MauledAgain

When a taxpayer signs a contract, the terms of that contract quite often dictate the tax consequence. This point was highlighted in a recent case, Sharp v. Comr., T.C. memo 2013-290. The taxpayer sued her former employer because she contended that she had been compelled to resign because the employer and other employees made her life so miserable that she ended up with muscle tension, migraine headaches, fear of going to work, fear of people, nightmares, and depression, for which she was hospitalized. She sued the employer on at least two grounds. The first was a workers’ compensation claim. The second was a claim for the gross negligence of the employees. The taxpayer and the employer settled the litigation. In the agreement, the employer promised to pay $210,000 in each of three annual $70,000 installments. The agreement described the payments as for “emotional distress damages only.” When the taxpayer received the first $70,000 payment, she excluded it from gross income, attaching a statement to her income tax return explaining that the payment was excluded under section 104(a)(2). The IRS disagreed and issued a notice of deficiency, recomputing the taxpayer’s tax liability by including the $70,000 in gross income. The attorney who represented the taxpayer in the case against the employer also represented her in the Tax Court, and also was the attorney who advised her to exclude the payment from gross income.

The taxpayer argued that the section 104(a)(2) exclusion applied because the payment was received under a statute in the nature of a workers’ compensation act. The Tax Court disagreed, pointing out that the language of the settlement agreement made no mention of a workers’ compensation claim being paid. The taxpayer offered no other evidence of the employer intending to pay any portion of the $210,000 in exchange for settling a workers’ compensation claim.

The taxpayer also argued that the section 104(a)(2) exclusion applied because the $210,000 was on account of personal physical injuries or physical sickness. Again, the Tax Court disagreed, noting that the settlement agreement provided that the payment was for “emotional distress damages only.” Accordingly, none of the settlement proceeds could be on account of personal physical injuries or physical sickness. The court also explained that emotional distress is not a personal physical injury or physical sickness even if it is manifested in physical symptoms, citing several earlier cases that had reached the same result.

I wonder whether, in settling on a $210,000 amount, the taxpayer, and her attorney, viewed this amount as a tax-free amount. Had they understood that it would be taxed, would they have insisted on, and held out for, a higher amount so that the after-tax equivalent would have been $210,000? I also wonder, if non-taxability was important, why did they not insist that the settlement agreement contain language that characterized the payments as settlement of workers’ compensation claims or claims for negligence causing physical sickness? If the employer was adamant in not conceding a workers’ compensation claim, or negligence of the other employees, that position would strengthen the taxpayer’s resolve to receive more than $210,000 in order to cover the tax liability.

Unfortunately, section 104(a)(2) remains a trap for those who do not fully understand how it applies. In this instance, the taxpayer and her attorney got caught in the bizarre distinction between physical injury and emotional distress. As I noted in The Strangeness of Tax: When “Bodily” is Not "Physical":

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.

Until Congress removes this artificial and questionable distinction from section 104(a), taxpayers and their attorneys need to be highly cognizant of the extent to which settlement contract language can affect income tax liability.

According to this story, an anonymous individual put a $3,500 diamond ring into a Salvation Army red kettle. This generosity follows a donation of $1,000 in cash last year, in the form of ten $100 bills, a donation of a gold nugget two years ago, and the donation of a gold nugget three years ago. Because the person calls the Salvation Army to alert the organization to look carefully at the contents of a particular red kettle, the Salvation Army knows that the donor is the same person.

Apparently, the anonymous donor does not care about the charitable contribution deduction that would be available if the Salvation Army issued the appropriate receipt for the donation. One reason for not caring about the deduction probably does not come into play, because it is unlikely that the donor’s itemized deductions are less than the standard deduction. Another reason also is improbable, because it is unlikely that the donor is buried in losses that generate zero or negative taxable income even without the charitable contribution deduction. Another possibility is that the items are stolen property and the donor is a thief trying to make good by finding a way to return the property, but would it not make more sense to deposit all of the loot at one time in an anonymous way with law enforcement authorities, who are capable of tracing the owners of recovered stolen property? The most likely reason is that the person does not want publicity.

So it remains a mystery, though a mystery that will bring some needed financial assistance to some people dealing with financial difficulties. It also brings a few dollars in tax revenue attributable to the unclaimed charitable contribution deduction.

When a snag in the tax law generates results for taxpayers that are undesirable in terms of policy, fairness, or computation, ought not any remedy enacted by the Congress apply to all taxpayers confronting that snag? One would think so, but that’s not how it works. When it comes to distributing presents, Congress is not necessarily even-handed.

Recent legislation provides a good example of the problem. Under section 501(c)(3), an organization cannot be tax-exempt, and under section 170 contributions to it are not tax-deductible, if, among other requirements, the organization benefits private rather than public purposes. Thus, when donors contributed to a fire company for the specific benefit of the families of two firefighters who had been killed in the line of duty, the fire company had to refrain from distributing the funds to those families because doing so would jeopardize its exempt status. The remedy was H.R. 3458, which was enacted last week and signed by the President on December 20. The bill does not fix the problem for all fire companies that find themselves in this sort of situation. Instead, it applies only to payments made with respect to “an emergency on December 24, 2012, in Webster, New York.”

Why is this a problem? The fire company in Webster, New York, has had to retain the donations until the legislation takes effect. That means the families have been waiting for financial assistance for almost a year. When the next emergency arises, in some other location, and firefighters are injured or killed, they and their families also will need to wait until Congress gets around to enacting legislation. How do we know this will happen? Because it happened to the Webster, New York, fire company. Unfortunately, it was not the first fire company to have members injured or killed in an emergency, for whom donations were made, and that had to hold the donations until special legislation was enacted permitting it to distribute the donations without losing tax-exempt status. It happened, for example, in 2007, in connection with donations made to assist the families of five firefighters who died fighting a Riverside, California, fire. Special legislation was required to permit distribution of donations made in the aftermath of the September 11, 2001, terrorist attacks.

It is not difficult to draft and enact legislation that would apply to all donations made for the benefit of emergency responders who are injured or killed in the line of duty while dealing with disasters, catastrophes, or other emergencies. That would permit fire companies and similar tax-exempt organizations to distribute expeditiously funds donated for the assistance of those who are injured and the families of those who are killed. It would eliminate the repetitive consumption of legislative resources moving bill after bill through the Congress and White House. It would be a nice gift to the nation and it would make sense. That’s why I doubt the Congress will do this for once and for all, the way it ought to be done.

The Reason Foundation has released a report, Unmasking the Mortgage Interest Deduction: Who Benefits and by How Much? in which the authors conclude: “We believe the most appropriate policy action would be a complete elimination of the mortgage interest deduction combined with reductions in marginal income tax rates to make the repeal revenue neutral.” The authors point out that the deduction is claimed on only one-fourth of individual income tax returns, and “almost exclusively benefits wealthy households and young Americans with large mortgages.” They argue that eliminating the deduction would “increase fairness and simplify the tax code.” This would permit reducing income tax rates.

Everything that the authors of the report argue makes sense. As an advocate of simplifying the income tax and not using it to accomplish purposes that are more appropriately achieved through other means, I support the conclusion. But it doesn’t go far enough. Everything that can be said about the mortgage interest deduction can be said about other deductions. For example, the charitable contribution deduction, the deduction for state and local income taxes, and the deduction for state and local real property taxes are claimed on less than half of income tax returns. These deductions benefit wealthier taxpayers because they benefit taxpayers who itemize deductions, most of whom are higher income taxpayers. See, for example, the Tax Policy Center report on deductions for state and local taxes.

What good reason exists to eliminate the deduction for mortgage interest but not the deductions for charitable contributions and state and local taxes? Unquestionably, advocates of the latter deductions have a list of reasons that they can offer, and that they have offered whenever someone suggests eliminating, or even scaling back, those deductions. The same can be said, however, of the mortgage interest deduction. Its advocates also have a list of reasons. For the most part, advocates of exclusions, deductions, and credits base their reasons on one common underlying claim, namely, that the tax break in question is essential because it does good things and because without it, the economy will collapse. The reality is that the economy will not collapse, generous people will continue to give to charity, and compliant citizens will continue to pay state and local taxes. The argument that removing the deduction reduces the incentive to give to charity, for example, is offset by the reality that reduced income tax rates will leave more money in the hands of taxpayers that can be used to offset the tax benefits lost by elimination of the deduction.

Simplifying the income tax by removing the hundreds of tax breaks that clutter the Internal Revenue Code makes sense. In fact, this approach makes so much sense that it was followed, though not as completely as it could or should have been, in 1986. Tax breaks were removed, and rates were reduced. So what happened? What happened is that the lobbyists showed up, arguing that the tax breaks benefitting their clients were so important, and so much more important than anyone else’s tax breaks, and persuading the Congress, ever in search of campaign contributions, to restore the tax breaks without bringing back the higher tax rates. Ultimately, this is a significant factor in the creation of annual budget deficits. What the lobbyists and Congress did is no different from what happens when one person agrees to pay for an item, the second person agrees to deliver the item, the first person pays, the second person delivers the item, and then the first person stops payment on the check. Breaking one side of the deal and not the other was and is wrong.

Perhaps the Reason Foundation has additional reports in the pipeline that will address other deductions. I certainly hope so. A quick check of its web site didn’t reveal if this is or will be the case, but sometimes things aren’t on web sites or are difficult to find. Though sometimes abandoned buildings need to be taken down brick by brick, sometimes it is more efficient and fair to knock the thing down with a wrecking ball. That is what should happen to the huge pile of tax breaks that benefit few and disadvantage many. There’s no point in picking on just one tax deduction.

Almost two years ago, In Judge Judy and Tax Law, I reacted to how a tax question entered into the discussion on the Judge Judy television show. Ten days later, in Judge Judy and Tax Law Part II, I commented on another episode of the show in which tax law made an appearance. Though tax showed up on at least two episodes of another television court show, as I explained in TV Judge Gets Tax Observation Correct and The (Tax) Fraud Epidemic, tax has not popped up on any of the Judge Judy episodes I’ve had the opportunity to watch during the past two years. That is, until earlier this week.

This time, the case involved a plaintiff who had started a tax return preparation business after having worked for other preparers for two years. The plaintiff offered the defendant $100 for each person referred by the defendant to the plaintiff who became a client. The defendant claimed she made 18 referrals but had not been paid. The plaintiff countered that it was only 17 and did not dispute the fact that she had paid nothing to the defendant. At that point, Judge Judy decided to accept the figure of 17. The plaintiff’s case rested on the claim that the defendant, after the plaintiff met with the people referred to her by the defendant, contacted those individuals and advised them to take their business elsewhere, which they did. The defendant counterclaimed, arguing that she had not been paid by the plaintiff for the referrals.

The testimony concerning the arrangement was almost as convoluted as tax law. The plaintiff explained that many of the people referred to her by the defendant did not have tax situations that would be profitable for the plaintiff’s business. In other words, their tax returns were relatively simple, and the fee charged to the client so low that the $100 referral fee either exceeded or came close to wiping out what the plaintiff could charge. The plaintiff decided to change the referral fee going forward, switching to an amount based on a percentage of the fee charged to the client. The defendant disagreed, claiming that the fee had been increased from $100 to $135. The confusion between the parties became even more pronounced when Judge Judy asked the defendant for proof that she had made the referrals, and the defendant produced some sort of spreadsheet on which there were the names of 14 clients referred by the defendant. The plaintiff explained that the figure of 17 came from including 3 clients who had been referred by the defendant’s husband. Judge Judy pointed out that the husband was not a party to the contract between the plaintiff and the defendant.

When asked why she had not paid anything to the defendant, the plaintiff replied that after obtaining W-2 forms and other documents from the clients, she was asked by them to return the materials and to stop working on the returns. The plaintiff stated that she had completed the returns by that point and was ready to submit them to the IRS on behalf of the clients. The plaintiff explained that the clients told her they were terminating her services because the defendant had called the police on the plaintiff. There was no explanation of whether or why that had been done.

Judge Judy decided that the plaintiff had failed to prove that the defendant interfered with the clients and was the cause of their terminating her services. Judge Judy awarded $1400 to the defendant.

Putting it nicely, this is no way to run any sort of business. There was no written contract. Had there been one, there would have been less energy and time invested in figuring out what the arrangement was between the parties. Crediting one person with another person’s referrals makes no sense unless, at the very least, there is a contract provision to that effect. Having second thoughts about the amount of a referral fee should trigger renegotiation of a contract in a way that does not leave one party claiming that the new arrangement was based on a percentage and the other party claiming that it remained a fixed, though higher, fee. Any contract needs to contain a provision that addresses what happens when a referred client terminates services, and also should include a description of the consequences attached to interference with the client relationship by the referring party, including a definition of what constitutes interference.

For me, the case also demonstrates why lawyers, detested as they are by many, can be valuable at the outset, long before there is litigation. Most people who have not explored the nuances of contractual arrangements fail to anticipate the pitfalls that can be encountered. I wonder how the plaintiff will handle her next referral situation. I suppose to find out, we should continue watching.

Last month, in Why This Tax Break?, I described legislation pending in Philadelphia City Council that gives a multi-million-dollar tax break to a private sector development company planning to build two hotels in center city Philadelphia. I criticized the proposal, because the hotels ought not be constructed if they are not economically feasible without tax breaks. Other hotel owners in the city assert that these two new hotels will put the other hotels, or at least some of them, out of business. Advocates of the legislation claim that the hotels will increase the tax revenue from the property compared to what is being generated from its current use as a parking lot. The flaw in that argument is that if the property promises to be financially successful to the extent of generating tax revenue, there ought not be any need for a tax break from the city.

It is highly unlikely that members of City Council read my post, or any similar commentary, because last week it voted, with one dissent, to favor these developers with a tax break not available to the general public. As explained in this report, the approval took place after the developers and union representatives worked out a deal “that would make it easier to organize future hotel workers.” Because details of the back-room deal are not available, it is impossible to analyze the extent to which the deal will have any sort of lasting or binding effect. Even if it turns out to be beneficial for workers, obtaining it by imposing the cost of a tax break on taxpayers with no say in the process is not a good way to govern.

The arrangement would be a little less unappealing if it came with a funded guarantee. If the project does not reap the benefits that the developers claim it will, then the developers should be obligated to make good on the difference. It’s time to put an end to empty promises for which there are no adverse consequences to the promisors when the promises are broken.

Though I don’t always agree with the folks at the Institute for Policy Innovation, occasionally I do. A recent essay by Bartlett D. Cleland gets my endorsement.

Cleland agues for elimination of the current practice of enacting tax breaks – exclusions, deductions, credits, and the like – with expiration dates, which creates a need for renewal legislation. He posits that this is not “a good way to run a tax system.” He is correct. He points out that the tax breaks are designed to “level a playing field” or encourage activity, but that they cannot have that effect when they are “uncertain or routinely reinstated after [they have] expired.” He also clarifies that the tax system would be better without the breaks, but that if they are going to be part of the tax system, they need to be permanent. Again, I agree.

The uncertainty generated by the annual or biennial “extender dance” harms the economy. It is difficult for taxpayers to plan when they don’t know what the tax rules will be. I wrote about this several years ago in Tax Politics and Economic Uncertainty. I explained:

The bottom line, no pun intended, is that it is easier for businesses to make decisions if they know what lies ahead, regardless of what lies ahead, than if they don’t know what lies ahead. Businesses can react to higher tax rates and to lower tax rates, if they know what the tax rates will be, but their decision modeling suffers when virtually everything in the tax law remains open to change, perhaps retroactively, sometimes at a moment’s notice.

Almost two years ago, in Tax Punting, Tax Uncertainty, and Tax Complexity, I disapproved of Congress permitting short-term provisions to expire at the end of 2011, leaving taxpayers in doubt as to what the rules would be. As I explained, “Unfortunately, for taxpayers who are trying to make plans for 2012, they are in tax limbo, uncertain of what the rules will be. Many tax-paying individuals and businesses will play it safe, waiting until the Congress clarifies what the rules will be. This waiting process will inject some degree of stagnation into the economy.” Taxpayers deserve better.

Cleland notes, perhaps in a tribute to tactfulness, that the tax breaks with expiration dates are “for whatever reason . . . not made permanent and thus expire periodically, often annually.” As my readers know, I don’t worry too much about being tactful when it comes to describing the flaws of the Congress and its processes. In Tax Politics and Economic Uncertainty, I addressed the situation in this way:

Why is the Congress unwilling to provide America with a sufficiently certain tax law for the future? Notice that I did not ask why it is unable. Congress is capable of doing so, but chooses not to do so. The answer is that uncertainty provides members of Congress with the opportunity to use the promise or threat future tax law changes as bargaining chips in their continued pursuit of political power for the sake of power. Greed, it should be noted, isn’t restricted to the desire for money per se, although one significant consequence of holding political power is, as has too often been demonstrated, access to money. Perhaps, once business leaders realize that the very conditions of which they complain that are making business decisions so impossible to make are generated by a Congress grown addicted to campaign contributions and lobbying efforts with respect to specific tax provisions, they will turn their attention to fighting for more certainty, even at the expense of those who profit by pushing for continual changes in the tax rules.

Cleland proclaims that “This annual ‘Festival of the Tax Extender” needs to end.” Yes, indeed. It is time to stop extending the practice of tax extenders.

Advocates of minimizing or reducing taxation and government regulation claim that the economy prospers when the marketplace is left alone to fend for itself. Of course, centuries of experience teach that the free market is not free, and that an unregulated market leads to fraud, deception, defective goods, shoddy services, and economic difficulties. But even if the free market were truly free of those afflictions, the capitalist nature of the marketplace inevitably leads to its own demise, or at least a near-demise that invites government rescue and bailouts, thus shifting the cost of market failure from those who cause it to those who already are suffering from it. By its nature, capitalism is a game in which the players try to acquire maximum capital ownership and maximum profits, which can be used to obtain additional capital. Its natural trajectory is a shifting of capital from a wider population to an increasingly narrow group. One need only watch the game of Monopoly being played to observe how this works.

The downside to the natural trajectory of capitalism is that once one person owns the market, there no longer is a market. A marketplace requires more than one person, and ideally requires a large number of participants. In a global economy, the marketplace requires an enormous membership. Once the capitalism game reaches the point that one person, or one cooperative family, owns pretty much everything, the economy collapses. I made this point, for example, in Tax Policy Converts, in which I explained, “It’s simple. Destroy the middle class and let the nation’s infrastructure fall apart, and the top one percent will succeed in owning 99 percent of everything, but the everything that they will own won’t be much more than a trash heap.” Three years ago, in Job Creation and Tax Reductions, I explained that sustaining the economy requires a robust consumer segment, anchored on a robust middle class, and that enriching the rich at the expense of the middle class and making it more difficult for the poor to enter the middle class is contradicted by letting the monopolistic and oligarchic economic trajectory continue to spiral into economic destruction.

A week ago, in There Are Now Two Americas. My Country Is a Horror Show, David Simon suggests that the flaw in capitalism that threatens itself is its disregard of labor. In other words, capitalism fails to recognize the value of human capital, instead focusing on financial and monetary capital. He posits that by letting that financial capital, measured by profit, become the measure of societal health has been a grave mistake. He explains that when the American economy was thriving, it was because neither capital nor labor was permitted to dominate the marketplace. Using his words, it’s “in the tension, it’s in the actual fight between [capital and labor], that capitalism becomes functional, that it becomes something that every stratum in society has a stake in, that they all share.” In other words, when the economy becomes a huge Monopoly game and people are kicked out, eventually the winner is left sitting there with a pile of money and no one with whom to negotiate or trade. The problem is that, unlike a game that can be put back on the shelf, the national economy cannot be permitted to come to such an end. Simon’s article continues, to explain how that end will come.

So how does taxation come into play? Taxation is the brake on the downward spiral of unchecked capitalism. It is the tempering effect on the monopolistic and oligarchic trajectory. It provides a way for everyone to stay in the Monopoly game so that the game does not end. Because if the game ends, the outcome will be far worse than the horror show described by Simon in his article. It’s a long article, it isn’t a sound bite fest, and it is essential that people invest more than 30 seconds to read and understand what has been masked by the slogans of politicians and the clichés of the media.

An article in Sunday’s Philadelphia Inquirer asked whether the premise of the movie Delivery Man, that a man could father 533 children, “could . . . really happen?” The answer not only is yes, in theoretical terms, but yes, in practical terms. A Toronto filmmaker has explained that after researching his origins, he discovered that he is one of approximately 1,000 children of the same sperm donor, a man who some decades ago operated a fertility clinic in Great Britain. And, of course, there is Genghis Khan, who almost certainly sired more than a thousand children, making him, as explained in this article, someone who claims 16 million direct male descendants and hundreds of millions of descendants through non-patriarchal lines.

There is no limit in the tax law on the number of dependency exemptions that a person can claim on account of having children, provided the requirements are met. Generally, the children of sperm donors do not qualify as dependents of the sperm donors, and thus there surely has never been a tax return on which hundreds of dependency exemption deductions have been appropriately claimed. The several returns on which taxpayers have claimed the entire population of the country as dependents, as an expression of protest against one thing or another, must be dismissed as irrelevant. Similar issues can exist with respect to the child credit, the earned income credit, and medical expense deductions.

All sorts of non-tax issues present themselves with respect to sperm donation, egg donation, and other forms of assisted reproduction. One question, or for some, a serious concern, is that one man becoming the father of numerous children raises the possibility that, absent knowledge of the identity of their biological fathers, people who meet, date, and marry could be having intimate relationships with a half-sibling without realizing it. Again, this is not a theoretical concern. It has happened. In Ireland, according to this story, an unmarried woman became pregnant, had a son, but did not tell the father, who married another woman, and had a daughter who some years later met the son, and had a child by him, not knowing he was her half-brother. According to another story, twins who were separated at birth met, married, and later had their marriage annulled. Some years ago, a similar situation happened in Massachusetts though I cannot find the story.

Though the question was posed in the Philadelphia Inquirer article on account of sperm donation, the issue can arise in other situations, as the two previous articles indicate. In England, legislation has been proposed to include on birth certificate information about both parents, and information about sperm donation and biological parents. Though sperm banks have rules in place intended to prevent these problems, those rules are based on statistical chance. Because sperm donation is not the only way children with the same father can grow up not knowing they are biologically related, the solution needs to rest with identifying the child’s DNA. Two people who want to confirm that they are not closely related ought to have the ability to compare parental DNA. Currently, people do not have legal rights to identify their ancestral DNA. That needs to change. That proposition surely will trigger objections, arguments, questions, and concerns. Of course it will. The same wave of technological advances that have revolutionized reproduction also has revolutionized information access. The two go hand-in-hand. One wonders how, if at all, the tax law will be implicated. If legislators do not hesitate to get the IRS and state revenue departments involved in health care law, energy law, education law, environmental law, and just about every other area of law, it is not unlikely that if legislators decide to deal with a growing problem they will involve the tax law to some extent.

A recent Tax Court decision, Katz v. Comr., T.C. Summ. Op. 2013-98, demonstrates the importance of filing forms in a timely manner. In this case, the form in question was Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent.

The taxpayer married in 1989. He and his wife had two children. The taxpayer and his wife divorced in 2005. The state court awarded join legal custody of the children to the taxpayer and his former wife, and awarded primary physical custody to the former wife. The decree also stated that the taxpayer and his former wife were each “entitled to claim one child for tax dependency exemption purposes” on their tax returns, and also provided that “[e]ither party may purchase the income tax exemptions awarded to the other party by paying to said party an amount equal to the tax savings received by said party as a result of utilizing the exemptions in the tax year. In 2009 or early 2010, the taxpayer and his former wife agreed that the taxpayer would pay $908 to her for the dependency exemption for 2009. On the 2009 federal income tax return, the taxpayer claimed a dependency exemption deduction for each of the two children. The former wife did not execute or deliver to the taxpayer a Form 8332 for 2009, until the day before the Tax Court trial, and immediately before trial the taxpayer furnished that form to IRS counsel. On her 2009 federal income tax return, the former wife claimed a dependency exemption deduction for each of the two children. The IRS did not audit her return nor disallow her claimed dependency exemption deductions. However, it disallowed the taxpayer’s claim for the two dependency exemption deductions.

The Tax Court began its analysis by pointing out that under section 152(e)(1), the child who is in the custody of one or both of the child’s parents for more than one-half of the calendar year and receives more than one-half of his or her support from parents who are divorced is treated as the qualifying child of the custodial parent. Section 152(e)(4)(A) provides that the custodial parent is the parent having custody for the greater portion of the calendar year. Under section 152(e)(2)(A), the child is treated as the qualifying child of the non-custodial parent if certain criteria are satisfied, including the signing of a Form 8332, or its equivalent, releasing the custodial parent’s claim to the dependency exemption deduction. Section 152(e)(2)(B) requires the non-custodial parent to attach that signed Form 8332 to his or her federal income tax return.

The Tax Court agreed with the IRS that the special provisions of section 152(e) applied because the taxpayer and his former wife were divorced, and that the former wife was the custodial parent in 2009. The Tax Court also agreed that the taxpayer was not entitled to claim the dependency exemption deduction unless a Form 8332 was signed, delivered to the taxpayer, and attached to his 2009 return. The Tax Court rejected the claim that the Form 8332 signed the day before trial and delivered to IRS counsel at the outset of the trial satisfied the requirement. It explained that because the former wife had claimed both dependency exemption deductions on a return for which the statute of limitations had expired, permitting the taxpayer to claim the deductions for the same two children “would contravene the intent of the statute by allowing both parents to claim a dependency exemption deduction” for the children. Quoting from another recent decision, the court explained that once the statute of limitations expired, “the custodial parent’s claim of the child as a dependent is not susceptible to being disturbed,” and thus “any statement by her that she ‘will not claim such child as a dependent’ for that year would be absurd.”

The Tax Court also rejected the taxpayer’s argument that he was entitled to the dependency exemption deductions because the divorce decree stated that each of the two parties was entitled to claim one exemption and permitted him to purchase, as he did, the other exemption. The court made it clear that “it is the Internal Revenue Code, and not State court orders or decrees, that determines a taxpayer’s eligibility for a deduction for Federal income tax purposes.”

There is a lesson here for those who prepare divorce decrees in cases where the parties want to make one or more of the exemptions available to the non-custodial parent. Whether the decree is prepared by the judge, prepared by lawyers and signed by the judge, or prepared by the parties using self-help software or forms found on the internet, the key to making the desired provision work as intended is ensuring that the Form 8332 is executed and delivered in a timely manner. Thus, the decree ought to impose a requirement that the Form 8832 be so executed and delivered, and as an incentive, provide that failure to do so requires the non-complying party to pay to the other party the amount of federal and state income tax liability increases to which the other party is subjected because of the failure of the non-complying party to sign and deliver the Form 8832.

Two separate experiences have caused me to think that the tide may be turning. Both experiences involve attitude changes by those who advocate reducing or eliminating taxes.

The first experience was stumbling upon a post on the Addicting Info blog. In Rich People Do Not Create Jobs – Wall Street Vulture Henry Blodget Has Epiphany, Egberto Willies describes how Henry Blodget, barred from the securities industry for “pumping up the value of stocks even as he privately expressed negative views of the companies the stocks represented” published Sorry, Folks, Rich People Actually Don't 'Create The Jobs', in which he repudiated the mantra espoused by so many of his peers that cutting taxes for the wealthy creates jobs. Instead, Blodget points out that jobs are created by “A healthy economic ecosystem — one in which most participants (especially the middle class) have plenty of money to spend.” His analysis builds on the perspective provided by another tax policy convert, Nick Hanauer. Interestingly, before Hanauer stepped forth, I had made the same point in Job Creation and Tax Reductions. A little more than a year later, when Hanauer came out with his revelation, I applauded Hanauer’s stand, and re-iterated my position. In Not All Wealthy Individuals Support Tax Cut Preferences for the Wealthy, I again pointed out that “What will create jobs is an increase in demand, 90 percent of which comes from the 99 percent who are not in the economic top one percent.”

The second experience occurred at the gym, one of my favorite spots for sounding out a cross-section of Americans on a variety of issues, including tax policy. On Wednesday, a friend who has been supportive of tax cuts commented that “they’re trying to double the federal gas tax, and Pennsylvania just raised it, so we’ll probably be paying four or five dollars per gallon.” Of course, I interjected to point out that the choice is between paying $100 in additional gasoline taxes or $500 in front end alignment fees, wheel balancing expenses, and new tire costs. His reaction surprised me. He said, not in these precise words, “The roads are a mess, they need to be fixed, and the people who use the roads should pay for the roads.” Indeed. I made this point in Potholes: Poster Children for Why Tax Increases Save Money and in several earlier posts cited in therein.

Perhaps America is waking up. Perhaps the tide is turning, and at least some of people formerly buying into the sales pitch of the anti-tax crowd and the ultra-wealthy whom they adore are now seeing what those awful “don’t tax but spend” policies of the first decade of this century have wrought. The Blodget article should be required reading in every home, in every business, and in every classroom in which economics is being taught. It’s simple. Destroy the middle class and let the nation’s infrastructure fall apart, and the top one percent will succeed in owning 99 percent of everything, but the everything that they will own won’t be much more than a trash heap.

Two weeks ago, in If They Use It, Should They Pay?, and its follow-up, The See-Saw World of Legislating Infrastructure Funding, I described the long and twisted path taken by Pennsylvania legislation that provided transportation infrastructure funding through, among other things, elimination of the cap on the wholesale liquid fuels tax. During the debate, some politicians suggested that at least part of the resulting increase in the cost of gasoline and diesel fuel might be absorbed by oil companies. According to this report, it is very unlikely that the resulting tax increase will be absorbed by oil companies, suppliers, or retailers. The increase will show up at the pump.

The report also noted that the price of gasoline is expected to drop by as much as 20 cents per gallon. The removal of the limitation on the wholesale tax translates to a 9.5-cent per gallon increase in the price of gasoline. Putting those two facts together caused me to consider the different reactions one sees among consumers when a tax is increased or decreased. For example, if the 9.5-cent tax increase kicked in at the same time gasoline prices were rising, or even if gasoline prices were steady, there would be much more unfavorable reaction than if the increase is offset or even exceeded by a reduction in product price. In the former instances, the tax increase is very noticeable. In the latter instances, it isn’t noticed at all by most consumers. Although people presumably are happier if the price of gasoline drops by 20 cents per gallon than if it drops by 10 cents per gallon, most people react happily when the price drops by 10 cents per gallon. Only a few are miserable because the price did not drop by 11 cents, 15 cents, 20 cents, or more, and of course some people are distressed and angry because the gasoline, unlike the food and other items provided to them by their parents when they were children, is not free.

The temptation facing savvy politicians is to raise taxes when prices are dropping. The increase is much less likely to be noticed. Consumers are fixated on the bottom line. Who thinks they have the better deal, the person who pays $106 for an item based on a price of $100 plus a 6 percent sales tax, or the person who pays $96.30 for the same item based on a price of $90 plus a 7 percent sales tax? Though it is not uncommon to find people driving to another state to make a purchase because the sales tax is lower in the visited state, do consumers drive to states with higher sales tax rates if the price of the product is lower? I think so.

Though timing an increase in sales taxes based on price fluctuations is difficult because the sales tax applies to such a wide variety of items that the price fluctuation is varied, it is easier to time increases in specific taxes because such a tax, such as a gasoline tax, applies to just one product or perhaps a handful of products. Thus, I wonder if part of the delay in getting the legislation through the Pennsylvania legislature reflected a decision to wait until gasoline prices were headed downhill. It’s not that the funding was unnecessary, it’s just that the timing makes it more palatable. And when it comes to taxation, that matters.

A recent Tax Court case, Tucker v. Comr., demonstrates how one word, in this instance, the word “may,” may make a tax difference. The taxpayer and his wife were married in 1985 and separated in 2004. In April of 2009, the state trial court issued a memorandum that identified and distributed the marital estate, established child support, and awarded spousal support. The memorandum ordered the taxpayer to pay $2,414 to his soon-to-be former wife, and also ordered him “to provide for [her] health insurance in the amount of $1,400 per month.” In August of 2009, the state trial court issued the final divorce decree, which affirmed, ratified, and incorporated by reference the memorandum. The court ordered that the taxpayer ‘shall pay to [the former wife] the sum of $1,400 per month in addition to spousal support to assist [her] in paying health insurance premiums. This is not in the nature of spousal support and shall not be taxable to [her] nor deductible to [taxpayer] for income tax purposes.” The taxpayer appealed the order, seeking to remove the “not in the nature of spousal support” language, arguing that the trial court did not have authority to order health insurance premium payment not in the nature of spousal support. The state appellate court affirmed the lower court’s decision with respect to the health insurance premiums, explaining that the lower court may designate a payment as “in the nature of spousal support” for bankruptcy purposes but as “not in the nature of spousal support” for income tax purposes. Because the case was remanded on other issues, the trial court issued a final decree, which retained the same language with respect to the health insurance premiums.

The taxpayer claimed an alimony deduction for the health insurance premium payments that he made to his former wife. The IRS disallowed those deductions. The taxpayer and the IRS agreed that the payments satisfied three of the four requirements for a payment in cash to be deductible alimony. They agreed the payments were made pursuant to a divorce or separation instrument, that the taxpayer and his former wife were not members of the same household, and that the taxpayer’s obligation to make the payments will not survive the death of the former spouse. The parties disagreed on whether the divorce or separation instrument designated the payments as not includible in gross income for the payee and not allowable as a deduction for the payor.

The taxpayer argued that even though the divorce decree characterized the payments as nondeductible by the payor, the statutory requirement is not satisfied unless the spouses intend for that designation to be made. The taxpayer pointed to Q&A-8 of Temp. Regs. Section 1.71-1T(b), which provides that the “spouses may designate that payments otherwise qualifying as alimony or separate maintenance payments shall be nondeductible by the payor and excludible from gross income by the payee by so providing in a divorce or separation instrument.” The taxpayer argued that the phrase “spouses may designate” demonstrated that the state trial court lacked the authority to include the non-deductibility language in the decree without the consent of both spouses. The taxpayer also argued that despite the “for income tax purposes” language in the decree, the state trial court had not contemplated an income tax designation for the health insurance premium payments.

The Tax Court rejected the taxpayer’s arguments. It noted that the language in Q&A-8 provides that the parties may agree to designate payments as non-deductible, but in doing so the regulations allow the spouses to so agree but do not provide the spouses with complete authority to define the payments. The Tax Court explained that the regulations do not contemplate or regulate a state court’s ability, in its discretion, to make the designation. In other words, the designation may be made by the spouses but there is no requirement that it must be made by the spouses. The Tax Court further explained that to accept the taxpayer’s arguments would require federal courts, in resolving the issue, to return to the practice of examining the intent of the spouses, an approach that the Congress eliminated when it amended section 71 in 1984.

Is it possible to write the regulation differently, in a way that would make it easier for taxpayers to avoid getting caught up in this sort of case? Yes. Consider this language: “If a divorce or separation instrument designates a payment as nondeductible for the payor and non-includable for the payee, the payment does not qualify as an alimony or separate maintenance payment, and thus is not deductible by the payor nor includable in the gross income of the payee. It does not matter whether the language appears in the instrument because the spouses agreed to the language and requested the state court to include it in the instrument, because one of the spouses requested the inclusion of the language, or because the state court on its own initiative and through exercise of its discretion included the language in the instrument.”