MauledAgain

A recent case addressing the validity of the "check the box" entity classification regulations illustrates why simplification isn't a simple task. In Littriello v. United States, No. 3:04CV-143-H (W.D. Ky. May 17, 2005), the District Court held that those regulations were valid. The significance of the case, the first in which the issue was decided, is tempered by several factors. It is a district court decision. The case may be appealed. Criticism of the decision abounds. Nonetheless, there may be a lesson in the story for advocates of simplification. It isn't and won't be easy.

The basic question is an easy one. So long as corporations and partnerships are taxed differently for income tax purposes, it matters whether an entity is a corporation or a partnership. Although many people unfamiliar with legal issues might react justifiably with the comment, "It is what it is," the simple (ha ha) fact is that sometimes it isn't clear what it is. Certainly something formed as a corporation under state law is a corporation. Yes, that's easy. And simple. But what about the hybrid creatures of state law and the law of foreign jurisdictions?

Some history is not only helpful, but necessary. An abbreviated outline must suffice, considering that extensive descriptions are easily found in the tax literature. Once upon a time, as all good stories begin, the tax law made being a corporation more advantageous than being a partnership. It had to do mostly with the treatment of deferred compensation, but those details don't matter. What matters is when the IRS interpreted the statutory definitions of corporation and partnership, which don't answer the tough question, it issued regulations that, in effect, made it difficult to be a corporation. Years passed, as sometimes happens in a good story. The first era of tax shelters dawned. Partnerships provided excellent vehicles for tax shelters because of, among other things, the pass-through rules, the inclusion of partnership debt in partner basis, and the then-wide-open ability to make all sorts of special allocations. When the IRS began challenging tax shelters, its principal attack rested on reclassifying the entity as a corporation. Because tax shelter operators preferred the limited partnership, and because limited partnerships do have some corporate-like features, such as limited liability, it wasn't all that outlandish to argue that they were corporations. In those days, the state of subchapter K meant that if the entity was a partnership, there were very few, if any, effective tools for the IRS to use to shut down the shelter. Thus, the conflict centered on entity classification.

Unfortunately, because the IRS' own regulations made it difficult for an entity to be a corporation, it also made it difficult for the IRS to prevail in court. Practitioners in the know had the expertise to structure a limited partnership so that it lacked sufficient corporate characteristics to be a corporation. As I told my classes, "If you want to be a partnership and know what you are doing, you can be a partnership." The folks who did NOT know what they were doing were the ones getting trapped, and their numbers were diminishing. Ironically, by this point many of the deferred compensation advantages accruing to corporations had dissipated because of legislation narrowing, and at that time, almost eliminating, the major differences between corporations and partnerships in terms of deferred compensation. So the IRS was left with regulations issued to prevent a perceived abuse that no longer existed to any substantial degree, but that made the task of shutting down tax shelters through judicial action almost impossible. So as limited partnership tax shelter "vehicles" proliferated, the IRS was drowning in ruling requests, audits, litigation, and other time-consuming efforts that went nowhere.

As time passed, state legislatures began to add other entity forms to the mix. The headline arrival was the limited liability company. What was it? Corporation? Partnership? In the meantime, the Congress, busily enacting not only a series of reforms to subchapter K that dampened the utility of partnerships as tax shelter vehicles (contributed property allocation rules, disguised sale rules, varying interest allocation rules, restrictions on special allocations, etc) but also the wider-focused at-risk and passive loss limitations, paid no attention whatsoever to the entity classification of LLCs or the other hybrids.

At this point, the IRS, knowing that expertised practitioners could cause the entity to be what it wanted to be, announced it was considering a regulation that permitted entities to file a form on which they simply "checked a box" to indicate that they wanted to be a corporation or a partnership, or, in the case of a single-member LLC, a sole proprietorship or division of a corporation. By the time the regulations were issued, the IRS shifted to a set of default rules, from which taxpayers could elect out. After all, why get deluged with hundreds of thousands of forms when most entities presumably would want to be partnerships? After all, by now the IRS had a stable of tools to use against improper tax shelters and no longer saw the issue decided simply on the basis of entity classification. Ironically, nowhere in the regulations is the phase "check the box" used. Someone searching a digital database of the tax regulations who uses that phrase as a search term will get nothing. Yet in the tax world, the regulations have that name. I use this as an example when teaching tax to explain how tax is more than a set of rules but a culture with its own terminology best known by its insiders.

In general, the check the box regulations are simpler than those they replaced. The ones they replaced required analysis of six characteristics. Determining whether an entity had a particular characteristic required an extensive analysis of its organic documents, its contracts, its side deals, its activities, and all other sorts of facts and circumstances. A flow chart of those regulations would fill dozens of pages. In contrast, most flow charts of the check the box regulations fill one or two pages, depending on how they are designed.

Most, if not all, taxpayers, took the check the box regulations as good news. They were simpler. They provided flexibility. They eliminated thousands of ruling requests, all sorts of classification audit attention, and litigation over classification. Essentially, entities formed as corporations are corporations. So, too, are a long list of specific foreign entities. Special entities, such as regulated investment companies and real estate investment trusts, are so classified and don't get treated as corporations or partnerships as such. Trusts are carved out and subject to the special tax rules applicable to trusts. All other domestic entities, including LLCs, are divided into two major groups: single-member and multiple-member. Single-member entities can elect to be corporations. Otherwise, they are disregarded, which means that if they are owned by an individual they are sole proprietorships and if owned by a corporation, they are divisions of the corporate owner. For multiple-member entities, they are deemed to be partnerships unless they elect to be corporations. The presumption is reversed for foreign entities in which no one has any liability.

So what happened?

Well, some commentators took the position that the IRS lacked the authority to permit something not a corporation to be taxed as a corporation. Or to let an LLC be treated as a division of a corporation. They rested their argument on the Supreme Court's decision in Morrissey v. Comr., 296 U.S. 344 (1935). In that case, the Court held that the Treasury was not barred from revising the entity classification regualations to treat business trusts as a corporations nor that it exceeded its powers in providing that the extent or lack of control by the trust beneficiaries was not solely determinative of the classification. The Court also held that because the trust's characteristics were like those of a corporation, it was an association taxed as a corporation. The commentators consider that decision, absent Congressional revision of the statute, to preclude Treasury (and the IRS) from permitting an entity that is like a corporation from being treated other than as a corporation. For example, in "Can Treasury Overrule the Supreme Court?, 84 B.U. L. Rev. 185 (2004)," (available here) Gregg Polsky argues, quoting from a message to me in response to my question about the issue, "that the regulations are invalid even assuming arguendo that they are consistent with the statute. In a nutshell, my argument is based on three Supreme Court decisions holding that the executive branch is bound by the Court's prior interpretations of a statute. *** Accordingly, I argue that, because the regulations are wholly inconsistent with Morrissey v. Comm'r, 296 U.S. 344 (1935), they would be determined to be invalid if challenged." Vic Fleischer, on the other hand, comes out on the other side, as he explains here. For another analysis supporting pass-through treatment as the default, see John Lee, Entity Classification and Integration, 8 Va. Tax Rev. 57 (1988).

So with commentators somewhat split on the issue, the next question is a practical one. Who is going to challenge regulations that not only are favorable to taxpayers but that pretty much let taxpayers elect what they want? The few taxpayers that have no choice, such as corporations formed as corporations, wouldn't stand a chance if they challenged the regulations. To have standing, a person must demonstrate that application of the regulation causes a direct detriment to that person. That's why none of us can sue if we don't like the fact, assuming we knew it, that the IRS accepted, on audit, the explanation of our neighbor concerning her deductions.

So the Littriello case came as a surprise to many. Why could the taxpayer challenge the regulations?

The taxpayer was the sole member of an LLC, which did not elect to be treated as a corporation for federal income tax purposes. Hence, it was treated as a sole proprietorship. Remember that under state law it was a separate entity. The LLC failed to pay over to the Treasury income and FICA taxes withheld from employees. So the IRS proceeded against the taxpayer, who paid and sued for a refund. The taxpayer argued that the LLC was liable but that he was not. After all, under state law, the LLC member is not liable for the LLC's debts. On cross-motions for summary judgment, the court held that the check the box regulations were valid and that the taxpayer was liable for the taxes because the taxpayer was the employer.

In analyzing the validity of the regulations, the court applied the two-part test set down by the Supreme Court in Chevron v. Comr., 467 U.S. 837 (1989). First, has Congres directly addressed the precise question at issue? Otherwise, the question is whether the agency's position is based on a permissible construction of the statute.

As to the first question, the taxpayer argued that the regulations violate the manifest intent of Congress that a partnership and corporation are mutually exclusive, because two identical business entities can elect different classifications, and the IRS replied that the term "association" in the statute is ambiguous. The court noted that the term "association" used in the statutory definition of corporation and the phrase "group, pool or joint venture" used in the definition of partnership are not clearly distinct. Because an LLC is not clearly a corporation or a partnership under state law, there is an ambiguity that justifies giving LLCs an elective choice.

As to the second question, the taxpayer argued that the plain meaning of the statute precludes an elective regime because "taxation as intended by Congress is based on the realistic nature of the business entity." The taxpayer's chief evidence supporting this argument were the former regulations that were replaced by the check the box regulations. Interestingly, the court noted that "The check-the-box regulations are only a more formal version of the informally elective regime under the [former] regulations. A business entity could pick at will which two corporate characteristics to avoid in order to qualify as a partnership under the [former] regulations." Although recognizing that "some reasonable arguments support [the taxpayer's] position," the court held that the check the box regulations "seem to be a reasonable response to the changes in the state law industry of business formation" and "also seem to provide a flexible permissible construction of the statute."

The Court then rejected other arguments advanced by the taxpayer. It was not persuaded that the regulations violate "the basic principle of treating like entities alike" under the Code. Even though a single member LLC with all six corporate characteristics listed in the former regulations can elect not to be treated as a corporation and even though a single member LLC with no traditionally corporate characteristics can elect to be treated as a corporation, those choices reflect the fact that "In today's business environment, not all corporations are alike and not all partnerships share the same characteristics." Likewise, the court did not agree with the taxpayer that the regulations impermissibly changed the legal status of the LLC created under state law because it disregards the separate status of the LLC accorded by state law. The court noted that the regulations apply only for purposes of federal tax liability. To the taxpayer's argument that any tax liability rested on his status as agent of the LLC and not as his personal obligation, the court responded that for tax purposes the taxpayer was the employer and was liable for the taxes as an employer.

The taxpayer concluded by arguing that the IRS had only one avenue of collection, namely, section 6672, which requires that the IRS prove that the taxpayer was a responsible person for the LLC's failure to pay over the taxes. The Court concluded that the IRS was going after the taxpayer as a sole proprietor, but the fact that it has section 6672 available does not close the door to other approaches. The existence of those other approaches does not make the regulations an impermissible interpretation of the statute.

Whew! Yes, this is long, and far from simple. But it's important. If the taxpayer appeals, and that's a big "if," there is a chance that the Court of Appeals would reverse. Imagine the uncertainty, confusion, and chaos in the entitly classification corner of the tax world. Should the regulations be put at risk in a case involving failure to pay over taxes rather than in a case dealing directly with the classification issue?

That question has generated a lot of speculation. Surely, this can't be where the IRS wants to be? Or is it? Perhaps the IRS consciously decided that this would be a good way to open the judicial fray with respect to the validity of the regulations. After all, although the regulations are taxpayer-friendly, the IRS must be aware of the criticism offered by some commentators, and must have figured that someday the issue would arise. It may very well be that the issue would NOT arise in a case dealing directly with the classification issue because there is almost no likelihood that taxpayers who can choose to do what they want to do would challenge that opportunity.

After all, as has been asked, why didn't the IRS go the usual employment tax responsible person route under section 6672? The simple answer is that we don't know. Borrowing from comments made by Steve Johnson of the University of Nevada at Las Vegas Law School, the opinion doesn't clarify if the taxes in question were only the employer's portion or included "trust fund" taxes (those withheld from the employees). But my reading of the case suggests that withheld taxes were at least part of the taxes at issue, because the court states, "It [the LLC] failed to pay withholding and FICA taxes." Steve also asks if the statute of limitations for section 6672 purposes had expired. We simply don't know. Was the taxpayer a responsible person? How not? The taxpayer was the ONLY owner of the LLC.

This story isn't over. There's a reason that television writers leave the viewers hanging. It brings them back. Eventually there will be another chapter. But for now, anyone practicing in this area should resist the temptation to relax at the news that "the check the box regulations were held valid by a court" and remain vigilant for news of an appeal and the decision of a Court of Appeals.

Hey, you know, this could go to the Supremes. The issues, rather than involving complicated tax computational gymnastics, are administrative law issues far more appealing to the Supreme Court than the substantive stuff. But I'm getting ahead of the story, so it's time to sit back and wait. A simple thing to do, right?

Wow, the baby as billboard thing is going prime time. The mother's photo made the "front page" of the Philadelphia Inquirer's web site. First, an update, because it raises more tax questions. Then, some more tax analysis.

According to this report, the mother in question is getting $999 from GoldenPalace.com, a web-based casino located in the Caribbean known for its adventuresome approach to advertising. For example, it paid a woman in Connecticut $15,000 to name her baby "GoldenPalace.com Benedetto." Imagine when that child reaches adolescence. It's a good thing there are lawyers who practice "name changing" law.

The Inquirer story also reports that GoldenPalace.com will provide baby clothes, bibs, and "other stuff." In addition, GoldenPalace.com is sending the mother, her husband, and their other child "a bunch of clothing," hats, long-sleeve shirts, T-shirts, and towels.

Having procured $999, the mother has decided to auction off August. Although she had ruled out any advertising connected with drugs, alcohol, profanity, or "sexual stuff," she seems completely unfazed that the winning bidder deals in gambling. And there's no mention of tobacco. The bid reserve will be $1,000. She added that she would not name her baby after a casino even if she were paid $1,000,000.

Now to the tax stuff. So not only is there the issue of WHO gets taxed on the $999, there's the issue of who gets taxed on the merchandise. Surely the merchandise received by the mother and father is taxed to them. The merchandise received by the two children? It's probably their income, unless one argues that because the merchandise represents items of support, it constructively satisfies the parent's support obligations and thus is income to them. I get the feeling that no one involved in the matter has considered the tax issues, but they're there. No, these aren't gifts, for surely GoldenPalace.com is not acting out of detached and disinterested generosity. And the "receipts from e-Bay are not income" argument goes nowhere, as I've previously explained.

There's more. As I noted in my first post on the story, another question is whether the income is rental income or personal services income. Ron Thomas contacted me to point out that under some circumstances there's another reason that the classification of the income (as rental or personal services income) matters. Ron had a client, a professional athlete, who wore a sponsor's log on his clothing. The athlete was a resident of another country, with which an income tax treaty was in effect. The treaty exempted residents of that other country from U.S. taxation on rental income but subjected them to taxation personal service income above a threshhold far below the athlete's income from the sponsor. There was an audit, but because it was settled the question did not get considered by a court. Ron reports that he found very little case law answering the question, "Is it rental or is it personal service?"

Ron passed along a citation to an article (Kenneth P. Brewer, How to Earn Millions of U.S.-Source Income for Doing Nothing, 83 Tax Notes 1375 (May 31, 1999)), from which I found a citation to an IRS Field Service Advise, No. 1999-790, which though released to the public in 1999 was issued in 1993. The reasoning used by the IRS to determine the source of income sheds light on how it will treat the income in the baby-billboard matter. The FSA involved a nonresident alien athlete who was paid by a company to film videos and commercials broadcast in foreign markets, to make personal appearances around the world, to wear clothing bearing the company's name and logo, and to refrain from wearing clothing with the names or logos of the company's competitors. The IRS recommended allocating the income between, on the one hand, royalties (rentals) for use of the athlete's name and likeness and wearing the company's name and logos, and on the other hand, personal services compensation for filming videos and commercials and making personal appearances. The rest of the IRS analysis isn't relevant to the question in the baby-billboard matter because it involves transfer pricing, and sourcing, which are relevant when there are activities overseas. It does not appear as though the baby in question will be traveling abroad during the July or August auction periods.

What's being rented? Is the baby's body a mannequin-like frame for advertising the GoldenPalace.com name and logo? Tax law requires that income from property, such as rentals and royalties, be taxed to the person who owns the property. Who owns the baby's body? Why, the baby does. Any other conclusion would generate unbearable collateral ramifications. But, isn't the billboard the clothes and not the baby? After all, it's not as though the baby will sport a tattoo, as did a woman paid by GoldenPalace.com to advertise its name and logo on part of her body that will get no further discussion here. So, should not the income be taxed to the owner of the clothes? On we go to the next question. Who owns the clothes? Can a 2-month-old "own" property? The tax law analyzes property ownership from a perspective of economic reality. That's why 2-month-old children are not treated as the "owners" of partnership interests, and that's why good planners would use trusts to deal with minors' property. Who makes decisions with respect to the clothes? Who has the right to sell them, use them, wash them, or reject them? Who decides which clothes are worn on which day? Who would submit a claim to the insurance company with respect to the clothes in the event of a loss? The parents.

The dollar amounts involved are far less than what was involved in the professional athlete's situation (a six-figure tax audit). Yet, despite common belief to the contrary, a low dollar amount is not insulation from tax audit. Many landmark tax cases involved small transactions. Why? Because if the transaction is very common, what's at stake in the case is the small dollar amount multiplied by the number of potential transactions. Already another woman has started an auction with respect to her child. In the today's competitive world, where kindergarten kids wear caps and gowns on the last day of class, where parents push their children to be better than the others (and tell them they are even if they aren't), where child competitions that should be fun and games trigger sports rage among frustrated reliving-their-youth parents, it's a good guess that a tide of baby billboards will sweep the country as competitive parents refuse to let their child be left out of the action.

My children must be glad they're of legal age. No fear that Dad will crank up some MauledAgain t-shirts for them to wear. Hmm. Wait a minute. MY kids would jump at the idea. The tougher question is whether someone could be paid to name their kid MauledAgain. And that child could grow up, marry GoldenPalace.com Benedetto, and if they have children they would have a Golden Maule and a Maule Palace.

OK, enough. Tax sometimes makes us crazy, doesn't it.

In my first analysis of the new domestic production activities deduction under section 199, I noted that the exclusion of gross receipts derived from the sale of food and beverages prepared by the taxpayer at a retail establishment from the domestic production gross receipts (DPGR) on which the deduction is based had opened up a Pandora's box of issues with respect to the distinctions between roasting and brewing coffee. I would have said it opened up a coffee can of issues but my mother informs me that her favorite coffee is now sold in plastic containers.

Now there are some more difficulties with the definition of "food and beverages prepared by the taxpayer at a retail establishment" to consider. I came across this letter from Costco to Treasury while looking for a document in which concerns are raised with respect to the definition of architectural services, a document that I still have not found. So, because today, Memorial Day, is a day on which many Americans make food an even more important highlight of the day, I decided to consider how, in the tax world, the definition of "food prepared at a retail establishment" can generate so much discussion. Ask a four-year old what food is, and the child will reply, "Anything you can eat."

Although Costco's letter described activities in which it engages with respect to food at its retail establishments, the situation it describes are not unique to Costco. They're rather common.

Costco, as most people know, sells all sorts of merchandise at discounted prices, often in bulk quantity. Among the items sold are a variety of groceries, beer and wine where permitted, frozen foods, bakery products, dairy products, meat, and produce. Are any of these items "food and beverages prepared by the taxpayer at a retail establishment"? Costco points out that several of its operations pose the question. In its butcher shop area, Costco employees take huge slabs of beef, trim them of fat, and cut them into roasts, steaks, and other cuts before packaging them in bulk amounts for sale. The butchers also grind meat and package it in huge quantities, usually no less than 6 pounds. Costco explains that none of these items are immediately edible, but require further preparation by the customer. I think it's right that the analysis not be clouded by the fact some people eat raw meat. So I'm told.

Costco store employees also process and package "home replacement meals," in huge quantities, most of which require additional preparation by the customer. In its bakeries, Costco bakes and cooks all sorts of items, again packaged in significant quantities, most of which are ready to eat.

When the IRS issued Notice 2005-14, in which it interpreted some of the issues arising under section 199, it invited comments. To that invitation, Costco responded, not only by describing its food operations and pointing out the issue, but by suggesting the analysis that the IRS should adopt.

There is no question that the Costco stores are retail establishments. However, the IRS Notice excludes facilities from the definition of retail establishment if less than 5% of the total gross receipts derived from the sale of food and beverages prepared at the facility are attributable to retail sales at that facility. Even though the statute does not so provide, the Notice permits allocation of gross receipts between those attributable to wholesale sales of food and beverages, which qualify as DPGR, and gross receipts from retail sales of food and beverages prepared at the retail establishment, which do not qualify as DPGR.

Costco's letter points out that the legislative history noted that gross receipts of a meat packing plant qualify as DPGR but receipts derived at a restaurant from sale of a venison sausage created by the master chef do not qualify. Wow, talk about cutting a fine line. After all, the master chef is doing what the meat packing plant employees do: process food from one form to another, prepartory to its further preparation through cooking. Considering the goals of section 199, which is to encourage taxpayers to perform manufacturing, production, and similar activities in the United States rather than abroad, what's the point of excluding the master chef's processing receipts? Costco's letter then describes the coffee roasting and brewing distinction that I explored in that earlier post. Finally, Costco's letter quotes the legislative history's description of receipts from the sale of bakery items, even if sold by a supermarket and not a dining establishment, as failing to be DPGR.

Costco proposes that for purposes of the denial of the deduction for "food and beverages prepared by the taxpayer at a retail establishment" the word "food" be defined as "an item prepared by the taxpayer that is ready for immediate consumption in a single serving size without regard to whether the item is intended for on-site or off-site consumption." Does this work?

The meat packing plant's receipts would qualify as DPGR because it does not sell items prepared by the taxpayer that are ready for immediate consumption in a single serving size. The proposed definition works.

The restaurant's receipts from the sausage prepared by the chef would not qualify as DPGR because it is an item prepared by the taxpayer (through the taxpayer's employee) that is ready for immediate consumption in a single serving size. Again, the proposed definition works.

The coffee shop's receipts from brewing coffee would not qualify as DPGR because the coffee is an item prepared by the taxpayer that is ready for immediate consumption in a single serving size. The definition gains strength.

What about bakery items? For bakeries that sell individual items to its customers, the receipts would not qualify because the items are prepared by the bakery and are ready for immediate consumption in a single serving size. To this point, the definition appears to be consistent with what it is Congress appears to be trying to do.

What happens, though, to the Costco butcher operations, its home replacement meals, and the bakery items? Costco's letter concludes that application of the proposed definition makes the receipts from the sale of those items DPGR. The cuts of meat and the ground meat are not ready for immediate consumption, putting aside the folks who eat raw meat. The home replacement meals need further preparation by the customer. These results make sense. Costco's butcher shop is, in some ways, a minature meat packing plant. Though I have some doubt about the home replacement meals, so long as they need cooking and not mere heating, the receipts should qualify as DPGR. My doubt arises because a pizza shop can sell a "home replacement meal" which, depending on the distance the customer needs to drive to get home, may require re-heating. Is it time to get into a discussion of the difference between cooking and heating? Some people claim that opening and heating a can of soup does not qualify as cooking. A can of soup, though, is not ready for immediate consumption. Regardless of what one calls the activity that makes it edible, receipts from its sale are DPGR.

The bakery items present some challenges. The example in the legislative history is, as the Costco letter points out, ambiguous and confusing. Does it mean that all receipts from the sale of products produced by the in-store bakery are ineligible? Does it mean that the receipts should be allocated between those arising from sales to retail customers and those sold to, for example, restaurants for re-sale? Does it mean that receipts from items that undergo additional processing qualify, such as sliced bread used by the bakery to make sandwiches sold to customers? Costco's letter notes that a fourth interpretation exists, because one could argue that even a cake prepared by the bakery is not ready for immediate consumption because the "normal" way in which individuals consume a cake is not to dig into it immediately. It needs to be unpackaged and cut into individual slices. Perhaps, the letter notes, the bakery's sale of a slice of cake would generate receipts not qualifying as DPGR.

Costco wants to apply the fourth interpretation. I'm not certain I agree. After all, if the fact that a customer must slice the cake in order to eat it should preclude the "food and beverage" exception from applying, ought not the fact that a restaurant patron must slice the steak likewise preclude the "food and beverage" exception from applying to the retail dining establishment at least to the extent the customer must do something other than put the item into his or her mouth?

These are the sorts of issues that cause people living outside the tax practice world to roll their eyes and exclaim, "Let's just get on with life." Even some of us inside the tax practice world, including yours truly, have that reaction more often than perhaps we are willing to admit. There surely must be a better way than to hyperanalyze the niceties of food preparation. That's not to cricitize the Costco letter, because it addresses issues that must be addressed considering what Congress has done. The criticism is better directed toward the Congress, questioning why it simply didn't exclude receipts arising from food sold at retail from the deduction. Instead of having to create yet another definition, the terms of which require further definition, Congress could have relied on a term that has been defined and refined after decades of application in the sales and use tax area. Such a definition would not work to the benefit of retailers performing wholesale activities, such as Costco, but if the deduction is to discourage taxpayers from moving production overseas, is that incentive necessary for production that is not at risk of being moved overseas, such as the butcher and bakery operations of an establishment such as Costco?

Or, to the extent it makes sense to encourage Costco to maintain its domestic operations, why not simply exclude from DPGR gross receipts arising from the sale of food or beverages for on-site consumption and gross receipts arising from the sale of food or beverages for off-site consumption that require no further activity by the customer other than those activities in which the customer would engage had the customer consumed the items on-site, such as slicing with knife or fork, spooning, pouring, shaking, or mixing? The fact that a customer needs to unwrap a package, slice a cake, pour soup into a bowl, divide 5 pieces of chicken among 5 family members, shake salt onto something, or pour dressing from a separate container onto a salad ought not be treated as food processing that makes the item not ready for immediate consumption. In other words, I'm not certain that the "not ready for immediate consumption" is sufficiently unambiguous to settle the question.

Please don't ruin your Memorial Day picnic or barbecue by starting a conversation about this topic. Wait until everyone is finished eating. Don't ruin their appetites.

So how many tax practitioners were aware, when they decided to enter tax practice, that someday they would be discussing how people eat cake, how meat is prepared, and whether a distinction between cooking and (re)heating can be adequately defined. Perhaps that's one of the reasons tax practice attracts as many folks as it does. One never knows where the next tax law changes will take us. Other than deeper into complexity and further from getting on with life.

This one was inevitable. A pregnant woman has decided to sell advertising space on her soon-to-be-born child's clothing. Setting up auctions on e-Bay and another site, with a minimum bid of $1,000, she has offered advertising space on the child's clothing for the month of July. She also is willing to accept payment for displaying logos on a stroller. This is a must-read story.

Her inspiration is the viewing of a story about a woman who offered to have temporary tattoos on her body for cash. Her justification is that her older son wears clothing with manufacturer's logos, which in her mind constitutes free advertising for the company. Of course, that's true. I wonder if manufacturers will claim that the amount paid for items with logos is the net of a higher gross purchase price and an advertising space discount.

Anyhow, my almost-instantaneous thought was a tax one. If she succeeds, there will be gross income because there is no question that amounts received for advertising space constitute gross income. But whose gross income? And what sort of gross income?

Is it her gross income because she is selling advertising space on clothing she buys and puts on the baby? Or is it the baby's gross income because it is the baby who is carrying the placard, so to speak? Gross income paid on account of child modeling is the child's gross income, but that's because section 73 of the Internal Revenue Code requires that income from the services performed by a child be treated as the child's gross income, even if the child does not receive the income. But does section 73 apply to amounts received for advertising on a baby's clothing? Is the baby performing a service in the manner of the old-time placard wear? Or is this rental income of some sort? If it is rental income, section 73 does not apply, but that does not preclude a determination that the gross income is the baby's gross income. As for the stroller, it is an easier question. That would be the gross income of the stroller's owner, presumably under the facts that are available, the parents.

Why does it matter? If the income is the baby's income, there will be the benefit of the small standard deduction available to shelter a portion of the income from taxation that would not be available if the income is the parents' or mother's gross income. If the income is rental income, it is unearned income and thus, if sufficient in amount, triggers the provisions taxing the net unearned income of a child under the age of 14 at the rates of the parents.

This isn't the first instance of a baby's wardrobe being offered as marketing space. An earlier attempt was ended after "a torrent of bad press." There are several instances of adults offering their wardrobe as advertising space, but in those situations the question of "whose gross income" is much easier to answer.

One adult couple, professional models, who are asking $25,000 have so far received a high bid of $20.50. As of the time the story was written, the high bid for the baby wardrobe advertising space was, ta da, $9.99.

So perhaps the tax issue won't be worth the time required to think about it. Except, of course, the story mentioned "people who have sold advertising on a bald head" and that has me thinking about the possibilities when what's left of my head hair finally falls out and I have to pay up on the deal with the children (when the top of my head is totally hairless, the rest of the head hair gets shaved, and then I'll look like my nephew-in-law, who, perhaps unlike me, wears it well). The advertising income might be soothing.

Hey, folks, do we see some exam questions here in the "we don't have to make this stuff up" category?

About two weeks ago the Third Circuit Court of Appeals (in Kean v. Comr., No. 8966-00, 9144-00 (10 May 2005)) handed down a decision requiring a payee spouse to include as income, and permitting the payor spouse to deduct, amounts transferred by the payor spouse to the payee spouse in compliance with a state court temporary support order effective for the period divorce proceedings continued to be underway. In reaching this decision, the Third Circuit took a different route than did the Tenth Circuit, which concluded, in a similar case (Lovejoy v. Comr., 293 F.3d 1208 (10th Cir. 2002)), that the payments were not deductible by the payor spouse nor includible in gross income by the payee spouse. These sorts of "inter-circuit" conflicts are a breeding ground for cases eventually taken up by the Supreme Court.

These cases are a good example of how challenging it can be to simplify the tax law. Many thought that when Congress amended section 71 some years ago that it would provide clear-cut answers for taxpayers sufficient to eliminate most, if not all, of the tax litigation that had sprung up with respect to the tax treatment of transfers between spouses in connection with divorce. Unfortunately, it appears that there is nothing in tax law, perhaps nothing in life, that cannot be made more complicated. Careful analysis suggests that the tax law complexity arises from state law simplicity.

The analysis turns on whether the payments qualify as "alimony or separate maintenance payments." If they do, the payor spouse deducts the payment and the payee spouse includes them in gross income. Otherwise, there is no deduction and there is no gross income. As students in my basic federal income tax course learn during our study of section 71, this simple rule is more than it appears to be. After all, the deduction/inclusion question simply gets shifted to one requiring the definition of "alimony or separate maintenance payments" which, for purpose of brevity, I will call "tax alimony." To be tax alimony, six conditions must be satisified. Most were not relevant to the case but I'll set them out so that the full context can be appreciated.

First, the payment must be in cash. Second, it must be received by or on behalf of the payee spouse under a divorce or separation instrument, which, yes, means yet another definition, but all that matters in this instance is that one understand that means divorce decree, separate maintenance decree, written instrument incident to a divorce decree, written instrument incident to a separate maintenance decree, a written separation agreement, or a decree requiring a spouse to make payments for the support or maintenance of the other spouse. Third, the payment must not be designated by the instrument as non-deductible and non-includible, a requirement that exists simply to permit spouses to forego the deduction and income if it makes sense to do so after making tentative tax liability computations. Fourth, if the spouses are legally separated under a divorce or separate maintenance decree, they must not be members of the same household when the payment is made, and I'll leave for another day what this requirement is about. Fifth, the payor spouse must not be obligated to make payments after the payee spouse dies, because then it would not be a payment for the support of the payee spouse. Sixth, the payor spouse must not be obligated to make payments as a substitute for such a payment after the death of the payee spouse. Only two of these requirements were the focus in Kean.

On top of all of this, the Internal Revenue Code provides that no deduction is available to the payor spouse, and no income arises for the payee spouse, with respect to the portion of any payment that is fixed by the terms of a divorce or separation instrument, whether as absolute dollars or percentage, as child support. The theory is that because a person does not get a deduction for paying his or her children's expenses if he or she is married to the other parent, and because the other parent does not have gross income because those expenses have been paid, the divorce or separation of the parents ought not turn child support into a deduction coupled with gross income.

Of course, because taxpayers generally hunger for deductions, and because the payee spouse often is in a lower tax bracket than the payor spouse, there is incentive for the spouses to try making the child support payment qualify as tax alimony through seemingly clever drafting, either in their own agreement or lobbied into the state court's decree. Thus, the Congress tried to cut this off at the pass by providing that if any amount in the instrument is reduced on the happening of a contingency specified in the instrument relating to a child, such as age, marriage, death, graduation, etc., or at a time that clearly can be associated with such an event, that amount will be treated as child support.

So what happens when a state court orders one spouse to make payments into an account for the other spouse to use for support of herself, the children, and the household expenses of their residence? in Kean, there was no question the payments met three of the requirements: they were in cash, there was no "tax switch" clause, and the spouses weren't in the same household even though that wasn't an applicable requirement anyhow because they were not yet divorced. As to the payee spouse's contention the payments had not been received by her, the court concluded that she had unrestricted control over the account into which they were deposited. As for the requirements that there be no obligations surviving the payee spouse's death, the court concluded that under New Jersey law a temporary support order terminates if the payee spouse dies.

But isn't part of the payment child support? Well, the decree doesn't specify a dollar amount or percentage as child support. Nor does it provide for a reduction in the payment based on an event in the child's life or a date matching up with such an event.

The Third Circuit, affirming the Tax Court, held that the payments met the definition of "tax alimony." The payee spouse made the "but this is child support" argument, obliquely, when she contended that a portion of the payments was for the support of the children, citing the Tenth Circuit's Lovejoy decision and citing a Tax Court decision (Gonzales v. Commissioner, 78 T.C.M. 527 (1999)), in which the Tax Court held, in a similar case, that New Jersey law would not have relieved the payor spouse of the obligation to pay family support if the payee spouse died.

In Lovejoy, the court explained that under Colorado law, amounts specified as child support must be paid after the payee spouse dies, whereas amounts paid for spousal maintenance terminate at death. There was no Colorado caselaw dealing with the treatment of unallocated temporary support. The parties in Lovejoy cited California cases, but, unfortunately, the California courts have split over the issue. Though, as the Lovejoy court notes, "it is not clear under Colorado law which rule trumps the other i.e. whether the abatement of dissolution proceedings upon a spouse's death would negate temporary orders providing for child support payemnts," it nonetheless explained "we are inclined to believe that the Colorado Supreme Court would hold that temporary orders providing for child support payments, even when included within a general unallocated payment obligation, do survive the death of the recipient spouse."

The Third Circuit rejected Lovejoy and Gonzales because it "believe[d] that the decisions rely too heavily on the intricacies of family law and fail to take into account the overall purpose of section 71." Whoa! Isn't the overall purpose of section 71 to limit the deduction/inclusion treatment to spousal support, in contrast to child support and property or equity transfers? The Third Circuit's decision has the effect of making child support deductible to the payor spouse and includible as income by the payee spouse. That result is flat-out contrary to the "overall purpose of section 71." Worse, the Third Circuit brushed off Lovejoy and Gonzales becauset they relied "too heavily" on the "intricacies of family law." Whoa again! Isn't that the real, though unfortunate, characteristic of law? Intricacy abounds. Is it brushed aside because it is too difficult? My students surely would like that approach, though I doubt their future clients would! The fact that the Tax Court concluded New Jersey law WOULD require continuation of the payments demands that the Third Circuit explore more carefully New Jersey law to determine whether, in fact, the fifth and sixth requirements of the "tax alimony" definition had been satisfied.

In all fairness, though, to the Third Circuit, this problem would not exist if the state courts, assisted by state legislatures, did a better job of being more precise. In fact, Lovejoy and Gonzales don't explore the intricacies of state law. They are intricate analyses of deficient state law. Why does state law permit unallocated support orders? Because they are simple and easy to frame? How complicated is it for the state legislature to require state judges to answer two questions. First, how much would the payor spouse be required to pay if there were no children? Second, considering that there are children, how much are you requiring the payor spouse to pay? Considering that the amounts generally are grabbed from tables or software, it isn't a long nor tedious task to answer the two questions. The first amount would qualify, assuming the other requirements are met, as tax alimony. The difference between the first and second amounts would be the non-deductible, non-includible child support.

Thus, because state legislatures are not thinking through the issues, the federal courts must struggle with (or in the case of the Third Circuit, toss aside) the task of determining what state law would be under the circumstances. It isn't unusual for state legislation to leave unanswered a parade of questions; for example, few, if any, state statutes dealing with wills have been amended to reflect the shift from quill pen to digital technology. So, in this instance, the attempt by Congress to simplify the alimony deduction/inclusion question runs aground on the simple question of whether an obligation would survive or not survive the death of the payee spouse.

One last point about the issue. When section 71 was reformed, the fifth and sixth definitional requirements included language to the effect that the expiration of the obligation at the death of the payee spouse had to be included in the text of the divorce or separation agreement. Savvy domestic relations lawyers thus requested state judges include language to that effect in their decrees. I've been told anecdotes by Pennsylvania lawyers who requested judges to include that language and were met with replies to the effect of, "Counsellor, state law provides that this obligation terminates on the death of the payee spouse so why should I put into the decree something already in state law?" In Pennsylvania, at least, payor spouses were unable to get deductions for alimony because the decree lacked language providing the obligation ended at death. That situation led to lobbying, and the Congress amended section 71 to remove the requirement that the language be in the divorce or separation instrument. Instead, the federal tax authorities (IRS, courts) must look to state law. Ah, even the intricacies of state law. All because state court judges were, and remain, unwilling, unable, or unpersuaded, to state in simple terms, in the language of the decree, what amount is for the spouse, what amount is for the children, and that the amount for the spouse terminates at death.

Truly a fascinating simplification conundrum.

Tax law is so wrapped up in economics and social engineering that it was impossible for me to ignore a letter in today's Philadelphia Inquirer's Dear Amy column. OK, I'm sure you're wondering, why is he reading that? The simple answer is that over the years I have discovered all sorts of fodder for my courses in the stories told by people writing in to Amy or her predecessor Ann Landers, and this contributes to my oft-repeated statement to students, "I don't need to make up this stuff to get a good hypo for class!" Today's column caught my eye because it carried "Professor reconsiders on reference" as a headline. I'll write about the "can you give me a recommendation?" topic at some future time. It's the second letter that highlighted some of the nutrients that let politicians blossom.

The letter writer explained that he or she live near a hospital that serves "thousands of seniors" and that it sits across from a high quality restaurant frequented by senior citizens. The writer disclosed that when he or she asked for a senior discount, the response was that the restaurant did not provide one. The writer argues that nothing is "more logical" than for a restaurant across from a hospital visited by thousands of senior citizens to offer senior citizen discounts. The writer conceded that there is no legal obligation to provide the discount, but that there is "no way to tell" if doing so would increase business. The writer concluded that because other businesses provide this "break" to seniors, it would be a win-win situation for the restaurant owner to do the same.

It was a joy to read Amy's response. She concluded that the restaurant owner would not be in a win-win situation, because there already is a "steady flow of seniors" patronizing the restaurant even in the absence of a discount. Amy kept her response short. Her space is budgeted, and she adapts to the restriction. Fortunately, I have a bit more space to expand on the question.

First, the economics. If the restaurant puts a senior citizen discount into place, the consequence will end up somewhere at or between two extreme outcomes. One outcome is that the discount reduces the restaurant's profits, perhaps generating a loss. The other outcome is that the restaurant increases its prices so that the discount to the senior citizens is offset by the increased revenue from other customers. Perhaps some combination of the two would be the practical short-term effect. In the long-term, the first outcome could lead to the failure of the restaurant, and the second outcome could do the same, as non-senior customers bolt for other establishments and the source of funding for the discount dries up.

Second, the federal budget analogy. To the extent a business offers a discount to any group, it must increase revenue from other customers in order to maintain profits. If senior citizens try to persuade this restaurant to offer a discount, they are also urging, though not stating outright, that they want the restaurant to increase prices for other customers. Or, if confronted with that outcome, they would argue, again without saying it so directly, that the owner should cut profits. How many of these senior citizens would have done that when they were running businesses? In any event, it's not unlike what happens when lobbyists for special interest groups approach legislatures asking for a tax break or a spending benefit. Why? Either the surplus is reduced or the deficit is increased, or other citizens must deal with tax increases or spending cuts to balance the goodie for the special interest group. What actually happens is that so many groups petition for so many breaks that the result is a jumbled mess known as the Internal Revenue Code. And so, the frightening thought occurs to me, that someone like the letter writer will start a campaign for yet another income tax credit, this one for businesses that offer senior citizen discounts. Spare us, please!

Third, fuel for the politicians. These sorts of pleas for special treatment as exemplified by the letter writer's request become grand entrances for politicians who seek votes by trading on the "I'll do something for you" approach to government. What's wrong with that? What's wrong with that is the absence of the "what's good for the nation" approach that recognizes no nation can stand if each citizen is an independent empire jockeying for advantage over every other citizen. Imagine the politician who sees in the letter writer's request an opportunity to gather votes by promising to vote for a law that makes senior citizen discounts mandatory. Or perhaps the letter writer enters politics on such a platform.

Fourth, common sense. The letter writer does not disclose much about himself or herself. Is the letter writer someone scraping by on social security? Is the letter writer retired with a comfortable and secure pension? Is the letter writer the beneficiary of an ample trust fund? Is the letter writer earning investment income on carefully managed investments acquired from prudent savings during his or her working years? Why does that matter? It matters because it goes to the heart of the deep flaw of special interest lobbying, namely, the trend during the past few decades to separate common sense from the process. The letter writer refers to logic. Logic dictates that breaks of any kind, whether government tax cuts, government spending, private enterprise discounts, or other assistance, ought to dovetail with need. A discount for impoverished customers, such as the young widow raising several children alone while mourning her late husband's death in war or at the hands of terrorists makes much more sense than a discount based on the Pepperian deception that "all senior citizens are poor." I'll grant that it might be a bit inconvenient or awkward to identify impoverished customers in need of a discount, but somehow enterprises figure out who is a senior citizen despite the many different definitions that are used.

Fifth, justice. It often is said that law seeks justice, and as a member of the legal profession I direct my efforts, or at least try to direct my efforts, toward the supremacy of justice over all its opposites. Deceit is not justice. Misinformation is not justice. Greed is not justice. Is it "just" to use age as a benchmark for discounts, tax cuts, and other benefits? In some instances, yes. There is nothing unjust about setting an age as the time at which a person can choose to retire and begin drawing on pension benefits, IRA distributions, and the like. But it is unjust, to other customers who are not as financially established, to award discounts based on age. How did we get here? We got here because Claude Pepper and his allies, reacting to the existence of impoverished retirees, embarked on a campaign that rested on the assumption that all senior citizens were in need of financial assistance, suing the same approach that turned social security from an insurance program into an entitlement program that ignores need. Ironically, during the time wealthy retirees began to enjoy more and more discounts and social security benefits were boosted, the proportion of children living in poverty significantly increased. This chart graphically illustrates the point.

My son tells me I'm eligible for certain senior citizen discounts. I'm sure he's right. After all, he's not unlike me when it comes to intellect. I haven't bothered to check. I don't want to know. The letter writer signed the letter "Proudly Way over 55" so I'll sign off "Proudly Passing Up Discounts I Ought Not Get." And no, I'm not over 55. Yet. I'm sure my children will let me know when that happens.

Anyone who teaches a tax course, most students who have been in a tax course, and a few faculty who have not taught tax courses, have experienced the consequences of the continous and eternal parade of tax law changes that impact not only tax practice but the design and teaching of a tax course. Although the steady stream of tax legislation gets much of the attention, the IRS does its part by issuing regulations and other administrative documents, and the courts decide case after case. Most courses share with tax courses the impact of the occasional case that turns part of the course on its head. Some courses are afflicted by serial administrative rulings. A few occasionally experience what tax law teachers consider part of the routine. For example, the recent bankruptcy law revisions will required bankruptcy law teachers to do some major revisions of their courses, but they don't get to to this every year as do the tax law teachers.

The constant changing is both an advantage and a disadvantage. The advantage is that new legislation or regulations require the teacher to re-examine that area of the course, to prepare new or revised notes, new or revised problems, new or revised problem solutions, new or revised powerpoint slides (if used), new or revised graded exercises, new or revised examination questions, new or revised student response pad questions (if used), and at times a new or revised syllabus. The advantage is that it transports the professor back to the first time a course was taught, namely, a time when the "newness" of things contributed to an enthusiasm and energy that sometimes is lacking when the notes haven't changed much for many years because the course hasn't changed much. The running joke is that the easiest task set belongs to someone teaching Law of the Middle Ages. To the best of my knowledge, there is no such course. But some come frighteningly close, at least in practical application. The disadvantage is that it takes time, often a lot of time, to revise the course. Sometimes schools and their administrations recognize this additional workload and its impact on other professional endeavors. Sometimes they do not. Sometimes it means the professor needs to make time to bring the course up-to-date by, gasp, working on weekends or evenings. When people react with "what a cushy job" when I explain that on average I have 6.5 hours a week in the classroom, I'm almost automatic explaining that each hour in the classroom requires at least several hours of preparation, and that after tossing in preparation and grading of examinations and other evaluative exercises, it's not what it appears to be. Unless, of course, one can simply transfer a course from one year to the next with little or no change. There's another running joke on this one, that of the faculty member who forgot to change the year on the syllabus. Except it's not a joke, it's a story, and I'll not tell it, and, no, it was not me.

I'm inspired to share this explanation because the IRS has just issued new proposed regulations on the transfer of partnership interests in exchange for services rendered to the partnership. If adopted, these regulations will not only clarify the treatment of transactions that did not exist when I first started teaching the course (such as the issuance of options for partnership interests) but also will change existing law and application of existing law by analogy to transactions for which there was no direct authority. To put it simply, the answers to the problems used in the Partnership Taxation, and Introduction to Taxation of Business Entities, courses with respect to the receipt of a partnership interest for services, will change. I had warned my students during the past few semesters that this was going to happen. What makes this more fun is that the publisher of the books I use in these courses is revising them, and has the book at the printer. (I know because I called and asked for page proofs so I can get started on the preparation of the fall courses. Yes, it's "only" May, but I learned years ago not to leave course preparation until two weeks before classes begin because something always happens, and it takes more than two weeks to prepare courses when all these revisions need to be made.) So the new editions are out of date before they are distributed.

So here's the segue from a posting on education to a posting on tax. I'm going to share some of the highlights of the proposed regulations, pointing out that on more than a few of the issues, the IRS has requested comments and suggestions from practitioners. It's a sure sign of the mess subchapter K is in when the IRS notes the practical administration problems and other challenges of getting two or more partnership tax law principles to reconcile. We continue to pay the price for that "make everyone happy" compromises that generated subchapter K, as it turns out it was a "make everyone think they are happy but wait until they see what a mess compromises are" compromise.

The regulations propose that transfers of ALL partnership interests, not just capital interests, be treated as property for purposes of section 83. That means the recipient would not be taxed until the interest vests unless the recipient elects to be taxed at the time of receipt. Under a special rule, the partnership and all of its partners would be permitted to elect determination of the fair market value of the interest using a liquidation value. Commentators had speculated, and courts had suggested, that section 83 applied to transfers of partnership interests, but the extension of section 83 to profits interests is an interesting foray into new territory, even though, as a practical matter, most transfers of profits interests were not subject to taxation by virtue of IRS administrative fiat.

The regulations propose that the general rule taxing a property transferor on the gain or loss realized from using property to satisfy a debt or to pay compensation, including its application to section 83 transactions, will not apply to partnerships transferring capital or profits interests in exchange for services. The preamble to the regulations explains that the nonrecognition concept of section 721 should trump the general rule. Even though the IRS notes that reverse section 704(c) principles in the section 704(b) regulations will ensure that the gain eventually is taxed to the transferring partners, and even though the rule would be good news for most taxpayers, it nonetheless is, in effect, an amendment of section 721, extending nonrecognition from property transfers by a partner to property and services transfers by a partner. Yes, a good argument can be made that section 721 should have been so drafted or so amended, and I tend to agree, but why is the IRS doing what Congress should be doing? The easy answer is that if the IRS doesn't "rescue" the taxpayers, who will? Surely not a Congress inattentive to a lot of important stuff (and not just tax). I understand that answer, but what is disturbing is that somehow the IRS needs to reply to those millions of taxpayers unintentionally afflicted by the alternative minimum tax who suggest ways the IRS can "rescue" them as well.

To synchronize all of this with other areas of partnership taxation, the regulations propose that the service partner's capital account be increased by the amount included by the service partner as compensation income, when that inclusion in fact occurs. It will occur when it is substantially vested, or, if the section 83(b) election is made, when received. And, of course, if there are no substantial restrictions, the vesting occurs on receipt. Similarly, the regulations propose that recognition of income by the services partner is an appropriate time for capital account revaluations.

Similarly, the regulations propose that if a section 83(b) election is made, opening the door to the possibility that the partner would forfeit the interest, the partnership nonetheless may allocate income and other items to the services partner despite the possibility of forfeiture. This is done through the addition of another "deemed to have substantial economic effect" rule because the allocation cannot have substantial economic effect because of the forfeiture possibility. But to qualify for the allocation, the partnership agreement would need to require "forfeiture allocations" if forfeiture occurs, and the usual "all other allocations must be valid" requirement is imposed. A "forfeiture allocation" is an allocation to the services partner, in the year of forfeiture, of items that in effect offset that partner's track record of allocations, contributions, and distributions up to that point. Note that I am paraphrasing a long, convoluted, arithmetic formula in the proposed regulations that I'll leave to the diehard partnership taxation fans to read on their own. This portion of the proposed regulation caps things off with a denial of allocations to the services partner if the forfeiture is planned. This is simply the IRS nipping abusive planning in the bud before it can blossom into something more devious, but I'm sure the artful planners will be culling the proposal looking for any hint of a tax shelter opportunity.

If you want to have a lot of fun, take a look at the proposed example. It's almost as long as one of my blog posts!

Are we done? NO!!!!!

Next, the regulations propose that the "transfer of property subject to section 83 in connection with the performance of services is not an allocable cash basis item within the meaning of section 706(d)(2)(B)." That means the daily proration rules are not mandatory, and the partnership can use interim closing in determining allocations to the service partner who arrives during, rather than at the end of, a taxable year. The regulations also propose that forfeiture allocations can be made out of partnership items arising at any time during the year even if the forfeiture takes place during the year.

The regulations then propose that amounts transferred in connection with the provision of services by the services partner, even if characterized as guaranteed payments, are included in the the service partner's income for the year in which section 83 requires inclusion, and not in the taxable year of the partnership's deduction as is the case for guaranteed payments generally.

Finally, the proposed regulations preclude treating as a partner someone to whom an interest has been transferred if that interest is substantially nonvested, unless the section 83(b) election is made. This makes sense, because it says, in effect, "wait until you really are a partner before expecting to be treated as one."

Back, now, to the education component of the post. There will be more for the students to read. They will need to read the regulations. They will need to read an explanation of the regulation, probably the preamble. Class time is needed to deal with the issues. What can be removed from class coverage without removing it from the course? These regulations, after all, do not make any of the other topics or subtopics any less important. If I take an "easier" topic and leave it to students to learn on their own, I do hear about it. But isn't it good practice to learn how to learn on one's own? After all, the many hundreds, if not more than a thousand, students who sat through Partnership Taxation or Introduction to the Taxation of Business Entities between January 1981 and two weeks ago must learn these new rules "on their own."

I will close with something else that causes anguish for students. These changes, if implemented, obsolete portions of "old student outlines" circulating in the dark corners of the student academic materials exchange alleyways. You can tell I'm not a fan of using old outlines, for the same reason I'm not a fan of trying to get into shape by watching someone else workout. This obsolescence means next year's students must create this portion of the outline for themselves. YAY! It also means I have some GREAT examination material, because students carelessly using old outlines don't do well with "new law" questions. And it makes it so much easier to shut down sympathy when a student inquiring about an undesired grade can be told, "I can tell you used an old outline." Fortunately, there's much less of that in my elective J.D. Introduction to the Taxation of Business Entities course because my warnings drive away students looking for the easy path. After all, according to the J.D. student grapevine, it's the most difficult course in the J.D. Program. As for the Partnership Taxation course in the Graduate Tax Program, the fact it is required means that at least some of the involuntarily enrolled students, unable to grasp the pervasive nature of partnership taxation in a tax practice, try to get by on the "quick and easy" and end up instead with "crash and burn." Yes, the Graduate Tax Program rumor mill describes Partnership Taxation as the most difficult course in the program.

Now folks can see why I make friends quickly when I meet people who teach quantum physics. Somehow, though, it seems as though they've got it easier because Congress doesn't change the laws of physics the way it changes tax law. Sure, Congress probably will try someday, but by then we'll be dealing with more serious problems.

Happy Monday. I'm off to get a root canal and eventually another dental crown. This tax stuff is bad for one's teeth, I guess.

Once again it's graduation day, and I could simply repeat what I said last year. But that would be boring. As far as I know, the "do they all have jobs?" question gets pretty much the same answer. Many do, some don't, and many of the latter will find something after the bar exam.

It's a big day for the students who are graduating, and their families. I'd like to see all of them return five years from now, not merely to attend the evening social event called a Reunion, but to participate in a day-time symposium attended by law students in the Classes of 2010, 2011, and 2012. At this symposium the alums would describe how their law school experiences did and did not contribute to their successes and shortcomings in practice. Perhaps, one hopes, hearing words of advice and caution from those a few years older, rather than from the chronologically distant faculty, will nudge some of them away from the bad habits and bad decisions that make law school, and practice after law school, tougher than it needs to be.

This might be the biggest class to have graduated. A few more than 250 is what I've heard. That's not counting the LL.M. (Taxation) graduates. It is a tradition that has survived from the beginning of the school's history to read the names of the graduates as the proceed across the stage to receive their diploma (or, honestly, a rolled up piece of paper that they turn in for their diploma at the Registrar's office). So we'll be there a little longer than usual.

This year, 8 of the 23 students in the top ten percent were enrolled in one or more of my classes, and of those 8, 5 were in one or both of my tax classes. That's as high as it has been for many years. The top ten percent avoid my class, chiefly because they dislike the "during semester" workload that comes with the course. They did well with the "wait until the end" approach used for first-year courses, so why let go of a familiar and successful approach? I'll answer that question next week, if I remember. Of course, if the other 18 enroll in another section of the basic tax course, fine, but how can they, when those faculty also impose "during semester" workloads? What's even more disturbing is the percentage who took the Decedents' Estates course (approximately 60%) and the estate tax and family wealth planning courses (at best 5%), and the percentage of graduates who report that they engage in will drafting and estate planning (far more than 5%). I wonder how many clients ask their attorneys whether they've taken courses in the area of the law applicable to the client's issues.

And, yes, it is raining. It seems it always rains on graduation. The ceremony is indoors, but one has to get there. I like to walk from the law school to the Pavilion because it's faster than driving, good exercise, and a pleasant stroll. Not today. One year a thunderstorm came in with those "sideways" rains that make umbrellas useless baggage. I have never seen so many people just drenched from head to foot while dressed in suits and other dressed-up attire. I do recall a few sunny graduations, and some with breaks in the rain that came at the right time.

This is my twenty-second, yes, twenty-second, graduation at Villanova (other than my own). Add in three at Dickinson, and today is the 25th graduation in which I have participated as a member of a law school faculty. There are few things I've done for as long. Other than life itself, and other than being my parents' child for far more than 25 years, there's being a member of the bar (29 years), the family history addiction (32 years), knowing how to ride a bicycle (almost 50 years), having a drivers' license (35 years), and a few other, well, boring things. Fewer than 25 years? That list is long. I guess that demonstrates I'm young, ha ha ha.

Thanks for rolling down this stream-of-consciousness reflective moment with me. When I mentioned that it was a big day for the graduates and their families, I didn't mean to imply that it wasn't a big day for anyone else. For the faculty, it's similar to sending one's children off to college. It's time for them to fly, though using the phrase "kicking them out of the nest" might be a bit harsh. I know that I will see a few of the J.D. graduates, especially those who come back to enroll in the Graduate Tax Program. I know that I will get email or phone calls from some, usually when they encounter a situation in practice that reminds them of my courses, either to ask me "hey, how did you know this would happen?", to add to my collection of practice lessons for future students in response to my standing invitation to share their experiences, or to ask for guidance in unraveling an issue. But I also know that I will never again see or communicate with many, perhaps most, of the graduates. I'll read about some of them. I'll hear about a few of them. I'll be asked about one or two of them. So the comparison to sending one's children off to college isn't sufficiently precise. It's much more a valedictory event than an "au revoir" moment.

Good luck to all.

The ongoing dispute concerning New York's practice of taxing nonresidents on their entire income derived from employment with companies located in or doing business in New York has taken an interesting turn, according to this report. As I explained in this post and followup, New York has succeeded, to this point, in taxing a Tennessee resident, who is not a New York resident, on all the income he earns in Tennessee doing computer work for a New York organization even though he spends about 25% of his time in New York. So after getting ahead in the count, New York has taken a strike. Swinging.

New York's theory is that it can tax all the income of a nonresident who works for a New York company except to the extent the employee does work outside of New York because the employer deems it necessary for the employee to work out of state. Thus, in the previous case on which I commented, the Tennessee resident was not permitted to exclude any of his income from New York taxation because his decision to tele-commute from Tennessee was not required by his New York employer. Whether that approach, as advocated by New York, is an appropriate or permissible test continues to be debated, and we wait to see if the promise of a further appeal by the Tennessee resident materializes.

In the most recent case, a New York company who employed, among others, a Connecticut resident, moved most of its operations to Viriginia. The New York resident continued to do work by tele-commuting from the company's New York office. At that point, there is no question New York can tax the employee's salary. Several years later, however, the company told the employee either to relocate to Virginia or to tele-commute from home. The company terminated his building pass for the company's New York site and reassigned his office to another employee. It changed the employee's status from New York employee to member of a technical group in Virginia. The employee chose to tele-commute from Connecticut. He no longer worked in New York.

So even though this person no longer had any employment contact with New York, other than being employed by a company that had New York employees, New York insisted it had a right to tax him. An administrative law judge held that because the employee was required to work from Connecticut and did not have the option of working in New York, it was improper for New York to subject him to income taxation. There's no news on whether New York will appeal.

The idea that New York thinks it can tax a person who has no employment contact with New York other than being employed by a company with contacts in New York is startling. Theoretically, what's to stop New York from trying to impose income tax on all the employees, no matter where located, of Citibank, NBC, or any other company with New York employees or even just New York contacts? The previous case involved someone who took 75% of his work out of the state. This case involves someone who took all of his work out of state. Will the next case be someone who never did work in the state? If New York does not go that far, is New York contending that once a person works in New York the person cannot ever escape taxation even if moving away? Suppose the fellow in the most recent case had decided to end employment with the company, stay at home, and begin working from home for Morgan Stanley, which happens to have some New York employees. Would New York try to continue taxing him? What if his neighbor, who never worked in New York, also took a job working from home for Morgan Stanley? Would New York try to tax her? If not, how can New York justify taxing him but not her if the only difference is the fact that in the past he, but not she, worked in New York?

New York has its budget problems. So, too, do many other states. However, the need for money ought not be permitted to encourage state taxation officials, or their attorneys, to get so "creative" that they make unwise decisions. Just as federal and state revenue officials decry the "creative" activities of tax-avoiding taxpayers and their lawyers, so, too, those same officials should set the standard to which they want taxpayers to aspire, and refrain from "creative" but unsustainable revenue collection theories.

After all, whatever might be argued in the case of the Tennessee resident who is in New York for 25% of his employment efforts, there's no way New York can justify taxing a Connecticut resident who tele-commutes from home and never sets an employment foot in the state. That Connecticut resident imposes no financial burdens on New York, and gets no benefits from New York. I'll go so far as to claim that there is a serious Constitutional issue lurking in this case, and that's why I'll predict that New York will not appeal. It has way too much to lose than just the revenue in the case.

It is said that imitation is the sincerest form of flattery. Perhaps that's also true of literary imitation in the form of substantial quotation. Yesterday, while amusing myself by googling my full name, I discovered that my April 20, 2005 post on the increase in the number of taxpayers with incomes of $200,000 or more who pay no taxes had been republished, in full, on the Quatloos Tax Practice and Policy and Tax Shelter forum.

Other than "# posted by James Edward Maule @ 10:08 AM" at the end, there is nothing to indicate that the post is a quotation-in-entirety of a MauledAgain post, and, most disappointingly, there's no link to the MauledAgain blog. Easily done, of course, so I'm not sure why it's not there. It could be a problem with incorporating "a href" links, because the links in my post also disappeared, causing another Quatloos poster to provide the URL for the report that I cited in the post.

Attribution concerns aside, the comments made in response to the message of the posting deserve some attention. Rather than responding on Quatloos I decided to drive some traffic to MauledAgain by sharing my reactions here.

Someone using the screen name "Investor" asked, "Are you suggesting that a tax system that allows 0.112% (which is roughly .0001% of the US population) of the high income taxpayers to escape income tax* needs "a major overhaul"?" and responded to his or her own question, "I would say that this indicates that a minor tweak is needed (maybe a phase-out of investment interest deductions for high AGI), not a major overhaul. There are other issues that lead me to believe that a major overhaul is needed, but not this one." Because of the attribution omission, it isn't clear whether Investor was querying ME or the Quatloos poster who posted my post. In any event, I'll respond. The point isn't that there is a gaping hole that demands a major overhaul. The point is that when an elite few can create for themselves, or have created for themselves, rules and contextual application that puts them in a "not tax paying" us versus everyone else who is the "taxpaying them," a serious erosion of taxpayer morale is planted like a cancer among the "taxpaying them." Another tweak is simply a further gaming of the system. The need for the major overhaul isn't the extremely small percentage of lost revenue. It's the need to restore taxpayer morale, and compliance, by junking a system that fertilizes "we'll find one way or another to avoid paying taxes no matter what tweaks what" cancers such as those that create the problem I blogged and that was then shared on Quatloos. Overlooked in Investor's analysis is another important fact, namely, the number of people with incomes over $200,000 who avoid paying tax is increasing at a rate that threatens to spread as does a rapidly metastizing cancer.

The next Quatloos poster, Levendis, pointed out that the alternative minimum tax was enacted in response to tax-avoidance abuses in which far fewer taxpayers engaged than currently escape taxation despite having more than $200,000 of income. What Levendis did not mention, but perhaps intentionally left unspoken, is the manner in which the AMT "remedy" has become an affliction on a huge number of taxpayers never intended to be caught by its net. That's the problem with tweaking a complex structure, as I pointed out some time ago in my Pleiotropy post. Investor replied, decrying the spread of the AMT to middle-class taxpayers, and characterizing complexity as the biggest problem affecting the tax system. Yet Investor had just finished suggesting another "tweak" rather than overhauling the system. Tweaks, or more precisely, bundles of tweaks and tweaks of tweaks, is what creates the hated complexity.

The Quatloos discussion then turned to two causes of the "over $200,000 tax escape," namely, the fact that the investment interest deduction and the medical expense deduction, which are not added back for AMT purposes, and which are not phased out as income increases, are the primary tax reduction factors in 23.1% and 8.6%, respectively, of the returns showing no income tax. Investor then raised an important consideration: "You may say that a system in which a person can have income of $200K and pay no taxes is unfair, but there are also a variety of other policy/economic considerations here. If someone has so much margin interest that it is completely eliminating their taxable income at the $200K AGI level, they obviously have huge investments. I would venture a guess that if you looked at these "zero income tax payers" over a span of 5-10 years, they pay more income taxes in the aggregate than the average American earns over that same period, and at a much higher effective rate. To look at one year and scream, 'this is unfair' is very narrow minded (I assume that this report does not imply that it is the same individuals year after year with $200K AGI and no tax liability)."

It is true that the report does not identify the taxpayers, and thus prevents the sort of 5-10 year analysis that would be more helpful in understanding the underlying economics. If, however, a person has no tax liability because of the investment interest deduction, it means not only does that person's investment interest expense equal or exceed investment income, that person also has little or no other income. So how are they paying their bills? Dipping into investments? But why would their investment interest expense exceed investment income? What's the sense in borrowing $5 in order to earn $4? The answer is that these folks may be "speculating" (translation: gambling) with investments. Should the tax law be "financing" that sort of "enterprise"?

Yet this discussion is too narrow. The investment interest expense and medical expense deductions account for 31.7% (and only 31.7%) of the situations in which no tax is paid by taxpayers with adjusted gross incomes equal to or exceeding $200,000. If one turns to taxpayers with expanded income equal to or exceeding $200,000, the single-most cause of no tax liability is the exemption from taxation of interest on state and local debt obligations. In the first group, miscellaneous deductions (at 21.4%) and "all other tax credits" (at 21.0%) are for all intents and purposes equally responsible for the non-taxation status of these returns as is the investment interest expense deduction. In fact, that latter deduction doesn't even show up as a separately identified cause of non-taxation on the returns with expanded income of $200,000 or more. So there's a lot more involved than simply the investment interest expense and medical expense deductions, and a "tweak" would need to be far more complicated than simply playing with those two deductions.

So long as specialty groups and their advocates continue to persuade the Congress that a dollar of one type of income is different from, and should be taxed differently (or not at all) than is a dollar of some other type of income, so long as those groups and their advocates continue to persuade the Congress that expenditures for some purposes should cause a reduction of tax liability, and so long as special interest groups and their advocates continue to push for direct tax liability reductions in the form of credits for every sort of favored activity, the tax burden distribution will be skewed in favor of the influential and powerful who use their energies to lobby for an unfair (and thus complicated) tax system. In turn, the number of wealthy who avoid taxes will increase. Similarly, the tax-disfavored will seek, in increasing numbers, a way to jump on the "tax reduction bandwagon." Some will fall prey to the hawkers of illegal tax shelters and off-shore schemes. Others will drop out of the system, or at least try. Still others will turn increasingly to "pay cash, pay less" arrangements. The corrosive effects of the "tax avoiding us" and the "tax paying them" cancerous divide will accelerate, and the tax system will begin to fail. Already, more than $300 billion a year goes unpaid, much of it unreported. The impact is far more serious than a million marchers parading down the Mall on a Sunday afternoon protesting this, that, or the next thing.

The Congress is losing touch with the overwhelming majority of taxpayers, who want to be law-abiding but who cannot help but think they are gullible fools for complying with laws that, to them, appear to be ignored or twisted by (or written to the advantage of) others who are more influential and powerful. Why Congress thinks it can fend off the problem by enacting tax cuts that reduce a person's taxes by several hundred dollars, while billions of tax dollars go uncollected baffles me. I suppose Congress thinks that throwing some bread to the masses will distract them, or sufficiently ease the disgruntled, while the rate on capital gains plumments toward zero, while the credits, deductions, and special exceptions for the influential and powerful grow in number and value, and while the quietly increasing "nibbling at the edges" noncompliance by the not-so-powerful replicates the impact of those silent termites lunching in the support beams. After all, who cares if a termite eats 0.112% of the wood? Each year. I've yet to meet a pest control technician who simply "tweaks" termites and stays in business.

The federal income tax law is groaning under the weight of ever increasing numbers of credits and deductions inserted in hopes that one or another of someone's worthy cause will be advanced by the supposed impact on taxpayer behavior of a tax incentive to behavioral change. Almost a month ago, I noted, in a somewhat mocking post that the Tax Reform Panel was "discovering" what everyone else has known for years when it issued an interim report that inspired this newspaper headline: Too many deductions, credits fill U.S. tax code, panel finds.

Everyone knows how this has come to be. Everyone agrees it must stop. Everyone understands the negative impact on tax compliance of these "my cause is so special it deserves to be in the tax law" provisions. Everyone knows the impact of these complexities on the rising cost of tax compliance. OK, maybe not everyone. Perhaps someone living under a rock missed out on the news.

Of course, not everyone will state publicly that he or she knows and understands the corrosive effect of using the tax law to try altering people's behavior. But that doesn't mean they don't know and understand those effects. The lemming mentality that grips politicians under pressure to do for their favored groups what some other legislator did for his or her devotees pervades legislatures.

If any of us thought that the Tax Reform Panel's warnings would change behavior, we were mistaken. Perhaps there ought to be a tax credit for legislators who refrain from introducing social engineering provisions into the tax code, with an additional credit for those who refuse to vote in favor of such measures. JUST JOKING. No, uh, maybe I ought to be serious about that.

Instead, the parade of tax goodies continues. So here we go again.

This time it's a dual-pronged tax proposal wrapped into wider-reaching proposed legislation that aims to accomplish a goal against no one with any degree of sense can speak negatively. Last week, Representative Carolyn Maloney re-introduced the Breastfeeding Promotion Act that has been introduced in at least two previous Congresses. In fact, it's been around so long that the Internal Revenue Code section that it proposes to add (section 45G) was used for another credit, as has been the next one in line (section 45I).

Quoting from the Representative's press release, "The purposes of this act are to promote the health and well-being of infants whose mothers return to the workplace after childbirth, and to clarify that breastfeeding and expressing breast milk in the workplace are protected conduct under the amendment made by the Pregnancy Discrimination Act of 1978." That it makes sense to encourage breastfeeding is undeniable, as painstakingly detailed in the 2003 Congressional Research Service Report, Breast-feeding: Impact on Health, Employment and Society. It's the use of the tax law, and the correlative complexity, rather than a more direct approach that injudiciously adds to the current crisis in tax law.

Again quoting from the Representative's press release, the bill covers four purposes: (1) to amend the Civil Rights Act of 1964 to protect breastfeeding by new mothers,(2) to provide tax incentives for businesses that establish private lactation areas in the workplace, (3) to provide for a performance standard for breast pumps, and (4) to allow breastfeeding equipment to be tax deductible for families."

The second tax prong, making breastfeeding equipment tax deductible, cannot be criticized so long as there is a medical expense deduction in the tax law. Breastfeeding equipment is medical equipment just as eyeglasses, hearing aids, and similar items, and so I would have responded "yes" to a question about its deductibility had I been asked this question before this bill prompted me to explore the question. But I'm not certain that the IRS would agree with me, because in one private letter ruling (PLR 8919009), it concluded that medical expenses did not include the cost paid by a pregnant woman for instruction with respect to "(g) Breast feeding/bottle feeding; and (h) Newborn care and the adjustments of becoming a parent." There is no other guidance from the IRS, and I could not find any cases addressing the issue. So, to the extent the bill clarifies that the medical expense deduction should cover breastfeeding equipment then this particular amendment to the tax law makes sense. In any event, it adds a five-word subparagraph and a one-sentence definition to the Internal Revenue Code, in language that doesn't defy comprehension.

It's the first tax prong, establishing a credit to encourage businesses to set up private breastfeeding areas in the workplace, that not only unnecessarily complicates the tax law but also falls short in accomplishing the goals of the bill's sponsors. The complication to the tax law is not only an entire Code section, consisting of five subsections, layered with dollar limitations, definitional challenges, the computational requirements of a recapture provision, the incorporation of other, existing, tax law rules, and an array of conforming rules with respect to such things as basis and double benefits, but the need for taxpayers to maintain additional records, pay return preparers additional fees to fill out forms, and to certify the qualification of expenditures and policies with respect to the matter.

Don't get me wrong, and don't take my objection to the proposed tax credit as an objection to the goals of Representative Maloney. I'm all for breastfeeding of infants. I agree that the practice is good for infant, mother, and society. If, and that's a big "if" on which I reserve judgment, it is appropriate and necessary for the FEDERAL government to step into the arena of how parents nurture and nourish their children (and I understand that some reasonable arguements can be made to that effect, as well as to the opposite conclusion), then the sponsors should be proposing a law that requires government and employers to accommodate the breastfeeding of infants. It ought not leave mothers at the mercy of whether their employer decided it did or did not need a tax credit. For example, employers that presently are in financial difficulties are swimming in deductions and credits, and thus the proposed bill gives them no incentive to accommodate nursing mothers.

So what to do? Make it a law. Make it mandatory. After all, the minimum wage is mandatory for covered employees. Employers aren't thrown a "take it or leave it" tax credit as an incentive to do something that they're left with a choice to do or not do. Federal law requires airline passengers to submit to pre-flight inspection. It doesn't leave the success of this security measure to the whims of people deciding whether to take an optional tax credit for choosing to undergo the inspection.

At best, tax incentives for behavior should do no more than to encourage behavior which society thinks is nice but not essential. Even so, I disfavor tax incentives for behavior, but I can understand the arguments made by their supporters when the behavior in question is something desirable but not within the scope of a government to command. If tax incentives must be used to entice people to do what they must do, then government has sunk to the level of bribing its citizens to behave. That, in a political world controlled by the under-taxed wealthy and their lobbyist allies, is not government but organized corruption.

The sponsors of this bill should be saying, and perhaps are trying to say, to employers, "You must accommodate nursing mothers." If an employer gets a reward for doing so, in the form of a tax reduction, then why not similar rewards to people who comply when told, "You must stop at stop signs," "You must put your clients' funds into escrow," or "You must report all outbreaks of mad cow disease in your herd." To the extent society is becoming a "what's in it for me" and "show me the money" culture, Congress is contributing to this degradation of civilization by enacting tax legislation that pays certain citizens to do what they ought to be doing aside from legal compulsion, let alone when required to do so by law.

If it doesn't stop here, where and when will it stop? When there are 43,583 tax credits for every imaginable cause, and the entire country shuts down because everyone is swamped with the task of identifying which 1,304 credits apply to their specific situations, while investing hundreds of hours into compliance?

Yes, Representative Maloney got herself some good press re-introducing this bill on Mother's Day. But she, and her co-sponsors, could do the country an even greater service by ditching the credit, making the accommodation of nursing mothers mandatory, and leaving it at that. After all, if the nation's employers need to be bribed to accommodate our mothers, we've reached a most pitiful sad condition such that more than the tax code needs to be ripped out by the roots.