Stamping Out Tax Misinformation

It’s a long story with a simple lesson. Not only is the story long, it’s about taxes. Nonetheless, it’s worth reading. I’ve tried to shorten it without losing the message.

It begins with a TaxProf blog post about a Canadian couple who won a lottery and gave almost all of their winnings to charities. In his post, Paul Caron pointed out that if the couple lived in the United States, they would have a tax problem, because only 50 percent of their charitable contributions would be deductible, leaving them taxable on roughly half of their winnings. Roughly, because they did not give away all of their winnings and they probably would have other deductions; perhaps they have other taxable income. But, give or take a little bit, they would be paying federal income taxes.

A student in a course taught by another tax law professor saw the TaxProf blog post and directed that professor to this Wall Street Journal article. In the article, the author tries to explain that deciding whether to make charitable contributions in late 2010 or early 2011 isn’t as easy as it might appear. Though some advisors suggest waiting until 2011, when higher rates might generate larger tax savings that offset the reduction in the present value of the tax savings arising from the delay, there are other considerations that favor donating in 2010. The author then writes:

Another consideration is the absence of limits this year on itemized deductions for charitable giving. Limits tied to income will come back next year unless Congress acts to stop that.

When I saw that, my immediate thought was, “Whoa! Was there a tax law change that I missed? When the basic tax course reaches the charitable contributions deduction topic in a few days, will I be teaching the wrong law?” I stopped what I was doing and did some research, even though the tax law professor to whom the student had pointed out the Wall Street Journal article had noted that this was something of which she had been unaware. But perhaps she and I were wrong. When in doubt, research it.

What I discovered is that there is nothing in section 170 suspending the 50 percent limitation on charitable contributions to public charities. I found nothing in any amendment to section 170 suggesting such an outcome. I found nothing in uncodified legislation. I discovered that the people at Grant Thornton think the limits are still in place; Go to their Year-End Tax Guide For 2010, go to chapter 7, and from there go to the charitable contributions chart. I shared with my tax law professor colleagues across the nation not only the results of my research but this thought: “I wonder if it was a change in a limit on something else related to charitable contributions?”

In response, another tax law professor noted that he did not see anything in section 1400S, where, to quote him, “most of the [section] 170 percentage limitation suspension rules reside.” He also informed us that he and his co-authors had not discovered anything suspending the 50 percent limitation while they were preparing their current developments outline, which, as he explained, “requires reading every new tax provision.” This response was comforting. I, too, read every new tax provision and had not seen anything. The fact that, by this point, four of my colleagues across the country were reaching the same conclusion reduced the odds of my having missed something.

Another tax law professor suggested, “Perhaps it had to do with charitable contributions of IRA accounts.” Yet another colleague chimed in that it was “probably a reference to the temporary elimination of the income-based deduction phaseout in section 68.” That phaseout affects many more itemized deductions than charitable contributions, and has no effect on the 50 percent charitable contributions deduction limitation. This same law professor had taken the research effort in a different direction, sharing a link to the IRS web site, where the August 25, 2010, version of Publication 78 Help, Part II, describes the 50 percent charitable contributions limitation as still in effect.

Still another tax law professor opined that the author of the Wall Street Journal article must have been referring to the return of the section 68 phaseout. He explained that there have been some articles, such as this one from SmartMoney magazine that recommends increasing 2010 charitable giving, especially if the taxpayer’s only itemized deduction, or perhaps only significant itemized deduction, is charitable contributions. This professor then warned, “these sorts of articles can confuse people into thinking that the [section 68 phaseout] is only for charitable gifts, when in fact it applies to all itemized deductions.” Exactly. The lack of precision opens the door to misunderstandings.

Someone suggested that the student who brought the Wall Street Journal article to the attention of his professor be encouraged to contact the Wall Street Journal and identify the error. We’ve been told that the student has been so advised.

One way of checking out something that is alleged about taxes is to put the question to others who have expertise in the matter. That is what happened in this instance when the professor to whom the Wall Street Journal article was shown had doubts and asked her tax law professor colleagues throughout the country for their reactions. Unfortunately, most people, when hearing or reading something about taxes, simply treat the information as true. And therein lies the lesson.

Whether the misinformation is accidental, as I’m very certain is the case with the Wall Street Journal article, or deliberate, its impact can be damaging. It’s not just the taxpayers who accelerate or delay charitable giving when in fact they should have done the opposite. Sometimes a substantial portion of the electorate can go to the polls and make decisions based on deliberate misinformation with respect to taxes, as discussed in this analysis. The ultimate lesson for everyone, not just tax law professors, tax students, or tax practitioners, is to figure it out for one’s self, with the help of the source material and those with expertise in the matter. Otherwise, tax misinformation that needs to be stamped out will proliferate. There is no good to be found in that outcome.

And So Now Philadelphia Listens?

Several months ago, in A Tax on Blog Writing or on Blog Business?, I reacted to the news that Philadelphia was subjecting bloggers to its $300 business privilege license fee no matter the amount of income received by the bloggers, even in instances where the blogger’s advertising receipts fell far below $300. I noted:

There’s a simple solution. City Council needs to define “business” so that the business taxes and fees apply only to those taxpayers who file a Schedule C or Schedule C-EZ with their federal income tax return.

Now comes news, as reported in thisPhiladelphia Inquirer story, that Councilman Bill Green, joined by five other members of Council, has introduced legislation that would prevent the city from imposing the business privilege license fee on individuals whose blogging is a hobby. The determination of whether the individual’s blogging was a hobby would be determined using federal income tax law. In other words, if the blogging income showed up on a federal Schedule C or Schedule C-EZ, the blogging would be treated as a business, but if the de minimis blogging income showed up as miscellaneous income, and was not treated as a business for federal income tax purposes, the blogging would be treated as a hobby. For federal income tax purposes, the effect of treating an activity as a hobby is that any deductions that would otherwise be deductible in full are limited to the total income, except for deductions allowable in any event, such as interest and taxes. For those interested, here is the text of the proposed Philadelphia legislation.

Coming on the heels of the news, on which I commented two days ago in Life for My Proposed Marcellus Shale User Fee?, that Pennsylvania legislators are now considering Marcellus shale natural gas extraction user fees as I suggested in Tax? User Fee? Does the Name Make a Difference?, this most recent development has me thinking that perhaps, just perhaps, legislators, or at least members of their staffs, are paying attention. It remains to be seen whether this change in Philadelphia tax law gets enacted.

Life for My Proposed Marcellus Shale User Fee?

More than a month ago, in Tax? User Fee? Does the Name Make a Difference?, I suggested that a key to breaking the stalemate in the Pennsylvania legislature, and between the legislature and the governor, with respect to the taxation of Marcellus shale natural gas could be reliance on user fees rather than on a tax. I reiterated this point almost a month later, in Giving Up on Taxes = Surrendering Taxpayer Rights?

Now comes news, in a Philadelphia Inquirer story, that is best summed up by the headline: “New Pa. GOP Leaders Eye a Fee on Natural Gas Instead of a Tax.” Have these people been reading my MauledAgain posts? It’s possible. One of the legislators, an incumbent re-elected without opposition, and who is moving up to a leadership position, is someone I’ve known since I was in high school. The House Republicans, who at first had been opposed to a tax, but later offered a low-rate version, have explained that they think there should be “a way for industry to contribute to local municipalities to help out with the impact” of road and environmental damage, to name two of the several burdens that otherwise would fall on local taxpayers. Though I commend the announced plans, I am troubled with the phrase “help out” because it suggests something less than a fee sufficient in amount to cover the full cost of what economists call the externalities. And, as usual, it remains to be seen whether the legislature gets anything done with respect to this issue. Announcing plans isn’t quite the same as accomplishing the goal, particularly with so many distractions, interruptions, roadblocks, negotiations, lobbying, and other impediments to legislative progress. Considering that the Republican governor-elect is opposed to taxes across the board, and that many House Republicans are willing to consider a tax, the idea of a user fee – as I proposed more than a month ago – indeed provides a pathway to breaking the legislative logjam.

The Horror of Halloween Widens

Last Wednesday, in The Horror of Halloween?, I noted that I was shocked, and certainly not treated, when a small girl whom I did not recognize and who had arrived at my door seeking candy, saw what I was handing out and said, “No thank you, I don’t like Reese’s Peanut Butter Cups.” There’s someone who doesn’t like Reese’s?

On Thursday, it got worse. A faculty colleague emailed me to tell me that two other faculty colleagues do not like Reese’s Peanut Butter Cups, because they do not like peanut butter. Wow. It’s worse than I realized. But is it bad news because it explains why the Reese's four-packs are no longer available in the places I look due to a declining market? Or is it good news because it means there are more Reese’s Peanut Butter Cups available for those of us who think they are the elite candy, even if they come in those tiny two-packs?

Perhaps I should be asking more people about their views on Reese's Peanut Butter Cups? Then emails such as the one I received on Thursday would not be so shocking?

Taxes and Religion: A Totally Different Perspective

No, this isn’t a post about the tax-exempt status of religious institutions. It’s not a post about the relationship between theological principles and tax policy. It’s about, well, keep reading.

Several days ago, while continuing a long project of working methodically through the database holding information on the descendants of Thomas Maule of Salem, Massachusetts, I reached the entry for Louis Blaul, who had married Mary C. Clendenon, a descendant of Thomas Maule through the Clendenon branch of the family. Louis was a well-known photographer in Philadelphia, operating a business that was taken over by his son, also named Louis, when he died. My google search for “Louis Blaul” brought me to an entry on google books. It was Volume 10, No. 1 (Jan–Feb. 1910) of the Single Tax Review, subtitled “A bi-monthly record of the progress of single tax and tax reform throughout the world.”

What was the single tax? A tax on unmarried individuals? No, it is a tax on the value of land, proposed by Henry George in the latter part of the nineteenth century. The theory was, and remains, that the revenue collected from taxing land would be sufficient to permit elimination of all other taxes. The underlying justification for the tax is that, although a person should be treated as the owner of all that he or she creates, that which is found in nature, such as land, belongs to society as a whole. The point of this post is not to get into a discussion of the single tax. It’s something else.

What caused google to send me to the Jan-Feb 1910 edition of the Single Tax Review was an obituary for Louis Blaul. Unfortunately, it contained no genealogical information, though it did illuminate some aspects of his personality. In a short, two-paragraph write-up under the simple headline, “DEATH OF LOUIS BLAUL,” an unidentified writer shared this information:

The death of Louis Blaul, of West Philadelphia, robs that city of an earnest and devoted Single Taxer. Though for years he has been a helpless invalid he has made his influence felt through an ever increasing circle of friends.

Though informative and interesting, the first paragraph is not what triggered the thought of “taxes and religion.” It was the second paragraph, which described something that I had not previously encountered:

The funeral was conducted as he had desired, not according to the rites of any church, but by officiating Single Taxers. Mr. Ross read from Progress and Poverty, portions of the “Central Truth,” and “The Individual Life.” Among other Single Taxers present were Henry C. Lippincott, Chas. F. Shandrew, Haines D. Albright, Miss Musson, Dr. and Mrs. Wright, and Dr. Sullivan, of Albany, N.Y.

The idea of having one’s funeral conducted by members of a tax reform movement opens up all sorts of stupefying possibilities. Would a staunch advocate of the, or should I say, one or another, flat tax want someone to read a portion, or perhaps all, of proposed flat tax legislation? Would an defender of the progressive income tax want someone to read from the legislative history of the Internal Revenue Code? Would a supporter of the unitary method of apportioning income for state income tax purposes prefer that someone read from the latest judicial opinion on the matter? Would anyone want a reading from a United States Supreme Court opinion dealing with a tax issue? People often cry at funerals and memorial services. I can’t imagine giving them even more reason to do so.

Could it be that devotion to a tax reform concept can rise to the level of being itself a religion, under which, for example, funerals are held? Would that open the door to weddings performed under the auspices of adherents to a VAT? Would meetings of consumption tax proponents morph into some sort of worship service?

At what point does it become, not “Taxes and Religion,” but “Taxes as Religion”?

The Horror of Halloween?

For me, Halloween started when, during an afternoon conversation with my neighbor, he asked me if I was planning to hand out candy this year. I assured him I was ready. He told me that I had a reputation in the neighborhood for handing out good candy. No kidding! I’ve been distributing Reese’s Peanut Butter Cups for years. True, my inability to find the four-packs has compelled me to hand out the smaller two-pack, but Reese’s Peanut Butter Cups it will be. This is the fifth year that I’ve come up short in the four-pack department, with the first episode of the bad news described in Happy Halloween: Chocolate Math and Tax Arithmetic, the continuation noted in Tricky Treating: Teaching Tax Trumps Tasty Tidbit Transfers and in A Truly Frightening Halloween Candy Bar. By last year, I had become so accustomed to the disappearance of the four-pack from my shopping venues that I considered it no longer noteworthy. This time around, I want to reassure the neighborhood children that I continue to look, and if I see four-packs return, I will acquire them. I have a candy-distribution reputation to maintain!

Shortly after 6 in the evening, children – many accompanied by parents, some coming to the door because they were carrying, or holding the hands of, little ones, and some standing off at a short distance – began ringing the bell, knocking on the door, or simply making noise loud enough for me to notice. They were delighted with the Reese’s Peanut Butter Cups. Having the chance to see what was in their bags, pumpkins, or other containers – hats off to the young teen who was using a 30-gallon drawstring plastic trash bag – it appeared to me that the per-ounce take from my premises was on the high side.

But then came the shocking non-treat of the night. A small girl whom I did not recognize said to me, “No thank you, I don’t like Reese’s Peanut Butter Cups.” I found some other candy to give her, though it may have been sitting around long enough to have become stale. That didn’t dawn on me until after she walked away. I was still in shock. There was someone who didn’t like Reese’s Peanut Butter Cups. Horrors! Later that evening, I wondered if perhaps she had turned it down because she was allergic to peanuts and didn’t want to disclose that fact. There’s a young man in the neighborhood who is allergic to peanuts, and who would tell me that every year. But a year or two ago, he stopped telling me that and took the Reese’s Peanut Butter Cups. Did he outgrow, or get cured of, the allergy? Perhaps, and hopefully so, but I think it is more likely that he uses the Reese’s Peanut Butter Cups as trade bait. We could have a future professional sports general manager in the making in our neighborhood.

The following morning, I heard on the radio that someone had ranked candy from worst to not-so-worst in terms of health aspects. After digging around, I discovered that the source must have been this candy ranking. The radio announcers disclosed the ten worst, and Reese’s Peanut Butter Cups was not among them. Of course not. Peanuts are protein and chocolate is, yes, medicinal. It took many, many clicks – as each candy has its own slide in the slide show – to determine that Reese’s Peanut Butter Cups came in 32nd out of 40. That means there are 31 candy bars worse for one’s health than the Cadillac of candy. But does this mean that, considering there must be hundreds of different kinds of candy bars, let alone candy – though I was unable to find any sort of accurate count or estimate – this could be even more bad news. Imagine this conclusion: “There are 643 types of candy healthier than Reese’s Peanut Butter Cups.” Impossible. How could, for example, hard candy – which is pure sugar – be healthier than Reese’s Peanut Butter Cups?

But the real horror was the percentage of children toting UNICEF trick or treat boxes. Zero. In a conversation at the gym the following morning, several other people noted the same phenomenon. What has happened to the UNICEF tradition? My children abandoned Halloween candy acquisition expeditions years ago, so I’m out of the loop. Perhaps we need a tax credit for families whose children take UNICEF boxes and collect money for a good cause while they make their candy rounds? That would be even more horrible. It reminds me of a parent I once overheard saying to a child, “If you’re nice to your brother, I’ll pay you a dollar.” Ouch.

Could Tax Law Professors Be More “Tax Return Hands-On” Than Tax Practitioners?

Thanks to an item on Paul Caron’s TaxProf blog, I found myself reading a Time Magazine article, “Why $1,700 Means Joel Stein is Rich.” There are all sorts of blogworthy tidbits in the article – ranging from the definition of income subject to the proposed $250,000 cut-off for extending tax cuts to some amusingly sarcastic commentary about how a tax cut should be used by the taxpayer – but the one that gets attention today is the comment made to Stein by a tax lawyer he contacted about the tax cut debate. Mike Foster, who practices with Venable LLP, said, “I don’t even do my tax returns anymore. I don’t know any tax lawyer who does their own tax returns. The forms are Greek even to us.”

Hopefully someone does a survey to determine how many tax lawyers do their own returns. Anecdotally, there is evidence that among tax law professors, a more than insignificant number do their own returns. I use that phrase generously, as I include not only those who prepare their returns manually but also those who use software such as Turbotax. Even if the latter doesn’t count as “doing one’s own return” – though I wholeheartedly think that it does – there are tax lawyers who do their own returns. It is interesting to me that one can find these tax lawyers in academia, whereas one might expect there to be a higher percentage among full-time practitioners. If Foster is correct, there exists what I would consider to be the reverse of the stereotypes, namely, academics doing tax returns and practitioners handing the task off to someone else. Hence the desire for a survey to corroborate or rebut this apparent counterintuitive outcome.

So here’s a project for someone in need of a research topic, particularly if it is one for which empirical research would be valuable. Are there any LL.M. (Taxation) students about ready to enroll in a Tax Research and Writing course? The only price I charge for coming up with the idea is a request that you share the results of the survey and provide a link to the paper that you write.

Happy Halloween: Revenue Department Scares Kids Into Abandoning Pumpkin Sales

It’s Halloween! It’s a frightening time of the year. Actually, considering how frightening the world has become for the rest of the year, let’s say that it is an even more frightening time of the year. And what could be more frightening than employees of a state revenue department descending on two children, both under the age of 7, and shutting down their pumpkin-selling fund-raising efforts?

Is it more frightening than Taxing "Snack" or "Junk" Food (2004)? More unnerving than Halloween and Tax: Scared Yet? (2005)? More intimidating than Happy Halloween: Chocolate Math and Tax Arithmetic (2006)? More alarming than Tricky Treating: Teaching Tax Trumps Tasty Tidbit Transfers (2007) and Halloween Brings Out the Lunacy (2007)? More unnerving than A Truly Frightening Halloween Candy Bar (2008)? More terrifying than Unmasking the Deductibility of Halloween Costumes (2009)?

Indeed, in many ways it is. According to this story, two children, ages 4 and 6, decided to raise money for school sports. They set out to sell pumpkins at a roadside stand outside their family home. Along came a state tax collector who told the children, and their parents, that because they did not have a state sales tax license they had to shut down. Shades of the Philadelphia business privilege license fee being imposed on baby sitters, as I discussed in A Tax on Blog Writing or on Blog Business?.

If I had any worthwhile artistic skills, I’d crank out a cartoon, showing two terrified youngsters looking up aghast at a big, stern, glowering tax department employee. The caption would simply be, “What’s a sales tax license, mister?”

The sad, ironic, and perhaps galling aspect of the story is the part that hasn’t been told. Why would two children who haven’t even reached the age of reason decide they needed to raise money for school activities? Is there some background information missing? Could, perhaps, their efforts be a reaction to the consequences of insufficient funding, a by-product of opposition to tax increases? I don’t know. Perhaps someone in Lewiston, Idaho, where this took place, can let us know. That’s assuming someone in Lewiston reads MauledAgain. I’m afraid that’s a mighty monstrous assumption. But I could be wrong, and wouldn’t that be such a nice treat?

P.S. Please do read the five-sentence story. See if you can find the five plays on words.

Juggling Tax Return Due Dates

The American Institute of CPAs (AICPA) has forwarded to the Congress a proposal to alleviate the procedural challenges posed by the current set of due dates for filing corporate and partnership returns. The problem that the proposal addresses is a serious one. For example, under current law, an individual who is a partner in a partnership must file his or her tax return by April 15, but the partnership is not required to file its return until April 15. As a practical matter, the partner does not have, by April 15, the information that is required to file the return by April 15. Even though extensions of time to file the returns can solve the problem in many, though not all cases, the taxpayer nonetheless must pay his or her taxes by April 15. This requires cautious taxpayers to overestimate their tax liabilities to avoid possible interest and penalty charges.

The AICPA proposal suggests the following:

Moves the original due date of partnership returns one month earlier and reinstates a 6-month extension (3/15 and 9/15);

Separates the due dates of S and C corporation returns;

Maintains the longstanding due dates of Form 1040 (4/15 and 10/15);

Moves the original due date of S corporation returns to two weeks after partnership returns and two weeks before the original due date of individual, trust and C corporation returns (3/31);

Moves the extended due date of both S corporation and trust returns so that they are two weeks after partnership returns and two weeks before the extended due date of individual and C corporation returns (9/30);

Moves the original and extended due date of C corporation returns one month later (4/15 and 10/15); and

Maintains the original due date of employee benefit plan returns on July 31 but allows for automatic three and one-half month extension by moving the extended due date one month later (11/15).

The proposal explains the reasoning for these changes, and the reasoning makes sense.

However, I would go further. Because there are so many partnerships that, in turn, are partners in other partnerships, I would set up an even more gradated schedule. Partnerships that have other partnerships as a partner would be required to file by the last day of February. Partnerships that do not have other partnerships as a partner would be required to file, as the AICPA proposes, by March 15. By providing an earlier due date for partnerships with other partnerships as partners, partnerships that do not have other partnerships as partners will not be delayed by having a due date that is the same as the due date for the partnership from which they are waiting for information. It would be nice if this pattern could be extended so that partnerships with partners that are partnerships with other partnerships as partners would have an even earlier due date, but two limitations make this unwieldy. First, it would move a due date to the middle of February, which is too early to have all the information ready. Second, a partnership with other partnerships as partners knows that it has other partnerships as partners, but does not necessarily know if that other partnership itself has other partnerships as a partner.

Further, in an effort to spread the demands on the IRS return processing functions over a longer period. I would move the due date for certain individuals to March 15. Individuals who have no gross income from partnerships, S corporations, trusts, estates, or other pass-through entities, and who thus are not waiting for information returns from pass-through entities, should have all the necessary information for filing their returns by the end of January and thus should be able to meet a March 15 due date.

Even without my suggested modifications, the AICPA proposal makes sense. It’s a substantial improvement over the current system. And it’s a far better idea than the one floated some years ago by a member of Congress who wanted to make tax returns due on the taxpayer’s birthday. Imagine how that would work.

Yet More Reasons to Prefer User Fees

Earlier this month, in Better to Tax Gross Receipts, Net Income, or a Combination?, I revisited the question of whether, and if so, how, the Philadelphia business tax structure should be changed, following up on comments I made on the issue in Don’t Like This Tax? How About That Tax?. The core question in the discussion, as framed by the City Council members advocating a change and those supporting the idea, is whether businesses should be taxed on gross receipts, on net income, or on some combination of the two. From my perspective, there exist other alternatives, such as the imposition of user fees to charge businesses for the costs that they impose on the city.

On Sunday, Mark Zandi, chief economist of Moody’s Analytics Inc., published an opinion piece, Philadelphia Business-Tax Code Needs Change, in the Philadelphia Inquirer. The point made in the headline is one with which few people disagree. The city’s business tax structure is antiquated, and does not serve well the city, its citizens, or the businesses operating in it. The challenge is identifying what sort of tax structure would be a worthwhile improvement.

Zandi argues in favor of shifting away from a hybrid structure that taxes both profits and sales to a tax based on sales. The existing structure, if left alone, will shift, by terms of already-enacted legislation, from its hybrid form to a tax on profits. Zandi advances several arguments in favor of a tax based on gross receipts.

First, he claims that taxing gross receipts “broadens the tax base,” by spreading the tax burden from profitable businesses to businesses that are profitable and businesses that are unprofitable. Here’s the catch. One of Zandi’s arguments demonstrating the need for business tax reform is the claim that combined with all other taxes, it puts businesses in a position where they “could pay more than half” their profits in taxes. If that’s a terrible thing, then how does one react to a tax that would be imposed on a business with little or no profits? Even if a business with $100 in profits pays $51 in total taxes – with the Philadelphia business tax being a small portion of that – is it better to ask a business with a loss of $20 to pay $5 in sales-based taxes, or to ask a business with $4 in profits to pay $5 in sales-based taxes? The broadened base would quickly disappear as these borderline businesses closed their doors or moved out of the city. Zandi’s goal of “lightening the load . . . for successful firms” would end up increasing the load for those firms as they ended up being the only businesses remaining in the city to be taxed, until, of course, they, too, departed.

Second, in a related argument, Zandi claims that by taxing profits and not taxing sales, the city will encourage successful businesses to leave the city. There’s logic in that argument, but shifting the tax burden in order to kill the chances of barely profitable firms becoming successful merely changes the sequence and timing of continued erosion of the city’s business tax base, as explained in the preceding paragraph. Though Zandi seems to argue that the many businesses that already have left the city did so because of taxes, other factors also entered into those decisions, including the decision to move operations to areas where employees live and customers and clients live and do business. Many suburbanites are reluctant to go into Philadelphia, for reasons other than tax policy, and thus to retain customers from among those individuals, it made sense for businesses to relocate.

Third, Zandi argues that a profits-based business tax is more easily avoided than is a sales-based business tax. He claims that profits are “harder to accurately measure and easier to manipulate than are sales.” It would be helpful to see proof of this proposition, particularly when far more tax dollars are evaded in the federal income tax arena through under-reporting of gross income -- think of the cash skimmed from the register – than are avoided through overstatement of deductions. A sales-based business tax would encourage more of the “pay cash, pay less” schemes. The advantage of a profits-based tax is that the city could let the IRS and state revenue departments do a good chunk of the auditing work. Granted, Zandi’s argument that “[a]nything that simplifies the tax code is likely, therefore, to produce greater compliance and more tax revenue” is valid in a general sense, but the argument carries within its message a suggestion that the answer might lie in something other than sales-based and profits-based business taxes.

Fourth, Zandi argues that profits are “extraordinarily volatile, swinging wildly with changes in the economy,” and thus making revenue based on profits unreliable and difficult to predict. That’s also the case with sales, as Zandi concedes, and though he claims that sales are less volatile, it isn’t difficult to appreciate that profits drop when the economy tanks because revenue declines faster than expenses can be cut. If anything, Zandi is again making a strong case to minimize reliance on both sales-based and profits-based business taxes.

Fifth, Zandi dismisses the impact of a profits-based business tax on small firms by pointing out the $100,000 sales exemption that is included in the most prominent of the proposals to reform the business tax. He also dismisses the impact of a profits-based business tax on less profitable companies by suggesting the concern about the impact “probably is overdone, as such firms also likely have weak sales.” Brushing aside the concern in that manner neglects the principal danger of a profits-based business tax on less-profitable enterprises, namely, these are often the fledgling companies whose rise to success would contribute to the well-being of the city’s economy, but are most at risk of going under if their $4 profit must be used to pay a $5 sales-based business tax.

Sixth, Zandi concedes that shifting to a sales-based tax “would benefit professional-services firms such as accountants, lawyers, and management consultants, along with some manufacturers, information-service companies, and the publishing and broadcasting industries.” No kidding, though I think very few manufacturers and very few publishers would be better off. Zandi also notes that “[h]otels, retailers, and construction firms would be hurt” by a sales-based business tax. His response to this issue is to claim that the companies that would benefit “generally employ educated workers, who bring lots of income and wealth to the city,” and that the businesses that would suffer “are less likely to leave the city even if they face higher taxes.” Is there any evidence suggesting that the “educated workers” employed by the firms that would be shifting their tax burden to the companies that are easy tax targets actually bring income and wealth into the city? Don’t most of these workers live in the suburbs? Don’t most of them spend most of their discretionary dollars outside of the city? Isn’t there something a bit alarming about a tax proposal that shifts the tax burden from highly profitable companies with their highly-paid educated employees to businesses employing lower-compensated individuals and having little or no opportunity to escape?

Zandi argues for a “more rational tax code.” Is it not more rational to determine the costs that a business imposes on the city and to charge it accordingly? Do not general taxes, such as a sales-based or profits-based exaction, skew the relationship between the benefits accorded a business and the amount it pays for those benefits? Don’t businesses have an obligation to bear the costs of their operations? Would it not make sense for the city to identify the services it provides to businesses and to utilize some cost accounting techniques to calculate the cost? Perhaps there is justification to calculate cost for a few services based on sales. For example, jewelry stores have relatively higher sales receipts per transaction, are more in need of police protection – perhaps because of the high-end value of their merchandise – whereas other enterprises are far less likely to be criminals’ targets, and thus dividing some portion of the cost of the police department by total sales in the city and allocating the cost in that manner would make more sense and move the tax system closer to a more rational, fair outcome. Fire protection should reflect the asset value of a business, an amount that may or may not be proportional to sales or profits. Businesses and their employees use city streets, and what an interesting opportunity to impose mileage-based road (or street) user fees. The city provides services that makes it a source of customers and clients, and ought not businesses be charged a user fee for this benefit, best measured by profits, not sales, because profits reflect not only the sales revenue brought by those customers and clients, but also the costs that a business must incur by reason of doing business in the city.

Reforming taxation in the 21st century, whether federal, state, or local, demands more creativity and courage than to kick around the same tired, worn-out, disproven, ineffective, and irrational tax structures that have been in place for more than a century. It is time for tax policy, and the politicians, economists, commentators, and others who are involved in tax policy decision making, to think beyond what they learned in school however many years ago they underwent that experience, to open their eyes and ears to ideas coming from sources other than the traditional power brokering segments of society, and to move past the present. Why? Because the citizens and taxpayers deserve nothing less.

Giving Up on Taxes = Surrendering Taxpayer Rights?

A week ago Friday, in Polls, Education, Taxes, and User Fees, I lamented the fact that the Pennsylvania legislature and the state’s governor were making no headway in keeping Pennsylvania from continuing its absurd status as the only state with no tax on natural gas extraction. I pointed out that the dispute pretty much came down to a disagreement on the rate of tax, and referred back to my suggestion, made in Tax? User Fee? Does the Name Make a Difference?, that a key to breaking the stalemate could be reliance on user fees rather than on a tax.

Now comes news that the governor has declared efforts to enact a natural gas extraction tax are dead. He blamed the Republicans in the legislature, claiming that they declined to accept his invitation to put a counterproposal on the table. The Republicans disagreed, arguing that they are interested in working not only for a “fair tax rate” but also on “a whole host of regulatory and safety issues.” Senate Republicans claim that they would support a 1.5 percent tax but only on wells producing more than 150,000 cubic feet of natural gas. The governor finds that idea unacceptable. If, next month, the Republican nominee for the governor’s mansion wins, it is unlikely any tax would be enacted, because, as he has stated more than once, he is “against a natural-gas tax.” If the Democrat nominee wins, nothing will happen unless the Democrats also take control of the legislature. That is not likely to happen. In other words, the easiest thing to predict is a continuation of the stalemate.

In the meantime, taxpayers continue to fund the costs imposed on the state and its citizens by the tax-free-riding gas drilling companies. As the politicians fiddle, the state’s economic well-being burns. Until a user fee, or even a tax, is imposed on these companies, the cost of repairing damage caused to roads by drilling and other equipment, the costs of cleaning up polluted groundwater and streams, the cost of removing waste dumped on land adjacent the wells, the costs of wildlife habitat disruption, the costs of dirtier air, and all other social, environmental, and economic costs triggered by gas extraction will be borne by the state’s taxpayers and not by the companies making a profit on the extraction activities. The companies, of course, are following a principle taught in business schools and permeating modern American capitalism: the secret to making money is getting someone else to pay one’s bills. The taxpayers have a right not to be cornered into paying what ought to be the expenses of the natural gas extraction industry, but those rights are being surrendered by the Pennsylvania politicians who lack the courage to do what needs to be done.

The irony is that most Pennsylvania taxpayers, if they understood the arithmetic, would support natural gas extraction taxes. Why? Because they face two alternatives. One is for THEM to pay higher state and local taxes to cover the costs of extracting natural gas. The other is for THEM to suffer life with torn-up roads, polluted wells and streams, disrupted wildlife, dirtier air, and a general decline in the quality of life. The few who are raking in royalties soon will discover that those royalties are insufficient to make up the short-term and long-term direct and indirect costs of extracting natural gas.

Dealing with this issues is a social and moral responsibility the governor and the legislature. A viable solution is at hand. Yet it appears that dedication to party ideology has trumped devotion to the common weal of Pennsylvania and its citizens. This travesty is but a microcosm of what has been happening at the national level, so it comes as no surprise. That, however, does not make the failings of the politicians any less unacceptable or any less justified. The price for this irresponsibility will be high, will last a long time, and will damage the state many times over what alleged “damage” would have been done by enacting a natural gas extraction tax or set of user fees. To paraphrase what I stated in Polls, Education, Taxes, and User Fees, most Pennsylvanians are “more interested in getting things done, whereas the legislators are more interested in finding political advantage.” If it were possible, the governor and the legislators ought to be compelled to remain in Harrisburg until they get this done, and until they get this done, they don't go home, even if that means they lose the opportunity to campaign. Getting the job done means much more to voters than tossing more electoral rhetoric around the neighborhoods.

Tax Law as Subterfuge: Best Use Valuation v. Current Market Valuation

An article in Sunday’s Philadelphia Inquirer asked an important question with its headline: More taxes on worn buildings, vacant land? The article was inspired by a 16-year-long dispute involving Philadelphia properties owned by the estate of Sam Rappaport, once a prominent Philadelphia landlord. The estate’s executor is a New Yorker, Richard Basciano. One of the problems is that the properties have not been put to their best use, thus causing them to be valued for real estate tax purposes at amounts lower than presumably would be assessed if they were developed beyond their current state. Philadelphia builders claim that they have tried to purchase the properties from Rappaport’s estate, but that Basciano wants them to “charge New York prices for Philadelphia lots.” Basciano’s attorneys explained that many of the properties were tagged with violations of the building code, and that the properties were severely encumbered with debt. They also explained that the estate indeed has sold some of the properties to Philadelphia developers. Apparently, though, those sales took place more than ten years ago.

The article asked another question. “If Basciano can afford to hold the properties in search of higher profits, what’s to stop him?” and answered it by proposing “Maybe Philadelphia’s tax assessment system.” It is undisputed that under the current system, an empty lot is assessed at a lower value than would be the same lot with a commercial or residential building on it. A lot used as a parking lot carries a lower assessment than the same lot with an office building on it. The chief of Philadelphia’s Center City District suggests that the real property tax system be changed so that properties are assessed at their highest and best use. The theory is that by being taxed at the best-use value, property owners would be encouraged either to develop the property or to sell it to someone who will. The practical impact, however, could be destructive.

The suggestion that the tax assessment system be changed to value properties at best-use value poses a serious threat to owners of properties that are more than empty lots or parking areas but that are not the best use of the property. Consider the number of properties in the city with buildings that, if resources were available, could be torn down and replaced with more efficient, more functional, and more attractive, in other words, buildings that would have a higher value. This sort of valuation process would adversely affect owners of properties with older, functional yet aging, adequate yet not modern-looking buildings.

The article notes that the idea that the property tax should be imposed on land, not buildings, is a very old idea, and is one that ensures “property owners feel pressure to erect buildings as valuable as their neighbors’ instead of leaving them speculatively vacant.” There are several serious flaws in this approach. First, this approach would encourage the disappearance of green space within the city and would discourage property owners from devoting some portion of land to something other than concrete and steel development. Second, any attempt to mitigate the effect by restricting best-use valuation either geographically, such as the center city district, or by limiting it to empty lots, would violate a variety of state, if not federal, constitutional and statutory provisions. Third, this approach opens up the need to determine, and thus to dispute and litigate, the question of what is the best use and the question of what value should be assigned to a hypothetical best use.

A proponent of the best-use approach explains, “But I have a fundamental issue with someone saying, 'For tax purposes, it's worth $1 million, but when I want to sell, it'll be $20 million." So do I. The problem isn’t one that can be solved only by shifting to a best-use system. The problem is that a property that sells for $20 million, barring an absurd surge in market values the day before the sale, ought not be “worth $1 million” for tax purposes. The problem is the same one that has afflicted the Philadelphia real property tax for decades, namely, erroneous assessments. I have previously commented on the Philadelphia real property tax system, and its flaws, in a long series of MauledAgain posts, starting in An Unconstitutional Tax Assessment System, and continuing in Property Tax Assessments: Really That Difficult?, Real Property Tax Assessment System: Broken and Begging for Repair, Philadelphia Real Property Taxes: Pay Up or Lose It, How to Fix a Broken Tax System: Speed It Up? , Revising the Board of Revision of Taxes, How Can Asking Questions Improve Tax and Spending Policies?, This Just Taxes My Brain, Tax Bureaucrats Lose Work, Keep Pay, Testing Tax Bureaucrats Just Part of the Solution, A Citizen Vote on Taxes, Freezing Real Property Tax Reassessments: A Nice Idea, The Tax Price of a Flawed Tax System, Can Bad Tax Administration Doom the Tax?, Taxes and Priorities, R.I.P., BRT, and A Tax Agency Rises from the Dead. Getting assessments done properly poses the same challenges whether the assessors are trying to determine current market value or a theoretical best-use value, although one could safely assume that assessors are more likely to miss the mark when trying to determine best-use value than when trying to determine current market value.

The same proponent also advocates a “flipper’s tax” on passive property investors. His argument is that people who improve a property pay “a lot more tax” than do people who simply buy land and hold it, or buy land with run-down buildings and let it “rot” while waiting for the value to increase. Are there not laws already in place that impose penalties on property owners who let their properties “rot”? If there is a tax on people who hold property such as a parcel of land waiting for the best time to sell or develop, will there also be a tax on someone who owns a residence but who doesn’t install a deck that would increase its value? Yet does this sort of thinking not lead to a tax on employers who fail to hire more employees?

It’s not permissible for a government to tell the owner of a vacant lot to build a building on it, even though it is permissible for the government to tell the owner not to dump toxic waste on it or to tell the owner to clean the trash piling up on it. The tax law ought not be used as an end-around subterfuge to accomplish the impermissible.

Gross Income from Finding Things

One of my favorite classes in the basic federal income tax course is the one that deals with the tax treatment of items that a person finds. The point of the discussion is to give students a chance to understand the scope of gross income, and to appreciate the fact that not every specific instance of gross income is set forth in the statute. The course book that I use includes a case dealing with a taxpayer who finds cash in a piano that was purchased. In my supplemental materials, I provide them with newspaper articles about a person who found a copy of a first printing of the Declaration of Independence inside a painting purchased at a flea market for $4, another couple who found cash – in this case $140,000 – in a piano purchased at an estate sale for $70, and a person who found valuable autographs inside a table purchased for $3 at an auction. I share with them other stories, noting that most semesters I hear or read about a new one in the news about the time we discuss the topic. The stories are fun. After learning of someone who purchased a used violin only to discover it was a Stradivarius, I ask the class why these sorts of things don’t happen to me or to them.

One of the attributes of all the stories and hypotheticals is the ease with which the person discovers the valuable item. Someone purchases an item at some sort of sale and, presto, it’s a Ming Dynasty vase. Or someone is walking down the street and sees a diamond ring, or a Rolex. In some examples, I have the person identify the owner and return the property, in order to get across some aspects of realization and increase in economic wealth.

Now comes a Philadelphia Inquirer story about another way in which people find things. The title alone says almost everything: Hidden Treasure in Philadelphia-Area Sewers. That’s right. Sometimes to find a treasure one must do more than go to an auction or watch the ground carefully while walking. Sometimes one must get down into the muck and get dirty. All that advice about keeping out of the gutter and staying out of the sewer turns out to be misleading when it comes to finding valuable things.

The tax side of the story is what gets my immediate attention, but there’s so much more to the article. So if you’re interested in the details about “guns recovered after a burglary,” “[k]ids will throw anything down a hole,” “We’ve had ducks,” “Are there alligators?,” “catfish,” “Curly . . . the ball python,” and the hundreds of Nerf footballs from a “marketing attempt gone bad,” read the story. Even if you don’t get a chance to drop some fun trivia on a first date, it’s a fun read.

The tax questions arise from several revelations on the part of the sewer workers. One worker explained that the “crew’s payload is about $10 in change every month,” and that “once every two months a worker will find a piece of jewelry – though mostly costume.” We’re told that “Most sewer departments have a finders-keepers philosophy. If the guy is willing to reach in and grab it, it is his.” As for small amounts of money, “The found money gets spent treating coworkers to lunch,” but “sometimes, [found coins] are just spent in the vending machine.” Rings and other jewelry often are so damaged that they are “sold to jewelers as scrap.” Old coins are taken in for appraisal. On one occasion, a worker was able to identify the owner of a 40-year old class ring, and returned it. See where this is going? The tax questions are jumping out at us. Does the worker who finds something of value and keeps it have gross income? Do the coworkers have gross income when they receive lunch courtesy of money found in the sewer pipes? What is the tax treatment of the worker who found the class ring and returned it to its owner?

These questions have fairly easy answers. I’m not going to provide them, because I or my tax professor colleagues across the country might turn this into an exam question or something to raise in the classroom. But perhaps the answer to my question about why these sorts of things don’t happen to me or to my students comes from one of the sewer workers interviewed for the story. “You have to be at the right place at the right time.” How true. When’s the last time you’ve been in the sewer? And digging through the tax law doesn’t count.

IRS Decides Not to Follow Tax Court Decisions That It Won

An unusual event has occurred in the tax world. The IRS issued Revenue Ruling 2010-25. The issuance of a Revenue Ruling, though something that happens much less frequently than it did twenty years ago, is not the unusual event. Nor is the conclusion reached by the IRS. What is unusual is that in the revenue ruling, the IRS concluded that the outcome in two cases in which it had prevailed was wrong. In other words, the IRS has decided not to continue taking the position that it had taken and that the Tax Court had upheld. Though from time to time the IRS announces that it does not plan to follow a Tax Court decision in which it lost, it is a rare occasion when the IRS wins, wins again, and then decides it should have lost.

The issue, on the surface, is fairly easy to set forth. How much of the interest paid by a taxpayer on a mortgage loan undertaken by the taxpayer to purchase a principal residence is deductible? The analysis is a bit more challenging.

Section 163(a) permits a deduction for all interest, but for individuals section 163(h)(1) disallows deductions for personal interest. Personal interest is all interest, other than trade or business interest, investment interest, passive activity interest, qualified residence interest, certain interest in deferred estate tax liabilities, and education loan interest. The relevant exception is the provision that allows a deduction for qualified residence interest.

Qualified residence interest consists of two components. One is interest in acquisition indebtedness with respect to a qualified residence. The other is home equity indebtedness with respect to a qualified residence. A qualified residence is the taxpayer’s principal residence and one other residence owned by the taxpayer that is selected by the taxpayer as a qualified residence. Acquisition indebtedness is any indebtedness “incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer” and that is secured by the residence. No more than $1 million of indebtedness can be treated as acquisition indebtedness. Home equity indebtedness is any indebtedness “other than acquisition indebtedness” secured by a qualified residence to the extent that it does not exceed, in effect, the lower of $100,000 or the excess of the residence’s fair market value over the acquisition indebtedness with respect to the residence.

So assume a taxpayer purchases a principal residence for $1,500,000, by using $300,000 of cash and borrowing $1,200,000 secured by a mortgage on the residence. The taxpayer owns no other residences. The taxpayer pays interest on the $1,200,000 loan. How much of that interest is deductible.

In Pau v. Comr., decided in 1997, the Tax Court agreed with the IRS that only the interest on $1,000,000 could be deducted, reasoning that there is $1,000,000 of acquisition indebtedness but no home equity indebtedness because the taxpayers did not prove that any of the debt was not incurred in acquiring, constructing, or substantially improving the residence. Three years later, the Pau decision was followed by the Tax Court in Catalano v. Comr.

The difficulty with the Tax Court’s reasoning is its conclusion that indebtedness cannot be home equity indebtedness if it was used to acquire, construct, or substantially improve the residence. But that is not what the statute says. The statute defines home equity indebtedness as indebtedness “other than acquisition indebtedness” secured by a qualified residence to the extent that it does not exceed, in effect, the lower of $100,000 or the excess of the residence’s fair market value over the acquisition indebtedness with respect to the residence. Thus, one must first identify acquisition indebtedness. The taxpayer used $1,200,000 of indebtedness to purchase the principal residence, but the statute treats only $1 million of this amount as acquisition indebtedness. In other words, the other $200,000 of indebtedness is NOT acquisition indebtedness. If the $200,000 is not acquisition indebtedness, then $100,000 of it can be home equity indebtedness provided the fair market value of the residence is at least $1,100,000. The Tax Court treated the statute as though it defined home equity indebtedness as indebtedness “not used to acquire, construct, or substantially improve a residence” that is secured by a qualified residence to the extent that it does not exceed, in effect, the lower of $100,000 or the excess of the residence’s fair market value over the acquisition indebtedness with respect to the residence.

Though it took ten years, the IRS finally decided that the conclusions reached on this point in the Pau and Catalano decisions are wrong. It issued Revenue Ruling 2010-25 to set forth the explanation that had been provided years ago by those who disagreed with the approach advocated by the IRS and adopted by the Tax Court in Pau and Catalano.

The IRS should be commended for giving up on an erroneous position. One wonders whether the IRS is prepared to give up on its erroneous position with respect to section 280A apportionment of interest and taxes that was first rejected by the Tax Court in Bolton v. Comr., rejected in every subsequent case, and rejected by every Court of Appeals that has considered the issue. There are similar issues ready for a similar admission of error by the IRS. The answer to why the IRS has not moved on those cases might lie in the answer to why the IRS challenged the taxpayer’s deductions in the Pau and Catalano cases. Could it be that not every IRS employee or Chief Counsel attorney fully understands the tax law? I wonder whose fault it is that the tax law is so difficult to understand because it is so confoundedly and needlessly complicated.

Polls, Education, Taxes, and User Fees

Efforts by the Pennsylvania legislature to deal with proposals to tax Marcellus Shale natural gas have, to borrow from the headline of this Philadelphia Inquirer story, reached a stalemate. The suggestions I made two weeks ago to prevent or break a stalemate, discussed in Tax? User Fee? Does the Name Make a Difference?, apparently have not been invited to Harrisburg. Nor have I. It only takes one read of the the Philadelphia Inquirer story to understand why. I’m more interested in getting things done, whereas the legislators are more interested in finding political advantage.

One of the reasons that a stalemate exists is the contradictory evidence generated by the pollsters. According to another Philadelphia Inquirer story, in one poll, only 35 percent of Pennsylvanians supported a tax on natural gas extraction, while 49 percent were opposed. Five months later, in a different poll, 78 percent of Pennsylvanians approved the idea of a gas severance tax, and 14 percent were opposed. Was there a sudden shift in voter attitudes? No.

The difference in the poll results are caused by the manner in which the poll question is framed. Consider the poll generating 49 percent opposition. After asking questions with respect to proposals to increase the tax on cigars and smokeless tobacco, and to impose tolls on I-80, the poll asked whether those questioned supported “increasing taxes on companies that extract and sell natural gas.” On the other hand, the poll generating 78 percent support asked a 123-word question – and, no, I did not write it – that explained what Marcellus shale natural gas is, that “large multinational gas-drilling companies from other states and other countries are coming here to lease land and extract this gas,” that “This discovery holds the promise of significant economic development and the creation of new jobs, but it has also placed new an difficult stresses on local services, harmed water supplies, and destroyed local roads,” and that “In other states, these companies pay a special tax to fund programs that will protect our environment and help local governments handle the increased demand on their services” before asking “Would you favor or oppose a special tax on these multinational gas companies for that specific purpose?”

The Philadelphia Inquirer story suggests that the difference is “all in how the question is asked.” That’s true, but it glosses over the meaning of “how.” To me, the differences in the poll results illustrate the differences in outcome when someone who is educated about an issue is answering a question and when someone who is not educated about an issue and is answering a generic sound bite question is answering a question. The director of the poll generating the 49 percent opposed outcome, which asked a short question without providing background information, agreed, saying, “I think it is not exactly the residents of the state know much about or are very much concerned about, despite the fact it’s a huge policy and political issue in the state.” I wonder how his poll would have turned out had he provided educational information before asking the question. Perhaps the answer can be found in a third poll, administered after the first poll and before the second one, that simply asked, “Do you support or oppose increased taxes on America’s oil and natural-gas industry?” and obtained a 31 percent favor, 61 percent opposed result. Notice that the question mirrors the current “don’t tax us” advertising campaign being waged by the fossil fuels industry.

The inconsistent poll outcomes demonstrate not only the need to educate the public, but the need to put the issue in terms that make sense to people. That’s why I suggested that what should be under consideration are user fees. Imagine a poll question that asked, “Should natural gas extraction companies be charged a fee for polluting underground water or should that cost be paid by taxpayers and homeowners?” and “Should natural gas extraction companies be charged a fee to pay for fixing the damage their large vehicles do to local roads, or should local taxpayers pay?” It would be shocking if people replied that they were willing to pay taxes and other costs to bear the burdens that generate benefits for the extraction companies and their owners.

The irony of the stalemate is that the governor and legislators are battling over rates. The Senate Republicans favor a 1.5 percent tax on natural gas extraction, House Democrats favor 9.8 percent, and the governor suggested 6.2 percent. If principle is going to stand in the way of compromise on a rate, perhaps principles can be unified to go the user fee route. There’s much less arbitrariness in selecting a fee based on actual costs than in selecting a rate that focuses on revenue generally rather than on costs and expenses.