Wednesday, July 30, 2014

Collecting An Existing Tax is Not a Tax Increase 

A recent commentary from The Institute for Policy Innovation bemoans the possible derailment of the Permanent Internet Tax Freedom Act by the addition of unrelated provisions to the legislation. Since its inception, the movement of legislation through the Congress has been hampered by extraneous amendments, a snag in the process that ought to be eliminated. On that point, I agree with the commentary.

The commentary points out that if the legislation does not pass, the existing moratorium on certain internet taxation will expire. The current moratorium prevents internet access taxation, and also prevents states from requiring use tax collection by out-of-state retailers with no connection with the state. The commentary carries the headline, “The Senate’s Plan to Increase Your Taxes,” and projects tax increase amounts that include both internet access taxes and use tax collections.

When it comes to internet access taxation, expiration of the moratorium, which in all fairness cannot be considered a plan of the Senate or even a plan of those who are using the legislation for other purposes with no avowed intention of derailing it despite their inability to see that outcome as a consequence, the commentary is correct. Letting the moratorium expire would permit states and localities to impose access taxes, and those taxes would qualify as tax increases.

But when it comes to the use tax, it is wrong to classify the tax as an increase. The use tax is an existing tax. People who are not paying the tax and thus violating the law are not facing a tax increase when they are obliged to comply with the law. The tax obligation exists and is not being increased when it is being collected. The use tax issue presents a different concern. States struggle to collect the use tax, as I have explained in posts such as Collecting the Use Tax: An Ever-Present Issue, a person who purchases taxable items in another state is required to pay the use tax, but does so only if avoidance is pretty much impossible because the purchase is a big-ticket item that needs to be registered, such as a vehicle or boat. Thus, for example, a resident of Pennsylvania who goes to Delaware, a state without a sales tax, to make a purchase owes a use tax to Pennsylvania. Pennsylvania cannot compel the Delaware merchant to collect the Pennsylvania tax. Nor should Pennsylvania be permitted to require the Delaware merchant to collect the tax if the purchase is made when the resident goes to the Delaware merchant’s web site, unless the Delaware merchant otherwise has enough activity in, or connection with, Pennsylvania to be subject to Pennsylvania jurisdiction. Letting the moratorium expire would open the door to states trying to compel out-of-state merchants to do tax collections, but it would not increase the use tax that already is owed. What would increase is the administrative burden and expense faced by out-of-state merchants.

One solution that ought to be considered is a simple one. If state 1 wants to collect an existing – not increased – tax from its residents’ purchases from out-of-state merchants, it ought to offer those out-of-state merchants a financial incentive to do the collection. Surely whatever cost there is in re-programming web sites and in-store point-of-sale terminals to collect the sales tax – something already done by the national retail businesses – can be more than offset with a payment equal to a percentage of the use tax being collected. Though the state would not necessarily receive as much as it would if the residents paid the existing tax, the state would be getting something, which is more than the nothing that that states usually receive.

The commentary’s main point, though not articulated as precisely as it could or should be, is important. Legislation addressing an issue ought not be sidetracked with unrelated matters. But that is not enough. Legislators ought to be focusing on ways of collecting an existing tax using sensible processes, and commentators ought to be encouraging productive efforts by legislatures.

Monday, July 28, 2014

Tax Myths: Part XIV: Retired People Do Not Pay Income Tax 

I must admit I was surprised to discover someone asserting that “Obviously retired people do not pay INCOME TAX.” I had not previously encountered this myth. In another post, a commentator provides some of the flawed reasoning behind this sort of assertion, explaining “there are some small percentage who retire before age 65 and these retired people do not pay taxes (due to no income, except that they are well-off to live on past earnings.” Someone who is retired and living off of accumulated savings surely has investment income, which is taxed. Retired individuals, no matter the age at which they retire, are taxed on their pensions, their retirement income, and in some instances, on a portion of social security benefits. To claim that retired people do not pay income tax is just one more unfortunate tax myth.

Friday, July 25, 2014

Tax Myths: Part XIII: Children Do Not Pay Tax 

It isn’t difficult to find web sites that contain statements claiming that children do not pay tax. For example, an answer to the question How many taxpayers are there in the U.S.? was tagged as “wrong” because “Children do not pay tax.” The statement was followed by another erroneous assertion. A similar reaction appeared in response to the question Is it really true half the country doesn’t pay income tax?, from someone who not only claimed that “children do not pay income tax,” but also delivered several other questionable assertions.

Though there are some exceptions to certain state taxes based on a person’s status as, for example, unemployed or elderly, the federal income tax does not contain any blanket exemptions based on age, physical condition, or occupation. A tax liability exists if taxable income exceeds zero, or if a taxpayer has positive taxable income but qualifies for a credits that reduce tax liability. Those credits, however, are not sufficient to exempt all children from having federal income tax liability. A child of any age, with gross income exceeding whatever standard deduction is available, has federal income tax liability.

Wednesday, July 23, 2014

Tax Myths: Part XII: The Internal Revenue Code Fills 70,000 Pages 

The assertion that the Internal Revenue Code consists of 70,000 pages is one of my favorite tax myths because it is so silly, so easily debunked, and so indicative of America’s tax ignorance. As I’ve explained in a series of posts, starting with Bush Pages Through the Tax Code?, and continuing with Anyone Want to Count the Words in the Internal Revenue Code?, Tax Commercial’s False Facts Perpetuates Falsehood, How Tax Falsehoods Get Fertilized, How Difficult Is It to Count Tax Words, A Slight Improvement in the Code Length Articulation Problem, and Tax Ignorance Gone Viral, Weighing the Size of the Internal Revenue Code, Reader Weighs In on Weighing the Code, and Code-Size Ignorance Knows No Boundaries, I have explained why the Code is nowhere near 70,000 pages, how the misinformation was developed and spread, and why the Code is no more than two thousand pages long.

This myth persists because some people want it to persist. There is political advantage in convincing people that the Internal Revenue Code is a behemoth. It makes it easier to eliminate the Code, the income tax, the Internal Revenue Service, and, eventually, government. If the campaign succeeds, it would not be the first time a group of politicians had their way by fueling misinformation and spreading myths.

Monday, July 21, 2014

Tax Myths: Part XI: Alimony Always Is Taxable 

Perhaps in the rush to be succinct, people present general rules as absolutes. For example, a responder in this threadadvised that “And yes, alimony is always taxable to the recipient, regardless of the form in which it is paid.” Similar advice, tainted by yet another error confusing gross income with taxable income, shows up in this commentary, which claims that “Alimony is always taxable income to the recipient.”

However, those statements are incorrect. They need to be qualified. For example, section 71 provides that if the divorce or separation instrument specifies that the alimony payments are not includible in the payee’s gross income and not deductible by the payor, they are not includible in gross income and not deductible. As another example, alimony paid while the spouses are members of the same household do not qualify as “alimony or separate maintenance payments” that are includible in the payee’s gross income and deductible by the payor. The use of the term “Generally,” or the phrase, “Unless an exception applies,” would change the statements from incorrect absolutes to accurate representations.

Friday, July 18, 2014

Tax Myths: Part X: The Flat Tax is Simple 

One of the most persistent, widespread, and enticing tax myths is the unfounded claim that the flat tax is simple. Three years ago, the Heritage Foundation claimed that the flat tax “is simple.” Sixteen years ago, Dick Armey characterized the flat tax as “simple.” For the past several decades, advocates of the flat tax have argued its simplicity by focusing on rate structures and ignoring everything else.

In 2011, I explained, in The Flat Tax Myth Won’t Die that the flat tax “does absolutely nothing to address the question of timing. It does not simplify, for example, installment sale rules, or the dozens of nonrecognition provisions that pepper the Code.” I also pointed out:
A flat tax does not resolve the continuing debate with respect to international taxation. The question of how nonresident aliens and foreign corporations should be taxed, and the question of how American taxpayers should be taxed with respect to overseas operations, is not one that goes away if section 1 is reduced to one tax rate.
Repealing nonrecognition provisions would generate cash flow burdens that would stifle the economy, and retaining those provisions to sustain the economy amounts to retention of tax complexity requiring multiple volumes to explain.

The flat tax, of course, is a sound bite, a nice-sounding phrase that suggests a magic solution to a complex set of problems. It is yet another indication of a theory struggling to survive when it meets reality. It’s a myth, one that falls flat.

Wednesday, July 16, 2014

Tax Myths: Part IX: The Tax Rate Confusion 

Most people do not understand income tax rates. Some law students enrolled in the basic income tax course struggle to understand tax rates. What confuses people is the difference between marginal tax rate and average tax rate. It is not unusual for someone to look at a federal tax rate schedule, find the bracket that fits their income, and conclude that they pay that percentage of their income in federal income tax. This generates all sorts of inaccurate claims to the effect that people with a certain income pay tax at a particular rate. For example, this writer claims that “Americans who take home over $400,000 are mandated by law to pay 39.6 percent in income tax.” Aside from the fact that tax brackets are based on taxable income and not take-home pay, in 2013, the year the article was published, a single person with, for example, $410,000 of taxable income does not pay an income tax of 39.6 percent. That person’s tax liability of $120,064 is 29.3 percent of taxable income.

Aside from the erroneous use of gross income rather than taxable income in selecting a tax bracket, the principal problem with the misuse of the tax rate schedules is the treatment of what is a marginal tax rate as though it were an average rate. For example, if taxable income of up to $50,000 is taxed at 20 percent, and taxable income above $50,000 is taxed at 30 percent, a person with taxable income of $60,000 would be subject to a tax liability of $13,000 ($50,000 x .20, plus $10,000 x .30). It is easy for someone in that situation to claim that they are taxed at 30 percent, but in fact, their tax liability of $13,000 is 21.7 percent of $60,000. Failure to understand the difference generates exaggeration, which in turn triggers more resentment than is warranted.

What makes this myth even more insidious is that when phase-outs are taken into account, and tax liability is divided by taxable income, the average rates are highest not for those with the highest taxable incomes, but for those in the middle brackets, and in some instances, for some taxpayers in lower brackets. I explained this tax quirk in A Foolish Tax Idea Resurfaces.

Americans’ confusion with average and marginal tax rates provides fertile ground for the growth of misleading claims and absurd hyperbole. The myth that people are taxed at the highest nominal marginal rate on all of their income is a myth that needs to die.

Monday, July 14, 2014

Tax Myths: Part VIII: The Use Tax Myth 

Retailers operating in states that do not have sales taxes entice out-of-state purchasers to cross the border to make purchases by emphasizing the notion of “tax-free” purchases. An article about a particular incident of this approach triggered A Peek at the Production of Tax Ignorance, in which I repeated an earlier explanation about the use tax, the tax imposed by the purchaser’s state of residence on out-of-state purchases of items brought back into the state of residence.

What sustains this myth is a combination of ignorance, experience, and revenue department inefficiency. Most taxpayers do not understand that a use tax exists, the conditions under which it applies, and their legal obligation to pay it. Most taxpayers who cross the border to make purchases in states without sales taxes and return home with their purchases do so without any adverse effect, aside from the classic situations involving vehicles, boats, and a few other “big ticket” items. Revenue departments have insufficient resources and mechanisms to collect use taxes aside from “big ticket” items, and because the cost of collecting use taxes is a much higher percentage of the tax when compared to the cost of collecting in-state sales taxes, use tax collection is inefficient and spotty, as I explained in Collecting the Use Tax: An Ever-Present Issue.

Many states are making efforts to educate the public with respect to use taxes. Some are trying to incorporate some sort of flag in state income tax forms. The effectiveness of those efforts is low. Until people become accustomed to paying use taxes, the myth will persist because the non-compliance persists. At some point, states might decide to bring tax education into their K-12 systems, and some have, to some limited extent, but until it is pervasive, this myth will endure.

Friday, July 11, 2014

Tax Myths: Part VII: Tips Aren’t Taxed Because They Are Gifts 

Though there are rare instances in which a tip can be characterized as a gift excluded from gross income, as a general proposition tips are included in gross income. It takes a very unique set of facts to pull a tip out of gross income by demonstrating that it is a gift, as I described some years ago in Should a Tip Be Excluded from Taxation as a Gift?. Thus, claims that, as a general proposition, tips are gifts and not taxed, are wrong. As the court in Cracchiola v. Comr., 643 F.2d 1383 (9th Cir. 1981), stated, “Petitioners’ first argument, that tops are not income is wholly without merit.”

It is understandable why this myth circulates and has traction. Most people who collect tips are paid very little, rely on the tips to make a living, and are unhappy to learn that tips are included in gross income. Worse, certain employers are required to report tip income on Forms W-2 issued to employees based on formulas, so that occasionally an employee might end up paying taxes on an amount of tips slightly higher than what the employee actually received. These situations also are very rare.

Another reason for this myth’s endurance is confusion generated by discussion of sales taxes. In most states, sales tax is computed with respect to the cost of goods and services exclusive of tips unless the tip is built into the stated price. Explanations of this principle often includes the words “tips are not taxable,” which people take out of context. The context provides the modifier “for sales tax purposes,” which should preclude treating the statement as applicable “for income tax purposes.”

Wednesday, July 09, 2014

Tax Myths: Part VI: “The IRS Gave Me a Refund” 

Sometimes, people say to me, quite excitedly, “The IRS Gave Me a Refund,” or “The IRS Is Giving Me a Refund.” Closely related to the “I’m Getting a Refund and Not Paying Tax” myth, this myth reflects two misperceptions.

In some instances a refund, or a portion of a refund, arises from a refundable credit. In these situations, the money paid to the taxpayer is coming from the United States Treasury courtesy of the United States Congress, or from a state treasury courtesy of a state legislature.

In many instances, the refund is nothing more than the IRS returning to the taxpayer some, or in some rare cases all, of what the taxpayer has paid in through withholding and estimated tax payments. I suppose that those who are concerned that the federal government or a state government might run out of money before the refund is paid are overjoyed when the refund arrives, but as a realistic, practical matter, simply getting one’s money back isn’t a joyous occasion. Actually, it’s a bit sad, because the money that is being refunded hasn’t earned interest.

Monday, July 07, 2014

Tax Myths: Part V: “I’m Getting a Refund and Not Paying Tax” 

Though I haven’t kept a count, I know that there have been dozens of times when someone would tell me that because they were getting a tax refund they weren’t paying tax. More than a few students entered my basic federal income tax course thinking the same thing, as evidenced by conversations in and out of the classroom, and as indicated on responses to semester exercises.

Whether a person has a tax liability cannot be determined simply from the existence of a refund. Though a person who is not getting a refund because additional tax is due surely is paying taxes, a person who receives a refund can fall into one of two categories. Some taxpayers receive a refund because they have a zero tax liability, and had taxes withheld, paid estimated taxes, or qualify for a refundable credit. But many taxpayers receive a refund and yet have a tax liability. The refund arises because they had taxes withheld and paid estimated taxes in amounts exceeding the tax liability.

When people want to know whether or not they are paying income tax, they need to look at the line on the return that shows “tax liability.” The lines for refund and for additional payment simply reflect the extent to which the amounts that have been paid match with the tax liability. A taxpayer who has $10,000 of federal income taxes withheld from wages and who has a tax liability of $7,500 rejoices at the prospect of a $2,500 refund, but ought not declare, “I’m not paying taxes.” That taxpayer has paid $7,500 in federal income taxes. Worse, they have made an interest-free loan of $2,500 to the applicable federal or state government.

Friday, July 04, 2014

Tax Myths: Part IV: It’s Not Income If It’s Not on a W-2 or 1099 

Most taxpayers understand that income reported on a Form W-2 or Form 1099 must be reported on their tax return. Whether they understand why those amounts are gross income, they usually understand that “the IRS knows about it, so I had best report it.” Many taxpayers take a leap, and conclude that if the IRS doesn’t know about it, there’s no need to report it. Coupled with that misperception is the proposition that if it’s not on a Form W-2 or Form 1099, the IRS doesn’t know about it. Thus, we find this advice: “If she has no w2 or 1099, no income then she does NOT have to file.”

This myth gets people in trouble. For example, one commentator suggested, “First of all, work in the underground economy: No w2’s or 1099’s.”

The reality is simple. Items that are gross income must be reported on tax returns whether or not a Form W-2 or Form 1099 is issued to the recipient of the income. Some types of income cannot be reported on such a form because there is no one to issue the form. For example, a taxpayer who finds a $100 bill on the street and keeps it has gross income, but will never receive a Form W-2 or Form 1099. In some instances, payors are not required to issue Forms 1099 if the amount in question is less than a specified amount, usually $600. That rule, designed to reduce reporting burdens on payors, does not mean that amounts of less than $600 are not gross income.

Wednesday, July 02, 2014

Tax Myths: Part III: If It’s Not Cash, It’s Not Income 

From time to time, someone asserts that because they have been paid with property and not cash, the payment is not subject to the income tax. Not only have I heard this from people generally, I’ve also heard it occasionally from students in the tax course. Fortunately, it’s usually early enough in the course for a correction to be made in how they understand the definition of gross income.

The “it’s not cash, so it’s not taxed” myth flourished in the early days of the barter boom. Some barter exchanges at the time listed “tax free” as one of the advantages of bartering. Eventually, the IRS engaged in an education effort that eliminated almost all of the barter under-reporting, at least among the commercial barter exchanges. There surely are barter transactions taking place in settings that are informal and occasional, with participants thinking that the absence of cash makes the transaction nontaxable.

What fuels the “it’s not cash, so it’s not taxed” myth are several perceptions. One arises from a notion that things usually taxed, such as wages and interest, are almost always paid in cash, a concept that some people translate into a conclusion that to be taxed, it needs to be in cash. Another arises from the rationalization that the lack of liquidity arising from the receipt of property rather than cash permits dispensation from taxation because of the lack of cash with which to pay tax.

This particular myth doesn’t circulate as often and as widely as the “IRS enacts Code provisions” myth. Whether it disappears entirely remains to be seen.

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