MauledAgain

If I thought my criticism of people pushing other people into making bad money decisions was harsh or called for too severe of a penalty, my perspective was quickly reaffirmed when I read, on the morning after I posted my commentary, a Philadelphia Inquirer story with the headline "Investment Seminars Found to Mislead Seniors Often." Unfortunately, by the standards of this day and age nothing in the story surprised me, cynic that I am. Is anyone surprised that investigators determined that the so-called "free lunch" investment seminars were accompanied by "high-pressure sales pitches masquerading as educational sessions" and that they included "pervasive misleading claims for unsuitable financial products, and even fraud"?

People with something to sell will push as far as they can to make the sale. It doesn't matter to most sellers whether the potential buyer needs the product or service or whether the product or service is good or bad for the potential buyer. Is it any wonder that when we find a dealer, retailer, or service provider who can be trusted and doesn't try to squeeze dollars from us for unnecessary or inferior products or services that we feel as though we have found a treasure?

The problems that are generated by aggressive marketers vary. In some instances pushing people to take out mortgages they cannot afford causes those folks to lose their homes. In other instances, persuading people to invest their money in some scheme causes those folks to lose their assets. Seniors may be the target of one sort of pushy sales pitches, whereas younger folks may be the target of others.

What does this have to do with taxes? To the extent user fees resemble taxes, then perhaps it is time to impose user fees on individuals and corporations that engage in tactics causing financial ruin for others. Perhaps those who offer financial services, a segment of the economy where so much of the problem occurs, should be required to put money in escrow so that when they damage someone financially there is a source for restitution. This user fee, or "tax" if that's what some want to call it, would consist of an initial deposit plus a percentage of the financial operator's earnings. Imagine, for example, if the brokers and agents who pushed people into unaffordable mortgages had been required to set aside, as a tax or user fee, a portion of profits to be used when their promises of guaranteed refinancing fell through. That would have done far more to alleviate economic suffering than will an exclusion for foreclosure gain.

Surely such a user fee and deposit arrangement will be opposed. But why? Those who conduct business honestly would get their money back as they demonstrated the integrity of their business operations. The ferocity of opposition might, in and of itself, speak volumes.

A friend, who had not yet read this morning's post, send me an email with the title "you've gotta see this.." Had it not come from someone I know I would have guessed it was spam. With a title like that, one's imagination can run wild thinking of what sorts of products or services are being marketed.

Instead, it turned out to be this link to a story about two mortgage brokers who bought a home, moved to another so they could renovate the second home, found themselves unable to cover the mortgage or sell the first home even after cutting the asking price from $750,000 to $600,000, ran into problems renting it to tenants, and then discovered the solution. Or what appeared to be the solution. The story's title almost tells all: "Housing Market Slump Forces Couple To Open Brothel"

I wonder what the Congress or the President's "fact sheet" has planned to assist these homeowners. It's very likely they are going to lose the house, if not to foreclosure then to seizure as property used for criminal purposes.

Tax issues aside, the way in which they were caught is instructive. Police responded to a Craig's List posting "offering dominatrix services with a grand opening special." Wow, there must be some interesting things for sale on Craig's List, but at the moment I don't have time to go look. I have a much more interesting event that begins in a few minutes called a faculty meeting. And if the Craig's List ad wasn't enough, someone had put "heavy shades" on the windows and a red ribbon out by the sidewalk.

And here I am, trying to figure out a way to remediate the mortgage lending crisis with a “took too much the wrong way” reclamation fee, as I described in this morning's post. It appears I'm just not all that creative.

What a mess greed, stupidity, and poor judgment can make, alone or together. It would be bad enough if those greedy, stupid, or careless enough to make the mess had to stew in it. It is particularly aggravating when the people who make the mess expect the rest of us to clean it up.

The recent downturn in the housing market, a predictable and predicted outcome of the rampant speculation in housing fueled by speculators and gamblers bored with the stock market and looking for something more exciting, more profitable, or more instantaneous, has created serious financial problems for homeowners who overreached when purchasing or investing in residential real estate. Those problems include not only loss of the home through foreclosure but higher federal and state income tax liabilities because the foreclosure can generate cancellation of indebtedness income.

The problem, the extent of which seems to deepen with each new report, has been brought into the spotlight by an article in the Wall Street Online Journal, One Family’s Journey Into a Subprime Trap. The story has been picked up and re-published throughout the web. When I ran the title through Google recently, there were more than 500 hits.

The story explains how a couple decided to purchase a $567,000 home even though they had almost no money for a down payment and could not afford the mortgage. Though once upon a time these circumstances would have closed the door on the deal, the couple discovered a mortgage company that would lend them the money with a very low down payment and low monthly payments that would reset themselves two years later. To deal with the anticipated increase in their mortgage payments, the couple banked on the mortgage broker’s assurance that they would be able to refinance. Unfortunately, when it came time to refinance, housing prices had dropped, the loan exceeded the value of the home, and interest rates were higher than the initial low rate that had been obtained for the first two years. Now that the housing gambling speculation bubble has broken, it’s impossible to find lenders making the sorts of deals that this couple managed to find several years ago. What happens? People in this position are unable to pay the higher monthly payments and eventually the lenders foreclose. That’s what the couple in the story fears. They’ve already stopped taking vacations and have reduced eating out from once or twice a week to once or twice a month. Not only do people in these situations end up losing their homes, they also find themselves with increased taxable income, and thus increased income tax liabilities, to the extent the loan is written off for an amount less than the principal balance, something that happens if the value of the home has declined and the lender does not or cannot hold the borrowers accountable for the balance. With home foreclosures climbing to an annual rate of almost one million, and with approximately 7 percent of houses having values less than the total debt encumbering them, the problem discussed in the story affects more than a few people.

Having to pay more income taxes when dealing with the loss of a home because the mortgage payments climbed to a level not manageable within the scope of one’s income isn’t something anyone wants to experience. It seems, to many politicians, that the only answer is to change the tax law so that gross income, and thus taxable income, does not include the income realized when the loan is written off for a value less than its outstanding balance. And that is precisely what the Congress intends to do. In April, a bill was introduced in the House of Representatives to amend section 108 so that income from the cancellation of qualified residential indebtedness is excluded from gross income. A month later, five Senators introduced almost identical legislation in the Senate. Two weeks ago, the President jumped on the bandwagon as part of his effort to “help homeowners avoid foreclosure.” Sorry, Mr. President, but excluding foreclosure gain from gross income doesn’t prevent foreclosure, because it arises from foreclosure, something that isn’t prevented by changing the tax consequences of foreclosure. And this tax break must be financed with one or another, or some combination, of two sources, either higher taxes on everyone else or an increased deficit that pretty much is a tax on some future generation.

The ineffectiveness of the proposed tax break as a solution to the problem is precisely the point. Even though it is possible that the proposed tax relief is being bandied about as some sort of problem prevention technique in order to acquire votes and public relations advantages, the bottom line is that the proposed tax relief doesn’t prevent the foreclosure, doesn’t put the people back into their homes, and doesn’t do much to help them straighten out the mess that their lives have or will become because of the misguided decision to bite off more financial responsibilities than their means would permit them to chew. Yes, it removes the additional tax liability as a burden, but what are the odds that the IRS would collect that liability anytime soon?

Let’s face it. At best, the proposed tax relief is nothing more than a band-aid. It doesn’t solve the problem. Worse, it distracts the nation from what needs to be done to deal with this problem, and it sets a bad precedent for dealing with similar problems. It makes ignorant citizens think that Congress is taking care of things and mitigating the crisis.

The problem arises from a confluence of several underlying weaknesses in American culture. The first is the decision to live beyond one’s means. Fueled by advertising that makes people feel inadequate if they don’t own a home, live in a large home, drive a fancy car, wear the latest designer-brand fashions, and eat at the trendiest restaurant, people overspend and then end up in a financial dilemma. Greed? Maybe. Stupidity? Sometimes. Poor judgment? Definitely. The second is the proliferation of lenders, brokers, agents, and others who enable the decision to live beyond one’s means. It’s one thing to cut people a break so that they can afford a home, such as a small reduction in the required down payment or a slight reduction in the interest rate. It’s something else to eliminate the down payment requirement and to doctor the interest rate so that in two or three years the home buyer is trapped in a mortgage hell. Greed? Yes. Stupidity? Perhaps on the part of the borrower. Poor judgment? Yes, on the borrower’s part. The third is the perception that someone else, usually “the government,” will step in to insulate people and businesses from the folly of their bad decisions. The ever-growing inability or unwillingness of people to accept responsibility for the consequences of their actions increasingly erodes the core values on which this nation rests. Greed? Yes. Stupidity? Yes. Poor judgment? Yes.

The solution to the problem lies at its root, which is not the tax treatment of cancellation of indebtedness income. The solution to the problem is to shift the financial consequences of bad lending decisions onto the individuals who made those bad decisions. Those individuals include not only the buyers who grabbed beyond their grasp, but also the real estate agents who encouraged them to buy what they could not afford, the loan officers who approved loans that should not have been made, the speculators and gamblers who drove up housing prices, made their money, and retreated in the face of the collapse they triggered, and the politicians whose failed education and economic policies have created an economy that increasingly turns the nation into those who have far more than they need (and usually far more than they deserve) and those who lose what little they have because they haven’t been sufficiently educated to resist the siren calls of those whose efforts to shift more and more wealth to the haves are turning the have-a-little-bits into have-nothings.

The long-term solution, of course, as it is with so many other of life’s problems, is improvement to the education system so that people who are buying houses know enough to avoid the traps set for them by the purveyors of life beyond one’s means. The couple in the story explain that they didn’t “understand the lingo” spoken by the loan broker. They claim they weren’t told that the refinancing solution, had it been possible, would have been accompanied by a whopping $12,000 “fee.” The President’s “fact sheet” asserts that the Administration will establish a Council on Financial Literacy and encourage private sector efforts to improve financial literacy. Why not just teach high school students about home buying and mortgages? Why not make the earning of a college degree conditioned, in part, on demonstrating an understanding of the basic concepts?

The short-term solution is to impose a “took too much the wrong way” reclamation fee on those who made money gambling in the real estate market at the cost of driving up home prices to the point where far too many Americans could not and cannot afford to own their residences, and on those who aided and abetted that wild speculation. People and industries who damage the nation’s economy, health, environment, or defense posture ought to face the consequences of what they have done.

I know that the advocates of free markets will claim that government intervention of the type suggested is wrong, but what happened was that a free market was enslaved by the greed of speculators and gamblers who call themselves investors. If government intervention is so wrong, then surely the proposed tax relief is wrong, but so too are the tax laws that encourage the sort of gambling that has contributed significantly to the mess. If capital gains were taxed at regular rates rather than at special low rates, would the behavior of the real estate speculators have had the same consequence of pushing housing prices and then letting them come crashing down? I doubt it. Layer on top of this the adverse impact of increased real property tax assessments driven by the artificially inflated “bubble” housing values, and using the tax law to collect damages for the harm done to the tax system by the speculators makes sense.

And I know that defenders of the lending industry will point out that it’s now an industry in deep distress, but surely that industry made money lending to the speculators when the going was good, trying to persuade people to borrow on their home equity so that they could spend today what they would need tomorrow. The lending industry charged higher fees when placing loans for people purchasing homes that were beyond their means. Loan brokers “guaranteed” that refinancing would be a cinch when it came time to deal with the increased interest rates that kicked in two or three or five years down the road. If the refinancing goes through, the lenders collect huge “refinancing fees.” The lenders created much of the problem, and the lenders should be required to disgorge the profits generated by this flurry of unwarranted lending. When warned that their lending practices were a recipe for disaster, the industry brushed the critics aside with the same disdain I expect will greet my commentary. We’ve had time to see how right the critics were on the first point, and how wrong the lending industry was. Will we get a chance to figure out that they’re just as wrong on the second point?

The notion that some sort of tax relief, even if it solved the problem, is the appropriate response to the mess creates a precedent that does not bode well. Perhaps, in some respects, it reinforces bad precedent. The problem was created because people exercised their private sector “rights” to engage in “free market” transactions through which they loaned or borrowed money, purchased or sold real estate, borrowed within or beyond their means, requested or did not request relevant information, provided full or misleading disclosures, and learned or did not learn what was appropriate and not appropriate when analyzing or explaining home mortgage lending transactions. Aside from the government’s role in failing to make public education as relevant and as useful to people who borrow money to buy a home as it needs to be, those engaged in the transactions that generated the current residential real estate market and mortgage lender crises did what they did pretty much free of effective government regulation. So what is the justification, now that things are such a mess, for seeking relief, ineffective as it would be, through the tax code, in other words, from the government? Some of those calling for government intervention, through the tax code and otherwise, would have been among those most vigorously resisting such interference if the government had required loan applicants to undergo an approval process based on genuine ability to pay. It’s not unlike the inconsistency, to use a gentle term, of those who choose to smoke or drive motorcycles without a helmet proclaiming libertarianism as their philosophy when government regulation of tobacco or helmets is proposed and yet who advocate federal health care when they come down with cancer or a cracked skull.

If those who are responsible for problem should be responsible for fixing it, then ought not those made responsible for fixing a problem be given the power to prevent it in the first place? The danger with government involvement in solving private sector problems is that there is a good argument for government involvement with that private sector before the problems can emerge. Of course, whether government can prevent or solve problems in an efficient and effective manner is a different question, but the private sector’s recent track record is making the government look less incompetent than it looked ten or twenty years ago.

I don’t propose to tax the people who intentionally or who through ignorance tried to live beyond their means. Losing their homes and other assets, and dealing with the mess their lives become, is more than enough of an economic price. There’s no need to add a tax, though I don’t see the utility of reducing a tax bill that isn’t going to be paid. Who knows? A few of them might hit the lottery and at that point they should be willing and able to pay their back taxes.

Lest anyone misconstrue the proposal as insensitive and cruel, I hasten to note that there are instances where societal remediation, through government, is appropriate. There are people who suffer through no fault of their own and who need assistance. Often there is no one to blame except nature or fate, and those cannot be taxed, sentenced to prison, or made to pay restitution. There are problems that are beyond the scope and reach of the private sector. In other words, there are times when governmental intervention is necessary, although that’s not to say that the tax code is the appropriate vehicle for doing so. In fact, it rarely is though the Congress uses it dozens of times a year. But if the private sector has created or contributed to the problem, then the private sector must bear its share of responsibility for cleaning up the mess. Nothing in the President’s “fact sheet” on the matter mentions anything about holding responsible those whose behavior fueled the crisis. Nor does anything in the proposed legislation introduced by the Congress focus on those whose greed, stupidity, and poor judgment got the nation to this point.

And that, in turn, reflects some combination of greed, stupidity, and poor judgment.

The last time I posted about Andrew Mitchel's new tax charts, I titled my comments "It's Sleeting Tax Charts," a spin-off of the title to my previous post on Andrew's charting activities, "It's Raining Charts". It turns out that yet another person put the summer to productive authoring use, joining myself and Julian Block in generating information useful to the tax practice community. It's too soon to say it's snowing charts or even falling charts, so I had to go with the post title you see above. Eventually I'll run out of weather analogies and will be required to put the chill on that approach to keeping up with the steady stream of charts from Andrew Mitchel.

Andrew has out-done himself this time. He added 129 charts to his collection. Yes, that's not a typo. It's not twenty-nine, it's ONE HUNDRED AND TWENTY-NINE. There are now more than 500 charts on his web site. They can be accessed by topic or chronologically. I've noticed what might be old news, but is new for me, and that is people can order color prints of the charts.

What's in the batch of 129 new tax charts? According to Andrew:

The latest installment includes charts of the recent Heinz case, 28 examples from recently proposed spin-off regulations, as well as charts of basic section 351 exchanges, section 721 exchanges, and much more!

The tax law being what it is, a complex ever-changing conglomeration of rules and exceptions to rules, it isn't surprising that Andrew was required to update "twenty-seven charts with examples of indirect stock transfers under section 367 ... to reflect changes made by Treasury Decisions 9243 and 9311."

For those needing cross-references to my previous commentary on Andrew's chart work, look here, here, here, here, here, here, here, here, here, here, here, here, here, here, here, here, and here.

Happy navigating!

It seems I wasn't the only person who did some tax writing over the summer, though I don't think Julian Block tapped on a keyboard while out on an ocean. Julian has added another title to his expanding list of tax books that permit a tax novice or someone not educated in tax law to grasp a discrete topic while working through a text of manageable size.

In February 2006, I reviewed his "MARRIAGE AND DIVORCE: Savvy Ways For Persons Marrying, Married Or Divorcing To Trim Their Taxes - And They’re Legal," in Tax and Relationships: A Book to Read and Give. August brought a review of Julian's "THE HOME SELLER’S GUIDE TO TAX SAVINGS: Simple Ways For Any Seller To Lower Taxes To The Legal Minimum," in A New Book on Taxation of Residence Sales: Don't Leave Home Without It. Julian's 2006 hat trick of books closed with my December review of "TAX TIPS FOR SMALL BUSINESSES: Savvy Ways For Writers, Photographers, Artists And Other Freelancers To Trim Taxes To The Legal Minimum," in A Tax Advice Book for People Who Write and Illustrate Books. Early this year, I reviewed "Year Round Tax Savings" in Another Tax Book for Tax and Non-Tax People to Read.

Summer 2007 brings Julian's latest work, "Travel and Moving Expenses: How To Take Maximum Advantage Of Every Tax Break The Law Allows." Off I go on a trip, and out comes Julian with a book about the tax implications. How nice. Now perhaps if I could deduct the cost, but that's not going to happen, and if I had any inclination to think that it would, and I don't, Julian's book would have steered me away from running aground with a bad tax return.

Julian's book is helpful not only because it showed up with coincidental timing and with good advice for me, but also because it takes the reader through what can best be described as a maze of tax law dead-ends, roundabouts, detours, and temporary roadblocks. Moving from the theoretical statement that travel expenses paid or incurred in carrying on a trade or business or the principle that moving expenses are deductible to the practical task of applying those concepts to a taxpayer's bundle of receipts and business records is about as daunting as finding one's way around Europe without a GPS. Julian's book is a nice, entry-level GPS for those trying to navigate the travel and moving expense deductions.

Julian begins in the same place I do when I teach these topics, specifically, the rule that commuting expenses are not deductible, unless one of several exceptions applies. He takes the reader on a tour of cases and rulings in which taxpayers have and have not docked their specific circumstances within the safe harbor of the tools exception and the "between jobs" exception. Drifting beyond what I have time to cover in the basic course, he takes readers on a tour of the restrictions applicable to the expenses of having one's spouse come along for the ride, so to speak. He explores the challenges faced by spouses who work in different cities, once a rare concern but now a situation faced by increasing numbers of couples. Julian closes out the travel expense section of the book by reminding all of us, myself included, that deductions are not allowed for the cost of travel that is in and of itself educational, in contrast to travel that is deductible because it transports the taxpayer to a place where the taxpayer takes courses the cost of which qualify for the education expense deduction. This is a subtle distinction that often derails students dealing with these issues for the first time.

With respect to moving expenses, Julian takes the reader on a path that leads from the distance test, through direct costs of moving household items and expenses of travel to the new location, past the time time test and the closely-related test, and to the cul-de-sac of nondeductible moving expenses. He outlines the paperwork that the taxpayer needs to prepare and maintain. He describes how taxpayers can accelerate the tax savings from the deduction by adjusting withholding so they are taking home more money each pay period rather than waiting for a larger refund the following spring.

Julian then devotes a chapter to travel expenses that qualify for the charitable contribution deduction, another chapter to those that qualify for the medical expense deduction, and yet another to those that qualify for the for-profit activity or investment deduction. These are travel expenses often overlooked by taxpayers and their return preparers.

As he has done in earlier books, Julian makes certain that the reader sees examples of the rules as applied to specific facts. Students who are trying to go further into tax law than time permits their course instructors to take them will benefit from strolling through this book. So, too, will taxpayers and tax return preparers who need to learn or refresh their understanding of these two very specific areas of tax law.

Joe Kristan responds to my analysis of the special low tax rates on hedge fund manager compensation with two concerns. Both are valid but neither should get in the way of fixing an injustice.

In response to my comment that "there's no unanimity in the mechanics of the reform, but once the competent put their minds together it ought not take long to work out the details" Joe notes that it is the Congress, and not the competent, that writes tax laws. Yet why not permit competent reformers to prepare the language of the statute in much the same way that special interest group lobbyists and their staffs have prepared much of what has been shoved into the Code during the past decade or two? Members of Congress haven't drafted tax statute language for decades, and one cannot expect them to produce anything of quality, but having let the lobbyists overshadow the tax-writing staffs is a bad trend reversal of which can begin with this particular reform.

Joe's seemingly bigger concern is that amendments making partnership interests received for services taxable as ordinary income would "disrupt.. the management structures of any number of LLCs operating real businesses." Good. A hedge fund is a business. So is the management of any business, including real estate, shoe stores, and lawn mowing services. I'm all for taxing compensation as compensation, and that means ordinary income tax rates should apply. Joe explains that "'Carried interests' are really just 'profits interests,' which are a way to let management share in the growth of a business without having to make a big cash investment or pay a bunch of taxes before they earn anything. Exactly. Profits interests, in contrast to capital interests, represent economic gains that taxable as ordinary income. That they get paid at a later date goes to the timing issue, which I address in my proposal. Joe then points out that carried interests "provide a result very similar to a grant of restricted stock coupled with a Section 83(b) election," which in some respects is an accurate representation. The difference is that because of the way C corporations are taxed, all sorts of ordinary income gets treated as capital gain. There is, for example, no section 751 equivalent for C corporations, aside from a few narrow situations. Even so, when a person receives stock from a corporation as compensation, its value is taxed as ordinary income either when received or when vested, depending on whether the section 83 election is made. By choosing to be taxed at the outset, the recipient is taxed at capital gain rates on future increases in the stock's value. I'm content to have a similar provision apply to compensation received by hedge fund and other managers and employees of partnerships. What currently happens with the hedge fund arrangement is that capital gains treatment applies without the employees and managers paying the price of having ordinary income at the outset. That doesn't happen in the C corporate context, which is why "in some respects" is the critical part of my comment that Joe's analogy "in some respects is an accurate representation." It's that difference that matters very much.

The bottom line is that tax reform of any sort must elevate the common good over the special interests, no matter how entrenched the special interest provisions are or how accustomed the select few are to their special tax breaks. The fact that the tax treatment of partner-employees has been wrong so long is no reason to worry about the supposed disruption that fixing an injustice will cause to those who benefitted from the unwarranted consequences of glitches in the tax law.

Now that the summer sojourn is over, and I've returned from journeys in places where Internet access is neither as available or as inexpensive as it is here, I can turn my attention to a variety of topics that made their way into my consciousness even though I was far away. I'm taking them in no particular order, neither alphabetical nor chronological.

Today I turn to an issue that brings out the worst in the tax law. It's the tax treatment of so-called carried interests. To put that in English, it's the question of what tax rate should apply to the money that someone earns for performing services, when that money is paid in the form of a partnership interest that can be "cashed out" at some time after the services are performed. Because of quirks and disjointness in the way partnerships and partners are taxed, people being paid to provide services to hedge funds, investment services enterprises, and similar operations are being taxed long after they are compensated with partnership interests and at those special low tax rates applicable to capital gains. In the meantime, people performing services for factory owners, service station owners, hospitals, fire and police organizations, fast food outlets, and other enterprises are taxed when they paid and at regular tax rates. Even the service station owner, fast food entrepreneur, and factory mogul are taxed at regular tax rates on the profits they generate from running a trade or business. I wonder how many of them know what is going on, and understand the realities that lie underneath all the arguments and spin being offered in defense of an unjustifiable situation. So I add one more item to the list of reasons that some basic tax policy ought to be taught in high school.

The outcry over this discrepancy has climbed to a crescendo during this past summer. Critics have made their voices heard, and proposals for "fixing" the problem, chiefly the flaw in the partnership taxation structure, have been advanced. For example, several members of Congress introduced this proposed legislation. Defenders of the status quo, initially caught off guard, have marshaled their resources and are lobbying the Congress most furiously, throwing time and money into preservation of a totally unjustified tax break. Even a few folks who seemingly have no stake in the matter have spoken or written in favor of special low tax rates for hedge fund managers. Oh, if you haven't figured out by this point where I stand on the matter, I'll give a hint with a question. What is it that hedge fund managers and others of that ilk do that entitles them to being taxed on compensation at rates far lower than those applicable to the compensation of other workers and sole proprietors?

To be fair, hedge fund managers and their advisors aren't doing anything legally or technically wrong. The tax law is flawed, and it leaves open an opportunity for what the hedge fund managers and their advisors have done and are doing. That flaw was not created by the hedge fund managers or their advisors. It exists because Congress tried to make everyone happy when it enacted, and continued to amend, the partnership taxation structure, without thinking through to the end the consequences of what it put into the statute. Surely the hedge fund managers and their advisors should get high grades for detecting the opportunity and taking advantage of what Congress carelessly provided. But now that the tax defect has been identified, it's time to fix it.

Congress, to its credit, has been holding hearings on the issue. It took testimony on July 12 and on July 31. In fact, more testimony is scheduled for tomorrow. Statements by some witnesses and by a few members of Congress suggest that they don't truly understand the justifications for the existence of special low tax rates on capital gains or, more importantly, why those special low rates ought not apply to a person's compensation income. A very good explanation of the "sentimental sophistry" in their reasoning can be found in the testimony of Professor Darryll K. Jones, a rising bright star in the world of partnership taxation.

The arguments raised by supporters of this unintended tax break range from the erroneous to the misleading. A helpful summary has been presented by the Citizens for Tax Justice in "Myths and Facts about Private Equity Fund Managers — and the Tax Loophole They Enjoy".

Consider this argument from the National Venture Capital Association (NVCA): "But the reality is this is always the way it's been. We basically say, It's worked for years, so why change it?" The answer is simple. Because it's wrong. It wasn't intended, it isn't the sort of activity that comes within the protective mantle of capital gains taxation, even if one is to accept, arguendo, that there should be special low tax rates on capital gains.

The NVCA also claims that taxing compensation at regular tax rates would discourage innovation. Really? If that's true, then ought not scientists, medical researchers, space shuttle engineers, highway bridge designers, and just about everyone else whose creativity and intellectual skills contribute to society, often contributing far more than some fund manager sitting at a desk shuffling other people's money does, get a similar tax break? Are we somehow to conclude that those folks aren't innovative and that the only innovation taking place is whatever it is that investment services advisors and hedge fund managers are supposedly contributing, when in fact it's their clients who are coming up with the few truly good ideas that have come out of the tens of thousands of wild ideas that have been financed with venture capital?

Then there is the old chestnut, the "changing our good deal will destroy the economy" argument. Used almost annually by the real estate industry to justify such things as depreciation of appreciating buildings and treatment of nonrecourse debt as recourse debt for at-risk purposes, the not-so-veiled and pipe-dream threat often succeeds in getting members of Congress to cave in to some special interest. Eventually every special interest will get special low tax rates, leaving the bulk of the tax burden to fall on the not-so-special interests. Of course, since (and I say this sarcastically) all of us are special, there won't be anyone left to tax at regular rates. The reason the "economy will suffer" argument is such nonsense is that the taxation of ALL compensation at regular tax rates will not stop the planet from rotating and will not stop people from doing their jobs. In other words, life will go on and the economy will continue to function. It is interesting how special interest groups not only consider themselves deserving of special treatment but somehow conclude that their presence on the planet is the sina qua non of everything good that happens to anyone. What nonsense.

Another argument, that fixing the flaw and taxing the compensation of hedge fund executives at regular rates would damage pension plans, has been refuted by the pension funds themselves. One would think that, for all their alleged brilliance, these super-special low-taxed employees would have touched base with the pension fund experts.

Two other arguments are suggested in this Wall Street Journal article. One is that there's not much revenue involved and the other is that Congress has other, more important things to do. To the first, I respond that every bit helps, and that the message sent by a Congress countenancing special low tax rates on the compensation of a select few further distances itself from an increasingly frustrated population. To the second, I respond that all of us have long "to do" lists and the Congress is quite capable of getting its work done if the members truly wish to do so. The second argument isn't very different from one that advocates letting bank robbers run wild because the police have too many homicides to handle.

What do these selected special few do with their tax savings? Apparently they contribute to the campaigns of members of Congress. These are partisan supporters. They send money to politicians of every party and every persuasion. They don't care who protects their tax break, and they're willing to pay. Considering the Administration's reluctance to support reform, the President being "very, very hesitant" to make changes, I wonder if this is the sort of political atmosphere that it prefers and that it is trying to export abroad.

Very little of what I've written is ground-breaking, and perhaps none of it is. While I was away, more than a few tax faculty chimed in on the issue. As Victor Fleischer points out in "The Academic Consensus on Carried Interest ", there is an "academic consensus" on the question. I find myself in agreement with a group of faculty whose perspectives are all over the tax policy spectrum, including some with whom I sometimes disagree on other matters. When the academic tax community is this much in agreement, it speaks volumes about the need for reform. As Victor points out, there's no unanimity in the mechanics of the reform, but once the competent put their minds together it ought not take long to work out the details. I would require inclusion in compensation income, taxed at regular rates, of the value of what is received, and if it cannot be valued, I'd require that the taxable year be held open until the interest is sold, liquidated, gifted, or passed at death, at which point I'd have the tax for the earlier year recomputed, and then paid, with interest, by the recipient or the recipient's estate.

But the academics are not unanimous in calling for reform. One academic who has come out in favor of the current special low tax rates on hedge fund managers, obtained funding for the research from the Private Equity Council. Another academic, a person I know and hold in high regard, points out that he addressed the subject in "The Taxation of Carried Interests, 116 Tax Notes 183," in which he addresses the "practical difficulties" that reform would generate. He notes that communication between tax academics and tax practitioners has declined significantly, an observation with which I agree, asserting that "these academics really don’t know much about what lawyers do." Yet the fact that some tax practitioners are, as he points out, "intellectual and curious" doesn't mean that the deals they cook up are appropriate or deserve a Congressional imprimatur. The proposal that I offer in the preceding paragraph deals with the practical problem of valuation in a manner not unlike that used in other areas of the tax law where valuation might otherwise be an obstacle. I'm simply not persuaded that there are any insurmountable practical problems, and if there is a challenge in making a transition to appropriate taxation of compensation, that's a small price to be paid for an unwarranted tax break that has been enjoyed for far too long. What might be impractical is going back and collecting the taxes that would have been paid had the compensation been taxed all along at regular compensation rates, so perhaps the advocates of this unjustifiable special tax break ought to consider seriously the risk of facing truly impractical legislative reactions.

Of course, all of the reform proposals, including mine, merely deal with a symptom. The issue would not exist if there were no special low tax rates for capital gains. To its credit, the Wall Street Journal article calls for the same genuine reform that I've advocated for more than three decades. Abolish the special low tax rates on capital gains. Those rates account for almost one-third of the Internal Revenue Code, as the Congress has had to apply piecemeal fixes to a bad idea gone very wrong. It is true, as some defenders of the tax break for hedge fund managers claim, surely some other arrangement will be structured that uses some other flaw in the tax law to turn ordinary income into capital gains. In the long-run, until and unless Congress repeals special low tax rates for capital gains, we will continue to learn about new and improved mechanisms for giving a select few an unintended tax break, we will continue to read and write about the outrage and the call for reform, we will continue to listen to the defenders of the unintended tax break hail its importance to the economy and all that is good, and we will continue to ride a never-ending tax circle. So I doubt this is the last word I will have to say on the issue.

The course concludes with a study of the assignment of income doctrine. Actually, the course concludes with my ten-minute summary that projects what the students have done into their future professional careers and, after I depart, with the course evaluations.

There has never been a semester in which more than 10 or 15 minutes have been left for the assignment of income topic, despite the budgeted 50 minutes. What prevents this from becoming a major problem is that the students have dealt with the question of whose income is it and whose deduction is it throughout the course. Early in the course the students are given a problem in which an employer makes a transfer to an employee’s spouse as incentive for the employee to refrain from resigning, and thus early on they come to understand the concept of indirect transfers, the step transaction doctrine, and the principles that income is taxed to the person who earns it and to the person who owns the property that produces it. Of course, underneath those rules lurk all sorts of questions that arise when specific fact patterns are analyzed.

Students also encountered the assignment of income issue when they looked at the deduction of taxes paid by one person with respect to another person’s property and when they focused on the reasons for the existence of the provision taxing the unearned income of certain children at the parents’ marginal rates. They would have learned much more if the chapters in the text addressing the taxation of trusts and business entities were covered, but those matters have always been left to other courses, with the expectation that students would enter them possessing a knowledge and understanding gleaned in the basic course that would serve them well. Ultimately, whether that happens pretty much is in the student’s hands.

The course is not finished. There remains the final examination, the score on which at the moment counts for 2/3 of the course grade, the other 1/3 coming from the dreaded but necessary semester exercises that ultimately earn the respect and even gratitude of most students. Even when the students are finished with the examination, I continue to tend to the course, investing time in the very educational process of grading the examination. And then it’s off to find and learn the next batch of annual changes and to update the course for the next academic year. That process is one I will describe some day, because few people, even my colleagues, grasp the complexity and depth required to update a tax course.

Next: There is no nextin this series, though there are many planned "nexts" for MauledAgain, especially if the list of pending post topics holds up. Hopefully this series of posts about the basic federal tax course have been instructive not only to those who teach basic tax courses but also to the students who enroll in them, to practitioners who hire law graduates who have been in them, and to people who are curious about this particular law school course even though they are not lawyers or law students. There surely are other effective ways to structure a basic federal tax course and to select depth of coverage for its topics, but perhaps my explanation of why I do what I do with the course will give someone an idea or two for their own course. In some ways, this series of blog posts is inspired by the fact that during the upcoming semester two of my colleagues will be joining me in teaching the basic federal tax course when they step in to succeed two colleagues who no longer will be teaching it. I figured that my responses to their articulated and anticipated questions would be of interest to more than just the two of them. And I also figure that there will be more questions.

The tax benefit rule is one of those tax doctrines that at one time or another affects almost, if not, all taxpayers. The core question is how to treat the receipt of money or property in one year that represents a return of amounts spent and deducted in an earlier year. For J.D. students in a basic tax course, the issue is best illustrated by its most common occurrence, the state income tax refund.

The basic rule is fairly simple. The amount received must be included in gross income to the extent it provided a tax benefit. In the case of a state income tax, the determination of whether a tax benefit occurs is accomplished by computing what the taxpayer’s taxable income would have been without the refunded tax having been deducted with what the taxpayer’s taxable income was with the refunded tax having been deductted.

There are two aspects of the topic that make a fitting next-to-last topic for the course. First, it requires the students to look again at the computation of taxable income and the big picture that illustrates the overall structure of the federal income tax. Second, it drives home the point made early in the semester and reiterated several times, namely, the tax law is dynamic. Students learn that in order to determine how much of a state income tax refund received in 2006 with respect to a tax paid and deducted in 2005, the preparation of the 2006 return requires a hypothetical reconstruction of the 2005 return, using 2005 law and inflation-adjusted amounts.

Next: So whose income is it?

Special rules apply when a taxpayer disposes of property and receives one or more payments for the property in a year or years after the year of sale. In the Graduate Tax Program property dispositions course, at least four 50-minute classes are required to explore the applicable provisions. Nothing of that sort can or should be attempted in a basic J.D. tax course. Instead, my goal is to get the students to understand the “spreading” of the gain across the years of payment and the option to elect out and report all gain in the year of sale, to focus on the computation of the gross profit ratio, and to appreciate the serious tax consequences of making transfers of installment obligations. Even though pressed for time, I usually manage to accomplish these goals in less than the scheduled 50 minutes. Yes, I speak a little more quickly, but having warned the students in the previous class to look again at how annuities are taxed, I know that the students who have assimilated that topic will recognize the similarities with installment sale treatment.

So the students don’t explore what happens when there is debt secured by the property being sold. They don’t learn about the treatment of wrap-around mortgages, in part because of the time shortage and in part because few of them know what they are. They don’t examine dispositions to related parties or the acceleration of the depreciation recapture portion of the gain. They don’t delve into conditional payments. The list of what they don’t study is far longer than the list of what is assigned.

Next: The tax benefit rule

Although throughout the semester students have touched on the question of when gross income or a deduction is taken into account, they don’t examine the application of the cash and accrual methods until the course is nearly finished. Again, to dig into these issues before both gross incoe and deduction topics have been completed would be premature.

Students are told there are yet other methods of tax accounting but because they are used in relatively narrow situations their definitions and application are ignored. Instead, students are asked to consider issues such as constructive receipt, the “all events” test, and economic performance. The opportunity arises to have them again visit the concept of time value of money, and to consider whether it always makes sense to try postponing income and accelerating deductions. Usually someone in the class picks up on the possibility that the taxpayer will be subject to a much higher or lower rate in the following year, either because of changes in other income and deductions or through legislation.

Of course, all of this is compressed. The scheduled 50 minutes don’t exist, so coverage is limited to what fits into 25 or 30 minutes, at best. This means many of the assigned problems go unexamined.

Next: Installment sales

Another component of gain characterization is depreciation recapture. Simply put, the portion of gain that reflects previous depreciation claimed with respect to the property does not qualify for capital gain treatment unless the property is real property and the depreciation was computed using the straight-line method or is no more than what would have been computed using that method.

It would make no sense to discuss this aspect of gain characterization when teaching the gross income from property dispositions topic because at that point in the course few, if any, students have a clue with respect to the depreciation deduction. In contrast, by this point in the semester the students have had several encounters with the recapture concept.

I teach students the “short cut” method rather than the technical statutory method for computing depreciation recapture. Why? Because, yes indeed, there isn’t sufficient time to focus on the statutory construct. At least the students will leave the course with at least some sense of yet another concern that will affect decisions that they and their clients will be making.

Next: It’s time to discuss timing

After taking the students through the basic definitions relating to capital gains and losses, my next goal is to have them explore the provision that turns net gains from the sale of certain business property, to use an imprecise phrase, into capital gain but that turns net losses from those sales into ordinary losses. It’s a “best of both worlds” approach from which the students can learn much, not only in technical terms but also in policy respects.

There are all sorts of wrinkles in the provision. Before the gains and losses are compared, a subset of the gains and losses, those involving casualty events, are compared, and the net result is included in the basic comparison only if it is a gain. Special rules bring certain condemnation gains and losses into the picture. Some gains and losses with respect to property that is not business property enter the fray. A variety of gains and losses from certain types of business property are precluded from the computations. Special rules for certain animals exist. Overlaying this entire morass of definitions and exceptions is a recapture rule designed to prevent yet another game that taxpayers play in an attempt to steer gains into one year and losses into another in order to make the “best of both worlds” even better.

Again, pressed for time, the students end up with not much more than a conceptual explanation and one or two simple examples. The special inclusions, the exceptions, and the recapture rule fall by the wayside. Students are encouraged to do the assigned reading and to try solving the problems, but the time pressure problem is not a secret and students know, from the experiences of their predecessors, that they will not be taken as deeply into these topics as they are taken into the other topics. Students who take themselves into the Graduate Tax Program’s course on property dispositions, whether or not matriculated in the program, don’t suffer in the long run but the other students sadly are being shortchanged. What is truly disappointing is that many students are happy that the material is being abridged, when in fact it will disadvantage them when they reach the practice world.

Next: And then there’s that depreciation recapture thing

Early in the course, when studying gross income derived from property transactions, students with some previously acquired tax knowledge will use the term “capital gain” in crafting an answer, perhaps correctly or perhaps as a technically incorrect substitution for the term “gain realized” or “gross income.” To their chagrin, I tell them that I am postponing the discussion of capital gains.

Why is the discussion of capital gains delayed until near the end of the course? There are several reasons. First, the characterization issue affects both gains and losses and to delve into the issue when focusing on gross income would be premature. Second, understanding the impact of characterization as a double-edged sword that benefits those with net capital gains and disadvantages those with net capital losses is easier at this point in the semester. Third, some of the elements incorporated into the definitions reflect issues that weren’t covered until later in the course or that are more easily understood at this point.

My goal is to introduce students to the definitions and to illustrate the impact of the special treatment of capital gains and the disadvantageous treatment of capital losses. They need to understand why and how the “make ordinary income look like capital gain” and the “make capital losses look ordinary” games are played. They should understand the whipsaw situation that has given the tax law a variety of cases that treat the same transaction differently depending on whether it generated a gain or loss and which position the IRS took. What I do not try to do is to have the students compute tax liability when a portion of taxable income consists of capital gain. A quick peek at the form or the statute is enough to persuade anyone that putting J.D. law students enrolled in a basic course through that computational nonsense would be counter-productive.

As a practical matter, at this stage of the semester I’m so far behind that this topic receives 15 or 20 rather than the planned 50 minutes of class time. Some of the time savings comes from omitting some problems and taking students through others without asking them to contribute. In other words, with one or two classes remaining, I shift to lecture mode, not by desire but by dint of circumstances.

Next: Gains and losses from transactions involving business property

The next topic receives at best one minute of class time, and the message essentially is a repeat of what was noted during the overview presented near the beginning of the semester. After computing tax liability, a taxpayer compares that amount with the applicable credits. If tax liability exceeds total credits, the difference must be paid. If tax liability is less than total credits, the difference can be refunded or left with the Treasury as an advance on subsequent year tax liabilities. Students learn that there are two types of credits. There are genuine credits, those that reflect amounts already paid by the taxpayer, such as amounts withheld from compensation and amounts paid as estimated taxes. There are policy credits, those that reflect policy determinations by the Congress that a particular activity or expenditure by a taxpayer warrants reducing that taxpayer’s tax liability by some amount.

The list of policy credits continues to grow at a rapid rate. There now are dozens. Many involve very narrow and specific transactions, and a few affect a significant number of taxpayers. All are structured on an arrangement of definitions, exceptions, computations, and limitations. In theory, if a student needed to learn about a specific credit, he or she should be able to read the provision and parse the language.

Unfortunately, there isn’t any class time available to explore the details of any specific credit. Thus, students are instructed to read several pages in the course text that describe the more important credits in general terms but they are not responsible for learning the details. Although many of the credits would not deserve attention even if time were available, there are several that should get a closer look, such as the earned income tax credit. There are good arguments for covering these credits but there simply isn’t anything that can be removed from the course to “make room.”

Next: Characterization of income and loss

The tax law is structured so that after taxable income is computed, a taxpayer must compute tax liability. Again students arrive with the same uninformed impression that often is voiced by other faculty and people who have never taken the course. They expect to put on green eyeshades, crank up the abacus, or perhaps power on a Texas Instruments calculator. Nothing could be further from the truth. Students quickly learn that with a printed chart or software program, a person can “plug in” the taxable income amount and filing status to get the tax liability. The course is not an arithmetic course, and I tell the students I will not test them on their ability to look up numbers in a chart or to do the actual tax liability computations. Yet, despite this, two 50-minute class sessions are allocated to the topic. Why?

The students do sit through illustrations because there are several important concepts that those examples provide. First, by showing how tax liability is computed I introduce students to the concept of progressivity in taxation. Second, by showing the impact of phase-outs I introduce students to the “bubble effect,” which generally causes the effective marginal rate of taxation on high income taxpayers to be less than the effective marginal rate of taxation on middle-income taxpayers, a phenomenon that begins to help those students who have not already done so to figure out where some of my undisguised disdain for the tax system originates. Third, by showing how tax liability differs depending on filing status, I introduce students to the joys and frustrations of the marriage penalty, and, yes, the marriage bonus. I provide the students with an illustration that involves a taxpayer who could easily be one of them in a few years. I show the tax consequences of this person marrying someone with similar income and, alternatively, someone with no or little income. It is one of the priceless moments in the course. Students who did not look at this illustration before class, and perhaps some who did but who didn’t quite figure out what was going on, become visibly shocked or even annoyed when they see how the tax law encourages and discourages different “types” of marriages. My warning early in the semester that tax law is everywhere and affects everything finally is hammered home.

If this wasn’t enough, the discussion then turns to the computation of tax liability for children who have not yet attained the age of 18. Once assured that they will not be required to do the calculations, students settle in for several illustrations of how this needlessly complicated provision operates. As a provision affecting all taxpayers under 18 and all taxpayers with children under 18, it is a provision with broad application. Although software exists that can handle the numbers, the concepts are much easier to comprehend when examples are presented. Those examples also illustrate the many practical problems arising when a theoretical solution was applied to a real concern.

Next: Tax credits

Many students share the same mistaken impression of the basic income tax course as do some law faculty and people not involved in the law. They perceive it as a tax return preparation training course. Nothing could be further from the truth. Students in my course are not required to prepare returns. Those who cannot wait for the opportunity are invited to invest time in the pro bono activities of the Tax Law Society, among which are the preparation of returns for low-income individuals under the IRS VITA program. Students do have copies of forms so that they can look at them to obtain a more complete perspective on an issue or to enjoy a more robust context for considering the inter-connections of tax law analysis.

This topic, computation of taxable income, is mostly a one-class examination of how the pieces already studied fit together. To the array of gross income, deductions allowable in computing adjusted gross income, itemized deductions, and the deduction for personal and dependency exemptions are added two phase-outs and a study of the standard deduction.

One phase-out that requires attention is the one applicable to itemized deductions, and the other involves the deduction for personal and dependency deductions. The computation reflects adjusted gross income, which is why they are discussed at this point. Each is computed differently, in ways that appear, and are, arbitrary. When students discover that one of the phase-outs depends in part on how many $2,500 amounts are included in the excess of adjusted gross income over an inflation-adjusted amount dependent on filing status, they roll their eyes. I don’t blame them. Those who have read several of my articles know that I consider the phase-outs not only nonsense but fraudulent deception of taxpayers by manipulative politicians, few of whom remain in office but whose legacy continues to afflict taxpayers and law students. Making things worse is the phase-out of the phase-outs, which itself is scheduled for phase-out in 2011. Finding ways to help students comprehend these complexities without taking them into the depths of a numerical world is a significant challenge, because expressing the concept without using numbers and illustrations is counter-productive. The saving grace is that the students know that I will not ask them to do a tax return or these sorts of computations on the exam or in a semester exercise.

The standard deduction, an alternative to itemized deductions for taxpayers with itemized deductions less than the applicable standard deduction, consists of two elements, both consisting of dollar amounts set forth in the statute and adjusted for inflation. Students have visited inflation adjustments when dealing with some earlier topics so that aspect of the analysis is review. The standard deduction also reflects the taxpayer’s filing status, and that topic is examined briefly because students are not required to learn the niceties of the rules applicable to more complex marital transformations.

It is fitting that when dealing with this topic the students return to a point emphasized very early in the course. They see first-hand that the tax law is dynamic and not static. Two phenomena confuse them, even after I explain it to them. First, the dollar amount for the standard deduction that appears in the regulations does not match what is in the statute or the revenue procedure containing the inflation-adjusted amounts. The explanation is simple. The IRS and Treasury attorneys responsible for updating regulations are so swamped that they leave to the back burner the changes that people should be able to figure out for themselves. Students share my doubts and their facial expressions confirm their disappointment at how tax law administration leaves much to be desired. Second, the regulations interpreting the terms used in the definition of one of the standard deduction components are not found where one would expect to find them. They continue to exist as an interpretation of the personal exemption deduction even though this particular tax break for age and blindness long ago moved from the latter deduction to the standard deduction. Some students bemoan how confusing it is, especially because the situation is preventable. Such are the realities of law practice that I try to share with my students.

Next: With taxable income in hand, let’s compute tax liability

It takes very little time to work through the computation of adjusted gross income. It’s simply a matter of looking at a list of those deductions which qualify for subtraction from gross income in order to compute adjusted gross income. Oh, well, sure, the list in the applicable statutory provision isn’t complete, and students learn that a few of these “preferred” deductions are hidden elsewhere. Why they’re not listed with the others is a question I cannot answer other than to guess sloppiness.

Students do need to learn why adjusted gross income is important. I tell them that a good mental exercise is to review their notes and to identify every instance in which adjusted gross income is a component of the analysis. I mention that it would make a good exam question. Does that qualify as motivation? Students also are told to think back to the beginning of the course, when they first met the overall structure of the taxable income computation and to ask themselves if corporations need to compute adjusted gross income. It’s a review question, I tell them. If they know the answer, I see a smile. If they don’t, I see frowns and sometimes worse.

Next: It’s time to compute taxable income

Finally, it is time to turn the students’ attention to the deduction for personal and dependency exemptions. It is yet another topic that reaches close to home for them, because all of them can identify with the special rules applicable to dependents who are students.

There are two major aspects of the topic. One reflects the definitions and the other is computational. I leave the computation issue, namely, the phase-out of the deduction, to the topic during which the students are taken through problems requiring the computation of taxable income.

The definitions are not, on the surface, particularly challenging. The elements are, for the most part, concepts with which the students are familiar. There are a few surprises, of course. Some students know that the spouse of a spouse’s sibling is not a brother-in-law or sister-in-law. Others learn this for the first time sitting in the tax classroom. The same phenomenon takes place in the decedents’ estates and trusts course that I teach, when some students learn that the spouse of their aunt or uncle is not their aunt or uncle, except under rather uncommon circumstances.

Another element in the definitions, namely, abode, causes special problems for students who are away at school and who otherwise qualify as a dependent. Because this particular issue is significant for most of their families, I let the students work through the analysis. If they learn anything, it’s that mundane decisions about driver licenses, voting registration, and selection of a permanent address to give to school officials end up affecting someone else’s tax return.

And, yes, they read about the disappearance of millions of dependents when taxpayers were required to provide social security numbers for dependents. They look at me, dumbfounded. There was that much cheating? Yes, and it simply has moved to other provisions. They laugh when I tell them that some people have claimed dependency deductions for pets. By this point, they know the outcome. Of course they laugh. Else they’d cry.

Next: It’s time to compute adjusted gross income

After working through the deductions that are covered in the course, it is time to turn to the overall restrictions that apply to deductions. Most students initially are confused, and it’s no wonder. Many deductions are subject to restrictions that apply solely to the deduction. For example, when the students are studying the deduction for home mortgage interest, they learn that only the interest allocable to the first $1,000,000 of acquisition indebtedness is deductible. When they are learning about the casualty loss deduction, they are introduced to the $100 floor and the ten-percent-of-adjusted-gross-income limitation. It’s no wonder that they are baffled by the addition of yet more restrictions.

What makes this part of the course, and this aspect of the tax law, confounding is the existence of multiple restrictions that apply to clusters of deductions. In some instances a particular deduction may be subject to more than one of these overall deductions. I don’t push J.D. students too far in dealing with how multiple restrictions interact because it simply is too complicated. Even tax practitioners get frustrated at the chaotic nature of the computations that reflect the inability of unwillingness of Congress and the inventors of these limitations to coordinate them in sensible ways.

There are five overall deduction restrictions that I put before the students. These are the at-risk limitations, the so-called hobby loss limits, the limitations on deductions with respect to rental residences and offices in home, the passive loss limits, and the general policy restrictions. Because I can allocate only three 50-minute class sessions to overall deduction restrictions, I limit coverage and I direct the students to teach themselves the policy restriction. I made that decision because the policy restriction does not involve computations, and requires analysis more similar to what they did during their first year of law school than is most of the analysis applicable to other topics in the course.

Coverage of the at-risk limitation includes a very basic introduction to the concept, a streamlined definition of amount at risk, an explanation of why the limitation was enacted and how it failed, the wrinkle that considers taxpayers at risk for their share of nonrecourse debt secured by real estate, and a quick peek at the recapture concept. I assure the students that they are not expected to do at-risk limitation computations.

The hobby loss restrictions are much easier to understand, and therefore I take the students through several examples. I do expect them to understand how the limits are computed, because they are not particularly difficult, though some students struggle with translating the statutory language into application. I cannot resist pointing out to the students the special rules for horse-related activities, just as I do not resist pointing out similar special provisions when I teach the depreciation material. On several occasions, comments to the effect that I hate horses or dislike horse lovers make their way onto evaluations and even into classroom discussion. I always invite students who wish to do so to defend the special treatment of horse-related activities. No student has ever taken up the challenge.

The residence limitations consume at least half of the allocated time because they are important. They affect many taxpayers. Though it is a guess, I tell the students that I’m confident at least half of them, and probably many more, will encounter these limitations in their own lives. Of course, that’s not to say they will be happy with the outcome. Most lawyers, for example, who have home offices are subject to the limitations. Because the IRS continues to adhere to its losing position in Bolton, despite losing every case it has litigated, the time required to teach the computation of deductions allowable in any event allocable to rental activities is twice what it would and should be. This situation provides an opportunity to describe to students the practical realities of taking a return position that is inconsistent with an IRS position but that will almost certainly be approved by a court if the matter is litigated. The intersection of theory and practice is a fascinating boundary to take students through.

Then it gets worse. The students meet the passive loss limitations. A topic that could be made the subject of an entire 2-credit LL.M. (Taxation) course gets squeezed into 30 minutes. To say that the students get just the basics is an understatement. There simply is no time to explore in depth the definition of passive, or the application of the rules to multiple activities. The carryforward rules and those applicable to disposition of a passive activity are left to some other time and place.

At least by this point, students understand why so many taxpayers who do their own returns are frustrated, why tax return preparers have become increasingly disenchanted, why tax software has more errors than there should be, and why my bias against the mess that passes for our income tax system is so difficult for me to hide. True, I don’t make much effort to disguise my evaluation of the tax law. Not surprisingly, few if any students disagree with me. The struggle is the realization that they need to learn so much nonsense because, as I tell them, no matter what I think and no matter what they think, it’s waiting for them when they enter practice.

Next: What do you mean there is no deduction for my dog?