MauledAgain

Last week, I was reading an article about partnership taxation when I came upon something very disturbing. Rather than embarrassing the author of the article, I will paraphrase what I read, maintaining the words that caught my attention. “To deal with this problem, the IRS enacted rules to prevent doing certain things.” This sentence was followed by a citation to an Internal Revenue Code section, which indeed does contain the applicable principles. From what I can figure out, the author is not a lawyer, but when someone delves into writing about tax for a tax journal, that person has an obligation to understand tax law, not only in terms of substance, but in terms of sources of law.

The simple upshot of this can be summed up thusly: The IRS DOES NOT ENACT INTERNAL REVENUE CODE SECTIONS. It is the CONGRESS that enacts Internal Revenue Code sections. That’s very basic stuff. Extremely basic stuff. Understandably, many of the propaganda ministries have a not-so-hidden agenda of trying to persuade people that it’s the IRS that generates the tax laws, as part of the effort to discredit the IRS and taxes generally. But tax professionals know, or at least should know, better. Every semester, for the first out-of-class graded exercise in the basic tax class, I search the internet for the latest version of the “IRS enacts Code sections” myth, present it to the students, and ask them to comment on the statement. This helps me identify which students have been paying attention, and aside from driving home the point that paying attention matters, gives students the opportunity to engage in remedial education. For some reason, although all Americans over the age of, say, fourteen, should understand that statutes are enacted by legislatures, the teaching of what was once the ubiquitous Civics course has been shelved in most school districts. Answering the question why is a matter for another post. Perhaps something about an uneducated electorate being less likely to throw out incumbent legislators, especially the ones that try to blame others for the laws they enact. Consider, for example, the situation I explored in If Congress Says So, Don’t Blame the IRS (“So long as people view the IRS as the source of all that is wrong with taxation and the tax system, or the cause of anything they dislike about tax law and tax enforcement, and overlook the responsibility of the Congress for the tax law, tax policy, and tax administration deficiencies afflicting the nation, the problems will not be solved.”)

Similar misusages of precision terminology abound in articles, discussion board postings, student exam responses, newspapers, and all other sorts of communication media. Too often, one sees sentences such as "The IRS held that . . . "

The precise terminology is as follows. The Congress enacts statutes. The Treasury Department promulgates regulations. The Tax Court holds that one or another outcome is the appropriate result. The IRS rules or concludes or advises that its position is one thing or another; it does not hold. Courts issue opinions, the IRS issues rulings, the Treasury Department issues regulations, the courts explain things, the IRS explains things, the Treasury Department explains things.

One of the things that might contribute to the imprecise transposition of terminology that has negative effects is the message that I received years ago in an English literature class. It is a message that I think is being repeated throughout the years and throughout education systems. I was told, “Aside from common words such as articles and prepositions, don’t use the same word more than once, especially on the same page. Buy a thesaurus.” That might be good advice for a novelist or poet, but it is atrocious advice for those who write in technical areas. Lawyers, engineers, physicians, scientists, actuaries, accountants, and those in other technically-focused professions can create confusing and even dangerous if not fatal errors when they use different words to mean the same thing. If the word “basis” must appear several hundred times in a tax article, so be it. Using “capital account” instead of basis “just to change things up” in the style of the fiction writers is ill-advised.

Almost four years ago, in Is Tax Ignorance Contagious?, which addressed a woeful reference to a so-called but non-existing “Tax Code 63-20,” I wrote:

It is not uncommon for law students to conflate legislation, regulations, and rulings. When I insist they demonstrate understanding, and push aside ignorance, some of them have argued that my call for precision is unwarranted, and that what they have done is acceptable. My rejection of imprecision, by students and by others, at times has been derided as picky or worse. But I usually quiet the complaints by asking if people want neurosurgeons operating on them, their children, or their parents to be imprecise. I wonder if people want engineers building bridges to be imprecise. I ask whether the folks making pet food, medicines, and other products should be imprecise. Perhaps speech references aren't as life-and-death as neurosurgery, bridge building, food manufacturing, or pharmaceutical formulation, but when dealing with billions of taxpayer dollars, precision is no less a sign of the care and attention to detail that should be demanded of public officials. If public officials are going to talk about taxes, they should make certain they know what they're discussing and take steps to make their words correct and precise.

At least some public officials can claim that they did not attend law school or any other educational institution that gave them the opportunity to learn something about precise language, but certainly those who are writing about tax in professional tax journals owe it to their readers to learn the language of tax and to use it properly.

For most people, trips to the gym generate benefits for their physical health. My gym visits not only improve my physical condition, at least in theory, they also provide opportunities to put my brain to work, especially when tax questions and discussions pop up. On at least five occasions in the past, conversations at the gym have produced MauledAgain posts. (See Flat is Not Simple, At Least Not with Taxes, Tax Talk at the Gym, A Zero Tax, A Zero Congress, Being Thankful for User Fees and Taxes, and Tax Policy, Elections, and Money.)

The other morning, as I walked in, one of my friends pointed to another person and said, “He has a tax question for you.” I turned, and was asked, “Is there a deadline for when people must send you the forms you need to do your tax return, like W-2s and 1099s.” Indeed there is. I pointed out that January 31 is the deadline for employers to mail W-2 forms and payors to mail 1099 forms, which means that some people won’t received these until early February. However, I noted, if an individual is a shareholder in an S corporation, the K-1 reporting the person’s share of S corporation items isn’t required to be sent until March 15, and that’s if the corporation does not file an extension. If the individual is a partner is a partnership or owns an interest in a limited liability company taxed as a partnership, the K-1 isn’t required to be sent until April 15, and, again, that’s without regard to any extension. The person who had asked the question commented, “Then these people are probably filing extensions.” Yes, they are. At that point, I could not resist the tendencies of law professors to pose hypothetical situations. “What if,” I asked, “the partnership is a partner in another partnership,” and as the person’s eyes widened, I added, “and that partnership is a partner in another partnership?” As my friend began to roll his eyes, I added, “and you can toss in some controlled foreign corporations for fun, too.”

As the conversation continued, I pointed out that the income tax rests on a set of theoretical notions that made sense when the world was much less complex than it is today. In the early and middle part of the last century, very few individuals were partners in partnerships that were partners in other partnerships, let alone in partnerships that were partners in partnerships that were partners in partnerships that were partners in partnerships, and so on. The inefficiencies of the current filing system are an inescapable product of the combination of an income tax with multi-layer business and investment structures. When making a list of arguments for and against some other sort of tax, these inefficiencies show up in the column holding the disadvantages of an income tax.

Years ago, a member of Congress introduced legislation that would require individuals to file their income tax returns on their birthdays. It was quite some time ago and I cannot find the legislation, and I don’t recall the specifics. For example, I don’t recall if special provisions existed for people whose birthdays would fall on a national holiday. In any event, imagine the challenges of implementing this absurd proposal. A person born on January 2 would not have the requisite information, unless the person were permitted to file on January 2 of the following year. The disadvantages of that delay include postponed government revenue and taxpayers even less likely to remember the details of transactions undertaken more than a year earlier.

Most of the timing problems illustrated by the partnership and S corporation examples arise from the flow-through taxation principles that apply to those entities. Perhaps it is time to rethink how those entities and their owners are taxed.

Adopting an approach taken in other states, Pennsylvania is adding to the income tax form a line on which people are expected to “declare ‘use taxes’ . . . or unpaid sales taxes on items from so-called ‘remote sellers.’” According to this KYW News Radio report, a state senator explains that this addition to the tax form “may come as a surprise to some.” I think it will come as a surprise to many.

State Senator Mary Jo White added, “When you now collect a tax that has never been collected before, the public perception is that it’s a new tax.” I agree. If an existing tax is not on someone’s radar, its appearance will cause the person to think that a new tax has been enacted. Public understanding of the use tax is woefully inadequate. Readers of MauledAgain know that eliminating tax ignorance is one of my goals, as demonstrated by my many posts on the issue, including Tax Ignorance, Is Tax Ignorance Contagious?, Fighting Tax Ignorance, Why the Nation Needs Tax Education, Tax Ignorance: Legislators and Lobbyists, Tax Education is Not Just For Tax Professionals, The Consequences of Tax Education Deficiency, The Value of Tax Education, Tax Ignorance of the Historical Kind, Is It Any (Tax) Wonder?, and Tax Myths, Tax Lies, and Tax Twisting).

Most Pennsylvanians living in the counties near the state of Delaware know that if they go to Delaware to make a purchase, they don’t pay sales tax, and that if they made the purchase in Pennsylvania they would pay the sales tax. What most Pennsylvanians making these “Delaware shopping trips” apparently don’t know is that under long-existing Pennsylvania law, they owe use tax on those purchases. The use tax simply is a substitute for the sales tax, to be applied to out-of-state purchases of items brought back to the state. Use tax compliance is so low that states try to find ways to compel out-of-state retailers to collect sales tax on the state’s behalf, even when there is little or no connection between the state and the nonresident retailer. A few years ago, several states began experimenting with putting a use tax line on their income tax returns, and other states, including Pennsylvania, have followed suit. Will it work? In a sense, it’s a no-lose proposition for the state. Adding a line to the return costs almost nothing. Even if the state collects only a small fraction of what is owed, the state is collecting more than it would in the absence of the change to the income tax return.

The income tax return solution for the use tax problem is insufficient. What is necessary is public education about the use tax. Why do Pennsylvanians, or residents of any state with a sales and use tax, for that matter, not know that the use tax exists? The answer is simple. No one has told them. How difficult would it be to include in the curriculum of the K-12 system an hour or two to explain state taxes in general, including the use tax? Most middle and high school students, if not all of them, understand the sales tax. Even some elementary school students have learned that saving one dollar to purchase a 99-cent item isn’t enough. I learned that when I was very young. It’s not rocket science, at least until an inquisitive child asks the dreaded question, “How do we know which items are subject to the sales tax and which aren’t?” Things have changed since the days of my youth, because now a student can be told to “look it up,” presumably on the internet, without worrying that the child would get lost in the library looking for statutes.

It will be interesting to watch what happens as increasing numbers of Pennsylvanians become aware of the use tax line on the income tax return. It’s an easy guess that there will be griping. What will hold my attention is the wait to see if some politician tries to benefit from this development by making loud noises about the “newly enacted tax.” After all, there’s nothing that says politicians are smarter about taxes than are people generally.

Back in December, when the Congress decided to extend the payroll tax cut by two months, I explained, in How Politics Generates Tax Complexity, that the legislation contained a new tax designed to prevent a two-month payroll tax reduction from becoming the equivalent of a full-year reduction. Because the tax that is reduced applies only to the first $110,100 of wages, taxpayers whose monthly income exceeds $18,350 were subjected to a new tax equal to 2 percent of wages and compensation exceeding that amount. I provided examples of why the new tax was needed and how it works in How Politics Generates Tax Complexity. In that posting I pointed out that if the payroll tax cut was extended through the remainder of 2012, “the additional tax should ‘disappear,’ but whether that happens depends on what the Congress does with the new tax.” Now that Congress has extended the payroll tax cut through 2012, it is time to examine what it did with the new tax.

The original payroll tax cut, for 2011, was enacted by section 601 of P.L. 111-312, The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. The reduction applied during the “payroll tax holiday period,” in turn defined as calendar year 2011. When the reduction was extended in December 2011 by section 101 of P.L. 112-78, The Temporary Payroll Tax Cut Continuation Act of 2011, the payroll tax holiday period was defined to be the “period beginning January 1, 2011, and ending February 29, 2012.” This was accomplished by having section 101 of P.L. 112-78 amend section 601 of P.L. 111-312. In addition, section 101 of P.L. 112-78 also amended section 601 of P.L. 111-312 to add a subsection (g) to section 601 that imposed the new tax previously described. The recently passed legislation, to be enacted when signed by the President, is called The Middle Class Tax Relief and Job Creation Act of 2012. It redefines the payroll tax holiday period to be “calendar years 2011 and 2012” and it repeals the new 2 percent tax.

Those who have been reading this post carefully will have noticed that nowhere have I mentioned the Internal Revenue Code or any of its provisions. That’s because none of the legislation changed anything in the Internal Revenue Code. I will repeat what I emphasized in How Politics Generates Tax Complexity. The payroll tax cut legislation “provides another example of a lesson I try to get across to the students in my basic tax class, namely, there is much statutory tax law that is NOT in the Internal Revenue Code.” When critics of tax law complexity point out “the size of the tax code,” they are understating the point they are trying to make. Assuming that the number of pages of statutory provisions is a good proxy for tax law complexity, and it is in some ways but isn’t in other ways, highlighting the length of the Internal Revenue Code understates the point. One needs to add in the uncodified legislation that has no less of an effect on tax law complexity. In some respects, the uncodified material adds disproportionately more to tax law complexity.

Suppose a person owes $2.5 million to another person. How much would be an appropriate monthly payment to pay off the debt plus interest accumulating while the debt is being serviced? The answer depends on two factors. First, the interest rate makes a difference. Second, the term of the loan payoff matters. For example, with a 5 percent interest rate and a 30-year term, the monthly payment would be $13,420.54.

In a recent case, Johnson v. U.S., No. 8:98-cv-03050-WDQ (D. Md. Feb. 15, 2012), the court approved an installment payment arrangement proposed by the IRS for a taxpayer who owed roughly $2.5 million in unpaid taxes and accumulated interest. The taxpayer had objected, claiming that requiring him to make installment payments of his debt would be a hardship. The taxpayer did not dispute the existence of the debt, which arose from the taxpayer’s failure as responsible person to cause his corporation to pay employment and withholding taxes.

The taxpayer’s evidence showed that he had annual income of almost $64,000. It was in the form of payments from his corporation to the lessor of his family’s home. The taxpayer arranged to take income in this manner because it is not subject to garnishment. In addition, the corporation paid his wife, who is not liable on the debt, a salary of between $130,000 and $140,000. The corporation’s salary decisions were made by taxpayer as president. The taxpayer resided in a home with his wife, adult son, niece, and sister-in-law. No information was provided with respect to the income of, or contribution to household expenses by, the other three, aside from the taxpayer’s explanation that he supported his adult son who has Asperger’s syndrome.

The taxpayer argued that the amount requested by the IRS “would impose an undue hardship on [the taxpayer], and by extension, his wife and children.” He also argued that the amount requested by the IRS was unreasonable, but did not offer an alternative amount.

So how much was the IRS requesting the taxpayer remit under its proposed installment agreement? It was $400 a month. That amount is 7.5 percent of the taxpayer’s income, and 2.35 percent of the combined income the taxpayer and his wife were pulling out of the corporation. The court, not surprisingly, held for the IRS. The court noted that the taxpayer’s adult son is not the taxpayer’s dependent alone, that the taxpayer is not supporting anyone other than paying rent on the home, that the annual salary of the taxpayer’s wife is double the taxpayer’s income even though she works substantially fewer hours than does the taxpayer, that the taxpayer controls how the corporation’s money is paid out in salaries, and that the intent of the installment payment provisions cannot be circumvented by the structure the taxpayer adopted for compensation.

I agree with the taxpayer that the amount requested by the IRS was unreasonable. It was unreasonably low. The court, however, could do nothing more than approve the IRS request. I tried to use a loan amortization calculator to determine how many years would be required to repay the $2.5 million debt if the monthly payment is $400, using a 5 percent interest rate. The calculator replied: “Error: The loan cannot be repaid using the parameters that you provided, probably because the Payment Amount is not sufficient to cover the periodic interest that is due. Try increasing the Payment Amount, or perhaps increase the Balloon Payment.” It did, however, permit me to make the computation using a zero percent interest rate. It would take 521 years. Even at a 1 percent rate of interest, the loan would grow despite the $400 monthly payments. At 1 percent, annual interest, ignoring compounding, is $25,000. At 5 percent, the annual interest would be $125,000. Annual payments of $4,800 aren’t going to make a dent. The loan would continue to grow. It would grow infinitely. It would exist eternally.

Of course, someone else is paying off this taxpayer’s debt. Either other taxpayers are paying higher taxes to make up the difference, or the budget deficit is growing because of the unpaid debt, shifting the burden to whomever it is that ultimately pays the deficit. Surely, there are five-person families who know how to live on far less than the taxpayer and his wife are making. Surely there are households of five who manage to provide themselves with housing for less than $64,000 a year. Why the IRS did not push for something more realistic, along the lines of $2,000 a month, puzzles me. I wonder how many other eternal tax installment payments are on the books. What does not puzzle me is why this taxpayer had the audacity to complain about a meager $400 monthly payment. The answer to that one is easy. Very easy.

A question on the ABA-TAX listserve [list subscribers can access the discussion here] gave me a reason to look more closely at how the tax law counts days, at least for purposes of the limitation on vacation home and rental property deductions under section 280A. The person asking the question was engaged in a discussion with unidentified individuals about how many days a vacation home is treated as rented. Under section 280A, the number of rental days is important for several reasons. First, if the dwelling unit is used by the taxpayer and rented for fewer than 15 days, the gross income and deductions attributable to the rental, aside from deductions allowable in any event, are disregarded. Second, a taxpayer uses a dwelling unit as a residence, thus triggering the section 280A(a) limitation, if the taxpayer uses the dwelling unit for personal purposes for more than the greater of 14 days or 10 percent of the number of days the unit is rented at a fair rental. Third, the number of rental days and the number of days of use are elements in computing the actual limitation that applies under section 280A.

The question was posed as follows. The questioner took the position that if a person rents a vacation home to six different tenants of one week each, there are 42 days of rental use. Those with whom he was having the discussion claimed that when the tenant arrives on a Saturday and leaves the following Saturday, there are 8 days of use because there are two Saturdays and one day of each of the other days of the week. The questioner pointed out that this sort of counting would cause the six one-week rentals to be treated as 48 days of rental, which makes no sense to him.

Because treating six one-week rentals as 48 days of rental also makes no sense to me, I set out to ascertain whether there was any authority for counting days. I found the answer in Proposed Regulations section 1.280A-1(f), which provides:

For purposes of section 280A, this section, and section 1.280A-3, the term “day” means generally the 24-hour period for which a day's rental would be paid. Thus, a person using a dwelling unit from Saturday afternoon through the following Saturday morning would generally be treated as having used the unit for 7 days even though the person was on the premises on 8 calendar days.

Thus, arriving on Saturday afternoon February 11 and leaving on Saturday morning February 18 would be 7 days of use: the 24-hour period ending on February 12, the 24-hour period ending on February 13, and so on through the 14th, the 15th, the 16th, the 17th, and the 18th. That's 7 days, even though use exists on eight calendar days.

As I thought about the initial question, I understood the goal of the regulatory rule is to prevent double counting days, whether days of personal use or days of rental. Technically, though, double counting is possible under the regulations but a reasonable interpretation should avoid the pitfalls of a rigid application of the language. Consider an example. Renter1 signs a lease to occupy the dwelling unit from Saturday, February 11, 10 a.m. until Saturday, February 18, 9 a.m. This counts as a seven days of rental under the proposed regulation. Suppose that an emergency delays renter1’s departure until 2 p.m. on February 18, but that renter2, who has a lease for February 18, 10 a.m. until February 25, 9 a.m., is willing to, and does, accommodate renter1 by delaying occupancy. The best interpretation would be to treat each lease as 7 rental days. Though renter1 has continued occupancy into an eighth 24-hour period, it would not make sense to conclude that there are 15 days of rental, 8 from renter1 and 7 from renter2. Doing so would double-count Saturday, February 18.

So why would someone want to treat a one-week rental as 8 days, thus turning six one-week rentals into 48 rental days? The calculations for the deduction limitation reflect days of rental, and increasing the days of rental works to the taxpayer’s advantage. In this instance, with clear regulatory authority on how to count days, treating six one-week rentals as 48 rental days is flat-out wrong. And worse.

When it comes to politics, I dine at the buffet. My focus is on the nation, principles, and policies, rather than on policies, caucuses, or individuals. It is not unusual for me both to praise and criticize the same organization or person. Here is an example.

Just last week, in When Double Taxation Doesn’t Exist, I criticized the position taken in issue 9.04 of Tax Bytes, published by the Institute for Policy Innovation, with respect to whether the taxation of income earned by investing after-tax salary income constituted double taxation. Those reading my post carefully would have noticed that near the end, I expressed agreement with the position taken in the same issue 9.04 of Tax Bytes with respect to the ReadyReturn concept.

Shortly thereafter, I received issue 9.05 of Tax Bytes. In this essay, the Institute for Policy Innovation weighed in against the use of the tax law to “manipulate behavior and micromanage the economy” through an assortment of Internal Revenue Code provisions. On this point, we are in agreement. More than six years ago, in “Prof. Maule Goes to Washington”, in which, at the request of a former student, I outlined how I would reform the federal tax law, I wrote:

Also trashed are all the social policy provisions that ought to be in some other law, if indeed the citizens think that the federal government should be providing financial assistance to particular individuals or communities or to those who engage in particular activities. I understand that the Congress, which consistently criticizes the IRS, has a habit of demonstrating its true thoughts about that particular federal agency by putting into the tax law provisions that deal with matters that are within the purview of other federal agencies because the IRS appears to be more capable of administering these programs, but it's time for Congress to demand of the other agencies the same sort of competence that it attributes to the IRS when it turns to the IRS to handle its pet project of the week.

Two and a half years later, in Not to Its Credit, I revisited the issue after the Congress used the Heartland, Habitat, Harvest, and Horticulture Act of 2008 to add and expand all sorts of tax credits:

I object to the Internal Revenue Service being turned into a institution that is focused more on the technical requirements of energy production activities than on administering revenue laws. I wonder why financial incentives to produce and conserve energy aren't administered by the Department of Energy. Well, I know the answer. The Congress, though every now and then publicly trashing the IRS and characterizing it as harmful, then turns to the same agency to administer its favorite incentives programs. Which should speak more loudly to America? What Congress says when it grandstands or what it does when it overburdens the tax law and the IRS because it apparently doesn't trust other agencies to administer laws relating to agriculture, energy, employment, or health?

And about a year ago, in The Unintended Consequences of Tax Policy As a Social Tool, I focused on one of the many dangers of using the tax law as a means to encourage or discourage particular behavior:

In every instance where the Congress has used the tax law to encourage behavior, all sorts of people have crawled out from under the wood pile to claim that they were engaging in that behavior and thus entitled to the tax break, even though they were not engaging in that behavior. One need think only of the abuses with respect to the credit for new home purchases, the earned income tax credit, the plug-in electric and alternative motor vehicle credits, and the biodiesel fuel credit, to name but a few, to understand the inherent weakness of trying to use tax law to do what should be done through other means.

The Institute for Policy Innovation, in issue 9.05 of Tax Bytes, correctly notes that both parties have abused the tax law in this respect. Whether it is one side trying to use the tax law to encourage and subsidize child-rearing or domestic manufacturing, or the other side trying to encourage home ownership or energy conservation, “it’s this drive to manipulate and micromanage that drives the tax code toward such incomprehensible complication.” My only quibble is that I think it’s not a matter of being driven toward incomprehensible complication. I think the tax law has already arrived at that destination.

The Institute for Policy Innovation, in issue 9.05 of Tax Bytes, asks:

. . . “What is the purpose of the tax code?” Is it to drive social outcomes and to try to shape society according to the vision and preferences of whoever happens to control the tax writing committees at any given time? . . . Rather, shouldn’t the purpose of the tax code be to raise the necessary revenue to fund government while creating as few economic distortions as possible? If you were going to write a tax code for a free society, wouldn’t you foreswear using the tax code to manipulate people’s behavior, and choose instead to have everyone subject to similar low rates, and eliminate virtually all credits, deductions, exemptions and schedules in the process?

In the broad outline I presented in “Prof. Maule Goes to Washington”, I mapped out the basics:

Income would include income, with very few exclusions... As for outgo, there would be two basic deductions. One would be for the expense of producing the income... The other would be a deduction (or perhaps a credit) that would reflect the wisdom of not imposing a tax on those whose incomes were barely sufficient to live life...Perhaps, because all citizens ought to contribute something to the cost of government, a small ($10) tax ought to be imposed on taxable incomes under the cutoff, and a very low rate imposed on taxable income above the cutoff but below, say 125% of the cutoff... Of course, no surprise, when it comes to rates, all taxable income is taxed under a rate schedule...This approach permits lowering the tax rates. The base would be broadened, and thus rates could be reduced...Finally, there is the matter of credits. Of course the credits for taxes withheld (and I'd withhold on all income payments exceeding $500, not just wages and certain other payments) and estimated tax payments would be retained...

There might be disagreement about which path to take, but at least in this case we seem to be pointing in the same direction.

Every so often I make a prediction in one of my blog posts. Every now and then one of them comes true. Admittedly, this was a fairly easy prediction. And the fact it came true isn’t anything to cheer about. In fact, that it came true is simply more evidence of how sad a state the tax law is in.

In late 2010, in A Section 107 Puzzle: Is “A” Just “One” or “Any”?, I analyzed the decision in Driscoll v. Comr., 135 T.C. No. 27 (2010), in which the United States Tax Court, in a case of first impression, held that the exclusion from gross income under section 107 of a minister’s parsonage allowance is not limited to the portion used to provide the minister’s primary residence but also extends to the portion used to provide a second home, which happened to be located in a vacation area. The question of whether the term “a home” in section 107 meant “just one home” or “however many homes” divided the Tax Court judges. Ultimately, the taxpayer prevailed, with the majority supporting the conclusion that the word “a” did not mean “one.” As I wrote in A Section 107 Puzzle: Is “A” Just “One” or “Any”?, “The case is yet another example of how courts struggle to determine what Congress intended when examining statutory language the Congress almost surely enacted without thinking about the issue. The existence of majority, concurring, and dissenting opinions indicates the extent of the struggle.”

In the last paragraph of A Section 107 Puzzle: Is “A” Just “One” or “Any”?, I asked five questions:

What’s left are several questions for the future. First, will the IRS appeal, and if so, will it prevail? Second, will the IRS continue to issue notices of deficiency in these sorts of cases, knowing that it would lose in the Tax Court but hoping that it would prevail on appeal to a different Court of Appeals? Third, might the Supreme Court end up dealing with this issue? Fourth, will the Congress amend section 107 to respond to the Tax Court’s decision, and, if so, what will it do? Fifth, might the Congress repeal section 107, the existence of which is difficult to justify under any sort of tax policy analysis?

It was at this point that I went out on a limb and explained: “I’m willing to predict that at some point in the future, a subsequent development with respect to this issue will be the subject of a future MauledAgain blog post.”

Well, here we are. Last week, in Comr. v. Driscoll, ___ F.3d ___ (11th Cir. 2012), the Eleventh Circuit reversed the Tax Court. Relying on Webster’s dictionary, the court concluded that “a home” refers to one home. Webster’s Dictionary provides three definitions of home. The first is “the house and grounds with their appurtenances habitually occupied by a family.” The second is “one’s principal place of residence” and the third is “domicile.” I suppose everyone who has a home in one area and a vacation property in another location is speaking improperly when they refer to their “vacation home” because that would suggest they have two homes. The court rejected the taxpayer’s argument that Congress, by using the term “principal residence” in other Code provisions but not in section 107, did not intend to limit section 107 to principal residences.

Aside from the substantive legal principle that emerges from this case, which of course is subject to a similar case being decided differently by another Court of Appeals, there are two lessons to consider. One is whether this issue demonstrates that section 107 has outlived its usefulness. My many clergy friends won’t be happy with the suggestion that it be repealed, but it presents a long list of issues, with this particular “how many” question being one of the less pervasive ones. The other lesson is the disadvantage of gargantuan tax codes. The Internal Revenue Code is so big that almost no one has a comprehensive understanding of its vocabulary and style. Different terms are used for the same concept because different individuals draft the language. The days when someone doing drafting could remember all the places where the same concept was referenced are long gone. Every additional provision brings the opportunity for additional ambiguities, inconsistencies, and language reconciliation challenges.

When one considers the time, energy, and other resources expended on this issue by the IRS, the taxpayer, and the two courts, it is easy to see the adverse impact that careless legislating has on people, the nation, and its economy. Once again, the root of the problem is with the Congress. Once again, the Congress has failed.

When I was a child, I was introduced to tall tales. Presented as supposed recounting of actual events, it was understood that they were fiction, generally resting their appeal on the exaggerations and improbabilities wrapped into the story. They were intended to be fun, and not to influence someone’s decision or to encourage or discourage particular behavior. Of course, because the exaggerations and improbabilities weren’t within the realm of reality, the phrase “tall tale” did double duty as a euphemism for misrepresentation or lie. Usually the term, at least in my experience, was brought into play when the misstatement was more of an exaggeration than an outright lie.

This morning’s question is whether the testimony offered by the taxpayers in a recent Tax Court case qualifies as a tall tale. Some of it might be just that. But other parts of it, to use the court’s words, “did not add up.”

In Esrig v. Comr., T.C. Memo 2012-38, the court was presented with one of those “everything but the kitchen sink” cases, in which a long list of unreported income items and challenged deductions were presented for consideration. The taxpayers had not filed timely returns from 1998 through 2003, and for some of those years they did not file at all, with the IRS eventually filing substitute returns for them. The taxpayers defense was that their losses and deductions exceeded their income. Even if true, how does that justify failure to file? To the contrary, he tax deficiency for the six years in issue exceeded $700,000. The notices of deficiency for three of those years asserted more than $1.5 million in unreported income.

The case came down to a matter of substantiation. Did the taxpayers have evidence to support their position? Two of the issues caught my eye because of the evidence that was offered. All of the evidence presented by the taxpayers consisted of the husband’s testimony.

The taxpayers claimed a section 179 deduction in the amount of $17,700. This was the “cost of a fish tank and dining room furniture.” The first thought that crossed my mind was, “Either the tank or table was huge, or they were made of platinum.”

The husband testified that he and his wife both used the dining room table primarily for business meetings. The court, which by this point in the opinion had consistently found the husband’s testimony inconsistent with the tax returns and other information and had characterized his testimony as not credible, simply stated, “We did not find [husband’s] testimony credible.” Some people do let things pile up on dining room tables and rarely use them for eating purposes, but the combination of the price tag, the doubts about whether the taxpayers actually conducted businesses, and the absence of any other evidence, such as photographs of the table being used for business purposes, doomed the taxpayers.

The fish tank presented even more interesting testimony. The husband testified “that they put in a fish tank in the foyer of their home where their business contacts would sit and wait for meetings.” Again, the court simply dismissed the testimony as not credible. Aside from the alleged cost of the tank, even if there were business contacts sitting in the foyer, is a fish tank an ordinary and necessary expense of conducting business? Perhaps, if the business consists of selling fish, selling fish tanks, or perhaps even teaching people to fish. None of the business activities in which the taxpayers claimed to engage had anything to do with fish.

The case then reached new heights when the court turned to the question of the addition to tax for late filing. The husband blamed the couple’s tax accountant. He testified that he asked the accountant to prepare extensions, but that the accountant did not do so because she was in prison serving a long sentence for murdering her husband. The husband claimed that the person still working in the accountant’s office “made a slew of mistakes.” Is it reasonable for a taxpayer to continue asking someone to prepare extensions over a seven-year period if the taxpayer learns that the person is in prison? Is it reasonable to continue returning to the same office staffed by the same employee if that employee is making a slew of mistakes? Of course, the claim that the accountant was in prison was either a tall tale or a lie. It isn’t that difficult to obtain proof of a person being sentenced to prison, but as the court put it, the taxpayers “had no evidence to corroborate this lurid tale.”

Lurid tale. Tall tale. Sad tale.

Last week I received an email conveying issue 9.04 of Tax Bytes, released by the Institute for Policy Innovation. Titled “Investing Earns You Additional – Not Lower – Taxes,” the essay attempts to demonstrate that the special low income tax rates on capital gain income constitute double taxation.

Claiming that the President’s State of the Union address demonstrates both the code’s complexity and the President’s failure to understand it, the essay claims that “income and capital gains are not the same thing.” Nonsense. Capital gain income is one type of gross income. Dividends constitute another type of gross income. Interest is yet another form of gross income. Wages are even another sort of gross income. There are others, such as rental income, prize income, alimony income, royalty income, and so on. Income is income. When a person buys a cup of coffee, no one cares whether the money being handed over came from wages, rents, prizes, capital gains, alimony, or whatever.

The essay compounds this misunderstanding by claiming that “Income tax is calculated as a certain percentage of a person’s earnings. A capital gains tax is a tax on capital gains.” There are two glaring errors in this assertion, errors that only the most negligent student in a basic federal income tax course would make. Income tax is calculated on TAXABLE income, not just earnings. The percentages vary based on the amount of the taxable income and the nature of the taxable income. There is no such thing as a capital gains tax. There are special low rates – or percentages – applicable to most, not all, different types of capital gains. There is one income tax, period. Note the subtle attempt to make it appear that the income tax is designed to apply to “earnings” and nothing more. Interesting, isn’t it?

The essay then gives an example. A person earns wages and pays income tax on the wages. The person takes a portion of the after-tax income and invests it in property. At a later time, the person sells the property for an amount more than what the person paid for the property. That gain is included in gross income, causes taxable income to increase, and is subject to tax at special low rates. According to the essay, the person “paid income tax on her earnings first and then paid an additional capital gains tax on the money second.” Note the vague and thoroughly imprecise language of that assertion. What is meant by the word “money”? It is not used earlier in the paragraph of the essay in which it appears. The essay correctly states that there is a tax on “the amount the property increased in value.” Shifting to the word “money” leaves the impression that the “money” from the sale of the property is subject to tax. That’s not the case. The amount that was paid for the property, called “basis” in the tax law, is subtracted from the “money” received in the sale, called “amount realized” in the tax law, so that the only thing that is subject to tax is the ADDITIONAL GROSS INCOME earned by the person.

The essay then concludes that people who save after-tax earnings, having already been taxed on earned income, are subject to an “additional, second 15% tax” on “one stream of earnings.” The essay then labels this “Double taxation.” Nonsense. Total, utter, complete nonsense. The earnings that were taxed and invested in the property are NOT taxed a second time. They are shielded from taxation through the mechanism of “basis.” When an investment generates additional income, the investment is not taxed. The income that it generates is taxed. Double taxation of the earnings that were invested does not exist because they are recovered, tax-free, when the property is sold.

For years I have dedicated myself to teaching people – students in my courses, friends, acquaintances, readers of MauledAgain, whoever will listen or read – how the federal income tax system works (and why it does not work as well as it ought). I am a staunch advocate of tax education, not only in law schools, but also in high schools and undergraduate institutions, as I have consistently explained in posts such as Tax Ignorance, Is Tax Ignorance Contagious?, Fighting Tax Ignorance, Why the Nation Needs Tax Education, Tax Ignorance: Legislators and Lobbyists, Tax Education is Not Just For Tax Professionals, The Consequences of Tax Education Deficiency, The Value of Tax Education, Tax Ignorance of the Historical Kind, Is It Any (Tax) Wonder?, and Tax Myths, Tax Lies, and Tax Twisting). It is deeply disturbing when tax misinformation is circulated. To claim that there is double taxation where there is no double taxation is disingenuous.

Even though the position taken by the president of the Institute for Policy Innovation in his essay on the Ready Return concept makes sense, it is disappointing that somehow one of his staffers made such a mess trying to create sympathy for taxpayers being taxed at already special low rates on capital gains. If the organization can get it right some of the time, there’s hope it might get it right more often. But in issue 9.04 of Tax Bytes, it didn’t.

A little more than a year ago, in Judge Judy and Tax Law, I commented on a tax question that popped up on the Judge Judy television show. Shortly thereafter, in Judge Judy and Tax Law Part II, I shared my thoughts on yet another episode of the show that involved tax law.

It may have taken a year, but Judge Marilyn Milian of The People’s Court found her own claim to TV judge tax law fame. Judge Milian was hearing a case involving a dispute over the private sale of a car. The plaintiff wanted his money back because of alleged defects with the vehicle. At one point, Judge Milian pointed out to the plaintiff that although he was suing for $3,700, the receipt he had was for $500. Why? The plaintiff admitted he asked the seller to provide a receipt showing a much lower sales price “in order to save on sales tax.” The judge replied, correctly, “That’s tax fraud.” She then noted, perhaps not in these exact words, that she found it amusing when someone asks for a low amount on the receipt to evade taxes but then claims in the lawsuit the he paid much more.

What Judge Milian did not point out is that the plaintiff has provided the revenue department of whatever state is involved, and I don’t recall where the sale occurred, with all the information it needs not only to collect the unpaid sales tax, but also to prosecute the plaintiff if it chose to do so. The defendant-seller might also face legal difficulties for agreeing to assist the plaintiff in the tax evasion scheme.

Then again, perhaps the car not running was some sort of Divine or cosmic retribution for what happened during the purchase transaction. I wonder how people would react if the plaintiff decided to fork over the unpaid sales tax, did so, and discovered that the vehicle then started to run properly?

Tax law complexity is more than a matter of computational gymnastics. Consider the following question, which does not require computations to answer. Is a taxpayer required to include in gross income the value of frequent flyer miles received from a bank for opening an account?

The story triggering the question broke last week. Citibank, which transfers frequent flyer miles to customers who open an account with the bank, issued Forms 1099 to its customers, reporting the value of the miles – that is another issue – as miscellaneous income. The practical effect is that failure by the customer to report the income will cause the IRS computers to make an adjustment because there is no entry on the customer’s income tax return matching the Form 1099.

Initial reaction to the story was interesting, to say the least. One tax practitioner quoted in the story asserted that he “never had an instance where [frequent flyer] miles have been treated as taxable.” Does that mean there are never any circumstances under which the frequent flyer miles are taxable?

Frequent flyer miles received from the airline when tickets are purchased are not gross income because they constitute an adjustment to the sales price of the ticket. A tougher question had arisen when airline tickets purchased on employer accounts generated frequent flyer miles for the employee’s personal use. In Announcement 2002-18, the IRS explained that, “Consistent with prior practice, the IRS will not assert that any taxpayer has understated his federal tax liability by reason of the receipt or personal use of frequent flyer miles or other in-kind promotional benefits attributable to the taxpayer's business or official travel.” The IRS did not address the tax consequences of receiving frequent flyer miles other than directly from the airline or indirectly through use of the employer account. Citibank, for example, purchased frequent flyer miles from airlines and transferred them to customers. Some rental car agencies and hotels have done the same, transferring frequent flyer miles to customers who rent cars or hotel rooms. The IRS also warned, though, that its decision to not treat frequent flyer miles as gross income does not apply to “travel or other promotional benefits that are converted to cash, to compensation that is paid in the form of travel or other promotional benefits, or in other circumstances where these benefits are used for tax avoidance purposes.” So although the quoted practitioner has never seen any instances of frequent flyer miles being taxable, it’s possible.

But must the frequent flyer miles received from Citibank for opening accounts be included in gross income? A Citibank spokesperson explained that it considers the miles to be prizes and awards, which must be included in gross income. To this analysis, the tax practitioner reacted by saying that “he couldn't think of any instance in which miles would be given out except as a prize or award,” and that, “This opens up the notion that all miles are taxable.” Not exactly. The miles that are received as rebates on the purchase price of an airline ticket are not included in gross income.

A few days ago, the IRS tried to clarify its position. According to this story, the IRS considers frequent flyer miles received for opening a bank account as gross income, but considers miles received for making purchases on a credit card or for paying for a hotel room or rental car not to be gross income. The distinction, according to the IRS, is that the first situation is equivalent to receiving cash or a toaster for opening an account, which under long-settled law generates gross income, whereas the second situation is equivalent to a rebate. Though it is easy to see the rebate when the airline provides frequent flyer miles to the purchaser of a ticket, it is a bit more challenging to see the rebate when the rental car agency provides the miles to a customer. Though some tax practitioners find the distinction difficult to understand, the key is to think of the miles as a rebate, not on the airline ticket, but on the cost of renting the car. Technically, if a person receives frequent flyer miles for making a credit card purchase, and the item purchased is one that requires a record of basis, the basis in that item should be reduced to reflect the rebate. Compliance with this principle surely is far from 100 percent.

Does the IRS position mean that all items received as an incentive to doing business with a company includible in gross income? No. If the incentive is in the form of a rebate, it is not includible in gross income. Nor should there be gross income if the incentive is part of a package. For example, a buy-one-get-one-free promotion is nothing more than a reduction of the market price to half the stated price. Similarly, a buy-three-suits-get-a-free-tuxedo arrangement falls into the same category. On the other hand, if no purchase is involved, such as opening a bank account, there is no transaction to which a rebate can be connected. There is gross income. As the IRS spokesperson put it, whether something received for doing business is taxed as a prize or award “depends on the nature, value, and other facts and circumstances.” That’s a way of generalizing what I just explained in the preceding sentences. When the author of the story claims that the IRS explanation is “a fancy way of saying the IRS doesn’t know,” he is falling into the trap of wanting a definitive answer for a range of situations that cannot be bundled together for analytical purposes.

When there is gross income, the next question is, “How much?” The answer is simple. Fair market value. That brings the next question, which is not so easy. What is the fair market value of these miles? Should the frequent flyer miles be valued at what they cost Citibank to purchase? Or should they be valued at what the airline says they are worth? Or should they be valued according to the airline ticket price reduction that can be obtained by using the frequent flyer miles?

When the story first broke, a Senator wrote to the CEO of Citibank, demanding that the bank cease sending Forms 1099 reporting the frequent flyer miles as income. He wrote, “The last thing Citibank should be doing is . . . placing a nonexistent tax burden on the backs of families who are already struggling to make ends meet.” Sorry, Senator, but it’s a real tax burden. Had Citibank given out toasters, and it didn’t because toasters are nowhere as desired as frequent flyer miles, would you have written the same letter? I hope not, but I think so. Tax ignorance, once again. If the Senator wants a result different from what current tax law provides, the Senator can try to persuade his colleagues in the Senate and the members of the House to change the law, the law that the Congress has enacted.

The author of the follow-up article notes that “this whole thing is a perfect illustration of why our tax system is so messed up.” Perhaps the tax system is so messed up because business transactions are so messed up. Once upon a time, a person paid a price for an item and that was it. Then the marketing gurus jumped in with all sorts of gimmicks, incentives, cross-arrangements and other “deals” that appear to be price breaks but in the long run cost the consumer. When Citibank buys frequent flyer miles, it incurs a cost, and to maintain profits, it must reduce the interest it pays on its accounts. That may be a good deal for someone who wants frequent flyer miles – although one customer quoted in the first story seemed to indicate that it wasn’t such a good deal – but for a person that doesn’t want frequent flyer miles, it’s not a good deal. Some customers would prefer a cheaper price for the three suits rather than the free tuxedo that they will never use. So if people want a simple tax system, simplify the unnecessarily complicated business arrangements.

One last point. It’s only a matter of time before someone claims that a flat tax would solve this problem. Nonsense. The issue at hand must be resolved long before one or more tax rates are applied to taxable income. Whether there are multiple rates or a single rate in section 1, the issues arising from the frequent flyer mile account-opening incentive would still be with us.

Several weeks ago, a reader passed along a link to a blog post asking the question, Will I Be Taxed on My Employment Law Settlement?. The answers focus on the inescapable conclusion under current law that, with few exceptions, damages received from employment law recoveries are included in gross income. The complaint raised in the post, which reflects a similar concern raised over the years, is the perceived difference between the taxation of damages for employment law violations and the taxation of damages for physical injuries. As the writer notes, “Right now, the law says that, if you are injured in a car accident or have another personal injury, your settlement or judgment isn’t taxable at all. However, if you’re the victim of discrimination and suffer emotional distress, you are taxed.”

The writer draws attention to the Civil Rights Tax Relief Act of 2011, which has been introduced periodically in the Congress but has not been passed. Under the proposal, gross income would not include amounts received on account of unlawful discrimination, but backpay, frontpay, punitive damages, and amounts that would be deductible if included in gross income, such as attorneys’ fees, would not be within the exclusion. Unlawful discrimination awards would be amounts received under the statutes listed in section 62(e).

So what would end up being excluded under the proposed section 139F? The author of Will I Be Taxed on My Employment Law Settlement? lists 12 types of damages that are received in employment litigation cases. The proposal, by its own terms, would not apply to back pay, front pay, severance, punitive damages, liquidated damages, attorney’s fees, costs, and overtime. It would not apply to damages for physical injuries, but those are excluded under current law. Thus, the proposal would exclude from gross income damages received for emotional distress, interest, and taxes.

Here’s one problem with the proposal. It rests on a justification that employment law recoveries ought not be treated less generously than other damages. Yet, if enacted, the proposal would treat employment law damages more favorably, because it would allow an exclusion for emotional damages not arising from a physical injury. The exclusion of interest also makes no sense in light of what the interest represents and how interest income otherwise is treated.

There’s another problem with the proposal. There are damages that do not fall into the gross income exclusion under section 104 damages nor under proposed section 139F. Why are recipients of those damages excluded from the proposal? If fairness is the banner under which the proposal is being advanced, why is that banner not all encompassing? Why the lack of, pardon the term, inclusiveness? Why would the recipient of damages for intentional infliction of emotional distress continue to be taxed and be precluded from any exclusion provision? The insufficiency of the actions covered by the proposal is demonstrated by its reference to section 62(e), itself a narrow provision reflecting the interests of those who lobbied for its enactment. In Being “Special” Never Ends?, I pointed out that section 62(e) permits “certain, but not all, plaintiffs to deduct their attorney fees in computing adjusted gross income (thus sparing them the inequities caused by treating the deduction as an itemized deduction and as an add-back in computing the alternative minimum tax).” This favoritism continues with the section 139F proposal.

If the lost wages component of section 104 damages were removed from the exclusion, the argument raised by the section 139F proponents would lose its footing. Though there is ample justification for not excluding lost wages from gross income under any circumstances, amending section 104 in this manner faces steep political hurdles because, as with so many things, emotion trumps logic.

The pending legislation also would enact a new section 1302, providing for a complex income-averaging provision for the wages portion of employment discrimination damages. This sort of income averaging was sought when section 62(e) was enacted, it was opposed because of its complexity, and its supporters promised they would try again. Here’s the problem with income averaging. Income averaging existed when the top tax rates were high, in the 70, 80, and 90 percent range, and a one-time “surge” in income would push the taxpayer into brackets much higher than the ones to which the taxpayer usually was subject. When rates were lowered so that there were no rates at or above 40 percent, the arithmetic benefit of averaging was considered too small to be worth the price of the complexity, and income averaging was repealed. If and when employment damage awards are taxed at 70 or 80 percent, a return to income averaging would make sense. Certainly damages for future wages can be paid out over time, so that they fall in the year in which they would have been received and taxed, and the use of arrangements similar to the structured settlements used in section 104 situations would alleviate the concern. The more challenging issue is back pay, but how is the employment plaintiff any worse off than any other plaintiff who receives in one year a damage award representing multiple years of misconduct or breach by the defendant? Consider the business that loses profits because of a contract breach, sues, recovers, and must report in the year of recovery an amount representing multiple years’ profits? What about all of the other taxpayers who have a “surge” in income, whether from lottery winnings, payment in one year of compensation for several years’ worth of labor, or any other transaction that creates a “bump” up in income? Why is there no section 139F proposal for them? Because section 139F is the product of a select group of attorneys who are focused only on their clients and have no concerns for the plight of anyone else.

Like the section 62(e) provision, the section 139F – section 1302 proposal is a pair of provisions applicable to a very small group of plaintiffs. It addresses problems afflicting a wide range of plaintiffs but provides relief for only a narrow group of plaintiffs. Why has this happened? The plaintiffs within the scope of the proposal are represented by a well-organized, influential group with clout and access to Congress, that succeeded with the discriminatory section 62(e) and are now poised to push into law a discriminatory section 139F paired with a discriminatory section 1302. The other plaintiffs don’t have that clout or that access. They don’t have what is required for access to Congress. When access to Congress is limited and clout is denied, democracy suffers and tax policy takes a turn for the worse.