Monday, July 21, 2014
However, those statements are incorrect. They need to be qualified. For example, section 71 provides that if the divorce or separation instrument specifies that the alimony payments are not includible in the payee’s gross income and not deductible by the payor, they are not includible in gross income and not deductible. As another example, alimony paid while the spouses are members of the same household do not qualify as “alimony or separate maintenance payments” that are includible in the payee’s gross income and deductible by the payor. The use of the term “Generally,” or the phrase, “Unless an exception applies,” would change the statements from incorrect absolutes to accurate representations.
Friday, July 18, 2014
In 2011, I explained, in The Flat Tax Myth Won’t Die that the flat tax “does absolutely nothing to address the question of timing. It does not simplify, for example, installment sale rules, or the dozens of nonrecognition provisions that pepper the Code.” I also pointed out:
A flat tax does not resolve the continuing debate with respect to international taxation. The question of how nonresident aliens and foreign corporations should be taxed, and the question of how American taxpayers should be taxed with respect to overseas operations, is not one that goes away if section 1 is reduced to one tax rate.Repealing nonrecognition provisions would generate cash flow burdens that would stifle the economy, and retaining those provisions to sustain the economy amounts to retention of tax complexity requiring multiple volumes to explain.
The flat tax, of course, is a sound bite, a nice-sounding phrase that suggests a magic solution to a complex set of problems. It is yet another indication of a theory struggling to survive when it meets reality. It’s a myth, one that falls flat.
Wednesday, July 16, 2014
Aside from the erroneous use of gross income rather than taxable income in selecting a tax bracket, the principal problem with the misuse of the tax rate schedules is the treatment of what is a marginal tax rate as though it were an average rate. For example, if taxable income of up to $50,000 is taxed at 20 percent, and taxable income above $50,000 is taxed at 30 percent, a person with taxable income of $60,000 would be subject to a tax liability of $13,000 ($50,000 x .20, plus $10,000 x .30). It is easy for someone in that situation to claim that they are taxed at 30 percent, but in fact, their tax liability of $13,000 is 21.7 percent of $60,000. Failure to understand the difference generates exaggeration, which in turn triggers more resentment than is warranted.
What makes this myth even more insidious is that when phase-outs are taken into account, and tax liability is divided by taxable income, the average rates are highest not for those with the highest taxable incomes, but for those in the middle brackets, and in some instances, for some taxpayers in lower brackets. I explained this tax quirk in A Foolish Tax Idea Resurfaces.
Americans’ confusion with average and marginal tax rates provides fertile ground for the growth of misleading claims and absurd hyperbole. The myth that people are taxed at the highest nominal marginal rate on all of their income is a myth that needs to die.
Monday, July 14, 2014
What sustains this myth is a combination of ignorance, experience, and revenue department inefficiency. Most taxpayers do not understand that a use tax exists, the conditions under which it applies, and their legal obligation to pay it. Most taxpayers who cross the border to make purchases in states without sales taxes and return home with their purchases do so without any adverse effect, aside from the classic situations involving vehicles, boats, and a few other “big ticket” items. Revenue departments have insufficient resources and mechanisms to collect use taxes aside from “big ticket” items, and because the cost of collecting use taxes is a much higher percentage of the tax when compared to the cost of collecting in-state sales taxes, use tax collection is inefficient and spotty, as I explained in Collecting the Use Tax: An Ever-Present Issue.
Many states are making efforts to educate the public with respect to use taxes. Some are trying to incorporate some sort of flag in state income tax forms. The effectiveness of those efforts is low. Until people become accustomed to paying use taxes, the myth will persist because the non-compliance persists. At some point, states might decide to bring tax education into their K-12 systems, and some have, to some limited extent, but until it is pervasive, this myth will endure.
Friday, July 11, 2014
It is understandable why this myth circulates and has traction. Most people who collect tips are paid very little, rely on the tips to make a living, and are unhappy to learn that tips are included in gross income. Worse, certain employers are required to report tip income on Forms W-2 issued to employees based on formulas, so that occasionally an employee might end up paying taxes on an amount of tips slightly higher than what the employee actually received. These situations also are very rare.
Another reason for this myth’s endurance is confusion generated by discussion of sales taxes. In most states, sales tax is computed with respect to the cost of goods and services exclusive of tips unless the tip is built into the stated price. Explanations of this principle often includes the words “tips are not taxable,” which people take out of context. The context provides the modifier “for sales tax purposes,” which should preclude treating the statement as applicable “for income tax purposes.”
Wednesday, July 09, 2014
In some instances a refund, or a portion of a refund, arises from a refundable credit. In these situations, the money paid to the taxpayer is coming from the United States Treasury courtesy of the United States Congress, or from a state treasury courtesy of a state legislature.
In many instances, the refund is nothing more than the IRS returning to the taxpayer some, or in some rare cases all, of what the taxpayer has paid in through withholding and estimated tax payments. I suppose that those who are concerned that the federal government or a state government might run out of money before the refund is paid are overjoyed when the refund arrives, but as a realistic, practical matter, simply getting one’s money back isn’t a joyous occasion. Actually, it’s a bit sad, because the money that is being refunded hasn’t earned interest.
Monday, July 07, 2014
Whether a person has a tax liability cannot be determined simply from the existence of a refund. Though a person who is not getting a refund because additional tax is due surely is paying taxes, a person who receives a refund can fall into one of two categories. Some taxpayers receive a refund because they have a zero tax liability, and had taxes withheld, paid estimated taxes, or qualify for a refundable credit. But many taxpayers receive a refund and yet have a tax liability. The refund arises because they had taxes withheld and paid estimated taxes in amounts exceeding the tax liability.
When people want to know whether or not they are paying income tax, they need to look at the line on the return that shows “tax liability.” The lines for refund and for additional payment simply reflect the extent to which the amounts that have been paid match with the tax liability. A taxpayer who has $10,000 of federal income taxes withheld from wages and who has a tax liability of $7,500 rejoices at the prospect of a $2,500 refund, but ought not declare, “I’m not paying taxes.” That taxpayer has paid $7,500 in federal income taxes. Worse, they have made an interest-free loan of $2,500 to the applicable federal or state government.
Friday, July 04, 2014
This myth gets people in trouble. For example, one commentator suggested, “First of all, work in the underground economy: No w2’s or 1099’s.”
The reality is simple. Items that are gross income must be reported on tax returns whether or not a Form W-2 or Form 1099 is issued to the recipient of the income. Some types of income cannot be reported on such a form because there is no one to issue the form. For example, a taxpayer who finds a $100 bill on the street and keeps it has gross income, but will never receive a Form W-2 or Form 1099. In some instances, payors are not required to issue Forms 1099 if the amount in question is less than a specified amount, usually $600. That rule, designed to reduce reporting burdens on payors, does not mean that amounts of less than $600 are not gross income.
Wednesday, July 02, 2014
The “it’s not cash, so it’s not taxed” myth flourished in the early days of the barter boom. Some barter exchanges at the time listed “tax free” as one of the advantages of bartering. Eventually, the IRS engaged in an education effort that eliminated almost all of the barter under-reporting, at least among the commercial barter exchanges. There surely are barter transactions taking place in settings that are informal and occasional, with participants thinking that the absence of cash makes the transaction nontaxable.
What fuels the “it’s not cash, so it’s not taxed” myth are several perceptions. One arises from a notion that things usually taxed, such as wages and interest, are almost always paid in cash, a concept that some people translate into a conclusion that to be taxed, it needs to be in cash. Another arises from the rationalization that the lack of liquidity arising from the receipt of property rather than cash permits dispensation from taxation because of the lack of cash with which to pay tax.
This particular myth doesn’t circulate as often and as widely as the “IRS enacts Code provisions” myth. Whether it disappears entirely remains to be seen.