W. Edward “Ted” Afield
Associate Clinical Professor and Director, Philip C. Cook Low-Income Taxpayer Clinic, Georgia State University College of Law
Thanks to Leandra for organizing this group of posts from the excellent discussion our AALS Discussion Group had about the future of tax administration and enforcement. During our discussion, I discussed how areas of tax administration and procedure are starting to become intertwined with other areas of law. Currently, in an article that I am finalizing, I am exploring this theme in the context of the various student loan repayment programs, such as Income Based Repayment and Pay As You Earn, and examining how these programs would benefit from being modeled after tax liability relief programs that emphasize providing relief based on a taxpayer’s ability to pay.
Although the student repayment programs were not instituted through the Tax Code, they have nevertheless implicated the Code by tying repayment to adjusted gross income and creating a potential tax liability through debt forgiveness. John Brooks has persuasively argued here and here that this model of student loan repayment is best analyzed as a system of taxation, or “quasi-public spending” rather than pure loan repayment. As Brooks explains, under these repayment programs, government funds are used to finance student education and are repaid with a percentage of students’ incomes, making these programs appear very similar to a tax imposed to pay for a government benefit. Brooks acknowledges that the analogy is not a perfect one, given that progressivity disappears at higher income levels, the “tax” is not due for life (rather, it is only due until the loan is repaid), there is currently a significant balloon payment for forgiven loans that produce taxable cancellation of debt income, the programs are administered by the Department of Education rather than by the Internal Revenue Service, and the benefit is predominantly funded by taxpayers who took out student loans (although taxpayers as a whole still fund a portion of the debt forgiveness). Despite these differences between the loan repayment programs and the income tax, the fact that repayment is tied to income rather than the amount of the debt or the interest rate on the debt prevent student loan repayment programs from functioning as pure loans.
Tying these programs to taxpayer income produces distortions and unanticipated inequitable outcomes such as:
- Institutions of higher education are insulated from market pressure. Because current student loan repayment programs remove much of the risk of borrowing large amounts of money for their educations, institutions of higher education do not have to worry as much about the market pressures that would be brought to bear by producing high debt loads and poor employment outcomes. Under these repayment programs, institutions are inherently less sensitive to the career outcomes of their graduates because they can still attract students who borrow to pay high tuition costs and are only concerned with obtaining employment that allows them to make the minimum monthly payments under these programs, even if they can never repay the full amount of the loan. This problem is especially pronounced in graduate and professional schools, which have much higher tuitions and also have much higher limits on the amount of borrowing eligible for these programs. See Tamanaha, Crespi, Audette, Simkovic, and Leff and Hughes.
- Taxation of debt forgiveness outside of the Public Service Loan Forgiveness program provides a preference for government and nonprofit workers over private sector employment that is not necessarily justifiable: The tax-free debt forgiveness of the PSLF program provides a significant benefit to public service and nonprofit employees with significant student loans over their counterparts in the private sector. Under PSLF, outstanding student debt is forgiven after ten years as opposed to 10 or 25 years. In addition, because PSLF eligible debt is currently forgiven tax free while non-PSLF debt is taxable, borrowers with debts forgiven under PSLF receive a benefit that can be worth up to $100,000. The favorable treatment of student loans under the PSLF program is justified with the argument that the government can forgo more revenue in the PSLF program if it incentivizes borrowers to fill needs in public service despite the fact that such positions often are compensated at lower levels than private sector positions. In essence, it amounts to the government providing additional compensation for employees in the public sector or in the nonprofit arena, and effectively provides a “double subsidy” to the borrowers who receive this benefit. In addition to picking winners and losers, it is unclear that providing favorable student loan treatment to these public service employees is the most efficient way to incentivize public service. See Crespi, Simkovic, and Sheffrin.
- Certain married couples are disadvantaged by being forced to file as married filing separately, which causes them to forgo valuable tax benefits: Married couples are potentially disadvantaged under the current student loan repayment system because repayment is tied to adjusted gross income. Because married couples filing jointly would have to include both spouse’s incomes in the repayment calculation, even if only one spouse has student debt, married filing jointly couples in which one spouse has low income and high debt while the other spouse has high income and low or no debt could become ineligible for the student loan repayment programs. In addition, married couples in which both spouses have student debt subject to current repayment programs end up having their incomes counted twice, which results in the couple paying much more of their discretionary income for student loans than they would if they filed separately or remained single. Accordingly, couples in this situation are incentivized to either forego marriage or to give up other tax benefits that are not available to couples who elect married, filing separately. See Layman, Haneman, Grossman and Caton, and Schrag.
- The debt forgiveness aspects of these programs allows students to plan for the possible tax consequences far enough in advance that they can potentially obtain free funding from the government over what they need for educational purposes without having to repay it: Most of the current student loan repayment programs require a “partial financial hardship” for participation and tie their repayments to the borrower’s income in relation to the poverty line and, crucially, cap the monthly repayment before eventually resulting in debt forgiveness. This structure has the unintended side effect of allowing some students who anticipate entering fields with lower incomes to take free money from the government that is not necessary for their education without ever having to repay it. This distortion occurs when students borrow the maximum amount for which they are qualified, regardless of whether they need all of the funds to pay for their education, and then enter one of the income based repayment programs that cap repayments and conclude in debt forgiveness. Even students with significant assets owned either at the time of borrowing or acquired during the term of repayment would potentially be eligible for this benefit, if their assets were structured in a manner so as not to generate significant income. While the eventual debt forgiveness outside of public service loan forgiveness would still be taxable, this deferred tax on the debt forgiveness is not as significant of a burden as it initially appears to be because of inflation and can be planned for by setting aside either a portion of the borrowed funds in advance or a portion of future income in order to pay the eventual tax bill. Furthermore, although taxable debt forgiveness occurs at a point in which many borrowers are likely to have significant assets that, even if exempt from creditors, would prevent them from taking advantage of the deferral of income under the insolvency exception in section 108(b), the amount of time that borrowers have to plan for this debt forgiveness allows for the possibility of planning techniques available to at least some taxpayers. For borrowers anticipating entering careers in public service or the nonprofit sector, this potential distortion has an even greater benefit because the excess borrowing will be forgiven tax free, negating the need to set aside any of the proceeds or future income for taxes. See Crespi here and here, Chung, Layman, Audette, and Leff and Hughes.
Because of the tax-like components of federal student loan repayment, principles of tax collection can be a useful analytical tool to the extent that they have already developed mechanisms for basing tax collectability on a taxpayer’s ability to pay an assessed liability. The OIC procedure, described in Part Five, Section 8 of the Internal Revenue Manual, is designed to provide relief to taxpayers who owe an existing liability but who cannot afford to pay it. It is designed to look beyond income as the only indicator of a taxpayer’s ability to pay and to focus on the taxpayer’s entire financial picture. When evaluating an OIC, the IRS considers the taxpayer’s income, necessary expenses, assets, and liabilities. In addition, the IRS considers the taxpayer’s potential to improve his or her financial situation in the future, which can influence the amount of the offer that the IRS is willing to accept. The goal of the program is to provide relief to taxpayers who legitimately need it while avoiding giving a windfall to taxpayers who are capable of paying their liability during the period of the collection statute of limitations, after which the debt is effectively cancelled because the IRS becomes barred from taking collection actions. The goals of OIC program are strikingly similar to the goals underlying the student loan repayment programs, but the OIC program accomplishes these goals in a way that produces fewer distortions than the current student loan repayment programs. Accordingly, OIC principles can be a useful guide in designing a Student Loan Compromise Program (the “SLCP”).
An SLCP would be expand the determination of ability to pay from current repayment programs’ myopic approach of just focusing on a borrower’s adjusted gross income. This expanded focus would require borrowers to provide information each year on their reasonable repayment potential, which would include the four primary elements that constitute reasonable collection potential under the OIC program: (1) likely future income; (2) net realizable equity in assets; (3) assets held by third parties on account of intentional borrower asset dissipation, fraudulent transfers, and similar transactions; and (4) borrower owned assets beyond the government’s reach, such as assets located in foreign countries. The borrower’s repayment amount would be a function of his or her overall ability to pay, rather than just being a function of the borrower’s income. Debt forgiveness would still play a role, but it would not occur at a fixed point but rather would only occur when the borrower was able to demonstrate that it was unlikely that the loan would ever be repaid.
Using the SLCP would have the advantage of being more predictable than the current bankruptcy standard, which produces different outcomes that often simply depend on the judge applying the standard. At the same time, the SLCP, through its use of collateral future income agreements, would also provide more flexibility than the bankruptcy system or IRC § 108 principles to consider potential future income and to avoid providing potential windfalls to borrowers who could eventually repay the loan. Furthermore, the SLCP would cause students to become more prince sensitive to the costs of education because forgiveness would not be guaranteed after a certain time, would reduce disadvantages currently experienced by married couples, and would minimize opportunities for tax and asset protection planning designed to exploit the relief provisions
Concerns about the increase administration costs of an SLCP could be mitigated by the potential for increased revenue from that would be derived from curtailing debt forgiveness only to those taxpayers who cannot afford to pay their loans. In addition, potential revenue losses to the government become less dramatic if this loan repayment approach is able to provide more relief (through tax-free debt forgiveness) to the most deserving borrowers who then would not then have to rely on increased government social safety net. See Oei and Simkovic.
While an argument certainly can be made that student loan repayment programs should have no connection to any aspect of the tax laws, it may be difficult to disentangle these areas of law fully, given the federalization of almost all student lending. Accordingly, if there is going to be a connection between these two areas of law, the laws surrounding the collection of taxes may provide a mechanism by which these two areas of law can be better harmonized by targeting relief to those who need it while minimizing unintended distortions.