MauledAgain

A recent Tax Court case, Holliday v. Comr., T.C. Memo 2021-69 [to see the full opinion, go to the case docket, scroll down to item 36, and click on that link], addressed the tax treatment of a legal malpractice award. In March 2010, the taxpayer’s then husband filed for divorce. The taxpayer retained J. Beverly as her attorney, and after she and the attorney engaged in mediation, she executed a settlement agreement. She objected to the agreement, though it is not clear why she objected to an agreement to which she had agreed and which she had signed. In April 2012, the divorce court entered the decree of divorce. The next month, Beverly filed a motion for a new trial, alleging that the taxpayer received $74,864 less than her equal share of the community estate. That motion was denied. Beverly told the taxpayer he would appeal, but he did not do so.

So in October 2013, the petitioner filed a malpractice lawsuit against Beverly, claiming that his representation constituted negligence and gross negligence and that he breached the duty of fair dealing and his fiduciary duties “by influencing * * * [her] to mediate and enter into a transaction that was not fair to * * * [her] under the circumstances” and by not pursuing an appeal. Later, she amended the malpractice petition to add claims for deceptive trade practices, treble damages, and attorney’s fees. She sought damages for “pecuniary and compensatory losses”, including “damages for past and future mental anguish, suffering, stress, anxiety, humiliation, and loss of ability to enjoy life”, as well as punitive damages and disgorgement of the attorney’s fees she paid in the divorce proceeding, resulting from the malpractice defendants’ conduct. In October 2014 Beverly and the taxpayer entered into a settlement agreement that stated, “while there remain significant disagreements as to the merit of the claims and allegations asserted by the Parties to this lawsuit, the Parties have agreed to compromise and settle such claims and allegations, without any admission of fault or liability on the part of any party.” Beverly and his firm agreed to pay $175,000 to the taxpayer “[i]n consideration for the mutual promises and obligations set forth in this Release”. The parties released each other from all claims related to the malpractice lawsuit “in exchange for the * * * [settlement proceeds]”. All claims included those “of whatever kind or character, known or unknown * * * which * * * [petitioner] may have against * * * [malpractice defendants] arising out of or related to the * * * [malpractice lawsuit].” Beverly and his firm did not admit liability or fault in the settlement agreement, and the parties did not allocate any of the settlement proceeds toward any particular claim or type of damages. The taxpayer received the settlement proceeds of $175,000, from which she paid her malpractice attorney’s $73,500 fee through direct payment to the attorney by the defendants so that she received a check for $101,500.

On her 2014 Form 1040, the taxpayer reported other income of zero, and she acknowledged the receipt of $101,500 through an attached Form 1099-MISC Summary and a “Line 21 Statement” on which she reported “Other Income from Box 3 of 1099-Misc” of $101,500. The Line 21 Statement also subtracted $101,500 with the description “Misclassification of Lawsuit recovery of marital assets”, resulting in total other income of zero. The IRS issued a notice of deficiency, determining that the $101,500 should be included in gross income. After the taxpayer filed her petition in the Tax Court, the IRS reviewed the settlement agreement and amended its answer to also include in the taxpayer’s gross income the $73,500 of her settlement proceeds that were paid to her malpractice attorney.

The taxpayer argued that the settlement proceeds were a nontaxable return of capital because they compensated her for the portion of her marital estate that she “was rightfully and legally entitled to, but did not receive, due to the legal malpractice of * * * [her divorce attorney].” The IRS argued that the settlement proceeds are taxable income because they compensated the taxpayer for the alleged failings of her divorce attorney and are not excluded from gross income. The taxpayer did not make any arguments based on section 104(a), dealing with compensation for personal injury, or section 1041, dealing with transfers of property between spouses incident to divorce.

The court first noted that settled case law provides that “when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee.” It also noted that under settled case law “recovery of capital is not income.” It then explained that whether a payment received in settlement of a claim represents a recovery of capital depends on the nature of the claims that were the basis for the settlement. The question to be decided is, “[I]n lieu of what was the . . . settlement awarded?” The answer is a question of fact, and finding the answer requires looking at the language of he agreement for indicia of purpose, focusing on the origin and characteristics of the claims settled in the agreement. Turning to the agreement in question, the court determined that it made clear that the settlement proceeds were in lieu of damages for legal malpractice. The text of the agreement stated that its purpose was “to compromise and settle * * * [taxpayer’s] claims and allegations” against malpractice defendants and that payment “in exchange for” release of claims related to the taxpayer’s lawsuit against the malpractice defendants.

The court rejected the taxpayer’s argument that the settlement proceeds were only for those claims that involved the marital estate and that they represented compensation for lost value or capital because they “are based on her recovery of the property interest that * * * [she] rightfully should have received from her divorce as her share of the marital estate.” The court rejected this argument because the settlement agreement stated that the settlement proceeds were for the release of “all claims * * * of whatever kind or character, known or unknown * * * which * * * [the taxpayer] may have against * * * [malpractice defendants] arising out of or related to the * * * [malpractice lawsuit].” The court treated the taxpayer asking the court “to look through the settlement agreement and consider only her claims related to recovery of marital property,” but the court refused to look past “the plain terms of the settlement agreement,” instead concluding that the settlement proceeds were to compensate the taxpayer for her attorney’s malpractice. Accordingly, the settlement proceeds must be included in gross income.

The court pointed out that it had “recently rejected a similar attempt to recharacterize the settlement of a legal malpractice claim arising from a personal injury lawsuit,” citing Blum v. Comr., T.C. Memo. 2021-18. In that case, the taxpayer filed a malpractice claim against her personal injury attorney, resulting in a settlement payment from the personal injury attorney. She asserted that the settlement payment represented a return of capital “in that it compensated her for a loss that she suffered because of the erroneous advice of her lawyers, viz, the nontaxable amount she would have received had she prevailed in her personal injury lawsuit.” The court in Blum focused on the language of the settlement agreement, which specified that it was entered into “for the purpose of compromising and settling the disputes”, and concluded that the settlement payment was not a return of capital to the taxpayer but rather to compensate her “for distinct failings by her former lawyers.”

The court also noted that even if the taxpayer had convinced it that some of the settlement proceeds were meant to replace her purported loss of marital property and that the loss was a nontaxable recovery of capital, she failed to provide a basis on which the settlement proceeds could be allocated between that hypothetically nontaxable recovery and other taxable amounts. The settlement agreement did not allocate any of the settlement proceeds toward any of the various claims or types of damages. According to the court, to the extent the proceeds included amounts representing interest, that portion could not be excluded from gross income in any event.

Though as Robert Wood pointed out earlier this year in Does IRS Tax Legal Malpractice Settlements? that there is “surprisingly little authority” to help drafters of settlement agreements “predict the tax treatment of legal malpractice recoveries,” the Holliday case and the Blum case that it cites teach and reinforce the lesson that the language of the settlement agreement is critical to the tax treatment of the settlement proceeds. I have written about the necessity for careful drafting, and the adverse impact of imprecise drafting, in posts such as Taxing Damages, In Tax, As in Much Else, Precision Matters, Contracting a Tax Outcome, and Looking for an Exclusion That’s Not in the Documentation.

It is understandable why the defendants in the litigation want the settlement agreement to cover all claims including those “of whatever kind or character, known or unknown * * * which * * * [petitioner] may have against * * * [malpractice defendants] arising out of or related to the * * * [malpractice lawsuit].” But that language in and of itself is not the problem. It’s the lack of additional language that allocates a specific portion of the settlement proceeds in this case to the taxpayer’s recovery of the amount that she would have received for her share of marital property had the divorce settlement agreement been drafted differently. It is the lack of that language that forced the Tax Court to conclude that no part of the settlement proceeds had been proven to be for return of capital and that, even if that had been proven, no part of the agreement provided sufficient specificity for allocating a specific dollar amount to what would have been excluded from gross income. As so often is the case, words, or the lack of them, matter.

Someone reading this blog might think that tax return preparers are the chief cause of tax noncompliance. They would get that impression from the many posts I have written about tax return preparers who have been indicted or charged or whose businesses have been shut down by authorities. I am referring to posts such as Tax Fraud Is Not Sacred, More Tax Return Preparation Gone Bad, Another Tax Return Preparation Enterprise Gone Bad, Are They Turning Up the Heat on Tax Return Preparers?, Surely There Is More to This Tax Fraud Indictment, Need a Tax Return Preparer? Don’t Use a Current IRS Employee, Is This How Tax Return Preparation Fraud Can Proliferate?, When Tax Return Preparers Go Bad, Their Customers Can Pay the Price, Tax Return Preparer Fails to Evade the IRS, Fraudulent Tax Return Preparation for Clients and the Preparer, Prison for Tax Return Preparer Who Does Almost Everything Wrong, Tax Return Preparation Indictment: From 44 To Three, When Fraudulent Tax Return Filing Is Part of A Bigger Fraudulent Scheme, Preparers Preparing Fraudulent Returns Need Prepare Not Only for Fines and Prison But Also Injunctions, Sins of the Tax Return Preparer Father Passed on to the Tax Return Preparer Son, Tax Return Preparer Fraud Extends Beyond Tax Returns, When A Tax Return Preparer’s Bad Behavior Extends Beyond Fraud, More Thoughts About Avoiding Tax Return Preparers Gone Bad, Another Tax Return Preparer Fraudulent Loan Application Indictment, Yet Another Way Tax Return Preparers Can Harm Their Clients (and Employees), When Unscrupulous Tax Return Preparers Make It Easy for the IRS and DOJ to Find Them, and Tax Return Preparers Putting Red Flags on Clients’ Returns.

Though there are tax return preparers whose antics contribute to tax noncompliance and thus the tax gap, most do not behave in that manner and most tax noncompliance occurs beyond the reach of tax return preparers. Sometimes, even if a tax return preparer prepared the return, the fraud cannot be attributed to the preparer. An example of this sort of situation is presented in a recent Department of Justice news release. According to that news release, the owner of a physical therapy and acupuncture business, who also co-owned a similar business, with the help of co-conspirators reduced taxable income by shifting funds to other entities that they controlled and that they deducted as business expenses. They also took checks made payable to those businesses and cashed them at a check cashing business. Though the checks represented income to the business, the owner and the co-conspirators did not disclose theses receipts to their tax return preparers. That had the effect of causing their tax returns to be fraudulent.

In this instance, there is no indication that the tax return preparers did anything wrong. A preparer asks a client to disclose transactions that affect gross income, deductions, credits, refunds, and tax payments. The preparer is not required, and rarely is in a position, to audit the client’s books or to do forensic analysis. Granted, if the information provided by the client is itself inconsistent, the preparer needs to ask more questions. But, as one of my former students in practice since the late 1980s, sometimes asks me, “Do you tell your students that some of their clients will lie?” Yes, I do. But figuring out if a client is lying is not easy. True, some people have that sixth sense and some learn to evaluate body language, eye movement, and other supposed clues, but it’s much easier to deceive some or most tax return preparers because they do not have the tools, the opportunity, or the right to dig into a client’s information the way, for example, the IRS and the Department of Justice can. My guess is that at least some preparers find a way to identify taxpayers who have previously been convicted of tax fraud and either decline to represent them or exercise extreme caution if they do accept them as clients.

The Biden Administration, according to reports such as this one from The Hill, is pushing for a 15 percent minimum corporate tax rate. The G7, according to reports such as this BBC News article, has agreed “in principle to a global minimum corporate tax rate of 15% to avoid countries undercutting each other.”

The Hill report explains that Biden “has long railed against the low amount of taxes some profitable corporations have paid, vowing to close loopholes.” The White House press secretary described the proposal as a “book tax,” explaining that the tax should be “based on” corporate “bottom lines.”

According to the White House Fact Sheet on the American Jobs Plan, the so-called 15 percent minimum tax on corporations would be something other than a minimum 15 percent rate on corporate taxable income. Instead, it would be a 15 percent tax rate on “the income corporations use to report their profits to investors,” which most financial analysts, accountants, and investors described as “book income.” The fact sheet states that it would “apply only to the very largest corporations.” According to the Tax Foundation’s analysis of the plan, it would apply to corporations with more than $2 billion in net income. According to the General Explanations of the Administration's Fiscal Year 2022 Revenue Proposals, the tax would apply to corporations with more than $2 billion of “worldwide pre-tax book income,” reduced by the corporation’s regular tax liability.

It is misleading to refer to the proposal as a “15 percent minimum corporate tax rate” because that phrase suggests that the proposal is to impose a 15 percent tax rate on taxable income. As anyone who understands tax law realizes, tax rates mean nothing when taxable income is zero. The problem is bigger than the rate. That is why the proposal focuses on a different base on which to compute the tax, specifically, income as reported for financial purposes. Since the income tax was enacted, corporations have tried to convince the Treasury that they have little or no income to be taxed while telling their shareholders and creditors that they are raking in the profits. Of course, individuals also play this game, trying to show low income to tax authorities and divorcing spouses while upping their claims when applying for loans or trying to impress others at the country club. Some of this nonsense can be attributed to the existence of foolish deductions for tax purposes, such as the allowance of a reduction for depreciation on real property that is increasing in value. Some of the nonsense is attributable to fraud and other tax evasion techniques. For corporations subject to supervision by regulatory agencies, some of the nonsense is attributable to the strange accounting rules used by many of those agencies. And yet another cause of the “high profit, no or low tax” game is the inconsistency in tax policy, taxable income computation, and tax rates among nations, a problem that the G7 appears willing to tackle, though whether its constituent members, and those belonging to the G20, where the proposal next goes, remains to be seen.

Yet it seems to me that it would make sense simply to require all businesses to report as taxable income the amount of income that they tell their owners, creditors, investors, and regulatory agencies that they are generating. By computing taxable income as equal to book income, the need for multiple computations of a tax base would be eliminated. Otherwise, as pointed out in this Tax Foundation commentary, corporations would need to add another computation layer to their tax reporting, though it is not as big a deal as the commentary suggests, because book income already is being computed by corporations.

Of course, taxation based on book income would require mechanisms to tax avoidance, such as a means to prevent corporations from computing a book income that reflects high salaries paid to top officers who are domiciled or reside in countries with no individual income tax, with low individual income tax rates, or with deductions and credits to reduce or eliminate the officers’ tax liabilities. And, of course, other reforms are necessary to deal with the tax avoidance opportunities presented by the flaws in, and abuse of, partnership taxation rules as I described in Partnerships: A Contributing Factor to the Tax Noncompliance Surge, a problem that requires more than a simple increase in the number of returns being audited.

Whenever attempts are made to reduce or eliminate tax abuse or tax avoidance techniques, those who benefit from the abuses or avoidance techniques rise up in opposition. Often, those who oppose the reform are the same interests who lobbied successfully for adding to the tax law the provisions that permit those abuses and avoidance techniques. Too often, those provisions are so complex or obscure that the typical taxpayer can easily be misled by the opponents of reform. The key to getting these reforms enacted is top-notch education of the public by those who are pressing for these reforms, in ways help typical taxpayers understand why the many will benefit from reforms that put an end to tax abuses and avoidance techniques the benefit the few.

There are several places in the Internal Revenue Code where age is a factor in determining a taxpayer’s right to, or the amount of, an exclusion, deduction, credit, or additional tax. In most instances, these age-defined provisions reflect a connection between age and the benefit. For example, withdrawals from a tax-favored retirement benefit plan made before a specified age can trigger an additional tax if one or more of several exceptions do not apply. Along the same lines, additional taxes are imposed if withdrawals are not made from a tax-favored retirement plan once the taxpayer reaches a specified age. Putting aside the question of whether the tax law should be the vehicle for retirement plan regulation, these age-based provisions reflect the reality that tax benefits for retirement savings should be restricted to taxpayers in retirement, and ought not be used as tax-avoidance devices that postpone tax reckoning indefinitely.

Another example are tax breaks related to children who have not yet attained a specified age. That age varies depending on the provision, but regardless of the inconsistency, a reference to age is necessary because in a general sense, all taxpayers are children, and remain children for all of their lives. Ask any parent.

Yet there are age-related provisions that make little sense. For example, the standard deduction increases when a taxpayer attains the age of 65, presumably because of some notion that people who reach the age of 65 are somehow in need of reduced tax liability. But does it make sense to base a reduced tax liability on need for tax relief and yet ignore income? No, because the assumption that people who have attained the age of 65 need tax relief totally disregards the fact that income, whether gross, adjusted gross, or taxable, is a far better indicator of ability-to-pay than is age standing alone.

And that brings me to a proposal that reader Morris brought to my attention. According to this Northwestern University press release, two economics professors, one at Northwestern and one at the University of Kent, have proposed that because workers become more productive over their working life, they should pay a higher rate of tax as they become older. Specifically, they claim that workers between the ages of 45 and 65 should pay at a rate 5 percent higher than the rate paid by workers between the ages of 20 and 44. Whether they mean 5 percentage points, for example, a 15 percent instead of a 10 percent rate, or 5 percent, for example, a 10.5 percent rate instead of a 10 percent rate, is unclear.

The two researchers claim that their proposal “could bring welfare gains to each taxpayer equivalent to those brought in by a 4% increase in annual consumption throughout their entire work life” and that these “gains are significant to warrant the consideration of policymakers and shape the debate on how to best reform existing tax codes in the U.S. and other developed economies.” They explain, “This is because age-dependent taxes permit the government to generate tax revenues more efficiently by reducing the distortions in labor supply of those workers, the young, whose investments in human capital count the most. Furthermore, by incentivizing the young to work more to boost their productivity, the government can take advantage of a more productive population when the young turn old, collecting taxes from them in a less distortionary manner, which also brings non-negligible welfare gains.”

Reader Morris asked me for my reaction. I pointed out several aspects of reality ignored by the researchers. First, the premise that workers are more productive as they get older holds only if they are in the same job or career. Present-day reality is that workers hop not only from employer to employer within the same field, but also change from occupation to occupation. It is possible for a 37-year-old working at the same job for 15 years to be far more productive than a 47-year-old who entered that job 6 years earlier after working for 20 years in some other occupation. Second, as workers become more efficient, they might receive wage increases or, if functioning as sole proprietors or partners, experience increased net profit increases. Or, as is happening to many workers, their wages might stagnate despite productivity increases. In the former situation, as wages or net profits increase, their tax liabilities will increase, and in some instances, they will be propelled into higher tax brackets. In the latter situation, absent tax law changes, their tax liabilities also will stagnate, and it would be absurd to jack up a worker’s tax rate when the worker attains the age of 45 even though their income is unchanged. Third, changing tax rates based on age is an unwarranted discrimination. Why should a 30-year-old making $600,000 a year pay less income tax than a 57-year-old making $600,000 a year (assuming other factors are the same)? Fourth, plenty of people between the ages of 20 and 44 are raking in substantial incomes while there are people between the ages of 45 and 65 are barely making ends meet. A tax system that favors high-income younger workers to the detriment of low-income older workers makes no sense. Put another way, ability-to-pay, a key concept underlying progressive income tax rates, has nothing to do with age and everything to do with income.

Several days ago, I read a Philadelphia Inquirer editorial, in which the writer, arguing that parking spaces should take a back seat to other uses, stated that, “City Council wants to slash the parking tax, a handout to wealthy parking garage magnates that incentives traffic and congestion.” The writer is correct that a proposal to reduce the parking tax is pending. According to this Philadelphia Inquirer story, a bill has been introduced in City Council to reduce the tax from 25 percent of parking charges to 17 percent. The tax was increased a year ago, from 22.5 percent to 25 percent, to offset other revenue reductions caused by the pandemic, with an automatic reduction back to 22.5 percent a year later. The bill to reduce the rate to 17 percent reflects the sponsor’s belief that reducing the rate will bring visitors back to the city, would “signal that Philadelphia is serious about our economic competitiveness,” would bring more parking lot and garage workers back to work, would help the hospitality and entertainment industries recover, and would Incentivize growth.

Though one can quibble whether a reduction in the rate from 25 percent to 17 percent is a slashing, and though one can wonder whether the introduction of a bill by one member of the Council translates into a majority of the Council wanting to reduce the rate, the big problem is the conclusion that a reduction in the parking tax is “a handout to wealthy parking garage magnates.” According to the city’s explanation of the tax, the parking tax is paid by every person “who pays to park or store a motor vehicle in or on a parking facility in Philadelphia.” Thus, the tax is paid by parking lot customers “directly to the parking facility.” In turn, the operator of “the parking facility is responsible for issuing the claim check, collecting the tax, and paying it to the City.”

First, the reduction in the parking tax itself does not directly benefit the owners and operators of parking lots and garages. If the tax is reduced, the owners and operators collect less from the customer and remit less to the city. Second, the writer might be thinking that the reduction in the parking tax will bring more vehicles into the city and into parking lots and parking garages, thus increasing revenue for the owners and operators of those facilities. That is a questionable conclusion. Based on current parking rates, an 8-percentage-point reduction in the tax would reduce a customer’s bill by roughly $2 for a 12-hour stay, and by roughly $25 for a one-month fee. It highly unlikely that someone otherwise not planning to drive into the city would change their mind because of a $2 difference, or that a $25 reduction in a monthly parking fee would deter the person from driving into the city on a regular basis. At best, the reduction might bring a few more vehicles into the city, but that revenue, even if monopolized by one owner or operator, would be too insignificant to be considered a handout to the wealthy.

My point isn’t that the parking tax should be reduced, or should not be reduced, or should be increased. My point is that when arguments for and against changes in the parking tax are lined up, “handouts to the wealthy” should not be on the list. Coming from someone who opposes tax breaks for the wealthy, that might seem surprising, but my point is that reducing the parking tax paid by vehicle owners, very few of whom are wealthy, is not a tax break for the wealthy. It’s a tax break for drivers of all economic groups.

Two news items showed up last week focusing on two former Philadelphia officials and their tax woes. Unfortunately, the new information adds to the evidence lists maintained by those who argue that Philadelphia is a corrupt city. Actually, cities cannot be corrupt. People can be corrupt. Politicians and officials can be corrupt. Fortunately, not all politicians and officials are corrupt, and plenty of people who are not politicians or officials are corrupt. Of course, it’s those in the spotlight who do bad things who get most of the attention.

The first story involves Vincent Fumo, a Philadelphia politician who served in the Pennsylvania Senate for about 30 years, and who was convicted on 137 counts of mail fraud, wire fraud, conspiracy, obstruction of justice, filing a false tax return, using state workers to repair his residence and to work on his farm, misusing state funds, misusing funds from his charity, and using government property for personal travel. I have previously written about some of Fumo’s tax problems in posts such as How to Fix a Broken Tax System: Speed It Up?, and Not the Sort of Tax Loss Taxpayers Prefer, addressing questions about property tax assessments on his Philadelphia residence.

This recent news involves Fumo’s connection with the Citizens Alliance for Better Neighborhoods, the charity referenced in the list of charges mentioned in the preceding paragraph. The misuse of the funds generated tax problems because the tax law is used to regulate aspects of transactions between tax-exempt organizations and people affiliated with them. In addition to misusing the funds, Fumo also was convicted of using his political power to compel PECO and the Delaware River Port Authority into making contributions to the charity. That, too, generates tax problems. The IRS contends that Fumo owes $354,000 in excise taxes on account of violating prohibitions against using tax-exempt organization funds for private purposes. When the case reached the United States Tax Court, Fumo argued, in response to an IRS motion for partial summary judgment, that “his role with the nonprofit was too insignificant for him to be subjected to the excise tax.” Fumo argued that he was not the founder of the charity nor was he an officer. The judge disagreed, pointing out not only that Fumo’s staff set up the charity at his direction and that he “exercised substantial influence over its activities,” but also that during his criminal trial, Fumo testified, “I viewed it as my nonprofit. I viewed it as my entity, my baby. I created it. I helped it. I guided it. I gave it strategy. I gave it my time and effort. I raised money for it. If it weren’t for me, it wouldn’t exist.” Accordingly, the Court granted the IRS motion for summary judgment in part – because other issues also are involved – and the case will proceed on the question of whether Fumo violated the prohibitions on dealing with a tax-exempt organization. From a legal perspective, the Court’s conclusion reflects the provision in the applicable Treasury regulations that a person can be within the scope of the prohibitions even if the person is not an officer, director, or high-level employee of a charity. For the Court’s opinion, go to the docket page for the case, scroll down to item 163, and click on the link, as the link for the opinion itself is too long to insert into an html URL llnk.

In addition to the excise tax, the IRS also claims that Fumo owes more than $2 million in unpaid income taxes because of his failure to report as income the value of the services he received from the crimes for which he was convicted. If that is not enough, the IRS also claims that he owes more than half a million dollars in unpaid gift taxes on account of a large cash gift to his son. Those cases are pending.

The second story, published on the same day as the first one, involves former Philadelphia Treasurer Christian Dunbar. Dunbar had been removed by the mayor after he was indicted for obtaining U.S. citizenship through a sham marriage and embezzling money from clients while working for Wells Fargo Bank. The new charges include failure to file tax returns for 2015, 2016, and 2019, and claiming false business losses on returns that he did file.

Politicians and government officials have always been under a spotlight. Modern technology has widened the scoped of that spotlight and has intensified its brightness. Though many people think being a public figure or celebrity is fun and wonderful, it comes with a price. That price is public scrutiny. For the well-behaved, that scrutiny is bad enough, but any sort of misbehavior or even simply inappropriate words or actions will go viral on social media, and often in mainstream media, in the blink of an eye.

Yes, there is corruption in Philadelphia. There also is corruption in many other big cities, small cities, suburban towns, and rural communities. Yes, there are localities where corruption is absent or perhaps a rare occurrence, but the problem is widespread. It’s just that the dollar amounts involved in big cities causes investigators to focus in those places rather than in other localities. And, true, corruption in large cities affects many more people than corruption in a small town, but every citizen, in every place, is entitled to live under governments free of corrupt politicians and corrupt officials. The corruption, unfortunately, is not so much a problem in and of itself, which it is, but a symptom of a deeper rot in present-day culture. And that is a something far beyond the world of tax and surely not manageable by using the tax law to clean things up.

On Memorial Day ten years ago, in Free, Freedom, Fees, and Taxes, I examined the extent to which Americans understand the meaning of the oft-heard and oft-written sentiment that those we are honoring today served to protect the freedom of the nation. I wrote:

Americans surely understand the word “free,” for it shows up frequently in the phrase “free market” and in the slogan “free to do what I want.” Yet when asked to pay for freedom, too many Americans balk, even when the cost facing them is far less than their time, their physical well-being, and their life. The notion that freedom is free is becoming ever more omnipresent in the culture.

I focused on a New Jersey Sea Grant Consortium contest in which beaches that did not charge a user fee emerged as the winner, even as other reports explained that even beach communities charging a fee were struggling to provide the services demanded by visitors, perhaps in part because the fees were nominal. The towns with free beaches were facing even steeper financial challenges. I suggested that these towns charge fees, even though officials worry about the risk of visitors not returning if fees are imposed but also threatening to stay away if services are diminished in quantity or quality. These same officials are aware that most visitors don’t care about the fiscal woes of the town they are visiting, and that their only interest is in having fun. The notion of “let’s have fun but let someone else pay for the things we get for free” is pernicious. I then shared these observations:

In order for a person to have something for free, someone else must pay. * * *

The question of who pays the bills to use a free beach would be irrelevant but for the fact that this nation exists, has beaches, and has a citizenry that is free to go to the beach. In some countries, people aren’t free even to travel outside their home village, let alone jump in a car, train, or plane to head for some resort. There are people who paid for that freedom with something far more than suitcases full of cash, namely, with their lives, and they deserve recognition and thanks on this Memorial Day. Paying taxes or beach fees pales in comparison to paying the price that has been paid by the veterans whom we cannot thank in person. The best we can do is to honor their memory. And the best way to do that is to respect freedom and to acknowledge that freedom is not free.

Though in that essay I centered my attention on the fiscal aspect of freedom, it is important to understand that the cost of freedom is not only the lives of those who have fought to defend it and the taxes and fees paid by those who enjoy it, but also other costs, costs too often ignored or at least noted without any reference to the impact on freedom.

Consider those who think that freedom means “free to do what I want.” This is the perception often heard from those making the transition from childhood to maturity, a transition that unfortunately does not happen for everyone. When someone making that proclamation is asked to describe what happens when encountering someone who makes the same proclamation but who wants to do something that interferes with the first person’s desires, the back-and-forth eventually results in what can best be described as a philosophy of “I am free to do what I want, and that means I am free to prevent others from doing what they want.” It is the essence of selfishness, self-centeredness, and immaturity. And it has been increasingly going viral.

Consider two examples. The person who claims that they are free to drive at whatever speed they select, regardless of speed limits, can end up imposing the cost of that “freedom” on the people they kill and injure when they learn, too late, that there are reasons a person should not, and cannot, drive at whatever speed they select at any time, in any place, and under any conditions. The person who claims that they are free to go maskless and unvaccinated can end up imposing the cost of that “freedom” on the people they sicken and even kill who are unable to be vaccinated or wear masks. It is no comfort that the person claiming the right to be free might also end up paying the price of injury, sickness, or death.

Too often, those who claim that this unregulated “freedom” is sacrosanct point to the arrival of Puritans in what is now Massachusetts. They are idolized as seekers of freedom, trying to escape religious and political persecution. Yet when they arrived in the Massachusetts Bay Colony, they immediately started acting in the same manner as had their tormenters, in turn suppressing those whose religious beliefs or political positions conflicted with those set down by the Puritans. The contrast with Pennsylvania, also settled by victims of religious persecution, but where those of diverse origins and religions were welcomed, is startling. I didn’t learn this in school because it isn’t taught in this manner, nor is this lesson noted. I learned this when I did the research to write the biography of Thomas Maule of Salem, reading not only his works and those of others, both in his day and thereafter, but also studying the social and cultural environment in which his fellow citizens, of a different religious persuasion, acquitted him of the seditious libel charges brought by Puritan authorities who resented being tagged as hypocrites. And they truly were. Seem familiar?

The question at the moment is what sort of “freedom” will this nation embrace? To ignore this question is to dishonor those who fought and died for freedom, because answering the question incorrectly makes the price they paid a price paid in vain. Will the model be the “freedom” to escape torment and persecution only to torment and persecute others? Or will the model be the “freedom” to welcome those with different perspectives while refusing to adopt the methods of those from whom freedom was sought?

Indeed, freedom is not free. It comes with a cost. The cost is more than monetary. The cost can be the reduction of speed, the stopping at a red light or stop sign, the obedience to the yield sign, the wearing of a mask, the ceasing of the 1 a.m. fireworks, the toning down of the party noise at 2 a.m., the picking up of the pet’s poop, the use of a trash or recycling container rather than the gutter when disposing of trash, the extinguishing of the cigarette when in a closed space or close to others, the use of words rather than weapons when in a disagreement, telling the truth, and learning to think critically.

Freedom is not free. It disappears when the cost, whether in lives, taxes, or proper behavior, no longer is paid. Memorial Day means little if the freedom for which the fallen fought is disregarded, abused, or limited to fewer than everyone. The cost of freedom is much more than taxes.

In its American Families Plan Tax Compliance Agenda report, the Department of Treasury told that world that during calendar year 2018, more than 4.2 million partnership returns were filed, but only 140 were audited by the IRS. Yes, 140 out of 4,200,000.

How did this low audit rate happen? The report tells us that over the last decade, “the IRS budget fell by about 20%, leading to a sustained decline in its workforce particularly among specialized auditors who conduct examinations of high-income and global high net worth individuals and complex structures, like partnerships, multi-tier pass-through entities, and multinational corporations.”

Why is this low audit rate a problem? As the report explains, and as more than a few tax professionals understand, and as some other people have learned, “noncompliance has been exacerbated by enhanced opportunities to shield income from tax liability, and even from audits. These opportunities are particularly available for those in the top end of the income distribution who can avoid taxes through sophisticated strategies such as offshoring, creating complex partnership structures, or moving taxable assets into the crypto economy.”

Why is auditing partnership difficult? Again, the report explains, during the last decade, “there has been a rise in complex business structures, such as partnerships, which also require significant efforts by IRS agents to obtain a complete understanding of interrelated business activities. Partnership income as a share of total income grew from less than 5% to more than 35% since 1990. * * * Examining these returns is resource-intensive for the IRS because many partnerships use tiered organizational structures where multiple levels of domestic and sometimes foreign business entities combine to obscure the ultimate beneficiaries of the business operations. Some recent research suggests that 30% of partnership income cannot unambiguously be traced to the ultimate owner.”

Why does auditing partnerships require more resources? In addition to the need to find, hire, and pay people with the ability to dig through the partnership manipulation in which many wealthy individuals engage, audit for partnerships “average around 333 hours per return. In contrast, routine field audits of less complex taxpayers average approximately 40 hours per return.”

What is the solution for this problem? The report concludes that the answer is to “[p]rovide the IRS the resources it needs to address sophisticated tax evasion,” to do things such as “modernizing information technology, improving data analytic approaches, and hiring and training agents dedicated to complex enforcement activities.”

It won’t be easy getting the IRS up to speed when it comes to auditing partnerships. I taught partnership taxation for almost 40 years. I taught more than 60 semesters of Partnership Taxation in Villanova’s Graduate Tax Program. I taught partnership taxation to J.D. students, in watered-down form, both in a Partnership Law and Taxation course and then in an Introduction to Taxation of Business Entities course. I have yet to meet a student who has not characterized these courses as the most difficult courses in their respective programs. Partnership taxation is so complex that it makes other areas of tax law seem simple in comparison, and as anyone familiar with taxation knows, those other courses are far from simple. The complexity of partnership taxation arises from the failure of the Congress to enact a complete entity approach or an aggregate approach because it chose to compromise and cobbled together a hybrid approach that creates the need for complicated provisions such as basis adjustments, “hot asset” rules, contributed property allocation rules, and special allocation provisions. These interconnected highly detailed cobwebs of almost incomprehensible provisions offer a maze which the engineers of tax avoidance schemes can manipulate to their benefit. On top of that, taxpayers who want to comply too easily make errors, not because they are trying to avoid tax, but because they and their tax return preparers understandably stumble and fall when they try to comply with the complicated mess that is partnership taxation.

It will be difficult for the IRS to find enough tax professionals willing to turn aside from highly compensated tax planning positions in the private sector to accept low government compensation jobs auditing the tax returns generated by those private sector planners. Partnership tax law complexity benefits the wealthy, generates significant costs for what I call “run of the mill” small partnerships, and harms taxpayers generally by contributing substantially to the tax gap.

Though hiring and training, or trying to hire and train, more partnership tax auditors is a worthy goal, in and of itself at best it will make a small dent in the problem. The solution lies with the Congress, frightening a thought as that is. Partnership taxation needs to be simplified. Publicly, almost everyone agrees, and privately, very few are willing to object while admitting that they and their client benefit from the complexity. Many years ago, before the exponential growth in the use of partnerships, I predicted the problem and proposed a solution. I did this at an ABA Tax Section meeting. The reaction was overwhelmingly negative, which surprised me because the same people claiming to dislike the complexity turned out to be even more disapproving of the solution. They knew their clients would object. And that is what will happen if Congress attempts to fix the problem, because those who benefit from the existence of the problem are the same people with the funds to ensure that the Congress serves their own needs rather than the needs of taxpayers generally.

The solution I proposed years ago was to treat partnerships as S corporations. Now, I think a better solution is to tax partnerships as entities, and to let the partners divide up the tax liability among themselves however they wish, so long as the tax is paid by the partnership. This is a topic for a future post, eventually.

About a year ago, in How Not to Write Tax Break Statutes, I described a decision by the Pennsylvania Commonwealth Court in Dechert LLP v. Pennsylvania Department of Community and Economic Development. The court held that the Pennsylvania statute providing tax beaks to businesses in Keystone Opportunity Zones (KOZs), Keystone Opportunity Expansion Zones (KOEZs) and Keystone Opportunity Improvement Zones (KOIZs) – all of which can be called Keystone Zones (KZs) – did not prohibit a law firm from getting KZ tax breaks while in one KZ and then obtaining a new set of KZ tax breaks by moving into another KZ. Although the agency that administers the KZ programs denied the law firm’s request because the program “is designed to encourage businesses to locate in economically distressed communities; to become economic anchors of the communities; and to re-enter the state and local tax rolls at the end of the KOZ term,” the court granted the law firm’s request for a declaration that it would not lose tax breaks by relocating into a new KZ.

The statute does not address the treatment of a business that relocates from one KZ to another. Though the agency administering the program argued that “zone hopping” would “frustrate the purpose of the statute,” the Court concluded that because the statute did not address movement from one KZ to another, nothing in the statute prohibited the law firm from obtaining the tax breaks available by moving into the new KZ. The Court noted that there is no prohibition on zone hopping in the statute. So it granted summary relief to the law firm and entered the declaratory judgment that it had sought. As I had predicted when I evaluated the possibility of an appeal and reversal, specifically, that “it is difficult to envision the Supreme Court reversing the decision,” the Pennsylvania Supreme Court, in a one-sentence order issued last week, affirmed the decision of the Commonwealth Court.

In its 2020 opinion, the Commonwealth Court pointed out that fixing what the agency considers to be a problem requires a legislative remedy. Put another way, the problem exists because the legislature failed to consider and address the question one way or the other. Apparently no one asked, “What happens if a taxpayer or business stays in a zone until it expires and then moves to another zone that is active? Should the taxpayer or business get another batch of tax breaks?” Answering the question would then cause the legislators and their staffs to realize another provision in the statute was necessary.

It took almost a year, but according to this Philadelphia Inquirer report, a bipartisan bill has been introduced in the Pennsylvania House of Representatives to prevent taxpayers from obtaining a second batch of KZ tax breaks if they move from an expired KZ into a new one. My guess is that the legislators waited to see if the Supreme Court would reverse the Commonwealth Court’s decision. Some legislators apparently took note of the law firm’s attorney who stated that he has “additional clients seeking the same relief.” The proposed legislation would also cut some of the KZ tax breaks. It also would deny the tax breaks to real estate investment trusts, venture capital funds, and hedge funds. The legislation odes permit zone hopping if doing so “is necessary to meet the expansion or operational needs of the business and the business anticipates a significant financial impact on the zone into which the business is relocating.” It isn’t difficult to envision lawyers and others finding ways to describe a business move as meeting that exception.

Interestingly, though the original 1999 KZ legislation was intended, as described by its legislative sponsor, to bring one-time economic relief to “bombed out” areas of the state, it was the legislature that added more and more sites to the list of places qualifying for the tax breaks, even though most of them were not in dire economic condition. Some were in much better shape. The city of Philadelphia has lost $400 million in tax revenue during the period when the KZ designation was in effect for the building in which the law firm is located and from which it has planned to move, though it is now unclear whether those plans will change because of the proposed legislation. Nor is it precisely clear how the city of Philadelphia will deal with future requests for KZ designations though it does have a list of places for which it has been authorized by City Council to seek KZ designations.

Much of this could have been avoided had the statute been drafted with a provision permitting or prohibiting zone hopping. This flaw, in failing to “think through” an idea, afflicts not only legislators but anyone drafting something. Overlooked consequences can pop up when drafting contracts, when writing law school exam answers, when giving advice, when posting on social media, or when designing and drafting computer code. It’s much easier to think things through when the solitary drafter or small drafting team has the opportunity to welcome comments from even more persons who bring different perspectives and thus might be more likely to spot the “what if” questions that need to be asked. It helps to have transparency when drafting. It helps to listen to, rather than block or shut down, those whose questions and observations can improve what is being drafted, even when the question initially seems inarticulate or dimwitted. It will be interesting to see what sort of public hearing and review process is undertaken for the proposed legislation.

On several occasions I’ve written about people who are unable or unwilling to focus on details when reacting to Biden’s tax increase proposals. For example, in Tax Lies and Misleading Tax Claims, I explained that it is foolish and dangerous to omit or ignore the qualification that the proposed increase would only apply to incomes exceeding $400,000.

In a recent letter to the editor of the New Hampshire Register, Norman Bender makes an important observation by pointing out that any increase would only apply to the income exceeding $400,000. Using his example, he apparently has encountered people with $500,000 of taxable income who think that a two percent increase in the rate would increase their tax liability by $10,000. Bender explains that a two percent increase applied to the excess of $500,000 over $400,000 would be $2,000, not $10,000. That’s a five-fold mistake and one that easily triggers a major emotional reaction. Of course, for someone with $10,000,000 of taxable income, the mistake is nowhere near five-fold. The erroneous conclusion that the increase would be $200,000 (two percent of $10,000,000) rather than $192,000 (two percent of the $9,600,000 excess of $10,000,000 over $400,0000) isn’t much of a difference.

Polls show that there isn’t much sympathy for the cries of poverty raised by someone with $10,000,000 of taxable income, who surely has more than that in actual income, when a $192,000 tax increase is proposed. There aren’t enough people in those income categories to make a dent in polling. But if they could somehow get significant numbers of other people to object, they might succeed in preserving their unwarranted previous tax cuts. How can that be done? It’s simple. Tell people that their taxes will increase without bothering to mention that those with taxable incomes equal to or under $400,000 won’t be affected. Tell people with taxable incomes exceeding $400,000 that the rate increase will apply to all of their income. Tell people with taxable incomes exceeding $400,000 that the proposed higher rate will apply to all of their income.

Why does this technique work? It works because too many people don’t understand the facts and are willing to let others do the work of analyzing the facts. They trust in those others without having checked the reliability of those others. They become susceptible to liars. They succumb to the lie because it appeals to them emotionally. When I started teaching tax a long time ago, I expected, perhaps foolishly, that after decades of doing so, in collaboration with thousands of others also teaching tax, the overall ability of the nation to understand the basic principles of tax would improve. Certainly I didn’t expect it to get worse, and certainly I did not expect that there would be people having as their goal the de-education of taxpayers and voters. Figuring out the impact of the proposed tax increase isn’t rocket science. Figuring out how to put an end to the lying apparently is, considering how successful the liars have been.

Someone reading this post’s caption probably reacts as did the spellchecker. What is a polyworker? Is it even a word? It is now. So, too, is “polywork.” An article that popped up late last week describes the formation of Polywork, described as “a new professional social network that has been created for people who do more than one type of work and cannot be defined by a single job title.”

According to the article, a study by the Polywork network “reveals that nearly half of young professionals (47 percent) consider themselves people who ‘polywork’ doing an average of five different types of work – with one in ten (11 percent) saying they currently do more than ten types of professional work at the same time.” Technically, I think “at the same time” doesn’t mean at the same moment, but during a period of time. The article gives examples by describing the activities of several people. One person “does more than five different types of professional work across multiple countries including software engineering, public speaking, writing, podcasting, investing, advising, and mentoring.” Another “has three different types of work on the go at once: producing a musical; managing his technology investments; and running a non-profit company.” This person added, “Modern working attitudes and flexible technology allows my generation to juggle a multitude of things in a way we’ve never been able to before.”

The study by the Polywork network revealed that “[t]he majority of 21 to 40 year-old professionals (81 percent) say the pandemic has changed their attitude towards work forever with 45 percent saying they would not consider doing one single type of work for life, but would choose to polywork instead. Three quarters of all young professionals (72 percent) say virtual ways of working have opened up more work possibilities in the last 12 months compared to previous years.” It also discovered that “[o]ver half of all 21 to 40 year-olds (55 percent) said an ‘exciting’ professional life is more important to them than money with 62 percent saying the opportunity to learn more skills, more quickly through different types of work is more rewarding than professional ‘security’.” Reflecting on this, the founder of the Polywork network explained, “There is a new generation of professionals who do more than one type of work both in their regular job and outside of it, and they no longer feel a single job title reflects what they do or who they are. During the pandemic people have re-evaluated what they want to do, which in turn has accelerated the trend of polywork, using technology to connect with different and varied opportunities, whatever and wherever they may be. We do not see this trend disappearing, not least because Gen Z and Millennials see a variety of work as a way to achieve a more exciting life.”

When I read the article, two thoughts entered my mind. The first was a question. Will increasing numbers of tax professionals engage in polywork? For example, will tax professionals who only prepared tax returns begin doing other tax-related activities? Will tax litigators do other things? The answer is easy. It was my second thought.

My second thought on reading the article was simple. Polywork is not new. Perhaps technology makes it easier for some people to polywork. Perhaps technology permits polyworkers to increase the number of work activities in which they are engaged. But polyworking has been with us for as long as there have been workers. Many tax return preparers also do tax planning. Many tax litigators also do tax advising. Some practicing lawyers also teach as adjunct faculty members. The list is long. By its very nature, tax involves polywork. So, too, does law. And surely those in other professions can share similar lists. I have known people in my parents’ generation, including my parents, who fit the definition of “polyworker.” It’s not a new concept. What’s new is the increasing numbers of polyworkers and the extent to which technology makes it easier to engage in multiple activities.

What made me think that polywork is not new is my own experience. There have been, and are, weeks when I can find myself teaching a class, writing a blog post, giving tax or legal advice, preparing tax returns, writing an article or book about tax, mentoring a student asking about a particular career path, doing my sexton tasks at the church, designing and programming computer assisted tax education modules, and preparing and offering a CLE program. Fear not, over the past few years I have backed away from or scaled down several of those activities. The Polywork network was “created for people who do more than one type of work and cannot be defined by a single job title.” I first encountered that challenge years ago when I had to decide what to put in the “occupation” box on the federal tax return. I learned that the box, in paper or digital form, is too small for “law professor, lawyer, author, programmer, tax return preparer, church sexton.” So I wonder, will “polyworker” now begin showing up in the occupation box on the federal tax return?

Last week, the Department of Justice announced in this press release that Charles Agee Atkins had pled guilty to “filing a false tax return and being a felon in possession of a firearm.” Atkins “controlled and operated several risk consulting businesses,” and from 2011 through 2017 he “underreported the income that he received from these businesses on his tax returns, causing a tax loss of more than $380,000 to the Internal Revenue Service.” He “also admitted that he failed to pay more than $420,000 in taxes he owed to the IRS for several previous years.” On top of that he “also pleaded guilty to being a felon in possession of a firearm.” Why was he a felon? Because in 1988 he had been convicted of tax fraud.

Curious, I dug up the appellate opinion, U.S. v. Atkins and Hack, 869 F.2d 135 (2d Cir, 1989), dealing with his previous conviction. In a jury trial, Atkins and his co-defendant were convicted of willfully making and subscribing false individual and partnership tax returns, and aiding and assisting in the filing of false individual and partnership returns. In total, Atkins was convicted on 28 tax-related counts. Atkins was the founder and principal owner of a limited partnership, one of whose activities was creating tax write-offs for investors in money market instruments, primarily United States government securities. Because the Treasury had shifted from issuing paper certificates to making entries on Federal Reserve system computers, it was possible for dealers to create artificial entries by simply putting something on their books “indicating a purchase of transactions or purchase of some volume of securities as of day one in a sale as of some later day and then have corresponding transactions with some other party that also is self-reversing in that way. And that could be done without any transactions actually having to exist or be delivered over the delivery network in the government securities market. It didn't require that treasury securities actually exist.” So at one point the limited partnership owned by Atkins had a balance sheet showing “$24 billion of assets and liabilities, with less than a $100 million of capital.” As the court explained, “Although the Groups' offering memoranda represented that the Groups intended to handle clients' investments for the primary purpose of realizing economic gains, its real purpose was to generate tax losses for investors who needed them to offset unrelated gains. Such investors were promised 4 to 1 tax write-offs based on an investment consisting of 25 percent cash and 75 percent notes.” The court noted that the government had proved beyond a reasonable doubt that Atkins, with the help of Hack and other unindicted accomplices, “created, purchased, and sold millions of dollars in fraudulent tax losses for his companies and his customers,” using rigged straddles and rigged repurchase agreements. Essentially, to avoid the risk in a straddle, which involves holding both a “long” position – a contract to buy securities for future delivery – and a “short” position – a contract to sell securities not necessarily presently owned, the limited partnership found accomplices willing to enter into artificial paper or computer transactions designed to eliminate the risk of market fluctuations. In this way, losses would be recognized in one tax year, with the offsetting gain postponed, thus, in effect artificially recognizing accelerating losses that did not happen. Similar arrangements were made with the repurchase agreements. On top of this, Atkins and Hack “backdated or caused to be backdated a large number of documents in order to increase the amount of their fraudulent claims.”

On appeal, Atkins and Hack argued that “they were deprived of due process because they did not know in advance that their conduct was unlawful.” The court dismissed this claim as bordering on the “specious” because of the “proven falsification and backdating of documents, the secret oral agreements, the lies and the concealment of facts.” It then cited a litany of cases that had made it clear what was being done was fraudulent. Several other arguments were dismissed as misplaced, affirming the same conclusions reached by the trial court.

At the time, as noted in this report, the case was called by the government “the largest tax-fraud case in U.S. history.” This report also pointed out that the clients for whom Atkins and his colleagues manufactured artificial tax losses included celebrities and public officials. They had rushed to invest in an arrangement that promised $4 in tax losses for every $1 invested. The list included Michael Landon, Andy Warhol, Sidney Poitier, Lorne Greene, Norman Lear, then Postmaster General Preston R. Tisch, and his brother Laurence A. Tisch, then head of CBS. These unfortunate taxpayers, though not charged with crimes, had to experience IRS audits and the joys of paying back taxes plus interest and penalties.

The report also noted that Atkins is “the son of former Ashland Oil Co. chairman Orin E. Atkins,” and that he “took Wall Street by storm in the early 1980s with a series of tax shelters and investment partnerships that attracted tens of millions of dollars.” With that sort of background, even aside from the previous conviction, surely it should be no surprise that the eyes of the IRS were watching closely.

Managing risk involves both minimizing risk and setting in place ameliorative mechanisms to offset the impact of the adverse consequences produced when a risk materializes. It’s risky to commit tax fraud. It’s very risky to commit tax fraud, get caught, get convicted, and then commit tax fraud again. It is very difficult to slip back under the IRS radar after being convicted of tax fraud. The best way to manage that risk is to refrain from committing tax fraud again.

When I taught the basic federal income tax course, which I stopped doing eight years ago, I did not invest much time in the cost of goods sold offset. I simply let the students understand a basic principle. If a business sells an item for $14 that it purchased for $9, there is $5 of gross income. I did not get into the computation of cost of goods sold, because it is complex, heavily arithmetic, and too detailed for a basic course. So I did not get into LIFO and FIFO, average cost, spreading the cost of shipment among multiple items, adding in indirect costs for manufactured items, and other issues.

What I never thought to mention to the students is that there is no cost of goods sold offset if no goods are sold. I figured it would and should go without saying. For example, there is no interest deduction if there is no loan on which interest is being paid or accrued.

So I found it interesting that the issue was addressed by the Tax Court. In BRC Operating Company v. Comr., T.C. Memo 2021-59, the Tax Court held that if no goods are sold there is no cost of goods sold offset. Technically, the issue was whether the economic performance requirement in section 461(h)(1) applies to, and precludes recognition of, estimated drilling costs reported by the taxpayer as cost of goods sold. To reach the case, go to the docket for the case, scroll down to item 71 and click on “Memorandum Opinion,” because the URL for the opinion is too long to include in an html URL tag.

The case involved BRC Operating Co., organized as a limited liability company in 2008, and wholly owned by another limited liability company, Bluescape Resources Co. BRC was treated as a disregarded entity. Bluescape was a partnership for federal tax purposes and used the accrual method of accounting. Bluescape purchased mineral and lease interests and planned to explore for, extract, and sell natural gas. On its partnership returns for 2008 and 2009, it treated $100 million and $60 million, respectively, as costs of goods sold, based on estimated drilling costs for exploration and extraction. Bluescape did not drill, receive drilling services from third parties, or receive drilling property during the tax years in issue. It reported no gross receipts or sales during these years attributable to the sale of natural gas.

The IRS disallowed the cost of goods sold offset, determining that Bluescape had not established that it satisfied the all events test and the economic performance requirement in section 461(h)(1). When the dispute reached the Ta Court, the IRS moved for for partial summary judgment, arguing that the undisputed facts show that economic performance under section 461(h)(1) did not occur with respect to the reported costs of goods sold during the years in issue, and, in the alternative, that the reported costs of goods sold should be disallowed because they were derived from Bluescape’s use of a method of accounting that failed to clearly reflect income. Bluescape and BRC moved for partial summary judgment, arguing that the economic performance requirement in section 461(h)(1) does not apply to the amounts claimed as costs of goods sold for the tax years in issue.

The IRS cited regulations section E.g., sec. 1.61-3(a), which provides, “[A]n amount cannot be taken into account in the computation of cost of goods sold any earlier than the taxable year in which economic performance occurs with respect to the amount[.]”). The taxpayers argued that the economic performance requirement does not apply because the regulations “extending” it to amounts included in cost of goods sold went too far. They argued that, as an offset against gross receipts to arrive at gross income, cost of goods sold is an “item of gross income” the timing of which is governed by section 451 and the corresponding regulations, and therefore the economic performance requirement in section 461 does not apply.

After the parties briefed their position, the Court scheduled a hearing on the motions to pose a basic question to the parties: Can Bluescape recognize costs of goods sold before it has any gross receipts from the sale of goods? The Court explained that before the question of whether cost of goods sold are subject to the economic performance requirement is answered, a precedent question must be resolved, namely, is there a cost of goods sold offset when there are no gross receipts to offset yet? The issue, the Court clarified, is not whether the estimated drilling costs can ever give rise to costs of goods sold but whether they can give rise to costs of goods sold for the years in issue before there are receipts to offset. The taxpayers argued that “matching” of cost of goods sold and gross receipts is not required.

After proving a history and explanation of the cost of good sold offset, the court cited previous cases for the proposition that “cost of goods sold is not allowable unless, and until, the taxpayer actually sells or disposes of goods,” and for the proposition that “taxpayers] have to capitalize an item’s cost in the year of acquisition or production and either amortize it or wait until the year the item’s sold to make the corresponding adjustment to gross income.”

So it turned out that this was not the first time a taxpayer tried to claim a cost of goods sold offset before selling anything or during a year in which nothing was sold. In keeping with the tagline for this blog, I point out that one of the cases cited by the Court involved a model train store that tried to claim cost of goods sold before it started selling to the public.

The Court explained that “Cost of goods sold does not exist in a vacuum, as a stand alone deduction in the Code, but serves as an offset against gross receipts.” The Court noted that the taxpayers had not cited, nor could it find, any cases that allowed an offset for cost of goods sold as a stand alone deduction in advance of any gross receipts. Thus, the court rejected the taxpayers’ argument that cost of goods sold need not “match” gross receipts because it could not bridge the gap in their logic. Some of the cases cited by the taxpayers in support of their position involved expenses claimed as business deductions not part of cost of goods sold or deductions for worthless inventory, neither of which was congruent with the facts of the case. Other cases cited by the taxpayers were put aside by the Court because the facts of those cases did not involve, as the taxpayers claimed, taxpayers who did not sell goods during the year.

Because of its resolution of the first argument made by the IRS, the Court did not reach its second argument that the reported costs of goods sold should be disallowed because the Bluescape used a method of inventory accounting that failed to clearly reflect income. The Court simply held that without gross receipts from the sale of goods, Bluescape may not recover its estimated drilling costs as costs of goods sold.

So if I were to ever again teach a basic federal income tax course I would include a simple statement that there is no cost of goods sold offset if there are no goods sold during the year. Because the chances of again teaching that course are extremely slim and for all intents and purposes, none, I am not planning to revise my eight-year-old teaching notes.

According to various reports, including this one, the governor of Georgia has, by executive order, suspended the collection of the state’s liquid fuel tax until Sunday, May 16. Why did he do this? The shutdown of the Colonial Pipeline thanks to a cyberattack, and other supply and demand pressures including a shortage of fuel delivery truck drivers and a surge in driving, has caused fuel prices to increase as well as fuel shortages in certain parts of the state.

Georgia’s governor explained that his actions will “probably help level the price for a little while.” The price f regular unleaded gas in the state has risen by 11 cents in one week though the suspension of the tax will drop the price of fuel by roughly 20 to 30 cents per gallon.

What will this do? One only needs to think of the words “toilet paper” to suggest the answer. Many people will conclude that filling up their vehicle tanks before Sunday is a wise thing to do. From a self-centered perspective, it surely is. And it’s not just vehicle tanks. It’s those 3 and 5 gallon cans used to supply lawn mowers, leaf blowers, and other equipment.

The governor is aware of this. According to the report, “he urged Georgians to avoid a rush to the fuel pumps.” He advised Georgians that they “don’t need to go out and fill out every five gallon tank you’ve got. Get what you need, let everybody else get what they need, get to work and do the things you need to do.” Of course, he assumes that the self-centered perspective will yield to a community-focused one. Good luck. Am I cynical? Perhaps. But it wasn’t that long ago when the mad stampedes for toilet paper, hand sanitizer, bleach, and other cleaning products made the headlines. According to this story, “panic buying and long lines” already were underway earlier this week.

How does reducing the price reduce demand? The governor explained, “We are seeing some shortages around the state, and we don’t want a run on the pumps.” Then don’t encourage a run on the pumps by lowering the price. That’s simple economics, a subject poorly understood by most Americans and especially badly understood by too many politicians. Add to this the temptation presented to residents of adjacent states, especially those living close to the Georgia border, to make tank-filling trips into Georgia because gasoline prices in that state have dropped because of the suspension of the tax. How does that help the situation for Georgia residents?

The report explained that two previous Georgia governors had either suspended the tax on fuel or halted an increase in the tax when fuel prices rose sharply for one reason or another. According to this study, only 2/3 of the tax reduction passed through to Georgia purchasers when the tax was suspended in 2005. This outcome had been predicted in an earlier study, which also identified other disadvantages to suspending the tax on fuels and offered other suggestions to deal with rising fuel prices. Interestingly, that study apparently caused every state other than Georgia not to suspend the tax in 2005, but Georgia did so and the predicted results indeed materialized.

I put this tax suspension into the category of “look, I’m doing something wonderful for you even though it isn’t what it appears to be and hopefully you won’t figure out that what it purports to do for you isn’t what it does for you and it actually can make things worse.” Of course, the cyberattack that has fueled this crisis is an example of what happens when government fails in its responsibility to protect the nation. Decades of anti-government, anti-tax, and anti-regulation sentiment fueled and funded by lobbyists for the private sector is demonstrating how inadequate the private sector can be when government is pushed aside. Distracted by debates reflecting divided opinions with respect to invented disagreements, the nation isn’t paying attention to the increasing size of the hacker fleet sitting offshore. Cutting fuel taxes not only fails to alleviate the supply problem, it also encourages more tax-cutting efforts when the last thing the nation needs is a reduction in support for defense of its people.

Ignorance is a bad thing. It is no less threatening than a biological virus. In some ways it is even more dangerous. The people it harms the most are the ones most resistant to efforts to eradicate it. I have written many times about ignorance, usually focusing on tax ignorance but also expressing my concern about ignorance generally and how it is ripping apart the threads that hold civilized society together. A probably incomplete list of my commentaries about ignorance and its dangers includes 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, Tax Ignorance As Persistent as Death and Taxes, Is All Tax Ignorance Avoidable?, Tax Ignorance in the Comics, Tax Meets Constitutional Law Ignorance, Ignorance in the Face of Facts, Ignorance of Any Kind, Aside from Tax, Reaching New Lows With Tax Ignorance, Rampant Ignorance About Taxes, and Everything Else, Becoming An Even Bigger Threat, The Dangers of Ignorance, Present and Eternal, Defeating Ignorance, and Not Just in the Tax World, Tax Ignorance or Tax Deception?, The Institutionalization of Ignorance, Disinterest in Tax: Should Difficulty in Understanding Justify Ignorance?, and When It’s About Numerals, A Majority of Ignorance.

Last week, the folks at Credello released the results of a poll about taxes. The headline alone is alarming: “SURVEY: Millennials & Men Are Most Likely to Be Overconfident About Their Tax Expertise.” The article begins with these two questions: “You remember that one (or multiple) guy(s) from high school who knew everything about everything? Or at least said he did?” My high school faculty was superb in ridding that thought from our brains even before our brains formed it. We learned to learn what we didn’t know, and we learned how to learn what we didn’t but needed to know and understand. Unfortunately, it’s too easy for people to believe those who claim they have all the answers, even ones who eluded the draft but claim to know more than the generals do.

According to the poll results, “[m]any respondents claimed to know more about taxes than they actually do. Millennials were particularly overconfident as 83% of Gen Yers surveyed said they know enough or everything about taxes, but about a third of respondents scored a B or lower on a relatively simple tax literacy quiz.” Wow. The author of the Credello report points out that this is another example of the “Dunning-Kruger effect, . . . a cognitive bias that people with a lower skill level overestimate their ability, thinking they’re smarter or more capable than they really are.” I love how the author put it: “ In other words, these dummies are too dumb to identify their own incompetence. And on the flip side, their higher-skilled counterparts tend to underestimate their ability.”

Some of the tax literacy quiz responses were telling. When asked whether the taxpayer or the taxpayer’s accountant is responsible for filing errors, 42 percent put the onus on the accountant. Wrong. Asked to select which one of two statements was true, 44 percent chose the wrong answer, “You can claim a pet as a dependent,” rather than the correct response, “Even illegal activity is taxable.” Presented with a question about marginal rates, an issue I recently described in Fixing a Subhead and a Sentence That Reference Tax Brackets, 51 percent selected “You pay your marginal tax rate on all of your income” as the correct choice rather than the correct statement, “You pay the same rate as others on income up to a certain amount, then a higher rate on every dollar until the next threshold.” This ignorance, of course, is used by the ultra-wealthy and their advocates to spread fear among the 99 percent to gain support for their opposition to tax increases that would have no effect on those who are not ultra-wealthy.

So what is the solution to ignorance, no matter the subject? The answer, in two words, is quality education. When education was once found in schools, books, newspapers, radio, and television, it now percolates not only in those sources but also on internet web sites, social media platforms, and other avenues that operate without the filters available when educators are educated people. The willingness to “learn” about taxes or some other matter from what some random person or manipulated robot posts online while pushing aside what the educated experts have to say about the issue is the product of deep psychological problems. The willingness to believe what one wants to hear opens the door to the scammers and spammers, and eliminates the very freedom that is the excuse given by those who believe they are free to believe whatever they want to believe, even when it conflicts with indisputable facts.

A little more than four years ago, in Ignorance in the Face of Facts, I wrote:

A recent survey by the Public Policy Institute of California reveals how the spread of misinformation through social media has contributed to the inability of Americans to distinguish fact from fiction. The survey asked people in California to identify the largest areas of state spending. Thirty-nine percent of the respondents identified prisons and corrections as the biggest expenditure. Less than ten percent of the California budget is spent on the prisons and corrections system. Only 16 percent of the respondents correctly identified K-12 public education, which consumes almost 43 percent of the state budget, as the largest expenditure. It’s not as though the information is classified or difficult to find. So few people know the answer in part because so few people care about learning this sort of information, and in part because it’s so easy to accept as true whatever information gets pumped out of someone’s favorite source of “news.” I wonder what would happen if the survey respondents were asked the question, and then given the opportunity to research the answer. How many could take themselves to an official California state budget web site to discover the answers?

Why does it matter? Who cares? It matters because decisions are made based on the facts people think exist. For example, in California, voters are given the opportunity to approve or reject propositions that directly affect taxation and spending. Advocates of more spending for a particular area of the budget strive to convince voters that the particular area in question is underfunded. Those seeking to cut spending on particular areas try to convince voters that those areas are overfunded.

Six years ago, in The Grand Delusion: Balancing the Federal Budget Without Tax Increases, I pointed out:

A month and a half ago, the Kaiser Family Foundation released poll results revealing that 40 percent of Americans “think that foreign aid is one of the two biggest areas of spending in the federal budget.” This, of course, is totally incorrect.

Yet this piece of tax misinformation persists. How can good decisions be made when reality is different from perception? Imagine what happens if surgeons, electricians, auto mechanics, and engineers made decisions based on misinformation rather than on actual facts. Just imagine.

Yes, just imagine. Is it any wonder that more and more unfortunate outcomes are afflicting the nation and the world? The price that is paid for ignorance is steep. Unfortunately, the price paid for one person’s ignorance is not necessarily paid by that person and too often is paid by many others. Ignorance can be eradicated. So when those opposed to what eradicates ignorance, that is, quality education, fight increases in education funding and push for decreases, when they advocate the establishment of and support for institutions of miseducation, when they fund and support media and web platform outlets that spew falsehoods, everyone else should ask, “Why are they doing this?” The answer is simple. They benefit from ignorance and miseducation, they know and understand the consequences of a fully educated national and world population. That is why they foster anti-intellectualism, because they cannot risk too many people being sufficiently educated to also know and understand the consequences of pervasive quality education. They prefer ignorance, and that is no less harmful than preferring the incubation and spread of a virus.

This recent story out of Long Island, New York is an example of how much work still needs to be done to make certain tax systems function properly. The story begins with a 94-year-old woman who had been paying $2,694 annually in local real property taxes on her home. This amount reflected two exemptions, one for her age and one for her status as a veteran. But then someone in the country tax office marked her as dead, even though she wasn’t and isn’t dead. The erroneous death tag cancelled the two exemptions, and the annual real property tax on her home jumped from $2,694 to $7,921. The mortgage company simply paid the increased amount, and debited the funds from the woman’s account.

When she learned that the monthly payments had been significantly increased because of the tax increase, the taxpayer had her daughter call the county’s Department of Assessment. That is when she and her daughter learned that someone had decided the taxpayer was dead. Someone in that Department’s office admitted that an error had been made, and told the taxpayer that the process for fixing it needed would take more than a year. In the meantime, the taxpayer overpaid the taxes by roughly $5,000 to $6,000, amounts beyond the taxpayer’s ability to pay. Apparently she had some financial assistance from her daughter.

The taxpayer and her daughter contacted county administration officials, including the county executive, but ran into a brick wall. They then turned to a county legislator for help, but he also could not get answers. So the legislator called a press conference to let people know what was happening.

A spokesperson for the county claimed that “corrections were made right away, along with a petition that will be approved by the legislature on Monday to refund the taxpayer.” He reported that a refund check should be mailed to the taxpayer by May 10, and noted, “it's unfortunate that an elderly woman was used as a political prop by politicians when a solution has already been found.”

No, what’s unfortunate is that someone marked the taxpayer as dead, no verification seems to have been made, no red flag popped up on a supervisor’s computer, no cross-checking with the state’s department of vital statistics to confirm the filing of a death certificate was processed, no rapid correction was made, no response was provided to the taxpayer by certain county officials, and perhaps no interest was paid on the refunded amount. No information has been provided on how the error took place. Did someone contact the tax office, perhaps as a prank, hoax, or attempt to steal the woman’s home, and report the taxpayer as having died? If so, what sort of confirmation was required? Did someone accidentally hit a button on a computer keyboard? If so, did a “do you really want to mark this person as deceased?” confirmation question pop up on the screen? Did a request for confirmation get sent to the supervisor? Worse, was a “you have been marked as deceased and the tax on the property has increased” notice sent to the taxpayer’s address? Was the taxpayer’s name confused with another taxpayer who actually did die? Was the box that should have been clicked above or below the box adjacent to the taxpayer’s name and associated with a different person?

System design is difficult. Everyone makes mistakes. The more costly a mistake, the more resources should be plowed into the design of a system. Systems that deal with taxes and other finances, such as banking, with health and medical issues, with arrest and prison records, and with similar “high consequences if an error” situations deserve careful planning and implementation. Not only do these systems need careful planning to prevent or at least reduce the number of mistakes and to reduce the impact of mistakes, they also need processes that fix mistakes, and quickly. Why it would have taken more than a year, absent the intervention, to fix the error is baffling. It was easy check the “taxpayer is dead” box, so it should be just as easy to uncheck it, and check a “send refund” box.

It is a story like this that turns public opinion even more sharply against taxes. This sort of error is bad public relations, and it would be behoove the county tax office in question to release an explanation of what went wrong and the steps taken to prevent similar and identical errors in the future. And it ought not take more than a year to do that.