MauledAgain

A recent Tax Court case, Cappel v. Comr., reminds taxpayers that tax danger lurks in every child support situation. Usually, divorcing couples avoid the consequences, but sometimes one of the two behaves in a way that makes a mess of the other person’s tax situation and leaves that person unable to dig out of it.

The taxpayer has three children, T, C, and P. T and C were born to the taxpayer and his first wife. P was born to the taxpayer and his second wife, with whom he is in divorce proceedings. During 2011, T, C, and P were 20, 16, and 12, respectively. In 2002, a Florida family court entered a child support order in the divorce
case between petitioner and his first ex-wife. The court ordered that the taxpayer “will receive the child dependency exemption for [T and C] each and every year beginning in 2001” but “only if he remains current from this point forward in his payments of child support.” The taxpayer credibly testified that he has been current in his child support payments at all relevant times, and the IRS did not contend otherwise.

The taxpayer timely filed a federal income tax return for 2011 on which he T, C, and P as dependents. Notwithstanding the Florida court’s 2002 order, the taxpayer’s first former wife also claimed T and C as dependents for 2011. The taxpayer’s second wife, the mother of P, claimed P as a dependent for 2011. Neither T nor C resided with the taxpayer during 2011, and he does not know where either of them resided. P resided with his mother in Pennsylvania for more than half the year during 2011; he did not reside with the taxpayer at any time during 2011. The taxpayer was the noncustodial parent of C and P during 2011. He did not obtain, from C’s mother or from P’s mother, an executed Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent.

The primary question before the court was whether the taxpayer was entitled to claim dependency exemption deductions for the three children. The answer to that question would determine whether he was entitled to head-of-household filing status and child tax credits.

The Tax Court analyzed whether each child was a qualifying child or a qualifying relative. None of the children were qualifying children because none of them satisfied the requirement that they have the same principal place of abode as the taxpayer for more than one-half of the taxable year. Neither C nor P was a qualifying relative because the taxpayer, though paying child support, did not provide evidence that he supplied more than 50% of their support, nor did he provide evidence that he supplied more than 50% of the support of T. Nor was the taxpayer within the exception for noncustodial parents because he did not file a Form 8332.

The court noted that the taxpayer “has acted honorably in paying child support for many years, but his ex-wife has apparently claimed two of their children as dependents in violation of a Florida court order. But while the result may seem harsh in these circumstances, the law is unfortunately clear. On the record before us, we have no alternative but to sustain [the IRS].”

So what’s the solution? The answer, I think, is for the taxpayer to sue his first former wife for breach of contract. Damages should reflect the increased taxes, interest, and penalties paid by the taxpayer on account of her failure to comply with the contract and the resulting court order. Going forward, it makes sense for divorcing couples to include in their divorce agreements a provision that concedes damages if either party breaches the agreement or violates the accompanying court order. That, too, might seem harsh when proposed, but in the long run, it’s best to insist on its inclusion.

The future of highway, bridge, and tunnel maintenance, repair, and expansion rests with the mileage-based road fee. Why do I make that claim? My analysis began with Tax Meets Technology on the Road, and has continued 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?.

Now comes news that the governor of Massachusetts has vetoed legislation that would have authorized a federally-funded pilot study of the mileage-based road fee in Massachusetts. The study would have used the experiences of volunteers, and no one who did not want to participate in the study would be compelled to do so. The governor stated, “It feels to me like it falls into a category of something people really ought to know a lot more about before they head down this road.” Exactly, governor, that’s what pilot programs are designed to do. It is federally funded, so it’s not costing Massachusetts very much, if anything. The governor’s response? Massachusetts can rely on the results of pilot programs in other states. And what if other states took the same position? That’s one element of twenty-first-century American political and cultural dysfunction. Let someone else do the work, let someone else do the testing, and let someone else take on the responsibility. Massachusetts residents deserve to have the opinion of Massachusetts volunteers testing out the pilot program, rather than restricting themselves to what people in other states experience. Though some things can be learned from the experience of volunteer testers in other states, those volunteers cannot replicate what the Massachusetts experience would be.

To me, it comes down to the governor of Massachusetts being afraid of trying something new or different. Staying with what works makes sense, but funding highways with liquid fuels taxes doesn’t work very well, and is heading down the road to failure.

Recently, the IRS sent a tremendous number of Failure to Deposit Notices to employers, treating monthly and daily deposits of payroll taxes as having been filed late. Someone figured out that these notices were wrong, because the due date was not the usual April 15 but April 18 on account of holidays. The IRS reacted by sending out an email, which the folks at Vision Payroll have shared, in which it explained the error and that it “is working to resolve the issue and correct the erroneous penalty assessments in the near future.” What a mess.

Only a small percentage of taxpayers file payroll taxes. Most taxpayers are not employers. But imagine if the IRS made a similar error if the ReadyReturn program were in effect. As readers of this blog know, I’m not a fan of ReadyReturn. In October 2005, I addressed the ReadyReturn concept, in Hi, I'm from the Government and I'm Here to Help You ..... Do Your Tax Return. I revisited the issue in March of 2006, in ReadyReturn Not a Ready Answer. A year later, in Ready It Was Not: The Demise of California’s Government-Prepared Tax Return Experiment, I shared the news that California’s experience with the program persuaded it to end the program. Yet I had to return to the topic in As Halloween Looms, Making Sure Dead Tax Ideas Stay Dead, where I noted the refusal of the ReadyReturn advocates to admit the failure of the program. And in December 2006, I reacted to the attempt to resurrect the failed program, in Oh, No! This Tax Idea Isn’t Ready for Its Coffin. Yet the advocates of the proposal, despite all of the many problems and its failure in California persisted. In October 2009, in Getting Ready for More Tax Errors of the Ominous Kind, I again pointed out why people should not fall for something described as simple, bringing relief, and carrying a catchy title. I looked at it again in January 2010, in Federal Ready Return: Theoretically Attractive, Pragmatically Unworkable. Later that year, in April 2010, I was interviewed by National Public Radio on the advantages and disadvantages of ReadyReturn; a summary of the discussion and the reaction to it, along with links to previous discussions is in First Ready Return, Next Ready Vote?. In 2012, as pressure from its advocates resurfaced, I extensively analyzed the ReadyReturn proposal, in a 14-part series. That, however, was not enough to diminish the insistence of ReadyReturn advocates that the only thing blocking success for the program was Intuit’s lobbying, a concern I addressed in Simplifying theTax Return Process.

A little more than a year ago, in Surely This Does Not Boost Confidence In The ReadyReturn Proposal, I shared my concern that an error made by the IRS that caused serious problems for one taxpayer could easily become an error that affected all taxpayers. The recent mistake with the Failure to Deposit Notices brings the tax world a step closer to the nightmare of an error making life miserable for all taxpayers.

What caused the recent error? Does anyone know? Perhaps, but perhaps not. Perhaps the IRS is still trying to figure out what went wrong. With its antiquated technology, funding shortages, and employee turnover, the list of possibilities is long. Though the IRS promises to fix the consequences of the error, the employer taxpayers will have additional work to do and information to process, as well as follow-ups to pursue to make certain money isn’t taken out of their accounts to pay an erroneous penalty. Worse, what guarantee exists that the error won’t happen again? Fixing the consequences of a problem isn’t the same as preventing the problem from happening again. Because an erroneous Failure to Deposit Notice is only one of tens of millions of possible errors, any sort of arrangement that accelerates the spread or widens the scope of an error ought not be implemented until and unless it is ironclad secure. The IRS, the nation, and its taxpayers are not ready for a federal ReadyReturn or any sort of equivalent.

When the Pennsylvania legislature enacted the most recent budget for the state, it included not only increases in the cigarette and tobacco tax, but also imposed a new tax on electronic cigarettes and e-liquids. The tax is an excise tax equal to 40 percent of the purchase price charged to retailers. The legislation also imposed a floor-stocks tax on wholesalers and retailers who hold inventories of cigarettes, tobacco, electronic cigarettes, and e-liquids. This tax is $1 per cigarette pack, 55 cents per ounce of tobacco, and 40 percent of the purchase price of electronic cigarettes and e-liquids. The taxes went into effect on August 1, and the floor-stocks tax must be paid within 90 days, though the tax on electronic cigarettes and e-liquids goes into effect on October 1, with the floor-stocks tax due within 90 days. In theory, the retailer pays the tax when acquiring the items, and then recovers it when selling to the customer. The legislature decided that the tax should apply to items already purchased by the retailer, that is, inventory in place. But practical reality hits home. The retailer must come up with 40 percent of the value of inventory within 90 days but won’t be able to recover that amount until the inventory is sold. According to this story, one retailer in Lycoming County will owe $40,000 by the end of the year, an amount that will compel him to close his business. Other retailers are in a similar position.

The floor-stocks tax is flawed. In effect, it is a retroactive application of the tax. Rather than applying only to future wholesale acquisitions, which a retailer can adjust to reflect the cash flow changes, it applies to purchases already made by the retailer, which cannot be undone. Some retailers are trying to dispose of inventory but doing so is a financially disadvantageous path.

At the very least, the tax should be phased in. Apparently, retailers lobbied the legislature but were unsuccessful in making their case. Some argue that the tax should be repealed. It’s not necessary to repeal the tax to fix the cash flow hit that it creates. It simply needs to be adjusted in some manner.

Proponents of the tax surely will point to the revenue that it generates. Though a very small portion of the state’s total tax revenue, it has a huge impact on retailers. The revenue can easily be made up by fixing another flaw in the tax. As I explained in When Does a Tobacco Tax Not Apply to Tobacco, and Why?, the taxes that apply to cigarettes, tobacco, electronic cigarettes, and e-liquids should apply to cigars. It is possible that doing so would not only permit a timing adjustment to the excise tax to prevent the cash flow hit on retailers, but also a reduction in the tax rates applicable to those products not fortunate enough to be a favorite among the legislature as are cigars.

The saga of how the tax cuts for the wealthy enacted at the behest of Kansas governor Sam Brownback has hurt the state now has a parallel tale. For too many years, citizens of Kansas have watched as government services have eroded and education funding has shrunk because the revenue windfall promised by those hawking the trickle-down theory of tax policy failed to materialize. It appears that the citizens of Kansas have had enough. As reported in various stories, including this one, voters in the Kansas legislative primary elections voted against at least eleven, and depending on final vote tallies, as many as 14, Kansas legislators aligned with the extremely conservative governor. The voters selected moderates who, at time, align with Democrats on particular issues.

Analysts suggest that the impetus for this first step in house-cleaning the state’s politics was voter frustration with the reduction in government services and especially the damage done to the state’s education system. It also appears that voters are increasingly recognizing the siren song of trickle-down tax policy theory. Some voters cited bad roads and declining school quality, and many expressed dismay at the failure of trickle-down economics to generate the promised jobs.

What is surprising about this story is that it comes as a surprise to some people, especially Brownback and his political allies who scrambled to portray the outcome as something other than failure of trickle-down tax theory. There is nothing surprising these days about the outcome of a failed tax policy experiment from a decade and a half ago. Maintaining allegiance to a failed policy and its advocates has terrible consequences, first for those afflicted by the failure and then, thankfully, for those responsible for insisting that the failure did not exist.

Anti-tax and anti-government advocates argue that tax cuts for the wealthy will increase private sector jobs. This argument appeals to those who want jobs, and it appeals to those with jobs who somehow think that the creation of more jobs will bring them salary increases. History has demonstrated that this argument not only is flawed, it is fraudulent. It hasn’t worked. One of the best examples of how this tax-cuts-for-the-wealthy-creates-jobs sales pitch has failed is Kansas.

In A Tax Policy Turn-Around?, I explained how the Kansas income tax cuts for the wealthy backfired, causing the rich to get richer, the economy to stagnate, public services to falter, and the majority of Kansans to end up worse than they had been. In A New Play in the Make-the-Rich-Richer Game Plan, I described how Kansas politicians have been struggling to find a way to undo the damage caused by those ill-advised tax cuts for the wealthy. In When a Tax Theory Fails: Own Up or Make Excuses?, I pointed out that the Kansas experienced removed all doubt that the theory is shameful. In Do Tax Cuts for the Wealthy Create Jobs?, I described recent data showing that the rate of job creation in Kansas was one-fifth the rate in Missouri, a state that did not subscribe to the outlandish tax cuts for the wealthy that Kansas legislators had embraced.

Now comes more evidence that what Kansas did was harmful and not, as the tax cut advocates had promised, beneficial. Kansas officials revealed that tax receipts were more than $14 million less than anticipated. Why? Sluggish retail sales combined with the reduction in corporate income triggered by reduced sales pushed down sales tax and corporate income tax liabilities. This shortfall comes after the state had reduced its prediction of tax receipts. So, in effect, the state collected even less in taxes than it had predicted trickle-down economics would have generated.

So what is Kansas going to do? The governor, the state’s chief champion of this obsolete tax policy, delayed payment of state aid to public schools. It is unfortunate that the best pathway to solving the economic mess created by trickle-down economics, educating the citizenry, is what gets short-changed. But that ought not be a surprise, considering that an educated citizenry is an impediment to the enactment of unsound tax policies. Other politicians are calling for reform, for the election of legislators who will dig the state out of the “financial hole [that] keeps getting deeper.” In the meantime, the state’s bond rating has dropped, increasing the interest rates that the state must pay to borrow money to cover the deficits.

In A Tax Policy Turn-Around?, I argued that tax cuts for consumers are more valuable than tax cuts for money stashers. The recent news out of Kansas proves that point. Improving the economic posture of the middle class and the poor generates more sales, which drives up sales tax revenue, and increases corporate profits, which increases corporate income tax receipts as well as shareholder return. During the past few years, increasing numbers of the wealthy are beginning to accept the proposition that the best path for their own long-term economic well-being is enrichment of the middle class and the poor.

As I’ve explained many times, for example, in Job Creation and Tax Reductions, people don’t create jobs unless they need workers. They don’t need workers unless they have customers who want to purchase the goods and services that they would provide. If the American middle class and those living in poverty or near-poverty don’t have money, they don’t make purchases. In fact, they cut back on purchases. And that, understandably, causes the owners of capital and the entrepreneurs of the business world to cut, not create, jobs.

Those who think that more tax cuts for the wealthy will solve the problems created by tax cuts for the wealthy are suggesting, in effect, that the solution to flash floods is more rain, that the solution to car theft is more car theft, and that the solution to food poisoning is eating more spoiled food. Seriously, that sort of thinking is not what made the nation’s economy great, nor is it a pathway to future prosperity.

A reader recently noted a several-years-old proposal in Portland, Oregon, to collect a tax based on adjusted gross income. The reader asked, “Is this a good idea? Why not use gross income or taxable income?”

If the choices are limited to gross income, adjusted gross income, and taxable income, and I were compelled to make a selection, I would choose adjusted gross income. The other two choices are worse.

Gross income does not properly measure a person’s change in economic position. For example, compare two sole proprietors. One provides services, receives $300,000 in gross income, and incurs $70,000 in business expenses. The other also provides services and receives $300,000 in gross income, but incurs business expenses of $140,000. To subject both sole proprietors to the same tax would be the equivalent of subjecting the second sole proprietor to a higher tax rate.

Taxable income also does not properly measure a person’s change in economic position. Taxable income reflects the effect of a variety of deductions. Some expenses are deductible, others are not, and whether a particular expense is deductible or not does not reflect an attempt to measure taxpayers’ changes in economic position in a comparable manner. In many instances, items that are deductible are deductible because of lobbying by particular groups, arbitrary decision, well-intentioned or not-so-well-intentioned efforts to promote particular policies, encourage specific behavior, or discourage unwanted behavior. For example, compare two taxpayers with identical gross income. One owns a home, the other rents. In all other respects their economic activities are identical. The use of taxable income in this instance is disadvantageous to the renter.

Adjusted gross income, though not without its flaws, comes closer to measuring a person’s change in economic position than do the other two choices. One flaw is that the gross income on which it is based, even after allowing deductions to remove the sort of discrepancies noted above, is also flawed because all sorts of economic income is excluded from gross income in much the same haphazard, arbitrary, and lobbied manner as deductions are created. For example, an employee with the opportunity to take less cash in exchange for receiving tax-favored benefits is better off than an employee who receives only cash and must use after-tax dollars to purchase the same benefits. This flaw, of course, afflicts all three choices. The other flaw with adjusted gross income is that the list of items deductible in computing it has grown to include not only items that need to be subtracted to avoid double taxation or to obtain a more accurate measure of change in economic position but also deductions accorded this special status because of lobbying efforts.

As often is the case when forced to choose from two or more less-than-perfect choices, I find a way to point out the unavailable but better choices. In this instance, my preferred solution is what I would call “genuine economic adjusted income,” namely, all income reduced by amounts necessary to reflect the cost of producing that income and to avoid double taxation. Of course, selecting the rate or rates to be applied is a different issue, as is the removal of all credits other than those reflecting payments already made.

Some would say that the premise underlying the reader’s question, namely, what is the best income tax base, is flawed because they consider the income tax less than ideal. I disagree with the proposition that income taxes are less than ideal, though I agree that the current income tax is far from ideal and is, in many ways, a disgrace. The income tax was enacted to mitigate the horrific consequences of the income and wealth inequality that arose during the 1890s and to prevent its recurrence, driven home by the fact that, in its early years, it applied only to the wealthy. The income tax, unfortunately, has become so twisted and corrupted by special interest groups that it is having the opposite effect and is making income and wealth inequality even worse. Using a “genuine economic adjusted income” as the base would undo the damage, and perhaps, in order to avoid yet another sabotaging of the income tax by the Robber Barons and their devotees, an amendment to the Constitution would be in order. One wonders how bad the economy will need to be before pressure for such a change reaches the level of the pressure that generated the Sixteenth Amendment, and in what form that pressure will appear.

The question posed by a reader was simply that simple. “Is tax avoidance avoidable?” The reader, a long-time follower of this blog, knows that I am no fan of ignorance, tax or otherwise. Surely this reader has read at least some of my posts on the topic, including Tax Ignorance, Is Tax Ignorance Contagious?, Fighting Tax Ignorance, Why the Nation Needs Tax Education, Tax Ignorance: Legislators and Lobbyists, Tax Education is Not Just For Tax Professionals, The Consequences of Tax Education Deficiency, The Value of Tax Education, More Tax Ignorance, With a Gift, Tax Ignorance of the Historical Kind, A Peek at the Production of Tax Ignorance, When Tax Ignorance Meets Political Ignorance, Tax Ignorance and Its Siblings, Looking Again at Tax and Political Ignorance, and Tax Ignorance As Persistent as Death and Taxes.

What prompted the reader to ask the question was a statement made by the judge who sentenced Argentine soccer star Lionel Messi to prison, along with the imposition of a fine, after he was found guilty of tax fraud. Messi, or more accurately, Messi’s lawyers had argued that he was innocent because Messi’s father was responsible for setting up the tax-haven-based shell companies used to evade taxes on income derived from Messi’s right to use his image. Messi admitted he signed the contracts that were part of the scheme but claimed he had no knowledge that the arrangements were wrong. The judge stated, “(His) avoidable ignorance, which was derived from indifference, is not an error, and it does not remove responsibility. The information that the accused avoided having was, in reality, within his reach via trustworthy and accessible sources.”

When the reader asked, “Is all tax ignorance avoidable,” I replied, “Yes. It might take a lot of work, or a little bit of work, a lot of time, or a little bit of time, but tax ignorance is avoidable.” Admittedly, that response is a bit overbroad, because a person in a coma, a person held hostage, and others in similar difficulties might not have an opportunity to do whatever is necessary to become educated. The avenue for avoiding tax ignorance are many. Some people can educate themselves by doing research and reading official sources and helpful commentaries. Most people need to, and should, seek independent advice, and if enough is at stake, should seek a second opinion. When the advice is too good to be true, even if a small amount is involved, a second opinion is valuable. The advice needs to come from someone with sufficient education and experience. The friend at the neighborhood bar or the anonymous internet commentator with no or false credentials are not good sources of information, whether with respect to tax or any other topic.

It’s easy to grab at the first twitter post or facebook meme that pops up, but intellectual progress requires more diligence, more thinking, and more focus than many people are, at present, willing to apply. The price for intellectual laziness, especially in the tax world, can end up being a prison term, a fine, or worse. There is no reason to fear intellectual effort.

There are many reasons why taxation is confusing. One of those many reasons is the willingness of legislatures to exempt someone from one tax but to subject that same person to a very similar tax. A recent case, Curet v. Comr., T.C. Memo 2016-138, illustrates this “principle of confusion” in the context of a Puerto Rico resident.

The taxpayer lived and worked in Puerto Rico during 2010. He was self-employed. For 2010, he filed Form 482.0, Individual Income Tax Return, with the Commonwealth of Puerto Rico. With the return he included a Schedule M, Professions and Commissions Income, which is the equivalent of the Schedule C, Profit or Loss From Business, on the federal Form 1040. He reported a profit on that Schedule. He did not file a Form 1040-SS, U.S. Self-Employment Tax Return with the IRS for 2010. On April 28, 2014, the IRS issued a notice of deficiency, asserting that the taxpayer owed self-employment tax on the profit from the business generating the profit on the Schedule M.

The Tax Court explained that although citizens and residents of the United States are subject to federal income taxation on taxable income no matter its geographical source, under section 933(1) a taxpayer who is a resident of Puerto Rico for the entire taxable year is not taxed on items of income from sources within Puerto Rico, other than compensation for services provided as an employee of the federal government. However, though that exemption applies to the income tax, under section 1401 and Regulations section 1.1402(a)-9, it does not apply to the self-employment tax. In other words, residents of Puerto Rico must compute net earnings from self-employment in the same manner as do residents of the United States.

The taxpayer argued that he was not subject to any federal tax for 2010 because he was a resident of Puerto Rico. That argument, unfortunately for the taxpayer, had to be rejected because it was in total conflict with the law. Yet it is understandable how someone, seeing the exemption in section 933(1), or, as is more likely, reading something along the lines of “Residents of Puerto Rico are not subject to U.S. taxation,” could conclude that they had no obligation to file either an income tax or self-employment tax return with the IRS. In fact, the taxpayer claimed he had reached this conclusion after consulting a Puerto Rico tax adviser. But because the adviser did not testify at the trial and because the taxpayer did not establish that the adviser was a competent professional with sufficient expertise to justify reliance, that the adviser was given necessary information from the taxpayer, and that the taxpayer actually relied on the adviser, the Tax Court concluded that there was no reasonable cause to avoid the penalties under section 6651(a)(1) and (2) for failure to file the return and failure to pay the tax.

The self-employment tax applies to residents of Puerto Rico because they are included in the social security system. The income tax does not, because the tax is remitted to the Commonwealth of Puerto Rico rather than to the Treasury Department. The distinction is logical. But it is confusing for those who are not focused on the subtle and precise nuances of tax law. If, in fact, the taxpayer had consulted a tax adviser, it is even more unfortunate that the taxpayer was led astray. A confused tax adviser is of little help for a confused taxpayer.

A recent Tax Court case, Probandt v. Comr., T.C. Memo 2016-135, presents a good example of how not to help your tax return preparer. The taxpayer earned a degree in business administration in the mid 1970s, and then worked for an accounting firm and later for a public company auditing financial statements. During the 1980s he worked for a securities brokerage firm and in the early 1990s worked at two money management firms managing investments. In 1995 or 1996 he began investing for his own account, and a few years later, along with several other individuals, acquired A&G Precision Parts. The taxpayer was a 20 percent partner, the managing partner, and the tax matters partner. During 2001 and 2002, the taxpayer explored business opportunities in China, separate and apart from the A&G operations.

For 2001 and 2002, A&G filed federal partnership income tax returns, which the taxpayer signed as tax matters partner. The returns were prepared by a CPA. A schedule K-1 was issued to the taxpayer for each of those years. The 2001 schedule K-1 reported $81,322 as his distributive share of ordinary income, $135,000 in guaranteed payments, $125,000 in cash distributions, and nondeductible expenses of $1,067. The 2002 s K-1 reported $234,067 as his distributive share of ordinary income, $145,000 in guaranteed payments, $25,000 in cash distributions, and nondeductible expenses of $2,055. The taxpayer received his Schedules K-1 before filing his individual federal income tax returns for 2001 and 2002.

The taxpayer filed delinquent federal income tax returns for 2001 and 2002 on April 10, 2004. The returns were prepared by a CPA. The taxpayer did not provide the CPA with copies of his 2001 and 2002 schedules K-1. Instead, the taxpayer provided the CPA with summary sheets of his travel, meals and entertainment, printing, and consulting expenses derived from his handwritten records. A schedule C was attached to the taxpayer’s 2001 return. It listed the principal business of the proprietorship as “Investments”. The entry for the business name was left blank, and the address reported for the business was the same address reported for one of A&G’s other partners his schedules K-1 for 2001 and 2002. The 2001 schedule C reported gross receipts of $231,000 and total expenses of $201,400 for a net profit of $29,600. A similar Schedule C, with an identical principal business and address and with no entry for the business name, was attached to the taxpayer’s 2002 return. The 2002 schedule C reported gross receipts of $201,900 and total expenses of $194,000 for a net profit of $7,900. No schedule E was included in the 2001 or 2002 return, and no partnership income was reported on those returns. The IRS issued a notice of deficiency, including, among other items, increases in the taxpayer’s income for those two years on account of the distributive shares and guaranteed payments from the A&G Partnership.

The IRS took the position that the income reported on the schedules C for 2001 and 2002 were from a business of the taxpayer separate from the partnership. The taxpayer explained that the amounts reported on the schedules C were the amounts from the partnership, except that he “mistakenly believed that he was required to report only the cash he received from A&G each year.” According to the taxpayer, this consisted of the guaranteed payment plus the cash distribution. The taxpayer also contended that he had no income from any other business in those years.

The Tax Court compared the sum of the taxpayer’s guaranteed payment and cash distribution for 2001 with the amount reported on the schedule C for that year, and noted that the latter was $29,000 less than the former. The taxpayer’s explanation was that $30,000 of the cash distribution was a disbursement from the partnership to buy used equipment for it, and when that failed to materialize, in 2002 it was agreed he could keep the $30,000 because cash distributions were low that year. Thus, the partnership’s CPA treated it as part of the 2002 guaranteed payment, and it was reported in 2002. The other $1,000 was described as “most likely small sums received from A&G for miscellaneous items.” The partnership’s president and operations manager corroborated the taxpayer’s testimony concerning the $30,000.

The Tax Court compared the sum of the taxpayer’s guaranteed payment and cash distribution for 2002 with the amount reported on the schedule C for that year, and noted that the latter was $31,900 more than the former. Of that difference, $30,000 reflected the 2001 disbursement treated as 2002 guaranteed payment, and the other $1,900 was described as “little checks” received from the partnership for miscellaneous items.

The Tax Court concluded that “the near match of the Schedule K-1 items that represent A&G’s cash disbursements to [the taxpayer] and the gross receipts he
reported on Schedules C for 2001 and 2002 is too close to be mere coincidence.” Further, though the taxpayer’s understanding of partnership taxation was incorrect, “his belief that he needed to report only cash distributions he received from the partnership and not undistributed partnership income was plausible.” It also concluded that there was no evidence of income arising from other business operations, and no evidence of bank deposits or spending in excess of reported income, to justify treating the amounts reported on schedule C as anything other than the partnership items.

After dealing with burden of proof issues, the Tax Court held that because the taxpayer conceded he failed to report properly his income from the partnership, a redetermination was necessary. It concluded that the taxpayer overstated income in 2001, and understated income in 2002. The Tax Court also resolved other issues not involving how the taxpayer reported income from the partnership.

Though the taxpayer was not a tax return preparer nor a CPA, the taxpayer did have a business education and experience with financial statements, investments, and business operations. The sensible and prudent thing to do is to turn over to the CPA all tax-related information, including schedules K-1. Either the CPA did not ask if there were any schedules K-1, or, having asked, was told, incorrectly, that there were none. The taxpayer and his partners acquired A&G in 1998, so presumably the taxpayer’s returns for 1998 through 2000 contained schedules K-1. If the same CPA prepared those returns, the CPA should have asked why there were no schedules K-1 for 2001 and 2002. If the CPA was a newly retained preparer, the question should have been a request for prior year returns.

Though it is not possible to determine where the breakdown occurred, and perhaps the CPA could have helped the taxpayer avoid at least some of his audit and litigation troubles, the most likely reason for the problem was the taxpayer’s lack of care in dealing with tax and business documents. That conclusion is supported by the fact that the taxpayer also failed to report dividend and interest income. Conversations with tax return preparers often include stories about clients and how they make the preparer’s job more difficult. This case is an instance in which the taxpayer didn’t necessarily make the preparer’s job more difficult, but made the taxpayer’s own life far more aggravating than it needed to be.

Usually, taxes are enacted or increased to provide funds for specific purposes or to provide resources for general funds used for a package of government services. Occasionally, a tax is enacted to discourage particular behavior, with the expected revenue earmarked for specific purposes related to the undesired behavior, or added to the general fund. What is unusual is the enactment of a tax on behavior that boosts local economies, with the use of the tax revenues deferred until the voters decide.

According to this story, when Georgia legalizes the sale of fireworks, it enacted an excise tax. Instead of specifying where the revenue from the tax would be used, the legislature authorized a vote on a constitutional amendment allocating 55 percent of the revenue to the Georgia Trauma Care Network Commission, 40 percent to the Georgia Firefighter Standards and Training Council, and 5 percent to local 911 systems. It is unclear what happens if the referendum fails. Presumably, another vote would be authorized, either with different percentage allocations or revised recipients of the tax revenues.

One problem I have with this approach is the commitment to enacting the tax before the use of the revenues are decided is that those voting on whether to enact the tax are being asked to make a decision without having all of the facts. The purposes for which the tax revenues are used are factors relevant to deciding whether to support enactment of the tax.

Another problem I have with this approach is that it shuts down voter opportunity to make choices other than those in the proposed referendum. What if voters want a different percentage allocation? What if they want other organizations or programs to receive some or all of the tax revenues? Under this approach, they vote down the proposal, a replacement is designed, another vote takes place, and time is wasted. Would it not have made more sense to offer a referendum to the voters before the tax is enacted, with a multiple-choice list that includes write-in suggestions? Modern technology makes this path as easy as an online survey.

A related problem is that the proposed recipients listed in the referendum are worthy causes. Voting against the referendum seems callous. Yet there are other worthy causes that perhaps should be included. Voting for the referendum suggests that those causes are not as worthy.

What would I do with the tax revenue? At least some of it would be funneled into a program that isn’t on the ballot, that is no less connected to fireworks sales and use, and that is no less worthy than the three programs on the ballot. I base my suggestion on the many news stories that have appeared in recent years. Why not use at least some of the revenue from an excise tax on fireworks sales to fund programs in the K-12 education system, and programs aimed at adults, that teach the safe and proper use of fireworks?

As part of its most recent budget deal, Pennsylvania has increased the tax on cigarettes, snuff, chew tobacco, and loose tobacco. However logical this might seem, all rationality goes up in smoke because cigars are exempt from the tobacco tax. Why?

Is it because cigars do not contain tobacco? Of course not.

Is it because cigars do not pose the health hazards and eventual burden on health care costs that cigarettes and other tobacco products do? Of course not, though at least one now-prominent politician seems to think, or perhaps is paid to say, that smoking does not cause cancer or death.

Is it because cigar manufacturing occurs in Pennsylvania? That’s what legislators provide as an explanation, describing the industry as “thriving.” That explanation is facetious. First, the cigar manufacturing industry in Pennsylvania employs roughly 1,000 people. That’s far from the tens of thousands employed in the health care sector, in education, in the hospitality industry, in the financial services industry, and in pretty much every other employment sector, and barely registers in economic statistics for the state. Second, because every other state but one treats cigars as being made of tobacco and thus subject to the tobacco tax, Pennsylvania manufacturers have nowhere to go, and there’s no guarantee that relocating to that one state would be an economically sound decision.

Is it because the cigar manufacturing industry does a good job “lobbying” Pennsylvania legislators? Of course. There are 34 lobbyists in the state capital advocating for the cigar manufacturing industry, which consists primarily of four companies. One company has spent $1.8 million on lobbying during the past two years. That apparently does not include campaign contributions. It also apparently does not include political contributions from individuals who are executives with the cigar companies. Perhaps it would be cheaper to pay the tax and skip the cost of avoiding the tax?

Is it because many state legislators like to smoke cigars? That claim has been made, though a reliable head count of cigar-smoking Pennsylvania politicians does not seem to exist. The claim also seems suspect because chewing tobacco is not exempt, and allegedly there are more than a few tobacco-chewing legislators. Perhaps the state needs a study to determine if there exists a connection between tobacco ingestion and inefficiency in legislation.

The problem with the “logic” advanced by the supporters of exempting cigars from the tobacco tax is that on closer examination it isn’t logic. If taxes cause jobs to leave, then why do jobs continue to exist in Pennsylvania? Have the stores selling cigarettes and chewing tobacco closed their doors? Have the employees paying income tax all fled to Wyoming? Have the hotels subject to room taxes shut down? The job preservation argument is, like the related job creation through tax cuts for the wealthy argument, total nonsense.

Worse, if the justification for the tobacco tax is to discourage behavior that is harmful not only to the user of tobacco but also to those afflicted with second-hand smoke and disadvantaged by the harmful effect of tobacco use on the health care system, why exempt cigars? Why encourage smokers to shift from cigarettes to cigars? Why not extend similar exempt status for other “sin taxes” where those activities create jobs? The dealing of illegal drugs is a “thriving” business in Pennsylvania, surely generating jobs and income for far more than 1,000 people, so should it be exempt from taxation?

There’s a parade underway. Unlike most performances, in which those watching pay and those performing are paid, this parade is special. Those who are being paid aren’t putting on much of a performance, and almost none of those being charged are getting to watch anything. Those who make an effort to look closely might see something, and that is the continuation of income, sales, property, and other tax dollars collected from the poor and middle class being transferred to a long list of highly profitable businesses and corporations.

Actually, there are many of these parades. Almost every state has one. The tax break parade that gets my attention is the one in New Jersey. Here is a list of some of those who have had their reached-out fists filled with taxpayer funds:

• The Philadelphia 76ers, as described in In When the Poor Need Help, Give Tax Dollars to the Rich.
  
  
• Lockheed Martin, as described in Fighting Over Pie or Baking Pie?.
  
  
• Subaru, as described in Why Do Those Who Dislike Government Spending Continue to Support Government Spenders?.
  
  
• Berry & Homer, as described in When Those Who Hate Takers Take Tax Revenue.
  
  
• Eggo Co., a subsidiary of Kellogg, and Clean Green Textile Service, as reported in Where Do the Poor and Middle Class Line Up for This Tax Break Parade?

Now comes a report that yet another economically successful corporation has jumped in. American Water has been promised $164 million in taxpayer dollars to reward it for moving its headquarters from Vorhees, New Jersey, to Camden, New Jersey. There is no indication that this move will create jobs for Camden residents or in any other way benefit that city. Although the program under which tax dollar are handed over to private sector companies was advertised as one that would help the city of Camden, in practical reality it is nothing more than the relocating of existing jobs at public expense. In When Those Who Hate Takers Take Tax Revenue, I wrote:

One of the arguments put forth by the anti-government-spending folks is that it is bad morally, socially, and politically to collect taxes from one group and to disburse the receipts to another group. These folks like to brand the first group as “makers” and the second group as “takers.” Yet when the takers are their friends and allies in the movement to feudalize America, not a peep is heard from them.

New Jersey, governed by a member of the political party that is trying to consolidate its power by demonizing “takers,” provides an excellent example of the hypocrisy entrenched in this modern reverse Robin Hood philosophy. * * *

Though this tax revenue giveaway game has been underway for several years, there is no sign that the economic condition of Camden’s residents have improved. The folks in Trenton who rail against government spending cut education spending, job training spending, social welfare assistance, and a variety of other expenditures denounced as enabling “takers” to feed at the public trough. Yet in the meantime, a state that faces deficits in its transportation infrastructure budget continues to funnel taxpayer dollars into the hands of companies with sufficient political connections to snag some funds for themselves. * * *

At what point will enough voters see through the con game and send packing the takers who took over political control by demonizing takers? When will political hypocrisy disappear? At what point will people realize that economic growth consists of creating something of economic value and not simply moving jobs from one place to another?

Previously, in Why Do Those Who Dislike Government Spending Continue to Support Government Spenders? I had written:

There’s something not quite right in the collective psyche of the anti-government-spending crowd. Enraged by high taxes, they manage to put into office, and keep in office, people who dish out tax revenues as though there were no limits on taxation. Of course, the tax breaks go to those who are in least need of economic assistance. Their excuse, that they will use the tax breaks to help those in need, is hilarious, because the best way to help those in need is to direct assistance directly to them so that they can infuse those dollars into the economy. That makes the economy grow. Handing tax dollars to those who don’t need financial assistance is nothing more than helping some people grow their Swiss bank stash.

When people complain about the sad state of the nation’s economy, rarely is this tax break parade brought to their attention. Instead, all other sorts of distractions are put in front of their eyes so that the tax break parade passes by almost silently. It’s always much easier to feel smug about not inviting someone to a parade if that person is unaware that the parade exists.

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.