Monday, May 31, 2021
The Price of Freedom Is Much More Than Taxes
Americans surely understand the word “free,” for it shows up frequently in the phrase “free market” and in the slogan “free to do what I want.” Yet when asked to pay for freedom, too many Americans balk, even when the cost facing them is far less than their time, their physical well-being, and their life. The notion that freedom is free is becoming ever more omnipresent in the culture.I focused on a New Jersey Sea Grant Consortium contest in which beaches that did not charge a user fee emerged as the winner, even as other reports explained that even beach communities charging a fee were struggling to provide the services demanded by visitors, perhaps in part because the fees were nominal. The towns with free beaches were facing even steeper financial challenges. I suggested that these towns charge fees, even though officials worry about the risk of visitors not returning if fees are imposed but also threatening to stay away if services are diminished in quantity or quality. These same officials are aware that most visitors don’t care about the fiscal woes of the town they are visiting, and that their only interest is in having fun. The notion of “let’s have fun but let someone else pay for the things we get for free” is pernicious. I then shared these observations:
In order for a person to have something for free, someone else must pay. * * *Though in that essay I centered my attention on the fiscal aspect of freedom, it is important to understand that the cost of freedom is not only the lives of those who have fought to defend it and the taxes and fees paid by those who enjoy it, but also other costs, costs too often ignored or at least noted without any reference to the impact on freedom.
The question of who pays the bills to use a free beach would be irrelevant but for the fact that this nation exists, has beaches, and has a citizenry that is free to go to the beach. In some countries, people aren’t free even to travel outside their home village, let alone jump in a car, train, or plane to head for some resort. There are people who paid for that freedom with something far more than suitcases full of cash, namely, with their lives, and they deserve recognition and thanks on this Memorial Day. Paying taxes or beach fees pales in comparison to paying the price that has been paid by the veterans whom we cannot thank in person. The best we can do is to honor their memory. And the best way to do that is to respect freedom and to acknowledge that freedom is not free.
Consider those who think that freedom means “free to do what I want.” This is the perception often heard from those making the transition from childhood to maturity, a transition that unfortunately does not happen for everyone. When someone making that proclamation is asked to describe what happens when encountering someone who makes the same proclamation but who wants to do something that interferes with the first person’s desires, the back-and-forth eventually results in what can best be described as a philosophy of “I am free to do what I want, and that means I am free to prevent others from doing what they want.” It is the essence of selfishness, self-centeredness, and immaturity. And it has been increasingly going viral.
Consider two examples. The person who claims that they are free to drive at whatever speed they select, regardless of speed limits, can end up imposing the cost of that “freedom” on the people they kill and injure when they learn, too late, that there are reasons a person should not, and cannot, drive at whatever speed they select at any time, in any place, and under any conditions. The person who claims that they are free to go maskless and unvaccinated can end up imposing the cost of that “freedom” on the people they sicken and even kill who are unable to be vaccinated or wear masks. It is no comfort that the person claiming the right to be free might also end up paying the price of injury, sickness, or death.
Too often, those who claim that this unregulated “freedom” is sacrosanct point to the arrival of Puritans in what is now Massachusetts. They are idolized as seekers of freedom, trying to escape religious and political persecution. Yet when they arrived in the Massachusetts Bay Colony, they immediately started acting in the same manner as had their tormenters, in turn suppressing those whose religious beliefs or political positions conflicted with those set down by the Puritans. The contrast with Pennsylvania, also settled by victims of religious persecution, but where those of diverse origins and religions were welcomed, is startling. I didn’t learn this in school because it isn’t taught in this manner, nor is this lesson noted. I learned this when I did the research to write the biography of Thomas Maule of Salem, reading not only his works and those of others, both in his day and thereafter, but also studying the social and cultural environment in which his fellow citizens, of a different religious persuasion, acquitted him of the seditious libel charges brought by Puritan authorities who resented being tagged as hypocrites. And they truly were. Seem familiar?
The question at the moment is what sort of “freedom” will this nation embrace? To ignore this question is to dishonor those who fought and died for freedom, because answering the question incorrectly makes the price they paid a price paid in vain. Will the model be the “freedom” to escape torment and persecution only to torment and persecute others? Or will the model be the “freedom” to welcome those with different perspectives while refusing to adopt the methods of those from whom freedom was sought?
Indeed, freedom is not free. It comes with a cost. The cost is more than monetary. The cost can be the reduction of speed, the stopping at a red light or stop sign, the obedience to the yield sign, the wearing of a mask, the ceasing of the 1 a.m. fireworks, the toning down of the party noise at 2 a.m., the picking up of the pet’s poop, the use of a trash or recycling container rather than the gutter when disposing of trash, the extinguishing of the cigarette when in a closed space or close to others, the use of words rather than weapons when in a disagreement, telling the truth, and learning to think critically.
Freedom is not free. It disappears when the cost, whether in lives, taxes, or proper behavior, no longer is paid. Memorial Day means little if the freedom for which the fallen fought is disregarded, abused, or limited to fewer than everyone. The cost of freedom is much more than taxes.
Friday, May 28, 2021
Partnerships: A Contributing Factor to the Tax Noncompliance Surge
How did this low audit rate happen? The report tells us that over the last decade, “the IRS budget fell by about 20%, leading to a sustained decline in its workforce particularly among specialized auditors who conduct examinations of high-income and global high net worth individuals and complex structures, like partnerships, multi-tier pass-through entities, and multinational corporations.”
Why is this low audit rate a problem? As the report explains, and as more than a few tax professionals understand, and as some other people have learned, “noncompliance has been exacerbated by enhanced opportunities to shield income from tax liability, and even from audits. These opportunities are particularly available for those in the top end of the income distribution who can avoid taxes through sophisticated strategies such as offshoring, creating complex partnership structures, or moving taxable assets into the crypto economy.”
Why is auditing partnership difficult? Again, the report explains, during the last decade, “there has been a rise in complex business structures, such as partnerships, which also require significant efforts by IRS agents to obtain a complete understanding of interrelated business activities. Partnership income as a share of total income grew from less than 5% to more than 35% since 1990. * * * Examining these returns is resource-intensive for the IRS because many partnerships use tiered organizational structures where multiple levels of domestic and sometimes foreign business entities combine to obscure the ultimate beneficiaries of the business operations. Some recent research suggests that 30% of partnership income cannot unambiguously be traced to the ultimate owner.”
Why does auditing partnerships require more resources? In addition to the need to find, hire, and pay people with the ability to dig through the partnership manipulation in which many wealthy individuals engage, audit for partnerships “average around 333 hours per return. In contrast, routine field audits of less complex taxpayers average approximately 40 hours per return.”
What is the solution for this problem? The report concludes that the answer is to “[p]rovide the IRS the resources it needs to address sophisticated tax evasion,” to do things such as “modernizing information technology, improving data analytic approaches, and hiring and training agents dedicated to complex enforcement activities.”
It won’t be easy getting the IRS up to speed when it comes to auditing partnerships. I taught partnership taxation for almost 40 years. I taught more than 60 semesters of Partnership Taxation in Villanova’s Graduate Tax Program. I taught partnership taxation to J.D. students, in watered-down form, both in a Partnership Law and Taxation course and then in an Introduction to Taxation of Business Entities course. I have yet to meet a student who has not characterized these courses as the most difficult courses in their respective programs. Partnership taxation is so complex that it makes other areas of tax law seem simple in comparison, and as anyone familiar with taxation knows, those other courses are far from simple. The complexity of partnership taxation arises from the failure of the Congress to enact a complete entity approach or an aggregate approach because it chose to compromise and cobbled together a hybrid approach that creates the need for complicated provisions such as basis adjustments, “hot asset” rules, contributed property allocation rules, and special allocation provisions. These interconnected highly detailed cobwebs of almost incomprehensible provisions offer a maze which the engineers of tax avoidance schemes can manipulate to their benefit. On top of that, taxpayers who want to comply too easily make errors, not because they are trying to avoid tax, but because they and their tax return preparers understandably stumble and fall when they try to comply with the complicated mess that is partnership taxation.
It will be difficult for the IRS to find enough tax professionals willing to turn aside from highly compensated tax planning positions in the private sector to accept low government compensation jobs auditing the tax returns generated by those private sector planners. Partnership tax law complexity benefits the wealthy, generates significant costs for what I call “run of the mill” small partnerships, and harms taxpayers generally by contributing substantially to the tax gap.
Though hiring and training, or trying to hire and train, more partnership tax auditors is a worthy goal, in and of itself at best it will make a small dent in the problem. The solution lies with the Congress, frightening a thought as that is. Partnership taxation needs to be simplified. Publicly, almost everyone agrees, and privately, very few are willing to object while admitting that they and their client benefit from the complexity. Many years ago, before the exponential growth in the use of partnerships, I predicted the problem and proposed a solution. I did this at an ABA Tax Section meeting. The reaction was overwhelmingly negative, which surprised me because the same people claiming to dislike the complexity turned out to be even more disapproving of the solution. They knew their clients would object. And that is what will happen if Congress attempts to fix the problem, because those who benefit from the existence of the problem are the same people with the funds to ensure that the Congress serves their own needs rather than the needs of taxpayers generally.
The solution I proposed years ago was to treat partnerships as S corporations. Now, I think a better solution is to tax partnerships as entities, and to let the partners divide up the tax liability among themselves however they wish, so long as the tax is paid by the partnership. This is a topic for a future post, eventually.
Wednesday, May 26, 2021
Seeking a Legislative Cure for a Tax Break Malfunction
The statute does not address the treatment of a business that relocates from one KZ to another. Though the agency administering the program argued that “zone hopping” would “frustrate the purpose of the statute,” the Court concluded that because the statute did not address movement from one KZ to another, nothing in the statute prohibited the law firm from obtaining the tax breaks available by moving into the new KZ. The Court noted that there is no prohibition on zone hopping in the statute. So it granted summary relief to the law firm and entered the declaratory judgment that it had sought. As I had predicted when I evaluated the possibility of an appeal and reversal, specifically, that “it is difficult to envision the Supreme Court reversing the decision,” the Pennsylvania Supreme Court, in a one-sentence order issued last week, affirmed the decision of the Commonwealth Court.
In its 2020 opinion, the Commonwealth Court pointed out that fixing what the agency considers to be a problem requires a legislative remedy. Put another way, the problem exists because the legislature failed to consider and address the question one way or the other. Apparently no one asked, “What happens if a taxpayer or business stays in a zone until it expires and then moves to another zone that is active? Should the taxpayer or business get another batch of tax breaks?” Answering the question would then cause the legislators and their staffs to realize another provision in the statute was necessary.
It took almost a year, but according to this Philadelphia Inquirer report, a bipartisan bill has been introduced in the Pennsylvania House of Representatives to prevent taxpayers from obtaining a second batch of KZ tax breaks if they move from an expired KZ into a new one. My guess is that the legislators waited to see if the Supreme Court would reverse the Commonwealth Court’s decision. Some legislators apparently took note of the law firm’s attorney who stated that he has “additional clients seeking the same relief.” The proposed legislation would also cut some of the KZ tax breaks. It also would deny the tax breaks to real estate investment trusts, venture capital funds, and hedge funds. The legislation odes permit zone hopping if doing so “is necessary to meet the expansion or operational needs of the business and the business anticipates a significant financial impact on the zone into which the business is relocating.” It isn’t difficult to envision lawyers and others finding ways to describe a business move as meeting that exception.
Interestingly, though the original 1999 KZ legislation was intended, as described by its legislative sponsor, to bring one-time economic relief to “bombed out” areas of the state, it was the legislature that added more and more sites to the list of places qualifying for the tax breaks, even though most of them were not in dire economic condition. Some were in much better shape. The city of Philadelphia has lost $400 million in tax revenue during the period when the KZ designation was in effect for the building in which the law firm is located and from which it has planned to move, though it is now unclear whether those plans will change because of the proposed legislation. Nor is it precisely clear how the city of Philadelphia will deal with future requests for KZ designations though it does have a list of places for which it has been authorized by City Council to seek KZ designations.
Much of this could have been avoided had the statute been drafted with a provision permitting or prohibiting zone hopping. This flaw, in failing to “think through” an idea, afflicts not only legislators but anyone drafting something. Overlooked consequences can pop up when drafting contracts, when writing law school exam answers, when giving advice, when posting on social media, or when designing and drafting computer code. It’s much easier to think things through when the solitary drafter or small drafting team has the opportunity to welcome comments from even more persons who bring different perspectives and thus might be more likely to spot the “what if” questions that need to be asked. It helps to have transparency when drafting. It helps to listen to, rather than block or shut down, those whose questions and observations can improve what is being drafted, even when the question initially seems inarticulate or dimwitted. It will be interesting to see what sort of public hearing and review process is undertaken for the proposed legislation.
Monday, May 24, 2021
An Important Observation About Biden’s Tax Increase Proposal
In a recent letter to the editor of the New Hampshire Register, Norman Bender makes an important observation by pointing out that any increase would only apply to the income exceeding $400,000. Using his example, he apparently has encountered people with $500,000 of taxable income who think that a two percent increase in the rate would increase their tax liability by $10,000. Bender explains that a two percent increase applied to the excess of $500,000 over $400,000 would be $2,000, not $10,000. That’s a five-fold mistake and one that easily triggers a major emotional reaction. Of course, for someone with $10,000,000 of taxable income, the mistake is nowhere near five-fold. The erroneous conclusion that the increase would be $200,000 (two percent of $10,000,000) rather than $192,000 (two percent of the $9,600,000 excess of $10,000,000 over $400,0000) isn’t much of a difference.
Polls show that there isn’t much sympathy for the cries of poverty raised by someone with $10,000,000 of taxable income, who surely has more than that in actual income, when a $192,000 tax increase is proposed. There aren’t enough people in those income categories to make a dent in polling. But if they could somehow get significant numbers of other people to object, they might succeed in preserving their unwarranted previous tax cuts. How can that be done? It’s simple. Tell people that their taxes will increase without bothering to mention that those with taxable incomes equal to or under $400,000 won’t be affected. Tell people with taxable incomes exceeding $400,000 that the rate increase will apply to all of their income. Tell people with taxable incomes exceeding $400,000 that the proposed higher rate will apply to all of their income.
Why does this technique work? It works because too many people don’t understand the facts and are willing to let others do the work of analyzing the facts. They trust in those others without having checked the reliability of those others. They become susceptible to liars. They succumb to the lie because it appeals to them emotionally. When I started teaching tax a long time ago, I expected, perhaps foolishly, that after decades of doing so, in collaboration with thousands of others also teaching tax, the overall ability of the nation to understand the basic principles of tax would improve. Certainly I didn’t expect it to get worse, and certainly I did not expect that there would be people having as their goal the de-education of taxpayers and voters. Figuring out the impact of the proposed tax increase isn’t rocket science. Figuring out how to put an end to the lying apparently is, considering how successful the liars have been.
Friday, May 21, 2021
Polyworker: A New Word for the Occupation Box on the Federal Tax Return?
According to the article, a study by the Polywork network “reveals that nearly half of young professionals (47 percent) consider themselves people who ‘polywork’ doing an average of five different types of work – with one in ten (11 percent) saying they currently do more than ten types of professional work at the same time.” Technically, I think “at the same time” doesn’t mean at the same moment, but during a period of time. The article gives examples by describing the activities of several people. One person “does more than five different types of professional work across multiple countries including software engineering, public speaking, writing, podcasting, investing, advising, and mentoring.” Another “has three different types of work on the go at once: producing a musical; managing his technology investments; and running a non-profit company.” This person added, “Modern working attitudes and flexible technology allows my generation to juggle a multitude of things in a way we’ve never been able to before.”
The study by the Polywork network revealed that “[t]he majority of 21 to 40 year-old professionals (81 percent) say the pandemic has changed their attitude towards work forever with 45 percent saying they would not consider doing one single type of work for life, but would choose to polywork instead. Three quarters of all young professionals (72 percent) say virtual ways of working have opened up more work possibilities in the last 12 months compared to previous years.” It also discovered that “[o]ver half of all 21 to 40 year-olds (55 percent) said an ‘exciting’ professional life is more important to them than money with 62 percent saying the opportunity to learn more skills, more quickly through different types of work is more rewarding than professional ‘security’.” Reflecting on this, the founder of the Polywork network explained, “There is a new generation of professionals who do more than one type of work both in their regular job and outside of it, and they no longer feel a single job title reflects what they do or who they are. During the pandemic people have re-evaluated what they want to do, which in turn has accelerated the trend of polywork, using technology to connect with different and varied opportunities, whatever and wherever they may be. We do not see this trend disappearing, not least because Gen Z and Millennials see a variety of work as a way to achieve a more exciting life.”
When I read the article, two thoughts entered my mind. The first was a question. Will increasing numbers of tax professionals engage in polywork? For example, will tax professionals who only prepared tax returns begin doing other tax-related activities? Will tax litigators do other things? The answer is easy. It was my second thought.
My second thought on reading the article was simple. Polywork is not new. Perhaps technology makes it easier for some people to polywork. Perhaps technology permits polyworkers to increase the number of work activities in which they are engaged. But polyworking has been with us for as long as there have been workers. Many tax return preparers also do tax planning. Many tax litigators also do tax advising. Some practicing lawyers also teach as adjunct faculty members. The list is long. By its very nature, tax involves polywork. So, too, does law. And surely those in other professions can share similar lists. I have known people in my parents’ generation, including my parents, who fit the definition of “polyworker.” It’s not a new concept. What’s new is the increasing numbers of polyworkers and the extent to which technology makes it easier to engage in multiple activities.
What made me think that polywork is not new is my own experience. There have been, and are, weeks when I can find myself teaching a class, writing a blog post, giving tax or legal advice, preparing tax returns, writing an article or book about tax, mentoring a student asking about a particular career path, doing my sexton tasks at the church, designing and programming computer assisted tax education modules, and preparing and offering a CLE program. Fear not, over the past few years I have backed away from or scaled down several of those activities. The Polywork network was “created for people who do more than one type of work and cannot be defined by a single job title.” I first encountered that challenge years ago when I had to decide what to put in the “occupation” box on the federal tax return. I learned that the box, in paper or digital form, is too small for “law professor, lawyer, author, programmer, tax return preparer, church sexton.” So I wonder, will “polyworker” now begin showing up in the occupation box on the federal tax return?
Wednesday, May 19, 2021
Risk Consultant Connects Again with Tax Fraud Risk
Curious, I dug up the appellate opinion, U.S. v. Atkins and Hack, 869 F.2d 135 (2d Cir, 1989), dealing with his previous conviction. In a jury trial, Atkins and his co-defendant were convicted of willfully making and subscribing false individual and partnership tax returns, and aiding and assisting in the filing of false individual and partnership returns. In total, Atkins was convicted on 28 tax-related counts. Atkins was the founder and principal owner of a limited partnership, one of whose activities was creating tax write-offs for investors in money market instruments, primarily United States government securities. Because the Treasury had shifted from issuing paper certificates to making entries on Federal Reserve system computers, it was possible for dealers to create artificial entries by simply putting something on their books “indicating a purchase of transactions or purchase of some volume of securities as of day one in a sale as of some later day and then have corresponding transactions with some other party that also is self-reversing in that way. And that could be done without any transactions actually having to exist or be delivered over the delivery network in the government securities market. It didn't require that treasury securities actually exist.” So at one point the limited partnership owned by Atkins had a balance sheet showing “$24 billion of assets and liabilities, with less than a $100 million of capital.” As the court explained, “Although the Groups' offering memoranda represented that the Groups intended to handle clients' investments for the primary purpose of realizing economic gains, its real purpose was to generate tax losses for investors who needed them to offset unrelated gains. Such investors were promised 4 to 1 tax write-offs based on an investment consisting of 25 percent cash and 75 percent notes.” The court noted that the government had proved beyond a reasonable doubt that Atkins, with the help of Hack and other unindicted accomplices, “created, purchased, and sold millions of dollars in fraudulent tax losses for his companies and his customers,” using rigged straddles and rigged repurchase agreements. Essentially, to avoid the risk in a straddle, which involves holding both a “long” position – a contract to buy securities for future delivery – and a “short” position – a contract to sell securities not necessarily presently owned, the limited partnership found accomplices willing to enter into artificial paper or computer transactions designed to eliminate the risk of market fluctuations. In this way, losses would be recognized in one tax year, with the offsetting gain postponed, thus, in effect artificially recognizing accelerating losses that did not happen. Similar arrangements were made with the repurchase agreements. On top of this, Atkins and Hack “backdated or caused to be backdated a large number of documents in order to increase the amount of their fraudulent claims.”
On appeal, Atkins and Hack argued that “they were deprived of due process because they did not know in advance that their conduct was unlawful.” The court dismissed this claim as bordering on the “specious” because of the “proven falsification and backdating of documents, the secret oral agreements, the lies and the concealment of facts.” It then cited a litany of cases that had made it clear what was being done was fraudulent. Several other arguments were dismissed as misplaced, affirming the same conclusions reached by the trial court.
At the time, as noted in this report, the case was called by the government “the largest tax-fraud case in U.S. history.” This report also pointed out that the clients for whom Atkins and his colleagues manufactured artificial tax losses included celebrities and public officials. They had rushed to invest in an arrangement that promised $4 in tax losses for every $1 invested. The list included Michael Landon, Andy Warhol, Sidney Poitier, Lorne Greene, Norman Lear, then Postmaster General Preston R. Tisch, and his brother Laurence A. Tisch, then head of CBS. These unfortunate taxpayers, though not charged with crimes, had to experience IRS audits and the joys of paying back taxes plus interest and penalties.
The report also noted that Atkins is “the son of former Ashland Oil Co. chairman Orin E. Atkins,” and that he “took Wall Street by storm in the early 1980s with a series of tax shelters and investment partnerships that attracted tens of millions of dollars.” With that sort of background, even aside from the previous conviction, surely it should be no surprise that the eyes of the IRS were watching closely.
Managing risk involves both minimizing risk and setting in place ameliorative mechanisms to offset the impact of the adverse consequences produced when a risk materializes. It’s risky to commit tax fraud. It’s very risky to commit tax fraud, get caught, get convicted, and then commit tax fraud again. It is very difficult to slip back under the IRS radar after being convicted of tax fraud. The best way to manage that risk is to refrain from committing tax fraud again.
Monday, May 17, 2021
Cost of Goods Sold Offset When No Goods are Sold
What I never thought to mention to the students is that there is no cost of goods sold offset if no goods are sold. I figured it would and should go without saying. For example, there is no interest deduction if there is no loan on which interest is being paid or accrued.
So I found it interesting that the issue was addressed by the Tax Court. In BRC Operating Company v. Comr., T.C. Memo 2021-59, the Tax Court held that if no goods are sold there is no cost of goods sold offset. Technically, the issue was whether the economic performance requirement in section 461(h)(1) applies to, and precludes recognition of, estimated drilling costs reported by the taxpayer as cost of goods sold. To reach the case, go to the docket for the case, scroll down to item 71 and click on “Memorandum Opinion,” because the URL for the opinion is too long to include in an html URL tag.
The case involved BRC Operating Co., organized as a limited liability company in 2008, and wholly owned by another limited liability company, Bluescape Resources Co. BRC was treated as a disregarded entity. Bluescape was a partnership for federal tax purposes and used the accrual method of accounting. Bluescape purchased mineral and lease interests and planned to explore for, extract, and sell natural gas. On its partnership returns for 2008 and 2009, it treated $100 million and $60 million, respectively, as costs of goods sold, based on estimated drilling costs for exploration and extraction. Bluescape did not drill, receive drilling services from third parties, or receive drilling property during the tax years in issue. It reported no gross receipts or sales during these years attributable to the sale of natural gas.
The IRS disallowed the cost of goods sold offset, determining that Bluescape had not established that it satisfied the all events test and the economic performance requirement in section 461(h)(1). When the dispute reached the Ta Court, the IRS moved for for partial summary judgment, arguing that the undisputed facts show that economic performance under section 461(h)(1) did not occur with respect to the reported costs of goods sold during the years in issue, and, in the alternative, that the reported costs of goods sold should be disallowed because they were derived from Bluescape’s use of a method of accounting that failed to clearly reflect income. Bluescape and BRC moved for partial summary judgment, arguing that the economic performance requirement in section 461(h)(1) does not apply to the amounts claimed as costs of goods sold for the tax years in issue.
The IRS cited regulations section E.g., sec. 1.61-3(a), which provides, “[A]n amount cannot be taken into account in the computation of cost of goods sold any earlier than the taxable year in which economic performance occurs with respect to the amount[.]”). The taxpayers argued that the economic performance requirement does not apply because the regulations “extending” it to amounts included in cost of goods sold went too far. They argued that, as an offset against gross receipts to arrive at gross income, cost of goods sold is an “item of gross income” the timing of which is governed by section 451 and the corresponding regulations, and therefore the economic performance requirement in section 461 does not apply.
After the parties briefed their position, the Court scheduled a hearing on the motions to pose a basic question to the parties: Can Bluescape recognize costs of goods sold before it has any gross receipts from the sale of goods? The Court explained that before the question of whether cost of goods sold are subject to the economic performance requirement is answered, a precedent question must be resolved, namely, is there a cost of goods sold offset when there are no gross receipts to offset yet? The issue, the Court clarified, is not whether the estimated drilling costs can ever give rise to costs of goods sold but whether they can give rise to costs of goods sold for the years in issue before there are receipts to offset. The taxpayers argued that “matching” of cost of goods sold and gross receipts is not required.
After proving a history and explanation of the cost of good sold offset, the court cited previous cases for the proposition that “cost of goods sold is not allowable unless, and until, the taxpayer actually sells or disposes of goods,” and for the proposition that “taxpayers] have to capitalize an item’s cost in the year of acquisition or production and either amortize it or wait until the year the item’s sold to make the corresponding adjustment to gross income.”
So it turned out that this was not the first time a taxpayer tried to claim a cost of goods sold offset before selling anything or during a year in which nothing was sold. In keeping with the tagline for this blog, I point out that one of the cases cited by the Court involved a model train store that tried to claim cost of goods sold before it started selling to the public.
The Court explained that “Cost of goods sold does not exist in a vacuum, as a stand alone deduction in the Code, but serves as an offset against gross receipts.” The Court noted that the taxpayers had not cited, nor could it find, any cases that allowed an offset for cost of goods sold as a stand alone deduction in advance of any gross receipts. Thus, the court rejected the taxpayers’ argument that cost of goods sold need not “match” gross receipts because it could not bridge the gap in their logic. Some of the cases cited by the taxpayers in support of their position involved expenses claimed as business deductions not part of cost of goods sold or deductions for worthless inventory, neither of which was congruent with the facts of the case. Other cases cited by the taxpayers were put aside by the Court because the facts of those cases did not involve, as the taxpayers claimed, taxpayers who did not sell goods during the year.
Because of its resolution of the first argument made by the IRS, the Court did not reach its second argument that the reported costs of goods sold should be disallowed because the Bluescape used a method of inventory accounting that failed to clearly reflect income. The Court simply held that without gross receipts from the sale of goods, Bluescape may not recover its estimated drilling costs as costs of goods sold.
So if I were to ever again teach a basic federal income tax course I would include a simple statement that there is no cost of goods sold offset if there are no goods sold during the year. Because the chances of again teaching that course are extremely slim and for all intents and purposes, none, I am not planning to revise my eight-year-old teaching notes.
Friday, May 14, 2021
A Counter-Productive Tax Cut?
Georgia’s governor explained that his actions will “probably help level the price for a little while.” The price f regular unleaded gas in the state has risen by 11 cents in one week though the suspension of the tax will drop the price of fuel by roughly 20 to 30 cents per gallon.
What will this do? One only needs to think of the words “toilet paper” to suggest the answer. Many people will conclude that filling up their vehicle tanks before Sunday is a wise thing to do. From a self-centered perspective, it surely is. And it’s not just vehicle tanks. It’s those 3 and 5 gallon cans used to supply lawn mowers, leaf blowers, and other equipment.
The governor is aware of this. According to the report, “he urged Georgians to avoid a rush to the fuel pumps.” He advised Georgians that they “don’t need to go out and fill out every five gallon tank you’ve got. Get what you need, let everybody else get what they need, get to work and do the things you need to do.” Of course, he assumes that the self-centered perspective will yield to a community-focused one. Good luck. Am I cynical? Perhaps. But it wasn’t that long ago when the mad stampedes for toilet paper, hand sanitizer, bleach, and other cleaning products made the headlines. According to this story, “panic buying and long lines” already were underway earlier this week.
How does reducing the price reduce demand? The governor explained, “We are seeing some shortages around the state, and we don’t want a run on the pumps.” Then don’t encourage a run on the pumps by lowering the price. That’s simple economics, a subject poorly understood by most Americans and especially badly understood by too many politicians. Add to this the temptation presented to residents of adjacent states, especially those living close to the Georgia border, to make tank-filling trips into Georgia because gasoline prices in that state have dropped because of the suspension of the tax. How does that help the situation for Georgia residents?
The report explained that two previous Georgia governors had either suspended the tax on fuel or halted an increase in the tax when fuel prices rose sharply for one reason or another. According to this study, only 2/3 of the tax reduction passed through to Georgia purchasers when the tax was suspended in 2005. This outcome had been predicted in an earlier study, which also identified other disadvantages to suspending the tax on fuels and offered other suggestions to deal with rising fuel prices. Interestingly, that study apparently caused every state other than Georgia not to suspend the tax in 2005, but Georgia did so and the predicted results indeed materialized.
I put this tax suspension into the category of “look, I’m doing something wonderful for you even though it isn’t what it appears to be and hopefully you won’t figure out that what it purports to do for you isn’t what it does for you and it actually can make things worse.” Of course, the cyberattack that has fueled this crisis is an example of what happens when government fails in its responsibility to protect the nation. Decades of anti-government, anti-tax, and anti-regulation sentiment fueled and funded by lobbyists for the private sector is demonstrating how inadequate the private sector can be when government is pushed aside. Distracted by debates reflecting divided opinions with respect to invented disagreements, the nation isn’t paying attention to the increasing size of the hacker fleet sitting offshore. Cutting fuel taxes not only fails to alleviate the supply problem, it also encourages more tax-cutting efforts when the last thing the nation needs is a reduction in support for defense of its people.
Wednesday, May 12, 2021
As Bad As Ignorance is for the World, There are Those Who Benefit from It
Last week, the folks at Credello released the results of a poll about taxes. The headline alone is alarming: “SURVEY: Millennials & Men Are Most Likely to Be Overconfident About Their Tax Expertise.” The article begins with these two questions: “You remember that one (or multiple) guy(s) from high school who knew everything about everything? Or at least said he did?” My high school faculty was superb in ridding that thought from our brains even before our brains formed it. We learned to learn what we didn’t know, and we learned how to learn what we didn’t but needed to know and understand. Unfortunately, it’s too easy for people to believe those who claim they have all the answers, even ones who eluded the draft but claim to know more than the generals do.
According to the poll results, “[m]any respondents claimed to know more about taxes than they actually do. Millennials were particularly overconfident as 83% of Gen Yers surveyed said they know enough or everything about taxes, but about a third of respondents scored a B or lower on a relatively simple tax literacy quiz.” Wow. The author of the Credello report points out that this is another example of the “Dunning-Kruger effect, . . . a cognitive bias that people with a lower skill level overestimate their ability, thinking they’re smarter or more capable than they really are.” I love how the author put it: “ In other words, these dummies are too dumb to identify their own incompetence. And on the flip side, their higher-skilled counterparts tend to underestimate their ability.”
Some of the tax literacy quiz responses were telling. When asked whether the taxpayer or the taxpayer’s accountant is responsible for filing errors, 42 percent put the onus on the accountant. Wrong. Asked to select which one of two statements was true, 44 percent chose the wrong answer, “You can claim a pet as a dependent,” rather than the correct response, “Even illegal activity is taxable.” Presented with a question about marginal rates, an issue I recently described in Fixing a Subhead and a Sentence That Reference Tax Brackets, 51 percent selected “You pay your marginal tax rate on all of your income” as the correct choice rather than the correct statement, “You pay the same rate as others on income up to a certain amount, then a higher rate on every dollar until the next threshold.” This ignorance, of course, is used by the ultra-wealthy and their advocates to spread fear among the 99 percent to gain support for their opposition to tax increases that would have no effect on those who are not ultra-wealthy.
So what is the solution to ignorance, no matter the subject? The answer, in two words, is quality education. When education was once found in schools, books, newspapers, radio, and television, it now percolates not only in those sources but also on internet web sites, social media platforms, and other avenues that operate without the filters available when educators are educated people. The willingness to “learn” about taxes or some other matter from what some random person or manipulated robot posts online while pushing aside what the educated experts have to say about the issue is the product of deep psychological problems. The willingness to believe what one wants to hear opens the door to the scammers and spammers, and eliminates the very freedom that is the excuse given by those who believe they are free to believe whatever they want to believe, even when it conflicts with indisputable facts.
A little more than four years ago, in Ignorance in the Face of Facts, I wrote:
A recent survey by the Public Policy Institute of California reveals how the spread of misinformation through social media has contributed to the inability of Americans to distinguish fact from fiction. The survey asked people in California to identify the largest areas of state spending. Thirty-nine percent of the respondents identified prisons and corrections as the biggest expenditure. Less than ten percent of the California budget is spent on the prisons and corrections system. Only 16 percent of the respondents correctly identified K-12 public education, which consumes almost 43 percent of the state budget, as the largest expenditure. It’s not as though the information is classified or difficult to find. So few people know the answer in part because so few people care about learning this sort of information, and in part because it’s so easy to accept as true whatever information gets pumped out of someone’s favorite source of “news.” I wonder what would happen if the survey respondents were asked the question, and then given the opportunity to research the answer. How many could take themselves to an official California state budget web site to discover the answers?Yes, just imagine. Is it any wonder that more and more unfortunate outcomes are afflicting the nation and the world? The price that is paid for ignorance is steep. Unfortunately, the price paid for one person’s ignorance is not necessarily paid by that person and too often is paid by many others. Ignorance can be eradicated. So when those opposed to what eradicates ignorance, that is, quality education, fight increases in education funding and push for decreases, when they advocate the establishment of and support for institutions of miseducation, when they fund and support media and web platform outlets that spew falsehoods, everyone else should ask, “Why are they doing this?” The answer is simple. They benefit from ignorance and miseducation, they know and understand the consequences of a fully educated national and world population. That is why they foster anti-intellectualism, because they cannot risk too many people being sufficiently educated to also know and understand the consequences of pervasive quality education. They prefer ignorance, and that is no less harmful than preferring the incubation and spread of a virus.
Why does it matter? Who cares? It matters because decisions are made based on the facts people think exist. For example, in California, voters are given the opportunity to approve or reject propositions that directly affect taxation and spending. Advocates of more spending for a particular area of the budget strive to convince voters that the particular area in question is underfunded. Those seeking to cut spending on particular areas try to convince voters that those areas are overfunded.
Six years ago, in The Grand Delusion: Balancing the Federal Budget Without Tax Increases, I pointed out:A month and a half ago, the Kaiser Family Foundation released poll results revealing that 40 percent of Americans “think that foreign aid is one of the two biggest areas of spending in the federal budget.” This, of course, is totally incorrect.Yet this piece of tax misinformation persists. How can good decisions be made when reality is different from perception? Imagine what happens if surgeons, electricians, auto mechanics, and engineers made decisions based on misinformation rather than on actual facts. Just imagine.
Monday, May 10, 2021
One Person’s Goof Triples Another Person’s Taxes
When she learned that the monthly payments had been significantly increased because of the tax increase, the taxpayer had her daughter call the county’s Department of Assessment. That is when she and her daughter learned that someone had decided the taxpayer was dead. Someone in that Department’s office admitted that an error had been made, and told the taxpayer that the process for fixing it needed would take more than a year. In the meantime, the taxpayer overpaid the taxes by roughly $5,000 to $6,000, amounts beyond the taxpayer’s ability to pay. Apparently she had some financial assistance from her daughter.
The taxpayer and her daughter contacted county administration officials, including the county executive, but ran into a brick wall. They then turned to a county legislator for help, but he also could not get answers. So the legislator called a press conference to let people know what was happening.
A spokesperson for the county claimed that “corrections were made right away, along with a petition that will be approved by the legislature on Monday to refund the taxpayer.” He reported that a refund check should be mailed to the taxpayer by May 10, and noted, “it's unfortunate that an elderly woman was used as a political prop by politicians when a solution has already been found.”
No, what’s unfortunate is that someone marked the taxpayer as dead, no verification seems to have been made, no red flag popped up on a supervisor’s computer, no cross-checking with the state’s department of vital statistics to confirm the filing of a death certificate was processed, no rapid correction was made, no response was provided to the taxpayer by certain county officials, and perhaps no interest was paid on the refunded amount. No information has been provided on how the error took place. Did someone contact the tax office, perhaps as a prank, hoax, or attempt to steal the woman’s home, and report the taxpayer as having died? If so, what sort of confirmation was required? Did someone accidentally hit a button on a computer keyboard? If so, did a “do you really want to mark this person as deceased?” confirmation question pop up on the screen? Did a request for confirmation get sent to the supervisor? Worse, was a “you have been marked as deceased and the tax on the property has increased” notice sent to the taxpayer’s address? Was the taxpayer’s name confused with another taxpayer who actually did die? Was the box that should have been clicked above or below the box adjacent to the taxpayer’s name and associated with a different person?
System design is difficult. Everyone makes mistakes. The more costly a mistake, the more resources should be plowed into the design of a system. Systems that deal with taxes and other finances, such as banking, with health and medical issues, with arrest and prison records, and with similar “high consequences if an error” situations deserve careful planning and implementation. Not only do these systems need careful planning to prevent or at least reduce the number of mistakes and to reduce the impact of mistakes, they also need processes that fix mistakes, and quickly. Why it would have taken more than a year, absent the intervention, to fix the error is baffling. It was easy check the “taxpayer is dead” box, so it should be just as easy to uncheck it, and check a “send refund” box.
It is a story like this that turns public opinion even more sharply against taxes. This sort of error is bad public relations, and it would be behoove the county tax office in question to release an explanation of what went wrong and the steps taken to prevent similar and identical errors in the future. And it ought not take more than a year to do that.
Friday, May 07, 2021
Tax Return Preparers Putting Red Flags on Clients’ Returns
This time, in a situation very similar to the one I mentioned last week, a tax return preparer made it easy for the IRS to spot the fraudulent returns cranked out by the preparer. Last week I pointed out the foolishness in falsely claiming that a client attended school at a particular institution despite knowing that the client had not done so. Was not the preparer aware that IRS computers or IRS personnel would cross-check the school listed on the tax return with information about students matriculated at that school?
According to this Department of Justice news release, a Florida tax return preparer was convicted by a jury of 14 counts of filing false returns on behalf of unknowing clients and 3 counts of filing false tax returns on behalf of himself. The preparer inserted into the clients’ returns “grossly inflated deductions for state and local sales taxes, unreimbursed employee expenses, and gifts to charity by cash or check.” On his own 2013 return, he reported $10,160 in income when he actually earned at least $83,848 that year. On his 2014 return, he reported $2,695 in income when he actually earned $252,652 that year. On his 2015 return, he reported $10,255 in income when he actually earned $234,936 that year. Did he really think he could omit 88 percent, 99 percent, and 96 percent of gross income an not get noticed by the IRS?
The news release described another red flag unfurled by the preparer. “For example, on one tax return, [he] claimed a sales tax deduction of $5,883 for a client who had a gross income of $43,476. In order for that client to claim a sales tax deduction that large, the client would have had to have made taxable purchases totaling $89,926 (including the tax) -- or more than twice the client’s claimed gross income.” Finding this sort of fraud is something that the IRS computers easily detect.
Because the preparer can be sentenced for up to three years for each count, he could be facing 51 years in federal prison. Restitution also is being sought. In When Unscrupulous Tax Return Preparers Make It Easy for the IRS and DOJ to Find Them, I wrote:
Some unscrupulous tax return preparers might be difficult for the IRS to spot, or perhaps avoid detection for long periods of time. But others seem to be raising red flags so obvious that they might was well post “Fraudulent Tax Returns Prepared Here” signs in their storefront windows or on their websites. Lack of ethics combined with lack of knowledge about how tax returns are examined and audited is a recipe for a much shorter time as a preparer.When tax return preparers don’t understand the chances of being caught and the high price paid when caught, and they are focused only on the seemingly quick and easy cash windfall from filing fraudulent returns, they are destined for disappointment despite any short-term success. It’s too bad that they not only mess up their own lives, they create inconvenience, aggravation, anxiety, and frustration for their clients. Please, people, take a look at my advice in More Thoughts About Avoiding Tax Return Preparers Gone Bad and save yourself some agony.
Wednesday, May 05, 2021
Can Long-Term Tax Collector Embezzlement Be Prevented?
Now comes another story about a tax collector in trouble. The story showed up in my local paper, and a day later reader Morris found the story in a different source. He described the subject of the story as “another candidate for worst tax collector contest,” but that’s not the sort of contest I’d want to run or judge. As I learned when I was a child, pointing out that someone else, for example, a sibling, did something worse is not a defense when called to account by a parents. As an aside, this is why the “whataboutism” that has infected the national discourse on a long list of issues is unhelpful.
In this instance, Jeanne Bowser, who served as tax collector for Center Township in Beaver County, in western Pennsylvania, for several decades, and who resigned in 2019 following an audit, has admitted to stealing $1,028,000 from the township’s tax revenue. As part of her plan, she used school tax revenue to fill township tax accounts and vice versa. She also failed to report the embezzled funds as gross income, and for those unfamiliar with basic tax law, stolen money must be reported as gross income. She pleaded guilty to wire fraud and filing a false tax report. She faces a prison sentence and a requirement to make restitution of the stolen funds and to pay the $275,000 in federal income taxes not paid on the embezzled funds. When she pays the $1,028,000, she will be entitled to a deduction but I doubt it will be of much use to her.
What is amazing is that she did this for eight years before being caught. In a world of dual authentication to reduce the risk of digital hacking, ought there not be some system to keep more than just the tax collector’s eyes on the receipt and deposit of tax revenues? Many businesses separate the tasks related to revenue receipt among multiple employees. It’s not my intention to map out how that can be done, but simply a question for officials in jurisdictions that haven’t set up such a system. The question is, “Why not now?”
Monday, May 03, 2021
Fixing a Subhead and a Sentence That Reference Tax Brackets
So that is probably what happened with the headline and subhead in this Kiplinger article. The headline is a question: “What Are the Income Tax Brackets for 2021 vs. 2020?” The subhead tells us, “For both 2020 and 2021, you can end up in one of seven different federal income tax brackets – each with its own marginal tax rate – depending on your taxable income.” Of course, that’s not true. The only taxpayers who end up in ONE bracket are taxpayers whose taxable income equals or is less than the cut-off amount for the lowest bracket. The taxable income of a person whose taxable income exceeds that amount would be in at least two brackets, the lowest bracket and the next highest bracket. The author of the article, though, got it right in an example but wrong in an explanation.
In the example, the author wrote:
Suppose you're single and have $90,000 of taxable income in 2020. Since $90,000 is in the 24% bracket for singles, would your tax bill simply be a flat 24% of $90,000 – or $21,600? No! Your tax would actually be less than that amount. That's because, using marginal tax rates, only a portion of your income would be taxed at the 24% rate. The rest of it would be taxed at the 10%, 12%, and 22% rates.This example demonstrates that the taxpayer’s taxable income falls into FOUR brackets, or perhaps one could say that the taxpayer’s taxable income is spread out over FOUR brackets. But certainly the example dispels any thought that the taxable income is within ONE bracket.
Yet in the article, the author also states, “That means you could wind up in a different tax bracket when you file your 2021 return than the bracket you're in for 2020 – which also means you could be subject to a different tax rate on some of your 2021 income, too.” Perhaps this use of the singular suggested to the headline writer that a taxpayer’s taxable income ends up in “a . . . tax bracket,” that is, ONE tax bracket. The sentence can be fixed by adding the word “MARGINAL” before the phrase “tax bracket” and before the phrase “tax rate.” So it would read, “That means you could wind up in a different marginal tax bracket when you file your 2021 return than the bracket you're in for 2020 – which also means you could be subject to a different marginal tax rate on some of your 2021 income, too.”
The same fix would work for the subhead. Adding the word “MARGINAL” before the phrase “income tax brackets” and removing that word from before the phrase “tax rate” produces this subhead: “For both 2020 and 2021, you can end up in one of seven different federal marginal income tax brackets – each with its own tax rate – depending on your taxable income.”
Why did I capitalize MARGINAL? I wanted to emphasize the importance of the various adjectives used to describe the phrases “tax rate” and “tax bracket.” Those adjectives have meaning, and omitting them or using the wrong ones can produce, in many instances, incorrect or misleading statements. There are marginal tax rates. There are average tax rates. There are effective tax rates. There are flat tax rate. There are progressive tax rates. There are regressive tax rates. There are nominal tax rates. Those are objective adjectives. There are dozens of subjective adjectives used to describe tax rate or tax brackets, including oppressive, heavy, high, severe, exorbitant, favorable, unfair, light, confiscatory, and many others.
Though there is pressure to shorten sentences, headlines, subheads, email texts, manifest with the proliferation of tweets, sound bites, and buzz phrases, the change I proposed to the subhead did not lengthen it because it simply moved a word from one place to another. In contrast, the change I proposed to the sentence in the text lengthened it by two words. So sometimes the issue is length and sometimes it’s word placement.
Note: reader Morris suggests that my suggestion “For both 2020 and 2021, you can end up in one of seven different federal marginal income tax brackets – each with its own tax rate – depending on your taxable income.” would be even better if it read, “For both 2020 and 2021, you can end up in one of seven different federal marginal income tax brackets – each with its own tax rate – depending on your taxable income and filing status.” Of course, that makes the subhead longer, which migh pose composition (font, spacing, etc.) issues. Perhaps an even better and no less technically correct subheading would be, “For both 2020 and 2021, your taxable income can end up subject to one of seven different federal marginal income tax rates.”