Tax Law Archives – Southern California Law Review

A New Look at Old Money

October 2025October 2025Miranda Perry Fleischer*

Taxing wealth—including inherited wealth—is a hot topic, making headlines and generating heated debate. Should millionaires and billionaires face an annual wealth tax, as championed by Senators and former presidential candidates Elizabeth Warren and Bernie Sanders? Should we strengthen the existing estate tax, as former presidential candidate Kamala Harris urged? Or, as opponents argue, are both annual wealth and once-a-generation wealth transfer taxes unfair and impractical? What makes this debate so intractable is not only that the public as a whole is divided on these issues, but that also many individual Americans hold simultaneous beliefs about wealth, opportunity, fairness, desert, and family that seemingly contradict each other. This Article cuts through that debate by proposing a novel solution for inheritance taxation that reconciles these deeply held beliefs with the benefits of wealth transfer taxation.

Our current estate tax treats the self-made millionaire the same as an heiress who has not earned a cent when they pass their fortunes on to their heirs. But this is misguided. Drawing on recent work on the psychology of taxation, this Article makes the case for an innovative inheritance tax system that taxes old money more heavily than new. This approach would allow individuals to bequeath wealth that they have earned—but not wealth that they have inherited—free of tax. Known as a Rignano tax, this proposal harnesses the finding that many Americans “silo” beliefs about wealth, holding seemingly contradictory beliefs that differ in part based on whether wealth is earned or inherited. By leveraging these findings and building on experience with the existing transfer tax system, this Article elaborates and advances a set of specific and concrete design recommendations for a Rignano tax.

This comprehensive analysis of a Rignano tax—the first in the law review literature—complements philosophical work that advocates for such a tax but does not address key design and policy questions. Further, it contributes to tax scholarship by advancing our understanding of the relationship between a tax’s normative goals and structural design choices. And for both advocates and opponents of the estate tax, it offers a nuanced and fair exploration of the debate surrounding inheritance taxation as well as a potential resolution of the enduring stalemate over taxing wealth.

Her voice is full of money.

—F. Scott Fitzgerald, The Great Gatsby¹

They were new money, without a doubt: so new it shrieked. Their clothes looked as if they’d covered themselves in glue, then rolled around in hundred-dollar bills.

—Margaret Atwood, The Blind Assassin²

Introduction

Compare Tom, who builds a multi-million-dollar business from the ground up, with Mary, an heiress who inherits millions and never earns a cent. Both want to leave their fortunes to their children. Although our current estate tax treats Tom and Mary the same, this approach is misguided. It ignores that not only is the public as a whole divided on the issue of taxing wealth transfers,³ but many individual Americans hold simultaneous beliefs about wealth, opportunity, desert, fairness, and family that seemingly contradict each other. Many believe, for example, both that working hard and saving in order to help one’s children is as American as apple pie and that it is unfair for some children to begin life with a substantial head start.⁴

As a result, the debate over taxing wealth—including inherited wealth—is at a longstanding impasse.⁵ Influential legislators including Senators and former presidential candidates Elizabeth Warren and Bernie Sanders champion annual wealth taxes on ultra-millionaires, while opponents passionately contend that even once-a-generation taxes on wealth transfers are unfair and impractical, calling them “expropriation” and “an especially cruel injury.”⁶ This Article cuts through that debate and reconciles those competing beliefs by proposing a novel inheritance tax system that taxes old money more heavily than new. This innovative approach—known as a Rignano tax⁷—would allow Tom to bequeath wealth that he has created free of tax, while taxing Mary, who simply inherited her wealth.

Drawing on recent work on the psychology of taxation, this innovation harnesses the finding that many Americans “silo” beliefs about wealth, holding seemingly contradictory beliefs that differ in part based on whether wealth is earned or inherited. A Rignano tax thus reconciles the benefits of wealth transfer taxation with deeply held beliefs about fairness, desert, private property, and family. Because these beliefs—which legal philosophers Liam Murphy and Thomas Nagel call “everyday libertarianism”⁸ and which economist Steven Sheffrin terms “folk justice”⁹—generally differ from those of policymakers and academics, they are often ignored. Recent work on the psychology of taxation suggests that this is a mistake.¹⁰ Policymakers who ignore these beliefs do so at their own peril, often undermining their own normative aims.

But taking these beliefs into account does not mean abandoning wealth transfer taxation altogether. People frequently hold views about fairness and morality in different domains that appear to contradict each other, a concept that Zachary Liscow terms “policy silos.”¹¹ A pro-life advocate, for example, may also support the death penalty; someone who opposes redistributive taxation may favor transportation policy that helps the poor. Crucially, evidence indicates that many Americans “silo” beliefs about wealth, holding seemingly contradictory beliefs that depend in part on whether wealth is earned or inherited.

These insights suggest a way out of the morass bogging down the debate over inherited wealth. Supporters of inheritance taxes should not dismiss out-of-hand public attitudes about hard work, thrift, and family, but instead harness the concept of policy silos. By allowing individuals to make tax-free transfers of wealth that they themselves have earned—but not wealth that they have merely inherited—a Rignano tax acknowledges the very real, deeply held value that the public places on hard work, entrepreneurship, and notions of desert while also addressing concerns about inherited wealth.¹²

Although the idea of taxing old money more heavily than new has long fascinated philosophers of all stripes,¹³ philosophical literature leaves key design and policy questions unanswered. This Article answers those questions, offering the only comprehensive analysis in the law review literature of a Rignao tax. It first justifies a Rignano tax as a normative matter, delving more deeply into both expert and lay arguments for and against taxing wealth and recent work on the psychology of taxation. Its key normative insight is that a Rignano tax balances the goals of wealth transfer advocates (such as enhancing equality of opportunity and minimizing dynastic transfers of unearned power) with those of opponents of such taxes (such as rewarding desert, hard work, and family). By acknowledging both the pros and cons of taxing wealth transfers, a Rignano tax can succeed politically where other proposals fail.

What remains to be resolved are important questions of design and administration. Charting new ground in the literature on Rignano taxes, this Article builds on experience with the existing transfer tax system to elaborate and advance a set of specific and concrete design recommendations for a Rignano tax. These are:

Base: Imposing a tax on gifts and bequests received by an individual when that wealth is the subject of a second transfer;

Rate: Levying a rate of 0% on first-generation transfers and 40% on other transfers;

Valuation: Using the risk-free rate of return to determine what portion of a gift or bequest is second-generation wealth;

Frequency: Taxing generation-skipping transfers;

Tracing: Using a first-in-time approach to allocate second-generation wealth;

Trusts: Treating distribution as the relevant date for both imposing the tax and “starting the clock” for determining future growth; and

Transition Rules: Treating one-sixth to one-third of existing wealth as inherited.

Together, these recommendations build upon the insights of the psychology literature to craft an inheritance tax system that balances how the public actually thinks about taxation with the goals of inheritance tax supporters. Taxing heirs instead of transferors harnesses the insight that people silo beliefs about wealth, distinguishing between inherited and earned wealth. It also lessens the pull of moral mandates about double taxation and hard work. At the same time, it reflects the moral intuitions shared by most supporters of inheritance taxation. For example, many of the concerns raised by inherited wealth—such as equality of opportunity—are best measured by how much wealth a given person inherits, not how much total wealth an individual bequeaths without regard to how that wealth is divided among beneficiaries.

Imposing a zero rate on initial transfers of earned wealth likewise diminishes the attraction of the double taxation and hard work arguments. It also minimizes the threat that people often feel when systems of which they are a part—such as the family or an economy that rewards hard work and entrepreneurship—are undermined. By suggesting a rate of forty percent for later transfers, it acknowledges that repeated wealth transfers raise normative

concerns without breaching the fifty percent threshold that is especially salient in tax debates.

Other recommendations address valuation and liquidity concerns to increase administrability and decrease opposition triggered by those difficulties. For example, even though most normative considerations suggest taxing trust beneficiaries when their interests vest, this Article proposes taxing them at distribution. At that point, accurate valuations—and not just estimates—can be made, and liquidity concerns disappear. This acknowledges the instinct many people have that taxing “paper gains” is unfair. And using the risk-free rate of return to determine what portion of an inheritance’s growth is earned versus unearned provides a simple, easy to administer method for distinguishing what portion of a second transfer is old money versus new.

A Rignano tax thus charts a course through the competing beliefs held by both supporters and opponents of inheritance taxation. Although implementing one will require some additional complexity and recordkeeping, these burdens are not insurmountable. Several European countries tax some bequests more heavily than others depending on the relationship between the transferor and transferee.¹⁴ And for the last decade or so, our current system has successfully allowed one spouse’s estate tax consequences to turn on the value of the other spouse’s property as well as actions taken by the predeceased spouse’s executor at his or her prior death. This suggests that tying a recipient’s tax burden to the actions of the transferor is feasible. Administrative concerns therefore do not derail a Rignano tax’s carefully charted course. What remains is a workable inheritance tax system that can gain traction with the public where other proposals fail.

This Article proceeds as follows. Section I offers an overview of the current estate and gift tax system and common alternatives. Section II explores the arguments for and against taxing wealth transfers. Section III describes the justifications for a Rignano tax, and Section IV details what implementing a Rignano tax would entail. Section V concludes by assessing how well a Rignano tax balances competing intuitions concerning inherited wealth and concludes that the Rignano tax is worth pursuing notwithstanding the potential complexities that attach to its design and implementation.

I. An Overview of Wealth Transfer Taxation

Taxing wealth transfers is a longstanding feature of our federal tax system. Our current estate tax dates from 1916, when Congress imposed a tax ranging from one percent on estates over $50,000 to ten percent on estates over $5,000,000.¹⁵ To prevent individuals from avoiding the tax by making lifetime gifts instead of bequests, Congress permanently added a gift tax a few years later.¹⁶ This system is “unified,” meaning that it taxes an individual’s gratuitous transfers once they cumulatively exceed a per-transferor exemption amount, whether those transfers are gifts or bequests.¹⁷ For simplicity, this Article refers to this unified structure as the “estate tax.”

Due to changes in the exemption and rates, the tax’s bite has fluctuated dramatically over the past two decades.¹⁸ As recently as the year 2000, the top rate was 55 percent; by 2013, it had dropped to 40 percent, where it remains.¹⁹ As rates were dropping, the exemption was increasing. Between 2000 and 2017, it grew from a comparatively small $675,000 to over $5,000,000,²⁰ and in 2017, the Tax Cuts and Jobs Act temporarily doubled the exemption to $10,000,000²¹ (adjusted for inflation to $13,990,000 in 2025²²). Although the exemption was scheduled to return to a benchmark of $5,000,000 in 2026, legislation in the summer of 2025 permanently increased it to $15,000,000, adjusted for inflation, starting in 2026.²³ Given the exemption’s size, the estate tax affects only a tiny sliver of the population. In 2020, roughly 4,100 estates were required to file an estate tax return,²⁴ and of those, only about 1,900 actually owed any estate tax—less than 0.1 percent of the estimated 2,800,000 decedents that year.²⁵ Despite the small number of taxable returns, the tax raises a non-trivial amount of revenue—roughly $16 billion in 2020.²⁶ Interestingly, the amount of revenue has not decreased as fast as the number of taxable estates has decreased, which suggests that exempting additional transfers from tax (as a Rignano tax would) would not necessarily eviscerate the tax’s revenue-raising capacity.²⁷

A few features of the estate tax merit mention. First, it focuses on the transferor. This contrasts with recipient-focused taxes, such as the inheritance or accessions tax schemes that are more common abroad.²⁸ Other than the marital and charitable deductions, the estate tax does not distinguish among recipients. Consider Anna, whose wealth totals $15,000,000. She is taxed the same whether she transfers her fortune to one child or splits it among ten cousins.

Second, individuals may make a number of tax-free transfers. Most importantly, each individual has a single lifetime exemption amount—currently $13.99 million—which applies to her cumulative wealth transfers.²⁹ Assume that Anna gifts her daughter $10 million during life and later dies with an estate of $5 million. The lifetime gift uses up most of her exemption amount, leaving only $3.99 million of it left for later transfers. At her death, $3.99 million of her estate will be shielded from tax by the rest of her exemption amount, and the remaining $1.1 million of her estate will be taxed. She does not get a new exemption for her bequests. In addition, the annual exclusion allows each individual to exclude the first $19,000 transferred to each recipient each year from the above calculations.³⁰ Anna can give as many people as she likes—her whole Tax I class, perhaps—$19,000, and the gifts are simply ignored. Anna can do this year after year, and the gifts do not use up any of her exemption amount. Further, there are unlimited deductions for marital³¹ and charitable transfers.³² If Anna bequeaths her entire estate to her spouse, her taxable estate is zero. She does not need to use her exemption amount, and it rolls over to her spouse for later use. Likewise, if Anna bequeaths her $15,000,000 to charity, her taxable estate is zero. In this case, however, her unused exemption simply disappears.

Third, the generation-skipping transfer tax precludes families from minimizing their total tax burden by “skipping” generations. If Anna bequeaths her estate to her daughter Bonnie, who in turn bequeaths the wealth to Anna’s granddaughter Chloe, the estate tax is imposed twice. But if Anna skips Bonnie and bequeaths her wealth directly to Chloe, the estate tax is imposed only once. To equalize the tax burden in these situations, the generation-skipping tax imposes a tax on transfers that “skip” generations.

Finally, this system is separate from the income tax. Gifts and bequests received are not included in a recipient’s income, regardless of size.³³ Later income tax consequences to the transferee depend on whether the transfer is a gift or bequest.³⁴ Assume that Anna buys stock for $100 and transfers it to Bonnie when it is worth $1,000. If the transfer is a gift, Bonnie takes Anna’s basis for income tax purposes and will pay tax on the $900 unrealized gain upon disposition.³⁵ If Anna bequeaths the stock to Bonnie, Bonnie takes a fair market value basis of $1,000.³⁶ The $900 gain that accrued in Anna’s hands disappears.

A transferor-focused estate tax is just one possible way of taxing wealth transfers. Numerous OECD countries, including Belgium, France, Germany, Japan, Spain, and Switzerland, impose either accessions or inheritance taxes that focus on beneficiaries.³⁷ Although the two terms are often used interchangeably, they are technically distinct.³⁸ The former taxes the recipient based on the total amount of gifts and bequests received during her lifetime, while the latter taxes the beneficiary on such receipts annually.³⁹ Inheritance tax rates often vary based on the relationship between the donor and beneficiary, with transfers between close relatives taxed more lightly than transfers between more distant relatives and unrelated individuals. Finally, both accessions and inheritance tax systems generally exempt transfers between spouses.

An alternative to taxing gifts and bequests through a separate estate, inheritance, or accessions tax system is to change their income tax treatment. Most obviously, gifts and bequests could be included in income, just like salary or lottery winnings.⁴⁰Although this is fairly rare, Latvia and Lithuania do this, and Lily Batchelder’s “comprehensive inheritance tax” is essentially an income inclusion scheme.⁴¹

Another option is to use carry-over basis for bequests as well as gifts so that when transferees sell, they will pay tax on any gain that accrued to the donor regardless of whether the transfer is a gift or bequest (returning to Anna and Bonnie, Bonnie would pay tax on the $900 gain that accrued in Anna’s hands in both circumstances). The U.S. has briefly experimented with carry-over basis twice before—once in 1976 (although it was repealed before going into effect) and again in 2010 (that year, estates could choose between the regular estate tax or a system without an estate tax but with carry-over basis).⁴²And finally, gifts and bequests could be treated as realization events to the donor that trigger tax on unrealized appreciation at the time of transfer.⁴³ The United Kingdom⁴⁴ and Australia⁴⁵ treat gifts as realization events. Canada takes this approach at death, and former President Biden and numerous Senators have proposed that the U.S. follow suit.⁴⁶ In theory, one could both change the income tax treatment of gifts and bequests and impose a separate wealth transfer tax, but in the real world, they tend to be treated as either/or propositions due to political concerns.

II. The State of The Debate over Estate Taxes

Taxing wealth transfers is extremely controversial. As the foregoing history demonstrates, opponents have successfully pursued legislation that has drastically weakened the estate tax over the past two decades. In spite (or perhaps because) of this political history, taxing wealth transfers (as well as wealth itself) remains popular with a substantial portion of the public.⁴⁷ Supporters of wealth transfer taxation focus on egalitarian and welfarist justifications, while opponents generally rely on libertarian arguments. This Article’s goal is not to evaluate the strengths and weaknesses of those arguments in depth, which an extensive body of work does elsewhere. Instead, it is to provide an overview of this debate so that readers can better understand how people think about the estate tax so that they can evaluate the attractions of a Rignano tax.

A. Arguments in Favor of Wealth Transfer Taxation

Equality of Opportunity

Perhaps the most popular argument for taxing wealth transfers stems from the principle of equality of opportunity.⁴⁸ This ideal holds that each individual—regardless of arbitrary characteristics such as race or gender—should have an equal shot at pursuing her vision of the good life, while still bearing responsibility for her decisions.⁴⁹ In tax and legal scholarship, the most common instantiations require “redistribution from those with greater means and opportunities to those with less.”⁵⁰

These “liberal egalitarian” theories⁵¹ rest on two arguments. First, the financial circumstances of birth impact one’s ability to develop one’s talents. An intelligent child born to poor parents generally does not have the same educational opportunities as one born to wealthy parents.⁵² Well-off parents can afford private school tuition or a house in a high-quality school district,⁵³ tutors, and challenging after-school programs. Parents of athletes pay for private coaches, travel teams, and expensive summer camps. Well-off children do not have to work to help pay the rent but can instead spend time on their studies and resume-building activities like internships. And once a child is grown, wealthy parents can provide seed money for a business, pay for graduate school, or cover the down payment on a house. Second, these circumstances are arbitrary. A child does not choose to be born into a rich or poor family, just as she does not choose her race.

Equal opportunity therefore requires some ex ante equalization of resources so that a poor child with an IQ of 150, Mozart’s musical genius, or a keen business sense has the same shot at success as a richer child. In theory, taxing wealth transfers both reduces their size (in turn diminishing the advantages of being born into a rich family) and creates revenue to fund redistribution to those with fewer opportunities.⁵⁴

Dynastic Power

A related justification is to minimize the intergenerational transmission of power.⁵⁵ As our founders recognized, rejecting hereditable power is one of our fundamental values.⁵⁶ Yet great wealth often brings economic and political power over others.⁵⁷ Those favoring wealth transfer taxes on these grounds point to the following.

First, money enables one to make substantial political donations. Donors become de facto gatekeepers and agenda setters, influencing who more easily stays in the race and which issues gain prominence.⁵⁸ Substantial contributions plausibly increase access to elected officials⁵⁹ as well as influencing legislative behavior.⁶⁰ Large contributors often obtain influential positions such as ambassadorships or bureaucratic posts.⁶¹ Having a lot of money also makes it easier to run for office. Consider recent presidential candidates Tom Steyer⁶² and Michael Bloomberg⁶³ as well as President Donald Trump.⁶⁴ Closer to home, numerous candidates in U.S. Senate and House races⁶⁵ and state and local elections⁶⁶ have also spent plentiful sums of their own.

Money also allows one to influence public opinion,⁶⁷ most directly through unlimited, anonymous contributions to Section 501(c)(4) social welfare organizations that can advocate for and against candidates, lobby, and conduct issue advocacy. The wealthy can shape the media’s news and editorial coverage through advertising purchases⁶⁸ or from owning media companies directly.⁶⁹ And finally, the ability to influence policy (both directly and indirectly) also accompanies wealth.⁷⁰ Threats to relocate businesses, cancel events, or abandon planned openings or expansions can influence elected officials eager to protect local economies, even when the policies in question are not directly business-related.⁷¹ Business leaders are often consulted for advice by policymakers,⁷² be it through informal conversations or official advisory councils.⁷³ And more directly, such leaders are often named to policy-making positions that require special knowledge precisely because of the skills and expertise that made them successful. Lastly, the traits that bring business success often enable business leaders to naturally become civic leaders.⁷⁴

Wealth can also mean having economic power over others, especially in areas where a few families dominate economic life. Although the days of official company towns are long-gone, some influential families still control much of the employment opportunities in certain communities—for example, the Kohler family in Wisconsin.⁷⁵Elsewhere, residents might depend on a small set of firms for groceries, housing or other needs, such as cars. Decisions about what food to stock and at what prices, whether to raise rents or wages, expand or close a firm, and the like directly impact residents’ lives.⁷⁶ Handing the family business (or controlling chunks of publicly traded companies) down to one’s heirs is therefore tantamount to handing them economic power over others.

Inheritances and Ability to Pay

A third justification for taxing wealth transfers proceeds from the principle that political institutions should maximize welfare.⁷⁷ This argument equates welfare with utility and assumes that individuals have identical utility functions that decline as wealth and income increase.⁷⁸ Redistribution from an individual with more income or wealth to an individual with less thus increases overall utility. The catch is that taxing higher-income (or higher-wealth) individuals may lead to reduced labor and investment, decreasing overall welfare. The optimal tax literature thus argues that the ideal solution would be to tax ability, which cannot be minimized the way one can choose to work less.⁷⁹ But since ability cannot be directly observed, the next best is to tax income as a proxy.⁸⁰

Starting from this premise, some theorists argue that gifts and bequests received also reflect well-being and ability and should be taxed as proxies therefore.⁸¹ The reasoning is two-fold. If you are comparing two individuals with identical labor income, ignoring the fact that one receives a large inheritance is nonsensical—just as ignoring any other inflow, such as winning the lottery, would be. Second, the receipt of gifts and bequests is linked to a variety of “nonfinancial inherited assets and traits that powerfully affect earning ability.”⁸² These theorists generally reject the standard optimal tax account that taxing capital (which an estate tax does) creates too many economic distortions on three grounds.⁸³ First, they argue that this account overestimates the share of bequests made for reasons that are responsive to tax versus those that are not responsive. For example, someone who is saving to fund a comfortable retirement or for medical and long-term care as they age, and who “accidentally” leaves whatever is left to their heirs, will not really be influenced by taxation. Second, they contend that observed declines in wealth accumulation that correlate to transfer taxes are plausibly attributable to tax avoidance or increased lifetime gifting rather than reduced savings.⁸⁴ Lastly, these theorists note that most studies ignore recipients, who often work less after receiving an inheritance.

A Wealth Transfer Tax as a Periodic Wealth Tax

The foregoing arguments focus on the significance of transferring wealth. In contrast, a second set of justifications focuses on its very existence. But because political and administrative hurdles render taxing wealth itself difficult (if not impossible), taxing wealth transfers is an indirect solution.⁸⁵

Wealth Inequality and Democratic Concerns. A first justification for taxing wealth is to protect our democratic institutions.⁸⁶ There is a strong link between money and political influence, and people have different amounts of money.⁸⁷ As a result, many argue that money muddles the ideal that “the political system should . . . treat[] all citizens as free and equal participants.”⁸⁸ One concern is that the preferences of constituents with money will be prioritized over those without.⁸⁹ A growing body of evidence suggests that policymakers are more responsive to the views of the former;⁹⁰ this phenomenon has been observed at both the state⁹¹ and federal level,⁹² across a range of policies,⁹³ and especially when the two sets of views diverge.⁹⁴ This is both fundamentally at odds with a core tenet of democracy,⁹⁵ and creates a second harm by distorting the deliberative process.⁹⁶ If the system ignores information about the preferences of a large chunk of society, policymakers may lack all the information necessary to make fully-informed decisions. This vacuum also prevents the deliberative system from benefiting from a diversity of viewpoints.⁹⁷ A similar yet distinct harm from overweighting the preferences of the affluent is inefficiency. Here, the concern is that neither the harms to the non-affluent from policies favored by the wealthy nor the benefits from policies favoring the non-affluent will be taken into account. As a result, the true costs of a

variety of policies are obscured, potentially resulting in indirect redistribution to the affluent.⁹⁸

Economic Externalities from Wealth Concentrations. A similar justification for taxing wealth is that large wealth concentrations harm the economy.⁹⁹ Although short-run studies are mixed, several long-run studies suggest that highly unequal concentrations of wealth are negatively correlated with economic growth.¹⁰⁰ Several plausible explanations exist, but two appear most likely.

First, high levels of inequality might lead to underinvestment in education and health. Poorer families often face borrowing constraints that encourage young adults to enter the workforce rather than continue with schooling that increases skills and later income. In turn, fewer resources will be available to pass on to the next generation, compounding the cycle.¹⁰¹ A complex link between wealth, fertility, and education may also exist. Wealthier families tend to have fewer children, leading to greater investment in each one; the opposite is generally true for less-wealthy families.¹⁰² At the societal level, societies with higher levels of inequality may invest less in educational opportunities for the less well-off.¹⁰³

Somewhat similarly, high levels of inequality might decrease societal investment in health care.¹⁰⁴ And on the micro-level, having a relatively low income or social status might negatively impact an individual’s health, which imposes costs in terms of lost human capital and diverted financial resources.¹⁰⁵ Second, unequal concentrations of wealth are linked to social unrest and diminishing social cohesion, both of which can also contribute to slower economic growth in a number of ways.¹⁰⁶ It is plausible that in highly unequal societies, individuals engage in more rent-seeking, which misallocates resources. Inequality also contributes to sociopolitical instability, which both disrupts normal market and economic activities (think

of labor strikes) and creates an environment of political and legal uncertainty.¹⁰⁷

Owning Wealth and Ability to Pay. A final justification for taxing wealth is that simply holding it reflects ability to pay. Consider two people who each have $75,000 of labor income. If one also has several million dollars in the bank, shouldn’t that change our assessment of whether the two have an equal ability to pay tax?¹⁰⁸ After all, the mere existence of wealth enhances one’s financial capacity.¹⁰⁹ It also brings comfort, security, and status, all of which are intrinsically valuable and plausibly make it easier to generate even more wealth.¹¹⁰ Second, recall the welfarist ideal that tax burdens should track ability or endowment, and that income is the best proxy. Due to the realization requirement, our income tax system does not tax all economic income as it accrues. Some therefore propose taxing wealth periodically to capture the same measure more fully.

B. Arguments Against Wealth Transfer Taxation

While advocates of wealth transfer taxes tend to rely on arguments that reflect egalitarian and welfarist ideals, opponents generally ground their criticisms in libertarian and libertarian-adjacent arguments about efficiency, property rights, and the appropriate role of government. These can be a bit hard to categorize because scholarly opposition to wealth transfer taxes is scant in comparison to scholarly support. Most of the arguments made by everyday estate tax supporters are also fleshed out with care by academics. This is less true, however, for many of the opinions held by everyday estate tax opponents. Nonetheless, we can sort these critiques into roughly two groups.¹¹¹ The first set opposes wealth transfer taxes because they have differing normative visions of the role of government, a just distribution of resources, and fairness. The last set focuses on the efficiency of wealth transfer taxes to argue that they are themselves harmful.

Equality of Opportunity Revisited

The argument that equality of opportunity requires redistributing resources from rich to poor is contested.¹¹² Another interpretation of equal opportunity, known as “careers open to talents” or “the merit principle,” instead focuses on open competition.¹¹³ On this view, resources are irrelevant to one’s ability to compete for jobs, school admissions and scholarships, and the like; what counts is whether all individuals have a chance as a formal matter to compete.¹¹⁴ This ensures that positions are awarded based on merit to the most talented, instead of to the less talented due to arbitrary and unrelated characteristics like race or sex. Advocates of the merit principle often point to rags-to-riches stories such as media personality Oprah Winfrey, clothing designer Ralph Lauren, and Starbucks CEO Howard Schultz as proof that formal nondiscrimination sufficiently ensures a level playing field. If one interprets equal opportunity in this manner—as many Americans do—then one would naturally oppose any tax designed to redistribute wealth or income on equality of opportunity grounds, including a wealth transfer tax.

Rejecting Declining Marginal Utility and Progressivity

Many similarly contest the various arguments relating to the declining marginal utility of wealth and income. Some oppose the estate tax because they believe that redistribution to maximize welfare is beyond the proper scope of government, even if they accept the premise of declining marginal utility.¹¹⁵ Others question the assumption itself.¹¹⁶ Richard Epstein emphasizes, for example, that dollars are not ends unto themselves, but rather means. As he writes, “The decline in the marginal utility of an additional steak after you have already eaten one may be very high. But wealth is convertible into any number of different goods, so in each case the decline in utility has to be measured by referring to the utility of the most desired good as yet unpurchased.”¹¹⁷ And there’s some evidence supporting this view,¹¹⁸ including work suggesting that although utility likely declines as income rises in the lower range, it then increases with income in the middle range before declining again, creating an S-shaped curve.¹¹⁹

A related set of critiques reflects the normative dispute over whether the overall tax system should impose progressive or proportionate tax burdens.¹²⁰ Supporters of progressivity favor taxes that target the wealthy—such as estate taxes—as a way to increase the progressivity of the overall tax system.¹²¹ Opponents of progressivity naturally oppose such taxes, favoring proportionate taxes for several reasons.¹²² Some accept the ideal that tax burdens should track one’s ability to pay but reject the assumption that declining marginal utility requires imposing higher tax rates on the wealthy—the “equal sacrifice” argument. If utility does not decline, then taxing everyone at the same rate imposes an equal sacrifice, negating the need for progressive rates.¹²³

Others reject the ability-to-pay principle, instead arguing that taxes should reflect how much one benefits from the societal infrastructure (the “benefit” theory). As Friedrich Hayek explains, “since almost all economic activity benefits from the basic services of government, these services form a more or less constant ingredient of all we consume and enjoy and that, therefore, a person who commands more of the resources of society will also gain proportionately more from what the government has contributed.”¹²⁴ Richard Epstein analogizes the state to a partnership, highlighting that partnerships default to the “pro rata division of gains and losses derived from any common venture,” which ensures that “every individual [is] made better off to the same degree, that is, receive the same rate of return on his proportionate investment in social infrastructure.”¹²⁵

Private Property Rights

A third normative objection is that estate and inheritance taxes unjustly interfere with private property rights.¹²⁶ Supporters of strong private property rights, ranging from John Locke¹²⁷ and John Stuart Mill¹²⁸ to Robert Nozick¹²⁹ and Richard Epstein, overwhelmingly argue that if someone justly acquires property, she has the right to transfer that property however she likes, including by making gifts and bequests.¹³⁰ Because estate and inheritance taxes interfere with this right, they are not simply unjust, but uniquely unjust. As philosopher Loren Lomasky argues, they are “an especially cruel injury because [they] deprive[] the dead of one of their last opportunities for securing the goods that they value.”¹³¹ On this account, choosing to make a gift or bequest expresses the identity of the donor in a way that selling property does not. It is a sign of her affection for the recipient, as well as her values.¹³² Just as other intimate family matters relating to the expression of values—such as which holidays to celebrate and whether to go to church—should be immune from state interference, so too should gratuitous transfers. Moreover, gifts and bequests take place in the private realm of the home and neither avail themselves of the market infrastructure nor represent a voluntary entrance into the public sphere. In contrast, most taxable activity—like selling labor or property—represents a voluntary entry into the public sphere whereby one willingly consents to the burdens of taxation in exchange for using the market infrastructure. Perhaps, then, the intrusive burden of taxing gifts and bequests (e.g., tracking, valuing, and reporting) in the private sphere should be given more weight than the burden from taxing transactions in the public marketplace.

Double Taxation

Many also view the estate tax as double taxation.¹³³ Although this critique is extremely common among members of the public, policymakers and scholars tend to be dismissive of it as betraying a misunderstanding of the broader tax system. They first note that because of the realization requirement,¹³⁴ many wealthy individuals have never paid income tax on the increase in value of their investments.¹³⁵Studies suggest that untaxed appreciation comprises an average of 32% of smaller estates (a few million dollars) to 55% of large estates (those in the $100 million range).¹³⁶ To some extent, then, estate tax supporters are correct that opponents wielding the double taxation argument either misunderstand this point or overstate their case.

But what about wealth that has already been taxed, such as labor income invested in assets such as taxable savings accounts? Estate tax opponents are correct that an estate tax taxes this twice.¹³⁷ And to many, that just seems unfair on a gut level, despite various counterarguments. One counter is that the same income is often taxed multiple times to the same person; think of income, payroll, and sales taxes. Another counter is that recipients of gifts and bequests do not include them in income. Therefore, taxing gifts and bequests simply matches up the number of people that benefit from the property with the number of times it is taxed. If Hannah gives Iris a gift of $1,000, many argue that taxing both of them makes sense since each benefits from the funds. Hannah could have spent that $1,000 on fancy cheese, but instead chose to give the money to Iris, and she enjoys the warm glow that comes with making a gift. And Iris has $1,000 to spend as she sees fit.¹³⁸

But many transfer tax opponents contest that Hannah benefits when she makes a gift to Iris the same way that she benefits when, for example, she pays Iris to paint her house. In their view, Hannah has transferred the ability to benefit from the funds to Iris. Since only one person—Iris—ends up benefitting, only one person should be taxed. Since Hannah was already taxed via the income tax, it makes no sense either to impose a separate transfer tax or require Iris to include the transfer in income.¹³⁹ Setting aside the issue of appreciated property, we can see that the double taxation argument comes down to a normative view about the definition of income. If Hannah benefits from making a gift just as she benefits from having her house painted, there is no double taxation. But if one believes that Hannah gives up her ability to benefit and passes it to Iris, then taxing gifts and bequests is double taxation. As with arguments about equality of opportunity and progressivity, this simply comes down to reasonable disagreements about normative priors.

Efficiency and Administrative Concerns

A final set of arguments highlight efficiency and administrative concerns. For some, these concerns alone are sufficient to oppose the estate tax, even if they otherwise sympathize with its goals; for others, these concerns buttress normative critiques.

Economic Incentives. At heart, transfer taxes are taxes on savings by donors.¹⁴⁰ As such, opponents contend that they punish savers and reward spenders by raising the price of saving relative to spending.¹⁴¹ This reaction seems intuitive to many laypeople, and is arguably backed up by two recent economic analyses finding a correlation between higher estate taxes and lower wealth accumulations at death—a reduction in wealth at death of roughly 10% for the very wealthiest taxpayers.¹⁴² Some theorists–such as economists who deploy optimal tax analysis—thus argue that transfer taxes decrease overall welfare by shrinking the size of the pie available for redistribution.¹⁴³ Professor Ed McCaffery offers a twist on this argument, arguing that the estate tax exacerbates inequalities of opportunity by encouraging lifetime consumption and early spending.¹⁴⁴ And many everyday people simply recoil at the idea of a tax that seems to single out behavior (working hard, saving, and frugality) that our society deems virtuous.

Harm to Small Businesses and Family Farms. A related critique—one that strongly resonates with the public—is that the estate tax harms small businesses and family farms. To that end, estate tax opponents frequently recount stories of families who allegedly have been or will be forced to sell farms and small businesses to pay the tax.¹⁴⁵ (The story of Lester Thigpen, an African-American tree farmer from Mississippi who was the grandson of slaves, is a prime example.)¹⁴⁶ Opponents also emphasize the costs that families must incur to plan for the tax, such as purchasing insurance to provide liquidity and paying advisors to help minimize potential taxes.

To the ire of estate tax supporters, however, many (if not all) of these stories are unproven. Namely, many of the individuals profiled by estate tax opponents would not have been subject to the tax, even at its pre-EGTRRA levels. And according to Michael Graetz, neither the American Farm Bureau nor New York Times reporter David Cay Johnston could find any farms that had actually been sold to the pay tax after a search in the late 90s.¹⁴⁷ Nevertheless, the possibility (however remote) that a family farm or small business could be harmed troubles many Americans. Moreover, many estate tax opponents overlook that this possibility becomes more likely were exemption levels to drop, and rates to increase, as they advocate.

Avoidance Costs. Another efficiency-related concern is that the tax raises little revenue while encouraging wasteful tax planning that renders the tax essentially voluntary.¹⁴⁸ In 2020, for example, the estate and gift taxes together raised only $17.6 billion—roughly 0.1% of gross domestic product.¹⁴⁹ Meanwhile, millions—possibly billions—of dollars¹⁵⁰ are spent each year on avoidance activities that involve complicated legal structures.¹⁵¹ Because of the availability of these structures to well-advised families, many view the estate tax as a “voluntary” tax that only the less-sophisticated, semi-wealthy pay, while the truly wealthy avoid it.¹⁵² Here, opponents of the estate tax see another reason to reject it, while supporters see a reason to strengthen it.

Administrative Costs. A related critique is the cost and difficulty involved in administering the estate tax. Some opponents estimate that taxpayers spend almost $20 billion annually complying with the tax,¹⁵³ although supporters of the tax dispute this figure. One contributor to high compliance costs is valuation difficulties.¹⁵⁴ While the assets of many middle- and upper-middle class individuals such as lawyers and doctors are fairly easy to value–cash, brokerage and retirement accounts, publicly-traded stock, and straightforward real estate like suburban houses—the same is not true for the wealthy. One estimate suggests that roughly half the assets owned by the wealthiest 1% of American families are hard to value, including unique real estate, closely held stock, noncorporate business assets, farm assets, private equity and hedge funds, art, limited partnership interests, and other miscellaneous assets.¹⁵⁵ Moreover, taxpayers can engage in a number of complicated transactions to artificially minimize the value of normally easy-to-value assets like stock.¹⁵⁶ To opponents, the fact that valuation is costly, time consuming, and imprecise is another reason its limited revenue is not worth the cost.

III. Settling the Debate with a Rignano Tax

As Section II shows, the debate over estate taxation is complex, implicating both normative values and empirical questions. The recent weakening of the tax suggests that opponents are winning this debate, to the great frustration of estate tax supporters who repeat the following laments: If only the public understood that the tax affects a mere sliver of the population and how few family farms and small businesses are impacted by it. If only the public knew that the tax’s burden likely falls on heirs, who have not in fact done anything to earn the wealth in question. If only opponents could see that the estate tax is not double taxation, due to the realization requirement and the step-up in basis. If only the public appreciated the harms of inequality.¹⁵⁷

Estate tax advocates thus keep recycling the same tactics. One approach is to try to correct the public’s factual misperceptions about double taxation, the impact on family farms and small businesses, and how many estates are hit by the tax.¹⁵⁸ Another is to argue that taxing the recipient instead of the transferor (via an accessions tax or income inclusion) would better display the tax’s goals and burdens to the public, thereby convincing them of the value of taxing wealth transfers.¹⁵⁹

But these approaches miss the mark by failing to adequately account for deeply held beliefs shared by a large portion of the population about fairness, desert, private property, and family. This Section first explores these beliefs, as well as seemingly contradictory views on equal opportunity and democratic participation that are also widely held. It then argues that a Rignano tax is the best way to reconcile the competing moral intuitions held by many Americans.

A. Attitudes Toward Taxation, Fairness, Redistribution, and Equality

Crucially, these beliefs about fairness, desert, and property rights—which Liam Murphy and Thomas Nagel call “everyday libertarianism” and which economist Steven Sheffrin terms “folk justice”¹⁶⁰—often do not overlap with the philosophical and economic frameworks favored by policymakers and academics. Sheffrin explains:

Ordinary individuals hold a set of psychological principles about fairness in taxation that are considerably broader and that differ in systematic and fundamental ways from the ideas of fairness that dominate our public debate today. . . . [T]he emphasis on tax fairness as redistribution comes from academic work in philosophy and economics that, in many ways, stands apart from the concerns that motivate everyday people. . . . [T]ax fairness is important, but it is not synonymous with redistribution. To the average person, tax fairness means something else, primarily receiving benefits commensurate with the taxes one pays, being treated with basic respect by the law and the tax authorities, and respecting legitimate efforts to earn income. The average person is not totally indifferent to inequality, but concerns for redistribution are moderated by the extent to which income and wealth have been perceived to be earned through honest effort.¹⁶¹

Because the public takes these views so seriously, policymakers who simply try to convince the public to change its views face an uphill battle. For example, Murphy and Nagel acknowledge that their argument that pre-tax income is meaningless is “counterintuitive” and that “[c]hanging this [belief] would require a kind of gestalt shift, and it may be unrealistic to hope that such a shift in perception could easily become widespread.”¹⁶² Sheffrin terms this “resonance,” arguing that “[a]ny ethical or social theory that does not resonate with folk ideas will be doomed to eventual failure as a vehicle for social change. Understanding folk ideas of justice is then essential to building effective social structures.”¹⁶³

Going further, many theorists argue that when policymakers fail to take these views seriously, they end up undermining their own normative aims.¹⁶⁴ Zachary Liscow illustrates with the common law and economics wisdom that redistribution should take place solely in the tax and transfer system. He argues that this approach makes sense in theory but fails in the real world because it “ignores how ordinary Americans think about [taxes] and thus ends up exacerbating inequality rather than mitigating it.” As a result, “tax policy runs up against political constraints—driven by ordinary people’s

attitudes about taxation” that prevent tax policy from accomplishing policymakers’ goals.¹⁶⁵

Taxation and Folk Justice

What are these attitudes? One key belief relates to what moral philosophers call “desert” and what Steven Sheffrin terms “equity theory.” To everyday people, there should be a roughly proportional relationship between effort and results.¹⁶⁶ People believe that the money they earn belongs to them,¹⁶⁷ and that if they “earn more money, they deserve to keep a decent share of it.”¹⁶⁸ Even those who critique this belief acknowledge that the “idea that people deserve to be rewarded for thrift and industry” is natural to many and that “it can seem preposterous” that hard-working individuals who are willing to take risks do not deserve more than the lazy and unadventurous.¹⁶⁹ Although scholars debate the merits of these views,¹⁷⁰ numerous studies suggest that substantial portions of the public subscribe to them.¹⁷¹ As Murphy and Nagel recognize, to many, these views are “instinctive[],”¹⁷² “ingrained,”¹⁷³ and “hard to banish from [] everyday thinking.”¹⁷⁴

These beliefs lead to a distaste for redistributive taxation generally, and to some extent, opposition to the estate tax simply reflects these general principles of folk justice. But Sheffrin identifies two further aspects of folk justice that supercharge these attitudes as applied to the estate tax. In his view, the fact that estate tax opponents have successfully capitalized on these folk justice beliefs—while estate tax supporters have ignored them—explains a large part of the tax’s deep unpopularity.¹⁷⁵ (Polls consistently suggest that roughly fifty percent of the population supports repealing it entirely).¹⁷⁶

Moral Mandates. One concept is that of moral mandates, which are deeply held, non-negotiable subjective beliefs about right and wrong. These beliefs are resistant to logical argument, and can be seemingly inconsistent, such as when a pro-life advocate also favors the death penalty.¹⁷⁷ When something contravenes a moral mandate, it generates a level of outrage that might seem excessive. An act becomes “wrong” and not merely “disagreeable.”

According to Sheffrin, several of the arguments discussed in Section II.B. rise to the level of moral mandates. One is that imposing a tax when someone dies is simply immoral. On this account, the estate tax “comes at the worst possible time for families – the death of their family’s breadwinner.”¹⁷⁸ People are simultaneously grieving their loved ones and worried about providing for the family that’s left behind. Telling people that it’s not death per se that triggers the tax but instead the transfer of wealth; or that grieving families have to deal with all kinds of logistical and business arrangements, such as funerals and the probate process; or that the families affected by the tax are wealthy and well-provided for, will not make any headway. The tax is associated with death, and that simply seems immoral to many.

Another moral mandate—one which polling data suggests has been extremely influential—is that double taxation is unfair.¹⁷⁹ People have deeply-held beliefs that if someone works hard and saves their whole life, paying taxes as she goes along, she should be able to leave her wealth to her family at her death without the government swooping in a second time.¹⁸⁰ And again, telling people that double taxation is not unique to the estate tax, or that much wealth subject to the estate tax has not already been taxed, is pointless.

And finally, people value entrepreneurship.¹⁸¹ They view the tax as disincentivizing hard work and wealth accumulation, thus undermining another deeply held value. Demonstrating that very few small businesses or family farms owe the tax, let alone need be liquidated to pay the tax, is largely fruitless.

System Justification. In addition to touching on moral mandates, Sheffrin argues that the tax also implicates “system justification theory.” This theory—somewhat like cognitive dissonance—posits that individuals adapt their beliefs to defend existing systems and the status quo, even when they do not appear to benefit from those systems. They thus react strongly to threats to that system, even when people other than themselves—such as the wealthy—will be the ones harmed by those threats.¹⁸²

Specifically, the estate tax appears to threaten two key systems: the family and our meritocratic system that rewards talent and effort. Even if the estate tax will not affect the majority of Americans, many view wealthy businesspeople as “valuable members of society who deserve their wealth and support the American economy.”¹⁸³ As such, a tax that affects them undermines an entire system of which they are a part. Likewise, even if the families affected by the tax are rich families, taxing them when they engage in a familial act of generosity threatens the family system that we are all a part of.¹⁸⁴

Policy Silos

At the same time that the public opposes estate taxes, however, it also shares many of the values highlighted by its supporters. Economist Stefanie Stantcheva’s recent empirical work on how people reason about income and estate taxes illustrates this seeming contradiction. In a large-scale representative survey, Stantcheva finds that 58% of respondents believe that parents should be able to pass along whatever they wish to their children, even if that creates unequal opportunities at a societal level, and that 61% of respondents believe that it is unfair to tax the estates of hard workers. Yet in this same group,

68% say that it is unfair that children from wealthy families have access to better amenities such as schools;

64% believe that the wealth distribution is unfair; and

46% view inequality as a serious issue.¹⁸⁵

Stantcheva is not the first to note that many people hold a variety of conflicting beliefs simultaneously. In fact, her findings illustrate another aspect of moral mandates—people form them on an issue-by-issue basis. They do not represent an overarching world view, and they may contradict each other, as when a pro-life advocate also favors the death penalty.¹⁸⁶

Zachary Liscow calls this phenomenon “policy silos,” meaning that “ordinary people hold category-by-category views about what is just for a given policy and apply those views partly in isolation.”¹⁸⁷ For example, people view taxation and transportation separately, such that they may oppose redistributive taxation but favor redistributive transportation policy. The former is “giving” money to the poor, while the latter is helping them get to work.¹⁸⁸ Stantcheva’s findings echoed this observation, as respondents’ views differed based on whether the questions focused on parents/transferors or children/transferees. To put it in Liscow’s terms, people appear to view estate taxes in a different silo than equal opportunity concerns.

As a result of siloing, public support for two economically identical but superficially different programs can vary based on framing.¹⁸⁹ This has two implications. First, Liscow argues that lawmakers should not rely on the tax system as the sole means of redistribution but should also implement redistributive policies elsewhere. A second implication is that when policymakers do use the tax system for redistributive or similar reasons, they should take advantage of siloing, as the public’s dislike of one tax might not necessarily translate into a dislike of a different tax. Joseph Thorndike has observed, for example, that even though the public hates the estate tax, it favors wealth taxes.¹⁹⁰

A Rignano Tax Reconciles These Competing Intuitions

What does all this mean for wealth transfer taxes? One common suggestion is to replace the estate tax with a recipient-focused accessions or inheritance tax.¹⁹¹ The hope is that focusing attention on recipients will shift the debate more firmly into the equal opportunity silo instead of the tax silo, as well as lessening the intensity of some of the moral mandates around double taxation, entrepreneurship, hard work, and thrift.

This Article takes that suggestion one step further. A Rignano-style accessions tax that exempts first-generation transfers does an even better job of incorporating folk justice and people’s everyday psychological intuitions about the estate tax. Imagine the following structure (which Section IV fleshes out in more detail): Grandfather builds a business from the ground up and bequeaths $10,000,000 to Mother. No tax is imposed, but if Mother does not create any wealth of her own and simply retransfers $10,000,000 to Daughter, all of Mother’s estate is taxed. In contrast, if Mother creates new wealth, different portions of her estate are treated differently. The inherited $10,000,000 that Mother re-transfers is taxed, while any newly earned wealth is not.

By allowing individuals to make tax-free transfers of wealth that they themselves have earned—but not wealth that they have merely inherited—a Rignano tax acknowledges the very real, deeply-held value that the public places on hard work, entrepreneurship, and notions of desert while also addressing the concerns people hold about the prevalence of inherited wealth.¹⁹²

IV. A Rignano Tax

The idea of taxing second- or third-generation wealth more heavily than newly earned wealth has a long history. Roughly 100 years ago, Eugenio Rignano offered the first sustained treatment of it, arguing that such a tax is the best way to move gradually toward socialism.¹⁹³ Rignano believed that the means of production should eventually be owned by the government, but that individuals, not the government, are better wealth-creators. He thus proposed a tax that would exempt transfers by wealth-creators, tax second transfers at 50%, and tax third transfers at 100%. This, he believed, would be the most efficient way to implement socialism.¹⁹⁴

Libertarian Robert Nozick later picked up this idea, albeit for decidedly non-socialist reasons. In The Examined Life, Nozick suggests that a Rignano-type structure is the best means of balancing competing intuitions about family ties, wealth and inheritance, and fairness. He first defends the right of individuals to bequeath what they have created themselves as an act of love: “Bequeathing something to others is an expression of caring about them, and it intensifies those bonds. . . . [T]he donor . . . has earned the right to mark and serve her relational bonds by bequeathal.”¹⁹⁵ But he does not view second-generation inheritances as a similar act of love, due to the lack

of connection between the person who created the wealth and the second recipient.

He also acknowledges, moreover, that when wealth is “passed on for generations to persons unknown to the original earner and donor, [it] produc[es] continuing inequalities of wealth and position” and that the “[t]he resulting inequalities seem unfair.”¹⁹⁶ Unfortunately, Nozick’s discussion of this tension is rather sparse. He does not explain, for example, why he believes the resulting inequalities are unfair. Nor do we know whether first-generation bequests are inherently fair, or whether they are unfair, but whose unfairness is outweighed by the value of the donor’s ability to express affection and love.¹⁹⁷

And most recently, philosopher Daniel Halliday argues that a Rignano tax furthers equality of opportunity ideals better than traditional estate and inheritance taxes. In his view, context matters—that is, whether someone is born into a family that has not just wealth, but long-standing wealth and the social and cultural capital that accompanies it (let’s call these “wealth norms”). Imagine that Grandfather starts with nothing, builds a successful business, and leaves all his wealth to Mother at his death. Halliday believes that this bequest does not give Mother a head start in life. Her life prospects were largely shaped long before receiving her inheritance, when she was young and Grandfather was still building his business. He had not yet amassed enough wealth to pay for private school and expensive tutors for Mother, to give her seed money to start her own business or to launch her own career. Moreover, Grandfather’s self-made status suggests that the family did not have wealth norms when Mother was growing up. Instead of golfing at a country club, Grandfather likely bowled in the neighborhood bowling league and did not have the same cultural norms and social and professional networks as families with older wealth.

But now consider Mother and Daughter. Halliday argues that “parental conferral of advantage compounds over successive generations. . . . Families that have been wealthy for longer possess a greater range of powers that keep their children privileged.”¹⁹⁸ Grandfather’s bequest allows Mother to provide advantages to Daughter that she herself did not have, such as high-quality schools, tutors and after-school lessons, and expensive camps. It also means that Daughter—unlike Mother—grows up in a family with wealth norms. The family belongs to a country club, not a bowling league. Mother’s contacts can give Daughter internships, and Daughter knows which fork to use during the interview lunch and how to dress for it. For these reasons, Halliday views the transmission of wealth across three generations as a contributor to and a tag for economic segregation, which he argues undergirds unequal opportunities. As such, these inheritances should be taxed.

In contrast, Halliday contends that first-generation inheritances should not be taxed. Not only are they not problematic, but they might even reduce economic segregation by serving as a safety net keeping middle-class families afloat in a stagnating or contracting economy. Halliday observes that in many areas, the costs of housing and other necessities have skyrocketed while middle-class wages have stayed flat, rendering home-ownership unaffordable to many such families. But if Grandfather leaves the family home to Mother, or enough money for a down payment, this helps minimize economic segregation in such areas. First-generation inheritances thus counteract inequality of opportunity and therefore should not be taxed.

Implementing a tax that exempts the first transfer but taxes the second might sound simple to those unfamiliar with tax policy. Yet the devil is in the details. Implementing a Rignano tax requires resolving seven design decisions, explored below: the (1) base; (2) rates; (3) valuation; (4) frequency; (5) tracing; (6) transfers in trust; and (7) transition rules. Although a Rignano tax is complex, crafting one is possible.¹⁹⁹ As we shall see, in many instances one solution is superior regardless of why one wants to tax old money more heavily than new. With other decisions, however, differing justifications for taxing repeated wealth transfers point in different directions.

A. The Base

This section addresses three base-related decisions: Should the tax focus on transfers or receipts? Should it treat gifts and bequests equally? And should it contain any exclusions or exemptions?

Transfers or Receipts?

The first base-related question is whether to tax receipts or transfers. If Grandfather earns a fortune, leaves it to Mother, and Mother in turn passes it along to Daughter, who does the tax focus on? Does it look at Grandfather and Mother in turn, and tax Mother because she’s the one who re-transfers wealth while exempting Grandfather because he’s the one who earned the wealth? This model is akin to a traditional estate tax, which focuses on the total amount of wealth transferred by an individual over the course of her lifetime.²⁰⁰ Or does it look at each and ask who among them received re-transferred wealth (here, Daughter)? This is similar to traditional accessions or inheritance taxes, which apply to transferees based on gifts and bequests received.²⁰¹

In either case, the tax is imposed once, at transfer.²⁰² But the distinction matters, both psychologically and normatively. At first glance, one might think an estate tax model makes the most sense. If Grandfather creates the wealth, and the goal is to allow him to transfer it tax-free, then the focus should be on him. Yet this ignores many of the normative aims of those who wish to tax wealth transfers in the first instance.²⁰³

Start with dynastic wealth and equality of opportunity concerns. Looking at the sum of gratuitous transfers received by a given individual tracks ex ante differences in opportunity better than looking at aggregate transfers made by an individual. Imagine a decedent with an estate of $5,000,000. An estate tax treats her the same whether she leaves it all to one child or splits it up among ten recipients. Yet receiving $5,000,000 impacts life opportunities much more dramatically than receiving $500,000. The same is true for dynastic wealth: what matters is how much wealth someone receives. An inheritance of $50,000,000 bestows political and economic power in a way that an inheritance of $500,000 does not. As numerous commentators have acknowledged, a recipient-focused accessions or inheritance tax better reflects these concerns.²⁰⁴

Next consider the welfarist argument that gratuitous transfers received should count toward an individual’s ability to pay, just like salary, business profits, and gains from property sales. This concern also suggests a recipient-focused tax. How much wealth a transferor has does not necessarily correspond to the ability to pay of the transferee. For example, Lily Batchelder and Surachai Khitatrakun estimate that “22% of heirs burdened by the estate tax have inherited less than $500,000, while about 21% inheriting more than $2,500,000 bear no estate tax burden.”²⁰⁵

An accessions-tax framework also better addresses the concern that wealth concentrations are in and of themselves harmful by encouraging donors to split their fortunes up. An estate tax would treat Warren the same whether he leaves his fortune in one big bundle to one lucky heir, or whether he splits it up among multiple recipients. But an accessions tax treats these two situations differently, since it focuses on cumulative gifts and bequests received in excess of an exemption amount. Since each recipient has their own exemption amount, splitting a large fortune up generates a lower overall tax bill.

Finally, the psychological insights discussed in Section III.B. also point to the superiority of an accessions tax. Recall, for example, Stantcheva’s findings that support for transfer taxes rises when people focus on recipients instead of transferors.²⁰⁶ This is likely due in part to framing and siloing, but perhaps also to the fact that focusing on recipients weakens the pull of moral mandates about double taxation and hard work.²⁰⁷

Gifts

A second decision is whether the tax should apply not only to bequests but also to gifts. Although Rignano clearly suggests taxing both, Halliday is more equivocal. Halliday’s equivocation is misplaced; the tax should apply to both equally.

a. Gifts in General

Consider the various reasons for taxing wealth transfers, starting with equality of opportunity. As Halliday notes, gifts are usually received earlier in life than bequests. This creates advantages sooner rather than later for the donee and her family, thus magnifying those advantages.²⁰⁸ For this reason, Anne Alstott has suggested varying inheritance tax burdens based on the recipient’s age.²⁰⁹ Further, the act of making a gift suggests that the donor feels financially secure enough to dispose of some of her wealth while alive, which makes it more likely that her heirs grew up in a family with wealth norms.

The ability-to-pay and dynastic wealth concerns also suggest taxing both gifts and bequests. Both gifts and bequests enable recipients to spend money for political purposes as well as influence the economic lives of others. Both gifts and bequests provide utility to recipients. In fact, declining marginal utility suggests that gifts might even provide more utility than bequests of comparable size, as individuals tend to have less money earlier in their lives. And both serve as a tag for one’s nonfinancial endowment. Again, gifts may signal greater nonfinancial advantages than comparably sized bequests, as families that engage in lifetime gifting are often wealthier than families who do not.

Moreover, Halliday’s arguments for excluding gifts from a Rignano tax do not withstand scrutiny. One argument is that transferors have such a strong preference for bequests that excluding gifts would not encourage them to make gifts instead.²¹⁰ Halliday correctly observes that many transferors do not maximize opportunities to make tax-free gifts under current law and that many people save more than enough to cover the expenses of old age. He also acknowledges, however, that these statistics reflect decisions made during periods with relatively low rates and that they likely underestimate the extent to which wealthier families will change their behavior. A key part of estate planning for such families is maximizing the tax advantages of lifetime gifts, and minimizing the ability of transferors to characterize bequests as gifts creates a great deal of complexity in the current estate tax system.

Halliday also argues that taxing gifts is essentially pointless.²¹¹ He believes that most gifts can be easily concealed—unlike bequests, which are documented during probate and hard to hide. But many large gifts are similarly hard to conceal. Stock transfers are recorded; large cash transfers are tracked. And even gifts of jewelry and other family heirlooms generate records when donees insure them. Of course, under-the-table gifts will always occur, but not at a level that makes attempting to tax gifts pointless. Because this Article advocates for treating gifts similarly to bequests, later references to “bequests” or “inheritances” refer to gifts and vice versa.

b. Gifts and Timing Complications

Taxing gifts does raise a complication related to timing. Return to Grandfather, Mother, and Daughter. We do not know exactly how much Mother will inherit—which affects the accessions tax imposed on Daughter—until Grandfather is dead. If the tax only applied to bequests, this would not be a problem. But what if the tax also applies to gifts and Mother makes a gift to Daughter while Grandfather is still alive, before he bequeaths any wealth to Mother?

To illustrate, imagine that Mother gives Daughter $1,000,000 and five years later, receives $10,000,000 from Grandfather. If we look just at the first gift of $1,000,000, it initially appears to be newly created wealth that should not be taxed. But money is fungible; if Mother knows she’s about to receive an inheritance, this frees her up to make a lifetime gift to Daughter, whether from her own or borrowed funds. The tax would be easy to avoid if we simply cast any transfer from Mother’s generation to Daughter’s generation as a first transfer of wealth if it comes before Grandfather transfers anything to Mother. Yet whether Mother inherits before or after the gift to Daughter seems irrelevant if the point is to tax the second generation in a family that inherits wealth. This is especially true if one views second-generation wealth transfers as more of a welfarist or equal opportunity concern than first-generation transfers.

A “catch-up tax” that applies to transferees who have themselves made prior transfers can account for this scenario. When Daughter receives $1,000,000 from Mother, the tax—as applied to Daughter—would treat it as a first-generation transfer because at that point, Mother has not yet inherited anything. When Mother later inherits $10,000,000 from Grandfather, the tax—as applied to Mother—would treat different parts of that bequest differently. It would treat $9,000,000 as first-generation wealth and any amounts previously transferred by Mother to Daughter—here $1,000,000—as second-generation wealth.

Now consider what might happen later. One possibility is that Mother consumes the $10,000,000 she inherits from Grandfather, making no more gifts to Daughter. Because Daughter receives nothing more, no more tax is imposed upon the family. In total, $11,000,000 has been transferred within the family ($10,000,000 to Mother, and $1,000,000 to Daughter.) Overall, the tax will have treated $10,000,000 as first-generation wealth (Daughter is taxed as receiving $1,000,000 of first-generation wealth and Mother is taxed as receiving $9,000,000) and $1,000,000 as second-generation wealth (imposed on Mother via the catch-up tax at Grandfather’s death).²¹² In essence, the price Mother pays for making a lifetime gift before receiving her own inheritance is that she, not Daughter, is treated as having received a second-generation transfer.

Another possibility is that Mother later passes her $10,000,000 inheritance down to Daughter. In that case, a total of $21,000,000 has been transferred within the family ($10,000,000 to Mother, and $11,000,000 to Daughter). Of this, $10,000,000 represents a second transfer, and $11,000,000 represents newly created wealth (Grandfather created $10,000,000 and Mother created $1,000,000). When Daughter receives Mother’s $10,000,000 inheritance, the tax should therefore treat only $9,000,000 as second-generation wealth. This accurately taxes $10,000,000 of the family’s total transfers as second-generation wealth (recall that when Mother received her inheritance, $1,000,000 was treated as second-generation due to the catch-up tax), and $11,000,000 as first-generation wealth ($1,000,000 when Daughter received Mother’s lifetime gift, $9,000,000 of Mother’s receipt from Grandfather, and another $1,000,000 when Mother dies).

Exclusions and Exemptions

The last set of base-related decisions concerns exclusions and exemptions. As both Rignano and Halliday suggest, each individual should have a relatively small lifetime exclusion amount.²¹³ Assume that after Grandfather bequeaths his $10,000,000 to Mother, she has several runs of bad luck and passes along only $1,000,000 to Daughter. Even though that $1,000,000 is second-generation wealth, it seems plausible to allow Daughter to inherit something free of tax for the same reasons that most (if not all) systems have such exemptions. In addition to administrative concerns, allowing small inheritances tax-free recognizes that bequests are a natural part of most families’ lives, and that they can provide a needed cushion for many less-wealthy individuals. Any amount chosen would be arbitrary, but something like $500,000 or $1,000,000 seems reasonable.

For similar reasons, the tax should have something similar to the annual exclusion described in Section I, but on a smaller scale. The annual exclusion’s purpose is to simplify record-keeping and to recognize that intra-family gift giving for birthdays, weddings, and holidays is a normal, everyday occurrence in almost all families that does not trigger any normative concerns. These same concerns are relevant in a Rignano tax. That said, the current $19,000 per recipient exclusion is far larger than necessary to cover regular birthday and holiday gifts, and in fact, allows for much tax-free giving that exacerbates unequal opportunities.²¹⁴ As with the lifetime exemption amount, any chosen number would be arbitrary, but something like $5,000 seems reasonable.

Most transfer tax systems also exempt marital and charitable transfers. Intra-spousal transfers should not be taxed, as they do not transmit wealth down to a lower generation.²¹⁵ Charitable transfers are a bit trickier from a normative perspective. In theory, their treatment should depend on what kind of charity receives the gift or bequest. If one’s concern is equality of opportunity, for example, a gift to an inner-city tutoring program furthers equality of opportunity while other gifts may undermine it (imagine gifts to private foundations that employ family members or to a private school that provides few scholarships).²¹⁶ But if one goal of a Rignano tax is to gain public traction where other transfer taxes flounder, charitable transfers should be exempted. Charities benefit from a “halo effect,” and the point that some charities exacerbate social ills is nuanced and hard for the public to understand. Further, giving to charity is seen as virtuous, and may invoke reactions similar to the moral mandates and systems justification theories discussed earlier.

A final question is whether the relationship between the wealth creator and the second recipient should matter in determining whether a gift or bequest received is second-generation. Specifically, should second-time-around transfers that originate in a different family be exempted if the recipient is the first in her family to inherit? Halliday, for example, suggests the tax should apply to anyone whose parents or grandparents have inherited, but not to individuals who are the first in their families to inherit. That makes sense if one’s concern is equal opportunity and if one agrees with Halliday that repeated wealth transfers are the real culprit in that context due to the creation of wealth norms and economic segregation.²¹⁷

Imagine two scenarios in which Grandfather starts with nothing, earns a fortune, and leaves it to Mother. In Childless, Mother has no children and leaves her wealth to Friend’s child. Mother’s Friend neither inherits from Friend’s parents nor bequeaths any wealth to Friend’s child. In Helping Hand Family, Mother has a daughter, to whom she leaves her wealth. In both cases, Mother inherited wealth and then passed it along a second time. In that sense, both Daughter and Friend’s child have received second-generation wealth. But if the concern is that repeated wealth transfers create or signal economic segregation and wealth norms, then Daughter and Friend’s child are not similarly situated. Friend’s child is the first in Friend’s family to inherit, and in that sense, what she receives is not second-generation wealth.²¹⁸ Daughter, by contrast, belongs to the second generation of Mother’s family to inherit. This suggests looking not only at the recipient, but also at the pattern of prior transfers in the recipient’s family—if one shares Halliday’s concerns.²¹⁹

However, other normative justifications for taxing wealth transfers point in other directions. If one’s focus is dynastic wealth and traditional equality of opportunity concerns, or welfarist concerns, then the source of the gratuitous transfer should be irrelevant. Receiving unearned advantage, power, or welfare is the main concern, more than whether that receipt followed an intra-familial chain of transmission. The same is true if one’s concern is the mere existence of wealth.

Likewise, the psychological insights of folk justice suggest that treating intra-family transfers worse than other transfers would not fare well. First, system justification theory indicates that a large factor in hostility to the existing estate tax is its perceived threat to the family.²²⁰Second, it is plausible that people hold moral mandates about family businesses and family farms that would be triggered if intra-family transfers were treated worse. Thus, any softening of the public’s opposition to inheritance taxes that comes from exempting first transfers would likely be undone if familial transfers were treated worse than other second transfers.

B. The Rate

After choosing a base, one must also choose a rate. Halliday and Rignano both use examples in which first-generation transfers are not taxed, second-generation transfers are taxed at 50%, and third-generation transfers are taxed at 100%.²²¹ This Article proposes completely exempting first-generation inheritances and taxing subsequent ones at a rate of 40%, although it acknowledges that any rate will be somewhat arbitrary. Although this Article’s normative arguments point to taxing later transfers more heavily than initial transfers, they do not point to specific rates the way they signal, for example, that gifts and bequests should both be taxed. Nor does past experience illuminate the perfect rate as a technical matter. Perhaps

more than any other design question, choosing a rate reflects balancing numerous political considerations.

Initial Transfers

The rate on initial transfers should be a simple, easy to understand zero. Work on cognitive psychology and tax suggests that individuals focus on “highly visible” and “easily recallable” aspects of a tax; this is known as “prominence” or “saliency.” When thinking about income taxes, for example, the public tends to focus on the highest marginal rate.²²² Completely exempting initial transfers of wealth provides a sharp and clear distinction between initial and successive transfers in a way that merely using a lower rate does not. “You are not taxed at all when you pass along wealth that you have earned” has a salience that “you are taxed less” lacks.

The former also harnesses the power of folk justice better than the latter. Start with systems justification theory and the notion that taxing wealth transfers threatens a system that people are a part of and value. Here, it is the act of taxation in and of itself which is harmful. Taxing transfers of earned wealth at a low rate is still taxing them. Telling people that a system they care about is damaged only “a little bit” will do little to assuage the concerns of those who value the family. Damaging something valuable a little bit still damages it.

Completely exempting initial transfers also better counters the double taxation argument. Once again, it is the act of taxation—not the level of taxation—that gives this argument weight with the public. The public believes (rightly or wrongly) that the wealth-earner has already been taxed on the wealth. Educating the public about untaxed appreciation and the step-up in basis has not countered that. Nor has emphasizing that what should matter is the total tax burden, not the number of times something is taxed. Telling the public that you are taxing earned wealth less than inherited wealth will be similarly fruitless. From a folk justice perspective, the best way to address concerns that earned wealth is being double taxed is to be crystal clear that transferring it does not trigger tax. Only completing exempting such transfers does this.

Subsequent Transfers

If first-generation transfers are completely exempted, how should later transfers be treated? Rignano suggested taxing second-generation transfers at 50% and third-generation transfers at 100%; although Halliday rejects the latter suggestion, he does not address whether second- and third-generation transfers should be taxed differently.²²³ This Article proposes treating them alike by taxing all later transfers at a flat rate of forty percent.

As an initial matter, second- and later-generation transfers should be treated similarly to each other. While the insights of folk justice strongly point to distinguishing first-generation wealth, they do not justify treating later transfers differently from each other. Nor do most of the justifications for taxing wealth transfers. Gifts and bequests received increase well-being and enhance ability to pay, regardless of whether the transferor earned or inherited the wealth in question. Money is money when it comes to political spending. Similarly, under traditional equality of opportunity concerns, money is money when it comes to paying for private school tuition or houses in top school districts, tutors, or fancy camps.

That said, other justifications are plausibly consistent with distinguishing among second-generation and later transfers, even if they do not necessarily mandate such an approach. Take Halliday’s linkage of wealth norms and equality of opportunity; it is likely that the older the family’s money, the stronger the wealth norms. Likewise, it is plausible that the longer a family has been politically or economically powerful in a given town, the more powerful they are. Knowing that another family has had power over yours for decades is probably more demoralizing the longer that has been the case.

In these cases, however, any difference in power or opportunity between second- and later-generation wealth diminishes over time. Let’s illustrate with wealth norms and equal opportunity: Grandfather creates wealth, which he passes along to Mother, who in turn passes her inheritance along to Daughter. Under Halliday’s reasoning, Mother enjoys substantially fewer advantages than Daughter, since Mother grows up in a family with first-generation wealth and Daughter grows up in a family with second-generation wealth. Yet it is unlikely that Daughter has substantially fewer advantages than Daughter’s children. The marginal advantage of growing up with third-generation wealth as opposed to second is likely much smaller than the marginal advantage of growing up with second- versus first-generation wealth. The case for distinguishing between second- and later-generation inheritances is therefore much weaker than for distinguishing first transfers.

And on a practical level, treating second and third inheritances alike minimizes the valuation, tracing, and record-keeping concerns addressed below. All that need be determined is how much an individual’s parents inherited. Given the weak theoretical case for distinguishing among later transfers, and the strong practical case against doing so, treating second and later transfers similarly to each other is preferable.

This Article thus proposes a rate of 40% on subsequent transfers, which is the current estate tax rate in the U.S. This number is admittedly arbitrary, and none of the theoretical considerations discussed above mandate any given rate. That said, something about tax rates that exceed 50% seem to hit a nerve with people. And given the prominence bias discussed above, it is likely that a Rignano tax that is seen as “raising rates” above current levels would face more opposition than one that does not raise rates.

Adjusting for Age

A final rate-related issue is whether gifts and bequests received earlier in life should be taxed more heavily than those received later in life. Here, practical and theoretical considerations are in tension. Several justifications for taxing wealth transfers point in the direction of adjusting for age, such as equal opportunity theory.²²⁴As theorists recognize, receiving an inheritance early in life alters one’s life prospects more than receiving one later in life. A $1,000,000 bequest at age twenty-five provides seed money for a start-up, while such a bequest at age sixty-five likely does no more than enable one to enjoy a more comfortable retirement. Other justifications, however, do not support adjusting for age. A large bequest increases one’s ability to pay regardless of one’s age, for example. And although such adjustments could be made,²²⁵ doing so adds another layer of complexity and is probably not worth that additional complexity.

C. Frequency: Determining the Number of Transfers

A further issue is determining how many times wealth has been transferred. Revisit Grandfather, Mother, and Daughter. Two questions arise. First, if Grandfather leaves his wealth directly to Daughter in a “generation-skipping transfer” that skips over Mother, is that a first- or second-generation transfer? Put another way, should that be treated the same or differently than if he leaves it to Mother, who in turn re-bequeaths it to Daughter? Second, what if Grandfather leaves his wealth to Mother, who

dies soon thereafter? Should adjustments be made for deaths in rapid succession?

Generation-Skipping Transfers

Let’s start with generation-skipping transfers. Current law imposes an additional tax on such transfers to ensure that families face an equivalent level of tax whether their wealth proceeds directly from one generation to the next or skips over one generation. This prevents ultra-wealthy families in which Mother’s generation may not need Grandfather’s wealth from minimizing their tax burden by having Grandfather pass his wealth directly to Daughter.

Although counterarguments exist, a Rignano tax should contain similar rules that treat a transfer by Grandfather directly to Daughter as a second transfer instead of a first. This would prevent families from avoiding one level of tax by skipping generations. As under current law, however, exceptions should apply if Mother pre-deceases Grandfather, such that Grandfather’s transfer to Daughter does not skip over a living person.²²⁶

To be sure, this design decision runs counter to folk justice principles. It renders transfers directly to grandchildren vulnerable to the double taxation argument and to system justification concerns about harming families. But the Rignano tax is not a tax designed to further folk justice principles; rather, it is a tax designed to take such principles into account when designing a wealth transfer tax that achieves other goals. Here, treating such transfers as first transfers would allow for too much game-playing, thus undermining the goals of taxing second-generation wealth. Moreover, it is plausible that the treatment of such transfers will be less salient to the public than the fact that the default for first transfers is complete exemption.²²⁷ For these reasons, the better approach is to treat generation-skipping transfers as two transfers, not one.

Transfers in Rapid Succession

A related issue is how to treat transfers in rapid succession. Imagine that Grandfather bequeaths his fortune to Mother, who dies unexpectedly a few months later, re-transferring his wealth to Daughter. Should this be considered a second transfer? Halliday argues that it should not be: “A short interval between bequests may mean that a donor has had less opportunity to save and accumulate due to an early death. It is harder to say, in that case, that this person’s bequests should still be taxed as if he or she had remained idle.”²²⁸

Halliday’s approach is misguided; transfers in rapid succession are still transfers. Halliday is correct that Mother has had less time to build upon Grandfather’s inheritance after receiving it. Yet he ignores that she had time before either her or Grandfather’s death to earn her own wealth, and that wealth will be taxed as first-generation wealth. Counting each transfer treats Mother and Daughter the same as other families.

D. Valuation

Perhaps the most difficult issue is how to value re-transferred wealth. Revisit Grandfather, who starts with nothing and builds a $10,000,000 fortune. He bequeaths his wealth to Mother, who later dies with a $50,000,000 fortune which she leaves to Daughter. How much of Mother’s $50,000,000 should be considered a second transfer of Grandfather’s wealth? Rignano and Halliday, without discussion, use a simple but flawed approach in their examples: they would treat $10,000,000 as a second transfer and $40,000,000 as newly created wealth.

The Problem

This approach erroneously overlooks the fact that asset values fluctuate over time due to a variety of causes—inflation, the time value of money, changing market conditions, and the owner’s efforts. Take inflation. Imagine that Mother invests her inheritance in an asset that keeps exact pace with inflation. $10,000,000 inherited in 1993 has an inflation-adjusted value of roughly $22,700,000 in 2025.²²⁹ The Rignano/Halliday default wrongly treats the $12,700,000 increase that is due to inflation as instead stemming from Mother’s efforts. But Mother has added no value. The asset has simply kept up with inflation.

Risk-Free Rate of Return as the Default Solution

A more accurate approach would impute the risk-free rate of return to Grandfather’s fortune. This better distinguishes between earned and inherited wealth by recognizing the dual roles of risk and choice. To illustrate, imagine that Grandfather leaves Mother a building worth $10,000,000 that is worth $30,000,000 when she re-bequeaths it to Daughter. As explained above, attributing only $10,000,000 of the building’s value to Grandfather overstates Mother’s contribution and understates Grandfather’s. Yet attributing all $30,000,000 to Grandfather does exactly the opposite. It overstates Grandfather’s contribution and understates Mother’s.

What is key is that when Mother inherited the building, she had a choice. At that point, she held $10,000,000 of wealth that she could invest however she liked. She could continue to hold that particular building, swap it for other real estate, or cash out and invest in stocks, bonds, or a risky start-up. If she keeps the building itself, some—but only some—of any later increase in value is due to her choice to do so.

More specifically, a later increase in value has three possible components: the risk-free rate of return, a return to risk, and (occasionally) inframarginal returns.²³⁰ The risk-free rate of return is the return one would receive by investing in a zero-risk project with a guaranteed return, such as a U.S. Treasury bond. This return is simply compensation for using the invested funds—a pure time-value-of-money return sometimes referred to as the “return to waiting.”²³¹

To illustrate, imagine a stock investor. Unlike a bond investor, the stock investor does not know ex ante whether she will recoup her investment. Because the company’s value could either increase or decrease, she will insist on a higher return to compensate her for taking on that risk. Most investment returns are comprised solely of these two elements, which means that the return to risk is the excess over the risk-free return.

Occasionally, an investment also yields an inframarginal return, which is a return above and beyond the market rate for risky investments. These arise from “special opportunit[ies] not generally available in the market” and are usually associated with “rents to ideas, managerial skill, or market power.” They can include unique returns to capital due to information asymmetries or imperfect markets, as well as returns to some combination of a person’s labor, ingenuity, and/or luck.²³²

Although distinguishing between inframarginal and market-rate returns is difficult, we need not do so. Mother—not Grandfather—should be credited for both whenever Mother has a choice about investing her inherited wealth. Any investment of Grandfather’s $10,000,000 would have triggered, at minimum, the risk-free rate of return and should be traced back to Grandfather’s bequest. Returns above and beyond the risk-free-rate of return, however, should be attributed to Mother.

The default rule should therefore be to attribute the risk-free rate of return—as measured by the average U.S. Treasury bond yield—to Grandfather’s investment. The best measure of this is the average yield on a U.S. Treasury Bond of comparable length. Imagine that Mother outlives Grandfather by 30 years. If so, the average rate of return for a 30-year bond should be imputed to Mother’s inheritance from Grandfather. Any “extra” wealth should be credited to Mother and treated as new, first-generation wealth.

Complications

The foregoing analysis assumes both that Mother has a choice about what to invest in, and that her investments are successful. But what if those assumptions are incorrect? Start with choice. Imagine that Grandfather bequeaths stock that skyrockets in value to a trust with an independent trustee over whom Mother has no control. Given that Mother has no say in how to invest the asset and assumes no risk herself, none of the stock’s value is attributable to her choices. The stock’s full value at her death should be credited to Grandfather. Moreover, we already have rules that identify when one has control over a trust; the Rignano tax could simply import the grantor trust rules.

Next let’s upend the assumption that Mother’s investments are uniformly successful. Imagine that Mother quickly squanders Grandfather’s fortune by investing his $10,000,000 in Blockbuster Video stock. She later, however, invests in a relatively unknown start-up called “Google,” parlaying a few thousand dollars into $10,000,000. How should Mother’s fortune be treated at her death?

Mother’s fortune should still be treated as inherited and traced back to Grandfather for three reasons (an approach favored by Rignano).²³³ First, Mother is able to leave Daughter $10,000,000 more than without Grandfather’s wealth. His bequest enables Mother to start at $10,000,000; lose $10,000,000; and nevertheless end at $10,000,000. Without the bequest, if Mother loses and re-earns $10,000,000, she ends at zero. Second, if we assume that Mother would have earned the risk-free rate of return when successfully investing Grandfather’s bequest, parity requires us to make the

same assumption even when the outcome is different. Either we assume that return or we do not.

Finally, ignoring Grandfather’s bequest ignores that money is fungible and creates incentives that undermine the goals of wealth taxation by essentially encouraging Mother to squander Grandfather’s bequest. Let’s say that Mother has an idea for a successful business that will earn her $15,000,000, and Mother also wants to spend $10,000,000 on a year-long first-class trip around the world. Compare two scenarios, Early Trip and Late Trip. In Late Trip, Mother saves Grandfather’s money and starts a business that earns $15,000,000 before taking the trip. The trip reduces her bank account from $25,000,000 to $15,000,000. Under the default rule established above, we’d use the risk-free rate of return to see what Grandfather’s wealth would have grown to. For the sake of illustration, let’s assume it would have grown to $14,000,000. If so, only $1,000,000 of Mother’s bequest to Daughter is treated as earned by Mother.

In contrast, imagine what happens if we use a rule that ignores Grandfather’s bequest if she spends it or invests it poorly. Mother can reduce her tax burden by travelling before earning her own money. In Early Trip, Mother spends Grandfather’s money on the trip and zeroes out her account. She then starts a business and earns $15,000,000, which she passes along to Daughter. If we ignore Grandfather’s bequest on the grounds that she spent it or wasted it, all her $15,000,000 wealth is treated as self-made.

Mother should not be treated differently depending on what she does with Grandfather’s money. Whether she spends it, invests it poorly, or invests it wisely, she had power over $10,000,000, and at her death, $10,000,000 (plus the risk-free-rate-of-return) should be credited back to Grandfather.

E. Tracing

A fifth issue—flagged by neither Rignano nor Halliday—is determining who receives inherited wealth as it moves downstream. This has two components, one normative and one administrative.

The Normative Question

Let’s start with the normative question. We’ve been using an example with one member in each generation for simplicity. Again, assume that Grandfather leaves Mother $10,000,000, but now imagine that Mother has not one but two children, Daughter and Son.

In applying the tax to Daughter and Son, how should we decide as a normative matter who receives Grandfather’s wealth, and who receives the wealth created by Mother? Ideally, we’d somehow allocate Grandfather’s wealth to each of them in proportion to how much wealth they actually receive from Mother. This would be possible if Mother does not make any lifetime gifts, instead re-transferring all of Grandfather’s wealth at her death. Lifetime gifts, however, render this impossible.

One option is to allocate Grandfather’s bequest pro rata among Daughter and Son by giving them each a $5,000,000 “taxable amount” that is essentially a mirror-image of existing exemptions (this represents the total amount of Grandfather’s wealth that should be taxed as a second transfer when Mother passes it along, divided by two since Mother has two children). Under this approach, transfers to each of them would be taxed until they reached $5,000,000; later transfers would be untaxed. This solution, however, has two problems. First, it undertaxes the family if Mother favors one child. Imagine that Mother does not earn her own wealth, and transfers all of Grandfather’s $10,000,000 to Daughter and none to Son. Under the pro rata apportionment approach, only $5,000,000 would be treated as second-generation. Second, assigning a per-capita amount at Grandfather’s death requires knowing who Grandfather’s bequest should be apportioned among—that is, who Mother is going to leave her wealth too—which may be unknowable at his death.

A better solution is a first-in-time approach that treats the first $10,000,000 received by either Daughter or Son as second-generation, regardless of how Mother splits $10,000,000 between them. This is essentially how the current system treats a donor’s lifetime exemption amount and allows Mother to allocate the tax burden via the timing of her transfers.

Administration

The next question is how one determines as an administrative matter, that a recipient of a gift or bequest has received wealth that has been inherited by the transferor. This requires more record-keeping than a traditional estate or inheritance tax, but not an insurmountable amount. And in fact, certain elements of this Article’s proposal exist in current estate and inheritance taxes in the U.S. and internationally.

Revisit Grandfather, Mother, and Daughter. As under current law, Grandfather’s executor will file a tax return at his death that shows the total amount of gratuitous transfers that Grandfather has made. To implement a Rignano tax, his executor would also make an election on that return to treat some or all of Grandfather’s wealth as first-generation, as well as recording to whom Grandfather left his wealth. Any wealth not elected by the executor will be treated entirely as a second-generation transfer. Absent malpractice, Grandfather’s executor will make the election. Mother, who receives Grandfather’s bequest, will also file a tax return upon receipt showing the bequest’s source and value, as well as indicating whether any assets are not under her investment control. Assuming Grandfather’s executor make the proper election, however, Mother will pay no tax.

These records enable us later to determine how much of any wealth that Mother later passes along should ultimately be traced back to Grandfather. When Mother makes a gift or bequest later, we need to know three things to calculate Daughter’s tax liability: the imputed value of Grandfather’s bequest to Mother at the time of Mother’s later transfer, the amount of that later transfer, and the value of any assets transferred from Grandfather to Mother over which Mother had no control.

We know the imputed value of Grandfather’s bequest by applying the risk-free rate of return to its value, as recorded on his and Mother’s tax return. This, of course, assumes Mother had investment control over the assets. If Grandfather also bequeathed assets to Mother over which she had no control, we’d determine both the imputed value of assets over which she control, and the current value of any assets over which she lacked control. This determines what dollar value of any transfers from Mother should be taxed to the recipients. Any excess will be treated as wealth created by Mother and not taxed.

This approach requires more record-keeping than under current law—namely, it requires both transferors and recipients to file returns, instead of just the transferor (in an estate tax) or just the recipient (in an inheritance tax). But the valuations required present no more difficulties than under current law. Transferors must already value assets at the time of a gift or bequest, and at times, formulas are used to impute such values based on current interest rates.

Two additional aspects of this approach are similarly used both in the U.S. and abroad. First, many inheritance tax systems tax recipients differently depending on from whom they inherit. (Generally, heirs who inherit from close relatives such as parents are treated more leniently than those who inherit from more distant relatives like cousins.). There is thus precedent for looking at the source of a gift or bequest when taxing the recipient.

Second, current law in the U.S. provides that in some circumstances, the tax consequences to a decedent turn on actions taken at the prior death of a spouse.²³⁴More specifically, the second spouse to die can use any of the first spouse’s unused exemption amount, so long as the first spouse’s executor made the proper election. The success of portability, as these rules are known, suggest that tying one person’s tax consequences to the actions of prior transferors is workable.

F. Transfers in Trust

The foregoing illustrations have used outright gifts and bequests. But many wealthy families transfer most of their wealth in trusts that last for several generations. For example, Grandfather may choose to create a trust that pays the income to Mother for her life, and at her death, distributes the corpus to Daughter. Applying a Rignano tax to transfers in trust raises additional questions. The first, which arises in any accessions tax proposal, is to determine when the taxable events occur. Note that for each trust beneficiary, there are potentially two important events—the date the tax is actually imposed, and the date the clock starts for valuation purposes for later transfers.

Remainder Interests

Let’s start with Daughter and her remainder interest. Should she be taxed at vesting, or at distribution?²³⁵ Most accessions tax proposals suggest distribution for administrative and valuation reasons.²³⁶ First, we do not know until distribution exactly how much Daughter receives. While we can often estimate the value of her remainder interest when Grandfather creates the trust based on current interest rates and Mother’s life expectancy, any figure is just that—an estimate. And for some trusts, additional valuation difficulties appear. Imagine that Grandfather’s trust was to Mother for life, and then to her children equally. Perhaps Daughter is the only living child at Grandfather’s death. But whether Mother has more children affects the share of the remainder Daughter will receive. Finally, many interests are subject to trustee discretion, as would be the case if the remainder interest in Grandfather’s trust passed to “Mother’s children in such proportions as the trustee determines to be in their best interests.” Second, until distribution, Daughter may not have liquid funds with which to pay the tax. Although some trust interests can be sold or borrowed against, many cannot.

These concerns apply with equal force to a Rignano tax. But where do normative considerations point, vesting or distribution? With a traditional accessions tax, one could argue that most (but not all) normative justifications suggest treating vesting as the taxable event. For example, if an accessions tax is designed to further welfarist principles, then vesting seems logical, as one’s welfare (from security, reputation, and the fungibility of money) increases upon vesting. Political influence likely starts accumulating at vesting, when politicians and PACs start courting the remainder beneficiary. And since money is fungible, a vested interest frees up other funds that can provide a head start when it comes to educational and economic opportunities. That said, Anne Alstott has argued that the choice/chance distinction counsels in favor of distribution if an accessions tax is designed to reflect equal opportunity concerns.

But a Rignano tax is not designed to further any single normative goal such as equality of opportunity or welfarism in isolation. Instead, it is designed to find a compromise among competing intuitions about wealth transfer taxation—even when those intuitions may seem “wrong” to tax theorists. To that end, some of the administrative considerations discussed above take on normative weight. Consider valuation. In theory, one could tax at vesting based on estimated values and then adjust at distribution to account for divergences from the estimate. But it is quite likely the public would react negatively to the taxation of undistributed yet vested interests, for the same reason the public reacts negatively to the possible taxation of unrealized gains. To many, it simply seems unfair to impose a tax when there has not yet been an event that provides liquidity, or when valuation is unclear. Given that one purpose of a Rignano tax is to make political headway where other inheritance taxes fail, the better course is to wait until distribution of remainder interests to impose the tax—that is, until we know exactly who gets exactly how much.

The same rule, with two exceptions, should apply when determining when Daughter’s clock starts ticking for purposes of valuing later growth for subsequent transfers. Daughter generally does not have control of the funds until distribution, and therefore none of their prior growth (or lack thereof) should be attributed to her to determine what part of subsequent transfers by Daughter stems from her own initiative or Grandfather’s wealth. The first exception would be if Daughter somehow had discretionary investment control of the assets during Mother’s income interest, in which case investment decisions could plausibly be attributed to her. The second is if Daughter could sell her remainder interest at vesting, in which case the decision to leave it invested in the trust should be attributed to her and any later distribution of wealth beyond the risk-free-rate of return should be deemed self-made.

Income Interests

What about income interests? Assume that Mother’s income interest has an estimated FMV of $1,000,000 at vesting based on the present value of its payment stream and is predicted to pay out $100,000 a year for the rest of Mother’s life. Or imagine that Daughter receives a secondary life estate instead of the corpus outright at Mother’s death. Should she be treated as receiving the inheritance all at once at vesting, or over time when she receives her annual income distribution? In theory, these are economically equivalent, assuming perfect information about interest rates and lifespans (just as the difference between taxing a remainder interest at vesting and distribution is).

The same considerations that apply to remainder interests should apply here as well. The normative considerations that justify a traditional accessions tax do not point clearly in one direction, while weighty valuation and liquidity concerns remain. The default should be that the taxable event, be it imposing tax or starting the clock for later valuation purposes, happens at distribution. Exceptions would be made where the beneficiary has control over investment assets or the ability to sell her income interest.

G. Transition Rules

A Rignano tax contains a unique transition issue. In the illustrations used throughout this Article, we have assumed that Grandfather was self-made. And in the example above, we know how much of Mother’s wealth to tax because Grandfather’s estate would have filed an election to treat his estate as first-generation wealth.

But what if Grandfather himself inherited some money, and was not completely self-made? How do we treat the first generation after a transition to a Rignano tax? Treating all existing wealth at the time of the tax’s imposition as self-made is unsatisfactory, for it essentially delays implementation of the tax for a generation and does not reflect reality. Instead, some existing wealth should be treated as self-made, and some should be considered second-generation wealth. Halliday and Rignano both acknowledge the need for a transition rule to determine that portion, with Rignano suggesting that one-third to one-half of current wealth should be treated as inherited.²³⁷ Fairly recent studies suggest that anywhere from 15% to 46% of current wealth is inherited. Although any number will be admittedly arbitrary, treating one-sixth to one-third of existing wealth as second-generation wealth seems reasonable.²³⁸

CONCLUSION

This Article has made the case for an inheritance tax system that—unlike our own—taxes old money more heavily than new. Specifically, it proposes completely exempting gifts and bequests of self-made wealth, but taxing heirs who receive re-transferred wealth. Although such a tax is more complex than our current system, the challenges are manageable and are well worth it.

Crucially, this proposal provides a way out of the enduring stalemate over taxing wealth. The estate tax has been the subject of passionate debate for decades, resulting in an ongoing state of political uncertainty. Rates and exemption levels have ping ponged back and forth for two decades, including a single year—2010—that had no estate tax at all. And although recent legislation ostensibly made the exemption’s expansion “permanent,” there is no reason a future Congress could not “permanently” shrink it again. Given the current political polarization, there is no doubt that questions about whether and how to tax wealth will continue to generate heated debate.

What makes this debate so intractable is not only that the public as a whole is divided on the issue of inheritance taxation, but that many individual Americans hold simultaneous beliefs about wealth, opportunity, desert, fairness, and family that seemingly contradict each other. Many of us, for example, have at least a sliver of sympathy for some of the claims of both supporters and opponents of the tax.

Yet our current system treats taxing wealth transfers as an all or nothing proposition, without acknowledging a key source of our seemingly contradictory beliefs: the finding that many of us silo beliefs about wealth, distinguishing among earned and inherited wealth. By harnessing this finding, as well as the insights of other recent psychological work on taxation, a Rignano tax thus reconciles the benefits of wealth transfer taxation with deeply held beliefs about fairness, desert, private property, and family. And by so doing, it offers an opportunity for a stable and lasting resolution to the debate over taxing inherited wealth.

98 S. Cal. L. Rev. 1439

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Miranda Perry Fleischer*

*Richard and Kaye Woltman Professor in Finance, The University of San Diego School of Law. For helpful feedback and suggestions, the author thanks Anne Alstott, Jordan Barry, Lily Batchelder, Heather Field, Dov Fox, David Gamage, Ari Glogower, Daniel Halliday, Shelly Layser, Ray Madoff, Shu-Yi Oie, Caley Petrucci, Jim Repetti, Diane Ring, Darien Shanske, and Mila Sohoni, as well as participants at the University of Virginia Tax Policy Workshop, the Boston College Law School/Tulane Law School Tax Roundtable, the Association of Mid-Level Tax Scholars Conference, the University of San Diego Colloquium Series, and the staff of the Southern California Law Review. Thanks to the University of San Diego Law Library and Carlisle Olson for invaluable research assistance.

Rethinking Tax Information: The Case for Quarterly 1099s

October 2024October 2024Kathleen DeLaney Thomas*

When an electricity provider wants customers to pay their bills monthly, it sends them a bill each month. Yet, this is not how the tax system works—at least not for independent contractors. Their taxes are due quarterly, but they receive a tax statement (Form 1099) only one time a year. It is up to the individual, then, to know when their taxes are due and how to pay them, and it is on that individual to estimate how much they owe each quarter. As a result, compliance for independent contractors—particularly for online platform workers—tends to be lacking. Failure to pay their estimated taxes subjects these taxpayers to potential penalties and causes the government to collect less tax revenue.

There is a simple—yet entirely overlooked—reform that could vastly improve compliance when it comes to paying estimated taxes: third-party information returns (Form 1099s) should be issued to taxpayers on a quarterly basis. The idea is straightforward and intuitive. If the government wants people to pay taxes four times per year, it needs to effectively “bill” them four times per year. This idea is supported by social science research showing that, the more taxpayers are reminded to pay their taxes, the more likely they are to do so.

This Article is the first to propose quarterly tax information returns. It offers a detailed proposal for a new Form 1099-ES, which would communicate quarterly earnings and provide guidance on how much to pay in estimated taxes. In doing so, this Article argues for rethinking the conventional wisdom surrounding tax information, taking a more taxpayer-focused approach. Rather than viewing Form 1099s solely as a source of information for the government to monitor taxpayers and deter cheating, we should also view the role of information returns as assisting taxpayers in tracking their income and estimating their tax liability. When viewed in this light, the goal should not necessarily be more year-end returns to more people, but instead should be more frequent and useful information for taxpayers.

INTRODUCTION

When an electricity provider wants customers to pay their bills monthly, it sends them a bill each month. It would border on the absurd to do it differently. But imagine if an electricity provider wanted customers to pay their bill every month, yet it sent only one bill at the end of the year showing the customer’s total electricity use. This would certainly cut down on billing costs for the company, but at a steep price. People would undoubtedly miscalculate their monthly bills, pay the bills late, or forget to pay the bills altogether. Thus, unsurprisingly, whether it is utility companies, mobile phone service providers, or credit card companies, businesses that want to be paid monthly bill their customers monthly, often sending multiple reminders. Those communications not only remind customers to pay, but they also provide instructions—such as a link to an online payment website or a pre-addressed envelope—to make it as easy as possible.

Yet this is not how the tax system works, at least not for independent contractors. Their taxes are due quarterly, but they receive a tax statement only one time a year.¹ By the time independent contractors receive a Form 1099 reporting their earnings, typically in February of the following year, all four quarterly tax payment deadlines have come and gone.² It is up to the individual, then, to know when their taxes are due and how to pay them, and it is on that individual to estimate how much they should pay in taxes each quarter.

The significance of this asymmetry cannot be understated: the government expects taxpayers to take affirmative steps to make a tax payment four times per year, yet the government requires taxpayers receive information (through a third-party Form 1099) only once a year. It is, therefore, entirely unsurprising that compliance for independent contractors, particularly for online platform workers, is lacking.³ Studies indicate significant noncompliance when it comes to paying estimated taxes, which subjects these taxpayers to potential penalties and causes the government to collect less tax revenue.⁴

There is a simple—yet entirely overlooked—reform that could vastly improve compliance when it comes to paying estimated taxes: third-party information returns (Form 1099s) should be issued to taxpayers on a quarterly basis. This new quarterly information return—what this Article calls “Form 1099-ES”—should communicate the taxpayer’s quarterly earnings and provide clear instructions for how to make estimated tax payments, including guidance on how much to pay.⁵ The idea is straightforward and intuitive. If the government wants people to pay taxes four times per year, it needs to effectively “bill” them four times per year. Further, this idea is supported by recent social science research. That research shows that informational “nudges” are effective at motivating individuals to act, including paying their taxes on time.⁶ In other words, the more taxpayers are reminded to pay their taxes and the easier the process is, the more likely they are to do so.

This Article is the first to propose quarterly information returns. It urges Congress to require quarterly 1099s be sent to online platform workers who are already receiving an annual Form 1099-K, but who otherwise receive no assistance in making estimated tax payments.⁷ In doing so, this Article argues for rethinking the conventional wisdom surrounding tax information, taking a more taxpayer-focused approach.

Traditionally, scholars and policymakers have viewed third-party information returns, such as a Form 1099-K, as having two main functions, both of which aid Internal Revenue Service (“IRS”) enforcement efforts.⁸ One function is to tell the IRS what the taxpayer has earned. The second function is to serve as a deterrent. If taxpayers know the IRS is going to receive information about their income from third parties, they are far more likely to report their income accurately.

Recent expansions to Form 1099 reporting reflect this traditional view of information returns. In 2021, Congress passed legislation requiring online platforms, such as Venmo, PayPal, Airbnb, and Etsy, to send a Form 1099-K to taxpayers earning more than $600 of business income during the year through those platforms.⁹ This was a substantial change from the prior threshold of $20,000 and was designed specifically to raise revenue by subjecting more taxpayers to information reporting.¹⁰ Some critics of the new legislation have questioned whether the IRS has sufficient capability to process the influx of new information returns, while others have lamented that the new rules will lead to taxpayer confusion, anxiety, and possible over-reporting of tax liability.¹¹

While the efficacy of the new Form 1099-K reporting threshold remains to be seen, the rule reflects the overall trend in improving tax compliance over the past half a century: more year-end tax forms to more taxpayers. In gradually expanding information reporting requirements over the past several decades, the government has cast an increasingly wider net. But this wider net has come with virtually no safeguards for the taxpayers newly covered by information reporting.

This Article urges policymakers to look beyond the traditional policing function of 1099s and proposes a third, equally important function of information reporting. Rather than viewing 1099s solely as a source of information for the government to monitor taxpayers and deter cheating, we should also view the role of information returns as assisting taxpayers in tracking their income and estimating their tax liability. When viewed in this light, the goal should not necessarily be more year-end returns to more people, but instead should be more frequent information to taxpayers who are already obligated to report taxable income. The current system, in which taxpayers do not receive information until their deadlines to pay quarterly taxes have come and gone, falls woefully short.

This Article’s ultimate argument is that rethinking tax information means harnessing the ability of third parties to quickly process and distribute tax information in ways that will first and foremost help taxpayers. The cost to third parties of sending these quarterly statements to taxpayers would be minor, and it would impose no additional administrative costs on the IRS. (The IRS would continue to receive the taxpayer’s Form 1099 at the end of the year, but only the taxpayer would receive it quarterly.)

Rethinking the role of tax information as assisting taxpayers in meeting their payment obligations not only protects taxpayers from penalties and other burdens, but it should also result in higher tax compliance and more revenue raised. In other words, rethinking tax information in this way would only strengthen and enhance the traditional goals of information reporting.

This Article proceeds in four parts. Part I provides background on tax information reporting and surveys recent legislative changes to expand Form 1099 reporting. It also discusses the benefits and risks of expanding year-end information reporting. Part II explores the challenges faced by independent contractors like online platform workers in making timely tax payments. Part III then explores social science literature supporting the idea that, the more tax communications taxpayers receive, the more compliant they will be. Part IV offers a concrete proposal for quarterly information returns for platform workers (a new Form 1099-ES), including how to best design these returns to maximize accurate and timely tax payment. Part IV also proposes a simple safe harbor formula for calculating estimated tax payments: five percent of gross payments. The safe harbor would allow taxpayers to quickly and easily figure out how much to pay each quarter to avoid estimated tax penalties.

Quarterly information returns are a viable solution to a problem that has taken on increasing significance in recent years due to a growing gig economy and rising number of independent contractors. Mandating that certain businesses send their workers a Form 1099 every quarter would impose tax compliance costs on those entities that are best suited to handle those costs efficiently. At the same time, this reform would make the tax system more equitable for lower income workers who struggle to meet their tax compliance burdens.

I. THIRD-PARTY INFORMATION REPORTING: BACKGROUND AND CONSIDERATIONS

This Part offers a brief overview on the current law regarding third-party information reporting and tax payment obligations. As this Part explains, information reporting is a vital tool that ensures tax compliance and aids in the government’s collection of revenue.

A. What Is Third-Party Information Reporting?

The United States tax system is generally based on “voluntary compliance,” meaning the government relies on taxpayers to voluntarily self-report their taxable income each year on their tax return.¹² However, the most important way in which the government ensures that taxpayers report their income accurately is third-party information reporting.¹³ Third-party information reporting describes a system in which a third party (that is, not the taxpayer or the IRS) reports the taxpayer’s income on an information return.¹⁴ The third party is often (though not always) the same person or entity that pays the income to the taxpayer. That information return, such as a Form W-2 or Form 1099, is sent to both the taxpayer and to the IRS after the end of the year.¹⁵ The IRS then uses the form to monitor whether the taxpayer has accurately reported the income on their tax return, often through an automated process.¹⁶

Whether income is subject to third-party information reporting depends on the source of the income and how much the taxpayer earns. Employee wages are generally reportable on Form W-2 and are also subject to withholding.¹⁷ Other forms of income, such as interest, dividends, and sales of securities by brokers, as well as certain payments to independent contractors, are reportable on a Form 1099 (though not subject to withholding).¹⁸

B. Purpose and the Benefits

In ensuring that taxpayers report and pay their taxes, the government’s primary challenge is information asymmetry: taxpayers have more information about their income than the IRS. The most powerful mechanism to correct this asymmetry, thereby ensuring that most income gets reported accurately, is third-party information reporting.¹⁹ IRS compliance statistics bear this out. The overall rate of compliance in the United States, measured by the ratio of taxes collected versus taxes owed, is about 85%.²⁰ Much of that high compliance rate is attributable to income that is subject to information reporting.²¹

For employee wages, which are both reported on a Form W-2 and subject to withholding, compliance is nearly perfect (99%).²² Income that is not subject to withholding but subject to substantial information reporting, such as interest and dividends, is also reported accurately at very high rates (94%).²³ On the other hand, compliance is significantly lower when information reporting is not present. The IRS estimates the compliance rate for income not subject to information reporting to be 45%, meaning less than half of such income gets reported by taxpayers.²⁴ Simply put, taxpayers are much more likely to report income that gets reported to the IRS by a third party and are more likely to cheat when their income is not being reported by a third party.

These statistics demonstrate that information reporting is highly effective at achieving its intended purpose of ensuring tax compliance. Commentators note two reasons that information reporting is so effective. First, providing the IRS with information about taxpayers allows the agency to pursue those who underreport their income.²⁵ Much of this matching of information returns with taxpayers’ tax returns is done automatically through IRS computer programs.²⁶ Second, information reporting acts as a deterrent because taxpayers likely know the IRS is receiving information about their income.²⁷ Professor Leandra Lederman compares this effect to red light cameras that catch drivers running red lights: “[T]he taxpayer is aware the government is watching.”²⁸

C. Information Reporting for Platform Workers

Two information-reporting provisions are particularly relevant for taxpayers earning income through online platforms, who are the focus of this Article. First, certain payments made to independent contractors are reportable on Form 1099-MISC if the payments exceed $600 during the year.²⁹ More specifically, if a business pays an independent contractor more than $600 for the provision of services, the business must send the individual (and the IRS) a Form 1099-MISC.

In 2008, Congress expanded information reporting for some independent contractors that are paid through “third party settlement organizations” (“TPSOs”).³⁰ A TPSO generally serves as an intermediary to facilitate online transactions between buyers and sellers, charging a fee for its services.³¹ TPSOs include online payment platforms, like Venmo and PayPal, as well as other types of platforms on which taxpayers earn income from performing services or selling goods, like Uber or Etsy.³² The 2008 legislation required the online platform to issue a Form 1099-K to any taxpayer who was paid more than $20,000 and accumulated payments from more than 200 transactions on the platform during the tax year.³³ The higher $20,000 threshold “trumped” the $600 threshold under the 1099-MISC rules if both applied, meaning independent contractors paid through online platforms were subject to a much higher threshold for information reporting.³⁴

Commentators criticized this disparity in the information reporting thresholds—$600 versus $20,000/200 transactions—as confusing and arbitrary.³⁵ For example, if a painter was paid $5,000 by a business for a job, they would receive a Form 1099-MISC. But if a painter was hired and paid through an online platform like TaskRabbit, the Form 1099-K rules only required information reporting if that painter earned over $20,000 through the platform and had over 200 payment transactions. As a result, many independent contractors earning income through online platforms were not subject to any information reporting at all, because they never met the high payment and transactions threshold.³⁶

In response to these criticisms, and due to growing concern about lack of tax compliance in the gig economy, Congress amended the reporting threshold for Form 1099-K in 2021.³⁷ The new rule, enacted as part of the American Rescue Plan, unified the reporting threshold between the 1099-MISC rules and the 1099-K rules.³⁸ Now, online platforms must issue a Form 1099-K to any taxpayer who earns more than $600 from the platform during the tax year; there is no minimum number of transactions required.³⁹ This new reporting threshold, which does not take effect until 2025, is expected to substantially increase the number of taxpayers subject to information reporting and raise an estimate $8.4 billion in additional revenue over the next decade.⁴⁰

Notwithstanding the revenue and compliance benefits from expanding Form 1099-K reporting to cover more platform workers, the new legislation has also been met with significant criticism from all sides. The biggest source of such criticism is that the new threshold casts too wide a net and will inadvertently capture transactions that are not subject to tax.⁴¹ Technically, the 1099-K rules only apply to business income and not personal transactions.⁴² For example, a painter earning fees on Venmo should receive a Form 1099 if total annual fees exceed $600. But if an individual collects contributions for a group gift on Venmo, those transactions should not be reportable because they are personal in nature. However, it is possible that TPSOs (like Venmo) will not be able to adequately distinguish which transactions are reportable and which are not, with the result that too many Forms 1099-K will be issued. This, in turn, is likely to cause confusion among taxpayers, who may mistakenly believe the Form 1099-K means they have to report a transaction even if that transaction is not taxable (for example, if it is a gift).⁴³

Another source of potential confusion is that Forms 1099-K generally report gross earnings, which may differ significantly from taxable income, particularly for taxpayers who engage in selling goods.⁴⁴ As an example, imagine a taxpayer knits scarves and sells them on Etsy. Further imagine this taxpayer spent $700 on materials during the year and earned $1,000 in gross sales through the platform. The taxpayer’s net income, after accounting for their costs, is only $300 ($1,000 minus $700), and therefore only $300 is reportable for tax purposes. But, under the new 1099-K rules, Etsy will issue the taxpayer a Form 1099-K reflecting $1,000 in sales, because that gross amount is over the threshold. Critics argue that taxpayers may fail to understand that, although their Form 1099 says $1,000, the taxpayer may report a lower amount of income on their tax return.⁴⁵ Commentators also argue that confusion about the new rules will deter taxpayers from participating in online marketplaces.⁴⁶

Even for taxpayers who understand that their Form 1099 shows income that is not taxable—either because the transaction is not taxable or because the Form 1099 reflects a gross income amount—there may be anxiety and confusion over how to reconcile the form with their tax return. Taxpayers may overreport their income just to avoid IRS scrutiny, or may have to incur the cost of a tax professional to ensure they are in compliance with the law.⁴⁷ The IRS has delayed enforcement of the new 1099-K rules by several years in response to these concerns, stating that the delay will help “reduce the potential confusion caused by the distribution of an estimated 44 million Forms 1099-K sent to many taxpayers who wouldn’t expect one and may not have a tax obligation.”⁴⁸

Another line of criticism of the new 1099-K rules is that the IRS does not have the enforcement capacity to handle the new influx of information returns, many of which may not even pertain to taxable transactions.⁴⁹ For example, the Coalition for 1099-K Fairness argues:

[T]his new requirement will place a greater strain on the IRS, increasing processing delays for American taxpayers and small businesses. At the end of May 2022, the IRS had a backlog of 21.3 million unprocessed paper tax returns. . . . Because many of these casual sellers will not have taxable income resulting from these transactions, the burden on the IRS will not result in collection of additional tax revenue.⁵⁰

Finally, even those who support expanding information reporting for platform workers have argued that the $600 threshold is simply too low, reflecting a reporting threshold for independent contractors that dates back to the 1950s and has not been adjusted for inflation.⁵¹ In response to concerns about the threshold level, Congressional Democrats have introduced a bill to raise the threshold for 1099-K reporting to $5,000.⁵²

D. Lessons Learned from Recent 1099-K Reform

The recent change to the Form 1099-K rules offers a compelling illustration of the tradeoffs inherent in expanding information reporting. On the one hand, the lower threshold for online platforms was a long time coming. Scholars and organizations like the Government Accountability Office (“GAO”) had been urging Congress for years to lower the $20,000/200 transaction threshold to account for the fact that many platform workers were not receiving a Form 1099.⁵³ And, as discussed above, information reporting is vital to ensure that platform workers and other independent contractors report their income. But while increasing the number of taxpayers receiving 1099s will reduce evasion and enhance revenue collection, it comes at a cost of added complexity for taxpayers, who may not know how to report income reflected on a 1099.⁵⁴ Taxpayer confusion or mistakes also impose an increased enforcement burden on the IRS, as does processing additional 1099s.⁵⁵

In sum, the new Form 1099-K rule, which lowers the reporting threshold for payments from online platforms to $600, reflects the general trend in expanding information reporting over the past several decades.⁵⁶ That trend is to require more year-end 1099s, which means more taxpayers will receive them. But receiving a Form 1099 at the end of the year, by itself, does little to help platform workers fulfill their tax obligations if they don’t already have a good understanding of the tax law. The next Part explores the tax compliance challenges faced by online platform workers and other independent contractors.

II. THE PROBLEM: NONCOMPLIANCE AMONG INDEPENDENT CONTRACTORS

This Part provides background on the tax compliance obligations of platform workers and other independent contractors. As this Part shows, because they are not treated as employees for tax purposes, platform workers often face significant tax compliance burdens and may lack the expertise to fully comply.

A. Tax Compliance Obligations of Platform Workers

Online platform workers are generally treated as independent contractors, rather than employees, for tax purposes.⁵⁷ The tax consequences of this distinction are significant for the worker: while employees have their taxes withheld and paid by their employer, independent contractors are responsible for paying taxes on their own.⁵⁸ This means platform workers generally must budget for taxes and make estimated tax payments four times per year,⁵⁹ in addition to filing a year-end tax return and paying any additional balance due. Failure to make estimated tax payments can result in a tax penalty.⁶⁰

Taxpayers have two options to calculate their estimated tax payments in a manner that avoids penalties. First, they can pay 100% of their prior year’s tax liability through estimated taxes, and they will not face a penalty even if they end up owing more tax after the year is over.⁶¹ For example, if a taxpayer paid $5,000 in taxes in 2022, they can pay $5,000 during the course of 2023 through estimated taxes. Even if their total tax liability for 2023 is $8,000, and they owe another $3,000 at the end of the year, they will not face a penalty for failing to pay enough estimated tax. The other option is to pay enough estimated taxes to satisfy 90% of that year’s tax liability.⁶² This means that, for a taxpayer who owes $20,000 in tax at the end of 2023, they must have paid at least $18,000 during the year to avoid an estimated tax penalty. In any case, taxpayers are not subject to an estimated tax penalty if the total tax owed for the year is less than $1,000.⁶³

Independent contractors are also responsible for paying self-employment taxes on their net earnings. For employees, employment taxes are split between the employee and the employer, with employees bearing responsibility for a 7.65% tax on their wages⁶⁴ and employers bearing responsibility for another 7.65% on those wages.⁶⁵ In addition to paying half of the employment tax, the employer withholds the employee’s share of employment taxes and pays them to the IRS,⁶⁶ so the employee can effectively ignore these obligations. On the other hand, independent contractors are responsible for both portions shared by employers and employees, or a 15.3% self-employment tax on net earnings.⁶⁷ These workers must include payments for self-employment tax in their quarterly estimated tax payments.

Finally, in addition to paying quarterly taxes, which include both income and self-employment taxes, independent contractors must track their deductible business expenses and report them on Schedule C to their Form 1040.⁶⁸ This imposes further compliance costs and complexity compared to employees because workers must know which expenses are deductible, keep records to substantiate those expenses, and spend additional time preparing their year-end tax return (or spend money hiring a tax professional).

B. Many Platform Workers Struggle with Tax Compliance Obligations

The rise of online platforms has made it easier than ever before to become an independent contractor.⁶⁹ But this low barrier to entry means that many platform workers are young and financially inexperienced, particularly when it comes to managing tax obligations.⁷⁰ Even taxpayers with years of employment experience do not necessarily know how to manage the tax obligations associated with independent contractor status. For example, a survey of platform workers published in 2016 found that a third of such workers did not know whether they had to pay quarterly estimated taxes.⁷¹ Nearly half of the respondents also did not know how much they would owe in taxes and did not set aside money for taxes.⁷²

In a 2020 Report to Congress, the GAO documented the top tax compliance challenges faced by platform workers, which include understanding the tax responsibilities of independent contractors, receiving adequate information about their earnings (particularly when there is no Form 1099 reporting), and saving for and making quarterly estimated tax payments.⁷³ As to the third challenge, the report observes:

Because earnings of some platform workers may be low and earnings and expenses may fluctuate, they can have difficulty estimating their taxes owed and setting aside money to pay the taxes. . . . To the extent these burdens and difficulties confuse workers, they are less likely to pay the estimated tax payments fully and on time and may incur a penalty as a result. . . . [I]f the penalty or amount owed is more than workers can afford, they are at risk of falling into a cycle of noncompliance.⁷⁴

Researchers have also noted that another negative effect of failing to properly save for and remit estimated taxes relates to platform workers’ Social Security contributions. Not only does failing to fulfill their tax obligations subject workers to possible penalties and cause the government to collect less revenue, but workers also jeopardize their future Social Security benefits, as such benefits are based on previously reported earnings.⁷⁵ Further, platform workers who do not report their income (or do not report enough income) may also miss out on tax credits that could help them financially, such as the Earned Income Tax Credit.⁷⁶

C. Estimated Tax Penalties Have Increased with Rise of Platform Economy

As further evidence that platform workers are struggling with their tax compliance obligations, IRS data shows that the number of estimated tax penalties has increased substantially over the past two decades.⁷⁷ Specifically, the number of individual returns for which an estimated tax penalty was assessed has risen significantly alongside the expansion of the platform economy.⁷⁸ For example, in 2012, 7.1 million individual estimated tax penalties were assessed, while in 2022, 12.2 million estimated penalties were assessed, representing a 72% increase.⁷⁹ While other factors may play a role in the number of estimated tax penalties assessed, the general trend is consistent with the growth in online platform work.⁸⁰ It is worth repeating that when platform workers fail to pay estimated taxes, it not only deprives the government of tax revenue, but also harms the worker, because they may find themselves subject to back taxes and penalties they cannot afford.⁸¹

Figure 1 shows the total number of individual estimated tax penalties assessed from 2000 to 2022, with a notable increase over the past decade.⁸²

Figure 1. Number of Individual Estimated Tax Penalties Assessed from 2000–2022 (in Millions)

III. SOCIAL SCIENCE LITERATURE SUPPORTING A SOLUTION

Part II explained the complexity faced by platform workers in meeting tax compliance obligations. In particular, because they do not have their taxes withheld, these workers must take affirmative steps to estimate and pay their taxes each quarter. This Part looks to social science research to understand why paying taxes is so psychologically difficult and what can be done to motivate taxpayers to comply. As this Part reveals, noncompliance by independent contractors is not just a matter of lacking sufficient knowledge. Rather, taking affirmative steps to pay taxes on time requires motivation, self-control, and planning. Research over the past several decades on so-called behavioral nudges shows that policy design can have a drastic impact on whether individuals engage in desired behaviors like paying taxes. This research shows that, the easier and simpler obligations are made for people, the more likely they will comply with those obligations. Section A first describes the broader social science research on nudges. Section B discusses specific studies relating to tax compliance that suggest that more frequent reminders to pay would likely improve tax compliance for independent contractors.

A. Reasons for Tax Noncompliance and How Nudges Can Help

This Section first discusses psychological factors that contribute to taxpayers not meeting their payment obligations, even when they are aware of them. It also introduces the concept of nudges and discusses how these behavioral interventions can motivate desired behavior, including compliance with legal obligations.

1. Why Taxpayers May Struggle to Pay Estimated Taxes

There are a number of reasons that taxpayers fail to report their income and pay their taxes. One is simply opportunity. Recall that when taxpayers are not subject to third-party information reporting, they demonstrate low levels of compliance, which is unsurprising because they are unlikely to get caught. Scholars have also explored many non-economic factors that may contribute to noncompliance, such as social norms of noncompliance or perceptions that the tax system is unfair.⁸³

The focus of this Article, however, is on independent contractors—particularly online platform workers—who receive an annual Form 1099-K. For these taxpayers, there is little opportunity to underreport their income without getting caught, yet their compliance is still often lacking, particularly when it comes to making timely payments of quarterly estimated taxes.⁸⁴ In other words, workers who receive a Form 1099 are less likely to try to conceal their earnings (since they are likely to get caught) but may fail to pay timely taxes on those earnings. As discussed above in Part II, research reveals that many platform workers may simply fail to understand the tax consequences of independent contractor status. However, lack of knowledge is unlikely to be the only reason for noncompliance.

Recall that platform workers and other independent contractors do not have the benefit of having their taxes withheld.⁸⁵ This means they are responsible for tracking their earnings, budgeting for taxes from those earnings, and making quarterly remittances. A number of well-documented psychological biases likely make this difficult for many taxpayers, even if they have no intention of cheating. First, humans have limited attention and are inherently forgetful.⁸⁶ This is why a doctor’s office or a restaurant sends us one or more reminders about upcoming appointments or reservations.⁸⁷ For platform workers and other independent contractors, making quarterly tax payments without any reminder to do so is no small feat.

Even aside from the fact that taxpayers may simply forget about estimated tax deadlines, people also tend to procrastinate and lack self-control.⁸⁸ This might make it hard for taxpayers to follow through with making estimated tax payments despite their awareness of the obligation and despite their best intentions. This tendency to procrastinate is well-documented in the context of saving for retirement, where people frequently save less than they think they should.⁸⁹

Finally, people might avoid paying estimated taxes altogether because they find it difficult or overwhelming. The payments themselves can be made online (or through the IRS2Go app), and finding and navigating the IRS website to make the payments is a relatively straightforward process.⁹⁰ But calculating the amount of the payments is not, and this difficulty only serves as a further source of psychological friction for platform workers.

Recall that independent contractors can avoid estimated tax penalties by paying 100% of their prior year tax liability or 90% of their current tax liability.⁹¹ While these rules are not as complex as other parts of the tax law, they are not quickly and easily applied. Taxpayers who do not prepare their own returns may not have quick and easy access to a copy of their return to refer to their tax liability for the prior year. Many are likely not even aware of the safe harbor that allows them to rely upon last year’s tax liability. Further, estimating tax liability to rely on the 90% rule is not easy. Taxpayers may not realize that they need to estimate both their income tax liability and their self-employment tax liability to meet these obligations. Studies also show that most people don’t know what their average or marginal tax rates are, making it difficult to estimate one’s prospective income tax liability.⁹²

A taxpayer who consults IRS Form 1040-ES: Estimated Tax for Individuals, will be confronted with twelve pages of instructions for estimating and paying these taxes.⁹³ To determine the amount of estimated tax one should pay, the form points taxpayers to the Estimated Tax Worksheet, which is a full-page worksheet containing fifteen line items.⁹⁴ Several of these line items have multiple parts (for example, a, b, and c) that require computations. One of the line items is the taxpayer’s self-employment tax liability, which is calculated on yet another full-page worksheet with six line items.⁹⁵

It is worth pausing here to observe the numerous obstacles that stand between platform workers and their tax obligations. One is simply knowledge; the taxpayer must understand what it means to be an independent contractor for tax purposes. But even if a taxpayer has a general understanding that they are solely responsible for their tax payments because they don’t have an employer to withhold, there are numerous sources of friction that make it less likely the taxpayer will comply. There are no required reminders to pay, the deadlines are not obvious, and the actual process of calculating estimated payments is complex and requires significant work on the part of the taxpayer.

2. Information Reporting as a Nudge

The reasons that independent contractors often struggle to pay their taxes on time are both intuitive and well-documented in the literature. Paying estimated taxes takes memory, planning, motivation, and self-control. In short, the current tax regime creates high levels of psychological friction for taxpayers who do not have their taxes withheld or who do not have access to tax advisors. There is a role here for a quarterly Form 1099 to help reduce this friction by serving as a “nudge.”

As defined by Richard Thaler and Cass Sunstein, a “nudge” is an intervention that “alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives.”⁹⁶ In other words, nudges encourage people to engage in desired behavior without offering them significant financial incentives or coercing them through the threat of punishment.⁹⁷ Nudges often accomplish this by making a desired action simpler or easier for people.⁹⁸ Research has shown, for example, that when employees are automatically enrolled in 401K savings plans as a default, enrollment in those plans is significantly higher as compared to when employees have to take affirmative steps to enroll in such plans.⁹⁹

In addition to helping people overcome inertia and procrastination, nudges might also provide information or reminders to encourage behavior, such as simplifying form instructions or sending text message reminders.¹⁰⁰ For example, a New York City program that sent text message reminders to people right before they were due to appear in court significantly reduced the number of people who failed to appear.¹⁰¹ The rate of failure to appear in court declined even more when the text reminders were paired with a redesigned summons form that more prominently displayed pertinent information, such as where and when to appear, and the consequences of not appearing.¹⁰² Governments around the world have increasingly employed nudges to achieve a variety of other public policy goals, from promoting health, protecting the environment, and encouraging people to vote.¹⁰³

As illustrated by the success of automatic enrollment in retirement plans, nudges are well suited to guide behavior when procrastination, inertia, and similar psychological frictions are involved. This makes payment of taxes by platform workers an ideal candidate for nudges. Particularly, a nudge that could provide both information and a reminder to the taxpayer about paying estimated taxes—similar to the text reminder and redesigned summons form in the New York City program—could significantly enhance compliance. And policymakers would not need to reinvent the wheel because a source of information for taxpayers already exists: the Form 1099. Part IV develops a specific proposal for a redesigned Form 1099 that a taxpayer would receive quarterly: serving both as a source of information (how much income was earned and what steps must be taken to pay taxes) and as a reminder to pay immediately prior to each deadline.

When considering why platform workers struggle to meet tax payment obligations, the Form 1099 has the potential to take on a new and powerful role in enhancing tax compliance. To be sure, the traditional function of the 1099—as a way to inform the government of the taxpayer’s earnings and to deter cheating—will always be paramount. But a well-designed system of information reporting can also serve as a nudge. The 1099 can provide information, simplification, and timely reminders to pay, with little extra administrative cost. Before turning to the specifics of the proposal for a quarterly 1099, the next Section explores the social science literature on what makes an effective informational nudge, particularly in the context of taxes.

B. Designing Effective Informational Nudges

This Section discusses recent studies showing how a well-designed nudge, in the form of a reminder letter, can improve tax compliance. It then uses the insights from these studies to describe how a quarterly 1099 could be best designed to improve tax compliance by platform workers.

1. Reminders to Pay Taxes Are Effective and Timing Matters

Several recent empirical studies show that sending letters reminding people to pay their taxes results in a higher likelihood of payment.¹⁰⁴ For example, one field study examined the effect of mailing reminder letters to property owners who had obligations to pay quarterly property taxes.¹⁰⁵ While one group in the study received brief reminder letters every quarter for a year, a second group in the study received a one-time mailing with a guide to develop a financial plan, as well as a follow up phone call from a financial counselor.¹⁰⁶ The one-time financial planning packet and offer of free counseling had no effect on timely property tax payments.¹⁰⁷ But the quarterly reminders reduced the rate of default on property taxes by one third.¹⁰⁸ The study’s authors concluded that “repeated, generic reminders” were more effective at prompting timely payment than “customized information about their obligations” that was sent to taxpayers only one time.¹⁰⁹

Another field study conducted with the Ministry of Finance in Ontario examined the effect of sending letters to business organizations who were late in meeting their payroll tax obligations.¹¹⁰ The experimental letter, which gave step-by-step instructions for how and when to make payment, increased the likelihood of payment in the year the letter was sent.¹¹¹ However, the study showed no evidence that receiving the experimental letter improved compliance in the following year.¹¹² On the other hand, when some businesses were sent another letter in the subsequent year, compliance increased, suggesting that such letters are “most effective when they proximately precede a decision point.”¹¹³

These studies indicate that nudging tax compliance through reminders is effective and, importantly, the timing of those communications matters. But for platform workers and other independent contractors, there is currently no system of reminders for when payment is due. While the annual Form 1099 does communicate vital information to taxpayers about their total earnings from a particular payer, it is only received after the tax year has ended, long after the taxpayer’s four estimated tax payment deadlines have come on and gone.¹¹⁴

The studies discussed above suggest that communications that do not immediately precede payment deadlines are unlikely to prompt payment and, concededly, the current Form 1099 was not designed to serve as a nudge. However, there is no reason that third-party information reporting can’t continue in its current role (mainly as a deterrent) while also serving as a reminder for the taxpayer. It is both intuitive and supported by empirical research that, if the government wants to encourage timely tax payments, it should prompt taxpayers to do so immediately preceding the deadlines for such payments. Thus, taxpayers should receive third-party tax information each quarter, leading up to the deadline for their quarterly estimated tax payments.

2. Planning Prompts Are Effective

Not only does the timing of information matter, but the content of reminder notices also impacts compliance. Specifically, the aforementioned experiment with the Ministry of Finance in Ontario showed that experimental late notices that contained “planning prompts” were more effective at improving compliance than a standard late notice.¹¹⁵ Planning prompts—nudges designed to help people make specific plans for how and when they will take an action—have been shown to help people overcome inertia and procrastination in a variety of settings.¹¹⁶ For example, planning prompts that ask voters to indicate where and what day they will vote have been shown to improve voter turnout.¹¹⁷ Similarly, text message reminders that included a link to make an appointment were found to increase uptake of COVID-19 vaccinations.¹¹⁸

In the Ontario tax study, the experimental letter gave taxpayers instructions about how and where to file their payroll tax return, along with a specific deadline of when to file it.¹¹⁹ By way of contrast, the standard letter (serving as a control) simply told taxpayers to pay “immediately.”¹²⁰ In summarizing the success of the experimental letter in improving compliance, the study authors observed:

Drawing on the insight that people often fail to act on their motivations, we argue that overdue tax payments might not only result from the lack of sufficient motivation or ability to pay, but also from the absence of a concrete plan of how to act on those motivations. Importantly, providing a plan with an explicit deadline and specific instructions for its implementation appears to encourage organizational taxpayers to act and aids in overcoming barriers of procrastination or forgetfulness . . . .¹²¹

The Ontario tax study, and other research on the effectiveness of planning prompts, indicates that a well-designed nudge may help people follow through on intended behavior by providing them with concrete steps for how to act. This indicates that quarterly tax information provided to independent contractors would be most effective if the content of the reminder provided specific details about how and when to pay estimated taxes. This idea is developed more in Part IV below.

3. Formality Matters

Finally, research shows that formal communications from the government may be more effective at nudging behavior than informal communications.¹²² A recent set of field studies documents this so-called “formality effect,” in which people responded more to communications that looked official, as opposed to communications that looked less official because they were in colorful font, accompanied by graphics, pictures, or informal language.¹²³ In the study, subjects were more likely to report taking a requested action, such as self-certifying a business or claiming a tax credit, if they received the more formal communication.¹²⁴ The study’s authors hypothesized that people see formality as an indicator of credibility, and that the formal letters conformed with their “expectations about how government communications should look, . . . signaling trustworthiness and competence.”¹²⁵

This recent research observing a formality effect suggests taxpayers may pay more attention to and take more seriously formal communications as opposed to other types of reminders. For this reason, nudging taxpayers to pay quarterly taxes through a Form 1099 is likely more effective than less formal reminders, such as email communications from platform companies.

Consider an Uber driver, for example. Presumably Uber could send the taxpayer an earnings statement each quarter with an explicit reminder to pay estimated taxes. But a Form 1099 is a well-known government form which undoubtedly holds an association in most taxpayers’ minds with reporting and paying taxes. A quarterly 1099 would be salient, formal, and likely received less frequently than other communications from Uber. All of these factors suggest a taxpayer would be more likely to pay attention to and respond to the 1099 than a less formal reminder.

IV. THE PROPOSAL: QUARTERLY INFORMATION RETURNS

Drawing on the lessons from the social science literature discussed in Part III, this Part offers a novel proposal for a quarterly Form 1099. Specifically, it proposes a new Form 1099-ES to be sent to certain taxpayers each quarter, in addition to the annual Form 1099-K. The 1099-ES would be issued to online platform workers ahead of each estimated tax payment deadline. However, unlike the annual Form 1099-K, the 1099-ES would go only to the taxpayer and not the IRS. Nothing would change with respect to the process of year-end reporting on Form 1099-K to both the IRS and the taxpayer.

A. Form 1099-ES: The Basics

This Section discusses the fundamental elements of a Form 1099-ES: when it would be issued and what the form would contain. As the social science research indicates, timing the delivery of Form 1099-ES to immediately precede estimated tax deadlines would help taxpayers comply with these deadlines.¹²⁶ This Section also draws upon the research about planning prompts to propose simple and clear instructions for paying estimated taxes.¹²⁷

1. Timing

Recall that estimated tax payments are due four times per year, fifteen days after each payment period ends.¹²⁸ Confusingly, the payment periods are not broken up into equal three-month quarters. Rather, the four payment periods and corresponding deadlines are as follows (with a two-month period in the spring and a four-month period in the fall)¹²⁹:

Table 1.
Payment Period	Estimated Tax Payment Due Date
January 1 – March 31	April 15
April 1 – May 31	June 15
June 1 – August 31	September 15
September 1 – December 31	January 15

Note that the uneven nature of the payment periods adds complexity and likely makes it even more difficult for taxpayers to remember when to make estimated tax payments.

To assist platform workers in meeting their tax payment obligations in a timely manner, platform companies could be required to send a Form 1099-ES to the worker during the window between the end of the payment period and the estimated payment deadline. Since this period is currently only fifteen days, the best approach to implementing quarterly 1099s would be for Congress to extend the estimated payment deadlines to thirty days after the payment period ends. This would allow for the payer to have fifteen days to issue the 1099-ES and the taxpayer to have fifteen days from receipt of the 1099-ES to make the payment. The proposed schedule would be as follows¹³⁰:

Table 2.
Payment Period	1099-ES Due Date	Estimated Tax Payment Due Date
January 1 – March 31	April 15	April 30
April 1 – May 31	June 15	June 30
June 1 – August 31	September 15	September 30
September 1 – December 31	January 15	January 30

If there were compelling reasons not to change the payment deadlines beyond fifteen days from the end of the pay period, the timeline for sending the Form 1099-ES would have to be shorter. There would be fifteen total days to split between the payer/sender of the 1099-ES and the taxpayer/recipient of the 1099-ES. Each of the two parties has their own obligation. The payer/sender must calculate how much the taxpayer/recipient has been paid that quarter and fill out and deliver the form. The taxpayer/recipient must determine how much estimated tax to pay by the deadline, using the information from the form.

As between the two parties, more time should be allotted to the recipient/taxpayer. Parties sending a 1099-ES will generally be large and sophisticated (for example, a company like Uber), and thus are likely to have the resources to handle their side of the obligations efficiently. On the other hand, as discussed above, individual recipients of a Form 1099 often lack knowledge about how to properly manage their tax obligations and are less likely to have automated processes in place to meet these obligations. Accordingly, the fifteen day period should be split in the taxpayer’s favor. For example, for the pay period ending March 31, the 1099-ES might be due within five days (April 5 in this example), which would leave the taxpayer ten days from receipt of the 1099-ES to meet the deadline. Such a schedule could be as follows:

Table 3.
Payment Period	1099-ES Due Date	Estimated Tax Payment Due Date
January 1 – March 31	April 5	April 15
April 1 – May 31	June 5	June 15
June 1 – August 31	September 5	September 15
September 1 – December 31	January 5	January 15

The key to this timing of delivery of Form 1099-ES would be proximity to the taxpayer’s estimated tax payment deadline. In this way, the 1099-ES would not only provide vital information to the taxpayer about how to meet their obligations (discussed more below), but the receipt of the 1099-ES itself would provide a reminder that estimated taxes must be paid, and that they are due shortly.

It is logical and intuitive that payment reminders would come in close proximity to payment deadlines, and that they come with the same frequency as payment deadlines. Indeed, people are accustomed to this schedule in virtually every other aspect of life in which regular payment deadlines occur. A monthly electricity payment deadline is almost certainly accompanied by the receipt of an electricity bill in the days leading up to the deadline. The receipt of a 1099-ES somewhere between five and fifteen days before estimated tax payments are due would serve the same function as a bill; it would not only help taxpayers determine what they owe, but it would also remind taxpayers that they must make payment.

Given the desirability of timing the Form 1099-ES to be close to the payment deadline, the most efficient means of delivery would be to send it to taxpayers electronically. Current IRS rules allow the annual Form 1099 to be sent electronically (as long as the taxpayer consents), and this method of delivery of tax forms is likely familiar to most platform workers.¹³¹

2. Content of Form

The goal of Form 1099-ES is twofold. First, the form provides a reminder of the taxpayer’s obligation to make a quarterly estimated tax payment. Even for taxpayers who might know exactly how much to pay (because, for example, they are basing their estimated tax payments on the prior year’s tax liability), the form will still serve as a reminder of when to pay. A second and equally important goal of the Form 1099-ES is to help taxpayers calculate and make their estimated tax payments.

Recall that, in the studies discussed above in Part III, individuals were more likely to complete tasks when they were given specific, simple instructions, and completion was made as easy as possible. For example, vaccine uptake increased when individuals were asked to pick a date and given a link to make an appointment.¹³² Similarly, parties were less likely to miss a court date when they received reminders and a simplified summons form with clear instructions about where to go and when.¹³³ In light of this research, the goal of the Form 1099-ES should be to make it as clear and easy as possible for the taxpayer to make estimated tax payments. To that end, the Form 1099-ES should be based on a simplified version of Form 1099-K, with brief instructions about how to calculate and pay estimated taxes.

The current Form 1099-K contains basic identifying information about both the payer and the recipient/taxpayer, along with eight boxes providing gross payments and certain tax information.¹³⁴ Boxes 1 and 5 are most relevant for this purpose: Box 1 shows gross earnings for the entire year, and Box 5, which is broken up into Box 5a-January, Box 5b-February, and so forth, shows earnings for each of the twelve months of the year.¹³⁵ Form 1099-K does not contain any instructions to taxpayers about how to report and pay taxes on their gross earnings reported in Box 1.¹³⁶

The Form 1099-ES would use the template for Form 1099-K as a starting point. In lieu of the current title, “Form 1099-K, Payment Card and Third Party Network Transactions,” the form would simply say “Form 1099-ES, Statement of Quarterly Payments.” The identifying information, such as the taxpayer/recipient’s name, address, and taxpayer identification number, along with the payer’s name and address, would be the same. The only substantive change would be to Box 1. Rather than saying “Gross Amount of Payment” as Form 1099-K does, Box 1 would be broken up into two parts: Box 1a and Box1b.

Box 1a of Form 1099-ES would say “Gross Payments for the Payment Period January 1–March 31” (or adjusted accordingly for the relevant payment period). Box 1a would then contain payments for that pay period only. This would be the key information for determining the taxpayer’s estimated tax payment.

Box 1b would show “Gross Payments Year to Date.”¹³⁷ Box 5 would fill in the payments for each of the relevant months (for example, January, February, and March) as on the regular Form 1099-K.

The top half of the Form 1099-ES would look much like the Form 1099-K, with the exception of the modifications described in the preceding paragraphs. However, the bottom half of Form 1099-ES would contain several short pieces of important information for taxpayers. (Currently, the bottom half of Form 1099-K is blank). The bottom half of Form 1099-ES should communicate the following information: (1) the exact deadline for making an estimated tax payment; (2) the link to make the payment online; and (3) specific, simple information for how to calculate the estimated tax payment based on the gross payments reported. Note, this tracks the social science research indicating that people are most likely to follow through with tasks when they are provided with step-by-step instructions about how to act.¹³⁸ A specific example of these instructions is discussed later in Section IV.B.

3. Simplified Safe Harbor Payment

Implementing an effective quarterly 1099 form would require one substantive law change, which would be a simplified method of calculating estimated taxes. Recall that currently, estimated tax penalties apply unless the taxpayer pays 100% of the prior year’s tax liability or 90% of the current year’s liability (or owes less than $1,000).¹³⁹ None of these lend themselves to a quick and easy calculation that can be communicated in one step on a Form 1099-ES.

The most effective way to encourage platform workers to make an estimated tax payment is to provide a new safe harbor rule that allows them to pay a fixed percentage of the quarterly gross payment that is reflected on the 1099-ES. Importantly, this does not require the taxpayer to have any other information at their disposal (such as last year’s tax liability) other than what is printed on the Form 1099-ES. For example, the Form 1099-ES might tell taxpayers that they can avoid an estimated tax penalty if they pay 5% of their gross payments in estimated tax. For taxpayers that want to do a more detailed calculation of their estimated tax liability, the form could also refer to the longer instructions (and worksheet) for how to do so.¹⁴⁰ The next Section further discusses how such a safe harbor could be calculated.

Although the 90%/100% rules for avoiding an estimated tax penalty are statutory, the Treasury and the IRS could likely implement an administrative safe harbor rule without congressional action.¹⁴¹ In other contexts, the IRS has enacted administrative safe harbor rules which taxpayers can choose to rely on to avoid penalties but are not obligated to follow.¹⁴² One example is the simplified home office deduction. Section 280A of the Internal Revenue Code (“Code”) provides statutory limitations on the deductibility of home office expenses.¹⁴³ However, in Revenue Procedure 2013-13, the IRS provides “an optional safe harbor method that individual taxpayers may use to determine the amount of deductible expenses attributable” to their home office for the year.¹⁴⁴ Under the optional safe harbor, rather than tracking and allocating actual expenses attributable to the home office (such as rent, depreciation, or utilities), taxpayers may instead elect to deduct $5 per square foot of home office space, up to a maximum of 300 square feet ($1,500 total).¹⁴⁵

In the case of this home office safe harbor, the government has made a decision to sacrifice accuracy in the name of tax administration. The Revenue Procedure states:

The Internal Revenue Service (Service) and the Treasury Department recognize that the calculation, allocation, and substantiation of allowable deductions attributable to the use of a portion of the taxpayer’s residence for business purposes can be complex and burdensome for small business owners. Accordingly, the Service and the Treasury Department are providing this optional safe harbor method to reduce the administrative, recordkeeping, and compliance burdens of determining the allowable deduction for certain business use of a residence under § 280A.¹⁴⁶

Taxpayers are not obligated to use the simplified home office deduction; if they think they can claim a higher deduction, they can simply apply the statutory rules for deducting home office expenses.

In the same way, a safe harbor estimated tax payment would offer platform workers an option for calculating estimated tax payments that would allow them to avoid an estimated tax penalty; they would multiply a fixed percentage amount (for instance, 5%) by the gross payment shown on their 1099-ES. For taxpayers who wanted to make a more precise calculation of their estimated tax liability, they would be free to use the statutory rules for avoiding penalties. Like the simplified home office deduction, the simplified safe harbor payment for estimated taxes would provide taxpayers with an easy-to-use formula that could be applied quickly with virtually no administrative hassle.

It is also worth noting that providing taxpayers with a simplified safe harbor payment in the form of a fixed percentage of gross receipts would have no bearing on the taxpayer’s ultimate tax liability. The key to the safe harbor would be to make paying estimated taxes as easy as possible to encourage better compliance with making estimated tax payments. This higher compliance would benefit both the government in its revenue collection efforts, and it would also benefit taxpayers by reducing the amount they must pay at the end of the year. However, a taxpayer’s year-end tax liability would still be calculated under the already existing tax rules.

If the taxpayer owed additional tax at the end of the year because the simplified safe harbor payments did not fully satisfy their tax obligations, the taxpayer would still be obligated to pay that tax with their return. However, they would not face an estimated tax penalty for paying it late. On the other hand, if the simplified safe harbor payments resulted in paying more tax than they owe at the end of the year, the taxpayer would claim a refund with their tax return. In this respect, they would be in the same position as many employees, who often claim refunds because they have more tax withheld than they ultimately owe.¹⁴⁷ This is also true for independent contractors who overpay or underpay their estimated taxes under the statutory rules for avoiding estimated tax penalties.

B. Scope and Implementation of the Form 1099-ES Requirement

A quarterly Form 1099-ES may not be cost effective in all cases, and it is still untested. Accordingly, this Article suggests gradual implementation of the form, starting with online platform companies that facilitate the performance of services (such as driving, errands, or household tasks). Within that group of platform companies, this Article proposes that the rollout of a quarterly 1099 requirement start with ridesharing platforms only, extending to other service-based platforms later after evaluating the initial rollout. Additionally, only platforms of a certain size (measured by gross receipts) should be required to send quarterly 1099-ES Forms to workers; the requirement is not intended to burden small businesses who work with independent contractors.

This Section discusses who would be required to send a Form 1099-ES, which payees (taxpayers) would receive the form, how to calculate a simplified safe harbor payment, and then offers an example of implementation for ridesharing service platform workers.

1. Who Would Be Required to Send Form 1099-ES?

At the highest level, a Form 1099-ES would only be required of payers who already have an obligation to send an annual Form 1099 to one or more independent contractors. As discussed in Part I, independent contractors generally receive either Form 1099-K or Form 1099-MISC if they receive over $600 during the tax year from a payer.¹⁴⁸ A Form 1099-MISC would apply to an independent contractor payment not made through an online application—for example, if a business hired a painter and paid them by check.¹⁴⁹ However, this Article focuses exclusively on payers who qualify as TPSOs (such as online platform companies),¹⁵⁰ and thus focuses only on payers required to send a Form 1099-K. In excluding Form 1099-MISC, the Article’s focus is intentionally limited to payers who are already transacting with payees electronically and thus likely have the technological capacity to efficiently process and issue electronic quarterly information returns. Such focus also recognizes the reality that online platform work is a growing and significant segment of the economy that presents unique tax compliance challenges.¹⁵¹

Within the realm of Form 1099-K issuers, the proposal does not include credit card companies, which also have obligations to issue 1099-Ks.¹⁵² This is, again, because the quarterly 1099 proposal is intended to help online platform workers and similar individual taxpayers. The 1099-K requirements for credit card companies require the form to be issued to a broader range of businesses, for example, a large brick and mortar retail business that accepts credit cards, which are not the taxpayers targeted by the proposal.

Excluding Form 1099-MISC issuers and credit card companies, the Form 1099-K rules apply to payers who qualify as TPSOs, which include online platforms like Uber and Etsy, payment applications like Venmo and PayPal, as well as some cryptocurrency processors.¹⁵³ Within this group, only online platforms that pay independent contractors for services (like Uber or TaskRabbit) should initially be subject to a Form 1099-ES requirement.

While many independent contractors earn income online that is not service related, such as by selling goods using Venmo or Etsy, gross income from these transactions is less likely to be taxable. This is because only net earnings after deducting the cost of the goods sold are subject to income and self-employment tax,¹⁵⁴ and many online sales are likely made at little to no profit. Consider, for example, someone who sells their used furniture using eBay. Even though they will receive a Form 1099-K if the gross payments for the furniture exceed $600, the seller would not have any taxable income to report unless they sold the furniture for more than they purchased it for (an unlikely result for used furniture). Without any tax liability, they would have no obligation to make estimated tax payments with respect to the sales. On the other hand, taxpayers who are paid for services are more likely to have reportable net income, even if they are able to claim some business deductions.¹⁵⁵

To be sure, many sellers of goods earn a taxable profit. A seller who knits blankets and sells them on Etsy is likely to earn more than they spent on supplies. However, it is harder to distinguish between casual sellers (who may be selling used goods at a loss) and professional sellers by looking at the platform alone. A payment platform like Venmo might be used to make casual sales and professional sales; it also is often used for transactions that are not taxable at all, such as gifts. Thus, for administrative ease, this Article proposes initially excluding these platforms altogether from the quarterly Form 1099-ES requirement.

If implementing the requirement for service platforms is successful, the quarterly 1099-ES could be implemented down the road for platform workers who sell goods. To target professional sellers who are likely to be making a profit (and thus have taxable sales to report), the government could consider raising the payment threshold substantially beyond the current $600 for a Form 1099-K. Thus, for example, it might only require quarterly 1099s for sellers on these platforms who earn at least $10,000 of gross receipts in the year or $5,000 in a single quarter.¹⁵⁶

In limiting its focus to service-based platforms, the proposal would also initially exclude platforms that allow individuals to rent residential spaces online, such as Airbnb and VRBO. The reason for this exclusion is that the primary goal of the proposal is to ease compliance burdens on non-employee service providers, which is the group that has been singled out by the GAO and commentators as in particular need of assistance in meeting tax compliance obligations.¹⁵⁷ Further, many property owners earn rental income through platforms like Airbnb passively and are therefore not treated as independent contractors subject to self-employment tax.¹⁵⁸ Like online sales platforms, Congress could decide to gradually extend the 1099-ES requirement in the future to cover property rentals, but the proposal herein is more modest in scope to start. Accordingly, the remainder of the Article will focus only on service-based platforms.

To implement the proposal, Congress could enact a statutory requirement that any TPSO that pays an individual in connection with the performance of services by that individual be required to send a quarterly 1099-ES if a certain dollar threshold of payment is met.¹⁵⁹ TPSOs that pay individuals for performing services could include ridesharing platforms like Uber and Lyft, delivery platforms like Instacart and DoorDash, and other service-based platforms like Handy and TaskRabbit.¹⁶⁰ However, as discussed further below, this Article suggests that quarterly 1099s first apply only to ridesharing platforms like Uber and Lyft, with later extension to other types of services.¹⁶¹

While the proposal is targeted at large platform companies (such as those mentioned in the preceding paragraph), it is possible a much smaller business could technically meet the definition in the statute and be swept into the Form 1099-ES requirements. On one hand, a quarterly information return benefits an independent contractor regardless of who the payer is. However, whether a quarterly 1099 is cost-effective depends, in part, on whether the administrative cost imposed on the third party who must send the form is justified.

Imagine, for example, that an individual began operating their own ridesharing business through a new online platform, and that they worked locally with just a few drivers and generated only modest revenue. For such an individual operating at a small scale, the relative cost of sending a quarterly Form 1099-ES might be high compared to the tax compliance benefit on the payee’s side of the transaction (both in terms of time saved by the payee and revenue collected by the government). On the other hand, larger platform companies are more likely to already have the infrastructure in place to quickly compute and produce an electronic form with quarterly earnings and, due to economies of scale, can likely do so at relatively low cost.

To account for the potential of burdening smaller payers where the administrative cost would not be justified, Congress should consider requiring quarterly 1099s to be issued only by payers that exceed a minimum amount of revenue.¹⁶² For example, the rule might only require quarterly 1099s to be issued by payers who earn at least $500,000 in gross revenue during the year. This would surely capture larger platforms that can handle the obligation at little administrative cost while excluding truly “small” businesses that might be unduly burdened by the extra administrative requirement.

2. Setting the Payment Threshold

In terms of setting the dollar threshold for quarterly 1099s, the starting point should be the current threshold for Form 1099-K. Since TPSOs must send a Form 1099-K to any payee who is paid more than $600 during the year, at a minimum, the Form 1099-ES requirement should be triggered if a payee receives $600 in payments in a single quarter.

What if the payee receives less than $600 in a quarter but appears on track to receive $600 by the end of the year? One quarter of the $600 threshold is only $150, and it is questionable whether this amount justifies the administrative cost of an additional tax form (particularly given the criticism that the $600 threshold has never been adjusted for inflation).¹⁶³ Thus, as long as the 1099-K threshold remains at $600, the Form 1099-ES threshold should not be set any lower. This would mean that a payer has an obligation to send a quarterly 1099-ES to a payee in any quarter where the total cumulative payments for the year thus far exceed $600.

For example, suppose Driver A drives for Uber and is paid $300 between January 1 and March 31 and then is paid $400 between April 1 and May 31. Uber would not have an obligation to send Driver A a Form 1099-ES for the first payment period because Driver A would not have exceeded the $600 threshold. But Uber would have an obligation to send a Form 1099-ES for the second payment period, because Driver A would have been paid over $600 ($700, in this example) by that point. The 1099-ES would be for the second payment period, but it would reflect both the payments for that payment period ($400 in this example) and the year-to-date gross payments ($700 in this example). Uber would also have an obligation to send a Form 1099-ES for any remaining payment period in which Driver A was paid any amount.

In the likely event that Congress eventually raises the $600 threshold for 1099-K reporting, the Form 1099-ES threshold should also be revisited and might not track the 1099-K threshold as precisely. For example, a current bipartisan proposal would raise the 1099-K reporting threshold to $10,000.¹⁶⁴ In that case, the quarterly 1099-ES threshold might start at something lower and might be tied to the amount of quarterly payment in addition to cumulative payments. For example, Congress could impose a requirement that a Form 1099-ES be sent to any taxpayer who earns at least $5,000 in any single payment period or has earned $10,000 cumulatively by that payment period. If the taxpayer ultimately did not earn enough to meet the Form 1099-K threshold by the end of the year, the payer would not have to issue the Form 1099-K, but the payee would still have the benefit of the reminder and assistance in paying estimated taxes. (Note, the payee would still have an obligation to report and pay tax on any taxable income even if the annual 1099-K threshold was not met.)

Finally, it bears repeating that the obligation to send a Form 1099-ES for a payment period would only be an obligation to send the form to the payee, not the IRS. This could be done electronically at little cost to the payer. At the same time, the IRS would not be overburdened with more forms to process.

3. Calculating the Simplified Safe Harbor Payment

Form 1099-ES would not only report a worker’s gross payments for the quarter but should also contain clear and simple instructions for how to calculate and pay estimated taxes. As discussed in Section III.A, this means providing the taxpayer with: (1) the exact deadline for making the payment; (2) a link to make online payments (and an address to mail physical payments); and (3) a simplified safe harbor method of calculating the estimated tax due.¹⁶⁵ This Section considers how to calculate that safe harbor payment and proposes using a formula of 5% of the gross payments for that payment period.

Recall that the goal of the simplified safe harbor payment is to provide taxpayers the ability to easily calculate estimated tax payments without having to track down any other information beyond what is reflected on the Form 1099-ES. To achieve this, the safe harbor estimated tax payment would have to be based on the taxpayer’s current year tax liability, rather than the previous year’s liability (which would require consulting last year’s tax return). Thus, the goal of the safe harbor payment would be to determine an estimate of how much income and self-employment tax would be due on the gross payment reflected on the current Form 1099-ES.

Determining a precise amount of tax due on a gross payment for an independent contractor is difficult to do without more information. First, only taxable income, not gross income, is subject to income tax, meaning that a worker would have to reduce their gross income by any available business deductions as well as so-called “below the line deductions” (either the standard deduction or itemized personal deductions) to arrive at taxable income.¹⁶⁶ Second, only net business income, after factoring in business expenses, is subject to self-employment tax.¹⁶⁷ Third, many independent contractors can also claim a deduction under Code § 199A of up to 20% of their business income.¹⁶⁸ Finally, although self-employment tax is generally calculated at a fixed percentage (15.3%), a taxpayer’s income tax rate depends on how much taxable income they have for the year.¹⁶⁹

More simply, 1099 Forms reflect gross payments, but federal taxes are generally only due on net earnings from self-employment. Thus, to provide a simplified calculation of how much tax is due on a gross payment, a formula would need to make several simplifying assumptions to arrive at estimated net income and an estimated tax rate.

First, net business income must be derived from gross payments. In other words, the formula must make an assumption about what portion of a gross payment will be left over after business expenses are deducted. To do this, policymakers could look to public IRS data showing the average ratio of net income to gross receipts for particular industries. For example, IRS data on sole proprietors shows that the average profit ratio for workers engaged in driving services, including ridesharing services, is approximately 30%.¹⁷⁰ In other words, net income after deducting business expenses was about 30% of gross income, on average. Similarly, a study conducted by the Office of Tax Analysis at the Department of Treasury examined profit ratios for gig economy workers and found that, on average, gross profit ratios were approximately 30%.¹⁷¹

Accordingly, to calculate a simplified safe harbor payment for the purpose of implementing Form 1099-ES, policymakers could assume a profit ratio of 30%. Note, in certain service industries, profit ratios are likely much higher. Ideally, a different safe harbor calculation could be offered to different workers according to industry. Further research might yield better data on average profit ratios in various sectors of the gig economy. For now, this Article suggests limiting the quarterly 1099 proposal initially to ridesharing platforms, where the profit ratio is more well established by IRS data.¹⁷²

Presuming a profit ratio of 30% means the safe harbor formula would assume 30% of the gross payment reflected on a Form 1099-ES represents taxable income. The next step would be deciding upon a tax rate. Taxpayers are responsible for both income tax and self-employment tax when they make estimated tax payments.¹⁷³ Self-employment tax is fixed at approximately 15% of net earnings.¹⁷⁴ Individual income tax rates range from 10% to 37%, depending on taxable income.¹⁷⁵ But since average platform earnings tend not to exceed the income levels associated with higher brackets, this proposal focuses on income tax rates of 10, 12, and 22%,¹⁷⁶ and does not consider higher marginal rates.¹⁷⁷

Combining income tax rates with self-employment tax would result in a total federal tax rate ranging from 15% to 37%, as reflected in Table 4 below¹⁷⁸:

Table 4.
Taxable Incomea	Income Tax Rate	Self-Employment Tax Rate	Total Federal Tax Rate
$0	0	15%	15%
Up to $11,000	10%	15%	25%
Up to $44,725	12%	15%	27%
Up to $95,375	22%	15%	37%
Note: aIt should be noted that these are marginal tax rates, so for a taxpayer who is taxed in a higher bracket, the first dollars of their income are taxed at lower brackets, and only the amount over the dollar threshold is taxed at the highest bracket. Because the purpose of this discussion is to arrive at a rough estimate of how much to pay in quarterly taxes for purposes of the simplified safe harbor, the marginal nature of the tax brackets can be disregarded.

Recall that the proposal assumes a 30% profit ratio for platform workers earning income from ridesharing services—in other words, that net income equals 30% of gross receipts. Setting aside any other deductions (other than business deductions), this would mean that the total tax due on a gross payment could be calculated as approximately:

30% x (the gross payment) x (the total tax rate)¹⁷⁹

Using this formula, the tax due on gross receipts can be derived as a single percentage of the gross receipts, as reflected in the Table 5 below:

Table 5.
Taxable Income	Total Federal Tax Rate	Presumed Profit Percentage	Tax Due as a Percent of Gross Receiptsa
$0	15%	30%	4.5%
Up to $11,000	25%	30%	7.5%
Up to $44,725	27%	30%	8.1%
Up to $95,375	37%	30%	11.1%
Note: aCalculated as 30% times the total tax rate.

As shown above, the tax due on a gross payment would range from about 4% to about 11% of the payment, depending on the taxpayer’s overall taxable income. However, a number of factors which are difficult to generalize are relevant in determining which rate in the range is appropriate for a particular taxpayer. First, taxpayers may earn income from other sources beyond platform work, putting them in a higher income tax bracket than their Form 1099 suggests. Second, although the table above accounts for business expenses by assuming a 30% profit ratio, it does not account for any other deductions and thus likely overestimates tax liability for many taxpayers. Recall that taxpayers can claim the standard deduction or itemized deductions, and independent contractors can generally claim an additional below-the-line deduction under § 199A.¹⁸⁰ Other above-the-line deductions (such as retirement account contributions or student loan interest) also reduce taxable income for taxpayers.¹⁸¹ Finally, workers may be entitled to other tax credits (for example, a child tax credit) that further reduce their tax liability.¹⁸²

These factors, on balance, point towards erring on the lower side of the range of possible percentages of gross receipts. For this reason, this Article proposes 5%, which is a flat and easy-to-remember percentage at the low end of the range reflected in Table 5 above.¹⁸³ Although this Article proposes only one rate to start, policymakers could implement different rates for different industries or groups of platform workers. For example, workers in industries that are purely service based (for example, childcare) likely have far fewer business expenses than ridesharing service drivers, which means 5% of gross payments as an estimated tax payment would probably be too low.¹⁸⁴ For such workers, 10% of gross payments might make more sense as a safe harbor.

4. Examples: Ridesharing Service Platform Workers

This Section illustrates the estimated tax safe harbor proposal with concrete examples involving four rideshare drivers. For the sake of simplicity, all four drivers are assumed to be single, childless, and have no other income.¹⁸⁵ Additionally, the examples assume each driver claims business expenses, a § 199A deduction, and the standard deduction, and no additional deductions or credits.

Assume that the first driver, Driver A, receives gross payments from a ridesharing platform of $25,000 for the year. The distribution of those payments across the four payment periods is shown in Table 6.A below. After business expenses (including fees to the platform and the standard mileage deduction), assume that Driver A’s net income from platform work is $7,500.¹⁸⁶ Driver A’s actual tax liability would be $1,060.¹⁸⁷ Driver A’s estimated tax payments using the 5% safe harbor calculation would total $1,250. Thus, Driver A would overpay their taxes slightly and be entitled to a $190 refund, as illustrated in the table below.¹⁸⁸

Table 6.A. Driver A
	Gross Payment from Platform	Safe Harbor Estimated Tax Payment (5%)	Actual Year-End Tax Liabilitya	Amount Owed (Refund)
Period 1	$6,000	$300	. . .	. . .
Period 2	$5,000	$250	. . .	. . .
Period 3	$8,000	$400	. . .	. . .
Period 4	$6,000	$300	. . .	. . .
Total	$25,000	$1,250	$1,060	($190)
Note: aSee supra note 187.

Assume Driver B receives gross payments of $50,000 from the platform and nets $15,000 after expenses.¹⁸⁹ Driver B would pay $2,500 in taxes under the estimated tax safe harbor and have $2,126 of actual tax liability, resulting in a refund of $374, as illustrated in the table below.¹⁹⁰

Table 6.B. Driver B
	Gross Payment from Platform	Safe Harbor Estimated Tax Payment (5%)	Actual Year-End Tax Liabilitya	Amount Owed (Refund)
Period 1	$12,000	$600	. . .	. . .
Period 2	$13,000	$650	. . .	. . .
Period 3	$10,000	$500	. . .	. . .
Period 4	$15,000	$750	. . .	. . .
Total	$50,000	$2,500	$2,126	($374)
Note: aSee supra note 190.

Assume that Driver C receives gross payments of $75,000 from the platform and nets $22,500 after expenses.¹⁹¹ Driver C would pay $3,750 in taxes under the estimated tax safe harbor and have $3,744 of actual tax liability, resulting in a $6 refund.¹⁹²

Table 6.C. Driver C
	Gross Payment from Platform	Safe Harbor Estimated Tax Payment (5%)	Actual Year-End Tax Liabilitya	Amount Owed (Refund)
Period 1	$20,000	$1,000	. . .	. . .
Period 2	$15,000	$750	. . .	. . .
Period 3	$25,000	$1,250	. . .	. . .
Period 4	$15,000	$750	. . .	. . .
Total	$75,000	$3,750	$3,744	($6)
Note: aSee supra note 192.

Finally, assume Driver D receives gross payments of $100,000 from the platform and nets $30,000 after expenses.¹⁹³ Driver D would pay $5,000 in taxes under the estimated tax safe harbor and have $5,366 of actual tax liability, resulting an additional $366 of tax being due with their return.¹⁹⁴

Table 6.D. Driver D
	Gross Payment from Platform	Safe Harbor Estimated Tax Payment (5%)	Actual Year-End Tax Liabilitya	Amount Owed (Refund)
Period 1	$20,000	$1,000	. . .	. . .
Period 2	$35,000	$1,750	. . .	. . .
Period 3	$12,000	$600	. . .	. . .
Period 4	$33,000	$1,650	. . .	. . .
Total	$100,000	$5,000	$5,366	$366
Note: aSee supra note 194.

Several observations follow from these examples. Generally, workers with lower income will owe less in taxes than those with more income, so lower income workers are more likely to receive a refund if they use the safe harbor, while higher income workers are more likely to owe additional taxes. In the examples above, Drivers A and B (who have the lowest income) made overpayments through estimated taxes resulting in modest refunds. Driver C’s estimated tax payments matched their tax liability almost exactly, while Driver D (the highest earner) owed a modest amount in additional taxes.

Since Drivers A and B are more likely to face liquidity constraints (due to earning less income overall), it is ideal that, as between owing money and receiving a refund, they do not owe money with their tax return. In other words, Drivers A and B are less likely to be able to come up with additional cash for taxes owed when they file their return, so it is ideal they would slightly overpay, rather than underpay. Driver D, on the other hand, is in a better financial position to owe money with their return since they made significantly more money during the year.

In sum, while estimated tax payments are almost never going to match up exactly with a taxpayer’s year-end liability, the goal here is to minimize how much overpayment or underpayment the taxpayer will experience. If taxpayers are paying too much in estimated taxes during the year, even though they can claim a refund, they might be depriving themselves of much needed liquidity during the year. For taxpayers who do not pay enough in estimated taxes, even though the safe harbor formula would protect them from penalties, they may not budget properly for a significant payment due with their tax return. The 5% safe harbor proposed here aims to result in most low-income rideshare drivers receiving a modest refund, while higher earners may owe some additional taxes but would not pay estimated tax penalties.

C. Addressing Potential Objections

This Section addresses three potential objections to the proposal for quarterly 1099s. First, critics might argue that requiring certain businesses to send a Form 1099 every quarter would create too much cost or complexity for the business, for the IRS, or both. Second, critics might argue that there is too much heterogeneity among taxpayers to come up with a fixed formula for a safe harbor estimated tax payment. Third, critics might claim requiring platform workers to receive more frequent tax statements would impose unfair burdens on these workers.

1. Quarterly 1099s Would Impose Undue Complexity and Cost

History has shown that, when Congress expands tax reporting obligations of third parties (such as through expanded 1099 requirements), those third parties generally oppose the change.¹⁹⁵ This is to be expected because it is the third parties who bear the administrative cost of obligations like issuing 1099s. Third parties may also be concerned that tax reporting obligations will make their customers reluctant to do business with them.¹⁹⁶ Thus, if Congress were to implement a new requirement for quarterly 1099s for platform workers, it is possible (if not likely) that the platforms would oppose the rule and claim it is unduly burdensome.

There are several responses to this claim that quarterly 1099s would pose undue burdens on the platform companies. First, the quarterly 1099 requirement would only apply to platforms already required to issue a Form 1099-K to the worker. This means that the IRS is already receiving information about the worker’s earnings. Thus, quarterly 1099s should not discourage workers from doing business with the platform because the IRS is not receiving any new or additional information. Rather, the quarterly 1099 is only for the worker’s benefit. In essence, the quarterly 1099 is a form of free tax assistance from the platform to the worker.

Second, while sending quarterly 1099s to workers will impose additional administrative costs on the platform, that cost will be minor. Particularly, the marginal cost of tracking earnings each quarter is relatively low since the platform already has an obligation to engage in year-end information reporting under the 1099-K rules. This means that additional administrative steps required for 1099-Ks, such as asking taxpayers to provide taxpayer identification numbers, will already be in place.¹⁹⁷ The platform companies also likely already have the necessary technology in place to send tax forms electronically to their workers. Since the quarterly forms only go to the workers, the platforms companies will have no additional filing obligations with the IRS.

Further, it should be noted that imposing some administrative costs on third parties is both efficient and foundational to our tax system. For example, withholding imposes administrative costs on employers, but it is more efficient to have taxes collected and paid by the employer than to impose payment obligations on each employee.¹⁹⁸ Withholding also results in higher tax compliance and more revenue collected.¹⁹⁹ Similarly, third-party information reporting in all areas, from investment income to broker transactions to independent contractor payments, is justified by the higher compliance it brings.²⁰⁰

The same reasoning applies to quarterly 1099s. The tradeoff for the minor cost it would impose on third parties (who can afford to bear it) is reduced administrative cost and higher compliance for the platform workers. In other words, the modest cost to the platform of additional communications to the taxpayer throughout the year should be outweighed by the benefit to the taxpayer of receiving a report of earnings with a reminder and instructions for how to pay estimated taxes.

Another related argument against the proposal might be that the IRS would also be unduly burdened by more 1099 forms, but this argument is misguided. Recall that the quarterly 1099-ES would be an obligation of the platform company to send to the worker, but not to the IRS. The IRS would receive a copy of the taxpayer’s Form 1099-K at the end of the year as under the current system, but the IRS would not receive quarterly information. Thus, there would be no additional returns for the IRS to process as a result of a quarterly 1099 requirement.

Quarterly 1099s would pose a minor administrative burden on the IRS in that the requirement would have to be policed in some way. Presumably, Congress could impose a penalty on businesses that fail to issue required 1099-ES forms to taxpayers in the same way that it imposes penalties for failure to file year-end information returns.²⁰¹ To enforce these rules, the IRS would need to monitor compliance through audits. However, this is already the case for enforcing the expanded 1099-K rules, so verifying compliance with quarterly reporting should not impose significant additional enforcement costs on the IRS.

Finally, it is worth noting that advances in technology have justified expansions to information reporting rules in recent years. As tax information is digitized and easily shared online, it is less costly to require third parties to issue 1099s, which means less political resistance and a greater net benefit to increasing 1099 reporting. These same technological advancements that have justified expanding the pool of 1099 recipients justify providing taxpayers with more frequent, and therefore more helpful, tax information.

2. The Safe Harbor Calculation Would Be Inaccurate

Critics of the 1099-ES proposal might also argue that it is too difficult to provide workers with a simple method of calculating their estimated taxes because each taxpayer’s situation is different. Those critics might further argue that the formulaic safe harbor proposed in this Article (5% of gross receipts) will result in underpayments or overpayments in too many cases.

It is certainly true that the simplified safe harbor formula for estimated tax payments—5% of the gross payment—relies on assumptions that will turn out not to be true for all taxpayers. For example, it assumes very few non-business deductions, and it assumes a 30% profit ratio that may be too high or too low for some workers.

But it is important to keep in mind that the 5% safe harbor is not intended to substitute for calculation of taxpayers’ actual tax liability. That is the function of Form 1040, the annual Individual Income Tax Return. The safe harbor is merely meant to be a simple way to give taxpayers some basis for making estimated tax payments. In this respect, it is not unlike the statutory rule that allows taxpayers to avoid estimated tax penalties by paying at least 100% of their prior year’s tax liability in estimated taxes.²⁰² In many cases, basing estimated tax payments on last year’s tax liability will result in significant underpayment or overpayment of estimated taxes; this will be true whenever the taxpayer’s current income is significantly different than the prior year’s income. (It will also be true if the taxpayer has a different tax situation from the prior year due to a change in marital status, dependents, deductions, or credits.) However, Congress has a made a rational decision to allow taxpayers to use last year’s tax liability as a reasonable basis to estimate taxes for the purpose of avoiding penalties. The 5% formula would have the same function.

Furthermore, the simplified safe harbor adds an alternative that is meant to better estimate the current year’s tax liability based on current earnings. This not only allows taxpayers to make payments without having to find last year’s tax return, but it also is more likely to help taxpayers avoid owing significant tax with their year-end tax return that they might not have budgeted for.

Further, using a fixed percentage of gross payments as a starting point, such as the 5% proposed in this Article, makes it much easier for taxpayers to make individualized adjustments to reflect their tax situation. For example, if a platform worker makes estimated payments based on 5% of their gross payments but ends up owing $1,000 with their tax return, they might decide to adjust the payments to 6% the following year. If they still owe money and prefer a refund, they might upward adjust to 7% the next year, and so on, until they are happy with their year-end tax situation. Relating estimated tax payments to a fixed percentage of gross payments gives taxpayers a better understanding of how their taxes relate to their earnings and more agency over the process of paying estimated taxes.

3. Quarterly 1099s Would Be Unfair to Low Income Workers

Finally, in the wake of the recent expansion of the 1099-K rules to cover more online transactions, some politicians and interest groups have claimed the rules imposed an unfair tax on low-income workers. For example, Senator Rick Scott released the following statement:

President Biden claims he won’t raise taxes on anyone making less than $400,000, but that’s a lie – he’s already done it. Along with trillions in unnecessary and unrelated in spending in the American Rescue Plan, Biden inserted a tax increase on gig workers, like hardworking Americans that work as drivers for Uber, Lyft or DoorDash.²⁰³

Similarly, the Coalition for 1099-K Fairness warned the new requirements would create “new IRS paperwork burdens” for small businesses.²⁰⁴ These same politicians and interest groups would likely repeat these arguments in response to the proposal for quarterly 1099s.

On one hand, the critique that more tax information is unfair to taxpayers themselves, particularly that it imposes a tax increase on them, is the easiest of all to address because it is based on a fallacious premise. However, because the argument is largely rhetorical, it may be the most pernicious.

Importantly, changes to information reporting rules are not changes to substantive tax law, so they cannot be correctly described as imposing a new tax or a tax increase. It has always been the case that platform income is subject to tax.²⁰⁵ The previous $20,000 threshold for receiving a 1099-K was not a rule that exempted transactions under $20,000 from income and self-employment tax. The rule simply triggered an obligation on the payer to send a Form 1099-K. It has always been the case that taxpayers are supposed to track and report earnings under the 1099 threshold.²⁰⁶ (Whether they do so is another story, but willfully failing to do so is tax evasion.²⁰⁷)

Although it might be politically persuasive to advocate leaving platform workers alone when it comes to their taxes, there is no valid reason that providing them with more information and with simplified instructions on how to pay their taxes is harmful. The only reason to withhold such information would be to give taxpayers a plausible basis for not paying their taxes.

There has been one line of critique about taxpayer burden that has merit, which is that the new 1099-K rules may be overbroad and cause confusion and anxiety for taxpayers (like sellers of used goods) who do not owe any tax.²⁰⁸ It is for this reason that the proposal in this Article does not cover sellers of goods but instead is aimed only at industries (like ridesharing services) that have an established history of earning taxable income. If, in the future, Congress decides to more narrowly tailor the 1099-K reporting rules to certain industries or income thresholds, Form 1099-ES could track these changes. In other words, the goal of quarterly 1099 reporting would always be to provide regular information to taxpayers that owe taxes and not to send needless forms to taxpayers who do not have estimated tax payment obligations.

CONCLUSION

Paying one’s taxes correctly and on time is exceptionally hard, especially for independent contractors. With the exception of employee withholding, our current tax system does very little to make paying federal taxes easy for people. Yet, the threat of punishment for getting it wrong looms large in many taxpayers’ minds. Perhaps nowhere is this sentiment better captured than in a 2020 viral TikTok video about paying taxes, which has earned over 2.2 million likes to date.²⁰⁹ The video is a parody of an interaction between a young taxpayer and an IRS agent, with the following dialogue:

Taxpayer: Hi, I’m 18 years old. This is my first time paying taxes. I really don’t know what I’m doing. Can you tell me how much I owe and I’ll just pay it?

IRS: No, we can’t do that. You have to figure out that amount for yourself.

Taxpayer: Oh, ok. If I’m just a little bit off in the amount that I owe, it’ll be ok because it’s my first time, right?

IRS: Oh no, we already know how much you owe, exactly, I mean, down to the penny, but you still have to figure that out for yourself.

Taxpayer: Well, what if I get that amount wrong?

IRS: You go to federal prison.

The post is humorous because of the truth that underlies it.²¹⁰ It portrays a system that borders on absurd: we expect compliance and accuracy from taxpayers, with the threat of punishment for noncompliance, with virtually no help from the government with getting it right.

This Article focuses on one of the most confusing yet important obligations for platform workers and other independent contractors: figuring out how and when to pay their estimated taxes. The proposal for quarterly 1099s is not a panacea, but it could go a long way towards helping taxpayers budget for taxes, calculate an estimated payment, and make their payments on time.

More importantly, although the proposal is modest in scope, it is also a call to policymakers to rethink the role of third-party tax information more broadly. While deterrence and monitoring taxpayers will always be crucial aspects of tax enforcement, tax information can also empower taxpayers. In this respect, third-party information returns should be thought of as sending an informational nudge to the taxpayer, rather than just reporting information to the IRS. Just as monthly bills help customers pay for services, quarterly 1099s would help taxpayers calculate and stay on top of quarterly tax payment obligations. This reform would not only raise revenue, but it would also be a much-needed step towards simplifying and demystifying the tax system for individual taxpayers.

97 S. Cal. L. Rev. 1527

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Kathleen DeLaney Thomas*

* Aubrey L. Brooks Distinguished Professor of Law, University of North Carolina School of Law. I am grateful to Leigh Osofsky and Courtney Thomas for helpful feedback on this Article.

“Bob Jones University” in the 21st Century: An Examination of Charitable Tax-Exempt Status and Religious Exemption from Title IX for Religious Colleges That Discriminate Against LGBTQ+ Students

July 2024July 2024Sydney Smith*

INTRODUCTION

On March 30, 2021, the Religious Exemption Accountability Project (“REAP”) filed a historic class action lawsuit with the goal of challenging the abusive conditions that many private religious colleges and universities have created for LGBTQ+ students. These unsafe conditions have been permitted for decades by the U.S. Department of Education’s policies surrounding religious freedom.¹ In the complaint, plaintiffs criticize the privileges—tax-exempt status and government funding—that are bestowed upon these institutions despite their discriminatory practices, denouncing the special treatment they receive simply for shrouding their behavior in religious justifications for protection. The complaint went on to criticize the religious exemption to Title IX, alleging that it “permits the Department to breach its duty as to the more than 100,000 sexual and gender minority students attending religious colleges and universities where discrimination on the basis of sexual orientation and gender identity is codified in campus policies and openly practiced.”²

There are many documented cases in which private religious institutions have engaged in discrimination against LGBTQ+ students without legal repercussions—often involving the enforcement of an “honor code” that prohibits certain types of gender and sexuality expression. For example, one student was expelled from Southwestern Christian University—a semester shy of graduation—when school officials discovered that she was married to a same-sex partner; the school pointed to a “lifestyle covenant” that prohibited “Lesbian, Gay, Bi-sexual and Transgender (LGBT) behavior or acts” to justify its decision.³ Another student, who is transgender, was expelled from California Baptist University after the school alleged that she committed fraud on her school application by listing her gender as “female.”⁴ Another student, after it was revealed that she was in a same-sex relationship, was barred from enrolling in her final semester at Grace University; she was told that she could re-enroll only “if she went through a restoration program involving mandatory church attendance, meetings with counselors and mentors, and regular communication with a school dean.” She was eventually expelled for continuing to date women, and the school demanded that she return thousands of dollars in federal financial aid money.⁵ The complaint filed by REAP alleged dozens of additional acts of discrimination against LGBTQ+ students. The named plaintiff on the lawsuit, Elizabeth Hunter, was subject to discipline from Bob Jones University after posting online about LGBTQ+ issues, including “her posts about reading a book with a lesbian main character, and about writing a book including a lesbian relationship.”⁶ Another plaintiff, Victoria Joy Bacon, alleged that school officials at Lipscomb University directed homophobic and transphobic statements against them, including slurs, and that resident advisors witnessed them being called slurs and refused to intervene.⁷ Nathan Brittsan only attended Fuller Theological Seminary for a few days before being expelled for being homosexual and married to a same-sex partner.⁸ Scott McSwain was told by Union University that he was “going to hell” and that he would be expelled if he did not attend sexual conversion therapy.⁹ These examples represent only a fraction of the reported discrimination that LGBTQ+ students have been subjected to by private religious institutions.

In the REAP lawsuit, plaintiffs argued that it is constitutionally impermissible for government funding to be distributed to private educational institutions that engage in discrimination against students, either through official policies and honor codes or unofficially through other channels. However, I argue that a bright line rule consistent with this position would be difficult to implement in any practical sense—not only because it is virtually impossible for schools to operate without any government funding at all, but also because taking any legislative action to restrict funding to these schools would be extremely unpopular in the current political environment. Under current IRS tax policies, it is unlikely that private religious institutions could have their tax-exempt status revoked for engaging in discrimination on the basis of gender identity or sexual orientation. The most promising route for holding schools responsible for such behavior by revoking tax-exempt status is the IRS promulgating a new regulation forbidding organizations that discriminate on the basis of gender identity or sexual orientation from being categorized as “charitable” for the purpose of tax exemption. The Court should then uphold this new policy by extending the holding of Bob Jones University v. United States beyond just racial discrimination. This order of operations is crucial, as it seems unlikely that a potential extension of Bob Jones University would be effective if not preceded by a new IRS policy. Congress, as the ultimate source of authority for the IRS, has the power to modify those policies which it considers improper. However, it seems likely that independent agency action coupled with judicial review would be more successful than getting the legislative branch to make the politically-unpopular decision to threaten the tax-exempt status of a large number of private religious colleges and universities. Even when Bob Jones University was engaging in blatant racial discrimination to such an extent that the majority of the public did not approve, it was the IRS and Supreme Court that took action, not Congress.

All of the schools mentioned above claim to be exempt from Title IX for religious reasons, and none has ever been subjected to substantive investigations or discipline from the federal government for civil rights violations against LGBTQ+ students. In the REAP lawsuit, plaintiffs argue that the religious exemption to Title IX, to the extent that it allows institutions to discriminate against students on the basis of gender identity and sexual orientation, is a violation of the Equal Protection Clause of the Fourteenth Amendment. However, I am highly skeptical that the Court would issue a holding consistent with this position any time in the foreseeable future. Thus, some practical stop-gap solutions are necessary. First, there needs to be a dramatic reconfiguration of the religious exemption to Title IX. At the very least, the current process of automatically granting religious exemption to any religious educational institution leaves a lot of ambiguity about what protections exist for students and what remedies are available; moreover, it gives implicit permission to such institutions to engage in more and more discriminatory behavior because they were given no conditions on which their exemption would be granted and they have no fear of losing the exemption. Beyond this, the enforcement mechanisms behind Title IX need to be bolstered so that schools operate with a more legitimate fear of negative consequences if they break the law. Currently, the Office for Civil Rights’ (“OCR’s”) only real enforcement mechanism is the threat of cutting off federal funding, but since this has never been done, it is a hollow threat.

There is an infinite number of questions that could be explored in relation to private religious colleges and universities and their religious free exercise rights. In this Note, I seek to limit my focus to just the issue of discrimination against members of the LGBTQ+ community—those who are gender-identity or sexuality minorities. For example, although Title IX governs the way that school administrations respond to sexual assault and sexual harassment allegations made by members of the campus community, this Note does not seek to address this facet of the Act’s effects other than to the extent that such actions (or lack of action) constitute sex-based discrimination (for example, failure to respond to sexual assault allegations made by LGBTQ+ students). I am aware of recent high-profile scandals at certain private religious institutions involving sexual assault and failure to follow proper reporting and investigation procedures laid out by Title IX; although important, addressing these systematic failures would distract from the religious exemption to Title IX and the disparate treatment that LGBTQ+ minority students are subjected to. Furthermore, this Note does not directly address discrimination perpetrated by primary or secondary schools; rather, the focus is placed on post-secondary educational institutions. Despite this narrow focus, the information and analysis provided in this Note will hopefully prove useful to other scholars who seek to apply my argument to a broader array of educational settings.

Scholarly literature has already examined the tax-exempt status question to a certain extent regarding the history and potential application of the Bob Jones University case. Some articles, like The Story of Bob Jones University v. United States: Race, Religion, and Congress’ Extraordinary Acquiescence, take the position that the case only came out the way it did because race is treated much differently than other protected categories.¹⁰ This is somewhat contrary to the argument of this Note: the holding in Bob Jones University should be extended to protect students against discrimination beyond that which is solely on the basis of race. Other articles criticize the Court’s holding in Bob Jones University as overly broad and failing to take into consideration the school’s viable religious liberty claims. One such article, Bob Jones University v. United States: A Political Analysis, highlights what it refers to as the “hazards” of the Supreme Court getting involved in such questions, holding out free exercise of religion as an important principle. Despite this article’s fundamental disagreement with my proposal that the holding in Bob Jones University be extended, the article contributes a great amount of political analysis of the history of tax-exempt status for religious institutions and the cases that have developed the Court’s jurisprudence on the issue.¹¹ This information allowed me to more fully understand how policy and jurisprudence might most effectively evolve in the future. Some articles, such as The Sexual Integrity of Religious Schools and Tax Exemption, touch on the Obergefell v. Hodges decision and how the recognition of same-sex couples’ fundamental right to marry may impact the civil rights owed to them in educational contexts. The aforementioned article notably takes the position that the Court’s decision in Obergefell is explicitly inconsistent with “applying Bob Jones to the disadvantage of religious schools that maintain sexual conduct policies”—which is at odds with the central position of this Note.¹² Other articles, such as Discrimination in the Name of the Lord and Discriminatory Religious Schools and Tax-Exempt Status, offer relevant analysis of the interaction between free exercise by religious universities and the civil rights protections afforded to students; however, their decades-old perspectives require updating in light of relevant legal and political developments.

Scholarly literature has also explored the issue of religious exemption from Title IX. One article, Should Religious Groups Be Exempt from Civil Rights Laws?, delves deeply into the issue, examining civil rights protections for race, sex, and sexual orientation.¹³ However, there is a gap in this article, written in 2007, which does not account for new developments in the law surrounding the definition of discrimination “on the basis of sex,” especially in the context of civil rights laws like Title IX and Title VII. This has important implications for what is thus categorized as discrimination on the basis of sex. In the U.S. Supreme Court’s October 2019 term, the Court released an opinion in Bostock v. Clayton County that held, “[a]n employer who fires an individual merely for being gay or transgender violates Title VII.”¹⁴ This opinion relies on a new (to the Supreme Court’s jurisprudence) definition of discrimination on the basis of sex. If this definition is applied to Title IX as well, there may be implications for how colleges and universities must act in order to remain in compliance with Title IX.

One work of scholarship stands out in particular for its similarity to this Note’s contribution to the debate. In 2022, the Brigham Young University Prelaw Review published an article entitled The Constitutionality of the Title IX Religious Exemption. This article responds to the Hunter v. Department of Education lawsuit, but its author, Madelyn Jacobsen, makes the opposite argument from mine by arguing that the religious exemption to Title IX is “crucial for maintaining [religious] diversity in higher education” and that restricting or eliminating the religious exemption to Title IX would necessarily constitute a restriction on free exercise of religion.¹⁵ Jacobsen mimics the language often used in legal disputes surrounding free exercise of religious “closely held beliefs.” This Note contributes a much-needed alternative perspective on the debate where the Jacobsen article left a clear gap. Another work of scholarship stands out in particular for the similarities that the author brings in personal background that contribute to the article’s perspective. The author of Loving the Sinner: Evangelical Colleges and Their LGB Students notes that she attended Wheaton College, a private Christian college that is one of the many targets of the Hunter v. Department of Education lawsuit, and reflects on this experience as being “encased in a protective coating of ignorance and denial” about her homosexuality.¹⁶ Because of this background, the author homes in on the personal experiences of LGBTQ+ students at private religious colleges and carefully considers the stakes of all major actors: the religious institution’s interest in maintaining the pure religious character of its student body and minority students’ interest in expressing themselves fully while still attending the college in question. The author conducts analysis through a framework of “institutional religious freedom,” focusing mainly on sexual codes of conduct, voluntary association, and third-party burdens. This Note adopts a similar perspective, due to my similar personal upbringing, but shifts the analytical angle from the religious freedom owed to institutional actors to the civil rights owed to minority students.

I. BACKGROUND

A. Government Funding and Tax-Exempt Status for Private Religious Colleges

Public institutions have historically provided the setting for legal challenges to laws that involve education; colleges like the University of Michigan and University of Texas have famously been involved in litigation over segregation and affirmative action because of their receipt of significant funds from state and federal sources. There is a bit more uncertainty surrounding the applicability of such laws to private institutions. Although private religious colleges may not be fully state sponsored like public institutions, almost none of them operate entirely independently from the government. Federal funds are given to private religious colleges through a variety of means, including loans and grants for construction and renovation of campus facilities;¹⁷ noncategorical state “capitation grants”¹⁸; Medicare reimbursements for campus medical centers; National Institute of Health (“NIH”) grants for science departments; and Health Resources and Services Administration grants to medical, dental, or nursing programs.¹⁹ Federal student loans, tuition tax credits, and federal Pell Grants allow colleges to be able to raise tuition rates without lowering enrollment.²⁰ Beyond direct grants and loans, private religious colleges also receive a tremendous amount of assistance from the savings received through tax-exempt status.²¹ Furthermore, gifts to religious colleges are treated as charitable deductions for income-tax purposes, which incentivizes giving.²² Thus, the perception that private educational institutions are independent from the public sphere is a myth.

An oft-repeated argument about the private sector (including privately-owned businesses and private colleges and universities) is that it should be subject to fewer government restrictions and regulations because of its independence from the public sector. However, since the vast majority of private religious colleges accept millions of dollars of public funds each year, plaintiffs in the Hunter lawsuit argued that there are constitutional restrictions on how those funds may be used. Plaintiffs acknowledge that the receipt of public funds is permissible; “[h]owever, when the government provides public funds to private actors . . . the Constitution restrains the government from allowing such private actors to use those funds to harm disadvantaged people.”²³ In light of this, it would be inconsistent to allow institutions that receive public funds or that benefit from tax-exempt status to discriminate against sexual and gender minority students.

This stance represents a logical extension of the U.S. Supreme Court’s 1983 opinion in Bob Jones University v. United States, in which the Court held that Bob Jones University (“BJU”), a private religious college, did not qualify as a tax-exempt organization under §501(c)(3) of the Internal Revenue Code because of its racially discriminatory policies.²⁴ In 1980, the IRS had issued a ruling providing that a private school with a racially discriminatory policy does not qualify as “charitable” within the common law concepts reflected in the Internal Revenue Code. The Court held that “an institution seeking tax-exempt status must serve a public purpose and not be contrary to established public policy.”²⁵ BJU continued to enforce its policy of denying admission to applicants who engaged in interracial marriage or applicants who were known to advocate for interracial marriage. In light of this discriminatory policy, the IRS revoked BJU’s tax-exempt status. The university was asked to pay a portion of federal unemployment taxes for a year, and then filed a refund action in federal District Court; the IRS filed a countersuit claiming millions of dollars in unpaid taxes.²⁶

The Court analyzed Internal Revenue Code (“IRC”) §501(c)(3)—the portion of the Internal Revenue Code that sets forth regulations that apply to charitable organizations—against the backdrop of the congressional purpose, which was to give preferential treatment to charities in exchange for the benefit that they provide to society, and their relationship with the public interest.²⁷ The Court invoked the history of charitable tax-exempt status; the status was originally conceived as similar to charitable trusts, which could not “be illegal or violate established public policy.”²⁸ In light of this purpose, the majority held that in order to qualify for tax-exempt status, an institution must “demonstrably serve and be in harmony with the public interest,” and that “[t]he institution’s purpose must not be so at odds with the common community conscience as to undermine any public benefit that might otherwise be conferred.”²⁹ Indeed, any institution that engaged in racial discrimination was excluded from the category of those that confer a public benefit and could thus be excluded from the charitable category and stripped of the accompanying tax-exempt status. Therefore, the IRS’s action stripping BJU of its charitable tax-exempt status was a valid exercise of its congressionally-granted authority.

One portion of the Bob Jones University decision that is potentially relevant to the question before us is which level of scrutiny the court should apply. It is worth noting that this analysis should not be interpreted to mean which level of scrutiny should be applied when sex is involved—a question that would involve its own analysis of what is included in the definition of “sex discrimination.” Indeed, the Court did not craft its ruling in Bob Jones University based on whether race is a suspect classification that triggers the application of strict scrutiny. Rather, the question is how closely the Court should scrutinize government policies that implicate religious freedom. In Bob Jones University, the Court applied strict scrutiny to the potential burden that the IRS rule placed on religious freedom for the university. Thus, this means that the relevant balancing test that the Court would have to consider in judicial review of a new IRS rule would be whether there is an overriding interest in protecting the LGBTQ+ community from discrimination that outweighs the religious freedom of private religious universities. In engaging in this examination, the Court should come to the same conclusion as the similar question, from Bob Jones University, regarding racial discrimination.³⁰

The First Amendment provides a baseline level of protection for religious freedom, providing that the government “shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof.”³¹ The Court’s jurisprudence regarding the Free Exercise Clause has evolved over time, beginning with a compelling interest test and eventually departing from it in Employment Division v. Smith.³² In Smith, the majority delivered a scathing criticism of the compelling interest test, claiming that its application would produce a “constitutional anomaly” and “a private right to ignore generally applicable laws.”³³ Smith explicitly rejected the compelling interest test’s expansion of the First Amendment’s protection of religious liberty and asserted that the Free Exercise Clause

does not relieve an individual of the obligation to comply with a law that incidentally forbids (or requires) the performance of an act that his religious belief requires (or forbids) if the law is not specifically directed to religious practice and is otherwise constitutional as applied to those who engage in the specified act for nonreligious reasons.³⁴

It may surprise a modern audience to learn that Justice Antonin Scalia wrote the majority opinion in Smith, which places limits on religious freedom when it clashes with a compelling governmental interest.³⁵

Congress reacted explosively to this inflammatory Supreme Court decision, fearful that it may lead to infringement on the free exercise of the religious beliefs of Christians. Shortly after Smith was decided, Congress passed the Religious Freedom Restoration Act (“RFRA”), which expanded the religious freedom protection granted by the First Amendment by legislatively establishing a compelling interest test (a test that had been explicitly rejected by the judicial branch). Under this new law, whenever the government imposes a burden on religious liberty, the courts are required to apply strict scrutiny in their analysis of the government’s justification.³⁶ RFRA prohibits the government from substantially burdening the free exercise of religion, “even if the burden results from a rule of general applicability,” unless the government is able to demonstrate that application of the burden (1) furthers a compelling governmental interest; and (2) does so by the least restrictive means.³⁷ Because of RFRA’s new permissive standard, the Court would be required to analyze any potential burden on the free exercise of religion by private religious institutions under strict scrutiny, using a compelling interest test. This law makes it more difficult to hold religious institutions responsible for engaging in discrimination against LGBTQ+ individuals because it provides such strong protections for religious groups against government intervention.

Government funding and tax-exempt status are one important piece of the puzzle when it comes to protecting LGBTQ+ individuals from experiencing discrimination at the hands of their private religious institutions. The other piece is Title IX, a historic legislative act drafted in the Civil Rights era to prevent discrimination in the realm of education, which applies certain standards to all educational institutions that are the recipients of government funding, including private religious schools. However, the efficacy of the Act is undermined by the blanket exemptions granted to religious organizations. The process for granting religious exemptions to Title IX should either be vastly reworked, or the exemptions should be done away with entirely. I will analyze these options and consider the legality and practicality of each option.

B. Title IX and the Religious Exemption

Title IX provides that “[n]o person in the United States shall, on the basis of sex, be excluded from participation in, be denied the benefits of, or be subjected to discrimination under any education program or activity receiving Federal financial assistance.”³⁸ In Cohen v. Brown University, the Court recognized Congress’s dual objectives in passing Title IX: (1) “to avoid the use of federal resources to support discriminatory practices;” and (2) “to provide individual citizens effective protection against those practices.”³⁹ Specifically, Title IX, also known as the Education Amendments of 1972, was intended to update Title VII of the Civil Rights Act, which had been passed in 1964. Title VII prohibits employment discrimination based on race, color, religion, sex, and national origin, but Title IX was intended to expand that prohibition against discrimination to the education system as well.⁴⁰ Without Title IX, the only aspect of the education system in which discrimination on the basis of sex would be prohibited is discrimination against employees of the school; Title VII left students largely unprotected.

Regulations that govern the implementation of Title IX are set forth in the Code of Federal Regulations (“CFR”), and the Office for Civil Rights (“OCR”)—a department within the U.S. Department of Education—has the legal authority to enforce Title IX.⁴¹ The OCR performs invaluable work: investigating complaints, ensuring that institutions are complying with necessary regulations, and even providing technical assistance.⁴² One of the most important tools that the OCR wields is the right to conduct compliance reviews. This provides a significant incentive for schools to comply with its legal obligations because if it is found to violate Title IX, there can be harsh consequences—at least on paper. First, an institution is given the option to voluntarily remedy the violation. If it refuses to do so, OCR may: (1) initiate a termination of the institution’s federal funding, or (2) refer the case to the U.S. Department of Justice to pursue a case in court.⁴³ However, these threats have proven hollow, as no university has yet had its federal funding revoked—a bold move that would send shockwaves through the higher education community in the United States. Separately from federal agency enforcement of Title IX through administrative channels, individuals have the authority to initiate proceedings against allegedly discriminatory institutions. An individual has the right to file a lawsuit in court alleging Title IX violations and to file a complaint with the OCR, but the former is not required to have standing for the latter.⁴⁴ Courts may order specific remedies or may award monetary damages to victims of sex discrimination who file lawsuits. Given that the OCR’s threat of revocation of federal funding is a largely hollow threat, the “implied private right of action” of Title IX has “given Title IX its teeth” and serves as a crucial enforcement mechanism.⁴⁵

Title VII contains a religious exemption section which restricts the protections afforded by the new piece of legislation. Section 2000e-1 states, “[t]his subchapter shall not apply to an employer with respect to the employment of aliens outside any State, or to a religious corporation, association, educational institution, or society with respect to the employment of individuals of a particular religion to perform work connected with the carrying on by such . . . .”⁴⁶ Thus, when Congress recognized that the protections of Title VII were exclusively restricted to the employment sector and set out to expand it to the education sector, Congress inserted a similar section exempting religious organizations from Title IX as well. Despite Title IX’s illusion of broad protection against discrimination, § 106.12 goes on to exempt educational institutions that are controlled by religious organizations, declaring that the act “does not apply to an educational institution which is controlled by a religious organization to the extent application of this part would not be consistent with the religious tenets of such organization.”⁴⁷ In the cases of both Title VII and Title IX, the religious exemption sections were crafted as a part of a political compromise with the religious right to pass the legislation.⁴⁸

For most of the history of Title IX, very few institutions sought religious-based exemptions. However, in 2013, there was a sudden increase in the number of official claims of religious exemption. In fact, between 2013–2021, more than 120 religious institutions claimed exemption from Title IX.⁴⁹ This development can largely be traced back to evangelical fears about the Obama administration—anticipation of a crackdown on religious freedom. Though it was not to the extent that the American evangelical community expected, the Obama administration did seek to expand the protections of Title IX. On October 26, 2010, the executive branch issued guidance to schools to include LGBTQ+ individuals under Title IX protections. The letter defined gender-based harassment under Title IX in a new way, labeling it sex discrimination “if students are harassed . . . for failing to conform to stereotypical notions of masculinity and femininity.”⁵⁰ The letter goes on to explicitly state that “Title IX does protect all students, including lesbian, gay, bisexual, and transgender (LGBT) students, from sex discrimination.”⁵¹

The Code of Federal Regulations lays out a very basic framework for how exemptions are to be granted. C.F.R. § 106.12, governing Educational Institutions Controlled by Religious Organization, suggests that no formal process must be followed in order to secure a religious exemption to Title IX..”⁵² The further relevant procedures provided by the Code do not serve to confer exemption on the institutions, but only to reassure the institutions that they are eligible for those exemptions. Indeed, even without such advance assurance of religious exemption, if the Department of Education notifies an institution that it is under investigation for non-compliance with Title IX, the institution may choose to raise its exemption at that time. To do so, the institution shall submit a letter to the Department of Education’s Assistant Secretary, “identifying the provisions of this part which conflict with a specific tenet of the religious organization”—regardless of whether or not the institution already sought assurance before the fact.⁵³ An institution may write to the Department of Education’s Assistant Secretary to seek assurance of their religious exemption. However, “[a]n institution is not required to seek assurance from the Assistant Secretary in order to assert such an exemption.”⁵⁴ Consistent with this interpretation of the automatic triggering of this exemption, in 1976, President Oaks of Brigham Young University wrote a letter to the Department of Education that he clarified was notifying the Department of BYU’s exemption from Title IX (rather than requesting exemption). President Oaks specifically noted that BYU “did not concede that the Department of Health, Education and Welfare has the power to review our claim of exemption on the ground of religion.”⁵⁵ Thus, there is a long history—stretching back almost as far as the origin of the exemption itself—of the automatic triggering mechanism of the religious exemption to Title IX.

Once exemptions started being requested, the Department of Education started approving requests—seemingly indiscriminately: “In the nearly 50 years since the enactment of Title IX, the Office for Civil Rights has never denied a claim to religious exemption. As a result, religious educational institutions decide for themselves whether and to what degree they are exempt from Title IX.”⁵⁶ In 2014, the Department of Education—under the Obama administration—issued guidelines making it clear that transgender students are also protected under Title IX. This guidance, paired with the growing contemporary evangelical panic surrounding transgender people, seems to have drastically increased the number of schools seeking exemptions from Title IX. In response to this avalanche of requested (or declared) exemptions, a number of Democratic Senators asked the Department of Education to publish a list, for the first time, of the colleges that specifically request waivers. In the letter, the Senators cited taxpayers’ “right to know when institutions of higher education—as recipients of tax dollars—seek and receive exemptions under Title IX.”⁵⁷ The Department of Education released the requested list, revealing that at the time 248 schools had been granted exemption to Title IX. Under the Trump administration, new regulations reversed the policy of transparency. However, under the Biden administration, the policy was again reversed; today, an official list is once again maintained by the Department of Education’s Officer for Civil Rights, along with a copy of the office’s response to each request.⁵⁸

Title IX’s private enforcement mechanism was put to use on March 9, 2020, when an individual filed a complaint with the OCR, alleging that Brigham Young University (“BYU”) discriminates against students on the basis of sex. BYU is a private university with enrollment of almost 35,000 students, and is affiliated with the Church of Jesus Christ of Latter-day Saints.⁵⁹ The university is known for its strict honor code, which until recently included a section explicitly titled “Homosexual Behavior” that banned students from “all forms of physical intimacy” with a member of the same sex.⁶⁰ That section was removed in early 2020, inspiring a number of members of the campus community to publicly come out as LGBTQ-identifying. However, the elation sparked by this move was short-lived; shortly after, the Church of Jesus Christ of Latter-day Saints clarified that same-sex romantic behavior remains incompatible with official school rules. In a public letter, Church Educational System Commissioner Elder Paul V. Johnson clarified that “[t]he moral standards of the Church did not change with the recent release of the General Handbook or the updated Honor Code. . . . Same-sex romantic behavior cannot lead to eternal marriage and is therefore not compatible with the principles included in the Honor Code.”⁶¹ This announcement was met with protest, as many students felt like they were experiencing whiplash with regard to the Honor Code—and even felt trapped if they came out while believing themselves to be in a newly-safe environment.⁶² It was in the wake of this policy reversal that an unnamed individual filed a complaint with the OCR, alleging that BYU was engaging in discriminatory behavior.

In response to the complaint, the OCR launched a rare investigation into the private religious university. The complaint specifically alleged that BYU “engages in the different treatment of students who are involved in same-sex romantic relationships by stating that such relationships are not compatible with the principles of the University’s Honor Code.”⁶³ In a letter dated October 21, 2021, the OCR notified BYU that it was opening an investigation into the individual’s complaint. BYU responded on November 19, 2021 by requesting assurance from the U.S. Department of Education that the university is exempt from Title IX and its accompanying implementing regulations.⁶⁴ On January 3, 2022, the Department responded by assuring BYU of its exemption from a number of specific regulations under Title IX “to the extent that application of those provisions would conflict with the religious tenets of the University’s controlling religious organization”—including regulations involving admission, recruitment, housing, counseling, financial assistance, athletics, and comparable facilities.⁶⁵ Thus, in a letter dated February 8, 2022, the OCR concluded that it lacked jurisdiction to address the individual complainant’s allegations. Although it was rare for the OCR to go through the motions of initiating a Title IX investigation into any private religious college for alleged discrimination against LGBTQ+ students, the investigation was ultimately halted prematurely because the religious exemption to Title IX blocked the OCR from exercising jurisdiction over the complaint. If the complaint had been filed against any other educational institution—a public university, or even a private one without a religious affiliation—the OCR would have initiated a fact-finding mission and published the results. This exposes the university to significant liability and serves as a deterrent to the implementation of discriminatory policies that violate Title IX.

Again, the text of the religious exemption to Title IX reads as follows: “[Title IX] does not apply to an educational institution which is controlled by a religious organization to the extent application of this part would not be consistent with the religious tenets of such organization.”⁶⁶ Thus, there are two parts to the religious exemption to Title IX that should be examined separately: (1) Title IX does not apply to an institution “controlled by a religious organization” (with “control” defined very broadly), and (2) institutions are exempt only to the degree that their “religious tenets” conflict with Title IX. Below, I will elaborate on both elements.

1. “Controlled by a Religious Organization”

Title IX does not apply to an educational institution “controlled by a religious organization.” There are six different ways that an educational institution may establish that it is controlled by a religious institution: (1) it is a school or department of divinity; (2) it requires faculty, students, or employees to be members of or espouse personal belief in the religion of the controlling organization; (3) it contains an explicit statement that it is controlled be a religious organization in its charter, the members of its governing body are appointed by the controlling organization, and it receives a significant amount of financial support from the controlling organization; (4) it has a doctrinal statement along with a statement that members of the institutional community must engage in the religious practices of or espouse a personal belief in the statement; (5) it has a published institutional mission that is approved by the governing body of the controlling organization and is predicated on religious tenets; or (6) other sufficient evidence as laid out in 20 U.S.C. § 1681(a)(3).⁶⁷ This inclusive qualifying language is problematic; with “control” defined so broadly, potentially up to 1,000 colleges are encompassed by the words “controlled by a religious organization.”

2. Conflict Between “Religious Tenets” and Title IX

There is an age-old debate in American legal jurisprudence about how to determine whether an action—or inaction—is actually motivated by “religious belief.” This question is especially difficult in the context of an organization, not just an individual. If construed too broadly, there is a risk that a religious organization might simply do anything or discriminate against anyone on any basis and then fall back on a loose claim that the action was based on religious belief. Therefore, it is important to know where the line is drawn. The A.S. Singleton memo, written by the Assistant Secretary for Civil Rights at the U.S. Department of Education in 1985, instructs that religious exemption claims be consistent with the requirements of the First Amendment and the Religious Freedom Restoration Act.⁶⁸ The Office for Civil Rights purports to follow a special procedure to determine whether a provision of Title IX conflicts with religious tenets, requiring that schools submit a statement reflecting either their religious tenets or religious practices.⁶⁹ “A school claiming an exemption may refer to scripture, doctrinal statements, catalogs, statements of faith, or other documents.”⁷⁰

When administration officials from educational institutions write to the Department of Education to formally request a religious exemption from Title IX, the Civil Rights Office writes—and publicly publishes—a response letter. In each letter, they note that the requested exemptions must be based on actual religious tenets, and if the “governing organization” does not agree that those are actual religious tenets, the exemptions may not be valid.⁷¹ This creates the impression that religious exemptions to Title IX must be claimed on the basis of legitimate religious beliefs; however, the reality is that the Court is unwilling to scrutinize such organizational claims. Generally, the Court has thus far shied away from articulating a bright line test for what constitutes a religious belief, seemingly out of fear of being under-inclusive and resulting in the legal condemnation of “religiously-motivated” activities that the Court wishes to protect. This hesitation has had an unfortunate impact on the amount of scrutiny applied to explanations for why religious educational institutions seek to be exempt from Title IX.

II. ARGUMENT AND ANALYSIS

In the following section, I will consider two main aspects of the issue of the constitutionality of discrimination by private religious institutions against LGBTQ+ students: the question of the tax-exempt status of those institutions and the question of those institutions’ religious exemptions to Title IX.

Race permeated the Bob Jones University case so thoroughly that scholars have struggled to extract any universal principles from it that are separate from race.⁷² For one thing, the details of the circumstances surrounding the case involve overt racial discrimination: BJU maintained a policy forbidding interracial dating, a regulation that succeeded an outright ban on African-American students enrolling in the university as a seeming-concession to changing cultural attitudes toward racism.⁷³ The language of the majority opinion makes it hard to ignore the racial elements that motivated the Court’s decision—especially with an eye to the historical effects of the systematic exclusion of African Americans from the educational system in the United States. However, I propose that the Court’s holding in this case is consistent with an extension to include other protected groups of people (specifically, members of the LGBTQ+ community). The most effective way to implement such an extension of legal protection is through the Court granting certiorari for a new case that presents a ripe opportunity and then issuing a holding that clarifies the extent of the application of Bob Jones University. An appropriate case should follow an IRS action, much like the IRS action taken against BJU; absent those circumstances, a lawsuit like the one REAP filed in 2021 is unlikely to be effective. In Bob Jones University, the Court held that as an official extension of Congress’s authority, “the IRS has the responsibility, in the first instance, to determine whether a particular entity is ‘charitable’ for purposes of § 170 and § 501(c)(3). This in turn may necessitate later determinations of whether given activities so violate public policy that the entities involved cannot be deemed to provide a public benefit worthy of ‘charitable’ status.”⁷⁴ It is the duty of the IRS in this instance to recognize the injustice of discriminatory anti-LGBTQ+ policies at educational institutions. The Court noted that these determinations should be made “only where there is no doubt that the organization’s activities violate fundamental public policy.”⁷⁵ Here, this is obviously the case, exemplified by Executive Orders and legislation forbidding discrimination against LGBTQ+ individuals and U.S. Supreme Court decisions like Obergefell and Bostock.⁷⁶

Even assuming that such protections are put into place, might these institutions be allowed to side-step any attempted regulation by opting out of receiving federal funds entirely and agreeing to pay federal taxes? A small number of private Christian colleges in the United States have attempted to opt out of federal funds entirely. Hillsdale College, a private Christian college in Michigan, refuses to accept any federal funds, remaining independent on principle.⁷⁷ Would Hillsdale College or another similar institution thus be allowed to discriminate against their LGBTQ+ students? One of the main arguments of this Note has been that acceptance of federal funding and tax-exempt status creates a legal responsibility for educational institutions to abide by generally-applicable laws, including civil rights laws. But is the inverse true? Does independence from taxpayer dollars immunize an institution from punishment for refusing to follow federal rules? This question forces us to turn to the second major issue of this Note: Title IX.

The complaint filed by REAP in Hunter v. Department of Education suggests that religious exemptions to Title IX are blanketly unconstitutional. However, this stance is unlikely to be adopted in the current political climate, in which religious freedom is highly prized and anti-LGBTQ+ discrimination is not at the forefront of most Americans’ minds. I predict that the Court will be unwilling to find that religious exemptions to Title IX are blanketly unconstitutional and the next step is to challenge the legality of the process by which such exemptions are granted. Automatic exemptions should be presumptively suspect. A better process would be for colleges to be required to request exemptions and have them formally approved. This would place the right to consider the reasoning behind the exemption requests and their validity in the hands of the executive branch—the Department of Justice. Though it is important to consider the applicability of Title IX to institutions that opt out of the public sphere, we must keep in mind the likelihood of many colleges adopting this approach. Even though a small handful of institutions have been able to stay afloat without federal funds—albeit for a short period of time—federal funds still constitute the lifeblood of most educational institutions in the United States. I find it unlikely that this “independence” movement will catch on past the small ranks that it claims today.

As I briefly mentioned above, before any legal action may be taken to protect the vulnerable LGBTQ+ population at educational institutions that are abusing the tax-exempt status they enjoy as charitable organizations, the source that holds the authority to take action must be identified. The Court considered this question in Bob Jones University. Given that Congress is the source of IRS authority, it has the discretion to modify IRS rulings. However, in the “first instance,” the IRS is responsible for construing the IRC, which courts then exercise review over. “Since Congress cannot be expected to anticipate every conceivable problem that can arise or to carry out day-to-day oversight, it relies on the administrators and on the courts to implement the legislative will.”⁷⁸ This proper order of operations is demonstrated in the successful alteration of rules that govern tax-exempt status in the Bob Jones University case. It was the IRS that first acted, modifying the IRC to exclude organizations that discriminate on the basis of race from the definition of “charitable.” This is why I argue that it would be most practical and effective for legal action to start with the IRS and proceed from there with an inevitable challenge before the judicial branch.

The current iteration of the U.S. Supreme Court, the Roberts Court, has skewed dramatically toward religious organizations and the free exercise of religious beliefs. According to a 2022 New York Times article, the Roberts Court “has ruled in favor of religious organizations in orally argued cases 83 percent of the time”—which is far more than any other recent Court.⁷⁹ This trend is especially pronounced when the religious organization in question is Christian, as there is a substantial Christian majority currently sitting on the Court, both Catholic and Protestant. Beyond the Court’s favoring of religion, the U.S. Congress is also very reluctant to take any steps to limit religious freedom or take away power from religious organizations (like powerful private religious educational institutions). Thus, even if the Court were willing to uphold a law seeking to hold private religious educational institutions accountable for discrimination, such a law would likely not even make it through both chambers of Congress in the first place. With regard to religious exemptions to Title IX, the same political forces are likely relevant here, creating another practical roadblock. One potential way that this roadblock may be overcome is a change in the social and political climate in the United States. This was crucial to how the Bob Jones University case ended up with the outcome that it did—the Court was motivated by the confidence that a majority of the American public despised racial discrimination and would support eradicating it from the educational system to whatever extent possible. Though BJU maintained its racially discriminatory policies, it was very much in the minority among its peer institutions. The legality of anti-miscegenation laws was put to the test in 1967, when the Court struck down a Virginia state law that banned interracial marriage.⁸⁰ BJU maintained policies forbidding interracial marriage almost two decades later. The public opinion had reached a tipping point such that religious freedom was not accepted as an excuse for overt racial discrimination and a ban on interracial marriage was much less widely accepted by that time. However, I believe that today, the United States has yet to reach this tipping point regarding religious freedom and LGBTQ+ discrimination.

This unwillingness to protect vulnerable LGBTQ+ individuals from religiously-motivated discrimination is exemplified by some of the Court’s decisions over the past five years. In 2017, the U.S. Supreme Court heard a case called Masterpiece Cakeshop v. Colorado Civil Rights Commission, in which the owner of a cake shop refused to make a wedding cake for a same-sex couple. The Court invalidated a ruling by the Colorado Civil Rights Commission that the cake shop had violated the civil rights of the same-sex couple; here, the Court clearly stood on the side of religious liberty and free exercise over the protection of civil rights.⁸¹ In 2021, the Court heard a case called Kennedy v. Bremerton School District, holding that a public school football coach was not prevented by the First Amendment from praying on the field with his players in what the court called “a personal religious observance.”⁸² Here, the Court continued to plow forward in carving out new rights to the free exercise of religious belief, which it had previously not recognized. In 2022, the Court heard 303 Creative v. Elenis, in which an individual Christian business owner challenged a Colorado law that banned businesses from discriminating against LGBTQ+ customers. During oral arguments, Justice Alito drew a distinction between discrimination on the basis of race and on the basis of sexual orientation, which would be consistent with a position that seeks to distinguish the Bob Jones University precedent from the Hunter v. Department of Education case.⁸³ These recent cases are among a series of examples of the Court demonstrating a strong preference for religion over other concerns—civil rights laws, anti-discrimination laws, etc.⁸⁴

One of the reasons that I advocate for either the revocation of tax-exempt status from private religious institutions that discriminate against LGBTQ+ students or the enforcement of Title IX (over claimed “religious exemptions” by those institutions) is that tax-exempt status and government funding should be considered a privilege, not an automatic and irrevocable guarantee. Clearly, charitable tax-exempt status was originally intended to protect the money collected by charities from being reduced through government taxation, thereby increasing the amount of good that a not-for-profit organization may do with it. However, in the modern era, tax-exempt 501(c)(3) status organizations have grown to incredible sizes, with private religious institutions reporting endowments topping $1 billion.⁸⁵ These institutions are able to avoid enormous tax bills through the privilege of tax-exempt status, which is now practically automatic—especially when you combine the status as an educational institution with the almost-untouchable status as a religious institution. Free exercise absolutists in the United States have begun to argue that religious organizations should be completely free from any scrutiny by the government, lest the government be considered to be interfering in religious affairs that it ought not be involving itself in. However, there is a difference between restricting free exercise (through banning a practice or criminally punishing those who engage in a practice) and simply withholding a privilege from those who have proven themselves unworthy of receiving American citizens’ hard-earned tax dollars. The Court made this clear in its holding in the Bob Jones University case, in which a religious institution was stripped of the privilege of tax-exempt status because of its refusal to obey universally applicable civil rights anti-discrimination laws. The Court did not force BJU to integrate or to change its policies on interracial marriage, actions which would be more constitutionally suspect as infringing on the university’s religious freedom. Indeed, the Court did not approve the use of a “stick” as a punishment; rather the Court approved the use of a “carrot” as an incentive. The solution advocated for in this Note is of the same fundamental nature, and thus should pass constitutional muster for the same reasons. Any view that would characterize the Court’s holding as infringing on BJU’s freedom to exercise its religious beliefs is unnecessarily absolutist in nature and sets a far different trajectory for First Amendment jurisprudence than I believe was intended or is practical. The First Amendment to the Constitution is deservedly revered for its guarantee that the free exercise of religion may be protected from government interference, harassment, or persecution; however, it should be correctly interpreted as conferring a negative right (the right to be free from persecution) rather than a positive right (the right to guaranteed access to tax dollars and exemption from taxation).

I have mentioned more than once the practical difficulties of enforcing Title IX over claimed religious exemptions, even of conducting any investigation at all into allegations of misconduct. There are also practical difficulties involved in the revocation of the tax-exempt status of private religious universities that are often wealthy, powerful, and politically well-connected.⁸⁶ Thus, I will briefly address a few solutions beyond what I have proposed as the ideal. For one thing, the recent decision in Bostock may have implications on how sex discrimination is interpreted by both the executive and judicial branches. If the executive branch adopts a definition of sex discrimination that is consistent with the Court’s definition in Bostock—especially if this is paired with public opinion that tilts the scales in favor of civil rights protections for LGBTQ+ people over absolute unchecked rights for religious organizations—this may pave the way for expanded protections. In March 2021, the Civil Rights Division of the U.S. Department of Justice issued a memo explaining the application of the decision in Bostock v. Clayton County to Title IX.⁸⁷ The memo references an executive order issued by the Biden administration—Executive Order 13988—that pairs well with the holding in Bostock, holding that “[a]ll persons should receive equal treatment under the law, no matter their gender identity or sexual orientation.”⁸⁸ The memo indicates that the Civil Rights Division has determined that “the best reading of Title IX’s prohibition on discrimination ‘on the basis of sex’ is that it includes discrimination on the basis of gender identity and sexual orientation.”⁸⁹ On its face, this seems to be a significant civil rights victory for the LGBTQ+ community, ensuring that Title IX includes robust protections for individuals in that community. However, one blatant roadblock stands in the way from this having made much of a measurable impact yet: the religious exemption to Title IX. This is a welcome policy interpretation overall—protecting students at a great number of colleges throughout the United States that are not religiously affiliated; however, given that the religious exemption is so robust and the process so lacking in oversight, even the aforementioned change in how Title IX is interpreted does not protect minority students at private religious institutions, where students are most likely to encounter discriminatory treatment.

Another potential respite for LGBTQ+ students at private religious institutions may be the Equality Act, which “prohibits discrimination based on sex, sexual orientation, and gender identity in areas including public accommodations and facilities [and] education.”⁹⁰ It does so by expanding the definition of “public accommodations,” authorizing the Department of Justice to intervene in equal protection matters in federal court that relate to sexual orientation or gender identity, and amending the Civil Rights Act to include “sex, sexual orientation, and gender identity” in the prohibited categories of discrimination.⁹¹ Notably, the Act explicitly states that it trumps the Religious Freedom Restoration Act (“RFRA”), meaning that an individual or institution sued for discrimination under the Equality Act would be unable to rely on RFRA as a defense. As the bill currently stands, it may provide a cause of action for students; the Religious Education Accountability Project endorses it, stating that it “ensures strong protections for LGBTQ students attending religious colleges—ensuring that no institution is permitted to claim religious exemptions in order to discriminate against its LGBTQ students while still receiving taxpayer money.”⁹² The measure passed in the House of Representatives in February 2021, but has yet to be taken up in the Senate. It faces strong opposition from absolutist proponents of religious liberty, who have even proposed language be inserted into the Act that would explicitly carve out another religious exemption for religious colleges and universities.

Another possibility is private enforcement by large associations or organizations that these private religious institutions are members of and rely on. For example, the National Collegiate Athletic Association (“NCAA”) wields extensive power among colleges that want to participate in competitive athletics—as do the individual conferences that the schools belong to. The Pac-10, a major athletic conference that includes several universities on the west coast, has overlooked Brigham Young University, a private university affiliated with the Church of Jesus Christ of Latter-day Saints, in a number of league expansions over the past few decades. Reportedly, this is because BYU is seen as “not a good cultural fit” for the conference.⁹³ Effective in 2023, BYU will be admitted to the Big 12 conference, a move that attracted harsh criticism from groups like Athlete Ally, which released a statement saying that “acceptance to an athletic conference is an honor and privilege, and . . . there should be standards of equality and inclusion that schools must meet to be included.”⁹⁴ Pressure from the NCAA or athletic conferences to adopt non-discriminatory policies may be an attractive option, given that there would be much less possibility of a religious freedom claim when the action is taken by a private association rather than the government. The First Amendment provides protection from government intervention, not absolute protection for religious groups against any hardship.

Finally, I would like to consider the likelihood of success for the aforementioned potential avenues of protection for LGBTQ+ students at private religious institutions. It has been a somewhat encouraging development that the Department of Justice has demonstrated a recent willingness to initiate investigations into claims of civil rights violations against LGBTQ+ students. As I mentioned above, in 2021, the DOJ announced a somewhat unprecedented investigation into BYU. However, this enforcement mechanism may not have any teeth after all because the investigation was subsequently dropped when BYU asserted its religious exemption based on relevant religious tenets consistent with its affiliation with the Church of Jesus Christ of Latter-day Saints.⁹⁵ It would surely be notable if the DOJ thoroughly investigated colleges for allegedly “over-extending” their exemptions, actually engaging in sufficient fact-finding and being willing to flex their enforcement muscles. It would be quite a development if these investigations were able to turn up anything substantial—and even more so if the Biden administration’s justice department categorically revoked the exemptions.

CONCLUSION

In this Note, I have considered the practicality and effectiveness of the argument that it is constitutionally impermissible to grant tax-exempt status and distribute any government funding to private educational institutions that engage in discrimination against LGBTQ+ students. I have concluded that the approach taken by the plaintiffs in Hunter v. Department of Education is unlikely to be successful. It is important to remain practical: a bright line rule consistent with this position would likely be impossible to implement, especially in the current political environment. The Hunter v. Department of Education lawsuit is still in the early stages of litigation; though it represents the best opportunity thus far presented in federal court, it is not a guaranteed win. Recently, a very unwelcome development spells trouble for the plaintiffs and the LGBTQ+ students they represent: the court ordered that the Department of Justice, over its objections and assurances that it would be able to effectively defend the suit itself, will be joined by intervening parties in the defense of the religious exemption to Title IX. Three Christian universities—Western Baptist University, William Jessup University, and Phoenix Seminary—along with the Council for Christian Colleges & Universities (“CCCU”) sought to intervene in the lawsuit. In the filing, CCCU adopts sweeping and broad language that the DOJ may be unlikely to adopt itself—that “the Title IX exemption is constitutionally required.”⁹⁶ On October 8, 2021, the court issued an order allowing this intervention and therefore opening up the suit to the much more hard-lined and sweeping rhetoric of the intervenors. There is some chance of victory—albeit small—for the plaintiffs at the lower court level. However, the chances of victory would wane even more if the case were to be elevated to the Supreme Court; I do not see a path to victory for the plaintiffs in front of the current conservative-supermajority Court.

It is noteworthy that the first time the scope of the religious exemption to Title IX was adjudicated, the court ruled against the civil rights of LGBTQ+ students—in favor of the free exercise rights of religious institutions. In Maxon v. Fuller Theological Seminary, plaintiffs brought a Title IX case against Fuller Theological Seminary because they were expelled for violating “school policies against same-sex marriage and extramarital sexual activity.”⁹⁷ In November 2019, a motion to dismiss was granted in federal district court, as the court held that the religious exemption to Title IX was valid and applied in the case. Although this is a discouraging step, this was only a district court, and the Supreme Court has yet to issue a final authoritative word on the issue.

97 S. Cal. L. Rev. 737

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Sydney Smith*

* J.D., University of Southern California Gould School of Law, 2024. B.A., Bowdoin College, 2019.

Miss-Stake by IRS: Proof-of-Stake’s Underinclusive Regulatory Guidance

June 2024June 2024Jack H. Duncan*

Death and taxes are the two certainties of life, and for some, the former may be more conceptually pleasant than the latter. To allay some of that unpleasantness, this Note uses the IRS’s guidance (or lack thereof) on the taxation of new types of digital currencies to provide a basic conceptual understanding of how tax law is formed. “Staking rewards,” which is income derived from new types of digital currencies, have sparked debate over when it should be taxed. However, such ambiguity has failed to elicit a clear response from the IRS.

It is understandable why this area of law feels convoluted to many. Unlike other disciplines, tax law is not judge-made law. Therefore, tax law often lacks clear natural-language holdings from case law. Instead, it is applied either statutorily (under the Internal Revenue Code) or administratively (through regulations, notices, and letters from the IRS). This Note illustrates that in many instances, our tax system is not as convoluted or ambiguous as it is appears.

This Note looks at the IRS’s non-response up until the Revenue Ruling on July 31, 2023, to argue that such silence regarding income from staking rewards was not only deliberate but also necessary, at least during that time. This argument analyzes the taxation of staking rewards in three parts. Part I explains the background and mechanics of staking rewards and how those traits factor into questions of how it should be taxed. Scholarship on taxing staking rewards is growing yet scarce, and typically published either by advocates or adversaries of digital currencies. Accordingly, Part I of this Note also provides a consolidation of arguments and analyses from both sides of the debate. Part II outlines what is left unclear by the Internal Revenue Code, the IRS, and case law. Part III explains what the IRS had ruled up until the recent Revenue Ruling, and what guidance may be expected to follow. Here, in Part III, is this Note’s novel contribution. Part III uses the debate on staking rewards as a lens to justify non-guidance by the IRS to balance the risk of stifling innovation in new technology sectors and avoid commitment to “unfair” tax guidance. These considerations draw on tort law to illustrate the need to allow for development of a sufficient “background of experience” before regulating developing technology into the ground.

INTRODUCTION

Digital assets, cryptocurrency, and blockchain are areas of rapid growth in the legal field and are consequently raising new questions about their legal and tax implications and treatments. The Internal Revenue Service (“IRS”) has provided some guidance on the taxation of a few mechanisms, such as proof-of-work (“PoW”), Mining, Hard Forks, and transfers to investors and service providers.¹

plus.lexis.com/document/openwebdocview/Tax-and-Accounting-Aspects-of-Virtual-Currency/?pddoc
fullpath=%2Fshared%2Fdocument%2Fanalytical-materials%2Furn%3AcontentItem%3A62PH-S571-JB7K-23MY-00000-00&pdcomponentid=500749&pdmfid=1530671&crid=eac337b2-6033-4b53-ad74-f9b9a36ae1f0 [https://perma.cc/46NG-ESGP] (last updated Nov. 30, 2023). However, newer applications to blockchain systems, namely proof-of-stake (“PoS”) consensus mechanisms, have highlighted the ambiguities in the existing guidelines. This Note will address two main questions: first, what are the different ways a statutory analysis may qualify the timing and character of staking rewards as assets or income, and second, whether and how the IRS may choose to provide guidance for interpreting and applying the Internal Revenue Code (the “Code”). This Note will only provide a high-level, normative assessment of what “should” be the approach to taxation of staking rewards. It will serve as a roadmap by compiling and interpreting the (limited) guiding authority that has been obscured for a variety of reasons, including writing on the topic, which is primarily the conjecture of staking advocates and cryptocurrency skeptics. This roadmap will explain why Congress and the IRS had, for so long, declined to clarify their intentions to regulate and interpret the reporting requirements of staking rewards, with a focus on why such ambiguity was and is justified for the developing nature of digital currencies under our tax system. More broadly, this Note should be used to understand how and why the IRS finally issued Revenue Ruling 2023-14 on July 31, 2023 stating its opinion that staking rewards should be taxed at receipt.² While there are some arguments that the recent ruling does not necessarily impose tax on all staking rewards, it is premature to explore such edge cases before the IRS’s opinion (which is not binding on courts) is interpreted by a court.³

I. BACKGROUND

A. What Is a Blockchain?

Another more descriptive name for blockchains is “distributed ledgers.” Information is shared among participants on the blockchain (“purveyors”), and transactions are constantly appended to the ledger, and then redistributed to users. Once a majority of those users agree that the new ledger is valid, it becomes the standard for all future transactions. The utility of the blockchain is that every user is incentivized to republish only validated ledgers because to publish an invalid ledger would conflict with the “distributed” version propagated by all the other users and cause the party publishing the invalid ledger to lose credibility and consequently, lose the ability to record its own transactions on the ledger.

If the utility of organizing data like this is not immediately clear, consider a typical property law topic: recording acts. Different jurisdictions have different ramifications for failure to properly record, or check the recording of, a real estate transaction in indices that are maintained by a county clerk. So, prompt recording and diligent record checking are important (but sometimes insufficient) to prevent title disputes in land transactions. For example, imagine purchasers A and B are both interested in purchasing Blackacre from seller X, in a state with a “notice” recording act. Here, A purchases Blackacre from X in year 1, and B “purchases” Blackacre from X in year 2 and records the deed of sale on the same day (before A had recorded her deed). So long as B is a bona fide purchaser, and she did not have notice of A’s transaction, her claim to the property would prevail. Blockchain systems are designed to solve exactly this type of problem. Through use of a “consensus mechanism,” each subsequent transaction is validated before it is added to the ledger, which maintains the integrity of frequently updated data sets. Had Blackacre’s state used such a consensus mechanism, the automatic validation of A’s transaction would generate notice to other buyers like B, not only cementing A’s deed, but also saving B from accidentally buying Blackacre from an unscrupulous seller. This illustrates how seamlessly this kind of technology can promote fair function of law without any change needed to our laws or regulations. While some people are still skeptical of “new blockchain applications,” in 2018, Burlington, Vermont, contracted with a blockchain startup, “Propy,” to provide exactly this kind of blockchain-supported recordkeeping for the County’s recording of land transactions.⁴

B. What Are Consensus Mechanisms and Staking Rewards?

A consensus mechanism is the way in which a blockchain validates transactions of cryptocurrency; the validation itself is carried out through cryptography (encryption or decryption).⁵

//perma.cc/F4DK-V9EK]. Consensus mechanisms used are either PoW or PoS. PoW is the older mechanism (launched by technologies like Bitcoin), which is why it is more familiar to the IRS. PoS mechanisms are newer, and accordingly, enjoy much less tax guidance from the IRS, specifically with respect to “staking rewards” (discussed below). A PoS consensus mechanism expands its ledger and confirms transactions by selecting users to “verify that a transaction is legitimate and add it to the blockchain,” rather than have every user assess the accuracy of each newly published ledger.⁶ Those who verify transactions are called “validators,” which is a desirable role because validators who successfully confirm a transaction receive a reward in the blockchain’s native cryptocurrency—a staking reward.⁷ Prospective validators must “stake” some of their own native cryptocurrency (or cryptocurrency that has been “delegated” to them by “stakers”) as a form of collateral to ensure that they will not verify fraudulent transactions. However, should they “improperly validate bad or fraudulent data, they may lose some or all of their stake as a penalty.”⁸ Validators receive a fee in the native currency, called “gas,” which they will use to pay staking rewards to the participants who delegated/staked tokens to them.⁹ Network participants also hope to be selected as validators because they desire to support the good function of the blockchain.¹⁰ This type of “skin in the game” means that the larger a stake, the more likely the network is to deem the person as a provider of trustworthy consensus votes, increasing the chance that the person will be selected as a validator.¹¹ This mechanism causes the participants holding only a small amount of native currency to pool their coins or delegate them to a validator (rather than trying to be a validator themselves) and receive staking rewards in return on a pro rata basis, similar in some respects to a partnership.¹² Tokens received as staking rewards are not distributed from a preexisting fund. Instead, they are actually created through the validation.¹³ This may lead to novel and unique tax treatment based on ambiguities of asset character or uncertainties in the timing of their receipt or credit.¹⁴ After an explanation of income, this Note will outline some difficulties in applying traditional timing rules for inclusion of income to staking rewards.

C. How to Measure Income

Defining what is income is a chronic question in the world of tax law, and for purposes of this Note, it is necessary to understand how to measure and identify income before we can decide if/when such income is “taxable income.” The Haig-Simons definition of income is widely accepted and illustrative of a non-statutory measurement of income: “Personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question.”¹⁵ This broad definition of income is constructed to measure a person’s change in wealth (∆W) by comparing the inflow and outflow of their assets. For example, Consumer B has $10 of wages per week, $100 in savings (S), and every week his only consumption (C) is purchasing groceries. To illustrate, assume two scenarios: in scenario 1, he consumes $5 this week (increasing his savings by $5) and in scenario 2, he consumes $15 (decreasing his savings by $5). In both scenarios his income will be the same because he still received $10 of wages. To maintain equivalency of income, the Haig-Simon algebraic sum compensates for the different consumptions by factoring in B’s change in savings (∆S). In scenario 1, B was underbudget, so his change in savings (∆S) was +$5, but in scenario 2, B went overbudget, which required spending $5 of his savings, generating a negative change in savings of -$5. The variables for this income definition are change in wealth (∆W), consumption (C), and change in savings (∆S), which are related as the following equation dictates.

Going forward, the relevant variable for questions of income from staking rewards is the change in savings (∆S) because it is a broader model for income, representing a taxpayer’s purchasing power, rather than just net receipts.¹⁶

D. Unique Tax Nature of Staking Rewards

Two fundamental aspects of measuring income are tax-free recovery of capital and determining when income is sufficiently concrete such that it should be taxed.¹⁷ Here, “capital” is the amount invested in an asset, the “recovery” of which is not taxed at the asset’s “disposition.”¹⁸ The amount invested in an asset (“basis”) is typically determined to be the amount paid for the asset (“cost basis”).¹⁹ For example, if Investor X buys Z stock for $100 in year 1, and in year 2 it has a fair market value (“FMV”) of $200, X has then realized $100 in gain (the $200 FMV less the $100 cost basis); however, because Investor X did not sell the asset, that gain is not seen as sufficiently concrete, and she does not recognize any taxable income. If instead our tax system treated X as recognizing her amount realized (that is, even though she had not sold the Z stock), she would owe taxes on the full $100. Additionally, there would be another problem if the system taxed the full FMV of $200. X bought stock Z with “post-tax dollars,” money that had already been taxed when it was first received. Now she is being taxed on that same $100 again, despite such value not reflecting any real gain. Commissioner v. Glenshaw Glass defined the test for recognition of real gain under I.R.C. § 61 as “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.”²⁰ The previous focus on measurements of ∆S or purchasing power flows from the emphasis that the Glenshaw Glass test puts on accessions to wealth.

1. New Property

The fundamental reason that the taxation of staking rewards is unclear is because of the meaning of “recognition.” If X had sold the Z stock for dollars, it would be clear (1) that she had realized gain and (2) how to measure amount of gain. However, because she continues to hold Z stock, it is harder to determine if she has experienced an accretion to wealth and how much that accretion is.

Application of our tax system is not always limited to strict statutory interpretation. In such gaps of explicit authority, the spirit of the law assumes that what an unrelated buyer is willing to pay X for an asset is an adequate estimated valuation from which the appropriate tax effect may be calculated. However, applying this question to staking rewards is not as simple as merely determining the market value of the reward because the tokens received are “newly minted”; therefore, there is no purchase or sale, and no third-party source has given up any tokens—even though the number of tokens held by a given person has increased.²¹ That said, determining gain when a taxpayer receives assets without any purchase or sale (and therefore no cost basis) is not wholly uncharted waters in tax law. For example, § 1221(a)(3) of the Code specifically excludes certain “self-created” assets from the definition of capital assets.²² Further, analysis of the relevance of staking rewards being “new property” is explored later as part of the review of staking rewards as capital assets.

2. Dilutionary Effect

The “dilutionary” characteristic of staking rewards is a result of their status as “created property” and is one of the main factors current cryptocurrency tax guidance fails to address. Recall that staking rewards are distributed because PoS consensus mechanisms provide participants with the opportunity to maintain the network.²³ Additionally, because validators increase their frequency of opportunities to maintain the network by pledging more tokens, they are willing to pay staking rewards to participants who pledge tokens roughly proportionate to the size of each pledge.²⁴ This is where issues of dilution can arise.

Abraham Sutherland, a professor at the University of Virginia School of Law and legal advisor to the Proof of Stake Alliance, explains that the amount of “true gains and losses” for stakers depends on two variables: the “staking rate” and the “token creation rate.”²⁵ The staking rate represents what percent of a network’s total tokens are actively staked, and the token creation rate represents the rate that tokens are created on the network through other means.²⁶ Describing or creating useful models that account for the token creation rate is beyond the scope of this Note, so the following analyses will assume there is no alternative method of token production, setting the token production rate equal to zero. Sutherland goes on to illustrate that as the staking rate increases, the amount of true economic gain decreases.²⁷ So, when enough participants on the network receive staking rewards in proportion to their initial holdings, they may hold more tokens, but that will not be indicative of a relative increase to their purchasing power (which is another measurement of “income”). Imagine if tomorrow every person in the world had their net worth doubled; the inevitable parallel result would be that the price of goods and services would also double. That is a simplistic illustration of Sutherland’s models of true economic gain on PoS networks and how applying IRS guidance intended for PoW mining income will result in the overstatement of income.²⁸

Understanding dilution’s effect on income is easier through analogy to inflation. For such an analogy, it is helpful to apply a non-statutory definition (such as section 61 of the Code). Recall the Haig-Simons definition of income modeled by equation (1) below.²⁹

As explained above, tracking ∆S is necessary to ensure income correlates with purchasing power.³⁰ For example, consider Investor X, who purchases $100 of stock B when the constant, annual rate of inflation is 10%. Inflation in this case, is “a rise in prices, which can be translated as the decline of purchasing power over time.”³¹ This means that for B’s stock to maintain its same purchasing power it must appreciate at a rate equal to the inflation rate, which would require stock B’s value rise to $110 by year’s end.³² Assume that B’s value does go up by $10. That change in savings would result in $10 of income despite X having no “real” income (“true income” in dilution explanation above) because inflation raised the prices of everything by 10%.³³ This illustrates how effects of dilution and inflation can be similar. Despite reductions in purchasing power caused by inflationary effects, there is no exception to the requirement that all of a taxpayer’s nominal gains must be included in the year of receipt.³⁴ Dilution in the cryptocurrency context is similarly insufficient (by itself) to justify an exception from inclusion at receipt. It does, however, indicate a need for a better method of valuing the true economic income of taxpayers.³⁵

Another real-world analogue is the taxability of stock dividends. A stock dividend is simply a payment from a corporation to its shareholders in the form of additional shares.³⁶ Receipt of stock qualifies as an “accession to wealth” under the Glenshaw Glass rule and would typically be includable as section 61 income.³⁷ But that was not the case in Eisner v. Macomber, in which a stock dividend was issued to all shareholders in proportion to the number of shares owned.³⁸ The Supreme Court justified the lack of income because of the non-change in positions of the corporation and the shareholders, based on the fact that the corporation’s “property [was] not diminished, and . . . . [t]he proportional interest of each shareholder remain[ed] the same.”³⁹

This stock dividend is similar to dilution, which is why it is cited by some staking advocates. There are, however, two differences between the dilution effects and the stock dividends in Macomber. First, the distribution was pro rata, exactly proportional to the recipients’ holdings, and second, the distributed shares had a definite “source”: the corporation.⁴⁰

First, staking rewards were only distributed exactly pro rata in the above hypothetical where the staking rate was 100% and every participant either received rewards for maintaining the network as a validator or delegated their tokens to a validator and received a pro rata share of that validator’s income. The Court in Macomber leaned heavily on the fact that the distribution was pro rata to show that the shareholder’s “interests [were] not increased.”⁴¹ The Court doubled down on the pro rata requirement for a stock dividend to be excluded from income in Koshland v. Helvering, in which the Court determined a stock dividend that “gives the stockholder an interest different from that which his former stock holding represented” is includable as income.⁴²

For the second issue, tax law generally does not always know what to do with an ambiguity, such as a lack of source, because it makes it harder to confirm that the tax consequences adequately follow the economic reality of a transaction.⁴³ Here, without a source like a donor or seller, there is nobody whose situation can be compared with the recipient. By confirming that the corporation’s “property [was] not diminished,” the Court illustrated that the corporation did not give up anything and reinforced the reasoning that a taxable event did not occur.⁴⁴

Proponents of preferential tax treatment for staking rewards point to the lack of source to support arguments varying from categorizing staking rewards as found property, created property, or even property entirely outside the scope of our tax system.⁴⁵ Conversely, opponents to preferential treatment for staking rewards point to the lack of source as an example of an ambiguity beyond the scope of reasonable speculation; the New York State Bar Association (“NYSBA”) even drafted a report requesting clear guidance to determine the source of the staking rewards.⁴⁶

Regarding staking income, the fact that the holder received additional tokens may not be determinative. In Macomber, the shareholder received additional stock from a “distribution,” which the Court qualified as essentially a stock split (a stock split is done by “splitting” outstanding shares that are in the hands of shareholders, which increases the stock issued while lowering the stock price in proportion to the number of shares into which each share was split).⁴⁷ Stock splits are analogous to staking rewards because neither have a source. Additionally, per I.R.C. § 305 (which partially codified Macomber), stock splits are not includable as income.⁴⁸ But for the difference that a stock split is virtually always exactly pro rata, Macomber and I.R.C. § 305 support the argument that staking rewards should not be included in taxable income at receipt.

3. Lack of Explicit Guidance

In 2014, the IRS issued IRB Notice 2014-21 (the “2014 Notice”), and, despite such Notices not being law or even binding authority,⁴⁹ it remains one of the most informative pieces of guidance on taxing cryptocurrency, due in part to the scarcity of any guidance at all.⁵⁰ The 2014 Notice determined that income from cryptocurrency “mining” was taxable; its applicability to the newer PoS and staking consensus mechanisms, however, is disputed.⁵¹ While some tax professionals believe that the differences between mining and staking are insignificant and assume the reasoning applied by the IRS to mining should also apply to staking, the IRS itself showed that it was not prepared to make that assumption in/after Jarrett v. United States, after successfully having the case dismissed as moot (such dismissal was affirmed on appeal this past July).⁵²

In Jarrett, taxpayers sued the IRS seeking a refund for taxes paid on staking rewards.⁵³ Not willing to offer a decisive ruling, the IRS decided to simply refund the taxes paid, and when the Jarretts declined the refund seeking a legal determination by forcing a case in federal court, the IRS (successfully) moved for dismissal for lack of subject-matter jurisdiction.⁵⁴ There are many possible reasons for the IRS’s refusal to provide clear guidance here; perhaps the IRS thought that an informed ruling was not yet possible because staking is too new, or the IRS could see material differences between mining and staking (mining requires computational “work” to receive mined tokens, which could liken it more to traditional income producing activities, while staking rewards are paid to holders who passively delegate their tokens to validators). This indeterminacy has split members of the tax and crypto community into two groups who disagree on the appropriate method of taxing staking rewards. The first group’s position, supported by the NYSBA, is that staking rewards should be immediately included as income.⁵⁵ The second group’s position, supported by groups like the Proof of Stake Alliance, is that taxes on staking rewards should be deferred until the disposition of the tokens.⁵⁶ The arguments of each of these groups are analyzed in Sections II.B and II.C.

II. WHAT HAS NOT YET BEEN DETERMINED

For PoS mechanisms, the two main questions regarding staking rewards are: (1) Character: What kind of income is it? and (2) Timing: When should it be taxed? The character analysis in this Note is only concerned with the effect capital asset status would have on the timing of inclusion in income.

A. Character: What Makes it Capital?

One of the main factors in determining the taxes one owes is determined by the “character” of the underlying asset/transaction that resulted in gain or loss of income. Generally, the character of gains and losses is either “ordinary” or “capital.” Capital gains/losses result from transactions in assets that were or are held for investment, with most other income being ordinary.⁵⁷ While asset character can be nuanced, the factors used to determine whether an asset is capital should be the same for digital assets and traditional assets.

Courts and the IRS have been resolving character determinations of digital currencies since well before the inception of blockchains and cryptocurrencies. The main example is litigation on the taxability of “miles” provided by airlines. In Charley v. Commissioner, the Ninth Circuit approved a tax deficiency assessed against a taxpayer due to his failure to report his receipt of airline miles as income. ⁵⁸ In this case, the court declined to comment on whether, “in the abstract” the receipt of airline credits was income, but the court did hold that here there was taxable income (that is, not capital gain) upon their redemption because the taxpayer (1) received the credits from his employer through his job, and (2) converted them to cash.⁵⁹ However, six years later, the IRS provided an announcement that taxpayers who fail to report frequent flyer miles received through their business would not be pursued for a deficiency.⁶⁰ This case and announcement illustrate the IRS’s familiarity with digital assets and its acknowledgment that determining the tax treatment of receiving digital assets is complicated. Unfortunately, it does not provide much guidance for staking rewards.

Whether an asset is capital or ordinary depends on multiple factors, like its intrinsic qualities, the nature of its use, and how it was acquired, among other factors.⁶¹ In the case of staking rewards, tax experts are unable to agree on a statutory determination under those factors for the character of staking rewards. Therefore, this Note first will look through a policy lens to assess whether staking rewards align with the justifications for preferential tax treatment of capital assets in the first place.

1. Policy Supporting Preferential Treatment Applied to Staking Rewards

When determining the character of new classes of assets, people seem to jump straight to the statutory analysis despite the lack of precedent for how courts and the IRS will apply the Code to that new class of assets. Here, the IRS is in fact likely waiting to assess the character of these assets to determine where the Code may be applicable and where it may require an update to accommodate the crypto sphere. Before analyzing the statutory application or inferring how new statutory language may mimic existing code, a step back to the policy level should be taken. This is important because in the past, the IRS has denied valid textual applications of the Code in favor of interpretations that it believed better carried out the intent of Congress.⁶² Generally, arguments in favor of preferential treatment of capital assets are grouped under “lock-in effect,” liquidity, bunching, inflation, double taxation, and investment incentives.⁶³

Crypto investments are subject to the lock-in effect, which is where a holder avoids selling an asset that has appreciated in value because the holder will recognize taxes on the realized gain at the time of disposition, sale, or exchange. This externality is a transaction cost, which may cause the asset to be held when it otherwise would have been disposed of, absent the imposed taxation. Taxing cryptocurrencies such that transactions that otherwise would have occurred are prevented reduces market efficiency by slowing the flow of assets to the holder who most values that asset. The lock-in effect is especially prevalent for assets (such as crypto) which taxpayers may hold longer than they would have absent tax incentives (such as stepped-up-basis, which allows the elimination of gains in appreciated property inherited from a decedent).⁶⁴

A justification for preferential treatment related to lock-in is the liquidity problem. A reduction in liquidity impairs the mobility of capital.⁶⁵ Liquidity is reduced when taxpayers realize gains on assets in excess of their income from other sources. For example, X has an income of $10,000 per year, and her most valuable asset is her house and the land it sits on, which are capital assets valued at $10,000. Absent preferential treatment for capital gains, if tomorrow some market force causes the fair market value of her home to jump to $100,000, she would owe taxes on $90,000 of appreciation. This would be consistent with the goal of tax law to track “accessions to wealth;” however, forcing taxpayers like X to satisfy her tax obligation by selling her home runs against the “efficiency” goals our tax system.⁶⁶ This treatment applies to assets like stock and securities too, and those same reasons also apply to crypto holdings.

“Bunching” is the recognition of lump sum gains all at once, which is the analogue to the lock-in effect. It results from the fact that we generally do not measure taxable gain “mark-to-market” (as value accrues), but rather only when the asset is sold. This means that gains accrued over many years may end up being recognized in a single year. In our progressive tax system, lower tax rates are applied to a taxpayer’s income up to a certain “bracket” threshold, after which a higher rate is applicable to each subsequent dollar earned. If instead, the gain was spread over a taxpayer’s holding period, they would normally enjoy the benefits of “running through the brackets” by having their first dollars earned each year enjoy the lower tax rates of the lower brackets. However, for a one time “lump” gain, the brackets are only “run through” once, and the excess gain is all taxed at the taxpayer’s marginal rate. The typical critique of this policy rationale is that bunching may not matter for most taxpayers, who already “run through the brackets” each year from other income. However, there is insufficient data on the average wealth of crypto investors, and accordingly, it is unclear if there is a need to counteract the bunching effect. Data is lacking because a feature of blockchains is the protection of anonymity. This illustrates potential support for delaying determinations about asset character until the IRS and Congress have sufficient information to inform their legislation.

Inflation (which this Note acknowledges above in Section I.D.2, does not warrant other tax benefits such as deferred reporting) is a concern for investment income across the board (regardless of whether measured in crypto or government legal tender—“fiat”). Taxes are supposed to correlate with “accessions to wealth” experienced by taxpayers. During times of inflation, an investor may see the nominal value of her assets rise, but not any faster than the costs of other goods did. This lack of “real economic gain” is why our tax system attempts to (partially) correct for taxing income that does not represent an accession to wealth. The two main ways our tax system addresses these issues are (1) by correlating (“indexing”) tax brackets to inflation⁶⁷ and (2) by allowing preferential treatment on gains prone to reflect inflation. Crypto investments can face inflation just like fiat investments, and it is a particularly tricky question to answer for staking income. As mentioned above in Section I.B, PoS consensus mechanisms impose “gas” fees (paid in additional native coins) to process the validation. Depending on the cost of the gas relative to the staking reward, some exchanges may be more inflationary, and others may even be deflationary. If staking rewards cause inflation in their markets, that may further suggest that their nature warrants preferential tax treatment because they are prone to growth without an accession to wealth.⁶⁸

One of the most established reasons given in support of preferential treatment for capital assets is that it incentivizes investment, which in turn promotes economic development. While there is still some skepticism on the merit of cryptocurrencies, taxes should not control investment in this sphere. An “efficient” tax system is not supposed to excessively alter the behavior of taxpayers or harm the good function of our free market.⁶⁹ Accordingly, tax incentives to invest in cryptocurrencies may be justifiable if there are substantial benefits derived from the development of cryptocurrencies, blockchain technologies like “web3,”⁷⁰ or other future applications. It is in that way that investment in this sector is akin to traditional investing. Evidence of Congress’s concern that the potential benefits of capital asset treatment for cryptocurrencies could be lost by improper regulation is shown in a letter from members of Congress to Treasury Secretary Janet Yellen.

Digital assets could be impactful technological developments in certain sectors, and clear guidelines on tax reporting requirements will be important to those in this ecosystem. It will be important that we continue to work to provide further clarity, and to help ensure that the United States remains a global leader in financial innovation and development, while ensuring that this technology does not become a vector for illicit finance, tax evasion, or other criminal activity.⁷¹

Ultimately, taxes are imposed to sustain the federal government’s budget. The Treasury would obviously like to have as large a fund as it needs; however, increasing the government’s tax revenue is not as simple as raising taxes on taxpayers. At a certain point, excessive taxes will result in reasonable taxpayers opting to engage in different activities because the tax burden of the activity will have exceeded the benefit of that activity. To illustrate this kind of “tax elasticity,” imagine two taxpayers, A and B. A lives in State Y and B lives in State Z, but otherwise, they are identical, working the same job, and paying 30% of their income in taxes. If tomorrow, State Z decides to raise the tax rate for B’s profession by 60%, a likely result would be that B would decide to move to State Y, where she may enjoy the better tax treatment that A has.

In this (exceptionally oversimplified) hypothetical, State Z raised taxes to pad its budget, but instead, it lost a source of taxable income by causing B to move to Y (think Cayman Islands). This concept is illustrated by economist Dr. Arthur Laffer’s “revenue maximizing rate,” which is the theoretical ideal rate of taxation to apply that will be as large as possible, without being so excessive that whatever action the tax is targeting begins to be avoided by taxpayers.⁷² Economists and tax professionals argue over what rate for capital gains would maximize revenue. However, there is a consensus that at some point, a marginal increase in tax rates will not raise the tax revenue to the Treasury. The key for taxing cryptocurrency, then, is to find that point.

Cryptocurrency investment has seen expansive growth and adoption, with many sources, including Coinbase, creating expectations among purveyors, without clear factual support, that growth to their assets will qualify as capital gains.⁷³ Perhaps a factor in causing this: 75% of Americans who invested in cryptocurrency indicated that they invested in cryptocurrency because they think “it is a good way to make money.”⁷⁴ If so, many people are choosing to invest based on expectations on their return, and such purveyors may be very sensitive to tax burdens reducing their returns on investment. So, explicit removal of preferential treatment, even only in part, may result in an outsized withdrawal from the crypto sphere.

While typically an argument in favor of giving preferential treatment to certain capital gains, “double taxation” does not support such treatment for staking rewards. Double taxation occurs in the corporate setting. Companies are taxed on their profits, and then may distribute a portion of those profits to shareholders as “capital outlays” (like stock or dividends). These capital outlays are then included as taxable income for the shareholders. Because the “same” income is taxed twice, here, some argue that shareholders/corporations should enjoy a lower tax rate on their receipts. Staking rewards are not taxed prior to the receipt of the validator, however, because they are not derived from a corporation’s profits. In short, one of the reasons relied on to justify preferential treatment for capital gains on financial instruments, such as stock, is not applicable to staking rewards. However, as is the case for other capital gains (such as dispositions of real property), double taxation is not a requirement to receive capital gain preferential treatment.

2. Statutory Determination of Capital Assets: Quality, Use, and Receipt

The following high-level statutory analysis is only intended to provide context for the inclusion of income analysis. The fundamental statutory authority on the matter is I.R.C. § 1221, with most character determinations starting or ending in § 1221(a), which lists assets that would otherwise be capital assets (“§ 1221 exceptions”).⁷⁵ The main § 1221 exception that might apply to staking income is § 1221(a)(3), which covers self-created property (generally, self-created property is not taxed until it is sold, but at that point, it is taxed as ordinary income—with certain exceptions).⁷⁶ Despite validators “making” rewards, some staking advocates argue that like the comparison to “new property,” this analogy is not applicable to the Code, which excludes from capital asset status any “patent, invention, model or design (whether or not patented), a secret formula or process, a copyright, . . . or similar property” held by “a taxpayer whose personal efforts created such property.”⁷⁷ The argument that the § 1221(a)(3) exception does not apply relies on the conclusion that staking rewards do not qualify as any of the explicitly listed property, nor would it qualify as “similar.”⁷⁸ The self-created property argument often analogizes a farmer’s crop or a mineral miner’s ore.⁷⁹ While these arguments can be pursued under a capital asset determination, this Note will not try to resolve disputes that tax experts have so far failed to resolve. Instead, this Note will revisit these arguments⁸⁰ to illustrate the different methods for tax accounting as that question is more aligned with the timing of inclusion for staking rewards.

B. Timing: When Is it Income?

Tax planning is a timing game of “pulling” benefits (like accelerating loss recognition) and “pushing” burdens (conversely, deferring gain recognition).⁸¹ This shifting of tax benefits and burdens can yield great value to a taxpayer, which is why taxpayers and the Treasury are so keen to determine when taxable gain/loss is recognized. Due to the time value of money, taxpayers derive benefit from pushing/deferring tax burdens, essentially getting the equivalent of an interest-free loan from the government.⁸² Reciprocally, deferrals taken by taxpayers reduce the government’s tax revenue, and such “tax expenditures” by the Treasury can sum to substantial burdens in funding the government.⁸³ The Treasury seeks timely and consistent payment of taxes to maintain its budget, which is why the Treasury may not want to grant tax-timing benefits like permitting stakers to defer inclusion of their income (that is, until they sell the newly received tokens).⁸⁴ This is further developed below in the context of tax accounting methods. Notwithstanding the time value of tax deferral, timing considerations (when a receipt should be taxed) are also important to ensure that taxes owed correlate to the taxpayer’s “ability to pay,” which is one of the main characteristics of a just tax.⁸⁵

Tax accounting is the method used by taxpayers to determine when receipts should be included for the purpose of “clearly reflect[ing] income.”⁸⁶ The two main methods of accounting for income are the “cash method,” which includes income at receipt, and the “accrual method,” which includes income at the time it was earned.⁸⁷ Deference is given to taxpayers to select their method of tax accounting.⁸⁸ Accordingly, most analyses of staking income apply the cash method, rather than the accrual method, because stakers have an easier time arguing the doctrine of constructive receipt than arguing that they never even nominally received the actual reward when new tokens were actually credited to their wallet.⁸⁹

The constructive receipt doctrine is used by stakers to argue that the amount received is an overstatement of their true economic income. Additionally, there may be grounds for a reduction in the amount of includable income based on the “cash equivalence doctrine,” which was added as a factor for determining constructive receipt. Constructive receipt is relevant because it requires an actual receipt of property or the right to receive property in the future.⁹⁰ When receipts, like staking rewards, lack sufficient determinacy as to what the “cash equivalent” is, an additional test may be applied to assess the kind of “economic benefit” received.⁹¹ Economic benefit can be a source of debate because “[a]lthough the courts are uniform in holding that a ‘cash equivalent’ is taxable on receipt, there is disagreement as to what types of property interests are cash equivalents.”⁹² So, a takeaway from this source of debate is that even though there may not be satisfactory legislation to inform stakers on when to include income, there are policy arguments that staking income should not be taxed on receipt. On the other hand, the failure of these accounting doctrines to produce a clear answer of when staking income must be included has supported arguments that immediate taxation is appropriate (such as the NYSBA’s suggestion that we should apply imperfect guidance like the 2014 Notice to staking income, even though staking income was not considered by the Notice at its time of announcement).⁹³

An investment vehicle similarly subject to a timing of receipt analysis is the taxation of Simple Agreements for Future Equity (“SAFEs”).⁹⁴ SAFEs are relevant because they are investment mechanisms promising to return some amount of stock to be determined at a future triggering event.⁹⁵ The IRS has ruled that SAFEs, which do not specify a “substantially fixed amount of property” are not “forward contract[s]” and therefore do not satisfy the requirements of a constructive sale, nor is their conversion into preferred stock a taxable event.⁹⁶ Simply put, SAFEs are an example of how the IRS and the Code have previously distinguished actual receipt of rights to property from constructive receipt of value.

C. Taxable at Time of Receipt

The IRS could resolve this issue by ruling that staking rewards will be treated the same way as mining rewards, taxing the rewards as gain at the time of receipt. This resolution would be easy to manage for the government and is justifiable because staking rewards appear to be income because the taxpayer actually received additional tokens. This is the position of the NYSBA, which argued in a 2022 report that there is not a significant difference between staking rewards and mining rewards (which the IRS has said is includable as gross income at receipt).⁹⁷ However, the NYSBA did acknowledge that this is an area lacking regulation and that “[t]he government should provide specific guidance clarifying that staking rewards should be includable as gross income when received at their fair market value at such time.”⁹⁸

1. Support for Taxation at Receipt

Taxation upon receipt would simplify the issue by bifurcating the timing and character determinations. Taxing the rewards at receipt may further simplify the determination of tax liability because without satisfaction of the § 1222 one-year holding period requirement, the gain would be taxed at ordinary rates whether or not the asset is a capital asset.⁹⁹ There may be a future need to determine the character for a later disposition, but having already been taxed at receipt, the issue of basis determination will presumably have been resolved—allowing the established rules of capital asset character determination to apply.¹⁰⁰ Lastly, this may be a palatable answer if legislators or the IRS are worried about tax evasion. The realization requirement is one of the greatest tax planning tools and by ruling that realization of income from staking rewards occurs immediately, the staker/validator would have no ability to manipulate the timing of tax liabilities to her benefit.¹⁰¹ This plan also helps the Treasury by providing tax revenues earlier, which is the preference of the government because of the time value of money.

D. Taxable at Time of Disposition

A key difference between crypto exchanges and fiat exchanges is that the market never “closes” for crypto currencies. Knowing the prices of stocks at the moment of receipt can be important for determining a purchaser’s cost basis, and that is possible because they are listed on nationally regulated exchanges.¹⁰² This may seem unimportant because cost basis (in the most basic case) is set at the amount an investor paid for the asset. However, while that is the most familiar scenario for assets on a secondary market like the New York Stock Exchange or NASDAQ, staking rewards (like stock dividends) are different because they are comprised of freshly “minted” coins, which were actually created by the staking process.¹⁰³ Lacking a bona fide sale or purchase, our tax system must apply some other way to assess the reward’s fair market value, potentially even by deferring taxation until there is a disposition that makes the value clear. This raises logistical questions like whether an asset’s value should be some average of each crypto exchange’s sale price measured at the precise instant of sale. Assuming stakers would even be able to determine and track such information across hundreds of transactions, what kind of administrative practicality could the IRS hope to enforce in an audit? The speculative nature of a solution like exchange price averaging shows the lack of clear solutions without a better understanding of the scope of the problem at hand.

1. Support for Taxation at Disposition

Immediate taxation of staking rewards generally benefits the government at the expense of taxpayers and the crypto industry. There are three main issues with this approach: (1) liquidity of taxpayers, (2) difficulty in valuation resulting in overstatement of income, and (3) the magnitude of the burden imposed by guidance.

First, the liquidity issue (defined above in Section II.A.1) is particularly problematic. Even if the IRS rules that staking rewards are recognized immediately, the taxpayer will not be able to use that income to satisfy her tax liability (because she cannot pay taxes with the cryptocurrency received). So, absent alternative income, she will not have the liquidity to pay her tax liability without selling her staked rewards immediately upon receipt.¹⁰⁴ The illustrative example of this problem is a farmer’s crop harvest.¹⁰⁵ In Schniers v. Commissioner, a cash basis farmer was found to have neither actually, nor constructively, received income until the sale of his raised cotton crop.¹⁰⁶ The tax court stated, in relevant part:

The point is that income is not realized by a cash basis farmer from merely harvesting his crops. He realizes income only when he actually or constructively receives income from the sale of those crops. He is not required to sell the crops in the year in which he harvests them. He may decide not to sell them until the following year.¹⁰⁷

However, proponents of immediate taxation compare staking rewards to Cesarini v. United States, in which the plaintiffs were deemed to have recognized income of cash found in a piano after they purchased it.¹⁰⁸ The flaw in this comparison is that the property creating income was actual cash, and while the court in Cesarini properly applied Regulation § 1.61-14, subsection (a) of that regulation stipulates that income from found property is includable “to the extent of its value in United States currency.”¹⁰⁹ And while staking rewards are not really “found property” to begin with, the importance of being able to determine an equivalent value in U.S. dollars creates a second problem with respect to immediate taxation of staking rewards: valuation difficulties.

The second issue, valuation, is driven by three factors. First, crypto exchanges are volatile and do not have closing prices. Second, there are dilutionary effects of the distribution of staking rewards (discussed above in Section I.D.2); and third, there is an excessive burden for taxpayers to document their rewards. Such difficulties illustrate a shortcoming of the NYSBA’s position that “staking rewards should be includable as gross income when received at their fair market value at such time.”¹¹⁰ Here, their suggestion takes for granted that the IRS can overcome the difficulty of determining fair market value in the first place. Additionally, there is no account for which of the multiple crypto exchanges (which often have different prices, unlike regulated stock markets) should be consulted for value determination, nor have they proposed a way to measure FMV factoring in dilution.¹¹¹

Finally, the third factor is one that should be carefully considered before presenting guidance on staking rewards. In assessing burdens, the IRS will want to consider the magnitude of that guidance’s impact, which is directly related to the number of taxpayers or size of industry that will be affected. For example, the IRS should be cautious of yielding to groups like the NYSBA, which argue that processes like mining and staking are so similar that mining guidance (like the 2014 Notice) also covers new forms of crypto income like staking rewards.¹¹² The NYSBA’s argument fails to account for the difference in magnitude of effect that would result from regulating mining and staking identically—the 2014 Notice affects so few taxpayers because miners make up a small percentage of PoW network participants.¹¹³ By contrast, the effect of applying this guidance to PoS networks, such as Tezos (the underlying asset in Jarrett), would have a much higher magnitude because around 70% of network participants actively stake, and would therefore be affected.¹¹⁴ This would compound the harm done by potentially imperfect legislation because it would be unjust to more taxpayers, possibly to the extent that the imposed compliance burden pushes people away from PoS networks.¹¹⁵ This raises three issues: compliance by stakers, administration by the IRS, and efficiency of the tax altogether.¹¹⁶ Sutherland uses the Jarrett case to illustrate the excessive burdens of compliance and administration if stakers were required to follow the 2014 Notice.¹¹⁷ Sutherland asserts that due to the frequency that staking rewards are distributed, even small stakers could have around 125 annual taxable events, each of which would need to be recorded for basis reporting purposes.¹¹⁸ He goes on to point out that administration would be practically infeasible too, as the IRS would need to pull excessive amounts of data to audit a staker.¹¹⁹

III. IRS RESPONSE

Tax law is typically seen as a discipline of well-defined and mechanical rules,¹²⁰ which is why the uncertainties of the application of the Code and the IRS’s legislative intent has generated confusion. Jarrett has become the (non)landmark case for exactly this type of uncertainty with respect to staking income.¹²¹

A. Governance So Far

The guidance provided prior to the recent Revenue Ruling was limited to the 2014 Notice,¹²² Revenue Ruling 2019-24 (with an accompanying FAQ) (“Rev. Rul. 2019”),¹²³ and expansion of I.R.C. § 6045.¹²⁴ These three pieces of guidance (hereinafter, the “Big Three”) do not make any mention of staking rewards or PoS networks, and only Revenue Ruling 2019-24 and § 6045 have the force of law.¹²⁵

com/terms/r/revenue-ruling.asp [https://perma.cc/SBM7-4FY9]. The review of gaps in guidance below is not exhaustive and is intended to illustrate the types of issues caused by inadequate guidance.

1. Ambiguities and Gaps in Guidance

In addition to not accounting for the implications of newer technology like PoS and staking rewards, much of the Big Three contains gaps and ambiguities resulting in variable interpretations. Section 6045 is particularly illustrative of this issue. This section’s recent updates (effective as of the start of 2024) primarily relate to the regulation of “digital assets” as securities and focus on transactions conducted by “brokers.”¹²⁶ The characterization of cryptocurrencies as securities is beyond the scope of this Note (and regardless, determination of a crypto currency as a security by the IRS is mostly independent from similar determinations by the SEC). However, § 6045 is still referenced by tax analyses.¹²⁷ Section 6045(g)(3)(D) defines a digital asset as “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.”¹²⁸ Without any distinction of the consensus mechanism, token type, or validation method, it is likely that this definition of “digital asset” was drafted with the intent of bringing cryptocurrencies under the applicable securities regulations, not to inform appropriate methods of taxation in general. Section 6045(c)(1)(D) was also expanded to include as “brokers,” those responsible for “effectuating transfers of digital assets on behalf of another person.”¹²⁹ This section defines brokers in order to require them to report cost basis of exchanged digital assets.¹³⁰ Some tax professionals are concerned with this requirement because the textual definition of a broker may now include miners and stakers if their activities were considered as “effectuating transfers of digital assets.”¹³¹ In response to these concerns, Congress attempted to pass two poorly-formed and conflicting amendments to clarify that § 6045 should not be read to have that effect. Failing to pass either of them resulted in the drafters of the legislation writing a letter to Secretary Janet Yellen (quoted above in Section II.A.1).¹³² Review of such previous attempts to provide guidance can be incredibly informative, especially when viewed with a consideration of why they failed.¹³³

The interpretations of the 2014 Notice and Rev. Rul. 2019 that followed demonstrate the problems with attempting to interpret legislative intent with respect to an application that essentially did not exist at the time of drafting.¹³⁴ For example, the NYSBA points out in their report, the 2014 notice did not address whether virtual currencies fall under an existing asset class or are a new class of assets, which is necessary to apply the Code, further illustrative of the gaps of the 2014 Notice.¹³⁵

Lastly, Rev. Rul. 2019 does not cover staking rewards either; it covers income from “airdrop[s],” another type of token distribution, which follows something called a “hard fork.”¹³⁶ However, Rev. Rul. 2019 is still referenced in the staking argument because it applies a rigid requirement to include income at the time of receipt even if “the airdropped cryptocurrency is not immediately credited to the taxpayer’s account.”¹³⁷ Recall the analysis of the constructive receipt doctrine in Section II.B to see how this is a divergence from the general rule of including income “in the taxable year during which it is credited to his account.”¹³⁸

The IRS’s relative silence is understandable because any determination, announcement, or notice would fill the vacuum of existing authority and possibly assume greater weight than the IRS is prepared to put forth at this time. The motion to dismiss the Jarrett case, and avoidance of providing a ruling, illustrates the IRS’s reluctance to be “pinned down” in the future, and its desire to have taxpayers carry some of the uncertainty.¹³⁹ The question is what the intended purpose of this kind of uncertainty is, and whether it is effective in accomplishing that purpose.

B. The Importance of IRS Action or Inaction

At a certain point, absent guidance from the IRS, the development of blockchain and cryptocurrency industries may be shaped by a reliance on continued non-regulation, or at least an expectation that potential future regulation will not be overly burdensome (or will be prospective). Cryptocurrency has a checkered reputation among many skeptics, and stories like the collapse of the world’s second largest crypto-exchange, FTX, do not help with that image.¹⁴⁰ And while the collapse of FTX is an issue of securities regulation, rather than tax-specific regulation, its effects were still hugely impactful to the market for cryptocurrencies as a whole, which indicates the possibility that more legislators will be calling for new swaths of legislation soon.

1. Appropriate and Unavoidable Uncertainty in Tax

In practice, the IRS wants to let taxpayers carry some uncertainty, particularly when it comes to new legal ground.¹⁴¹ The IRS has good reason to avoid the creation of bright-line rules, especially in the case of emerging technologies. Taxpayers carrying uncertainty caused by a lack of regulation must act with a certain degree of reasonableness for fear of pushing the bounds of what is permissible too far. Once taxpayers know exactly when they trigger tax effects, they will often allow that limit to dictate their behavior, in some cases engaging in activities which they would not have done but for those tax effects. Take for example the annual gift tax exclusion. Each year, the IRS sets a limit on the size of a gift that one may make without paying taxes (for 2022 that amount was $16,000).¹⁴² A common practice among the wealthy is to gift their children this maximum amount each year.¹⁴³ Naturally, this tax benefit is disproportionately enjoyed by the wealthy, and is an example of how our system fosters generational wealth among the rich. This shows how even if the IRS determines a “limit” which it is okay with, such bright-line rules can cause taxpayers to let tax effects change their behavior, which may be an efficiency cost if that behavior is bad.¹⁴⁴

While clear guidance from Congress and the IRS may help address concerns that cryptocurrency transactions are underreported, such clear limits in tax law may cause taxpayers to try and game the system. This “gaming” can be particularly pernicious in the face of illogical or poorly planned rules. For example, consider the Cohan rule, which was intended to reduce the compliance burden of recording certain deductible expenditures by allowing taxpayers to approximate their total deductions.¹⁴⁵ Taxpayers realized that the lowered burden of compliance made it nearly impossible to audit the accuracy of their “approximations,” resulting in increased abuse of the rule; this resulted in the amendment of § 274(d), which closed this loophole by imposing substantiation rules (requiring taxpayers to maintain adequate records).¹⁴⁶ So, if Congress or the IRS present illogical rules, they risk opening opportunities for tax arbitrage.

Congress and the IRS must therefore weigh the need for regulation now against the risk of providing regulation without enough information to do so as thoughtfully as is necessary.

2. Risk of Stifling Innovation

Regardless of the public’s perception of cryptocurrency, it is a large part of web3, the next generation of the internet.¹⁴⁷ As the letter from members of Congress to Secretary Yellen shows, there is real reason/motivation to avoid inhibiting this development with poor regulation.¹⁴⁸ It is helpful to look outside of tax law to an area of law rich in considerations of how to balance regulation of new technology: tort law. For example, in Pokora v. Wabash Railway Co., Judge Cardozo limited another case, which required drivers to fully exit their vehicles to look down each side of a railroad before crossing, or else the drivers risked being found contributorily negligent if hit by a train.¹⁴⁹ In his ruling, Judge Cardozo explained the risk of arbitrary and uninformed rule making:

Illustrations such as these bear witness to the need for caution in framing standards of behavior that amount to rules of law. The need is the more urgent when there is no background of experience out of which the standards have emerged. They are then, not the natural flowerings of behavior in its customary forms, but rules artificially developed, and imposed from without.¹⁵⁰

While Judge Cardozo ruled with respect to railway accident tort law, his reasoning was truly premised on the fact that (at the time) railroads were new and disruptive technology in some respects. Requiring drivers to fully exit their vehicle was a burdensome and often ineffectual (as was the case for John Pokora, who followed the regulation and was still hit by a train.)¹⁵¹ Judge Cardozo’s reasoning was particularly sound, considering that trains were so fast that a perfectly compliant person, such as John Pokora, could still end up injured because a train could appear in the time it took a driver to turn around and reenter their car. Today, the clear answer is to retrofit crossings with gate arms that indicate when a driver may cross safely. At the time, such technology was not available. The point, however, is that prematurely creating rules that may have led to the public resenting the adoption of railways could have chilled the development of infrastructure that would inevitably become crucial to the economy of the United States. Regulations on cryptocurrencies and blockchains may have the same effect if those rules are not informed by a “background of experience,” which is still expanding.¹⁵² Previously advanced amendments have been conflicting, and sometimes, practically ineffective.¹⁵³ This implies that we may still be waiting for the “crossing-gate arm” that the crypto space needs. Now, if you are convinced that the utility of railroads seems greater than that of blockchain technology, refer to the legislators in Boston (now a hub of the tech industry) who decided that computer sales was too risky of a business and therefore barred the purchase of Apple stock by individuals in Massachusetts when the company went public in 1980.

In Boston, state regulators said the offering is too risky and barred sale of the shares in the Bay State.

The decision affects individual investors, but doesn’t extend to financial institutions, which are presumed to be sophisticated. . . .

Under the Massachusetts ruling, the Apple stock falls short of several provisions aimed at weeding out highfliers that don’t have solid earnings foundations.¹⁵⁴

Limiting regulation like Boston’s is especially frustrating when the opportunity was only withheld from individuals but not large entities, which is another illustration of the harm that may result from poorly informed regulation.

3. Other Concerns the Treasury and IRS Must Consider

In general, the IRS wants to be careful when outlining rules. Putting aside the obvious concerns of allowing tax planning avenues conducive of tax evasion, whenever a bright-line rule is put forth, tax planners will now have a hard limit on what is permissible, and therefore may act in ways that take their tax saving right up to the edge of what may be permitted by the IRS (recall Section III.B.1 detailing the abuse of the Cohan rule).¹⁵⁵ This is exactly why the IRS tends to prefer taxpayers carry some of the uncertainty, which requires taxpayers to plan more carefully, and often, more reasonably. A sequential point for the IRS and Treasury to consider is related to the potential for stifling invention discussed above. Taxing PoS participants like PoW miners could have a large negative impact on the viability of PoS networks. By overburdening PoS networks with taxes that may push more people to PoW networks, and because PoW networks consume much more energy than PoS networks, there may even be a negative environmental impact based on applied taxes, which had not been considered.¹⁵⁶

C. Possible Points of Reference for Predicting Future IRS Action

There have been a multitude of other possible interpretations not explored by this Note, which may form the basis for future action by the IRS. For instance, Sutherland examined the argument that tokens on a PoS network should be treated as interests in a partnership, where the tokens are just used as a way of “voting” how the network should be maintained.¹⁵⁷ If the IRS took that position, it would then be at least partially constrained by subsection K, the Code’s rules of partnership tax. It is also possible that the IRS will determine staking rewards are “new property,” warranting actual amendment of the Code. The “new property” argument is popular among staking advocates, and legal experts have already pointed out that the recent Revenue Ruling 2023-14 made no determination of whether or not staking rewards are “new property,” implying that the ruling may not cover every mode of receipt regarding staking rewards.¹⁵⁸ In any scenario, it is important to recognize that the IRS does not promulgate the Code; rather, it is “organized to carry out the responsibilities of the secretary of the Treasury under section 7801 of the Internal Revenue Code.”¹⁵⁹ Accordingly, before attempting to use past actions of the IRS to predict the trajectory of tax legislation over cryptocurrencies, one should remember that the IRS is not the legislating body (it only seems that way in the context of staking rewards due to the lack of actual legislation). As an arm of the government, it acts more like a computer, applying information to the Code and returning answers of “compliant” or “noncompliant.”

1. Determinations Based on All Facts and Circumstances

Deferral of explicit guidance on staking income is not to say that the IRS may not adopt flexible regulation as we wait for a sufficient background of experience to develop. There are plenty of instances in the Code of overbroad rules intended to apply where individualized review is needed, but providing such review would be too difficult administratively. One such code section, possibly informative of additional future action by the IRS (albeit substantively unrelated to staking rewards), is the “loose” rule of § 302 relating to stock redemptions when corporations repurchase stock from its shareholders.¹⁶⁰ Section 302 is “loose” in two ways: first, it sets an apparently arbitrary threshold of 80% on what constitutes “substantially disproportionate” with respect to reduction in voting control by a shareholder following a redemption.¹⁶¹ Second, the accompanying regulation § 1.302–3 requires that a “facts and circumstances” assessment should be used to smoke out any intent that indicates a “substantially disproportionate redemption.”¹⁶² The 80% threshold in § 302 seems “loose” for the lack of explanation of what materiality 80% holds. This implies that at one point the Treasury may have decided that precise measurements of control were too difficult to apply, so using a high precision test would not have resulted in a significantly more efficient application of the rule. Accordingly, it is not unreasonable to assume that the IRS could administer guidance similarly vague for staking rewards, which are incredibly burdensome to track as they stand. The second “looseness”—stemming from the facts and circumstances test in § 1.302-3—illustrates the Treasury’s willingness to apply flexible guidance that accounts for the unique aspects of different applications. In the face of calls for guidance, the Treasury may adopt similarly flexible approaches to staking rewards in an attempt to balance the importance of express rulings with its desire to avoid premature regulation.

CONCLUSION

Pressure on the IRS to provide guidance has waned after Revenue Ruling 2023-14, but there is still lingering uncertainty on the need for additional guidance,¹⁶³ and many possible solutions risk replacing current uncertainties with new ones. Therefore, the IRS should consider Judge Cardozo’s concerns on premature regulation by observing whether the effects of this Revenue Ruling indicate that this guidance waited for PoS networks to develop a sufficient “background of experience” with which the IRS was equipped to provide informed guidance.¹⁶⁴ Such retrospection by the IRS will be important for any further guidance down the track, else we risk “shutting down the railroad” just because we have yet to invent the crossing-gate arm.¹⁶⁵

97 S. Cal. L. Rev. 537

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Jack H. Duncan*

* Senior Submissions Editor, Southern California Law Review, Volume 97; J.D. Candidate 2024, University of Southern California Gould School of Law; B.S. Mechanical Engineering 2019, Tufts University. Thank you to my dad, John B. Duncan, and my academic success fellow, Tia Kerkhof, for each of their support. I would also like to thank Professor Edward McCaffery for his guidance. Finally, many thanks to all the Southern California Law Review members for their invaluable work on this Note.

Technology, Markets, and the Income Tax Frontier

April 2024April 2024Andrew T. Hayashi*

Income tax law and policy are fundamentally intertwined with private markets—causal effects run in both directions. The vitality of public markets can be stifled or invigorated by the way that they are taxed. The power to tax is the power to destroy. In turn, the computation and collection of income taxes depends upon the valuation and liquidity provided by markets. Moreover, the economic properties of tax rules are contingent upon the underlying market structures. Changes to these structures induced by technological innovation can alter the efficiency and equity properties of the prevailing income tax rules. In this Article, I explain how innovations associated with the digital transformation of business will—as an unintended consequence—reduce the administrative barriers to taxing income and improve the economic tradeoffs, thereby making it both feasible and desirable to push outward the frontier of the income tax’s domain.

INTRODUCTION

Tax law operates on a background of individual preferences, cultural norms, institutions, markets, and a complex architecture of other laws and regulations. It is conventional in tax scholarship and policymaking to take those background conditions as fixed, and to consider questions about what to tax, how to tax, and how much to tax, using theoretical models and empirical estimates derived from those background conditions.

This is a sensible division of labor. It is hard to imagine tax scholarship making sustained progress if it could not take those conditions for granted and rely on shared assumptions about how markets operate and how economic behavior is expressed though the laws that regulate it. But, of course, these conditions do change. New markets form and evolve, old markets disappear, laws change, and new technologies enable new business practices. Some of these changes may have little effect on good tax policy, but others might be more significant.

For example, consider the evolution of the U.S. labor force over the last century. One of the most important changes—economically as well as culturally—is the dramatic increase in women’s participation in the paid-labor market.¹ When women’s labor moved from the home to the marketplace, it became visible for both national accounting purposes and tax accounting purposes, resulting in a measured increase in output and taxable income.² The change was also accompanied by an increased demand for market services to replace the work previously done by women without pay,³ creating a market where there had not been much of one before.

Such labor shifts from the private sphere to the public sphere register as an increase in economic activity because of the decision—for reasons of policy or administrative feasibility—to ignore the private sphere in national income and tax accounting. In the same way, renting out a spare room in one’s home gives rise to income, whereas enjoying the benefits of that room oneself does not. And so, as a general feature of national accounting, the relocation of previously private activity to the public sphere and to the marketplace will be reflected as an increase in income and output.⁴ The income tax also follows the private/public distinction. The income tax reaches income that is generated in the public sphere, and it relies on public markets both to measure the amount of income that people have and to provide people with the cash liquidity they need to pay the taxes that they owe. And so, as markets proliferate and more of our time and resources are exchanged on those markets, the reach of the income tax stretches outward and income tax law applies to an ever-larger domain of our lives.⁵

Market proliferation also changes the tradeoffs that must be negotiated when trying to decide how much to tax, specifically the tradeoff between revenue needs and the ways that taxes distort and disturb the choices and plans that people would otherwise have made in the absence of the tax.⁶ It is conventional in the economic literature to measure this disruption by the change in taxable income resulting from a change in tax rates.⁷ For example, increasing the tax on wages and salaries reduces the amount that people work, thereby reducing their taxable income as they shift from paid market labor to unpaid and untaxed leisure or household labor, or as they find other ways to lighten their tax burden.⁸

But the magnitude of this response to a wage tax increase is not a permanent fixture of the world, or even of the United States, over time. It will depend on relative costs and benefits of paid and unpaid labor, and the flexibility that households have to respond to the higher tax—and these conditions evolve. For example, in a world of mostly single-earner married couples, the effect of an increase in this tax rate on a household’s taxable income is almost certainly different than the effect in the world of mostly dual-earner couples that exists today. The difference in the sensitivity of labor supply choices—and taxable income—to higher tax rates implies a new outcome to the tradeoff between the efficiency costs of taxation and the need to raise revenue equitably.

In this Article, I consider how the emerging digital economy will draw more and more of our time, property, and activity into the income tax’s domain. The mechanism for this process is the increasing marketization of activities that currently reside in the private sphere. As we spend more of our time, energy, and resources transacting with other people and technology, more of our lives become observable to—and therefore capable of being regulated and taxed by—the government. Traditional tax policy criteria will generally regard this as a good development, because extending the reach of the income tax will tend to make it more efficient.

I. THE CODEPENDENCY OF TAX AND PUBLIC MARKETS

The federal income tax “base” begins with gross income and then provides a variety of allowances and deductions to arrive at taxable income—the quantity that is subject to tax under a progressive rate structure. What is gross income? The Internal Revenue Code (the “Code”) defines it as “all income from whatever source derived,”⁹ including a list of specific kinds of income, such as gains from dealings in property,¹⁰ dividends,¹¹ and compensation for services.¹² This list is only illustrative, however, and case law has had to draw boundaries around the statutory (and constitutional) meaning of income. For example, what about money that one discovered hidden in a recently purchased piano?¹³ What about debts that are repaid for less than their face amount?¹⁴ What about lodging or meals received from one’s employer?¹⁵

A useful touchstone for the definition of income is sometimes referred to as economic income, or the Haig-Simons definition of income, defined by the economist Henry Simons as “the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question.”¹⁶ Although a useful place to start, Haig-Simons income is broader than the meaning of income in Section 61 of the Code. Differences between gross income and the Haig-Simons definition of income can generally be grouped into two categories. There is income that is excluded as a deliberate matter of policy, generally with the objective of encouraging people to engage in the kinds of activities that earn that sort of income. For example, interest on certain state and local bonds is excluded from gross income by Section 103 of the Code, notwithstanding that interest is generally included in income.¹⁷ And up to $500,000 of gain on the sale of one’s home can be excluded from gross income,¹⁸ for reasons—mostly obscure—of deliberate public policy.

There would not be any particular difficulty in taxing income from state and local bonds or gains on the sale of one’s home. In the case of interest payments received in respect of bonds, the amount of interest—and therefore the amount that needs to be included in gross income—is easy to observe. The fact that interest is paid from the borrower to the lender, typically through a financial intermediary, makes it easy for the IRS to collect information about the payment by imposing reporting obligations—or even a tax withholding obligation—on the intermediary, and thereby easier to enforce compliance with the taxpaying obligation. In the case of gain on the sale of one’s home, the amount of gross income is again usually easy enough to calculate—as the excess of the amount paid for the property over whatever the seller paid herself for the home.¹⁹ Real estate transactions also generally leave a paper trail (through title transfer systems, for example) that could in principle be used to facilitate accurate income tax reporting.

Moreover, in both the cases of state and local bond interest and gain on the sale of one’s home, the taxpayer’s income typically takes the form of cash, obviating the “liquidity” problem that can arise in other contexts. Income need not take the form of cash. If you win a car at a game show, the fair market value of the car is income to you.²⁰ If a lawyer provides legal services to a client and accepts property or different services performed by the client as payment, the value of the property or those services is income to the lawyer.²¹ The liquidity problem arises when the taxpayer has income, but not the cash to pay the tax.²²

There are no administrative difficulties with taxing interest on state and local bonds or gain on the sale of one’s home. We could do it, but Congress has chosen not to. But there are other kinds of income that we do not tax because of these administrative challenges. For example, an increase in the value of one’s home over the course of a year represents an increase in wealth—and therefore income in the Haig-Simons sense—and yet we do not tax that gain generally until the property is sold.²³ This is the “realization requirement.” There are two reasons that we generally do not tax increases in the value of property until that increase has been crystallized by some transaction, such as a sale of the property. The first is the difficulty of measuring changes in the value of the property over time without the evidence of a market transaction. The second reason is concern about the potential hardship imposed by requiring taxpayers to come up with the cash to pay a cash tax on non-cash income.²⁴

In some cases, the remedies for valuation and liquidity concerns may be worse than the disease. The realization requirement, for example, has been called the original sin of the income tax.²⁵ Because tax on gain is deferred until the gain is realized by some transaction, this naturally creates an incentive to delay the timing of that transaction as long as possible. The ability to defer the recognition of gain in this way not only creates pernicious distributional effects—lowering the effective tax rate on capital income, which tends to be concentrated in the hands of the highest-income taxpayers—but also economic inefficiencies, as taxpayers have an incentive to leave their investment capital locked into underperforming investments to avoid triggering the recognition of taxable gain.²⁶

Invariably, the rules that provide relief to taxpayers from challenges associated with valuation and illiquidity create an attractive nuisance for well-advised taxpayers who steer their activities to transact in forms that benefit from this kind of relief. This nuisance then requires its own response, in the form of anti-abuse rules that prevent these relief provisions from excessively eroding the income tax base or creating too much distortion to economic activity and the distribution of the tax burden. For an example of this kind of rule, consider Section 1259 of the Code, which treats a set of transactions as “constructive sales” of certain financial positions, triggering the taxable recognition of gain (or loss) just as if the positions themselves had been sold.

Barter transactions, in which goods or services are exchanged for other goods or services (rather than cash) give rise to taxable gain or loss, notwithstanding the fact that there may be difficulties valuing the goods or services and collecting a cash tax in respect of the income from the transaction.²⁷ Consider, for example, the lawyer who provides legal services to an artist in exchange for one of her works of art. The market value of the art is income to the lawyer, even though it may be difficult to value.²⁸ The reason why valuation and liquidity concerns cannot be sufficient to exclude such arrangements from the tax base is easy enough to understand: failure to tax barter transactions would create a strong incentive for people to create a barter economy, which would be both less efficient than a cash economy and would allow them to avoid tax on their economic gain and shift the burden of funding government to people who, for whatever reason, cannot connect themselves to a barter network.²⁹

The barter example illustrates a general effect of the income tax. When one kind of income is taxed but another close substitute for that income is not, then people will tend to rearrange their affairs to take advantage of the tax difference. In this way, the income tax law affects which markets flourish and which falter. Consider the fact that health insurance provided by an employer to its employees is generally excluded from gross income,³⁰ even though the insurance has economic value to the employees and that it serves as a form of compensation that would be taxed if it were paid in cash. The effect of this favorable tax treatment has likely played an important role in the amount of resources directed toward the provision of health insurance.³¹ Conversely, an increase in the effective tax rate on income from certain goods or services will tend to suppress the public market for those goods and services, redirecting resources either towards market substitutes or toward a black-market in the goods or service.

Historically, an enormous amount of income from economic activity has been left out of the tax base because the activity takes place within a single household or because the income arises from activities performed by a taxpayer for her own benefit. This latter category of income is known as “imputed income.”³² Recall that Haig-Simons income includes the market value of consumption benefits derived from goods and services. It is irrelevant for this purpose who the provider of the goods and services is. If an employee is given the rent-free use of an apartment by her employer, then the rental value of the apartment is Haig-Simons income to the employee and it is also gross income under the Internal Revenue Code. By contrast, if the employee enjoys the use of an apartment that she herself owns, then the rental value of the apartment, while it is Haig-Simons income to the employee, is not taxable.³³

The same is true of the benefit that people get from using any durable good that they own—but might otherwise rent from somebody else—including washing machines, automobiles, and boats. Similarly, if a barber earns thirty dollars at his job and uses the money to pay for his own haircut, then he has thirty dollars of economic income and thirty dollars of taxable income for federal income tax purposes. But if he cuts his own hair (and we assume that he does just as good a job on his own hair as he would do on another person’s hair) then he has Haig-Simons income of thirty dollars, but we do not, of course, tax the barber on the benefit he gets from cutting his own hair. Needless to say, we have never tried to tax the “consumption” benefit one gets from leisure, whatever the theoretical merits of doing so.

For these reasons, the shift of activity from the private sphere to the public, from self-reliance to interdependent transactions, results in a measured increase in taxable income. If my friend and I care for our own children and clean our own houses, then neither of us has income for federal income tax purposes, but if we watch each other’s children and clean each other’s houses, then the value of our childcare and household cleaning services become subject to tax. Interpersonal transactions make income legible to the tax system. As the number of these barter transactions increases, a market is likely to emerge that uses cash or some other fungible good to function as a currency. The shift from barter to using money to mediate transactions supercharges the market, increasing the volume of transactions and the amount of economic income created. As the number of transactions increases and money is used to price the goods and services exchanged, the amount of income becomes easier to measure and concerns about taxpayer liquidity will diminish. The emergence of a public market may also make it possible to impose information reporting or tax withholding obligations on market participants or intermediaries, thereby facilitating tax collection. In this way, the development of a market, along with the use of money, can increase the amount of taxable income and render previously untaxed activity—childcare and house cleaning, for example—subject to taxation.

This increase in the marketization of the economy, shifting activity from the private sphere where it is untaxed, to the public sphere where it is taxed, not only leads to an increase in taxable income and therefore tax revenue, but it also tends to increase the efficiency of the income tax rules. The efficiency of the income tax is measured in terms of how much it distorts the choices that people make, by inducing them to devote their time, capital, and effort to activities that avoid taxes rather than activities that generate the greatest real economic returns.³⁴ For example, someone facing a 30% tax rate would prefer to purchase a tax-exempt municipal bond paying 6% interest than purchase a taxable corporate bond paying 7% interest, because the tax-exempt bond yields a higher after-tax rate of return, notwithstanding the higher pre-tax rate of return on the corporate bond, which operates as a market signal of the fact that the corporation has a more productive use for the investor’s capital than the municipality.

Or consider the choice of a second earner in a household with small children deciding whether to take paid employment outside the home and pay for childcare, or work in the household where the services he renders to his family are not subject to income tax. This person will forego paid employment opportunities even if he is more productive working outside the home because he must earn a substantially higher wage outside the home to allow him enough after-tax income to pay for the household work that he could otherwise provide. Or consider a homeowner with a spare bedroom that she rarely uses. Although she may derive only a modest amount of personal benefit from the room, in order to make it worthwhile to rent it out to a tenant, she must receive enough in rent such that, after the rental income is taxed, she is compensated for the inconvenience of having someone in her home, complying with whatever laws and regulations may apply to rental properties, advertising her space, processing rental payments, and so on. Increasing the tax rate on corporate bond interest, employment compensation, or rental income, will tend to encourage people to move their capital into tax-exempt investments, move their labor into the private sphere, and use their property for personal consumption rather than to rent it out.

It would be better from an efficiency perspective to tax all income at the same rate,³⁵ thereby encouraging people to use market signals of scarcity and value to allocate their capital, time, and property to where it can generate the highest pre-tax rates of return. But we do not tax all income—including imputed income—at the same rate, or at all. How can market proliferation increase the efficiency of the income tax? The first is simply by providing a high enough rate of return to make remaining in the market worthwhile. Markets that create enough value for participants can induce them to participate and earn taxable income in that market. A modest increase in the tax rate will not push them out of the market if there is enough value created there. Ubiquitous and efficient markets that allow people to earn high pre-tax rates of return from deploying their resources make it possible to increase income tax rates without driving people out of those markets. This effect is well understood in developing economies, where the transition from informal to formal economies and the effects of marketization on tax capacity are starker. For example, there is evidence that as the labor force shifts from contract work toward more stable employment relationships, the standard deduction falls—meaning that the effective tax rate on labor income rises.³⁶ That is, the development of a formal labor market facilitates an increase in labor income tax rates.

II. THE DIGITAL TRANSFORMATION AND MARKETIZATION

The digital transformation of business and the economy increases the marketization of our lives, relocating personal, private activity into an observable transactional space that both creates enormous value—as markets typically do—and converts untaxed imputed income and leisure into taxable income. Time that was previously spent in leisure, volunteerism, or other untaxed activities can now be spent on any number of “side hustles,” running errands, or performing one-off tasks for someone else. Consider the platform Taskrabbit, which connects users with “skilled Taskers to help with odd-jobs and errands.”³⁷ Or consider the widespread use by researchers of Amazon Mechanical Turk³⁸ or survey vendors such as Qualtrics,³⁹ which make it easy for people to spend small amounts of time on their smart phones or digital devices participating in online research studies.

The digital transformation of business enables this easy conversion of unpaid leisure time into paid work time through a variety of mechanisms. Digital platforms make it easy for the buy and sell sides of the short-term labor market to match, lowering search costs dramatically.⁴⁰ Platforms typically provide mechanisms for developing and evaluating the reputations of counterparties, alleviating adverse selection issues.⁴¹ And they provide payment processing, advertising, and legal compliance services that would almost certainly be cost-prohibitive for individual users if they had to obtain them themselves in the marketplace.⁴² As a consequence, it is easier than ever before to perform paid labor during brief periods of downtime.

Not only has digitization made it easier to substitute paid work for leisure, but considering the value placed on data in the digital economy and the way that so many of us spend our time on social media platforms, it is now increasingly difficult to even draw a clear line between the two. The distinction made by economists, tax law scholars, and tax law itself, between work—typically viewed as toil engaged in solely for pecuniary compensation—and leisure—which is its own source of pleasure—has always been a simplification that glosses over the intrinsic enjoyment that people get from some aspects of their jobs.

Tax law generally places property and activity in discrete “buckets” identified by the predominant character of the property or activity. For example, a security may be debt or equity, but not a hybrid of the two, notwithstanding that its economic characteristics may not fit neatly in either category. Individuals are treated as engaging in an activity because of a business or profit motive—in which case the expenses associated with the activity will generally be deductible—or for personal reasons—in which case the expenses are not—but not both.⁴³ But of course certain activities hold out the potential for both profit and personal consumption benefit.⁴⁴

But what is the predominant nature of social media engagement? On the one hand, scrolling though one’s Twitter or Instagram feeds, signaling one’s approval or disapproval of other people’s views or vacation photos, seems to be primarily a leisure activity. Even producing new content—TikTok videos, for example—is something that appears to be a source of enjoyment. But, of course, all of this “leisure” activity is mediated by platforms and there is an implicit barter exchange between users and the platforms, whereby users receive the services of the platform for “free” and the platform, in turn, is enabled to target advertising to the user and generally to collect and perhaps sell the user’s data from interacting with the platform.⁴⁵ Are users engaged in the sale of personal property or the performance of services for the platforms in exchange for their services?

The blurriness of this distinction is most apparent when considering social media “influencers,” individuals who cultivate a platform presence (often characterized by conspicuous consumption or an aspirational lifestyle) that allows them to be compensated for advertising products using that platform. An individual engaged in a trade or business may deduct all the ordinary and necessary expenses paid or incurred in carrying on that trade or business, including travel and meals while away from home.⁴⁶ This naturally encourages influencers to take aggressive positions about whether their lavish travel, personal care products, and meals, are business expenses.⁴⁷

III. THE SHARING ECONOMY

Just as they allow people to monetize their leisure time more easily, digital platforms also make it easier to rent one’s property to others when one is not using it, or when one can get a higher return in the rental market than the imputed return from personal use of the property. In this Section I consider the significance of these new markets for durable-good rentals. I describe some of the important economic features of the so-called “sharing economy,” the market for short term rentals of durable consumer goods such as housing, cars, bicycles, and so on, and then describe some of the consequences of these new markets for tax law and policy.

Consider, for example, using one’s own car to drive for Uber or Lyft, the compensation from which reflects both the cost of the driver’s time (converting leisure into paid work) and the rental value of the car itself. Or consider Airbnb and other short-term property rental platforms, which allow people to rent out a portion of their residence or give landlords the option to rent investment properties on a short-term basis rather than enter long-term leases. Digital platforms provide the infrastructure to match cars and drivers or homes and guests, provide advertising, payment processing and reputational management, all of which make it cost-effective for people to drive during their spare time or rent out a portion of their property. Although the logic is mostly the same for all durable-good rentals, I will focus on the short-term property rental market.

The economic benefits of short-term rental markets are relatively clear, facilitating mutually beneficial transactions that would not otherwise take place, leaving both property owners and would-be renters better off. In economic jargon, there is an increase in consumer surplus in the market for housing services and an increase in the amount of housing services consumed overall.⁴⁸ This is not to say that there are not some new costs associated with the emergence of the short-term rental market. For example, some worry that short-term renters are poor neighbors, imposing noise and other externalities on residential neighborhoods.⁴⁹ There are also concerns that short-term rentals evade laws and regulations,⁵⁰ exacerbate affordable housing issues, and increase home prices.⁵¹ At the same time, the availability of a short-term rental option creates significant benefits for both the renters and property owners that did not exist before.

The economists Apostolos Filippas, John Horton, and Richard Zeckhauser have argued that low-cost rental options can have important implications for the ownership of real estate in the long run.⁵² People who wanted to own a home but previously could not afford it may now be able to become owners by renting out a portion of a property. And people who were reluctant owners, buying property only because there was no other option, may now be able to rent on terms that are more favorable to them. The authors argue that the overall effect of a rental market on the number of owners vis-à-vis renters is ambiguous. Interestingly, whether the number of owners goes up or down, the ease of renting introduces a decoupling of real estate ownership from preferences for the personal enjoyment of real property. In a world where renting is very costly, the people who own durable goods such as homes and automobiles are those who value the consumption benefits the most. But as the cost—regulatory, advertising, payment processing, and taxation—of renting property to others falls, then the relationship between who owns property and who values it the most will weaken.

In the extreme case where it is costless to rent property, there is no correlation at all between who owns the property and how much they value its use.⁵³ The reason is simple: when there are no meaningful costs to renting the property, the people who own the property need not be the people who value it the most—they can simply be people who rent it to the people who value it the most. But this does raise the question of which factors will determine the pattern of real estate and durable good ownership. If it is not the people who value the use of the property the most, then factors such as the cost of financing the acquisition of the property, or maintaining and managing it, may become more important. These are factors that are likely to benefit property owners operating at a large scale, which may suggest greater consolidation of property ownership following the emergence of rental markets.

The substantive tax treatment of income from participating in the sharing economy is relatively straightforward, even as there are challenges with tax enforcement and compliance in these new markets.⁵⁴ But there are ways that tax rules may operate to impede the development of flourishing and efficient rental markets by increasing the after-tax costs of bringing residential properties to the market.⁵⁵ In a few places, tax law places a thumb on the scale of using property that one owns as one’s principal residence, favoring the imputed income from homeownership over the taxable income from renting it.

Most obvious, of course, is the fact that imputed income is not taxed while rental income is taxed. A limited exception exists if one uses a “dwelling unit” as one’s residence during the year and rents it out for less than fifteen days. In that case, the rental income is excluded from gross income, but no deductions otherwise allowable because of the rental use of the property are allowed.⁵⁶ Second, a homeowner who has a separate structure or room that would otherwise qualify as a home office is not entitled to deductions for that office if they rent the space when it is not in use.⁵⁷ And third, under current law, expenses incurred for the production of income—such as the various costs incurred to make space available for short-term rental, including cleaning services, any fees paid to the digital platform, and so on—are not allowable until 2026.⁵⁸ Individuals who are actively engaged in the business of renting out residential property are still able to deduct their expenses, but someone renting out a portion of their home for supplemental income would not be treated as being in the business of being a landlord.⁵⁹

At the very least, the costs of participating in sharing economy markets should be fully deductible to reduce the asymmetry in the taxation of rental income and imputed income and help facilitate the growth of these markets. Not only do these markets directly benefit the participants, but there is also a feedback effect that benefits tax administration as well. Rental income data can provide information to improve home value estimates used in determining assessments for local property tax purposes, and the option to rent one’s property helps alleviate the illiquidity concern.

CONCLUSION

One of the most dramatic changes wrought by the digital economy is the ease with which we can shift our time and property between the private and public spheres, between personal use and the market. This change not only unlocks enormous economic value, but it also expands the income tax’s domain, creating new frontiers for taxation and improving the efficiency of the income tax along the way.

96 S. Cal. L. Rev. 1371

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Andrew T. Hayashi*

* Professor of Law and Nancy L. Buc ’69 Research Professor of Democracy and Equity, University of Virginia School of Law.

Crack Taxes and The Dangers of Insidious Regulatory Taxes

December 2022December 2022Hayes R. Holderness*

An unheralded weapon in the War on Drugs can be found in state tax codes: many states impose targeted taxes on individuals for the possession and sale of controlled substances. These “crack taxes” provide state officials with a powerful means of sanctioning individuals without providing those individuals the protections of the criminal law. Further, these taxes largely escape public scrutiny, which can contribute to overregulation and uneven enforcement.

The controlled substance taxes highlight the allure to lawmakers of using tax law to regulate behavior, but also the potential dangers of doing so. Surprisingly, the judiciary has an underappreciated role in creating the allure of regulatory taxes. Because courts apply less scrutiny to taxes than to other types of laws, regulatory taxes get a blank check when challenged, incentivizing their use. Courts must reconfigure the way they approach regulatory taxes to remove the judicially created incentive for insidious regulatory taxes like controlled substance taxes.

Introduction

“ ‘It was going through the mail and the mail lady smelled it and called the police . . . . I’m not ever gonna get out from underneath this, ever, not unless I win the lottery and become a millionaire’ . . . .”[1] The North Carolina woman offering these statements was troubled not by her arrest and charge of attempted drug trafficking, but by the twenty-thousand-dollar tax assessment she received for possessing controlled substances (that is, illegal drugs). North Carolina brings in millions of dollars from its so-called “crack tax”[2] or “Al Capone law”[3] each year,[4] and several other states use similar taxes on the possession and sale of controlled substances to further regulate already criminalized activities.[5]

The idea of taxes as a weapon in the War on Drugs may seem surprising, but perhaps it is predictable that lawmakers wanting to look tough on drugs would co-opt tax law in this way. More surprising though is the underappreciated role courts have in incentivizing lawmakers to enact controlled substance taxes and other regulatory taxes to achieve their goals.

How do courts incentivize the enactment of regulatory taxes? At its core, the answer to this question is a story of veiled consequences of elevating form over substance. Courts have habitually treated tax laws with the utmost respect,[6] resulting in a privileged regime of relaxed judicial scrutiny for taxes.[7] Governments must raise revenue, and taxation is a powerful tool to raise that revenue from whatever members of society lawmakers see fit. Unelected judges, the line of thinking goes, should be hesitant to upset these fundamentally political decisions.[8] This hesitancy has pushed courts to be exceedingly cautious when examining laws labeled “taxes.”

In addition to their revenue-raising role, taxes have also long been recognized as legitimate and powerful tools to regulate behavior.[9] One might expect courts to heighten their scrutiny of taxes with intentional regulatory goals (as opposed to mere revenue-raising taxes) to ensure that the interests of regulated individuals are appropriately considered. However, this is rarely the case, even when the taxes’ revenue goals are insignificant compared with their regulatory goals.[10]

In short, as critics of “tax exceptionalism”—the idea that tax law is categorically different from other areas of law and should be treated so—have long observed and frequently lamented, courts often employ a unique approach to analyzing tax laws.[11] Once a court determines that laws are tax laws, those laws become privileged before the judiciary, even when the laws have intentional regulatory effects.[12] This subtle elevation of form (tax law) over substance (regulatory effects) results in the judicially created incentive for lawmakers to pursue their regulatory goals through taxation rather than through direct regulation: taxes will not face as much scrutiny from courts.[13]

Lawmakers have noticed and responded, using taxes to achieve regulatory goals where other laws might receive more scrutiny from courts.[14] Though this phenomenon may appear benign, it can generate serious harms for individuals, as controlled substance taxes illustrate.[15] By adopting the taxes rather than increasing existing criminal sanctions, lawmakers impose punishment on those possessing and selling controlled substances without running up against legal protections for criminal defendants.[16] Even those people who would be acquitted under the criminal law can still be sanctioned for their behavior through these insidious regulatory taxes.[17] Thus, controlled substance taxes are a potentially powerful and unchecked weapon in the War on Drugs. Given the biased manner in which the War on Drugs has been carried out,[18] skirting protections for individuals is particularly concerning, as tax law becomes a tool of state oppression of overpoliced communities.[19]

The harms of these taxes do not stop with those cavalierly imposed on individuals. Regulatory taxes like controlled substance taxes also impose stealth costs on society because they are less effective than their direct regulation alternatives.[20] For example, controlled substance taxes are often burdensome laws for tax authorities to administer, making the taxes a costly alternative to laws directly regulating controlled substances, which are enforced by those more familiar with the substances.[21] Further highlighting the insidious nature of these taxes, they also obscure the total amount of regulation that an activity is subject to by remaining out of public view, leading to harmful overregulation that is difficult to address.[22]

Despite the dangers of regulatory taxes like controlled substance taxes, these insidious taxes have gone largely unnoticed in the tax literature. Rather, tax scholars have focused on the relative substantive strengths of taxation versus direct regulation when analyzing the best options for achieving regulatory goals.[23] Literature regarding the related phenomena of fines and civil forfeiture laws has not considered the unique situation of tax laws before the courts.[24] In short, the role of judicial deference regimes in tilting the scales toward regulatory taxes and the resulting consequences for individuals and society are underappreciated. This Article is the first to home in on these issues,[25] analyzing them and demonstrating how courts should take them into account to correct for the inadvertent judicial incentive for lawmakers to enact insidious regulatory taxes.

Courts can remove this incentive and head off future insidious regulatory taxes by recognizing the potential for these taxes to exist and placing such taxes under more scrutiny when exposed.[26] This Article builds on scholarly developments in modern tax expenditure analysis—which explores the role of taxes as a tool for achieving regulatory goals[27]—to propose an analytical framework for uncovering insidious regulatory taxes. A comparatively weak tax law passed to take advantage of the privileged judicial scrutiny regime for taxes is an insidious regulatory tax, and, once that tax is uncovered through the proposed analysis, a court should scrutinize the tax as it would a similar direct regulation.

Controlled substance taxes offer a prime example of insidious regulatory taxes and their dangers, but not all regulatory taxes are insidious. Regulatory taxes like carbon taxes that are more effective than their direct regulation counterparts are substantively justified and do not raise the concerns associated with insidious regulatory taxes.[28] However, as regulatory taxes continue to become more prevalent,[29] the proposed framework will become more crucial to aid courts in separating the insidious regulatory taxes in need of heightened scrutiny from the unobjectionable ones.

The Article proceeds in three parts. Part I provides background on controlled substance taxes and the judicial privilege granted to all types of taxes. The resulting allure of regulatory taxes can be too much for lawmakers to ignore, resulting in the enactment of insidious regulatory taxes like controlled substance taxes. Part II then details the dangers of insidious regulatory taxes in more depth, exposing the problems created by the judiciary’s current approach to taxes. Finally, Part III fleshes out the proposed framework for analyzing tax laws to remove the judicially created incentive for insidious regulatory taxes, using the controlled substance taxes as a case study to illustrate the framework’s operation.

[1]. Michael Hennessey, Inside the North Carolina Law Requiring Drug Dealers to Pay Taxes, myfox8.com (May 10, 2019, 10:21 AM), https://myfox8.com/news/inside-the-north-carolina-law-requiring-drug-dealers-to-pay-taxes [https://perma.cc/DT5B-NDPS].

[2]. See Jeremy M. Vaida, The Altered State of American Drug Taxes, 68 Tax Law. 761, 787 (2015).

[3]. See Anne Barnard, In Taxing Illegal Drugs, the Trouble Comes in Collecting, N.Y. Times (Jan. 24, 2008), https://www.nytimes.com/2008/01/24/nyregion/24drugs.html [https://perma.cc/PMS5-YBU
7] (quoting an associate of the Federation of Tax Administrators describing the taxes as hearkening to “the Al Capone model”); Christopher Paul Sorrow, The New Al Capone Laws and the Double Jeopardy Implications of Taxing Illegal Drugs, 4 S. Cal. Interdisc. L.J. 323, 323 (1995); Christina Joyce, Expanding the War Against Drugs: Taxing Marijuana and Controlled Substances, 12 Hamline J. Pub. L. & Pol’y 231, 239 (1991).

[4]. See N.C. Dep’t of Revenue, Statistical Abstract of North Carolina Taxes 2019 tbl. 15 (2019) (showing tax revenues ranging from approximately $6.5 million to approximately $11.5 million for fiscal years 2005 through 2019 from the state’s controlled substance tax, which includes taxes on illicit liquors in addition to illicit drugs).

[5]. See infra note 34.

[6]. See infra Section I.B.

[7]. See, e.g., Eric Kades, Drawing the Line Between Taxes and Takings: The Continuous Burdens Principle, and Its Broader Application, 97 Nw. U. L. Rev. 189, 192 (2002) (“At times, judges and legal commentators have declared that Congress’ power to tax is beyond constitutional review.”).

[8]. See Nat’l Fed’n of Indep. Bus. v. Sebelius, 567 U.S. 519, 531-32 (2012) (“We do not consider whether the Act embodies sound policies. That judgment is entrusted to the Nation’s elected leaders.”). As Justice Felix Frankfurter articulated,

[Governments] need the amplest scope for energy and individuality in dealing with the myriad problems created by our complex industrial civilization. They need wide latitude in devising ways and means for paying the bills of society and in using taxation as an instrument of social policy. Taxation is never palatable, and its exercise should not be subjected to finicky or pedantic arguments based on abstractions.

Felix Frankfurter, The Public and Its Government 48-49 (1930).

[9]. See infra note 30.

[10]. See infra Section I.B.

[11]. See, e.g., Alice G. Abreu & Richard K. Greenstein, Tax: Different, Not Exceptional, 71 Admin. L. Rev. 663, 663-64 (2019) (surveying tax exceptionalism scholarship and arguing that tax is not different in kind from other types of law and should not be analyzed as though it were); Paul L. Caron, Tax Myopia, or Mamas Don’t Let Your Babies Grow Up to Be Tax Lawyers, 13 Va. Tax Rev. 517, 518-31 (1994) (highlighting and criticizing the perception that tax law is different from other areas of law).

[12]. See, e.g., Gillian E. Metzger, To Tax, to Spend, to Regulate, 126 Harv. L. Rev. 83, 90 (2012). Part of the opinion from Department of Revenue of Montana v. Kurth Ranch illuminates this claim. While observing that taxes are subject to constitutional constraints, as are criminal fines and civil penalties, the Court notes demanding constraints for criminal sanctions and relatively trivial constraints for taxes, even if those taxes fall on the same criminal activities as the criminal sanctions do. Dep’t of Revenue of Mont. v. Kurth Ranch, 511 U.S. 767, 778 (1994).

[13]. See infra Section I.B.

[14]. See Michael S. Kirsch, Alternative Sanctions and the Federal Tax Law: Symbols, Shaming, and Social Norm Management as a Substitute for Effective Tax Policy, 89 Iowa L. Rev. 863, 865–66 (2004) (describing how federal tax laws are used for regulatory goals); Stanley S. Surrey & Paul R. McDaniel, The Tax Expenditure Concept: Current Developments and Emerging Issues, 20 B.C. L. Rev. 225, 247 (1979) (describing how taxes have been used when direct regulations might be unconstitutional or difficult to enact). See generally R.A. Lee, A History of Regulatory Taxation (1973). Lee examines a number of federal taxes with regulatory effects in his work. In describing the historical context and creation of each tax, Lee uncovers the statements of many members of Congress demonstrating their understanding that they could achieve their goals in a less constitutionally suspect manner by using the taxes instead of direct regulations. For example, in detailing a proposed federal tax on grain futures in 1921, Lee describes a discussion in which Congressman Marvin Jones opined that “if that approach [of direct regulation] were used . . . ‘a constitutional question might arise’ but the Supreme Court had ‘allowed us to go a long ways in the taxing power,’ so he believed this was the ‘wiser method.’ ” Id. at 73. In a later passage, Lee describes a 1937 House Ways and Means Committee Report as finding that “ ‘the law is well settled’ that a regulatory tax, although controlling a subject reserved to state jurisdiction, would be valid ‘if it appears on its face to be a revenue measure.’ ” Id. at 182.

[15]. See infra Part II.

[16]. See infra notes 117-22 and accompanying text.

[17]. See, e.g., Barnard, supra note 3 (reporting comments of a tax administrator recognizing the potential for the taxes to impose punishment when criminal sanctions cannot); Robert E. Tomasson, 21 States Imposing Drug Tax and Then Fining the Evaders, N.Y. Times (Dec. 23, 1990), https://www.
nytimes.com/1990/12/23/us/21-states-imposing-drug-tax-and-then-fining-the-evaders.html [https://per
ma.cc/VD68-HAJF] (reporting on controlled substance taxes as effective tools in combatting illegal drug sales because of their ability to avoid the protections afforded to criminal defendants).

[18]. See authorities cited infra note 125.

[19]. Indeed, the taxes are often enforced only against individuals charged with violations of criminal controlled substance laws. See authorities cited infra note 57.

[20]. See infra Section II.B.

[21]. See infra Section III.A.2.

[22]. See infra Section II.C.

[23]. See, e.g., Stanley S. Surrey, Pathways to Tax Reform: The Concept of Tax Expenditures 148-54 (1973) (discussing tax expenditures and the choice between taxation and spending programs); Surrey & McDaniel, supra note 14, at 227-28 (same); David A. Weisbach & Jacob Nussim, The Integration of Tax and Spending Programs, 113 Yale L.J. 955, 959-64 (2004) (same); Eric J. Toder, Tax Cuts or Spending—Does It Make a Difference?, 53 Nat’l Tax J. 361, 361-63 (2000) (same); Edward A. Zelinsky, James Madison and Public Choice at Gucci Gulch: A Procedural Defense of Tax Expenditures and Tax Institutions, 102 Yale L.J. 1165, 1165-67 (1993) (same); Eric M. Zolt, Deterrence Via Taxation: A Critical Analysis of Tax Penalty Provisions, 37 UCLA L. Rev. 343, 348 (1989) (same).

[24]. See, e.g., Ariel Jurow Kleiman, Nonmarket Criminal Justice Fees, 72 Hastings L.J. 517, 520 (2021) (detailing similar issues surrounding criminal fees); Beth A. Colgan, Fines, Fees, and Forfeitures, 18 Criminology, Crim. Just., L. & Soc’y 22, 28 (2017) (detailing the use of fines, fees, and forfeitures as sanctions for criminalized activities); Suellen M. Wolfe, Recovery from Halper: The Pain from Additions to Tax Is Not the Sting of Punishment, 25 Hofstra L. Rev. 161, 197 (1996) (detailing similar issues surrounding civil forfeiture laws); Kenneth Mann, Punitive Civil Sanctions: The Middleground Between Criminal and Civil Law, 101 Yale L.J. 1795, 1799-1800, 1802, 1870 (1992) (observing the harms of failing to provide protections for individuals subject to civil state sanctions); Marc B. Stahl, Asset Forfeiture, Burdens of Proof and the War on Drugs, 83 J. Crim. L. & Criminology 274, 274-79 (1992) (critiquing civil forfeiture laws).

[25]. As far back as 1979, Stanley Surrey, former Assistant Secretary of the Treasury for Tax Policy, predicted that “Congress, by inserting spending programs in the tax law, essentially has forced the courts to apply to tax law the legal provisions hitherto imposed on direct spending.” Stanley S. Surrey, Tax Expenditure Analysis: The Concept and Its Uses, 1 Can. Tax’n 3, 9 (1979) [hereinafter Surrey, Tax Expenditure Analysis]; see also Surrey, supra note 23, at 46-47; Surrey & McDaniel, supra note 14, at 246. Though this prediction seemed based on Surrey’s conclusion that “tax expenditures”—the normatively unnecessary provisions of tax law designed to achieve regulatory results—should not be entitled to the privilege given to revenue-raising tax provisions, Surrey and others since have not fully analyzed the issue of judicial scrutiny of regulatory taxes and its implications. This Article fills that void.

As an aside, Surrey’s prediction may have come true in some cases regarding special tax breaks offered in lieu of direct spending. See, e.g., Espinoza v. Mont. Dep’t of Revenue, 140 S. Ct. 2246, 2260-61 (2020) (holding tax credits for education to the same level of scrutiny under the Free Exercise Clause as direct spending measures); Mueller v. Allen, 463 U.S. 388, 393-404 (1983) (holding tax breaks to the same level of scrutiny under the Establishment Clause as direct spending measures). However, surely Surrey would be surprised to find that his prediction has largely failed to materialize in the case of tax laws used in lieu of direct regulations. Rather, courts have continued to privilege tax laws regardless of the regulatory effects those taxes might have.

[26]. See infra Section III.A.4.

[27]. See generally Weisbach & Nussim, supra note 23 (laying the foundation for modern tax expenditure analysis, which focuses on the comparative institutional competencies of taxes and direct spending measures); see also infra notes 151-62 and accompanying text.

[28]. See generally Shi-Ling Hsu, The Case for a Carbon Tax: Getting past Our Hang-Ups to Effective Climate Policy (2011) (comparing economic, social, administrative, and political merits of carbon taxes versus direct regulations and concluding that a tax would be the most effective policy); Reuven S. Avi-Yonah & David M. Uhlmann, Combating Global Climate Change: Why a Carbon Tax Is a Better Response to Global Warming than Cap and Trade, 28 Stan. Envtl. L.J. 3, 6-8 (2009) (similar).

[29]. See, e.g., Lucy Dadayan, Tax Pol’y Ctr., Are States Betting on Sin? The Murky Future of State Taxation 3-4 (2019), https://www.taxpolicycenter.org/publications/are-states-betting-sin-murky-future-state-taxation/full [https://perma.cc/K6AX-5D4C] (reporting upward trends in the imposition of “sin taxes” on unwanted behaviors); Rachelle Holmes Perkins, Salience and Sin: Designing Taxes in the New Sin Era, 2014 BYU L. Rev. 143, 145 (2014) (describing increasing use of sin taxes).

* Associate Professor, University of Richmond School of Law. For their helpful thoughts and comments, I would like to thank my outstanding colleagues at the University of Richmond and the participants in the 2019 Junior Tax Scholars Workshop, the 2019 Junior Faculty Forum, and the 2021 AALS New Voices in Taxation program. I owe specific thanks to Aravind Boddupalli, Beth Colgan, Erin Collins, Jim Gibson, Ari Glogower, Mary Heen, Dick Kaplan, Ariel Jurow Kleiman, Corinna Lain, Sarah Lawsky, Ruth Mason, Lukely Norris, Tracey Roberts, Erin Scharff, and Allison Tait. I am indebted to Chris Marple, Tyler Moses, and Whitney Nelson for their excellent assistance with research.

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Taxing Guns

May 2022May 2022Thomas Griffith*, Nancy Staudt†

Policymakers across the nation have recently adopted new taxes on guns. As expected, these policies are controversial. Supporters believe the taxes will increase the cost of weapons, decrease sales, and provide the revenue necessary to fund the costs of gun violence across America. Critics, by contrast, argue the taxes are nothing more than poll taxes and will drive the market for weapons underground.

Lost in the debate is the fact that gun taxes have been on the books for over a century. Congress adopted the first of such taxes during World War I to address the nation’s extraordinary wartime revenue needs. Since then, policymakers at every level of government have added more taxes, creating a capacious system of modern gun taxation in the process.

Despite the significance of guns in America and the increasing role that taxes play, no study has systematically analyzed the underlying reasons for and against the laws or, more importantly, offered a detailed framework for recognizing the rights and responsibilities of gun ownership. In this Article, we begin to fill this surprising gap in the extant literature. We review three theories of public finance and find that all provide useful ideas for improving our system of firearm taxation. We argue that one approach, however, provides the best framework for shaping gun tax policy in the future: the Pigouvian theory of taxation. We explain how and why legislators should pursue Pigouvian taxation, and we outline policies for improving the nation’s approach to taxing guns.

* Thomas Griffith is the John B. Milliken Professor Emeritus of Law and Taxation at the University of Southern California Gould School of Law.

† Nancy Staudt is currently serving as the vice president of innovation at the RAND Corporation and the Frank & Marica Carlucci Dean at the Pardee RAND Graduate School. The views, opinions, findings, conclusions, and recommendations contained herein are the author’s alone and not those of RAND, the Pardee RAND Graduate School, or its research sponsors, clients, or grantors. We would like to thank Lee Epstein, Mitu Gulati, Kim Krawiec, and participants in many workshops, including at Duke Law School, Florida International University College of Law, Missouri State University, and Washington University School of Law, for helpful comments and suggestions. We also thank Tara Katelyn for her excellent research assistance and Sara Hubaishi for her excellent “Bluebooking” skills.

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How the States Can Tax Shifted Corporate Profits: An Application of Strategic Conformity by Darien Shanske

August 2021March 2022Southern California Law Review Admin

Article | Tax Law
How The States Can Tax Shifted Corporate Profits: An Application of Strategic Conformity
by Darien Shanske*

From Vol. 94, No. 2
94 S. Cal. L. Rev. 251 (2021)

Keywords: Tax Law, Corporate Law, State Law

The combination of pandemic, recession and federal dysfunction has put severe fiscal strain on the states. Given the scale of the crisis and the essential nature of the services now being cut, it would be reasonable for states to contemplate inefficient—and even regressive—revenue-raising measures. Yet surely they should not start with such measures. They should start with making the efficient and progressive improvements to their revenue systems that they should have made anyway.

Improving the taxation of the profits of multinational corporations—the topic of this Article—represents a reform that would be efficient, progressive, and relatively straightforward to administer. Not only would such a reform thus represent good tax policy, but it would also raise significant revenue. And, if substantial revenue, efficiency, progressivity and administrability are not sufficiently motivating, then I will also add that it would be particularly appropriate to make these changes during the pandemic so as to raise revenue from those best able to pay during the current crisis.

To be sure, the argument that states can and should tax multinational corporations more has the whiff of paradox. After all, there is general consensus that no nation-state is currently taxing multinational corporations very effectively and, further, that subnational governments are in an even worse position to do so. This is because multinational corporations can exploit the mobility of capital even more easily between parts of the same country. Nevertheless, I will argue that the American states find themselves in a particularly strong position to do better at taxing multinational corporations and this is in part precisely because of the missteps made at the federal level.

The Tax Cuts and Jobs Act (“TCJA”), passed in December 2017, contained several provisions, including rules concerning Global Intangible Low-Taxed Income (or “GILTI”), that were meant to combat income stripping. The GILTI provision identifies foreign income likely to have been shifted out of the United States and subjects it to U.S. tax.

In this Article, I argue that the states should and can tax GILTI income. The basic policy argument is simple: states should not miss a chance to protect their corporate tax bases. The amount of revenue at stake is not trivial; it could be as high as $15 billion per year for the states as a whole or the equivalent of a 30% boost in corporate tax collections.

The basic legal argument is also simple: it cannot be the case—and it is not the case—that states need to take corporations at their word as to where their income is earned. If the states can make a reasonable argument that nominally foreign income has in fact been shifted out of the United States, then their choices as to their tax system should be respected.

This Article makes several other core arguments. First, the Article argues that returning to mandatory worldwide combination as a complete alternative to GILTI conformity would be preferable to GILTI conformity alone. Second, the Article argues that offering taxpayers a choice between GILTI conformity and worldwide combination is preferable to GILTI conformity alone.

Finally, this Article places all these issues in a larger framework of strategic conformity. As with GILTI, the states should look for other opportunities where they can take advantage of federal miscues while also advancing sound tax policy.

* Professor, UC Davis School of Law. Many thanks to audiences at the Association of Mid- Career Tax Professors, the NorCal Tax Roundtable, the University of Minnesota Law School Perspective on Taxation Lecture Series and to Eric Allen, Revuen Avi-Yonah, Kimberly Clausing, Steven Dean, Peter Enrich, Michael Fatale, David Gamage, Mark Gergen, Kristen Hickman, Ken Levinson, Michael Mazerov, Amy Monahan, Susie Morse, Michael Simkovic and Adam Thimmesch. I am particularly grateful to David Gamage who coauthored some shorter pieces on which this Article is based. All opinions and mistakes are my own.

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Shanske

Introduction

I. An Overview of Wealth Transfer Taxation

II. The State of The Debate over Estate Taxes

A. Arguments in Favor of Wealth Transfer Taxation

Equality of Opportunity

Dynastic Power

Inheritances and Ability to Pay

A Wealth Transfer Tax as a Periodic Wealth Tax

B. Arguments Against Wealth Transfer Taxation

Equality of Opportunity Revisited

Rejecting Declining Marginal Utility and Progressivity

Private Property Rights

Double Taxation

Efficiency and Administrative Concerns

III. Settling the Debate with a Rignano Tax

A. Attitudes Toward Taxation, Fairness, Redistribution, and Equality

Taxation and Folk Justice

Policy Silos

A Rignano Tax Reconciles These Competing Intuitions

IV. A Rignano Tax

A. The Base

Transfers or Receipts?

Gifts

a. Gifts in General

b. Gifts and Timing Complications

Exclusions and Exemptions

B. The Rate

Initial Transfers

Subsequent Transfers

Adjusting for Age

C. Frequency: Determining the Number of Transfers

Generation-Skipping Transfers

Transfers in Rapid Succession

D. Valuation

The Problem

Risk-Free Rate of Return as the Default Solution

Complications

E. Tracing

The Normative Question

Administration

F. Transfers in Trust

Remainder Interests

Income Interests

G. Transition Rules

CONCLUSION

98 S. Cal. L. Rev. 1439

INTRODUCTION

I. THIRD-PARTY INFORMATION REPORTING: BACKGROUND AND CONSIDERATIONS

A. What Is Third-Party Information Reporting?

B. Purpose and the Benefits

C. Information Reporting for Platform Workers

D. Lessons Learned from Recent 1099-K Reform

II. THE PROBLEM: NONCOMPLIANCE AMONG INDEPENDENT CONTRACTORS

A. Tax Compliance Obligations of Platform Workers

B. Many Platform Workers Struggle with Tax Compliance Obligations

C. Estimated Tax Penalties Have Increased with Rise of Platform Economy

III. SOCIAL SCIENCE LITERATURE SUPPORTING A SOLUTION

A. Reasons for Tax Noncompliance and How Nudges Can Help

1. Why Taxpayers May Struggle to Pay Estimated Taxes

2. Information Reporting as a Nudge

B. Designing Effective Informational Nudges

1. Reminders to Pay Taxes Are Effective and Timing Matters

2. Planning Prompts Are Effective

3. Formality Matters

IV. THE PROPOSAL: QUARTERLY INFORMATION RETURNS

A. Form 1099-ES: The Basics

1. Timing

2. Content of Form

3. Simplified Safe Harbor Payment

B. Scope and Implementation of the Form 1099-ES Requirement

1. Who Would Be Required to Send Form 1099-ES?

2. Setting the Payment Threshold

3. Calculating the Simplified Safe Harbor Payment

4. Examples: Ridesharing Service Platform Workers

C. Addressing Potential Objections

1. Quarterly 1099s Would Impose Undue Complexity and Cost

2. The Safe Harbor Calculation Would Be Inaccurate

3. Quarterly 1099s Would Be Unfair to Low Income Workers

CONCLUSION

97 S. Cal. L. Rev. 1527