MauledAgain

The extent to which guaranteed payments affect adjusted basis in a partnership interest is unclear. This is yet another question for which there is no authority found in the statute, regulations, administrative issuances, or judicial decisions.

A partner must include a guaranteed payment in gross income in the taxable year for which the partnership properly claims the deduction or makes the required increase in the basis of an asset. Thus, if the partnership uses the accrual method and the partner uses the cash method, the partner includes the guaranteed payment in gross income even if it has not been paid. A mechanism is required to prevent the partner from including the guaranteed payment in gross income when it is eventually paid. This mechanism is basis.

The question is whether the basis acquired by reason of including the guaranteed payment in gross income is a stand-alone basis in the guaranteed payment or is added to the partner’s adjusted basis in the partnership interest. Though one might expect something to be found in section 705 or even section 707(c), or the regulations interpreting those sections, there is no answer there or in revenue rulings, notices, or court opinions. There is dictum in one case suggesting that the partner increases adjusted basis in the partnership interest, but there are inferences in the regulations that the partner does not increase adjusted basis in the partnership interest, though the reasoning is quite attenuated.

An example illustrates why the question matters. Assume that at the beginning of year 5, A’s adjusted basis in the partnership interest is $100. During year 5, the partnership accrues a $400 guaranteed payment to A but does not pay it. After deducting the guaranteed payment, the partnership breaks even, so there are no partnership items to allocate among the partners. During year 6, the partnership again breaks even, but there is no guaranteed payment. During year 6, the partnership sells a capital asset in which its adjusted basis is $1,000. It sells the asset for $1,000, and distributes $200 to each partner, including A. During year 7, the partnership again breaks even, and again there is no guaranteed payment, but the partnership pays to A the $400 guaranteed payment accrued during year 5.

If the inclusion of the guaranteed payment in gross income for year 5 increases A’s adjusted basis in the partnership interest, the results are as follows. The basis of A’s partnership interest at the end of year 5 is $500 ($100 plus $400). The sale of the asset during year 6 has no effect on A’s adjusted basis in the partnership interest. The distribution of $200 reduces A’s adjusted basis in the partnership interest to $300 ($500 minus $200). The payment of the guaranteed payment of $400 in year 7 reduces A’s adjusted basis in the partnership interest to zero, and generates gain of $100 under section 731(a)(1) ($400 minus $100).

If the inclusion of the guaranteed payment in gross income for year 5 creates a stand-alone basis in an item that could be called, for ease of reference, guaranteed payment receivable, the results are as follows. The basis of A’s partnership interest at the end of year 5 remains $100, and A also has a basis of $400 in the guaranteed payment receivable. The sale of the asset during year 6 has no effect on A’s adjusted basis in the partnership interest. The distribution of $200 reduces A’s adjusted basis in the partnership interest to zero, and generates gain of $100 under section 731(a)(1) ($200 minus $100). The payment of the guaranteed payment of $400 in year 7 reduces A’s adjusted basis in the guaranteed payment receivable to zero, but does not generate any gain.

The difference, therefore, essentially is one of timing. Either way, A must report ordinary income of $400 in year one, and gain of $100. If the inclusion of the guaranteed payment in gross income for year 5 increases A’s adjusted basis in the partnership interest, the gain is reported in year 7. If the inclusion of the guaranteed payment in gross income for year 5 creates a stand-alone basis in a guaranteed payment receivable, the gain is reported in year 6. Put another way, the issue is whether the basis obtained from including the guaranteed payment in gross income can be used to offset distributions and not just payment of the guaranteed payment.

However the question is resolved, clarifying amendments to the Internal Revenue Code or the regulations are necessary. Even if the situation arises only for partners with zero or relatively low adjusted basis in their partnership interests, taxpayers deserve an answer.

Section 704(e)(2), which attempts to apply two assignment of income doctrines to partnerships, is difficult to read, challenging to explain, and questionable in its application. Section 704(e)(2) is designed to prevent a partner who provides services on behalf of a partnership from shifting the income generated by those services to other partners who received their partnership interests by gift or who are family members. It also is designed to prevent a partner who provides capital to a partnership from shifting the income generated by that capital to other partners who received their partnership interests by gift or who are family members.

There are better ways to accomplish what section 704(e)(2) is designed to accomplish. In addition, the principles of section 704(e)(2) ought to apply across the board, and not merely in the limited circumstances to which it applies. Unlike sections 704(c) and 737, which also deal with assignment of income concerns but do not have subchapter S equivalents, section 704(e)(2) has a subchapter S equivalent, so this aspect of assignment of income apparently is of greater concern to the Congress.

With section 704(b) having been amended and regulations issued under section 704(b) in the years after section 704(e)(2) was enacted, it makes more sense to incorporate the concerns of section 704(e)(2) in section 704(b). In determining a partner’s interest in a partnership, including a partner’s interest in the income, gain, loss, deduction, and credit items of a partnership, the extent to which a partner’s services or capital generates the partnership’s income is a factor that needs to be taken into account. The repeal of section 704(e)(2), and its accompanying section 704(e)(3), needs to be done in tandem with the enactment of language in section 704(b) that states, “In determining a partner’s interest in a partnership, including a partner’s interest in the income, gain, loss, deduction, and credit items of a partnership, the extent to which a partner’s services or capital generates the partnership’s income is a factor that must be taken into account.”

In determining whether a partnership exists, it is necessary to identify at least two partners. The question of whether a individual or entity is a partner is wrapped up in the question of whether a partnership exists. These questions are factual in nature. Though the “check the box” regulations provide some rules, ultimately the initial question is whether an entity exists that ultimately can be classified as a partnership. In light of these regulations and the questions that must be answered, one is left wondering why section 704(e)(1) continues to exist.

Section 704(e)(1) provides that “a person shall be recognized as a partner . . . if he owns a capital interest in a partnership in which capital is a material income-producing factor. . .” Section 704(e)(1) was enacted in response to the Supreme Court’s decision in Culbertson, which essentially tagged the question of whether a person is a partner as a factual question. To the extent section 704(e)(1) was intended to reduce the amount of factual analysis necessary to answer the question, it has failed. First, it only applies to certain partnerships, and is of no value for partnerships in which capital is not a material income-producing factor. Second, section 704(e)(1) takes one factual question, namely, does the person in question intend to be a partner, and turns it into two questions, namely, when is capital a material income-producing factor in a partnership and what does it mean to own a capital interest.

The process of determining whether a partnership exists should also determine who the partners are. This is true even if two persons are identified as partners and the status of a third person is in question. The reason is that the technical question is whether a partnership exists among all three persons, not whether the third person is a member of a partnership between the first two persons.

In any event, no matter how the issue of whether a person is a partner is resolved, section 704(e)(1) is of no help whatsoever. Its repeal not only would remove useless language from the Internal Revenue Code, it would eliminate the need to answer the two questions of when is capital a material income-producing factor in a partnership and what does it mean to own a capital interest.

One of the more complicated areas of Partnership Taxation is the treatment of contributed property. Sections 704(c) and 737 are challenging, not only in terms of language, but also in terms of application and computations. These provisions are necessary to the extent it is necessary to prevent gain or loss inherent in property contributed by one partner from being shifted to other partners. But how necessary is that goal? The answer can be found by looking at S corporations.

If an S corporation shareholder contributes appreciated or depreciated property to the S corporation, the gain or loss recognized by the corporation, which includes the gain or loss inherent in the property when contributed, is allocated among all the shareholders. Thus, the inherent gain or loss is shifted to other shareholders. Why is there no section 704(c) and section 737 equivalents in subchapter S? Apparently, preventing the shifting of the gain or loss isn’t as terribly important as one might have guessed. The practical explanation probably is that enacting section 704(c) and section 737 equivalents in subchapter S would make subchapter S “too complicated.” So why is it acceptable to have a “too complicated” subchapter K when it comes to contributed property?

Until and unless subchapter S is graced with section 704(c) and section 737 equivalents, subchapter K ought to be relieved of a computational and interpretational complexity that does not afflict subchapter S. Surely the shifting of income and loss either is good or bad, but whatever it is, it ought to be the same whether it is being done by partners or by subchapter S shareholders.

For students who think that tax law is nothing more than a set of rules that they need to memorize, I emphasize that there are numerous situations in which not only must the rules be applied to a variety of different factual situations but also situations in which the rules are not known and advice to clients must be based on a careful analysis using comparative application of other provisions. One such example in the subchapter K area is illustrated by the following question. Is a loss carryforward under section 704(d) available to a transferee of the partnership interest? Those unfamiliar with tax, and even those somewhat familiar with tax, are likely to conclude that the answer is in the Code, the regulations, an administrative issuance, or a court decision. But in this instance they would be in for a surprise. There is no authority providing an answer to that question.

When I taught Partnership Taxation, I did not try to provide the students with an answer to the question of whether a section 704(d) loss carryforward is available to the transferee of a partnership interest, though some students reacted negatively to the lack of a definite answer. Instead, I encouraged them to look at other provisions in the tax law that deal with the transfer of losses, an approach which also bothered some students who considered forays outside of subchapter K to be “irrelevant” to the course. I pointed out to them that there are provisions that prohibit or discourage the transfer of losses. I also pointed out to them that there are provisions that permit the transfer of losses. Finally, I directed them to examine the language of section 1366(d)(2)(A), which provides that the corresponding S corporation loss carryover is available “with respect to that shareholder,” referring to the shareholder who owned the stock when the loss pass-through was disallowed.

So why, I asked and continue to ask, does the language “with respect to that partner” not appear in section 704(d)? Should its absence be interpreted as an intent by Congress to permit the 704(d) loss carryforward to be available to the transferee? There are canons of statutory construction that would permit that conclusion. From a policy perspective, is there any reason to treat section 704(d) losses and section 1366(d) losses differently when it comes to the treatment of the transferee? I use this issue to demonstrate the difference between the issue of what the law should be and the issue of what the law is as demonstrated by the question of what one tells the client.

The answer to this one is easy. Section 704(d) and section 1366(d) loss carryforwards, in terms of availability to the transferee, must be treated in the same manner. Preferably, section 704(d) should be amended to include the language “with respect to that partner.”

The language of section 705, which provides for the computation of a partner’s adjusted basis in a partnership interest, is unwieldy and requires inefficient calculations. Section 705 provides that basis equals basis reflecting the contribution of money or property and basis reflecting purchase price, increased “by the sum of [the partner’s] distributive share for the taxable year and prior taxable years of” taxable income, tax-exempt income, and excess depletion, and decreased by distributions and “by the sum of [the partner’s] distributive share for the taxable year and prior taxable years” of losses and non-deductible expenditures not chargeable to capital account.

For example, consider X, who contributed $100 to a partnership at the beginning of year 1. X’s distributive share of the partnership’s taxable income for year 1 is $50, for year 2 is $60, for year 3 is $30, and for year 4 is $80. There are no other partnership items and no distributions. Following the statute, X’s adjusted basis at the end of year 1 is $150 ($100 plus $50). Following the statute, X’s adjusted basis at the end of year 2 is $210 ($100 plus $50 plus $60). Following the statute, X’s adjusted basis at the end of year 3 is $240 ($100 plus $50 plus $60 plus $30). Following the statute, X’s adjusted basis at the end of year 4 is $320 ($100 plus $50 plus $60 plus $30 plus $80). This example, of course, is too simple. Imagine what the computation looks like in the fifteenth or twentieth year, and imagine, as likely is the case, that there are items of tax-exempt income, losses, distributions, and non-deductible items not chargeable to capital account.

What happens in practice, of course, is that practitioners begin with adjusted basis as of the end of the previous year, and then add the items for the current year to compute adjusted basis as of the end of the current year. Thus, in the example, X’s adjusted basis at the end of year 3 would be computed by adding $30 to $210.

Is it possible to rewrite section 705 to reflect practical reality? Of course. The model already exists. Section 1367, which provides for the computation of a shareholder’s adjusted basis in S corporation stock, provides that basis “shall be increased for any period by the sum of [the various items] determined with respect to that shareholder for such period.” Section 1367 is a newer provision than section 705 and reflects advances in technical drafting that took place during the intervening years. There is no good reason not to clean up section 705 so that it parallels section 1367.

For as long as I had been teaching Partnership Taxation, students have asked why section 707(b) exists. The question is not why the substantive rules of section 707(b) exist, as the answer to that question is simply to prevent abuses in terms of characterization and loss shifting. The question is why not simply make sections 267(a)(1) and 1239 applicable to partnerships. In fact, section 1239 does apply to partnerships and thus, in some ways, duplicates section 707(b).

My guess is that those drafting the original subchapter K worked in isolation and did not view subchapter K as part of a larger tapestry. Even to this day, it is not uncommon to observe proposed tax legislation, and even enacted tax legislation, that demonstrates a lack of cohesion with other provisions in the tax law. Granted, my suggestion would not change the law, and thus would not simplify tax compliance and practice, but it would make the Internal Revenue Code shorter and more concise. Every little bit helps.

Under sections 771 through 777, certain partnerships with 100 or more partners are permitted to elect simplified treatment for computing taxable income, for reducing the number of separately stated items, and for combining items that would be separately stated under the generally applicable subchapter K provisions. From a technical perspective, these special provisions distort partners’ income and loss because they circumvent the limitations and other restrictions that would apply at the partner level.

The justification for these provisions is simplification of what would otherwise be complicated computations for these large partnerships. Yet partnerships with fewer than 100 partners are not relieved of these computational complexities and challenges. It is odd that the large partnerships, in a better position to afford the professional assistance or software to do the computations, are afforded relief unavailable to smaller partnerships generally not in quite the same position to afford the tax preparation help.

These special provisions were added sixteen years ago, before tax preparation software had evolved into the relatively sophisticated programs that are now available. If a partnership with 97 partners is required to comply with sections 702 and 703, there is no reason that a partnership with 103 partners ought not be in the same position.

There are two possible solutions to this disparate treatment. One is to repeal the special provisions. The other is to make them available to all partnerships. Technically, the better solution is to repeal the special provisions. That is what I would advocate. The existing caste system for partnerships is simply wrong.

The treatment of charitable contributions as not part of a partnership’s taxable income under section 703(a)(2)(C) adds unnecessary complexity to the process of determining distributive shares. The only possible justification for excluding charitable contributions from taxable income is the fact that the deductibility of charitable contributions by the partners depends on each partner’s particular adjusted gross income and other charitable contribution transactions. Yet the same can be said for items such as capital gains and losses and section 1231 gains and losses, but those items are not kept out of the computation of taxable income.

Separating the charitable contribution deduction from the computation of taxable income also adds complexity to the computation of the partner’s adjusted basis in the partnership interest. Rather than being included in the increase on account of taxable income, charitable contributions must be taken into account separately under section 705.

There is no reason not to leave charitable contribution deductions as part of taxable income, just as the capital loss deduction is part of taxable income. The separate statement of items requiring particularized treatment by partners is sufficient to preserve the character and other attributes of charitable contributions in the same way it preserves the character and other attributes of capital losses, and the other hundreds of items that require separate statement treatment.

A simple repeal of section 703(a)(2)(C) solves the problem. Section 702(a)(7) and the regulations under section 702 already contain language that would require the separate statement of the charitable contribution deduction.

Though the debate over the treatment of carried interests has been long, deep, and intense, for me, the solution is easy. To the extent that a partner provides services, in contrast to investment capital, the income or gain that the partner derives from the partnership should be treated as ordinary compensation income to the extent of the value of the services provided. Because the question ultimately is a factual one, that is, the value of the services that have been provided, the outcome in each situation will depend on a variety of factors and will be resolved through the usual process of negotiations among the parties, IRS audits, and litigation. Though the proposed principle can be applied beyond subchapter K, the focus of the proposal is on the appropriate tax treatment of compensation received by partners for providing services.

As an example, consider a partnership formed by three individuals, A, B, and C. A and B each contribute $100, which is used to purchase several assets that are not depreciable and that are not ordinary income assets. C contributes services and is promised one-third of the partnership’s value after subtracting the $200 contributed by A and B. C is not entitled to any income generated by partnership operations, and is not responsible for partnership losses. The partnership earns $500 of income each year, which is allocated to A and B and which is distributed to them. At the end of five years, the partnership terminates by selling its assets to X for $2,600. The partnership section 1231 gain is $2,400. It is allocated equally among the partners. Of the $2,600, $900 is distributed to A, $900 to B, and $800 to C. Under current law, C reports $800 of section 1231 gain, and in the absence of any other 1231 transactions, treats the $800 as capital gain, thus avoiding ordinary income taxation for amounts that reflect services provided by C.

Alternatively, assume that instead of selling its assets to X, the partnership distributes $100 to each of A and B, so that the partnership has a value of $2,400 and each partnership interest is worth $800. X acquires the partnership by paying each partner $800 for each one-third partnership interest. Under section 741, C reports long-term capital gain of $800. Again, under current law, C is obtaining capital gain treatment for amounts received for performing services.

It is possible that the services performed by C are worth only, say, $500, and that the other $300 is a result of appreciation in the assets of the partnership in which C has an interest. That is why the proposal is not to treat all of C’s gain as ordinary income, but only a portion reflecting the value of the services that C has performed. Though determining that the services are worth $500 requires factual analysis particular to each case, that sort of analysis already is done with respect to the same sort of issue in other areas of the tax law, for example, reasonable compensation determinations.

Now that, barring unexpected and extraordinary developments, I am no longer teaching Partnership Taxation, it is an appropriate time to share revisions to subchapter K that would not only improve tax practice and administration but also make the subject matter easier for students and practitioners. I am not focusing on wholesale revisions of subchapter K, such as those currently being floated to combine subchapters K and S. Those sorts of revisions are far less likely to make it into law than are smaller-scale tweaks. In sharing these thoughts, I have given no attention to revenue effects. Some of these changes probably increase revenue, some decrease revenue, and many would have such a negligible overall effect that it’s not worth even trying to focus on the question at this point.

Why did I wait until I finished teaching Partnership Taxation? I did not want students to conclude that what I happened to think should be done with a particular subchapter K glitch is the law, as students often decide, or that my proposal should be the focus of their attention. In contrast, I gladly pointed out the glitches and repeatedly pointed out the need for the Congress to something about the problem. In many instances, I suggested to students that if they needed a topic for their required tax paper course, they could dig into one or another of these problems. In many instances, I shared the arguments that could be made for one particular solution or another, but left students with the precautionary note that what I thought should be done wasn’t worth anything more than what any of them thought should be done.

The proposals do not extend to changes that extend beyond subchapter K even though they would simplify subchapter K. For example, the special treatment of capital gains and losses accounts for a substantial amount of complexity in subchapter K, and elsewhere, but that discussion is one that transcends subchapter K and thus is beyond the scope of the revisions I plan to discuss.

I have identified nineteen changes that I would make to subchapter K or to the regulations under subchapter K. Surely there are more things that need attention, but I am not trying to be exhaustive. My goal simply is to put these on the table, until someone either removes one or more for further study and development or sweeps them off the table to make room for something else. I address these changes in the sequence in which they were discussed in the Partnership Taxation course.

When I was a child I was told, and of course I long since saw actual evidence, that during World War II Americans were encouraged to be very secretive about all sorts of things. “Loose Lips Sink Ships” was one of several slogans that were circulated among citizens. It isn’t difficult to understand why so much information directly and indirectly related to the war effort was kept under wraps, disclosed to few, and in some instances put away until years after the war ended.

Now comes a report that Senators have been promised by the Finance Committee that their tax reform proposals will be kept secret from America for 50 years. Presumably, if tax reform moves forward and proposals make it into publicly disclosed legislation, no one will know which Senator or Senators suggested, pushed for, or sponsored a particular provision in the legislation.

What’s the point of keeping tax reform proposals secret? Are there comparisons to keeping military plans hidden from the enemy? It seems that the reason for the confidentiality promise is to protect Senators from retaliation by their campaign contributors. In other words, the secrecy is to protect the system that now afflicts American politics, namely, the purchase of legislators and the funding of special interest legislative provisions by those wealthy enough, selfish enough, and arrogant enough to do so.

Tax law legislation should reflect what is best for the country. It ought not be the outcome of secret back-room deals between legislators and well-funded lobbyists. It’s “of the people, by the people, for the people,” not “of the people with money, by the people with money, for the people with money.” Instead of hiding things, there ought to be a disclosure of the names of people, corporations, and other entities that obtained existing tax law provisions through moneyed influence. To begin reform of tax law, there first needs to be reform of the tax legislative process.

A recent Tax Court Case, Williams v. Comr., T.C. Summ. Op. 2013-60, demonstrates yet again why it is important to put things in writing in a timely manner. This is a point not unlike the one I have made in other posts, such as In Tax, As in Much Else, Precision Matters.

The taxpayer was an ordained minister who entered into an employment agreement with a church in September 2005. Under the agreement, he became the church’s pastor, and received a salary of $80,000. The agreement also provided that the church would pay the taxpayer a $500 housing allowance for six months. The six month period was subject to an extension if the church’s Deacon Ministry approved. The taxpayer excluded from gross income payments received after the six-month period expired. The IRS issued a notice of deficiency that treated the payments received in 2007 as gross income.

Section 107(2) excludes from gross income “the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home and to the extent such allowance does not exceed the fair rental value of the home, including furnishings and appurtenances such as a garage, plus the cost of utilities.” Under regulations section 1.107-1(b), the rental allowance must be designated before it is paid. The designation can be in the employment agreement, in minutes, in a budget, or in any other instrument that evidences the action.

The taxpayer did not argue that the six-month period had been extended. Instead, the taxpayer provided a second employment agreement dated 2005, but signed by the church and the taxpayer in 2012. The taxpayer argued that the second agreement was intended to clarify the September 2005 agreement because that agreement was a “generic type layout contract” between the parties in which “some of the stuff * * * had not been defined”. The second employment agreement provided for a parsonage allowance that included all costs associated with facilitating proper living facilities. Accordingly, the Tax Court held that the second agreement did not designate rental allowances paid in 2007 because it was not executed until 2012.

It appears that the parties, after realizing that the September 2005 contract lacked the necessary language to trigger the section 107 exclusion for the taxpayer, decided to fix the problem. Unfortunately, the revised contract executed in 2012 was too late to provide the outcome that would have been obtained had the language in the September 2005 contract covered more than six months, had the six-month period been extended before it expired, or if the second agreement had been executed by March 2006 rather than in 2012. Whether the delay was a consequence of procrastination, of a late realization that the September 2005 agreement was inadequate, or both, is unclear, but what is clear that taking tax issues into account needs to be done when drafting contracts rather than after the fact.

Readers of MauledAgain know that I am a harsh critic of the foolish claim that reducing tax rates increases revenue. The chief flaw of that approach is that a reduction of the tax rate to zero demonstrates that rate reduction does not translate to revenue increases. It can translate to revenue elimination. Once the tax cut advocates – whether clamoring for more relief for economically battered upper classes or tax cuts for everyone in a time of war, for example – admit that their “tax rate reductions increase revenue” mantra is nothing more than an electoral ploy, they are stuck defending which tax rate works best. And on that issue, they fare badly.

On Sunday, it became clear that the “reduce tax rates” is just the tip of a bigger flawed policy iceberg. During an interview on CBS News, House Speaker John Boehner let a bit more of the agenda cat out of the bag when responding to an accusatory question. Boehner was asked to describe how he felt about presiding over one of the “least productive” and “least popular Congresses in history.” Boehner’s response was that the Congress “should not be judged by how many new laws we create,” but “ought to be judged on how many laws we repeal.” He claimed that there are “more laws than the administration could ever enforce.”

So it’s clear that the ultimate agenda of those who control the House of Representatives is to eliminate as many laws as possible. The argument that reduction in the number of laws increases law and order runs into the same absurd outcome as does the foolish “tax rate reductions increase revenue” nonsense. If Boehner concedes that zero laws is not ideal, where is the magic number? It’s the same challenge as finding the best tax rate. There is an additional factor, though, because Boehner and his comrades can make it impossible for the administration to enforce any laws, through cutting appropriations for the enforcement of laws and through enacting moratoria on the enforcement of laws. Both are tactics used by Congresses in the past.

There’s a simple reason laws are needed. People are unable to regulate themselves. If every employer took steps to put the health, safety, and welfare of employees above his or her or its profit-seeking efforts, would an OSHA be required? If no one chose to rob a bank, would laws criminalizing bank robbery be needed? If every corporation made certain to refrain from polluting air and water, would the EPA need to exist or be of its existing size?

When opponents of laws and taxes argue that the number of laws has increased during the past however many years, they fail to take into account the fact that the nation’s population has grown during those years. As the population grows, the number of potential events requiring regulation increases. The increase is not proportional to population, but proportional to the number of connections. Adding a person to a population of 300 million adds at least 300 nillion possible opportunities for behavior that require regulation that is not self-generated. Toss in the millions of corporations, LLCs, trusts, estates, partnerships and other non-people entities treated as people, and the amount of economic and personal activity that cries out for regulation grows at exponential rates that challenge the largest computers.

History will judge Boehner and his Congress. It will not award prizes for encouraging pollution, poverty, hunger, gerrymandered electoral districts, voting repression, and concentration of wealth in the elite.

A reader sent along an interesting story about the City of Philadelphia’s assessment of a tax against establishments that provide lap dances. The writer of the story suggests that Philadelphia decided to assess this tax after “[f]ailing to institute hikes on soda and cigarettes.” Though it is true that the city’s attempt to increase the taxes on cigarettes and alcoholic beverages went nowhere, as I described in Taxing Activities or Things That Can Disappear, and its repeated efforts to enact a soda tax also hit a dead-end, as I explained in posts such as What Sort of Tax?, The Return of the Soda Tax Proposal, Tax As a Hate Crime?, Yes for The Proposed User Fee, No for the Proposed Tax, Philadelphia Soda Tax Proposal Shelved, But Will It Return?, Taxing Symptoms Rather Than Problems, It’s Back! The Philadelphia Soda Tax Proposal Returns, The Broccoli and Brussel Sprouts of Taxation, and The Realities of the Soda Tax Policy Debate, it may simply be coincidence that the city has focused on compliance with its amusement tax. Or perhaps it indeed is connected in some way with the inability to collect revenue through cigarette and soda taxes.

An attorney for two of the establishments against which the city is attempting to collect the amusement tax claims that the city’s action is “financial desperation” and constitutes an attempt to “tax the same thing twice.” The attorney explained that the establishments have been paying the amusement tax as required, on “the admission fee or privilege to attend or engage in any amusement.” An unidentified “source close to the matter” explained that the lap dance is “a separate experience” and thus subject to an amusement tax.

If a fee is paid for the lap dance is in addition to the admission fee, then the amusement tax should be computed not only by taking into account admission fees but also by including amounts paid for lap dances, if in fact the lap dance is an amusement. As I told students in the basic income tax class, tax attorneys need to resolve all sorts of issues, many not involving numerical computations, and some of which give tax law practice a level of interest very different from the “tax is boring” mindset of those whose perception of tax practice is limited. Thus, the first issue* that must be decided is whether a lap dance constitutes amusement. Having never had a lap dance, and having never seen one in person, I do not know. I doubt that perceptions gleaned from news reports, documentaries, and movies are dispositive of the question. So I will let readers chime in on their conclusions. I wonder if there are folks who can be called as expert witnesses on the question. If the taxpayers’ challenge to the assessments makes it to trial, it may be worth attending for that aspect alone.

*Another issue is whether the fee paid for the lap dance goes directly to the dancers, who would be liable for the tax if it applied, or whether the fees are turned over to the establishments, which in turn would be responsible. Again, not knowing how the fees are handled precludes resolving the issue until the experts step in.

A recent Tax Court case, Nye v. Comr., T.C. Memo 2013-166, illustrates why document drafters need to pay close attention to what they are drafting, why they ought not expect judges to bail them out, and why understanding basic tax is important for all lawyers and not just the tax practitioners.

The facts are not uncommon. In 1990, John David Nye and Alice C. Nye divorced. The Florida state court’s final judgment dissolved the marriage, and incorporated and attached a separation and property settlement agreement into which the two had entered. That agreement provided that John would pay Alice alimony of $3,600 each month until she remarried or either of them died. It also provided that he would pay rehabilitative alimony of $200 each month for 30 months, also to terminate if Alice remarried or either of them died. The agreement provided that at the earlier of John’s death or the death of both of his parents, he would transfer to Alice title to certain real property in which his parents were then living. The agreement also provided that if Alice decided to purchase a residence within three years of the date of the agreement, John would provide her down payment assistance not to exceed $10,000. The agreement further provided that John would attempt to obtain and would maintain major medical health insurance for Alice, but if she was uninsurable or he could not obtain insurance, he would pay her $150 each month for as long as he was obligated to pay the $3,600 monthly payment.

In 2006, Alice filed for additional alimony and additional medical insurance funds. In 2007, John and Alice entered into a second agreement, in which John agreed to pay Alice $350,000 before March 6, 2008, and in which Alice agreed to quitclaim certain real property to John. The agreement provided that once those transfers had been made, all obligations from John to Alice would terminate. John made the payment, and the state court issued a final judgment incorporating and approving the second agreement.

On their 2008 federal income tax return, John and his then wife claimed an alimony deduction of $350,000. The IRS allowed $3,750 to reflect one month’s payment of $3,600 and $150, and disallowed the other $346,250.

The Tax Court agreed with the IRS. It pointed out that a deduction under section 215 for alimony paid requires that the amount in question qualify as alimony or separate maintenance payments under section 71(a), which also would require the payee to include the payment in gross income. Under section 71(b), a payment does not constitute alimony or separate maintenance payments unless, among other things, the obligation to make the payment does not survive the death of the payee and there is no obligation to make a substitute payment after the payee’s death. The Court first examined the agreement to determine if there was any provision specifying whether the obligation to pay the $350,000 survived the payee’s death, and determined that no such provision existed. The Court accordingly examined Florida law and concluded that under Florida law, as set forth in several cases, including one very similar to the Nye situation, the obligation did survive the payee’s death. Accordingly, the payment did not qualify as alimony or separate maintenance payments, and no deduction was allowable.

The lesson is simple. If the alimony deduction is desired, the payor must persuade the payee not only to agree to the concomitant gross income inclusion for the payee but also to accept the risk of having the payor’s obligation terminated if the payee dies before the payment is made. An offer to increase the payment to compensate the payee for the payee’s income tax liability on the gross income inclusion and to cover the actuarial cost of the death risk might bring about success in the attempt to obtain the payee’s agreement. The agreement signed by both parties ought to reflect what they have agreed to do, and the question of whether the obligation survives the payee’s death should be set forth in the agreement, particularly if state law provides, in the absence of an agreement, for an outcome contrary to what the parties intend.

It is unclear what the parties in this case intended. It is obvious that the payor desired a deduction, but it is unclear whether that desire was communicated to the payee’s attorney by the payor’s attorney. It is unclear whether the issue was discussed. It is unclear whether the issue was considered when the agreement was drafted, and whether the lack of a provision was the consequence of a deliberate decision not to address the issue or the consequence of the issue not being considered at all. The court is not in a position to guess what the parties intended or what they discussed. It is the responsibility of the parties, and their lawyers, to deal with the issue, resolve the issue, and to draft the agreement in accordance with that resolution.

Among the many political decision that I consider foolish, privatization of functions that belong in the public arena is high on the list. Privatization takes control away from taxpayers, and in some instance even the legislators foolish enough to fall for the private sector’s siren song. Privatization increases the cost of services, a cost borne by taxpayers in their role as consumers of the product or service in question. Privatization usually fails to generate increased efficiencies. Privatization puts profits in the pockets of a small, elite segment of the private sector that would not exist but for those elite dipping into the public till. I have explored these concerns in earlier posts, including Are Private Tolls More Efficient Than Public Tolls?, When Privatization Fails: Yet Another Example, and How Privatization Works: It Fails the Taxpayers and Benefits the Private Sector.

Now comes a report that the privatization of the tax refund process in Virginia is yet another kick in the face of ordinary taxpayers, this time in Virginia. Republicans who control Virginia’s legislature, working with the state’s Republican governor, passed and signed a law that required the Department of Taxation to stop issuing refund checks, except in unusual situations, and to replace the checks with debit cards issued by a private sector entity. Accordingly, the Department of Taxation contracted with Xerox Corporation to provide debit cards issued by Comerica Bank, at no cost to the state. However, Xerox was given the right to charge fees in connection with the use of the debit cards.

So how has this privatization move worked out? The simple answer is bad for the taxpayers, good for the folks at Xerox and Comerica.

As explained in this report, taxpayers attempting to transfer their refunds into their bank accounts are being charged $2. When they call to find out why, they are charged $1 per call. Getting through to a live human is almost impossible. Taxpayers who try to dispute fees are charged yet again for calling customer service. One taxpayer, told that the fees would be reversed, called after nothing happened for almost two weeks, and was then charged another fee for making that call. Another taxpayer who tried to use an automated phone system to make the transfer but who cancelled the process when a pre-recorded voice explained that the transfer would take two days, discovered that he nonetheless had been charged for using the automated phone system. When he called again in an attempt to get the fee cancelled, he was “put on hold for 1 hour and 51 minutes before being hung up on.” Some banks refuse to permit cash withdrawals from the debit cards. Banks also are refusing to provide cash withdrawals to taxpayers holding debit cards if the taxpayers do not have accounts with the bank. Apparently, other problems have arisen because the Department of Taxation has referred to efforts to deal with unidentified other issues.

Of course, the Department of Taxation attributes the problems to the challenges of starting up the privatization process. Xerox claimed that there was a problem but that it was unable to fix it quickly. Perhaps Xerox ought to stick to photocopiers and leave the tax refund business to Department of Taxation professionals who aren’t trying to masquerade as photocopier manufacturers. Surely the Department of Taxation is investing more time and resources dealing with the mess than it would have expended had the privatization stunt not been enacted. Comerica refused to comment. I wonder why.

As one frustrated Virginia taxpayer put it, “There certainly isn’t any incentive for the card provider to operate in a just, moral fashion.” But perhaps there are a bunch of $1 and $2 incentives for Virginians to vote out of office the Republicans who have sold out to the segment of the private sector that continues in its attempt to take over the nation.

Mike Razar, at American Thinker suggests, surely tongue-in-cheek, that the federal tax system should be reformed by abolishing the IRS and basing tax collection on the honor system. Doing this would be a most interesting experiment. Granted, it would be dangerous, but educational.

One key question is the definition of “honor system.” To me, an honor system means that a requirement exists to do or to refrain from doing something, and though no one is enforcing the requirement, compliance is mandatory. To others, an honor system means “comply if it suits you.” Though some honor systems use random enforcement as an incentive to encourage compliance, that is not what Razar is suggesting, because the current federal tax system uses that approach. Razar is describing a system where no enforcement exists.

Another key question is which existing system provides the best comparison. For example, what sort of compliance rate exists under existing honor systems for stores in small towns when the proprietor needs to step away from the counter? Compliance with certain laws is quite high, even in the absence of visible enforcement. On the other hand, compliance with speed limits is almost non-existent except when heavy traffic eliminates all other options.

The effectiveness of the honor system depends on the culture, norms, and self-discipline of a society. I’m told, for example, that in Japan, because stores are so small, people leave their packages at the door, and they are there when the patrons exit. On the other hand, consider that, according to this article, airport baggage retrievals are no longer on an honor system in many South American and Asian countries, suggesting that the incidence of theft had become too high. Hotel mini-bars, once based on a absolute honor system, are now rigged with computer sensors that automatically charge the guest’s invoice. I am confident that the compliance rate was so low that hotels computed a revenue recovery in excess of the cost of the refrigerators equipped with computer sensors. Quite recently, according to this story, the honor system has been ditched by the Los Angeles Metro system. In the tax world, to use this article as one example, compliance with the use tax is woeful. So it’s fair to predict that an “honor system” approach to federal taxation would reduce revenues tremendously.

Why are honor systems generally so ineffective? The answer is that the primary incentive for compliance, shame, has lost its power in present-day culture. I discussed this phenomenon in the context of taxation in Taxes, Citizenship, and Shame. Cheating, Taxes, and Shame, Taxes, Citizenship, and Something More Than Shame, and Raising the Tax Shame Noise Level. Surveys show that most people do not consider cheating on taxes to be shameful. I concluded, “We live in an age when shame does not have the effect it once did.” A person needs only to look around for a few hours, for example, by sitting and watching people in a shopping mall, to understand why I, and others, have reached this conclusion.

The bottom line is that no tax system works unless there is some sort of enforcement authority. Whether it is called the Internal Revenue Service, the Department of Revenue, the Bureau of Internal Revenue, the Division of Taxation, or the Franchise Tax Board does not matter.

One of the questions posed to me, especially by several high school and elementary school classmates, is how the math-and-science guy ended up in law, a social science. The answer is both simple and complex. The simple part is that math and science thrive in tax law. The complex part is that many other disciplines are wrapped up in law, and my intellectual interests are nowhere near as constrained as they appeared to my classmates.

My fascination with numbers and structures reaches back to very early childhood. So it’s no surprise that over the years I have enjoyed reading and taking courses in arithmetic, science, computer programming, and languages. But I have also immersed myself in books and courses dealing with history, theology, and geography.

The path to taxation is easy to describe. When, in high school, I decided to apply to the University of Pennsylvania, the undergraduate business program at Wharton grabbed my attention. When I arrived at Wharton and started selecting my courses, I was drawn to accounting, which to me was a combination of math, science, and language. One of the advantages of the Wharton undergraduate program at the time was its business law department. I took every available course, benefitting from sitting in courses taught by outstanding practitioners and law faculty. At about the same time I started working part-time for an accounting firm. The partners quickly detected my facilities with tax, and had me preparing and reviewing returns within months of my arrival. They began to talk of bringing me in full-time after I graduated, to be groomed to replace the tax partner who was nearing retirement. But I had noticed that among the firm’s clients were a dozen or so law firms, some of whose partners were doing tax work and bringing home significantly more than the accounting firm partners were earning. It was one of the few times in my life that dollar signs influence me more than I would have expected. I decided to attend law school, explaining to the partners that it would make me better at dealing with tax issues. And that was the route I was ready to take until I arrived at law school, the teaching urge resurfaced, and I changed directions. It was all for the better, because the accounting firm merged with another firm and eventually was absorbed into oblivion. I doubt that I would have ended up as the firm’s partners had projected. It was, as it often is said, all for the better. And the rest, as they also say, is history.

Two of the tasks that teachers do, though some don’t list it among their most favorite aspects of teaching, are creating examinations, quizzes, and similar assessment devices and grading student responses. Creating a valid and fair assessment device is not easy. Getting the right mix of questions of high, medium, and low difficulty requires a combination of experience and awareness of the goals of the course. Grading a well-designed examination isn’t as simple as many people think that it is.

Though I had administered quizzes when I was teaching Latin to eighth-graders many years earlier, examination administration and grading were not parts of the other teaching activities in which I had engaged. So it was with some degree of delight that I responded in the affirmative when the Chief Judge of the Tax Court asked me, and another attorney-advisor, to design and prepare the examination administered to non-lawyer tax practitioners who want to be admitted to practice before the court.

We did not construct the exam in a vacuum. Our work product was reviewed by several judges. We were quizzed on why we included the questions we had selected. We were asked why and how we developed the choices that were offered on the multiple-choice questions. When it came time for me to prepare my first law school examination as a law professor, I could look back and make use of what I had learned from developing the Tax Court’s admissions exam. That exam was superseded time and again during the more than 30 years that have since zoomed by.