MauledAgain

A recent case, Chapel v. Comr., T.C. Memo 2014-151, illustrates why the “tax is numbers” mentality that convinces too many law students to ignore tax courses is so wrong. Though numbers matter, much of tax analysis involves words. In Chapel, a divorce decree incorporated a separation agreement into which two spouses had entered. The agreement provided that the former wife would receive “[a]n award of property settlement in the sum of $63,500.00, which amount shall be paid within thirty (30) days” of June 6, 2008. The agreement also provided the former wife an additional property settlement of $85,723. The agreement contained separate provisions under which spousal support would be paid to the former wife until she remarried or died or the former husband died.

In each of the first seven months of 2008, the former husband wrote checks to the former wife. The first five were for $4,300, the sixth for $4,944.33, and the seventh for $321.34. He also wrote a check, on July 23, 2008, for $63,500. The words “spousal support” were handwritten on the check and then crossed out. The former husband deducted $90,264 as alimony on his 2008 federal income tax return, with no explanation for the $1.67 discrepancy between that amount and the $90,265.67 total of the eight checks. The amount of another check, written in September for $3,761, was not deducted.

The IRS issued a notice of deficiency, determining that $63,500 of the payments was not deductible because it was a property settlement payment and not alimony. The Court concluded that the payment failed the requirement of section 71(b)(1)(B), which provides that, among other things, a payment is not deductible alimony unless “the divorce or separation instrument does not designate such payment as a payment which is not includible in gross income under this section and not allowable as a deduction under section 215.” Because property settlement payments are not alimony, designating a payment as a property settlement is the equivalent of designating it as not includible in gross income and not deductible. The Court relied on several facts. First, the agreement stated that the former husband was required to make a $63,500 property settlement payment. Second, the $63,500 was provided in one category of issues addressed by the agreement, and spousal support, or alimony, was addressed in another category. Third, the July 23, 2008 payment was the exact amount of the property settlement specified in the agreement.

The Court rejected the former husband’s argument that the July 23, 2008 payment was an alimony payment reflecting proceeds of his sale of stock, and that the $63,500 property settlement payment required by the agreement had been made in another transaction. The bank statement provided by the former husband to prove that the $63,500 payment was made in another transaction contained no information supporting that claim.

The former husband lost more than a deduction. The Court upheld the IRS imposition of the section 6662(a) accuracy-related penalty.

Words matter. The parties in Chapel could have arranged their financial settlement differently, reducing the property settlement and increasing the alimony. There are non-tax reasons why this might not appeal to one or the other of the parties. It is unknown whether they considered other options, but once they agreed that there would be a $63,500 property settlement payment, it was too late, when it came time to file the tax return, to characterize the payment as something other than a property settlement payment. Words matter. They tell us what we can do with the numbers.

Now that public attention is being turned to the corporate inversion tax-savings scheme, the spin doctors are coming out in full force. Nothing inspires the anti-tax crowd as fervently as any sort of criticism of, or legislative attack on, their inability to understand or accept the apportionment of social costs.

In Tax inversions help, not hurt, the economy, Diana Furchtgott-Roth argues that corporate inversions “have benefits for the American economy.” She claims that, “They make it easier for companies to invest in the United States.” She points to the 35 percent marginal rate as imposing a 35 percent cost on bringing overseas earnings back into this country. The flaw in that argument is that a variety of deductions and credits reduces the EFFECTIVE tax rate from the NOMINAL rate to a much lower rate. This is the same flaw in reasoning that underpins the claims that the wealthy pay more than 40 percent of their income in federal income taxes, when in fact that is a MARGINAL rate and not the AVERAGE rate. That’s why comparing nominal rates in various countries is irrelevant. In her example, if a company brought back earnings to construct a factory, it would reduce its taxes through depreciation deductions. Of course, that’s not what the shareholders want to do. They want to bring back the earnings to put into their pockets, for subsequent re-transfer abroad, and that sort of transaction would be taxed, as it ought to be.

She claims that inversions “raise profits for U.S. shareholders, who can channel more funds back to America.” If inversions raise profits, they do so by cutting taxes, not by increasing productivity. If those profits are paid to U.S. shareholders, yes, they CAN bring funds back to America, but the question is, will they? The answer is no. Just as the “cut our taxes, we’ll re-invest the increase in our after-tax income in jobs” promise turned out to be the cry of a Pied Piper, so, too, the promise of re-investment in America is simply a case of corporations and their shareholders taking a page out of the Bush tax cut playbook. And we know who lost that game. Not the people getting the tax cuts.

If, as she claims, foreign corporations have an advantage over domestic corporations when it comes to investing in America, the answer is easy. Increase taxes on the activities of foreign corporations in this country to the point where the advantage is negated. What she fails to mention is that these foreign companies are owned by shareholders not only abroad but also in the United States. The much better solution, one that is beyond this post and way beyond political possibility, is to tax corporations the way we tax S corporations, a solution that I can support. Furchtgott-Roth seems to endorse that sort of approach, but fails to mention the political roadblocks, which will be steeper than those effectively raised when Congress tried to do the simple thing of requiring withholding on dividends.

Another point to remember is that the reason other countries have lower NOMINAL rates on corporations is that they have higher rates on individuals. But the anti-tax advocates don’t want that. They want the elimination of taxes so the resulting failure of government opens the door to ownership and control of the citizenry by the self-appointed, non-elected one-tenth of one percent.

In Three Cheers for Tax Inversions, Ross Kaminsky makes similar arguments. Yet he, too, confuses NOMINAL rates with EFFECTIVE rates. Few, if any, American multi-national corporations are paying 35 percent of their income in federal income taxes, not with the variety of tax breaks provided by their friends in Congress.

Kaminsky brings up the “we’re good for you so don’t tax us” canard. He rejects the idea that corporations should pay taxes because they gain benefits from doing business in the United States. Instead, he spotlights the gains these companies bring to the United States. If he pushed his reasoning to its limit, no one should pay any taxes because everyone brings a benefit by being here. High-taxed middle-class workers surely bring benefits to this country on account of the goods they manufacture and the services they provide. Everyone who eats food brings benefits by injecting money into the economy by buying food. It smacks of the perspective that the one percent are far more valuable to society than the 99 percent.

Kaminsky then argues that “Companies don’t pay tax; people do.” But, the Supreme Court has said corporations are people. They contribute to political campaigns. They even have religious beliefs. So, as people, they can pay taxes. Yes, I’m being a bit facetious, but the “Companies don’t pay tax; people do” argument is a red herring.

Kaminsky reveals his underlying philosophy when he describes the paradise created by eliminating corporate income taxes. Money would go to consumers, workers, and shareholders rather than to “our wasteful and largely incompetent government.” Again, we saw what happened when this argument was pushed in favor of the tax cuts for the wealthy. His suggestion that corporations would raise worker pay flies in the face of what has happened since 2001. The increase in after-tax cash flow has poured into the overseas coffers of the wealthy, while the economic position of workers has declined.

On the other hand, eliminating the corporate income tax and taxing corporate income in the way S corporation income is taxed, as Kaminsky seems to suggest, makes sense and is an approach I can support. Kaminsky, like Furchtgott-Roth, doesn’t mention the opposition to that approach that would come from the anti-tax crowd. Also, like Furchtgott-Roth, Kaminsky claims that foreign corporations have an advantage over American corporations, but he doesn’t explain why that advantage cannot be eliminated by taxing those corporations when they do business in this country. If other nations want to cut corporate taxes and make up the difference by taxing individuals, so be it, though that, too, is an option that exist for this country though, again, the anti-tax crowd will oppose it because its goal is the elimination of all taxes.

Kaminsky is disturbed by the idea that the nation needs “a new sense of economic patriotism, where we all rise or fall together.” He finds this even more upsetting than the claim that “There is nobody in this country who got rich on his own.” In an attempt to spin around from reality, he claims that “There is nothing patriotic about being a slave to your country and unable to succeed on your own efforts, courage, and creativity.” Aside from the fact that a good chunk of the wealthy did nothing but emerge from their mother who happened to be wealthy or happened to have hooked up with wealthy, those who were not born into wealth but attained wealth status did not get there on their own. They used public infrastructure. They were protected by public military and public police. They were also protected by public social norms. They were enabled by customers and clients who tolerated their flaws. Those underlying structures cannot exist without government, because there is no such things as an unregulated free market. Without regulation, markets become the playground for economic bullies. When Kaminsky claims “I don’t succeed or fail based on whether my neighbor does,” he totally misses the point. If your neighbor cheats in the marketplace, steals your trade secrets, cyber-attacks your data, or damages the pubic infrastructure on which you rely, it not only can impede you, it can destroy your business. Ask the folks who dealt with Enron, Adelphia, Worldcom, and that wonderful parade of losers.

Furchtgott-Roth asks, “What is more American than doing what is best for your company?” The answer is, doing what is best for America no matter what it does to the company. That is what America did during World War II. If today’s generation of “capitalists” were the folks around back in the 1940s, we’d be speaking German or Japanese. The better question for these right-wing economists who think they know everything about money is one that determines if they understand the bigger picture. “What’s worse than godless communism?” The answer? “Godless capitalism.” And ultimately, that is what is wrong with twenty-first century global capitalism.

My recent post on the latest developments in the attempt by Philadelphia to subject lap dances to the amusement tax, Philadelphia Lap Dance Tax Effort Bumped Up to Court, Which Grinds It Down, inspired a reader to ask me if I had seen a recent story about the judicial decision treating strippers as employees for labor law purposes.

Though there are some differences between the tests used for labor law and for tax law purposes when trying to decide if someone is an employee or independent contractor, the analysis in the case is quite similar to that found in tax cases. It is reasonable to assume that when the tax aspects of these arrangements are raised, that the analysis will end up bringing a court to the same outcome.

According to the decision by a federal district judge in Philadelphia, the strippers are employees, and thus must be paid minimum wage, must be compensated for overtime work, and are entitled to retain all of their tips. The judge based this conclusion on these facts:

-- the club at which the strippers work determines the price paid by customers, and dictates the length of lap dances.
-- the club requires the strippers to share their tips with the club’s DJ, “house mom,” and “podium host.”
-- the club fines the strippers for arriving late, leaving early, using cell phones, chewing gum, entering and leaving the stage other than through the stairs, or not wearing their hair down.
-- the club specifies how the strippers are to make themselves appear physically, providing a salon on the premises for this purpose.
-- the club requires strippers to work at least four shifts a week to avoid paying shift fees.
-- the club keeps each stripper under management review.

The bottom line is that the club controlled the strippers’ work. That is the same principle that underlies the approach taken for tax purposes.

That the IRS and state revenue departments will be paying attention to this decision is evident from the amount of money involved. There’s quite a bit of FICA, unemployment compensation tax, worker compensation premiums, and withholding when an employee stripper can earn, according to the club, as much as $1,600 per shift. With a minimum of four shifts per week, the arithmetic suggests a stripper could bring in north of $300,000 in a year.

Too often, those trying to make even more money, including schemes taking advantage of tax law provisions, are blinded by visions of short-term gain because they cannot see past the glittering buckets of gold. Thus, they fail to see what is waiting in the wings, or what is lurking behind the horizon. Savvy investors know that the long-term mattes no less than the short-term, because even with time value of money being taken into account, omitting long-term effects is a recipe for disaster. Of course, sometimes that disaster is foisted on unwitting investors who consider this shortcoming by others to be yet another opportunity to funnel wealth into their insufficiently-filled bank vaults.

Recently, the public and some politicians have had their attention drawn to corporate inversions, a technical tax-elimination ploy with which international tax practitioners have been familiar for more than the few months the topic has made headlines. Dozens of American companies, resting on the principle that their shareholders ought not ever pay taxes and deserve infinite rates of return on their investments, have resorted to the inversion trick, prompting outcries from politicians. But politicians are not a threat to the inversion game, because collectively they lack the willingness or ability to do anything about it, thanks to being owned by the very companies using the technique.

But the public poses a very different, and real, concern. Recently, reports began to circulate that Walgreen planned to move forward with an inversion. The news generated ripples of indignation across the country. According to this report, Walgreen decided not to undertake an inversion. The reason? According to the CEO, “hard-to-quantify but significant potential for consumer backlash.” Indeed. What happens to a company if, perhaps magically, most or all of its customers decide to turn elsewhere because they do not approve of the company’s policies? The answer should be obvious.

Of course, the boycott approach to dealing with companies that put infinite profit growth above all other concerns does not work if the product or service is necessary and there is no alternative source. This is the major reason the handful of people who own almost everything push for deregulation, repeal of antitrust laws, and creation of monopolies. People laughed when, decades ago, I began using “Megaowneverything Corp.” in some of my questions. “Won’t ever happen,” they claimed. It hasn’t happened yet, but we’re getting there.

Another challenge to corporations that want to consider long-term effects of a decision when analyzing the sense of making the decision is what the report called “pressure from investors.” Most investors, reflecting modern (or is it “post-modern”) culture, want instant gratification. They want to invest a dollar today and receive a bazillion dollars tomorrow. Rather than trying to make a living or make a good investment, they want to make a killing. They will, but what they kill won’t be what they expected to kill. Their investment, their revered golden goose, will end up in a grave. But unfortunately, the not-so-golden geese of hundreds of millions of people will go down just as well.

There are ways to put an end to the greed frenzy that is the root of this nation’s problems. But that won’t happen until people do more than simply suggest their boycott of one corporation. Until long-term considerations are given their due, short-term success remains nothing but a mirage.

About a year ago, in Lap Dance Tax?, I described the City of Philadelphia’s decision to impose its amusement tax on establishments that provide lap dances. The establishments argued that the tax applies only to the admission fee, a tax that they have been paying, and does not apply to the “separate experience” of the lap dance. I shared the opinion that the tax should apply to the lap dance fee if “in fact the lap dance is amusement.” I pointed out that that if the lap dance is amusement, the tax should be paid by the recipient of the lap dance fee, which could be the dance or the establishment, depending on how the fees are handled.

A few months later, in Tax Review Board Strips City’s Lap Dance Tax Attempt, I shared the news that the city’s Tax Review Board unanimously concluded that the amusement tax applies only to the cost of admission to an establishment. I pointed out that the Board “did not reach the issue that I think needs to be decided, which is whether the lap dances constitute amusement.” I explained:

If the tax applies only to admission fees, then why is the statute not phrased in those terms? The language “to attend or engage in” is broader than “to be admitted to,” but rather than focusing on dissecting the language in that manner, the city argued that the lap dance fee was the equivalent of a new admission fee, an argument rejected by the Board. Because the Board concluded that the amusement tax did not apply to lap dances, it did not reach the issue, raised by the establishments, of whether the lap dances are exempt from the tax on the basis of being theatrical performances.

Now comes news that a Common Pleas Court judge has upheld the Board’s decision. Because I cannot find the judge’s opinion, and I’m not sure there even is a written opinion, I cannot evaluate how the judge reached this conclusion. The reports do indicate that lawyers for the establishments pointed out that if the city prevailed, it could go into a restaurant and impose a separate amusement tax on account of the piano player or go into a bar and impose a separate amusement tax on account of each karaoke performance. The lawyers suggested that the city’s effort to expand the tax started with gentlemen’s clubs because “no one feels sorry” for them.

A lawyer for one of the establishments opined that the court decision “should be the end of it.” But though the city has not announced whether it will appeal, the city solicitor stated, "We believe we are legally justified." Unlike lap dances, which I’m told don’t last very long, this dispute over taxing them might become a dance tax marathon. My guess is that the lawyers will need to wiggle through a few more proceedings.

According to this report, the Pennsylvania House adjourned until September 15 without considering a proposal for a new Philadelphia cigarette tax designed to offset shortfalls in funding for the city’s schools. School officials suggested that the schools would not be able to open on time. They are “annoyed, disappointed, and frustrated,” but the Pennsylvania legislature, in abandoning the capitol, seems to be taking the lead from the Congress, also champions of being absent more than present.

In all fairness, there are serious questions about the wisdom of the proposed tax, but facing the issue and voting on it is what legislators are paid to do. If the Philadelphia School District is given authority to collect this tax, will other school districts ask for the same and should their requests be granted? Another question, raised by Stu Bykofsky in this commentary, is why schools should be funded with a tax on cigarettes. Bykofsky points out that most smokers are “on the bottom of the socioeconomic ladder” and are among those least able to deal with the extra tax burden. He points out, as is the case with all “sin” taxes, that if the tax causes people to reduce, or even stop, smoking, the revenues it generates will fall or even disappear. Taking the same position that I do with respect to user fees, as I noted in When User Fee Diversion Smacks of Private Inurement and its predecessor posts, it doesn’t make sense to “tax smokers to use the Walt Whitman bridge.” Bykofsky suggests taxing “the actual users of the schools” or their parents. On this point, I disagree. Public education benefits more than just the children enrolled in the schools. It benefits the employers who hire the schools’ graduates, it benefits society through the contributions the graduates make by using their education, it benefits civilization by adding intelligence to the voter gene pool.

I’m not sure how serious Bykofsky is, because he seems to suggest that his proposal isn’t “real,” and that instead the tax should be imposed on laywers, lobbyists, bankers, and politicians. He claims that lawyers use the taxpayer-funded court system “for free,” but that’s factually inaccurate because lawyers pay to be members of the bar, and they and their clients pay all sorts of filing fees and court costs. Taxing lobbyists would run into First Amendment problems, and taxing politicians isn’t going to happen. Why tax bankers and not hedge fund managers?

The tax that makes the most sense to fund public education is the income tax. Most public education is funded through the real property tax, which lets off the hook more than a few people who benefit from public education. Of course, the anti-tax, anti-government crowd objects to any taxation and objects to public education. An educated electorate is the enemy of an oligarchy.

Though tax law is not the only area of law, or life, that is complicated by the twists and turns of retroactive repeals and pretending something that existed didn’t ever exist, it certainly is a contender for being at the top of the list of law practice areas afflicted by yet another sort of complexity that bedevils not only tax practitioners but also taxpayers trying to comply with the law. Worse, there are times that the “pretend it never existed” becomes “pretend it never existed except for the times we pretend that it does exist.”

The provision in question is section 121(d)(11). Last week the Office of Chief Counsel to the IRS issued CCA 201429022, in which it explained the status of that particular paragraph of the Internal Revenue Code. The question presented to the Chief Counsel was a simple one. Is section 121(d)(11) still in effect?

Section 121(d)(11) was originally enacted as section 121(d)(9) by section 542(c) of P.L. 107-16, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). It became section 121(d)(10) when re-numbered by section 101(a) of P.L. 108-121, the Military Family Tax Relief Act of 2003, and then became section 121(d)(11) when again re-numbered, this time by section 403(ee)(1)-(2) of P.L. 109-135, The Gulf Opportunity Zone Act of 2005.

Section 121(d)(11) provides that when deciding if a taxpayer qualifies for the section 121 exclusion on gain from the sale of property acquired from a decedent, the taxpayer may take into account ownership and use by the decedent in determining whether the ownership and use periods required by section 121 have been met. Section 121(d)(11) was effective for estates of decedents dying after December 31, 2009, but under section 901 of EGTRRA, it would not apply in taxable years beginning after December 31, 2010.

However, section 301(a) of P.L. 111-312, The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRUIRJCA) repealed section 121(d)(11), as though it “had never been enacted.” Nonetheless, section 301(c) of TRUIRJCA provided that the executor of a decedent dying in 2010 could elect to apply section 121(d)(11) as though the repeal in section 301(a) did not apply to property acquired or passing from the decedent. Subsequently, section 101(a)(1) of P.L. 112-240, The American Taxpayer Relief Act of 2012 (ATRA) repealed the title of EGTRRA that contained section 901. Section 101(a)(1) of ATRA does not repeal section 301 of TRUIRJCA nor does it reenact section 542(c) of EGTRRA.

Thus, when the dust and smoke of this jumble of legislative juking and dodging cleared away, the bottom line is a bit less complicated. If the decedent died in 2010, and the executor makes the election under section 301(c) of TRUIRJCA, section 121(d)(11) does apply, despite being repealed as though it never existed, and the decedent’s periods of ownership and use can be taken into account in determining if section 121(a) applies to the property acquired from the decedent. Otherwise, the decedent’s periods of ownership and use are ignored. Thus, for property acquired from decedents dying before or after 2010, or in 2010 if the executor does not make the election, the decedent’s periods of ownership and use are irrelevant.

So section 121(d)(11), originally enacted as section 121(d)(9) but repealed before it could spring into life under its original terms, survives for a very limited number of taxpayers. So the answer to the question of whether it is still in effect is the classic, “It depends.” It is, for a very few taxpayers, and it is not, and never was in effect, for most taxpayers.

It’s getting to the point where it is difficult to decide what is worse, a Congress that like the present one, does nothing other than gripe and complain, or a Congress that does things but produces the sort of muddled legislative history summarized in the preceding paragraphs. But, as too often now happens, they make it harder than it needs to be.

A recent commentary from The Institute for Policy Innovation bemoans the possible derailment of the Permanent Internet Tax Freedom Act by the addition of unrelated provisions to the legislation. Since its inception, the movement of legislation through the Congress has been hampered by extraneous amendments, a snag in the process that ought to be eliminated. On that point, I agree with the commentary.

The commentary points out that if the legislation does not pass, the existing moratorium on certain internet taxation will expire. The current moratorium prevents internet access taxation, and also prevents states from requiring use tax collection by out-of-state retailers with no connection with the state. The commentary carries the headline, “The Senate’s Plan to Increase Your Taxes,” and projects tax increase amounts that include both internet access taxes and use tax collections.

When it comes to internet access taxation, expiration of the moratorium, which in all fairness cannot be considered a plan of the Senate or even a plan of those who are using the legislation for other purposes with no avowed intention of derailing it despite their inability to see that outcome as a consequence, the commentary is correct. Letting the moratorium expire would permit states and localities to impose access taxes, and those taxes would qualify as tax increases.

But when it comes to the use tax, it is wrong to classify the tax as an increase. The use tax is an existing tax. People who are not paying the tax and thus violating the law are not facing a tax increase when they are obliged to comply with the law. The tax obligation exists and is not being increased when it is being collected. The use tax issue presents a different concern. States struggle to collect the use tax, as I have explained in posts such as Collecting the Use Tax: An Ever-Present Issue, a person who purchases taxable items in another state is required to pay the use tax, but does so only if avoidance is pretty much impossible because the purchase is a big-ticket item that needs to be registered, such as a vehicle or boat. Thus, for example, a resident of Pennsylvania who goes to Delaware, a state without a sales tax, to make a purchase owes a use tax to Pennsylvania. Pennsylvania cannot compel the Delaware merchant to collect the Pennsylvania tax. Nor should Pennsylvania be permitted to require the Delaware merchant to collect the tax if the purchase is made when the resident goes to the Delaware merchant’s web site, unless the Delaware merchant otherwise has enough activity in, or connection with, Pennsylvania to be subject to Pennsylvania jurisdiction. Letting the moratorium expire would open the door to states trying to compel out-of-state merchants to do tax collections, but it would not increase the use tax that already is owed. What would increase is the administrative burden and expense faced by out-of-state merchants.

One solution that ought to be considered is a simple one. If state 1 wants to collect an existing – not increased – tax from its residents’ purchases from out-of-state merchants, it ought to offer those out-of-state merchants a financial incentive to do the collection. Surely whatever cost there is in re-programming web sites and in-store point-of-sale terminals to collect the sales tax – something already done by the national retail businesses – can be more than offset with a payment equal to a percentage of the use tax being collected. Though the state would not necessarily receive as much as it would if the residents paid the existing tax, the state would be getting something, which is more than the nothing that that states usually receive.

The commentary’s main point, though not articulated as precisely as it could or should be, is important. Legislation addressing an issue ought not be sidetracked with unrelated matters. But that is not enough. Legislators ought to be focusing on ways of collecting an existing tax using sensible processes, and commentators ought to be encouraging productive efforts by legislatures.

I must admit I was surprised to discover someone asserting that “Obviously retired people do not pay INCOME TAX.” I had not previously encountered this myth. In another post, a commentator provides some of the flawed reasoning behind this sort of assertion, explaining “there are some small percentage who retire before age 65 and these retired people do not pay taxes (due to no income, except that they are well-off to live on past earnings.” Someone who is retired and living off of accumulated savings surely has investment income, which is taxed. Retired individuals, no matter the age at which they retire, are taxed on their pensions, their retirement income, and in some instances, on a portion of social security benefits. To claim that retired people do not pay income tax is just one more unfortunate tax myth.

It isn’t difficult to find web sites that contain statements claiming that children do not pay tax. For example, an answer to the question How many taxpayers are there in the U.S.? was tagged as “wrong” because “Children do not pay tax.” The statement was followed by another erroneous assertion. A similar reaction appeared in response to the question Is it really true half the country doesn’t pay income tax?, from someone who not only claimed that “children do not pay income tax,” but also delivered several other questionable assertions.

Though there are some exceptions to certain state taxes based on a person’s status as, for example, unemployed or elderly, the federal income tax does not contain any blanket exemptions based on age, physical condition, or occupation. A tax liability exists if taxable income exceeds zero, or if a taxpayer has positive taxable income but qualifies for a credits that reduce tax liability. Those credits, however, are not sufficient to exempt all children from having federal income tax liability. A child of any age, with gross income exceeding whatever standard deduction is available, has federal income tax liability.

The assertion that the Internal Revenue Code consists of 70,000 pages is one of my favorite tax myths because it is so silly, so easily debunked, and so indicative of America’s tax ignorance. As I’ve explained in a series of posts, starting with Bush Pages Through the Tax Code?, and continuing with Anyone Want to Count the Words in the Internal Revenue Code?, Tax Commercial’s False Facts Perpetuates Falsehood, How Tax Falsehoods Get Fertilized, How Difficult Is It to Count Tax Words, A Slight Improvement in the Code Length Articulation Problem, and Tax Ignorance Gone Viral, Weighing the Size of the Internal Revenue Code, Reader Weighs In on Weighing the Code, and Code-Size Ignorance Knows No Boundaries, I have explained why the Code is nowhere near 70,000 pages, how the misinformation was developed and spread, and why the Code is no more than two thousand pages long.

This myth persists because some people want it to persist. There is political advantage in convincing people that the Internal Revenue Code is a behemoth. It makes it easier to eliminate the Code, the income tax, the Internal Revenue Service, and, eventually, government. If the campaign succeeds, it would not be the first time a group of politicians had their way by fueling misinformation and spreading myths.

Perhaps in the rush to be succinct, people present general rules as absolutes. For example, a responder in this threadadvised that “And yes, alimony is always taxable to the recipient, regardless of the form in which it is paid.” Similar advice, tainted by yet another error confusing gross income with taxable income, shows up in this commentary, which claims that “Alimony is always taxable income to the recipient.”

However, those statements are incorrect. They need to be qualified. For example, section 71 provides that if the divorce or separation instrument specifies that the alimony payments are not includible in the payee’s gross income and not deductible by the payor, they are not includible in gross income and not deductible. As another example, alimony paid while the spouses are members of the same household do not qualify as “alimony or separate maintenance payments” that are includible in the payee’s gross income and deductible by the payor. The use of the term “Generally,” or the phrase, “Unless an exception applies,” would change the statements from incorrect absolutes to accurate representations.

One of the most persistent, widespread, and enticing tax myths is the unfounded claim that the flat tax is simple. Three years ago, the Heritage Foundation claimed that the flat tax “is simple.” Sixteen years ago, Dick Armey characterized the flat tax as “simple.” For the past several decades, advocates of the flat tax have argued its simplicity by focusing on rate structures and ignoring everything else.

In 2011, I explained, in The Flat Tax Myth Won’t Die that the flat tax “does absolutely nothing to address the question of timing. It does not simplify, for example, installment sale rules, or the dozens of nonrecognition provisions that pepper the Code.” I also pointed out:

A flat tax does not resolve the continuing debate with respect to international taxation. The question of how nonresident aliens and foreign corporations should be taxed, and the question of how American taxpayers should be taxed with respect to overseas operations, is not one that goes away if section 1 is reduced to one tax rate.

Repealing nonrecognition provisions would generate cash flow burdens that would stifle the economy, and retaining those provisions to sustain the economy amounts to retention of tax complexity requiring multiple volumes to explain.

The flat tax, of course, is a sound bite, a nice-sounding phrase that suggests a magic solution to a complex set of problems. It is yet another indication of a theory struggling to survive when it meets reality. It’s a myth, one that falls flat.

Most people do not understand income tax rates. Some law students enrolled in the basic income tax course struggle to understand tax rates. What confuses people is the difference between marginal tax rate and average tax rate. It is not unusual for someone to look at a federal tax rate schedule, find the bracket that fits their income, and conclude that they pay that percentage of their income in federal income tax. This generates all sorts of inaccurate claims to the effect that people with a certain income pay tax at a particular rate. For example, this writer claims that “Americans who take home over $400,000 are mandated by law to pay 39.6 percent in income tax.” Aside from the fact that tax brackets are based on taxable income and not take-home pay, in 2013, the year the article was published, a single person with, for example, $410,000 of taxable income does not pay an income tax of 39.6 percent. That person’s tax liability of $120,064 is 29.3 percent of taxable income.

Aside from the erroneous use of gross income rather than taxable income in selecting a tax bracket, the principal problem with the misuse of the tax rate schedules is the treatment of what is a marginal tax rate as though it were an average rate. For example, if taxable income of up to $50,000 is taxed at 20 percent, and taxable income above $50,000 is taxed at 30 percent, a person with taxable income of $60,000 would be subject to a tax liability of $13,000 ($50,000 x .20, plus $10,000 x .30). It is easy for someone in that situation to claim that they are taxed at 30 percent, but in fact, their tax liability of $13,000 is 21.7 percent of $60,000. Failure to understand the difference generates exaggeration, which in turn triggers more resentment than is warranted.

What makes this myth even more insidious is that when phase-outs are taken into account, and tax liability is divided by taxable income, the average rates are highest not for those with the highest taxable incomes, but for those in the middle brackets, and in some instances, for some taxpayers in lower brackets. I explained this tax quirk in A Foolish Tax Idea Resurfaces.

Americans’ confusion with average and marginal tax rates provides fertile ground for the growth of misleading claims and absurd hyperbole. The myth that people are taxed at the highest nominal marginal rate on all of their income is a myth that needs to die.

Retailers operating in states that do not have sales taxes entice out-of-state purchasers to cross the border to make purchases by emphasizing the notion of “tax-free” purchases. An article about a particular incident of this approach triggered A Peek at the Production of Tax Ignorance, in which I repeated an earlier explanation about the use tax, the tax imposed by the purchaser’s state of residence on out-of-state purchases of items brought back into the state of residence.

What sustains this myth is a combination of ignorance, experience, and revenue department inefficiency. Most taxpayers do not understand that a use tax exists, the conditions under which it applies, and their legal obligation to pay it. Most taxpayers who cross the border to make purchases in states without sales taxes and return home with their purchases do so without any adverse effect, aside from the classic situations involving vehicles, boats, and a few other “big ticket” items. Revenue departments have insufficient resources and mechanisms to collect use taxes aside from “big ticket” items, and because the cost of collecting use taxes is a much higher percentage of the tax when compared to the cost of collecting in-state sales taxes, use tax collection is inefficient and spotty, as I explained in Collecting the Use Tax: An Ever-Present Issue.

Many states are making efforts to educate the public with respect to use taxes. Some are trying to incorporate some sort of flag in state income tax forms. The effectiveness of those efforts is low. Until people become accustomed to paying use taxes, the myth will persist because the non-compliance persists. At some point, states might decide to bring tax education into their K-12 systems, and some have, to some limited extent, but until it is pervasive, this myth will endure.

Though there are rare instances in which a tip can be characterized as a gift excluded from gross income, as a general proposition tips are included in gross income. It takes a very unique set of facts to pull a tip out of gross income by demonstrating that it is a gift, as I described some years ago in Should a Tip Be Excluded from Taxation as a Gift?. Thus, claims that, as a general proposition, tips are gifts and not taxed, are wrong. As the court in Cracchiola v. Comr., 643 F.2d 1383 (9th Cir. 1981), stated, “Petitioners’ first argument, that tops are not income is wholly without merit.”

It is understandable why this myth circulates and has traction. Most people who collect tips are paid very little, rely on the tips to make a living, and are unhappy to learn that tips are included in gross income. Worse, certain employers are required to report tip income on Forms W-2 issued to employees based on formulas, so that occasionally an employee might end up paying taxes on an amount of tips slightly higher than what the employee actually received. These situations also are very rare.

Another reason for this myth’s endurance is confusion generated by discussion of sales taxes. In most states, sales tax is computed with respect to the cost of goods and services exclusive of tips unless the tip is built into the stated price. Explanations of this principle often includes the words “tips are not taxable,” which people take out of context. The context provides the modifier “for sales tax purposes,” which should preclude treating the statement as applicable “for income tax purposes.”

Sometimes, people say to me, quite excitedly, “The IRS Gave Me a Refund,” or “The IRS Is Giving Me a Refund.” Closely related to the “I’m Getting a Refund and Not Paying Tax” myth, this myth reflects two misperceptions.

In some instances a refund, or a portion of a refund, arises from a refundable credit. In these situations, the money paid to the taxpayer is coming from the United States Treasury courtesy of the United States Congress, or from a state treasury courtesy of a state legislature.

In many instances, the refund is nothing more than the IRS returning to the taxpayer some, or in some rare cases all, of what the taxpayer has paid in through withholding and estimated tax payments. I suppose that those who are concerned that the federal government or a state government might run out of money before the refund is paid are overjoyed when the refund arrives, but as a realistic, practical matter, simply getting one’s money back isn’t a joyous occasion. Actually, it’s a bit sad, because the money that is being refunded hasn’t earned interest.

Though I haven’t kept a count, I know that there have been dozens of times when someone would tell me that because they were getting a tax refund they weren’t paying tax. More than a few students entered my basic federal income tax course thinking the same thing, as evidenced by conversations in and out of the classroom, and as indicated on responses to semester exercises.

Whether a person has a tax liability cannot be determined simply from the existence of a refund. Though a person who is not getting a refund because additional tax is due surely is paying taxes, a person who receives a refund can fall into one of two categories. Some taxpayers receive a refund because they have a zero tax liability, and had taxes withheld, paid estimated taxes, or qualify for a refundable credit. But many taxpayers receive a refund and yet have a tax liability. The refund arises because they had taxes withheld and paid estimated taxes in amounts exceeding the tax liability.

When people want to know whether or not they are paying income tax, they need to look at the line on the return that shows “tax liability.” The lines for refund and for additional payment simply reflect the extent to which the amounts that have been paid match with the tax liability. A taxpayer who has $10,000 of federal income taxes withheld from wages and who has a tax liability of $7,500 rejoices at the prospect of a $2,500 refund, but ought not declare, “I’m not paying taxes.” That taxpayer has paid $7,500 in federal income taxes. Worse, they have made an interest-free loan of $2,500 to the applicable federal or state government.

Most taxpayers understand that income reported on a Form W-2 or Form 1099 must be reported on their tax return. Whether they understand why those amounts are gross income, they usually understand that “the IRS knows about it, so I had best report it.” Many taxpayers take a leap, and conclude that if the IRS doesn’t know about it, there’s no need to report it. Coupled with that misperception is the proposition that if it’s not on a Form W-2 or Form 1099, the IRS doesn’t know about it. Thus, we find this advice: “If she has no w2 or 1099, no income then she does NOT have to file.”

This myth gets people in trouble. For example, one commentator suggested, “First of all, work in the underground economy: No w2’s or 1099’s.”

The reality is simple. Items that are gross income must be reported on tax returns whether or not a Form W-2 or Form 1099 is issued to the recipient of the income. Some types of income cannot be reported on such a form because there is no one to issue the form. For example, a taxpayer who finds a $100 bill on the street and keeps it has gross income, but will never receive a Form W-2 or Form 1099. In some instances, payors are not required to issue Forms 1099 if the amount in question is less than a specified amount, usually $600. That rule, designed to reduce reporting burdens on payors, does not mean that amounts of less than $600 are not gross income.

From time to time, someone asserts that because they have been paid with property and not cash, the payment is not subject to the income tax. Not only have I heard this from people generally, I’ve also heard it occasionally from students in the tax course. Fortunately, it’s usually early enough in the course for a correction to be made in how they understand the definition of gross income.

The “it’s not cash, so it’s not taxed” myth flourished in the early days of the barter boom. Some barter exchanges at the time listed “tax free” as one of the advantages of bartering. Eventually, the IRS engaged in an education effort that eliminated almost all of the barter under-reporting, at least among the commercial barter exchanges. There surely are barter transactions taking place in settings that are informal and occasional, with participants thinking that the absence of cash makes the transaction nontaxable.

What fuels the “it’s not cash, so it’s not taxed” myth are several perceptions. One arises from a notion that things usually taxed, such as wages and interest, are almost always paid in cash, a concept that some people translate into a conclusion that to be taxed, it needs to be in cash. Another arises from the rationalization that the lack of liquidity arising from the receipt of property rather than cash permits dispensation from taxation because of the lack of cash with which to pay tax.

This particular myth doesn’t circulate as often and as widely as the “IRS enacts Code provisions” myth. Whether it disappears entirely remains to be seen.