How Simple and Fair is Fair?

Advocates of the Fair Tax are treating Mike Huckabee's victory in the Iowa Republican caucus as a triumph for the Fair Tax proposal. According to the Fair Tax web site, Huckabee's victory indicates that the Fair Tax proposal is getting ready to sweep into the next set of primaries as a prominent factor in the 2008 election. It is not unrealistic to suppose that during the next few months, the Fair Tax proposal will get even more attention, though it is competing with a variety of other hot-button issues. Keeping public attention on the details of a tax issue is challenging, but important.

What is the Fair Tax?

The Fair Tax website lays out the basics. Under the Fair Tax, all federal personal and corporate income taxes would be repealed. So, too, would be the gift tax, the estate tax, the alternative minimum tax, social security taxes, medicare taxes, and self-employment taxes. Surely that will get people's attention. These federal taxes are replaced with a federal retail sales tax administered by state sales tax officials in state revenue departments. Each household would receive a check covering the estimated tax on expenditures up to the household's annual consumption allowance. This so-called prebate is intended to eliminate the proposed sales tax on expenditures up to the poverty level.

Proponents of the Fair Tax claim that one of its advantages is the elimination of the IRS. They assert that it would be a very simple system. They also claim that it would enable workers to keep their entire paycheck, retirees to keep their entire pension, American products to compete fairly, Social Security and Medicare funds to be maintained, along with some other alleged benefits.

Criticism of the Fair Tax is easy to find. One can read analyses by Bruce Bartlett, Linda Beale, The New York Times, and others. There have been so many criticisms that the Fair Tax advocates have dedicated a portion of their web site for rebuttals of the criticisms.

For the moment, I am going to focus on five concerns. The Fair Tax is not as simple as alleged. The administration of the Fair Tax will not be uniform. People will not keep their entire paychecks and pensions. To provide the promised funding, the Fair Tax will raise overall federal tax revenues. The Fair Tax isn't necessarily fair.

Though advocates of the Fair Tax assert it is simple and transparent, consider the proposed definition of a household and who is considered to be a member:

The term “qualified family” means one or more family members sharing a common residence. A qualified family consists of all family members sharing the common residence. Family members include an individual and his or her spouse, children and grandchildren, parents, and grandparents. Children/students living away from home are considered family members if they are registered as a student for at least five months out of the year and receive at least 50 percent of their support from the family unit. Children of divorced parents are considered to be family members of the custodial parent. Incarcerated individuals are not eligible to be members of a qualified family.
In order for a person to be counted as a member of the family for purposes of determining the size of the qualified family, a person must have a valid Social Security number and be a lawful resident of the United States. Unlike the Earned Income Tax Credit, the application/registration form that families who choose to receive the prebate must file is simple and straightforward. Those choosing not to register will not receive a prebate. The registration form requires only the following information:
1. The name of each family member who shares the residence;
2. the Social Security number of each family member;
3. the family member to whom the monthly prebate check should be paid;
4. a sworn statement that all listed family members are lawful residents, that all family members sharing the common residence are listed, and that no listed family members are incarcerated;
5. the address of the shared residence; and
6. the signature of all family members 21 years of age and older.

Each of the terms in this description need to be defined. What is a common residence? Who is the spouse? Is a person a spouse if he or she abandons the residence during the year? Who qualifies as a student? How is support calculated? What constitutes incarceration? What happens if someone is not a member of the household for some portion of the year due to illness? How are kidnaped children counted? In other words, all of the complexities that afflict sections 151 and 152 of the current Internal Revenue Code would still be with us. There are special rules for hobby losses that resemble section 183, special rules for gaming activities, an exemption for intermediate sales, provisions affecting purchases by governments, rules for mixed-use property, not-for-profit organizations, and financial intermediation services. Each of these provisions includes all sorts of terms that need to be defined. For example, the need for complex definitions dealing with non-profit organizations will be no less under the Fair Tax than under the current income tax. Bottom line? The Fair Tax is nowhere near as simple as advertised. That it is presumably less complicated than the current income tax is not a noteworthy achievement. Everything is less complicated that the current income tax.

The proposed administration of the Fair Tax will be a nightmare. Advocates of the Fair Tax, intent on eliminating the IRS, propose that each state administer the program through their revenue departments. What about states without a sales tax? Will they be compelled to create special departments to handle their Fair Tax duties? Where do they find people to administer the tax? Hire them away from other states? Outsource the work to other nations? Have the advocates of the Fair Tax ever taken a close look at the administration of state sales (and use) taxes? Do they think this is an improvement over IRS administration? What if one state defines a non-profit organization differently than does another? What if one state deals with kidnaped children differently than another? A tax that is not administered uniformly is not fair.

The assertion that workers will keep their entire paychecks and retirees their entire pensions is a semantic tap dance. When workers and retirees pay the proposed federal sales tax, they will be using part of their paychecks and pensions. Whether tax is withheld, or paid out of pocket, when the dust settles, the person does not have in his or her hand all of the paycheck or pension. A tax is a tax. Trying to fool people into thinking that they will receive a paycheck and not pay any taxes because there is no withholding is the style of snake oil sales reps. Playing on people's misunderstandings is manipulative. And wrong.

Advocates of the Fair Tax claim that enough revenue will be raised to fund Social Security, Medicare, and other federal programs. If that's to be the case, then the Fair Tax must raise more revenue than do current federal taxes, because the current system is causing the nation to incur deficits. In other words, the Fair Tax would increase federal revenue. That means somebody's federal tax payments will increase. Or perhaps a bunch of somebodies will incur tax hikes. Why not advertise this fact? Why lure people into thinking that the Fair Tax will reduce everyone's taxes and yet somehow increase total tax revenue? Something is out of whack.

The Fair Tax isn't all that fair. The impact on the people with incomes at or below the poverty line would be minimal, because the prebate would offset the taxes they pay. In contrast, because the wealthy spend relatively little of their income, their tax burden would be far less than what it would be if it applied to their entire income. So who pays the bill? The middle class, which spends most of its income and which therefore would pay a higher percentage of its income in tax than would the poor or the rich. Somehow, it seems to me that the Fair Tax is a refined version of what has been done with the income tax, namely, absolve the wealthy, particularly through the special low capital gains and dividends rates, and the poor, through the earned income tax credit, and let the middle class pay. Of course, once the middle class is taxed out of existence, what will the wealthy do with the hordes of poor people, particularly when they are frustrated and feel hopeless?

Finding the actual language of the proposal on the web site isn't easy. In fact, one must go to the Library of Congress Thomas website and search for the bill language. How many people can do that? Why not put the text of the bill on the Fair Tax web site? Perhaps because once people see it, they will question some of the assertions.

A quote from the current standard bearer for the Fair Tax, presidential candidate Mike Huckabee, reveals quite a lot about his own understanding of the Fair Tax: "Instead, we will have the Fair Tax, a simple tax based on wealth.” Excuse me, Mr. Huckabee, a tax based on wealth would not be computed by reference to consumption.

Chances of the Fair Tax becoming law are between nil and none. If those who seek the unquestionably necessary change in the federal tax system could direct their energies to support of a plan that did not require complex transition, did not shift more tax burden onto the middle class, eliminated computations based on joint and household concepts, and tied ability to pay with incidence of taxation reflecting benefits provided by society, federal tax reform's chances might slip beyond none into the realm of slim and possible. I am confident that if Americans avoid the sound bites and think carefully about the Fair Tax plan, they will see whose ox is going to be gored.

Tax Cuts = Deaths?

Almost four years ago, in A Tax Trifecta: Gas, Enforcement, and Special Interests, I commented on a Philadelphia City Council plan to reduce the local tax burden of an insurance company. The tax relief followed the company's announcement that without the tax reduction it would take itself and its 1,000 jobs to some other place. I asked:

So what happens if this [plan is] approved? Are new jobs created? No. Do city tax revenues increase? No. Do city tax revenues decrease? Yes. How does the city make up for the decrease? It could reduce services, increase taxes on other taxpayers, or borrow money. The first choice drives more individual taxpayers (and small businesses) out of the city or out of business. The second choice does the same thing. The third choice requires further cuts to finance the interest payments, and poses a long-term threat to the city's financial stability. It wasn't that long ago that New York City almost defaulted on its debt.

It turns out that the first alternative, reducing services, does more than drive individual taxpayers and small businesses out of the city or out of business. It can kill people.

According to Philadelphia's City Controller, the city's ambulances are so slow in responding to emergency calls that there is only a 60 percent chance that they will arrive in time to save a person's life. In this Philadelphia Daily News report, Alan Butkovitz, the City Controller, explained that at least 40 percent of ambulance runs do not arrive within the nine minute period recommended by EMS experts as the standard, that the city has insufficient ambulances, insufficient paramedics, increasing calls for assistance, and a deteriorating communications and dispatch system. The chief of the Fire Department, which runs emergency services, admits that it is a struggle to keep up with public demand for help. The problems were anticipated by union members and by journalists, but little has been done to repair the system. Why?

The reason simply is lack of resources. The City Controller suggests that scheduled business tax cuts should be delayed. The incoming Mayor ran in part on a pledge to accelerate those cuts. What will happen? Will tax cuts be maintained? Accelerated? Postponed? Will people begin to die?

A few days after Butkovitz issued his statement, a woman died after waiting for more than an hour after calling 911 for an ambulance. According to this Philadelphia Daily News story, the ambulance that eventually showed up then broke down. It was based in south Philadelphia, and was responding to a call from Northeast Philadelphia. Not what one would call a neighborhood service. Forty minutes later another ambulance arrived but it was too late. I'm sure the City Controller is far from pleased that his prediction has come true. People are dying for want of sufficient emergency services.

In my earlier commentary on the disadvantages of tax breaks targeted for specific, usually large, business entities, I wrote "The city is in a spiral. A revenue death spiral." Little did I know that my figurative use of language would turn out to be literal. People are dying. The politicians should be more than embarrassed, and should do more than express their apologies. As I wrote almost four years ago,

How can it get out of [the revenue death spiral]? What is needed is clear: it needs a tax base. It needs jobs. It needs businesses willing to set up shop in the city and it needs people willing to live in the city. It needs a reversal of the trends of the past 30 years.

Why do people not live in the city? Most say it is the high taxes and the low quantity and quality of services. I think it is more than that. I think it is a matter of people not wanting to live or work in a place that suffers from the inefficiencies and political games that afflict Philadelphia government. People don't "see" Philadelphia as a great place to live and work. Philadelphia needs to examine WHY people are reluctant to live and work within its boundaries. It needs to ask questions and it needs to be prepared for answers that it won't like and that will cause much angst. It needs to admit that the policies of the last 30 years, even if suspended for a mayoral term here or there, don't work and should be rejected. THAT will require a huge shift in the way things are done in Philadelphia.

I concluded that "My guess is that it will not happen." I wonder if the unfortunate death of a citizen left without timely assistance will change things. Or, will my initial prediction, that "It won't happen because people are walking away rather than staying to fight for change," turn out to be correct?

When All Else Fails, Throw Tax Money At It

I wonder how many people are aware that the government, through the National Telecommunications and Information Administration, is giving away $40 coupons to help people purchase converter boxes for analog televisions that are incapable of picking up the over-the-air digital television signals that will take over broadcast television as of February 18. According to the CNN story, Government offers TV coupons, the coupon give-away began on Tuesday. Happy New Year?

According to the story, the NTIA will accept requests for two $40 coupons per household. Congress budgeted $1.5 billion to fund the coupons. After allowing for the cost of administering the program, there's enough money for 33.5 million coupons. Who gets them?

CNN reports that "The giveaway basically works under the honor system." Does that make you feel as wonderfully confident as I do that the people who need the converter boxes and who lack the resources to acquire one are the people who will get the coupons? Surely the con artists, the identity thieves, the credit card imposters, the greedy, and the troublemakers will sit this one out. What controls are in place to prevent the well-intentioned, confused, and yet affluent citizen who notices the giveaway from requesting, and getting, two coupons? Apparently, none.

The only distribution arrangement that appears to be in place is a reservation of 22 million coupons to anyone who asks for one or two. In theory, those who enacted and administer the program expect the requests to come from people who, despite having televisions connected to cable or satellite systems, also own analog televisions not connected to those systems, or who own only analog televisions without any cable or satellite connection. In practice, I predict that some coupons will be requested by people who understand that when the cable or satellite system goes down, over-the-air broadcast might be the only communication connection to the outside world, and that for analog televisions, the converter box will be necessary. Of the 33.5 coupons, 11.5 are set aside for people who do not have cable or satellite television. Even if people requesting coupons are asked about their television situation, what's to prevent them from saying what they need to say to get the coupons? And even if the honor system works perfectly, industry information suggests that there are 2.8 million more households without cable or satellite system connections than there are coupons reserved for those households.

The Government Accountability Office has criticized the NTIA, claiming that there is no comprehensive plan in place for the transition to digital television. Of the $1.5 billion set aside by Congress to finance the transition, only $5 million was earmarked for programs that explain to the public what is involved in the changeover. One survey indicates that slightly more than half of Americans do not know that the shift from analog to digital is underway. Now the government, through the FCC, is considering a regulation that will require broadcasters to donate air time to educate the public about the new technology.

It also is the government that mandated the shift from analog to digital. The change permits television stations to send a signal using much less of the broadcast spectrum than currently is used. Some of the space that is freed by the changeover will be allocated to emergency services and the rest will be auctioned off to wireless providers. That auction process also is stirring up controversy, the description of which I will leave to others.

When all is said and done, some of the taxes paid by taxpayers will be given to people regardless of genuine need, so that technological changes benefitting wireless providers can be implemented through government planning that is far from comprehensive or sensible. The government is implementing a system financed by taxpayers and designed to help not-so-poor wireless providers, with no controls to prevent $40 coupons from enriching those not in need, with no guarantees that the planned auctions will reimburse the taxpayers.

The only good news is that the coupon distribution is not tied to the tax system, was not enacted in the form of a tax credit, is not implemented by the IRS, and is not reflected on federal income tax returns. I wonder how that happened.

New Year's Tax Resolution: Careful with Those Worker Classifications

Any taxpayer who pays another person to do work should consider very carefully the payee's tax status. Is the person an employee? Or is the person an independent contractor? The determination carries significant consequences. Generally, if the payee is an employee, the payor is subject to tax withholding obligations, liability for the employer's portion of social security, possible qualified plan coverage and other fringe benefits, and other consequences. If the payee is an independent contractor, the payor might have an information reporting obligation and, in rare instances, a backup withholding responsibility, but generally far less onerous burdens than does an employee.

Although many situations are easy to diagnose, others are more challenging. That's not to say that the easily diagnosed situations are properly treated, but those instances usually sort themselves out once the IRS gets wind of the matter. On the other hand, when the relationship between the payor and the payee resembles both an employment situation and an independent contractor transaction, the chances of getting it wrong increase significantly.

The most recent situation to take center tax stage is the decision by FedEx Corporation to classify as independent contractors a group of drivers who own and maintain their own trucks while making deliveries for the company. According to this Business Week story, FedEx has reported on an SEC filing that the IRS "has tentatively concluded" that the drivers are employees. The IRS has focused on 2002, but reportedly is examining 2004 through 2006. It's a safe guess that other years also are, or will be, under the IRS microscope. A few days ago, the Massachusetts Attorney General revealed that FedEx had been fined for intentionally misclassifying 13 drivers as independent contractors who should have been classified as employees.

There's more at stake than simply income tax withholding and employer social security tax liability. The drivers in question, having been treated by FedEx as independent contractors, are not entitled to fringe benefits provided to employees. The dispute is not limited to tax issues. Some of the drivers have sued FedEx, raising employment law issues, and contending that they are employees who should receive expense reimbursements, lost wage coverage, and other fringe benefits. Because of litigation in California, FedEx is trying to restructure its arrangements with the drivers.

FedEx has announced it plans to challenge the IRS reclassification. It pins its hopes on the fact that in 1994, the IRS examined similar arrangements and agreed that the drivers were independent contractors. Because the details of that decision and the current one are not available, it is impossible to examine the many factors that enter into the employee classification determination to identify any possible differences between what was done in 1994 and what has been done more recently.

The announcement by the Massachusetts Attorney General sheds some light on the situation, though it is unclear if the same factors exist in all of the FedEx arrangements. Apparently, even though the drivers own and maintain their trucks, they are not permitted to deliver for other companies, must keep to schedules set by FedEx, and are performing the "core business" of FedEx. The work done by the drivers is not work "customarily" performed in an independent contractor manner. According to the Massachusetts Attorney General,

The Massachusetts Independent Contractor Law provides that an individual performing any service shall be considered to be an employee unless: (1) the individual is free from control and direction in connection with the performance of the service, both under his or her contract for the performance of service and in fact; and (2) the service is performed outside the usual course of the business of the employer; and, (3) the individual is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service performed.

Relying on this statute, the Attorney General concluded that FedEx had "intentionally violated all three prongs of the Independent Contractor Law."

The issue of whether a person is an employee or independent contractor has always been on the front burner. From time to time, the heat gets turned up. Considering all that is at stake, it is not unrealistic to expect even more federal and state examinations of worker classifications. Unless a payor takes pains to structure the arrangement so that the majority of the independent contractor factors are satisfied, the safer course of action is to treat the person as an employee, making appropriate salary adjustments in order to generate the funds necessary to provide social security tax and other benefits.

I cannot avoid commenting that no sort of flat tax, fair tax, curved tax, or magic tax will make this issue go away. It might morph into a different set of responsibilities and standards, but so long as there are income and similar taxes, there always will be a need to identify the relationship between a payor and a payee transacting in the market place. Perhaps abandonment of the income tax in favor of a "transaction tax" would apply to all transactions regardless of the relationship, but that's not likely to happen and ought not be something on which the hope of solving the worker classification issue should be pinned.

When is a 15% Tax Rate Not a 15% Tax Rate?

Last Wednesday, the Tax Court issued its opinion in Weiss v. Comr., 129 T.C. No. 18 (2007). The case highlights the dangers of using sound bites, as Congress often does, to describe a tax law change or tax break.

People who know something about taxation, and even some who don't, are familiar with the provision that taxes qualified dividends at 15 percent. It's quite a simple concept, even if it is objectionable. Would it not make sense, if asked for the tax on $100 of qualified dividends, to respond, "$15"? Would it not make sense to conclude that if a person shifted investments from tax-exempt bonds to stocks generating qualified dividends of $24,376, that their federal income tax liability would increase by $3,656?

Well, surprise. Adding $24,376 of qualified dividends to gross income can increase a taxpayer's federal income tax liability by much more than $3,656. Much to the taxpayer's chagrin, this point was made clear to Tobias and Gertrude Weiss by the IRS and the Tax Court. What the Weisses did was to leave the qualified dividends out of gross income, and to add $3,656 to the tax otherwise computed. That omission, however, caused their alternative minimum taxable income, and their alternative minimum tax, to be understated. It also caused their regular taxable income to be understated, because adding the qualified dividends to gross income increases adjusted gross income, and thus increases the limitations that apply to various itemized deductions. It also increases the amount of social security benefits included in gross income, an issue in the Weiss case.

This phenomenon, that the net increase in federal income tax on account of an additional dollar of qualified dividends can exceed fifteen cents, is a characteristic of the famous "bubble." A similar outcome is generated when someone in the 15-percent marginal bracket who also receives social security benefits earns an additional dollar of gross income. The tax increase can be as much as 22.5 cents.

I wrote about this problem 16 years ago, in Getting Hamr'd: Highest Applicable Marginal Rates That Nail Unsuspecting Taxpayers, 53 Tax Notes 1423 (1991). It has been cited and quoted almost a dozen times. I doubt, though, that anyone in Congress has read it. That's too bad, because repairs could be made if members of Congress understood the wool that was pulled over their eyes and the eyes of the citizenry by the folks who shoved phaseouts into the tax law as a way of raising taxes without raising rates. The alternative minimum tax, patched yet again, is so flawed that it, too, needs adjustment. Either it should be repealed and the regular tax fixed, or the regular tax should be repealed and the alternative minimum tax, in some modified form, should take center stage. Having both a regular and alternative minimum tax is nothing more than a blood-soaked band-aid masking the need for deeper surgery.

Part of me sympathizes with the Weisses. They thought that they'd be paying tax at a rate of 15 percent on their qualified dividends. That's what the politicians told them, as they toured the country crowing about the wonderful thing they had done. Unfortunately, the Weisses incurred tax on their qualified dividends at an effective rate exceeding 15 percent.

Of course, part of me doesn't sympathize with the way the Weisses filled out their tax return. They ignored the instructions, notwithstanding a feeble argument that the form and the instructions were ambiguous. On that point, the answer simply is that qualified dividends are a subset of taxable dividends. So had they filled out the form properly, they would not have invested time and money pursuing their case.

On balance, though, all of us benefit from the approach taken by the Weisses. Though they lost, they brought this embarrassing problem with the tax law into the spotlight. Nothing I write today can change the result in the Weiss case. But perhaps it will contribute to tax law reform that will spare others the same rude shock.

Tax Relief = Return to Serfdom?

The challenges faced by people on fixed incomes when local property taxes increase has been widely reported. For example, I explained one facet of the problem in Independence, Taxes, and Homeownership.

A variety of plans to alleviate the difficulties have been proposed, including one that I reviewed in Tax Relief Based on Age and Income? and a cluster of others I dissected in New Pennsylvania Tax "Reform" Doesn't Add Up.

Now another arrangement has begun to catch on with public officials in a few communities. There's quite a message in the headline for this story: New York Town Lets Senior Pay Off Property Tax Bill With Cheap Labor, which was reported on Christmas Day.

At first glance, the deal appears to be a no-brainer, win-win, great solution invention. People on fixed incomes in the town of Greenburgh, New York, trying to find ways to pay higher and higher real property taxes, can be hired by the town at $7 an hour. Their wages are used to pay a portion of their real property taxes. The town prefers that these people not sell their homes and leave, and these people want to stay. A town official suggests that it could use the services of retired physicians and accountants, lawyers, and people who can thins such as the work of receptionists. Greenburgh and its officials, however, are not the pioneers. Similar arrangements have been crafted in Concord, Massachusetts, Boulder County, Colorado, and in other locales.

At second glance, there are some disadvantages. In Boulder County, not every person who wants a job under the plan can get one. Unions worry that when the local government hires people on fixed incomes at low wage rates, the number of jobs available for union members decreases. Unless state legislatures make changes to their income tax laws, the wages earned by the people in the program are subject to state income tax, and thus the real property tax bill is not reduced by as much as the full amount of the wages. Unless the person has unused standard deduction or personal exemption deduction amounts, his or her federal income taxes also would increase.

At third glance, the arrangement appears to be a u-turn in the history of public fiscal policy. For centuries, people rendered unto their overlords and governments chiefly by providing unpaid labor. Yes, there have always been fees, customs, duties, and excises, but for most of those with little economic wealth, their "contributions" to whatever form of society existed were made in their capacity as serfs. As economies changed, and people were "untied" from the lands that they worked, a variety of taxes replaced the practice of providing services to the government through laboring on the fields or in the entourage of a nobleman. Feudal tenure, though leaving remnants of its practices and customs in modern law, faded away.

But now serfdom may be making a comeback. Imagine a society in which citizens do not pay taxes but answer government phones, teach in government schools, work in government hospitals, file papers in government offices, and perform other tasks in exchange for whatever the government provides its citizens. At what point would towns and counties try to restrain their serfs from going to another location? At what point would the serfs be prohibited from switching careers? Proponents of the arrangements, which admittedly have some positive values, probably would argue that things would never reach such a point. Without a doubt, they would claim that safeguards would remain in place. I wonder, though, what advice we would get if we could bring forward in time someone who benefitted from the practice of feudal tenure and who was told that guarantees were in place to ensure there would always be sufficient numbers of people to work the land owner's lands.

Despite the benefits of these arrangements, there is something unsettling when people on low or fixed incomes, many of them retired, must go out to the fields and offices, earning very low wages, in order to retain ownership of their homes. Will the future bring more "Will Work for Real Property Tax Relief" signs than "Will Work for Food" signs?

I suggest that those designing these arrangements, and those who inevitably will craft the second generation of such plans, go slowly and very carefully. Sometimes society doesn't realize it's riding a trend toward an undesired result until the journey is already underway.

A Tax on Christmas? Really?

According to this Daily Express political commentary, people in England face a 225 pound "stealth tax bill" for this Christmas. That's roughly US $450. The claim is that when a household adds up what it pays in value added tax on gifts, excise duties on alcohol, and fuel tax on petrol used in traveling to visit friends and relatives, it will discover that it has contributed roughly 225 pounds to a 5.65 billion tax haul by the government.

I'm in no position to dispute the calculations reported in the story. I have no basis to think that the VAT on a personal music player isn't 30 pounds, or that the excise on a bottle of champagne isn't 6 pounds. From what little I know, those figures seem to be correct. Of course, I have no idea how many bottles of champagne are purchased in England because of Christmas, let alone the number of personal music players purchased as gifts.

What bothers me is the notion that these are "stealth" taxes, in other words, taxes that are collected without anyone knowing that they are being collected. Perhaps there are people in England who do not realize a VAT is imposed on their purchases. When I've been in England, I've seen notices and packaging legends disclosing the fact that a particular percentage of the price is for VAT. The petrol pumps set forth the fuel tax. I don't know if the alcohol excise duty is prominently displayed, but I wasn't looking for it and wasn't focused on alcohol acquisition.

For me, a stealth tax exists if the seller of a product does not disclose that a portion of the price is being used to reimburse the seller for a tax paid by the seller, or if some component of an income tax computation is altered in a manner that changes effective rates without changing stated rates. The latter is a feature of the several phase-outs that infect the American Internal Revenue Code.

The terminology is not the invention of the political commentator. The Shadow Treasury Chief Secretary used the term in a criticism of the Labour government. The criticism implies in some sense that there were no VAT, fuel, or excise taxes until Gordon Brown stepped up to be prime minister. Can that really be the case?

The row over taxation, not unlike the soundbite battles to which we are treated here in the States, does generate some interesting assertions. Mike Denham, a former Treasury economist, is reported to have said: “While Santa Claus is coming down the chimney, Gordon Brown is sneaking through the back door and taking the presents from under the tree.” It definitely makes for a fine visual, and probably will inspire someone to make a cartoon for YouTube.

The same reasoning could be used to conclude that there is a stealth tax on Easter, on Valentine's Day, on every holiday, and even on people's birthdays and wedding anniversaries. I wonder how many people see it for what it is. Perhaps next year folks will ask Santa to bring a gift card entitling the bearer to some free tax law, economics, and public policy courses at one of England's many fine institutions of higher learning.

A Holiday "Gift" from the Congress

Two years ago, in Legislatures Take a Holiday From Taxes, I carped about the unwillingness and inability of legislators to schedule their tasks so that they do what they are elected to do, or to do what they are elected to do in a timely manner. I pointed out that the "ran out of time" excuse is unacceptable.

The first example that I presented in 2005 will trigger deja vu. I wrote:

First, the United States Congress whiffs on reform of the alternative minimum tax that would prevent 15 million more taxpayers, mostly from the middle class, coming within its reach for the first time in 2006, even though the tax was designed to prevent the wealthy and ultrawealthy from using deductions to lower their tax liabilities below a specified minimum. According to Senate Majority Leader Bill Frist, as reported by a number of sources, including this Los Angeles Times story, earlier this week asserted that Congress "had run out of time" to finish work on the proposed legislation fixing the problem.

Change the number of affected taxpayers, change a few names, and we're ready for the reruns.

This year, Congress managed to enact a "patch" to the AMT. I remember when I was a child, fixing my own bicycle tires and tubes, that one would reach a point where yet another patch on the tube was a guarantee of a flat tire, or worse, shortly thereafter. There are only so many patches that can be slapped onto something. If in doubt, check out patched software. But at least there is a patch, so it could have been worse.

The timing of the "patch" is awful. Congress enacted the patch and sent it to the President for his signature on December 19. Shortly thereafter, its members went home. They leave behind a cadre of IRS employees who are faced with the unenviable task of updating forms and computer software to reflect the enacted patch in time for the upcoming filing season. In When Congress Can't Do Things On Time, I explained how the legislative delay would cause all sorts of problems for taxpayers and the IRS. To its credit, the IRS, along with the Treasury Department and the President, has promised, to quote the TaxProf blog, "to minimize the disruption and delays in the tax filing season caused by the late passage of the bill." As a practical matter, the effort falls on IRS employees. Trust me, the President isn't going to be giving up his holiday break to get IRS software updated or to change tax forms. Nor is the Secretary of the Treasury.

So while the Congress and others get to enjoy this holiday period with family and friends, some IRS employees will be putting in extra hours, perhaps to the point of missing family get-togethers, to do work that they were scheduled to do one or two months ago, simply because the Congress cannot manage itself. The public has a negative view of the IRS, but can it not come to understand that the IRS is a creation of the Congress and that in this instance IRS employees are going above and beyond the call of duty to fix yet another mess created by the Congress? The idea of Congress walking out to enjoy a holiday while others must labor on isn't all that different from factory bosses and other economically powerful magnates living the high life while their employees put in long hours without holiday breaks. If Dickens were alive, he'd have material for another novel.

So this year, while enjoying the food, the gifts, the gatherings, and the fun, stop for a moment and think of the people at the IRS, and at some commercial software firms, who are racing the clock, trying to minimize or eliminate the filing season delay that can postpone your receipt of a refund that will pay for those gifts and the food. If you're one of those people caught between the Congress and the calendar, grinding away in your office so that the rest of us can begin filing tax returns on or near the usual starting time, the rest of us thank you. I have tried to make the voters aware not only of why their refunds may be delayed, but of the effort you are making to compensate for the shortcomings of a Congress afflicted by time management deficit disorder.

Taxation of Kidney Swaps: Dispelling the "Ivory Tower" Myth

Almost two years ago, in The Taxation of Kidney Swaps, I concluded that taxpayers who swapped kidneys for transplantation into their respective spouses have gross income because that's what the black letter law of tax states. I also questioned whether the IRS would pursue the matter if the taxpayers did not report gross income. About a month later, BNA published my essay, Taxation of Kidney Swaps, as part of its "Insights and Commentary" series, but the link no longer works and I cannot find the article on-line.

Only recently have I discovered that both the MauledAgain post, The Taxation of Kidney Swaps, and the BNA essay have generated reactions. In Blawg Review #46, Sean Sirrine writes: “If you want to get real serious, you can read [Prof. Maule’s] "The Taxation of Kidney Swaps" in which he makes a good argument that people who are swapping kidneys should (legally speaking) be paying taxes on the exchange. Talk about a topic to get your blood boiling!” My tax blogging colleague Joe Kristan, in KIDNEY SWAPS: NOT A 1031 EXCHANGE?, suggested, tongue in cheek I’m sure, that the solution is for the two couples to divorce and make use of the section 1041 nonrecognition provision.

But over at Tax Guru, Kerry Kerstetter recorded a question that pointed out the BNA version of Taxation of Kidney Swaps and that wondered “Can you be taxed on receipt of a kidney? What I wonder is, if you and I each have a car of equal market value and we trade them, would we be taxed? Beyond the obvious bio-ethics issues, I don't see the difference.” Kerry’s response:

As learned and entertaining as Professor Maule is, this is a perfect example of how ivory tower academics (and some attorneys I have known) love to let their imaginations go wild and conjure up scary tax scenarios out of what are actually innocent events.

If I were advising these people from my real world perspective on tax matters, I would have them sell their kidneys to each other for one dollar each and completely avoid the entire subjective valuation of a bartering transaction. While the black market price for kidneys may be as much as $50,000 (per a recent episode of Nip/Tuck), each person is actually entitled to establish her own price. While some cold-hearted bastards might say they should auction the kidneys to the highest bidders, basic private property rights allow us to set out own prices for things we own; so who is to say one dollar isn't appropriate?

They can each prepare a bill of sale for one dollar and report the transactions on Schedule D of their 1040s, with a cost basis of zero. The tax on one dollar of long term capital gain (acquisition date = date of their birth) will be the least of their worries.

When I read this planning tip two thoughts crossed my mind. First, no one in the ivory tower considers me an ivory tower academic, as I am one of the few who focuses on the law practice world far more than on the legal philosophers’ arena. Second, it just can’t be that the tax consequences of a barter exchange are avoided simply by pegging each component as a one-dollar sale. So, off I went to do some research. Not on the first question, though that might be a fun survey to conduct, but on the second.

In Rev. Rul. 79-24, 1979-1 C.B. 60, the IRS analyzed the tax treatment of barter club members who exchanged legal services for housepainting services. The IRS concluded that the fair market value of the services received by the lawyer and the housepainter was includable in income. The fair market value of the services is not a nominal one dollar, but the amount for which the services would sell or trade on the open market.

The courts that have dealt with the question make it clear that when there is an exchange, the value must be determined according to an objective market place and not according to values arbitrarily assigned by the taxpayers. For example, in Rooney v Commissioner 88 T.C. 523 (1987), the Tax Court held that “under sec. 61, I.R.C. 1954, an objective measure of fair market value must be employed to measure compensation received in goods or services; thus, Ps must include in income their share of the normal retail price of the goods and services received by the partnership.” The Court explained:

We agree with the court's reasoning in Koons. In our judgment, section 61 requires an objective measure of fair market value. See Koons v. United States, 315 F.2d at 545; Kaplan v. United States, 279 F. Supp. 709, 711 (D. Ariz. 1967). Under such standard, the petitioners may not adjust the acknowledged retail price of the goods and services received merely because they decide among themselves that such goods and services were overpriced.

The Court further concluded:

In our judgment, the petitioners must value their compensation by applying an objective measure of fair market value. For such reasons, we hold that the fair market value of the goods and services received by the petitioners is the prices charged by the partnership's clients to their retail customers.

Similarly, in Baker v. Commissioner, 88 T.C. 1282 (1987), the Tax Court explained:

Gross income includes the fair market value of property received in payment for goods and services. Sec. 61(a); 1 sec. 1.61-2(d)(1), Income Tax Regs. The amount of commission income received by petitioner in 1981, therefore, is to be determined on the basis of the fair market value of the trade units petitioner received as commissions in 1981. This apparently is the first case involving the valuation, for Federal income tax purposes, of trade units received by members of an organized barter exchange. Our recent opinion in Rooney v. Commissioner, 88 T.C. 523 (1987), involved accountants who, on an ad hoc basis, agreed to accept goods and services in payment of delinquent accounts. We held that in valuing the goods and services received by the accountants, an objective standard was to be used. We stated that -

section 61 requires an objective measure of fair market value. * * * Under such standard, [taxpayers] may not adjust the acknowledged retail price of the goods and services received merely because they decide among themselves that such goods and services were overpriced. [Rooney v. Commissioner, supra at 8-9.]

In Koons v. United States, 315 F.2d 542 (9th Cir. 1963), an employee received household moving services in partial payment for accepting a job at a new location. The Ninth Circuit in Koons rejected the argument that the amount of income charged to the employee with respect to the moving services should be measured on the basis of a subjective valuation thereof by the taxpayer. The Ninth Circuit stated that -

the use of any such [subjective] measure of value as is suggested is contrary to the usual way of valuing either services or property, and would make the administration of the tax laws in this area depend upon a knowledge by the Commissioner of the state of mind of the individual taxpayer. We do not think that tax administration should be based upon anything so whimsical. * * * We think that sound administration of the tax laws requires that there be as nearly objective a measure of the value of services that are includible in income as possible, and the only such objective measure * * * is fair market value. * * * [315 F.2d at 545.]

In the context of summons enforcement proceedings, a number of courts have accepted as reasonable respondent's contention that barter exchange transactions create circumstances that are conducive to improper tax avoidance. United States v. Pittsburgh Trade Exchange, Inc., 644 F.2d 302, 306 (3d Cir. 1981); Korpi v. United States, an unreported case ( D. Mass. 1984, 84-1 USTC par. 9203 at 83,344 n. 1, 53 AFTR 2d 84-1048 n. 1); United States v. Island Trade Exchange, Inc., 535 F. Supp. 993, 996-997 (E.D. N.Y. 1982). We share that concern.

In 1982, Congress expanded the return reporting requirements of section 6045 to make barter exchanges, among other organizations, subject thereto. Sec. 311 of the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. 97-248, 96 Stat. 324, 600-601. The purpose of this change in section 6045 was to improve compliance with respect to the reporting of taxable transactions conducted through barter exchanges. S. Rept. 97-494, at 246 (1982). Thus, it appears that Congress also has recognized the potential for tax avoidance inherent in barter exchange transactions.

The absence of the use of currency and the tax reduction motives suggested in literature of the exchange suggest to us that the operations of the exchange and the tax effect of transactions occurring within the exchange deserve close scrutiny. The above factors also further support the adoption, for tax purposes, of an objective test for the valuation of trade units received by petitioner and by members of the exchange.

In other words, the idea of avoiding the tax consequences of a barter exchange by setting the value at a nominal amount such as one dollar had been tried, and generated a strong negative reaction by Congress, and thereafter by the courts. The revenue ruling and cases that I’ve noted have been cited with approval and followed in more than a few other cases, and in an FSA. Paul Caron reached a similar conclusion through a similar analysis in Tax Consequences of Kidney Donations.

So what Kerry proposes won’t fly. I worry that the IRS not only would reject the nominal amounts, but impose penalties for trying to avoid tax consequences through a strategy that has been roundly rejected by the authorities.

I hesitate to make a comment about the supposed “ivory tower” nature of my original The Taxation of Kidney Swaps post. Support for my conclusion can be found in IRS pronouncements and court opinions. It doesn’t get much more real world than that. Whatever shortcomings I have, and I have them, it doesn’t include being an ivory tower academic, much to the chagrin of many in the so-called law school academy.

Raising Revenue Through Tolls Isn't Simple

As reported in this story, the Federal Highway Administration in effect told Pennsylvania to revise its request for approval of the I-80 toll plan. The federal government adopted a plan that permits three states to impose tolls on interstates "for the purpose of reconstructing and rehabilitating interstate highway corridors that could not otherwise be adequately maintained or functionally improved without the collection of tolls." Virginia and Missouri have claimed two of the spots, and Pennsylvania is trying to take the third.

The FHA did not reject or approve the plan. It concluded that Pennsylvania's proposal did not adequately meet the threshold for the three-state federal plan. The FHA noted that Pennsylvania did not demonstrate that the tolls would be used only for I-80 improvements. The FHA did not seem to agree that toll revenues used to fund highways and bridges elsewhere in the state constituted operating costs of I-80. The FHA raised procedural issues, seeking proof that local planning organizations were contacted and that local, regional, and interstate travelers had input.

Although the final federal decision is a year away, speculation that the toll plan won't fly has increased. If the plan fails, funding for mass transit and highway repairs needs to be found in some other revenue source. Suggestions include higher state gasoline taxes, increased vehicle registration fees, mass transit fare hikes, and the controversial plan to lease the Pennsylvania Turnpike. In fact, the next day, Governor Rendell renewed his call for the turnpike lease.

As I pointed out in Selling Government Revenue Streams: A Bad Idea That Won't Go Away and Selling Off Government Revenue Streams: Good Idea or Bad?, the leasing of the turnpike is a bad idea. Without repeating all of the arguments, the plan comes down to the killing of the goose that lays the golden eggs. The arguments made on behalf of the plan fall apart when throughly dissected, and what remains is nothing more than a grab by particular segments of the private sector for assets and wealth that belong to the public.

The FHA reaction to the I-80 toll plan tosses another consideration into the turnpike leasing plan. The Turnpike is an interstate highway, though it was a toll road before it became an interstate highway and thus is subject to a different set of rules when it comes to imposing tolls on interstate highways. Yet if the point of the leasing plan is to extract cash for purposes other than repair and maintenance of the turnpike, isn't there the same general concern that underlies the federal requirement not met by the current I-80 toll plan application? In other words, as a user fee, the tolls collected from users of the turnpike, or I-80, should be used to pay the costs that those users impose, namely, the damage and wear-and-tear to the highway that is being used. An argument can be made that a portion of the toll, or user fee, can be expended to improve air quality in the corridor through which the highway passes, because users inject pollution into that area as they use the highway.

Unfortunately, the issue isn't going to be resolved on the basis of economic analysis, the weighing of public costs and utility, the worth of user fees, or the disadvantages of selling government out to wealthy private interests. Instead, as has happened with so many federal and state legislative decisions during the past several decades, it will come down to politics. More specifically, it will come down to campaign contributions and the granting of favors. And we know, when that is how the game is played, the people with money and assets end up with more, everyone else ends up paying more, and the promised benefits do not materialize as promised. Someday Pennsylvanians and those using Pennsylvania highways are going to rub their eyes, blink, and ask, "How did this happen?" The response will be, "While you were sleeping."

Deadlines for Turning In Grades

The faculty at Wayne State Law School has a very strict grade due-date policy, which came to my attention thanks to Paul Caron's TaxProf Blog. If a faculty member fails to turn grades in by the deadline, the Dean can impose sanctions on the faculty member. Those sanctions range from reducing or eliminating travel and research funds to casting negative evaluations on the faculty member's teaching competence for purposes of retention, promotion, tenure, and merit compensation.

Thinking that Wayne State had a deadline with which compliance might be difficult, I looked at its rules. Faculty have four weeks in which to do the grading, and in some instances more than four weeks because the deadline is measured, in some cases, from the end of the examination period, which could be one or several or more days after a particular exam is administered. Apparently failure to comply with the deadline is not a recent problem, because the Wayne State policy getting attention is a revision of one adopted twenty years ago.

I began grading on Friday. I began on Friday because the exam in one of my courses was administered on Thursday evening. Because the examination schedule is known before the semester begins, I can block off time on my calendar to do grading. Why start grading right away? First, the exam and what I expect student answers to express are fresh in my mind. Second, it doesn't get easier to grade an exam if one waits. Third, I am paid to teach, and teaching includes providing feedback, including the feedback that comes in the form of the course grade, of which the exam is a component. Fourth, the sooner I grade, the less likely an intervening event will cause me to be unable to grade or incapable of finishing the grading on time.

My views on grading are not widely shared, nor are they popular. So what's new? One reason I grade as soon as the exams are ready to be graded, though it is not the primary reason, is to demonstrate that it can be done. Why do I want to make that point? I think that students deserve feedback in a timely manner. I am not permitted to tell students what they have earned in the course until grades are officially released. By the time that happens, the students' recollection of the exam, and why they wrote what they wrote, is stale. For spring semester grades, so much time goes by that students rarely seek to discuss or learn from their exam experience. To the extent that a student considers a grade to be a factor in deciding whether to take another course in that subject matter area, the student learns of fall semester grades too late to add or drop courses for the spring semester.

Surely there are stories from Wayne State about faculty who did not turn in grades on time. Otherwise there would not have been a need for the policy and the approved penalties. It is unlikely that the situation arose on account of a faculty member's unforeseen illness or other intervening emergency. Administrations find ways to deal with those sorts of situations when they arise, though in many instances none of the alternatives are ideal. I've heard stories about adjunct faculty neglecting to turn in grades, and leaving examinations at the bottom of a pile of papers in their offices. Yet the Wayne State policy appears directed toward full-time faculty, because adjuncts are not eligible for tenure, and usually are not eligible for merit compensation programs. It is much easier to terminate the contract of a noncompliant adjunct than it is to dismiss a tenured member of the faculty.

Administrators usually do a pretty good job of reminding faculty that grades are due. I have seen reminders distributed two weeks and one week before the deadline. Of course, for me, they are irrelevant, because my grades have been turned in by that point, but it does make it difficult, if not incredulous, for someone to claim that he or she forgot that grades were due. Grading, to me, is no less an essential aspect of teaching than going to the classroom to teach that it bewilders me how someone could forget to do the grading.

What I don't know is if Wayne State has ever invoked its policy with respect to a full-time member of its faculty. I surely hope not. Law students deserve better than to have grades delayed even longer than they are under current deadlines.

Lawyers Are Just Like People: Some Good, Some Bad

People don't like lawyers. So I'm told. People like their own lawyers but not the other person's lawyer. So I've also been told.

Yet most lawyers are decent people, hard working, well-intentioned, and caring. It only takes a few, though, to tarnish the profession's image.

Even though the same can be said of other professions, it's the lawyering profession that gets the spotlight when it comes to the pervasive effect on the many of the bad deeds of a few. Consider the impact on people's perception of lawyers of these recent news items:

1. Lawyer charged with running 25-year fraud: A Philadelphia lawyer sent runners out to find cracked sidewalks in front of businesses. They returned with a friend or relative in tow, who would claim to have fallen and suffered injuries. The injuries either were pre-existing, or were alleged soft tissue injuries. The fake lawsuits numbered at least in the hundreds. Fifteen people have been arrested.

2. U.S. v. Partridge: The Seventh Circuit issued an order to show cause why the attorney representing the taxpayer "should not be fined $10,000 for his frivolous arguments and noncompliance with the Rules, and why he should not be suspended from practice until he demonstrates an ability to litigate an appeal competently and responsibly." The Court described the attorney's behavior as "obstructionism" and noted that "[t]he problem is not simply his inability to distinguish between plausible and preposterous arguments. It is his disdain for the norms of legal practice (19 issues indeed!) and the rules of procedure." The statement of facts prepared by the attorney did not, according to the Court, contain any facts.

3. Court Supervision of Attorney Ordered due to Lack of Civility: A judge in New York orders court supervision of an attorney who referred to opposing counsel as "hon," "dear," and "girl" and who asked why she did not have a wedding ring on her finger. According to the judge, the lawyer's behavior reflected gender bias and "a lack of civility, good manners and common courtesy." The lawyer has appealed and claims things were taken out of context, suggesting that "hon" was intended to be "Hun [a]s in Attila." The deposition was being taken in a legal malpractice case. The lawyer also objected to the appointment of a supervising referee Because he was "not aware of any rule or law which requires civility between counsel."

4. Solo Convicted in Sex Scam: An attorney was convicted of assisting her husband, also an attorney, obtain compensation from four men with whom she had affairs. The husband threatened to sue the men unless they settled the alleged emotional distress cases. The husband had been convicted earlier this year. The wife's attorney claims that what she and her husband did "was ordinary conduct that lawyers do. The only thing not ordinary is it was about sex." The husband has appealed and the wife plans to do so.

5. Heading To Prison, Yagman Goes Down Fighting: Los Angeles lawyer Stephen Yagman was convicted of tax evasion and other criminal charges, and was sentenced to three years in prison. Yagman alleges he was singled out for prosecution because he filed police brutality and other lawsuits on behalf of clients against government officials.

6. Lawyer Convicted of Tax Evasion Blames High-Profile Partner: An attorney pled guilty to tax evasion, and then explained his behavior on the financial difficulties of his law partner. During a five-year period, the attorney earned $1,800,000 and did not pay more than $600,000 in taxes on that income. The partner with the alleged financial difficulties has been investigated by the IRS and was reprimanded by the state bar grievance panel for failure to provide a client with a written fee agreement and for providing insufficient information to the panel when it investigated the complaint.

I wish the media, the popular press, and others would report on the lawyers who do pro bono work, who solve problems for their clients, who participate in Habitat for Humanity projects, who tutor children in underprivileged schools, who contribute time and services to charitable organizations, and who take active and productive leadership roles in their communities. Every once in a while I see such a story. But for each story I see, I come across a half dozen or dozen that shine the news spotlight on an attorney who has not served the profession or society very well.

IRS Issues Medical Expense Deduction Ruling But It Has No Surprises

The IRS has released Revenue Ruling 2007-72, in which it rules that the following three expenses qualify as medical expenses, and are deductible to the extent they are not reimbursed by insurance or otherwise, subject to the various limitations that apply to the medical expense deduction:

Item 1: the cost of undergoing an annual physical examination performed by a physician, with the cost including not only the physician's services but also laboratory tests.

Item 2: the cost of a full-body electronic scan, performed at a clinic by a technician, without prior consultation with a physician.

Item 3: the cost of a home pregnancy test kit.

Considering the definition of medical care, and the list of expenses that the IRS or courts have already treated as medical expenses, the surprise would have been a conclusion that one or more of these three items did not qualify. Section 213(a) allows a deduction, subject to limitations, for expenses for medical care and certain other items. Section 213(d)(1)(A) tells us that medical care "includes amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body." Regulations section 1.213-1(e)(1)(ii) tells us that medical care "includes X-rays and laboratory and other diagnostic services" and that "[a]mounts paid for obstetrical services are deemed to be for the purpose of affecting a structure or function of the body and therefore are paid for medical care." In PLR 200140017, the IRS ruled that amounts paid for the following tests qualified as medical expenses: ankle brachial index, abdominal aortic aneurysm, carotid ultrasound scan, thyroid ultrasound scan, body composition, blood and pulse pressure, oxygen saturation, lung capacity screening test, hearing screening, vision screening, urine analysis, osteoporosis screening test (for women only), complete blood count with differential (blood study), chemistry panel (blood study), h pylori screen (blood study), lipid panel (blood study), cholesterol screen (blood study), c-reactive protein (blood study), fibrinogen (blood study), homogysteine (blood study), thyroid stimulating hormone screen (blood study), T uptake, T4, T7 thyroid studies (blood studies), CEA test for pancreatic, liver, bladder, and colon cancer (blood study), CA-125 test (blood study), prostate cancer screen (PSA blood study), fasting glucose screen (blood study), hepatitis C screen (blood study), CT heart calcification scan, CT lung scan, nutrition panel and iron studies, diabetes hemoglobin Al c, lupus screen, lupus Level II (double stranded DNA), hemochromatosis, gout screen (uric acid), rheumatoid arthritis screen (rheumatoid factor), sickle cell disease, hormone blood studies package (estrogen (estradiol), follicle stimulating hormone (FSH), testosterone, luteinizing hormone, prolactin), and take-home screening kits that aid in the detection of conditions such as colon cancer, hepatitis C, and HIV.

The IRS explained that a "diagnosis may encompass a determination that disease is absent. The determination of a medical condition may include testing for changes in the functions of the body, such as those resulting from pregnancy, that are unrelated to disease." It also reasoned that [i]n determining whether an expense is for either medical or personal reasons, the recommendation of a physician is important," and cited several cases to support that proposition.

The question that interests me is not whether the IRS has reached the correct conclusion. There is no doubt that it has. The question that interests me is why it has taken the IRS so many years to issue a revenue ruling explaining that the cost of several very common and long existing medical procedures, the annual physical and routine lab tests, qualify medical expenses. It is a safe assumption to conclude that people have been treating these expenses as medical expenses for decades. The Revenue Ruling in effect says, "What you have been doing is correct." I cannot imagine what would have happened had the IRS reached a different conclusion.

Though full-body electronic scans and home pregnancy tests haven't been around nearly as long as annual physicals and routine lab tests, they have been with us for more than a few years. Again, why did it take so long for the IRS to deal with these fairly common procedures in a Revenue Ruling?

But perhaps there is a more interesting question: Why did the IRS even issue a Revenue Ruling? Would not a PLR suffice? Did not PLR 200140017 suggest what the outcome would be with respect to the second and third items? Was there a flood of requests for private rulings with respect to these matters? Did a taxpayer or a tax advisor wanting ironclad authority for a return position somehow persuade the IRS that a revenue ruling was essential? Or did someone on Capitol Hill cause the IRS to issue the revenue ruling because it was of utmost importance to a particular, influential constituent?

It's nice that the IRS has issued this ruling and has settled whatever microscopic shred of doubt that might have existed about the matter. It is true, as Joe Kristan points out, that most taxpayers end up not deducting medical expenses, either because they elect to claim the standard deduction or because of the various limitations on the medical expense deduction and itemized deductions generally, and so the ruling doesn't have a practical impact on very many taxpayers. It would be much, much more encouraging if the IRS would issue Revenue Rulings with respect to the many issues that involve large dollar amounts and significant numbers of taxpayers but for which there is no clear answer and reasonable arguments that can be made in support of the various proposed conclusions. With the IRS being as busy and underfunded as it is, and with so many issues needing guidance, it is a bit puzzling why a revenue ruling was issued with respect to three questions that affect very few taxpayers and for which the answers were relatively obvious to those familiar with federal income taxation, especially considering the number of years taxpayers have managed to file returns without the benefit of the revenue ruling. Perhaps this is the opening entry in a restoration of the days when the IRS issued as many as six or seven hundred revenue rulings each year.

A Closer Look at a Technical Self-Employment Tax Issue

My posting late last month, Social Security Email: Nonsense Breeds Nonsense triggered several inquiries from a reader. He pointed out that when a self-employed individual computes self-employment taxes, which is what self-employed individuals pay in lieu of FICA, the individual's earnings from self-employment are multiplied by .9235, even though the individual also is permitted to deduct for income tax purposes one-half of the self-employment tax. He asked why do the "discount" and the deduction co-exist? He suggests that the deduction and the "discount" are redundant if the rationale is to put self-employed individuals on par with employees. He also asked why the discount applies to all earnings from self-employment even though only the Medicare portion (2.9%) applies to all earnings from self-employment.

The income tax deduction exists because employers deduct the employer portion of FICA. By permitting the self-employed individual to deduct one-half of the self-employment tax, the individual is being put into the same income tax position as he or she would be if he or she were two people, both an employer and an employee. For example, assume R hires E and pays a salary of $10,000. R would withhold $765 from E's salary for FICA, and R also would pay $765 in FICA taxes, for a total of $1,530. E's take home pay, ignoring other taxes and withholdings, is $9,235. Ignoring other compensation costs and other taxes, R would deduct $10,765. If, for simplicity sake, R is in a 30% income tax bracket, R's income tax liability is reduced by $229.50 on account of the $765 deduction. If E were self-employed and had net earnings of $10,000, then, ignoring the "discount," E would pay a self-employment tax of $1,530. Without a deduction for $765 of that tax, E would be in a less advantageous position than if E were an employee. Thus, the income tax deduction of $765 for self-employed E causes E to save income taxes of $229.50, assuming E is in a 30% income tax bracket.

That part was easy. The second part of the question is more difficult.

Let's return to E, who decides to quit employment and turn to self-employment. Because E must now pay $1,530 rather than $765 in social security taxes, lacking an employer who will kick in the other $765, E must generate earnings from self-employment of $10,765 in order to end up with $9,235 "take-home" compensation. If the 15.3% self-employment tax rate is applied to $10,765, the resulting tax is $1,647.05. This is more than the $1,530 paid by R and E collectively when E was employed by R. With the "discount," only 92.35% of E's net earnings from self-employment is taxed. Multiplying $10,765 by .9235 generates taxable net earnings of $9,941.48. Close enough, I suppose, for government work. The multiplier should be .9289, because $10,765 multiplied by .9289 is $9.999.60. Perhaps that is close enough.

It appears that the "discount" and the income tax deduction address two different equalization concerns, and do not generate duplicate results. For example, after applying the "discount," self-employed E then incurs self-employment taxes of $1,521.05 ($9,941.48 x .153), and only the deduction of $760.52 of that tax puts E into the same position as E would have been had E been employed by R.

The third part of the question also is challenging. Does it make sense to apply the discount to self-employment income exceeding the OASDI cap, considering that employers and employees do not pay social security taxes on wages exceeding the cap? The answer appears to be no. The solution would be a more complicated computation of self-employment taxes. If the Congress eliminates the OASDI cap, as some have proposed, this part of the question disappears.

This exercise demonstrates that sometimes I learn from my readers when they send me information, and sometimes I learn when they ask me questions that compel me to think. I wish every law student understood that one can learn other than through a diet of information deliveries, and that being compelled to think exercises the brain in ways no other pedagogical method can. It's fun being a student when a reader asks a question. Sorry, I'm not paying tuition for the privilege!

But I do want to return to that small discrepancy between a discount of .9235 and what I compute as an appropriate discount of .9289. Does such a small difference matter? Yes. According to the IRS Statistics of Income, Individual Income Tax Returns, 2005, roughly $22.7 billion was paid in self-employment taxes for 2005, the latest year for which information is available. Working backwards, this suggests that roughly $148,366,013,071 of taxable self-employment income was reported ($22,700,000,000/.153). Working backwards yet again, this suggests that before application of the .9235 "discount," individuals reported earnings from self-employment of $160,656,213,396 ($148,366,013,071/.9235). How much self-employment tax would be reported if the a discount of .9289 rather than .9235 were applied? First, take $160,656,213,396 and multiply by .9289, for a result of $149,233,556,624. Second, multiply $149,233,556,624 by 15.3%, for a result of $22,832,734,163. That is an annual increase of roughly $132,734,163 in self-employment taxes. It's not much as a percentage of the currently reported total, but it would be a welcome increase to the social security trust funds. It won't solve the social security funding problem, but sometimes every little bit helps. Of course, the income tax deduction for self-employment taxes would increase by roughly $61,367,081, so there would be a bit of a decrease in general fund revenues.

And for those who are curious, no, I do not expect the students in the basic federal income tax course to do these sorts of computations. Nor do we address the topic of self-employment and social security taxation at a level that reaches this deep into the questions. It does give me, however, yet another example to share with them of how complicated tax law truly is.

The Social Security Reform Game

Jonathan Barry Forman, who is the Alfred P. Murrah Professor of Law at the University of Oklahoma College of Law, passed along a link to the American Academy of Actuaries Social Security reform game. It is common knowledge among those who pay attention to important current events that there is a funding shortfall in the social security program, and that unless changes are made, insolvency will occur sooner rather than later. The numbers are staggering. Jon passed along two tidbits: Over a 75-year period, federal budget, in Analytical Perspectives (page 189) estimates predict a $6.4 trillion shortfall, and in perpetuity, it's $153trillion. That's a lot of money.

I had not seen this American Academy of Actuaries Social Security reform game. Thank you, Jon, for bringing it to my attention.

The American Academy of Actuaries Social Security reform game challenges players to solve the program's financial problems. It permits players to try different alternatives, such as increasing taxes, cutting benefits, raising normal retirement age, eliminating some or all of the cap on taxable wages, and other choices.

I've tried it. It's fun. If you are the sort of person who enjoys playing Monopoly because you're not playing with your own real money, then the American Academy of Actuaries Social Security reform game is for you. It's better than being banker. Of course, in the long run, some of the dollars are our own real money, and what Congress decides to do will have much more of an impact on our lives than whether we win or lose at Monopoly.