Business Tax "Breaks" Funded by Students?

When I teach the depreciation and asset expensing deductions in the basic federal income tax course, I purposefully do more than discuss the concept and theory of depreciation. I show the students some fairly simple computations, for several reasons. One is that by seeing the actual numbers students can see the actual impact of the acceleration feature of MACRS, the front-loading effect of section 179, and the difference in results when the straight-line method is used. Another reason is to give students an appreciation for how legal rules reflecting theoretical principles are applied to real-life practice-world facts. Yet another reason is to show students the dynamic nature of the tax law so that they grasp more fully the notion that law, and tax law in particular, is not a static set of rules but an ever-changing array of principles that present more than enough opportunities for mistakes to be made.

When I turn to section 179, I have yet another goal in mind. I want students to see the application of inflation-based adjustments. Doing planning and compliance work without an understanding of how changes in dollar amounts, or the lack of changes in dollar amounts, matters can doom a practitioner to an unpleasant malpractice experience. Waiting until the turn of the year to execute a transaction may or may not make sense, and determining whether it does requires a sense of how the “playing field” can change.

I don’t play games with the students when I teach depreciation and asset expensing deductions. A fair-sized chunk of the topic consists of presentation rather than demands that the students solve problems and answer questions.

So, for example, when I reach section 179, there comes a time to explain the two limitations. One is the absolute dollar amount limitation, in contrast to the other, which is the taxable income limitation. The slide, as it exists at the moment, says this (without the color, font change, and other visual attributes):

The first is an absolute dollar limitation.
1. For 2003 through 2009, that limit is $100,000. §179(b)(1).
It has increased in stages: $20,000 for 2000, $24,000 for
2001, $24,000 for 2002. Don’t get tricked by references
to the 1999 $19,000 limit or to earlier limits.
1996, 2003, 2004, and 2006 legislation amended §179.
2. This amount is REDUCED by the excess of the cost of
§179 property placed in service for the year over
$400,000. §179(b)(2). (For years before 2003 and years
after 2009, $200,000 is used instead of $400,000.)
3. For 2004 -- 2009 these amounts adjusted for inflation.
For 2006, $100,000 is $108,000, $400,000 is $430,000.

Now I must change the slide. I also need to change my class notes, the examples, and the problem solutions. I also need to change the problems because I try to keep the computations and examples limited to round numbers.

Why do I need to change the slide, the examples, my class notes, the problem solutions, and probably some other things I’m not recalling at the moment?

The reason is Public Law 110-28. It’s called the U.S. Troop Readiness, Veterans' Care, Katrina Recovery, and Iraq Accountability Appropriations Act, 2007, though people are calling it the Iraq Appropriations Act. Buried in it is the Small Business and Work Opportunity Tax Act of 2007. Isn’t it absurd how Congress puts Acts within Acts? I suppose it’s some sort of Russian doll syndrome.

The text of the act can be obtained by going to the Library of Congress Thomas web site and selecting 110-28 under Public Law. The site’s search mechanism works in such a way that the URL showing up when I searched won’t work.

Of particular interest is section 8212 of the Act:

SEC. 8212. EXTENSION AND INCREASE OF EXPENSING FOR SMALL BUSINESS.
(a) EXTENSION- Subsections (b)(1), (b)(2), (b)(5), (c)(2), and (d)(1)(A)(ii) of section 179 (relating to election to expense certain depreciable business assets) are each amended by striking `2010' and inserting `2011'.
(b) INCREASE IN LIMITATIONS- Subsection (b) of section 179 is amended--
(1) by striking `$100,000 in the case of taxable years beginning after 2002' in paragraph (1) and inserting `$125,000 in the case of taxable years beginning after 2006', and
(2) by striking `$400,000 in the case of taxable years beginning after 2002' in paragraph (2) and inserting `$500,000 in the case of taxable years beginning after 2006'.
(c) INFLATION ADJUSTMENT- Subparagraph (A) of section 179(b)(5) is amended--
(1) by striking `2003' and inserting `2007',
(2) by striking `$100,000 and $400,000' and inserting `$125,000 and $500,000', and
(3) by striking `2002' in clause (ii) and inserting `2006'.
(d) EFFECTIVE DATE- The amendments made by this section shall apply to taxable years beginning after December 31, 2006.

In other words, the numbers have changed yet again.

What disturbs me isn’t so much the additional work that the Congress has created for me, or even the additional aggravation for students and practitioners. It’s my inability to understand the point of making the change. There standard justification for the long parade of increases in the section 179 limitation is that the increase will encourage businesses to make equipment purchases that they otherwise would not make, thus boosting the economy. That explanation seems plausible, at least on its face, but I cannot imagine that more than a few people will run out and spend an additional $25,000 on equipment because they’ll save $8,000 in taxes. Where will they get the net cost of $17,000? My guess is that they would cut back spending in some other area, thus causing a negligible impact on the economy generally, though perhaps boosting one segment at the expense of another.

Here’s what I think happens. Businesses that have already spent, or plan to spend more than $100,000 but less than $400,000 on new equipment, get a windfall. Suddenly, they benefit from as much as an $8,000 tax decrease. Yes, this stimulates the economy because it gives them $8,000 to spend. But at the same time, others will be paying additional taxes because this most recent bill allegedly is revenue neutral.

Here’s one of the revenue offset provisions:

SEC. 8241. INCREASE IN AGE OF CHILDREN WHOSE UNEARNED INCOME IS TAXED AS IF PARENT'S INCOME.
(a) IN GENERAL- Subparagraph (A) of section 1(g)(2) (relating to child to whom subsection applies) is amended to read as follows:
`(A) such child--
`(i) has not attained age 18 before the close of the taxable year, or
`(ii)(I) has attained age 18 before the close of the taxable year and meets the age requirements of section 152(c)(3) (determined without regard to subparagraph (B) thereof), and
`(II) whose earned income (as defined in section 911(d)(2)) for such taxable year does not exceed one-half of the amount of the individual's support (within the meaning of section 152(c)(1)(D) after the application of section 152(f)(5) (without regard to subparagraph (A) thereof)) for such taxable year,'.
(b) CONFORMING AMENDMENT- Subsection (g) of section 1 is amended by striking `MINOR' in the heading thereof.
(c) EFFECTIVE DATE- The amendment made by this section shall apply to taxable years beginning after the date of the enactment of this Act.

Fun, isn’t it? The upshot is that more children will have their taxable income taxed at their parents’ rates. Added to that group are children between the ages of 18 and 19, and children between the ages of 19 and 24 who are students, provided that their earned income does not generate more than one-half of their support.

So, put simply, the tax burden on some taxpayers, age 18 through 24, will be increased so that some businesses can get tax reduction windfalls from equipment purchases they would have made in any event. Interesting, isn’t it? Yet more is being put on the backs of teenagers and those barely out of their teens.

Anyone want to guess how much of the $8,000 windfall sustained by a business will be used to create a job for a student trying to work his or her way through college?

I thought so.

It's Nice to Get Attention

OK, I confess. It's nice to get attention. More particularly, it's nice to see my work getting attention.

So here's an incomplete list of articles and commentary that comment about what I'm doing on MauledAgain:

Scott McLeod, "Professors Who Blog"

Blawg Review, "Best Law Professor Blog"

Warren Rojas, "Tax Bloggers Use Internet To Widen Tax Policy Appeal"

Lubna Kably, "Piercing the Glass Ceiling"

Andrew Blackman, "Blog Watch"

Getting To Know You Tuesday: James Maule from Tax Girl

Last evening I googled MauledAgain. Up pops "Results 1 - 100 of about 22,000 for "mauledagain". (0.14 seconds)." That's encouraging. However, I just don't have the time to visit all 22,000 web pages that link to MauledAgain. Several entries on the google results list caught my eye. What were they saying at Biker Law Blog? Turns out that my most recent Memorial Day post was quoted and drew this comment: "This is a good read that puts Memorial Day 2007 into prospective." That's what I was trying to do. Over at Kaedrin Weblog I found this fascinating comment: "One wouldn't think in-depth discussions of tax law would be that interesting, but James Edward Maule manages to do so about as well as one could expect. I honestly don't remember how I found this one, but I'm glad I did." It reminds me of all the students who enter the basic tax course saddled with anxiety and expectations of boredom and who emerge with the same sense of wonder that tax is far from boring and, with due effort, can be understood to some extent.

The "Right on, JEM" comment at Wandering Tax Pro in response to my commentary on How Political Blackmail Enhances Tax Law Complexity took me back several decades to a time when I heard that phrase far more often than I do today. The accompanying notes alerted me that I need to google Mauled Again as two words, though that search phrase also will generate all sorts of material not connected with the blog. A google search for "mauled again" brought 67,200 hits, but when I added "maule or blog" to the search, it dropped to 55! Adding "villanova or law or maule or blog" brought it up to 86. But not all were related to my blog. One, for example, involved someone named Jim who was "mauled again." Not guilty.

J.D. Hull of What About Clients tossed some praise my way that would have been unheard of several decades ago: "Blawg Review #53: Jim Maule, Tax Day and Taxation as Pervasive. Blawg Review #53 by Villanova Professor James Edward Maule at MauledAgain is further support for my relatively new but ever-strengthening theory that tax lawyers after all really are creative--and have both depth and breadth, big personalities and writing ability as well." There's no surprise in the big personality and writing ability, I suppose, but creative? That was never a strong point back in my K-12 days. I guess we do change. I've surely had enough time! If "creative" is heartening, the folks at the Wills, Trusts & Estates Prof Blog called MauledAgain "wonderful." That's a word I don't hear very often. Thanks.

The web-like nature of the Internet became even more evident when I looked at the web pages that linked to MauledAgain with or without commentary. There's a reason it's called World Wide Web. For example, over at Musings - You and Yours Blawg, Deirdre R. Wheatley-Liss, Esq. credits MauledAgain with making her aware of A Taxonomy of Legal Blogs.

Sometimes, though, it gets a bit strange. Over at Alexa, the site information for MauledAgain declares that I rank 5,708,484. Had I done that well in Law School perhaps I would have won an award. But the fun part is this note: "People who visit this page also visit: The Tax Guru, ADG Productions, Accordion Links." No suprise with Tax Guru, considering I link to Kerry Kerstetter's blog. But second and third place toADG Productions and Accordion Links. Accordion Links? The former describes itself as "Music Education Into The New Millennium" and the Latter as "A Huge List of Accordion Websites." Yes, I'm into music, though I've rarely blogged much about music, and, no, I don't play the accordion and have discussed accordions on MauledAgain. But, well, if all the musicians and accordion players in the world visit MauledAgain, perhaps the blog will move up to position 5,708,483.

Tax Ideas Without Details: Useful?

Senator Clinton gave a speech today. It's a long one, but surely I am not one to criticize on that score. She covered a wide swath of problems and policies, but it's her tax commentary that interests me. Thanks to Paul Caron of TaxProf Blog for the heads up.

Senator Clinton: "I'm going to work to level the playing field and reduce the special breaks for big corporations."

Me: Which special breaks, Senator? Tax-free reorganizations? Exceptions to the $1,000,000 limitation on deductions for executive compensation?

Senator Clinton: "Second, let's once and for all get rid of the incentives for American companies to ship jobs and profits overseas. It is one thing for the marketplace to encourage overseas investment. It's another for our own tax code to do so....We will consider eliminating the deduction for the actual costs of moving jobs."

Me: How would this work? Deny deductions for the portion of a corporation's expenses that are somehow attributable to relocation of jobs? And, incidentally, why single out corporations? What about partnerships and sole proprietorships that outsource work? And what about the entities subject to special tax rules, such as banks and insurance companies? Do you intend to include them within the scope of "corporations"?

Senator Clinton: "Today, American companies that ship jobs overseas don't have to pay a penny in American taxes on the profits they make abroad unless they bring those profits back to the United States. And, of course, they don't bring them back because they don't want to pay taxes on them."

Me: There are those who claim that American enterprise can compete in a global marketplace only if the United States leaves foreign profits untaxed. I prefer the basic principle that income is income, and if a person or organization has income, it is taxed. If there is some reason that a special allowance ought to be made, it should be done in an up-front, transparent, nationally publicized government grant to the person or company. I wonder how many such grants would be approved, in contrast to all the hidden breaks put into the Code by stealth.

Senator Clinton: "And when the president's irresponsible tax breaks for high-income Americans expire, we will return to the income tax rates for upper- income Americans that we had in the 1990s, rates that were consistent with a balanced budget and economic growth."

Me: What do you want to do with those special low rates for capital gains? Far more tax imbalance exists with respect to the capital gains preference than with the ordinary income rate differences.

Senator Clinton: "For middle-class Americans, who haven't seen their paychecks increase, let's keep the middle-class tax cuts and reform the alternative minimum tax in order to give middle-class Americans the tax relief they deserve to have."

Me: Why not fix the regular tax so that there is no need for an AMT? Keeping the AMT means that the preferences would be retained. Why?

Senator Clinton: "let's expand and simplify the Earned Income Tax Credit so no one working full time lives in poverty."

Me: Do you have a blueprint for doing this in a manner that doesn't increase EITC fraud?

Big on theory, big on concept, big on ideas, but way, way short on details. Of course, every detail that Senator Clinton adds to her proposals probably costs her 100 votes.

And they wonder why I don't become a politician.

Memorial Day: How Important are Taxes Really?

The other day as I was reading an article about the Ardennes Offensive, or as it is also known, the Battle of the Bulge, my attention turned to several facts to which I had not previously given much notice. In a period of slightly more than one month, U.S. military forces alone suffered more than eighty thousand casualties. On reflection, that’s not terribly surprising, considering the scale and suddenness of the German attack. What did surprise me was the shortage of replacements, a lack of sufficient personnel to replace those who had been killed, wounded, captured or who had gone missing.

As a child, when my parents, particularly my mother, would tell me about the Second World War, an experience very fresh in their memories, they spoke with a particular sense of awe when they described the Battle of the Bulge. From my conversations with them at that time and later, and from what I’ve since read, the impact on the home front was significant, because people had come to believe that the war in Europe would be over by Christmas. It was shortly before Christmas when the Ardennes Offensive triggered a serious reality check among Americans and citizens of other Allied nations. Sometimes things take longer than expected.

This summer I plan to visit the area in southern Belgium and northern Luxembourg where the battle raged. I also plan to visit Waterloo, but that wasn’t an American story. Suddenly a question popped into my mind, one of those questions I can imagine my librarian friend asking me, “So how many American battlefields have you visited?”

Good question, even if asked of myself. I suppose Valley Forge, the first American military site that I visited, doesn’t count, because it was not a place of battle. The local ones, the ones near the place where I grew up, have found me wandering about more than once. Brandywine, White Marsh, Germantown, Matson’s Ford, and Paoli are close to my hometown. I’ve been to Lexington, Concord, and Bunker Hill. I’ve been to Gettysburg and Manasses.

I have visited the Normandy Beaches, from Pointe d’Hoc to Pegasus Bridge. I have walked through the American Cemetery at Colleville Sur Mer. The number of graves is staggering. There are markers that seem to fill the space to the horizon.

The numbers, of course, represent much more than just an arithmetic figure. Whether numbers are used to compute taxes or tally casualties, they tell us only so much. One thing is obvious: without a nation the question of taxes is irrelevant, and without taxes there is no nation. Yet all the taxes in the world cannot repurchase the lives that have been lost or shattered in war.

Today, Memorial Day, is an appropriate moment to stop and reflect on the sacrifices made by many so that the life we live today, including picnics and trips to the beach, can be what it is. Close to 1,225,000 Americans have died in war, either in combat, on account of disease, in accidents, or under other circumstances. More than 1,500,000 Americans have been wounded. Almost all of them, though surely not all, were young. Many were in their late teens or barely out of their teens. Their lives were cut short, to something much shorter than the lives with which the rest of us have been blessed, whether or not we have made the most of what we have been given. Yet in those short lives these heroes and heroines have done far, far more, of much greater importance and worth, than what most of us have done with two, three, or four times as many years of life, and with 10, 20, or 50 times as much adult life. It truly is sobering. To all of those who served and serve, thank you.

Taxing the Internet: Reprise

Three years ago, in Taxing the Internet, I reacted to a series of proposals to "tax the Internet." Explaining that taxing the Internet is like taxing a highway, I explained that the proposals actually consisted of two ideas: "One is taxation of transactions and activities conducted on or through the internet. The other is taxation of access to the internet. Continuing with the "information superhighway" metaphor, the first is similar to taxing gasoline used by vehicles to drive on a toll road, and the second is similar to the toll charged for access to the toll road."

It's time to revisit the question. Why? Senator Enzi has introduced a bill allowing states to impose sales tax collection responsibilities on internet sellers that have no other connection with the state. Lobbying for the proposal, deceptively named the Streamlined Sales Tax Agreement, has been intensifying, orchestrated and led by state governments that somehow seem incapable of enforcing their own use taxes on their citizens. Of course, it's understandable that state politicians would prefer to put tax collection duties on merchants, considering that the alternative -- collecting the use tax -- would be too obvious to state citizens. It's also cheaper to have merchants in other states -- who have no voting rights in the state imposing the sales tax -- bear the collection burden. But is it right?

On top of this renewed effort galvanized by a perception that the new Congress is more tax friendly, state and local governments are seeking power to impose taxes on Internet access. According to this story yesterday by Declan McCullagh, one senator even predicts taxes on email. Now there's an idea that should earn someone a nomination to the high intelligence hall of fame.

The justification is amazing. Enzi claims that states are losing sales tax revenue, and thus will be compelled to raise income and property taxes. The problem with this claim is that states have no right to collect sales tax on transactions taking place outside the state. What's hurting the states is their unwillingness to do what must be done to collect use taxes. These ancient bureaucracies, some of which have only recently become familiar with the Internet and still have miles to go before their web sites are as good as they can and should be, struggle to make adjustments as the world around them changes. How easy to pass the work off to distant merchants.

The director of federal relations at the National Governors Association claimed, "The independent and sovereign authority of states to develop their own revenue systems is a basic tenet of self government and our federal system." Really? There does happen to be something called the federal Constitution, and the last time I looked at the case law state 1 has no "independent and sovereign authority" to impose a sales tax on a transaction that takes place in state 2. Whether the state 1 resident travels to state 2, phones a merchant in state 2, or contacts the merchant in state 2 through the internet, state 1 is powerless to impose any tax until the state 1 resident returns to state 1 with the item. If state 1's legislature and tax bureaucracy cannot figure out how to do that, perhaps they can resign and make room for those who do. If the fear is that state 1's residents don't want a use tax, or don't want to pay one, then state 1 needs to repeal its use tax, and even its sales tax, and enact whatever tax its residents wish to have.

The so-called Streamlined Sales Tax Agreement supposedly deals with the existence of more than 7,500 taxing jurisdictions, each with its own definitions and rules with respect to sales taxes. That prediction is nothing more than a promise. It's another of those "trust us and we will spare you the details" arrangements of which politicians are so fond.

Three years ago I set forth the principle that should apply when dealing with this issue:

when it comes to taxing transactions and activities conducted on or through the internet, or taxing access to the internet, those transactions, activities and access should be taxed no differently from the way in which transactions and activities conducted through means other than the internet are taxed.

I pointed out that "This principle, though, is ignored by those who take either extreme position with respect to taxation and the internet." Goodness, no one has proven me wrong. Those entrusted with the care of the nation continue to behave as though they never sat through a tax class. Oh, wait, most of them haven't and most of the ones who did were there reluctantly. Tax? Boring. Too difficult. Of course. It's extremely important and it requires serious diligence. Not willing to pay the price? Don't meddle with something about which not enough is known by the meddler.

As I re-read my three-year old Taxing the Internet, I see descriptions of the same arguments being advanced today by the "tax the Internet" crowd and by the "no taxes at all" group. The flaws in the rationales for taxing email continue to exist. I urge all those involved with, or interested in, this latest round of "tax the Internet" to read Taxing the Internet. Then it will be fairly easy to understand my proposal: "(1) tax access as is taxed telephone and cable access, (2) tax retail transactions as catalog sales are taxed, imposing use tax collection responsibilities on those with sufficient nexus to the taxing state, (3) eliminate and prohibit "Internet only" taxes, and (4) find another way to deal with spammers, casinos, and other social behavior that is considered unacceptable or inappropriate."

Now what are the odds that politicians will follow this sensible approach?

Turnpike Cash Grab Heats Up

About three months ago, in Selling Off Government Revenue Streams: Good Idea or Bad?, I explored the wisdom of proposals to have Pennsylvania and New Jersey sell their toll roads to private enterprises in exchange for lump sums that presumably would be used to reduce taxes. Though I approached the issue with a list of questions, there's no hiding my disfavor for the idea. There are too many risks, and insufficient benefits, to embark on this quick money grab.

Yesterday brought news, more fully reported in this story, that the governor of Pennsylvania has submitted his "turnpike lease plan" to the legislature. The carrot that he dangles is a suggestion that the proceeds of the deal would pay for repairs to the state's damaged roads and bridges and might even generate funds for public transit. There are no guarantees, are there? Yes, there is one. Analysts and the governor's deputy chief of staff point out that under the plan, tolls will increase. No kidding.

The Philadelphia Inquirer story explains that the current $19.75 toll for the main eastbound section could climb to $287.20 in 50 years. Wow. The governor's response? No problem, people's salaries will increase. Sure. If the past few years are any indication, most people will far less of an increase than the projected toll increase, which might explain who would see the increase in income. The folks with enough spare cash to buy, oh, sorry, lease, the turnpike.

Why charge turnpike users to fix other highways? Why not impose tolls on I-76 east of Valley Forge, I-95, I-80, I-468 south of Plymouth meeting, and on other, highly traveled routes? Those whose driving contributes to the deterioration of roads and bridges should be the ones who pay. It's called a user fee, and in this instance they make sense, particularly with the sorts of technology now available that eliminates the need to build toll booths.

The plan can be classified under the "trust us" category. The governor seeks legislative authority to solicit bids and to select a lessee, without any additional involvement by the legislature. It is difficult to imagine any legislature, let alone Pennsylvania's, abdicating its authority and handing the golden goose to the governor. Of course, everyone knows that the proposal transmitted yesterday is nothing more than a first offer.

Not surprisingly, more than a few legislators oppose the idea. Letters to editors and other expressions of public opinion confirm that there is no groundswell of support among Pennsylvania residents. Considering Harrisburg's track record, it's a wonder anyone in the state is comfortable with anything that happens in the capital.

The administration, taking cues from the private sector, is using the term "monetize" to describe its goal. Sadly, some people can be persuaded that an idea is worthwhile because a fancy, glittering, snazzy word is invented to describe it. It's one of those qualities of post-modern culture that doesn't endear itself to me. Neither does the term "post-modern," but I'm not ready to campaign for a more descriptive and sensible term to describe our current culture. Finding one that will get past the censors is part of the challenge.

The icing on the cake is that the administration continues to hold back information on all but one of the 48 proposals that have been received. The one that has been made public? The information received from the Turnpike Commission. In other words, the governor wants the ok to make a deal without telling any of us anything other than his final decision. How would anyone know if that deal was the best possible, and in the best interests of the Commonwealth and its citizens? Remember that third great lie? "Hi, I'm from the government and I'm here to help you."

Somehow, it has been learned that proposals have been submitted by New York investment banks, the governor's former employers, previous employers of New Jersey's governor, law firms, construction companies, a think tank, and international developers. A think tank? Theory this and theory that? Perhaps we will pay theoretical tolls to ride on theoretical roads? Law firms? Running a toll road? What's next, attorneys doing heart surgery?

Ought not this entire scheme be put in front of voters through a referendum? I wonder if the outcome in last week's referendum has generated some distaste for a repeat with respect to the turnpike shuffle?

No Deductions for Medical Marijuana Distribution Expenses

A recent case highlights the inconsistent boundaries that the tax laws draw between different types of illegal activity. It's no wonder that students and practitioners alike struggle to reconcile the differences.

First, some general background. The IRS, in regulations, has concluded that an otherwise deductible trade or business expense is not disallowed merely because allowing the deduction would frustrate a sharply defined public policy. Despite that position, some courts had held, under some circumstances, that otherwise deductible expenses should not be allowed if the allowance would frustrate a sharply defined public policy. In 1958, in Commissioner v. Sullivan, 356 U.S. 27 (1958), the Supreme Court held that business expenses paid by a taxpayer operating an illegal bookmaking business were deductible because they were ordinary and necessary expenses of the business, noting in dictum that if the expenses were paid to avoid the consequences of violating the law or otherwise contravened federal policy. Seemingly, this overruled an earlier Tax Court decision in which a taxpayer illegally selling whiskey was prohibited from treating the cost of confiscated liquor either as part of cost of goods sold or as a loss, based on public policy grounds.

Yet even though the Supreme Court seemed to have limited the denial of deductions on public policy grounds, lower courts proceeded to render decision that were inconsistent. In some instances, deductions were not disallowed solely due to the illegality of the business. For example, taxpayers running illegal numbers games, illegal lotteries, and illegal gambling operations were allowed to deduct the expenses of their businesses. Nonetheless, the Tax Court held that no deduction was permitted for illegal gambling proceeds forfeited to the government, and other courts held that no deductions were permitted for the value of illegal gambling devices seized by authorities.

On the other hand, taxpayers have been permitted to include in cost of goods sold the amounts paid for extra bottles of liquor purchased illegally at posted prices. Yet life insurance agents were not permitted to deduct rebates illegally paid to persons buying policies, even though in once instance the deduction was allowed because the insurance commission knew that rebates were being paid. A taxpayer convicted of price fixing was permitted to deduct rebates granted by the taxpayer in order to meet the competitors' prices.

Despite the position taken in the regulations, the IRS has concluded the compensation paid to someone to burn down a building is not deductible. The Tax Court has treated blackmail payments as nondeductible, but on the ground that blackmail payments are not ordinary expenses.

Second, some specific background. In a series of cases in the late 1970s and early 1980s, the Tax Court held that persons engaged in selling or transporting illegal drugs were permitted to deduct the expenses paid or incurred in connection with their business activities. In response, Congress enacted section 280E, denying deductions for "any amount paid or incurred during the taxable year in carrying on any illegal drug sale trade or business." Congress explained that it so acted because there is a "sharply defined public policy against drug dealing."

Third, the case. In Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. No. 14 (2007), the Tax Court was presented with the deductibility of expenses incurred by an organization that provided its members with medical marijuana pursuant to the California Compassionate Use Act of 1996 and instructed those individuals on how to use medical marijuana to benefit their health. CHAMP (what an acronym!) required each member to have a doctor’s letter recommending marijuana as part of his or her therapy and an unexpired photo identification card from the California Department of Public Health verifying the authenticity of the doctor’s letter. CHAMP prohibited its members from reselling or redistributing the medical marijuana they received.

The Tax Court determined that section 280E applied to CHAMP's drug distribution expenses. The court held that CHAMP's activities constituted trafficking in illegal drugs. It also held that section 280E does not disallow all of CHAMP's deductions, but only those connected with the drug distribution activities. Finally, the court decided that CHAMP had two businesses, providing care to its members and providing medical marijuana.

Fourth, my two cents. The court's decision was inevitable. Section 280E says what it says. It's tough to see how the court could have reasoned to any other conclusion.

The case, though, presents several questions:

1. Why should the deductibility of an expense turn on the nature of the business? Persons engaged in illegal activities don't pay higher bridge tolls, sales taxes, or real property taxes, so increasing their income tax liabilities seems inconsistent.

2. Why should the tax law be used to enforce other laws? Is the IRS really that much more efficient than the agencies primarily responsible for enforcing non-revenue law?

3. Does anyone think that the denial of the deduction actually deters people from engaging in illegal activities?

4. Why dedicate a Code provision to the denial of deductions for the expenses incurred by dealers in illegal drugs, without dedicating Code provisions to the denial of deductions for the expenses incurred by dealers in illegal guns, illegal fireworks, illegal counterfeit products, and stolen goods?

I guess each of my rhetorical questions is worth half a cent. Surely tax practitioners asked for advice about the deductibility of expenses incurred by clients who are operating near the boundary between legal and illegal activities will cost more.

Taxes and School Funding

Last Friday, in A Perplexing Tax Vote Decision, I looked at the local school district income tax proposal and noted, "It will be interesting to see what happens on Tuesday." I concluded that "I don't have any clue as to the fate of the proposals."

Now, I do, after reading this story. The proposal was overwhelmingly rejected. Not only did it fail in all but 4 school districts in the entire state reject it, including 63 of the 64 school districts in the Philadelphia area, the margins of disapproval were significant. The voters have spoken.

What's next?

Three ideas are getting attention. The first is an increase in the state sales tax, dedicated to school funding. The second is an increase in the state income tax. The third is an increased emphasis on cutting school spending.

The sales tax is pretty much as regressive a tax as is the local property tax. It's difficult to imagine the folks on fixed incomes trying to deal with real property tax increases being any more thrilled with a sales tax increase than they have been with property tax increases. The difference is that the legislature can vote to increase the sales tax without holding a referendum. Considering the voter backlash last November against Pennsylvania legislators whose antics did not earn much admiration, one must wonder if the state legislature would be agreeable to a sales tax increase.

Increases in the state income tax are certain to face all sorts of challenges. Some legislators already are setting up their position by noting that "people don't want taxes increased, period." If voters nixed local income taxes, why would they support increases in state income taxes?

Cutting school spending is a soundbite phrase almost as old as the hills. The challenge in cutting school spending is finding the expenditures to cut. If we value our children and their education, it makes no sense to cut teacher salaries, already too low for all the things they are called to do and the roles they must fulfill. One local school cut its foreign language programs. How short-sighted. The school board did so under the pressure of "cut school funding" from taxpayers, who I suppose must think that the residents of the planet will speak English to accommodate their children. Anyone who proposes a cut in athletic programs must be ready for a barrage of bitter invective.

Let's face it. Good things don't come cheap. We get what we pay for. There may be some waste and bad decision making in school spending, but surely it doesn't count for so much that elimination would generate any sort of noticeable tax decrease. There are inefficiencies, but it is unlikely that proposals to eliminate them would fall on happy ears. Some state legislators are knocking on this door, suggesting that the state reduce the number of mandates it imposes on local schools. The twist to this issue is that the federal government has been adding to the list of mandates for many decades, with little regard for the funding challenges presented to local taxpayers.

The tax question is not the problem but a symptom. The discussion needs to focus on the tension between what people want schools to do and what people are willing to pay for whatever it is that schools do. The more people demand that schools provide everything for everybody, the more expensive it will be to operate the schools. For the discussion to make sense, the schools need to disclose their expenditures in ways that educate the taxpayers. The true cost of each program, each mandate, and each activity needs to be publicized. Some school districts do this, some come close, and others don't. Many taxpayers don't look at the details, even though we live in a world where details matter and in a world where many people don't like details. Fix that and the door might open to a meaningful examination of the underlying problem.

Getting to Know You, from Taxgirl

A 17-question virtual interview of yours truly has been posted by Lawmummy on theTaxgirl Blog. It was nice to have an opportunity to share some thoughts that I almost certainly would not have shared on MauledAgain on my own initiative. There's more on Taxgirl Blog than just the "Getting to Know You Tuesday" feature. For example, there's "Fix the Tax Code Friday," quite an ambitious undertaking. There's commentary and news. It's well worth a visit.

P.S. My next post will look at the outcome of the local tax reform proposals that on yesterday's Pennsylvania primary election slate. They don't get the headlines and television coverage of other questions, such as the Philadelphia mayoralty race.

A Downside to Electronic Tax Filing

Today brings another increase in postage rates. This development can be seen as yet another reason to endorse and use electronic tax filing. For me, though, that consideration is offset by a new disadvantage of electronic filing, namely, the opportunity to use a particular postage stamp on envelopes transmitting tax returns and tax forms.

Among the new 41 cent postage stamps is one carrying the image of Darth Maul. Go to this story, scroll down to the Star War series, and then click several times.

It would have helped had his name appeared on the stamp. Think of all those unfortunate folks who don't know about Darth Maul.

Don't ask where the "e" went. It's an easily misspelled name. If you are so inclined, you can slog through a long, technical explanation, called A DISCOURSE ON THE SURNAME "MAULE" AND ITS VARIANTS. Pop quiz next week.

Note to self: Add to one of my "to do" lists the task of getting my picture on a widely circulated postage stamp.

A Perplexing Tax Vote Decision

Along with the usual nominee selection decisions, next Tuesday's primary election also contains a tax question for voters living in some school districts. The question is whether the district should adopt a plan that will provide property tax abatements, financed by an income tax and some projected but not guaranteed state funds from gambling revenue. The plan is complicated, debate has been underway for quite a while, many people are frustrated by extent of guesswork involved, and many people are convinced that when all is said and done they will be paying more in taxes if the plan is adopted.

Among the many issues that have been raised, one in particular strikes me as a good example of why these sorts of major tax policy and tax reform questions are so difficult. One of the objections to the plan is that renters will become subject to a school district income tax but will not receive property tax relief because they are not property owners. The plan, as proposed by the legislature, does not take into account the portion of rent payments that reflect the landlord's need to collect enough so that property taxes can be paid. Accordingly, renters are expected to vote against the proposal because for most of them - there is an exception for renters who work in, and pay wage tax to, Philadelphia - would incur a tax increase if the proposal passes.

But what of property owners? Should the plight of the renter be taken into account in determining whether the proposal deserves an affirmative vote? I suppose many people will simply decide whether the plan reduces, or is likely to reduce, their overall tax burden, and if it does, cast a vote in favor of it. Even some people who think their tax burden would be reduced at the outset might be so untrusting of future decisions that they choose not to give their school districts access to an income tax. Other people might base their vote on their perception of the plan's fairness and practicality. For these people, the renter situation should be a factor that is taken into account.

The plight of the renter is reflected in what I call the windfall of the landlords. If the income tax is limited to wages, which is the case in some of the school districts, then the landlords will receive real estate property tax abatement checks without incurring an income tax liability. Even if the income tax reaches all income, most landlords show a net tax loss with respect to their rental activities - chiefly because of depreciation deductions - while experiencing positive cash flow. There is nothing in the plan that requires landlords to pass on to their tenants the real estate tax relief that they will obtain if the plan passes. Nor is there anything in the plan to pay real estate tax abatements to tenants, even though tenants indirectly pay real estate taxes.

So perhaps fairness dictates that the renters plight be solved, in a way that pretty much eliminates the windfall of the landlords. Theoretical determinations of fairness so suggest. But what about the practical reality? Both possible approaches pose challenges. Should landlords be required to reduce rents? How would that be accomplished? Who would determine the amount of the decrease for each tenant? Who would police and enforce the reductions? Would there not be the risk that some sort of rent control arrangement, horrible as it sounds and is, would emerge? Perhaps the alternative is better? Instead of sending property tax relief checks to landlords, the school district could send them to tenants. How would the school district determine how much each tenant should receive? How would the school district identify and locate the tenants, considering that they are not on the rolls of real property tax taxpayers? Because tenants often are highly mobile, how would school districts catch up with tenants who move from the district?

Both methods of dealing with the fairness issue would be cumbersome. Both present all sorts of administrative and logistical problems. Both present costs that would eat into the tax relief. Perhaps the solution is to exempt renters from the income tax. Supporters of the plan would balk at that solution, in part because it would reduce the available property tax relief, thus increasing the number of plan opponents, and in part because it would shrink the pool of taxpayers for future income tax increases.

If we were starting on a clean slate, the plight of the renter and the windfall of the landlords would not be a serious issue. Changing from one tax system to another, whether in whole or in part, presents transitional issues that are thornier than then underlying question of choosing a taxation type. Transitional issues are the almost insurmountable hurdle to federal income tax reform. How does one say, and not lose support by saying, "You've had a good deal that you ought not to have had, and although we're not taking away what you reaped in the past, going forward you no longer have your good deal." Transitional issues pit landlord against renter, employee against employer, cities against rural areas, and young against old. The person who finds a way to close these divides indeed will deserve the praise he or she earns. No such person has yet appeared.

It will be interesting to see what happens on Tuesday. I haven't seen anything that projects the outcome, probably, I suppose, because the nomination races - such as that for Democratic nominee for mayor of Philadelphia - are getting most or all of the attention. So I don't have any clue as to the fate of the proposals. Do you?

When Your Client is a Dog

A former student, helping me prove what I tell my classes, namely, "we don't need to make up hypotheticals," sent along this story about the appointment of an attorney to represent a dog. A man who committed suicide, though worth several million dollars, did not have a will. Are the survivors fighting over the money? Yes, but they're putting their best efforts into attempts to get ownership of his golden retriever.

Four people claim the dog. The decedent's parents, who are divorced, each claim a right to Alex, now 13 years old. The decedent's fiancee also was interested in having Alex. To round out the quartet, the decedent's former girlfriend put in a claim, noting that the dog stayed with her because the decedent's father, who has had custody since his son's death, has cats in his house. The former girlfriend has known Alex since he was a puppy.

It doesn't take a degree in psychology to understand what's really going on. The dog's attorney put it best when he explained that the case "is similar to a bitter custody battle involving children" to which they bring their attempts "to punish each other for past transgressions." In the Decedents' Estates and Trusts course that I teach, I try to persuade my students that there is more to lawyering than knowing law, and that learning how to deal with people and reach beyond black-letter rules is essential to developing a successful practice, no matter the area of law under consideration. Stories such as this one demonstrate why it is so important for law faculty to acclimate students to the realities of their clients' lives.

One of the issues I pose to my students early in that course is why people should have wills. Like most people, many law students think that wills and estate planning are luxuries for the wealthy. I ask my students whether they care who gets their clothes, i-pods, and books, pointing out that even if saddled with student loans, the banks are unlikely to seek ownership of these items. I then ask them if they have pets. From year to year, the response rate remains about the same, somewhere in the neighborhood of one-half. "Who gets your dog?" I ask them. They look at me as though I am out of touch with reality. Perhaps they will be lucky, and no one will fight over their pets. Perhaps they will be busy fighting over their emails. But that is a different story for another day, although I have mentioned it in the past, in this series of commentary: Sorry I Wrote....? , The Impact of Death on Web-Based Content, Now It's Time for Taxes Meet Emails at Death, and News in the "Emails at Death" Case.

Oh, the judge in the case awarded cyclical custody to the decedent's parents. Each will have the dog for two weeks at a time. I'm not so sure that this is good for the dog. The mother has expressed an intent to permit the fiancee to spend time with Alex.

Cutting Off One's Tax Nose to Spite One's Ex-Spouse's Face

It is a fascinating scenario. It begins as do millions of similar tales. A couple is getting divorced. The wife seeks a settlement that includes her share of the value of the husband's business. The husband seeks to put as low a value as possible on the business. There's a tangent percolating there, which will blossom in full flower when husband, a year or two later, tries to convince a lender that the business is worth many times what it was worth at the time of the divorce.

One way of valuing a business is to examine its gross receipts. Generally, higher gross receipts correlate with higher value. So wife asserts that the actual gross receipts of the business are higher than what has been reported on the couple's tax returns over the years.

Could it be that wife has made a startling discovery? One that shocks her not only in terms of the property settlement discussions and litigation but also in terms of the tax return? Could it be that the wife finds herself as having signed tax returns that understated gross receipts and thus taxable income?

Absolutely not. Wife, it turns out, was the bookkeeper for the business. This is how she knows the gross receipts were understated. And according to wife's lawyer, she is ready to testify to this effect.

Wow.

So wife, trying to make life difficult for the husband, now is prepared to testify under oath that she, as bookkeeper, was involved in the underreporting of gross receipts, gross income, and taxable income. After all, she signed a joint return as to which she had knowledge of unreported cash receipts she handled as bookkeeper.

If wife is telling the truth at this point, either she is a strangely incompetent bookkeeper, a highly unlikely outcome, or she participated in tax fraud. If the wife is lying at this point, then she is attempting to commit fraud with respect to the valuation issue that has arisen in connection with the divorce proceeding, a fraud on both husband and the court.

Wife has an attorney. He has issued a subpoena to the accountant. Seemingly determined to prevail on the valuation issue, he appears to have overlooked the tax compliance implications. It's a common phenomenon among law students to analyze a problem or hypothetical question by zooming in on one issue to the detriment of related matters. Students often struggle with, and complain about, professorial attempts to get them to pull back and look at the larger picture. The word "tangents" pops up in evaluations critical of the course and the teaching. Oh, were life and law so simple.

More than once have we seen situations in which a wife asserts that the husband's mistress was the bookkeeper and they were in cahoots to make the income (and thus the value) of the business lower so that wife gets less than the amount to which she thinks she is entitled. If wife is correct, on this point she earns sympathy (which she may or may not forfeit once the rest of the story is told). Yet it's a totally different thing for the wife herself to assert that she herself either (a) assisted in making the amounts on the tax return lower than what she knew them to be from doing the bookkeeping work or (b) signed a joint return showing gross receipts less than what she knew they should be. Why in the world would she admit to such behavior, when, if she succeeds, she is damning herself with her own testimony?

Someone suggested that the answer is greed. Perhaps. Yet ultimately the effect of wife's testimony will be a visit or call or letter from the IRS, and what's left for husband and wife to share will probably be reduced to the point that wife ends up with less than she would have received had she not said anything. Supposedly, in the situation being described, despite the business having some value, the couple is pretty much close to broke.

Someone else pointed out that "rational decision making goes out the window in many divorce cases, as many spouses adopt a 'Give me what I want or I will take us both down' attitude." Or as someone else put it, in a "divorce case[, t]he hatred is so intense . . . . each party does not care what the consequences to themselves will be, only that it will bring shame or harm to their soon to be ex-spouse." It turns out that the situation isn't as unusual as I would have expected. Unhappy spouses often threaten to expose financial wrongdoing in which both have participated, such as hidden offshore bank accounts, unreported income, or jointly embezzled funds. It's one thing, though, for these threats to pass between the spouses, and another for them to be elevated into the public arena through subpoena and litigation.

Someone asked, rhetorically, "Is it wise to admit under oath assistance in tax fraud?" and then answered his own question, "Obviously not."

It seems wisdom, like rational thought, too often takes a back seat to emotion. Such is perhaps both the blessing and curse of the human condition.

An Epidemic of Cheating: Tax and Otherwise

It is so disheartening. For me, what some might see as two seemingly unrelated recent stories easily connect, and in turn mesh with an ongoing story. Paul Caron of TaxProf Blog relayed a Wall Street Journal story telling us that "55% of Lawyers Pad Bills; 35% Double Bill" and highlighted with this news: "Study Suggests Significant Billing Abuse." Five thousand attorneys were surveyed by a Samford University Cumberland School of Law professor, and 251 replied. More than half, up from 40% a decade ago, admitted "they had sometimes performed unnecessary tasks just to bump up their billable output." Some clients are billed for work that isn't done, and others are billed for time exceeding the time actually invested for the client. More than a third of the attorneys admit to "double billing," the practice of billing one client for travel time while using that time to do work for another client who is billed for that time. Only 52% of attorneys consider the practice unethical, down from almost-two thirds a decade ago.

Perhaps the typical non-attorney's reaction simply is that everyone knows that attorneys, or most attorneys, or many attorneys, cheat. For those who view lawyers as having the classic stereotypical lawyer personality, the news is probably not a surprise. Unfortunately, it simply fuels the stereotype.

Many of those who single out attorneys as dishonest might consider them a breed apart from the rest of the population. But the second story refutes such a view of society. According to a CNN story, the largest cheating scandal in the history of Duke's business school triggered the proposed expulsion of nine students, the proposed suspensions of another 15, and grade reductions for yet another 10. The university expects the students to appeal. Those who think lawyers have some sort of monopoly or near monopoly on cheating ought to consider the finding of a Rutgers University professor whose surveys revealed that 56 percent of MBA students admitted cheating in 2005, compared to 47 percent of students in other graduate programs.

It's a total disgrace. This sort of cheating is designed to do one thing, and only one thing. It is designed to persuade others that the cheater has attained a level of accomplishment that the cheater does not have. In the long run, not only does the cheater suffer but many others can end up dead, injured, impoverished, or otherwise damaged.

Think about it. Someone cheats on a statistics exam. A few years later, the student, now being paid by an employer to do work, is asked to prepare a report requiring knowledge and understanding statistics. Does the person cheat again? How? Trick someone else into doing the work? Or does the person turn in a flawed report? Do we want engineers who cheated through school certifying airframes? Do we want physicians who cheated through school performing surgery? What's the point of trying to persuade others that a particular accomplishment exists when the lack of skill is going to be discovered sooner rather than later?

The excuses that cheating is necessary because the material is too difficult, or because there wasn't enough time to study because of other commitments, are terrible excuses. If the material is too difficult, withdraw from the program and find something that is manageable. If there isn't enough time, reorganize the schedule or postpone studies until there is enough time.

According to the Duke business school cheating story, if the proposed punishments hold, the determinations will remain on the students' records for three months to three years. Why? Is there some magic that turns a cheater into a non-cheater after three months or three years elapse? More than 1,140 individuals applied for the 411 openings in the program, so what's the disadvantage to the school of kicking out the cheaters and taking in some of the 729 who didn't get in when they applied?

Is it any wonder that tax cheating is so rampant? So long as most students who cheat don't get caught, they will conclude that they have at least as much a chance of success when it comes to cheating with respect to taxes. Yes, the type of cheating that takes place with respect to taxes isn't so much a matter of trying to persuade someone that an absent or weak skill exists in high quality as it is a matter of trying to avoid an obligation. The similarities aren't difficult to spot, though, because both types of cheating involve trying to get something that isn't deserved (a high grade, a degree, extra money) while making a presentation (exam, paper, tax return) that isn't a true reflection of what it should be indicating.

To be fair to the schools and to the legal system, integrity is a value that needs to be learned early in life. Parents need to instill qualities in their children long before the children head off for their education. Why is cheating so rampant? Do parents not value integrity? Do they not know how to teach it to their children? Is peer pressure to cheat too strong when compared with beneficial influences? Has the pretense of post-modern "reconstructionism" affirmed the notion of pretending to have skills one does not have? Is cheating rewarded far too often and punished far too infrequently? Are the punishments for cheating too lenient? Society had best answer these questions, and answer them quickly. The alternative is more than worrisome.

Tax Records: Don't Let Go

Recently an interesting question was posed to tax practitioners and taxpayers: How long should tax records be retained?

Answering the question requires a definition of tax records. Tax returns are tax records. So, too, are supporting schedules not filed as part of tax returns. Also included are the receipts, contracts, and other documentation that justify the inclusions, exclusions, deduction, and credits reported and claimed on the return.

Many commentators look at statutes of limitations and conclude that once a statute closes, it's acceptable to trash (or shred) the files. I disagree.

My answer to the question is simply "forever." In an age when information can be digitized and preserved, the principal objection that traditionally has been raised, the need for storage space, can be dismissed as insignificant. Yes, there are some issues. Relying on a program like Turbotax to be the archive is dangerous; when I installed my first Windows XP system I discovered that earlier versions of Turbotax could not be loaded and thus there was no way to access the datafiles created by Turbotax. But the print-outs of the returns can be scanned and retained in a format no so proprietary as that used by Turbotax. It would not be surprising to discover that an enterprising entrepreneur will write a utility that permits read-only access to tax returns stored in proprietary format.

Why do I say "forever"?

First, to assume that a statute of limitations has closed is to put too much faith in the IRS taking the same view of the taxpayer's return as does the taxpayer. If the IRS asserts fraud, despite the fact it has the burden of proof, a savvy and prepared taxpayer should have in hand the documentation to refute any IRS allegations.

Second, to trust the IRS to provide a copy of an old return is to put too much faith in the IRS computer systems. The sorry state of IRS technology is well documented.

Third, tax data may be useful in litigation that deals with years for which the tax statute of limitations has closed. Tax data has value for more than simply determination of tax liability.

Fourth, many tax computations use adjusted basis, which in turn reflects transactions entered into during all the years that the taxpayer has owned the property or predecessor property and perhaps years during which the taxpayer's predecessor owned the property. Tossing a stock purchase record or a home improvement invoice once the tax statute of limitations closes for the year in question is foolish. Even if the IRS were totally reliable in producing old tax returns, even if the IRS accepted the taxpayer's denial of fraud, and even if tax data were useless in other litigation, this fourth reason alone compels the retention of tax records.

Strangely, the IRS itself advises taxpayers to dispose of records after specific periods of time, usually three to seven years. I'm not about to rely on IRS advice with respect to this issue. In all fairness, the IRS describes the period for which records MUST be retained, whereas I'm addressing the question of whether it is prudent to dispose of tax records for longer periods. And in all fairness, the IRS advises retaining records with respect to property until three to seven years after the taxpayer disposes of the property.

Considering how much time it would take to sort through each year's tax file, it's faster, safer, and cheaper simply to retain the file. If space is an issue, digitize it. In the long run, it makes the most sense.