Battle for the Tax Code

The Decades Long Battle for the Soul of America.

Appeals Court Judge Learned Hand vs President Roosevelt

Anyone may arrange his affairs so that his taxes shall be as low as possible. He is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.” Judge Learned Hand.

The history of the tax code boils down into a massive fight for the soul of America between two men, President Franklin Roosevelt and Billings Learned Hand, an American judge and judicial philosopher. who was an avid supporter of free speech and noted for applying economic reason to American tort law. Their battle ground was the tax code. Roosevelt fought for an autocratic approach to tax, and Judge Learned Hand fought for a democratic approach to the code more in line with the 16th amendment itself. 

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

But in addition to the wording of the 16th amendment, above, there was another consideration which Roosevelt did not like.  After Congress released the wording to be voted on by the nation, Congress became aware that the amendment would not pass. So they took out ads in newspapers all over the country saying,

“We will only tax profits.”

That did the trick; the 16th amendment passed; and the ad became part of the legislative intent requiring the courts consider that important limitation in any litigation.

Most of Learned Hand’s career he spent as a judge on the United States of Appeals for the Second Circuit. He was never nominated for the Supreme Court, despite being one of the most respected and accomplished jurists in American history, because Roosevelt hated him. 

This fight between these two men is responsible for the evolution of tax law into the backbone of the philosophy of America. Without a liberal tax code, America would not be the same. The battle was fought over the meaning of the 16th Amendment. The stance each man took was completely opposite the other man’s  Roosevelt favored ditching the democratic approach to taxation & the 16th amendment after 16th amendment was passed in 1913.  Over the entire battle, Roosevelt made the IRS became extremely, inducing Congress to create powerful judicial safeguards against the government. Hand was responsible for much of those protections.

Roosevelt was born in 1883 and died in 1946. Learned Hand was born in 1872 and died in 1961. Their careers and their influence overlapped each other. Although Learned Hand won the argument, the eventual result wasn’t obvious for years. Their result of their long battle was decisive in determining the extent of Presidential and government power.  Hand was one of the most influential jurists in American history, but he spent the entire apex of his career on the Court of Appeals. He was never nominated to the Supreme Court because Roosevelt hated him. Their battle was a fight to the death.

The Issues

Roosevelt’s position on income tax was he could do what he wanted with it. His administration was very aggressive on income tax. For his entire presidency, the top tax rate was between 80% and 90%. From 1934 to 1937, during a time when the top tax rate was 90%, Roosevelt carried out a tax trial charging Andrew Mellon with tax fraud, The prosecutor didn’t think the evidence supported Roosevelt’s position, but he prosecuted the case for four years and won the case. Mellon had to pay $600,000 is back taxes. You can read about it here.

Roosevelt was also generally opposed to tax deductions, including business tax deductions. He & Learned Hand fought over taxes and other issues until Roosevelt died. The battle ended with his death in 1945, and the results came in, in 1954 with the Supreme Court Case now referred to as Glenshaw Glass. That case provided the basic framework of the American tax system when it made the case that tax deductions had to be ordinary, necessary in pursuit of profits by a legitimate business.  Over time it evolved to …

“Tax deductions must be ordinary, necessary & reasonable in pursuit of profits by a legitimate business, and they must meet the additional tests of valid business purpose & economic substance”

Also in 1954, the issue was also dealt with by Congress in Section 162, Trade or Business Deductions, in much the same way the Supreme Court dealt with it.

Learned Hand is a legitimate American Hero. He saved the Republic. If the government could tax at high rates and no deductions, we would have a much different country today. Roosevelt’s tax policies were driving companies out of the U.S. for greener pastures overseas. But Learned Hand ended that. The same thing happened in the Obama administration, but tax reform is bringing U.S. dollars back from overseas.

Learned Hand is noted for applying economic reason to American tort law. Among his quotes are the following.

Top quotations about U.S. taxation. 

First. A given result at the end of a straight path is not made a different result because reached by following a devious path.  Minnesota Tea Co. v. Helvering, 302 U.S. 609 (1938).

Second. A transaction is to be given its tax effect in accord with what actually occurred and not in accord with what might have occurred. While a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not.  Commissioner v. National Alfalfa Dehydrating, 417 U. S. 134 (1974).

Third. Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed. New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934)

Fourth. Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes. Judge Learned Hand.

Fifth. Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.

My favorite. “Anyone may arrange his affairs so that his taxes shall be as low as possible. He is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.” This is the essence of tax planning. Judge Learned Hand.

Employment Tax Bombshell

The IRS is shifting it’s emphasis from income taxes to employment taxes, starting in three states: Wisconsin this month; Texas & Arkansas next month. At that pace they will be auditing employment taxes in every state with a year.

That is going to hit like an atomic bomb.

Despite the tone of the article, this is a fundamental shift in IRS audit focus and it is going to be far more dangerous than the typical tax audit. Particularly in California. This is going to rattle through California like a runaway freight train. In fact, this is going to raise more money for California than the UBER case.

You can be legal in California and still break Federal law.

Stay tuned. 

Read the third paragraph in the Accounting Today article. That spells it out. The IRS can no longer afford to audit tax returns with limited success. Very few cheat on their tax returns, because the risk is to high. The constant threat of audit worked. But in most states, the contractor / employment laws are widely ignored. And there is little consequence to pay. Consider the Uber decision. In some states, like California, they are relatively easy to get around.

For every contractor making $130,000 or more, the IRS will net nearly $30,000. Plus penalties & interest. A single employee shifted from contract to employment under federal law reaps more tax than any audit I have ever been involved in.

The Accounting Today article.

Federal Law on employer vs. contractor.

To better determine how to properly classify a worker, consider these three categories – Behavioral Control, Financial Control and Relationship of the Parties.

Behavioral Control A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. Behavioral control categories are:

  • Type of instructions given, such as when and where to work, what tools to use or where to purchase supplies and services. Receiving the types of instructions in these examples may indicate a worker is an employee.
  • Degree of instruction, more detailed instructions may indicate that the worker is an employee.  Less detailed instructions reflects less control, indicating that the worker is more likely an independent contractor.
  • Evaluation systems to measure the details of how the work is done points to an employee. Evaluation systems measuring just the end result point to either an independent contractor or an employee.
  • Training a worker on how to do the job — or periodic or on-going training about procedures and methods — is strong evidence that the worker is an employee. Independent contractors ordinarily use their own methods.

Financial ControlDoes the business have a right to direct or control the financial and business aspects of the worker’s job? Consider:

  • Significant investment in the equipment the worker uses in working for someone else.
  • Unreimbursed expenses, independent contractors are more likely to incur unreimbursed expenses than employees.
  • Opportunity for profit or loss is often an indicator of an independent contractor.
  • Services available to the market. Independent contractors are generally free to seek out business opportunities.
  • Method of payment. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time even when supplemented by a commission. However, independent contractors are most often paid for the job by a flat fee.

Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. This includes:

  • Written contracts which describe the relationship the parties intend to create. Although a contract stating the worker is an employee or an independent contractor is not sufficient to determine the worker’s status.
  • Benefits. Businesses providing employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay have employees. Businesses generally do not grant these benefits to independent contractors.
  • The permanency of the relationship is important. An expectation that the relationship will continue indefinitely, rather than for a specific project or period, is generally seen as evidence that the intent was to create an employer-employee relationship.
  • Services provided which are a key activity of the business. The extent to which services performed by the worker are seen as a key aspect of the regular business of the company.

Consequences of Misclassifying an Employee

Classifying an employee as an independent contractor with no reasonable basis for doing so makes employers liable for employment taxes. Certain employers that can provide a reasonable basis for not treating a worker as an employee may have the opportunity to avoid paying employment taxes. See Publication 1976, Section 530, Employment Tax Relief Requirements for more information.