MauledAgain

A recent discussion on the ABA-TAX listserve ultimately revealed a rather disturbing error in an IRS audit guide. The issue involves the computation of section 751(a) ordinary income or loss. Section 751(a) applies when a partner sells a partnership interest, and is designed to characterize as ordinary the portion of the selling partner’s gain or loss that is attributable to the partnership’s ordinary income items.

Until 1999, Regulations section 1.751-1(a)(2) provided the following rules for determining the amount of ordinary income or loss that a selling partner must recognize:

The income or loss realized by a partner upon the sale or exchange of his interest in section 751 property is the difference between (i) the portion of the total amount realized for the partnership interest allocated to section 751 property, and (ii) the portion of the selling partner's basis for his entire interest allocated to such property. Generally, the portion of the total amount realized which the seller and the purchaser allocate to section 751 property in an arm's length agreement will be regarded as correct. The portion of the partner's adjusted basis for his partnership interest to be allocated to section 751 property shall be an amount equal to the basis such property would have had under section 732 (including subsection (d) thereof) if the selling partner had received his share of such properties in a current distribution made immediately before the sale. See §§1.732-1 and 1.732-2. Such basis shall reflect the rules of section 704(c)(3), if applicable, or any agreement under section 704(c)(2). Any gain or loss recognized which is attributable to section 751 property will be ordinary gain or loss. The difference between the remainder, if any, of the partner's adjusted basis for his partnership interest and the balance, if any, of the amount realized is the transferor's capital gain or loss on the sale of his partnership interest.

In 1999, to reflect amendments to section 704(c), and for other reasons, the Treasury amended the regulation. When the regulation was proposed, the preamble (see 63 Fed. Reg. 4408) explained:

B. Section 751.

Section 751(a) provides that to the extent an amount realized on the sale or exchange of a partnership interest is attributable to the transferor's interest in unrealized receivables or inventory items of the partnership, the amount realized is considered to be an amount realized from the sale or exchange of property other than a capital asset. Thus, the transferor partner may recognize ordinary income or loss on the sale or exchange of its partnership interest. Under the current section 751 regulations, the amount of income or loss realized by a partner on the sale or exchange of an interest in section 751 property is equal to the difference between: (i) The portion of the total amount realized for the partnership interest allocated to section 751 property, and (ii) the portion of the transferor partner's basis in its partnership interest allocated to the property. Generally, the portion of the total amount realized allocated to section 751 property is determined by the seller and purchaser in an arm's length agreement. The portion of the partner's adjusted basis in the partnership interest allocated to the section 751 property equals the basis that the property would have had under section 732 if the transferor partner had received its proportionate share of the property in a current distribution immediately before the sale.

The proposed regulations amend these rules for determining the transferor partner's gain or loss from the sale or exchange of its interest in section 751 property. Rather than attempting to allocate a portion of the transferor partner's amount realized and adjusted basis to the section 751 property, the proposed regulations adopt a hypothetical sale approach. Thus, the income or loss realized by a partner from section 751 property upon the sale or exchange of its interest is the amount of income or loss that would have been allocated to the partner from section 751 property (to the extent attributable to the partnership interest sold or exchanged) if the partnership had sold all of its property in a fully taxable transaction for fair market value immediately prior to the partner's transfer of the partnership interest.

The proposed regulation was adopted by T.D. 8847, and reads as follows:

Par. 6. Section 1.751-1 is amended by:

1. Revising paragraphs (a)(2) and (a)(3).

* * *

The addition and revisions read as follows:

§ 1.751-1 -- Unrealized receivables and inventory items.

* * * * *

(a) * * *

(2) Determination of gain or loss. The income or loss realized by a partner upon the sale or exchange of its interest in section 751 property is the amount of income or loss from section 751 property (including any remedial allocations under § 1.704-3(d)) that would have been allocated to the partner (to the extent attributable to the partnership interest sold or exchanged) if the partnership had sold all of its property in a fully taxable transaction for cash in an amount equal to the fair market value of such property (taking into account section 7701(g)) immediately prior to the partner's transfer of the interest in the partnership. Any gain or loss recognized that is attributable to section 751 property will be ordinary gain or loss. The difference between the amount of capital gain or loss that the partner would realize in the absence of section 751 and the amount of ordinary income or loss determined under this paragraph (a)(2) is the transferor's capital gain or loss on the sale of its partnership interest.

During the course of the discussion about section 751(a) on the ABA-TAX listserve, a participant suggested that it would be helpful to look at a section 751 audit guide that the IRS had posted on its website. The IRS document, chapter 7 of the Partnership – Audit Technique Guide, Dispositions of Partnership Interest, states:

The amount of the disposing partner's ordinary gain or loss is the difference between the amount realized attributable to the hot assets less the partnership's adjusted basis associated with these assets.

What appears in the IRS audit guide is a paraphrase of Regulations section 1.751-1(a)(2) as in effect before the 1999 amendment by T.D. 8847. Thinking perhaps that the document was old, I checked its date. According to the website, it was revised in March 2008. At the bottom of the web page is a tag line stating that the page was “last reviewed or updated: January 25, 2012.”

What’s happening here? Are IRS auditors examining sales of partnership interests and applying old law? Are taxpayers, where old law produces a less advantageous outcome than does current law, citing the current version of the Regulations and demonstrating the obsolescence of the audit guide? Is anyone even aware of this discrepancy?

Partnership tax law is complex, conceptually challenging, and daunting. It’s easy to misapply the applicable law. It’s easy to overlook a critical fact. It’s easy, but dangerous, to apply old law, and that’s true for any area of tax law, not just partnership tax law, as well as any area of law, period. It is not unknown for students in my Partnership Taxation course, and in other courses, to apply old law, and almost always it’s a result of using an old outline passed down through the years.

As another ABA-TAX listserve participant noted when I posted a much shorter version of this discovery, “Well, so much for trusting information provided by the ‘Horse's mouth’.” So true, but not surprising, as there are more than a few cases in which taxpayer reliance on erroneous IRS advice was not treated by the court as justifying the erroneous position taken by the taxpayer on the tax return. But it indeed is disturbing that the agency charged with administering tax laws does not understand those laws. Can taxpayers be expected to do any better?

It’s bad enough that federal income tax returns are bloated with multiple forms, and that most forms are crammed with dozens of lines of information and computational entries. Much of what contributes to this aspect of tax complexity is the use of the tax law as a substitute for direct spending programs and use of the IRS as a substitute for other federal agencies that ought to be charged with administering programs in their respective areas. I have explained why using the tax law and the IRS in this manner is inefficient, ineffective, and deceptive, in posts such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, and When Tax Credits Aren’t Worth the Trouble.

The latest proposal to add more clutter to tax returns comes from the president of Muhlenberg College, Peyton R. Helm. With the goal of finding a way to deal with the growing concern over the cost and quality of higher education, Helm, in a Philadelphia Inquirer editorial, suggests “adding three simple questions to the IRS’s 1040 form.” He wants to ask, “What college or university, if any, did you attend?, What degree did you receive?, and Was it worth it?” Helm is motivated by a disdain for any sort of regulatory structure that requires educational institutions to “create massive databases” or to “spend more on data collection and compliance.” Whether the federal government should be regulating higher education is a question that reaches far beyond the specific proposal in question. Perhaps it should. Perhaps it is the federal government, rather than a state government or even a private organization, that takes on the task of protecting consumers against fraudulent reporting, misleading advertising, educational malpractice, unsafe campuses, and other problems faced by students and prospective students. But surely, even assuming that it is the federal government that should take on this role, and I am not at all convinced that it should, using the IRS and tax returns to deal with a Department of Education function is simply unwise, totally impractical, and counterproductive.

First, how does the IRS find the space to add these questions to the various 1040 forms? Does it reduce the font size of the print? Does it jettison other lines that are far more relevant to revenue collection that questions about a person’s educational experience?

Second, how do graduates who do not file tax returns – because they’re yet to be employed – express their opinions? Do they file a zero return simply for the sake of answering these questions?

Third, who audits the answers to these questions? Are the answers taken at face value, or is some method employed to make certain that the taxpayer filing the return in fact did attend the university that the taxpayer claims to have attended? Who ensures that the taxpayer earned the claimed degree, particularly in an age where people falsely claiming academic credentials have proliferated? Who pays to redesign the form? Who pays to have people transcribe the answers into software, considering that, as noted in the next paragraph, automation poses issues? Who pays to accumulate and sort the answers? Who pays to report the results? Which audits and which taxpayer service programs are subjected to further cuts to fund this education satisfaction data collection?

Fourth, who handles the lack of consistency in providing the names of colleges and universities? How does the software know that Penn State, PSU, and Pennsylvania State University are the same school? Which school is “Loyola”? Will we end up with substantially enlarged instructions for the 1040 forms in order to provide a “code” for each college and university in the country?

Fifth, what happens if the taxpayer attended multiple universities? What if the taxpayer transferred after sophomore year from one school to another? What school is reported by the taxpayer who attended an undergraduate institution, a master’s program at another university, and a doctoral program at yet another school? Would the IRS need to insert multiple lines for each of the three proposed questions? Or would taxpayers be asked to fill out yet another schedule to include this information?

Sixth, would colleges and universities in other countries be included? Or would taxpayers who earned their degrees abroad simply be ignored?

Seventh, what, if anything, would be done to gather information from graduates who are not taxpayers because they pursued education in this country and returned home? Do their opinions not count?

Eighth, would the reporting be mandatory? Would there be penalties for failing to answer the questions? Would there be penalties for providing incorrect answers, such as claiming to have earned a degree that was not earned?

Ninth, how is this reporting system protected against the games that could be played by graduates of other institutions? For example, if students and graduates of university #1 are unhappy because they think university #2 defeated university #1’s football team under questionable circumstances, what is to prevent them from claiming, en masse, that they attended university #2 and that their degree was not worth it? Without an extensive system of auditing, coupled with penalties for false reporting, the proposed system fails. Keep in mind that most return penalties are based on tax understatements, and the sort of nonsense that this proposal invites does not generate tax understatements.

Tenth, considering that Helm’s goal is to measure “the real value of their education,” how does his proposal distinguish between the negative reaction of the recent graduate who remains unemployed, and the positive reaction of the graduate who eventually ends up realizing that the education was worth it despite rough going during the first few years after graduation?

In his editorial, Helm refers to alumni surveys that are circulated among his school’s graduates. It’s unclear whether the school does the survey directly or pays an independent survey firm to do the work. Why not simply mandate that schools conduct alumni surveys, that the surveys be conducted by independent organizations, and that the results, including comments, be made available to the public? Well-designed surveys are orders of magnitude more informative, and far less prone to misreporting and gamesmanship, than the “three simple questions” that are proposed by Helm.

The IRS has better things to do than to conduct surveys on behalf of America’s colleges and universities. The IRS should be collecting revenue, period.

The Pew Center on the States has released a report on the effectiveness of state tax incentives. The report, titled “Evidence Counts: Evaluating State Tax Incentives for Jobs and Growth,” concluded that although a few states attempt to determine whether state tax incentives have had the intended effect, half of the states haven’t even tried to measure the outcome of the tax provisions that have been enacted. Even though some states try to evaluate the incentives, most do so every now and then, and none do so with the sort of in-depth analysis required to determine the effectiveness of the incentive. The study concludes that “no state regularly and rigorously tests whether those investments are working.” Every state has at least one tax incentive program, and most states have at least three or four; some states have dozens. Collectively, these incentives cost the states billions of dollars of lost revenue. The question that needs to be asked, that hasn’t been asked often enough, and that rarely is answered even when it is asked, is a simple one. “Are state tax incentives worth the lost revenue?”

One example provided by the report is the New Mexico tax credit for film production. One study determined that for every dollar of lost revenue caused by the incentive, New Mexico’s economy received a 14 cent boost. Another study concluded that every dollar of lost revenue generated 94 cents of economic activity. Though these outcomes suggest that the incentive should be repealed as a waste of taxpayer money, the New Mexico legislature continued the program but with a cap. The same thing happened in Wisconsin, which determined that its film tax credit was ineffective. Louisiana conducted a study that demonstrated its enterprise zone credit produced one-third of the jobs that the incentive’s lobbyists promised it would create. Pennsylvania examined its Keystone tax incentive, initially determined it had created 64,000 jobs, on a re-examination reduced that number to 35,000, and finally concluded that it had no idea what, if anything, the incentive had done for the state’s economy.

The idea of testing the outcome of a change, particularly when the change is hawked as being beneficial, is simple common sense. Decades ago, when I requested and obtained permission to require law students in my courses to turn in graded exercises during the semester, a concept that was alien to legal education and that met resistance and criticism at the time, I not only argued why it made sense but promised to provide reports to the faculty on the impact of the practice. The reporting idea was mine, and I offered it because I wanted to find out if I was correct in my assumptions, and to have evidence to support continuation or discontinuation of the semester-exercise approach. It worked, it’s something I continue to do, and it’s something that within the past several years has caught on with many, though unfortunately far from all, law faculty throughout the country. Innovation and experimentation need to be encouraged but oversight is essential, and outcomes measurements are necessary.

Why do so many states neglect following through with tax incentives? My guess is that there are several reasons. No one thinks of doing so. Perhaps someone requests an outcomes measurement but political constraints jettison the provision. It is not unlikely that legislators simply swallow, hook, line, and sinker, the lobbyists’ “guarantees” of the incentive’s value. It is also plausible that the fear of discovering the incentive’s wastefulness obstructs future evaluation.

It is quite probable that the vast majority of state tax incentives turn out to be boondoggles for the taxpayers who get tax reductions without generating the promised benefits for everyone else, including the state. Almost all state tax incentives are targeted at specific areas of economic activity that would be better regulated and encouraged using programs other than tax law provisions. As I pointed out in posts such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, and When Tax Credits Aren’t Worth the Trouble,

Artificial tax credits, in contrast to true credits arising from payments made to the [revenue department] by or on behalf of a taxpayer, aren’t worth the trouble. They’re not advantageous for taxpayers. They’re not advantageous for government economic policy. They’re not advantageous for the simplification and efficiency of the tax law. They’re not worth it, except to those who find them useful tools for the deceptive process of increasing [government] spending.

I’m still waiting for the opponents of government spending to step up and challenge tax incentives. Their failure to do so is a silence that speaks loudly.

An unfortunate fatal fire in Philadelphia has focused attention on the double whammy of absentee property owners who are derelict both in meeting their tax obligations and complying with safety regulations. These two faces of government, fire and taxes, though a favorite target of anti-tax advocates, come together in this instance in multiple ways. It is unfortunate that it takes the death of two public servants to bring serious issues to the forefront in the public arena.

The tax and safety facts, as reported in a flood of stories, including this one, are rather simple. Two firefighters were killed when a wall of a burning building collapsed on them. The building is owned by a Brooklyn, N.Y., family that owes the city almost $400,000 in real estate taxes on 31 properties, including $60,000 on the building that burned down. Residents who lived in the neighborhood where the building was located complained incessantly to the city about the building’s unsafe condition, particularly the lack of security to keep out vagrants. Though some complain that the city moved too slowly, during the past five months, the city issued three citations to the owners, trying to compel them to secure the building. The owners failed to respond, and the city initiated proceedings to move the matter into the judicial system, with the eventual goal of subjecting the property to sheriff’s sale. According to court records, during the past ten years, the city has issued more than 30 citations to the family and the entities through which it owns the properties. The owners not only have failed to comply with building, fire, and safety code provisions, they also have failed to pay water and sewer bills.

When asked about the city’s alleged failure to seal the building on behalf of the owners, the City Controller explained that the responsible department is overwhelmed by the number of vacant properties with which it has to deal. He noted that the department has a limited budget, limited personnel, and limited resources. Surely there is a connection between funding deficiencies and the unpaid taxes.

The afflictions caused by insufficient revenue attributable to noncompliance are undeniable. No matter how easily some folks think tax noncompliance can be brushed aside as a small matter, there is no doubt that the lack of compliance led directly and indirectly to the deaths of two firefighters. If the city had received the taxes that are owed, it would have had funds to provide the resources necessary to eliminate the dangers posed by vacant and insecure properties.

How bad is noncompliance with the city’s real property tax? According to another article, taxes on almost 20 percent of properties in the city are in arrears. There are more than 100,000 properties in the city on which taxes are not current. The average delinquency is 6.5 years. The city’s attempts to bring these properties to sheriff’s sale is thwarted, yet again, by a lack of funding for the responsible department. Almost half a billion dollars remains unpaid.

Tax delinquency and building code noncompliance seem to go hand-in-hand. That’s not surprising. The same philosophy that causes people to toss aside their civic responsibilities as taxpayers also leads them to disregard building and safety code compliance. Consideration of how the decision to ignore their obligations adversely impacts other people appears to matter not at all. One wonders the extent to which they toss aside their responsibilities because of the continued anti-tax and anti-regulation mentality that infects the public discourse.

Some commentators, officials, and politicians have mentioned the possibility that criminal charges will be brought against the owners of the building in question. Even if those charges are brought, and even if there are convictions, it’s too late to bring back two firefighters. Taking action after the fact is easier than taking action before the fact. How many more people must die before the tax delinquents and the code violators are compelled to do what they are required to do?

The Transactional Records Access Clearinghouse (TRAC) has released a new study of IRS Global High Wealth Group (GHWG) audits. The GHWG was formed to focus on taxpayers with tens of millions of dollars of assets or income. According to the Internal Revenue Service Data Book for 2011, in 2010 there were 291,831 individual tax returns reporting $1 million or more in total positive income, of which 8,274 reported adjusted gross income of $10 million or more.

According to TRAC’s analysis of internal IRS documents obtained under a court order, the IRS targeted for 3 large corporations, 15 S corporations, and 60 partnerships for audits under the GHWG program in fiscal year 2011, and 7 large corporations, 2 large foreign corporations, 26 S corporations, and 70 partnerships in fiscal year 2012. In fact, for FY 2011 the IRS conducted 18 audits, of which 4 cleared the process with no change. The other 14 audits generated more than $20 million in increased taxes. For the first five months of FY 2012, the IRS conducted 18 audits, of which 8 cleared the process with no change. The other 10 audits generated more than $27.5 million in increased taxes.

The writers of the TRAC report express some degree of surprise or alarm at the fact that one-third of the 36 audits generated no change. But I don’t find that very surprising or alarming. It’s not unrealistic to expect that some high-income returns are rather straight-forward, provide fewer opportunities for error, and are filed by taxpayers who are complying with the tax law without attempting to game the system. Consider the tax return of a professional athlete or celebrity whose income is reported on a W-2, who makes simple investments generating interest and dividends reported on Forms 1099, and whose deductions are nothing more than some charitable contributions and perhaps some mortgage interest and real estate taxes. It’s not a surprise that this sort of return passes an audit with flying colors.

On the other hand, the writers of the TRAC report are dead-on when they question the small scale of the GHWG program. The returns that generated tax increases generated an average of more than $2 million per return. Though it’s not clear if the returns that were audited were in the over-$10-million or over-$1-million category, multiplying $2 million times two-thirds times the number of returns that could be audited generates a significant amount of revenue that has not yet been paid.

Not only is the IRS auditing a small fraction of the number of returns it has targeted for audit, it is targeting a woefully small percentage of the total returns available for audit. Auditing 18 returns out of 8,274 over-$10-million returns, or, worse, 18 returns out of 291,831 over-$1-million returns is appalling. It raises the question, where is the IRS directing its audit resources? A clue comes from another batch of information obtained and shared by TRAC. There are a variety of groups within the IRS focusing on different clusters of returns and taxpayers. As of January 31, 2012, the average group, other than the GHWG, consists of 1,012 revenue agents. The GHWG consists of 101 revenue agents. Further, the TRAC report indicates that most audits of millionaire taxpayers, including those not within the GHWG program, are fairly cursory, don’t consume much time, and leave 87.5% of millionaire taxpayer returns unexamined.

Why not shift revenue agents from other programs to the GHWG, considering the rate of return from these audits? Is it possible that the IRS has an insufficient number of auditors trained and expertised in the sorts of tax issues that are involved with the returns of millionaires who are not filing the simple return described several paragraphs ago, but who are engaging in what the IRS explained in 2009 were “sophisticated financial, business, and investment arrangements with complicated legal structures and tax consequences.”? Is it possible that one of the effects of insufficient funding of the IRS is the lack of resources to train a sufficient number of revenue agents to work in the GHWG?

Recently, in Barnes v. Comr.,, T.C. Memo. 2012-80, the Tax Court addressed two interesting questions concerning the basis of stock in an S corporation. Two arguments advanced by the S corporation shareholders were rejected by the IRS and by the Tax Court.

The first argument made by the shareholders was that they were entitled to increase the adjusted basis in their S corporation stock by the amount of S corporation income erroneously reported by them on their individual returns. The IRS and the Tax Court emphasized that section 1367 provides for an increase in basis that reflects an S corporation shareholder’s actual share of the corporation’s income. According to the court, the IRS speculated as to why the shareholders reported income when, in fact, the corporation reported a loss, of which a portion was allocated to the shareholders. On their 1995 return, the shareholders reported a loss of $66,553 from the corporation even though their adjusted basis in the stock was $44,271. The shareholders, according to the IRS speculation, then erroneously calculated an adjusted basis of negative $22,282, and then reported that amount as income in 1996, increasing their adjusted basis to zero, and ignoring their $136,228 distributive share of loss of 1996. On this point, the IRS position and the Tax Court decision affirms the principle that basis cannot be negative. Perhaps the taxpayers, or their tax return preparers, were thinking of the at-risk recapture principle that triggers income when amount-at-risk becomes negative. Interesting, if that indeed was the case, but it’s an analogy that fails to withstand statutory analysis.

The second argument made by the shareholders was that they were not required to reduce adjusted basis in their stock if they chose not to deduct on their return their distributive share of the S corporation’s loss for the year. In a later year, after making contributions that caused their adjusted basis in the stock to be positive, the shareholders decided not to deduct their distributive shares of the corporation’s loss that had been suspended in earlier years and carried forward to the year in question. Accordingly, they did not reduce their adjusted basis in the stock by the amount of these losses. The IRS and the Tax Court determined that section 1367(a)(2)(B) requires S corporation shareholders to reduce adjusted basis by their shares of the corporation’s losses, even if they choose not to deduct those losses on their individual returns. It is unclear why the taxpayers chose not to deduct their losses. Perhaps they, or their tax return preparers, were thinking of the depreciation recapture principle that does not require recapture of depreciation which the taxpayer is entitled to deduct but that the taxpayer, for whatever reason, does not deduct.

Was this simply a case of someone not understanding the tax law? Was something else going on that’s not apparent from the facts set forth in the opinion? Though the answers to those questions probably will never surface, the appropriate impact on adjusted basis of an S corporation shareholder’s share of the corporation’s income and loss is clear. Sometimes, though, it takes litigation to get that point across.

As an aside, it is worth noting that the taxpayers were not challenged in their decision not to claim the losses. In other words, they were not compelled to claim the losses, but simply tagged with the consequences of having those losses, namely, reduction of basis. For a discussion of whether taxpayers are required to claim deductions, losses, and credits to which they are entitled, see James Edward Maule, No Thanks, Uncle Sam, You Can Keep Your Tax Break, 31 Seton Hall Leg. J. 81 (2006), available here.

According to a flurry of recent reports, including, for example, this one, an increasing number of state governments are looking for ways to deal with computer software written expressly for the purpose of assisting business owners in their efforts to hide cash receipts from revenue departments. The software, known as a tax zapper, is installed on a flash drive that is plugged into the register. It generates an accurate report for the benefit of the business owner, and then generates a set of false numbers to be used on the tax return. Reportedly states are losing billions of dollars in revenue thanks to this programming scheme. It also has been estimated that 30 percent of businesses operating primarily on cash receipts are using the software. Some establishments, such as restaurants, are evading so much tax that they are paying their employees in cash under the table, permitting the employees to report income low enough to qualify for welfare assistance from the state.

Legislation passed in several states and proposed in others makes it illegal to possess or install devices designed to generate false records. Would it not make sense to add to the list of illegal activities the acts of designing, programming, marketing, and producing this software? Only if the judicial system would do something less foolish than what was done in Detroit, where a self-employed software salesman who sold a tax zapper program was sentenced to the grand total of one day in jail and two years of probation. What sort of deterrence is that? Spokespersons for a variety of business associations have expressed support for legislation of this sort, because law-abiding entrepreneurs dislike being disadvantaged by the illegal behavior of competitors.

Taxpayers who comply with the tax law but who are concerned about high tax rates ought to think about the impact on the tax system of tax cheaters. When a tax cheat fails to pay tax, one or more of three things can happen. Taxes on honest taxpayers are raised to maintain revenues. Spending is cut, leaving honest citizens with deteriorating roads and bridges, inadequate safety inspections, reduce police patrols, longer waits for fire fighters and EMTs, and all other sorts of deprivations that jeopardize the existence of civilized society. Governments incur deficits as revenues drop and programs are maintained because the impact of spending cuts is so devastating.

For the most part, tax cheats are not acting from a philosophical approach. People who object to taxes and fail to file returns, or who file returns tagged with all sorts of anti-tax or other rebellious messages, aren’t hiding their position or their actions. They’re much easier to identify and may want to be identified so that they can make a statement. There’s a perverse sort of courage in behaving that way. Tax cheats who use tax zapper software do not want to be identified. They simply want to let others bear the burden while they take a free ride. They are probably among the folks who don’t want to pay for health insurance but demand free treatment when they have an emergency and show up at the urgent care clinic. The behavior exhibited by the tax cheats and free riders is about as far from courageous as one can get.

It’s time not only to criminalize ownership, use, design, production, sale, or other activities with respect to tax zappers, it’s time to make the penalties sufficiently harsh that others are deterred from engaging in this sort of dishonest behavior. It’s also time to publicize the names of those who are convicted, the names of their businesses, and the amounts that they have stolen from the public. Lest this be thought too rough, think of the person who dies when their vehicle hits a pothole and goes out of control, a pothole not repaired because of revenue shortfalls and spending cuts triggered by the actions of a group of people who refuse to pitch in and fulfill the obligations of citizenship.

The Philadelphia real property tax system, riddled with flaws, inefficiencies, and injustice, has provided yet another reason that it needs to be terminated, pronto. This news ought not be surprising, given its long troubled history, as I’ve discussed in posts beginning with An Unconstitutional Tax Assessment System, and continuing through Property Tax Assessments: Really That Difficult?, Real Property Tax Assessment System: Broken and Begging for Repair, Philadelphia Real Property Taxes: Pay Up or Lose It, How to Fix a Broken Tax System: Speed It Up? , Revising the Board of Revision of Taxes, How Can Asking Questions Improve Tax and Spending Policies?, This Just Taxes My Brain, Tax Bureaucrats Lose Work, Keep Pay, Testing Tax Bureaucrats Just Part of the Solution, A Citizen Vote on Taxes, Freezing Real Property Tax Reassessments: A Nice Idea, The Tax Price of a Flawed Tax System, Can Bad Tax Administration Doom the Tax?, Taxes and Priorities, R.I.P., BRT, A Tax Agency Rises from the Dead, and Tax Law as Subterfuge: Best Use Valuation v. Current Market Valuation, How to Kill a Bad Tax System That Will Not Die?, and momentarily ending with The Bad Tax System That Will Not Die Might Get Another Lease on Life.

To understand the news reported in this Philadelphia Inquirer article, it is necessary to explore a little bit of how the property tax works. Generally, a property tax equals the fair market value of the property multiplied by a tax rate. That’s a fairly simple approach, although the determination of fair market value is a challenging factual question, and establishment of the tax rate involves the usual political discourse and maneuvering characteristic of taxation generally. What makes Philadelphia’s property tax system more complicated, and more flawed, is something called “common level ratio.” Instead of applying the tax rate against fair market value, the city applies the tax rate against an assessment that is supposed to equal 32 percent of fair market value. It is unclear what advantages this approach provides. From my perspective, none.

To make certain that assessments are fair, an entity known as the State Tax Equalization Board (STEB) examines property sale documents to compare the real property tax imposed on the property with the amount of the tax that would have been computed if the assessment equaled 32 percent of fair market value. The STEB computes a number called the common level ratio, which reflects the assessments actually used compared to fair market value. If the common level ratio is less than 32 percent, then any property owner whose assessment exceeds the common level ratio can appeal the assessment and have it lowered to reflect the common level ratio. To the extent an appeal is successful, the city’s revenue and the school district’s revenue decreases.

In July of 2011, the STEB concluded that the city’s common level ration was 18.1 percent, not 32 percent. The city appealed, giving the STEB more information, and earlier this week the STEB revised the common level ration to 24.8. After the July announcement, more than 2,000 appeals were filed, and most had been put on hold pending the city’s attempt to have the common level ratio revised. Had the common level ratio not been revised, and the appeals successful, the city and school district would have lost $80 million in revenue. With the revised STEB, the city stands to lose $18 million and the school district $23 million. These are not revenue decreases that either the city or the school district can afford.

The city has filed cross appeals in the assessment cases. Its budget director has asked City Council for $1.8 million to hire private assessors to develop evidence supporting the city’s cross appeals. City Council has not yet acted on the request. The Philadelphia Inquirer, Carnegie Mellon University, and the University of Pennsylvania Wharton School have independently computed the common level ratio and have concluded that it is more in the neighborhood of 12.2 percent. Property owners who make good use of these independent studies face favorable prospects in the litigation.

Proposals to base assessments on actual value, along with other reforms, have been floated for years. Several years ago the city adopted an Actual Value Initiative, but the process of assessing each property is taking quite some time. It remains to be seen whether City Council puts a final seal of approval on the initiative. This most recent addition to the string of property tax glitches ought to be the final nail in the property tax coffin, but somehow I get the feeling that the burial isn’t going to be quite so simple.

The debate over the type of tax best for funding public education has been underway for decades. In most jurisdictions, the revenue is generated by local real property taxes. The primary reason for this choice is that when public education took hold, real property taxation was one of the few viable options available. Income taxation had not yet been authorized, and sales taxes were yet to be considered an efficient source of revenue. The difficulty with funding education through real property taxes is two-fold. When property values go down, revenue goes down, and when people’s income flattens out, such was when they retire and begin to live on fixed incomes, ever-increasing real property taxes threaten their financial well-being.

According to Joseph N. DiStefano’s recent article, No More School Property Taxes?, once again a proposal has been floated to alleviate the school funding crisis precipitated in part by the inadequacies and inefficiencies of the real property tax. Two members of the Pennsylvania House, one a Republican and one a Democrat, have joined together to sponsor a bill that would do away with real property taxes and replace the revenue with increases in the state’s personal income tax and its sales tax. The bill also would jettison a variety of other taxes, such as the gross receipts tax, the business privilege tax, local earned income taxes, and a handful of local taxes often characterized as nuisance taxes. The two representatives have gathered more than 50 co-sponsors, almost evenly divided between both parties.

Sounds simple, doesn’t it? Certainly administrative costs would be reduced, by eliminating many existing taxes while retaining the administrative structures already in place for the income and sales taxes. Compliance costs would be reduced, as a variety of forms and other paperwork would be retired. The disadvantages of the real property tax would disappear as that tax disappeared. And there’s even bipartisan support, something not often seen these days in national or local politics.

But perhaps it’s not so simple. In addition to raising the state income tax and sales tax rates, the bill also would expand the scope of the sales tax to include items currently exempt. The shifting of education funding entirely to the state raises issues about how the revenues are allocated among school districts. Schools currently in property-poor districts that suffer from inadequate revenue are not guaranteed improved funding under the proposal. In fact, according to a detailed description of the proposal, school districts would be funded at current per-pupil levels, and school boards would lose their taxing power other than for referenda for local income or earned income taxes to fund school construction or other major projects.

And despite the bipartisan support, the proposal is simply another in a long line of tax reform ideas that have been tossed aside by the Pennsylvania legislature. Several legislators who were on board abandoned the proposal when constituents began to complain about higher sales tax rates. People selling items and services currently exempt from the sales tax are lobbying against the idea of subjecting their products to the sales tax, even though the sales tax is imposed on the purchaser and not the seller.

Another point of disagreement is the issue of economic stability. Although real property taxes are subject to the risk of property devaluation, sales and income taxes also decrease in tough economic times. Joe Bright, an experienced state and local taxation attorney in Philadelphia, pointed out the higher volatility of sales and income taxes compared to real property taxes. There is no tax that guarantees a specific revenue stream, because all taxes are measured in some way by amounts dependent on economic activity.

Individuals and businesses that decide to take a position on the proposal based on how it would affect them need to do a somewhat complicated computation. First, they need to add up what they currently pay in the taxes that would be repealed. Second, they need to compute the additional income tax that they would pay. Third, they need to compute the additional sales tax that they would pay on currently taxable items. Fourth, they need to compute the entire sales tax that they would pay on items currently exempt but taxable under the proposal. Then they need to add up the last three amounts and compare it to the first amount. It is a safe prediction that some people would do better under the proposal and some would do worse. What’s tough to predict is how many are in each category. What’s even tougher to predict is the fate of this proposal in the Pennsylvania legislature.

About a month ago, in Taxes, Citizenship, and Shame, I reflected on the effectiveness of publishing the names of tax scofflaws, noting “We live in an age when shame does not have the effect it once did.” Last week, the Shelton Group released the results of a survey that asked people how embarrassed they would be if someone they admired discovered they were engaging in particular behaviors. Although 57 percent said they would be embarrassed if someone they admired discovered they were cheating on their taxes, that means 43 percent would not be ashamed of cheating on their taxes. Three behaviors generated more embarrassment. Being revealed as having shoplifted would embarrass 73 percent, getting a DUI would similarly affect 65 percent, and throwing trash out the car window would cause 59 percent to be ashamed. On the other hand, only 17 percent would be ashamed at someone discovering they leave the water running while brushing their teeth. Other percentages: being discovered smoking cigarettes, 36 percent; being caught not using their seatbelt, 32 percent; driving a vehicle that gets 13 or 14 MPG, 26 percent, not recycling plastic bottles, 18 percent; using paper plates, towels, and napkins instead of reusable products, 18 percent; and keeping their thermometer set to 73 degrees year-round, 18 percent.

It is disheartening, though not surprising, that significant numbers of Americans think it’s no big deal, so to speak, to engage in some of these behaviors. One cannot be embarrassed being caught doing something that one has no shame in doing. According to the survey, more than one-fourth of Americans are not ashamed to be caught shoplifting by someone they admire. What does that say about the American value system? Almost half of Americans have no shame about cheating on their taxes. Put another way, to the extent that tax cheating imposes greater burdens on compliant taxpayers, almost half of American taxpayers hold their heads high while free riding or inching toward free riding by letting others carry a heavier load. History teaches us that societies permeated by those sorts of values don’t persist very long. What happens when everyone sits back and concludes, erroneously, that someone else will step up?

It’s no secret that I disagree with those who use the tax law to accomplish indirectly what should be handled directly by government agencies other than the IRS and state revenue departments. In posts such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, I have pointed out the disadvantages of having the IRS administer programs designed to achieve national policy goals with respect to energy, environmental protection, employment, health care, education, and other matters that are within the purview of agencies established and operated to deal with those issues. Several weeks ago, in The Futility of Tax Incentives, I noted that a recent survey had corroborated the drawbacks to using tax incentives to influence behavior. I shared the outcome of a survey that indicated about two-thirds of respondents, mostly tax professionals, were “mostly or completely unfamiliar” with the production tax credit for wind projects.

Now comes even more corroboration of why it is bad policy to use the tax law to manage policies in other areas of the law. According to a very recent Philadelphia Inquirer article, the small business health care tax credit, available to businesses with fewer than 25 employees and with average annual wages under $50,000, has turned out to be a tax incentive whose “benefit often outweighs the cost of figuring out whether the business qualifies.” The credit, correctly described as “very complicated” and “burdensome . . . to compute” ended up being claimed on fewer than 10 of the 150 corporate returns filed by one tax practitioner who was interviewed for the article.

The arguments against inserting non-tax provisions into the tax law continue to grow. As a matter of general policy, it is wrong to use a revenue law to do anything other than raise revenue. There are so many tax incentives, especially credits, that taxpayers and tax professionals end up not even knowing they exist. These tax provisions are complicated. They are expensive to compute. Administration of these incentives is put in the hands of an agency that the Congress continually underfunds.

The arguments for overloading the Internal Revenue Code with tax incentives are specious at best. The claim that the IRS is the best agency to administer them flies in the face of reality, for the IRS is an agency expertise in revenue collection and not in the specifics of energy, health, environment, education, and other matters within the purview of agencies tasked with handling those matters. Justification for putting these provisions into the tax law actually opens up yet another reason to oppose this practice. Given the choice between authorizing a department to spend $x on a program, and setting up a tax credit that reduces revenue by $x, the Congress, particularly the members who are opposed to federal spending, find it expedient to hide spending increases in the tax law and treat them as revenue reductions.

Artificial tax credits, in contrast to true credits arising from payments made to the Treasury by or on behalf of a taxpayer, aren’t worth the trouble. They’re not advantageous for taxpayers. They’re not advantageous for government economic policy. They’re not advantageous for the simplification and efficiency of the tax law. They’re not worth it, except to those who find them useful tools for the deceptive process of increasing federal spending.

It is not uncommon for me to use a sports analogy when teaching tax law to illustrate, emphasize, or clarify a point. I’m not the only tax professor who does so, as one learns from this interview with Joseph Darby. I’ve brought a few into this blog, as evidenced by Noncompliant Tax Attorneys Are Dangerous to the Tax System, Getting It Right, and Tax Policy: It's OK for Us But Not For You.

A few mornings ago, while listening to the John Kincade show on ESPN Radio, I discovered the flip side of the analogy. Instead of someone trying to make a point about tax by referencing sports, Kincade tried to make a point about sports by referencing tax. He was discussing the penalties imposed by the NFL on the New Orleans Saints and their coaches for their role in the bounty scandal. Kincade was responding to critics of the penalties, specifically focusing his attention on the fact that the Saints and their coaches had been warned on previous occasions to put an end to the bounty practice. Kincade compared the situation to a person who, according to his formulation, is contacted by the IRS and told that his tax return had problems and ought to be fixed, does nothing, is warned again, and finally is audited. According to Kincade, there’s no grounds for the taxpayer to complain that the audit is a surprise, or undeserved. Perhaps as he was sharing his tax analogy he began to wonder if his audience would appreciate it, so he followed it with an analogy to the traffic world, involving a police officer who stops a speeding motorist, gives a warning, stops the same motorist the following day, gives another warning, and on the third day issues a ticket. Kincade’s point, that receiving a warning for the first offense does not bar a stronger reaction on a later offense, applies to much more than sports, taxes, and traffic enforcement.

One of the reasons some of my analogies in tax class end up in the sports world is that for most people, including students, sports is more interesting than tax. Making an analogy to tax on a sports show may amuse someone like me, but I’m confident I’m in the minority. It was a rare event, one that I had not previously encountered, and one that I doubt I will encounter again.

There is another chapter in the continuing and almost eternal story about Philadelphia’s attempts to fix its broken property tax system. My commentary on the story began in An Unconstitutional Tax Assessment System, and continued through Property Tax Assessments: Really That Difficult?, Real Property Tax Assessment System: Broken and Begging for Repair, Philadelphia Real Property Taxes: Pay Up or Lose It, How to Fix a Broken Tax System: Speed It Up? , Revising the Board of Revision of Taxes, How Can Asking Questions Improve Tax and Spending Policies?, This Just Taxes My Brain, Tax Bureaucrats Lose Work, Keep Pay, Testing Tax Bureaucrats Just Part of the Solution, A Citizen Vote on Taxes, Freezing Real Property Tax Reassessments: A Nice Idea, The Tax Price of a Flawed Tax System, Can Bad Tax Administration Doom the Tax?, Taxes and Priorities, R.I.P., BRT, A Tax Agency Rises from the Dead, and Tax Law as Subterfuge: Best Use Valuation v. Current Market Valuation, to How to Kill a Bad Tax System That Will Not Die?. The most recent chapter establishes that the title of my last post on the topic was unfortunately too good of a prediction.

A recent Philadelphia Inquirer report reveals that a member of City Council has introduced legislation to postpone reform of the property tax system by keeping the current assessment process and tax rates in effect for another year. The issue has become complicated because the mayor has proposed coupling the assessment reform not with rate revisions that would keep property tax revenue the same, but with permanent adoption of two previous rate increases that were characterized as temporary when they were enacted. Apparently some other members of City Council have been voicing concern about the impact of coupling the assessment reform with rate increases.

There seems to be a consensus that the current assessment process is seriously flawed and that it must be changed. The concern is that the revised assessments, which are being determined by an Actual Value Initiative that is underway, will not be ready for prime time until later in the year. However, the city budget must be approved by June 30. The mayor has proposed a budget that would seek $1.13 billion in property tax revenue, with an adjustment to the rates once the results of the Actual Value Initiative are available.

As a practical matter, once the reassessments are complete, real property tax bills for people living in homes that have significantly increased in value during the past several decades will increase by quite a bit. Though some people would be facing reduced property taxes, many would be dealing with increases. The member of City Council who introduced the legislation represents a district where a sizeable number of properties would be subjected to significant property tax increases.

Another problem is that the $1.13 billion figure includes a $90 million increase above current revenue, intended to alleviate shortfalls in the school system budget. Some members of City Council think that this aspect of the mayor’s plan should be split off and subjected to a separate vote. At least one member of City Council argued, “If you want to vote for a tax increase to support the school board then the public should know what we're doing.”

The mayor argues that it would be “irresponsible” and “disrespectful” to ignore the revised assessments. He is opposed to continuing the use of assessments obtained under a system which he described as “broken.” Others in the mayor’s administration view the plan as an opportunity to make up for tax revenues lost on account of current assessments not reflecting property value increases since the last full reassessment.

One member of City Council argued that the implementation should be “as close to perfect as you can,” otherwise “people have a right to turn on you.” Another member of council, one who supports the mayor’s approach stated, replied, “The majority of folks know we need a fair system, not a perfect one,” explaining, “There is absolute no way we are going to do AVI perfectly. The folks who know they have not been paying their fair share – the loud minority – will scream about it because it’s time for them to pay up.”

If asked, I would advise the mayor and City Council to separate assessment reform from tax increases. That would permit people whose properties are woefully under-assessed to understand that the bulk of the tax increases that they face under the mayor’s current plan arises from the repair of an assessment system that has caused them to be under-taxed for many years. It also permits the tax rate increase proposal to be debated independently of the assessment question. Mixing the two together creates the sort of confusion that perpetuates the flaws in Philadelphia’s real property tax system.

Recently, as explained in New York State Sales Tax Technical Memorandum TSB-M-12(3)S, the New York sales tax exemption for clothing and footwear costing less than $110 is restored as of April 1, 2012. When I read a news alert about this change, the first question that came to mind was whether the limitation was applied on a per-purchase basis or a per-item basis. By looking at the Technical Memorandum itself, I learned that the limitation is applied per item of clothing and per pair of footwear. That simply led to the next question. What is an item? Specifically, if a person wanted to purchase a suit costing $205, could they avoid the sales tax by turning the transaction into two separate deals, one for the jacket at $105 and the other for the trousers at $100?

To find an answer, I followed the Technical Memorandum’s reference to yet another Technical Memorandum, New York State Sales Tax Technical Memorandum TSB-M-06(6)S, which addresses “Year-Round Sales and Use Tax Exemption of Clothing, Footwear, and Items Used to Make or Repair Clothing.” Though the Technical Memorandum addresses a variety of issues, including the treatment of clothing and footwear purchased through mail and telephone orders, the treatment of rain checks and coupons, the application of the exemption to shipping and delivery charges, and the definition of clothing, it does not address my question. The closest example involves the sale of a combination package. The Technical Memorandum explains:

If exempt clothing or footwear is sold with other taxable merchandise as a single unit, the full price is subject to sales or use tax, unless the price of the clothing or footwear is separately stated. For example, a store has a boxed gift set for sale that has a French-cuff dress shirt, cufflinks and a tie tack. The gift set is sold for a single price of $50. Although the shirt sold by itself would be exempt, the full price of the boxed gift set would be taxable because the cufflinks and tie tack are taxable and the selling price of the shirt is not separately stated.

In other words, the exemption can be obtained by splitting the combination package into separate items. Although this approach suggests that splitting a suit, which can be considered in some ways to be a combination package, into separate items each costing less than $110, qualifies for exemption, it can be distinguished using a very technical analysis, by classifying it as a situation involving the dividing of a package between exempt and non-exempt items, something technically different from dividing a package of exempt items into multiple exempt items.

The policy question is interesting. If the suit cannot be broken into two transactions that separately qualify for the exemption, then the sales tax will apply to the purchase of the suit. On the other hand, a person who purchases trousers and a blazer, each of which costs less than $100, would not be subject to the sales tax. Should this outcome be translated into some sort of “anti suit” policy of New York State? Or, to put it affirmatively, is New York State using tax policy to encourage the jacket-and-slacks dress code? My guess is that the legislature did not give any thought to this question.

This particular question demonstrates once again that the application of a simple concept to a world that is increasingly complicated generates complexity that should not be attributed to the law. Though many laws are in and of themselves complicated, on their face, a substantial amount of the complexity afflicting people in tax situations, as well as in other situations, arises from the complexity of the facts or from the complexity of applying the law to the facts, in contrast to the complexity of the law.

The rapidly growing legal education crisis (which I explored seven years ago in The Future of Legal Education and Law Faculty Activities) has inspired lawyers, judges, law faculty, politicians, and clients to toss out all sorts of ideas for fixing the problems and making legal education relevant for the twenty-first century. Recently, Brian Leiter weighed in with Four Changes to the Status Quo in Legal Education That Might Be Worth Something. One of the ideas that he highlighted is borrowed from the judiciary:

2. Judge Posner suggested some time ago that law school be shortened to two years, with a third year optional depending on a student's career goals. Those who want to be tax lawyers could do what is, in effect, the LLM in tax in the third year; those who want to be legal scholars could devote the third year either to cultivating scholarly skills or teaching skills, depending on their academic goals (per #1); those who haven't secured permanent employment after two years could use the third (at some appropriately reduced cost) in externships designed to enhance marketability, with some supervision from academic or clinical faculty; and so on. Of course, this dramatic change would only work if many legal employers would be prepared to hire students for "summer jobs" after the first year, so that they'd have the kind of 'hard' evidence they most value about suitability for the job (as well as collegiality, which is often more important). And, of course, in the short-term, shortening law school would have the perverse effect of increasing the supply of new lawyers in an already depressed legal job market.

Aside from the two disadvantages that Brian notes, namely, a transitory increase in the number of law school graduates and the need to find summer experiences for first-year law students, there is at least one other significant disadvantage to shortening a student’s time in law school.

My focus this morning is on the example of structuring legal education so that “[t]hose who want to be tax lawyers could do what is, in effect, the LLM in tax in the third year.” This is not my first exploration of the question of how long a law school education should be, a topic I addressed in Beer, Softball, 4-Day Weekends: Is This Any Way to Learn Law?. Though it may not please law students or law faculty to read this, there’s no escape from the reality that is encountered in LL.M. (Taxation) programs. Though many LL.M. (Taxation) students have had three years of law school and most of the others are in joint programs structured so that they will have completed three years of law school before taking the second half of their LL.M. courses, too many LL.M. (Taxation) students continue to struggle with basic legal concepts that form the foundation for study in tax law or any other area of the law. Too many are unable to write clearly, to identify issues, to work their way methodically through a checklist, to appreciate the interrelationships among tax concepts and between a tax concept and an associate legal concept, or to understand source of law differences. Far too many have had insufficient exposure to specific areas of law that are pervasive in tax practice, such as international law, wills and trusts, business entities, labor law, and administrative law. Just as law schools pay no attention to the array of courses on an applicant’s undergraduate transcript when making admissions decisions, so, too, LL.M. (Taxation) programs, and perhaps other LL.M. programs, are far less interested in the specifics of an applicant’s J.D. course array than they are things like GPA and identify of J.D.-granting school.

LL.M (Taxation) programs bank on J.D. graduates having had exposure to, and intellectual practice with, enough of the basic law courses that one or two missing ingredients can be overlooked. I don’t think that works very well but perhaps it’s better than nothing. The alternative, requiring certain prerequisites, poses the same economic survival risks to LL.M. programs as it does to J.D. programs. The problem with reducing law school by one-third is two-fold. First, barring changes in the J.D. program, students who struggle mightily because of the deficiencies in their J.D. experience will struggle even more. Second, at least some of the students who don’t struggle because they arrive with a solid J.D. experience will be disadvantaged when one-third of that experience is removed. In short, the number of students struggling will increase, and the reach of the struggle will deepen.

Reducing the law school experience to two years provides several advantages, not the least of which is a presumed one-third reduction in the cost of attending law school. I say presumed because I think law schools will make up the lost revenue in other ways. But at a time when law school easily could be expanded to four years considering the meteoric growth the scope, depth, and breadth of law during the past century-plus, a reduction would be counter-productive unless it were offset with an increase in intensity, an increase in rigor, and serious changes to what transpires in the educational experience. There is room to improve the efficiency of legal education. Though repetition is a helpful learning device, it is wasteful when credit hours are scarce and even more wasteful if credit hours are cut by one-third. Though Socratic and quasi-Socratic discourse is helpful in many ways, it the time that it consumes – in contrast to other pedagogical methods – does not provide concomitant benefits. When students complain that my three-credit courses cover four credits worth of material, they are correct in terms of class hours – which usually are tied to credit hours – but I jokingly ask whether perhaps some of their other three-credit courses in which they are enrolled aren’t covering enough. Students could accomplish more learning in the classroom if they do more preparation outside of the classroom and more assimilation after they leave the room. Some of the most productive experiences for law students involve academic activities that occur outside the classroom, and in this respect I am thinking of well-supervised clinics, externships, and directed research efforts.

Perhaps reducing law school to two years – less than one-half of the total time physicians invest preparing themselves for professional practice – would be effective if students enrolled in courses during the summers before each of those two years. Perhaps reducing law school to two years would be effective if the number of credit hours required each semester were increased from the usual 14 to 16 to something on the order of 20 to 24. Perhaps reducing law school to two years would be effective if in addition to intensifying the experience, there was a change in what happens in courses and what students are required to do, as I explored in Is the J.D. Degree Merely a Ticket to More Training?

Five years ago, in Law Grads: Time to Start Reading Lots of Tax and Law Books, I commented:

The more I think about Larry's question and the reader's experience, the more I wonder what is happening in the law schools. To those who claim that there is no way three years of law school can prepare a person for the sort of situation in which the reader, and many other law graduates, were put, I suggest that law school be expanded so that sufficient years are available to provide time to do the course work required for the underlying LL.B. and the J.D.

So perhaps reducing law school to two years would be effective if law students arrived with an undergraduate education that prepared them for the study of law without the need for remedial courses or for remedial instruction in law courses. To quote one of my colleagues, “It is shocking how many law students don’t know what present value is.” Indeed. Shocking.

One thing to consider is that devoting one of the three years of law school to externships or clinics is not a reduction in the length of law school from three years to two years. Aside from the question of whether that sort of shift would reduce the overall cost of law school, that change is something far more overdue. The issue isn’t so much the length of law school but what is being done in law school. Once the latter question is resolved, the former question can be answered. Deciding that something can be accomplished in two years when two years is insufficient time merely increases the risk that what is accomplished in two years will be insufficient.

[Reposted from January 2005 because it no longer appears in the monthly archive because of blogspot page length restrictions]

Time to wander from tax into another area of interest (and one in which I also teach), that of wills and trusts. Specifically, time to explore the application of superficially simple legal principles to practical application in a context often overlooked by people when they are looking at their estate planning and setting things in order.

Last month, the medial outlets lit up momentarily on a story that quickly faded into the background as other, more pressing and serious developments moved onto center stage. The story involves the family of an American soldier who was killed in Iraq and who want Yahoo to turn over his emails. The soldier had used Yahoo to send emails to members of his family.

Yahoo refused, citing language in the contract that the soldier had with Yahoo. It states: "No Right of Survivorship and Non-Transferability. You agree that your Yahoo! account is non-transferable and any rights to your Yahoo! I.D. or contents within your account terminate upon your death. Upon receipt of a copy of a death certificate, your account may be terminated and all contents therein permanently deleted." This language, and the entire contract, can be found at Yahoo's web site. Yahoo risks all sorts of legal problems, including actions by the FTC or a state's attorney general, if it violates these privacy provisions. The soldier's family could seek a court order directing Yahoo to turn over the emails, and that would absolve Yahoo from the risks it sensibly has tried to avoid.

There is, though, a lesson for all uf us in this unfortunate situation. Whether one's correspondence is digital (email) or pre-digital (paper letters), a person needs to consider what happens to that material when the person dies.

One view is that the correspondence is property, and as such becomes part of the decedent's estate. In the case of the Yahoo email, the contractual provision does not so much make the email Yahoo's property as it prohibits Yahoo from releasing the property to anyone (because there is some question as to the ownership of the property). Of course, emails and letters in the possession of recipients are not the decedent's property, and thus could not be the estate's property, but those items raise a totally different issue that transcends death. After all, a recipient of a letter or email who is not otherwise bound to confidentiality faces few legal obstacles to releasing the correspondence (and as a practical matter, the biggest obstacle is that the recipient usually has little to gain and much to lose by doing so, but if that's not the case, the tabloids and others can have a feeding frenzy).

If this view is correct, then the decedent's will dictates the disposition of the letters, subject to some restrictions. How many people deal with this issue in their wills? Few. If there is no will, the intestacy law applies. Does intestacy law deal with this issue? Not really, other than through some tortured analogies that are great efforts to deal with an overlooked problem. So what is the executor to do? Technically, absent a provision in the will, the correspondence goes to the residuary beneficiary. What if the residuary beneficiary is a charity? Or a distant relative? Or a casual friend? The information in the correspondence could easily be on the market within weeks.

Can the executor claim that the fiduciary obligation imposed on executors require or permit destruction of the emails and letters? No. In fact, even if the decedent directs the destruction of the correspondence it is questionable whether such a command will be followed. The law in this area is confusing and fascinating.

Courts have long held under principles of public policy, that a decedent cannot direct the destruction of property after death. Thus, even though a person, while alive, can light a proverbial cigar with a proverbial rolled up $20 bill, one cannot order one's cash burned after death. Nor, according to several cases, can one order the razing of one's home (even if one could do so during lifetime), and this is an issue aside from permits and environmental concerns.

So in the classic hypothetical, when the decedent dies, love letters written to the decedent are found. Make the hypothetical interesting by identifying the writer as either a famous person or, better yet, someone whose position and status makes those letters scandalous (as if today there's much left that can fall within that term). So, however one wants to set up the facts, do so in a way that gives the love letters value. In our world of Warhol minutes, reality TV, and gossip run amok, it's unlikely that any love letters would lack value. The same is true of any other sort of letter (though love letters makes the hypothetical more interesting and gets the students' interest). The more secrets, the deeper the secrets, the more widespread those impacted or interested in the secrets, the higher the value of the email or other correspondence. I suppose that for celebrities' correspondence, the value reaches a peak and the issue is more likely to be litigated.

So if a decedent cannot order the burning of cash or the razing of a home, should a decedent be permitted to order the destruction of correspondence that has value? If the answer is yes, then those carving out an exception need to define the line, and I'm not convinced that the line can easily be drawn. Would it extend to home movies? Audiotapes? Photographs? Art work?

Surely one can think of reasons that the decedent would want the material destroyed, but then again, the decedent could have destroyed the material while alive. Except that destroying email on the email server of a commercial internet provider isn't easily accomplished, and might not be possible with emails less than 30 or 60 or 90 days old. But one also can think of reasons OTHER people would want the decedent's email and other materials destroyed: as one person pointed out (archived at Politech), "the emails might reveal the secret abortion of the sister or the secret first marriage of the father."

Digital technology puts yet another wrinkle on the issue. Paper correspondence sent to another person is in that other person's hands, and unless a photocopy was retained, it is beyond the reach of the decedent. The decedent cannot destroy it. Nor do the decedent's executor and beneficiaries have access (though, of course, the recipient's executor and beneficiaries might get their hands on it). With email, not only is the incoming correspondence on the server or computer, so too is the outgoing correspondence, or at least some of it is. Keep in mind that email is far more voluminous than is paper correspondence, perhaps by an order of magnitude.

Putting a direction in a will to destroy "love letters" could be counterproductive because wills aren't private. They become public when probated. "Destroy the love letters ....." or "Burn the letters received from ...." language would create all sorts of an uproar, and even if the contents never became public, the existence of the material would fuel the rumor mill for a long time, even if the decedent was not a national or international celebrity. After all, each one of us is a celebrity in our own little world. And, of course, "burn all correspondence" is overkill that by reaching legitimately retained financial and other information necessary for tax return and other compliance would give a court even more reason to hold to the principle that one cannot order the destruction of property after death.

It makes more sense to direct all property to a pre-existing trust and to give direction to the trustee (assuming, of course, that there is a right to order destruction of property). If the will inadvertently or deliberately incorporates the trust by reference, all bets are off because the trust is part of the probated will rather than a separate entity.

This is a huge issue for estate planners, but I don't think it gets enough attention. Perhaps, in days long gone, it wasn't an issue because there wasn't as much material, it was confined to letters, destruction could take place without anyone's knowledge except the executor or close family member, and the world wasn't as interested in the information. The digital world of email bring internet service providers into the picture, technology has opened the door to audio and video, the culture has become one very interested in the doings of other people, and the lure of money has become even stronger. All of those factors combine to make this issue one of growing, not lessening, importance.

Let me prove my point this way. When I teach this issue (and unfortunately it gets about 10 minutes), I ask my students to think about a possible premature death and the contents of their laptops and email accounts. A hush settles over the room, broken by sighs and groans. Clearly I have disturbed them, or at least their comfort zones. Then I point out that deletion of a file on a computer really isn't deletion (proving yet again why it is extremely difficult to practice or teach law effectively without having a good grasp of current and future technological developments).

I will close with a bit of theological insight that I don't share in my class (not only because of time constraints but also to spare taking the students on too wide of an analogy). In some of the theologies that include belief in an after-life, knowledge is universal. In the afterlife, everyone knows all things and all people, because everyone fully knows God, and by knowing God one knows all God knows. I don't profess an ability to explain this, though I can aver it was taught to me though not in those precise words. So if it does turn out that way, the only advantage to hitting the shred (not delete) function, and burning letters, is an information delay in the present temporal sphere. None of that, however, is going to reduce the tribulations of those whose secrets and private goings-on end up publicized among a small or wider audience because someone's email or letters were property with value that could not be destroyed.

Though I cannot give an "answer" to these questions, I can return to the tax world and share this conclusion: if the executor destroys the correspondence, there is no casualty loss deduction for the estate. Query whether the beneficiary who fails to recover damages from the executor for an unauthorized or illegal destruction has a casualty loss deduction.

So, estate planners and will drafters, what have your clients been asking you to do? And, for everyone, if you've thought about this question, what have you decided to do?

One of my readers alerted me to a story of which I had been unaware. It involves a tax return preparation enterprise that has created nightmares for its clients.

The story involves a business called Mo’ Money Taxes, which is based in Memphis, Tennessee. The company is a lender and offers tax return preparation services. It has been sued by several state attorneys general. For example, according to this report, the Illinois Attorney General sued the company, charging it with filing inaccurate returns without client authorization, and with hitting clients with almost a million dollars in hidden fees. The attorney general explained that many clients had not received refund checks.

Illinois is not the first state to file charges. According to this article, two Virginia legislators have asked a crime subcommittee of the Virginia House to hold hearings into the activities of Mo’ Money Taxes. Not only have some of the company’s clients in Virginia not received promised refund checks, other clients who did receive checks discovered that the checks either were less than anticipated or could not be cashed. One of those legislators, teaming up with a different colleague, has asked the U.S. Attorney General, the FBI, and other agencies to initiate a probe into the company’s transactions.

It gets worse. According to this story, thousands of tax documents related to the company’s clients in Tennessee, its home state, were found in dumpsters behind an office building from which the company had been evicted for failure to pay rent. The documents contain clients’ personal information, ranging from income and expense information to addresses, driver license numbers, and social security numbers. The company claims the landlord put the documents into the dumpster, but the landlord asserts that it did not do so.

Yet another story sheds some light into what might be at least part of the reason for what has happened. The owner of Mo’ Money Taxes, Markey Granberry, is in the middle of a nasty divorce proceeding. Amidst claims of physical assaults, adultery, unfit parenting, and drug use, the litigation revealed that the couple is fighting over a significant amount of assets. They own a $1.3 million home, which Granberry’s wife wants, along with their luxury automobiles, which include at least five top-end models. She also wants $800 a month for housekeeping and, shades of the disallowed deduction discussed in Tall Tax Tales, $200 a month for “fish tank maintenance.” According to the divorce papers, the owner of Mo’ Money Taxes owns 11 businesses and 19 properties. It is easy to speculate that the combination of being in over one’s head financially while distracted from business operations by difficult personal matters can lead to business failures, though it does not excuse the abhorrent conduct that has been alleged nor justify the imposition of similarly difficult financial and personal burdens on thousands of innocent clients.

According to the report from Illinois, the attorney general is working with the legislature to enact laws that would increase required disclosures with respect to refund anticipation loans and similar offers, and that also would put limits on the high fees charged by companies dealing in these products. It is a safe guess that those who oppose government regulation and complain about the growth in government will provide the usual objections to this sort of legislation, but it would not be necessary if the private sector was not so infected with unscrupulous practices. Similarly, those who complain about the regulation of compensated tax return preparers, though raising understandable concerns about the details of how it has been implemented, are saddled with the reality that the tax return preparation industry, though predominantly above-board and competent, is tainted by the existence of enterprises that give the profession a very bad name.

My advice to taxpayers is that they ought not retain a tax return preparer until they have done due diligence and research, particularly opinions from existing clients, about the reputation and quality of the potential preparer. My concern is that the people most often victimized by the unscrupulous companies are those least able to check out the business. That is why the idea of requiring tax return preparation be done by preparers who have earned an IRS-issued “seal of approval” is so tempting. Given the choice between a bigger government or thousands of victimized taxpayers, I’m compelled to choose the former, even though ideally I’d prefer to purge the marketplace of the perfidious businesses. Oh, wait, considering the terrible job the market itself and the private sector has done policing itself, we need ourselves, that is, the government, to step in. Eventually the private sector will figure out that government regulation of tax return preparers, or any other industry segment, can be rendered unnecessary if the market polices itself properly. If the idea of an IRS-issued “seal of approval” is so frightening, what about a “seal of approval” by a private sector self-policing group that is given teeth by private enterprises willing to sue miscreant preparers?

For many years reaching back to long before MauledAgain existed, and in many postings on that blog, I have rejected the use of tax law to accomplish indirectly what should be handled directly by government agencies other than the IRS and state revenue departments. In posts such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, I have pointed out the disadvantages of having the IRS administer programs designed to achieve national policy goals with respect to energy, environmental protection, employment, health care, education, and other matters that are within the purview of agencies established and operated to deal with those issues.

Now comes corroboration in the form of survey results that suggest the futility of tax incentives designed to influence behavior. A few days ago, Bloomberg BNA and Bloomberg New Energy Finance released the results of a survey in which participants, mostly tax professionals, were asked if they were familiar with particular tax incentives. The results are astounding.

Of the participants, 65 percent replied that they were “mostly or completely unfamiliar” with the production tax credit for wind projects. Only 7 percent described themselves as “extremely familiar.” When those who had not made or whose clients had not made a clean energy tax equity investment, 21 percent explained that they were unaware that they had such an option.

The chief executive of Bloomberg New Energy Finance put it succinctly. He stated, “These results suggest an information disconnect,” and added “Apparently though, many in the tax community have failed so far to spot the opportunity for their clients.”

If energy departments handled energy, and education departments handled education, and housing departments handled housing, the tax agencies could focus on collecting revenue. Financial rewards for complying with energy, education, housing, or other incentives would be disbursed through the respective agencies. In addition to matching administrative expertise with legislative goals, and in addition to increasing the likelihood of an incentive being publicized by the department responsible for the area in question, this approach would make visible the hidden spending buried in the tax law that most taxpayers don’t see and that legislators refuse to admit exists. One wonders whether the use of the tax law for purposes other than revenue collection is nothing more than a ploy to hide spending that the anti-spending crowd wants to preserve, a possibility mentioned and criticized in In Tax, as in Life, Just One Word Can Matter (“Let’s turn the nation’s attention to the federal spending that, until recently, has gone unnoticed by the public because it is hidden in a labyrinth of badly drafted and deliberately obfuscated tax law.”)

So, in addition to the disadvantages of burying expenditures in the tax law in the guise of incentives, the supposed advantage of this approach to tax and economic policy turns out to be far more theoretical than real. Purging the tax law of this hidden spending is long overdue.

Tax professionals, tax educators, school board members, high school principals and teachers, and taxpayers generally ought to set aside several minutes to view a heartening story about high school students learning to prepare, and preparing, income tax returns. The students participate in the Volunteer Income Tax Assistance program, but to do so they must pass a tax preparer exam. At the high school featured in the story, the students begin learning about taxes in a course that is part of the business curriculum. The course begins in January and by the end of February students are helping lower income individuals with their tax returns.

The people who put this program in place, including the teacher featured in the story, the school administrators who gave him the go-ahead, and the school board that approved the effort, deserve a commendation for taking this important step. It’s possible, of course, that similar programs have been put in place at other high schools. Perhaps somewhere there is a web site that lists the high schools that are doing this. If you know of such a site, let me know.

This program is promising not only because it teaches high school students about taxes, but also because it teaches them much more. They become aware of the world in which they will live, one in which they have responsibilities as citizens, including tax return filing. They learn to help people who are in need of assistance. The learn responsibility, by taking ownership of the tasks carried out under the program. These are values that will enhance their lives no matter what career path they choose. Of course, it was nice to hear one student suggest that he was headed for a career in taxation.

Over the years, I’ve shared more than a few commentaries about the need to introduce students to taxation before they leave high school. For example, five years ago, as I explained in Congress Invites My Ideas for Improving Tax Compliance and Of Course I Respond, I suggested to Senators Baucus and Grassley that “Making tax education a part of high school curricula throughout the nation would go a long way in reducing noncompliance.” More than a year later, in The Tax Fraud Environment: Sniping at the Congress, I noted, in connection with one of my discussions about the tax woes of Wesley Snipes, that, “Because an educated citizenry is less likely to believe the twisted logic of those trying to sell tax fraud plans, it makes sense to require high school students to take a course in basic rules of taxation.”

Thus, it is important for me to acknowledge that, at least in one high school, this is being done for some of the students. Progress!

The other day I heard a commercial on the local news radio station. A jewelry store chain was singing the praises of its business, and closed the advertisement by advising potential customers that if they went to the chain’s Delaware store, they could avoid Pennsylvania sales tax. This nugget of “wisdom” followed other claims designed to demonstrate the superiority of this enterprise over its Pennsylvania competitors.

Finding this commercial on the internet either is impossible or is a task beyond my skill set. In the process of searching for the commercial, I came across a web site that, for all I know, could be the source of the ad writer’s claim. According to this article by an unnamed contributor, it is possible to avoid sales taxes by following these instructions:

1. Find out how to avoid paying sales tax. Nearly all states do not have sales tax on items purchsed [sic] via the internet when the company you are buying from does not have a physically presence in that state. For instance, items purchased from Amazon.com or Blue Nile have no sales tax because they do not have a physical store in the states they are selling.

2. If you do not want to buy over the internet, then you can also find a regular brick and mortar store (while you are travelling out of state) that doesn't have a presence in your home state. For example, if you buy a sweet new Rolex in Tourneau in New York and have the store ship it to to your home in Colorado (where the is not a Tournea), you pay no sales tax.

3. Finally you can buy the item in a state that doesn't have any sales tax to begin with and bring it home with you. States that do not have sales tax are: Alaska, Delaware, Hawaii, Montana, New Hampshire, New Mexico, and Oregon.

Though technically these are ways to avoid the sales tax, they are not ways of avoiding the use tax. The same article then offers some “tips and warnings” for its readers: Among the tips are two that are no less oblivious to reality as is the failure to mention the use tax. Readers are told that “This works best with small items that are expensive, i.e. use this for wedding rings but not for cars!” It doesn’t work at all for cars, because when it’s time to register the vehicle, proof that the sales tax has been paid will be requested, and if it is not produced, especially if title is being transferred from out-of-state, a use tax will be imposed. Readers are also told, “The IRS may still hold you liable for tax even if the company did not charge you, check with your accountant.” The only good advice is the suggestion that a phone call be made to, or an email sent to, an accountant, though other tax professionals also can be helpful. The IRS is not going to impose a sales tax with respect to the purchase, and the making of the purchase will not generate gross income for the purchaser.

I explained the use tax in, among other posts, Tax: Perspective Matters. That post was yet another in the long series of commentaries on tax ignorance, including Tax Ignorance, Is Tax Ignorance Contagious?, Fighting Tax Ignorance, Why the Nation Needs Tax Education, Tax Ignorance: Legislators and Lobbyists, Tax Education is Not Just For Tax Professionals, The Consequences of Tax Education Deficiency, The Value of Tax Education, Tax Ignorance of the Historical Kind, Is It Any (Tax) Wonder?, and Tax Myths, Tax Lies, and Tax Twisting. So here is another. It is frightening how much misinformation pollutes the nation. Genuinely alarming.