MauledAgain

Two years ago, in Unmasking the Deductibility of Halloween Costumes (2009), I examined the deductibility, for federal income tax purposes, of the cost of Halloween costumes. Usually, my Halloween posts, which apparently have become a tradition, involve candy and other treats, such as Taxing "Snack" or "Junk" Food (2004), Halloween and Tax: Scared Yet? (2005), Happy Halloween: Chocolate Math and Tax Arithmetic (2006), Tricky Treating: Teaching Tax Trumps Tasty Tidbit Transfers (2007), Halloween Brings Out the Lunacy (2007), and A Truly Frightening Halloween Candy Bar (2008), though last year, in Happy Halloween: Revenue Department Scares Kids Into Abandoning Pumpkin Sales (2010), I focused on a different sort of edible that surely is not candy and for many is not a treat. Now it’s time for another Halloween item that is not candy, and though it may be a treat, the tax aspects are somewhat tricky.

Not too long ago, I had occasion to notice that Halloween costumes were subject to sales tax in some states but not others. In some states, such as New Jersey, costumes are considered clothing and are exempt from sales taxation because clothing is exempt from sale taxation, though before the law was amended adult costumes were not considered to be clothing though children’s costumes were so treated. In Florida, there is no exemption for costumes. Some states, for example Mississippi, exclude costumes from sales taxation if they are purchased for purposes of making a film for which a film production income tax credit is available.

In just about every states, costume accessories, such as masks, are subject to sales taxation. That is the case, for example, in New Jersey. The same principle applies to accessories such as wands, swords, baskets, and broomsticks.

What is scary is that the nation’s legislators cannot agree on whether a costume is clothing, an alarming prospect even aside from the inability to agree on whether clothing should or should not be subject to sales tax. A costume is something that is worn. Clothing is something that is worn. The difference is that a costume is worn only for special occasions. A tuxedo is clothing even though it is worn only on special occasions, and surely there have been men wearing tuxedos who have called the thing a costume. To use a common definition, clothing is something that covers. Costumes cover. The same definition also uses the word “garment” to describe clothing. From the same source comes a definition of costume that uses the terms dress and garment. Some costumes so resemble everyday wear that drawing the distinction becomes arbitrary and nonsensical. Truly horrifying.

It is easy to understand why accessories such as wands and broomsticks do not fall within the clothing exemption. These are not items that are worn, they are not garments, and they do not cover. On the other hand, a mask is worn, and it covers. Why is it classified as something not clothing? It should be terrifying that tax policy rests on analysis devoid of logic, common sense, and consistency. The only logical explanation, aside from the simple expedient of increasing sales tax revenues by narrowing exemptions, is the notion that exempt items are “necessaries” and that costumes and masks, unlike clothing, are not “necessaries.” The difficulty with this analysis is that tuxedos, ballroom gowns, and someone’s fiftieth pair of shoes or thirtieth cocktail dress, are not “necessaries” and yet they are exempt. Frightening, isn’t it? For most people, tax always is, no matter how the rules sort out, but when it comes to the sales taxation of Halloween costumes, it’s simply ghastly.

One of my readers, noting that I had disclosed having read the Internal Revenue Code, asked if I agreed that all of the Code, and even the regulations, are “complex and hard to decipher.” He asked, “Can complexity be measured? Would some of the criteria be the number of pages, number of interrelated sections or regulations, number of topics covered in the section, etc. Is there a top ten list of complex code sections?”

My response added questions. The primary question was simply, “How does one measure complexity?” I elaborated on my question: “Number of words? Not necessarily. There is something somewhere floating about that deals with ‘What is the longest Code section?’ but I don’t have a cite offhand. Number of challenging computations? Number of difficult definitions? Number of exceptions? Number of exceptions to exceptions? Difficulty of application? The black letter law ‘gifts are excluded from gross income’ is simply stated, but the question ‘What is a gift?’ requires complicated analysis to come up with something that separates gifts from payments for services. Does it matter if the provision affects 10 people or 1000 people? In other words, is something with a complication level of 6 (whatever that means) affecting 200 people (1200 points) more complicated than something with a complication level of 8 affecting 5 people (32 points)? Some of the most complicated things are the transition rules and effective dates, which technically are in the amending act and not in the Code itself.”

In a follow-up, the reader shared the link to Janet Novack’s Forbes article, The Most Confusing Part of the Income Tax Code, which describes ten areas of tax law that are complex. The reader then asked, “Should you consider the number of tax cases litigated regarding a particular section? Should you consider the National Taxpayer’s Advocate Report 2010 stating that 80 million taxpayers are affected by family status issues such as earned income credit, marital status, child tax credit, and child and dependent care credit? Should you consider if you are wrong about filing status the taxable income and total tax owed or refunded is affected? Should you consider if section 107 parsonage allowance with only 81 words is extremely complex because it has resulted in hundreds of tax cases about the law and whether the section is constitutional?” In yet another follow-up, he asked, “Should you consider the [flush language] sentence from Section 509(a)(4) [509(a)]? Should you consider the premise that if tax experts or AICPA argue for simplification of particular tax codes [sections] then those tax codes [sections] are too complex?”

I don’t agree with the proposition that every code section and regulations section is complex. For example, section 701 provides, simply, that partnerships are not subject to the federal income tax. But I think there is unanimous agreement that many, perhaps most, Code sections are complex. And I think it is safe to conclude that there is unanimous agreement that too many Code sections are complex.

In addition to the issue of deciding which factors should enter into the determination of complexity and the issue of determining how much weight should be assigned to each factor, there is the further, sorry, complication caused by the existence of different types of complexity. For example, some Code sections are complex primarily, or even solely, because of computation complexity. Section 82, prescribing the calculation of social security gross income, falls into this category. Another sort of complexity is interpretational complexity. For example, the flush language of section 509(a), noted by the reader, surely qualifies, as it reads, “For purposes of paragraph (3), an organization described in paragraph (2) shall be deemed to include an organization described in section 501(c)(4), (5), or (6) which would be described in paragraph (2) if it were an organization described in section 501(c)(3).” Still another type of complexity is technical complexity, when redundancies, ambiguities, poor drafting, and slipshod organization complicate the task of trying to determine what the words mean. Often this sort of complexity arises not from any Code section in and of itself but from the intersection of multiple code sections. Yet another type of complexity is revision complexity, the confusion that results from constant changes to the provision, with effective dates, exceptions to the effective dates, grandfather provisions, and other special rules, many of which remain in the amending act but don’t end up in the Code itself.

Should the analysis be limited to entire Code sections? Or is it acceptable to tag particular subsections, paragraphs, subparagraphs, clauses, and subclauses? It is not uncommon to find a Code section with a very simple subsection (a), only to discover that it’s (b), (c), and (d) that cause eyeballs to spin around in a person’s head. Should provisions that are in amending acts but not in the Code qualify? I think so, though that technically makes the question something different from “What is the most complex Code provision?”

If the only requirement to win the complexity contest is number of words, the victor is section 341(e)(1), as described in this web page:

Internal Revenue Code Section 341(e)(1) - Its a 455 word sentence about "Collapsible Corporations"

(1) Sales or exchanges of stock for purposes of subsection (a)(1), a corporation shall not be considered to be a collapsible corporation with respect to any sale or exchange of stock of the corporation by a shareholder, if, at the time of such sale or exchange, the sum of - (A) the net unrealized appreciation in subsection (e) assets of the corporation (as defined in paragraph (5)(A)), plus (B) if the shareholder owns more than 5 percent in value of the outstanding stock of the corporation the net unrealized appreciation in assets of the corporation (other than assets described in subparagraph (A)) which would be subsection (e) assets under clauses (i) and (iii) of paragraph (5)(A) if the shareholder owned more than 20 percent in value of such stock, plus (C) if the shareholder owns more than 20 percent in value of the outstanding stock of the corporation and owns, or at any time during the preceding 3-year period owned, more than 20 percent in value of the outstanding stock of any other corporation more than 70 percent in value of the assets of which are, or were at any time during which such shareholder owned during such 3-year period more than 20 percent in value of the outstanding stock, assets similar or related in service or use to assets comprising more than 70 percent in value of the assets of the corporation, the net unrealized appreciation in assets of the corporation (other than assets described in subparagraph (A)) which would be subsection (e) assets under clauses (i) and (iii) of paragraph (5)(A) if the determination whether the property, in the hands of such shareholder, would be property gain from the sale or exchange of which would under any provision of this chapter be considered in whole or in part as ordinary income, were made - (i) by treating any sale or exchange by such shareholder of stock in such other corporation within the preceding 3-year period (but only if at the time of such sale or exchange the shareholder owned more than 20 percent in value of the outstanding stock in such other corporation) as a sale or exchange by such shareholder of his proportionate share of the assets of such other corporation, and (ii) by treating any liquidating sale or exchange of property by such other corporation within such 3-year period (but only if at the time of such sale or exchange the shareholder owned more than 20 percent in value of the outstanding stock in such other corporation) as a sale or exchange by such shareholder of his proportionate share of the property sold or exchanged, does not exceed an amount equal to 15 percent of the net worth of the corporation.

If there were a way to measure the amount of money expended in an effort to understand and comply with specific Code sections or components thereof, perhaps that would be the best measure of complexity. I don’t think information of that sort is available.

Some complexity, however, is attributable to the transaction under consideration and not to the tax law. If a taxpayer, in an attempt to end-run the system, sets up a business or investment enterprise by using hundreds of entities located throughout the world, cross-linked in complicated ways and engaging in roundabout interactions, the challenging task of applying tax law principles to the arrangement is not the fault of the Code. There also is the reality that what one person finds complicated another person understands with little effort. That, in turn, raises the question of who should be the judge of complexity. Should it be the practitioners who collaborate on ABA and AICPA commentary and proposals for simplification? Should it be taxpayers generally? I think it should be anyone who works with the tax law. So I invite readers to nominate candidates for tax law complexity, specifically Code and Regulation provisions, whether entire sections or specific components, or intersections of multiple provisions. To keep things manageable, readers should select their one candidate for “most” complex. I understand that all of us could easily list ten or twenty or even a hundred complex provisions but the question is “most” complex. If there are sufficient nominations (and am I setting myself up for colossal embarrassment if only two or three readers submit entries?), I will then try to learn how to set up an online poll that permits everyone to vote (and I welcome suggestions on how to do that, and, at the risk of making this complicated, ha ha, on whether the winner needs a majority or simply a plurality). Oh, nominating speeches are not required, as complex provisions speak for themselves!

Though it sounds good at a theoretical level, the practical problem with cutting taxes in order to force a cut in government spending is that the health and safety of citizens is what gets cut. I pointed this out in The Price of Insufficient Tax Revenue, explaining that the combination of additional tax cuts and the refusal to restore revenue lost through previous tax cuts had compelled the city of Camden, New Jersey, to make huge cuts in its police and fire fighting forces. I returned to the same point in Cut Taxes, Cut Spending, Cut Safety?, explaining that the short-term savings predicted from cutting vehicle inspections would end up being swamped by the long-term economic costs of damages caused by uninspected but dangerous vehicles. I questioned the validity of the cut-spending rationale in Whether There Is Money Depends on Who’s Asking, criticizing the decision to pour taxpayer money into the hands of a shopping and entertainment center developer. Not a peep was heard from the anti-government-spending crowd when the spending flowed to their political allies.

Now comes more news of cutbacks in citizen protective services on account of tax revenue shortfalls. In a story appearing a few days ago, readers of the Philadelphia Inquirer learned that Pennsauken Township, in New Jersey, gave notice that they would release 12 police officers at the end of the year. Last year, when a similar notice was given, some police retired, averting the need for pink slips, but reducing the township’s police force. The mayor of the township stated, “We’re very concerned. This is a reduction in force that’s unprecedented.” No kidding.

According to the story, almost 1,400 police officers and fire fighters were laid off in New Jersey during 2010. Even more would have been dismissed but for retirements, compensation reductions, or redirecting state funds to re-hire some police and fire fighters.

The issue has become a political football. Charges of fiscal mismanagement have been tossed about. Questions are being asked, particularly why township workers received raises if there is insufficient money to retain all the members of the township’s police and fire fighting forces. The answer to that question surely is in the simple fact that the raises are a contractual obligation, and do nothing more than maintain the real dollar value of salaries. The question that needs to be answered is why are tax revenues insufficient to cover the township’s spending. A related question is whether the township’s citizens enjoy the choice that is being presented, the choice being one of paying the price of more taxes or the price of reduced police and fire protection.

Is it simply a matter of the citizens of a town being unable to afford what they want? In that case, the town needs to learn to live without the things that cannot be afforded, though the price may be a town wracked by fire and crime. Or is it a matter of the citizens of a town being unwilling to pay for what they want? Or is it a matter of funds that should be used for what citizens want being used for what citizens don’t want? Or is it some combination of affordability, resistance, and diversion?

It has been said that the low must be reached before the climb back to the heights can begin. But for that to be true, there must be knowledge that the low has been reached, and it needs to be reached at a local level. As the Pennsauken Township, Camden, and other New Jersey municipal layoff stories repeat themselves throughout the nation, perhaps attention will turn from the sound bite nonsense being spewed by political candidates to serious fiscal and economic analysis of reality.

A few readers have suggested to me that I dislike, or worse, hate the wealthy. That’s not true. I dislike what many, not all, wealthy do in terms of co-opting Congress and dictating tax policy that favors the wealthy and that has brought the nation’s economy to its knees. Indeed, there are wealthy individuals who advance economic arguments similar to the ones I make, but they quickly become the target of other wealthy individuals and those who are devotees of the agenda that has brought us so much economic misery.

Whether William H. Gross is wealthy is information I do not know, though my best guess would be that he, as manager of a very large investment fund, probably is not in the “other 99 percent.” What I do know is that he has advanced an argument that ought to be given serious attention by his economic comrades. They may learn something about the benefits of long-term rather than short-term planning. In his analysis, Gross describes four factors that triggered the nation’s economic distress: falling interest rates, lower taxes, deregulation, and financial innovation. He notes that attempts to solve the problem focus on cyclical financial issues rather than structural policy solutions. He concludes, “[A]lmost all remedies proposed by global authorities to date have approached the problem from the standpoint of favoring capital as opposed to labor.” He explains that the reason attempts to stabilize banks, to push markets back to their previous peaks, to increasing debt by lowering interest rates have failed. The reason, he asserts, is that when “Wall Street” (capital) benefits at the expense of “Main Street” (labor), both ultimately will collapse.

Gross suggests that “Even conservatives must acknowledge that return on capital investment, and the liquid stocks and bonds that mimic it, are ultimately dependent on returns to labor in the form of jobs and real wage gains. If Main Street is unemployed and undercompensated, capital can only travel so far down Prosperity Road.” In other words, as I have contended, the past decade has seen a resounding growth in capital, translated, the assets and income of the wealthy, to use Gross’s words, “at a great cost to labor.” Fear of unemployment drives down spending, reduced spending drives down housing prices and in the long-run, business profits. To quote Gross again, “Long-term profits cannot ultimately grow unless they are partnered with near equal benefits for labor.” He adds, “The United States in particular requires an enhanced safety net of benefits for the unemployed unless and until it can produce enough jobs to return to our prior economic model which suggested opportunity for all who were willing to grab for the brass ring – a ring that is now tarnished if not unavailable for the grasping.” Over the past few years, in response to my inquiry as to why some who are not wealthy become so defensive when something as simple as repealing the Bush tax cuts is advocated, I’ve been told that failure to reduce even further the taxes on the wealthy will make it impossible for those who are not wealthy to attain the American Dream. Well, perhaps coming from someone like Gross the news carries more heft than when it comes from me. At the moment, folks, the American Dream is pretty much out of everyone’s reach except those who have already achieved it. Gross concludes with a warning that should alarm those who support the policies that have brought us to where we are, especially considering that he is an investment fund manager. He writes, “Investors/policymakers of the world wake up – you’re killing the proletariat goose that lays your golden eggs.”

Aside from feeling a bit vindicated after reading Gross’s newsletter, I began thinking, “How can the private sector adjust to forestall the inevitable crash pattern promised by current practices? Can the private sector do it alone?" Hardly. The private sector’s track record is abysmal in this regard. Many in the private sector resist outside intervention, specifically, government regulation and taxes, but that is the unsurprising reaction of those too proud to admit that their experiment failed. But how can the government intervene? If it orders the private sector to create jobs, the private sector replies that it doesn’t need workers. The government already imposes minimum wage laws in an effort to ensure that capital invests in labor, though ironically some of the unsuccessful economic experimenters are now crying for a reduction in the minimum wage and a narrowing of the situations to which it applies. Gross seems to suggest that higher and longer unemployment benefits is a or the solution, but from a productivity perspective, it makes more sense for the government, that is, society, to get something in return. In the 1930s, people were paid, not to “collect unemployment” while job-hunting, but to do things, such as cleaning up national parks, preserving archival records, and repairing infrastructure. The nation has things that need to be done, ranging from bridge repair to education of the young, and the nation has people capable of doing these things who need jobs, so it’s a match that works, except that just the other day the Senate, in all of its wisdom, said “no” to this sort of solution.

Perhaps another approach is to use the tax law not only to reward those who create jobs, as the current tax law supposedly does, but also to punish those who fail to create jobs. Two-edged swords are much more effective that one-sided blades. The mechanism for doing this already is in place. It’s the corporate accumulated earnings tax, which is avoided by companies that claim they are hoarding profits for “future growth.” Nonsense. Those who wish to avoid the tax can invest the profits in construction of productive facilities and hiring of employees. And the tax needs to be extended to all business entities. I can hear the howls now. “You will kill capital.” To the contrary, capital is killing itself by focusing on short-term profit at the expense of long-term investment in labor. Capital needs to be taxed to save itself. For example, the special low rates for dividends and capital gains need to go, and if there is to be a special low rate, it ought to be on wages, which would reduce the cost of labor. And if capital doesn’t want to be taxed, it can avoid the imposition by hiring people. Recall that I have argued that the best way for the wealthy to lower their tax burden is to create jobs and take a compensation deduction, thus reducing taxable income. For example, in Why the Tax Compromise is a Mistake, I wrote, “If the job creators want a cut in their tax liabilities, they need to do what I’ve been advising them to do for quite some time. Hire people, take the compensation deduction, thereby reduce taxable income, and watch tax liability go down. It’s that simple. Corporations and wealthy individuals are awash in cash, but they’re not creating jobs. Nor will they create jobs as their cash hoards grow from continued tax breaks.” This comment summarized the more detailed explanation in the earlier post, Job Creation and Tax Reduction. The answer is easy, and if the wealthy, including wealthy cash-bloated corporations, cannot understand this and figure it out, then society needs to give them a tax push. They will scream, but iIt’s tough to sympathize with people who reject such an easy approach to solve their alleged high taxation problem, an approach that also solves the jobs problem that afflicts the not-so-wealthy of the nation.

Almost five years ago, in A Tax Advice Book for People Who Write and Illustrate Books, I reviewed Julian Block’s “TAX TIPS FOR SMALL BUSINESSES: Savvy Ways for Writers, Photographers, Artists and Other Freelancers to Trim Taxes to the Legal Minimum. He has now released a new edition, with a modified title, “Julian Block’s Easy Tax Guide for Writers, Photographers, and Other Freelancers.” Once again, Julian has given tax practitioners and taxpayers with any sort of connection to the literary or artistic world a handy and helpful explanation of tax tips that they might otherwise neglect.

Julian opens the book with several questions posed by readers of the earlier edition. What are the tax consequences of writing a book for an agreed price, incurring reimbursable expenses only to discover that the publisher went out of business and did not pay? Are the tax consequences different if the writing business is a part-time one? How should an author react when one publisher sends a Form 1099 net of agent’s commissions and the other publisher sends a Form 1099 showing the gross royalty? Must expense reimbursements included in a Form 1099 be reported? Are the expenses incurred for a spouse who accompanies a writer to a conference deductible? What is the tax treatment of a speaking honorarium that the speaker asks be paid to a charity? What sort of charitable contribution is available for donating papers, original manuscripts, and correspondence to a charity? Is a charitable contribution available for an artist who paints a portrait and donates it to a church bazaar? There are more questions. Yes, there are answers, but to discover them, buy the book.

Julian then discusses, in succession, the hobby loss and for-profit rules, the tax treatment of awards received for writing and other accomplishments, depreciation deductions for writers and artists, how freelancers compute health insurance deductions, automobile expenses, travel expenses for spouses, the tax consequences of hiring one’s children, home office deductions, sales of homes for which home office deductions have been claimed, and clothing expenses. Julian then deals with some planning and compliance issues, including the timing of making payments near year-end, sending payments to the IRS, self-employment taxes, net operating losses, retention of tax records, extensions of time to file, amending returns, obtaining tax advice from the IRS and others. He deals with these topics in language suitable for those who are not familiar with the technical verbiage of the Internal Revenue Code.

Julian’s book was sent to the printer near the end of 2010 and was released later in 2011. Shortly after the book entered printing, Congress lowered the employee FICA rate and the self-employment rate for 2011. The book does not reflect this change. One of the challenges in writing tax books, and I speak from experience, is that the subject of the book too often becomes a moving target. If tax books were judged solely by this standard, no tax book of practical utility would qualify. There are sufficient disclaimers in the book, as there are in tax books generally, alerting readers to consult professionals and to check for the latest changes in the tax law.

Writers and other freelancers, especially those unfamiliar with the impact of tax law on their activities, should get themselves a copy of this book. I recommend it just as I recommended Julian’s previous books, "MARRIAGE AND DIVORCE: Savvy Ways For Persons Marrying, Married Or Divorcing To Trim Their Taxes - And They’re Legal," which I reviewed in Tax and Relationships: A Book to Read and Give (Feb. 2006), "THE HOME SELLER’S GUIDE TO TAX SAVINGS: Simple Ways For Any Seller To Lower Taxes To The Legal Minimum," reviewed in A New Book on Taxation of Residence Sales: Don't Leave Home Without It (Aug. 2006), "TAX TIPS FOR SMALL BUSINESSES: Savvy Ways For Writers, Photographers, Artists And Other Freelancers To Trim Taxes To The Legal Minimum," reviewed in A Tax Advice Book for People Who Write and Illustrate Books (Dec. 2006), "Year Round Tax Savings," reviewed in Another Tax Book for Tax and Non-Tax People to Read (Feb. 2007), "Travel and Moving Expenses: How To Take Maximum Advantage Of Every Tax Break The Law Allow," reviewed in Tax Travels and Tax Moves: Book It with Block (Sept 2007), "Ultimate Tax-Saving Resource '08," reviewed in Helping Tax Clients Understand Taxes (June 2008) and "Julian Block’s Tax Tips for Marriage and Divorce," reviewed in Julian Block Talks Tax with Married, Divorced, and Other Couples (Jan. 2011) and “Tax Deductible Travel and Moving Expenses: How To Take Advantage Of Every Tax Break The Law Allows!,” reviewed in Julian Block: On the Road Again (July 2011).

On Monday morning, while listening to KYW news radio, I heard a report that caught my attention because the reporter mentioned the word taxes. After listening through the 22-minute news cycle, I paid closer attention when the report ran again, and subsequently found the transcript on the KYW web site. The report focused on a familiar issue, specifically, the struggle that states face in trying to collect use taxes on purchases made by state residents from out-of-state retailers. According to the report, Pennsylvania’s Governor Corbett has joined the long line of state officials across the nation who are trying to deal with this thorny issue.

The problem is that when a Pennsylvania resident makes a purchase on-line from an out-of-state retailer, the resident often does not pay sales tax. Technically, because the purchase is not being made within the state, a use tax is due in lieu of the sales tax, though the use tax is computed at the same rate and on the same items as is the sales tax. Estimates for Pennsylvania’s lost use taxes are in the hundreds of millions of dollars.

What the report got wrong, though, is the applicable law. The reporter quoted Christopher Rants, the president of the Main Street Fairness Coalition, which argues, understandably, that out-of-state on-line retailers not collecting sales or use taxes have an advantage over in-state, bricks-and-mortars retailers. According to Rants, states “can only collect from out-of-state retailers on a voluntary basis.” That is true only if the retailer has no nexus with Pennsylvania. If the retailer has a Pennsylvania nexus, it is required to collect the tax. Though there are many retailers who avoid nexus with as many states as possible, there are far more than a few retailers that have nexus with a significant number of states.

The issue pre-dates the internet, though the emergence of the internet has exacerbated the problem. For decades, Pennsylvania residents have traveled to Delaware to make purchases, because there is no sales tax in Delaware. Anecdotes have been told about Pennsylvania revenue officials watching for vehicles crossing from Delaware into Pennsylvania that appear to be driven by people who have made substantial purchases, but I have my doubts that this sort of enforcement is efficient or effective. In contrast, Pennsylvania’s Liquor Control Board seems to have had better success dealing with attempts to avoid Pennsylvania alcohol duties.

The upshot of the issue comes down to a simple administrative problem. Technically, Pennsylvania residents who purchase items from retailers with no Pennsylvania nexus, whether by going to some other state or ordering on-line, owe a use tax. Very few residents pay that tax, because the state rarely knows about the purchases. When the state does know, for example, when a person brings into the state and seeks to register a boat or vehicle, the use tax is imposed as part of the titling process. Very few items, however, are subject to the sort of titling process required for vehicles and boats.

It is easier, of course, for a state to put the burden of use tax collection on retailers. Retailers bear the burden for sales tax collection, but that obligation is easy to enforce because it applies to in-state purchases and thus to retailers who are physically present in the state and whose in-state businesses are subject to a variety of regulations, including other business taxes, that bring their existence to the attention of the Department of Revenue. On the other hand, a retailer located in some other state, with no Pennsylvania connections, that sells an item to a Pennsylvania resident by way of the internet, is beyond the reach of Pennsylvania’s jurisdiction, just as a French farmer with no United States connections is beyond the reach of the federal income tax. Some states have placed a line on their income tax returns inviting people to report use taxes on out-of-state purchases, but what little evidence exists of the success of this approach doesn’t suggest it is the answer.

This is not my first commentary on use tax collection in an internet age. Seven years ago, in Taxing the Internet, I pointed out that “when it comes to taxing transactions and activities conducted on or through the internet, or taxing access to the internet, those transactions, activities and access should be taxed no differently from the way in which transactions and activities conducted through means other than the internet are taxed” and proposed that states should “tax retail transactions as catalog sales are taxed, imposing use tax collection responsibilities on those with sufficient nexus to the taxing state.” Three years later, in Taxing the Internet: Reprise, I reacted to the introduction of legislation allowing states to shift use tax collection responsibilities to merchants with no connection to the state, noting that despite the claims of advocates for this approach, state 1 has no “independent and sovereign authority” to impose a sales tax on a transaction that takes place in state 2, or to require a merchant in state 2 with no nexus in state 1 to collect use tax on behalf of state 1. I reminded readers that “What’s hurting states is their unwillingness to do what must be done to collect use taxes.” Three years later, in Back to the Internet Taxation Future, reacting to a reappearance of the proposal to permit state 1 to require retailers in state 2 with no state 1 connection to be taxed by state 1, I explained why progress had not been made, pointing out the inability of legislators and others to distinguish between sales and use taxes, the silliness of claims that internet retailers are not required to collect sales taxes at all for any state, the unwillingness of state legislatures and state revenue departments to identify and audit taxpayers not in use tax compliance, the mischaracterizations of the Supreme Court’s 1992 decision in Quill Corp. v. North Dakota, and the inability of legislators, state employees, and citizens to understand the limitations of the Due Process Clause. A week later, in A Lesson in Use Tax Collection, I took a look at California’s approach of requiring in-state business entities to register and report their out-of-state purchases, an approach not without flaws but a step forward in the correct direction.

States, such as Pennsylvania, trying to bring use tax collections closer to what they should be under current law, need to do something more than the cheap “shift the work to out-of-state retailers” approach that violates Constitutional safeguards. Instead, they need to examine what other states have done, to learn, for example, from California officials whether the California approach worked out, to invite businesses to offer their proposals, to start examining tax returns and other records to identify taxpayers most likely to be deficient in use tax payments in amounts making audit and collection procedures worth the effort, and to publicize these efforts in an attempt to educate other residents of their use tax obligations. Perhaps states might consider paying out-of-state retailers to act as collection agents, as it is likely that retailers would be willing to engage voluntarily in use tax collection if the cost of doing so was defrayed by the state with a wee bit of profit thrown into the payment. Surely there are other ideas that are efficient, effective, and within the bounds of Constitutional restrictions.

Anyone looking closely at the “Links to Other Tax Blogs” on the left side of this page will notice that I’ve added a link to Due Diligence. Though this blog includes commentary on white collar crime, legal malpractice, and several other areas where the lack of due diligence can get lawyers and others into trouble, it also includes a significant number of tax cases and other tax situations where the failure to exercise due diligence sparked adverse consequences. I’m particularly glad this blog exists because it is something to which I can direct students who respond favorably to my advice that those who find both tax and criminal law to be interesting can carve out a niche occupied by relatively few lawyers and that demands a confluence of analytical skills that transcend those used in tax and those used in criminal law analysis.

The Due Diligence blog runs a series of headlines, from which users can follow links to complete stories. The headlines remind me of the sound bite teasers aired by local television stations that are followed by “news at 11” or, for some, “news at 10.” Those teasers almost always are attention-getting descriptions of crimes, accidents, fires, and other ratings-making catastrophes. Consider not only these headlines but the cumulative impression they provide of the condition of the nation’s business sector:

* More Offshore Indictments – This Time Julius Baer Is Target
* Ed May: A Sentence That Ends a Dour Chapter
* Merrill Lynch Tagged Again – This Time for $800,000
* Merrill Lynch Fined $1mm For Fraud
* Lawyer and Client Indicted in Asset Protection Gone Wrong
* NBA Player Arrested for Alleged Ponzi Scheme
* Stock Traders More Reckless Than Psychopaths? Yes Says Study!
* Edward Jones Brokers Under FBI Scrutiny
* New Charges Against Milwaukee MD For Unreported Foreign Accounts

And that’s just the front page with the news from the past several weeks. Why was I not surprised to learn that stock traders are more reckless than psychopaths?

After reading the stories linked to these headlines, and others on Due Diligence, two thoughts popped into my head. First, those who sing the praises of the private sector might not realize how flat their tunes are when one considers that these headlines are but the tip of the iceberg. It’s a significant factor in my conclusion that the “choice” presented by the “free” market is a false choice, as I noted last week in From Fat Tax to Accountability: The Failure of Choice. Second, the resounding chorus from the anti-government, anti-tax crowd for a reduction and even elimination of laws, rules, and regulations protecting society from the rapacity of those who generate the sort of headlines featured in Due Diligence is another chant that fails to resonate with reality. Imagine how much busier the Due Diligence blog would need to be if the regulation bashers had their way. Sadly, it would be reporting the crimes, rip-offs, and scams but not investigations, indictments, convictions, fines, or sentences. I suppose there are some people who would find that to be a better world. I’m not among them.

Tax professionals, as well as other professionals, will find keeping tabs on Due Diligence to be worth the few minutes they invest. That’s why Due Diligence has been added to “Links to Other Tax Blogs.” Check it out.

In last Friday’s post about The Fat Tax, I commented on a Danish citizen’s concern that taxes designed to influence behavior raise the specter of government becoming “big brother” by pointing out that the private sector is a “big brother” orders of magnitude beyond anything government can construct. I asked “whether the cameras, the information collection, and the laws should be imposed by a non-accountable private sector oligarchy or by a government accountable through the ballot box.”

Joe Kristan over at Tax Update Blog, though accepting of my position on the fat tax, took issue, in Just Try and Fire the IRS, with my suggestion that the private sector is non-accountable and the government is accountable. Though quoting the entire paragraph, including my claim that the private sector engages in more information collection, more regulation, and more camera installations than government, it does not appear that Joe is contesting my assertion that the private sector collects far more data than does the government.

Joe rests his disagreement on two propositions. First, if he is unhappy with what a private sector enterprise or actor is doing, he can take his business elsewhere. Second, his vote is diluted because he is one of hundreds of thousands or millions, and might even live in a jurisdiction where his vote is meaningless because he is outnumbered by those who vote in the opposite way than he does.

Joe’s proposition with respect to the private sector reflects the theory of a free market but not the reality of the market in practice. Joe gives as an example his ability to take his coffee purchasing activities to Java Joes or Timbuktuu if he becomes dissatisfied with Starbucks. From what I can determine, Java Joes and Timbuktuu are local businesses in Des Moines. How long until they are purchased or run out of business by Starbucks? The notion that businesses thrive by providing good service and go under if the service is bad may be true in some instances for short periods of time, but too many good, small, local businesses have gone under while unaccountable international conglomerates foist bad quality on the market place because of predatory and other questionable practices by the giants. For all the complaints that taxes and regulations kill small businesses, which tend to be of a higher quality, what kills small businesses is the overbearing size and activities of the international giants. Joe’s other example, involving grocery stores, will soon be history. During the last five years in my area, one grocery chain bought out another, another went bankrupt, and a third is scaling back in what many would agree is the first step in its disappearance. The big box conglomerates are killing not only small business but even the larger regional outfits. The danger of an oligarchy is that it stands poised on the edge of a monarchy. The choices may exist, but they are diminishing. The trend isn’t very promising.

But aside from the occasional instances of local choice, there remains the practical effect of monopolistic practice. For example, though I have the theoretical opportunity to use an operating system and software other than Microsoft’s, the insistence of those with whom I interact to receive documents in a Microsoft format means that to exercise my theoretical right to use another operating system I must invest time and money in applications to convert things into Microsoft format. Not that Microsoft products are superior, as the tidal wave of complaints about Microsoft software failures, security breaches, and other problems indicate, yet Microsoft dominates the industry. Why? Because it has managed to persuade government to back off from its antitrust responsibilities. How? Money talks.

Yes, there are private sector organizations that do a good job, even a superb job, with the quality of the product and the quality of the service. But their number is few. And, as I’ve noted, they’re likely to be snatched up by an inefficient corporate mega-monster looking to pounce on every money-maker in sight. Unfortunately, the market is riddled with private sector companies that deliver failure after failure, causing death, injury, and destruction. The private sector delivers not only Pintos, some of whose owners never had the information and opportunity to seek and select a safer alternative, but also things like bad pet food, moldy wall board, unsafe environmental impacts, repeated Blackberry service outages, spotty Internet access, and hundreds and thousands of other bad products and flawed services. Interestingly, far more of this comes from the international companies than from the local, hometown businesses, probably because the latter have a more personal relationship with customers and clients and thus see their revenue sources as people and not anonymous numbers.

Joe’s proposition with respect to the government sector rests on the observation that he is one of hundreds of thousands or one of millions. But that’s true for Joe in the private sector as well. His one vote matters, because of its value when combined with other votes. His walking out of Starbucks because of bad service or poor quality coffee is one decision that matters, because of its value when combined with other similar decisions. Just as Joe can leave Starbucks, he can move from Des Moines, he can move within Des Moines to a different district, he can move out of Iowa. If he’s sufficiently unhappy, he can move out of the country, and as extreme as that choice may be, if Joe can find a country whose government is more to his liking, then he has that option. I doubt we will be waving goodbye to Joe anytime soon.

Joe’s proposition with respect to the government sector suggests that government services are worse than those provided by the private sector. In some instances that’s true. But in other instances it’s far from true. Knock on wood, but I’ve never had a problem with Pennsylvania’s Department of Transportation in terms of licensing and vehicle registration. I can’t say that about the insurance companies. I’ve never had a problem with township-provided, tax-funded trash and recycling pick-up, but I cannot say that about the private contractors with whom I dealt when I lived in townships that went with private collection. When I have had difficulties with government services, in most instances it was a consequence of a government law, regulation, or policy adopted at the behest of a large private sector enterprise or actor with the money to wield influence over the government legislature or agency in question.

And that brings me back full circle to the notion that government somehow is a failure. For every failure of government service, there are disproportionately far more failures in the private sector. When government does fail to respond to the needs of the electorate, it’s often because the private sector organizations are devoting too many resources into owning government and insufficient resources into providing quality products and services. That government-imposed monopoly that Joe mentions as the exception to his free market choice model is the product of the private sector co-opting government. The solution is not to punish the captive government but to put the oligarchs and monopolists out of the vote-buying business.

I maintain my position that those who fear governmental big brother are worrying about a threat that is miniscule compared to the threat of corporate big brother. I maintain my opinion that government is accountable through the ballot box in a way that the private sector is not. Joe can leave Starbucks but he cannot vote out its officers or board, and when he wakes up tomorrow and finds that Starbucks bought out Java Joe’s and Timbuktuu, he cannot run for office as he might if he wakes up to find that a candidate not of his liking was elected.

In theory, a free market working as it should requires a small government to protect that market. In reality, we have a market that is free only for those with money to be free to do what they want, and an oversized government trying to keep up with protection of those afflicted by the abuses of the market place, but hamstrung by the opposition to regulation advocated by those who have the most to lose if they were required to obey the rules of a truly free market. When all is said and done, the lack of transparency and accountability in the private sector makes the government look downright benevolent in that regard. It’s not, of course, but when compelled to choose between two things that are broken, it’s best to put one’s repair skills to work on the thing that’s easiest to fix and whose repaired condition will make it easier to fix the other broken item. A repaired government can fix the broken free market. A repaired free market cannot repair the government.

Ever since the Marcellus Shale natural gas boom got rolling, I argued that the Commonwealth of Pennsylvania, as representative of its citizens, needs to impose a user fee to recover from the gas developers the costs that otherwise would be borne by the state government and thus, indirectly, by its taxpayers. I first made that suggestion in Tax? User Fee? Does the Name Make a Difference?. I followed up in Giving Up on Taxes = Surrendering Taxpayer Rights?. A month later, in Life for My Proposed Marcellus Shale User Fee?, I asked, “Have these people been reading my MauledAgain posts?” and answered “Perhaps.” Five months ago, in Revenue: Is It All in The Name? I described an impact fee proposal offered by the President of the Pennsylvania Senate who defended the revenue raiser by noting that it was a fee and not a tax.

Now comes news that the governor of Pennsylvania will propose that individual counties set a per-well fee on the natural gas developers. The fee would be split between the county and the state. The county would use the revenue to recoup the cost of improving infrastructure, repairing roads and bridges, and dealing with the effects of the local population growth that the drilling has sparked. The state would use its share, at the moment pegged at 25 percent, to deal with issues affecting the entire state, such as pipeline safety, environmental effects beyond the counties in which drilling occurs, road and bridge repairs on traffic arteries leading to those counties, health studies, and similar matters.

Not surprisingly, no sooner had the plan been released than the criticism rolled in. Some legislators want the state’s cut of the revenue to be more than what is being proposed. There is concern that counties without wells will engage in “border wars” with counties imposing the fee. The proposed limit on the fee, $40,000 per well, does not have unanimous support, particularly because it will not raise nearly enough revenue to repair the transportation infrastructure or offset the environmental and health damage, and the proposed phasing out of the fee over a 10-year period also does not sit well in some quarters. Still others worry about administrative burdens.

The previous governor pointed out that the fee nonetheless is a tax, and that by shifting its enactment to the county commissioners, the current governor is finding a way to impose a tax without breaking his pledge to prohibit the state from increasing taxes. He has a point. It turns out that the key to getting around the Norquist no-tax-increase pledge is to call the revenue raiser a fee and to have constituent government entities impose the fee. It will be interesting to see, if this plan is adopted and the governor runs for re-election, whether he will claim that he did not raise taxes. It will be even more interesting to see if voters and citizens buy that argument.

As further proof that those who teach learn by doing so, I share a question that arose recently when I was guiding the students in the basic federal income tax course though the technicalities of the section 119 meals and lodging exclusion. We were focusing on the unsettled issue of whether groceries constitute meals, an issue that has the IRS and the Tax Court saying “no” and the Third Circuit responding affirmatively. To get the students thinking about the issue, I ask them to give examples of groceries. Of course, they immediately offer the usual items that are not food, such as plastic wrap, paper towels, and cookware. This semester, one of the students pointed out that grocery stores sell pet food.

Until this semester, I had never given any serious thought as to whether pet food fell within section 119. If groceries are considered meals, pet food would qualify, as would the paper towels, but that surely is not the correct result. Because a person can buy “ready to eat” meals at a grocery store, an employer who provides groceries in the form of “ready to eat” meals surely is providing a meal. What about food items that require preparation? A reasonable reading of section 119 should include those items. Why? Consider the paradigm employer-provided meal, that is, food served to employees at a table or collected by employees at a buffet. Not all of the food in those situations is ready to eat. Bread needs to be buttered. Baked potatoes need to be split open and filled with whatever the diner chooses. Sugar and milk or cream needs, for many people, to be added to coffee. These observations might help refine the definition of “meal” when it comes to food delivered by an employer to an employee other than in a dining room, including food that requires additional preparation, but does it help answer the pet food question?

Section 119 applies to meals “furnished to [the employee], his spouse, or any of his dependents.” At first glance, this rules out the pet food because it is not furnished to the employee, the spouse, or dependents. But, on the other hand, the statute does not say “consumed by” the employee, the spouse, or the dependents. Consider the following situation. The employee resides in employer-provided lodging on the employer’s business premises. For example, the employee is employed by a K-12 boarding school and must reside on campus for the convenience of the employer and as a condition of employment. The employer has groceries delivered to the residence on a weekly basis. Ignore the paper towels. Presumably the value of the foods delivered on behalf of the employer are excluded from the employee’s gross income. Suppose that on one evening, the employee’s brother, who is not the employee’s dependent, stops by for dinner. Must the employee include the value of the food consumed by the brother in gross income because it was not “furnished” to the employee, the spouse, or the dependents? Would that not be administratively burdensome? But is it not possible to argue that the meals were furnished to the employee, who chose to share? If so, is it not possible to argue that the pet food shared with the pet dog or cat of the employee’s family falls within the term meals because the food is furnished to the employee?

In my mind, the matter is not resolved. If there has been a case or ruling on the pet food issue, I haven’t found it. But for those who think tax law is “just numbers” and poses no unanswered questions, I offer this question as yet one more example of why tax law is more than numbers and fixed rules.

No, the fat tax is not a tax on fat cats. Nor is there a typographical error, as the fat tax is not the flat tax. The fat tax is a tax enacted in Denmark, applicable to foods with saturated fat content exceeding 2.3 percent. According to this report, Denmark is believed to be the first country in the world with a tax on saturated fat. It is also reported that Finland and Romania are considering a similar tax. Denmark officials explain that the purpose of the tax is not to curb obesity, as Danes are thinner than average, but to increase life expectancy, a measure on which Danes lag behind.

It is unclear what use is made of the proceeds from the fat tax. Ideally, the proceeds would be funneled into health care, either specifically for research and treatment of diseases caused or worsened by the intake of saturated fat or generally for overall health care. Denmark also taxes soda and candy, but it’s also unclear where those tax proceeds are expended.

Readers of MauledAgain know that I have consistently objected to a tax on soda and sugary beverages. As I have explained in a series of posts beginning with What Sort of Tax?, and continuing in The Return of the Soda Tax Proposal, Tax As a Hate Crime?, Yes for The Proposed User Fee, No for the Proposed Tax, Philadelphia Soda Tax Proposal Shelved, But Will It Return?, Taxing Symptoms Rather Than Problems, It’s Back! The Philadelphia Soda Tax Proposal Returns, The Broccoli and Brussel Sprouts of Taxation, and The Realities of the Soda Tax Policy Debate, my objection rests on singling out sugary beverages as a target when there are many other substances ingested by people that contribute to the rising cost of health care. As I explained in The Realities of the Soda Tax Policy Debate:

The problem with these attempted explanations for why sugary beverages are singled out in the “we need revenue, let’s tax something” version of the defeated proposal is that they rest on erroneous factual assumptions, conflate information, and ignore reality. First, though moderate and sensible use of sugar does not trigger obesity and other illnesses, there is no such thing as moderate use of tobacco because any use of tobacco ramps up the risk of cancer and other disease. Second, sugar is not the only substance that, consumed excessively, causes health problems. Excessive intake of fat, for example, is just as dangerous, if not more so. Even water can be deadly, as evidenced by people who have died in foolish water drinking contests. Where is the logic behind “Sugar is bad, tax it, fat is bad, don’t tax it”? The notion that people will take in more sugar drinking soda because soda is not filling ignores the fact that gulping down a huge amount of liquids will leave a person with less stomach room, and less desire, to take in food. Does it make sense to encourage the ingestion of Twinkies rather than soda because it’s better to fill the stomach with sugar and fat? Finally, the notion that cigarette taxes has cut smoking is debatable, particularly with respect to tobacco use among younger people, who supposedly are the targets of the “tax will teach you a lesson” proponents.

From a health perspective, the target needs to be the items originally indicted by the Yale researcher, namely, high-calorie, low-nutrition substances. The issue isn’t so much the item, other than the true poisons such as nicotine and trans-fats, but the quantities being consumed. Even low-calorie, high-nutrition foods can be dangerous if consumed in excess. The focus on soda, intense as it is on the part of the soda tax advocates, suggests something more is at work. I wonder if we would be seeing “donut tax” proposals offered with the same zealousness had it been donut manufacturers who tossed money at school boards to install vending machines in the schools. I wonder.

Interestingly, according to the report, Denmark has banned the use of trans fats, and thus there is no tax on them. Although saturated fats also contribute to cardiovascular disease and cancer, Denmark has opted not to ban them but to tax them, not unlike what governments in the United States do with tobacco.

One Danish citizen interviewed by ABC News explained, “Denmark finds every sort of way to increase our taxes. Why should the government decide how much fat we eat? They also want to increase the tobacco price very significantly. In theory this is good — it makes unhealthy items expensive so that we do not consume as much or any and that way the health system doesn’t use a lot of money on patients who become sick from overuse of fat and tobacco. However, these taxes take on a big brother feeling. We should not be punished by taxes on items the government decides we should not use.” These observations demonstrate the tension between individual liberty and societal responsibility. Governments care about the health of its citizens, or, because governments are the citizens, citizens care about the health of other citizens for several reasons. An out-of-shape citizenry is in no condition to defend the nation. An unhealthy citizenry diverts scarce resources from efforts to make progress economically, socially, culturally, and technologically to efforts to repair the damage caused by unhealthy practices. To the extent health care is covered through insurance systems, it is in the interest of every insured to keep the overall risk as low as possible. That goal is enhanced when unhealthy behavior is reduced, either through education and encouragement or through prohibition and penalty. A balance between individual liberty and societal intervention can be reached if responsibility for individual decisions rested solely on individuals. Thus, the person who engages in unhealthy and risky behavior and who is unwilling to participate in societal insurance or to be subjected to societal restrictions must be willing to bear the full cost, without societal assistance, of the consequences of that behavior. What sort of society, though, is willing to tell a person who shows up at an emergency room, “You chose to ignore the speed limit, not wear a seat belt, and not purchase health or accident insurance, so we cannot assist you.” Frighteningly, there are increasing numbers of people who want to take that approach. But there is a flaw in their reasoning. What if the unhealthy behavior brings consequences beyond the person engaging in that behavior? What does a society say to a person who is injured, or whose family member is killed, because another person’s unhealthy behavior led to, for example, a heart attack that triggered a traffic accident?

The Danish citizen’s concern about big brother is real but misplaced. The fear that government is becoming or has become big brother is a distraction. The deeper concern is that private actors in the private sector act as big brother. For every government security camera, there are many more private sector cameras. For every government form that citizens fill out with personal information, there are many more private sector information collection devices doing the same and more. For every government rule or law, there are many more private sector regulations. The question is whether the cameras, the information collection, and the laws should be imposed by a non-accountable private sector oligarchy or by a government accountable through the ballot box. The latter option, of course, is rapidly disappearing as the oligarchy continues to acquire increasing amounts of electoral power disproportionate to the principle of one person, one vote.

There is value in shifting the cost of health care to the practices and substances that jeopardize good health. But that shifting needs to be consistent. Selecting one or two items, such as soda and saturated fat, while ignoring others, is a recipe for ultimate failure. The ideal tax is one that, for the moment at least, cannot be administered. One of the most serious contributors to health issues is excess caloric consumption. Because calories abound across the menu, a tax on all foods accomplishes nothing in this respect. That is why the better approach is education. Again, there is a serious tension between those who think that dietary and nutritional should be delivered by the public sector, for example, schools, and those who think it is a matter for the private sector. But a quick look at this country’s population is visible proof that reliance on the private sector to promote good health and educate people with respect to beneficially healthy practices has been pretty much a failure. That is why some people advocate soda and fat taxes. Though that advocacy is understandable and well-intentioned, it is too narrowly focused, and if focused appropriately, runs into the barrier of impractical application.

It is a basic principle of federal income tax law that gross income includes all income unless an exclusion can be identified that applies to the transaction. Thus, it was surprising to me to discover that a taxpayer had litigated the question of whether a qui tam payment constituted gross income. It surprised me even more that this issue has been litigated more than once.

Before analyzing the federal income tax consequences of a transaction, it is important to understand the transaction. This challenge is one of the significant contributors to the struggles that law students face when trying to learn basic federal income tax law. So what is a qui tam payment? Simply, it is a lawsuit brought by a citizen on behalf of a government. A qui tam payment is an amount awarded to the citizen for his or her efforts in bringing the action.

Once that is understood, it ought to be fairly easy to determine that qui tam payments are gross income. First, there are no exclusions applicable to qui tam payments. Second, there is settled case law that a reward is included in gross income, and section 74 makes it clear that awards are included in gross income, with two exceptions not relevant to qui tam payments. Third, considering that a qui tam payment essentially is compensation for performing a service, it must be included in gross income.

The case that caught my attention was the Eleventh Circuit’s affirmance, in Campbell v. Comr., No. 10-13677 (11th Cir. 2011), of an earlier Tax Court decision in the case (134 T.C. No. 3 (2010)), which somehow I didn’t notice when it was published. The Tax Court concluded, following an earlier decision, that the qui tam award must be included in gross income. That qui tam payments and their tax treatment are no small matter is evidenced by the size of Campbell’s award, specifically, $8.75 million. Campbell, who had been employed by Lockheed, filed two lawsuits under the federal False Claims Act, and Lockheed eventually settled by paying the government almost $38 million. The Justice Department issued a Form 1099 to Campbell to reflect his $8.75 qui tam payment.

The payment was wired to Campbell’s attorneys, who took out their $3.5 million fee, and sent Campbell a check for $5.25 million. Campbell, who prepared his return without consulting anyone, put the $5.25 million on line 21 as other income but left it out of taxable income. Neither the Tax Court opinion nor the Eleventh Circuit opinion explains how Campbell managed to remove the $5.25 million from taxable income. The amount reported as taxable income did not include the amount on line 21.

Campbell argued that a person who brings a qui tam payment acts for the government, and because the government’s recovery is not taxable to it, the qui tam payment is not taxable to the person who receives it. The flaw in the argument is that no one has ever decided whether or not the recovery is included in the government’s gross income, because the government has no need to compute gross income.

Campbell was not the first taxpayer to raise the issue. In Roco v. Comr., 121 T.C. 160 (2003), the Tax Court held that a qui tam payment is gross income. In Brooks v. U.S., 383 F.3d 521 (6th Cir. 2004), the Sixth Circuit concluded that the qui tam payment is a reward, is not within any exclusion, and is gross income. In Trantina v. U.S., 512 F.3d 567 (9th Cir. 2008), the Ninth Circuit reached the same conclusion.

The IRS asserted an accuracy-related penalty against Campbell. The Tax Court upheld that determination. The Eleventh Circuit affirmed. The Eleventh Circuit rejected Campbell’s claim that the payment was disclosed on the return, because disclosure requires more than a mere mention, especially when the taxpayer “incredulously and conveniently ignored or overlooked the amount when it was time to do the math.” The Eleventh Circuit rejected Campbell’s argument that substantial case law authority exists for excluding the payment, a conclusion so obvious that it led the court to consider Campbell’s citations to alleged authority “neither reasonable or persuasive.” Campbell’s claim that of reasonable cause for omitting the payment from gross income also was rejected, in part because Campbell “is a sophisticated taxpayer” and “chose not to consult a professional tax consultant in preparing” the return. Thus, neither exception to the penalty applied.

Though some people think that tax is “just math” with no debatable or uncertain points of law to be resolved, there are more than a few issues with respect to which there is no authority, or there is a split of authority among the Courts of Appeal, or there is some question of applicability or scope. The question of whether qui tam payments constitute gross income is not one of those questions that disproves the fallacy of treating tax as “just math” with no open legal questions to be resolved. Hopefully, the Campbell case is the last one in which government resources need to be expended to hammer home the inescapability of the requirement to include qui tam payments in gross income.

Section 104(a)(2) of the Internal Revenue Code excludes from gross income “ the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.” The flush language to section 104(a) clarifies that “For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness. The preceding sentence shall not apply to an amount of damages not in excess of the amount paid for medical care (described in subparagraph (A) or (B) of section 213(d)(1)) attributable to emotional distress.”

Thus, if a person negligently inflicts emotional distress on another person, for example, by yelling “boo” and frightening the person in a traumatic manner, any damages recovered by the victim resting on a claim of negligent infliction of emotional distress are included in gross income. But as Robert W. Wood explains in Post-1996 Act Section 104 Cases: Where Are We Eight Years Later?, “[E]xclusion under section 104 is still appropriate for any damages that are based on a claim of emotional distress attributable to physical injuries or physical sickness.” So if the defendant had grabbed the victim while yelling “boo,” causing bruises and other physical injuries, the victim can exclude from gross income the entire amount of the compensatory damages, including not only those based on the bruises and physical injuries, but those based on the emotional distress.

Now comes a Pennsylvania case involving an insurance company’s liability under an automobile insurance policy that adds a wrinkle to the analysis. In this Superior Court case, reported in this story, the court held that a policy covering “bodily injury” extended to emotional distress suffered by plaintiffs who witnessed a family member hit and killed by an automobile, even though the plaintiffs did not suffer physical injury. In reaching this conclusion, the court held that the emotional distress is a “bodily injury” even though there was no physical injury. The policy defined “bodily injury” as “bodily injury to a person and sickness, disease, or death which results from it.” The defendant insurance company argued that the definition in Black’s Law Dictionary should apply, specifically, that bodily injury means “physical damage to a person’s body.” The court explained that although it distinguishes “ ‘bodily injuries’ from purely emotional injuries,” it also rejects “the notion that bodily harm or physical injury necessitates physical impact.” The concurring opinion emphasized that the policy did not require that the person suffering the emotional distress be the person suffering the bodily injury. The court noted that it has not decided whether the family members’ emotional injury claims include a physical or bodily component, pointing out that the usual symptoms of emotional distress “may not involve blunt trauma to muscle, tissue, or bone, but our precedent recognizes them to reflect the significant physical or bodily toll severe emotional distress may take."

Section 104(a)(2), of course, uses the adjective “physical” and not the adjective “bodily.” Given the Pennsylvania approach, these two terms must be treated as having different meanings for tax purposes. In other words, because section 104(a)(2) does not apply to the damages in the Pennsylvania case, the action resting solely on emotional distress grounds, the plaintiffs must be treated as having suffered no physical injury or sickness even though they suffered, for state law purposes, a bodily harm. Does this make sense?

The distinction between physical and non-physical injuries is, to me, rather outdated. When it comes to illness and disease, the distinction between “physical” and “mental” is disappearing, if not entirely gone. Emotional distress causes changes in brain chemistry, which clearly is a physical matter, just as a disease that changes blood chemistry is a physical matter. Perhaps an injury arising from slander or libel is not physical, in the absence of emotional distress symptoms, but the idea that emotional distress damages should be treated differently from those for a broken leg doesn’t make sense in the world of twenty-first century medicine. This is especially so considering that damages for emotional distress arising from a physical injury or illness are excluded.

So the tax adviser to the plaintiffs in the Pennsylvania case will need to explain, “Even though your damages are for a bodily injury, the tax law does not consider them as having been received for a physical injury.” No wonder people think the tax law is bizarre.

It is, of course, time for Congress to fix section 104 by either by repealing it or by tearing it down and building it back up into something sensible, justifiable, and understandable. Taxpayers deserve no less.