Is This White House Tax Break Really Fair?

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Most taxpayers only deal with the most basic elements of the tax system, with most of their earnings coming in the form of wages that get taxed at ordinary tax rates. But the tax laws have a huge number of highly specialized tax breaks, some of which are designated for a select few. There's often a good reason to single out certain groups of people for preferential treatment, but it can always raise questions about whether that preference is appropriate.

One particular tax break that's back in the news is a special provision for government officials. The provision, which offers a chance to defer taxes indefinitely that would otherwise be due immediately, is one that outgoing Secretary of State Rex Tillerson used to put off paying millions in capital gains taxes when he joined the cabinet. That's now drawing new controversy, as Tillerson's departure still won't trigger the tax that he'll eventually have to pay.

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What tax break do government officials get?

The tax benefit in question involves capital gains on assets that newly appointed government officials are required to sell to comply with ethics rules. Government officials have to comply with rules governing potential conflicts of interest, and there are several ways in which people serving in the government can handle their specific situations. Sometimes, recusing themselves from matters involving companies in which they've invested can be enough to avoid conflicts. But in other situations, ethics advisors recommend that the best way to avoid a potential conflict of interest is to sell off the assets that could create one.

Government officials who choose to sell off positions to comply with ethics rules would ordinarily have to pay capital gains tax on their profits. Most of the time, the holdings that these officials have would be long-term in nature, and so preferential tax rates would apply to the sales. Yet the tax break goes further, allowing officials effectively to transfer their low basis in sold assets to the diversified investments they choose to replace them, according to Section 1043 of the Internal Revenue Code. They'll then have to pay the tax if they later choose to sell off those replacement investments, but it's up to them to determine the timing of when the tax comes due.

The scope of the provision, which is codified in Section 2634 of the government ethics portion of the Code of Federal Regulations, is broad but not limitless. Shares of stock, partnership interests, and foreign currencies are eligible assets allowing the Office of Government Ethics to issue a certificate of divestiture granting favorable tax status for sales and replacement assets. However, if asset sales would result in ordinary income -- which is often the case for certain types of stock option grants -- the ethics office can't give officials the favorable treatment, and tax is immediately due.

Why the divestiture tax break is a big deal

In Tillerson's case, the outgoing Secretary of State had been CEO of ExxonMobil (NYSE: XOM) before joining the cabinet. In addition to owning tens of millions of dollars' worth of Exxon stock, Tillerson also had a vested interest in retirement benefits from the oil giant. As part of his deal in becoming Secretary of State, Tillerson sold off shares that he already owned, and he also had the value of shares he would have received had he stayed at Exxon put in a special independently managed trust. All of that money will potentially qualify for the preferential treatment that the divestiture break offers.

The tax break isn't new, having been in place since 1989. Officials in just about every administration have used it, as have judicial officials. Yet because President Trump chose several high-profile business leaders for the cabinet who had extensive wealth, the value of using the tax break in total was greater than had been the case for past administrations.

Good idea or not?

The justification for having the tax break makes sense on its face. Without the provision, officials would have to sell their holdings and pay extensive taxes immediately. That would result in a very high immediate tax bill that would in turn dissuade some people from taking government jobs. In some cases, that could prevent the best candidates for a position from taking on public service without an extremely large financial penalty that they might not be willing to pay.

What many find objectionable, though, is the idea that the deferral of tax continues beyond the period of public service. Even the year of service that Tillerson had was enough to keep the tax break for as long as he chooses to retain the replacement assets without selling them. Opponents would prefer to see either a time limit or a phased-in recognition of gain over a period of years after leaving government service.

Future changes to the ethics divestiture tax break are possible. But for now, those who've served up until now will get the full benefit of deferred capital gains on their divested assets, giving public servants with extensive wealth a huge tax break for the indefinite future.

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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.