One of the more controversial provisions passed by Congress in its attempt to reduce the burgeoning federal deficit was the luxury excise tax. The tax, introduced as part of RRA 90, levies a 10% surcharge on certain high-priced items to the extent that they exceed certain statutory limits. Effective January 1, 1991, the tax applies to the "first retail sale" of luxury goods with a sales price above the following thresholds: automobiles $500,000; boats $100,000; aircraft $25,000; and jewelry and furs exceeding $10,000. the tax was originally projected to provide revenues of $9 billion over the next five years. It has become obvious that the original projections are, at best, unrealistic. In addition, on a larger scale, the imposition of the excise tax has been reported in the press as aggravating the plight of the luxury industries already hard hit by current economic conditions.

Legislators levied the tax on only five industries, allegedly to make the tax easier administer. It was decided, for example, that electronics should be dropped as a category since there are too many different types of dealers and equipment. Needless to say, the industries affected have been quite vocal in their criticism. The producers singled out are concerned that consumers who misunderstand the "threshold" concept may be resistant to purchase so called "luxury items." This would occur, for example, if consumers were to believe that $3,000 in additional tax would be owed on the purchase of a $30,000 automobile, when in fact none would actually be due. For the consumer, the tax is particularly worrisome because, once the statute is in place, it is simple to lower the threshold amounts or increase the rate. Opponents claim that the provision will affect not only the consumers, but also the industries, and in time will translate into lost jobs.

In the boating industry, this has already become obvious. According to a recent The Wall Street Journal editorial, the Labor Department estimates that in Florida, the nation's leading boat building state, builders laid off 5,000 out of 18,000 laborers by the end of 1990 and these layoffs are not isolated. Retailers, manufacturers, and services aligned to the boating industry are simultaneously affected. To provide even the slightest justification for these job losses, the government should at least be realizing substantial revenue gains. Nevertheless, according to the same editorial, the Joint Committee of Taxation has released collection estimates of which only $3 million were attributable to boats in 1991. Where is the justification?

Enacted in Haste

Ostensibly, a surcharge on luxury items is an equitable means by which to shift the burden of deficit reduction to those who can best afford it. It is hard to argue that an individual who can afford a $40,000 car cannot afford an additional $1,000 contribution to Uncle Sam. This perceived equity is exactly what the legislators were striving for when the legislation was introduced. Unlike most tax legislation which is the subject of extensive comment and review, accountants, attorneys and the public had little input into the 1990 act, which was drafted and presented almost exclusively behind closed doors. Now, in light of both the regulations released in late December 1990 and the revised revenue projections, which place the projected revenue of five years at only $1.5 billion, the tax is not quite as appealing as it may have seemed. In order to reach an agreement within a reasonable time frame, it appears that legislators were hasty in their analysis of the ramifications of the new luxury tax. Aside from the fact that the tax probably unjustly places its burden on only five industries, many argue that it will be an administrative and compliance nightmare that may actually use more resources than it can provide. Moreover, the newly issued regulations appear to leave open many technical issues, the ambiguities of which may produce extremely inequitable results.

Administrative Nightmare

From a practical standpoint, ambiguities as to who is liable for the tax make administration quite a problem. Under the regulations, the general rule is that the luxury tax is to be paid by the individual who makes the first retail sale. In the case of subsequent additions to taxable vehicles and to the other so-called luxury goods, the additional tax is imposed on the owner-operator or lessee who installs the part or accessory or who carries it for subsequent installation. The owner of the trade or business that installs the addition must collect the tax and is secondarily liable for failure to do so. Furthermore, in the case of a qualified lease, if the lease is canceled or otherwise terminated, the balance of the tax that would have been required if the lease continued is imposed. For these purposes the lessor is treated as the seller. For purposes of the tax, prior use of demonstration models is treated as a sale. According to a representative of the National Automobile Dealers Association, this places an unfair burden on dealers who have to pay the tax until they are finally able to sell the car. In addition, taxing such vehicles at the time of first retail sale would actually be of benefit to the government because these models typically sell at higher prices than other cars and higher than the "lowest retail price" called for under the regulations. This is just one example of how simplification and clarification would be of benefit to all parties. Examples may be found in each of the industries. The luxury tax regulations present a host of specifications and exceptions that are both internally inconsistent, as well as inconsistent with other code provisions.

Specific Industries

While the proposed rules provide a business use exemption for all vehicles, they employ a different standard for business use for passenger vehicles than they do for boats and aircraft. To be exempt from the luxury tax, automobiles must be utilized by the purchaser exclusively in the active conduct of the trade or business of transporting property or persons for compensation or hire, unless other use is de minimis. For boats, the exemption is a bit more liberal. In particular, the tax does not apply to boats used exclusively for commercial fishing, transportation for compensation or hire, or for use in any other trade or business, unless the boat is used predominantly for an activity generally considered entertainment, amusement or recreation. There is an exception for entertainment boats for hire, i.e., cruise ships, sightseeing boats, etc.

Aircraft enjoy the most liberal business use exemption. The tax will not apply for the first two years ending after the date the plane is placed in service if at least 80% of its hours of flight time is for use in a trade or business. This means that if an aircraft is regularly flown between New York and Florida for pleasure, and to and from Europe for business, the aircraft could conceivably meet the test for exemption.

Subjectivity Abounds

Unlike the test for airplanes, the test for automobiles and boats is extremely subjective and, therefore, far more difficult to meet. The regulations present an example of an individual who owns a luxury taxi cab for use in his business of providing taxi services to the public. In addition, he often uses the cab to pick up family members and to go shopping. These other uses are not considered de minimis non-business uses, and the taxi will not qualify for exemption. Therefore, a limousine driver is basically prohibited from using his automobile during the "off" hours even if it is only for local transportation. As a consequence of this discrepancy, on July 4 when ABC Company decides to use its exempt aircraft to fly its employees to the sunny beaches of Florida, Fred, their limo driver, is faced with the dilemma of asking his mother-in-law for a ride to the airport to preserve his business use exemption.

On top of providing different standards for business use exemption for the different classes of vehicles, within the same vehicle class the standards imposed are different from those for other code provisions. For deduction purposes, the IRC permits a limited depreciation expense for luxury automobiles. Unlike the luxury excise tax, which applies only to what is generally perceived to be expensive cars, the luxury automobile limitations apply to limit the depreciation deduction if the taxpayer's cost basis in the auto, used 100% for business, exceeds $12,800. The luxury auto rules allow for personal use of the automobile, but require an allocation between non-business and business use. The allocation is used to further limit the amount of depreciation allowed. In the case of a $50,000 automobile used 80% for business and 20% for personal use the taxpayer would be liable for a luxury excise tax on the full amount. The payment of $2,000 in additional tax should bring the car's depreciable basis to $52,000. However, although the code allows depreciation on the automobile, its depreciable basis would be capped at $10,240 (80% x $12,800). Therefore, the taxpayer would derive no benefit from the payment of the tax, and would be afforded no excise tax relief for his portion of business use. The result of the discrepancy between the code sections appears to impose a double burden on the taxpayer.

Examples of the Inequities

The inequities created by discrepancies between the luxury tax and other code sections is also apparent with respect to boats. Preferential treatment is afforded homeowners under the IRC, presumably to encourage home ownership long considered an integral part of the "American Dream." The regulations also recognize that one man's home may be another man's boat or castle, and accordingly, for purpose of the mortgage interest deduction, the IRC provides a liberal definition of a "qualified residence." Under the regulations, the determination of a residence should be based upon all facts and circumstances, including the good faith of the taxpayer.

Boats are specifically included in the definition, provided that they contain a sleeping space, toilet, and cooking facilities. Unlike the income tax, the luxury tax provides no special provision for house boats. As such, any boat over $100,000 is subject to tax as a luxury item even if it is purchased as a residence. This appears unjust because it is highly unlikely that a $100,000 house would be considered a luxury. Wouldn't it be more equitable to tax a second vacation home? If a boat qualifies as a home for purposes of a liberal exemption, why should one be forced to choose a different type of home to avoid the excise tax?

Opponents of the tax in the boating and marine industry claim legislators failed to recognize the significant cost of electronic equipment in relation to the cost of boats. Although electronics were dropped as a category subject to the excise tax, in the case of boats, electronic equipment may actually cause the cost of the boat to exceed the threshold and be subject to the additional tax. Although it is difficult to take exception to the inclusion of recreational boats as luxury items, there is no apparent justification for subjecting equipment to the tax. A radar device is far less a luxury than a necessity to a boat pilot. But, from an economic standpoint, he would be better off investing in a hi-tech stereo system and a big screen color television.

There's More

To further compound the inequities created by inconsistencies within the regulations and the incompatibility of the luxury tax with other sections of the IRC, there are some obvious problems with the structure of the tax and the way it is imposed on the affected industries. In the automobile industry, European manufacturers claim that the tax is aimed at them, since they produce approximately 80% of the automobiles with a sales price over $30,000. The European Community Commission is considering whether the tax is in violation of GATT (General Agreement on Tariffs and Trade) and what, if any, action to take against it. The industry, both domestic and foreign, also discounts the alleged ease of administration of the tax and the details of its computation. In a letter to IRS submitted on behalf of BMW, a law firm raises many technical issues with regard to imposition of the tax. In reference to the burden of tax collection, the letter points out that it is not clear who would ultimately be responsible for the tax if a series of transactions are to occur, i.e., sales from manufacturers to importers, or importers to dealers and then to customers. Secondly, according to the letter, since the tax is deemed an obligation of the seller it is required to be included in the seller's gross income. Although, for federal purposes, the excise tax is ultimately deductible from gross income, its initial inclusion distorts the true income of the taxpayer.

This, in turn, impacts various determinations, such as state sales taxes levied upon gross proceeds and tax liabilities for multi-state dealers and may further impact the cost of floor stock insurance for the affected dealers. The letter also demonstrates that the structure of the provision is such that for other purposes of the IRC, such as the determination of personal holding status, the resultant increase in gross income may work to the detriment of IRS. Clearly, even from IRS's perspective, this is an unintended result and the issues must be addressed.

Unlike boats, airplanes and automobiles, it may be difficult to find fault with the inclusion of jewelry and furs as luxury items, especially since the provisions specify that furs and jewelry subject to the tax are those purchased for personal enjoyment. However, industry representatives are quick to point out the problems with the implementation and structure of the tax. In addition, according to a recent article in The New York Times, most analyses claim that while the tax on autos, planes, and boats for which licenses are required will leave a paper trail, the tax on jewelry will be difficult to collect.

The tax on jewelry applies to articles worn for adornment and includes watches, custom made jewelry and jewelry made from materials supplied by the customer. The tax on furs applies to all items made from fur in which fur is a major component. Although the repair of an existing article of jewelry or fur is not treated as production, any change in design or pre-existing value will cause the entire article to be subject to tax. Therefore, the resetting of a stone supplied by a customer to another ring or piece of jewelry is considered production, as is the alteration or modernization of a fur coat. As Michael Roman, chairman of the trade group Jewelers of America noted, if a jewelry heirloom in the family for generations worth $20,000 were brought in for a new $1,000 setting, taxes under the new law would be assessed on the resulting value of a $21,000 piece of jewelry. The regulations present the example of a diamond brooch purchased prior to 1/1/91 which is reset as a necklace after the effective date of the luxury tax. The customer was charged $1,000 for labor and materials, however, since the fair market retail value of the necklace when delivered is $12,000 the jeweler is liable for a tax of $200 ($12,000-$10,000 X 10%) on the transaction. The justification under the regulations is that the jeweler has produced a new article of jewelry from material provided by the consumer and therefore tax is imposed at delivery. This is an outrageous result especially considering that the heir or owner would never have had the original jewelry subjected to the tax; moreover, the actual modification itself could possibly cost more than it adds to the jewelry's value. For purposes of the luxury tax, it is irrelevant whether the jewelry is modified within the U.S. or abroad. The regulations present the example of a person who has a diamond from an existing ring reset in a new mounting while traveling outside of the U.S. The person later returns to the U.S. with the ring. The ring is considered to have been manufactured abroad and imported. Assuming the fair market value of the ring exceeds the threshold, the person is liable for tax on the first use of the remanufactured ring after it is imported. How is this to be collected? Edward S. Cohen, a former undersecretary of the Treasury, raises the issue of a pair of diamond earrings that cost $20,000. Under the new law, these earrings would require a tax of $1,000. However, he asked in an article for Tax Notes, what if two movie stars each liked to wear an earring in one ear only, and bought one of the earrings for $10,000? Would there be no tax due?

Where Do We Go From Here?

Although a luxury tax of some sort may be justified on such articles, it is obvious that the regulations must clarify implementation in order to achieve at least some degree of equity. The government's luxury to continue to post huge deficits is obviously in question. Whether the inclusion of a luxury excise tax will, in fact, be productive in the budget struggle is at best debatable. There are no popular forms of taxation, but the luxury tax may be more than unpopular; it may be unjust and counter-productive.