MauledAgain

This is about a month late, but fortunately I remembered it when it popped up when I googled my full name the other night. So it was moved to the front of the "waiting to be blogged" line.

In the year since I posted Maule on Legal Education, 2006 Edition, another column has been added to the list. That's pretty much the norm, especially because there are only so many Gavel Gazette soapbox spots available and I ought not appropriate more than my share. Of course, the powers-that-be aren't going to let me turn the front page of the law school newsletter into my own weekly column.

So, once again, here are the links, in chronological order (and with the latest URLs, which again were changed):

Money for Nothing and Work for Free?, The Gavel Gazette, at 1 (March 5, 2001)

Crumbling Myths & Dashed Expectations, The Gavel Gazette, at 1 (Sept. 3, 2002)

Learning to Teach and Teaching to Learn, The Gavel Gazette, at 1 (Sept. 29, 2003)

Time CAN Be on Your Side. Or at Least by It, The Gavel Gazette, at 1 (Feb. 16, 2004)

Doing Puzzles While Learning & Practicing Law, The Gavel Gazette, at 1 (Sept. 20, 2004)

Up All Night = Grades Go Down, The Gavel Gazette, at 1 (Nov. 7, 2005)

Thinking About Thinking, The Gavel Gazette, at 1 (Feb. 5, 2007)

No matter how busy a first-year student thinks he or she is, the few minutes invested in reading these short essays and grabbing the free advice in them will provide worthwhile payback in the form of countless hours saved from using more efficient study habits, from figuring out how to allocate time, and from avoiding mistakes that require investment of additional time to remedy. These essays have been republished in other media, at least two have been reprinted, several have been quoted, at least seven law faculty at other schools distribute one or more of them to their first-year students during orientation or the first week of class, and collectively they have been cited at least several dozen times.

Yes, the eighth in the series is taking shape.

Few people like to pay taxes, even if they're receiving more from the government than they're contributing, and even fewer like to experience a tax increase. So it's no surprise that the tax reform group, Philadelphia Forward, has urged all Philadelphia real property owners to file appeals in response the city's reassessment of their properties for real property tax purposes.

Philadelphia Forward advocates use of full market valuation for property tax purposes, something that the city of Philadelphia does not use. Under full market valuation, properties are assessed at full fair market value, and the tax rate is applied to that assessment. The advantages of full market valuation include fairness, ease of determining whether properties are being properly assessed, and logical correlation between taxation and value. The disadvantage is that costs money and takes time to pin a fair market valuation on each property.

Citing the Clifton case that I discussed a few months ago in An Unconstitutional Tax Assessment System, Philadelphia Forward explains that Judge Wettick found that "Using income tax terminology, one out of every four Philadelphia property owners was in a tax bracket of at least 3.35% and one out of every four property owners was in a tax bracket that did not exceed 1.42%." It also notes that

The Philadelphia Tax Reform Commission established that: "Philadelphia’s property assessments do not meet industry standards for accuracy; all across the city, assessed values diverge widely from market values. Philadelphia’s property assessments do not meet industry standards for equity; properties in poorer neighborhoods are, on average, assessed at a higher percentage of market value than properties in more affluent neighborhoods. The inaccuracy and regressive nature of Philadelphia’s assessments violate standards of vertical and horizontal equity."

A map of the disparities in effective rates gets the point across in a strong visual way.

It's more complicated than just convincing city officials to value properties at fair market value rather than at some other amount determined in some way that isn't very clear or obvious to homeowners or taxpayers. The people who make the assessments have no authority to set or change the tax rate, so if the assessments are established at fair market value, most property owners in the city would experience whopping tax increases, and the city would experience a surge of tax revenues.

The determination of how much property tax revenue the city should collect is a question separate from determining how that tax should be apportioned among property owners. The first question is part of the larger issue of establishing city spending, the scope of services provided by the city, and related matters such as public employee retirement and other benefits. The second question has been answered by the state Constitution and judicial decisions, including that of Judge Wettick in Clifton. Property taxes must be assessed uniformly. Someone who owns a property worth twice the value of a property owned by a second person should pay real property taxes twice the amount imposed on the second person.

Because determinations by two different components of city government establish a property owners' real property tax, those two components need to sit down together and map out a plan under which properties are assessed at fair market value, and the rate adjusted so that the overall tax revenue is unchanged. Thereafter, if the city wishes to increase revenue, it can do so using the process for increasing the real property tax rate, in a way that is transparent and provides taxpayers with an opportunity to comment on the wisdom or folly of such an increase.

As it presently stands, the so-called reassessments not only would fail to bring uniformity, they also would trigger a tax increase. I'm not sure what would happen to the assessment appeals system if all 400,000 property owners take the advice of Philadelphia Forward and appeal, but we may be finding out soon. On the Philadelphia Forward web site are instructions for filing the appeal, and the organization pledges to assist property owners and accompany them to hearings.

The system needs to be fixed. I have a sense things will become more complicated and frenetic before they are resolved.

The National Law Journal, in Law Profs Debate Mandatory Attendance Policies, picks up on an issue that has resurfaced recently, as evidenced by the quantity and intensity of comments to Dave Hoffman's Paternalism and Compulsory Attendance posting on Concurring Opinions. Dave takes the position that compulsory class attendance cannot be justified sufficiently to warrant continuation of the ABA accreditation standard that requires law schools, in effect, to make attendance mandatory. It is important to note that he nonetheless does follow his school's attendance policy.

Dave does a good job of tackling each of the arguments made in support of compulsory attendance. Some of the folks posting comments in response to his analysis make important points about the value of attending class, and in a few instances, about the sense of requiring attendance.

My approach to attendance has evolved through the several decades that I have been teaching. The realities of what I have encountered surely cause me to think again and again about the question. Keep in mind that I've never had serious attendance problems in my classes, perhaps because the word has been out for a long time that to do well one needs to attend. But almost every semester there are a few students whose attendance is spotty, and every other year or so there is a "phantom," namely, a student who rarely, if ever, appears in the classroom.

Initially, my approach was simple. The students are adults, and so they can decide whether or not to attend class. Of course, if the consequences aren't to their liking, they will find no sympathy from me. It is difficult to accept the excuses for poor performance offered by a person who is complaining about a low grade but who also is someone I've never seen until that day.

But at the same time, I began my teaching career dedicated to helping students learn how to provide their clients with the best possible legal services they could provide. That meant my classes needed to provide students with something that justified my existence in the room. I committed myself to helping students learn how to teach themselves and how to synthesize the out-of-classroom preparation and assimilation that I expected them to undertake.

After a few years, it became apparent to me that, contrary to the conclusions reached by Rafael Pardo in Class Absences and Grades, there was a correlation between grades and significant non-attendance. That did not surprise me, because I design my examination so that students who attend class have an opportunity to demonstrate that they learned from what the class adds to the materials, and so that students who missed more than a few classes would need to put in corresponding extra effort to attain the same level of achievement. Not many phantoms, as we call them, succeeded in doing so. For what it's worth, I also charted grades against students' seats in the room, finding that those on the "edges" tended to have lower grades, perhaps because they were not as connected to the classroom discussion or perhaps because they deliberately chose "distant" seats because they were unwilling to engage the classroom experience. Students closer to the front tended to be absent much less, if at all, but that would be consistent with the notion that enthusiastic students want to be front and center.

The next evolution was triggered by my increasing frustration with repeated one-on-one conversations with students about their grades after grades were released by the school several months after the course ended. Not only did I find myself saying the same thing numerous times, I also discovered that both students and myself came to appreciate the value that my comments would have had if they were shared during the semester before the examination. This frustration was reinforced by the continued evidence that students taking the "reading period means leave the reading to the end of the semester and justifies cramming" approach did not do nearly as well as students who learned incrementally during the semester, building subsequent lesson on well-learned previous lesson.

This evolution first brought the in-class quiz. I would administer them in class, and because they counted toward the grade, another reason to attend class was created. However, when approving during-semester quizzes, the faculty required me to give make-up quizzes for students who missed class for a valid reason. One of the Associate Deans took on the task of deciding if an absence was for a valid reason. It became a burden for him. So despite the fact that examination performance improved and attendance improved from the typical 85 or 90 percent to 98 percent, the experiment was dropped.

Unsatisfied with that outcome, I resurrected the concept a few years later when developments in technology made it easier to do. I did away with the word "quiz" and substituted the phrase "semester exercise." Some were administered using email and discussion boards, and some were administered in class. By this point, the faculty's policy on grading had also evolved, so I did not need to seek faculty approval. To deal with valid absences for in-class exercises, I permit students to drop the lowest 2 scores, which would include the zero for an exercise not performed. Though some students initially gripe about "this high school approach," whereas many others welcome the feedback and the opportunity to correct bad academic habits before the examination, by the end of the semester almost all students come to realize the value of semester exercises. The emergence of student response pad ("clicker") technology a few years ago enhanced the process. The effect on attendance was an increase, though it still hasn't reached 100 percent.

The use of semester exercises gave me the opportunity to watch for students who were failing to provide responses to out-of-class graded assignments and failing to show up when in-class graded questions were posed. I began paying even more attention to tracking their attendance by looking to see if they were in the classroom. When I noticed a student missing more than one or two assignments in a row and failing to attend class, I contacted the student. The point of the contact was not to force a withdrawal but to give a stern warning to the effect that if the student did not turn things around, he or she was almost certain to end up with a miserable grade in the course. If the student did not respond to my contact attempt, something that happened more often that I would have predicted, I enlisted the assistance of the Associate Dean for Academics. In far too many instances, it turned out that habitual absentees were dealing with serious issues in other areas of their lives. One student was being physically abused, and once the appropriate people in the law school administration became involved, the matter was resolved in a better way than it might have otherwise turned out. Because of these situations, I try to watch closely the attendance and participation patterns of students who appear to be developing status as a "phantom." It may be parentalistic, but if it saves a student from a serious problem, it's worth it. Students who miss a few classes because of interviews or illness appear not to suffer in terms of examination performance or grades, and I don't fret about them or keep score. If they miss 7 or 8 classes for these reasons but are taking steps to compensate, they'll more than get by.

So, ultimately, I don't compel attendance directly. I try to induce it by making the classroom experience not only something students conclude they need to attend but also something students conclude they want to attend. I try to encourage attendance by providing four or five in-class exercises that provide not only feedback but also a small component of the course grade. I keep an eye out for chronic absentees and non-participants so that I can contact them to determine the reason for their disappearance and to refer them to the administration if need be.

My current approach to attendance does not violate the law school's policy of requiring "regular and punctual" attendance. At the same time, it appears to minimize the sort of problems that arise when half or more of the students are missing most classes. Will the way I handle attendance continue to evolve? Probably. It would be foolish to consider what I am doing now as set in stone.

Thanks to this item on Paul Caron’s TaxProf Blog, I learned that three members of the Senate Finance Committee sent a letter to the Secretary of the Treasury, urging him to “take immediate steps to encourage working families” facing increased tax liabilities from mortgage foreclosures to submit offers of compromise to the IRS and to have the IRS accept those offers. I described the circumstances generating these liabilities in ”Greed, Stupidity, Poor Judgment, and Taxes. One of the points I made was that elimination of this tax liability does not put ownership of the foreclosed home back in the hands of the taxpayer. The solution is more sensible lending practices and resistance by home buyers to overextending their budgets.

What the three Senators are urging the IRS to do rests on the authority given to the IRS under section 7122 of the Internal Revenue Code to negotiate tax liabilities and to arrange payment schedules. Regulations section 301.7122-1(b)(3)(ii) explains that the “. . . IRS may compromise to promote effective tax administration where compelling public policy or equity considerations identified by the taxpayer provide a sufficient basis for compromising the liability.” As I pointed out in ”Greed, Stupidity, Poor Judgment, and Taxes, it’s unlikely these tax liabilities would be paid in any event. Yet, as I also pointed out, ought not the liability simply be deferred, in case one or another of these taxpayers has a reversal of fortune?

There are several things I don’t understand about the Senators’ letter. The first one is trivial but symbolic. The letter refers to relief for working families. What about working singles? What about families out of work because the economy isn’t quite what some people claim that it is? What about retired people who are losing their homes because of increased property taxes? Restricting relief to working families, though I don’t think that’s what the Senators intend, is foolish and unjustified. My point is that this blind attachment to slogans can contribute to a poorly phrased document.

The other things I don’t understand is the entreaty to have Treasury and the IRS step in to fix a mess that is not of their making. If any component of the federal government is responsible, it is the Congress. The Senators write, “Americans shouldn’t have to wait to get the relief that is needed right now.” In that event, why can’t the Senate act quickly? Is there not a lesson to be learned here by the Congress to help it understand why it’s time to deal with the ever-increasing inefficiency of the legislative process?

The Senators themselves write, “We recognize that it would be simpler to change the law to provide relief...” So why ask someone else to do your work? Yes, I know that shoving work and costs onto others is a feature of present-day culture, but that doesn’t make it right.

Worse, it would take longer for the taxpayers’ cases to work their way through the offer-in-compromise system than it would take for the Congress to enact legislation. So despite what the Senators claim, this isn’t about faster relief and it wouldn’t be “immediately.” It has been suggested it’s about tax relief that avoids the legislative mandate to find offsetting revenue to fund the tax reduction.

The letter also points out that lenders are sending Forms 1099 to taxpayers with amounts of debt forgiveness that are higher than the actual amounts. This is not news. The Senators suggest, “The IRS should be aggressively educating lenders, practitioners and affected taxpayers to ensure that accurate 1099s are being provided.” and then claim, “Too often the IRS emphasizes dealing with problems on the back-end as opposed to preventing a problem at the beginning.” Excuse me. The beginning of the problem is where the tax law begins. It starts with the legislation enacted by the Congress. If the tax law were simple, rather than a repository of payoffs to special interest groups and voting blocs, it would be much easier for lenders, practitioners, and affected taxpayers to get it right.

Do these Senators think that the IRS will drop some of its other responsibilities and put their request at the top of the list? I don’t think so. The letter is campaign fodder. The Senators can crow to the electorate that they took steps to solve a problem that they won’t simultaneously describe as of their own making.

While most fans of professional football, NFL-style, have been debating the appropriateness of the fines imposed on the New England Patriots and their coach Bill Belichick for violating NFL filming rules, the tax world has been pondering the tax implications of the Commissioner’s decision. One commentator, in Goodell Misses a Big Tackle gives this take on the Belichick fine: "Now, certainly, $500,000 is nothing to sneeze at. It's a big number, and reportedly about 12 percent of Belichick's annual salary. But it is tax-deductible."

Is it? Are the fines imposed on the Patriots and on Belichick deductible for federal income tax purposes?

The easiest piece of the analysis to undertake is the application of section 162(f), which prohibits deductions for fines and similar penalties. That provision does not apply, however, because the fines and similar penalties that it makes nondeductible are those imposed by governments. The NFL, despite what some might think, is not a government.

The determination, therefore, turns on the application of section 162(a). That provision allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” For the NFL fines to be deductible, they need to be ordinary and necessary, they need to be expenses, they need to be paid or incurred during the taxable year, and they need to be paid or incurred in carrying on a trade or business.

There’s not much disagreement among those who have commented on the question that the fines are expenses, in contrast to being capital expenditures, that they have been or will be paid or incurred during the taxable year, and that they are paid or incurred in carrying on a trade or business. The Patriots are in the business of operating an NFL franchise, and Belichick is in the business of being employed as an NFL head coach.

The critical portion of the analysis involves the interpretation of the phrase “ordinary and necessary.” In other words, is the payment of an NFL fine by a franchise and by a head coach for violating filming rules an ordinary and necessary expense? Or is it something else?

The Supreme Court, in Deputy v. DuPont, 308 U.S. 488, 495 (1940), has defined ordinary as “normal, usual, or customary.” Courts have defined necessary as “appropriate and helpful in the taxpayer’s business.” Note that the judicial approach to the definition bifurcates the phrase into two defined terms. Ultimately, according to the courts, the definition will turn on the facts and circumstances of each particular case.

When trying to apply a legal definition to a set of facts, it helps if there are other situations, either identical or similar in detail, where the same question has arisen. Though there are no cases or rulings dealing with fines imposed by professional sports leagues, there is a case dealing with fines imposed by a mercantile trading exchange.

In Rothner v. Commissioner, the Tax Court held that fines paid by a trader to a mercantile exchange for violating certain trading rules was deductible by the trader. A close look at this case is instructive, because in both Rothner and the Patriots/Belichick situation the fine was imposed by a private organization under contract law, not by a government under a statute.

Rothner and several other traders were fined by the exchange for violating its rules. The Patriots and Belichick were fined by the NFL for violating its rules. Rothner and the other traders had been warned and had previously been fined. The Patriots and Belichick had been warned. Rothner and the other traders were suspended, but Belichick was not.

If Rothner did not pay the fine, he would have been denied the right to trade on the exchange's floor. The exchange would also have the right to forfeit his seat and sell it, using the proceeds to pay the fine. It is unclear what the NFL would do if Belichick does not pay the fine. Presumably he would be suspended but that's a guess.

In Rothner's case, "it was a common occurrence for the [exchange] to fine members for violations of its rules, and a list of persons fined was issued weekly." In 1987, 87 fines were imposed, in 1988, 141, and in 1989, 139. The number of fines imposed by other exchanges were at least in the “several hundreds” annually. The number of fines imposed by the NFL is something I haven't ascertained, but it is nowhere near being in the thousands annually. The number of fines imposed by the NFL for violation of filming rules appears to be two: the Patriots and Belichick.

According to the Rothner court, the

”principal function of the term 'ordinary' * * * is to clarify the distinction, often difficult, between those expenses that are currently deductible and those that are * * * capital expenditures". Additionally, the term "ordinary" has been defined as "normal, usual, or customary" [citing Deputy v DuPont]. A payment of an expense is "normal" if it arises from an action that is ordinarily to be expected of one in the taxpayer's position [citing Commissioner v. Heininger]. Although an expense may be incurred only once in a taxpayer's lifetime, it is ordinary if the transaction that gives rise to it is "of common or frequent occurrence in the type of business" in which the taxpayer is engaged [citing Deputy v. DuPont, Welch v. Helvering, Lilly v. Commissioner]. As respondent concedes that petitioner's payment of the CME fine was not a capital expenditure within the meaning of section 263, we need not further consider that aspect of the term "ordinary".

The Rothner court then concluded that "a private wrongdoing in the course of conducting a business is not extraordinary." How can that be? Whether something is ordinary or extraordinary depends on the facts. The court should have said that "a private wrongdoing in the course of conducting a business is not FOR THAT REASON ALONE extraordinary" --- a conclusion which makes perfect sense. But then the court backs up:

Moreover, even if improper conduct were extraordinary in business, the payment of a settlement or judgment attributable to the conduct is generally expected to be made by the person in the course of whose business the conduct occurred.

What happened to the court's statement "it is ordinary if the transaction that gives rise to it is "of common or frequent occurrence in the type of business" in which the taxpayer is engaged." Isn't that the test?

Well, that's the test the court applied. It pointed out that there were 356 disciplinary proceedings that resulted in fines, of which 53 involved the type of infraction in which Rothner and the other traders engaged. The parties also had stipulated that other exchanges "imposed monetary sanctions on their members for alleged violations of their rules several hundred times per year." So based on these facts, the court concluded that "payments of fines pursuant to disciplinary proceedings by securities and commodities exchanges were a common and frequent occurrence in the type of business in which petitioner was engaged."

So that leaves the question of whether what Belichick and the Patriots did was a transaction "of common or frequent occurrence" in the NFL. At the moment, allegations of filming rule violations appears limited to the Patriots. To me, this is the distinction between ordinary ("everybody does it") and extraordinary (Belichick and the Patriots are alone in their transgressions). Belichick and the Patriots stand alone for the type of infraction for which they have been fined, a far cry from 53 fines in a 3-year period (or more, counting the other exchanges). They are among a very very rare (dare I say extraordinary) group of select persons and clubs fined by the NFL generally (perhaps dozens, but surely not the 356 (hundreds or even thousands counting the other exchanges) in a 3-year period.

Next, the Rothner court explained that an expense was necessary if it met "the minimal requirement that it be appropriate and helpful for the development of the taxpayer's business." I suppose Belichick and the Patriots would argue that breaking the rules was appropriate and helpful. Appropriate? Hmm. Helpful? Of course. If it wasn't helpful to cheat, only the pathological would cheat. I'm not quite ready to label all cheaters as pathological because that would mean we're living in an asylum. Why do I doubt it is appropriate? The clients of the traders don't seem to care if their traders violate a trading limit on the floor of the exchange. NFL fans do care if the NFL's integrity is impugned, and if the reaction has a negative economic impact on the NFL or the Patriots, then Belichick's actions will directly or indirectly HURT --- not help --- the business operated by the New England franchise, and thus would not have been an appropriate thing to do. In other words, for the Patriots, acting honestly had a value that was of a higher order than it appears to have had for mercantile exchange traders.

This analysis compels me to conclude that the Rothner case is distinguishable from the Patriots/Belichick situation. Someday perhaps it will lose its distinction, but that will be a day when violations of filming rules and fines for those infractions are an everyday occurrence in the NFL much as they were (and hopefully no longer are) in the exchanges. Pity that day ever arrives.

The notion that the ordinary and necessary requirement precludes deduction of expenses that are extraordinary, unusual, not normal, or not customary is troubling. Consider what happened in Trebilcock v. Commissioner. The taxpayer, a business entrepreneur, paid an ordained minister to minister spiritually to the taxpayer and his employees, through prayer meetings designed to raise their spiritual awareness level, and through counseling with respect to personal and business problems. When presented with a business problem the minister would pray and then propose a solution based on prayer. The Trebilcock court relied on the outcome in another case, Amend v. Commissioner, in which the taxpayer paid a Christian Science practitioner for assistance in raising the taxpayer’s spiritual awareness. According to the Trebilcock court, “The Amend court conceded that the consultations promoted the taxpayer’s spiritual balance and thus allowed him to cope more easily with the strain of running a large business.” The court then noted that the assistance did not sharpen business skills and was no different from that provided by any minister, making the payments personal rather than business expenses. The Trebilcock court, analyzing the portion of the payments for counseling, concluded that they were not ordinary because the taxpayer did not offer evidence to show that these sorts of payments were ordinary in his type of business. In other words, he failed to prove that the transaction giving rise to the expense, the retention of a minister to inject spiritual awareness into business problem solving, was “of common or frequent occurrence” in his business. Trebilcock reinforces the basis for distinguishing Rothner.

The outcome in Trebilcock makes sense. What Trebilcock was doing was extraordinary. He was a pioneer. Not long after, American business owners concerned about the then-seemingly dominance of the Japanese business economy, adopted some of the techniques used by Japanese businesses. The idea that worker productivity improved when employees were spiritually grounded (and note that in this sense, spiritually does not necessarily mean religiously) caught on. Today, it is not uncommon for businesses to spend money to bring spiritual values into the workplace. An interesting analysis of this phenomenon, including a list of large companies now using the Trebilcock and Amend approach, can be found in Spirituality and Ethics in Business. Ironically, I doubt that the IRS is challenging the deductions claimed by the companies noted in the article.

For me, the notion that pioneers get the short end of the tax stick because what they are doing is extraordinary rather than normal and usual doesn’t make sense. Ought not the tax law not impose a disadvantage on business entrepreneurs who are trying new and different methods? If the idea of allowing the Patriots and Belichick to deduct the fines is distasteful, it’s not because what they did is not ordinary. Yet despite the questionable wisdom of the ordinary requirement, the determination of whether the fines are deductible must be made under the law as it is, not the law as we would prefer it to be. There is a very good argument that under current law the fines are not deductible.

Most commentators disagree with the conclusion that the better argument supports nondeductibility. They base their conclusion on several analyses.

Some claim that the “ordinary” requirement is designed to prevent deduction of personal expenses. I disagree. Not only has no court or ruling so concluded, the statutory language supports the conclusion that personal expenses are blocked by something other than the “ordinary” requirement. They are blocked by the trade or business requirement. An ordinary and necessary expense of carrying on a personal endeavor isn’t deductible because it’s not an expense in carrying on a trade or business. If that’s not enough, section 262 disallows deductions for personal expenses. If the “ordinary” requirement did so, section 262 would be superfluous in that regard. The same rejoinder applies to the argument that the “necessary” requirement exists to push personal expenses out of section 162(a).

Some claim that the “ordinary” requirement exists to keep capital expenditures out of section 162(a). The courts, however, have given a dual meaning to “ordinary.” One is the requirement that the expense not be a capital expenditure. The other is the requirement that the underlying transaction be “of common or frequent occurrence” in the business. The first prong is the redundant one, because section 263 establishes the principle that capital expenditures are not deductible. It is not extraordinary to build a building in which to operate the business, but the cost of the building is not deductible as an ordinary and necessary expense because it is a capital expenditure. That leaves the “ordinary” requirement with some meaning other than “not a capital expenditure.”

Some have claimed that “ordinary” means reasonable or that it means not lavish or extravagant. However, Congress uses those terms in section 162(a) with respect to specific types of business expenses but not in the general definition. By having used the terms, Congress demonstrates that they have a meaning and that if Congress wanted that meaning to apply to the general definition it would have used those terms rather than “ordinary.” To put a “reasonable” or “not lavish” gloss on the general definition would make the Congress’ use of those terms with respect to specific expenses superfluous.

Some argue that the term “ordinary and necessary” is an indivisible phrase and that the individual words have no independent meaning. If this is so, why have the courts provided a definition of “ordinary” and a definition of “necessary” in ways that treat those words as separate words?

Some argue that “ordinary and necessary” was a general accounting phrase used to indicate payments that accountants treated as appropriate deductions in determining business profits, and that it now is a phrase with little or no meaning. This argument rests on the premise that an interpretation such as “appropriate and helpful” was intended to strip “ordinary and necessary” of meaning rather than to create a new substantive test. I disagree. The words are in the statute, the drafters intended to put them there, and there is nothing in the statute itself making those words or that phrase irrelevant. That’s not to say I disagree with the underlying view that the phrase ought not be in the statute, but trying to render it void of meaning, or to use it as a substitute for “not personal” or “not a capital expenditure” is inconsistent with its existence and the statutory construct.

Some argue that the cases denying deductions because an expense is not ordinary because no one else is engaged in the transaction are wrongly decided. From a policy perspective, I agree, because these decisions put business pioneers at a disadvantage. But from a doctrinal perspective, I disagree, because these cases are interpreting a requirement inserted into the statute by the Congress. The courts, in some respects, don’t have much choice because to reach the opposite result would require either ignoring the word ordinary or giving it a redundant meaning. Either approach would render the word ordinary irrelevant.

The more interesting, and probably more important, question is what to tell the Patriots and Belichick when they ask for advice when doing their tax returns. Although some have suggested that they would simply tell them the fines are deductible, I would be much more circumspect. I would share with them my analysis of the question, including an explanation of the outcomes in Rothner and Trebilcock. I would explain the advantages and disadvantages of claiming or not claiming the deduction. I would let them decide how much risk they were willing to incur and how much risk they wanted to avoid. My guess is that they would decide to claim the deduction. I would make it clear to them that if the IRS audited and challenged the deductions, then they would have no basis to complain that I had given them bad advice, because I would not be surprised if the IRS did challenge the deduction. I also would not be surprised if the IRS paid no attention to the deduction.

The cynic in me thinks that if the IRS challenged the deduction and prevailed, Congress would enact some sort of moratorium barring the IRS from challenging the deduction of fines imposed by the NFL. Not far behind would be special legislation making sports fines explicitly deductible no matter how common or rare the underlying transaction, unless the fine was imposed on account of violation of a government’s criminal law.

In my last post, I asserted that "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." That's probably not news to anyone. Or perhaps it is. Perhaps it is too easy to think that someone selling a product or service will do what's best for the purchaser. For centuries, the marketplace relied on the legal doctrine of "caveat emptor" (that's Latin for buyer beware), but in recent decades legislatures and courts have eroded the scope of the doctrine because it had become a shield not only for seller fraud but also for seller overreaching.

The latest rage among consumers, though perhaps by now something else has supplanted it as the latest rage, is the Apple iPhone. I don't have one, simply because I don't need one. The cell phone that I have does what I need it to do. But apparently some people derive some sort of utility from being the first in the neighborhood to own a new product. The iPhone apparently comes with an interesting feature that isn't noticed by its purchasers unless they read the very fine print.

The feature is what I'll call the "never off" state of the phone. According to this story, the iPhone remains on even when the user turns it off. Aside from the insanity of that sort of engineering design --- which if used in other appliances or in vehicles could be deadly -- there's the question of letting people know what the ramifications are of the "off" button not having an "off" effect. Here's one: Because the iPhone is not off when it is turned off, it continues to communicate with the iPhone servers, so if the iPhone is taken abroad it racks up charges at international rates. That's how Jay Levy, according to the same story, got hit with a $4,800 monthly iPhone bill from AT&T Wireless. Levy isn't alone. Herbert Kliegerman received a $2,000 bill for a month when he spent some time in Mexico. He has sued Apple, but that's going to be another story.

Apple's defense is that its web site explains that charges will accrue when the iPhone is taken abroad. It states, "Substantial charges may be incurred if phone is taken out of the U.S. even if no services are intentionally used." That sentence is buried in an almost 7,000-word boilerplate explanation of terms of use. And notice it says "may be incurred" rather than "will be incurred."

Let's start with greed. The greed is the desire by Apple to sell as many iPhones as it can, because more sales translates to more profits. It also includes the charges imposed by AT&T Wireless and by its European providers for international cell phone use. Do the buyers of iPhones really need them? Perhaps some do. But most are caught up in the marketing hype that permeates materialistic societies. Apple, of course, is not entirely responsible for the culture that encourages the trashing of operable equipment in favor of the latest consumer rage. But when it signs on with AT&T in an exclusive tying arrangement that includes $25/megabyte charges for international use of the iPhone, and when it designs the iPhone so that it cannot be turned off and thus is guaranteed to generate huge bills, it is impossible to eliminate greed as a factor in the business plan. The high charges for international service reflect as much the exploitation of the consumer as it does the genuine cost of providing service. Someone who thinks that they have turned off their phone isn't trying to use a service, and doesn't want that service, so to charge that person for an unwanted service isn't very different from telling a homeowner that she needs a new roof when in fact a bit of caulking would stop the leak.

Let's turn to stupidity. In the long-run, Apple's arrangement with AT&T and its "never off" feature for the iPhone will prove costly. It makes no sense to gouge customers to this extent so pervasively. How can anyone think that the news would not circulate quickly and widely? How many people who were thinking of buying an iPhone have now asked themselves if it's worth doing so and if they really need to do so? The short-term grab may have been clever but neglecting the long-term consequences is stupid.

Let's turn to poor judgment. For the same reason one can accuse Apple's iPhone business plan of being stupid, one can also attribute its decisions to poor judgment. It simply is unwise to mistreat the customers who are the source of the company's revenue. At the same time, consumers ought to understand the need for reading the fine print. Kliegerman, who has filed the law suit, claims that people generally ignore the boilerplate language, and I think he's right. They do. But they ought not. After all, the devil is in the details, and so the details deserve attention. True, as he points out, the Apple website disclosure is confusing at best and arguably is misleading. But why not ask questions and demand responses in writing? How would one react if Apple refused to answer such questions in writing? It would cause me to ramp up my cynicism to an even higher level.

Let's turn to taxes. There are at least two implications in this story for taxation.

To the extent that a state or local tax on telephone service is based on the amount charged for the service, the increase in AT&T revenue from charges imposed for international use of a supposedly turned-off phone causes an increase in the state or local tax. That is a revenue windfall that cannot be justified, because it makes the state or local government a beneficiary of reprehensible business practices. Not that I expect state or local governments to refund any of these taxes.

The nature of the iPhone allegedly is prompting the United Kingdom to reconsider the tax consequences of employer-provided cell phones. According to various stories, including this one, Revenues and Custom might change the tax status of the phones from a tax-free employer benefit to taxed compensation because they include features that are far less likely to be used for business purposes. The more iPhones sold in the U.K., the more likely their tax status will be reviewed by tax authorities. If the classification change is made, experts predict that keeping track of the phones and reporting their distribution to employees will impose additional compliance burdens on taxpayers. Employers selecting a phone to make available to employees will need to find ways to restrict usage to business purposes. Whatever was the point of the iPhone -- and it looks to me a lot like the long-ago "put a little weekend in your week" Michelob beer advertising campaign slogan -- its impact will be far less advantageous than was claimed by its zealous fan club. Businesses, which would prefer employees not turn the week into the weekend, will probably look to alternatives that don't involve giving out recreational devices to employees. What business would want to incur $2,000 a month per employee in hidden phone costs?

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?