate taxes under current law, 1984 tax rates and law are used, even when the taxpayer’s most recent available numbers are from the 1983 tax year.

Among the case studies, the individual “winner” has relatively low income while the individual “loser” is a wealthy man with substantial tax shelters. The family for whom the proposed changes would result in a wash, falls somewhere in the middle.

The business “winner” is in retailing, an industry that isn’t favored under the current tax system. The corporate “loser” is a high-technology company. Some analysts had speculated that high-tech companies would fare well, especially in comparison to smokestack industries.

He is a wealthy Southern California businessman who saves hundreds of thousands of dollars in taxes each year through tax shelters, the favorable treatment of capital gains and numerous personal and business deductions.

Call him Norman Bayer. He is the epitome of the tax-simplification plan’s target.

If the tax plan were adopted exactly as proposed, Bayer would face a 71% tax increase. And for that, he has reason to feel fortunate. If only one minor change were made in his finances, he would have to pay 159% more than his current $202,408 tax bill under the Treasury’s tax plan.

Bayer’s name has been altered here, for reasons that have more to do with his domestic relations than with any reluctance to publicly disclose his personal finances.

Bayer is divorced and claims two sons as dependents. He derives his $1.9 million in income from wages, interest, dividends and the stock market, in which he is an active player.

He shelters nearly half of his income from taxes through losses (for tax reporting purposes) on rental property, business ventures and real estate partnerships. And in 1983, he avoided taxation on an additional $760,000 in profits from the sale of stocks, benefitting from the capital gains laws, which allow taxpayers to exclude 60% of such gains from taxation.

Bayer reports wages of $37,602, interest income of $127,089, dividends of $453,909 ($454,009 minus a $100 per-taxpayer exclusion) and $491,700 in capital gains (40% of his $1.23-million gain from the sale of several thousand shares of stock).

Accounting losses from consulting and an equipment leasing business, real estate limited partnerships and rental property drop to $348,445 his total income subject to taxation.

An $8,063 deduction for employee business expenses, $3,000 in personal deductions for himself and his two sons and itemized deductions for state and local taxes, interest expenses, charitable contributions and such miscellaneous deductions as tax return preparation and professional subscriptions shave another $128,021 off his income subject to taxation.

The tax bill on Bayer’s $222,724 in taxable income is $98,892. A $7,861 investment tax credit and a $3,039 research and development credit reduce the bill to $87,992. On top of that, he pays $114,416 in so-called alternative minimum taxes, which basically is government insurance that individuals who benefit from preferential treatment on such things as dividends and capital gains pay at least a minimum amount of tax.

Highest Tax Bracket Bayer’s total tax bill is $202,408 and he is in the 50% tax bracket, the highest under current law.

Fortunately for Bayer, the limited partnerships in which he participates (and which in turn are involved in other partnerships, for a double-tiered tax shelter) comprise fewer than 35 individuals. If there were more than 35 partners, it would be taxed as a corporation under the Treasury’s proposal and Bayer would lose a $525,324 write-off, which would increase his tax bill by $322,912, or 159%.

As it is, his total income and his adjusted gross income nearly triple in the Treasury package, his allowable itemized deductions are reduced by two-thirds, his taxable income more than quadruples and his tax bill rises by $144,070, or 71.2%, to $346,478.

His $37,602 wage and the $25,478 deduction allowed for home mortgage interest are the only two entries on Bayer’s lengthy and complicated tax return that wouldn’t change under the Treasury plan.

The only other bright notes for Bayer are the lower overall tax rates--he would fall into the 35% tax bracket, the highest under the proposed system--and the reduction of his reportable interest income to $76,253 from $127,089 after taking advantage of the Treasury’s inflation-adjustment provision. The Treasury allows an inflation adjustment for interest income as well as interest payments because it assumes inflation is partially responsible for both. There is no adjustment if the overall level of prices goes down.

Much Bigger Bite On the negative side, his taxable dividend income would increase by $100 with the disallowance of the dividend exclusion. The $50,000 life insurance policy his employer carries on him, currently exempt from taxes, would become taxable income of $174 a year under the Treasury’s plan to begin taxing employer-paid fringe benefits such as life and health insurance premiums. And his capital gain, only 40% of which is taxed under current law, would be fully taxable after an adjustment for inflation.

Had the Treasury tax package been law when he received $1.4 million for stock he acquired for about $200,000, Bayer would have adjusted his original cost to account for inflation over the period he held the stock. He would have had to report as income the entire resulting gain of $1,176,433. As it was, he only paid tax on $491,700 of that gain.

Not surprisingly, therefore, Bayer is vehemently opposed to this provision and says he definitely would rethink his investment philosophy were capital gains to lose their preferential tax treatment. His reaction is precisely what many publicly held companies have predicted and explains why this proposal is one of the most controversial components of the Treasury package.

Some of Bayer’s tax shelters also would lose their advantages, just as the Treasury architects intended.

His leasing and consulting businesses would provide losses of just $152,878 instead of the current $201,549 after interest expenses are indexed for inflation, entertainment expenses are disallowed and depreciation on an airplane and a car are recalculated for inflation and for the slower write-off Treasury proposes.

The proposed depreciation and income expensing changes also would substantially reduce the tax advantages of Bayer’s rental property. Only $3,709 of his $7,925 loss would be allowable. (Real estate taxes would remain deductible for income-producing property, but not for individuals.)

Bayer’s $552,381 loss from real estate partnerships also would be eroded slightly--to $516,775--because $35,606 in interest expenses incurred in these businesses would have to be reported as an itemized deduction, indexed for inflation and allowed only to the extent they exceed 1% of adjusted gross income.

From his adjusted gross income of $1,063,654 (versus $340,382 under current law), he would be allowed to itemize just two deductions: $25,478 in home mortgage interest and only a $23,381 portion of his $43,969 in other non-mortgage interest expenses. Under the Treasury proposal, the first $5,000 in non-mortgage interest expenses would be allowed in full. The remainder would be indexed for inflation and then allowed only to the extent the taxpayer has investment income.

No longer deductible would be $71,680 in state and local taxes, $2,565 in contributions to charities and $8,872 in miscellaneous deductions. Charitable contributions would be limited to amounts over 2% of adjusted gross income and miscellaneous deductions would be subject to a floor of 1% of adjusted gross income. Bayer’s deductions aren’t large enough to qualify.

After allowing for the increase in the Zero Bracket Amount--the income level below which no one is taxed--to $3,500 from $2,300 for heads of households and for the proposed doubling of personal deductions to $2,000 per person from $1,000, Bayer’s taxable income becomes $1,012,295. His tax on that amount would be $346,478.

Although the Treasury plan doesn’t specifically mention abolishing the research and development credit for individuals, it is scheduled to be repealed next year and President Reagan has shown little interest in resurrecting it. So, Price Waterhouse assumed in the analysis of Bayer’s return that he would lose his $3,039 R&D; credit.

An even bigger loss for him would be his $7,861 investment tax credit, taken for the purchase of two cars and office furniture. This credit, allowed for the purchase of capital equipment, would be abolished as part of the Treasury’s effort to rid the tax laws of provisions that blatantly encourage or discourage specific investments--other than the deduction for home mortgage interest. That incentive Treasury was instructed by Reagan to keep.