Should Scholarship Recipients Be Taxed on the Portion Used for Student Health Fees?

An interesting question raised by a tax listserve colleague yesterday provides a wonderful example of how a simple tax law concept can become complicated, and how an attempt to keep it simple raises the possibilities of abuse. Because the tax provision in question is one easily understood by most people, and relevant to tens of millions of taxpayers, it provides a wonderful object lesson.

The concept is that students should not pay income tax on scholarships. In implementing this concept, Congress limited the exclusion from gross income to "qualified scholarships." See section 117(a). Technically, the exclusion is limited to "qualified scholarships" received "by an individual who is a candidate for a degree at an educational organization described in section 170(b)(1)(A)(ii)." Because the specific question involves the definition of "qualified scholarship" the other requirements for an exclusion need not receive additional attention.

Section 117(b)(1) of the Internal Revenue Code in turn defines a "qualified scholarship" as "any amount received by an individual as a scholarship or fellowship grant to the extent the individual establishes that, in accordance with the conditions of the grant, such amount was used for qualified tuition and related expenses." Again, because the specific question involves the definition of "qualified tuition and related expenses" the other requirements of the definition of "qualified scholarship" can be ignored.

Section 117(b)(2) of the Internal Revenue Code in turn defines "qualified tuition and related expenses" as follows:

For purposes of paragraph (1), the term "qualified tuition and related expenses" means--
(A) tuition and fees required for the enrollment or attendance of a student at an educational organization described in section 170(b)(1)(A)(ii), and
(B) fees, books, supplies, and equipment required for courses of instruction at such an educational organization.

Regulations proposed by the IRS pretty much repeat this definition and then add a requirement not relevant to the specific question, namely, that "in order to be treated as related expenses under this section, the fees, books, supplies, and equipment must be required of all students in the particular course of instruction."

The specific question is whether health fees charged by a university to its students and which are covered by a full scholarship grant are eligible for the exclusion. Neither the Code nor the proposed regulations, nor, as best as I can tell, any other source of guidance, deals with this specific question.

One approach is to take the language for what it says. Tuition and fees required for enrollment attendance are within the exclusion. If the health services fee is required for enrollment, then it is within the exclusion. That seems simple enough. Why complicate it?

The other approach points out that the simple approach opens the door to abuse. Using an extreme example, what if the school charged a "BMW fee" and provided BMWs to all its students? Should the portion of a scholarship covering this fee (assuming there would be such a scholarship) be excluded from gross income? Would that make sense in light of the presumed intention of Congress in enacting the scholarship exclusion, which is to prevent a federal income tax from obstructing the use of scholarships granted for educational purposes. What's educational about using a BMW?

Perhaps this is a theoretical concern. After all, political pressure and state legislative oversight would discourage or even prohibit state-funded schools from charging BMW fees. And market pressure would do the same to private schools. But the issue of the health services fee, a commonly charged fee, is far from theoretical.

It is easy to see that the simple approach does open the door to abuse. Forget BMWs. That's too obvious. What about fees for TGIF parties, intramural sports, computer equipment use, or the so-called "general fee"? Those concerned about abuse suggest that the portion of the scholarship used for a fee should be excluded only if the fee is used for a "related expense" and that to be a related expense, the charge must be related to tuition.

In one respect, it makes sense for there to be some sort of definition that restricts the exclusion to amounts used for education or for things directly related to education, such as lab fees, textbooks, computers used for course work, and similar items. The portion of a scholarship used to pay activity fees, sports fees, health care fees, and similar items would be treated in the same manner as the portion of a scholarship used for room and board. It would not be excluded from gross income.

But in another respect, this would elevate form over substance. Even those advocating a restrictive interpretation of "related" agree that the portion of the scholarship used for tuition is excluded from gross income. Consider a school that charges tuition, but no fees. There does not appear to be any requirement, either in the statute or by the IRS, that the school separate the tuition into the portion used for course work and the portion used to operate the university's student health care facility. Of course, many schools charge fees because it keeps the stated tuition lower, permits the school to announce lower tuition hikes while jacking up fees, and permits the school to charge fees to its employees who qualify for free tuition. Thus, a narrow interpretation of "related" puts a scholarship recipient at a tax disadvantage if he or she attends a school that breaks out fees from tuition.

There is another concern. The term "qualified tuition and related expenses" is a term of art. Even if each word in the phrase should be interpreted, the word "related" should mean "related to tuition" and not "related to classroom and course work" or some similar restrictive definition that excludes health care fees. The definition of the term "qualified tuition and related expenses" in turn encompasses two types of fees that qualify for the exclusion. One is the fee required for enrollment or attendance at the school. The other is the fee required for a course of instruction at the school. The latter fee is included in the group that the proposed regulations restrict to those required of all students in the particular course of instruction. There doesn't seem to be any justification for carving out a definitional gloss.

Is it abusive to permit exclusion of the portion of the scholarship used for student health fees? I don't think so. The school has determined that providing basic health services to its students furthers the educational purpose. The rationale, I think, is that the school would shut down if students not sick enough for hospitalization but sick enough to infect the campus aren't treated, and treated quickly. Yes, there is some parentalism involved, but that's nothing new, even for universities (in contrast to private K-12 schools where parentalism is a sina qua non of the experience).

If someday, somehow, somewhere, a school manages to charge fees for things beyond the pale, such as BMWs, Congress will need to revisit the provision. The outcome surely would be more complexity. Complexity would arise if school-required fees had to be sorted into two different piles, with some fine line separating those charged for things more closely related to education and those charged for things less closely related to education. If schools avoid charging fees for BMWs and other over-the-top things, as I expect they will, the complexity will not enter the tax law. The lesson? Complexity often is the product of taxpayer attempts to push the envelope. In this particular instance, because the schools are tax-exempt, they have far less incentive to push the envelope, and most likely are not going to do so on behalf of their scholarship students' income tax exclusions.

Many thanks to Reggie Mombrun of Florida A&M College of Law, who presented the question, and to Alan Gunn of Notre Dame, Mike McIntyre of Wayne State University, Margaret Raymond of the University of Iowa, and anyone else whose name I've overlooked who contributed to the discussion.

No Such Thing as a Fraudulent Tax Shelter?

According to this report, federal prosecutors have convened a grand jury in New York to investigate three lawyers at a well-known Dallas law firm who allegedly marketed illegal tax shelters. This news suggests that the federal government is casting its criminal prosecution net beyond the KPMG waters. The article provides very little specific information about the shelters, because the proceedings are sealed and only small bits of information have found their way into the public sphere. At least for the moment.

This news does not sit well with J. Craig Williams, of May It Please the Court. In this posting he argues that it is wrong for the IRS to prosecute lawyers who "come up with tax shelters". He explains:

It's just plain wrong. Think about it. Congress passes laws that require us to pay taxes. Once you establish the rules and write them down, it's up to the lawyers to figure out the loopholes and the way around them. * * * * * So, when enterprising lawyers go out there and successfully figure out how to shelter money from taxes, the IRS takes aim and prosecutes the lawyers for being smart enough to figure out what they did wrong when they wrote the code. I'm not sure if the lawyers are being prosecuted because they showed the ________ (fill in your own word) of the IRS and Congress to the rest of us or because the result of their work actually means less dollars in the government's hands and more money in our hands.

Sure, there's another way to look at it: the lawyers actually did something illegal that was precluded by the code, and they should be punished. As you can see just from these paragraphs, however, there's no such thing as black and white in the Internal Revenue Service code.

I suggest that it is premature to evaluate the wisdom or appropriateness of the federal government's investigation of these lawyers. Perhaps there will be an indictment. Perhaps not. If there is an indictment, it means that a grand jury was persuaded that what transpired was more than simply good chess playing.

We don't know the facts. There are tax shelters that rest on fraud, and not on the ambiguities of the tax law. The notion that "there is no such thing as black and white in the Internal Revenue Service code" is nonsensical. Not only is there no such thing as the Internal Revenue Service Code, but there are clear tax rules. The fact that some tax issues are unresolved, or that there are ambiguous provisions, or that application of particular principles to specific facts is near impossible, there's no escaping the existence of numerous unambiguous provisions that are turned to a tax savings benefit only through fraud or similar manipulation. For example, no taxpayer is entitled to deduct a dependency exemption for his or her pet canary. That's an easy rule, though it isn't one that will generate much in the way of fees when explaining it to a client. Somewhere there is an attorney trying to figure out how to make the canary a child of the taxpayer. The unsophisticated were in the habit of putting the canary on the return as a dependent, but then Congress required that the dependent's social security number be provided. Perhaps some clever attorney is figuring out how to get a social security number for a canary. Silly example? No. After all, credit cards have been issued in the name of dogs.

There are tax shelters in the Code, and though most require the assistance of an attorney to set up, none require the invention skills of an attorney. For example, real estate investment is a huge shelter, because a person can invest a few of her own dollars and many dollars of a bank, watch the property increase in value and simultaneously claim depreciation deductions. Though an attorney's assistance in drafting the acquisition documents and setting up the ownership vehicle is most helpful, no attorney is going to rake in huge fees simply by inventing the "real estate tax shelter."

What gets attorneys, and others, in all sorts of trouble is the attempt to take a transaction that does not provide a tax benefit and turn it into one that does. Layers of nominal owners, transparent entities, and circular transfers are pasted onto the core transaction to generate the appearance that the transaction is something that it is not. A great example is the attempt to classify a debt as recourse for purposes of the creditor, who unequivocally wants recourse to the borrowers, while claiming to the IRS that it is a nonrecourse debt (which generates tax advantages) even though that assertion requires taking a position inconsistent with the reality. The reality is hidden underneath a panoply of smoke and mirrors.

It is true that lawyers, and other tax practitioners, can and should assist their clients in minimizing their taxes to the least amount required by law. If a lawyer figures out that an S corporation makes more sense than a C corporation, there's no problem in steering the client to the more tax-advantaged form. But trying to make a C corporation look like an S corporation when in fact it does not qualify is an effort of a totally different character.

J. Craig Williams leaves us with the impression that it is impossible to do something "precluded by the code," and thus illegal, because "there's no such thing as black and white" in the tax law. Baloney. If it turns out that the three attorneys under investigation did counsel tax law transgressions, and we don't know if they did or did not, then so be it. Disbar them, imprison them, fine them, and, yes, cheer for the folks duped by their clients' tax shelters who already have filed civil lawsuits against them and their firm. If it turns out that the three attorneys did not break the law, so be it.

The whole purpose of empaneling a grand jury and conducting an investigation is to find out what happened. J. Craig Williams seems to think that there is some sort of per se rule that no tax attorney can possibly commit tax fraud while creating tax shelters. Thus, he rails against the idea of federal criminal investigations. Why? If he is correct, all of the grand juries (surely there will be more) will refuse to return indictments. I wonder if the real concern is that the grand juries will return indictments, causing the culture of greed and self-centered selfishness so prevalent during the past 14 years to come crashing down.

I am sure we will be hearing more about these investigations. Put on the breathing masks, put on the shades, and get ready for a tour through the smoke and the glaring mirrors. If they exist in this case. Or the next. Or the one after that. Odds are, they'll turn up.

Tax Practitioner, Heal Thyself

Now that the start of the income tax return filing season is upon us, I decided it was time to pull this item from my "blog this someday" list and to transform it into a quiz.

Question 1. According to the IRS Office of Professional Responsibility, what percentage of certified public accountants failed to file a tax return for the last year for which the statistics were compiled?

A. 48%

B. 37%

C. 24%

D. 18%

E. 11%

F. 1%

G. None. Certified public accountants always file their returns.

Question 2. According to the IRS Office of Professional Responsibility, what percentage of tax attorneys failed to file a tax return for the last year for which the statistics were compiled?

A. 46.5%

B. 33.5%

C. 20.5%

D. 13.5%

E. 8.5%

F. 1%

G. None. Tax attorneys always file their returns.

If you chose answer E for both questions, give yourself an A. If you chose answer F or G, perhaps it is time to retire the dreams. If you chose answers A, B, C, or D, you're even more pessimistic than I am. Of course, I knew the answer. It was in a BNA Daily Tax Report email of a few months ago. I saved the data so that all of us who are filing tax returns, for ourselves and others, can find some inspiration when we're several hours into the task and ready to give up.

It is rather shocking, isn't it? After all, the non-filing CPAs and tax attorneys don't have some of the reasons/excuses offered up by most non-filers. "I didn't know I was required to file." That might seem plausible coming from some people, but not from a tax professional. "I couldn't figure out how to do it so I gave up." Ditto.

My guess is that the reasons fall into these sorts of explanations: "I forgot." "I was too busy with other things." "I'm like the shoemaker whose kids go barefoot, because I was so dedicated to filing returns for my clients I neglected my own responsibilities." "I don't like paying taxes."

Perhaps when someone is looking to retain a tax professional, in addition to the usual questions about education, experience, pricing, and deadlines, the person ought to ask, "Have you been filing YOUR tax returns?" According to the BNA information, roughly one in ten, if honest, would say, "No." But I wonder how many would answer honestly. Perhaps one in ten?

The irony is that one would think that tax professionals would know that the IRS has a greater chance of discovering their failure to file than it does of discovering anyone else. Especially considering that the IRS is taking affirmative steps to track them down.

Every time I teach the basic tax course, I point out to the students that attorneys are among the groups targeted by the IRS for special audit consideration, that failure to file tax returns is one of the leading reasons for disbarment and suspension, and that their education and experience makes it more difficult for attorneys to avoid the penalties for failure to file and pay taxes. Whether this news has any impact, or changes a student's values, I don't know. But I will continue to hope that it is worth the several minutes I set aside for it.

How Not to Survive Accusations of Tax Fraud

Numerous reports, such as this one, are popping up with the newest explanation offered by "Survivor" winner Richard Hatch for his having filed an incorrect income tax return. My summary of Hatch's tax adventures is in the "Honorable Mention" cluster of TaxProfBlog's The Top 10 Tax Stories of 2005.

During a break in Hatch's trial for tax fraud, his lawyer explained to the judge that he planned to question his client about a deal allegedly reached between Hatch and the show's producers. After telling the producers that he had caught his competitors cheating, Hatch was assured by the producers that if he won they would pay his tax bill. But when testimony resumed, Hatch was not asked about this new development.

Although some have questioned whether the cheating Hatch claims took place could have happened, I'll skip over that debate because I simply don't know enough to evaluate the allegations. Maybe the other competitors had friends who figured out how to sneak them food. Maybe not. That doesn't matter.

Why does it not matter? Because I find it difficult to believe that someone could conclude that they were not obligated to report their income on a tax return, despite having been told by tax professionals that it had to be reported, simply because someone else promised to pay the tax bill. I might accept such an explanation if the taxpayer didn't pay the tax due, because I can accept the idea that a person's mistaken though sincere belief that they don't need to pay taxes that they think someone else has already paid should block a criminal conviction for wilful failure to pay tax.

But Hatch filed a return that did not report the income. He was told by tax professionals that the income had to be reported. He filed a return that was generated to show what his tax situation would have been had he not won the money. He was told not to file that return. And his explanation has nothing to do with hundreds of thousands of dollars of other income that he failed to report.

The trial continues. Unquestionably the saga has not yet ended.

Thanks to Mark Morin for the initial tip about this new twist in the story, which he sent me several days ago but which I've had to leave aside while other professional duties with a higher claim to my time took hold.

Electronic Tax Payment Alert!

There has always been a tension in the tax law, and in law generally, between theory and practice. Some of the tension simply reflects the unwillingness of individuals, corporations, and other entities to comply with requirements that, at least in theory, have been put in place through a democratic process reflecting the will of the people. Some of the tension reflects the disconnect between the textbook civics lesson of how tax and other laws come into being and the reality of how they are made. There are a variety of other causes for the tension. One that has always fascinated me is the tension that arises from the chasm between a theory made law and the inability of taxpayers to comply with that law. Another is the cluster of traps for the unwary that illustrate the extent to which taxpayers can get caught by conflicting regulations.

Consider the matter of electronic filing and electronic payment of taxes. Among the many advances delivered by digital technology is the convenience, and occasional cost reductions, of filing a tax return through the internet rather than through the postal service or a delivery company. Another of the many advances brought to us by digital technology is the convenience, and presumable cost reduction, of moving money from one account to another through an internet or touch-tone telephone connection.

So, in theory, one might think a taxpayer can proceed as follows. On April 14 or 15, take one last look at the Turbotax or other software-generated tax return, click the appropriate menu items, and send the return on its way to the IRS. Technically, it goes to the Turbotax or other electronic filing service, which then checks it for compliance with electronic filing standard, sends it to the IRS, and notifies the taxpayer that the return has been filed. In the meantime, if the taxpayer owes taxes, the taxpayer can instruct Turbotax or its counterpart to make payment on behalf of the taxpayer, or can go directly to the Electronic Federal Tax Payment System and make payment of the taxes.

It's the digital world equivalent of the "old paper days" when a taxpayer would complete the return, write a check, put the return and the check in the envelope and get it postmarked by midnight on April 15. The return and check would reach the IRS some days later, and the check would be cashed at some point after April 15.

But guess what? It doesn't work that way.

Thanks, again, to Jim Counts CPA CTFA, for an important alert. Jim shares a response he obtained from the IRS after he made an inquiry following up on something he heard at a professional meeting. The question simply is this: is the tax timely paid if the electronic payment is directed to take place on April 15? The answer:

Yes, it would be best if the taxpayer scheduled his/her payment at least 48 hours in advance of the payment due date, using electronic payment options. It does not always happen, but it could take up to 48 hours to receive acknowledgment of the IRS' receipt of the payment. If a
return were filed on the due date, or even the day before, it would be in the taxpayers' best interests to make sure that any payments for tax liabilities were received by the IRS by the due date in order to avoid potential penalties.

A return could be filed or mailed on the due date, and still be timely, since the postmark date is used to determine a timely filed return. However, a[n electronic] payment must be received by the payment due date, to be considered as timely paid by the IRS.

Of course, once everyone knows this, it ought not be a big problem. It's easily solved if people pretend that returns and taxes are due on April 11, but that's not always possible. My question is this: if writing a check and mailing it by April 15 is sufficient, why is it inadequate to direct electronic payment on April 15? The IRS almost always gets the cash from depositing the check long after it gets the cash from the electronic transfer.

What's a taxpayer to do? Jim Counts recommends one approach, and I agree that it works. File the return electronically but mail the payment the old-fashioned way. Alternatively, process the electronic payment earlier than April 15, though that may require paying more than is necessary if the return is not finished by April 8 or 9.

Jim adds a "final thought." He says, "This issue needs to be fixed by the IRS and Treasury." Indeed. Whoever is writing the regulations and rules relating to electronic payment of taxes needs to provide that taxes are deemed paid when the electronic payment is ordered, just as they are deemed paid when a check is placed in the mail. If the electronic payment "bounces," deal with it in the same manner as a bounced paper check is handled.

After all, the IRS has been pushing taxpayers, and in some instances, requiring them to file returns electronically. The IRS has been encouraging, and in some instances requiring, electronic payment of taxes. So why throw an impediment in front of taxpayers who are trying to be twenty-first century citizens? Why the disconnect between what's encouraged on the one hand and made difficult on the other? Why the trap for the unwary, which surely would have caught even more people were it not for the alertness of Jim Counts and his generous willingness to share what he learned on the ABA-TAX list and with the readers of MauledAgain?

So until the IRS and Treasury fix this, the song continues:

In theory use the internet to file and pay
In practice pay up the cash on an earlier day
Else send the IRS a check the old-fashioned way
This is the path to keeping tax penalties at bay

[Yeah, it rhymes and the meter is right. But, ok, see why I teach tax and not poetry?]

Students Fail When We Fail Students

My recent post on the shortcomings in K-12 and undergraduate education, "No Wonder Tax Law Seems So Difficult," brought a response from a long-time, loyal reader whose writing style, at least in this one, rivals the sarcasm sometimes found in my retorts.

The comments were directed to this particular portion of my post:

The answer? Graduate schools must become more demanding of the K-12 and undergraduate education systems. They must abandon the notion that they can teach anyone anything, and dictate to their applicants an appropriate list of skills that must be held before they can enter. Hopefully, the spillover to the college students not intending to pursue a graduate education will, as it is said, be a rising tide that makes all the boats ride higher.

After sharing this quote from CNN,

Without "proficient" skills, or those needed to perform more complex tasks, students fall behind. They cannot interpret a table about exercise and blood pressure, understand the arguments of newspaper editorials, compare credit card offers with different interest rates and annual fees or summarize results of a survey about parental involvement in school.

this reader explained:

Soon to be release new curricula for all public school districts:

The Newest, Latest, and Greatest Planned Course Outline:

1. Students will interpret an exercise table.

2. Students will interpret a blood pressure table.

3. Students will understand the arguments of newspaper editorials (even if the editors do not).

4. Students will compare credit card offers, noting differing interest rates and annual fees.

5. Students will summarize the results of a survey about parental involvement in school (even if zero parents took the survey).

However, students will not be encouraged to understand that the latest changes in course syllabi are directly related to the inability of politicians to interpret literacy studies. They will not be expected to understand that the reduction of course expectations from grades K-12 to a sequential list of skills that produce proficient and advanced test results does not necessarily result in students who can problem-solve or engage in witty repartee.

Likewise, no consideration is to be given to home environments and any expectation of learning from parents. Furthermore, more individuals without education degrees will be encouraged to leave their high-paying jobs (where they're likely to be laid off a few years before retirement) and become teachers.

Still under consideration by politicians is the bill to take infants from parents from birth to college graduation, at which time children will be returned to parents. In all likelihood, their college diploma will not enable them to find employment that pays well enough to live on their own; all high-paying jobs will be taken by children who attended private schools and were encouraged to use their multiple intelligences.

Wow. Lurking in this satirical response are several very important points:

1. There are good teachers and there are bad teachers in every sort of school system, whether public or private, and whether K-12, undergraduate, or graduate. The more money that is invested in education, the more likely that the teachers are better. Yet some underpaid teachers excel, and some overpaid teachers are an embarrassment. Why? Because some of the characteristics of good teachers aren't measured by mere competence tests. How does one measure caring? Or patience? Or perseverance? Or holding the well-being of students more dear than the addiction to office and faculty politics?

2. When is the appropriate time to measure outcomes? As the students are completing a year of study? Or six months, two years, or a decade later, when time tells us what sticks and what doesn't, and when subsequent events in a real world are more indicative than artificial measurements that may or may not tell us what needs to be known?

3. Too many parents think that education is the task of everyone but themselves. No school system can read bedtime stories to children. No school system can engage in constructive dialogue at the dinner table. No school system can direct children's activities when school is not in session, seeing to it that the children get a balanced blend of physical activity, passive absorption, and active learning.

4. Being competent in a subject matter is no more a guarantee of teaching competence than is brilliant classroom demeanor devoid of intellectual value. Being knowledgeable doesn't guarantee the ability to inculcate understanding in the minds of students. Great teachers, even good teachers, are like athletes: born with skills, and coached to excellence.

5. Society speaks volumes about the value it places on teaching by supporting economic structures and policies that pump more money into the hands of a professional athlete or name celebrity than some public school systems have for their annual budget.

6. Academic discipline is a key ingredient to learning. Concentration, diligence, perseverance, and respect for others are core elements of a disciplined student. Discipline cannot be learned when discipline is avoided because children, and their parents, claim that their "feelings are hurt" when attempts are made to nurture discipline. Has anyone counted the number of good teachers who finally broke and left because the parents, politicians, and professional administrators cared more about votes and public image than the long-term educational effects of good discipline?

7. When will the message that learning occurs not by attending class but by getting immersed in a course become the standard fare of school systems? I'll find out when I notice fewer, rather than more, students with the "I'm paying the tuition to purchase a degree" mentality. Somehow they think that having letters after their name, or a piece of paper saying they were physically in a building for 200 days, means that they have the requisite ability to prevent and solve problems.

8. Students who learn by rote tend to become "memorizing regurgitators" who panic when presented with a fact situation similar but not identical to ones with which they are familiar. I see this too often among law students, and I wonder why the skill of "reasoning through analogy" which supposedly is a hallmark of "learning to think like a lawyer" isn't just as valuable to almost all other professions, occupations, and activities, and thus emphasized in every learning environment.

I am sure that some teachers will read this and be offended. But first, understand that I am not trying to indict all teachers. In some respects I'm not trying to indict teachers. It's the system, which in large part is the product of educational systems being subjected to the whims of politicians and politics, to the power of money, and to the influences of the wider culture. Understand that I know many teachers, almost all of whom are superb. Yes, I guess either I'm lucky in having met mostly great people or perhaps I'm just a snob who doesn't make friends with very many less than competent or priority-disordered individuals.

Yet we know there is a problem. The assessment I discussed in the earlier post tells us so. Something is seriously wrong, not just in the superficial trappings but in the very center of the educational universe, and if it isn't fixed quickly, it will be too late.

The entire nation, and not just some solitary blogger and some interested readers, should be alarmed. A poorly educated citizenry makes for a poorly prepared nation, a country that cannot compete economically, a land that suffers from bad decision making, a people who are disordered and ill-served. The nation's children are the nation's future. It's bad enough that today's youngsters are being put in harm's way because of structural budget deficits project to last generations but also because they're not learning what they need to learn so that they have a chance to save themselves by the mess being created for them to handle.

For if we don't give our children and grandchildren the education they'll need to enjoy the American dream, there won't be an American dream for them to experience, or perhaps even envision. The opportunities that a poorly educated nation presents to the nefarious oppressors of the world are no less expansive than those a well-educated nation presents to itself.

A Third Visit to Overpaid Employer Taxes

The issue of whether employers ought to get a return of excess social security taxes as do employees, which I first discussed last Friday, and visited again on Wednesday needs yet another bit of attention.

An enrolled agent in Michigan wrote to remind me that the Federal Unemployment Tax (FUTA) also generates the same sort of overpayment problem. It's on a far smaller scale, because the limit is $56, and the total amount involved is far less than the billion dollars caught up in the social security overpayment trap.

But if the problem is to be fixed, all of the taxes should be given appropriate attention.

No Wonder Tax Law Seems So Difficult

The National Center for Education Statistics undertook a National Assessment of Adult Literacy. The ensuing report, called "A First Look at the Literacy of America's Adults in the 21st Century" contains all sorts of interesting, disturbing, and important information. As a teacher of students who have completed four years of college education, I was most interested in the survey results describing the literacy status of college graduates.

The survey focused on three types of literacy: prose, document, and quantitative. Prose literacy is defined as "the knowledge and skills needed to perform prose tasks (i.e., to search, comprehend, and use information from continuous texts). Document literacy is "the knowledge and skills needed to perform document tasks (i.e., to search, comprehend, and use information
from noncontinuous texts in various formats). Quantitative literacy is "the knowledge and skills required to perform quantitative tasks (i.e., to identify and perform computations, either alone or sequentially, using numbers embedded in printed materials)." Unquestionably, these are skills that law students need to bring with them when they arrive in August of their first year.

The Center administered the assessment to a nationally representative sample of 19,714 adults ages 16 and older. Calculators were permitted. From the test results, the Center determined what percentage of each group possessed skills that were below basic, basic, intermediate or proficient. For each type of literacy in each of the four levels, the report provides an example of a task typical of the level:

Below Basic:

Prose: ability to searching a short, simple text to find out what a patient is allowed to drink before a medical test
Document: ability to sign a form
Quantitative: ability to add the amounts on a bank deposit slip

Basic:

Prose: ability to find in a pamphlet for prospective jurors an explanation of how people were selected for the jury pool
Document: ability to use a television guide to find out what programs are on at a specific time
Quantitative: ability to compare the ticket prices for two events

Intermediate

Prose: ability to consult reference materials to determine which foods contain a particular vitamin
Document: ability to identify a specific location on a map
Quantitative: ability to calculate the total cost of ordering specific office supplies from a catalog

Proficient:

Prose: ability to compare viewpoints in two editorials
Document: ability to interpret a table about blood pressure, age, and physical activity
Quantitative: ability to compute and compare the cost per ounce of food items

As a law professor, I surely want my students to be proficient in all three types of literacy. After all, they are going to be reading and comparing two or more judicial opinions, documents far more complex that editorials. They are going to interpret statutes in the light of regulations, in an exercise much more strenuous than looking at a matrixed table. They are going to deal with numbers when working out personal injury settlements, preparing tax analyses, and negotiating child support and alimony payments. They need to reach levels far beyond proficient as defined in the Center's assessment.

So how do college graduates fare with these skills? For prose literacy, 3 percent were below basic, 14 percent were at the basic level, 53 percent were at the intermediate level, and 31 percent were proficient. For document literacy, 2 percent were below basic, 11 percent were at the basic level, 62 percent were at the intermediate level, and 25 percent were proficient. For quantitative literacy, 4 percent were below basic, 22 percent were at the basic level, 43 percent were at the intermediate level, and 31 percent were proficient. (Due to rounding, not all totals are 100.)

This means 69 percent were less than proficient with respect to prose literacy, 75 percent were less than proficient with respect to document literacy, and 69 percent were less than proficient with respect to quantitative literacy. It is appalling to think that the majority of college graduates are being awarded degrees even though they cannot do what are basic life skills. We're not talking rocket science. For example, according to this summary of the report, non-proficient "students could not estimate if their car had enough gas to get to the service station."

What's worse is the trend. Although skill levels for quantitative literacy remained the same, give or take a percentage point as they were in the 1992 study, the drop-off in prose and document literacy is frightening, especially if the trend continues. In 1992, 40 percent of college graduates were proficient in prose literacy, but in 2003, only 31 percent attained that level. That's almost a 25% decline in the number of college graduates proficient in prose literacy. For document literacy, the percentage dropped from 37 to 25. That's almost a one-third decline.

What's happening? This isn't the first survey to reveal some serious deficiencies in the educational achievements of students eligible to apply to law school, one example being a National Council on Economic Education survey I previously discussed. As I wrote almost two years ago:

Yes, there is something about teaching children to think that would make law school a natural next step rather than the jarring awakening that it is for most students. I am no fan of most pre-K, K-12, and undergraduate education programs. There are some very good ones, and there are some very good teachers. Remembering that parents, entertainers, celebrities and politicians also are teachers, in one way or another, too many teachers aren't teaching what needs to be taught.

Not only are many of the youngsters being encouraged to let feelings stifle rational thought, they end up thinking that the acquisition and regurgitation of information is the essence of education. It isn't. In this regard, most law school faculty, especially in the dreaded first-year, don't help. Closed-book final examinations that constitute 100% of the course grade encourage cramming and memorization, and rewards those with good memories. The best thinkers often don't have the best memories.

Or, as I opined just a few months ago:

There are folks, I think, who have the impression that the government can command an increase in the oil supply. These same folks think food is grown in supermarkets. Perhaps they're among the 90 percent of American adults who do not know what radiation is, the more than two-thirds who cannot identify DNA as a key to heredity, or the twenty percent of American adults who think the sun revolves around the earth. No, I don't make this up, for it comes from Dr. Jon D. Miller of Northwestern, who thinks that this ignorance "undermines" the ability of citizens to participate in democracy in a meaningful way, as explained in this New York Times story. And people wonder why I keep griping about the miserable overall condition of the K-12 and undergraduate education system in this country, especially after we set aside the schools catering to the elite.

A Philadelphia Inquirer report on the Center's study quotes both Stephane Baldi, a director at the American Institutes for Research, and Joni Finney, vice president of the National Center for Public Policy and Higher Education, who expressed hope that "state leaders, educators and university trustees will examine the rigor of courses required of all students."

The Center's assessment, according to the same story, "showed a strong relationship between analytic coursework and literacy. Students in two-year and four-year schools scored higher when they took classes that challenged them to apply theories to practical problems or weigh competing arguments."

So now there is even more proof that academic rigor is a good thing, and that analytic study (translate, problem solving and problem prevention) rather than mere memorization, is a much better way to get the most out of one's education.

A report in InsideHigherEd provides some additional information and some speculation about the causes of the problem. It also conveys the reactions of educators and others, none of which I will repeat, all of which are less than stellar comments on the K-12 and higher education systems in this country, and all of which can be read by reading the report.

One problem is the "declining interest in reading and a culture that increasingly 'takes as heroes people who dropped out of school in eighth grade and made a gazillion dollars'". Another is the possibility that many of the people contributing to the growth in college enrollments are academically underprepared, an explanation that shifts blame from the higher education system to the K-12 system but which doesn't get to the root of the problem. Another is that we live in a culture that dances from sound bite to sound bite, factoid to factoid, in a world of "flashes and bits of material," with no one being challenged to "use the information or analyze it in some way.”

But here is what can be considered both a symptom and a huge part of the problem. According to the InsideHigherEd report, "One study at Illinois State found that honors students were assigned an average of fewer than 50 pages of reading a week, and that two of five students acknowledged completing less than half of that work. 'Students seem to spend a lot of time on Facebook, and when you think about the literate practices involved in Facebook, that’s probably not contributing a lot to the scores on something like this literacy test.'"

No wonder students complain about the reading load they face in my courses, despite the fact that they are asked by me to do far less reading than I was asked to do as a law student. The desire to "buy a degree" is overtaking the desire to pursue the natural outcome of intellectual curiosity and the mature and responsible awareness that life demands people get themselves educated. More than one student has expressed the opinion that having the degree is more important than learning the subject.

And then what?

Well, then what is what we see and experience. Incompetence and ignorance at every turn. The failure of cosmetic window dressing to make up for the deficiencies in preparation. Fortunately, there are people who are proficient, who work diligently to polish their natural talents, who do a good job, who care, who never stop learning, and who understand what sapiens sapiens means. Unfortunately, they aren't as numerous as they once were, as the survey demonstrates. And, unfortunately, they're not necessarily the ones in the spotlight, the ones making the tens of millions, and the ones with the power.

The answer? Graduate schools must become more demanding of the K-12 and undergraduate education systems. They must abandon the notion that they can teach anyone anything, and dictate to their applicants an appropriate list of skills that must be held before they can enter. Hopefully, the spillover to the college students not intending to pursue a graduate education will, as it is said, be a rising tide that makes all the boats ride higher.

Whither Legal Scholarship?

The latest posting from Rosa Brooks on the new LawCulture blog has triggered many comments and reactions. She suggests that she may shift her writing away from law reviews and into other genres.

Other than several law review articles that I have published because a topic came to mind that was best handled in a law review article, I said goodbye to law review articles a long time ago. In fact, I started that trend before I earned tenure. Early on I chose to write books, and did several before earning tenure, because I saw little value in writing for the small audience of law review readers. I want what I say and think to reach as many people as possible, and most of the people whom I wish to reach, and help, are taxpayers and citizens who rarely look at law review articles.

Of course, there are many in "the academy" who look down on my writing. Fortunately, deans, who know what really is involved in teaching to more folks than just those currently matriculated, and who delight in any positive mention of the law school in any venue, have been supportive. Hey, my school's dean has a blog. He encouraged me to blog (and thus remains, sometimes bemused, as an unofficial godfather of MauledAgain).

So to those who are pondering Rosa Brooks' observations and dilemma, there are several things to consider:

1. Law schools with merit compensation systems in place give higher value to articles published in journals than to blogs, op-ed pieces, etc. Of course, if money doesn't matter, this point is irrelevant. Well, no, it's not. Consider the next point.

2. Law schools encourage post-tenure publishing (as well as pre-tenure publishing) because they want points in the rankings game and they like the publicity that scholarship brings. Whether law schools have the valuation priorities in appropriate order is questionable. Why?

3. Law review articles are read by few people, but among those few might be people filling out US New Surveys, though I've never figured out why someone on the faculty of a top 40 school would put a non-elite school ahead of an elite school. After all, folks who have claimed seats at the head table may fight over the seating placement at that table but they'll gang up to keep interlopers from grabbing a seat.

4. Publicity in terms of quality rather than quantity has its advantages, but not for most of the purposes for which law schools desire scholarship. A well-written article in a poorly circulated journal carrying little reputation is far less likely to better the reputation of that journal than to wallow in the dark shadows of the edge of the cosmos.

5. Publicity in terms of quantity is better served by books than by law review articles, better served by being quoted extensively in newspapers and magazines than in other law review articles, and better served by writing a blog read by hundreds or thousands a day than by publishing some obscure paper delivered at some closed membership obscure society. Law school valuation of scholarship does not match publicity as such, but familiarity among members of a closed and small elite.

6. "Newer" forms of writing about legal issues don't get the same respect from most law faculty because most law faculty are unfamiliar with those newer forms, insecure about using them, or caught up in the pack mentality that, surprising to many outside the legal academy, permeates most law school faculties. Conformity is so enforced by the self-appointed guardians of what's right that only a few dare shift to publishing through blogs, wikis, and similar outlets. And, almost all of those who do so keep at least one foot in the "traditional legal scholarship" room.

7. Some law faculty define book by the binding, giving no allowance for digital publication or bindings that permit rapid updating because the area of law is one that changes with the speed of law practice rather than with the glacial movement of academia. There's something ironic about claiming legal scholarship is a dynamic, breathing, vibrant fuel for reform of and change in the law, and yet giving highest accolades to ideas published in a fixed, unalterable, hard cover bound book. Think about it. Seriously. Law publication ought not be considered scriptural and unerring, and thus is best published in ways that permit rapid correction and update: spiral bound monographs, looseleaf binders, blogs, wikis, listservs......

8. Doing "scholarship" the wrong way detracts from law faculties' ability to fulfill their primary obligation, which is preparing law students to assist their clients who need to have problems solved and problems prevented. Doing "scholarship" the right way enhances that ability. Absolutely nothing assures anyone that hard bound books and traditional legal student-edited journal scholarship is the "right" way.

Generations ago, someone had the courage and vision to write the first law review article. Will the current generation of law faculty have the courage and vision to move legal scholarship into the twenty-first century?

More on Overpaid Employer FICA Taxes

My post about the windfall to the Treasury from excess employer FICA payments brought a variety of interesting responses and comments.

CPA Elaine Soost wrote:

As usual you hit upon a “real life” issue that is generally overlooked, both from the perspective of the employer and the employee (for whom it is a time value of money issue for having taxes withheld that shouldn't be). However, it is not just applicable to Federal social security taxes. In some cases it happens with state taxes as well, CA in particular.

She also pointed out that when an employer merges with another company, the acquiring company ends up as a "new" employer, and thus wages earned from the acquired employer earlier in the year aren't aggregated with the earnings from the acquiring corporation for purposes of the $94,200 limitation. Additionally, the California state disability insurance premium charged against employees, which is subject to an annual limitation, ends up being treated in the same manner. The process of getting a refund of over-withheld state disability insurance premiums when there has been a merger of employers, at least in California, is cumbersome at best. Supposedly the employees are to seek refunds from the most recent employer, who in turn is supposed to seek a refund from the state. Does anyone involved in writing these laws and setting up the procedures go through a complete "if this then that else something else" analysis that covers all the possibilities? Do they understand the realities of the workplace and the burdens put on employees?

Elaine also asked if there are statistics indicating how many taxpayers file for over-withheld OASDI payments, how much excess OASDI is paid by small business employers in contrast to larger ones, and whether the disproportionality is higher in states where wages are generally higher, such as California, New York, and Hawaii. A quick bit of research turned up some interesting information. According to these summaries, in 1985 there were 870,892 income tax returns on which a total of $600,136,000 in excess social security payments were claimed. In 1990 the numbers had risen to 931,283 returns and $905,327,000 of excess payments. And in 1995, the numbers grew to 1,033,189 returns and $1,081,454,000 in excess payments. Theoretically at least, and surely as a practical matter, for every dollar of FICA over-withheld from an employee there is a dollar of excess FICA paid by an employer. We're talking more than a million taxpayers, and perhaps more considering that many of these returns are joint returns involving two taxpayers with excess social security payments. More important, we're talking in excess of a BILLION dollars.

I could not find anything, at least not on a quick search, breaking things down by size of employer or by state of residence. The latter information might exist in a detailed appendix to an IRS Statistics of Income report. I haven't invested the time seeing if it exists. I have my doubts if there is anything providing a breakout by employer size.

Someone else pointed out that in some states, state employees are not within the social security system but instead pay into a state retirement system. A state employee who has other wage or self-employment income is required to pay FICA or SECA even if their state earnings exceed the $94,200 OASDI limitation. To me, this is an apples and oranges situation. Many employees who pay FICA, and many self-employed individuals who pay SECA, also pay into a retirement system. Payments into the retirement system don't, and ought not, absolve the individual from paying into social security. What exists for these state employees is nothing more than an exemption from social security, both from paying into it and from taking benefits out of it. Are they better off? I don't know. Someone paying into both social security and a retirement system may be better off, but perhaps they are not. It depends, as they say, on the numbers. Speculation is that the exemption was designed to benefit the employees of one particular state, a representative from which was at the time a very powerful member of Congress, but because several other states had identical systems, the exemption ended up applying to their employees. That powerful member of Congress, by the way, ended up resigning in disgrace, for other reasons.

During the same day that these comments were arriving, another email arrived from a totally different source, from someone who, to the best of my knowledge, does not read this blog and is not a tax practitioner. It was one of those emails that the recipient is asked to forward to all their email contacts. The point of the email is that "Our Senators and Congresspersons do not pay into Social Security and, of course, they do not collect from it." Congress has their own plan. Here's how it works: "When they retire, they continue to draw the same pay until they die. Except it may increase from time to time for cost of living adjustments. For example, Senator Byrd and Congressman White and their wives may expect to draw $7,800,000.00 (that's Seven Million, Eight-Hundred Thousand Dollars), with their wives drawing $275,000.00 during the last years of their lives. This is calculated on an average life span for each of those two Dignitaries. * * * * Their cost for this excellent plan is$0.00. NADA....ZILCH...." The email proposes this solution: "Jerk the Golden Fleece Retirement Plan from under the Senators and Congressmen. Put them into the Social Security plan with the rest of us. Then sit back..... and see how fast they would fix it." Interesting concept. Merely bringing a few hundred people into the system moves some petty cash around the federal budget. On the other hand, perhaps if members of Congress faced the same prospects as those relying on Social Security, they would fix it. But are not members of Congress also entitled to a retirement plan? After all, many Americans have retirement plans. And many do not. Some state employees have retirement plans, perhaps not as generous as the Congressional plan, and like members of Congress, are not subject to social security. Uniformity would be helpful. What would be more helpful is a thorough overhaul of how America plans for the retirement years of its citizens. Let me correct that. What would be more helpful is a thorough overhaul of how American citizens plan for their retirement years. It's an issue that extends beyond over-withheld employer FICA payments. Perhaps understanding how poorly they dealt with this aspect of social security, or perhaps how intentionally they made it so, might help us understand why the repairs needed to deal with retirement income security are so difficult to identify and make.

Attack of the Tax Form Clones

It pays to read the TaxProfBlog because sometimes Paul Caron picks up on news stories with a tax angle that I don't otherwise notice. True, he has a highly trained corps of observers "out there" with their eyes wide open for cool tax news. Oh, yes, I'm one of them. This mutual "share the stories that show tax is everywhere and sometimes is bizarre" arrangement works well.

For example, consider this story that could be made into a movie called "The Attack of the Tax Form Clones." Brian and Jackie Lawson made a arithmetic mistake on their 2003 income tax return. Because of the error, they've been paying $300 a month in back taxes. Wanting to fix the problem, they asked the IRS for a copy of the instructions for the 2003 Form 1040.

The IRS responded. With 24,000 copies. UPS delivered 12 boxes, each containing 2,000 copies of the instruction booklet. For 2005 tax returns. In boxes with errors on the mailing label, but UPS figured out that "Chimacum, D.C." was "Chimacum, Wash."

Then the other shoe dropped. The folks at UPS called the Lawsons to tell them that ANOTHER 12 boxes, each with 2,000 booklets, had arrived at a UPS warehouse. For the Lawsons. Who told UPS not to deliver them.

Whoa. Maybe the IRS figured out its mistake and sent the instructions for the 2003 Form 1040?

Brian Lawson has been unable to get the IRS to return his calls. After all, don't they want these booklets returned? That's 48,000 other taxpayers who will either go without or, to be serviced, will require additional federal money to be spent at the print shop. The newspaper that picked up on the story likewise has struck out trying to contact the IRS.

Brian Lawson also contributed two wonderful quotes. The first: "''We're hoping they'll be more understanding of our error since they made this big error." The second: "We should have had someone else do our taxes."

Now before we jump all over the IRS for this goof, remember, perhaps it isn't as it appears. Perhaps the IRS sent one booklet, and somehow, in transit, it cloned itself. A bunch of times. Perhaps the IRS shipment met up with something being sent by one of those super-secret Area pick-your-number hidden-alien-spaceship Defense Department project offices?

Seriously, I'm sure someone clicked on something in a software program that ought not have been clicked. But considering that the person did not understand the difference between "Wash." and "D.C." (and that only "Washington" precedes "D.C."), it might be something even more goofy. Perhaps something caused the computer to enter a loop that cycled 48,000 times before self-terminating.

Or, perhaps it's still cranking out orders, and by the time you read this the Lawsons will have received a few more calls from UPS about additional packages having arrived at a warehouse addressed to them. In the meantime, the folks over at the fulfillment center in the IRS forms and instructions shipping center must be going batty. "Who are these Lawson people?" "Oh, some tax practitioners with a whole bunch of clients."

Here's my suggestion to the Lawsons: Donate these booklets to local area senior high schools. One for each student. That's 48,000 soon-to-be-eligible-to-vote citizens getting a first-hand look at the niceties of the tax law, Form 1040 style. The teachers will appreciate not having to create a civics project for the year. And who knows? Maybe one or two of the 48,000 students will decide to become a tax practitioner. This is how a mistake can be turned into a good deed.

Prospects for Tax Law Changes in 2006

The debate over the wisdom of making the 2001 and 2003 tax changes permanent is edging closer to center stage. A Heritage Foundation report argues the case for the proposition, claiming that failure to make the cuts permanent would cause "millions of working families ... see their economic prospects dim, their job opportunities diminish, and economic uncertainty rise." Hmmm. Considering the state of the economy, one wonders if permanency had already been enacted. Of course, nothing is said about the misery waiting to befall the non-working investor class if capital gains and dividends were taxes as are other types of income. And nothing is said about extending the rates for another year or two, rather than making them permanent. What fascinates me is the illusion of permanence. No matter what this Congress does, a subsequent Congress can repeal the so-called permanent changes. Nothing in the tax law is permanent. The Treasury and the White House are indicating that making these changes "permanent" is their top legislative priority, but some members of Congress are questioning whether there are sufficient votes in the Senate to make it happen.

In the meantime, according to this report, the President has rejected the Tax Reform Panel's recommendation to tax a portion of employer-provided health benefits. It won't be long, I predict, until the President rejects the proposed cap on mortgage interest deductions, as his finger in the tax wind tells him it won't help his party in the 2006 mid-term elections. What will remain? The proposal to eliminate taxes on capital gains, interest, and most dividends. In other words, if some people had their way, the nation will have a federal wage tax rather than a federal income tax. Something like the woefully embarrassing wage tax levied by local municipalities and school boards in Pennsylvania. In other words, a disgrace. I do hope I am very, very wrong. About the prospects for a federal wage tax.

Independent Contractor or Employee? Don't Get It Wrong

Almost a year ago, I explained the conundrum in which many law students find themselves come April 15. Classified as independent contractors by their payors, when almost always they truly are employees, the students get whipsawed by the consequences of the misclassification. At the end of December, according to this report, a judge ordered FedEx to pay more than $5 million in back pay to a group of drivers that the judge "found had been improperly classified as independent contractors." Three thoughts entered my brain when I read this. First, employers who do this sort of misclassification are attempting not only to save taxes but to cut corners in other areas. Second, surely the IRS will be visiting, or has been visiting, the tax returns filed by FedEx. Third, other employers ought to look carefully at the FedEx case and the tax cases before taking the advice they pick up from the internet, at a bar association happy hour, or from a supposedly learned colleague or friend.

Imagine MauledAgain Getting Sirius

Another report explains that Howard Stern received 34.4 million shares of Sirius Satellite Radio stock because of the number of new subscribers his move to that provider had triggered. The shares had doubled in value, to $219 million, from the time they had been issued in October and the time they vested in January. Howard Stern has some interesting tax issues. Because it's unclear whether he received stock, or options, or whether the deal qualified under section 409A, or precisely what was involved in his contract, it's pointless to dig into all the possible variations. Suffice it to say that a quote from one of my colleagues pretty much sums it up: "I wouldn't mind having Howard Stern's tax problems." Maule to Sirius Satellite Radio: Interested in broadcasting an audio version of MauledAgain?

Let's See Who Goes for This Tax "Cut"

A recent discussion among tax law professors caused me to pay closer attention to something that I knew but had left in the shadows of my tax law thinking. Under current law, employees are subject to a 7.65% FICA tax on their wages. Employers are subject to a FICA 7.65% tax on the wages that they pay. FICA, which is an acronym for Federal Insurance Contributions Act, is commonly called social security, and the tax is generally called the social security tax. Self-employed individuals, who have no employer, are subject to a 15.3% tax, though they are permitted to deduct half of the tax for income tax purposes, because employers are permitted to deduct the FICA tax that they pay. The tax imposed on self-employed individuals is SECA, short for Self Employment Contributions Act, but also gets pulled within the more common phrase "social security tax." The social security tax does not apply to all wages, but that's a different question needing no further elaboration at the moment.

Technically, FICA/SECA consists of two portions. One, OASDI, which is an acronym for old age, survivors, and disability insurance, funds the benefits paid to retirees, disabled employees, and survivors of employees who die during or after employment. The other, HI, short for hospitalization insurance, funds what is commonly called Medicare. Of the 7.65% tax rate, 6.2% is for OASDI and 1.45% is for HI. The OASDI portion of the tax is applied to wages that do not exceed an annual limit, which for 226 is $94,200. The HI portion applies to wages no matter the amount. Thus, in 2006, the most OASDI tax that an employee should pay is $5,840.40.

Because there is a limit on the OASDI portion of the tax, an issue arises when a person has two or more employers during the taxable year. If there is only one employer, that employer can keep track of the individual's wages, and stop withholding the OASDI portion once the wages exceed the limit. But if there are two or more employers, they don't know how much the individual earns from the other employers, and there is no practical way, at present, for the multiple employers to coordinate their withholding. Individuals with multiple employers and sufficient wages may find that they have paid OASDI tax exceeding the limit. Under present law, an individual who pays more than the limit, for example, who has an aggregate of more than $5,840.40 withheld as OASDI taxes by all his or her employers, can claim an income tax credit for the excess. Even though the employers did not know how much OASDI tax was withheld by all of the employers, the employee does, and thus is in a position to compute the excess.

The glitch is on the employer side, there is no mechanism in place to determine that an excess has been paid. Thus, it is possible for an individual's multiple employers to pay, collectively, more than the limit. But there is no procedure for any of the employers to seek a refund. In other words, more OASDI tax is being paid simply because the individual has multiple employers. Incidentally, having multiple employers includes not only the situation in which a person simultaneously holds two or more jobs, but also the situation in which a person changes jobs during the year. The second employer not only withholds OASDI without regard to what the first employer did, but also pays the employer portion of OASDI without regard to the fact that the first employer has paid OASDI and perhaps has paid the full amount for the year.

It's difficult to decide whether this glitch is intentional, considering that it does increase the revenue, or simply the result of Congressional oversight. Yet it's not that Congress is unaware that people hold multiple jobs or change jobs. The existence of the mechanism to refund excess employee OASDI establishes that knowledge.

But why are employers denied the opportunity to obtain a refund for the excess employer OASDI? Perhaps, years ago, the logistics were insurmountable. However, today, with digital technology and comprehensive reporting of wage amounts to the IRS and the Social Security Administration, it would not require hundreds of accounting clerks to do the computation. Once the year has closed, and the IRS and SSA have received the wage data for an individual, the determination that the person has earned more than the limit permits a determination of how much excess employer OASDI has been paid. That excess could be refunded, or credited, to the employers in proportion to the amount of OASDI that they paid.

From a policy perspective, so long as the OASDI limit exists, and so long as employees move from job to job, the same notion of portability that is so prominent in compensation taxation considerations should similarly apply to this issue. The portability concept is that employees and employers should not be disadvantaged, in terms of the tax and other consequences of retirement savings, simply because employees change jobs. The same concept should apply to OASDI.

Of course, some argue that the limit on OASDI should be repealed. There are some strong points raised in those arguments. After all, if social security payments continue to be paid without application of a means test, so too OASDI should be imposed without regard to an income limitation. It might cause multimillionaires to pay in as much as they get in return, or more, but until the I in FICA is applied to a full-scale reform of the social security system, eliminating the cap on OASDI is not a silly idea worthy of instant dismissal. That, however, is a different question.

The more immediate question is why employers continue to be saddled with a collective employer OASDI tax higher than the limit. Considering the changes in American workplace practices in the many decades since social security was enacted, the assumptions underlying the present law, that people remain with the same employer for a lifetime and that people have one employer, should be disregarded. That would open the door to sensible reform.

Will it happen? I doubt it. Where are the tax cut advocates on this issue? Perhaps it's not as important to lighten an unjustifiable tax load on small employers as it is to make the inadequate rates on capital gains and dividends permanent. Who, I ask, really is your friend in Washington?

The Flaming Rodent Tax Trilogy Gets a Sequel

It's not the mouse that will not die. It's the casualty loss deduction real life hypothetical that keeps oscillating between two universes. If this continues, the mouse ablaze tale will end up with more episodes than Star Wars.

Thanks again to Mark Morin, who passed along an Associated press update on the now legend of the Fiery Mouse.

Apparently, the man whose house burned down in New Mexico last Saturday has once again changed his story back to the version that puts the blame, at least in part, on the mouse. But this time there are more details. And this time it is the man and his nephew who have clarified what happened. The homeowner, who admits to having "an awful hate" for mice, explained that a mouse got stuck to one of the glue traps he had set. The mouse, though trapped, was still moving. The homeowner tried to pull the mouse off the trap, but the glue was too strong. So that's why he tossed the mouse, still attached to the trap, into the burning leaf pile. Now, he claims, the mouse fully ablaze, scrambled back into the house through a window. Ninety seconds later, the house was burning.

When asked how a mouse glued to a trap could manage to get back into the house, the homeowner stated that the fire melted the glue. But apparently, I guess, not the mouse. Sounds a bit far-fetched.

But the local fire chief says he thinks it's possible. He says there's no reason for the homeowner to lie, and he has no doubts about the story. The fire chief says that the most recent reported story is the story given by the homeowner to the firefighters when they first arrived at the scene. The homeowner's nephew also claims that his uncle has shared the same story "many times."

It is sad. According to the nephew, all the family photos were lost. All the homeowner's papers are gone. The nephew conceded that his uncle, a World War II vet who has "been through a lot," might be "a little confused."

The fire chief noted that no further investigations are planned, and that the department's official report will include a statement that the burning mouse ran back into the house.

Now, who wants to volunteer to help this fellow with his tax return? Just don't grill the guy during the intake interview.

Tax and Other Legal Filings: Registered? Certified?

One of the challenges in teaching law school is to find the appropriate balance between a focus on theory, philosophy, and principles and a focus on practical application and practice world reality. Going too far in one direction produces graduates who enter practice in need of intense mentoring, something far less feasible than it once was because of the "bottom line" pressures in the legal profession, whereas going too far in the other direction brings the "don't be [we're not] a trade school" admonition.

But no such challenge exists on this blog. If something has philosophical or theoretical value, and I'm interested in commenting on it, I do so. Likewise, if something has practical value, and I think it deserves attention, it will get it. The nice thing about blogs is that the artificial, but pragmatically inescapable limitation of 50 minutes at a time, 42 sessions a semester doesn't exist.

So today I want to share a posting made to several tax related listservs by Jim Counts CPA CTFA (james.counts.cpa@earthlink.net), who shared some very practical advice about mailing important documents, such as Tax Court petitions. What he says is relevant to just about any sort of legal filing, tax or otherwise. As long as I've been around, I've not encountered as useful and important an explanation about the difference between certified and registered mail as the one Jim offers. So, with his permission, I share it:

On one of my other listserves I just posted the following. Generally I get asked this a couple of times a year. So I thought I would post it here for those that might be interested.

Those that like Certified say in Tax Court etc it works just as well as Registered. In their mind they just want to prove they mailed the item. For me I do not want to have to spend time in Tax Court or dealing with the IRS to prove that the item was mailed on or by a certain day. I want it to actually get there. So I like registered.

In certified once the PO Clerk accepts the item they put it with all the other mail. When it gets to where it is going if that clerk sees the return receipt then they will get it signed. For registered that PO Clerk will LOG IN THE ITEM and everyone that has control over that item WILL SIGN FOR THAT ITEM until it is given to the one it is addressed to.

So in my opinion if someone signs for something and knows that later if they lose it someone will eventually come asking what did they do with it then I think they are less likely to lose that item and are likely to get the next person to sign saying they received it. I think that means it is less likely to get lost than a certified item. So I think I have just increased my odds that the item will actually make it to where it is addressed. So given that it is less likely that I will have to prove in Tax Court or with the IRS that my item was mailed on or by a certain date. Now I have just saved myself some time.

In the past prior to doing registered I had to spend some time on proving certified mailings. I have as of now I have not had to prove a registered mailing. Would I have to if I had sent all of that stuff certified? Do not know but I think I would have had a few over the years.

So the cost is only about $1.75 (not sure now new rates) more. If I did the mailing taxes saved half of that so I made an investment of the balance that I would not have to prove something mailed. If clients mailed an item and did not follow my recommendation of doing registered and now we need to prove a mailing then I charge them for the time.

Some different rules apply for registered mailings. No windows on the envelope. No tape on the item unless it is paper tape. No labels on the envelope. This is one of the reasons I still have a typewriter. My typewriter has memory for addresses so I can tell it to type my address in the return area. Also for IRS and FTB I have it memorized for mailing of returns.

So that is why registered and not certified.

What particularly impresses me is how Jim takes a long-term view of the problem when making his analysis. Weighing the additional cost of registered mail against the aggravation of proving that a certified item was sent, he considers the value to the client of having things go as smoothly as possible.

In Jim's analysis, concern for the client takes its rightful place. That is a principle I stress in my teaching. I am preparing law students to become professionals who serve their clients and their clients' best interests. In some respects, my focus is on the future clients of my students and not on my students in an isolated educational environment. I'm not alone in this approach. Far from it. But I'm probably far more vocal about it than students expect, something I've concluded after being told by students that they rarely hear the word "client" in most of their classes. That's too bad. Clients are real. Clients bring problems that make the law real. Clients need help that makes it essential that practice reality inform the law school experience. But I've not taken class time to deal with how documents should be mailed. I do discuss why lawyers ought not wait until the 89th day to get a Tax Court petition (due on the 90th day) written and sent. Why the difference? I've assumed, perhaps erroneously, that when students get to their first job, someone will teach them or tell them or show them how it's done. Someone like a paralegal or legal secretary, who provide the glue that keeps the law practice world from falling apart over seemingly mundane things.

But now, all I need to do is to point them to this blog. I can get the message to them without investing class time, and without having to argue about whether dealing with such issues in a classroom brings a "trade school" taint to the tax course.

Note: For what it's worth, I don't require students to fill out tax forms, nor do I fill out forms in class, even though some students complain on student evaluations that my courses are way too theoretical because I don't have them doing tax forms. My courses? Too theoretical? Next thing you know they'll be claiming I'm taciturn and reserved.

Tax Law and Rodents Afire

At first it appeared that a flaming mouse, trying to escape from being tossed onto a pile of burning leaves, ran back all afire into the house where it had been caught, triggering a fire that caused it to burn down. What a great story to use as the framework for discussing casualty loss deductions and public policy.

Then came news that the mouse was dead when cast into the flames, and wind carried sparks into the house. The casualty loss deduction issues remain, but the story just isn't as interesting or attention-getting.

To the rescue comes Mark Cochran, who teaches tax at St. Mary's University School of Law. He reminds us of a famous torts case, United Novelty Co. v. Daniels, 42 So. 2d 395 (Miss. 1949). Quoting the facts as summarized by the Supreme Court of Mississippi:

Appellees include the members of the family of William Daniels, a minor aged nineteen years, who was fatally burned while cleaning coin-operated machines as an employee of appellant.

The work was being performed in a room eight by ten feet in area, in which there was a gas heater then lighted with an open flame. The cleaning was being done with gasolene. The testimony yields the unique circumstance that the immediate activating cause of a resultant explosion was the escape of a rat from the machine, and its disappointing attempt to seek sanctuary beneath the heater whereat it overexposed itself and its impregnated coat, and returned in haste and flames to its original hideout. Even though such be a fact, it is not a controlling fact, and serves chiefly to ratify the conclusion that the room was permeated with gasolene vapors. Negligence would be predicated of the juxtaposition of the gasolene and the open flame. Under similar circumstances, the particular detonating agency, whether, as here, an animate version of the classic lighted squib, or as in Johnson v. Kosmos Portland Cement Co., 6 Cir., 64 F.2d 193, a bolt of lightning, was incidental except as illustrating the range of foreseeability.

And so into the law, more than a half century ago, entered the flaming rat. Yes, though the court was addressing a torts issue, casualty loss deduction issues lurk under the surface, assuming, of course, that there was no or inadequate insurance coverage for the damage.

These "animal afire" stories reach back centuries. Consider the fifteenth chapter of Judges, verses 4-6:

And Samson went and caught three hundred foxes, and took firebrands, and turned tail to tail, and put a firebrand in the midst between every two tails. And when he had set the brands on fire, he let them go into the standing grain of the Philistines, and burnt up both the shocks and the standing grain, and also the oliveyards. Then the Philistines said, Who hath done this? And they said, Samson, the son-in-law of the Timnite, because he hath taken his wife, and given her to his companion. And the Philistines came up, and burnt her and her father with fire.

Someday, when I have time (ha ha), I might sit down and see how many Bible stories can generate tax issues. For the moment, though, I'm content with warning folks not to let their pets play with matches.

Follow-Up Report Extinguishes Blazing Mouse Tale (but not the tax issues)

Yesterday, I analyzed the tax issues arising from the survival attempts of a mouse tossed into a pile of burning leaves. Fleeing the flames, the mouse ran back into the house in which the owner had caught it, and somehow set the place ablaze, destroying the residence and all its contents. But now the extinguisher of exaggeration has come to smother the fun.

Drat. It was such a great story. But it turns out that the house fire in New Mexico was NOT caused by a fleeing, flaming mouse. According to a WSB television report, the mouse was killed before it was tossed into the burning leaf pile. The fire apparently was caused by high winds spreading the embers. WSB has initially reported the story along with many other news services, and initiated further investigations after the news had spread world-wide. I guess people were questioning what they thought was an account just a wee bit on the other side of totally bizarre.

According to the most recent report, the homeowner has no insurance. So, despite throwing cold water on the supposed antics of an allegedly blazing mouse, the story keeps the flame of the hypothetical alive. How? The issue of gross negligence remains, continuing to present the question of whether leaf burning at the time violated any local laws, and adding the question of whether it is grossly negligent to burn leaves close enough to a home such that winds could carry burning embers into the structure. The area has been afflicted with unseasonably dry and windy conditions for at least several weeks. We still don't know if a casualty loss deduction is allowable.

So where did the tale of the flaming mouse come from? The local fire department captain explained that the rumor "probably got started because there was 'a little too much excitement' at the time of the fire." A little too much excitement? Sounds like tax class to me, even if the students aren't all fired up.

I feel bad for Paul Caron. Yesterday, in a post nicely titled, "Of Mice and Casualty Loss Deductions," he picked up on my analysis of the story. He stated, "Jim Maule has enlivened my income tax class for years to come by posting a wonderful Associated Press story that ran in newspapers across the country today, Blazing Mouse Torches House." Now, I guess he's back to a less-enlivened pedagogical prospect. OK, I'll keep my eye out for a similarly discussion sparking news item.

And thanks to Mark Morin for the tip.

Why Tax Law Can Fire Us Up

Classes begin today. I should be fired up. But I have good reason to hesitate, when it comes to fire.

First, the background. The Internal Revenue Code permits a deduction for casualty losses, in excess of certain limits, that are caused by fire, storm, shipwreck, or other casualty. Section 165(a) and (c)(3), to be more precise. Generally, despite the tax law being replete with cases dealing with whether something, such as termite damage or massive Southern pine beetle attacks, constitutes a casualty, fire pretty much is self-defined.

But there is another limitation. It arises from the public policy doctrine, which has been applied by courts to limit all sorts of deductions, not just casualty losses. A fascinating case that nicely explains the law, and life, not only to the taxpayer but to students of tax (and not just those enrolled in a tax course), is Blackman v. Commissioner, 88 T.C. 677 (1987). I cannot do justice to the facts through paraphrase, and because they are set forth by the court in three paragraphs, here they are:

The petitioner's employer transferred him from Baltimore, Maryland, to South Carolina. The petitioner relocated his wife and children to South Carolina. Mrs. Blackman was dissatisfied with South Carolina and returned, with the couple's five children, to Baltimore. During the 1980 Labor Day weekend, the petitioner returned to Baltimore, hoping to persuade his wife to give South Carolina another chance. When he arrived at his Baltimore home, he discovered that another man was living there with his wife. The neighbors told the petitioner that such man had been there on other occasions when the petitioner had been out of town on business.

On September 1, 1980, the petitioner returned to his former home to speak to his wife. However, Mrs. Blackman was having a party; her guests refused to leave despite the petitioner's request that they do so. He returned to the house several times, repeating his request, and emphasizing it by breaking windows. Mrs. Blackman's guests did not leave the house until about 3 a.m., September 2, 1980.

Later, on September 2, 1980, the petitioner again went to his former home. He wanted to ask his wife whether she wanted a divorce. They quarreled, and Mrs. Blackman left the house. After she left, the petitioner gathered some of Mrs. Blackman's clothes, put them on the stove, and set them on fire. The petitioner claims that he then "took pots of water to dowse the fire, put the fire totally out" and left the house. The fire spread, and the fire department was called. When the firefighters arrived, they found some of the clothing still on the stove. The house and its contents were destroyed.

Mr. Blackman was arrested, charged with arson, and sentenced to probation without verdict. The homeowners insurance company refused to pay. And, Mr. Blackman claimed a casualty loss deduction on his tax return. The relevant portions of the court's opinion are worth reading:

* * * * *the Commissioner argues that the petitioner intentionally set the fire which destroyed his home in violation of Maryland's public policy, that allowing the deduction would frustrate that public policy, and that, therefore, under the doctrine of Commissioner v. Heininger, 320 U.S. 467 (1943), and subsequent cases, the petitioner is not entitled to a deduction for the damage caused by his fire. * * * * *

Moreover, it is well settled that the negligence of the taxpayer is not a bar to the allowance of the casualty loss deduction. * * * * * On the other hand, gross negligence on the part of the taxpayer will bar a casualty loss deduction. * * * * * "Needless to say, the taxpayer may not knowingly or willfully sit back and allow himself to be damaged in his property or willfully damage the property himself."

In our judgment, the petitioner's conduct was grossly negligent, or worse. He admitted that he started the fire. He claims that he attempted to extinguish it by putting water on it. Yet, the firemen found clothing still on the stove, and there is no evidence to corroborate the petitioner's claim that he attempted to dowse the flame. The fact is that the fire spread to the entire house, and we have only vague and not very persuasive evidence concerning the petitioner's attempt to extinguish the fire. Once a person starts a fire, he has an obligation to make extraordinary efforts to be sure that the fire is safely extinguished. This petitioner has failed to demonstrate that he made such extraordinary efforts. The house fire was a foreseeable consequence of the setting of the clothes fire, and a consequence made more likely if the petitioner failed to take adequate precautions to prevent it. We hold that the petitioner's conduct was grossly negligent and that his grossly negligent conduct bars him from deducting the loss claimed by him under section 165(a) and (c)(3).

In addition, allowing the petitioner a deduction would severely and immediately frustrate the articulated public policy of Maryland against arson and burning. Maryland's policy is clearly expressed. Article 27, section 11, of the Maryland Annotated Code (Repl. vol. 1982), makes it a felony to burn a residence while perpetrating a crime. * * * * * We are mindful, also, that Maryland has an articulated public policy against domestic violence. We refuse to encourage couples to settle their disputes with fire. We hold that allowing a loss deduction, in this factual setting, would severely and immediately frustrate the articulated public policies of Maryland against arson and burning, and against domestic violence.

So now, having been brought up to speed to the point where a student in a tax course should be when entering the classroom on the day casualty loss deductions are discussed, everyone is ready for the professor's hypothetical. Except it is not a hypothetical. It is a story reported in this morning's Philadelphia Inquirer (free subscription site). The headline is almost priceless: "Blazing Mouse Torches House." When I saw this, I wondered, "What is a blazing mouse?" The story answered the question:

A man in Fort Sumner, New Mexico, caught a mouse inside his house. To dispose of it, he threw it on a pile of leaves that he was burning outside the house. The mouse, on fire, escaped from its hellish environment and ran back into the man's house. And somehow set it on fire. The firefighters, who claimed this was a first for them, determined that the mouse had run to a point underneath a window. Though the story doesn't explain what happened, I'm guessing that there were curtains on the window. The house, and everything in it, was destroyed.

Can this man claim a casualty loss deduction?

More facts are needed. When I point that out to students, they often groan. More facts? Yes. If, for example, the man has homeowners insurance and it fully covers the loss, then there is no casualty loss deduction, because there is no loss. Nothing in the story tells us if there is insurance. Of course, to get an education from this "hypothetical" we need to assume that there is no insurance.

Where does that take us?

Was the man grossly negligent? Was the house fire a "foreseeable consequence" of tossing of a captured mouse into a pile of burning leaves? Would it matter if outdoor leaf burning was illegal? Ah, this question means that there is more information that is required. Some towns have permanent bans on outdoor leaf burning, and others impose temporary bans during droughts or periods of high fire risk. Considering the number of wildfires that pop up in New Mexico, this is more than a theoretical possibility. Is it against public policy to throw living mice into burning leaf policies? Did the man have a chance to extinguish the fire at the window? Did he try? Oh, if it matters, the man was 81 years of age. Maybe that matters. Maybe not.

I'm not going to determine if a casualty loss deduction would be permitted. I don't know. I don't have the necessary facts. Nor do I want to devalue this story's utility as a future examination or semester exercise question.

So this morning, as I head off to class, I'm going to be careful about getting the students fired up about their new courses. They may have a burning interest in the subject matter, but I'd rather they not flame me.

OK, that's enough. I'm running the risk of extinguishing my readership.