Tax Cheating and Tax Complexity

Late last week I received a press release describing a new book, Tax Cheating: Illegal – But Is It Immoral?, written by Donald Morris, an associate professor of accounting at the University of Illinois Springfield, a CPA, a certified fraud examiner, and a former tax practitioner. According to the press release, the book focuses on the question, “But who is to blame for tax cheating when most partaking in the activity don’t even realize they are breaking the law and are merely victims of the complexity of the tax code which is born out of 100 years of adding special provisions and exceptions?”

When I read this question I was taken aback. If a person does not realize he or she is breaking the tax law, the person is not committing fraud. Depending on the circumstances, the taxpayer could be accused of being negligent, perhaps even reckless. But in order to commit fraud, there needs to be intentionality and knowledge. For example, in Conforte v. Comr., 692 F.2d 587, 592 (9th Cir. 1982), the Court of Appeals for the Ninth Circuit explained that tax fraud is “intentional wrongdoing on the part of the taxpayer with the specific intent to avoid a tax known to be owing.” The Ninth Circuit repeated this position in Estate of Trompeter v. Comr., 270 F.3d 767, 773 (9th Cir. 2002), and in Maciel v. Comr., 489 F.3d 1018, 1026 (9th Cir. 2007), to cite just two of the cases demonstrating the vitality of this analysis.

There is no doubt, as Morris and many others assert, that the tax law is woefully complicated. There is no doubt it ought not be so complicated and need not be so complicated, and that at least some of the complexity is attributable to the campaign and other political games played by the legislators entrusted with the fiduciary duty of providing the nation with the best possible tax law. There also is not doubt that the pervasive complexity of the tax law causes taxpayers to make mistakes, even when they are putting forth their best efforts to comply. If a taxpayer makes a computational error, doesn’t realize that a deduction claimed last year isn’t available this year, is unaware of a newly enacted credit limitation, or mis-identifies a window as qualifying for an energy credit, the taxpayer is not committing tax fraud. The taxpayer is negligent, and perhaps there is a question of whether failure to research the tax law, keep up with changes in the tax law, or refer tax return preparation to a professional is immoral, but those acts do not rise to the level of tax fraud.

It is possible, though, that some taxpayers view the complexity of the tax law as increasing the probability that they will not get caught. Those taxpayers, however, are intent on cheating, and simply let the cover of complexity weaken whatever other deterrents exist to discourage tax cheating. Yet tax cheats do not limit themselves to complicated tax laws. Some of the most simple tax laws – such as a per-carton cigarette tax, the use tax, and the real property transfer tax – are the targets of significant numbers of tax evaders. Tax complexity might make it easier for tax cheats to rationalize their behavior, convinced that they need to cheat to keep up with the citizens sufficiently wealthy to purchase tax breaks for themselves. The irony is that most taxpayers convicted of criminal tax fraud or penalized for civil tax fraud either are among the ranks of those active in purchasing tax breaks or are among the large groups of taxpayers benefitting from decades-old widespread tax breaks.

Blaming dishonesty on complexity is totally off the mark. Complexity might enhance the temptation, but it does not create the noncompliant tax evader. The noncompliant tax evader is a reflection of the same cultural deficiency that encourages people to go straight out of the left turn lane, to go through EZPass toll booths without an EZPass device, to file false Medicare and Medicaid claims, and to assert that they were one of the 5,000 people on a public transit bus that crashed.

Robbing Peter to Pay Paul, Tax Style

Philadelphia’s School District is in financial trouble. That’s not news. Tax revenues are down, spending cuts have not eliminated the budget deficit, and steeper cuts could cause the school system to collapse. The mayor has proposed increasing school district real property tax revenues by working a tax increase into the real property assessment reform, a proposal noted in The Bad Tax System That Will Not Die Might Get Another Lease on Life.

Now comes a Philadelphia Inquirer story that describes efforts by some state legislators to divert gaming revenue from wage tax reduction to supplementing the school district’s revenue. The legislators advocating this move are trying to prevent the shuttering of numerous schools while protecting city property owners from real property tax increases. The problem, according to the city administration, is that the city would then face a revenue shortfall unless it increased the wage tax by half a percentage point, which is roughly a 15 percent increase.

Hence the dilemma. There are four choices. Let the school system fall apart. Cut city services significantly. Increase the wage tax by 15 percent. Increase real property taxes on properties that are, and have been, grossly undervalued for at least a decade.

What would you do? What will the legislators do? Do you think they will do what you would do?

Tax Credit = Reverse Tax

Almost a year ago, Pennsylvania State Representative Jesse White announced plans to introduce legislation “that would provide a tax credit for the adoption of a dog or cat.” Late last week, as reported in this article, the attempt to add the credit to the state income tax law failed by a vote of 97-96.

This effort is a textbook example of why it is so difficult to clean up the tax law. Any sort of objection to this credit will bring howls of protest and derision from many of those who like animals and have pets. I say many and not all because I like animals and have had pets, but I’m no fan of cluttering the income tax law with a provision whose goals can and should be accomplished in other ways.

The goal of the legislation is “to encourage adoption and discourage puppy mills and also ease the burden on shelters.” Those are noble goals. The tax law, and the Department of Revenue, are not appropriate vehicles for accomplishing those goals. I have criticized the use of tax incentives to achieve non-tax purposes at the federal level, as discussed in posts such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, When Tax Credits Aren’t Worth the Trouble, The Disadvantages of Tax Incentives, and
Tax Incentives Gone Wild, and I am no less critical of similar approaches at the state level. For example, would the Department of Revenue be responsible to make certain that taxpayers who claim the credit keep the adopted dogs and cats and don’t abandon them or drop them off at a shelter a few months later after filing their tax returns?

The state of Pennsylvania has a history of providing financial support to animal shelters. This is a classic case of good public spending, no matter what the so-called smaller-government and anti-tax advocates claim. Public health and safety is threatened when animals run wild that ought not be running wild, and the establishment of shelters provides a public service. Thus, the public ought to fund the efforts to take those animals off the street. In recent years, however, the anti-spending forces have succeeded in cutting state funding for shelters in half and have proposed to eliminate the funding altogether.

Representative White’s proposal would limit the credit to $7.5 million. It’s unclear what would happen if 25,001 taxpayers claimed the credit. That issue aside, why not simply provide $7.5 million of funding to animal shelters? Surely that is a more efficient use of $7.5 million than dishing out tax credits to taxpayers who may or may not even need the financial support to adopt a dog or cat. Despite the claims of the cut-taxes, cut-spending crowd, the $7.5 million credit increases the state’s budget deficit by the same amount as would $7.5 million in spending. Once again, I make the point that a tax credit is spending in disguise, and yet anti-spending legislators vote for tax credits without blinking.

The proposed credit has several other flaws. Why is it limited to dogs and cats? Is that not discrimination against those who favor other animals? I have a law school classmate friend who rescues birds and who has successfully advocated on behalf of birds that have been mistreated. Is her work no less noble than the work of those trying to save abused, abandoned, and neglected dogs and cats?

The proposed credit suffers from the same misguided notions as does the federal income tax adoption credit. It is inconceivable that anyone would consider the credit the tipping point between adopting and not adopting. Considering that the cost of raising and caring for a child or pet exceeds the credit or proposed credit by orders of magnitude, no one should rely on the credit as the financial wherewithal to taking on the responsibilities of having a child or pet.

The worse aspect of the credit is a defect that it shares with all other credits. The credit is a reverse tax. Setting aside the increased budget deficits generated by tax credits, if revenue is to be maintained when a tax credit is enacted, taxes must be raised across the board to fund the credit. Thus, those who, for whatever reason, cannot or do not adopt a dog or cat, are being taxed, whereas those who receive the credit, even net of the taxes they pay due to the across-the-board tax increase, are not paying additional tax. Thus, the enactment of a funded tax credit is a tax on those who fail to do whatever it is that those who qualify for the credit are doing. And if taxes are not increased to fund the credit, everyone pays through the economic effect of increased budget deficits. Either way, those who do not adopt pets are being taxed or charged. I wonder, once those who support the anti-tax groups because they don’t want to pay more taxes figure out the reverse tax implicit in the tax credits enacted by the supposed anti-tax, anti-spending legislators, will they shift their support to those who take a more sensible approach to taxation and spending?

Tax Incentives Gone Wild

Two separate developments that appeared last week provide even more warnings about the dangers of relying on tax incentives to accomplish goals that are far beyond the scope of a rational tax law. This is not the first time that I’ve addressed this concern, as evidenced by posts such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, When Tax Credits Aren’t Worth the Trouble, and The Disadvantages of Tax Incentives, and I doubt it will be the last.

The first development was the introduction in Congress of a proposed “Qualifying Renewable Chemical Production Tax Credit Act of 2012”. This is truly a bi-partisan effort, as the each of the two members of Congress who introduced the bill belong to one of the two major political parties. The legislation would add a section 45S to the Code equal to 15 cents per pound of eligible content of renewable chemical produced by the taxpayer during the taxable year. Each taxpayer’s credit is limited to its share of a $500 million limitation allocated by the IRS among taxpayers claiming the credit. The definition of eligible content is a long, technical, and exception-ridden description that chemical engineers can understand, though few, if any, tax practitioners or IRS employees would appear to be well versed in terms such as biobased content, renewable chemical, biobased content percentage, biological conversion, thermal conversion, and renewable biomass. I daresay that the legislators who introduced this bill did not write it, and if compelled to hazard a guess, I’d put this language in the hands of lobbyists.

Not only would this legislation require the IRS to jettison revenue officers so that it could hire chemical engineers, it also would require the IRS to fire even more revenue agents so that it could hire more economists and scientists. Why? In allocating the $500 million spending increase masquerading as a tax credit, the IRS would be required to determine “the number of jobs created and maintained (directly and indirectly) in the United States” by each taxpayer’s credit allocation, “the degree to which the production of the renewable chemical demonstrates reduced dependence on imported feedstocks, petroleum, non-renewable resources, or other fossil fuels,” “the technological innovation involved in the production method of the renewable chemical,” “the energy efficiency and reduction in lifecycle greenhouse gases of the renewable chemical or of the production method of the renewable chemical,” and “whether there is a reasonable expectation of commercial viability.” It is not the role of the IRS to engage in these sorts of determination. Putting aside the question of increased government spending, why not allocate $500 million to the Department of Energy and tell it to administer this program? The answer, of course, is all sorts of nonsense about how the tax law is the better vehicle for accomplishing the purposes of the spending program, but the true answer is that it’s simply a way to spend money without disclosing the expenditure. That might resonate with people who don’t understand that reduced revenue, whether through credits or otherwise, and increased spending have the same effect on the budget deficit. It doesn’t resonate with those of us who can see through the ploy. But, speaking of ploys, it’s an election year, and the introduction of this bill might be nothing more than a sop to some campaign contributors.

The second development was a GAO report, Energy Conservation and Climate Change: Factors to Consider in the Design of the Nonbusiness Energy Property Credit, that explores the possibility of changing the section 25C nonbusiness energy property credit to one that is calculated using performance-based standards rather than simply the cost of the improvement incurred by the taxpayer. In a sentence set in bold and much larger font, the report declares: “Performance-based credits may have significantly higher compliance and administrative costs than cost-based credits.” And on what agency would these higher costs fall? The IRS, of course, which would need to dismiss even more employees tasked with tending to the agency’s primary revenue collection function. The report also explores the use of floors in the computation of the credit, which would make the tax law even more complicated, adding to the misery of taxpayers and the administrative and compliance burdens placed on the IRS.

Considering that the GAO issued the report in response to requests by the Congress, there is a significant possibility that the tax law will become even more complicated, even as the Congress tosses about the phrase “tax simplification.” Rather than listening to the Congress, Americans ought to be watching what the Congress does. And one of the things that it does is to make the tax law more complicated, for reasons that have nothing to do with sound tax policy.

Using the Tax System to Steal Identities

They are persistent, that much must be conceded. I’m referring to people whose intelligence and cleverness could accomplish much to benefit society, but who choose to use their talents to do evil. The other day I received an email with the subject line “RE: Tax Exemption Notification” from a person using the name Isabella Charlotte. I doubt this person exists, and if she does exist, I doubt she is the sender of the email. I doubt that Charlotte is her surname. In the body of the email was a purported IRS logo, and a letter that began, “Sir/Madam, Our records indicate that you are a Non-resident.” Really? Guess what, Isabella Charlotte or whoever you are, I am not a non-resident. I cannot imagine what IRS records would exist showing me to be a non-resident. Of course, at that point I knew the letter was a scam, a product of a twisted and devious mind, but I kept reading.

The letter continued, “As a result you are exempted from United States of America Tax reporting and withholdings. . .” Even if I had not yet concluded that the letter was a scam, that phraseology would seal the deal. It’s not professional tax terminology. The letter then proceeded to request that I “recertify” my status by filling out “form W-4100B2.” Attached to the email was a concocted Form W-8BEN, not a “form W-4100B2.” The letter asked that the form be sent by fax to 1-815-390-1251, but the attached form requested that it be sent to 1-267-427-1363. The attached form actually asked that it be sent “to fax no- 1-267-427-1363 Via Email TO irs.usa@5acapital.com.” The forms, of course, ask for all sorts of identifying information, including social security number, bank name and account number, and so on.

Perhaps I give this “Isabella Charlotte” too much credit for intelligence and cleverness. Consider the sloppiness of this attempt to steal identities. Inconsistent form numbers. Inconsistent fax numbers. Grammatically confusing sentences. Absurd email address. Perhaps “Isabella Charlotte” doctored up a more sophisticated scam in an effort to avoid being linked to the originator of this particular phishing attempt. The clincher is the claim by “Isabella Charlotte” to represent “IRS Public Relations.”

So who is responsible for ridding the planet of this behavior, and curtailing the activities of those who engage in these counterproductive enterprises? Government? Which ones? The private sector? Who pays? The funneling of resources that could be used for more productive endeavors into the prevention of, and punishment for, fraudulent activity is a sad commentary on the failure of the species to make better progress. Sadder still is the probability that somewhere, someone will provide to this “Isabella Charlotte” and others like her the requested information. Again, it comes down to education, combined with careful monitoring of those who lack or lost the capacity to deal with these sorts of scams. And again, who is responsible? And who pays?

I wonder how much more prosperous the economies of every nation could be if this sort of behavior could be stamped out. Whatever is being done isn’t enough, because the practice continues. It will stop when it becomes a fruitless exercise. That hasn’t happened yet. Why?

Obstacles to Property Tax Reform

Consider the situation in which two homeowners find themselves. Each lives in the same real property tax jurisdiction. Each owns a home worth $300,000. One pays real estate taxes of $1,500. The other pays real estate taxes of $3,500. Why the difference? A variety of factors contribute to the inequity. Appraisals are inconsistent. Appraisals are done at different times. Appraisals are not updated. The tax is computed using an arbitrary fraction of presumed value.

This sort of situation is the poster child for the Philadelphia real property tax system, although similar problems surely afflict localities across the nation. I’ve been writing about the Philadelphia real property tax dilemma since my first post, An Unconstitutional Tax Assessment System, and I have continued with a series of posts, 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, A Tax Agency Rises from the Dead, and Tax Law as Subterfuge: Best Use Valuation v. Current Market Valuation, How to Kill a Bad Tax System That Will Not Die?, and The Bad Tax System That Will Not Die Might Get Another Lease on Life.

Fixing the problem should be simple. Appraise properties at current market value, and divide current revenue by total valuation to obtain the rate. One difficulty, as noted in The Bad Tax System That Will Not Die Might Get Another Lease on Life, is the temptation to increase revenues in the process of fixing valuations. The two processes should be kept separate. Another major problem, as discussed in a recent Philadelphia Daily News article, is the reaction of property owners who suspect that an appraisal set at market value will cause their real property taxes to increase. Though some property owners who have that worry might be worrying needlessly, there is no doubt that a substantial number of properties in fact are undervalued, and their owners will face higher taxes.

One taxpayer quoted by the article claims that her property taxes will increase to $5,500 a year. How does she know that? Does she have both the new appraisal and the new rate? No, because the new rate continues to be the subject of debate among the city’s leaders. This person also claimed, “I feel like I love the city and it doesn’t love me back.” How is a city supposed to show love? By selecting random individuals for tax breaks in the form of under-market valuations? By giving tax breaks to those who claim to “feel like I love the city?” How does one identify individuals who qualify? If the test were a matter of finding people willing to speak those words, the real property tax base and its revenues would plummet. Should the fact that someone has benefitted from years of inequitably low taxes, in comparison to property owners paying at higher effective rates, matter?

There are in place a variety of arrangements that property owners can use to blunt the impact of real property tax increased caused by the restoration of equity to the system. Some taxpayers qualify for programs designed to assist those who are economically disadvantaged in terms of income and those who qualify for certain benefits for the elderly. There also is a law that permits property owners to defer tax payment if their assessments increase by more than 15 percent. The deferred payments, plus interest, are due when the property is sold. In addition, the city is considering phasing in the tax increase, though no mention is made of phasing in the tax decrease for the taxpayers who have been relatively over-paying during the past several decades. The city also is trying to persuade the state legislature to enact a $15,000 across-the-board homestead exemption.

Coalitions of taxpayers are urging the city to delay switching to assessments based on actual value. One risk of doing so is a $41 million revenue loss triggered by a state tax board decision that opens the door to more appeals by taxpayers whose properties are over-valued. Ultimately, the question is how much longer should some taxpayers in the city, who have been paying disproportionately higher real property taxes, continue to subsidize taxpayers who have been paying disproportionately lower real property taxes? This question, it must be understood, overlooks the tougher question of how to ameliorate the effect of years of this unjustifiable subsidization, because the practical answer to that question is simply that it won’t happen. For that, the subsidized property owners have something for which to be thankful and a reason to appreciate the fact that things could be much worse.

A Questionable Health Tax Proposal

Earlier this month, the Institute of Medicine of the National Academies released the third in a series of reports on the state of public health in this country. In the third report, the Institute turned to the question of funding federal public health efforts to cope with the “large proportions of the U.S. disease burden” that can be prevented. The proposal rests on the belief that the need for medical care and its associate costs can be reduced by preventing disease, illness, and injury, and on the belief that the cost of prevention is less than the cost of treating the disease, illness, or injury. The report mentions the benefits of reducing tobacco use, and increasing immunizations, seat belt use, healthy nutrition, and physical exercise.

The Institute proposes that federal public health funding be doubled, that state and local funding currently directed into clinical care be redirected to public health purposes when the clinical costs become reimbursable under Medicaid or Affordable Care Act state health insurance exchanges, and the enactment of “a national tax on all medical care transactions.” The Institute considered pretty much every sort of tax possibility, including increases in estate taxes, sales taxes, intangibles taxes, life insurance proceeds taxes, property taxes, and value-added taxes.

It may shock some readers of MauledAgain, but I question the wisdom of dealing with these issues in the manner the Institute suggests. The idea of encouraging prevention efforts has my full support. It is logical and makes sense to use seatbelts, to wear helmets when riding motorcycles, to exercise, to eat healthily, and to avoid tobacco use.

The tough question is how to increase prevention efforts and to decrease choices that ultimately contribute to the escalation in health care costs. There are three pathways, not mutually exclusive, to achieving better prevention efforts. The first is to compel people to engage in prevention efforts. The second is to pay people to engage in prevention efforts. The third is to educate people so that they conclude that prevention matters, decide that they want to make better choices, and learn how to make those choices.

The first pathway is blocked by a variety of obstacles. Compelling people to go to the gym, or to eat broccoli, meets public resistance. There’s the matter of the federal Constitution and state Constitutions. There are lessons to be learned from Prohibition, one of which is the realization that alcohol consumption, in moderation, has health benefits, and is not the per se bad practice that some believe. That there are statutes requiring the use of seat belts and prohibiting texting while driving is encouraging, but there’s as much pressure to repeal those laws as there is to expand them to widen the scope of obligatory safe behaviors and prohibited unhealthy activities.

The second pathway is nothing more than a bribe, though many probably prefer the less glaring term incentive. Though money might induce some people to change their health habits, the amount required to do so might consume whatever savings can be obtained through prevention.

The third pathway is the most efficient route to implementing the sort of changes that will reduce long-term medical costs. Education costs money, but does it require the sort of funding that the Institute proposes? Is it not possible to reform elementary and secondary education to include in the curriculum information and instruction in preventative care and common sense health measures? Is it not possible to insert health prevention education into existing social programs that serve adults who are beyond their school years? Even so, even with all the education money could buy, some people are dead-set, pun intended, on living in ways that are unhealthy and that ultimately will lead to increased medical costs. There are some things taxation cannot cure.

The Disadvantages of Tax Incentives

A recent case provides good insight into the disadvantages of using the tax law in an effort to encourage or discourage particular economic or other activity. In previous posts, such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, and When Tax Credits Aren’t Worth the Trouble, I have shared a variety of reasons that it makes little or no sense to use the tax law as a substitute for direct funding and oversight by the agencies expertised in the area in question.

In McGuire v. Comr.,, T.C. Summ. Op. 2012-34, the Tax Court held that the taxpayers, a married couple, did not qualify for the section 36 first-time homebuyer credit. The taxpayers failed to qualify because they signed the lease-purchase agreement for the property on March 20, 2008. Although the parties agreed that the agreement constituted a purchase and the property was used as a principal residence, the credit applied to property purchased after April 8, 2008, and before July 1, 2009.

Hindsight suggests that had the taxpayers waited 20 days, they would have obtained a $7,500 credit. The lesson appears to be that if there is any possibility of a tax incentive being enacted with respect to a particular type of transaction or activity, a person should wait, unless the transaction or activity is essential. It’s silly to postpone purchasing groceries for months on end on the off-chance the Congress might enact a food market stimulation credit. But is it so silly to hold off making other sorts of acquisitions? Not at all. According to a recent report from the National Restaurant Association, roughly thirty percent of restaurants are delaying expansion and renovation projects because they don’t know if Congress is going to restore the expired special 15-year recovery period for restaurant property. The projects that are on hold would put $30 billion into the economy through direct expenditures and ancillary economic impacts, and create roughly 200,000 new jobs.

What makes the use of tax law incentives particularly detrimental is the refusal of the Congress to enact a set of rules that have any sort of long-term sustenance that permits long-term business and personal planning. The pattern of letting incentives expire, or come close to expiration, only to re-enact them, sometimes retroactively, is a practice designed to permit members of Congress to solicit funds for their electoral campaigns. There’s much more to sell when dozens of tax law provisions are on their death beds. The well-being of the national economy demands stability, continuity, predictability, and reliability in the tax system. By putting personal electoral goals ahead of the nation’s well-being, Congress is selling the nation short and ultimately risks selling it out.

Trust and Taxes

Perhaps there is another element in the raging debate about taxes. Perhaps the disagreement has less to do with how much a government collects and spends and more with whether the taxpayers trust those who are serving in government positions. This observation surfaces from a story about a town whose citizens voted to oppose tax increases and then, a year later, voted to increase taxes.

In New Jersey, local governments are not permitted to increase taxes by more than 2 percent without voter approval. More than a year ago, the town of Medford found itself with a huge budget deficit. At that time, the mayor and town council requested approval by the voters of a 25 percent increase in property taxes. The proposal was defeated, by a factor of five to one. The town eliminated its recreation department and programs, cut back public works expenditures, chopped salaries for town officials, and laid off police. Next up on the list of expenditures to be cut was municipal trash collection.

In the meantime, the town’s mayor resigned after being caught in a sex scandal, and discovery of financial mismanagement compelled the departure of four members of town council. In January of this year, a new mayor and new members of council, from the same political party as those who had departed, were elected. They brought back the proposal to increase property taxes by 25 percent. The proposal passed, 57 percent to 43 percent.

What happened? Why did so many voters change their minds? There appear to be two major considerations.

First, according to interviews with voters, some of whom were ready to vote “no” in the most recent referendum but who changed their minds, it seems that they wanted to give the newly elected officials a chance, considered them sincere, and went from distrusting the town government to trusting the newly elected slate of officials. One voter noted that she now had a better idea of what was happening with the tax revenues.

Second, according to these interviews, residents concluded that if the town eliminated municipal waste removal, the cost of contracting with private companies for the same services would be costlier than paying taxes to have the town provide the service. As one voter put it, “The logistics would be difficult.” Another voter explained, “I don’t know how I could afford to have them [the items put out for collection] all taken away unless we all pay for it as a community.” Unlike private contractors, municipalities do not operate with a need to build profit into the price, and provided – and this is a big provided – the town operates efficiently, it makes more sense to leave public functions to the public.

These two factors readily combine. The voters deserve to be treated in a manner that justifies trust in public officials, and public officials need to treat that trust as a sacred and fiduciary obligation. As the town’s new mayor put it, “[We were] humbled by the idea the people trust us, and it’s not lost on us.” As New Jersey Governor Christie, who championed the limit-unless-overridden-by-vote plan and who urged the voters to reject the 25 percent increase proposal, put it, “"Good for them. Higher property taxes for Medford. Congratulations. If the people of Medford want to pay higher property taxes, that's their call. . . . I said I would vote no, but . . . this is a democracy." Democracy provides the opportunity to kick out incompetent, corrupt, and manipulative politicians, which the people of Medford did but which too few voters across the country do in local, state, and national elections. Democracy does not exist in the private sector, and the so-called free market is a woeful failure when it comes to purging the planet of incompetent, corrupt, and manipulative business entities and their operatives.

Two years ago, I addressed the question of tax referenda in Tying Tax Revenue to Voter Responsibility, explaining:

The key to balancing government budgets is not a simple matter of limiting tax revenue and triggering a free-for-all among the proponents of particular state services. The key is to price out and advertise the cost of each service that voters tell their representatives that they wish to receive. Pennsylvania has a similar property tax limitation in place, but it can be exceeded if the voters approve a budget that is based on an increase above the cap. By shifting responsibility onto voters, and making it clear that they must pay for what they want, particularly with respect to items that take the form of a user fee, governments can move away from spending decisions that are made by legislatures without any specific directive from voters. The cap ought not be an iron-clad revenue increase restriction that has no bearing to the actual costs of providing government services, but a cap on the spending decisions that are not specifically authorized by voters.

Ultimately, when complaints about high taxes circulate, the response, “You voted for it,” should either dampen the griping or inspire people to reconsider, and cut back, their government services wish list. The debate before each tax referendum, though probably loud, intense, and heated, will be educational, worthwhile, and productive. Imagine how cathartic it will be to listen to the proponents of a tax for a particular service debate those who do not want to pay taxes to provide that service. It will take the issues out of the back rooms and put them on the table Tying ownership of the expenditure process with ownership of the taxing process makes much better sense in the long-run than unworkable and impractical absolute revenue caps.

It seems to have worked that way in Medford. The governor of New Jersey may not agree with the outcome, but to his credit, he pushed through legislation that has moved the politics of government finance closer to the system I advocate.

If the IRS Can’t Get It Right, Is It Any Wonder Taxpayers Struggle?

A recent discussion on the ABA-TAX listserve ultimately revealed a rather disturbing error in an IRS audit guide. The issue involves the computation of section 751(a) ordinary income or loss. Section 751(a) applies when a partner sells a partnership interest, and is designed to characterize as ordinary the portion of the selling partner’s gain or loss that is attributable to the partnership’s ordinary income items.

Until 1999, Regulations section 1.751-1(a)(2) provided the following rules for determining the amount of ordinary income or loss that a selling partner must recognize:

The income or loss realized by a partner upon the sale or exchange of his interest in section 751 property is the difference between (i) the portion of the total amount realized for the partnership interest allocated to section 751 property, and (ii) the portion of the selling partner's basis for his entire interest allocated to such property. Generally, the portion of the total amount realized which the seller and the purchaser allocate to section 751 property in an arm's length agreement will be regarded as correct. The portion of the partner's adjusted basis for his partnership interest to be allocated to section 751 property shall be an amount equal to the basis such property would have had under section 732 (including subsection (d) thereof) if the selling partner had received his share of such properties in a current distribution made immediately before the sale. See §§1.732-1 and 1.732-2. Such basis shall reflect the rules of section 704(c)(3), if applicable, or any agreement under section 704(c)(2). Any gain or loss recognized which is attributable to section 751 property will be ordinary gain or loss. The difference between the remainder, if any, of the partner's adjusted basis for his partnership interest and the balance, if any, of the amount realized is the transferor's capital gain or loss on the sale of his partnership interest.

In 1999, to reflect amendments to section 704(c), and for other reasons, the Treasury amended the regulation. When the regulation was proposed, the preamble (see 63 Fed. Reg. 4408) explained:

B. Section 751.

Section 751(a) provides that to the extent an amount realized on the sale or exchange of a partnership interest is attributable to the transferor's interest in unrealized receivables or inventory items of the partnership, the amount realized is considered to be an amount realized from the sale or exchange of property other than a capital asset. Thus, the transferor partner may recognize ordinary income or loss on the sale or exchange of its partnership interest. Under the current section 751 regulations, the amount of income or loss realized by a partner on the sale or exchange of an interest in section 751 property is equal to the difference between: (i) The portion of the total amount realized for the partnership interest allocated to section 751 property, and (ii) the portion of the transferor partner's basis in its partnership interest allocated to the property. Generally, the portion of the total amount realized allocated to section 751 property is determined by the seller and purchaser in an arm's length agreement. The portion of the partner's adjusted basis in the partnership interest allocated to the section 751 property equals the basis that the property would have had under section 732 if the transferor partner had received its proportionate share of the property in a current distribution immediately before the sale.

The proposed regulations amend these rules for determining the transferor partner's gain or loss from the sale or exchange of its interest in section 751 property. Rather than attempting to allocate a portion of the transferor partner's amount realized and adjusted basis to the section 751 property, the proposed regulations adopt a hypothetical sale approach. Thus, the income or loss realized by a partner from section 751 property upon the sale or exchange of its interest is the amount of income or loss that would have been allocated to the partner from section 751 property (to the extent attributable to the partnership interest sold or exchanged) if the partnership had sold all of its property in a fully taxable transaction for fair market value immediately prior to the partner's transfer of the partnership interest.

The proposed regulation was adopted by T.D. 8847, and reads as follows:

Par. 6. Section 1.751-1 is amended by:

1. Revising paragraphs (a)(2) and (a)(3).

* * *

The addition and revisions read as follows:

§ 1.751-1 -- Unrealized receivables and inventory items.

* * * * *

(a) * * *

(2) Determination of gain or loss. The income or loss realized by a partner upon the sale or exchange of its interest in section 751 property is the amount of income or loss from section 751 property (including any remedial allocations under § 1.704-3(d)) that would have been allocated to the partner (to the extent attributable to the partnership interest sold or exchanged) if the partnership had sold all of its property in a fully taxable transaction for cash in an amount equal to the fair market value of such property (taking into account section 7701(g)) immediately prior to the partner's transfer of the interest in the partnership. Any gain or loss recognized that is attributable to section 751 property will be ordinary gain or loss. The difference between the amount of capital gain or loss that the partner would realize in the absence of section 751 and the amount of ordinary income or loss determined under this paragraph (a)(2) is the transferor's capital gain or loss on the sale of its partnership interest.

During the course of the discussion about section 751(a) on the ABA-TAX listserve, a participant suggested that it would be helpful to look at a section 751 audit guide that the IRS had posted on its website. The IRS document, chapter 7 of the Partnership – Audit Technique Guide, Dispositions of Partnership Interest, states:

The amount of the disposing partner's ordinary gain or loss is the difference between the amount realized attributable to the hot assets less the partnership's adjusted basis associated with these assets.

What appears in the IRS audit guide is a paraphrase of Regulations section 1.751-1(a)(2) as in effect before the 1999 amendment by T.D. 8847. Thinking perhaps that the document was old, I checked its date. According to the website, it was revised in March 2008. At the bottom of the web page is a tag line stating that the page was “last reviewed or updated: January 25, 2012.”

What’s happening here? Are IRS auditors examining sales of partnership interests and applying old law? Are taxpayers, where old law produces a less advantageous outcome than does current law, citing the current version of the Regulations and demonstrating the obsolescence of the audit guide? Is anyone even aware of this discrepancy?

Partnership tax law is complex, conceptually challenging, and daunting. It’s easy to misapply the applicable law. It’s easy to overlook a critical fact. It’s easy, but dangerous, to apply old law, and that’s true for any area of tax law, not just partnership tax law, as well as any area of law, period. It is not unknown for students in my Partnership Taxation course, and in other courses, to apply old law, and almost always it’s a result of using an old outline passed down through the years.

As another ABA-TAX listserve participant noted when I posted a much shorter version of this discovery, “Well, so much for trusting information provided by the ‘Horse's mouth’.” So true, but not surprising, as there are more than a few cases in which taxpayer reliance on erroneous IRS advice was not treated by the court as justifying the erroneous position taken by the taxpayer on the tax return. But it indeed is disturbing that the agency charged with administering tax laws does not understand those laws. Can taxpayers be expected to do any better?

Another Bad Tax Return Clutter Idea

It’s bad enough that federal income tax returns are bloated with multiple forms, and that most forms are crammed with dozens of lines of information and computational entries. Much of what contributes to this aspect of tax complexity is the use of the tax law as a substitute for direct spending programs and use of the IRS as a substitute for other federal agencies that ought to be charged with administering programs in their respective areas. I have explained why using the tax law and the IRS in this manner is inefficient, ineffective, and deceptive, in posts such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, and When Tax Credits Aren’t Worth the Trouble.

The latest proposal to add more clutter to tax returns comes from the president of Muhlenberg College, Peyton R. Helm. With the goal of finding a way to deal with the growing concern over the cost and quality of higher education, Helm, in a Philadelphia Inquirer editorial, suggests “adding three simple questions to the IRS’s 1040 form.” He wants to ask, “What college or university, if any, did you attend?, What degree did you receive?, and Was it worth it?” Helm is motivated by a disdain for any sort of regulatory structure that requires educational institutions to “create massive databases” or to “spend more on data collection and compliance.” Whether the federal government should be regulating higher education is a question that reaches far beyond the specific proposal in question. Perhaps it should. Perhaps it is the federal government, rather than a state government or even a private organization, that takes on the task of protecting consumers against fraudulent reporting, misleading advertising, educational malpractice, unsafe campuses, and other problems faced by students and prospective students. But surely, even assuming that it is the federal government that should take on this role, and I am not at all convinced that it should, using the IRS and tax returns to deal with a Department of Education function is simply unwise, totally impractical, and counterproductive.

First, how does the IRS find the space to add these questions to the various 1040 forms? Does it reduce the font size of the print? Does it jettison other lines that are far more relevant to revenue collection that questions about a person’s educational experience?

Second, how do graduates who do not file tax returns – because they’re yet to be employed – express their opinions? Do they file a zero return simply for the sake of answering these questions?

Third, who audits the answers to these questions? Are the answers taken at face value, or is some method employed to make certain that the taxpayer filing the return in fact did attend the university that the taxpayer claims to have attended? Who ensures that the taxpayer earned the claimed degree, particularly in an age where people falsely claiming academic credentials have proliferated? Who pays to redesign the form? Who pays to have people transcribe the answers into software, considering that, as noted in the next paragraph, automation poses issues? Who pays to accumulate and sort the answers? Who pays to report the results? Which audits and which taxpayer service programs are subjected to further cuts to fund this education satisfaction data collection?

Fourth, who handles the lack of consistency in providing the names of colleges and universities? How does the software know that Penn State, PSU, and Pennsylvania State University are the same school? Which school is “Loyola”? Will we end up with substantially enlarged instructions for the 1040 forms in order to provide a “code” for each college and university in the country?

Fifth, what happens if the taxpayer attended multiple universities? What if the taxpayer transferred after sophomore year from one school to another? What school is reported by the taxpayer who attended an undergraduate institution, a master’s program at another university, and a doctoral program at yet another school? Would the IRS need to insert multiple lines for each of the three proposed questions? Or would taxpayers be asked to fill out yet another schedule to include this information?

Sixth, would colleges and universities in other countries be included? Or would taxpayers who earned their degrees abroad simply be ignored?

Seventh, what, if anything, would be done to gather information from graduates who are not taxpayers because they pursued education in this country and returned home? Do their opinions not count?

Eighth, would the reporting be mandatory? Would there be penalties for failing to answer the questions? Would there be penalties for providing incorrect answers, such as claiming to have earned a degree that was not earned?

Ninth, how is this reporting system protected against the games that could be played by graduates of other institutions? For example, if students and graduates of university #1 are unhappy because they think university #2 defeated university #1’s football team under questionable circumstances, what is to prevent them from claiming, en masse, that they attended university #2 and that their degree was not worth it? Without an extensive system of auditing, coupled with penalties for false reporting, the proposed system fails. Keep in mind that most return penalties are based on tax understatements, and the sort of nonsense that this proposal invites does not generate tax understatements.

Tenth, considering that Helm’s goal is to measure “the real value of their education,” how does his proposal distinguish between the negative reaction of the recent graduate who remains unemployed, and the positive reaction of the graduate who eventually ends up realizing that the education was worth it despite rough going during the first few years after graduation?

In his editorial, Helm refers to alumni surveys that are circulated among his school’s graduates. It’s unclear whether the school does the survey directly or pays an independent survey firm to do the work. Why not simply mandate that schools conduct alumni surveys, that the surveys be conducted by independent organizations, and that the results, including comments, be made available to the public? Well-designed surveys are orders of magnitude more informative, and far less prone to misreporting and gamesmanship, than the “three simple questions” that are proposed by Helm.

The IRS has better things to do than to conduct surveys on behalf of America’s colleges and universities. The IRS should be collecting revenue, period.

Are State Tax Incentives Worth It?

The Pew Center on the States has released a report on the effectiveness of state tax incentives. The report, titled “Evidence Counts: Evaluating State Tax Incentives for Jobs and Growth,” concluded that although a few states attempt to determine whether state tax incentives have had the intended effect, half of the states haven’t even tried to measure the outcome of the tax provisions that have been enacted. Even though some states try to evaluate the incentives, most do so every now and then, and none do so with the sort of in-depth analysis required to determine the effectiveness of the incentive. The study concludes that “no state regularly and rigorously tests whether those investments are working.” Every state has at least one tax incentive program, and most states have at least three or four; some states have dozens. Collectively, these incentives cost the states billions of dollars of lost revenue. The question that needs to be asked, that hasn’t been asked often enough, and that rarely is answered even when it is asked, is a simple one. “Are state tax incentives worth the lost revenue?”

One example provided by the report is the New Mexico tax credit for film production. One study determined that for every dollar of lost revenue caused by the incentive, New Mexico’s economy received a 14 cent boost. Another study concluded that every dollar of lost revenue generated 94 cents of economic activity. Though these outcomes suggest that the incentive should be repealed as a waste of taxpayer money, the New Mexico legislature continued the program but with a cap. The same thing happened in Wisconsin, which determined that its film tax credit was ineffective. Louisiana conducted a study that demonstrated its enterprise zone credit produced one-third of the jobs that the incentive’s lobbyists promised it would create. Pennsylvania examined its Keystone tax incentive, initially determined it had created 64,000 jobs, on a re-examination reduced that number to 35,000, and finally concluded that it had no idea what, if anything, the incentive had done for the state’s economy.

The idea of testing the outcome of a change, particularly when the change is hawked as being beneficial, is simple common sense. Decades ago, when I requested and obtained permission to require law students in my courses to turn in graded exercises during the semester, a concept that was alien to legal education and that met resistance and criticism at the time, I not only argued why it made sense but promised to provide reports to the faculty on the impact of the practice. The reporting idea was mine, and I offered it because I wanted to find out if I was correct in my assumptions, and to have evidence to support continuation or discontinuation of the semester-exercise approach. It worked, it’s something I continue to do, and it’s something that within the past several years has caught on with many, though unfortunately far from all, law faculty throughout the country. Innovation and experimentation need to be encouraged but oversight is essential, and outcomes measurements are necessary.

Why do so many states neglect following through with tax incentives? My guess is that there are several reasons. No one thinks of doing so. Perhaps someone requests an outcomes measurement but political constraints jettison the provision. It is not unlikely that legislators simply swallow, hook, line, and sinker, the lobbyists’ “guarantees” of the incentive’s value. It is also plausible that the fear of discovering the incentive’s wastefulness obstructs future evaluation.

It is quite probable that the vast majority of state tax incentives turn out to be boondoggles for the taxpayers who get tax reductions without generating the promised benefits for everyone else, including the state. Almost all state tax incentives are targeted at specific areas of economic activity that would be better regulated and encouraged using programs other than tax law provisions. As I pointed out in posts such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, and When Tax Credits Aren’t Worth the Trouble,

Artificial tax credits, in contrast to true credits arising from payments made to the [revenue department] by or on behalf of a taxpayer, aren’t worth the trouble. They’re not advantageous for taxpayers. They’re not advantageous for government economic policy. They’re not advantageous for the simplification and efficiency of the tax law. They’re not worth it, except to those who find them useful tools for the deceptive process of increasing [government] spending.

I’m still waiting for the opponents of government spending to step up and challenge tax incentives. Their failure to do so is a silence that speaks loudly.

Taxes and Safety

An unfortunate fatal fire in Philadelphia has focused attention on the double whammy of absentee property owners who are derelict both in meeting their tax obligations and complying with safety regulations. These two faces of government, fire and taxes, though a favorite target of anti-tax advocates, come together in this instance in multiple ways. It is unfortunate that it takes the death of two public servants to bring serious issues to the forefront in the public arena.

The tax and safety facts, as reported in a flood of stories, including this one, are rather simple. Two firefighters were killed when a wall of a burning building collapsed on them. The building is owned by a Brooklyn, N.Y., family that owes the city almost $400,000 in real estate taxes on 31 properties, including $60,000 on the building that burned down. Residents who lived in the neighborhood where the building was located complained incessantly to the city about the building’s unsafe condition, particularly the lack of security to keep out vagrants. Though some complain that the city moved too slowly, during the past five months, the city issued three citations to the owners, trying to compel them to secure the building. The owners failed to respond, and the city initiated proceedings to move the matter into the judicial system, with the eventual goal of subjecting the property to sheriff’s sale. According to court records, during the past ten years, the city has issued more than 30 citations to the family and the entities through which it owns the properties. The owners not only have failed to comply with building, fire, and safety code provisions, they also have failed to pay water and sewer bills.

When asked about the city’s alleged failure to seal the building on behalf of the owners, the City Controller explained that the responsible department is overwhelmed by the number of vacant properties with which it has to deal. He noted that the department has a limited budget, limited personnel, and limited resources. Surely there is a connection between funding deficiencies and the unpaid taxes.

The afflictions caused by insufficient revenue attributable to noncompliance are undeniable. No matter how easily some folks think tax noncompliance can be brushed aside as a small matter, there is no doubt that the lack of compliance led directly and indirectly to the deaths of two firefighters. If the city had received the taxes that are owed, it would have had funds to provide the resources necessary to eliminate the dangers posed by vacant and insecure properties.

How bad is noncompliance with the city’s real property tax? According to another article, taxes on almost 20 percent of properties in the city are in arrears. There are more than 100,000 properties in the city on which taxes are not current. The average delinquency is 6.5 years. The city’s attempts to bring these properties to sheriff’s sale is thwarted, yet again, by a lack of funding for the responsible department. Almost half a billion dollars remains unpaid.

Tax delinquency and building code noncompliance seem to go hand-in-hand. That’s not surprising. The same philosophy that causes people to toss aside their civic responsibilities as taxpayers also leads them to disregard building and safety code compliance. Consideration of how the decision to ignore their obligations adversely impacts other people appears to matter not at all. One wonders the extent to which they toss aside their responsibilities because of the continued anti-tax and anti-regulation mentality that infects the public discourse.

Some commentators, officials, and politicians have mentioned the possibility that criminal charges will be brought against the owners of the building in question. Even if those charges are brought, and even if there are convictions, it’s too late to bring back two firefighters. Taking action after the fact is easier than taking action before the fact. How many more people must die before the tax delinquents and the code violators are compelled to do what they are required to do?

Taxes, Audits, and the GHWG

The Transactional Records Access Clearinghouse (TRAC) has released a new study of IRS Global High Wealth Group (GHWG) audits. The GHWG was formed to focus on taxpayers with tens of millions of dollars of assets or income. According to the Internal Revenue Service Data Book for 2011, in 2010 there were 291,831 individual tax returns reporting $1 million or more in total positive income, of which 8,274 reported adjusted gross income of $10 million or more.

According to TRAC’s analysis of internal IRS documents obtained under a court order, the IRS targeted for 3 large corporations, 15 S corporations, and 60 partnerships for audits under the GHWG program in fiscal year 2011, and 7 large corporations, 2 large foreign corporations, 26 S corporations, and 70 partnerships in fiscal year 2012. In fact, for FY 2011 the IRS conducted 18 audits, of which 4 cleared the process with no change. The other 14 audits generated more than $20 million in increased taxes. For the first five months of FY 2012, the IRS conducted 18 audits, of which 8 cleared the process with no change. The other 10 audits generated more than $27.5 million in increased taxes.

The writers of the TRAC report express some degree of surprise or alarm at the fact that one-third of the 36 audits generated no change. But I don’t find that very surprising or alarming. It’s not unrealistic to expect that some high-income returns are rather straight-forward, provide fewer opportunities for error, and are filed by taxpayers who are complying with the tax law without attempting to game the system. Consider the tax return of a professional athlete or celebrity whose income is reported on a W-2, who makes simple investments generating interest and dividends reported on Forms 1099, and whose deductions are nothing more than some charitable contributions and perhaps some mortgage interest and real estate taxes. It’s not a surprise that this sort of return passes an audit with flying colors.

On the other hand, the writers of the TRAC report are dead-on when they question the small scale of the GHWG program. The returns that generated tax increases generated an average of more than $2 million per return. Though it’s not clear if the returns that were audited were in the over-$10-million or over-$1-million category, multiplying $2 million times two-thirds times the number of returns that could be audited generates a significant amount of revenue that has not yet been paid.

Not only is the IRS auditing a small fraction of the number of returns it has targeted for audit, it is targeting a woefully small percentage of the total returns available for audit. Auditing 18 returns out of 8,274 over-$10-million returns, or, worse, 18 returns out of 291,831 over-$1-million returns is appalling. It raises the question, where is the IRS directing its audit resources? A clue comes from another batch of information obtained and shared by TRAC. There are a variety of groups within the IRS focusing on different clusters of returns and taxpayers. As of January 31, 2012, the average group, other than the GHWG, consists of 1,012 revenue agents. The GHWG consists of 101 revenue agents. Further, the TRAC report indicates that most audits of millionaire taxpayers, including those not within the GHWG program, are fairly cursory, don’t consume much time, and leave 87.5% of millionaire taxpayer returns unexamined.

Why not shift revenue agents from other programs to the GHWG, considering the rate of return from these audits? Is it possible that the IRS has an insufficient number of auditors trained and expertised in the sorts of tax issues that are involved with the returns of millionaires who are not filing the simple return described several paragraphs ago, but who are engaging in what the IRS explained in 2009 were “sophisticated financial, business, and investment arrangements with complicated legal structures and tax consequences.”? Is it possible that one of the effects of insufficient funding of the IRS is the lack of resources to train a sufficient number of revenue agents to work in the GHWG?

S Corporation Stock Basis, Contrived Income, and Unclaimed Losses

Recently, in Barnes v. Comr.,, T.C. Memo. 2012-80, the Tax Court addressed two interesting questions concerning the basis of stock in an S corporation. Two arguments advanced by the S corporation shareholders were rejected by the IRS and by the Tax Court.

The first argument made by the shareholders was that they were entitled to increase the adjusted basis in their S corporation stock by the amount of S corporation income erroneously reported by them on their individual returns. The IRS and the Tax Court emphasized that section 1367 provides for an increase in basis that reflects an S corporation shareholder’s actual share of the corporation’s income. According to the court, the IRS speculated as to why the shareholders reported income when, in fact, the corporation reported a loss, of which a portion was allocated to the shareholders. On their 1995 return, the shareholders reported a loss of $66,553 from the corporation even though their adjusted basis in the stock was $44,271. The shareholders, according to the IRS speculation, then erroneously calculated an adjusted basis of negative $22,282, and then reported that amount as income in 1996, increasing their adjusted basis to zero, and ignoring their $136,228 distributive share of loss of 1996. On this point, the IRS position and the Tax Court decision affirms the principle that basis cannot be negative. Perhaps the taxpayers, or their tax return preparers, were thinking of the at-risk recapture principle that triggers income when amount-at-risk becomes negative. Interesting, if that indeed was the case, but it’s an analogy that fails to withstand statutory analysis.

The second argument made by the shareholders was that they were not required to reduce adjusted basis in their stock if they chose not to deduct on their return their distributive share of the S corporation’s loss for the year. In a later year, after making contributions that caused their adjusted basis in the stock to be positive, the shareholders decided not to deduct their distributive shares of the corporation’s loss that had been suspended in earlier years and carried forward to the year in question. Accordingly, they did not reduce their adjusted basis in the stock by the amount of these losses. The IRS and the Tax Court determined that section 1367(a)(2)(B) requires S corporation shareholders to reduce adjusted basis by their shares of the corporation’s losses, even if they choose not to deduct those losses on their individual returns. It is unclear why the taxpayers chose not to deduct their losses. Perhaps they, or their tax return preparers, were thinking of the depreciation recapture principle that does not require recapture of depreciation which the taxpayer is entitled to deduct but that the taxpayer, for whatever reason, does not deduct.

Was this simply a case of someone not understanding the tax law? Was something else going on that’s not apparent from the facts set forth in the opinion? Though the answers to those questions probably will never surface, the appropriate impact on adjusted basis of an S corporation shareholder’s share of the corporation’s income and loss is clear. Sometimes, though, it takes litigation to get that point across.

As an aside, it is worth noting that the taxpayers were not challenged in their decision not to claim the losses. In other words, they were not compelled to claim the losses, but simply tagged with the consequences of having those losses, namely, reduction of basis. For a discussion of whether taxpayers are required to claim deductions, losses, and credits to which they are entitled, see James Edward Maule, No Thanks, Uncle Sam, You Can Keep Your Tax Break, 31 Seton Hall Leg. J. 81 (2006), available here.