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Wednesday, April 28, 2004

The Marriage Penalty That Will Not Die! 

Sounds like the name of a horror movie, except that it's not a movie but a real problem. For married people. And for unmarried people. Anyone who pays taxes, whether or not married, is affected by this issue, and really should take some time to understand it.

The marriage penalty gets a lot of attention. It plays well in the soundbites of politicians. If you listen to them (the soundbites), you might end up thinking that the problem has been solved. It hasn't been solved, and relying on soundbites and the chest-thumping self-declared hero-annointing of politicians who think that they are solving the problem (and that they are heroes for doing so) is dangerous. It causes people to be mis-informed. As an educator, I simply hate that. People being mis-informed, that is.

Today's Philadelphia Inquirer carries a report [go to the Philadelphia Inquirer site, search for "marriage penalty" and then log in (or register if need be (it's free))] explaining that the Democrats and Republicans are in "rare accord" on making the marriage penalty relief enacted in 2001 permanent.

Let's clarify what happened. In the 2001 tax legislation, an attempt was made to eliminate the marriage penalty by "equalizing" the 15% bracket and the standard deduction. To reduce the negative tax revenue impact, the changes, even though enacted in 2001, were scheduled to be phased in beginning in 2006. Legislation enacted in 2003 accelerated these changes to 2003 and 2004, and left them set aside for 2005, to be followed by another phased in beginning in 2006, which would make the changes fully in place by 2009, but under the terms of the 2001 legislation these changes would be "undone" in 2011. [If you ever wonder why the tax law is so complex, it's this sort of political maneuvering and gaming that shifts to taxpayers the compliance burden of deciphering what is behind the smoke and mirrors. All of this "it's there, later, no, now, but just part of it, and wait, then it's back, slowly, and yep, then it's gone" silliness is an attempt to make the budget impact appear to be less severe than it otherwise would be.] What's at issue now is legislation to leave these changes in place not only for 2004, but for 2005 through 2010. The 2011 "undoing" affects ALL of the changes made in the 2001 legislation, a list of provisions that reaches far beyond this marriage penalty issue. The legislation to "make the marriage penalty solution permanent" passed the House of Representatives earlier this week. Of course, it isn't permanent because of the 2011 problem.

Let's clarify something else. These changes soften the marriage penalty. They do not eliminate it. They cannot eliminate it. There are at least two dozen elements of the federal income tax law that contribute to the marriage penalty. There surely are more, because it's easy to miss things that are buried in the law and not labelled as such. The legislation in question affects two of those elements. Technically, there are multiple marriage penalties, and that, too, needs some attention to understand what is happening in Congress.

Is this confusing? Sure. If the folks reporting the news can't figure it out, how are taxpayers supposed to learn? (Easy. Keep reading my blog, haha. Better yet, enroll in a tax course.) For example, read what the Philadelphia Inquirer report says: "The provisions in the 2001 tax-reduction legislation that eliminated the marriage penalty are set to be gradually reduced starting next year and to expire by 2010 unless Congress extends them." Well, that's not correct. I'm sorry that I need to nitpick, but it's essential that readers understand what really is happening, and the preceding quote is incorrect in several ways. First, the provisions in the 2001 tax legislation did NOT eliminate the marriage penalty. It softened it a bit. And it didn't happen in 2001, but in a future year that eventually became 2003. Second, those provisions are not set to be gradually reduced starting next year. They end next year. Abruptly. Not gradually. Third, that's not the end of it. They are scheduled to gradually come back into the tax law and will be fully back in place in 2009. Fourth, they will expire in 2011, not "by 2010."

But there's a problem, and according to the report some Democrats (but I'm sure some Republicans also are on board) are pointing out that straightening out the mess involving the equalization of the 15% bracket and the standard deduction doesn't do a thing to solve the marriage penalty that afflicts lower-income taxpayers who claim the earned income tax credit. And they are correct. So the current tax legislation has been amended in an attempt to deal with THAT marriage penalty. One of the sponsors of that fix was a Republican, so there's no doubt that this is not a partisan issue. Unfortunately, the softening of the earned income tax credit marriage penalty (that afflicts lower income taxpayers) won't be fully in place until 2008. Why should those folks wait while married couples with higher incomes get more immediate relief? Perhaps money talks?

But there are more problems. Even with these changes, the marriage penalty will survive. Big-time. How big? Imagine two people who discover that by getting married their tax bills climb from $12,462 each (filing as unmarried individuals) to $37,135 when they file a joint return. I've put the computations on another web page (partly because this post is long enough already and partly because I yet haven't figured out how to get these into the blog in a sensible format). True, it's an extreme example, but it illustrates that tweaking the standard deduction does nothing for taxpayers who itemize their deductions, and whose marriage puts them into a higher bracket, triggers deduction and exemption phase-outs, and removes the active management loss exception to the passive loss rules applicable to rental property. And that's just a few of the tax law elements intensifying the marriage penalty. You'll note that this is an item I make available to students in my Introduction to Federal Taxation course at Villanova's Law School, and one of the best days of the semester is when I take them through this and observe the body language and hear the gasps (especially from the students who are seeing it for the first time in the classroom because they didn't bother to do their reading and prepare for class as required [which is another story for another day, even though it connects because it suggests an answer to the question, "Where do all these unprepared lawyers and legislators come from and how did they get to be that way?"] It gets even better. Keep reading.

The interaction of all these "marriage penalty elements" in the tax law with one another doesn't just cause marriage penalties. Marriage penalties afflict some married couples. Other married couples end up with what the scholars call the "marriage bonus." If one of the two individuals in the example of the marriage penalty ended up marrying a person with no income rather than a person with comparable income, the tax liability DECREASES. In the same example, the tax liability of $12,462 goes down to $8,425. The numbers are on that same other web page.

This is when the fun starts in the tax course. "So," I ask, "what effect is the tax law having?" The response is usually in the form of "Well, it seems that if you marry someone who stays home rather than working the tax system provides a reward, but if you marry someone who has income of more than some small amount, the tax system penalizes you." "Quite correct," I reply, "and do you think it is intentional?" They look at each other and part of the "welcome to adulthood" light bulb array turns on. It's fun. There have been years when students spontaneously cried out, without waiting to be recognized, "You're kidding" and "This *****." I do my best to convince them that it's not my doing (even though I'm a "tax person"), that it's not the fault of the IRS, but that it is ... yes ... the Congress.

Oddly, as a general proposition, the marriage penalty is not an issue for folks with very high income. Consider the marriage of two people earning two, three, ten million dollars a year. [Yes, we could be talking celebrity or celebrity-athlete marriage here, but you can figure those out for yourself. After all, THEY didn't write the tax law, and I doubt that "marriage penalty" is in their conversation.] The person earning several million dollars a year already is in the highest tax bracket, has had their deductions and exemptions fully phased out, and pretty much has already been subjected to the marriage penalty elements in the tax law. So the marriage doesn't have the same tax penalty impact as it does for two people earning 80, 90, 120, or 150 thousand dollars a year. Strange, isn't it? I'll leave aside for now, because this post is beginning to become a law review article, the impact of the alternative minimum tax which can put marriage penalty salt into its stealth tax wound.

When I updated that other web page from 2003 to 2004, I noted two things. First, the marriage penalty decreased by a few hundred dollars. Second, the marriage bonus increased. That is not surprising. Whatever is done to soften the marriage penalty intensifies the marriage bonus. That is why all the tweaking and twisting won't solve the problem.

So even though the pending legislation doesn't solve the problem, what little it does is expensive. It will cost at least $96 billion over 10 years, an amount computed without considering the recently added changes to soften the earned income tax credit marriage penalty. So, of course, the "how do we pay for this?" debate once again has jumped into the spotlight. Here it gets partisan. Oddly, it's the Democrats who want to cut spending (or, as I am sure is their preference, raise taxes) and it's the Republicans who rejected those ideas but who haven't explained what they plan to do other than let the deficit increase.

So what's the solution? Simple. Admit that marriage should have nothing to do with income taxes. I know that sounds blasphemous to some, but let's consider how marriage affects other taxes. A single person purchases a $300,000 home. That person pays a property tax, let's say, of $5,000 a year. If a married couple purchases that home, the property tax is $5,000. A single person eats dinner at a restaurant in Pennsylvania and orders $40 of food. The sales tax is $2.40. If two single persons have dinner together, and order $80 of food, the sales tax is $4.80. If the two people get married and return to the restaurant for another $80 dinner, the sales tax is, yes, $4.80. User fees generally are the same. Whether the two people in the car are married or not, the bridge toll is $3. There are some user fees, for example, the National Park fee, which provide discounts for "families" and I'll leave for another time the various arguments that can be made in favor of, and against, such discrimination against people who do not constitute families (e.g., widows and widowers).

An income tax is measured by taxable income, which should be some sort of "ability to pay" marker. Once upon a time, the justification for joint returns was the practice, in community property states, of splitting the income of the sole-wage-earning (usually) husband between the spouses, so as to get lower rates on each. After common law states enacted community property schemes to permit their citizens to use this technique, Congress codified the practice with the joint return. Big mistake. Throughout the Code there are provisions that state, "For purposes of ....., community property laws shall not be taken into account." (or terms to that effect). So there's no reason on this account for joint returns.

Defenders of the joint return point to the different financial dynamic of families. One argument is that the two spouses commingle their funds, so how could they possibly separate their finances into two returns. The answer is simple. Income is reported by the person on whose W-2 or 1099 reports it, and if it is a joint account, it is split. Deductions are reported by the person who made the expenditure, and if it is made from a joint account, it is split. Advocates of joint returns also suggest that married couples should incur lower tax liabilities because they have more expenses. I disagree that they necessarily have more expenses because they very well could be getting the benefit of economy of scale (after all, they probably have one home instead of two, and they still have two cars). The biggest expense would be the costs of raising children, a matter that should be addressed through adjustments to the deduction for dependency exemptions.

Ideally, at the same time Congress would junk the AMT, the phaseouts, most of the deductions and credits, increase the exemption amount per person to the poverty level, permit persons who don't need the exemption (because they have no or little income) to sell the exemption to others (just as corporations can sell pollution allowances), and lower the tax rate to a 2 or 3 tier structure that would provide serious progressivity when measured against gross income.

The chances of this happening? About as high as my getting elected to Congress to make the futile attempt to get such reform enacted. There are too many vested interests whose primary commitment, dedication and loyalty is to themselves, their cause, their organization, their political party, their wallet, and their friends, rather than to their country and the taxation ideals on which it was originally built.

So, go ahead. Believe the headlines. "Congress Eliminates Marriage Penalty." Then take a peek at your return. Run the numbers (or get someone to do that for you if you really, really hate or fear numbers, though I doubt you really do). Then decide who's inviting you to a good education and who's trying to con you.

Monday, April 26, 2004

How Private is Confidential? 

I've never done a survey, and I haven't been able to find anything, but it seems to me that most taxpayers think that the information on their tax returns should not be disclosed by the IRS. Many probably think that it ought not be disclosed ever. I'm also guessing that many taxpayers have little confidence that their tax return information will remain private. Part of that, I think, is based on the stories that emerge from time to time about IRS employees "checking up" on their neighbors' or friends' tax returns, or from a general sense that one "cannot trust" the government.

As a general matter, the IRS is prohibited from disclosing tax return information. But the Internal Revenue Code provision imposing that restriction contains a long list of exceptions. The IRS is required to make a report each year to the Congress (technically, to the Joint Committee on Taxation) disclosing each instance it discloses tax return information under one of the exceptions.

The report for 2003 has been published. It covers disclosures made during 2003.

Total number of disclosures of tax returns or tax return information: 3,744,087,686. Yes, that is three BILLION plus. Keep in mind that roughly 125,000,000 federal income tax returns have been filed for each of the past few taxable years. So that's roughly THIRTY instances of disclosure for each tax return.

To whom are these disclosures made?

Leading the list are disclosures to state officials with responsibility for administering state tax laws. Of the 2,430,943,771 disclosures, most were made by sending extracts of Master File tapes (the digital record of the information filed on the return). At approximately 20 per return, these numbers reflect transmission to the states of information on items such as dividends, interest, property sales, business income, etc.

Next on the list are disclosures to the Bureau of Census and Bureua of Economic Analysis. There were 1,147,490,191 disclosures. I'm guessing that some or many of these were probably in the form of statistical summaries and groupings.

Third place went to disclosures to Congressional Committees and their agents, including the General Accounting Office. These disclosures cannot carry identifying information other than in closed executive session or with the written permission of the taxpayer. These disclosures, therefore, are most likely summaries of taxpayer filing "habits" with respect to particular types of transactions. Oh, there were 149,235,637 of these disclosures.

In fourth place, at 8,781,942, were disclosures to child support enforcement agencies. It's pretty clear what this is about, and it's pretty clear that identifying information is a necessary part of the disclosure. This disclosure is one of many exceptions falling into the "disclosure for purposes other than tax administration" category.

Fifth through seventh places were claimed by the three remaining categories that numbered in the millions: 2,809,898 to the General Accounting Office (to assist it in auditing the IRS and other agencies), 2,446,199 to the Department of Agriculture (to assist with agricultural censuses), and 2,305,866 to the tax treaty authorities of foreign countries. Surely this last batch included identifying information.

Then the numbers drop off significantly, but the identity of those to whom disclosure is made is a stark reminder that even if tax returns are filed carefully and honestly they can put a taxpayer in an awkward situation. Of course, if the tax return is filed dishonestly, it gets worse. Consider these statistics: 57,849 disclosures to U.S. Attorneys, the FBI, the Drug Enforcement Agency, and other law enforcement agencies, along with 455 disclosures to U.S. Attorneys of return information other than certain taxpayer information, 1,763 disclosures to apprise appropriate officials of criminal or terrorist activities or emergency circumstances, 1,724 to U.S. Attorneys in connection with ex parte orders, and 6 disclosures to Department of Justice employees preparing for or conducting grand jury proceedings.

Sometimes it's the taxpayer who triggers the release of information: 11,118 disclosures to persons designated by the taxpayer as approved to receive the disclosure (these are usually instances in which the taxpayer has lost tax returns and is letting his or her tax advisor obtain copies from the IRS).

So what taxpayers may not realize is that although their tax return information is confidential, and ought not appear on a web site somewhere, it doesn't simply "go to the IRS and stay there." Even if the system worked flawlessly (and I doubt that it does), information on the return finds its way to other places, sometimes tagged with the taxpayer's identity.

Is this bad? Not necessarily. The idea of using tax return information to track down child support deadbeats, to assist in the enforcement of state tax laws, to support criminal proceedings against a criminal, or to be used to improve the tax law and its administration (e.g., through audits of the IRS, reviews of taxpayer filing patterns) makes sense. Because this is being done, taxpayers ought to understand that the tax return is more than a tax return. It has elements of a census form, and creates a trail of evidence which should disturb those not abiding by the law (but which seems to bother law-abiding citizens far more than it does those who disregard the law).

Some folks do not like the idea that the IRS shares this information. One in particular is James Plummer, a Policy Analyst at Consumer Alert. He awarded the National Consumer Coalition Privacy Group's "Privacy Villain of the Week" designation to the IRS because of these disclosures. In his explanation, he makes some important points but then overstates the case against the IRS.

It is true, as he explains, that the IRS computer systems are "insecure and vulnerable to hackers." But whose fault is that? I continue, with little success, to help people understand that it is the Congress, perhaps in trying to keep taxes low (he says sarcastically), that doesn't appropriate sufficient funds (and then when it does try to deal with the situation, finds an IRS that has a variety of tax administration problems reflecting years of Congressional neglect).

And yes, the IRS (for reasons that baffle me and don't seem defensible) signed people up for junk mail. If you find this rather bizarre, take a look. And maybe the IRS web site uses too many third-party "cookies," as explained in this report, though I doubt that puts tax return information at serious risk of disclosure.

But I think that Mr. Plummer goes a bit overboard when he asserts that the disclosures to the Census bureau were made so that "pointy-headed bureaucrats can engage in social-engineering schemes designed to undermine the free market choices individuals make in their daily lives." There surely are social engineering schemes, but they're not hatched or cultivated in the Census Bureau. There are enough politicians out there buying votes by promising another goodie from Uncle Sam and theoreticians hiding behind think tank and academy walls conjuring up these schemes without any need for the Census Bureau to help out.

His claim that the disclosures made to the Department of Agriculture were "so that that Department's bureaucrats could actively work to control the market for food, which results in higher prices for consumers at the grocery store" startles me. If there is federal government interference afflicting the food markets (and I don't doubt that there is), it is a gift of, YES!, the Congress.

And, when he argues that the disclosures made to foreign taxing authorities "undermines foreign investment in America, resulting in a weaker economy, with fewer jobs, higher prices and less innovation." he overlooks the long-term inefficiency of attracting foreign investment by assisting individuals and corporations in tax evasion schemes. This nation should be selective in making decisions to lure businesses to operate within its borders. Refusing to turn down money no matter its source or its tax-evasion impact sells out the principles on which this nation was built. If the only way to attract foreign investors is to be a tax haven, then this nation is in horrendous shape.

Finally, Mr. Plummer's statement that "this disclosure habit of the IRS is just one way the bureau undermines privacy" suggests to me that he thinks the IRS is making these disclosures because it wants to do so. To the contrary. The IRS makes these disclosures because it is REQUIRED to do so. By the law. Law enacted by, c'mon, you can see this one coming a mile away, YES, the Congress. Does Mr. Plummer want the IRS to ignore the disclosure laws? If he does, he'd be advocating the very sort of non-compliance that he justifiably criticizes when he notes that the IRS has not cracked down the way it should and ought to crack down on IRS employees "browsing" tax return information of their friends and neighbors.

The IRS makes for an easy target. Congress helps make it an easy target. It takes the heat off Congress. Mr. Plummer, please don't let your important and valid points miss their mark by being directed at the IRS rather than the Congress. And please don't overstate your case because it distracts us from the genuine problems in the tax return disclosure area.

Of course, if we simplified the tax law, there would be far less information sent to the IRS. But that's another topic for another day.

Friday, April 23, 2004

AAG (Tax) Speaks at Harvard 

.... and gets blogged.

Sounds bad, but it isn't. It's nice to show up in someone's blog. And that's what happened to Eileen O'Connor, Assistant Attorney General for the Tax Division at the Department of Justice. Her speech at Harvard Law School has been written up on Per Curiam, a law blog maintained by two students at Harvard. She addressed three topics: tax shelters, the "wall" between tax law enforcement and intelligence, and the use of John Doe summonses in tax cases.

Word of Warning: if you find yourself drifting to their affiliated Sports Law blog, you could end up browsing for hours. So don't go there 10 minutes before a meeting or class, because it will be tough to drag yourself away from the computer. Trust me, I speak from experience.

Getting it Right 

No, that's not a political statement. It's about being correct. Oops, not politically correct. Tax correct.

The tax law is complicated. So complicated that many taxpayers shell out dollars to preparers and to tax software vendors because they cannot do the return without help.

Let's for a moment accept the tax world as it is. Tax law is complicated. Returns are difficult for the typical taxpayer to prepare. Commercial assistance is available but it comes at a price. Where does the taxpayer unable or unwilling to pay for assistance turn? Where does the confused preparer (yes, they exist) turn?

For taxpayers, there are VITA programs (Volunteer Income Tax Assistance) programs. Those programs don't exist everywhere. And where they do, they have a limited range of expertise.

Ah, let's contact the IRS. On Wednesday, the IRS Commissioner shared some information with the House of Representatives Appropriations Committee's subcommittee that handles IRS oversight.

When the IRS fields a phone call (it answers roughly 85 percent of them, so I guess the other 15 percent tire of waiting and hang up?), its representatives answered roughly 80 percent of the questions correctly.

They had started at a lower rate, apparently because the IRS changed the scripts that are used by the representatives to interview the folks calling for help. The drop-off in correctness compared to last year was so significant that the IRS re-wrote the scripts. This caused the correctness rate to climb back to within one percentage point of last year.

Before getting to the plans disclosed by the IRS for dealing with this, let's think about two things.

First, why are the IRS representatives using scripts? A person who knows the tax law doesn't need a script. A checklist, perhaps. The problem with a script is that it cannot predict the taxpayer's response. (I've dealt with software vendor representatives who use scripts, and it's almost laughable at times, because the person's second question often has nothing to do with my answer to the first question. It also reminds me of the football coach who scripts the first, say, 20 play. So if the quarterback is sacked for a 12-yard loss on second down, the team blunders forward with the halfback plunge because that's the next play in the script? Bizarre (except, in all fairness, most coaches using scripts have some flexibility built into their plan.)) My guess is that the scripts are being used by the IRS representatives because they wouldn't otherwise know what to say. And that brings me to the second concern.

Second, is 80 percent (give or take a few percentage points) acceptable when it is the government to whom the taxes are paid that is giving the assistance? My answer: no. There are places where 80 percent is phenomenal and unlikely to happen (think baseball batting average or basketball shooting percentage). But in the things that matter, how can 80 percent be acceptable? Of course, the IRS says it isn't and has plans to change it. Would our society accept an 80 percent successful surgery rate? Or 80 percent of traffic signals properly functioning? Or 80% of children in day care being returned safe and sound each day to their parents? No.

In my classes, I use 80 percent as a benchmark in grading. A student who can do at least 80 percent of what I could do on the exam earns an A. Why is 80 percent acceptable in that context? Because I'm dealing with a student (who may or may not intend or decide to practice in the subject matter). The student has had 14 weeks to learn a significant amount of material while also learning 4 or 5 other subject areas. The student is not being held out as a professional. The student is not being paid. The student does not, and should not, have the life or property of a client at risk.

I teach my students not so much the actual law but how to learn the law, because the law keeps changing. I teach my students how to identify the "bad habits" or tendencies that prevent them from attaining a correct response, and then assist them in making adjustments. It's similar to coaching.

Is the IRS training its representatives? Are the representatives being fed "information" which they don't process but simply read back from a script? Do the representatives UNDERSTAND the tax law or merely KNOW some rules? When the IRS says that it wants to make managers more accountable for improving services (that's half the plan), does it plan to have the managers do the teaching? If they're not, then it's the teachers who need to be held accountable. When the IRS says that it wants to set up teams to supervise the program, identify problems and set priorities (that's the other half of the plan), does it intend to emphasize training (or retraining) in one area at the expense of another?

Does the IRS have enough funding to handle the millions of calls that it receives? Would it have an easier time of it if Congress refrained from enacting so many complicated provisions and then tinkering with them each year? Is the 80 percent rate a combination of many representatives with rates in the upper 90s and a few with rates in the 40s? If so, is the IRS constrained from firing the representatives because of civil service protections? (Moving a representative to another position, even if the representative is more suited to that other position, leaves a gap in the phone answering team, because the IRS would need more resources to replace the representative.)

Who is being hired to be a representative? Someone who has been through a law school tax course or two? Someone with a college degree? A high school diploma?

How much training do the representatives receive? What sorts of exercises and active learning are used? Are the representatives taught to solve problems? Do they ever read the actual law, such as the Code or regulations? Are they using summaries of the law? If so, how accurate are those summaries?

Leave it to a teacher (by profession, by avocation, and by genetic heritage) to ask these sorts of questions, but it boggles my mind that the federal agency charged with having sufficient expertise to administer the tax law can get only 80% of the questions correct.

Tax law, fortunately or unfortunately, is not baseball or basketball. Eighty percent doesn't cut it. It's time, again, he says exasperatedly, for the Congress to step up to the plate and GET IT RIGHT.

Closing thought: I wonder if any member of Congress, doing his or her own return (hahahaha), called the IRS for help. I wonder if the answer that was provided was correct or incorrect. I wonder.

Wednesday, April 21, 2004

Well, Did He or Didn't He? 

File his own tax returns, that is.

Who?

Roosevelt. Franklin.

I mentioned in my last post that when looking at the tax returns of several previous Presidents, it appeared to me that Franklin Roosevelt had done his own return. The handwriting and the signature show similar writing strokes and ink density.

I tried to research this, though I admit I haven't dug up all the published biographies of Roosevelt. A search of the web didn't produce much. (Among the links produced by the various search term combinations I used was a page explaining how George Bush, John Kerry, Hugh Hefner, and Franklin Roosevelt are related to each other. That's a totally different topic, and if you can't wait for me to dig into it, visit the Maule Family Genealogy page and click on the link to "My Cousins, the Presidents.")

The best I can find is a letter that Roosevelt sent to "my dear commissioner Helvering" [the famous (in tax circles) Guy T. Helvering, long-time commissioner of the Bureau of Internal Revenue (the predecessor of the IRS)] in which he asks for help doing the actual computation of tax liability. The logical inference is that he was indeed preparing his own tax returns. Though his characterization of the arithmetic needed to do the computation as "higher mathematics" is a bit exaggerated (perhaps deliberately so), I do admire his foray into self-compliance in the truest sense. It's not surprising the Roosevelt would not pay others to do what almost all Americans had to do themselves.

It is interesting that a law Roosevelt signed was the cause of the complexity that baffled him. Remember, there were no hand-held calculators or personal computers in his day. A President who experiences the impact of complexity is likely to disfavor additional complexity. Roosevelt's reaction to today's income tax law, congested with computational mazes and definitional labyrinths, would be interesting to see. Of greater interest would be his reaction to the fact that the President, Vice-President, and most (if not almost all) members of Congress do NOT prepare their own income tax returns. Of course, most citizens do not prepare their own returns. If trends predict the future, by 2010 most tax returns will be prepared in India.

Despite all the complexity, defended by its proponents as a necessary evil to bring fairness, the income tax continues to be saddled with the same sort of tax avoidance (chiefly by the wealthy) that at times infuriated Roosevelt. What would he say if he noticed that among the beneficiaries of the tax avoidance techniques available under our hypercomplex tax law were present and past Presidents of the Republic?

Maybe it's time for a "sign here if you think legislators should be required to do their own tax returns" with a "let's be nice and let them use Turbotax" option. Someone can teach me the technology or programming to set up that sort of "poll." What do you think?

Monday, April 19, 2004

CBO Report on AMT 

The CBO has released a report on the alternative minimum tax, which is full of useful examples, explanations, graphs, and projections. The CBO website sometimes is slow, but it's worth re-trying if one has a deep interest in the topic. Many taxpayers should, because they are or will be paying this stealth tax, as I described and explained it in a previous posting.

Presidents and Taxes 

As the first part of tax season rolled to an end (the second part ends August 15), the President, the Vice-President, and the presumptive Democratic Party presidential nominee released their 2003 tax returns, or at least principal parts of them. They can be found at the Tax History website.

With all the chatter about tax rates and whether (and on whom) they should be increased or decreased, the information provides some interesting insight. Quiz time: what do these numbers reveal about the types of income and deductions claimed by the taxpayers?

                                    2003 Federal Taxes
                                               Bush**     Cheney**     Kerry*
Adjusted Gross Income (AGI)   822,126   1,267,915    395,338
Federal Income Tax Liability      227,490      253,067       90,575
Tax as % of AGI                       27.67%      19.96%     22.91%

* filed separately, does not include wife’s tax information
**filed joint return

Do the computation for your own return. Where do you fit in the array? Of course, a better comparison
would also include the impact of social security and medicare payroll taxes. As a general proposition, the lower the adjusted gross income and the higher the proportion from wages and other earned income, the higher the overall tax rate in comparison to these returns.

Which of the three benefitted the most from the "Bush tax cut" ?

                                Comparison of 2003 with 2002

                       2003      2003         2002        2002      2003      2002
                         AGI      Taxes         AGI      Taxes      Taxes      Taxes
                                                                                 as %    as %
                                                                                of AGI    of AGI

Bush**        822,126   227,490     856,056   268,719   27.67%   31.39%
Cheney**  1,267,915   253,067  1,166,735   341,114   19.96%   29.24%
Kerry*         395,338     90,575     111,540     29,946   22.91%   26.84%

* filed separately, does not include wife’s tax information
**filed joint return

When I visited the Tax History website, I noticed that returns for several other presidents were
available. For what it's worth, here are a few selected returns. Visit the site to see the others.

                Year       AGI        Taxes     Taxes as % of AGI
Bush        2003     822,126   227,490     27.67%
Clinton     1999     416,039     92,104     22.14%
Clinton     1995     316,074     75,437     23.87%
Bush        1991  1,324,456   204,841     15.47%
Carter      1977     189,160     48,162     25.46%
Roosevelt  1934      64,251     16,139     25.12%

Interestingly, it appears as though Franklin Roosevelt did his own return. The handwriting and ink seem to be the same. I don't have the time at the moment to research the question. Surely somewhere a biographer would have made note of it. I continue to think that anyone who votes to enact a tax should be obligated, constitutionally, to do his or her own tax return for that tax. This proposal is not so much an attempt to eliminate taxes (though surely most of the thousands that exist are best suited for the dust bin of history), but to encourage keeping the law simple, understandable, and favorable to compliance.

So, here we are, the first part of tax season is over. For those of you who have filed, may you proceed without hearing from the IRS (other than to receive any expected refund). For those of you who filed for an extension of time to file, and must file by August 15, may you proceed to get this behind you before it hangs around all summer like an unwelcome guest at the vacation rental home.

Friday, April 16, 2004

Numbers, Numbers, More Numbers 

OK, so "tax day" is behind us. (Isn't every day a tax day?)

This posting is brief because I'm investing some time wandering around the newly released statistics at the TRAC IRS web site. There is statistical information on audits, enforcement, and aggregate tax return data. The folks at TRAC (Transactional Records Access Clearinghouse) released their ninth edition of TRACIRS just as the April 15 tax filing deadline appeared.

TRAC IRS is the source for the information about IRS audit rates that I discussed in a previous post. Rather than describe everything that is on the site, I urge you to visit. Take a good look at the county-by-county summaries of adjusted gross income, wage income, average number of dependents claimed per return, etc. They paint a very interesting picture of the nation, because tax information tells us a lot about the socio-economic condition of a county.

TRAC also has statistical information for about eight other agencies, including the FBI, ATF (Alcohol, Tobacco and Firearms), DEA (Drug Enforcement Agency), Customs, and the federal government generally.

It's a playground for people who enjoy numbers. A visit to the site ought to be a requirement of every civics course in the country. (Do they still teach civics?) A careful study of the site's information would be worthwhile for every citizen who wants his or her vote to be informed. There's a lot to learn, and TRAC surely fills the supply side of the equation.

Wednesday, April 14, 2004

John, How Can That Be? 

Presumptive Democratic Presidential nominee John Kerry asserts that under his tax plan, "98 percent of Americans will get a tax cut."

Really?

Let's see. Does that include Americans who don't pay taxes?

OK, maybe what he meant to say was "98 percent of Americans who file tax returns will get a tax cut."

Uh, no, that won't work either. Americans who file tax returns on which tax liability is zero cannot get a cut in taxes.

OK, maybe what he meant to say was "98 percent of Americans who file tax returns that report a tax liability will get a tax cut."

OK, that might make sense.

Does it?

No. The only tax cut affecting individuals in Kerry's proposal is a tax credit for college education costs. This, of course, has no effect on the tens of millions of American taxpayers who are not paying college education costs. Perhaps their children are grown, or perhaps their children are too young for college, or perhaps their children chose not to attend college.

It's a wonderful soundbite, to claim that 98 percent of Americans would get a tax cut. It flat out cannot happen.

Kerry also claims that under his proposal "99 percent of American businesses... will get a tax cut." Does that include the corporations that aren't paying taxes? How do their taxes get cut? As I described in a previous posting, a majority of corporations don't have tax liabilities. Kerry knows this, because his proposal includes steps to curtail corporate tax shelters and increase corporate taxes. John, are you playing immovable object and irresistable force games with us?

Here we go again. Does Kerry mean "99 percent of American businesses that report tax liability will get a tax cut"? Maybe. It would be nice to know.

What's scary is that people hear these soundbites, and believe them. What's worse is that their electoral decisions are affected by them.

Of course, Kerry's presumed opponent has favored us with similar soundbites, so it's rather obvious that one prerequisite for being a politician or running for office is the ability to frame, or speak, soundbites that declare the impossible.

That settles it. I'm just flat out not qualified to run. I know too much about taxes.

And I'm also unwilling to sell out principles in order to make everyone my friend or to maximize popularity.

C'mon, Pennsylvania, You Can Do Better 

Bear with this rant for a moment.

Several years ago, after filing a Pennsylvania S corporation income and franchise tax return for entity #1, I received a letter from the Pennsylvania Department of Revenue Bureau of Corporation Taxes asking for a copy of the federal income tax return for entity #1. The federal return must be included with the state filing, and I was certain I had included it, as I had done every year. "Oh well," I thought, "maybe I missed it." So I made a copy of the federal return, put in in an envelope (because the reply envelope provided by the Department is way too small), went to the post office, and sent it certified mail, return receipt requested.

A year passed. After filing a Pennsylvania corporation income and franchise tax return for entity #2 (an LLC), I again received a letter from the Pennsylvania Department of Revenue Bureau of Corporation Taxes asking for a copy of the federal income tax return, this time for entity #2. Could I have messed this up AGAIN? No, especially as I hadn't messed it up in the first place. (Years ago I created a chart indicating how many copies of each schedule in each return is needed, where it goes, etc., a technique I learned in college when working part-time for a long defunct accounting firm.) So again I made a copy of the federal return, put in in an envelope (because the reply envelope provided by the Department is way too small), went to the post office, and sent it certified mail, return receipt requested.

This past Friday I get a letter from the Pennsylvania Department of Revenue Bureau of Corporation Taxes. Guess what? Yep, they want a copy of the 2002 federal return for entity #3 (also an LLC). Now I know that something is wrong. I was very careful filing the 2002 returns (and the 2003 returns, which I had filed a few weeks before getting the letter concerning the 2002 return).

I'm doing other things so I leave the copying and mailing for this week. Good thing because on Saturday, guess what I get? YES!!! Another letter from the Pennsylvania Department of Revenue Bureau of Corporation Taxes. A different individual wants a copy of the 2002 federal return for entity #2.

Yesterday I made what is becoming an annual "fix the Department's mistakes" pilgrimage to the post office, shelling out close to $10 to send the two copies, one to one person and one to another person.

I included a copy of the Department's letter, on which I explained several things:

(1) I am absolutely certain a copy of the federal return was STAPLED with the Pennsylvania return, as the instructions provide.

(2) The Pennsylvania return apparently is showing up on the desk of the person in the Bureau of Corporation Taxes WITHOUT the federal return.

(3) That means that someone is REMOVING the federal return from the Pennsylvania return.

(4) That someone must be working in the Department of Revenue's Bureau of Receipts and Control.

(5) That someone must be opening the envelope, seeing a federal return stapled to the Pennsylvania return, thinking it must have been included by mistake, and removing it.

(6) That person must not know much about Pennsylvania tax law or filing, else that person would be working in one of the tax bureaus and not the Bureau of Receipts and Control.

(7) The person in the Bureau of Corporation Taxes asking for the copy of the federal return has no supervisory control over the "someone" in the Bureau of Receipts and Control.

So, now I must figure out to whom to send a letter explaining that the Pennsylvania Department of Revenue has a serious communication and process problem. At least it's not the FBI or CIA... they have their own problems, and no one has been killed.

But, c'mon folks in Harrisburg. You can do better than this? Or maybe you can't. Maybe this is just way too complicated. As in "leave the contents of the envelope alone and let the folks in the Bureau of Corporation Taxes deal with it."

I mentioned this tale to a practitioner friend. He said, "Oh, this happens all the time." He explained that the agency with the contracts to handle local income taxes routinely loses the attached federal return even though not only is it stapled, but my friend's practice is to put a legend "FEDERAL RETURN ATTACHED AS REQUIRED. DO NOT REMOVE" on the front of the return.

This isn't rocket science. It is a frightening thought to consider why people can't do such simple things as refraining from removing federal return copies that ought not be removed.

Is it ignorance? Stupidity? Wilful maliciousness? Misguided helpfulness?

It surely isn't laziness because it burns more calories to remove the federal return copy than to leave it attached to the state or local return to which it is attached.

If this is a trend of where society is going: Scary.

Very scary.

Monday, April 12, 2004

Tax Audits and Tax Compliance 

Almost every fall, in the basic federal income tax course, a student will ask something like this: "How do they know that you had that income?" And a student will ask how the IRS decides which taxpayers should be audited.

The answer to the first question is fairly simple. Most transactions that generate income must be reported by the payor to the IRS. Think about W-2 forms, and the different versions of Forms 1099. A few types of transactions escape reporting, generally because they involve small amounts, and of course there's too much noncompliance on the part of some payors.

The answer to the second question is complex. The IRS has a variety of approaches to selecting tax returns for "audit." Keep in mind that an audit can be as simple as a computer program looking for matches between the W-2 provided by an employer and the reporting of the salary on the employee's tax return. An audit can be as complex as the eternal residence maintained by IRS auditors at the corporate headquarters of multinational corporations. Most audits are in between those two extremes. Audits can be handled by correspondence and they can take place face-to-face over a table at an IRS office. Again, there are variations between those two.

Although the IRS supposedly has not yet fully programmed its computers to match every W-2 and Form 1099, its computers are getting closer to that goal. At this level, many, and eventually most, tax returns will be audited. If one considers the computer's checking for arithmetic errors to be an "audit" (technically it isn't), then everyone's return is being "audited" though in a way that isn't surprising and that, more importantly, isn't delving into the correctness of the input numbers. It's only the computations that are being reviewed.

When it comes to audits, that is, checking on the validity of the amounts entered onto a return, the IRS should be using strategies designed to maximize the revenue outcome. It claims it does. One strategy is to focus on changes in the tax law. When the tax law is changed, tax returns with transactions within the boundaries of the tax law changes should be more likely to be audited. For example, if Congress adds a new deduction, the likelihood that most taxpayers and tax return preparers are not familiar with the provision increases the chances or errors and abuse, so tax returns claiming that deduction would get more attention.

Another strategy is to identify professions and occupations for which tax compliance is weak. The first batch included four groups, one of which was... ready? Lawyers!! Hmmm. Now there are several dozen occupations on the list.

Another strategy is to audit returns based on tips from citizens. High on the list are ex-spouses and soon-to-be ex-spouses ratting each other out. Also high on the list are tips from disgruntled employees.

Another strategy is to evaluate the status of each possible income, deduction, or credit in terms of the level of improper reporting associated with that item. For example, there are far more errors made in claiming the earned income tax credit than in claiming the standard deduction. The IRS has a system in which points are assigned to each type of income, deduction, or credit, and tax returns with higher point scores are more likely to be audited. This strategy has been difficult to apply in recent years. In order to determine which items are more likely to be reported incorrectly, the IRS needs to do full and complete audits of randomly selected returns. Whereas other audits focus on a particular item, these audits examine everything on the return, starting with the taxpayer's name and taxpayer identification number and ending with the last of each dollar or other amount entered onto the return. These audits consume much time, and for a taxpayer randomly selected to undergo such an audit, it is a nightmare. A few years ago, needing to update its scoring system, the IRS set out to do another batch of these random audits (they're not done every year). Taxpayers complained to Congress. Congress told the IRS not to do these audits. Why? They're too complicated and thus time consuming. Why are they too complicated? Because the tax law is complicated. Who made the tax law complicated? Goodness, the Congress. So the IRS is using old scoring that doesn't even include the hundreds of provisions added to the Code or amended during the past decade.

So is the IRS "getting to" the taxpayers it needs to check out? Or is it wasting its time auditing people whose returns are correct? Is the IRS doing enough audits? How would we know?

We know some things because the IRS releases information. A great place to get this information (and a lot of other government data) is the Transactional Access Records Clearinghouse which is affiliated with Syracuse University. I was invited, when TRAC was started, to be a beta tester. I recommended that it go forward, and at least this time, my prediction was correct. It has flourished. Go visit the site when you have a chance if you have any interest in government data, statistics, or even trivia to supply your dinner party conversation resource databank.

The TRAC report inspired an interesting article on MSNBC's web site. It contains much more information about related news, some of which has already found its way onto this blog in previous postings.

As expected, the debate isn't over the data but over its meaning and its relevance. Consider:

Percentage of business tax returns audited during Oct 1, 2002 to Sept. 30, 2003: 0.73 percent (that's 73 returns out of every 10,000).

Percentage of business tax returns audited during Oct 1, 1996 to Sept. 30, 1997: 2.62 percent (that's 262 returns out of every 10,000).

The odds are low in both instances, which helps explain why taxpayers tempted to ignore tax compliance are encouraged to succumb. The drop-off, though is severe. It's a 72 percent decrease in business tax return audits. It's easier to find a lottery winner among one's neighbors than to find someone whose business has been audited.

But most businesses are small, and so is it worth trying to find $5 or $50 of underreported tax liability? Isn't the big chunk of "missing revenue" to be found among the big corporations? Yes. How's the audit rate there?

Percentage of businesses with assets over $250 million audited during Oct 1, 2002 to Sept. 30, 2003: 28.98 percent.

Percentage of businesses with assets over $250 million audited during Oct 1, 1995 to Sept. 30, 1996: 33.68 percent.

That's not as much of a slide (14 percent) but it's a slide. It's no less encouraging to big companies than the overall slide is to taxpayers generally.

A decade ago, there were more than 1,000 tax fraud cases. In 2003 there were 538 tax prosecutions. In 1999 there were 247 civil tax fraud penalties, and in 2003 there were 170.

This sort of information makes it tough for the IRS to persuade taxpayers to comply, to file correct returns, and to push aside the urban legend that "everyone else is cheating on his or her tax return."

The IRS notes that the audit rate for individuals with income of at least $100,000 has increased 52% over the past two years. But most of this increase comes from the computer-generated letters checking returns for mistakes. The pace of 16 face-to-face audits for every 10,000 individual taxpayer returns continues.

What about sole proprietors, many of whom engage in small transactions not subject to Form 1099 reporting and some of whom engage in "pay cash, pay less" arrangements? In 2002, 114 sole proprietors out of every 10,000 were audited, and that fell in 2003 to 110 out of 10,000.

The IRS takes the position that increasing the number of audits is not the principal key to increasing compliance. Instead, it prefers to target tax scams, such as the "tax protestor" packages marketed by brave folks who file tax returns while encouraging others not to do so, as well as similar plans shared by folks who at least prove their consistency, though not their intelligence, by setting an example by refusing to file returns or by filing blatantly frivolous or false returns.

Apparently the IRS resources are being pumped into audits of corporations engaged in corporate tax shelter schemes. It takes an average of 7.5 months to figure out what's going on in the smoke and mirrors arrangements.

Where do those resources come from? Not from a Congress that keeps trying to show that penny-wise pound-foolish is its approach to government spending. No, those resources come from other areas within the IRS, principally audits of other taxpayers.

The proposed budget should add 600 business auditors and 4,400 other auditors, tax collectors, investigators, and the like. But even if Congress approves the requested budget (which I doubt it will), the IRS will STILL be fielding an audit staff that is 2,000 less than what it had in 1996.

As discussed in an an earlier posting on this blog, most of the increase in the IRS budget, if it gets it, will go to salary increases that Congress requires but does not fund. Anyone getting an idea here of who's responsible for this mess?

The TRAC information also shows that more than 600 top-notch revenue agents left the IRS last year. Although the number of individual returns has risen by more than 16 million, there are now roughly 16,500 revenue agents at the IRS. In 1995, there were more than 24,000.

Last week, Tax Notes reported that the IRS Oversight Board concluded that the IRS needs a budget increase twice what has been requested by the Administration. Of course, at least one member of Congress immediately criticized the Oversight Board's report.

And there's the root of the problem. Many members of Congress, eager to earn support among their constituencies, take an "anti-tax" posture that is more rhetoric than reason. Surely they don't advocate "no taxes." And surely they don't advocate "unenforced taxes." Or do they?

But perhaps these members of Congress simply are reflections of our society. Consider this analogy. Everyone "knows" that there's very little chance of being stopped for speeding on an interstate highway when driving at 5 or even 10 miles an hour over the limit. If highway police tried to enforce the speed limit without exception, there would be an outcry. It has happened. So, for years, drivers have edged their speedometers to 63 when the limit is 55. But during the past year or two, a few drivers are ramping their speeds up to 90 and 100. On urban interstates. Even during rush hour. Why?

The psychologists can jump in at this point. A little "cheating" on a tax return (such as padding an expense account) gathers the same hardly-noticed social disapproval as does a little "cheating" on the speed limit. But then along comes a group that takes the tax return noncompliance into the world of gross fraud, and a group that takes highway speed limit compliance into the world of gross stupidity.

The driver demonstrating the meaning of "sapiens sapiens" might be drunk or on drugs. Taxpayers may be driven to such behavior after dealing with their tax returns, but substance abuse hardly qualifies as a reason for tax noncompliance. The racing driver might be late, and a deadline-pushing taxpayer might makes some sloppy mistakes. But none of this is implicated in most of the tax noncompliance cases or highway madness.

What's implicated is the mushrooming of the "I'm special and more important than you" philosophy that has spawned itself from the "me generation" mentality of the 70s. Anti-authoritarian, noncompliant, socially offensive, and short-sighted in their thinking, these folks are tearing down the walls of civilization here at home. Politicians appear to be afraid of them. After all, many of them have money, power, and influence. Others simply figure that they'll "get theirs" by imitating the ones who have the money, power, and influence.

So before joining the chorus of those who condemn the anti-authoritarian, noncompliant, socially offensive, and short-sighted behavior of small groups of people in other nations, let's consider how we tolerate and succumb to the same sort of activity by small groups of people here at home. The first step in resisting a movement is refusal to join.

Here's to filing a well-intentioned, as correct as possible, compliant tax return. Here's to avoiding 90 mph driving on urban interstates.

April 15 is only 3 days away. There are 83 hours until the "file the return or file the extension" deadline.

Oh, my returns are finished. Have been. For a week. How else would I have time to chatter on and on about taxes on April 12?

Friday, April 09, 2004

Reduce Taxes, Increase Employment? 

The other day the GAO released a report on A Comparison of the Reported Tax Liabilities of Foreign and U.S.-Controlled Corporations, 1996-2003. The information is not surprising to those who keep current with news about corporate culture. Corporate tax departments, rather then being charged with compliance, are treated as profit centers, compelled to generate "profits" by finding ways to make each year's tax liability less than that of the previous year.

The major findings (quoting from the report, in which USCC means U.S.-controlled corporation and FCC means foreign-controlled corporation) include:

** A majority of all corporations reported no liabilities during these years [1996-200] with a higher percentage of FCCs doing so than SCCs, an estimated average of 71 percent and 61 percent, respectively. However, the results were reversed for large corporations with a greater percentage of large USCCs reporting no tax liability.

** A greater percentage of USCCs than FCCs reported tax liabilities of less than 5 percent of their total income, an estimated 94 percent and 89 percent, respectively, in 2000. The results were similar for large corporations. In 2000, an estimated 82 percent of large USCCs and 76 percent of large FCCs reported taxes of less than 5 percent of their total income.

** However, FCCs reported less tax liability per gross receipts than USCCs; in 2000, an estimated average of $11.88 in tax liability per $1,000 in gross receipts compared with an estimated $14.75 reported by USCCs. A similar relationship held for large corporations.

Keep in mind that for the period in question, 1996-2000, the U.S. (and much of the world) economy was robust, corporate profits rose, and the stock market ballooned.

Other data shows that by 2003, corporate taxes had fallen even further. They fell so far that there is only one year for which those receipts were lower: 1934. Moost of us weren't around then, but if we paid attention to our parents or our history books we know that 1934 was during the height of the Great Depression. It is unlikely corporate profits in 1934 were anything like those in 2003.

Here's the million dollar question. Or perhaps it is a billion dollar question.

If corporate taxes decrease while corporate profits increase, what are the corporations doing with the excess? If profits go from 30 to 40 and taxes drop from 15 to 8, the amount available after taxes increase from 15 to 32.

Let's see. Are corporations using this money to hire more employees? Hardly. Most of them are dismissing employees.

Are they using this money to improve their products? Not if the floor tiles I bought are any indication. Not if the Microsoft blue screen of death is representative. Ironically, automobiles and small trucks do appear to be getting better. Of course, they're more expensive.

Are the corporations using this money to increase charitable contributions? Not really. The tax law limits the corporate charitable contribution deduction to 5% of income so there's not much of a tax incentive to donate.

So where's the money going?

Some of it is flowing overseas to pay independent contractors to arrange for work done by laborers paid a fraction of what U.S. employees earn.

Some of it supposedly is being paid in the form of higher dividends, but the preliminary data on that issue suggest this is not the case. see Story Number Five in my earlier posting on that topic.

Could it be higher salaries for the CEOs and CFOs and COOs and other upper-level management? Higher salaries that permit them to set up foundations that are used to influence and control matters of social policy, government, and life generally in ways far more disproportionate than what the typical citizen can do?

The politicians need to be careful. This information isn't going to be easy to spin into anything other than what it says.

* * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * *

An addendum. As tough as the job market is, several railroads are scurrying about trying to find workers. Apparently there's a shortage of people who are qualified. Sorry about this, but when I read this news my first thought was, "Goodness, these people apparently haven't been trained."

Have a nice weekend.

Wednesday, April 07, 2004

Tax Law Changes Pay a Dividend of Confusion 

One might think that a tax law amendment that reduces the tax rate on dividends would be simple. Perhaps "dividends are taxed at a rate of 15 percent."

Simple isn't allowed. Simple lets too many people understand what's going on. Simple puts tax experts out of work.

So, instead, Congress chose complicated.

"For purposes of this subsection, the term "net capital gain" means net capital gain (determined without regard to this paragraph) increased by qualified dividend income."

OK, that means, "dividends are taxed at the rates applicable to capital gains."

But what's "qualified dividend income"?

It means dividends received during the taxable year from domestic corporations and qualified foreign corporations.

Ah, the old "define something by using terms that themselves must be defined" approach. It takes 20 lines of text to define "qualified foreign corporation."

Wait.

"Such term" (that is, qualified dividend income) "shall not include...." Here follows a list which need not be repeated to make the point. Seven lines of text, followed by eight lines of text co-ordinating the reduced rate with the deduction for dividends received that can be claimed by corporations that receive dividends. Then there is an 11-line subparagraph dealing with "special rules."

All of this, however, fades when it is time to deal with the effective date. The effective date for the reduced rate of tax on dividends is "taxable years beginning after December 31, 2002." For almost all individual taxpayers, that means the lower rates first apply to 2003. Tax returns for 2003 are those being prepared at this time. The effective date is NOT in the Internal Revenue Code. It is in the amending act.

However, a special rule states: "In the case of a regulated investment company or a real estate investment trust, the amendments made by this section shall apply to taxable years ending after December 31, 2002, except that dividends received by such a company or trust on or before such date shall not be treated as qualified dividend income (as defined in section 1(h)(11)(B) of the Internal Revenue Code of 1986, as added by this Act.)"

Huh?

To understand this provision, it is necessary to understand how a regulated investment company (RIC) and a real estate investment trust (REIT) is taxed. Generally, if it receives income and passes it out to its shareholders, then it gets a deduction. In other words, the shareholder and not the company is taxed. The shareholders are the folks who invest in these companies.

So, dividends received before 2003 but paid out in 2003 don't qualify for the lower tax rate. There is a requirement that RICs and REITs provide to their shareholders Forms 1099 that tell the shareholders how much of what they earned is a qualified dividend. That makes sense, as only the RIC and REIT managers would know.

Except that they don't.

In a much-needed article on this matter, a Philadelphia Inquirer reporter takes readers behind the scenes to see tax Forms 1099 in the making. To read the full article, go to the Philadelphia Inquirer and go to the business section for today (April 7), click on the article, and then log in or register (it's free).

Todd Mason points out that these companies sent out Forms 1099, and then discovered they hadn't done the computations properly. So they send corrected Forms 1099. Sometimes they correct the corrected Forms 1099.

If the taxpayer has already filed his or her return, there may be a need to file an amended return. What fun.

But first, why are the companies having such problems figuring out what portion of the dividends qualify for the lower rate?

First, because although some dividends clearly qualify, and some clearly do not, others are in an in-between area that requires so much additional analysis that companies sent the Forms 1099 before that analysis was complete. Why? Because the tax law requires that those Forms be sent by January 31. No matter that Congress has made things more complicated.

Second, the IRS changed its mind on some technical points, and issued revised rules. But by the time it did this, it had already posted on its web site, and mailed, instructions to Form 1040. Which, of course, became out of date, and wrong. So, taxpayers must go to the IRS web site to get the correct instructions.

Another wrinkle in the mix is the requirement that the shareholder (the taxpayer) own the stock for at least 61 days in a 121-day period during which the dividend is paid. The IRS puts the burden of determining if this requirement is met on the taxpayer, not the company.

In many instances, the change on the corrected Forms 1099 will be such a low dollar amount that filing an amended return won't be prudent. There's no point in spending money and investing time because the tax liability is a few dollars lower on account of a few dollars of dividend income previously characterized as not qualified being re-characterized as qualified.

The IRS reminds taxpayers that if an amended return is warranted (an increase in tax liability or a significant decrease in tax liability) it should not be filed until the original return is processed, usually a matter of a month or two.

It's not that there should be a better way to enact and administer tax laws. There is. The question is why the Congress insists on making the simple complicated. The answer is that someone benefits. And it surely isn't the typical taxpayer who is compelled to deal with this nonsense.

Do you think any of the presidential candidates even understands this?

Ask them.

Monday, April 05, 2004

Fixing the Tax Mess: Reaction to a Journalist's Proposals 

Allan Sloane, a Newsweek journalist, has shared Six Fixes for the Tax Mess". Though he claims it is arrogant for an "unelected media-elite guy like [him]" to make these proposals, I disagree. As he says, "as April 15 nears, we all become tax experts." It's not arrogant, it's useful. Would that everyone give some thought to the matter. Would that a certain 535 people who work in D.C. give some thought to the matter.

He's talking policy, not technical drafting. So here's my quick reaction to his proposals.

1. Reform the Estate Tax.

He suggests keeping the tax, with a much higher indexed exemption ($3.5 million a person), with the top rate cut from 48% to the maximum individual income tax rate (35% at the moment).

My take: If the estate tax stays, these modifications make sense. As long as there has been an estate tax, there have been people finding ways to avoid it. Each ploy is met with a legislative response, making the law even more complicated, and dragging in the not-so-wealthy (even aside from the exemption amount problem). Instead, I'd rather see unrealized gains subject to income tax at death. The income tax is graduated, the starving orphans don't have parents with unrealized gains in their assets (because they don't have assets), and without a huge exemption the use of death as an income tax avoidance planning tool would be significantly curtailed.

2. Keep the 10% Bracket and 'Marriage Penalty'

I think Mr. Sloane means keep the 10% bracket and marriage penalty relief, because that's what he describes.

My take: I agree, and I'd go further: marital status should be irrelevant in computing taxes, just as it is irrelevant in computing bridge tolls. See James Edward Maule, "Tax and Marriage: Unhitching the Horse and Carriage, 67 Tax Notes 539 (1995)."

3. Create a Trust Fund We Can Trust

Mr. Sloane suggests letting the Social Security trust funds buy mortgage-backed securities and such, but not Treasury securities or stocks. He would require the Treasury to pay cash interest on the fund's T-bonds, rather than paying with Treasury IOUs.

My take: Mr. Sloane's conclusion that this would put the Social Security funding mess in our faces is correct, and it is a good idea. Call it full disclosure or truth-in-advertising. Anything that clears out the smoke and breaks the mirrors is a good idea.

4. End the Tax Cut For Dividends And Capital Gains

He starts by sounding like me in my income tax classes. "Come on, already. Income is income." Bingo.

My take: I'm all for this proposal. But I would add indexing of basis because the current tax code is premised on a reluctance to tax artificial amounts generated by inflation. Not too long ago I shared an overview of the arguments on both sides of the capital gains rate debate and the reasons for my support of full taxation with indexed basis.

5. A War Surcharge

Mr. Sloane suggests a 10% temporary war tax to pay for the war on terror, rather than financing it with borrowings from foreign central banks. Families with relatives stationed in Iraq and Afghanistan would be exempt. He points out that "Civilians are supposed to sacrifice during a war. ... Instead of sacrificing, civilians are partying with tax cuts."

An interesting idea. Close to a user fee, which I've always supported. Two quibbles: some people who have received tax cuts aren't partying, but he's right: many people are living their lives as though there is no war. There is. The other quibble is that I'd extend the exemption to all military (definitions already in the Code) because Iraq and Afghanistan are not the only places where the military is fighting the war on terror.

6. Fix the Alternative Minimum Tax

Mr. Sloane is quite right in pointing out that the two major presidential candidates are steering clear of the "mess" that is the AMT. He wants to eliminate it and raise rates to offset it.

My take: I agree. Mr. Sloane admits he doesn't know exactly how it would play out, and as he wanders closer to the tax labyrinth he hesitates. No wonder. Get too close and there are few brain cells left with which to write Newsweek columns!! Seriously, this is a huge problem, one that I have previously discussed.

So, all in all, high marks to Mr. Sloane. I'm going to try to send him an email and invite him to comment on my comments. I'll let you know if he replies.

Friday, April 02, 2004

Taxes and.... yes, Parking 

Taxes are everywhere. Some, like the income tax and even the sales tax, jump in our faces. Others aren't so obvious. Take a close look at the itemization on a phone bill. We can do that when we have the time.

But do we ever look closely at the breakdown of what we pay to park our cars? Probably not. At least, I haven't. The rare occasions when I drive into center city Philadelphia and park, I pay the garage fee and never thought about the tax.

Until today, when KYW, the local news station, reported that the mayor was proposing an increase in the parking tax to help reduce the budget deficit. Reaction was mixed, and instructive.

An opponent claimed that even a $1 increase in the tax would deter people from coming to Philadelphia and would contribute to the growing erosion of Philadelphia as a city that's in the loop of fashionable places. Advocates of the tax increase expressed hope that it would encourage more people to use public transportation, which one particular advocate described in very favorable terms.

I disagree with both of them. A $1 increase to a $20 parking fee, which is a 5% increase, isn't going to get much attention from tourists and occasional visitors. The percentage is low and so is the absolute dollar increase. Commuters who drive and park every day will notice what would amount to a $250 increase in parking expenses. But do the commuters have much of a choice? (Of course, some do. They can try to find jobs in the suburbs. Or, if they own businesses, they can move to outside the city limits.)

If the public transportation system was reliable, safe, and timely, perhaps it would draw more riders. An increase in the parking fee might cause ridership to grow. My experience with public transportation in Philadelphia is that it rarely gets me from where I am to where I need to be, rarely runs on time and thus is useful only if I don't care when I get to where I need to be, and is never available when I arrive back in town on an Amtrak train bringing me to 30th Street Station. The system is still locked into the "live in the suburbs work in the city" mentality of the mid twentieth century. As a private system, the city system began to struggle financially as employers and businesses fled the city, the state caused a government agency (SEPTA) to be formed to take it over, SEPTA grabbed the profitable suburban lines (Frontier, Red Arrow and others) and everything would have collapsed but for taxpayer money used to shore it up. Drivers and mechanics go out on strike on a regular, staggered basis (city division running, suburbs on strike is followed by city division contract settled but suburbs are out on strike), and the word unreliability glows even more brightly.

I predict that the proposed parking tax increase, if enacted, will have minimal effect on jobs leaving the city. It will have no noticeable effect, and maybe no effect at all, on the number of cars entering center city. It's one of those taxes to which so few people pay attention that it can be raised by a $1 here and a $1 there and the complaints and criticisms offered by those who do notice are drowned in the noise of car engines and squealing tires.

Personally, because I advocate user fees, I favor parking taxes. Bringing a vehicle into center city and parking it there imposes burdens on society that are borned by governments on behalf of society. It wouldn't surprise me that the per-day cost of burdens imposed on center city by the arrival of a car exceeds what the parking tax would be after the proposed increase. Exhaust soot blackens buildings and fouls the air, long-term health care costs rise on account of the damage to lungs and skin and other body parts from the fumes, police are needed to handle traffic congestion, traffic lights need to be maintained, accidents impose costs in a variety of ways, and the list goes on and on and on.

I wonder what would happen if the parking tax were set at the true economic cost. I suspect it would cause a significant decrease in the number of cars being driven into center city. And it would also cause more jobs to leave.

Hint: "The hidden costs of driving in the U.S. amount to at least $184 billion per year, including $40 billion for road costs not covered by fees and tolls and $56 billion for health damage due to air pollution." (from The Center for a New American Dream, citing "The Roads Aren't Free," a July 1998 paper by Clifford Cobb of Redefining Progress.

One last tidbit, from the web site of the Perimeter Transportation Coalition, a site well worth the visit if you are interested in a full discussion of the true costs of driving a car:

"This one is a little mind-numbing, but its worth slogging through.

"Are you living far away from work so that you can afford "more house?" Most couples will "consume" approximately eight (8) cars during their 30 year mortgage. We assume that you would buy an average-priced new car (about $20,000 in 1996) every seven years, and that the value of that car at the end of seven years would be practically nil. Calculating fuel, depreciation and maintenance at $.22/mile, and about 15,000 miles each year, you would tally up about $185,000 in operating expenses during the life of your house mortgage. Figuring an average annual inflation in the price of a new car (and its out of pocket expenses) to be 5%, and that average finance rates would be about 10%, your investment in cars over a 30 year mortgage would be about $400,000. How much "more house" closer to work would that buy?"

After all of this, maybe I should walk home. It's only a mile and a quarter. So what that it's raining and there are no sidewalks? I only have 35 pounds of computer equipment to lug.

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