MauledAgain

The drop in sales and use tax revenue experienced by states because online purchases keep growing continues to stymie state governments seeking a way to reverse the trend. The problem isn’t new, it was predicted in the 1990s, and I’ve been writing about it from time to time since 2004, in posts such as Taxing the Internet, Taxing the Internet: Reprise, Back to the Internet Taxation Future, A Lesson in Use Tax Collection, Collecting the Use Tax: An Ever-Present Issue, A Peek at the Production of Tax Ignorance, Tax Collection Obligation is Not a Taxing Power Issue, Collecting An Existing Tax is Not a Tax Increase, How Difficult Is It to Understand Use Taxes?, Apparently, It’s Rather Difficult to Understand Use Taxes, and Counting Tax Chickens Before They Hatch, and A Tax Fray Between the Bricks and Mortar Stores and the Online Merchant Community.

For those who are unfamiliar with, or who have forgotten, the issue, here is a brief summary. When a resident of a state with a sales tax makes a purchase in another state and brings the item back into the state, that resident must pay a use tax. Of course, compliance is unsatisfactory. The only items with respect to which states manage to collect most of the use tax that is due are items requiring title, such as vehicles, boats, airplanes, and a few similar items. The rise of Internet commerce has made it even more difficult for states to collect the use tax, because the number of people who crossed state lines to make purchases to bring home is dwarfed by the number of people who can make out-of-state purchases without leaving their home or business. So, of course, states want out-of-state retailers to collect the use tax on their behalf, even if the retailer has no physical presence with the state.

A variety of suggestions to fix the problem have been made. In Our Online Sales-Tax Loophole, Robert Verbruggen describes a proposal now getting a good bit of attention. Representative Bob Goodlatte of Virginia offers the following plan. An online retailer would collect a sales/use tax based on the sales tax rate applicable to the purchaser’s state of residence, but using the exemptions in the sales tax law of the state in which the retailer is based. The amounts collected would be distributed to the various states through a clearinghouse. Verbruggen points out, correctly, that there are pitfalls. Some states might refuse to participate. Retailers in states without a sales tax would need to use the exemptions set forth in the laws of some other state, perhaps the state where the online retailer has the highest revenue. Alternatively, the retailer could simply report the transaction to the purchasers’ “home state.”

As with almost every proposed solution, Goodlatte’s plan is a band-aid that might slow the revenue hemorrhage, but doesn’t get down to the underlying causes. Sales and use tax avoidance pre-dates the internet. The internet simply took a loophole and made it huge. Goodlatte’s plan does not address, for example, the sales and use tax revenue loss experienced by Pennsylvania, New Jersey, and Maryland when their residents drive to Delaware to make sales-tax-free purchases. Nor does it address the scheme through which a resident of, say, New Jersey, uses a prepaid debit card to make a purchase that is delivered to a friend or relative who lives in Delaware. A variation on the scheme is to have the Delaware friend or relative make the purchases, with reimbursement taking place out of the sight lines of the revenue department and the retailer.

Verbruggen concedes that the problem needs to be “handled at the federal level.” For those whose political philosophy includes reducing the power of the federal government and minimization of federal regulation, the idea of state tax collection shifting to a federal clearinghouse must be anathema. Verbruggen also points out that attempts to shut the door on tax avoidance and tax evasion arrangements are too easily seen by some people as “tax increases,” though I suppose those folks might consider the receipt of a speeding ticket as a “reduction in the legal speed limit.” Needless to say, I do not admire the intellectual shortcomings of those who think enforcement of an existing tax is a tax increase.

Short of imposing a federal sales tax in place of state sales taxes and sharing the revenue, an idea fraught with its own problems, what’s the answer? I proposed a solution in Tax Collection Obligation is Not a Taxing Power Issue:

Perhaps a better approach is for states to seek voluntary contracts with out-of-state retailers, compensating them for serving as tax collectors. There may be state Constitutional provisions or legislation that prohibits contracting tax collection to out-of-state individuals or entities, though I doubt that is the case. For some businesses, being compensated to engage in use tax collection might help the bottom line.

Though taking this route doesn’t shut down, for example, the “use a friend or relative in a state without a sales tax” scheme, it is more consistent with free market principles than is converting out-of-state businesses into involuntary workers or setting up another federal bureaucracy with an additional layer of transactional transmission and another set of opportunities for errors, fraud, and complications.

Running for office presents candidates with numerous opportunities to slip up. This is particularly a problem when the issue is a complicated one. Taxation, for example, can present traps for candidates who are not careful with how they articulate their position.

Recently, there has been a call for exempting the value of Olympic medals from gross income. Some people think it’s wrong to require winning athletes to pay taxes on pieces of metal symbolizing their achievements. I disagree, but the point of this commentary isn’t whether an Olympic medal exemption makes sense. It’s to point out what happens when that issue becomes campaign fodder.

Senator Charles Schumer of New York, a Democrat, has introduced legislation that would add an Olympic medal exemption to the Internal Revenue Code. According to this news story, his Republican opponent, Wendy Long, criticized both Schumer and the proposal. She called the proposal “another example of cronyism in the tax code.” She added, “It makes no sense. My contention is that giving tax breaks as he does to his favored ones – the Broadway stars, the Olympic medalists, the hedge funders – means that a greater burned is placed on the average New Yorkers who toil in obscurity but work just as hart and are as deserving of a tax break.” She referenced members of the military, asking “Where’s the tax break for them? Even if they come home victorious and have won a war, instead of the 400 meter freestyle, no tax break for winning?”

Three thoughts crossed my mind when I read this. All three fit within the general reaction, “It makes no sense.”

First, the Broadway tax break to which Long apparently was referring is not a tax break for Broadway stars. It is a tax break for those who invest in live theater productions, making available to them the same tax break already in existence for television and movie productions. And the measure in question was the extension of the tax break, which had been enacted previously with an expiration date. I’m no fan of this tax break, but I’m even less of a fan of a tax break that treats television and movie productions more favorably than live theater. What matters is that this tax break accelerates tax deductions for investors, who are not members of “the middle class that Long claims Schumer pretends to champion.” And thus it is a tax break pretty much for the wealthy, a tax break in line with many others supported by the political party under whose flag Long is running. It would be great if she made it clear that she opposes the long-standing pattern of Republican tax breaks for the wealthy, but if she is elected she might find herself at odds with at least some of her political colleagues in the Senate. Still, describing the tax break as one for the actors casts the issue in the wrong spotlight.

Second, the tax break for hedge funds has been attacked primarily by Democrats and although some Republicans have joined in the criticism, perhaps seeking something that dresses them in populism, most Republicans and their supporters have opposed any attempt to change the tax break. Some even demand lower taxes for carried interest, as described in this article. Again, it is great to see another tax break for the wealthy coming under attack from a Republican, but what happens to Long’s Senatorial career if she is elected? And what happens to Schumer, a Democrat, who breaks ranks with his party and opposes elimination of the tax break for carried interests? Politics is a strange world, and in this instance, the two candidates are taking positions contrary to their labels. Perhaps they ought to switch parties?

Third, there exist a variety of tax breaks for members of the military. Long is playing on emotions when she suggests there are no tax breaks for them. Section 112 excludes from gross income compensation paid to members of the Armed Forces for serving in a combat zone, or was hospitalized on account of injuries incurred while serving in a combat zone. Section 122 excludes from gross income certain portions of retirement pay far too complex to describe in one sentence. Section 134 excludes from gross income the value of most allowances or in-kind benefits provided to a member or former member of the Armed Forces. I am unaware of any instance in which the IRS has required a member of the Armed Forces to include in gross income the value of any military honor, medal, badge, bar, or ribbon awarded to that person. Making it appear as though there are no federal tax breaks for members of the military does not nurture confidence in a candidate’s tax policy prowess.

There are far better ways to criticize an exclusion for Olympic medals than to confuse the issue with references to tax breaks for Broadway stars, hedge funds, and members of the military. The merits, or lack thereof, of an Olympic medal exclusion are a separate matter.

Perhaps it’s fortuitous that on labor day I share some thoughts about the prospect of even more jobs disappearing. According to this recent article in an Australian newspaper, robots using artificial intelligence could be preparing tax returns for Australian taxpayers.

Though I have always been eager to read about, play with, and even adapt technological advances, I have always done so carefully and with the imposition of a high standard. The standard is simple. The technology needs to generate results that have at least the quality they would have if an expert did the work. Because I understand technology, I understand how it can fail. And I understand that failure can be at least as bad, if not worse, than the outcome when an expert fails.

For me, until a technological “advance” is ready for prime time, it needs to remain in the world of testing and experimentation. It ought not become mandatory or widespread until it proves its superiority. It’s for that reason that I remain skeptical of self-driving vehicles, and my reluctance to embrace that technology has been affirmed by the unfortunate series of accidents, some fatal, generated by failures in the technology being used. Similarly, I remain hyper-critical of traffic signal software that leaves one vehicle sitting a red light for a minute and a half early on a Sunday morning when there are no other vehicles within half a mile of the intersection. The same disapproval exists for the systems that turn the light green for three seconds.

Technology is no better than the programmers who design the hardware and software. Sometimes I wonder if the advantages of multiple sets of eyes and brains reviewing the product are being lost on account of cost-cutting goals that misperceive the difference between long-term and short-term success.

The folks who think that artificial intelligence, which is nothing more than complex software, can replace tax return preparers face a stark reality. For some taxes, surely artificial intelligence has advantages. But for any tax preparation that requires judgment, wisdom, experience, and intuition, artificial intelligence fails. Perhaps decades from now, when neuroscientists have figured out how judgment, wisdom, experience, and intuition are reflected in the biochemical and electromagnetic functions of the human brain work, and software engineers have figured out how to translate those functions into computer code, the idea of robots doing federal income tax returns might come to a worthwhile fruition. Until then, the likelihood of crashes that weren’t supposed to happen and time wasted at badly programmed traffic signals will make the robot tax return preparer a fine wine that no one should drink before its time.

In a recent opinion piece, Catherine Rampell predicts, “Tax cheating is about to rise in the United States.” Is she correct?

Rampell gives six reasons for her conclusion. Each deserves attention.

First, Rampell notes that “Congress has gutted Internal Revenue Service enforcement.” This is true. Will the attempt by certain members of Congress to hamper or destroy the IRS encourage more cheating? I think so.

Second, Rampell notes that “Budget cuts have also hurt IRS customer service.” This, too, is true. Will the decline in IRS assistance cause more cheating? I don’t think so. Those who call the IRS for help want to do the right thing. They pretty much are people who, without IRS help, will do their best to do the right thing. Will they make more mistakes? Certainly. But making mistakes while trying to comply with the law does not constitute cheating.

Third, Rampell points to “The growing perception that everyone else is doing it.” Is there a growing perception that everyone else is cheating? Probably. Does that mean that more people will cheat? Probably, though there are many people who have been raised properly and understand that just because “everyone else” is doing something is no reason to follow suit, particularly if what “everyone else” is doing is illegal or just plain stupid. The “everyone else is doing it” mantra is a characteristic of adolescence. Though some people don’t get past that stage, most people do.

Rampell calls attention to “Declining trust in government.” In one sense, with approval ratings of Congress almost as low as they can go, it’s challenging to think that trust in government can decline any further. In another sense, though, willingness to comply with the tax law is declining. However, a person who is less willing to comply is not necessarily cheating. Laziness in obtaining accurate information isn’t quite the same as inventing false information or hiding true information. On balance, taxpayers’ understandable distrust of many politicians and government officials, which is not quite the same as distrust of government, will create an environment more conducive to cheating.

Rampell reminds us that “The tax code gets more complicated every year.” This is so true. Complexity, though, is just as likely to encourage laziness and carelessness as it is to trigger active pursuit of fraudulent schemes and other tax cheating devices. Yet complexity alone is not a cause of noncompliance. Many laws and rules are particularly simple and yet are the object of overwhelming noncompliance. Speed limits, littering regulations, and restrictions on shoplifting are easy to understand, and yet are violated regularly by a higher percentage of the population than commits tax fraud.

Rampell notes “The rise of the ‘gig economy.’” She explains that the increase in jobs not subject to third-party reporting and withholding correlates with an increase in noncompliance. This is true. The question, though, is whether the increase in the “gig economy” is accompanied by a disproportionate increase in transactions not subject to third-party reporting. Rampell concedes that fewer business transactions are being undertaken for cash payments, and the increase in data collection generally gives the IRS more places to look for unreported income.

Rampell does not mention factors that I consider to be significant contributors to tax cheating. It is the increase in self-focus, the increase in greed, and the increase in harsh economic conditions that coalesce to tempt people to cheat on their taxes. It is the weakening of concerns for integrity and responsibility that make it possible for increasing numbers of people to succumb to that temptation. These are problems that will not go away with a simplified tax law and adequate IRS funding, as Rampell advocates. Of course I support simplifying the tax law and adequate funding of the IRS, but I also support increased attention to tax education in middle and high schools, and a broader dissemination and explanation of what happens with tax revenue. And somehow, some way, the sense of integrity and responsibility that was once a core value of the culture needs to be reinvigorated. That, however, is more than just a tax compliance problem.

So is tax cheating going to increase? Yes. The rate of increased noncompliance is debatable and subject to guessing, and the causes of tax cheating can be argued, but there’s no denying the trend lines.

Recently, the Treasury Inspector General for Tax Administration (TIGTA) released a report with the tongue-twisting title, “The Integrated Production Model Increases Data Access Efficiency; However, Access Controls and Data Validation Could Be Improved.” What does THAT mean?

The report contains the result of an audit that TIGTA conducted, examining the IRS Integrated Production Model (IPM). The IPM provides one point of access to taxpayer data contained in a centralized database. In other words, rather than accessing multiple databases, IRS employees can “pull up” relevant taxpayer data from one gateway. TIGTA explains that the reduction of redundant databases “has improved the efficiency of data access.”

However, the report also explains that “access controls were not documented,” and that it was “unable to definitively verify that the IPM pulls data from only designated source systems.” In other words, there is insufficient control over what goes into the centralized taxpayer information database. Worse, of the 18 source systems that TIGTA was able to examine, 14 had “no validation of data for accuracy, completeness, and reliability.” Put another way, “The IPM database acts as a data repository, and there are no controls to validate received data.” That means erroneous information can find its way into the database and no one knows that it is there. So when IRS employees look at what they think is data on a particular taxpayer, that data could be incomplete or, worse, erroneous. For example, when a malcontent files a false Form 1099 in the name of a particular individual or business for spite, revenge, or other reasons, it’s possible that the false information will find its way into the centralized database.

TIGTA made three recommendations to the IRS to fix the problem The IRS agreed with two, and disagreed with one. Even if the IRS manages to implement the two recommendations it accepts, there still will be reasons for taxpayers to be nervous. And imagine, there are folks who want the IRS to take the data in this repository and use it to prepare tax returns on behalf of taxpayers.

What was not mentioned in the report is the cost of implementing the recommendations. I wonder if Congress will provide the funds. I wonder if Congress understands the problem. I wonder if the Congress cares. TIGTA does. The IRS appears to care. Do you?

A recent letter to the editor of the Philadelphia Inquirer illustrates why taxpayers are more confused than they need to be when it comes to understanding the tax law. According to Jodine Mayberry, she purchased a home and paid a real estate transfer tax, as do all purchasers and sellers of real estate in Pennsylvania. She told her accountant she wanted to deduct the transfer tax. The accountant told her that it was not deductible because it was not a tax but a fee. Jodine explained that it “sure felt like a tax.”

Jodine’s instincts with respect to the character of the payment are correct. So, too, is the label placed on the payment on her settlement sheet. The transfer tax is a tax. It is not a fee. The accountant was wrong in calling it a fee. However, the accountant was correct in concluding that the tax is not deductible.

Jodine’s instincts with respect to the deductibility of taxes are incorrect. Her letter suggests that she considers all taxes to be deductible. That is not the case. To be deductible, the tax must be within the scope of section 164(a), which specifies which taxes are deductible, and also not be within the scope of section 275, which lists taxes that are not deductible. That is why the federal income tax is not deductible but state income taxes are, assuming the taxpayer itemizes deductions. That is why gasoline taxes are not deductible, unless paid in connection with a trade or business or for-profit activity, but real estate property taxes are. That is why inheritance taxes are not deductible but state and local personal property taxes are.

The flush language of section 164(a) specifically provides that the real estate transfer tax paid by a purchaser, and any other taxes paid in connection with the acquisition of property, are treated as part of the cost of the property, and become part of the property’s basis for tax purposes. When paid by a seller, the transfer tax, and any other taxes paid in connection with the disposition, reduce the amount realized on the sale, which is the starting point for computing gain or loss on the disposition of the property.

By telling Jodine that the real estate transfer tax was not deductible because it was a fee, the accountant implied that if it were a tax it would be deductible and that fees are not deductible. In fact, some taxes are not deductible, and some fees are deductible. It’s understandable that taxpayers who are not tax professionals would be confused. Assuming that Jodine is accurately repeating what the accountant said, it is not helpful for a person preparing tax returns, who should know how taxes and fees are treated for tax purposes, to add to a client’s confusion. It would have been helpful simply to explain that real estate transfer taxes not only fail to appear in the list of deductible taxes, they also are specifically described as non-deductible and as part of the purchase price or as a reduction of the sales price in computing amount realized.

Readers of this blog know that I am not a fan of targeted tax credits ostensibly designed to generate more tax revenue than they cost, in part because they do not generate the additional revenue their supporters claim will materialize, in part because they complicate tax laws, and in part because they are fueled by and fuel the dark side of special interest lobbying. One of the tax credits that states have dished out with reckless abandon is the credit for producing films and other productions in the state. I have discussed this problem in posts such as Using Taxes to Rescue a Non-Drowning Film Industry?, Do Profitable Companies Need Tax Breaks?, You’ve Gotta Give 'Em (a Tax) Credit?, and Another Problem with Targeted Tax Credits.

So it was no surprise when I noticed that a new study has reached the same conclusion that I, and others, have reached. The core of the abstract is worth noting:

This study evaluates the impact of motion picture incentive programs, an array of tax incentives employed by over 40 states to entice film and television productions out of California and New York, on labor and economic conditions from 1998 through 2013. Results suggest that sales and lodging tax waivers had no effect on any of four different economic indicators. Transferable tax credits had a small, sustained effect on motion picture employment levels but no effect on wages. Refundable tax credits had no employment effect and only a temporary wage effect. Neither credit affected gross state product or motion picture industry concentration. Incentive spending also had no influence.

So why do state legislators continue in their mad rush to throw taxpayer dollars at an industry that is far from impoverished and in no need of financial assistance? Anyone who stays current on current news knows the answer. As the author pointed out, “If it’s such a successful industry and a profitable industry, you shouldn’t need a subsidy.”

The only good news is that a few states have downsized, eliminated, or failed to renew these giveaways. Yet during the past several decades some states that have scaled back or eliminated these ineffective credits have reinstated them. It would be interesting to map this pattern against election cycles.

Fairfax County in Virginia imposes a personal property tax on motor vehicles (and some other items). To collect the tax, the county requires registration of motor vehicles. Getting the information isn’t very difficult when the vehicle is purchased from a dealer in the county or elsewhere in the state, because information is sent directly to the county. But if vehicles are purchased outside the state, the owner must register the vehicle. Many don’t. Because it is so close to Washington, D.C., Fairfax County experiences a high residential turnover rate. So to keep up with the influx of vehicles that are not registered, the county invites residents to report vehicles not bearing Virginia license plates. Though the country lists the categories of vehicles that are exempt, such as those belonging to members of the military temporarily assigned to the area, diplomats, and full-time college students, someone who decides to report an out-of-state license plate would not necessarily know the status of the vehicle’s owner. The web site permits those who report a vehicle with out-of-state tags to check on the status of the report and the vehicle.

It does not appear that rewards are offered for reporting motor vehicles that lack Virginia plates. The incentive, I suppose, is that the tax increases caused by failure of owners to register their vehicles in Virginia are avoided if those owners are reported and compelled to pay the tax. According to the web site, “within the last fiscal year, more than 1,800 previously unregistered vehicles were added to car tax records . . . which will yield more than $2 million in tax revenue to support the county budget.”

So, would you report your neighbor’s unregistered vehicle if a similar tax and reporting program existed in your locality? Will this question become obsolete as tracking technology permits revenue officials to determine where vehicles are garaged?

New Jersey has a problem, though I doubt it’s the only state with this sort of challenge. The federal government also faces a similar issue. Put simply, the state’s fund for maintaining, repairing, and improving highway and other transportation infrastructure is almost depleted. So what happens when there’s no money in the fund and a bridge collapses. According to this report, New Jersey Governor Chris Christie issued an executive order directing state officials to use general funds budgeted for other state services to deal with projects that threaten the “healthy, safety, and welfare” of residents. This action comes after he shut down construction and other nonessential work.

Why is the fund almost out of money? The state legislature has been unable to agree on a funding plan. Legislators agree that the state gasoline tax needs to be increased by 23 cents per gallon. But they disagree on how to “cushion” this change. Christie and some legislators want to reduce the sales tax from 7 to 6 percent and to increase the retirement income exclusion. The Senate president wants to repeal the estate tax, increase the retirement income exclusion, increase the earned income credit, and create tax breaks for commuters and veterans. The head of the Assembly supports both proposals. It has been suggested that the impasse could last for months.

Common sense tells us that taking money from other services means that to fund transportation infrastructure emergencies, the state will need to reduce state police protection, or debt payments, or some other service. Does that not also impair the “health, safety, and welfare” of New Jersey residents? And what highway repairs can be tossed aside as not endangering “health, safety, and welfare”? Try to think of a problem that can be ignored. Broken traffic lights? Potholes? Missing stop signs? Sinkholes? Bridge collapses?

Common sense also tells us that one must pay the price for what one wants. Residents of New Jersey, not unlike those of every other state, want safe highways and transportation infrastructure. If that requires a liquid fuels tax increase, and the legislature agrees that it does, then the answer is clear. But the idea of cutting back other taxes to “cushion” the cost simply means that services funded by those other taxes will be cut. Time and again, people seem to want a lot and want to pay little. Eventually, one gets what one pays for.

It’s not as though the situation is a surprise. Sympathy for legislators facing an unexpected problem is understandable. But the highway funding crisis was predicted, it was avoidable, and it could have been handled months ago, if not years ago. The process of legislating requires making tough decisions. Those who cannot make tough decisions ought to stay away from jobs and offices that require tough decisions.

So how can the legislature be pushed into getting this problem solved? I think of a story I read when I was in my teens. In 1271, the College of Cardinals could not come to agreement on the election of a new pope. The debate dragged on for almost three years. At the time, the College met in Viterbo. Eventually, the people decided to lock the cardinals in the palace, and to limit them to bread and water until they selected a new pope. Supposedly, they also removed the roof from the palace. A new pope was quickly elected. Though I do not remember the name of the book in which I read the story, accounts are readily available, including this one. So is the solution to getting legislatures to do what needs to be done a dose of bread, water, and roof removal? It’s a tempting proposition.

A reader alerted me to this story and asked if voters can be given too many tax propositions. According to the story, voters in Amarillo, Texas, will be asked in November to vote yes or no on each of seven tax propositions. Each proposition is for the issuance of general obligation bonds to be repaid through a tax. The amount for each proposition varies, and the proceeds of each bond issue would be used for different purposes. For the curious, here are the propositions:

Proposition Number 1: "The issuance of $89,495,000 general obligation bonds for street improvements and the levy of a tax in payment thereof."
Proposition Number 2: "The issuance of $20,080,000 general obligation bonds for public safety improvements and the levy if a tax in payment thereof."
Proposition Number 3: "The issuance of $41,475,000 general obligation bonds for municipal buildings improvements, including a senior citizen center, and the levy of a tax in payment thereof."
Proposition Number 4: "The issuance of $22,250,000 general obligation bonds for neighborhood park and recreation facilities and the levy of a tax in payment thereof."
Proposition Number 5: "The issuance of $83,430,000 general obligation bonds for Civic Center improvements and the levy of a tax in payment thereof."
Proposition Number 6: "The issuance of $16,295,000 general obligation bonds for the fleet services department including equipment and vehicles therefor and the levy of a tax in payment thereof."
Proposition Number 7: "The issuance of $66,625,000 general obligation bonds for athletic facilities, including soccer, softball and baseball fields and gymnasium, basketball and aquatics facilities and the levy of a tax in payment thereof."

My response reflected my first thought, “It depends.” Surely if there were dozens or hundreds of propositions on the ballot, it would be burdensome for a voter to go through each one, though some might review the propositions ahead of time and walk in with a list of the propositions with a Y or N written next to each one. But seven? That’s not particularly burdensome. I also suggested in my response that it makes more sense to break each proposal into a separate proposition rather than bundling them into one. When bundled into one, objections to one of the proposal could doom the others, and in some instances strong support for an essential proposal would bring along one that does not otherwise deserve approval.

After I responded to the reader, two more thoughts popped into my head. I share them here.

First, would it not be ideal if legislatures acted in the same manner, rather than shoving into an essential piece of legislation a provision that would not pass if it stood alone? Granted, legislators need to deal with dozens and even hundreds of proposals, but they’re being paid to do that. If they stayed in the legislative halls for a sufficient period of time, they could work through even thousands over the course of a year, with each proposal standing alone and not hiding behind another provision.

Second, do not those who live in households that budget engage in a similar process? Does a person, or a couple, or a family not consider a series of decisions on spending, and whether to borrow to make an expenditure? Just as the voters in Amarillo need to examine each proposition, so, too, those who are making budget and financial decisions need to examine each proposed expenditure. My guess is that there are more than seven to be considered.

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.