MauledAgain

The news wires, blogosphere and even discussion boards are all abuzz about the bartender who received a $10,000 tip. Most of the stories, such asthis one and this one provide the same facts. Unfortunately, for those whose angle on the tale is an inquiry into the tax consequences, there's probably not quite enough for some tax practitioners to resolve the tax question. Does the bartender have $10,000 of gross income?

The basic black-letter tax principles are simple enough. Under section 102, gifts are excluded from gross income. There is case law that suggests tips are gross income as a matter of law, and there is case law that suggests there could be circumstances in which tips are not gross income, but no case has ever so held. The Tax Court, in Bevers v. Comr., 26 T.C. 1218 (1956), stated:

What is material, however, is the fact that the sums in question were received [*1221] by him as an incident of the services which he performed. They were obtained as the direct result of his employment. Had he been merely an observer, taking no active part in these games of chance, he would not have received the side money. It came to him in his capacity of dealer, and therefore we can only conclude that it represented gains derived from his labor as a dealer.

In Olk v. United States, 536 F.2d 876 (9th Cir. 1976), rejected two "findings of fact" by the district court, namely, that "The tokes are given to dealers as a result of impulsive generosity or superstition on the part of players, and not as a form of compensation for services." and "Tokes are the result of detached and disinterested generosity on the part of a small number of patrons."

The reference by the district court to "detached and disinterested generosity" is a reference to language offered by the Supreme Court in Commissioner v. Duberstein, 363 U.S. 278 (1959), in which it explained:

The course of decision here makes it plain that the statute does not use the term "gift" in the common-law sense, but [*878] in a more colloquial sense. This Court has indicated that a voluntary executed transfer of his property by one to another, without any consideration or compensation therefor, though a common-law gift, is not necessarily a "gift" within the meaning of the statute. For the Court has shown that the mere absence of a legal or moral obligation to make such a payment does not establish that it is a gift. Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 730, 73 L. Ed. 918, 49 S. Ct. 499. And, importantly, if the payment proceeds primarily from "the constraining force of any moral or legal duty," or from "the incentive of anticipated benefit" of an economic nature, Bogardus v. Commissioner, 302 U.S. 34, 41, 82 L. Ed. 32, 58 S. Ct. 61, it is not a gift. And, conversely, "where the payment is in return for services rendered, it is irrelevant that the donor derives no economic benefit from it." Robertson v. United States, 343 U.S. 711, 714, 96 L. Ed. 1237, 72 S. Ct. 994. A gift in the statutory sense, on the other hand, proceeds from a "detached and disinterested generosity," Commissioner Of Internal Revenue v. LoBue, 351 U.S. 243, 246, 100 L. Ed. 1142, 76 S. Ct. 800; "out of affection, respect, admiration, charity or like impulses." Robertson v. United States, supra, at 714. And in this regard, the most critical consideration, as the Court was agreed in the leading case here, is the transferor's "intention." Bogardus v. Commissioner, 302 U.S. 34, 43, 82 L. Ed. 32, 58 S. Ct. 61. "What controls is the intention with which payment, however voluntary, has been made." Id., 302 U.S. at 45 (dissenting opinion).

So, ultimately, whether the $10,000 is gross income or excluded from gross income as a gift is a question of fact.

What facts relevant to the tax issue are known? The customer has always tipped well, according to the bartender, usually leaving $15 on a $30 tab. Two weeks ago, the customer left the bartender a $100 tip on a tab of under $50. Then came the $10,000 tip. The customer put the tip on a credit card. Rather than following his usual practice of turning the credit card receipt upside-down after signing it, he kept it facing up and said to the bartender, I want you to know this is not a joke." During an interview, the bartender said, "I hate to say it, but I really don't know him. You become friends with your customers ... I think he just appreciated the fact that I took the time to talk with him."

Assuming the customer's intention matters, does any of this disclose customer's intention? Yes and no. He did not say, "Here is a gift." He put the $10,000 on the credit card receipt, presumably on the line that is left there for tips. Where else would he have added it in? He is a generous tipper. Fifty percent is generous. So, too, are the $100 and $10,000 tips. It looks like a tip, it walks like a tip, it talks like a tip, so is it or any part of it an excludable gift? The burden would be on the bartender to prove it is a gift. The restaurant withheld federal income tax. I predict the $10,000 will be reported on the W-2 it provides to the bartender next January. That creates a very challenging burden. Can the bartender show they were friends after saying she doesn't really know him? Was it her birthday? Did they interact outside of the restaurant? Was there any communication outside of her employment activities? There are no facts so indicating. Looking to the transferor's intent poses problems, because the taxpayer may not ever have the opportunity to ascertain the intent or to present it in some way as evidence during an audit or in litigation. It wasn't a joke, but that doesn't mean it was a gift. Or was not a gift. When we think of gifts we think of birthdays, anniversaries, get well wishes, and similar transactions between people who have something more than a business relationship. I don't think the $10,000 was a gift. There's no evidence that it was, and what evidence there is suggests that it is not.

I'm not sure that the bartender plans to do anything other than report the $10,000 as gross income. Yet throughout the blogosphere and even among tax practitioners one finds suggestions that she ought to take the position it is a gift. This has triggered discussions of whether it would be appropriate for a tax return preparer to so advise, and whether tax law professors ought to encourage students to proceed in that manner when they reach practice. Perhaps a case will arise where the facts make a finding of a gift plausible. This is not one of them.

It's interesting to read the blog comments to get the view of the folks on the street. Two major concerns show up. One is whether she must share the tip with other employees. In this instance, the answer appears to be no, because she talks about how she will use the money as though she has all of what was not withheld for taxes. If she were required to share it, that would generate more tax questions, which are best left for some other day because there's enough to discuss with the situation as it is. The second concern is a dislike of the fact that taxes are withheld (although a few people seem to think that the restaurant withheld to benefit itself, which demonstrates a total misunderstanding of how the tax system works, something that could be alleviated if high schools would return to teaching civics, government, and tax basics, which is yet another topic left alone today). This comment is an interesting insight into the chasm between law and habit:

Speaking as someone who has worked as a bartender and server for (too many) years, I'll say this -- she'll hafta declare it to Uncle Sam, because it was left on a credit card. Had it been in cash...well, that's a different story. One must declare 8.5 percent of total sales as tip income, so if he'd slipped her 10K in cash, she'd be declaring....oh, let's see...about $2.25.

The comment generated this riposte: "The jerk put it on his credit card...paper trail=TAXES. She must be pretty hot!" And this one : "A thoughtful patron would tip in cash." The notion that a generous person is a jerk because they don't aid and abet tax avoidance (or evasion) is a telling commentary on the state of values in the nation. But my favorite is a third response to the initial comment: "i say blackmail. she knows something he doesn't want her to say lol. when is the last time that a rich person tipped so well just for kicks? or maybe he's in love with her." Perhaps. But will we ever know?

If the bartender, contrary to my expectations, decides to take the position that the $10,000 is a gift, she has two options. She can leave the $10,000 off her return, which almost certainly would trigger an audit because of the mismatch between her return and the W-2. If she sticks to her position she'd receive a notice of deficiency, at which point she could take the matter to the Tax Court or she could pay the deficiency and sue for a refund. Alternatively, she could file her return with the $10,000 reported as gross income, file a claim for refund, and when it is rejected, as I am sure it would be, she could sue for a refund. If she ends up in the Tax Court, I am 99.9% convinced that she would lose. If she ends up in district court, she stands a very good chance of winning if she gets a jury filled with folks such as those who have been posting the sort of comments mentioned in the preceding paragraph. If she chooses a non-jury trial, she still has some chance of prevailing, because there's no telling what a district judge, untrained in the tax law, would do with the case. If whichever party loses in the Tax Court or district court decides to appeal, it is very likely that the IRS would prevail, but, again, the Murphy decision demonstrates that even appellate judges aren't necessarily expertised in tax law.

What is needed is legislative, or even regulatory, guidance along the following lines. Transfers between family members or friends are presumed to be gifts unless there is evidence that business, employment, or similar circumstances bring the transfer outside of the gift arena. Transfers between employers and employees in the context of the employment relationship are not gifts, as provided in current law. Transfers between people in any other relationship are presumed not to be gifts unless there is evidence to the contrary. The tax law already defines family, although in several different ways, so it would simply be a matter of picking the most appropriate definition. There is no definition of friends in the tax law, but proving that two people are friends or not friends is a much more objective, and thus easier, task than proving whether something is a gift. In keeping with my advocacy of a shorter tax code, I'd make up for the new section 102(d) by eliminating the nonsense currently in section 74(c). As for the proposals to repeal the gift exclusion, or at least to repeal the gift exclusion for transfers of money, I suggest that the necessary record keeping and reporting would be so onerous as to make such a provision ineffective.

Don't misread the headline. It has nothing to do with guns, although I could have written "Tax Law Professor Gunning for the Senate." Ouch. "Tax Law Professor Running for the Senate" might work.

In a three-way race for the Republican Party nomination for Senator from the State of Delaware, Temple law professor Jan Ting received 42.5% of the vote, edging Michael Protack who received 40.1% and Christine O'Donnell, who received the other 17.4%. The complete results can be found on the Delaware State Elections website.

If Italy's lead in realignment of political parties, mentioned in my post of a few minutes ago, is followed, perhaps a Tax Law Professor party will gather momentum. Considering the mess that the Congress has made of the tax law, giving tax law professors a chance to fix things might make sense. There have been tax experts in the Congress, but they are outnumbered and their message is drowned in the cacophony of lobbyists bleating for their newest handout.

What I don't know is whether any tax law professors have served in the Congress, either before or after teaching law. If you know, share the information and I'll post it. Perhaps there's a new web page in the offing.

BNA reports, in a subscription article, that Italy plans to increase capital gains taxes and lower rates on bank interest. Under the plan, the same tax rate will apply to both types of income. During the past few years, Italy has lowered capital gains tax rates and enacted other changes not unlike those made to the federal income tax in this country. One must wonder whether this modest elimination of at least part of the special low tax rates for capital gains in Italy foreshadows similar changes in American tax law. These changes come on the heels of electoral change in Italy. Electoral politics in Italy underwent a huge upheaval a few years ago, with several political parties, including a major one, dissolving, and new political parties emerging and securing substantial voter support. Could that development also foreshadow the course of political behavior in this country? Perhaps more attention should be given to Italian taxation and politics. Perhaps something could be learned.

Early during the Saturday evening newscast on the local ABC station, the words "tax preparation business" were spoken, and my attention ratio turned from 80% computer/20% television to 100% television. Having missed the beginning of the story, I went to the station's web site to find the story, but what I found was a condensed version of what was read on the newscast. But I had heard enough to fill in the missing pieces using google, and that sealed my decision to comment today on an unusual connection between taxation and September 11.

Most tax practitioners are familiar with the many tax provisions that were enacted in the wake of the September 11 attacks. Special credits and depreciation allowances, for example, were put in place for what the tax law calls the New York Liberty Zone. These statutory provisions, however, focus on the rehabilitation and restoration of the New York economy. They don't address memorialization. That's where Elsie Caldwell, a Philadelphia accountant who runs a tax return preparation business enters the spotlight.

Elsie, who lost her son Kenny in the World Trade Center destruction, spearheaded an effort to have a September 11 memorial for the Philadelphia people who died that day. She not only did fund-raising, she made available for the mural the outside wall of the building in which she practices her profession. Sometimes tax return preparation practitioners get criticized or find themselves the subject of bad press, but Elsie Caldwell deserves accolades from the rest of us in the tax profession. She stepped up, beyond the call of professional duty, and as was apparent from the newscast, has brought much healing and joy to more than a few people.

Elsie not only had to cope with the loss of her son, she had to withstand the aggravations of litigation stemming from the appearance of her former husband, who had abandoned Elsie and her two sons 30 years earlier. His efforts to become executor of her son's estate were thwarted, but a New York appeals court held that he could collect half of the workers' compensation death benefit because the statute did not exclude parents who had reneged on paying child support from sharing in these awards even though another statute precluded them from sharing in distribution of the child's estate. Wisely, the court then offset his portion of the award by the amount of the delinquent child support payments.

Perhaps other people, under these circumstances, would have folded. Or perhaps turned their anger and grief into something destructive. Elsie Caldwell did not do those things. She found a positive in the sadness and undertook a challenging project for the sake not only of her own loss but those of many others, who, until a few years ago, were strangers to her. And her efforts have created a memorial mural that is a genuine gift to the people of Philadelphia and the visitors from elsewhere who take a look.

I've never met Elsie Caldwell. Perhaps someday I will. In the meantime, I'll say here what I'd say to her if I met her: "What you've done is outstanding, a tribute to your courage and determination, a gift to many, and a reminder that as geeky as people might think tax folks are, you've made it unquestionably clear that immersion in tax does not shut down the heart. Thank you."

On a day like today, when the world is reminded of the power of evil, I prefer to remind myself that there is goodness on the earth, too. The planet needs more people like Elsie Caldwell.

Lots of tax things have been happening recently, so I don't get to all the stories right away. I try to put the tax news items into a sequence reflecting urgency, and sometimes stories drop off the bottom of the list because too much time has passed by. That's not the case with today's topic. About a week ago the IRS announced how it would generate refunds of the telephone excise tax.

Taxpayers will have a choice. They can select what I will call the standard refund, or they can itemize from their bills. The standard refunds are $30 for a tax return with one exemption, $40 for one with two exemptions, $50 for one with three exemptions, and $60 for a return with four or more exemptions. For an itemized refund, taxpayers add up the tax paid for services billed after February 28, 2003, and before August 1, 2006.

So, of course, being curious, I sat down and looked at my telephone bills. Yes, I kept them. Don't make me tell you how far back the file goes. Please.

So I added up the federal tax charges. The total? $26.07. Oh, well, I guess I'll take the standard $30 refund.

But that's the residence phone line.

I also have a business phone line. The IRS will require businesses and nonprofit organizations to calculate the actual amount of tax paid, but it also is considering coming up with some sort of estimation method. So I added up the federal tax charges for that phone line. The total? All of $16.01.

Now, if get a refund of the $16.01, am I not required to include the refund in gross income under the tax benefit rule? Of course. Unless the IRS comes up with some estimation method that lets me claim a larger refund, the after-tax benefit of the refund for the business phone line probably would not let me buy a decent dinner.

And if I take into account the presumed value of 20 minutes of my time, which is what I expended to go through the old phone bills, this entire adventure does not go down as a financial success. But it was intellectual fun. No wonder a good friend called me a geek yesterday evening (when I commented I had diminished my non-tax reading because I was updating another tax book). Yes, only a tax geek would sit down and rummage through old phone bills. And only a good friend could smile when identifying me as a geek.

So all that phone bill analysis would have been pretty much for naught but for the fact it generated a blog post. A blog post that's certain to trigger a stampede of readers. Seriously, I wonder if anyone has tallied up the federal tax on their long-distance phone bills and generated a total exceeding the standard refund. Let me know.

Suppose you know that someone is committing tax fraud. Or suppose you have very strong evidence that tax fraud is taking place. What should you do?

The answer, of course, depends on who you are and who the other person is. Goodness, if you are the other person, the answer is obvious. Stop committing fraud. Suppose that the other person is a spouse, a business partner, a parent, a child, a professional colleague, or a neighbor. Then what?

The answer to this question isn't something that can be taught in law school. It requires a blend of wisdom, experience, judgment, knowledge, and understanding. A variety of factors comes into play. How was the information obtained? How strong is the evidence? What risks, such as the risk of retaliation, arise if you approach the IRS? Is it better to look the other way and to let the IRS discover it on its own?

An interesting discussion is underway on the ABA-TAX listserv in response to a question posed by a tax practitioner. The initial question was proof that law professors don't invent hypotheticals:

Would I have potential for liability of any kind (to IRS under Circular 230, to state CPA boards for ethics violations, to the person accused of tax fraud) if I assist a third party (who I'll call Jane Doe) with the filing of Form 3949 A Information Referral?

Jane Doe (100% credible and with documentation) has asked me if I would submit to the IRS the Form 3949 A Information Referral regarding the ex-spouse. The Form 3949 A would be prepared based on information supplied to me by Jane Doe. The documentation was acquired over several months during family litigation issues with the ex-spouse. Her attorney obtained copies of tax returns and other documents that support the suspicion of income tax fraud.

My plan is to prepare and submit the Form to IRS, stating that I am doing so on behalf of Jane Doe who desires to remain anonymous. For valid personal reasons, she doesn't want to be the one who contacts the IRS. Neither Jane Doe nor her ex-spouse are, or ever were, clients of mine.

What are your comments and suggestions?

Those who responded agreed that the tax practitioner ought not be the informant. After all, the tax practitioner has no first-hand knowledge. The tax practitioner's judgment that Jane Doe's documentation and credibility makes a strong case can inform his decision to represent her but does not transform him into the informant. It was pointed out that if the practitioner becomes the informant, the practitioner risks acquiring the reputation of being someone who turned a taxpayer in to the IRS. Another comment explained that although the Form 3949 (yes, there's a form!) does not require identifying information about the informant, the ex-husband nonetheless will have a pretty good idea as to who blew the whistle. If Jane Doe is trying to position herself to state truthfully that she did not turn in her ex-husband, that should not persuade the tax practitioner to take her off the hook. A more interesting question is whether she is trying to find someone else to be the informant. Is she trying to sidestep a confidentiality restriction? If so, I don't see the difference between her giving information directly to the IRS or giving it to the tax practitioner to pass along. Either way, she is breaching any such confidentiality restriction.

Another subscriber made a point that illustrates the benefits of looking at problems through a wide, rather than narrow, lens. In this instance, the subscriber noted that Jane Doe could be implicating herself, or at least creating a problem for prior year tax returns, especially those filed jointly with the now ex-husband. Another subscriber noted that the ex-husband could have amended his tax returns.

One of the reasons given for advising the tax practitioner not to become an informant for Jane Doe is that tax practitioners are retained by taxpayers and don't work for the IRS. This comment resonated with me: "I also think we have a duty to respect the law and to consider what our duty is when we become aware of someone else's illegal activities that evade their fair share. After all, every dollar they don't pay is another dollar the rest of us, and our clients, have to pay."

For those who are interested, here is what I had to say on the matter early in the discussion:

High on the list of situations in which taxpayers are reported to the IRS are disclosures by former (or soon to be former) spouses. (Also high on the list are disgruntled employees and nosy neighbors). If Jane Doe wants to report her former spouse's alleged fraudulent activities, she can do so. If she chooses to retain someone to assist her, she can do so. At that point, isn't the retained advisor working for her? Isn't she a taxpayer whose taxes are higher than they ought to be because of the fraud committed by other taxpayers? How does assisting Jane Doe make her advisor someone who works for the IRS?

The question was whether the advisor is opening himself to risk for taking Jane Doe as a client and assisting her. (Note: Jane Doe may not have been the advisor's client, but once the advisor starts advising and assisting, she becomes a client.) If the advisor knows or has good reason to know that Jane Doe herself is being untruthful, or has doubts about the prima facie validity of her allegations, the advisor ought not take her on as a client because there would be some risk. If Jane Doe is revealing information obtained under circumstances that obligated her to keep it confidential, there also would be some risk. If the information she has was obtained illegally or in an improper manner, then again there is some risk.

The question ought to be whether the advisor should become the informer. That, I think, is unwise. As someone pointed out, there are ways for the person with the information to remain anonymous. The advisor does not have first-hand knowledge and by making the assertions moves from the somewhat protected role of advisor to a more visible, and much riskier, position as an informer. I suppose that might be the crux of the idea that the advisor ought work for the client (advise and assist Jane Doe) and not the IRS (don't become an informer on matters of second-hand information).

As for tax practitioners, they ought not be informants for second-hand situations. As for first-hand situations, as someone put it, ultimately each person must decide for himself or herself what he or she will do. In these instances, a tax practitioner is in the same position as is anyone else, though perhaps the tax practitioner's understanding of the tax system makes the situation a bit less intimidating.

I've long been a proponent of an open admissions policy for law school. Rather than selecting future lawyers on the basis of undergraduate cumulative averages, post-college careers (if any), and standardized entrance examinations, I would open the doors to anyone who expressed an interest in attending law school, save for those few who carry criminal records or psychological disorders of a pathological nature, or those lacking an undergraduate degree from an accredited college or university. The best test of a person's ability is administered when the person is given an opportunity.

This position is one I adopted years ago. The defining moment may have been the time when a student admitted from the wait list on the first day of class graded onto law review. That means the person finished in or near the top ten percent, even though the usual admissions guidelines had the person sitting out on the front lawn waiting for the Registrar to tell the Admissions Committee that this or that admitted applicant had failed to show up, thus making room for one or two or three more students. The slots are filled as they open because law school budgets count on a certain number of "tuitions" as they're called in financial discussions.

My position has been solidified as I watch students with numbers "predicting" average accomplishment do well and students with outstanding "predictors" wobble along and drift to the bottom of the class. I suppose it's because the predictors don't measure heart, and willingness to work. Work. That's what we celebrate today, those who work. Or, as I prefer to think of it, those who work hard.

So how would open admissions work? [Ouch, I'm going to hear about that one!] Simple. Open the doors. Something not unlike Dick Vermeil's open tryouts for the Eagles several decades ago now getting attention in the movie "Invincible." There are some gems out there who might otherwise pass unnoticed. It's true in football, and I'm convinced it's true in law school admissions. Of course, open admissions means there will be more students who don't perform at a satisfactory level. That means more students who don't move into the second year, but are instead asked to turn in their playbooks, clean out their lockers, pack up, and go. Don't laugh. There are lockers in this law school. It wasn't just a football analogy.

Is this sort of competition healthy? Yes. Open admissions means a return to the days of "look to your left, look to your right, at least one (or two) of the three of you won't be here next year." In our post-modern world, the idea of failure seems so horrible that too often too many try to make failure obsolete. Sometimes failure is good. It means we tried, and learned what we can and cannot do. Better to have tried and failed than not to have tried at all. [I think I'll hear about that one, too.] Knowing that admission isn't a "ticket" to a "purchased degree" might shake up those students who think the game is won when the acceptance letter arrives. After all, few law students fail to graduate, and those who do fail almost always have done something outrageous or have been afflicted with some sort of catastrophe outside of their academic lives, such as health setbacks, family troubles, or serious financial problems.

The American Bar Association, which accredits law schools, requires that "A law school shall not admit applicants who do not appear capable of satisfactorily completing its educational program and being admitted to the bar." This is in Standard 501(b). In its Interpretation 501-1, the ABA states: "Sound admissions policies and practices may include consideration of admission test scores, undergraduate course of study and grade point average, extracurricular activities, work experience, performance in other graduate or professional programs, relevant demonstrated skills, and obstacles overcome." In Interpretation 501-3, it explains: "Among the factors to consider in assessing compliance with Standard 501(b) are the academic and admission test credentials of the law school's entering students, the academic attrition rate of the law school's students, and the bar passage rate of its graduates." Nothing makes test predictors the sole criterion, and nothing precludes admitting anyone who has managed to earn a degree from an accredited undergraduate school.

The ABA Standards and Interpretations reflects the following concern. Is it appropriate to charge a student tuition if that student does "not appear capable of satisfactorily completing" law school? Is it wrong to hold out false hope? Is it improper to fleece dollars from someone who lacks the prerequisite skills?

No. Yes. Yes. But what does it mean to hold out false hope? It means law schools ought not send the message, "If you're admitted, then you'll be a lawyer barring some highly improbable turn of events." Yet that's what happens, isn't it, when admission becomes almost a guarantee of graduation. The incentive to work, and work diligently, erodes when that message meets up with mandatory curves and rankings. Is it any wonder so many upperclass law students ease back? And what does it mean to fleece dollars from someone who lacks the prerequisite skills? It means law schools ought not admit students and take their money without making it unquestionably clear that law school requires an amount of work that the student most likely has not achieved at any time in his or her life. That's the nature of a graduate program designed to prepare students for a professional career once they earn their doctoral degrees. What better way to make that clear than to point out the odds of making it to the second year?

So my attention was grabbed on Friday when I saw the National Law Journal article with the eye-opening headline "Law School Sued for Expelling Students" and the even more eye-stopping byline: "Suit alleges St. Thomas cut 25 percent of first-year class to bolster bar pass rates." I brought the article to the attention of my faculty colleagues early Friday morning, along with a few comments. Some of what I said I've already written. Here are a few more points, elaborating on the relatively short email I sent around to the faculty.

1. Some schools that do the opposite are probably doing more long-term harm to the legal education system. In an effort to rack up rankings points, some schools are restricting their first-year admissions to a very select few with "high numbers" and then make up the lost tuition by "raiding" the top students from other law schools. Never mind the difficulty of adjusting to a new law school one year after adjusting to law school. There always have been a few transfers on account of personal or family issues, but when the average of 2 or 3 departures becomes 10 or 15, or more, something's not right. Thank you, U.S. News and World Reports. My three most recent posts on rankings (here, here, and here) don't disguise the fact that I'm no fan of the rankings game as currently played, and this "false exclusivity" phenomenon is just another reason for my dislike of the game.

2. The attorney for the student who is suing claims that the school is "culling" students it should not have admitted in the first place, and adds, "They're not supposed to accept students who don't have a reasonable prospect of completing law school." The standard is "appears capable" and not "have a reasonable prospect of completing" law school. I have not seen the admissions letter and other information made available to the student, so I don't know whether the student was told that he was not guaranteed success. The student, in my view, paid for the chance to perform well enough to move on to the second year. The view that payment of tuition guarantees graduation and its accompanying degree is one that has become widespread among many students, and perhaps fuels the current litigation. I hasten to add that there is another bit of factual confusion, namely, whether the applicable standard was changed before or while the student was enrolled, because the student's reported grades are sufficient to meet one described standard but not another. Perhaps when the facts are sorted out the issue will be somewhat different from what it appears to be.

3. Provided a student is given timely notice of what must be done to advance and graduate, what's so wrong with dismissing students who, given the chance, cannot perform? I wonder if the law student in question would have sued on some other basis had the law school denied admission because it thought he lacked the requisite ability. There's a bit much of "heads the student wins, tails the student wins" in the situation.

4. It is essential, therefore, that in an open admissions system, the applicant be sent something along these lines, "We don't think you have much of a chance, though you appear capable if you put your mind to it, and because one never knows, we'll let you in if you're willing to pay for the chance. With the chance, you have the opportunity to become a lawyer if you do all that is required with diligence, faithfulness, and maturity. Without the chance, you have no chance of being an attorney."

5. The allegation that the school violated its mandatory grading curve is significant if it flies. Not only do mandatory grading curves (and even strongly recommended curves) disadvantage students who do well but are matched with other students doing well, they also compel (hence the allegation in the lawsuit) giving higher grades to poorly performing students because, reversing the curve in question, 85% of the students must earn a C+ or higher. Sorry, if 40% of the students do C and D work, law schools ought not pretend they've achieved a C+ or higher. That's why measuring against a standard makes more sense.

6. This is a case worth watching if it proceeds. I wonder if the law school will seek discovery of the academic work habits of the students in question. "How many hours a week did you study?" "Did you attend class?" "Were you prepared for class?" "Describe how you prepared for class." "Did you work during the semester or cram at the end?" "Did you participate in class?" "Did you create your own outline, charts, and graphs or did you use someone else's work?" This is important because the law school cannot be at fault for dismissing a student whose failure to progress is caused by the student's inadequate work habits and academic immaturity rather than underlying intellectual deficiencies. It has always amused me to read the answers that Graduate Tax Program students give to the question on the course evaluation that asks how many hours a week outside class they invested in the course. Surprisingly, even though they should be investing six to eight hours a week outside of class, there are students who honestly answer "one," "two" or some other deficient number. I am convinced that the students with the most complaints about the work load and high expectations of the instructors and course are among those who invest so little time. Why we don't ask this question of J.D. students remains a mystery to me. I can't imagine why we wouldn't want to know.

So here is hoping that everyone celebrating Labor Day however they celebrate it can look back and forward to their contribution to working. Working hard.

Happy Labor Day.

The Murphy case is creating quite a stir. Considering what the court said, it's not a surprise. When I commented on the opinion last Wednesday, I focused on the technical deficiencies in the opinion, something that triggered a response to which I replied the next day. This afternoon I was interviewed by a reporter for Tax Notes, whose article should show up next week.

Like many others, both within and without the tax profession, I am riveted by this case. Why? It's not just the technical flaws. Those aren't infrequent when tax cases reach the courts, particularly when the tax expertise isn't quite what it ought to be. It's also the inspiration that the opinion is giving to the tax protest movement. Specifically, the folks who have argued that wages are not gross income because they are not income have relied on the idea that wages are received in return for "human capital" and thus cannot be "incomes" within the meaning of the Sixteenth Amendment.

So what does the Murphy opinion do for these folks? Consider these two excerpts from the opinion, and understand that tax protestors love to take pieces of judicial opinions and connect them together:

Broad though the power granted in the Sixteenth Amendment is, the Supreme Court, as Murphy points out, has long recognized “the principle that a restoration of capital [i]s not income; hence it [falls] outside the definition of ‘income’ upon which the law impose[s] a tax.”

* * * * *

According to Murphy, the Supreme Court read the concept of “human capital” into the IRC in Glenshaw Glass. * * * * In Murphy’s view, the Court thereby made clear that the recovery of compensatory damages for a “personal injury” -- of whatever type -- is analogous to a “return of capital” and therefore is not income under the IRC or the Sixteenth Amendment.

Under tax protestor logic, because Murphy won her appeal, the court accepted her arguments as valid. Of course, a court that is aware of the "wages are not gross income" tax protester movement easily could put into its opinion language that restricts its opinion to the specific issue in front of it, but considering that the court was so quick to hold unconstitutional a Code provision that isn't "responsible" for the taxation of which Murphy complained it's no surprise that the court was not considering the impact of its opinion on the administration of the tax law.

Will these sentences be cobbled together by the "wages aren't income" crowd? Undoubtedly. Don't believe me? Or the others making the same prediction? Take a look at the way bits and pieces of legal authorities are mixed and matched in an attempt to prove that the Constitution prohibits the taxation of wages. It takes deep concentration to make it through this explanation. Someone named "bonked" shares this thought: "You see, a tax on wages is not authorized by the constitution, unless it is apportioned..." I could have fun with this one, but I'll restrain myself. And the comments following this LibertyPost article, which proclaims that "Court ruling shakes ground under IRS," are worth reading, but don't be distracted by the references to things such as "Section C of the Tax Code."

What happens if these arguments are made in front of a judge who analyzes the tax law in the same manner as did the three-judge panel of the D.C. Circuit in Murphy? Imagine how small the jump from "unconstitutional to tax damages from human capital" to "unconstitutional to tax wages" looks to someone who doesn't quite grasp the nuances and accepts the language of the Murphy opinion on its face. It will take only one such case. Just one. What will Congress do? Start the process for a constitutional amendment? Hope for a Supreme Court reversal? How long will either of those reactions take? Remove wages from the income tax base and tax revenues plummet.

A footnote: As I wandered the Internet last night, I came across an interesting commentary on a post that quoted part of my first commentary on Murphy. The sentence begins "Maule's of course right that". How could I not keep reading?

Andrew Mitchel has another tax chart for us. It's a flowchart covering the section 7701(b) individual income tax residency rules. He also provides a printer-friendly version.

This is yet another in the long parade of additions to the Andrew Mitchel chart collection. This time around, I'll simply refer to the previous litany of his chart creations.

Take a look even if you're not dealing with this issue. Take a look even if you're not a tax expert. Why? First, because it's an amazing "picture" of how Congress somehow makes everything as complicated as it possibly can be. Second, it's a wonderful insight into the meticulous construction work Andrew undertook to create this multi-page monster.

Ha, next time someone asks you "where do you live?" tell them you need to check the chart. As I write this, I continue to shake my head in amazement at how a simple concept can become an adventure into a rabbit warren.

Roughly six months ago I noted the publication of Julian Block's "MARRIAGE AND DIVORCE: Savvy Ways For Persons Marrying, Married Or Divorcing To Trim Their Taxes - And They’re Legal." On the heels of that useful tome comes another, "THE HOME SELLER’S GUIDE TO TAX SAVINGS: Simple Ways For Any Seller To Lower Taxes To The Legal Minimum." Though the latest title seems just as gimmicky as the first, the second book, like the first, is far from a taxpayer's guide to cutting corners and ending up cornered by the IRS. It's a solid, well-organized explanation of the tax rules that apply when someone sells a home. Its numerous examples illustrate almost every possible variation on the home sale theme.

Not only does he address the "typical" home sale, Julian also discusses the specific challenges faced by home sellers in the process of separating and divorcing, the sale of vacant land, rent-controlled apartments, condominiums, and cooperatives, offices in home, and inherited properties. He provides several checklists to assist homeowners in separating non-deductible repairs from expenditures that increase basis and thus reduce gain. He talks about record retention, and the advantages and disadvantages of turning to the IRS for tax advice when turning to a tax professional isn't an option.

The book isn't designed so much for the tax professional as it is for the person who is not schooled in tax law. My own personal experience, taken in conjunction with anecdotes from friends and families, suggests that every real estate agent and broker in the country who handles residential home transactions ought to acquire Julian's latest book. Why? Because too often they are either giving bad tax advice or giving advice on other matters that reverberates in a bad way when it's time to file tax returns. There are times when it isn't expedient of cost-efficient to retain a tax expert, and yet someone needs to inject some sensible tax law information into the conversation. Julian's book does that. As more and more people sell their homes without the assistance of realtors, the risk of bad tax advice or missing tax advice becomes more serious. These folks, too, are less in need of a professional treatise or an IRS publication on the subject than they are of an easy-to-read and accurate explanation.

Though giving a bit of attention to casualty loss deductions and medical expense deductions for certain home improvements, Julian does not delve into the other tax aspects of home ownership. In some respects, that makes sense, because his book, as the title makes clear, is focused on home sales. Of course, what happens during the home purchase informs the sale consequences, because the basis used in determining gain on the sale has its origins in the purchase. Likewise, depreciation of an office in home requires adjustments to the home sale tax consequences, but it appears Julian is leaving detailed discussion of home office depreciation and other deductions to another book.

To order a copy, send $19.95 for a postpaid copy to J. Block, 3 Washington Sq., #1-G, Larchmont, NY 10538 or go his website, julianblocktaxexpert.com. Or, as was the case with the previous book, email Julian at julianblock@yahoo.com and you should find the book in your mailbox even sooner.

I doubt that Andy Cassel's column in yesterday's Philadelphia Inquirer, College Ratings' Critics Miss Point was in any way inspired by my recent facetious proposal, Ranking Tax Faculty by Tax Management Portfolio Authorship, or its more serious followup, Ranking Tax Faculty: What Really Matters?. As Andy points out, the annual parade of school rankings from U.S. News and World Report, Time, Newsweek, and others has begun. That's to be expected, because within a few weeks the application process will be well underway.

Andy notes that college administrators and faculty are not big fans of the magazine rankings, unless, of course, they're at or near the top of the list. Educators, as Andy acknowledges, have complaints about the "purpose, methodology or integrity" of the rankings. Even legislators and parents have joined in the chorus of concern that "rankings have become a kind of tune that schools have to dance to, whether they want to or not." There's no question that tuition dollars, as Andy mentions, are being channeled into publicity stunts of one kind or another as schools jockey for the spotlight. Too many such dollars, in my opinion.

Then Andy gets to the good part:

I can understand the concern. But speaking as a prospective purchaser of higher-education services (knock wood), I think the criticism misses the point.

College is what economists like to call an "experience good." The term simply means you have to consume it - experience it - to really know what you're getting.

And by then you've already bought and paid for it.

***

You can't easily compare prices - how do you know what's a bargain, or what might be worth paying up for? So consumers seek help.

***

That means consumers' need for help - and the demand for magazine rankings, individual admissions counselors, and who knows what else - is probably here to stay.

I don't think this diminishes or "commodifies" higher education. It simply makes more information available to all sides, creating more transparency and efficiency.

To the extent that Andy is arguing information dissemination is important, I totally agree. To the extent that he argues what's currently available in terms of rankings gets the job done, I totally disagree.

College students and their parents need information. Rankings provide little of what matters, distort some of it, and then mix it into a brew according to arbitrary weights to generate some sort of number that has no genuine meaning. The attempt to rank college football teams through a complex formula is a good example of another, justifiably criticized, and yet far more refined, attempt to sort data.

Let's turn to where the rankings go wrong, and why the product that the magazines and other reviewers are making available is of such dubious quality. I'm not going to rank the rankings, because I think all of them are inadequate. Consider this a consumer review of consumer reviews.

First, the rankings omit important information. What information matters? It depends on what the applicant wants. Someone interested in a chance to showcase his or her talents for a professional sports league probably doesn't care about the dollars of research grants obtained each year by the physics department. Someone headed for a career in astronomy probably has little interest in the number of prizes won by the English literature faculty. I'm not certain either of those statistics, important, of course to youngsters interested in physics or English literature, find their way into the rankings data. One of the rankings that gets right to the point is the "party school ranking," which is described and analyzed in articles such as this one from the Chronicle of Higher Education. I'm sure both students and parents can find value in that ranking, but perhaps for different reasons.

Other useful information might include the range of salaries and average salary for graduates who major in each discipline at the school, measured at 1, 5, and 15 years after graduation. I've seen such statistics for particular schools and programs, though I'm not sure how public they are. True, students going to college to get some sort of holistic experience might not be interested in these figures, but parents and students who are contemplating the investment of $150,000 or more into four years of education just might want to see what sort of economic return awaits. How about information revealing the acceptance rates experienced by a college's graduates when they apply to specific graduate schools?

Perhaps information on campus security, which the government requires colleges to publish but which some schools allegedly doctor, would be important. What about ease of transportation to and from home or jobs? Would parents and prospective applicants be interested in statistics on the downtime of the university's information systems?

Second, some of the rankings are based on information acquired in ways that generate misinformation. The use of surveys has drawbacks, because they are so subjective, but even if subjective opinion of reputation is useful, the surveys need to be refined. Having been on the "surveyee" side several times, I quickly concluded that the questions were poorly designed, as I explained several years ago in Ranking Tax Programs. It's as though a car magazine ranking 2006 model automobiles included places on the survey to rank Ramblers, Packards, and Studebakers. Garbage in, garbage out.

Third, rankings acquire bad information. Stories abound about schools providing doctored information. It's an open secret that schools manipulate information. There are some law schools that restrict first-year admissions so that their "numbers" look better, and that admit scores of transfer students for the second year to make up for the tuition loss. What the rankings tell us about such schools isn't a representation of reality. It's spin. Spin is useless. No consumer should pay for it.

Fourth, and this is perhaps the worst aspect of the rankings, someone decides that some statistic is worth 3.484484 percent of the total weighted score used to rank. Some other factor is worth 9.939203 percent. How do we know that? We don't. It's a number grabbed out of the air. The problem is that for some applicants, the crime rate is important, for others, the number of Nobel Prizes per decade won by the faculty matters, and for still others, the number of bars and taverns within walking distance of the campus has value. Relying on some editor's weights is about as good as relying on some neighbor's opinion. As Andy points out, "In the old days (before U.S. News), they got it from friends, or family, or high-school guidance counselors. Or they looked for signals, such as ivy-covered buildings or winning football teams, that seemed to connote quality." However inadequate the old days were, the new days are no better. At least in the old days we knew our friends and family. How many of us know the new days' rankings editors, those anonymous folks who are hidden away and can't be asked the followup questions we'd get in dialogues with friends and family?

What would be a great service for prospective students and their parents are the sorts of things that we get with respect to other goods and services. Surveys of a college's recent graduates, with the sort of scoring and commentary we find when looking to purchase cars or computers, would be far more interesting and valuable. Why can't the ranking folks simply provide alphabeticized lists of education institutions, along with the underlying data, rather than burying the data behind formulas and weights? Perhaps adding a variant in which the schools are listed geographically or by tuition would be helpful. Hah, why not make the information available in a manner that lets parents and students enter their own weights for each factor? Why not, therefore, separate the reporting of information (news) from the weighing of the factors (editorializing), and permit (and encourage) applicants and their parents to do some thinking for themselves?

I suppose that what we have is better than nothing. That argument is the canard that every rankings outfit hauls out as the ultimate defense of what is offered. But having something that is better than nothing is no reason to abandon the effort to offer something better. In this instance, the something better can be generated, not by adding features, but by stripping away the data manipulation and presenting unadulterated information. Then we truly would have something that does what the current and flawed rankings system fails to provide.

After posting my criticism of tax refund anticipation loan practices (Should Tax Refund Anticipation Loans Be Blocked?), I received emails from two readers who provided more insight into how these loans originate.

John Flanagan wrote, speaking from his past experience as a tax return preparer for companies other than H&R Block, to explain that H&R Block does not handle the lending aspects of it refund anticipation loans. Though H&R Block has a mortgage lending business, it uses a partner financial institution. John explains, "For Block or any other tax
preparation firm to originate RALs would not merely be unethical, but is in fact prohibited by Treasury regulations." Another reader, an H&R Block preparer, explained that H&R Block uses HSBC bank for the loans and is not funding the loans. Its staff carefully explains to the taxpayer that when they apply for the loan they are entering into a relationship with HSBC. The loan papers are turned over to the client whether or not the loan is approved. I asked this reader if H&R Block was paid some sort of finders fee or origination fee by the bank, because I wanted to know why all the taxpayers were directed to only one bank. The response was "I don't know."

John Flanagan also explained that borrowers pay a flat fee, typically $25 to the bank and $25 to the preparer. Because lending disclosure rules require inclusion of the fees in interest, and because the loans often are small, the interest rate ends up being rather high. In fact, interest is charged only if the IRS does not issue a refund, and the interest rate is comparable to credit card rates. I asked John if that meant the refund anticipation loan lender made its money from the fees on most transactions, and he clarified: "As for the RAL charges, I should clarify by adding that in addition to the flat rate, lenders typically charge a percentage of the amount borrowed, usually 2-3 percent of the loan. For a RAL of $5,000, total fees will run about $200, but the customer might pay $60 on a RAL of $500." The reader who prepares returns for H&R Block explained that there are loan fees of about $15, and interest fees that can run between 100% to 200% APR. The taxpayer is told that there is a high APR because the loan is short-term.

John described a variant of the transaction that is puzzling. "In addition, similar processing fees apply even when the transaction is not a loan. In those cases, the taxpayer receives a check after the refund is issued, net of the preparation and processing fees. Even though the customer must pay $50-75 for this service, there is almost nothing said about this type of transaction. For preparers, it means that they can be fairly certain of being paid, so long as the customer is entitled to a refund." Why would the taxpayer do anything other than wait for the refund check and cash it? Why pay $50 to $75 for the privilege of waiting until the preparer receives the refund check and then issues a check for $50 to $75 less to the taxpayer? That's a pretty steep check cashing fee.

The H&R Block preparer explained the problems with same-day loans. Even if initially approved, they could be denied the following day after the bank does its analysis. The taxpayer is contacted and asked to return the money, but usually it has been spent and the client is unable to pay. This reader explained that clients were "highly discouraged" from choosing the instant check method and encouraged to wait several days for the loan to be processed by the bank. Though I wonder why same-day loans would be offered, this reader explained that sometimes the taxpayer is in dire need of cash, and gave as an example the need to pay for transportation to a funeral in another location. I commented that if I were a shareholder in the bank, I'd not be happy with the idea of money being loaned before the full credit check was complete. The danger is very real. The H&R Block preparer explained that some taxpayers know that the loan will be rejected on review and that they will be asked to return the money, but take the instant check because they have no intentions of repaying it because they know if there is a refund it will go to the bank. But, what if there is no refund? Although I understand people sometimes have a need for instant cash, I don't get the idea of lending money first and asking questions second.

John Flanagan pointed out something I've known for years, and on which I comment when I teach the basic tax class. Taxpayers receiving refunds often ignore the opportunity to adjust their withholding so that they're not making interest-free loans to the government. John says, "Many people look at excess withholding not as an interest-free loan to the government, but as a disincentive to spending or, given the time of the year, a way to pay for Christmas bills or spring vacations. While I agree that there is much to dislike about RALs and similar financial arrangements, it may not be possible to pin the entire blame on the preparation firms. In the end, it is possible to outlaw certain transaction types, but some people will always choose sub-rational economic behavior." In a subsequent email, John elaborated:

As far as the psychology of the matter is concerned, I think it has something to do with the gratification of seeing a large sum of money. The overwithholders treat the refund as found money, and the larger the amount, the greater the rush. For these people, getting an extra $80 in every paycheck is not as satisfying as getting a single check for $2,000. I would attribute it to a lottery mentality (speaking of financial practices that prey on the poor. . . .)

I asked John why taxpayers wouldn't simply take their completed return to a bank and obtain a loan. His response:

I don't know of any bank that might do that sort of thing. To begin with, most RALs are between $300 and $5,000; in fact, many RAL providers set $5,000 as a maximum. Since it is difficult to get a secured loan such as a car loan for amounts in much of this range, I would figure it well nigh impossible to get a loan based on a tax refund for such an amount. The second factor in making loans like this is that approval of the loan is based on an assessment that the return is likely to be correct. The banks that make the RALs are dealing with thousands of returns, so the "preparer risk" is probably lower than it would be for a branch bank. The alternative for the bank would be to have a staffer review all of the tax documentation, which would probably require them to hire a person with tax preparation experience. The final issue is that many RAL customers don't have bank accounts, which means they must pay a fee of 3-5 percent to get the check cashed. That's another racket entirely.

In the wider context of wehther refund anticipation loans, at least as they are now offered and processed, are disadvantageous to the poor, John noted:

It has always seemed to me that when people speak of "the poor," they're really talking about two groups. There are those who just need a leg up with training, education, or small business assistance, and there are those who make bad choices. The latter group includes people who had money at one time. This is the group that is much harder to help, because one of the bad choices people make is listening to the wrong advice (look at a list of some things people think they know about taxes, for instance). This is why I'm pessimistic about whether attempts to restrict RALs will do any good. All some people will need is accurate information and they can make the right decision on their own. On the other hand, some people will always find a way to keep themselves down, and government can only delay the process.

I wonder if at some point Congress will make it a violation of federal law to use tax refunds as collateral, security, or justification for a loan, and prohibit the IRS from sending refund checks to banks and other lenders making the refund anticipation loan.

My post yesterday on the unnecessary declaration of unconstitutionality of section 104(a)(2) by the D.C. Circuit in the Murphy decision brought this strong response from an unidentified reader:

Dear Mr. Maule,

I just read your post. With all due respect I recommend you take down your post, for the four reasons below.

Many people would have preferred that the court exercise judicial restraint and not reach the constitutional issue. That would have been less jarring. However,

1. It is crystal clear, from the legislative history, that congress intended its modifications to 104 to tax emotional distress damages.

2. I can not think of one case where a federal appellate court read a congressional statute in a way which directly contradicted crystal clear legislative intent -- without pointing to the constitution (even if just in dicta.) I challenge you to find such a case.

3. The court didn't necessarily even reach the constitutional issue. They said that *if* 104 taxes emotional distress damages then it is unconstitutional. They didn't definitively say that 104 taxes emotional distress damages. Ironically by confusing "the IRC is unconstitutional" with "if the IRC taxes emotional distress damages it is unconstitutional" you are doing the *exact* same thing you criticize the judges of doing! (confusing "ED damages are taxable income" with "if ED damages are taxable income then they will not be excluded under 104.")

4. A law professor should exercise greater diligence and restraint before criticizing three appellate judges, especially before claiming they are not competent enough to pass your introductory tax course.

Thank you,

In my response, I maintained accuracy, precision, and restraint:

Dear [initials removed],

1. Congress intended the amendments to section 104(a)(2) to free section 61 of the exclusion that overrode the inclusion in gross income of these sorts of damages in gross income by section 61. Section 104(a)(2) does NOT state that damages for reputation injury and emotional distress are included in gross income.

2. It is not a matter of the court misinterpreting Congressional intent. Congress did have an intent. That intent was to let section 61 include damages for reputation injury and emotional distress in gross income. It was not an intent to have section 104(a)(2) include these damages in gross income because section 104(a)(2) is not an inclusion provision.

3. At no point have I stated that the court held the IRC to be unconstitutional. That was a headline in a blog post by a non-tax law professor, and I presented it as evidence of the confusion sparked by the DC Circuit's opinion. The court stated: "Therefore, we hold §104(a)(2) unconstitutional insofar as it permits the taxation of an award of damages for mental distress and loss of reputation." It also stated "Therefore, insofar as § 104(a)(2) permits the taxation of compensation for a personal injury, which compensation is unrelated to lost wages or earnings, that provision is unconstitutional." It did not use the term "*if*" as you assert. The term insofar does not mean "if." It is used by the Court to make certain no one thinks that it is holding the exclusion from gross income of damages for physical injury to be unconstitutional. If section 104(a)(2) is unconstitutional because it "permits" section 61 to tax damages for reputation injury and emotional distress, then so, too, every other provision in the Code is just as unconstiutional because they, too, fail to provide an exclusion. But no exclusion is required if, as the court asserts, these damages aren't income in the first place.

4a. I am amazed that you think I did not exercise diligence. I know this area of the law. I have taught it for more than two decades. I have written about it. The position that I took has found agreement among other tax law professors, with whom I engaged in an extensive discussion yesterday on a listserv. A collection of their thoughts can be found on Paul Caron's TaxProf blog at http://taxprof.typepad.com/taxprof_blog/2006/08/tax_prof_commen.html#more. Several almost mimic the point I made when I began the discussion yesterday morning (and that appears in the posting you dislike) about the lack of need to deal with the constitutionality of section 104(a)(2).

4b. Your assertion that I did not exercise sufficient restraint is not justified. I fairly criticized the logic, or lack thereof, in the opinion. I have read comments about this case that go beyond an analytical examination of the opinion and delve into the backgrounds and philosophies of the judges. They are not my comments, and those that are not public are not for me to share. Those that are public I leave for you to find, but I will point out, for example, several comments from the aforementioned posting on the TaxProf Blog, such as "I’m astounded that Judge Rogers joined it." and "By the way, wasn't the opinion' author they guy who lost a seat on the Supreme's for smoking dope?" I hardly think that my precision analysis lacks restraint.

Your email address suggests you are a law student. I do not know if you have taken the basic tax course, and I do not know what you learned or did not learn in that course. Any student who writes on an examination or other graded exercise that section 104(a)(2) is what taxes or permits taxation of damages for reputation injury or emotional distress would earn zero points. If a student performed at this level on every question, he or she would not pass the course. I did not say the three judges would not pass the course, I stated that "the grade that the court would earn in my basic tax course on this particular issue would not be a passing one."

The Murphy opinion is flat out a bad opinion, not only for the reason I have stressed but for other reasons, including those I also mentioned and those discussed on today's TaxProf Blog post cited above. It has also been roundly criticized by at least one tax practitioners. See Joe Kristan's commentary at http://www.rothcpa.com/archives/002087.php. It has been criticized by some of the nation's most renowned constitutional law faculty. E.g., Stephen Bainbridge at http://www.professorbainbridge.com/2006/08/this_ones_for_t.html, Orin Kerr at http://volokh.com/posts/1156261829.shtml, Marty Lederman at http://balkin.blogspot.com/2006/08/is-federal-tax-on-damages-for.html, and Eugene Volokh at http://volokh.com/archives/archive_2006_08_20-2006_08_26.shtml#1156283499.

If you do not mind, I would like to post your comments. It would be anonymous, of course, because you chose to be anonymous when you emailed me.

James Edward Maule
Professor of Law
Villanova University School of Law
http://vls.law.villanova.edu/prof/maule/myresume.htm

I suppose I am demanding when I insist that my students take great care with words and even greater care with their analysis. The Murphy opinion is a good example of what happens when murkiness trumps precision.

The email from Paul Caron, carrying a link to his TaxProf Blog post on the news, put my tax brain on full alert. "D.C. Circuit Holds § 104(a)(2) Unconstitutional Under 16th Amendment; Not All Receipts Constitute 'Income'" isn't the sort of news that circulates in the tax world on a regular basis. Without doing extensive research, I quickly thought to myself that it had been decades since a federal court had invalidated a substantive federal income tax law provision on constitutional grounds. That was in 1972, when the Tenth Circuit, in Moritz v. Commissioner, 469 F.2d 466, reversed the Tax Court, held that the then dependent care deduction violated the due process clause because it was unavailable to unmarried men, and accordingly permitted the taxpayer, an unmarried man, to claim the deduction for which he otherwise had qualified. It's not surprising that invalidation of federal income tax law substantive provisions is a rare occurrence, in part because courts avoid deciding cases on constitutional grounds unless there is no other avenue of resolution, and in part because the federal income tax law has been crafted in ways that obviate most constitutional challenges. Only once has the Supreme Court invalidated a substantive federal income tax law provision, and that was in 1920.

So it was with great interest that I, and others, including not only tax lawyers but also those specializing in constitutional law and other areas of the law, turned to Murphy v. United States, No. 03cv02414 (D.C. Cir. Aug. 22, 2006). As I read the opinion, I cringed. Here's why.

The case was brought by a taxpayer who had brought an administrative action against her former employer and recovered compensatory damages for emotional distress and loss of reputation. She included the damages in gross income and then sued for a refund. She made two principal arguments. First, she argued that she was entitled to exclude the damages from gross income because they were "on account of personal physical injuries or physical sickness" and thus within the exclusion provided by section 104(a)(2) for such damages. Second, she argued, in the alternative, that "[section]104(a)(2) is unconstitutional insofar as it fails to exclude from gross income revenue that is not 'income' within the meaning of the Sixteenth Amendment." The district court rejected her arguments and she appealed.

On the first argument, the D.C. Circuit agreed with the district court and the IRS. Murphy had received damages "for mental pain and anguish" and "for injury to professional reputation." Because the statute limits the exclusion to damages received on account of physical injuries and not damages manifested by physical injuries, Murphy's reliance on section 104(a)(2) as justification for not being taxed on the damages was rejected. Properly so, I must add.

On the second argument, the D.C. Circuit disagreed with the district court and the IRS. The court reasoned that the Sixteenth Amendment restricts the income tax to the taxation of "gains" and "accessions to wealth" and prohibits taxation of "returns of capital." The court then explained that the question was not one of return of capital, "except insofar as Murphy analogizes human capital to physical or financial capital" but whether "the compensation she received for her injuries is income." To deal with this question, the court asked "In lieu of what were the damages awarded?" The court answered its question as follows: "[T]he damages were awarded to make Murphy emotionally and reputationally 'whole' and not to compensate her for lost wages or taxable earnings of any kind. The emotional well-being and good reputation she enjoyed before they were diminished by her former employer were not taxable as income." Accordingly, said the court, "it would appear the Sixteenth Amendment does not empower the Congress to tax her award."

The court then noted, however, that this conclusion was tentative because it needed to explore the "commonly understood meaning of the term" "incomes" in the Amendment that was "in the minds of the people" when they adopted it. Examining the House Report on the Revenue Act of 1918 and a Treasury Department ruling issued in the same year, the court decided they strongly suggested that "incomes" does not include amounts received solely in compensation for a personal injury and unrelated to lost wages or earnings. The court noted that in 1922 the IRS opined that "there is no gain, and therefore no income, derived from the receipt of damages for ... defamation of personal character. ... If an individual is possessed of a personal right that is not assignable and not susceptible of any appraisal in relation to market values, and thereafter receives either damages or payment in compromise for an invasion of that right, it can not be held that he thereby derives any gain or profit." The court then stated, "Note that the Service regarded such compensation not merely as excludable under the IRC, but more fundamentally asa not being income at all."

Based on this analysis, the Court then stated, "Therefore, we hold [section]104(a)(2) unconstitutional insofar as it permits the taxation of an award of damages for mental distress and loss of reputation." It then remanded the case with instructions to the district court to enter an order and judgment in favor of Murphy's refund claim.

Was the court correct in concluding that damages received for injury to reputation and for emotional distress are not "incomes" within the meaning of the Sixteenth Amendment? Perhaps.

Some think not. It has been suggested that the damages are not an "accession to wealth" and that the court did not explain how they are not so. In a footnote, the court seems to endorse the taxpayer's argument that compensation for harm to one's personal attributes, is "but a restoration of the status quo ante" analogous to a restoration of capital, and that "in neither context does the payment result in a 'gain' or 'accession to wealth.'" It also has been suggested that if damages are not an accession to wealth because they simply replace "human capital," which is what the court seems to suggest, then the same conclusion must be reached with respect to wages, which also represent the conversion of human capital into dollars. I hasten to add that the difference, that one is involuntary and the other voluntary, is meaningless, the law being well established that a person who receives more money for property than he or she paid for it has gain, whether the receipt comes from a voluntary sale or an involuntary conversion such as condemnation.

Several commentators have noted that the D.C. Circuit failed to determine if the income tax applied to these damages was a direct tax, for if it is not, then it need not pass muster under the Sixteenth Amendment. It also has been suggested that the authorities cited by the court don't stand for the propositions attributed to them. That is a debatable point. For the moment I will leave these concerns aside. Why? Because the court's "incomes" analysis is isn't, by far, the worst part of the court's opinion.

Where the court goes haywire is its conclusion that section 104(a)(2) is unconstitutional. This conclusion reflects a total misunderstanding of how the Internal Revenue is structured. There is no need to comment on, or decide, the constitutional validity of section 104(a)(2), and doing so opens up a hornet's nest of problems. Here's why.

Section 104(a)(2) is an exclusion provision. It says in effect, as do all other exclusion provisions, "Even though something would otherwise be included in gross income, this particular thing is not." Thus, if something is not otherwise included in gross income, there is no need to examine exclusion provisions. They are irrelevant. What makes something included in gross income? Section 61 states that unless an exclusion provision applies, anything that is income is included in gross income. So the question becomes one of determining if something is income. What is income? That question is asked of law students early in the basic federal income tax course. After working their way through hypothetical after hypothetical, they conclude that there needs to be some sort of increase in economic wealth that is clearly realized. Overshadowing this analysis is the Sixteenth Amendment's prohibition on taxing something that is not within the term "incomes," namely, something that is not a gain or accession to wealth. It would be unconstitutional for Congress to require taxpayers to include in gross income, and pay tax on, the repayment of a loan for which the taxpayer had never taken a bad debt deduction. Why? Because there is no gain or accession to wealth when a person receives back the money they lent to another person.

So if, as the court concludes, correctly or incorrectly, damages for injury to personal reputation and emotional distress are not accessions to wealth and thus not "incomes," that ends the matter. If these damages are not "incomes" they cannot be income. If they cannot be income, they cannot be gross income. If they are not gross income, exclusions are irrelevant.

When the IRS took the position that Murphy's damages were taxable, it essentially made a two-step analysis. First, the damages are otherwise included in gross income. Second, section 104(a)(2) does not change that result. When the court rejected the first step in the IRS position, it mooted the second step. Section 104(a)(2) does not include the damages in gross income. It is not an inclusion provision. Therefore, because it does not make the damages taxable, it cannot be branded as unconstitutional for making the damages taxable.

Understanding the difference between an inclusion provision such as section 61 and an exclusion provision such as section 104 is one of the "core" achievements that a student must demonstrate in order to earn a passing grade in the basic federal income tax course. Another, for example, is understanding the difference between an exclusion and a deduction. There are others. The point is that a student who does not understand the precise nature of these provisions is going to get into trouble as he or she seeks to build a broader understanding of the tax law on what would end up being his or her flawed foundation. The same holds true for a court. By failing to understand the difference between section 104(a)(2)'s rule as an exclusion provision that is relevant only if there otherwise would be gross income and section 61's role as an inclusion provision, the court decided a constitutional issue that did not exist, did not need to be decided, and that as decided, is decided incorrectly. As I wrote yesterday to a listserv of tax professors, the grade that the court would earn in my basic tax course on this particular issue would not be a passing one.

It's worse. The combination of the court's "human capital" analysis and its declaration of constitutional infirmity in section 104(a)(2) will encourage the tax protest crowd to treat the decision as justification for the invalidity of imposing an income tax on wages. As Stephen Bainbridge put it, "Let a 1000 lawsuits bloom. Every tax nut in the country is probably getting ready to file suit challenging some tax or another using Murphy as a template." If these cases come before the same panel of the D.C. Circuit that decided Murphy, we'd get an interesting view of a court either agreeing with the tax protestors and spawning a tax crisis of huge proportions or twisting and shifting in an attempt to dig itself out of the mess it has created. Even folks who should know better are mischaracterizing the case: Is the Internal Revenue Code Unconstitutional? No, it isn't, and the post makes that clear, but the headline is more than a wee bit over the top, and certain to attract tax protesters the way sugar attracts ants.

There has been speculation on how the court could have gone so far off kilter. The suggestion that the judges cannot read statutes, or cannot figure out the tax statute, may or may not be correct. Their biographies on the D.C. Circuit's website suggest that they have the education and experience that would have exposed them to statutes, though probably not the Internal Revenue Code. But we're not talking here about complex portions of the Internal Revenue Code. We're talking about very, very basic concepts learned early in the basic tax course.

What happens next?

Hopefully the government asks for a rehearing by the D.C. Circuit and the court gets it right. There's the remote chance that after reading blog commentary the three judges realize the mess the opinion creates, withdraw it, and revise it. The former is much more likely than the latter.

If things remain as they are, expect the government to take this case to the Supreme Court. Though there has been some disagreement about the probability of that Court taking the case, I think that it will. Perhaps it won't get it right, but I think there's a far better chance that it would, as for example, does Orin Kerr. There also would be the opportunity for tax lawyers and tax professors to file amicus briefs, something that I don't think happened in the Tenth Circuit because this case seems to have flown in under the radar.

Stay tuned. As these things go, it's early and much more awaits us.

My posting the other day about ranking tax faculty by relying on SSRN downloads prompted some rapid and thought-provoking responses. Somewhere along the way the facetiousness of my proposed "Ranking Tax Faculty by Tax Management Portfolio Authorship" effort was lost.

Ted Seto, who extracts the tax faculty rankings from the SSRN data, shared some perspectives and asked some questions. He noted that Tax Management portfolios are not held in the same high regard in some portions of the academy as are articles. He's right. That's one of my pet peeves about the rankings game and the evaluation of law faculty. Treating law review articles as superior to all other forms of publication is a an anachronistic remnant of a dying elitism. Though there are good, but easily countered, arguments that some forms of tax publication, such as blogs or listserv postings, aren't as carefully reviewed as are law review articles, it makes no sense to consider treatises, portfolios, and articles in practitioner journals such as Tax Notes and Journal of Taxation to be inferior to something published in a traditional academic law journal.

Ted also pointed out that court citation counts don't interest most academics. Again, he is quite right. The reason probably is that many, perhaps most, law review articles are not cited by the courts, which is in and of itself telling. Why be interested in something that sends an unwelcome message?

Ted also pointed out that reputational surveys, which lie at the heart of some rankings, such as the ones done by US News, are biased by extraneous factors. If a school's athletic teams do well, somehow that translates into academic prominence. Academics on the West Coast claim that East Coast schools do better in the rankings because of their location, press coverage, and similar factors.

Ted asked me: "What objective proxy measure would you use instead? Or would you really prefer to stick with reputational surveys?" Here's my reply:

Ted,

I think you and share similar concerns. The focus on academic journal articles to the detriment of books and other publications, to say nothing of digital course materials, etc., skews the rankings. I confess that to placate my dean and colleagues I periodically (no pun intended) put something into an academic journal. The impact of university name on program rankings is very real, and another source of skewing. Reputation surveys canvas opinions, which are worth, well, sometimes a lot and often not much.

Why have rankings? Supposedly to give various groups some sort of baseline against which to make decisions. Prospective applicants need information, hiring partners need information, law schools seeking faculty need information. So perhaps there should be different rankings based on the group seeking information. Not that I'd go so far as to
rate "party law schools" (as is done for undergraduate schools) to assist prospective applicants, but things such as percentage of students receiving scholarship financial aid, work study opportunities, and the like would be factors useless to hiring partners. On the other hand, bar pass rate should be a factor with meaning for most rankings
constituencies, and that's a statistic that is more objective than many of the others.

For me, in measuring faculty (individually or collectively, for different purposes), I want information on what faculty should be doing: teaching effectiveness, publication, and service. The first and third I'll leave for now. When it comes to publication, what is the purpose? To enrich teaching? Then its measure is within the measure of teaching
effectiveness. Is it to get attention for the school? Where? Among whom? Is it to contribute to an academic environment? I think the point of publication is to demonstrate to the various constituencies that a school's faculty can think, express itself, and be persuasive. What's the best test of its effectiveness in doing so? The extent to which
their publications (of any sort) are favorably quoted, reprinted, republished or cited by courts, journals, mainstream media, blogs, etc. and the extent to which their publications are so quoted, etc., as reference sources. In contrast, I'd subtract for cites and quotes that demonstrate serious flaws in a publication, such as a court's dismissal
of an article because it omits consideration of relevant precedent.

Thus, mere cite counts is insufficient, for the same reason SSRN downloads don't tell us why there was a download or what someone's reaction to the downloaded article was. To do what I propose would require resources, of time and/or money, to sift through the cites so that they could be evaluated as positive, neutral, or negative. It's not
a matter of looking for the A publications (the universally accepted treatise, for example) or F publications, for they, like student grades, announce themselves. It's in the middle that it matters, and so the measure of quote/cite/etc. would need to be carefully done.

As you can tell, I would consider all publications. So there would need to be some interesting research. I've yet to figure out how to identify all the people who have cited/quoted me in the digital world. Every once in a while I come across something very positive that I didn't know was "out there."

One idea that occurs to me, that probably will never fly, reflects the fact that at many schools faculty are subject to a merit compensation system. So perhaps some sort of "citation bank" where faculty provide their publications and discovered cites, perhaps supplemented with cites found by others (student research assistants independent of the school?). Then this pool of information would be available not just to those doing rankings but also to Deans and administrators seeking a better measure of faculty value beyond "I published an article in X" or "I have z downloads" or "it was cited y times." So we could factor out the times I cite myself, or the 20 downloads of someone's article by the entire faculty of his or her institution!

The fight over what to count means something with compensation committees. I've been there and I've skirmished, though because of what I publish it never has been an issue because there's enough traditional stuff to let administrators defer the question of how to value the blog, for example. But for someone doing rankings, there's no fight ... the rankings are created and then people can argue about its value, and those who make good points contribute to refinement of the rankings system (as I think has happened with U.S. News to a small extent).

If the goal of faculty publication is simply to get the school's name "out there," then a variant statistic would be relevant though perhaps of dubious quality. As I've mentioned to my faculty, a portfolio sent to 10,000 subscribers gets something in front of far more people than an article published in a journal with 300 subscribers. Of course, we don't
know if 1 person or 20 people share a portfolio or article, and we don't know if a subscriber to her law school's journal reads a particular article in it. So mere numbers are as unhelpful as mere cite counts or download statistics. At the moment, I remain fond of my "analyzed quote/cite/etc" approach.

I must hasten to add that I appreciate your SSRN download analysis. It is information, and it has its uses. But it also has its limits, and my concern is that unknowing folks (e.g., non-tax faculty) would consider it to be much more than what it is. My Dean wanted to know why and how we were behind Chapman, and I responded that somehow we were ahead of Florida. Tax folks would know that those three are in inverse order, but non-tax people might not.

Mike McIntyre made several observations. Though he suggested that they might be "perhaps useless," I find them helpful, perhaps because I agree with them to some extent. One, for students selecting law schools, the US News rankings have credibility, a sina qua non of any rating system. Two, a rating system should reflect its audience, but it might not make sense to invest resources into a system that helps faculty making lateral moves pick their destination school. Three, it's difficult for schools to make significant moves in the U.S. News rankings but it probably is a bit easier than it was before U.S. News rankings appeared, when national reputations were "nearly immutable." Four, there may be some East Coast bias in the rankings, but West Coast schools are beginning to attract "top students and top scholars" and have "caught up a lot quicker" because of U.S. News rankings. Five, bar passage and job hunting success might be sensible factors in theory, but in reality few schools' "actual worth fluctuates anywhere near as much" as those factors do. Six, counting books and articles says little about quality, but because no one can agree on how to measure quality, we end up using things that can be counted, though counting is sufficiently flawed that reputational surveys may be better.

I addressed several of Mike's points:

The serious flaw in U.S. News or any subjective evaluation-based ranking is that it polls people who are not necessarily aware of what changes have been taking place in legal education. How many of the polled judges and practitioners who graduated years ago will shift their perception from what the relative positions were 20 years ago? In other words, much of the pre-U.S. News lock-in that you describe continues to exist, to a great extent, in the subjective polling. When reputation numbers are inconsistent with other information, which should be considered suspect? Depends on the numbers, I suppose. There are some schools, as you point out, that have changed significantly, but are those changes showing up in US News as they should? Some are. Some aren't.

As for rankings audiences, the other group, perhaps, of substantial size with interest would be employers. But perhaps their minds are already made up, and no ranking will convince them otherwise.

Of course, law faculty are interested, not only for issues of lateral movement and even (perhaps) law review submission selection, but for purposes of convincing central administration that their efforts in upping the school's ranking warrants more money staying at the school and not going to main campus. Now to persuade some Deans that this proposition has some merit ....

In turn, Mike agreed that there is a flaw in the reputational aspect of the rankings, but it probably was not too important because in making decisions, law school applicants react to reputation and not to the outcome of objective measurement. That applicants behave in this manner is evident from the extent to which they will pass by lower-tuition high quality state schools for more expensive prestigious schools. Mike also noted that the ignorance of survey responders with respect to many schools is muted if there are sufficient survey responses. I'm not so sure of this. Ten times as many ignorant responses doesn't filter out the nonsense. Mike agrees, though, that there is a bias, as demonstrated by the high ratings that a Princeton Law School gets in some tests, simply because Princeton has a fine reputation. Mike wonders why the academy would do rankings for employers, and I agree. I'm not proposing that law schools do the rankings, I'm just suggesting that if employers, or someone in the private sector on behalf of employers, did a ranking the reflected the needs of employers, translate, the needs of clients, we might see something very different, and surely not paying much attention to SSRN downloads though perhaps paying a bit of attention to Tax Management portfolios. Mike sees a risk in employer-focused rankings, because law schools might succumb to student pressure to "teach to [those] ratings," but I'm not convinced that's in and of itself a bad thing. Employers have as much incentive to tell law schools, in effect, "this is what we need you to provide to us" and law schools seem to have to tell employers, "this is how we educate lawyers-to-be so figure out how to adapt your practice to their arrival in your offices." Mike closes by noting that "[a] 'objective' rating system that truly measured quality would be a disaster for a large number of schools." Do tell. That's my point. Using the wrong ranking masks problems. As Elliott Manning put it: "In short the ratings are like the drunk looking for the car keys under the street light, instead of the middle of the block where he dropped them--because the light is better there.  This also part of the national trend of judging schools by scores on standardized tests, because they are easier to measure--never mind whether they actually teach students to think."

Finally, Paul Caron weighed in with a defense of rankings based on SSRN downloads. Because the SSRN rankings tend to correlate with "the right top schools," Paul concludes that "most people would find SSRN's tax faculty ranking more persuasive" even though I claim that ranking by Tax Management portfolio author is "no more or less meaningful than any other tax faculty ranking." Paul agrees that SSRN is incomplete, but defends it on the basis that 3,500 law faculty have posted 11,500 papers on SSRN. Paul is correct that the response is "not to go in the other direction and focus on the offerings of a single publisher." I agree. As I noted at the beginning of this post, there was an intended facetiousness to my rankings. Of course ALL publishers should be considered. Think not only Tax Management, but the various editions of Tax Notes, the practitioner journals, and all the other forums in which good, sound legal reasoning is displayed. There may be 2.4 million SSRN downloads, whatever that measures, but how many millions of times has a publication that is not an SSRN article been opened and used by someone trying to solve or prevent a tax or legal problem?

I think Paul agrees, because he quotes his previous proposals to use "all faculty publications" and to weigh them in some manner that reflects utility and value. He suggests that an extensively quoted publication should carry more weight than a mere cite in a footnote. Of course. Here's the challenge. Even if the resources are acquired to do such a ranking, it will be resisted, chiefly by those who don't do as well under it, on the ground that "we've been using SSRN-download rankings and why change something that isn't broken?" That's why I prefer to abandon SSRN-based rankings so that the advantage it obtains by showing up early in the game doesn't overshadow the fact that it shows up early because it quick and easy. The defense of using SSRN-download rankings because anything is better than nothing ought not apply because there are all sorts of anythings and somethings that are not preferable to nothing.

I'll close with my two responses to Paul's commentary. The first deals with a systemic SSRN flaw:

SSRN is biased in favor of recent articles, having almost nothing, as best I could tell, that was published before the mid to late 90s. Some of the most influential pieces of tax publishing, whether in article form or otherwise, was generated long before the mid 90s.

The second summed up the point I tried to make on Friday:

Don't take my facetious jab at SSRN rankings too seriously. The point of my post wasn't to advocate using one publisher, but to

(a) count everything, not just the self-glorified world of articles, beyond which the world has moved,

and

(b) count something that has meaning in terms of influence, such as citations by courts and other authors, filtered for approval and disapproval, rather than download numbers that can easily be bloated, don't tell us if the downloaded item was read, and, most importantly, don't tell us anything about the quality of the downloaded item.

The point of my post was an exaggerated display of the "easy to count, therefore gets attention" game that is going in with the rankings game, whether by US News, Leiter, or any of the others, except for a few attempts here and there to introduce something of greater value.

In a world where "money talks," perhaps a fun way to figure this out would be a web site that offered free subscriptions to lawyers, gave them $1,000,000 in non-redeemable credit, provided a list of all law faculty publications, and asked the lawyers to spend the $1,000,000 as though they were purchasing what they needed for whatever it was they were doing as lawyers. Assuming the Justice Department didn't brand such a technique some sort of on-line gambling national security threat, it might trigger a high response rate by combining the concepts of money, lawyers, and games. So what would they buy? Yes, I know that some would argue that some truly valuable legal scholarship would fare badly in such an experiment, and my response would be, "Why?"