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HUMPTY DUMPTY LAW AT IOWA DEPARTMENT OF REVENUE AND FINANCE

May 17, 2005

"When I use a word," Humpty Dumpty said in a rather scornful tone," it means just what I choose it to mean -- neither more nor less."

"The question is," said Alice, "whether you can make words mean so many things."

"The question is," said Humpty Dumpty, "which is to be master -- that's all."

                          -Alice in Wonderland

Statutes allowing exemptions from taxation are to be strictly construed with all rational doubt regarding the meaning of any words or phrases contained in them resolved against exemption and in favor of taxation

                       -Iowa Dept. of Revenue, in 
                        protest response released yesterday.

The spirit of Humpty lives on at the Iowa Department of Revenue tax policy section. Follow us through the looking glass for a peek at a protest response posted on the Department website yesterday.

Michael Fereday tried to take advantage of the Iowa "ultra-long term" capital gain deduction, which allows some taxpayers to avoid Iowa taxes on the sales of business assets or real estate held for more than 10 years. Mr. Fereday appeared to meet all of the requirements for the deduction, and his "holding period" for the property began in 1986.

But the Department can make words mean so many things -- even "held."

Because many federal tax rules - in particular, lower capital gain rates - turn on how long an asset is held, the tax law has developed a detailed set on "holding period" rules.

In 2002, Mr. Fereday sold property he had acquired in a 1997 like-kind exchange. In such exchanges, the basis and holding period of like-kind property given up carries over to the replacement property acquired in the exchange; the exchange itself isn't taxed. The property swapped away in the 1997 exchange had been acquired in 1986, giving him a 16-year holding period.

THE ROLE OF FEDERAL TAX LAW IN IOWA TAX LAW

Like most states, Iowa's tax rules piggyback the federal tax law. If they didn't do so, each state would have to re-invent the wheel; it is much easier to simply latch on to the extensive body of federal tax law that has evolved since 1913. Iowa specifically recognizes this in its "code conformity" provision for computing taxable income. The Department's own rules indicate that they will lean on federal definitions:

Federal rulings and regulations. In determining whether “taxable income,” “net operating loss deduction” or any other deductions are computed for federal tax purposes under, or have the same meaning as provided by, the Internal Revenue Code, the department will use applicable rulings and regulations that have been duly promulgated by the Commissioner of Internal Revenue, unless the director has created rules and regulations or has exercised discretionary powers as prescribed by statute which call for an alternative method for determining “taxable income,” “net operating loss deduction,” or any other deductions, or unless the department finds that an applicable Internal Revenue ruling or regulation is unauthorized according to the Iowa Code.

Yet the Department doesn't think this means "held" has the same meaning for federal purposes as it does in Iowa:

The Iowa capital gains deduction is unique to Iowa. The Internal Revenue Service does not have such a deduction. Therefore, without specific statutory authority, there is no reason to include like-kind exchange provisions in the interpretation of the Iowa statute.

WHAT PART OF 'HELD' DON'T YOU UNDERSTAND?

The Department is simply wrong. While some specifics of the Iowa capital gains deduction are indeed unique, the concept of different rates based on holding period length has been in the Code for many years.

Iowa has had no difficulty adapting federal holding period rules for other "unique" Iowa purposes. For example, Iowa has a special exclusion for farmers for sales of cattle or horses held for 24 months. The Department adopted federal holding period rules for this deduction, which has no direct federal counterpart. (Subrule 40.38(2))

If the legislature doesn't provide a specific definition of a word when it passes a tax law, the sound and sensible assumption is that it means the same thing that it means elsewhere in the tax law.

Yet, incredibly, the Department says that unless the legislature provides a definition for every term in a statute, the Department gets to make one up. In fact, they say, they must do so, and in the most taxpayer-hostile manner possible.

LET'S MAKE THIS HARD

This exclusion is itself an item of complexity created by the legislature. Rather than having low rates on a broad base, Iowa has high rates and lots of narrowly-focused exclusions. Not to be outdone, the Department has made it more narrow and more complicated.

The Department's approach illustrates why states normally piggyback on federal law. Without federal tax rules to guide them, Iowa taxpayers have to guess whether an otherwise sensible transaction causes an Iowa problem. The Department has never provided comprehensive guidance as to its own holding period rules here, so taxpayers have to guess what the Department will do, or seek transaction by transaction guidance -- an expensive and slow process. If the Department instead simply adopted the federal definitions, taxpayers would be able to know where they stand.

Of course, we charge by the hour, so maybe we should just shut up. Useless busy work for tax practitioners - Iowa's path to progress!

(Thanks for George Davis for the tip).

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