MauledAgain

To make an even bigger mess of the tax code?

Here we go again. This time it's the ENERGY POLICY TAX INCENTIVES ACT OF 2005, which was approved by the Senate Finance Committee several days ago. Let's see what it does to the tax law:

* it adds a new investment tax credit to the energy credit, applicable to qualified projects that generate power using integrated gasification combined cycle and other advanced coal-based electricty generation technologies.

* it adds a new investment tax credit to the energy credit, applicable to qualified gasification projects, which are projects that convert coal, petroleum residue, biomass, or other materials recovered for their energy or feedstock value into a synthesis gas composed primarily of carbon monoxide and hydrogent for direct use or subsequent chemical or physical connversion.

* it adds a new investment tax credit to the energy credit applicable to clean coke/cogeneration manufacturing facilities.

* it provides a credit for non-business energy-efficient property, which consists of advanced main air circulating fan, a Tier 1 natural gas, propane, or oil water heater, and tier 2 energy-efficient building property used in a trade or business.

* it provides a credit for the purchase of combined heat and power property, the definition of which includes four conditions and an alternative.

* it provides a nonrefundable business energy credit for the cost of energy efficient appliances.

* it provides a personal tax credit for the purchase of qualified photovoltaic property and qualified solar water heating property used for purposes other than heating swimming pools and hot tubs.

* it provides a business energy credit for the purchase of qualified fuel cell power plants.

* it provides a credit for the purchase of new qualified fuel cell motor vehicles, new qualified hybrid motor vehicles, and new qualified alternative fuel motor vehicles, and the credit would reduce the existing deduction for qualified clean-fuel vehicles.

* it extends the nonrefundable business energy credit to include energy-efficient property installed in a qualified new energy-efficient home during construction by an eligible contractor.

* it creates a new category of tax credit bonds, namely, clean renewable energy bonds, .

* it creates a new category of tax credit bonds, namely, clean energy coal bonds.

* it provides for a temporary election to expense the cost of qualified refinery property.

* it provides a deduction for energy-efficient commercial building property expenditures made by the taxpayer, limited to $2.25 per square foot of property for which the expenditures are made.

* it provides a deduction for the purchase of qualified energy property, which consists of advanced main air circulating fan, a Tier 1 natural gas, propane, or oil water heater, and tier 2 energy-efficient building property used in a trade or business.

* it treats natural gas distribution lines as 15-year property for MACRS purposes.

* it repeals the phaseout of the electric vehicle credit, and increases the credit to varying amounts depending on the specific characteristics of the vehicle.

* it increases the clean-fuel vehicle refueling property credit, and changes certain definitions relating to that credit.

* it increases, from 10 to 30 percent, the credit for solar energy property.

* it modifies the enhanced oil recovery credit, increasing it for qualified projects that use certain carbon dioxide injections.

* it extends the electricity production credit to electricity produced at advanced nuclear power facilities.

* it extends and modifies the renewable electricity production credit, by postponing the sunset date by three years, and adding fuel cells as a qualifying energy resource.

* it postpones the sunsetting of the biodiesel fuel mixture credit.

* it eliminates the sunsetting of certain income exclusions for tax-exempt rural electric cooperatives, and modifies some other highly technical provisions dealing with those cooperatives.

* it creates an excise tax credit for alternative fuels, allowed against the excise tax on alternative fuels.

* it creates an excise tax credit for alternative fuel mixtures, allowed against the excise tax on alternative fuels.

* it permits independent electric transmission companies to use the 8-year ratable gain deferral provision applicable to sales of property used in providing electricity transmission when the proceeds are invested in exempt utility property.

* it provides for the passing through, by cooperatives to their patrons, the deduction for costs paid or incurred to comply with the Highway Diesel Fuel Sulfur Control requirements.

By my count, there are 12 new income tax credits and 2 new excise tax credits, 6 modifications and expansions of existing credits, 3 credit sunset extensions, 3 new deductions, a deduction modification, and 2 other provisions. In the meantime, down the street, the Tax Reform Commission is studying ways to simplify the tax law and increase compliance. Up the street, Treasury and IRS struggle to find ways to deter taxpayers from manipulating complex code provisions to achieve goals not intended by the Congress, noting that the more provision are enacted, the more game-playing fields are opened to the tax shelter manipulators.

Is this any way to run an enterprise, whether a government, a private business, a charity, or any other institution?

No.

Of course energy conservation and the discovery and development of new types of energy sources are activities critical to national defense, economic viability, and preservation of a culture that nurtures democracy and human rights. But is turning the tax law into a chemistry and engineering handbook the appropriate approach?

No.

Notice how the credits are tailored to specific and narrow segments of subdivisions of the energy industry. It appears that, once again, lobbyists have had a field day. Where are tax credits for helping people purchase homes near their place of work, thus cutting down commuting time, which saves energy and reduces pollution. Where are the tax credits for teaching children not to leave the doors wide open in winter, or to teach people not to open a refrigerator in summer and stand there looking over the contents while debating their next move? Where are the tax credits for joining community swimming pools and closing down individual residential pools? Where are the tax credits for designing traffic light systems that don't keep cars waiting, getting zero miles per gallon, while invisible cars proceed on the cross street? Where are the tax credits for encouraging use of passenger trains, oh, wait, Congress is cutting Amtrak funding. Sorry.

Will the Congress authorize the hiring of dozens more Treasury and IRS employees to write the regulations and rulings required to interpret these dozens of new provisions? Will it pay for the hiring of IRS employees to develop the dozens of forms that will be required for these new provisions? Will it authorize the hiring of hundreds more IRS employees to audit the tax returns on which these credits and deductions are claimed? Will it fund programs to ferret out the tax shelter manipulators who will be offering various energy credit investment deals? I doubt it.

If the goal is to persuade individuals and businesses to engage in energy conservation and to develop new types of energy sources, why not let the market do its job? For example, when the price of gasoline reaches $6 a gallon, the demand for hybrid and other alternative fuel vehicles will soar, as demonstrated by the increased interest in hybrid automobiles as gasoline prices climbed over $2 a gallon. What's the point of giving a credit for something people would do on account of market conditions? If the concern is that some people would not be able to afford the purchase, and that a small credit would make the difference, why not operate a grant program for impoverished individuals through the Department of Energy? Well, the answer is that Congress apparently thinks that the IRS is the most efficient federal agency to operate energy and other grant programs disguised as tax credits. Yes, the same Congress that publicly bashes the IRS in order to "get" votes turns around and entrusts administration of its energy program to the IRS. Think about it.

As another example, when the cost of home heating oil and natural gas reaches comparably high prices, the incentive to shift to fuel-efficient appliances and fuel-conserving behavior will increase. Again, if there is a concern with the plight of those unable to afford new heaters and appliances, set up a grant program. After all, of what use is a tax credit, unless it is refundable, to someone with so little income that they don't have tax liability against which to set the credit. Note that, as best I can tell, only one of the credits is refundable.

The notion that American businesses and individuals will conserve energy and switch to more efficient, less expensive forms of energy only if bribed with tax credits is appalling. If that is indeed the case, it speaks volumes about a nation that perhaps is narrow-minded and short-sighted. And if Americans won't otherwise act in energy-wise ways, then it's time to enact laws dictating that they do so. Americans should be expected to do what is right, even if laws need to be enacted to tell us what is right. But to rely on tax incentives to get people to do what they ought to be doing, and very well might already be doing, is wrong. Very wrong. After all, what's next, a tax credit for stopping at stop signs? A tax credit for owning a gun and going a full year without shooting someone out of anger or revenge? A tax credit for eating broccoli? As sarcastic as these questions may appear, it would not be a surprise to see another several dozen lifestyle credits enter the Code next year, another several dozen neighborly behavior tax credits enter the Code the year after that, and for the entire system to become the playground of the monied special interest groups who have no sense or understanding beyond their own little worlds. And if the nation succumbs to being controlled by these narrow-minded and short-sighted special interest groups, it will make the tax code mess one of the lesser concerns of the citizenry.

So what happens when the Tax Reform Commission comes in with a proposal to simplify things, assuming that it will do so. And I think it will do so, if for no reason other than to rack up PR points for the Administration. Can this addicted-to-lobbyists Congress resist the temptation to desimplify the proposal? I doubt it.

Watching Congress turn the tax law into a bureaucratic, inefficient, compliance-deterring nightmare is distressing, frustrating, and frightening. At least, for me, it is. I suppose it's not yet that way for enough other folks for it to matter. Congress, after all, won't stop until it is told to stop. Why else should it stop? That's where the frightening part comes in. Think about it.

My post the other day about skyrocketing housing prices brought some interesting comments from several tax law professors across the nation. Without unveiling their identities to the world, they collectively made these suggestions:

** The cause is twofold: low interest rates and a worldwide glut of capital.

** It's not a phenomenon limited to the U.S.; housing prices are skyrocketing in much of the world.

** Population increase is indeed a factor.

** Consider Mark Twain's (or Will Rogers') comment on investing in land because they aren't making any more of it, but also consider that there are separate land markets for farm, seasides, and residential development, the last of which has been increasing.

** To some extent wetlands preservation limits land supply.

** Housing markets rest on what new home sellers can command in the market, and they price new homes by capitalizing the stream of montly mortgage payments that the purchaser can afford.

** Even though the home mortgage interest deduction has the effect of reducing the buyer's monthly payment, becasuse it increases what the buyer can pay, it contributes to a higher asking price by the seller, and thus subsidizes sellers, and, to the extent they increase interest rates to reflect the deduction, banks.

** The combination of low interest rates and zero-principal, interest-only mortgages is drawing many renters into the home purchase market.

** The $5,000 tax credit for first-time homebuyers in the District of Columbia has had an impact.

** Increases in the cost of lumber and other building materials is contributing to the increase in home prices.

I had forgotten about the D.C. first-time homebuyers credit, and although it has very little impact on housing prices throughout the nation, it is an interesting example of government interference in the markets. Is the credit still necessary now that D.C. residential real estate has become much more attractive?

It's not just wetlands preservation that limits land supply. It's preservation of forests, open areas, historic properties such as battlefields, and any other building restriction that limits what an owner can do with the land, if it means fewer or no residential units being built on it.

Even though the cost of building materials affects chiefly new home construction, when new home prices rise, the cost of used homes will follow. This happens because potential buyers of the new homes who are priced out of the market or who cannot find a suitable new property will turn to the used home market, where prices generally lag behind new home prices by a few percent.

Interestingly, there is much concern that farmland is decreasing because of the "intrusion" of housing developments as population growth pushes out the boundaries of urban and suburban areas. If a disruption in global trade required America to increase its domestic food production, would there be enough farm land? Even though America exports food, such as grain, it also imports food, such as fruit from the Southern Hemisphere when the growing season in much of the continental United States has ended. Ultimately, there is a finite limit on how many people the continent and the planet can support. And one principal reason is the finite amount of usable land.

Home prices are highest in areas that are most desirable. Thus, housing prices on the two coasts lead the way. Clearly this reflects the demand side, as the portion of the country's population living within 200 miles of either ocean continues to grow. As small town after small town in the heartland closes up shop, will the D.C. homebuyer credit be expanded to cover those areas? Assuming, of course, that policy makers should, and do decide to, try influencing home purchasing decisions. Although one response, that people move to where the jobs are, makes sense, isn't that offset by the opportunity to telecommute? We know that people are telecommuting, as the tax tribulations of one particular telecommuter has been highlighted in several earlier posts (here, here, and here).

The zero-principal, interest-only mortgage surely is a factor, and some reports claim that anywhere from one-fourth to one-third, and even one-half, of new mortgage loans written during the past few months are this type of mortgage. The attraction to the buyer is the ability to take out a higher loan for the same monthly payment. But in the long-run, the zero-principal, interest-only mortgage is more expensive. Jeff Brown had a good explanation of why this is so in his Philadelphia Inquirer column yesterday. He's the one, incidentally, who noted that the proportion is as high as 50% of recent mortgage loans.

Much of the discussion about the skyrocketing housing prices has been a concern that there is a bubble that is going to pop. If that happens, there will be foreclosures, so we're told, on a scale similar to that during the Great Depression. Lenders will end up holding properties whose values are tumbling. Evicted homeowners will be flooding the rental market, or moving in with parents or other relatives. Will this happen? Is there a bubble? Andy Cassel, in today's Philadelphia Inquirer column, asks that very question, and in the style of a good law teacher, presents information and leaves the rest of the analysis and the reaching of a conclusion to his readers. He points out that household monthly debt service payments, as a percentage of household income, has remained steady since 1980. But he also points out that household debt has doubled. Andy notes that the "it's a bubble and will burst soon" cry has been with us now for quite a while, and yet new home construction and existing home sales continue to climb, and are on the verge of setting yet another record.

I worry about two things. First, because property taxes are based on home value, people on fixed incomes are going to be hit with yet another round of increased property taxes, unless localities scale back the millage rates. That's unlikely, because local governments, particularly school districts, are under all sorts of financial pressures as they struggle to comply with all the federal and other mandates specifying the long list of services that they must provide.

Second, if the geniuses who make national tax and economic policy start fiddling with the tax law to "control" housing prices, the fallout might not be limited to another stack of Internal Revenue Code pages filled with hyperlexic regulation. The fallout might be an overcorrection, or a dampening effect, that causes the baby to be thrown out with the bathwater. (Yes, nice (sarcasm) expression, but did it ever really happen???). I noted this concern in my Wednesday post, and Andy Cassel makes a similar point, namely, if the escalating prices are generating an even bigger bubble, "then it makes sense for government to try somehow to correct them" but if the home market is a rational reflection of supply and demand, "then government is likely to do more harm than good by stepping in." Considering the government's track record using the tax code to "step in" the ideal of using the tax code to tinker with the housing market is alarming.

One last question: So who is it that has all this excess capital available for infusion into the housing market? Home buyers? Surely not the ones, who like my former student Nakul and his wife, are experiencing sticker shock. How many people in this country have excess capital on their hands? Even though 75% of households own their homes, I truly doubt that 75% of Americans have excess capital. My guess is that the excess capital is being funneled into mortgages, marketed with an enticing "interest only" feature that in the long-run will, following Jeff Brown's analysis, shift even more wealth into the hands of those with the excess capital. Unless, of course, home prices continue to escalate. And if they do, at what point does the "interest only" feature fail to bring in new buyers?

This is going to remain a most interesting story to follow.

One of my former students, Nakul Krishnakumar, whose comments on previous postings have found their way to the MauledAgain blog on two occasions (and here), pointed me to an article in Capitalism Magazine about the causes of escalating housing prices. Nakul and his wife are experiencing sticker-shock first hand, as they set about house hunting and moving forward from Nakul's graduation last month. As a more passive observer, I'm not unaware of the significant increases in recent sales of homes throughout the area, but they don't have the same impact that they would had I been out shopping.

The point of the article, by Thomas Sowell, is that government intervention has caused the increase, bringing to an end, at least for the moment, an era of affordable housing attributed to the free market system. Sowell suggests that the passage of laws that restrict building, impose time-consuming review procedures, and subject home construction to planning commission review contribute significantly to the price increases. Sowell is particularly bothered by the fact that most of the people who vote for these types of laws already own homes and won't be paying higher home prices. True, at least until they move. Considering Americans move every seven years, on average, it is likely that a sizeable number of the voters Sowell describes will eventually get to write a check of some significant amount. Likely, but not certain. After all, there's more than a wee bit of a lottery characteristic in the home market.

Sowell points out that land is the biggest cost. He writes about prices in the San Francisco area, where average home prices have reached one million dollars. Though most other areas haven't reached that level, in every community I have lived or about which I have read, land is the biggest cost. Why? Aside from some minor reclamation projects, land pretty much is a known, finite resource. Oil is finite, but no one knows how much exists. But we know how much land, and buildable land, exists. We have maps. Supply and demand affect land. Sowell focuses on the supply side, pointing out that as more land is zoned off-limits to home construction, land prices will increase. He dismisses the impact of the demand side, claiming that overpopulation isn't a factor. His proof is that the population of San Mateo County, for example, declined by 9,000 people during a four-year period while housing prices rose. That, however, proves nothing. It isn't population, per se, but household quantity and size. If, over a period of time, 50,000 homes occupied by 5-person households are put on the market, and 80,000 3-person households seek to acquire homes, home prices will rise even though when all is said and done the population of the market has declined. I don't disagree that restricting supply drives up prices, but I think it is only a piece of the puzzle. Whether the supply should be restricted is a serious question, because American taxpayers and consumers are getting tired of paying taxes and insurance premiums that eventually are used to rebuild, yet again, a home built on a barrier island, a mudslide-prone hill, or in a wildfire-ready thicket.

There are two other factors to consider. One is the purpose for which homes are being purchased. The other is, of course, taxes.

What little data exists suggests that the number of people who are purchasing homes primarily as investments rather than as residences, including the number of homes purchased by buyers who have no plans to occupy the structure, is increasing as a percentage of home buyers. Consider this quote from John McLaughlin two years ago: "But in point of fact, investors have not lost confidence; they are investing. They're investing in houses like you, Pat, who own several houses -- many houses, I might say." There are all sorts of books touting housing as an investment safer and more profitable than the stock market, such as this one and this one, to mention two picked randomly from a flood of such publications. There is no doubt that the entry of investors into the housing market has a demand-side impact on prices. If, and when, those investors leave, housing prices will fall. Will they crash? Perhaps not, because other demand-side pressures could continue.

The tax question is whether the tax law fuels, dampens, or has no effect on the home price surge. Without doing empirical research, I'm going out on a limb by suggesting that current tax laws nourish the increases but aren't the primary cause. Here is why I reach this conclusion.

First, the tax law favors investments that generate capital gains and dividends, rather than investments that generate interest. In recent years, tax rates on capital gains and dividends have been significantly reduced, and reductions in other tax rates pale in comparison. This rate difference makes a house a more attractive investment, from a tax perspective, than is an investment in a mortgage. The tax law appears to be neutral in terms of rate differentiation when it comes to the stock market and housing, because both would generate capital gains if the investment is successful. To the extent, though, that the recent reduction of tax rates on dividends has driven money out of interest-paying investments, it contributes to the infusion of investment money in the housing market even though the tax law is not responsible for investor wariness about the stock market.

Second, the limitation on the amount of gain that can be excluded from gross income on the sale of a residence, and its availability every two years, might, and I emphasize, might, encourage a sort of churning by young, especially childless investor-residents, who move from property to property to extract the gains while they are under the $250,000 (or $500,000) cap. This practice was not unheard of years ago when the tax law permitted total gain deferral, as the facts of a few cases involving badly planned and poorly timed relocation indicate. Why go for one $250,000 exclusion over 10 years when moving five times during that period makes it possible to exclude as much as $1,250,000, especially if the taxpayer is childless and not burdened with several moving vans' worth of possessions? It is, after all, as those books point out, a matter of timing and location. That's true of much of life, but I won't go there now.

The bigger questions, though, are the interesting ones. How long until some vote-seeking member of Congress decides that it would make sense to use the tax law to curtail home price increases, or to offset the impact on those shut out of the market because of the increase in demand, coupled with the supply decreases? What sort of proposal would be made? Some sort of credit? Disincentives to the purchase of housing as an investment? Lengthening of the two-year period applicable to the residence sale gain exclusion?

The final questions, though, are the scary ones and surely more important and larger than the tax issues. Will the phenomenon of rapid and substantial price increases that have afflicted the housing market, due to a combination of demand-side pressures, supply-side shortages, and questionable government tax and other policies interacting with a finite resource, land, not only afflict another finite resource,oil (and its products), but yet another finite resource, clean water? Or some other finite resource, such as clean air? Or some other life-critical substance? Aren't those, too, subject to a combination of demand-side pressures, supply-side shortages, and questionable government tax and other policies? Toss in the renewable resources that require a long time to renew (rain forests, deep sea fish schools, lumber, and the like), and the picture becomes quite ugly. It is not without careful reasoning that some suggest the next, and most devastating, world war will involve water. The recent oil, concrete, steel, lumber, and housing market experiences could be very instructive.

I can’t help it. It’s built into me. It’s true. As Andy Cassel wrote last fall in his column about my tax class, "Maule himself not only understands the tax structure, he sees evidence of it pretty much everywhere."

Every which way I turn, I see tax rearing its ugly head. The latest opportunity came thanks to this news alert posted by Paul Caron on the TaxProf Blog. Paul noted that he “could not find much of a tax angle” in this Smoking Gun story about a Florida busboy who found Jimmy Buffett’s cell phone, kept it for a week, possibly called Bill Clinton, whose number was in the phone, refused to return the phone despite a $200 reward offer, and finally surrendered it when police and Secret Service agents showed up.

It took but a moment. Yes, there’s an examination question, with several subparts, in this story. A few more facts need to be added. The phone had the numbers not only of Bill Clinton, but Al Gore, Bill Gates, George Clooney, Jimmy Carter, Cam’ron, Harrison Ford, Alan Jackson, and other celebrities and politicians. The busboy was fired from his job at the establishment where he found the phone after Buffett had visited in May.

Rather than hand the answers to students who might be reading this, and, yes, a few do, I’ll set forth the questions, which hopefully will encourage them, and everyone else, to think about the tax implications. The tax principles involved are fairly basic, and don’t involve computational gymnastics.

1. Does the busboy have gross income when he finds the phone? Why or why not?

2. Does the busboy’s refusal to return the phone matter in the gross income analysis? Why or why not?

3. If there is gross income, how much must be reported? Is it the value of the phone as a phone? Or is it a value that includes some amount attributable to the worth of the celebrity phone numbers stored in the phone?

4. Had the busboy returned the phone in exchange for the $200 reward offer, would it be treated as a sale of the phone or would it negate any gross income on account of finding the phone in lieu of simply $200 in gross income from receipt of a reward?

5. Is there a loss deduction on account of the phone being confiscated, in effect, by the authorities? If so, is the amount of the deduction equal to the amount of any gross income?

6. Is there any sort of deduction arising from the busboy’s loss of his job?

Here’s a hint. If there is gross income, the busboy’s basis in the phone would equal the amount of the gross income. That basis, in turn, would have an impact on some of the questions focused on subsequent events with respect to the phone.

OK, I’ve asked the questions. Now it’s your call. For students and former students, these questions ought to ring a bell. They’re simply an extension of several topics discussed in the basic tax course. Don’t get hung up on computation of fair market value.

Today I'm turning from getting the J.D. Program Introduction to Federal Taxation course ready for the fall to preparing the Graduate Tax Program Partnership Taxation course. It's going to take longer than usual, because there is a new edition of the "casebook." The "law" has changed, so the authors have revised the text and the problems. For me, every place a page reference is made must be changed. Each problem needs to be reviewed. After all, in some instances even if the problem hasn't changed, the answer has.

Just as the book went to the printer, the IRS issued several sets of regulations. I described one set, dealing with the tax treatment of partnership interests issued for services, a few weeks ago.

So I wondered, could these changes possibly be in the book? I know it will change the answer to at least one problem set. The response, no, the regulations were issued too late.

That's one of the frustrations of dealing with tax. It never stands still. The authors update their book, and even as it goes to press, it's out of date. There once was a joke, back in the industrial age, about equipment taking so long to build tha it was obsolete before it left the factory. I don't remember the entire joke.

On Wednesday I received my author's copies of 597 T.M., Tax Incentives for Economically Distressed Areas, which discusses all the enterprise zone, empowerment zone, renewal community, New York Liberty Zone, etc., etc., provisions in the tax code designed to alleviate economic problems in specific areas. I wrote the manuscript two years ago. Then Congress made changes. The manuscript was revised. Then Congress made more changes. The manuscript was revised again. I suppose I could accept the phenomenon if the changes were vital and critical. They're not. Most of them are window dressing or deferential catering to specific special interests.

So after I dig through the new Partnership material, I'll have some time, perhaps, to discuss one of the latest topics circulating among some practitioners. Can a sole proprietor elect, under the check-the-box regulations, to be a corporation?

I surrender. I can no longer resist commenting on some news from several weeks ago. It's an excellent example of tax policy run amok. Full credit to Paul Caron of the TaxProfBlog for picking up on this story and alerting us to it.

Denmark has an income tax. It excludes from taxation income earned by men who donate sperm to sperm banks. Stop. What's the reason for this exclusion? To encourage sperm donation? What's next, a deduction for purchasing chocolate?

Danish officials see the light. According to stories reported by the BBC and Reuters, the Danish government plans to revoke the exclusion. Good tax policy, as suggested by this Tax Foundation report on the story, demands that the source of income should not affect its taxation.

Denmark is home to Cryos International Sperm Bank, one of the world's biggest. It objected to the requirement that it report information about the men to whom it pays $85 for each donation. The term "donation" is misleading, of course, because when a person gets paid for transferring something, it isn't a donation.

The issue affects about 160 men, down from 250 five years ago. Most are students. Cryos, which earns about $1,700,000 a year, which presumably is taxed, assists in generating about 1,000 pregnancies each year. For Cryos, the concern is that its source of product will "run dry." Interestingly, only three years ago, Pravda, yes, Pravda, was reporting that there were too many sperm donors in Denmark.

So Cryos argues against revocation of the exclusion. Its argument is simple. "It is a special kind of work and the fees paid cannot be compared to normal working income." Huh? Are the rest of us NOT engaged in special work? Should governments restrict income taxtion to normal working income and exclude abnormal working income? Can we make a list of abnormal jobs?

Cryos claims that taxing the fee would cause 93% of current "donors" to stop participating. The reason isn't the money, but the privacy concern arising from the government learning the identities of the men, who fear being sued for child support. Huh? Danish law permits the sale of sperm but doesn't insulate the sellers by maintaining anonymity? Yes, but some politicians and activists have proposed abolishing anonymity to remove an objection to making artificial insemination available to lesbians, namely, that a child should have a mother and father.

So if the anonymity protection for sperm sellers is removed, would it matter that the payor would be reporting names and income to the government? So perhaps this isn't as much a tax problem as a cultural, social, moral, and theological problem. Hold on. Most tax issues are cultural, social, moral, and theological problems in disguise.

Such is the case here. According to this New York Times report, there are laws that limit the number of children that a sperm donor can "father." The reason for the limit is to reduce the risk of accidental incest. So the United Kingdom caps it at 10, Denmark at 25, and the United States uses a more complex limit of "25 births for each donor within a population of 800,000." Yet one man, a Cryos client, has sired (interesting word) 101 children, a fact that even does not know. Egads, if he and his children keep up that pace, in 300 years half the world will be his descendants. It took 1200 years for Charlemagne's descendants to reach some much lower fraction of the population.

Does society want this? Perhaps. Perhaps not. Yet it is safe to predict that the tax laws will end up being implicated to put the policies, whatever they are, in place. There already exist several tax incentives for adoption. What's next for the tax law in the world of reproduction policy? I have no clue. That's part of what makes tax fun, at least sometimes. Yes, the thrill of not knowing what surprises are around the next legislative corner.

I have “discovered” something rather interesting about the inflation adjustments that pepper the federal income tax. Even taxpayers who would never claim to be tax experts are aware that many of the “fixed” amounts applicable in computing income taxes, like the standard deduction and personal exemption, have increased annually due to inflation adjustments.

I use the word “discovered” because I hadn’t seen any mention of another phenomenon I noticed last week when preparing my Introduction to Federal Taxation course for J.D. students. Yes, it’s “only” June but it is unwise to wait until mid-August to begin preparing the course. Anyhow, when I teach depreciation the best I can do, because of time limitations, is to take the students through an overview. So when it comes time to look at section 280F, which imposes caps on depreciation deductions for vehicles and other listed property, there’s about 3 minutes to describe the concept and to show the inflation-adjusted caps so that the scale of the limitation can be appreciated. Rest assured, I don’t require the students to do any section 280F computations.

When I took last year’s materials and Powerpoint slide and started revising the numbers, I noticed something that caused me to think I had made a typo or had mis-read last year’s or this year’s revenue procedure prescribing the numbers. For autos placed in service during 2004, the deduction limits for each of the first four years of service are, respectively, $2,960, $4,800, $2,850, and $1,675. For autos placed in service during 2005, the deduction limits for each of the first four years of service are, respectively, $2,960, $4,700, $2,850, and $1,675. Yes, look again, as I did. The limit goes DOWN, not up. An INFLATION adjustment not going UP?

I looked again at the two revenue procedures. The inflation adjustment for the section 280F depreciation limits reflect the new car component of the consumer price index (CPI). It was 115.2 for October 1987, the base period, 133.5 for October 2003, the reference period for the 2004 limitations, and 133.0 for October 2004, the reference period for the 2005 limitations.

So even though the standard deduction increases from 2004 to 2005, for example, from $4,850 to $5,000 for unmarried individuals, and even though the personal exemption jumps from $3,100 to $3,200, the section 280F limitation goes DOWN. Apparently the other elements in the CPI increased sufficiently to outweigh the decline in the cost of new vehicles.

Apparently the CPI components for manufactured items, not just cars, but sporting goods, appliances, clothing, and the like, have been declining ever so slightly for the past few years. So why is the CPI increasing? Medical care, energy, education, to name several components that have been increasing more than moderately as most taxpayers know and have experienced.

I’m told that the CPI components for manufactured goods are adjusted not only for actual price changes but also for quality changes arising from newer technology. I was directed to the Bureau of Labor Statistics website, including an example with respect to one sort of appliance, a report by Paul Liegey, “Hedonic Quality Adjustment Methods for Microwave Ovens in the U.S. CPI..” To paraphrase my source, when’s the movie being released? If microwave ovens aren’t your thing, the BLS CPI home page contains similar articles about clothes dryers, college textbooks, refrigerators, VCRs, DVD players, and camcorders. Amazing the places tax research takes us!

One problem with the the modification of the adjustment with respect to technological improvements is that some things considered to be improvements might not be improvements, and some service degradations aren’t taken into account. Someone pointed out to me that the on-pump credit card reader was considered an improvement, but that no adjustment was made for the removal of traditional service station services such as window washing.

Another problem with the modification of the adjustment is that if taxpayers pay 5% more this year than was paid last year for vehicles that are 8% better, the result is a DECREASE in the depreciation limitation. Does it make sense for the tax benefit to be DECREASED when the taxpayer’s investment reflects an improvement in quality? I don’t know the answer. It’s a question worth pondering.

Is it possible that one of these years the standard deduction and personal exemption will DECREASE? I can only imagine what taxpayer reaction will be when that decision is announced. My guess is that they’ll be somewhat deflated by the news.

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.