MauledAgain

Decades ago, when the federal income tax rate structure included as many as 24 different rates, with the highest reaching 91 percent, the tax law included a computational process known as income averaging. In effect, income averaging permitted a taxpayer whose income spiked in a particular year to avoid being pushed into the very high tax brackets by taxing the income as though it had been earned during the preceding three years, thus subjecting it to the lower rates to which it would have been subject had it in fact been earned somewhat proportionately over those years. Income averaging was complex. The first portfolio that I wrote for what is now Bloomberg BNA was devoted entirely to Income Averaging. It is the only one of the portfolios that I have written that I do not periodically revised, because it was withdrawn when Congress repealed income averaging.

In 1986, when Congress reduced the number of income tax brackets and reduced the top rate to 28 percent, in exchange for removing many exclusions, deductions, and credits, it eliminated income averaging because there ni longer was a possibility that a surge in income would push the taxpayer into very high tax brackets. Though there was still a possibility that someone usually in the 15 percent bracket would be pushed into the 28 percent bracket by a sudden spike in income, the impact was considered too small to warrant retention of a provision that contributed to tax law complexity.

A recent case, Francis v. Comr., T.C. Summ. Op. 2012-79, involved taxpayers who sought to obtain the benefits of income averaging in a different manner but who failed to persuade the Tax Court that they were entitled to do so. In 2008, the taxpayer received a payment of almost $25,000 representing backpay representing amounts that would have been received by the taxpayer in 1998 through 2002 had the taxpayer not been wrongfully passed over for promotion in 1998. The taxpayer failed to report the backpay on the 2008 return. In Tax Court, the taxpayer argued that the backpay should be allocated to, and reported on, their 1998 through 2002 returns, because the marginal tax rate applicable to their income for those years was lower than the rate applicable to their income in 2008. The taxpayer did not prove, and nothing in the record indicated, that the taxpayer constructively received the backpay in a year before 2008. Accordingly, under section 451(a), regulations section 1.451-1(a), and prior case law, the backpay was includible in the taxpayer’s 2008 gross income. In fact, a taxpayer in a previous case had unsuccessfully attempted a similar allocation of one year’s income to prior years.

The Tax Court noted that, “Although not clear from the record, it may very well be that petitioners would have paid less tax with respect to the promotion backpay if the promotion denial had never occurred. Under the circumstances we can appreciate petitioners’ dismay.” However, even if the taxpayers were permitted to compute tax as though the backpay had been received during the 1998 – 2002 period, the interest for period beginning with the year of inclusion and ending in 2008 would more than offset the tax savings obtained by computing tax using the presumably lower marginal rates applicable in those earlier years. But if the income spike had not been $25,000 but $2,500,000, the interest component most likely would not wipe out the tax savings.

There are two types of income spikes, but only one is deserving of income averaging. It is sufficiently uncommon that Congress decided to leave income averaging out of the Internal Revenue Code even when the top rate was increased from 28 percent to 39.6 percent and subsequently 36 percent. When a taxpayer has a business that generates little income in some years and significant income in other years, income averaging is warranted because the annual nature of income tax liability computations is detrimental to taxpayers whose business activities are pegged to a cycle that extends over more than one year. Just as some businesses are seasonal within a year, such as ski resorts or Christmas tree retailers, some businesses are seasonal within a decade or half-decade. On the other hand, if a taxpayer’s income spikes because the taxpayer wins a $100,000 lottery prize, the justification for treating that income as though it was earned over a period of years does not exist. In the Francis case, the income was attributable to a period of years. In that sense it was much more similar to the half-decade seasonal business rather than the one-time lottery win.

Though most half-decade and decade seasonal businesses have ways of spreading the income, such as using the completed contract method of accounting, the taxpayer in Francis did not have that opportunity. Even though the backpay was designed to put the taxpayer in the same position he would have been in had the promotion been made when it should have been made, it did not have that effect because the tax consequences were not taken into account. Certainly it is possible to work into the computation of the award the tax impact, with adjustments for the interest factor. The Francis case involved military compensation, and perhaps it was not permissible for the parties to take those factors into account. In that event, Congress needs to change the statutes regulating the computation of military backpay, but that is a topic beyond the scope of this blog.

The experience of the taxpayer in Beach v. Comr., T.C. Summ. Op. 2012-81, demonstrates how easy it is for a taxpayer to make errors when filing a federal income tax return. Compounding the situation was an error made by the IRS.

The taxpayer owns a 2001 Saleen Ford Mustang. On February 6, 2007, it was damaged in an accident caused by an uninsured motorist who was at fault. The taxpayer’s adjusted basis in the Mustang was $25,482. It was worth $28,500 immediately before the accident and $2,250 immediately after the accident. The auto body shop determined that the cost of repairs would be $18,772.79, and taxpayer’s insurance company, after subtracting the $250 deductible, paid $18,522.79 to the auto body shop. The insurance company then initiated attempts to recover $18,772.70 from the uninsured motorist. The auto body shop returned the repaired Mustang to the taxpayer on June 29, 2007.

The taxpayer claimed a $17,287 casualty loss on his 2008 federal income tax return. The taxpayer did not enter any amount on the line for insurance or other reimbursement.

On December 10, 2010, the IRS issued a notice of deficiency for 2008, because of the taxpayer’s failure to subtract the insurance reimbursement. After the taxpayer filed his Tax Court petition and the IRS filed its answer, the IRS moved to amend its answer in order to add a second reason for its determination of a deficiency, specifically, that the casualty occurred in 2007 and should not be reported on the 2008 return.

The Tax Court concluded that any casualty deduction should be deducted in 2007. In fact, at trial, the taxpayer admitted that he “filed in the wrong year.” In addition, the Tax Court concluded that even if the deduction was proper in 2008, it would amount to zero, because the $250 remaining after subtracting the $18,522.79 reimbursement did not exceed 10 percent of the taxpayer’s adjusted gross income.

The IRS also determined that the taxpayer was liable for the 20 percent accuracy-related penalty. The IRS, having the burden of proof, argued that the taxpayer was negligent or disregarded rules or regulations. The Court concluded that the taxpayer was liable for the penalty because the taxpayer failed to subtract the reimbursement, thus failing to exercise ordinary and reasonable care in the preparation of the return. Petitioner’s attempt to avoid the penalty by arguing that he had not received a reimbursement because the insurance company had not paid him anything failed, because reimbursement can occur when payment is made to a third party on behalf of the taxpayer, as happened in this instance when payment was made to the auto body shop.

It is not merely a tax law proposition that a person who is out of pocket $250 does not suffer a $17,287 loss. It is not merely a tax law proposition that a person does not suffer a $17,287 loss if an insurance company pays all but $250 of an $18,772.79 accident repair bill. Even if there had been a deduction, reporting the transaction on the wrong return compounds the error. It is unclear why the taxpayer waited until early 2009 to report a 2007 transaction. And yet the taxpayer was not alone. The IRS did not pick up on the improper year issue until after it had filed its answer in the Tax Court. The IRS, however, was not subject to any sort of accuracy penalty. It pays to be careful.

EDIT: Yes, it pays to be careful. I wasn't. It's now fixed, though this post is spreading through cyberspace faster than I can catch up. The repaired sentence: "The Tax Court concluded that any casualty deduction should be deducted in 2007." Somehow (well, I know how, it involves learning how to use new versions of software) I had the wrong year in that sentence. It pays to have a proofreader.

Over at Forbes Magazine, Nick Schulz brands Exxon-Mobil a “Tax Hero” for paying three times as much in taxes, to governments world-wide, as it made in profits. At first glance, that seems impressive. But, after the careful analysis so lacking in the post-modern sound bite world, it’s not.

First, 77 percent of the taxes are the equivalent of fees and expenses that are recovered by passing the tax through to the consumer. For example, if Exxon-Mobil sells a gallon of gasoline for $4.00, it collects that $4.00 from the consumer. Included in the $4.00 is, depending on the state, some amount of liquid fuels tax. If Exxon-Mobil makes a profit of 30 cents on that gallon, it can claim it has “paid” far more than 30 cents in taxes, but in reality, the consumer is paying the tax and Exxon-Mobil is simply passing it through to the particular governments imposing it. Retailers collect and pay over significant amounts of sales taxes, but those taxes are being paid by the purchasers.

Second, Schulz appears to have pulled his numbers from consolidated financial accounting statements. The amounts shown as taxes are not amounts that are paid, but, at least in the case of income taxes, consist in part of figures representing amounts that are “set aside” as potential future tax liabilities. There is no guarantee that these taxes ever will be paid, and there is a long history of amounts charged as reserves for taxes by corporations generally never being paid.

What is appalling about this perspective, though, is that it highlights the internal inconsistency in the approach taken by those who seek to reduce taxes on corporations and the wealthy. One of the arguments tossed about is the notion that half the population is not paying tax, a proposition I debunked in Tax Myths, Tax Lies, and Tax Twisting and debunked again in Lying About Tax Myths. When careful analysts point out that everyone pays taxes, they are denounced for drawing attention away from the income tax. Yet, advocates of corporations as “tax heroes” are quick to include all sorts of taxes other than income taxes because, as for example in the case of Exxon-Mobil, profits exceed income taxes, even when using the “reserve” rather than the actual payment amount. Why the double standard? Of course, what’s overlooked is that in 1913 the income tax was designed, not as a general revenue raiser – that didn’t happen until World War II (though it happened to some extent during World War I) when sensible people, unlike the Congress and Administration in 2002, acknowledged that one does not jack up military spending without increasing tax revenue – but as a mechanism to prevent the wealthy from continuing and enlarging its purchase of elections. It was enacted as a device to preserve democracy against its destruction by the oligarchy. When enacted in 1913, the income tax applied to fewer than half a million people in a nation with a population of almost 100 million. The same could be said of the estate tax. They were directed squarely at the wealthy elite who were turning the nation into their own private fiefdom.

To claim that a corporation is a “tax hero” because it is so big that it collects huge amounts of taxes from its customers and passes them on to governments, and thus is a huge taxpayer, is total nonsense. It is “spin,” a buzz word for another word that I won’t type here but that would have brought out the soap had I said it as a child. It’s an attempt to mislead the tax-ignorant. It needs to be exposed for the chicanery that it is, which is what I have attempted to do.

A recent case, Alltel Communications Inc v. South Carolina Department of Revenue, No. 27156 (8 Aug. 2012), demonstrates yet again why the reduction of a theoretical concept to a practical application is what makes simple tax law concepts misleading. South Carolina has a corporate license fee – in effect a combination of a property tax and a gross receipts tax – that is computed at higher rates for certain types of companies, including telephone companies. The taxpayers in the case are in the business of providing wireless communication, or “cell phone,” services using radio waves. As the Supreme Court of South Carolina put it, the question is whether cellular service providers are telephone companies.

The administrative law court granted summary judgment in favor of the taxpayers, finding that they were not telephone companies for purpose of the license fee in question. Alternatively, the administrative law court concluded that if the statute were ambiguous, the taxpayers would prevail because ambiguities in a taxing statute must be interpreted in favor of the taxpayer. The revenue department appealed, and the Court of Appeals reversed and remanded for additional fact finding. The taxpayers applied for certiorari, and the South Carolina Supreme Court reversed, holding that “telephone company” is not a defined term, its application to the taxpayers is doubtful, and that this ambiguity must be resolved in favor of the taxpayers.

The parties had stipulated that the taxpayers were “radio common carriers” because they owned or operated in the state equipment or facilities for the transmission of intelligence by modulated radio frequency signal, for compensation to the public, that telephones and telephone companies transmit intelligence over a vast network of wires located in public rights of way and in easements over private property, that the taxpayers do not have facilities located in public rights of way, and that petitioners provide wireless voice and data communications using radio communication towers or facilities that the taxpayers own, lease, or license. Relying on these stipulations, the administrative law court concluded that the taxpayers were not telephone companies, but the Court of Appeals disagreed, concluding that additional facts were required to determine if the taxpayers were telephone companies. The taxpayers argued that because a “telephone company” is a company that uses landlines and wires, they are not telephone companies. The Supreme Court of South Carolina described this argument as having “ostensible merit,” buttressing its strength by examining the history of the license fee, and describing it as an excise tax imposed for the special privileges that had been granted to telephone companies to run their wires and install their poles in public rights of way. The court also noted that unlike the telephone company at the time the tax was enacted, the taxpayers were not a monopoly but participants in a competitive industry. Yet, despite the strength of this reasoning, the court also concluded that the lack of a definition of “telephone company” in the statute made the question ambiguous. It then proceeded to resolve the dispute in favor of the taxpayers because ambiguities in tax law must be interpreted in favor of the taxpayer.

To a tax neophyte, it probably is surprising that a statute imposing a higher tax on a telephone company does not contain a definition of telephone company. To the experienced – or jaded – tax practitioner, it is business as usual and work for tax litigators. The Supreme Court pointed out that the tax was enacted in 1904 and “yet more than a century later the term ‘telephone company’ remains undefined by the legislature.” What? A legislature not doing something it needs to do and procrastinating for more than 100 years? So the affliction has infected more than just the federal Congress. Though the legislature’s failure to act may have generated fees and income for some lawyers, it also imposed costs on the taxpayers that eventually will be passed on to its customers. A long time ago, someone said, “Let’s tax telephone companies at a higher rate.” Someone else said, “That’s a good idea.” Perhaps no one asked, “What is a telephone company?” Perhaps someone did and was rebuffed with, “Everyone knows what a telephone company is.” Over the years, as new technologies entered into the world of communications someone surely asked, “Is a cellular telephone company a telephone company?” but the legislature remained silent. Perhaps its members were too busy campaigning for re-election.

For as long as I have been teaching, students in my tax classes have been amused or frustrated by the frequency with which “it depends” surfaces as the answer to a question. Of course, many of the questions are designed to elicit responses to the follow-up question, “on what?” and to develop student’s fact-finding skills. Tax practitioners well know that some of the questions are simply the consequence of badly drafted tax laws that leave the answer up in the air until resolution arrives through subsequent legislation, a regulation, a ruling, or a judicial opinion.

Thus, it is not surprising that many statements about tax law begin with the ubiquitous “Generally,” or its variation, “In general.” It’s a rather obvious way of hedging one’s answer against the unknown exception. Unfortunately, in a world demanding absolute answers to questions within microseconds, any suggestion of a hedge earns demerits. In turn, absolute assertions spring up. This is true, and quite a problem, not only in the tax world, but for the moment, the focus is on tax.

Last week I received an email that contained a tax analysis that was replete with absolute statements. Though many were correct, two were wrong. The discussion, which can be found here, focused on the tax consequences of a project funding effort called Kickstarter. People in need of funds for a project, called creators, submit details of the project to Kickstarter, and if Kickstarter things it is worthwhile, the project and its details are posted on the Kickstarter web site. This permits anyone who likes the idea to “donate” money to help the project raise funds, and thus to become a backer. The creator submits a financial goal, and if the “donations” are sufficient the funds go to the creator, minus a 5 percent fee for Kickstarter. If insufficient funds are raised, the funds are returned and the creator gets nothing. If the project moves forward, backers “are rewarded with something in return, ranging from the backer’s name on a list of contributors, to a tee shirt, to a DVD of the documentary, to an invitation to the initial performance, to a signed photo of the work in progress by a famous photographer.”

Under the caption “What’s the tax angle?,” the description of Kickstarter provided the following propositions:

1. “Backers are not donating money in the way one donates to a charity. The money someone gives toward a project is just that, a gift. The gift is not deductible on the donor’s tax return. There is an exception: If the project is classified as a 501(c)(3) not-for-profit organization then the donation is a personal — not business — charitable deduction on the donor’s tax return.”

2. “The value of these rewards [the tee shirt, the DVD, etc.] are not taxable to the donor.

3. “The cost of the rewards is a business expense for the creators.”

4. Creators will be sent a 1099-k at year-end from Kickstarter. The money the [creator] receives is taxable income. It is included as part of business gross income.”

I take exception to the claim that the amounts contributed by backers are gifts. In some instances they are. But to the extent the backer receives something in return, the money, or at least part of it, is not a gift, but the purchase price of the item received by the backer. The word “generally” would have allowed room for this aspect of the transaction.

I also take exception to the claim that the value of the rewards are not taxable to the donor. Under some circumstances, and it depends on the language of the contract and the specific arrangements into which the parties have entered, gross income can be generated if the value of what is received exceeds the amount that has been paid. This is unlikely to happen other than in rare circumstances, but it is another instance for use of the word “generally.” It is tempting to think that if the circumstances are so rare it is acceptable to dismiss them as though they did not exist. Yet the tax law, as is the case with other areas of law and other disciplines, is highlighted by situations thought to be quite rare but which were very real to the people who experienced them.

And although Kickstarter explains that backers do not obtain ownership interests in projects, it is only a matter of time before a creator gets creative. Trying to summarize the tax consequences of establishing an ownership interest in an enterprise without using the word “generally” is, generally speaking, quite a challenge.

From a tax perspective, there’s a little something to be said about the value of those television court shows. Twenty months ago, in Judge Judy and Tax Law and Judge Judy and Tax Law Part II, I shared my reaction to several tax propositions that were articulated on Judge Judy’s version of television court. In the second post, I asked, “I wonder what sort of impact on the viewers this episode has made. Has it taught people that it doesn’t pay to commit tax fraud, . . .” Apparently the answer is no.

Last week, I found myself watching an episode of People’s Court. The facts were fairly simple. The plaintiff had purchased a used car from a used car dealer. For some reason, he did not test drive the car, nor did he take it to a mechanic for a pre-purchase examination. He admitted that he had made “a lot of mistakes.” Of course, the car turned out to be a clunker, so the plaintiff sued to get his money back. Judge Marilyn Milian asked for proof of how much he had paid. She asked for the bill of sale. The response? There is no bill of sale. The dealer noted that the price was $500. The plaintiff disagreed, claiming that the $500 was the price the dealer agreed to put down in order to save the plaintiff from paying sales taxes on the much higher amount that the plaintiff claimed to have paid. The judge asked, “And that was the dealer’s idea?” Of course, the plaintiff began to squirm. The judge then observed, “You know that is tax cheating, right?” She then remarked, rather sarcastically, that she likes the cases when someone sues for the actual purchase price even when there is a bill of sale that has a fabricated lower price designed to reduce the purchaser’s sales tax.

While trying to find a transcript of the episode – I failed – I discovered that a similar situation had arisen in at least two earlier episodes. One of those episodes was noted in TV Judge Gets Tax Observation Correct. In the other case, the dealer left blank the space for filling in the purchase price so that the purchaser could fill in a lower number for sales tax purposes. The parties in the more recent case either did not watch the earlier episode or, if they did, figured they were special enough to pull off the stunt without being caught. Judge Milian apparently does get more than a few of these sorts of cases.

I wonder if the revenue department for the states in which these transactions took place followed through with an audit. Is it any wonder that governments face revenue shortfalls?

It wasn’t that long ago that in Sometimes When It Comes to Tax Violations, Voters Get It Right, I asked, “What’s going on in the heads of people who think they can escape responsibility? Perhaps it reflects the tax fraud defense offered in Browning v. Comr., T. C. Memo 2011-261. In that case the taxpayer explained, 'I]t’s like running a red light or going the speed limit. You do things you shouldn’t while you can.' ” Every which way one turns, someone is trying to rip off someone else, whether it is society at large, individual consumers, voters, property owners, or some random victim. Using lies, scams, con games, fake smiles, fancy words, and every other tool known to the deceiver, these perpetrators are growing in numbers and in boldness. It’s no wonder, as it reflects the example being set by persons in position of authority, in both the public and private sector, and in for-profit and not-for-profit organizations. The tax fraud epidemic is part of a larger fraud pandemic that threatens more than the dollars purloined or the people victimized. It threatens to turn the nation into a den of thieves.

At the end of July, voters in Georgia had the opportunity to approve or reject, through a referendum, a one percent increase in the state sales tax to fund highway and transit improvements. For purposes of the vote, the state was divided into twelve regions, with each region having a list of improvements for that region. Presumably, one purpose of arranging the voting in this manner was to avoid the not uncommon, and frequently criticized, pattern found in many states of transportation taxes in one region being used for improvements in another region.

According to this report, voters in nine of the 12 regions rejected the tax increase. The discussion leading up to the vote generated some strange alliances and divisions. Business owners who usually support anti-tax Republicans supported the tax, whereas the so-called Tea Party, not surprisingly, opposed it. Some Democrats opposed the proposal because the project lists did not, in their view, include sufficient spending in African-American communities.

Reasons for the failure of the proposal in the Atlanta area are as varied as the voters. According to this report, some voters rejected the proposal because they don’t trust the government. Others voted no because they perceived that they would not benefit individually, or would benefit less than people in other areas of the region. Mass transit supporters voted no because some of the funds would benefit car drivers. Still others voted no because the project list included mass transit expansion, with almost one-half of those polled explaining that mass transit causes increases in crime.

There is no question that there are traffic and transit problems in Georgia, particularly in the Atlanta area. Some predict that with traffic woes becoming an impediment to business growth, “valuable young workers” and jobs would leave the region. As one supporter of the tax noted, when employers consider where to locate new jobs, traffic is a major factor in the analysis. So unless and until the voters of Georgia unite behind some sort of funding plan, congestion will increase, highways and bridges will continue to deteriorate, accidents and fatalities will rise, and front-end alignment spending will skyrocket past the small amounts that would have been paid if the proposal had been enacted. The business owners who supported the tax, despite their alleged anti-tax outlook, understood that the tax in question was a cost of maintaining and expanding the transportation resources necessary for their enterprises to thrive and grow. The inability of most people to understand the issue is reflected by the statement made by an opponent of highway funding increases in Texas, as shared in this report. “We don't want more taxes, especially to use roads we've already paid for with tax money.” The problem is that there are two aspects of paying for roads. One is to pay for construction of the highway. The other is to pay for the maintenance and repair of the highway. When teenagers begin to talk about purchasing a car, sensible parents explain to them that the cost of the car is more than the purchase price because they need to take into account fuel, insurance, and repairs. Similar advice is given to those seeking to purchase a home if they are fortunate enough to be exposed to wisdom, as the cost of a home includes not only the purchase price but utilities, insurance, maintenance, and repairs. The long-term effects of failing to teach financial common sense in the nation’s school systems is now threatening the well-being of the country’s physical infrastructure.

Regular readers can easily guess what went through my mind when I picked up the Philadelphia Inquirer and saw this report. Apparently Nadya Suleman, better known as Octomom, joined an online dating service that permits users to pay other users to go on a date. Users bid for the privilege of going out with someone, and Nadya has put the opening bid at $500.

Regular readers will remember that a little more than a year ago, in The Tax Consequences of Being Paid to Date, I addressed the income tax consequences, and touched lightly on the sales tax consequences, of transactions undertaken through that web site. Yes, it’s still in business. I concluded that the amount received by the person being paid to go on the date is gross income. I explained that it is not a gift, and that it is paid in exchange for the person’s time in the same manner as a psychologist, plumber, or painter has gross income when paid for his or her time, making it compensation for services provided.

When Paul Caron picked up my post on TaxProf Blog, 23 comments were left by his readers. Some agreed it was gross income. Several argued that there was no profit, after taking into account the expenses of “prepping” for the date, but that doesn’t eliminate the status of the fee as gross income nor, turning to another aspect of the question, the requirement that it be reported. There also is some question about the wisdom of assuming that the prepping expenses are deductible, as many people are obligated to “look nice” for their jobs but that doesn’t transform their commuting, attire, or hair care expenses into deductions. Some of the more interesting comments highlighted practical concerns, such as the question, “How would the taxman know you got pay for your dates?” It is true, as someone else noted, that the income tax “‘really’ invades privacy.” Indeed it does, as I explain to my basic tax students every fall. I challenge them at the beginning of the course to be prepared to answer at the end of the semester the following question, “What aspect of your life is not affected by the income tax law?”

Some of those who commented expressed the opinion, shared by the writer of the most recent Philadelphia Inquirer report that the transactions are nothing more than escort services or prostitution arrangements. If that is so, the amounts received unquestionably are gross income. Yes, there are cases addressing this issue. As I noted in The Tax Consequences of Being Paid to Date, I did not go to the site in question. One of those commenting on Paul’s TaxProf Blog post, a person by the name of “anon,” wrote, “That site is terrible. I joined it yesterday and deleted my account only 1 hour later.” I have no intention of replicating anon’s research.

The Philadelphia Inquirer story that triggered last year’s post, The Tax Consequences of Being Paid to Date, revealed that the site in question has 50,000 members, and receives bids averaging $138. With that level of activity, surely it’s just a matter of time before one of these transaction ends up as the subject of a Tax Court or district court opinion.

Indeed, sometimes voters get it right but too often it takes way too long. This was demonstrated recently in the case of Philip Lewis Hart, a member of the Idaho legislature. Hart by profession is a structural engineer, he happens to think that the federal income tax is unconstitutional, and he has written a book explaining his position. He has fared no better in court than have any of the other tax protestors who make the same worn-out, illogical, misguided, and warped arguments. See, e.g., Hart v. Comr., T. C. Memo 2000-78.

Several months ago, with his tax debts heading north of half a million dollars, Hart filed for bankruptcy. According to this story, Hart also owes money to a law firm and is fighting a U.S. Justice Department attempt to foreclose on his home. According to another story, Hart has proposed to pay $12,000 over a five-year period to settle $600,000 of debt. One wonders if Hart noticed the absurd deal worked out for Ford T. Johnson, which I noted and criticized in From Tax Until Eternity. Johnson had complained about a deal permitting him to pay off a $2.5 million debt in $400 monthly installments.

What’s going on in the heads of people who think they can escape responsibility? Perhaps it reflects the tax fraud defense offered in Browning v. Comr., T. C. Memo 2011-261. In that case the taxpayer explained, “[I]t’s like running a red light or going the speed limit. You do things you shouldn’t while you can.” According to this story, the house that Hart is trying to save from foreclosure “was built in part with logs he illegally harvested from state school endowment land.” Despite his claim that citizens are permitted to take the logs for free, he repeatedly lost his appeals but never paid off the judgment. Some people interpret “freedom” and “rights” as licenses to do whatever they want, whenever they want, with no regard for the freedom or rights of anyone else.

Somehow, Hart got himself elected to the Idaho legislature and was re-elected three times. It’s unclear whether voters knew about his log acquisitions and his tax return behavior. Surely some of them did, but perhaps those who did were the ones who voted for the other candidate. Eventually, to avoid ethics sanctions, he stepped down from the Idaho House tax committee. But the good news is that several weeks ago he lost in the GOP primary and will not be serving a fifth term. Enough voters opened their eyes and ears, and used their brains. Why it took so long is unclear.

Suppose for a moment that the Bush tax cuts are extended for taxpayers with taxable income of less than, say, $250,000. Is it possible for taxpayers with taxable incomes of $250,000 or more to avoid the resulting increase in their tax liabilities? Of course. If they hire people to do work that is connected to the trades and businesses that they operate and the for-profit activities in which they engage, their taxable incomes will decrease because of the deduction for the salaries that they pay. Every taxpayer with a taxable income of $250,000 or more has the ability to bring their taxable income to less than $250,000 through lawful means. If they hire and spend wisely, they obtain full value for what they pay, so their wealth position is not compromised. In the meantime, their new employees will be paying taxes on their newly acquired incomes, permitting those new employees in turn to purchase goods and services. The section 162 compensation deduction is not the only existing incentive to help people reduce their tax liabilities by reducing taxable income. Perhaps the problem is that much of what those with incomes of $250,000 or more want to do with their money doesn’t generate a tax incentive. I wonder why.

Recently, in Carlebach v. Comr., 139 T.C. No. 1 (July 19, 2012), the Tax Court upheld the validity of a regulation dealing with the definition of a dependent that illustrates why tax statutes are long. Had the statute been even longer, there would have been no justification whatsoever to challenge the regulation because there would have been no need for the regulation.

The issue was simple. The taxpayers claimed dependency exemption deductions for their children. In some of the years in question, none of the children were citizens of the United States. In other years, some of the children were citizens but others were not. The Court first addressed the taxpayers’ argument that their children were citizens during the years in question but rejected the argument. The Court then turned to the core tax question.

Section 152(b)(3)(A) provides that a dependent “does not include an individual who is not a citizen or national of the United States . . .” Regulations section 1.152-2(a)(1) provides that “to qualify as a dependent an individual must be a citizen or resident of the United States . . . at some time during the calendar year in which the taxable year of the taxpayer begins.” The taxpayers argued that the requirement in the regulations that their children be citizens during the calendar year in which the taxable year of the taxpayer begins is invalid. They rested their contention on the argument that Congress enacted a statute that did not include the calendar year time requirement. The taxpayers argued that it was sufficient that their children were citizens by the time they filed their returns, though the Court pointed out that the logic of the taxpayer’s argument was equivalent to a claim that a person qualified so long as they became a citizen by some point before the return was filed.

The taxpayers argued that because Congress included “during the calendar year” language in other parts of section 152, and omitted it from section 152(b)(3)(A), Congress did not intend for the latter provision to be interpreted as provided in the regulations. The Court, however, noted that the language of the Code must be examined in context, and that the annual accounting system inherent in the federal income tax, as explained by the Supreme Court in Healy v. Comr., 345 U.S. 278 (1953) makes it clear that the requirements for status of a dependent must be determined with respect to an annual period. Even if the statute could be construed as ambigous, the Court explained, the regulation is a reasonable intepretation. Though not determinative, the Court noted that the interpretation in the regulation has been in place since 1944.

Certainly, it would be easier if section 152(b)(3)(A) provided that a dependent “does not include an individual who is not a citizen or national of the United States . . . during the calendar year in which the taxable year of the taxpayer begins.” Doing so would make the Code even longer, to the distress of those who think the Code is too long as it is. The problem is that a simple concept, specifically, the dependency exemption deduction, is transformed into an increasingly complex Code provision, interpreted by even longer and more complicated regulations, as a defense against mis-interpretation and gaming, and in response to mis-interpretation and gaming. Even if the Code were significantly shortened by removal of all special interest provisions and all credits, exclusions, and deductions substituting as spending programs belonging to other agencies, the tax law would continue to be more than a grouping of simple concepts. It’s in the application that concepts, no matter how simple, become complicated.

It is not difficult to find professionals who advise, whether in person, on web sites, or otherwise, that tax records should be retained for three years. Some advisors suggest that tax returns should be kept for longer periods or even indefinitely, but that receipts and other supporting evidence can be shredded or trashed after three years. Too infrequently does the advice include a warning that receipts connected with basis determinations need to be kept for at least as long as the property is owned.

A recent Tax Court decision, Roberts v. Comr., T.C. Memo 2012-197, demonstrates the pitfalls of not retaining basis-related records. The taxpayer purchased a property in 1980 and sold it in 2005. The taxpayer testified that he paid $63,500 for the property and the IRS accepted this claim. The taxpayer also testified that he expended $75,000 for improvements to the property but offered no evidence other than what the court characterized as “vague self-serving testimony.” It’s very possible that the taxpayer made improvements of some amount, but because of the failure to retain and produce evidence, the taxpayer was taxed on gain that perhaps did not exist.

One of the interesting aspects of this case is that the taxpayer was an appellate lawyer. Worse, the taxpayer failed to file federal income tax returns for 2004 through 2007. Presumably the taxpayer attended law school. Perhaps the taxpayer took a basic tax course. Somewhere along the line the taxpayer should have learned about record retention, not only for tax purposes, but for other purposes as well. I know I make the record keeping point to my students. I wonder, though, if it sticks. In some instances, I’m sure it does. In others, unfortunately, it’s tossed almost as quickly as the records that taxpayers ought to be retaining.

Several readers requested an index to the series of posts on the federal Ready Return proposal. Here it is.

Federal Ready Return, Part One: Introduction

Federal Ready Return, Part Two: The Value of Self-Compliance

Federal Ready Return, Part Three: Income Tax Return Accuracy

Federal Ready Return, Part Four: The Persistence of the Tax Gap

Federal Ready Return, Part Five: Efficiency

Federal Ready Return, Part Six: Security Risks

Federal Ready Return, Part Seven: Taxpayer Acquiescence

Federal Ready Return, Part Eight: Burden on Business

Federal Ready Return, Part Nine: Economic Impact

Federal Ready Return, Part Ten: IRS Capacity

Federal Ready Return, Part Eleven: Conflict of Interest

Federal Ready Return, Part Twelve: Taxpayer Acceptance

Federal Ready Return, Part Thirteen: IRS Authority

Federal Ready Return, Part Fourteen: Conclusion

In the current atmosphere of anti-taxation sentiment, opposition to tax increases, and efforts to curtail government, it was surprising but very telling that the coach of the University of Alabama football team proposed, according to this story, that “one option to address the Penn State tragedy might be a ticket tax on athletic events and giving the proceeds to child-abuse funds.” Saban’s precise words, “Maybe they ought to tax all the tickets that they sell on athletics” clarifies that his proposal did not reach beyond Penn State ticket transactions. He surely was not suggesting that University of Alabama tickets, nor those of other schools, be taxed. To his credit, Saban admitted that his comments “had to do more with philosophy than a real recommendation,” which probably is why he “didn’t go into details of how a tax would be implemented.”

Details aside, Saban’s proposal is unsound. If the tax is paid by the ticket purchasers, it puts an economic burden on people who did not commit the crimes in question, and did not engage in the behavior that contributed to the wrongdoing. If the tax is paid by the University, it would ultimately be paid by some combination of students through tuition, alumni through contributions, and taxpayers through state grants. Again, its incidence would fall on the wrong people.

The economic cost of the crimes in question ought to fall on the perpetrators. The practical problem is that the combined economic cost, taking into account not only penalties of the sort Saban suggests but also the damages that surely are going to be awarded in the civil suits that are pending, far exceeds the economic resources of the perpetrators and those who are guilty through dereliction of duty and failed oversight. When someone worth $100 causes $1 million of damages, who pays? This nation too often cannot bring itself to impose economic penalties on wrongdoers who have more than adequate resources to compensate the victims of their bad decisions, so it’s even less likely that its justice system would, even if it could, require the perpetrators to pay for the impact of their decisions.

The Penn State situation requires solutions, but a tax on people not responsible for the crimes is not one of the answers.

The nation is not ready for federal Ready Return. Nor will it ever be, until and unless the federal income tax law is overhauled. Ready Return rests on the idea of government-computed tax bills, which works for taxes such as the real property tax or the sales tax. Those taxes, though not simple by any stretch of the imagination, are child’s play compared to the federal income tax.

There are all sorts of reasons to reject Ready Return. In its 2011 Report, the Electronic Tax Administration Advisory Committee provided its list:

little relief for taxpayers with complicated returns or business income, or low-income filers in complicated living arrangements; lack of an IRS computing infrastructure; absence of timely third-party information reports needed to pre-fill a return; need for considerable investment in technology and manpower; potential that a pre-filled return that omitted income, or misstated the return in a taxpayer’s favor could reduce tax compliance and collections; difficulty or impossibility of adapting Simple Return to address all the special credits for low-income households; and, finally, even with technological improvements, the inability for many taxpayers to prepare returns as soon after the close of the year as they currently file their returns in order to obtain their tax refunds.

To that list, I add the loss of civic virtue nourished by the self-compliance aspect of the income tax, ineffectiveness in reducing the tax gap, expanded risk of privacy loss and identity theft, increased burden on businesses, adverse impact on the economy, creation of conflict of interest problems for the IRS, and taxpayer rejection of the idea.

Ready Return is a classic example of a theory that cannot survive in a practical world. Like most theories, it deserved an experiment. It had that chance, not in a small laboratory, but in the nation’s most populous state. It failed. How many times has someone said, “I have a good idea,” no one had the courage to offend the person by explaining it was not a good idea, and the implementation led to all sorts of problems for unsuspecting “beneficiaries” of the outcome? Though in many instances the worst effect is inconvenience, sometimes the results can be far more serious. Fooling around with the nation’s primary source of revenue in this manner is unwise, unwarranted, and dangerous.

Ready Return is something that the IRS has authority to implement. Section 2004 of the Internal Revenue Service Restructuring and Reform Act of 1998 provides:

The Secretary of the Treasury or the Secretary’s delegate shall develop procedures for the implementation of a return-free tax system under which appropriate individuals would be permitted to comply with the Internal Revenue Code of 1986 without making the return required under section 6012 of such Code for taxable years beginning after 2007.

Nonetheless, as the debate about Ready Return has heated up, one member of Congress decided it was necessary to introduce a bill, H.R. 1069, expressly permitting the IRS to implement a limited Ready Return system. Another member of Congress, joined by several dozen other legislators, introduced a competing bill, H.R. 2528, which prohibits the IRS from doing so and repeals section 2004 of the 1998 legislation.

Few people pay attention to Ready Return. The 1998 legislative provision received very little attention when it was enacted and not much since. Outside of a small circle of Ready Return advocates and opponents, the idea of government-prepared tax returns has a flickering moment in the spotlight on rare occasions. Even then, it’s a handful of survey respondents, a tiny fraction of California taxpayers, and several bloggers, journalists, and lobbyists who take notice. Of these, a still smaller subset pays close attention. If and when the IRS launches Ready Return, it will come as a surprise. All sorts of people will exclaim, “They can’t do this,” but under present law, “they” can.

Ready Return will not work if taxpayers do not accept it. All indications are that Ready Return will fall flat.

As I pointed out in First Ready Return, Next Ready Vote?, “Only three percent of taxpayers eligible to have the state of California prepare their return took advantage of the opportunity. Only 60,000 people out of 2,000,000 were willing to put their tax fortunes in the hands of an anonymous revenue department bureaucrat or its computer.”

According to New Poll Shows Voters Overwhelmingly Reject Proposal To Have IRS Prepare Individuals' Tax Returns, a Computer and Communications Industry Association poll discovered that 71 percent would not “trust the IRS to prepare their returns, determine their refund and/or how much they owe in taxes.” Of those polled, 73 percent agreed that Ready Return would create a conflict of interest. These results crossed party affiliation, with 80 percent of voters claiming to be “less likely to vote for a candidate who backed an IRS expansion that involved the agency taking over tax return preparation.”

Respondents to the poll expressed other positions consistent with those taken by opponents of Ready Return. Of those polled, 63 percent “said they did not trust the IRS to keep their personal information safe and secure from hackers and identity thieves.” And 75 percent “believe the IRS would be most concerned with getting the maximum tax revenue possible from individuals.”

Ready Return creates a conflict of interest, not, as some claim, because it gives the IRS the dual roles of tax return preparer and tax collector, but because it cause the IRS to function both as preparer and as auditor. As I explained in Ready Return Not a Ready Answer:

ReadyReturn removes third-party protection from taxpayer-revenue department relationships. Will one branch of the FTB audit the work of another branch? Isn't there a conflict of interest when the auditor is preparing the return to be audited? Absolutely. Has not a lesson been learned from Enron about the importance of independence? Apparently not.

In Policy Analysis of “Return-Free” Tax System, Robert A. Boisture, Albert G. Lauber, and Holly O. Paz reach the same conclusion:

A third possible source of increased tax collections under a tax agency reconciliation system could be over-reaching by tax-collection authorities. In a very real sense, this type of system would create a conflict of interest on the part of the IRS. On the one hand, the IRS has an obligation to maximize tax collections in order to protect the federal fisc. On the other hand, a tax agency reconciliation system would require the IRS to act in effect as a fiduciary for taxpayers – analogous to an accountant or return preparer – with an obligation to prepare tax returns accurately, but also in the taxpayer’s best interest. Such a system is inherently subject to abuse.

Similar concerns were expressed by Joseph Cordes and Arlene Holen in Should the Government Prepare Individual Income Tax Returns?.

Ready Return would impose significant demands on IRS resources. Imposing Ready Return on an IRS saddled with computer system problems is unwise. Launching a Ready Return program while the IRS core customer account database system is being implemented, a system still not ready despite several years of work, also is unwise.

Assuming Ready Return is operational, what happens if a taxpayer finds a discrepancy between what the IRS puts on the return and what the taxpayer knows is correct? Would the error be fixed in time for the taxpayer to have a final return in place by the due date? Would the taxpayer file a return inconsistent with the Ready Return, and would doing so increase the risk of a subsequent audit? What happens when the person or entity originally filing the W-2 or 1099 form amends it? Would the IRS have the resources to change the inaccurate data on information returns imbedded into the system? Under current procedures, the IRS sends notices after returns are filed if there are mismatches with information returns, and yet far too many of these automated notices do not match the information returns or otherwise contain erroneous information.

Ryan Young, in A Backdoor Tax on the Poor (Nov. 8, 2011), argues that if the IRS contracts out the software design for Ready Return, there is no guarantee that what the contractor provides will work correctly. He suggests that additional expenses will be incurred by the IRS to pay for software updates and corrections.

To these concerns, I add several more. What happens if a web-based Ready Return system goes down? What happens if mobile Ready Return apps fail to work because of overloads on phone networks? What is the likelihood that malevolent individuals or thrill-seeking youngsters initiate a denial of service attack against the Ready Return web site? What happens if they launch it on April 14 and succeed?

Ready Return proponents claim that it will save people several billion dollars in taxpayer return preparation fees. If that’s true, that puts a lot of preparers out of work. But it’s not true, and tax return preparers would continue to make money. As I noted in Federal Ready Return: Theoretically Attractive, Pragmatically Unworkable:

Let’s face it, if the IRS adopts a federal Ready Return, tax return software companies would have a ready advertising opportunity, namely, offering its products as tools to check on the accuracy of returns prepared by an agency so long underfunded that it’s not surprising it makes so many errors processing returns. . . . Taxpayers would end up taking these “tentative” returns to tax return preparers or using software to see what results it generated, so the alleged efficiencies of a federal “Ready Return” is another theoretical construct that falls apart when put to the test in the practical world.

On the other hand, if Ready Return puts preparers out of work, it is unlikely that the jobs created by contractors preparing the IRS software would make up for these losses. But where is funding acquired to pay for the development of Ready Return software? The IRS continues to be underfunded. Can the nation afford an expensive experiment that does not provide the claimed savings and requires infusions of cash? Should taxpayers be financing a government tax return preparation department in the IRS? I think not.