Cat and Mouse

I’m signing off a day early this week, because I’m leaving later today to present a paper at the Midwestern Law & Economics Association conference. The paper is not explicitly about nonprofits, but it is a tax paper. And given that the Venn diagram between nonprofit experts and tax experts is nearly a perfectly overlapping set of circles, I’d be curious to hear your thoughts on the piece, too. I’ll post it on SSRN soon. It is entitled Tax Basis under the Lens, and it is an empirical study of basis valuation disputes in federal courts.

Here is the abstract:

“Tax basis is one of the most important—and least studied—concepts in federal income taxation. Basis protects against double taxation, structures the realization requirement, and serves as a constitutional guardrail on the taxing power. Yet, when taxpayers inflate basis and the IRS responds by assigning assets a basis of zero, the safeguard collapses. Courts, caught between these strategic extremes, often default to the government’s position, even at the cost of accuracy and legitimacy.

This Article is the first empirical study of tax basis litigation, analyzing more than two decades of cases where courts confronted dueling taxpayer and IRS valuations. The findings are striking. Individual taxpayers, even when poorly substantiated, fare better than corporations and partnerships, which face heightened judicial skepticism. Sophisticated tax planning and certain asset classes—real estate and S corporation interests—systematically depress judicial determinations of basis. Most troubling, when the IRS assigns a $0 basis, courts frequently uphold it, effectively converting basis from a protection against double taxation into a penalty.

Using game theory, this Article explains why taxpayers and the IRS are locked in a mutually reinforcing cycle of “cheating” that produces a Nash Equilibrium—stable but inefficient and inequitable. The Article then considers the doctrinal fallout, particularly the uneven application of the Cohan rule and the erosion of realization’s constitutional foundations, and proposes reforms to realign incentives: shifting the burden of proof to the IRS in $0 basis cases, creating safe harbors for unsophisticated taxpayers, clarifying evidentiary standards in corporate contexts, enhancing judicial training, and modernizing basis reporting.

Tax basis may look like a technical footnote, but it is a structural pillar of the income tax. By exposing the incentives that distort basis determinations—and by offering reforms to correct them—this Article reframes basis disputes as a constitutional and economic problem at the heart of federal tax law.”

CJR