Friday, April 16, 2021
The difficulty was the generality of the question. It did not specify the state, which matters, though presumably because it was posted to a web site focused on New Jersey that was the state in question. The question did not specify the nature of the refund, state or federal, but the context of the question suggested it was a reference to a federal income tax refund. We live in a sound bite, buzz phrase, tweet world, where everything, even complex situations, are reduced to oversimplified generalities that confuse people and erode the niceties of the exceptions and parameters that provide the necessary information and guidance.
There actually are four questions embedded within that one question.
First, “Are federal income tax refunds included in gross income for federal income tax purposes?” The answer is no. The reason is that there was no federal income tax deduction for the payment of the federal income tax, so a refund of some or all of that payment does not generate gross income.
Second, “Are federal income tax refunds included in gross income for state income tax purposes?” The answer is, “it depends.” When I last looked, six states allow a deduction for federal income taxes paid, so a refund must be taken into account, either as gross income or as a reduction in the deduction for federal income taxes paid in the year the refund is received. In the majority of states not allowing a deduction for federal income taxes, the federal income tax refund is not included in gross income for state income tax purposes.
Third, “Are state income tax refunds included in gross income for federal income tax purposes?” The answer is, “it depends.” To the extent that the state income tax deduction provided a tax benefit, determination of which requires a multiple-step computation, the refund is included in gross income for federal income tax purposes. Thus for example, a refund of a state income tax for which no deduction was claimed because the taxpayer took the standard deduction would not be included in gross income for federal income tax purposes.
Fourth, “Are state income tax refunds included in gross income for state income tax purposes?” The answer is no. The reason is that there was no state income tax deduction for the payment of the state income tax, so a refund of some or all of that payment does not generate gross income.
Fitting the previous four paragraphs into a sound bite, a buzz phrase, or a tweet is impossible. The concern isn’t the question and answer posted on the web site. The answer provided was correct given the assumptions about the state in question and the refund in question. The danger is that someone not closely examining the entire context might conclude that the answer suggests that federal income tax refunds are never included in gross income for state income tax purposes, which is not true.
Wednesday, April 14, 2021
Though tax evasion and tax avoidance cut across economic, social, cultural, and geographic boundaries, a substantial portion of the tax gap is attributable to evasion among large corporations and wealthy individuals. As I explained in Tax Noncompliance: Greed on Steroids, summarizing a report by the Treasury Inspector General for Tax Administration, the IRS failed to pursue 369,180 of 879,414 high-income nonfilers who failed to pay almost $46 billion in taxes. The other 510,235 were “sitting in one of the Collection function’s inventory streams and will likely not be pursued as resources decline.” The “success” of these high-income taxpayers who fail to file certainly encourages other taxpayers to ignore their responsibilities, and their “success” in turn will cause non-compliance to spiral into a revenue collapse.
Several years ago, in Taxing High-Income Individuals, I advocated, among other things, a way to reduce the federal deficit without raising tax rates. I explained what Congress needed, and still needs, to do: “Increase funding for the IRS so that it can track down and deal with tax shelter promoters, offshore schemes, fraudulent returns, and other gimmicks used to make a person with high income pay taxes at rates lower than those imposed on the middle and lower income echelons.”
In Another Way to Cut Taxes: Hamstring the IRS, I wrote:
Though it is easy to suggest that Congress needs to wake up and provide sufficient funding to the IRS, especially because every dollar invested returns roughly seven, but the Congress is incapable of doing this. Enough of It is controlled by the anti-tax, anti-government crowd that it lacks the ability to do what needs to be done. Until the makeup of the Congress changes, the tax gap will persist and even increase, adding to the growing deficit that threatens to cause havoc more catastrophic than what currently afflicts the nation. The greed that is fueling the income and wealth inequality contributing to so many of the nation’s problems is growing as though on steroids, and needs to be neutralized expeditiously.Well, the makeup of the Congress has changed, though not quite to the symmetrical opposite of what it has been during the most recent anti-tax, anti-government period. So it is no surprise that according to this report, among others, the current Administration is proposing a 10 percent, or $1.2 billion, increase in IRS funding, with most of it dedicated to “increasing resources for oversight of corporate and wealthy Americans' tax returns and ensure compliance.” The funding would help the IRS replace the 21,000 employees lost since 2010, which hampered its ability to deal with tax evasion by the wealthy, who now fail to report more than one-fifth of their income according to a recent National Bureau of Economic Research study.
As I wrote in 2011, in Another Way to Cut Taxes: Hamstring the IRS, when a previous Administration sought to increase IRS funding:
The Administration wants to increase IRS funding. Why? Aside from the creation of jobs, it would cut the deficit and restore moral balance to the revenue system. Think of it. Every dollar brings back ten. What advocate of the free market would walk away from such a deal? One dollar brings back ten. The private sector wouldn’t toss that opportunity aside, and neither should the fiduciaries of the public trust. America deserves no less.It remains to be seen whether the current Congress is better at investing that the Congresses of the past decade.
Monday, April 12, 2021
Though most of the indictments and criminal informations arise from tax fraud, several of the indictments involve other types of fraud and even assault and gun charges. Last week, the Department of Justice issued a press release describing the indictment of yet another tax return preparer. In this instance the preparer has been charged with four counts of wire fraud.
According to the indictment, the preparer owned and operated a tax and investment consulting business in Bridgeview, Ill. The indictment alleges that from April to October of 2020, he submitted Paycheck Protection Program and Economic Injury Disaster Loan Program applications on behalf of hundreds of the company’s customers. The applications that the preparer submitted allegedly contained “materially false statements and misrepresentations about the customers’ businesses, such as gross revenues, expenses, and number of employees.” Because of the preparer’s alleged false statements and misrepresentations, millions of dollars in PPP and EIDL funds were disbursed to those customers.
If that’s not bad enough, the preparer charged customers an upfront fee of “approximately several hundred dollars” before submitting the applications. If the application was approved and the customer received funds under either program, the preparer charged the customer “an additional fee of approximately $1,000.”
What’s unclear from the press release is whether the customers knew that the applications contained false information. If they did know, the Department of Justice might still be working on indictments, or perhaps has decided not to indict them in exchange for the customers serving as witnesses. If the customers did not know, it’s yet another situation in which a tax return preparer uses confidential customer information to get money by filing fraudulent loan applications. In When Tax Return Preparers Go Bad, Their Customers Can Pay the Price, I wrote about the adverse consequences to the customers of tax return preparers who file false income tax returns. The advice that I gave, essentially suggesting doing background checks on tax return preparers, is important not just because of the need to avoid being audited for a false return, but to avoid being caught up in prosecutions for fraudulently obtained loans. Of course, if the customers aren’t so innocent and participated in scheme, then the customers probably will end up reaping the consequences of their own bad behavior.
Friday, April 09, 2021
Reader Morris pointed out that I had written, “The American Rescue Plan Act of 2021 amended Internal Revenue Code section 85 to provide that the first $10,200 of unemployment compensation is excluded from federal gross income if the taxpayer’s adjusted gross income is less than $150,000.” He directed my attention to a revised IRS instruction and explanation publication that begins, “If your modified adjusted gross income (AGI) is less than $150,000, the American Rescue Plan enacted on March 11, 2021, excludes from income up to $10,200 of unemployment compensation paid in 2020, . . .” His implicit question was why the difference between the phrase I used, “adjusted gross income,” and the phrase the IRS used, “modified adjusted gross income.”
In my reply to reader Morris, I first shared the text of the amendment to section 85 made by section 9042 of the American Rescue Plan Act of 2021:
SEC. 9042. SUSPENSION OF TAX ON PORTION OF UNEMPLOYMENT COMPENSATION.I noted to reader Morris that the statute does not use the term “modified adjusted gross income.” Instead, it defines adjusted gross income by reference to certain other Internal Revenue Code sections. I invited reader Morris to compare section 86, which deals with taxation of social security benefits:
(a) In General.—Section 85 of the Internal Revenue Code of 1986 is amended by adding at the end the following new subsection:
“(c) Special Rule For 2020.—
“(1) IN GENERAL.—In the case of any taxable year beginning in 2020, if the adjusted gross income of the taxpayer for such taxable year is less than $150,000, the gross income of such taxpayer shall not include so much of the unemployment compensation received by such taxpayer (or, in the case of a joint return, received by each spouse) as does not exceed $10,200.
“(2) APPLICATION.—For purposes of paragraph (1), the adjusted gross income of the taxpayer shall be determined—
“(A) after application of sections 86, 135, 137, 219, 221, 222, and 469, and
“(B) without regard to this section.”.
SEC. 86. Social security and tier 1 railroad retirement benefitsProbably thinking it would simplify things, the IRS decided to “rewrite” the statute by using the term “modified adjusted gross income” to describe the result of using the different definition for adjusted gross income provided in section 85(c)(2). Though this “rewrite” or this different way of describing the computation rules might be an improvement, It also poses a danger. Someone looking at the term “modified adjusted gross income” might think that the term refers to one computational concept, when in fact that is not the case. A close look at the definition of the term in section 86 and the definition of recomputed adjusted gross income in section 85 reveals differences.
* * * * *
(b) Taxpayers to whom subsection (a) applies
(1) In general. A taxpayer is described in this subsection if—
(A) the sum of—
(i) the modified adjusted gross income of the taxpayer for the taxable year, plus
(ii) one-half of the social security benefits received during the taxable year, exceeds
(B) the base amount.
(2) Modified adjusted gross income. For purposes of this subsection, the term “modified adjusted gross income” means adjusted gross income—
(A) determined without regard to this section and sections 135, 137, 221, 222, 911, 931, and 933, and
(B) increased by the amount of interest received or accrued by the taxpayer during the taxable year which is exempt from tax.
Does it need to be this complicated? Not necessarily. The reason that there is a need for recomputing or modifying adjusted gross income is to get a measurement of a taxpayer’s income that is closer to economic income than is adjusted gross income. Adjusted gross income reflects a long list of exclusions, so that a taxpayer with substantial economic income might have an adjusted gross income that is much lower. Because Congress uses adjusted gross income as a benchmark to determine whether a taxpayer’s economic situation is “low enough” to warrant access to gross income exclusions intended to assist those with “low income,” it can bring within the exclusion taxpayers with high economic income. To block those taxpayers from taking advantage of the exclusion, Congress creates another benchmark.
The complexity could be reduced by eliminating many of the exclusions, particularly those subject to some sort of adjusted gross income limit, and in turn lowering tax rates for taxpayers with lower incomes. Not only would that reduce complexity by removing the words and efforts required to determine if an exclusion applies, it would also simplify the need to play with adjusted gross income definitions because there would be fewer exclusions requiring a redefined adjusted gross income and fewer adjustments needed to reflect exclusions in the process of redefining adjusted gross income for purposes of computing the exclusion.
Wednesday, April 07, 2021
Reader Morris posed these questions: “Was the man accused of stabbing a fake tax preparer, a ghost preparer, an unlicensed tax preparer, a licensed tax preparer, etc.? How would you describe the stabber? Do we have enough facts to describe the accused stabber? Does it matter what you call the stabber?” My response included the following points. First, we don’t know if the perpetrator held himself out as a tax return preparer and was engaged in the business of preparing taxes or if he simply helped in some minor way. We don’t know if there was an agreement in place for payment or whether the expectation of payment arose from some internalized sense of expectation. We don’t know if the perpetrator was licensed as a tax return preparer. No, we don’t have enough facts. Nor does it matter what terms are used to describe the perpetrator.
But if we assume the perpetrator was a tax return preparer, that is, he did enough to assist the victim to be treated has having contributed to the filling out of the return, the story brings up the flip side of the situation described in my previous post. Yes, it’s shocking to learn that a tax return preparer assaulted a client. It’s shocking in part because it is rare. Yet the flip side, unfortunately, is not so rare. Clients attack tax return preparers, for a variety of reasons, particularly unhappy with the bad news received from the preparer. Clients expecting a large refund don’t want to learn that their refund is small or non-existent. Clients expecting a refund don’t want to learn that they need to pay additional taxes.
Curious, I did a bit of research. I looked for instances of tax return preparers attacked by their clients. I found two, but did not try to create an exhaustive list of all such events. The point can be made with these two stories. According to this story, an H&R Block customer assaulted an H&R Block employee because he was “so upset about his taxes.” He “pushed his tax man to the ground and tried to choke him.“ The customer was charged with third degree assault. According to this report, a tax return preparer’s client and the client’s brother asked the preparer to meet with them at LA Fitness “to discuss the progress of client’s tax returns.” The report continues, “During (the meeting), the client and his brother attacked the victim, then burglarized his vehicle of $700 cash.”
Reader Morris quoted my statement in my earlier post, in which I wrote, “If people who wanted to be tax return preparers were required to obtain a license, would a background check on the gun-toting preparer have turned up the previous conviction? Would it have led to a denial of the license?” and then asked, referring to the truck stop story, “Would any regulation, law, or licensing requirement have prevented the stabbing?” My answer is no. Though perhaps licensing tax return preparers would push out unskilled preparers and thus reduce the number of instances in which a client is upset, licensing preparers does not regulate nor significantly affect the attitudes and behavior of their clients. Licensing is not designed to prevent crimes, as that is the role of criminal law statutes. There already are laws prohibiting stabbing.
Reader Morris observed, “Sometimes money, emotions, or being in the wrong place will override any licensing scheme.” That is very true. Yet the fact that licensing tax return preparers won’t identify violence-prone clients, it should identify, and keep out of the return preparation business those who want to be preparers but who bring a history of previous violent behavior.
Of course, a point that I often make on social media is that the underlying problem of violence reflects the sorry state of American mental health care. Identification, treatment, and prevention are insufficiently funded, inadequate in terms of outcome, and too often ignored. Dealing with these problems is not a matter of licensing. We know that because where licensing of a profession or occupation is required, it does not have any impact on whether or not a client or customer commits violence against the person who is licensed.
Monday, April 05, 2021
In a news release, the Department of Justice announced that it has filed a complain in federal court requesting that two tax return preparers in the Miami, Florida, area, and their business, be enjoined from preparing federal income tax returns for other people. In the complaint, the Department alleged that the preparers “significantly understated their customers’ tax liabilities, . . . that in reporting their customers’ itemized deductions, [the preparers] fabricated or inflated charitable deductions, medical expenses, and employee business expenses,” and that they reported “false or inflated business losses” on their clients’ returns. The two preparers allegedly prepared more than 1,900 returns during 2018 and 2019, and on average understated tax liability by thousands of dollars.
Until and unless an injunction is issued, what is to prevent an unwitting customer from walking into the preparers’ business and having a return prepared? Yes, the IRS maintains a web site where someone can get information on tax return preparers, but as the site warns, “All tax return preparers are not in this directory. This directory contains only those with a PTIN who hold a professional credential or have obtained an Annual Filing Season Program Record of Completion from the IRS.” I looked up the names of the two preparers mentioned in the Department of Justice new release and, not surprisingly, the searches came up empty.
In past commentaries I have offered some advice. In Are They Turning Up the Heat on Tax Return Preparers?, I wrote, “I will simply repeat what I have written several times in the past: ‘The lesson at the moment? Choose a tax return preparer as carefully as choosing a surgeon or child care provider. In other words, do research, talk to friends and neighbors, look at online reviews, and interview the preparer.’” I had shared that advice earlier in More Tax Return Preparation Gone Bad and Another Tax Return Preparation Enterprise Gone Bad. In Need a Tax Return Preparer? Don’t Use a Current IRS Employee, I noted, “[I]t is best to do some background checks and research just as one would do when looking for a physician or roofer.” In When Tax Return Preparers Go Bad, Their Customers Can Pay the Price, I elaborated:
What’s a taxpayer to do? Talk with relatives, friends, and business associates. Ask them to describe their experiences with the tax return preparer that they use. Seek out a tax return preparer who has been preparing the other person’s returns for many years free of problems. Beware of the advice to use a tax return preparer who has been used only once, or even not at all. Look at reviews on various web sites. Google the name of the tax return preparer. If the preparer is a company, ask for the names of its owners and managers, and google those names. If the return that is prepared is “too good to be true,” don’t agree to its being filed, but ask for a copy and take it to another preparer for a second opinion. If it’s good to go, return to the original preparer and approve the filing. If it’s not good to go, file a complaint about the preparer with the IRS, and seek a fee refund from the original preparer.Because it is unlikely that tax return preparers under indictment and waiting for trial put “under indictment” signs in their windows or “under indictment” tags on their web sites, it is essential that clients exercise due diligence not only when seeking a new preparer but even when returning to a preparer in an earlier year.
Yet while I was thinking about these situations, I wondered about the taxpayer who neglects to look for warning signs or sees them but ignores them. Why would a taxpayer do that? Because the “deal” offered by the preparer resonates with the taxpayer’s need or desire for a bigger refund. In other words, though I have sympathy for the many victims of tax preparer fraud, who don’t realize what preparers are doing to their returns, I am concerned that taxpayers who use law-breaking preparers but who are aware or should be aware of the fraudulent return items are enabling and thus helping perpetuate the scourge of tax return preparer fraud that is contributing to the shakiness of the tax system.
Put another way, if the first thing that turns up on a google search is “This tax return preparer is great, saved me thousands, got me a huge refund,” don’t stop. Keep looking. That first discovery could have been posted by a friend or associate of the preparer, or even by the preparer. If doing research on a physician can include the name and the word “malpractice,” a search to check on a preparer can include the name and the words “indictment,” “charged,” “alleged,” and “pleaded.” Be careful out there in tax return preparation land.
Friday, April 02, 2021
Yet as complex as a particular income tax system might be, things get even more complicated when multiple tax systems are in play. In the United States, not only must taxpayers deal with a federal income tax system, they also must face state income tax systems in most states. Some taxpayers are subject to more than one state income tax system if they live in one state and work in another. Add to that local tax systems and taxpayers’ heads understandably spin, even if a tax return preparer is doing the heavy lifting.
An example of this complexity can be found in the recent changes to the tax treatment of unemployment compensation. Until this year, the basic rule was simple. Unemployment compensation was included in gross income for federal income tax purposes. Some states also included unemployment compensation in state gross income though others did not tax unemployment compensation. Though the existence of two different rules, taxed and not taxed, creates complexity, it’s nothing like the complexity that has shown up for tax year 2020.
The American Rescue Plan Act of 2021 amended Internal Revenue Code section 85 to provide that the first $10,200 of unemployment compensation is excluded from federal gross income if the taxpayer’s adjusted gross income is less than $150,000. States that automatically conform to the federal tax law automatically adopt this change though a state legislature can choose to amend state income tax law to ignore the exclusion or to cause it to apply to more or less than $10,200. States that already did not include unemployment compensation in gross income are unaffected by the federal change. States that do not conform to federal tax law and states that conform to the Internal Revenue Code as of a particular date earlier than March 11, 2021, and that tax unemployment compensation will continue to do so. It appears that the $150,000 adjusted gross income limit applies in states that adopt the exclusion by conformity, but if a state legislature adopts the exclusion, not only might the amount of the exclusion be different but there may or may not be an adjusted gross income limit and if there is one it might be different from the federal limit. At least one state that does not conform to the federal tax law is administratively permitting an exclusion matching the federal revision. And on top of this, the IRS changed the instructions for computing the limit, causing taxpayers and tax return preparers to learn new rules in the middle of tax season.
So, for example, for 2020, the first $10,200 of unemployment compensation is excluded from gross income in Iowa. In Rhode Island, unemployment compensation will continue to be taxed. Because state rules are changing and some states have not yet finalized their positions on the issue, I am not providing a state-by-state listing, and will leave that to the various commercial publishers that are doing so.
In an increasingly mobile society, the existence of separate rules in 50 states, the District of Columbia, and territories imposes friction on business and commerce. When the nation’s population was relatively isolated, and people’s employment and businesses generally confined to one state, it did not matter much that different states had different rules. Times have changed. Though it is understandable that states would want to impose different rates of taxation, to define income differently makes it difficult for taxpayers to find any sort of consistency in the concept of gross income or taxable income. All states agree with the federal income tax principle that the receipt of loan proceeds does not constitute gross income because the recipient is not wealthier. But unemployment either is income, and ought not income either be taxed or excluded from taxation on a consistent basis? Differences in the answer to that question creates complexity. That complexity is made worse when the rules change, and change with respect to amount that can be excluded, and change with respect to the adjusted gross income limit on the exclusion.
The major point is that the existence of multiple applicable tax systems compounds complexity orders of magnitude beyond the complexity created by any one tax system alone. Though most tax professionals understand this problem, most taxpayers tend to focus their complaints about tax complexity on the federal system even though some state tax systems alone are at least as complex as the federal system. States that conform to the federal system without date limitation minimize this complexity but do so in the face of criticism that they are “giving up independence” or “relinquishing sovereignty to Washington, D.C.” States that do not conform to the federal system or that do so subject to a date limitation impose additional compliance costs on their taxpayers for the sake of some abstract sense of “independence.” Though the voters in such a state can support or reject that approach when they go to the polls, the nonresident taxpayers do not have representation in the legislature in such a state.
Tax complexity is undesirable, much of it is unnecessary, too much of it arises from political rather than public benefit pressures, and a good bit of it could be reduced or eliminated through careful consideration and review of federal and state income tax laws. To paraphrase what I wrote in Tax Filing Deadlines: Theory and Practice in the connection with the extension of the federal filing deadline, “Though advocates of states’ rights champion the notion that states can serve as ‘living laboratories’ for experimenting with various public policy initiatives, the reality of modern life is that the interconnection among states is so tightly wound that” having a half dozen or more approaches to the taxation of a particular transaction does more harm to taxpayers than the cost to of conforming to the federal system.