MauledAgain

Recently, reader Morris sent me an email with the subject line, “What grade would you give this student?” In the body of the email was a link to The Bottom Line / Ask Marilyn: What to Do with a Financial Windfall.

The question posed by a reader of the column was a simple one. The reader found a diamond ring and wanted “to limit her tax liability around the sale” of the ring that the reader wanted to make.

The response was surprising:

“Yes, the gain of the sale is taxable. If you've held that asset less than a year, then it will be taxable at your regular income tax rate. However, the big question is your long-term tax rate of capital gains.

“Capital gains are defined as the profit from the sale of property or of an investment, and you have to pay taxes on it. (The IRS considers jewelry is considered a capital asset, not a “collectible,” which is taxed at a higher rate.) This rate could be as high as 20% or as low as 0%, depending on your income level.

“This means that if you hang onto the ring for over a year, the tax rate on the income from selling it will be lower.

“Even with the above, it might be beneficial to sell the ring under someone else's name–a parent or a child, for instance. However, that could affect that other person's tax liability, as well. For instance, if your parent is getting social security benefits, having them report the sale could end up making their benefits taxable. Make sure to consider the tax situation of anyone you consider having report the sale, so you can plan for the best outcome.”

Let’s begin at the beginning.

When the person finds the diamond ring and keeps it, whether or not legally doing so, the person has ordinary income equal to the value of the ring. That is well-settled federal income tax law. It is a topic that students in a basic federal income tax course encounter early in the course. As a corollary to that outcome, the person acquires a basis in the ring equal to the amount of gross income reported. If the person sells the ring within a short period of time, the person will have zero gain and zero loss. In fact, the sale price of the ring is a major factor in determining the value of the ring at the time it was sold, with the passing of a few weeks or months having no practical impact on the valuation issue. That means the determination of whether the gain is short-term or long-term is an issue that does not need to be addressed. Of course, if the reader holds the ring for a longer period of time and its value does change then there would be gain or loss, its long-term or short-term character depending on the length of time the ring is held before being sold.

The advice that “it might be beneficial to sell the ring under someone else's name” is tantamount to fraud unless the ring is the subject of a bona fide gift to the other person. That would require the finder to wash their hands of any involvement in the decision of the done to sell or not sell the ring or any of the details with respect to any sale. The idea of having someone else “report the sale” is downright dangerous advice.

So what grade would I give the answer if the question were an examination question and the answer came from a student in the course? My method of grading examinations generates scores, which are then combined with scores from other facets of the course to generate a course grade. The examination contains more than one question, so the best I can do is to offer two conclusions. First, this answer would earn zero points. Second, if this question was the only question on the examination and there were no other score-generating activities in the course, the course grade would be an F.

If I were to put a question as simple as this one on an examination it, along with one or two others, would fall into a category designed to make it easy for a student to show that they learned at least something in the course, and scoring well on those questions, and only on those questions, would bring the course grade to a D. In my grading construct, the D is the grade indicating “well, at least you learned something.”

For those who, not unlike students, would argue that the answer indicates a knowledge of short-term and long-term capital gain rates, my response is that the question did not seek any discussion of that point. One of many skills that need to be acquired or polished in law school – in fact, in every discipline – is to answer the question that is asked and not the question the person wishes would have been asked. To see how this works in the practice world, check out any Judge Judy episode when she asks a question and gets an answer that isn’t an answer to the question she asked. And let’s not mention the negative effect of the horrible advice to put the sale in another person’s name.

Both major party candidates for the presidency have expressed support for the notion of eliminating federal income (and perhaps employment) taxes on tips. There is no question that this is a ploy designed to gather votes, especially since the proposal wouldn’t amount to much of a benefit, if at all, for most workers who rely on tips to make ends meet.

Why would this proposal do little or nothing for workers who rely on tips? According to several reports, such as this one from Axios, and this one from Alternet, Alex Morash of the advocacy group One Fair Wage, in a report compiled in collaboration of the University of California at Berkeley Food Labor Research Center, concluded that nearly one-half of tipped workers in restaurants earn less than the $13,850 cutoff for paying federal income taxes. About two-thirds of them live in households with income too low to create federal income tax liability. In other words, excluding tip income from the gross incomes of these workers does absolutely nothing for them. I think the number of workers who would not benefit is even higher, because these computations apparently do not take into account any credits to which the workers may be entitled to claim. This conclusion is supported by analyses offered by the Tax Policy Center. And if tips are exempted from employment taxes, it jeopardizes the eligibility of tipped workers for Social Security and Medicare coverage or reduces what they are eligible to collect.

So who would benefit from excluding tip income from gross income? Most likely, the small percentage of tipped workers who collect large amounts of tips. Those workers, estimated to constitute about 5 to 10 percent of tipped workers, gather their tips at luxury hotels and restaurants. Though they would welcome a reduction in their federal income tax liabilities, assuming they have any, in the long run it would work to their detriment. Let’s see why.

Cutting federal income taxes on tips gives the employers of tipped workers another argument against raising the minimum wage or at least reducing any increase. Though excluding tips from gross income would benefit only a small percentage of tipped workers, the concept would help employers spare themselves the expense of raising wages for all workers, including those who are barely getting by even with tip income.

Who else might benefit? Tips are nothing more than another form of compensation for the performance of services. It should make no difference whether money flows directly from a customer to a worker or from the customer to the worker through the employer. In both instances the worker is receiving compensation. If the handful of tipped workers who pay taxes on their tips should be excused from doing so because they are perceived to be earning insufficient income, then the same benefit should be given to all other workers who are earning the similar amounts of insufficient income. In other words, raise the standard deduction or make adjustments in the tax rate schedules rather than singling out one class of worker for special treatment.

Then there are those who would manipulate the system to convert non-tip forms of compensation into tips. Already there are planners thinking about ways to make this happen. It’s not my intention to provide blueprints for this sort of behavior other than to note that it is possible. Imagine the impact on the economy, to say nothing of the operation of government, if suddenly all wage earners were being paid minimum wage and the rest of their pay in “tips.” It could be worse, as clever planners find ways to convert partnership and S corporation distributions, C corporation dividends, and other forms of income into “tips.” At least the presumptive nominee for one major political party includes in the proposal plans to find ways to prevent this from happening.

Of course, as is the case with many special interest tax provisions, the proposal is nothing more than a band-aid designed to soften rather than address the impact of the underlying problem. Even if the proposal to exclude tips from gross income was a sincere effort to help underpaid workers and not a vote-grabbing ploy in the state where it was announced, a state where a high proportion of workers rely on tips, it is a feeble excuse of a solution for the problem of underpaid workers. There needs to be an increase in the federal minimum wage, which has not been changed since 2009. Even though some states have stepped up to deal with this Congressional neglect, there are workers in states that have not done anything to deal with the problem. Worse, the federal minimum wage is sharply reduced for workers in industries where tipping is the norm, so long as the tips bring the worker’s hourly pay up to the federal minimum wage. This exception encourages tipping.

Tipping is a major ingredient of American culture. It’s different in other countries, where workers are paid a living wage and do not need to rely on the decisions of customers. Though many customers tip based on the quality of service, too many cut tips if they are unhappy with other aspects of their experience beyond the control of the tipped worker, too many don’t leave tips (or leave very tiny tips) because they “don’t believe in tipping,” too many “forget” to tip, and too many, including the many tourists from other countries, simply don’t understand the tipping culture. Making a shift from the “American way” of compensating workers in certain service industries to the pattern in place in other countries would be difficult but not impossible, and in the long run far more efficient.

Those who oppose changing the culture of tipping want to retain “a way to show the business that its services is terrible.” The way to show a business that its service is terrible is to stop patronizing the business. Then the business in theory fixes the problems or goes out of business. If the problem is the worker, the worker needs to be retrained or released. If the problem is something else, as it often is though “taken out” on the worker through a reduced or eliminated tip, then the business either fixes the problem or goes out of business.

Once again, it is apparent that blurting out something that “sounds good” in a sound bite or tweet isn’t so good when the idea is subjected to examination, analysis, and critical thinking. Very few Americans understand the full ramifications of a simple “stop taxing tips” ploy. It’s not that simple.

It’s been a while since I wrote about a television court show. Today reader Morris directed me to an episode of Justice For All with Judge Cristina Perez. He asked me about the tax consequences of the transactions at issue. I have addressed tax issues in television court shows many times, in posts such as Judge Judy and Tax Law, Judge Judy and Tax Law Part II, TV Judge Gets Tax Observation Correct, The (Tax) Fraud Epidemic, Tax Re-Visits Judge Judy, Foolish Tax Filing Decisions Disclosed to Judge Judy, So Does Anyone Pay Taxes?, Learning About Tax from the Judge. Judy, That Is, Tax Fraud in the People’s Court, More Tax Fraud, This Time in Judge Judy’s Court, You Mean That Tax Refund Isn’t for Me? Really?, Law and Genealogy Meeting In An Interesting Way, How Is This Not Tax Fraud?, A Court Case in Which All of Them Miss The Tax Point, Judge Judy Almost Eliminates the National Debt, Judge Judy Tells Litigant to Contact the IRS, People’s Court: So Who Did the Tax Cheating?, “I’ll Pay You (Back) When I Get My Tax Refund”, Be Careful When Paying Another Person’s Tax Preparation Fee, Gross Income from Dating?, Preparing Someone’s Tax Return Without Permission, When Someone Else Claims You as a Dependent on Their Tax Return and You Disagree, Does Refusal to Provide a Receipt Suggest Tax Fraud Underway?, When Tax Scammers Sue Each Other, One of the Reasons Tax Law Is Complicated, An Easy Tax Issue for Judge Judy, Another Easy Tax Issue for Judge Judy, Yet Another Easy Tax Issue for Judge Judy, Be Careful When Selecting and Dealing with a Tax Return Preparer, Fighting Over a Tax Refund, Another Tax Return Preparer Meets Judge Judy, Judge Judy Identifies Breach of a Tax Return Contract, When Tax Return Preparation Just Isn’t Enough, Fighting Over Tax Dependents When There Is No Evidence, If It’s Not Your Tax Refund, You Cannot Keep the Money, Contracts With Respect to Tax Refunds Should Be In Writing, Admitting to Tax Fraud When Litigating Something Else, When the Tax Software Goes Awry. How Not to Handle a Tax Refund, Car Purchase Case Delivers Surprise Tax Stunt, Wider Consequences of a Cash Only Tax Technique, Was Tax Avoidance the Reason for This Bizarre Transaction?, Was It Tax Fraud?, Need Money to Pay Taxes? How Not To Get It, When Needing Tax Advice, Don’t Just “Google It”, Re-examining Damages When Tax Software Goes Awry, How Is Tax Relevant in This Contract Case?, Does Failure to Pay Real Property Taxes Make the Owner a Squatter?, Beware of the Partner’s Tax Lien, Trying to Make Sense of a “Conspiracy to Commit Tax Fraud”, Tax Payment Failure Exposes Auto Registration and Identity Fraud, A Taxing WhatAboutIsm Attempt, When Establishing A Business Relationship, Be Consistent, as the Alternative Can Be Unpleasant Litigation, Sadness on Multiple Levels: Financial Literacy, Factual Understanding, Legal Comprehension, When the Lack of Facts Produces “Rough Justice” in a Tax-Related Case, and Is the Tax Return Preparer or the Client Responsible For Unjustified Deductions?.

The case that reader Morris brought to my attention interested me not only because of the tax issues, which are actually very straight-forward, but also because of the underlying facts. A young woman, who was tired of attending family events by herself because everyone else was married or had a significant other, hired a young man to pretend to be her date for Thanksgiving weekend with her family. She found the fellow on a website that provides a platform for those who want a date to contact those who are willing to be, as the judge put it, “fake dates.” The young woman not only paid the young man $750 per day for the four days, but also paid about $2,400 to cover the cost of his flight, hotel room, and transportation. One of the terms of the contract was that the young man’s status as a fake date was not to be revealed.

Things went well the first day. One of the young woman’s cousins who was at the family gathering stayed, with her boyfriend, at the same hotel at which the young man was staying. On Thursday night or Friday morning, the cousin broke up with her boyfriend because he was getting multiple phone calls from another woman, with whom he met up after the breakup. When the “fake date” showed up at the family home he was accompanied by the cousin, and the two of them were being very affectionate. According to the young woman who hired the date, he pretty much ignored her and focused on the cousin.

After the four-day date ended, unbeknownst to the young woman, the young man entered into a relationship with the cousin. About a month later, when the young woman’s family held its Christmas gathering, the young man showed up with the cousin, as boyfriend and girlfriend. Things took a bad turn when the cousin “told everyone” that the supposed boyfriend of the young woman was a “fake date” hired by her. It turns out that the young man had told the cousin about the hired date arrangement in order to assure her that he was not in a relationship with the young woman.

The young woman sued the “fake date” for a return of the $5,400 that she had paid directly to him and to provide him transportation and lodging. Judge Perez declared that it was the easiest case she had heard all week, and held in favor of the young woman for the full $5,400.

Reader Morris asked me four questions: “Does the defendant have gross income? Is it business income on Schedule C? Does the Plaintiff have any federal tax consequences? Can the defendant deduct the judgement for breach of contract as a business expense on his Schedule C?”

My answer was rather short. “Yes, the defendant has gross income that is reported on Schedule C. The defendant also offsets gross income by the amount refunded to the plaintiff, just as any service provider refunds a customer when the service fails to comply with the contract. Thus there is no need for a deduction. The plaintiff has no tax consequences because the transactions were personal in nature and not connected with a trade or business or for-profit activity.”

The tax conclusions aren’t novel or complex or bewildering. The underlying facts, though, are far more interesting than, for example, a lawn service customer suing a lawn maintenance company for damaging trees or breaking a fence. When people tell me that tax is boring, I reply that it often is but the underlying stories are what makes it interesting.