Capital Gains Forum

A big investment tax break with a tangled legal history is under scrutiny as state officials search for ways to address Oklahoma’s budget crisis.

The Oklahoma capital gains deduction allows individual investors and businesses to avoid paying state income taxes on all profits from sales of ownership interests in Oklahoma-based firms or real estate.

It encompasses a wide range of transactions, from selling a few shares of common stock to selling an entire business or property.

Approved by voters in 2004, the tax break has reduced state revenue collections by an average of $115 million annually over the past three years, according to the Oklahoma Tax Commission. In fiscal year 2014 alone, it cost the state $157 million.

In terms of cost, it’s at the top of the list of business incentives that are contributing to the state’s budget crisis.

It is used by a relatively narrow slice of taxpayers, generally those with higher incomes and substantial investments. In 2014, it was claimed by 18,085 tax filers, compared to 331,854 who claimed the earned income tax credit for low-income people.

The tax deduction works in this way for individual investors: An Oklahoman who doubled her money by buying Sonic Corp. stock, holding it two years and selling it for a $100,000 net profit would pay no state income tax on the gain because Sonic is headquartered in Oklahoma. Another Oklahoman who netted a $100,000 profit on McDonald’s Corp. stock would pay up to $5,000 in state taxes on the trade because McDonald’s is headquartered in Illinois. (Oklahoma’s top individual income tax rate is 5 percent.)

In the view of one tax specialist, the deduction has been on shaky legal ground all along.

“Endangered? Yes. You could put a tombstone on it,” said Jim Heatherington, managing partner of Heatherington & Fields CPAs in Tulsa. Heatherington has been expressing doubt about the deduction’s constitutionality ever since its enactment because it provides special treatment for Oklahoma-based companies.

“The reason I think it would be a good item to get rid of is that it’s probably not going to survive in court,” said Heatherington, who predicted it’s only a matter of time before somebody files a successful court challenge. “But the voters voted for this thing. I think if you want to get rid of it, you’ve got the get the voters to vote again. That should be interesting.”

Several other tax accountants, tax attorneys and state finance officials interviewed by Oklahoma Watch disputed Heatherington’s assessment that the deduction is unconstitutional.

Even so, some of the tax break’s initial architects said they now have reservations about its merits.

Former Senate President Pro Tem Cal Hobson, a Democrat, was the principal Senate author of a big 2004 tax bill that contained the capital gains deduction along with a tobacco tax increase and other provisions. Hobson, who left the Legislature in 2006, said he probably would vote today to get rid of the capital gains break.

“What the Legislature ought to do, now that they’ve got a month left to get in front of this, is repeal it. Show good faith and stop the drain. We’re in a crisis,” Hobson said.

Former State Treasurer Scott Meacham, a Democrat, played a key role in the deduction’s creation. (At the time, he was Gov. Brad Henry’s budget director.) Meacham said he still thinks it has value as an investment incentive, but probably would choose to scale it back because broad income tax cuts enacted since 2004 have reduced its effectiveness as an investment lure. If the state’s across-the-board rates are lower, the net value of a tax deduction is not as great as it was when they were higher.

“To me it doesn’t make a lot of sense to do both,” said Meacham, who now runs a business startup investment firm called i2E. “Since they’ve cut the income tax so much in so many different ways, I think it’s fair to look at this and say, ‘Should this be recalibrated? Should it be kept? Should it be eliminated?’ That’s definitely something that ought to be considered.”

Other state officials said they think the deduction should be preserved.

Senate Finance Committee Chairman Mike Mazzei, a Republican, was Senate author of a 2008 law that adjusted the required holding periods for the deduction. An investor now must own a business equity interest for at least two years to be able to claim the tax break. The holding period for real estate is five years.

Mazzei said he thinks the deduction should be retained because it encourages Oklahoma-based capital investment that can generate economic and employment growth in the state. He said that in the view of many economists, it is better to tax economic activity than to tax investment.

“The numbers I have studied in previous years have indicated that it is a benefit to production and capital investments,” Mazzei said. “I’ll be looking forward to the incentive review commission’s analysis to see if it concurs with my own.”

Reconsideration of the tax break could be in the cards, although probably not soon enough to have any impact on next year’s estimated $1.3 billion budget gap.

In April, state finance and tax officials presented the newly-formed Oklahoma Incentive Evaluation Commission with a list of business incentives it might consider for scrutiny over the next four years. The commission is slated to decide in the next few weeks which ones it will study this year for possible legislative action in 2017.

The capital gains deduction, with its average annual cost of $115 million, was the biggest incentive on the list. (Many incentives had no cost impact estimates, but it appears doubtful that any of them would exceed the capital gains tax break in size.)

Meacham said the deduction was included in the 2004 tax package because majority Democrats needed at least a few Republican votes to pass a 55-cent-per-pack cigarette tax increase to provide funds for state health programs.

Republicans were pressing for an income tax cut, he said, and Democrats thought a targeted investment incentive would cost less money and produce more economic benefits than an across-the-board reduction in the top income tax rate.

When the measure appeared on the ballot, the tobacco tax provisions were described in nine sentences. The capital gains provision was summarized in 12 words: “The measure allows certain earnings of an individual to not be taxed.”

State Question 713 was approved by a 53-to-47 percent margin.

Even before the measure passed, some tax experts and policy analysts were questioning its future impact.

“A measure in Oklahoma would raise much-needed new revenues for health care and other services for the next few years, but the measure also contains income tax cuts such that over time, the measure is likely to become a net revenue-loser for the state,” the Washington-based Center on Budget and Policy Priorities warned in October 2004.

The deduction’s favored treatment of in-state firms was challenged several years ago by CDR Systems Corp., a Florida-based manufacturer that operated a fiberglass plant in Waynoka. (The plant has since been closed.) When the entire company was sold at a profit, it tried to exclude nearly $4 million in profits from taxation in Oklahoma. Its claim was denied because its corporate headquarters was located out of state.

The company filed a lawsuit challenging the deduction’s preference for Oklahoma-based companies. The Oklahoma Court of Civil Appeals ruled in CDR’s favor. But in 2014, the Oklahoma Supreme Court reversed the appeals court, ruling 5-4 that the deduction was constitutionally sound and the Tax Commission was justified in denying the claim.

Despite that ruling, the Tax Commission later entered into some kind of agreement with CDR. Commission officials declined to discuss the case, citing taxpayer confidentiality laws. CDR’s attorney in Oklahoma City did not respond to an interview request.

Heatherington, the Tulsa CPA, said the commission settled with CDR because the company was prepared to appeal the case to the U.S. Supreme Court. The U.S. high court had struck down a different kind of state-based tax preference in North Carolina in 1996, saying it violated the Commerce Clause of the U.S. Constitution.

Writing for the court, Justice David Souter noted that the Commerce Clause “prohibits economic protectionism — that is, regulatory measures designed to benefit in-state economic interests by burdening out-of-state competitors.”

Oklahoma Tax Commission Executive Director Tony Mastin declined to discuss the CDR case. But he said the commission would continue to process claims for the capital gains deduction as long as it remains on the books.

“The (Oklahoma) Supreme Court ruled in our favor on the constitutionality of it,” Mastin said. “So we still enforce the statute as it’s written. Until the court determines otherwise, we will administer it.”

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