MauledAgain

A recent Tax Court case, Jackson v. Comr., T.C. Summ. Op. 2016-33, demonstrates why couples who decide to live together in a house that they purchase need to be scrupulous about keeping records that proves there is a co-ownership between them. The outcome of the decision probably came as a surprise to the taxpayer.

The taxpayer lived with his girlfriend in a house she purchased in 2005. She financed the purchase with a loan provided by a third party bank. Because the taxpayer’s financial problems precluded including him on the loan, his girlfriend was listed as sole owner on the deed and as the only debtor on the loan secured by a mortgage on the property. The taxpayer testified that each month he transferred $1,000 in cash to his girlfriend to make “interest-only” payments on the loan. He paid in cash to avoid bank fees, but did not submit any evidence, such as receipts, to prove he made those payments. He did produce a copy of a letter from his girlfriend, addressed to the IRS, in which she stated that the taxpayer had paid her $1,000 each month for the past ten years. The taxpayer testified that his girlfriend paid the real property taxes and the homeowner insurance premiums. He also testified that he and his girlfriend shared maintenance costs.

When the taxpayer filed his federal income tax returns, he deducted mortgage interest of $15,720. It is not clear how $1,000 a month for 12 months works out to $15,720. The IRS disallowed the deduction, and the taxpayer petitioned the Tax Court for a redetermination of the IRS notice of deficiency.

Interest on a debt is deductible by a taxpayer only if the debt is an obligation of the taxpayer and not an obligation of someone else. Under regulations section 1.163-1(b), interest paid by a taxpayer on a mortgage loan secured by real estate of which the taxpayer is a legal or equitable owner is deductible even if the taxpayer not directly liable on the bond or note secured by the mortgage. The Tax Court treated the loan in question as acquisition indebtedness on a qualified residence for purposes of analyzing the issue facing it.

Thus, the taxpayer was required to show that he had legal, equitable, or beneficial ownership in the residence. To achieve this, the taxpayer argued that he and his girlfriend were domestic partners and thus shared equal ownership of the residence. Thus, for example, in Uslu v. Comr., T.C. Memo 1997-551, the taxpayer, unable to obtain financing because of a recent bankruptcy, was treated as an equitable owner of property financed by a loan obtained by his brother because the taxpayer and his brother agreed that the taxpayer would pay the mortgage and all expenses for maintenance and improvement. The key is that the taxpayer made himself legally obligated to pay the mortgage.

The Tax Court upheld the IRS determination because the taxpayer did not have a legal obligation to make mortgage payments, and did not hold legal title to the property. The court explained that whether a taxpayer has equitable or beneficial title depends on whether the taxpayer has the right to possess the property and to enjoy its use, rents, or profits, has a duty to maintain the
Property, is responsible for insuring the property, bears the property’s risk of loss, is obligated to pay the property’s taxes, assessments, or charges, has the right to improve the property without the owner’s consent, and has the right to obtain legal title at any time by paying the balance of the purchase price. The Tax Court noted that the taxpayer did not produce any evidence that he made the monthly payments he claimed to have made, dismissing the girlfriend’s letter as deserving no weight. He did not pay taxes or insurance premiums. There was no evidence he could make improvements to the property without his girlfriend’s consent. There was no evidence that he could obtain legal title by paying the balance due on the mortgage. There was no evidence of any agreement between the taxpayer and his girlfriend with respect to the ownership and use of the residence. Though the girlfriend’s testimony would have been relevant to some of these issues, she did not appear as a witness in the case.

The lessons that this case presents to cohabiting taxpayers is obvious. First, just as people about to marry should enter into pre-marital agreements, so, too, people about to cohabit should enter into agreements that address issues such as ownership and financial responsibilities with respect to the residence in which they plan to live. Second, transfers between the cohabiting couple that are relevant to the ownership and use of the residence need to be memorialized in some manner so that when questions arise in the future, the taxpayers can produce the requisite proof of what they claim took place.

It’s no secret that I’m a strong advocate of education. It’s also no secret that I’m a strong advocate of tax education in high school, so that citizens understand their rights, their responsibilities, and how tax systems work. In posts such as Tax Ignorance, Is Tax Ignorance Contagious?, Fighting Tax Ignorance, Why the Nation Needs Tax Education, Tax Ignorance: Legislators and Lobbyists, Tax Education is Not Just For Tax Professionals, The Consequences of Tax Education Deficiency, The Value of Tax Education, More Tax Ignorance, With a Gift, Tax Ignorance of the Historical Kind, and A Peek at the Production of Tax Ignorance, I have lamented how poorly Americans, to say nothing of legislators, fare when dealing with tax issues.

A recent development provides yet another example of how tax ignorance is dangerous. This time, scammers are calling people, claiming to be the IRS, and demanding payment of a “federal student tax.” The scam has been so successful that colleges and universities are notifying students, and in some instances, recent graduates, informing them of the scam and the need to refrain from sending money to someone who is not an IRS representative. Perhaps these schools should have required their students to understand tax basics before sending them out into the world. I’m not advocating mandating the study of complex computations and statutory detail. I’m suggesting that students learn some general principles, not unlike what would be covered in the first few classes of a law or business school taxation course.

It saddens me when I hear or read of someone forking over cash, a credit card number, or a prepaid debit card because they did not have the opportunity to learn enough to protect themselves from the likes of despicable scammers. By the time the word gets out, and gets circulated, thousands or tens of thousands of victims have dished out funds to scammers who use those funds for all sorts of purposes, most of which are far from noble.

One of the flaws in the anti-tax philosophy is the tendency of emotions to override rationality. “They want to raise our taxes” becomes a rallying cry because tax increases are, emotionally, an undesirable event. Yet with a bit of careful reasoning, it sometimes turns out that the alternative to a tax freeze, or tax cut, is far worse. The emotional reaction at that point comes too late.

For many years I have argued that the long-term financial cost, to individual taxpayers, of avoiding tax increases and even cutting taxes, is far greater than the paltry savings conferred on 99 percent of taxpayers when taxes are frozen or cut. My favorite example involves potholes. It’s an easy example, in part because almost everyone dislikes potholes. Perhaps the people who make money from potholes, such as front-end alignment shops, wheel and tire manufacturers, and tow truck operators, like potholes, but I suspect that they, too, aren’t particularly enamored of them. I’m confident that they aren’t singing the praises of potholes if one of their relatives or friends is killed or injured on account of a pothole. I described one such incident in When Tax Cuts Matter More Than Pothole Repair, and that was just one out of tens of thousands. Opponents of tax or user fee increases to fund pothole repairs argue that the money should come from other spending, and yet, as I described in Funding Pothole Repairs With Spending Cuts? Really?, when that idea was floated in Michigan, poll respondents objected to cuts being made in education, health care, public safety, and every other program. These respondents understood that fixing potholes at the expense of other outlays simply shifted the problem to the back burner.

As I have repeatedly pointed out, potholes are a financial imposition on taxpayers. Though not every taxpayer is directly affected by potholes, over a period of years, most are. At some point, almost every taxpayer will be saddled with the cost of new tires, new wheels, new shock absorbers, new catalytic converters, replacements for air bags and other vehicle parts, front-end alignments, accidents, injuries, and death. I wonder if anyone who, after hitting a pothole and careening off the road in the direction of a tree or telephone pole, thought, “Perhaps opposing a tax increase for pothole repair wasn’t such a good idea.”

The facts are indisputable. As I described in Potholes: Poster Children for Why Tax Increases Save Money, I related a report from the United Kingdom revealing that one-third of drivers had suffered damage to their vehicles caused by potholes. I described a report out of Los Angeles explaining that potholes cause an average of $750 each year for car repairs for each driver, and yet some people objected to paying an additional $35 each year to fix potholes. The suppression of rationality by emotion, a disease that has swept with virulence throughout the nation, is starkly evident in that anti-tax reaction.

Now comes news, in a report from several months ago shared by one of my readers, that drivers in this country are paying $6.4 billion annually in car repairs due to potholes. In addition to those costs, there are the indirect costs of detours, traffic congestion, increased travel time, and increased transportation and shipping expenses borne by businesses. On top of that are the costs of injuries and deaths. The report, citing a Bankrate.com survey, points out that 63 percent of Americans have less than $1,000 in spare cash on hand to deal with financial emergencies. In other words, more than half of the people who incur pothole damage are in a financial bind when it comes to dealing with the consequences. The report selected Alabama as an example of the problem. In Alabama, 18.6 percent of the population lives below the poverty line, the roads in Birmingham were ranked 20th worst among cities with a population of 500,000 or more, and 43 percent of that city’s streets are in poor condition. Each Alabama driver incurs more than $1,200 annually due to higher vehicle operating costs, accidents, and delays on account of damaged roads.

It was a little more than a year ago, in Battle Over Highway Infrastructure Taxation Heats Up in Alabama, that I pointed out the absurdity of tax increase opposition in a state desperately in need of a solution to a serious problem. When the governor proposed raising taxes to fund deficits in the transportation budget, Republican state senator Bill Holtzclaw rented a billboard to proclaim, “Governor Bentley wants to raise your taxes. I will not let that happen. Semper Fi - Senator Bill Holtzclaw." So the state Department of Transportation suspended funding for highway projects in Holtzclaw’s district. Who suffers? Just the people who voted for him? Hardly. It’s an sad example of how politics in this nation have sunk into the pit of emotionality. Surely the people of Alabama, given a choice between paying an additional $50 or $100 per year to fix the state’s highways or continuing to shell out $1,200 per year in pothole damage costs, would choose the former, provided they could get past the emotions stirred up by the anti-tax crowd. If a tax increase puts $1,100 in motorists’ pockets, then it’s a giving and not a taking.

Law school tuition is expensive. Claiming it as an income tax deduction reduces the financial burden on the taxpayer. The difficulty is that, aside from a very rare instance unique to California, law school tuition is not deductible. That, however, does not stop taxpayers from trying to fashion arguments to squeeze past the no-deduction barrier. In a recent decision, O’Connor and Tracy v. Comr., the Court of Appeals for the Tenth Circuit affirmed a Tax Court decision rejecting arguments made by a married couple seeking to deduct law school tuition paid for the husband.

The husband, a United States citizen, studied law in Germany. He completed the minimum requirements to be a lawyer in Germany in June 2007 and was licensed to practice as an attorney, civil servant, or judge. He finished those requirements while living in Utah. In 2007 he took over project management of a residential building project in Salt Lake City. In 2009, he entered law school in San Diego. During 2010 and 2011, he was not employed nor did he report any self-employment income. He earned his J.D. degree in 2012, and passed the New York bar examination in 2014. At some point during this time period, he became involved in investigating a qui tam action, and filed a qui tam complaint in September 2014.

The taxpayers deducted the tuition and other costs of the husband’s J.D. law studies. The IRS disallowed the deductions and issued a notice of deficiency. The taxpayers filed a petition in the Tax Court, and argued that because the husband had fulfilled the requirement to practice law in Germany, he had met the minimum requirements of being a legal professionals and thus was entitled to deduct the expenses. They contended that the minimum requirements were met because he could have been licensed in New York without earning a J.D. degree. They argued that he was carrying on a trade or business because of his involvement with the project management and the qui tam action.

The Tax Court upheld the disallowance of the deductions. It concluded that the husband was not established in the legal profession in the United States, making his J.D. education expenses incurred in connection with entering a new trade or business. It also concluded that even if the husband’s involvement with project management and the qui tam action existed in 2010 and 2011, he had not shown they were connected with the law school education. The taxpayers appealed to the Tenth Circuit.

The taxpayers argued that the Tax Court erred by relying on theories that the IRS had not included in the notice of deficiency. The Court of Appeals concluded that although the “new trade or business” theory was not explicitly raised in the notice of deficiency, the Tax Court is not limited to theories in the notice of deficiency and is permitted to apply the correct law to the facts. The Court of Appeals noted that in many previous cases the Tax Court allowed the IRS to raise new theories even when Tax Court proceedings were well underway. When the IRS raises a new theory, taxpayers must demonstrate surprise and disadvantage as a prerequisite to blocking IRS reliance on the theory, but the Court of Appeals concluded that the taxpayers had not only failed to demonstrate surprise and disadvantage, they had recognized the “new trade or business issue” when they addressed it in their amended 2010 return.

The taxpayers argued that the Tax Court defined the term “legal professional” too narrowly, pointing out that the husband was “active in both creating a new business model based upon his acquired knowledge of the [German Civil Code] and German construction standards as well as qui tam litigation.” The Court of Appeals noted that the argument was based largely on facts not before the Tax Court. It also noted that a long line of cases and rulings have concluded that that a person licensed to practice law in one jurisdiction and who incurs expenses to be admitted in another jurisdiction is considered to be entering a new trade or business.

The taxpayers argued that the Tax Court improperly required them to show a nexus between the J.D. education expenses and the husband’s business activities. The Court of Appeals dismissed the argument as making “little sense,” because the primary requirement for a deduction is that the expense be an ordinary and necessary expense bearing a proximate and direct relationship to the taxpayer’s trade or business. The taxpayers’ complaint that the Tax Court improperly imposed an “additional temporal requirement” was rejected because the Tax Court assumed that the husband was engaged in the activities in question during the years in issue even though there was no evidence that he did so.

The Court of Appeals upheld the accuracy-related penalties imposed on the taxpayers. The court noted that the facts were very similar to a 45-year-old case denying a deduction for law school expenses by a taxpayer who earned a law degree in Poland, practiced law in Poland, earned a law degree in Germany, moved to Ohio, earned a law degree in Ohio, was admitted to the Ohio bar, and practiced law in Ohio. The Court of Appeals rejected the taxpayers’ attempt to distinguish that case, and that the Tax Court was correct in concluding that the husband had failed to heed relevant precedent.

The list of cases in which deductions for law school tuition and related expenses have been disallowed is very long. It now is longer. Yet surely as the sun rises in the east, someone else will end up adding a case to that list. And almost certainly it will be a lawyer.

Readers of MauledAgain know that I am not a fan of using tax systems to encourage or discourage behavior. Advocates of behavior-focused taxes claim that imposing taxes on unwanted behavior and giving tax breaks for desired behavior pushes and pulls society into a better place. In theory, these taxes ought to work as advertised. In practice, sometimes they do, and sometimes they don’t. In theory, taxes designed to discourage behavior generate no revenue if the taxes succeed in ending the undesired behavior.

A recent article about taxes on disposable plastic shopping bags points out the mixed results that those taxes generate. These taxes are designed, not to raise revenue, but to reduce the adverse impact of the bags. Aside from filling landfill and creating litter, these bags also endanger wildlife and habitats. Montgomery County, Maryland, enacted a nickel-per-bag tax in 2012. Revenue from the tax grew 3.2 percent from fiscal 2014 to fiscal 2015. Why? In part because the population increased and in part because people made more shopping trips thanks to an improving economy. But part of the increase is attributable to grocery stores handing out more disposable bags. This is not what county officials had expected. Even more puzzling, the number of disposable bags handed out by convenience stores, pharmacies, and department stores decreased. And reports from environmental field workers disclose that the number of plastic bags caught in stream traps dropped roughly 10 percent from 2011 to 2015. The District of Columbia also enacted a nickel-per-bag tax, in 2010. It, too, reports a growth in revenue from the tax and a decrease in the number of bags found in the stream traps.

What’s the alternative? One possibility is to prohibit the undesired behavior. For example, several localities on the West Coast, simply ban the use of disposable bags. What’s the drawback to this approach, aside from the claims that liberty assures all people the right to do whatever they want to do without limits? Enforcement of the ban is more expensive than imposing a tax, because part of the administrative burden of imposing of the tax falls on merchants. Would fines and penalties imposed on violators of the ban raises as much revenue as would a tax? I don’t know. If the goal of the tax is not to raise revenue, then the question of whether fines and penalties would raise revenue in lieu of the tax makes no sense, because revenue supposedly is irrelevant.

I suspect that revenue is, in fact, a goal. Why? Legislators know that it is impossible to bring a total end to undesired behavior. The nation’s unfortunate flirtation with Prohibition demonstrated that outright bans on alcohol did not stop people from drinking alcohol. Taxes on alcohol have not prevented sales of alcoholic beverages from growing over the years. So, if an undesired behavior is a sure thing, imposing a tax on it guarantees revenue.

When a person lives in one state and works in another, the usual pattern is for the state of residence to require the person to compute an income tax based on all of the person’s income, and then to provide a credit for income taxes imposed by the other state on the income earned by that person in the other state. The credit is limited to the amount of income tax that the state of residence would impose on the income earned in the other state. To use a simple example, suppose X lives in State 1 and works in State 2. Suppose X’s only income is a $50,000 salary earned in State 2. Suppose State 2 imposes a $5,000 income tax on the salary. Suppose State 1 has a flat 3 percent income tax. X would compute a $1,500 income tax in State 1, but would then be permitted a credit not to exceed $1,500. In this example, X would not pay any tax to State 1.

In some instances, states enter into reciprocal agreements. Under these agreements the each state agrees not to tax the income earned within its borders by someone resident in the other state. The purpose of these agreements is twofold. First, it eliminates the complexity of computing the credit, something that often is much more intricate than demonstrated in the simple example above. Second, it shifts revenue so that taxpayers are paying income tax to their state of residence. How that works out in terms of revenue shifting depends on the numbers.

Now comes news that New Jersey’s Governor Christie has instructed state officials to examine and report to him on the possibility of withdrawing from the reciprocal income tax agreement that exists between New Jersey and Pennsylvania. New Jersey officials estimate that the income tax they would collect from Pennsylvania residents working in New Jersey would “far outweigh” the taxes New Jersey collects on New Jersey residents working in Pennsylvania. Because Pennsylvania has a flat 3.07 percent rate and New Jersey has a progressive system with rates ranging from 1.4 percent to 8.97 percent, the impact on residents of each state working in the other state will vary. Pennsylvanians working in New Jersey for higher salaries will pay more tax because they will pay at New Jersey’s higher rates, and the Pennsylvania credit will be limited to Pennsylvania’s 3.07 percent rate. Pennsylvanians working in New Jersey for lower salaries will pay New Jersey income tax but then receive a Pennsylvania credit, leaving them with the same tax liability they otherwise would have had. New Jersey residents working in Pennsylvania for higher salaries will not pay more taxes, because they will receive a credit for the taxes paid to Pennsylvania. But New Jersey residents working in Pennsylvania for lower salaries will end up paying more taxes, because the credit for taxes paid to Pennsylvania will be limited to the lower tax paid to New Jersey. For example, a New Jersey resident earning $20,000 in Pennsylvania currently is not taxed in Pennsylvania. Ignoring deductions and assuming no other income, this person would have a $280 New Jersey income tax liability. If the reciprocal agreement is terminated, this person will be taxed in Pennsylvania in the amount of $614, will compute a New Jersey tax of $280, and will claim a credit of $614 limited to $280. This person will end up with a $334 income tax increase.

According to this graphic, roughly 100,000 south Jersey residents work in the southeastern Pennsylvania area. I did not try to figure out how many other New Jersey residents work in other parts of Pennsylvania. Roughly 40,000 southeastern Pennsylvania residents work in south Jersey. Again, I did not try to determine how many other Pennsylvanians work in New Jersey. The point is, Christie’s proposal would affect far more than a few people.

Fourteen years ago, another New Jersey governor floated a proposal to end the agreement. Opposition was rapid and strong. The agreement survived. What will happen this time if Christie decides to move forward with his proposal? Yes, there will be opposition. Will it succeed? We’ll find out soon enough.

Readers of MauledAgain know how dedicated I am to the proposition that the only viable and sensible solution to the highway funding crisis is the mileage-based road fee. I have been discussing this proposal for a dozen years, beginning with Tax Meets Technology on the Road, and continuing through Mileage-Based Road Fees, Again, Mileage-Based Road Fees, Yet Again, Change, Tax, Mileage-Based Road Fees, and Secrecy, Pennsylvania State Gasoline Tax Increase: The Last Hurrah?, Making Progress with Mileage-Based Road Fees, Mileage-Based Road Fees Gain More Traction, Looking More Closely at Mileage-Based Road Fees, The Mileage-Based Road Fee Lives On, Is the Mileage-Based Road Fee So Terrible?, Defending the Mileage-Based Road Fee, Liquid Fuels Tax Increases on the Table, Searching For What Already Has Been Found, Tax Style, Highways Are Not Free, Mileage-Based Road Fees: Privatization and Privacy, Is the Mileage-Based Road Fee a Threat to Privacy?, So Who Should Pay for Roads?, Mileage-Based Road Fee Inching Ahead, Rebutting Arguments Against Mileage-Based Road Fees, and On the Mileage-Based Road Fee Highway: Young at (Tax) Heart?.

Here and there across the nation, a few state governments have started examining the advantages and disadvantages of the mileage-based road fee. One state, Oregon, has gone so far as to implement a pilot program, to see how a theory works when confronted with practical reality. In the east, the I-95 Corridor Coalition, a multi-state group examining the possibilities for maintaining and improving one of the nation’s busiest and most essential interstate highways, has been looking at possibilities. Recently, it applied to the Department of Transportation for grant money to be used to set up a pilot program. The Coalition wants to study how mileage-based road fees could be computed in the I-95 corridor.

Then, according to this story, some Republicans in the Connecticut legislature got wind of the grant application. Immediately, they accused the state’s governor of “planning a new tax.” Their claims demonstrate what happens when emotions trump logic and reasoning. According to state senator Toni Boucher, the supposed new tax “will hit drivers every day.” She continued, “It will hit you everywhere you go, even if you are driving to a hospital emergency room.” Did it ever occur to Boucher that the existing liquid fuels tax hits drivers every day? Did it occur to her that the existing liquid fuels tax applies when someone is driving to an emergency room? Did it occur to Boucher that the existing tax is insufficient to maintain Connecticut’s highways? I’ve driven in Connecticut enough times to realize the inadequacies of I-95 as it passes through Connecticut, though in all fairness the same problem exists for I-95 in other states as well. Potholes abound. With exits and entrances every mile or so, particularly in the western part of the state, increased traffic volume poses risks that need remediation, and remediation requires money. Connecticut needs at least $100 billion to fix its failing transportation infrastructure.

Boucher and her anti-tax colleagues also fail to understand that Connecticut taxpayers are financing the cost of providing highways for nonresidents who travel through the state, especially those who do not stop and patronize Connecticut businesses. There are no toll roads in Connecticut, perhaps another indication that somehow, some way, magically, highways will appear and take care of themselves without anyone being “hit” by a tax, fee, or other charge, ever.

The fact that the grant being sought by the interstate coalition is nothing more than money for learning about the mileage-based road fee doesn’t matter to the anti-tax crowd. Opposition to funding this grant is nothing more than opposition to education. It does not surprise me that anti-tax and anti-education efforts are political comrades, if not one collective.

Another Republican legislator, state senator Fasano, claims that “More taxes and more burdens on Connecticut drivers is not the way to improve transportation in our state.” Then what is the way, senator? Taxes on milk? Slave labor? Pretense that potholes don’t exist? Deporting half the population and thus cutting down on traffic congestion? Walls at the border so that nonresidents of Connecticut cannot use Connecticut highways? What wonderful plan do you have to fix the problem? Criticizing everyone else is not a plan. It’s an indication that you have no plan, other than to appeal to the basic selfishness of drivers who want free highways and think someone else is going to pay for them. It’s an appeal for support from “takers not makers” who you claim to despise.

The anti-tax crowd claims that the mileage-based road fee is unpopular. It is. Every tax, every fee, every purchase price is unpopular. That’s human nature. What overcomes the baser instinct is education. Once people understand that a mileage-based road fee reduces what is paid by those who drive relatively less and shifts the burden to those who are using and burdening highways disproportionately more than what they are paying, they will realize that the mileage-based road fee is exactly what solves one piece of the “taker not maker” syndrome they so detest.

If the anti-tax crowd had their way, there would be no taxes. But then there would be no highways, or police, or anything else. Or there would be corporate-owned highways, corporate-owned police, and corporate-owned everything else, dictated by the oligarchy and impervious to the voting booth. Once we reach that point, surely most of the people sucked into the anti-tax movement will realize it was nothing more than a front for oligarchic takeover of public services, and they’ll be screaming for the do-over or reset button. Unfortunately, in much of life, there is no reset button.

A recent Tax Court case, Haag v. Comr., T.C. Summ. Op. 2016-29, sheds some light on how metropolitan areas are defined for tax purposes. More specifically, the case tells taxpayers how not to define metropolitan area.

Both of the taxpayers, a married couple, were electricians and members of the International Brotherhood of Electrical Workers. They belonged to Local 150. They lived in Lake County, Illinois. Both taxpayers worked for several employers at different sites in the Chicago area, and the husband also did work in Joliet, Illinois, in Champaign, Illinois, and in Florida. Both taxpayers drove their personal vehicles to and from work. The taxpayers recorded only the miles he drove beyond Lake County, relying on conversations the husband had with other union electricians.

The IRS agreed that the husband had driven 330 miles round-trip to Champaign, Illinois, and conceded that a deduction was allowable for that mileage. The Tax Court also allowed a deduction for the cost of round-trip miles driven by the husband to Chicago Midway International Airport in connection with a trip to Florida to perform work.

The IRS argued that the other miles driven by the taxpayers were personal commuting transportation and thus not deductible. Because the IRS permits the deduction of expenses incurred in traveling to work locations outside the metropolitan area where the taxpayer lives and normally works, the taxpayers argued that the expense of driving beyond Lake County was deductible. They contended that because the jurisdiction of Local 150 was limited to Lake County, Illinois, Lake County was their metropolitan area. The Tax Court disagreed with the taxpayers. The court noted that the taxpayers usually worked in Chicago or Joliet, roughly 65 miles from their home. The Court explained, “Without suggesting the adoption of any rigid definition of the term ‘metropolitan area’ for this purpose, we conclude that Lake County and petitioners’ work sites in Chicago and Joliet fall within the Chicago metropolitan area. The distances that petitioners routinely traveled to work were not so unusually long as to justify an exception to the general rule that commuting expenses are nondeductible personal expenses.”

For most people who think about the meaning of metropolitan area, what comes to mind likely is the statistical metropolitan area defined by the Office of Management and Budget, for various purposes, including the census and resulting statistical information. A closer look at the definitions reveals that ascertaining a metropolitan area is not as simple as looking at a map. There are overlaps, gaps, and variations in boundaries. As the author of this explanation put it, “In practice, the parameters of metropolitan areas, in both official and unofficial usage, are not consistent.”

Taken narrowly, the Tax Court decision simply tells us that the jurisdictional area of the union to which a taxpayer belongs is not necessarily a metropolitan area. If it is, it’s happenstance that the union’s jurisdictional area matches a metropolitan area. The resolution of the question appears to be one that rests on the facts and circumstances of each case.

Pennsylvania localities have a tax problem. They’re not good at sharing taxes, and the rules imposed on them by the state give Philadelphia special treatment. According to this article, localities in the Philadelphia area are pushing back. Legislation has been introduced to change the rules.

The current system, though easy to describe, isn’t easy to explain or justify. Generally, when a locality imposes an earned income tax on a nonresident, it remits the tax to the worker’s locality of residence. Thus, as the article explains, if a person lives in Cheltenham but works in Lansdale, Lansdale collects an earned income tax but sends it to Cheltenham. The exception is Philadelphia. If a resident of Cheltenham works in Philadelphia, Philadelphia collects its city wage tax, and keeps it. In Pennsylvania, localities are permitted to enact earned income taxes, not to exceed one percent. Philadelphia’s wage tax is 3.5 percent. Localities are supporting legislation that would require Philadelphia to remit to the localities an amount equal to one percent of the wages taxed by Philadelphia that are earned by nonresidents who live in other Pennsylvania localities.

The structure in Pennsylvania is strange with or without the Philadelphia exception. It is inconsistent with how income-based taxes generally are shared. For example, if a Pennsylvania resident works in New Jersey and pays New Jersey income tax, the Pennsylvania resident is permitted to claim a credit for the taxes paid to New Jersey, limited to the amount of Pennsylvania income tax imposed on those wages. For example, if the Pennsylvania resident earns a $100,000 salary in New Jersey and pays an income tax of $5,000 to New Jersey, the Pennsylvania resident is permitted to claim a $3,070 credit against Pennsylvania tax liability. This eliminates double taxation. It leaves the tax in the hands of the state where the income was earned.

In Pennsylvania, the earned income tax ends up in the hands of the locality where the taxpayer resides, unless the taxpayer works in Philadelphia. In that case, it ends up in Philadelphia’s hands. So, in some respects, the treatment of Philadelphia is not what is out of line with general practice. It’s what happens among the other localities that is out of step.

The question comes down to which locality should end up with the tax on earned income. What is not permitted, and what would be unfair, is for both the locality of residence and the workplace locality each to impose a one percent tax on the taxpayer. That would discriminate in favor of the taxpayer who lives and works in the same locality.

Localities offer excellent arguments for the current system, and Philadelphia offers excellent arguments for its special status. All point out that they are delivering services to the taxpayer, in the form of roads, police protection, and similar services. It is in these arguments that a solution can be found.

The earned income tax should be split into two components. One would be called the resident earned income tax and the other would be called the worker earned income tax. Each could be set at a rate of 0.5 percent, or each could be set a different rate that attempts to approximate the relative level of services provided to the taxpayer. For example, because a worker spends roughly one-fourth of a week’s hours at the workplace, perhaps the worker earned income tax would be .25 percent and the resident earned income tax .75 percent. Because that is a rather crude computation, some other ration could be found. The key would be limiting the total of the two percentages to one percent. Under this plan as applied to the earlier example, Lansdale would remit to Cheltenham a portion of the earned income tax that it collected, as would Philadelphia. Similarly, the portion of any earned income tax collected by Cheltenham on a Philadelphian working in Cheltenham would be remitted to Philadelphia.

Would this work? I think so. Why not try?

When taxpayers decided to purchase rental real estate, one of the factors that affects selection of property and the amount to offer for purchase is the anticipated deductions arising from interest payments on loans secured by mortgages on the purchased property. The best-designed plans, however, can fall apart if anticipated income does not materialize. The resulting inability of the taxpayers to make the interest payments causes them to lose the anticipated interest deductions.

The taxpayers in Slavin v. Comr., T.C. Summ. Op. 2016-28, found themselves in financial difficulties when they were unable to generate sufficient income from rental properties purchased several years before the economic collapse of 2007-2008. In 2004, the taxpayers purchased rental property, borrowing $975,000 on a promissory note, on which interest at six percent would be due annually until the note was due in 2034. The note was secured by a mortgage on the property. During 2008 and 2009, the taxpayers did not pay the interest that was due because the property did not generate sufficient income. Instead, the taxpayers and the creditor added the unpaid interest to the principal balance of the loan, on June 10, 2008, and again on October 15, 2009. The interest rate was unchanged. On January 8, 2010, the taxpayers and the creditor modified the loan by reducing the interest rate from six percent to three percent. The taxpayers, who use the cash method, deducted the amount of unpaid interest that was added to the loan balance. The IRS disallowed the deduction.

Citing established case law, the Tax Court explained that the taxpayers were not entitled to deduct the interest because they were cash method taxpayers who had not paid the interest. The modifications adding the unpaid interest to the loan balance did not constitute payment of the interest.

The taxpayers argued that the modification was a “substantial modification” under regulations section 1.1001-3, but the Tax Court rejected the argument. The court concluded that the substantial modification rules apply to recognition of gain or loss on dispositions and exchanges of debt, and have no relevance to the determination of whether interest has been paid. The court also concluded that there had not been a substantial modification.

The risk with tax shelters is that when financial problems reduce or eliminate the viability of the shelter, the tax benefits also disappear. In other words, the financial problems compound the adverse after-tax consequences. When taxpayers are considering the purchase of rental real estate, the computations ought to include the possibilities not only of financial downturns but also of disappearing tax benefits.

So Philadelphia now has a so-called “soda tax, though legal challenges could postpone or eradicate the enactment. And, as I pointed out in Bait-and-Switch “Sugary Beverage Tax” Tactics, the tax applies to products other than soda, and although justified as an anti-sugar-consumption measure, doesn’t touch most sugar-containing items. Worse, it is imposed on products that do not contain sugar. I have explained these flaws in 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, The Realities of the Soda Tax Policy Debate, Soda Sales Shifting?, Taxes, Consumption, Soda, and Obesity, Is the Soda Tax a Revenue Grab or a Worthwhile Health Benefit?, Philadelphia’s Latest Soda Tax Proposal: Health or Revenue?, What Gets Taxed If the Goal Is Health Improvement?, The Russian Sugar and Fat Tax Proposal: Smarter, More Sensible, or Just a Need for More Revenue, Soda Tax Debate Bubbles Up, Can Mischaracterizing an Undesired Tax Backfire?, The Soda Tax Flaw in Automotive Terms, Taxing the Container Instead of the Sugary Beverage: Looking for Revenue in All the Wrong Places, and Bait-and-Switch “Sugary Beverage Tax” Tactics.

Yet this tax contains within its provisions a road-map for evasion. Aside from the obvious tactic of purchasing items outside the city, the wholesalers and distributors who are responsible for paying the tax have been presented with an avoidance mechanism. As explained in the city’s summary, the tax does not apply to “[u]nsweetened drinks that the purchaser or seller can add sugar to at the point of sale.” Aside from being another example of the hypocrisy of the justification for the tax, this exemption provides a pathway for escaping the tax. Though it won’t work for all of the taxed items, it will work for many of them.

Here is an example of what distributors could do, if they conclude that the cost of implementing this approach is worth it. It might not be cost effective at the moment, but if other cities and localities follow Philadelphia and the “soda tax” becomes a national phenomenon, this avoidance technique probably will get close scrutiny by the manufacturers and distributors. Beverages that are sold in bottle could be sold in unsweetened form, just as coffee is sold in unsweetened form. The beverage would thus not be subject to the tax no matter where it is sold or consumed, because the tax does not apply to unsweetened beverages. Purchasers could then add their own sweetener, re-cap the bottle, shake it, and find themselves with a sweetened drink. In fact, purchasers could adjust the amount of sweetener that they add, satisfying their own preferences, and ending up with a beverage that is sweeter or less sweet than what was originally being sold. Of course, this won’t work well with beverages that are sold in cans under pressure, such as soda, and might not work with soda sold in bottles. The shaking of those bottles after adding a sweetener to unsweetened soda probably would make a mess.

Eventually, the jurisdiction imposing the tax would realize that a sugar tax doesn’t work when applied to sweetened beverages, because actual revenues would be far less than those anticipated. Jurisdictions would then attempt to tax sales of sugar at wholesale and retail levels, which would spread the incidence of the tax over so many items that its impact would be different and perhaps less noticeable. At the same time, extending the tax to non-sugar sweeteners would be such an obvious revelation of the hypocrisy behind the claim that the tax is health beneficial because it encourages the reduction of sugar consumption that attempts to tax items containing non-sugar sweeteners would fail.

If that is the eventual outcome, it is disappointing to see politicians learning by making a mess of things instead of sitting down and using their intellectual skills to figure out in advance that the sort of tax enacted by Philadelphia is a product of emotions and not rational thought, afflicted by politics. What a bitter way for the people of Philadelphia to learn that they’ve been the target of a bait-and-switch game that so easily can backfire.

As the nation’s infrastructure, particularly roads, bridges, and tunnels, continues to deteriorate thanks to tax hate, states and localities are trying all sorts of approaches to finding revenue to fulfill their obligations to protect citizens who travel or commute. I learned recently, thanks to this article, that several towns in Indiana have enacted a “wheel tax” under authority granted by the state legislature. Unlike a liquid fuels tax, which badly approximates road use, or a mileage-based road fee, which much more closely approximates road use, the wheel tax does not distinguish between the car that is driven 10,000 miles annually and a similar car that is driven 2,000 miles annually, even though the former imposes five times as much wear-and-tear on the road as does the latter.

The wheel tax is not based on the number of wheels attached to a vehicle. The tax on passenger vehicles, which almost always have four wheels, is $25. The tax on motorcycles, which have two wheels, is $12.50. My immediate reactions was, “That’s $6.25 per wheel.” But I was wrong. The tax on commercial vehicles, which can have as few as four and as many as eighteen, or perhaps more, wheels, is $40. I would have expected some sort of sliding scale, so that a ten-wheeled truck would be subject to a $62.50 tax. And what about recreational vehicles, which can have as few as four, or as many as ten wheels? The tax is only $12.50. And personal trailers, which usually have two, but sometimes four, wheels? Again, $12.50.

It seems to me that some wheeling and dealing was in play when this tax was authorized and enacted. The big clue is simple. When logic is missing, something isn’t quite right. Some people might tire of hearing me write the praises of the mileage-based road fee, but the wheel tax does nothing to change my mind. Nor should it. Nor should it be called a wheel tax, because it has nothing to do with the number of wheels on the vehicle.

A recent New York Times article focusing on tax compliance by small businesses shared information from a several-years-old IRS Taxpayer Advocate report that I had not noticed when it was published. The report, Factors Influencing Voluntary Compliance by Small Businesses: Preliminary Survey Results, addressed various aspects of tax compliance among small business owners. One set of survey results stood out.

One of the survey’s findings is not surprising, at least to me. According to the report, “Taxpayers in the low-compliance communities appeared in more concentrated geographic clusters across the country, especially in the South and West.” Those areas of the country have higher proportions of individuals who dislike national government and cling to fierce independent individuality.

Other findings were surprising, at least to me. For example, “Respondents from the high-compliance communities most frequently clustered in ‘other services’ . . . , whereas those from the low-compliance communities most frequently clustered in “professional, scientific, or technical services. . . . Those from the high-compliance communities were more than twice as likely to speak a language other than English at home.” Had I been asked, before seeing these results, whether compliance was higher or lower among those for whom English is not their first language, I would have answered, “lower,” and I would have been wrong. As another example, “Low-compliance community respondents were more likely than high-compliance com¬munity respondents to belong to a trade association . . . , volunteer organization . . . , or church or other religious congregation . . . and to vote . . . or send children to local schools.” I would have expected people active in their community, particularly church-goers, to be more cognizant of, and more compliant with, tax compliance obligations.

The finding that surprised me the most? “Both groups responded without significant difference to questions about how complicated the tax rules are (64 percent of the highly-compliant vs. 63 percent of low-compliance respondents) and the clarity of income reporting rules (73 vs.68 percent).” I would have expected more than 95 percent of respondents in any category to characterize tax rules as complicated. I find it amazing that if three people are asked if the tax rules are complicated, one would respond in the negative.

Almost every person teaching a basic federal income tax course requires students to learn the income tax consequences of divorce. In addition to the rules dealing with alimony, there is a seemingly simple provision in section 1041 that affords nonrecognition treatment to spouses when they separate their marital property. A recent case, Belot v. Comr., T.C. Memo 2016-113, demonstrates how application of a simple rule to a seemingly simple set of facts can generate complexity.

The taxpayer and his former spouse had formed and jointly owned three businesses while they were married. In 2007, they divorced. In their settlement agreement, they agreed to own and operate the businesses as equal partners. Because their interests in the businesses were not equal, they engaged in several transfers in order to bring their sharing ratios to 50-50. It did not take very long for them to discover that they were unable to function as business partners, and the taxpayer’s former spouse sued the taxpayer to obtain full ownership of the businesses. In 2008, sixteen months after the initial settlement, the taxpayer and his former spouse entered into another agreement, under which the taxpayer transferred his interests in the businesses to his former spouse in exchange for a cash, some paid immediately and some to be paid over ten years as evidenced by promissory notes. The taxpayer did not report any gain or loss from the transfer, relying on section 1041.

Section 1041(a) provides that “No gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of) -- (1) a spouse, or (2) a former spouse, but only if the transfer is incident to the divorce.” Section 1041(c) provides that “For purposes of subsection (a)(2), a transfer of property is incident to the divorce if such transfer -- (1) occurs within 1 year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage.”

Temporary regulation section 1.1041-1T(b), Q&A-7 includes five sentences explaining how Treasury interprets section 1041(c):

First, “A transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument, as defined in section 71(b)(2), and the transfer occurs not more than 6 years after the date on which the marriage ceases.”

Second, “A divorce or separation instrument includes a modification or amendment to such decree or instrument.”

Third, “Any transfer not pursuant to a divorce or separation instrument and any transfer occurring more than 6 years after the cessation of the marriage is presumed to be not related to the cessation of the marriage.”

Fourth, “This presumption may be rebutted only by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage.”

Fifth, “For example, the presumption may be rebutted by showing that (a) the transfer was not made within the one- and six-year periods described above because of factors which hampered an earlier transfer of the property, such as legal or business impediments to transfer or disputes concerning the value of the property owned at the time of the cessation of the marriage, and (b) the transfer is effected promptly after the impediment to transfer is removed.”

The IRS did not argue that the division of property under the second settlement agreement was not “made to effect the division of property owned by the former spouses at the time of the cessation of the marriage.” Instead, the IRS argued that the transfer under the second settlement agreement did not qualify under the regulations because the transfer did not relate to the divorce instrument.

The Tax Court rejected the IRS argument. It explained that the IRS argument that the division of marital property must relate to the divorce instrument is based on the first, second, and third sentences of the regulation, which refer to the divorce instrument, but overlooks the fourth sentence. The third sentence of the regulation provides that there is a presumption that section 1041 does not apply to “[a]ny transfer not pursuant to a divorce or separation instrument.” The Court decided that the taxpayer had rebutted that presumption consistent with the provisions of the fourth sentence “by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage.” The IRS, however, claimed that the taxpayer did not rebut the presumption as provided in the fourth sentence because his transfer of the business interests to his former spouse was not due to “legal or business impediments that prevented a transfer called for by the divorce decree”. To support this analysis, the IRS relied on the fifth sentence of the regulation. The court, however, set that argument aside because the fifth sentence merely provides examples and does not create a requirement that petitioner must satisfy to
rebut the presumption.

The IRS also argued that the 2007 settlement resolved all of the marital property issues between the taxpayer and his former spouse, but the Tax Court noted that nothing in section 1041 or the temporary regulations limits section 1041 to one, or only the first, property settlement or property division. The IRS then argued that the 2008 settlement was in substance a sale, but the court explained that exchanges of cash for property are not excluded from section 1041 by its own terms or by the regulations. The IRS further argued that the former spouse’s dissatisfaction with the 2007 settlement was a business dispute, but the court noted that section 1041 and the regulations apply to marital property that consists of business-related property. The IRS offered another argument, that when the former spouse sued the taxpayer in 2008, she brought her action in the superior court civil division rather than family court, but the Tax Court rejected this distinction because section 1041 has no restrictions on the forum in which spouses seek to resolve their marital property disputes.

The IRS attempted to distinguish an earlier case permitting section 1041 to apply to multiple property settlements by arguing that, unlike the earlier case, the 2008 dispute did not involve disagreement over the terms and obligations of the 2007 agreement. The Tax Court disagreed, pointing out that in both the earlier case and the one under consideration, the former spouse alleged problems in implementing the first agreement, and negotiated a revised agreement with the other spouse that caused a different division of the marital assets. The court concluded that the transfers under the second agreement in both cases were made to “effect the division of property owned by the former spouses at the time of the cessation of the marriage” and were “related to the cessation of the marriage.”

Accordingly, the Tax Court concluded that section 1041 applied to the transfers made under the 2008 agreement. That outcome is not surprising. It’s the outcome that any teacher or student of section 1041, and its regulations, would reach if presented with the facts of the case. What is surprising is that the IRS, for unknown reasons, chose to take the position that section 1041 did not apply. In order to do so, it had to invent eight rationalizations in a failed effort to persuade the court to disregard previous decision that made clear the outcome. Though there are various reasons tax law is complicated, one of the more easily avoided causes is the proliferation of arguments, by taxpayers and by the IRS, that try to make distinctions where none exist, thus making the analysis more complicated than is necessary. Though it is fairly easy to understand why taxpayers, especially pro se taxpayers, engage in this sort of approach, it is baffling why the IRS would try to prevail in a case that could easily be resolved by a student who has successfully completed a basic federal income tax course or at least the portion that deals with section 1041. Just because there was a second agreement, or cash involved in the transfers, or marital assets involving a business is no reason to disregard the clear and simple language of section 1041 and the temporary regulations. The resources of the IRS would have been better utilized dealing with other taxpayers who in fact have failed to comply with the tax law.

My objections to so-called “soda taxes” are well known. The stated goal does not match the scope of the tax, which is touted as a means of reducing sugar consumption but which fails to tax every form of sugar consumption other than certain beverages. Even if the revenues are dedicated to worthwhile purposes, the tax is flawed. I have explained why this particular tax is flawed in a series of commentaries, beginning with What Sort of Tax?, and continuing through 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, The Realities of the Soda Tax Policy Debate, Soda Sales Shifting?, Taxes, Consumption, Soda, and Obesity, Is the Soda Tax a Revenue Grab or a Worthwhile Health Benefit?, Philadelphia’s Latest Soda Tax Proposal: Health or Revenue?, What Gets Taxed If the Goal Is Health Improvement?, The Russian Sugar and Fat Tax Proposal: Smarter, More Sensible, or Just a Need for More Revenue, Soda Tax Debate Bubbles Up, Can Mischaracterizing an Undesired Tax Backfire?, The Soda Tax Flaw in Automotive Terms, and Taxing the Container Instead of the Sugary Beverage: Looking for Revenue in All the Wrong Places.

In recent days, the Philadelphia soda tax proposal has been modified in several ways. As reported in many news stories, including this one, the tax has been modified to include diet soda. Someone please explain to me how sugar consumption is reduced by imposing a sugary drinks tax on drinks that do not contain sugar, while leaving drinks containing sugar, such as coffee purchased at Starbucks into which all sorts of sugar and sugar-based substances are added free of taxation. As also reported, not all of the revenues from this tax will be devoted to the wonderful projects paraded in front of City Council and citizens as justification for the tax, because some of the revenues will be added to the city’s general fund. Neither of these changes does anything to generate more support for the tax, and they certainly make it easier for opponents to demonstrate the flaws of the tax.

What makes this particularly annoying is the manner in which the tax has been championed by its supporters. Advertised as a necessary evil to fund pre-kindergarten programs, community schools, parks, and recreation centers, at the eleventh hour, actually fifteen minutes before the Council vote, the city’s finance director announced that some of the revenues would be used for the general fund. If a business operator in the private sector did something like that, bait-and-switch charges would be hovering nearby. As one critic put it, the city “administration misled the public.”

In The Russian Sugar and Fat Tax Proposal: Smarter, More Sensible, or Just a Need for More Revenue, I wrote:

One of the arguments I offer in rejecting a tax limited to soda or soda and some sweet drinks is that such a limitation is inconsistent with the avowed goal of improving health. I have suggested that these taxes are not much more than an attempt to raise revenue, with lip service paid to issues of health. I have contended that if health improvement is a serious goal, and assuming that a tax would actually change eating habits, the tax needs to reach more than soda, and should extent to include items such as cookies, cakes, donuts, candy bars, and junk food.

The fact that the Philadelphia tax applies to beverages that do not contain sugar puts into the spotlight the absurdity of the entire soda tax movement. If, and I emphasize if, society is in favor of a “sin tax” on sugar, then advocate a tax that applies to all sugar-containing items and only sugar-containing items. What is happening in Philadelphia is counterproductive to the claimed health goals of the soda tax lobby.

A reader, after reading this article, contacted me with several questions. Before turning to the questions, I summarize the article.

Because of the Surgeon General’s initiative to reduce the incidence of skin cancer, sunscreen dispensers are being installed in places like beaches, golf courses, fishing piers, water parks, pools, hiking trails, and similar locations. Non-profit public health organizations are covering most of the cost. The installations generally occur under programs approved by city and local governments. It started in Boston, then Miami Beach, and then was picked up by several West Coast localities. Health and wellness advocates and skin cancer experts are encouraging cities and towns throughout the country to join in the effort to reduce skin cancer.

The reader asked, “Is the providing of dispensers with sunscreen a tax subsidy?” and “Are public health nonprofits a tax subsidy?” The reader prefaced his questions by remarking, “The use of the word ‘free’ in this article is misleading and/or incorrect . I was taught by my parents there is no such thing as a free lunch.”

First, the appropriate use of the term “free” depends on the context. If nothing is expected in return, then the recipient of something for which nothing is paid can consider the item “free.” On the other hand, it is not unusual for a person who receives a “free” item to encounter a request or demand for something in return. Consider a food manufacturer who distributes “free samples” of a new item to shoppers in a grocery store. Are the items truly free? For the recipient, yes, because there is no obligation to purchase the product. For the purchasers of the product, or of the food manufacturer’s other products, there is a cost, because the manufacturer needs to purchase the materials and labor to produce the free samples.

Second, whether a tax subsidy is involved depends on how the sunscreen and dispensers are being funded. Certainly if they are being purchased by the state or local government using tax revenues, then they are not free for the town’s taxpayers even though they might be free for visitors who are not taxed or otherwise charged for the sunscreen. If the cost is borne by nonprofit tax-exempt organizations, the question of whether a tax subsidy exists is answered depending on how one views tax-exempt status. For decades, arguments have been delivered from those claiming that it is and those claiming that it is not. The cost of tax-exempt status is that additional taxes are paid by taxable persons and entities in order to make up the revenue not received from the tax-exempt organization, and to some, this is a tax subsidy. To others, a government is not giving anything to a tax-exempt organization when it refrains from taking some of its income or assets in the form of a tax. The concept of tax-exempt status, at a theoretical level, is that the monies not paid in taxes are used by the organization to provide services and assistance that otherwise would burden society and government. At a practical level, of course, it doesn’t work quite that way.

Would the analysis change if users of the sunscreen were required to pay, through an iPhone app, the swiping of a debit card, or other payment mechanism? It would remove the reader’s questions, because it would no longer be free in any sense. Why have the providers of the sunscreen elected not to charge? Because, as one spokesperson pointed out, “[s]unscreen is expensive, and for some people, it’s just not in their budget.” If those who cannot afford to pay don’t use sunscreen, many will develop melanoma, and in turn put economic costs on society, through a combination of higher health insurance premiums for everyone, that far exceed the cost of the sunscreen. Just as the food manufacture hopes to recover far more than the cost of the free samples through increased sales, the providers of sunscreen hope to recover far more than the cost of the sunscreen through decreased health care cost expenditures.

So what’s free? Perhaps not lunch, but the wisdom of planning ahead and paying a little now in order to receive or save much more in the future. Of course, with the current trend of monetizing everything, unless the trend changes, perhaps ultimately nothing, even the air we breathe, will be free.

A recent Tax Court case, McAuliffe v. Comr., T.C. Summ. Op. 2016-25, demonstrates the importance of creating and maintaining proof that tax returns are filed, and when they are filed. Though the case involved whether refund or credit of an overpayment was barred by the statute of limitations, the preliminary issue was whether the taxpayer filed a federal income tax return for 2003, and if so, when.

The taxpayer, an attorney, lived in Ohio, where he served as a municipal court judge. On April 23, 2003, he was indicted for mail fraud and money laundering offenses. He was charged with burning down his house and seeking insurance proceeds. He was taken into custody by April 28, 2003, held without bail, and convicted by a jury in February 2004. In December 2005, he was sentenced to 156 months of imprisonment. He was incarcerated in West Virginia when the petition was filed with the Tax Court. After he was released in August 2014, he moved to Florida. The taxpayer’s appeal of the conviction and his collateral attacks on the conviction failed. The Supreme Court of Ohio disbarred him from the practice of law.

The taxpayer received approximately $80,000 of gross income in 2003, and $12,156 in federal income taxes was withheld from his pay. The record of the IRS do not reflect a timely filed return for 2003, but do reflect the timely filing of a request to extend the due date for the 2003 return to August 15, 2004. The IRS records reflect the receipt of a return for 2003 filed in November 2008 while the taxpayer’s case was pending before the IRS Appeals Office.

The taxpayer testified that after his arrest, his tax affairs were handled by his attorney-in-fact, Craig Maxey, and by Cindy Grimm, a full-time parole officer and part-time, seasonal, return preparer for H&R Block. The taxpayer testified that after his arrest he was not thinking about taxes and had no involvement in them. Grimm obtained the request for extension of time to file, and Maxey provided her with the taxpayer’s 2003 tax information. Though neither Maxey nor Grimm testified at trial, the parties stipulated that she did not recall whether she filed the taxpayer’s return or sent it back to Maxey for filing. They stipulated that Grimm stated that if she filed the return, she would have done so electronically. They also stipulated that Maxey stated he did not mail the 2003 return to the IRS.

In or about 2007, the IRS commenced an examination for the taxpayer’s 2003 taxable year. There being no return, the IRS created a substitute for return, and proposed a deficiency in tax and additions to tax.On May 5, 2008, the IRS sent a notice of deficiency to the taxpayer in prison. The taxpayer filed a petition on July 14, 2008. Thereafter, the IRS requested from the taxpayer a copy of the 2003 return. In November 2008, the taxpayer sent a copy of the 2003 return, explaining that the first time he had seen the return was when he received a copy from Maxey a few days earlier. The return provided by the taxpayer did not have his actual signature but had a stamped signature. At trial, the taxpayer testified that Grimm possessed his signature stamp and used it for tax and nontax purposes. The return had Grimm’s actual signature as preparer. The return showed zero taxable income, zero total tax, and an overpayment equal to the amount of withheld tax. Also in evidence were incomplete extracts from a transcript dated May 30, 2012, from the Ohio Department of Revenue for the taxpayer’s 2003 Ohio taxable year. The extracts did not definitively establish when the Ohio return was filed, nor whether a federal income tax return was filed for that year, although they refer to the amount of the taxpayer’s AGI as reported on the return provided to the IRS Appeals Office in November 2008.

The Tax Court concluded that the record demonstrated the taxpayer himself never prepared or signed a return for 2003. The taxpayer did not know whether Maxey and Grimm did what he thinks they were supposed to have done. He surmised that they did, because the Ohio income tax return for 2003 was filed. But nothing in the abstracts from the transcript indicate whether or when a federal income tax return was filed. Based on Grimm’s inability to remember whether or not she filed the return, and Maxey’s testimony that he did not mail a return, the court decided that it could not conclude that either Grimm or Maxey filed the return.

The best proof that a tax return has been filed depends on how it is filed. If it is filed in paper form through the mail, a return receipt is proof not only of transmission but also of receipt by the relevant tax office. If a return receipt is requested but not received, the taxpayer has an early warning that the return probably was not received, and can begin to track it down. If the return is filed electronically, the software generates a receipt, and thereafter provides a notification that the return was accepted by the relevant tax office. It is unclear whether Grimm or H&R Block received such a confirmation, but presumably a search was made for it and it was not found.

Though advice to obtain receipt for the mailing or filing of a return is easy enough to give to a taxpayer who is preparing his or her own return, or who is working with a preparer, it is of much less help for taxpayers who are not involved in the preparation of their return because they are in prison, in a coma, or otherwise in a position that prevents them from being involved in the return preparation. At that point, it becomes the responsibility of the person handing the taxpayer’s tax matters to obtain a receipt for filing the return. Though it might be easy to wonder why Grimm did not do so, considering that she was a tax return preparer, it is unclear what responsibilities Grimm undertook with respect to the taxpayer’s return. Even if the taxpayer had made direct contact with Grimm and requested her to file his 2003 return as he was being led off into the criminal justice system, it’s a bit much to expect him to provide a checklist of what ought to be done or to request specifically that a return receipt be obtained. Perhaps that request should have been made by the attorney-in-fact.

We now live, fortunately or unfortunately, in which assertions of actions taken and not taken, of things said and not said, are easily offered and more easily circulated. The best protection is to keep good records, obtain receipts, and retain evidence of what has and has not happened. The cost of not doing so can be steep, and can be more than a lost overpayment.

Several weeks ago, in Taxation of Androids and Robots, and Similar Pressing Issues, I commented on discussions at a science fiction conference that focused on the question of who would qualify as “people” for purposes of taxation. The participants addressed the tax status of androids, robots, sentient non-human aliens, and zombies. Though the question of whether a zombie is subject to taxation might seem far-fetched and irrelevant to current tax practice, the treatment of what could be characterized as a “zombie corporation” arose in a recent Tax Court case.

In Allied Transportation, Inc. v. Comr., T.C. Memo 2016-102, the Tax Court considered whether it had jurisdiction to consider a petition filed in response to a notice of deficiency. Allied was incorporated on August 23, 2001, by Sukhjeet Singh Gill. It was issued a taxpayer identification number by the Maryland Department of Assessments and Taxation, Corporate Charter Division. On October 8, 2004, the department revoked and annulled Allied’s corporate chapter for failing to file a required property tax return. On February 12, 2007, Gill attempted to file articles of revival on behalf of Allied, but on March 6, 2007, those were declared void for nonpayment.

On August 14, 2014, the IRS issued a notice of deficiency to Allied for taxable year 2010. It alleged a federal income tax deficiency of $79,812 along with additions to tax of $18,000. On October 14, 2014, Allied filed a petition with the Tax Court, signed by Gill. On October 14, 2015, the IRS filed a motion to dismiss for lack of jurisdiction, arguing that the petition was not filed by a party with capacity to sue. Counsel for the IRS explained in the motion that he had discussed the motion with Gill, who stated he no longer had any involvement with Allied and did not intend to proceed any further with the case. On October 20, 2015, the court issued an order to Allied directing it to respond to the IRS motion to dismiss. Allied did not respond.

Rule 60(c) of the Tax Court Rules of Practice and Procedure provides that the capacity of a corporation to litigate in the court is determined by the law under which it was organized. In Maryland, when a corporation forfeits its charter, the powers conferred on it by law are inoperative, null, and void as of the date of forfeiture. The power to sue or to be sued is extinguished. In other words, the corporation is dead. However, the corporation is treated as continuing to exist after the forfeiture, for purposes of litigating matters that have a rational relationship with the legitimate winding up of the corporation. This post-forfeiture existence is limited to the completion of corporate business existing at the time of the forfeiture.

The Tax Court pointed out that Allied filed the petition more than ten years after the forfeiture. It held that ten years is an excessive period within which to conduct winding up activity. It also noted that the tax liability in question was for 2010, six years past the forfeiture. The court commented, “The notice of deficiency determined, on the basis of a bank deposits analysis, that Allied had unreported gross receipts of $247,595 for that year. Given that Allied had forfeited its charter six years previously, it seems unlikely that it (as opposed to a related party) could have earned those gross receipts.” The court concluded that litigation concerning income arising in 2010 would not seem to have a rational relationship to the winding up of corporate business that existed in 2004.

From this case, it is easy to conclude that zombie corporations exist. These are corporations that die when their charters are revoked or otherwise terminated, but that are treated as alive for limited purposes related to the winding up of the corporation. The case also demonstrates that a dead corporation cannot have gross income. The case does not answer the question of whether a zombie human can have gross income. When and if that case arises, hopefully after I’ve left the planet, there might be some basis for arguing from analogy from the principles illustrated by this case. I have no intention of returning as a zombie to obtain first-hand experience with respect to the question.

Those television court shows continue to supply material for MauledAgain. The tax aspects of these television cases have inspired me to write posts such as Judge Judy and Tax Law, Judge Judy and Tax Law Part II, TV Judge Gets Tax Observation Correct, The (Tax) Fraud Epidemic, Tax Re-Visits Judge Judy, Foolish Tax Filing Decisions Disclosed to Judge Judy, So Does Anyone Pay Taxes?, Learning About Tax from the Judge. Judy, That Is, Tax Fraud in the People’s Court, More Tax Fraud, This Time in Judge Judy’s Court, and You Mean That Tax Refund Isn’t for Me? Really?. This time, the inspiration comes from an episode of Hot Bench, which previously gave me the material for Law and Genealogy Meeting In An Interesting Way.

The plaintiff bought a car from the defendant, who claimed to be an independent car wholesaler. The plaintiff did not get title to the car. Title had been transferred from a third party to an auction house, and from the auction house to one of the defendant’s companies. The defendant explained that his attempt to transfer title to the plaintiff hit a snag with the Missouri Department of Motor Vehicles because it considered him to be a dealer rather than the independent car wholesaler he claimed to be.

The plaintiff paid $2,300 for the car. She was given a receipt for $800. The receipt was issued in the name of another of the defendant’s companies, and not the one that purchased the vehicle at the auction. When asked why the receipt was for $800 and not $2,300, the plaintiff responded that the defendant issued her a receipt for $800 so that she pay state sales taxes on $800 rather than the entire $2,300.

The court did not look favorably upon the defendant’s behavior. It held for the plaintiff, awarding her return of the $2,300, and giving possession of the car back to the defendant. Nothing was said about the sales tax fraud, nor was it clear whether the plaintiff had any part in it.

This is not the first television court case involving sales tax evasion. A similar case was the inspiration for The (Tax) Fraud Epidemic. I wonder how prevalent this particular style of sales tax evasion has become. There’s no avoiding the conclusion that it is fraudulent to say to a customer, “I’m selling this to you for $2,300, you will pay me $2,300, but I will issue a receipt that can be used in support of the lie that I sold this to you for $800.” The question is whether the buyer should be held accountable for not saying, “No, I want a receipt for $2,300 and I will pay sales tax on that amount.” My guess is that, in this case, even if the plaintiff had said that, the defendant would have had a plausible explanation for why “This is the way it is done.”

Each year, the underground economy accounts for hundreds of billions of dollars of evaded federal income taxes. This “tax gap” gets a good bit of attention. I wonder how much tax gap exists for state and local non-income taxes. I suspect that it’s not in the hundreds of billions of dollars. It’s probably in the tens of billions of dollars. That’s a lot of unrepaired roads, delayed emergency services responses, and education gaps.

Some members of Philadelphia’s City Council who are opposed to the sugary beverage tax proposed by the mayor have offered an alternative. The Non-Reusable Beverage Container Tax would apply to non-reusable beverage containers supplied to, acquired by or delivered to retailers. A non-reusable beverage container is any individual, separate, and sealed glass, metal, or plastic bottle, can, jar, or carton, not ordinarily collected from consumer for refilling, that contains a beverage of more than seven fluid ounces and that is intended for consumption off premises. A beverage is any soft drink, water, ready-to-drink tea or coffee, fruit juice, vegetable juice, or energy drink, but not baby formula, products with milk as the primary ingredient, and milk substitutes. The preceding summary does not do justice to the complexity of the proposal, particularly the collection and procedural requirements.

In terms of how I analyze taxes and user fees, the beverage container tax fares no better than does the soda tax. I have analyzed the latter in numerous commentaries, beginning with
What Sort of Tax?, and continuing through 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, The Realities of the Soda Tax Policy Debate, Soda Sales Shifting?, Taxes, Consumption, Soda, and Obesity, Is the Soda Tax a Revenue Grab or a Worthwhile Health Benefit?, Philadelphia’s Latest Soda Tax Proposal: Health or Revenue?, What Gets Taxed If the Goal Is Health Improvement?, The Russian Sugar and Fat Tax Proposal: Smarter, More Sensible, or Just a Need for More Revenue, Soda Tax Debate Bubbles Up, Can Mischaracterizing an Undesired Tax Backfire?, and The Soda Tax Flaw in Automotive Terms.

So what’s the justification for the beverage container tax? According to this report, the member of City Council introducing the bill stated, “This tax needs to be shared by all, from soda to Perrier.” Of course, the beverage container tax does not ensure that the revenue burden is shared by all. Some people will have the ability to purchase beverages outside the city, whereas others do not have that opportunity. The flat 15-cents-per-container tax is regressive, because a person who purchases beverages 500 times during the year would pay $75, which might not be much for a wealthy or economically comfortable individual but which would be a big dent in the wallet of a poor person.

Just as the soda tax has no rational connection to the programs its revenues are intended to finance, so, too, there is no rational connection between a beverage container tax and the programs its revenues are intended to finance. As a practical matter, both tax proposals are designed to finance the same bundle of programs. It’s not that those programs are bad ideas. It’s the lack of a rational funding connection that underscores the flawed nature of both proposals.

The soda tax is designed to cut sugar consumption. But it fails to reach its intended target because it does not apply to most sources of sugar. It’s unclear what the beverage container is intended to target other than containers as containers. Perhaps some sort of justification could be offered in terms of reducing the proliferation of containers filling landfills, polluting the ocean, and contributing to street trash. However, the nature of such an argument as pure pretext would be obvious because the proposed beverage container tax would not apply to most sources of detrimental containers. Worse, it would apply to containers that are recycled, even though those containers create far fewer environmental disadvantages than do containers that are not recycled. Even worse, it would not apply to those styrofoam containers used to deliver food and other items. Inexplicably, it would apply to container filled with beverages intended for off-premise consumption but not containers filled with beverages intended for on-premises consumption, even though both containers contributes to pollution and landfill overflow if they are not recycled.

The beverage container tax is nothing more than the soda tax expanded to cover other beverages, some healthy and some not-so-healthy. Designed in that way, the tax no longer can be justified as a means of reducing sugar consumption. It cannot be justified as environmentally sensible. It’s nothing more than a matter of looking for revenue in all the wrong places.