David J. Rotfleisch, CPA, JD, is the founding tax lawyer of Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law firm.
Recent reports that Donald Trump declared a $916-million (U.S.) loss on his 1995 income-tax returns and speculation that he could have avoided paying any federal income taxes for up to 18 years resulted in much spin by both Republicans and Democrats, but not a lot of tax policy analysis or understanding.
What we appear to know is that in 1995, Mr. Trump declared a tax loss of almost $1-billion. That loss was carried forward to subsequent years and was used to reduce income in those subsequent years.
An unfair loophole for the rich? Not really.
Can Canadians do the same? Frequently, yes.
There are two different tax issues at play here. The first is the nature of the tax loss, that is to say how the tax loss is computed.
What's included? The New York Times reported that deductions such as "business expenses, real estate depreciation, losses from the sale of business assets and even operating losses to flow from the balance sheets of partnerships, limited liability companies and S corporations" flow into the personal tax returns of the owners.
The Times story did not say that Mr. Trump claimed those expenses, only that those types of deductions are available.
That is, of course, true.
From a simple tax-policy point of view, the deduction of business expenses and operating losses follows basic accounting rules.
All expenses incurred in the course of earning taxable income are, and should be, deductible. It would be unconscionable to tax income and not allow related expenses.
Similarly, if you earn income from one business and have a loss on another, those losses should reduce income. And it applies to U.S. presidential candidates or, under our laws, to Canadian entrepreneurs.
The other possible deductions are more nuanced, and are in effect government policy. Depreciation is an accounting concept. The rate of depreciation for tax purposes is an economic concept modified by government policy as to what rate should be allowed. Depreciation is a non-cash expense, so it does not immediately impact cash flow. Permitting a deduction for taxes has a real reduction of tax liability. All of these deductions are permitted by the Canadian tax system. However, in Canada, a rental loss cannot be created or increased through a depreciation claim. Again, a policy decision by the government.
The use of losses from the sale of business assets is different from a Canadian point of view, and would not be permitted to reduce business income. In Canada, capital gains are treated differently (they are taxed at half rates, a vestige of the pre-1972 system that fully exempted capital gains from taxation), so capital losses can only be deducted against capital gains.
While Canada does not have limited liability companies and S corporations, it does require a flowthrough of partnership income (or losses) to the partners, so in that respect, Canada's tax system is the same as that of the United States.
From a policy point of view, if income from partnerships did not flow into the income of the partners, the partners could defer paying tax on their earnings by leaving them in the partnership. Again, if income is taxable in the hands of the partner, then losses must be deductible too.
While it can be argued that depreciation is a loophole, it is a government-sanctioned and well-known loophole used by everyone with depreciable assets.
For Mr. Trump not to have claimed the maximum depreciation to which he was entitled would have been foolish tax planning.
The second tax issue is the ability of Mr. Trump to carry his loss forward to subsequent years.
Again, from a policy point of view, not to allow someone who incurs a business loss to utilize that loss against future income would be fundamentally unjust. Who would make a business investment if the income was taxable, but any loss was of no use?
And if a business owner's losses in a given year exceed all income. then the only uses of those losses is a carryover or a sale of the loss itself to a third party, which has far more potential for abuse. Again, the rules in Canada are similar. A business loss can be carried back three years and forward 20 years, to be used to offset income earned in those other years.
While the composition of Mr. Trump's $971-million loss may be in part the result of government loopholes, notably depreciation, the carry forward of that loss is a basic requirement of tax equity and is far from unfair.