Liquidity Factor on Taxable Income

Written by: Mark Rokow, Associate Editor

There should be a deduction for liquidity when recognizing Taxable Income under the Internal Revenue Code to help remedy inequitable tax applications to both domestic and international transactions. Liquidity, in this instance, is defined simply as how quickly an individual can turn an asset into money. The quicker an asset can become cash, the more liquid it is. Section 63 of the Internal Revenue Code defines taxable income as gross income less deductions allowed.[1] Section 61 defines gross income as “all income from whatever source derived.”[2] Based on these two definitions, taxable income is all non-excluded income, from whatever source, less deductions.[3] This definition does not consider an asset’s value at the time it can actually be liquidated, which can lead to an inequitable application of tax.

Including a consideration for liquidity is extremely important because a volatile or illiquid asset could force a recipient of such asset to pay a higher tax rate than the asset’s actual value. While reporting a loss does help mitigate the tax impact, it does not necessarily fully remedy the tax paid.[4] Examples make this clearer. If person A transfers $50,000 worth of milk and $50,000 of a volatile stock to person B, person B is taxed on a total of $100,000.[5] While the $100,000 valuation is appropriate at the time of transfer, what happens if the milk cannot be sold and the stock price plummets prior to being able to sell? What if Person B did everything they could to liquidate the milk and stock, but the milk and stock could only be sold for $50,000 collectively? Person B has paid a tax on $100,000 while only realizing $50,000.

The example is a bit extreme since many people do not get paid in milk and volatile stock, and writing off the loss will help mitigate the impact on Person B. However, external factors that impact how quickly someone can liquidate occur often in business and are often not fair. While some decisions can be considered poor business sense, many outcomes are out of an individual’s control, especially when dealing with international transfers due to time delays that accompany Customs obligations, transportation, and other naturally occurring constraints. The tax system should attempt to remedy those factors when they result in a decreased asset value.

The difficulty of implementing a liquidity factor on taxable income is attempting to determine what is fair. The simple solution would be to create a new deduction, as exemplified by Sections 151 through 260 in the Internal Revenue Code.[6] A deduction that specifically addresses factors that decrease asset value (contra accounts), such as the loss due to illiquidity, would create a more equitable tax. This new deduction can be based on the existing contra account deductions, such as depreciation and amortization, and will help organize how taxes are applied to a devalued asset.[7]

[1] I.R.C. § 63.

[2] Id § 61.

[3] Id § 63.

[4] I.R.C. § 1001; I.R.C. 1016.

[5] Commissioner v. Glenshaw Glass Co., 211 F.2d 928, 932-933 (3d Cir. 1954) (outlining what constitutes taxable income), aff’d, 348 U.S. 426 (1955).

[6] I.R.C. § 151-260.

[7] Id § 167-169.

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