Inside: Guest Editor’s Column

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In this issue, we looked for the tax topics that we face every day in our respective practices.  We explore the recapture of tax in the bankruptcy setting; ERISA issues for the business and estate tax attorney; gain exclusion for small business owners for the corporate attorney; the future of environmental taxes for the environmental attorney; domestic partnership update, income sharing and dependency exemptions for the family law lawyer; foreign bank account reporting for the international and tax attorney; income tax consequences as damages for the litigator; and use of the CDP appeal and recent changes in the Tax Court rules for the tax attorney.  Interestingly, when you take out the tax issues associated with foreclosures and short sales and deferred taxation transactions under §1031, which has been covered at length in recent issues, we found no hot real property issues.

Mark Ericsson

I find history fascinating and with the rest of the column, I am going to take you on a whirlwind tour of the history of taxation in California.  In California, we pay taxes to the Internal Revenue Service (Income and payroll taxes), Franchise Tax Board (income taxes), State Board of Equalization (sales and use taxes), and the Employment Development Department (income tax withholding and unemployment insurance).

As the Mexican War came to an end and California claimed statehood, the military continued to collect the customs tax and California appeared financially sound.  This came to a quick end in 1849, when President Taylor seized the nearly $3,000,000 in revenues held in California, leaving California penniless.   California reacted quickly, passing several taxes, chief among them the property tax which was to become the primary source of county and state funds for years to come.

While Californians were digging for gold, the seeds of the civil war were growing to the east.  California voted to outlaw slavery and sided with the north.  To finance the war, Congress passed an income tax in 1861.  Having forgotten to create an agency to collect the tax, Congress created the Bureau of Taxation the following year and the first commissioner, George Boutwell, set about developing an infrastructure which has generally remained to this day.  Districts were established following the Congressional districts and California was divided in five districts, four being in northern California.   The first tax collectors were paid on commission to collect a three percent tax on incomes of $600 to $10,000 and five percent thereafter.  The average income was about $300 per year and the tax probably produced less than one percent of the total tax revenue.

With the end of the civil war came a reduction in federal taxes.  From 1868 through 1913, when the income tax was reinstated following passage of the sixteenth amendment, nearly 90% of the taxes federally collected were excise taxes on alcohol and tobacco.  The current offer in compromise program originally addressed these taxes.   Until 1951, the job of commissioner was a patronage job often going to the party loyal and charges of corruption were the news of the day throughout.

During the late nineteenth century, the railroads refused to pay the property taxes so vital to the state (they owned the collectors) and the mining interests were paying about one-fourth the rate of the farmers.  The California constitution, passed in 1879 to ease difficulties with labor conditions, state taxes, monopolies, railroads and the treatment of the Chinese, created a board of equalization to insure that all property owners paid their proportionate share of the tax.  Subsequent legislation provided that the state would keep the revenues from banks, railroads and utilities with the balance going to the counties.

With the great depression, the state found itself underfunded and property owners unable to pay their taxes.  California was forced to look for new sources of revenue.  In 1929, the legislature passed the bank and corporate franchise tax imposing a tax on corporate income.  Most onlookers supposed the Board of Equalization (made up of representatives from four districts and the state controller) would administer the tax, but Ralph Riley, a popular and politically well connected controller persuaded the legislature to create a separate Franchise Tax Board headed by the controller, the director of finance and the chairman of the Board of Equalization.  This was a blow to the Board of Equalization, although the Board was given appellate review over Franchise Board decisions.  Several reports to the legislature during this time called for abolition of the Board of Equalization, but the legislature declined to act.

In 1932, the legislature established the Tax Research Bureau within the Board.  Led by Board executive secretary Stewart Pierce, who held that position for 37 years, and counsel Roger Traynor, later to become famous in his position as Chief Justice of the California Supreme Court, the bureau recommended numerous changes to the Bank and Corporations tax and drafted bills for an income tax (administered by the Franchise Tax Board) and a sales and use tax (administered by the Board of Equalization).  The sales tax was enacted at a two and one-half percent rate.  At the height of the depression, the state relieved the counties of their responsibility to finance education, assuming a $40,000,000 annual burden which was about equal to the revenue generated by the sales tax.

The Second World War flooded the state treasury, while causing the federal government to widen its tax base to pay for the war.  Tax rates quickly climbed.  Withholding was instituted in 1943 and the number of taxpayers increased from eight million to fifty million.  The IRS was hiring so fast that employees were not tested.  With the victory tax, the wartime surtax, the income tax and the 1942 tax forgiveness provisions, the return was voluminous.  In 1944, the IRS allowed people to send in their Withholding Receipt in lieu of a return.

Property values soared as people returned to the state after the war.  The taxpayers revolted against soaring property taxes by passing proposition 13 in 1978, purportedly protecting the elderly, but also making local communities more dependent upon state funds and probably leading to a state educational system that has fallen from one of the country’s finest to one of the worst.  State revenue became more volatile as taxes from capital gains, taxed in California at ordinary income rates, flooded the treasury in good years and dried up during recession.  Recent attempts to even out the boom and bust nature of California revenue have been rejected by the voters.

The IRS has also seen its problems.  Senator Bob Kerry investigated the IRS during the mid-nineties and rumors abounded that the IRS would be abolished.  The IRS responded with its “kinder and gentler” culture which resulted in declining revenues.  Quite predictably, the pendulum has swung again and the IRS has now tightened the reins.  Today, both the federal and state agencies are vast agencies working their way through a depression that is taxing the resources of the agencies themselves.

There is much talk today about revamping the tax system.  It is generally agreed that the 34% corporate tax, about 10% higher than most of our competitors, needs to be brought into line to level the playing field.  Many point out that the corporate tax impact is not equally distributed and preferential treatment to, say, the oil companies, should be abolished.  With about 50% of individual taxpayers paying no tax, some feel that the franchise should be broadened.  Others feel that those who can afford should carry a greater part of the burden.   There is talk of discontinuing the estate tax in 2013.  Some would tax consumption rather than income.  It certainly appears that there will be significant changes over the next few years as the United States seeks to get its house in order.


Mr. Ericsson practices taxation, business and estate planning law as a partner in the Walnut Creek firm Youngman, Ericsson & Low, LLP, and was the 2006 Contra Costa Bar Association president.

 

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