Heading Out the Door But Coming Right Back In

It’s official. Today is the first day, since January 2, 1981, that I am not a full-time member of a law school faculty. After three years in a “staged retirement” plan of my design adopted by the law school, I retired as of May 31, 2016. Staged retirement permits a faculty member to reduce teaching load to one semester, and to be relieved of committee assignments and scholarship expectations (though the latter was irrelevant to me as I continued to write).

Through the years, though most of the faculty who have retired headed out to other pursuits, several returned to teach one or two courses. A combination of institutional need and individual desire to stay connected to the classroom has created admirable symbioses. For those two reasons, the plan is for me to return in the spring semester of 2017 to teach a course, and, perhaps, two. Two? To use one of my favorite phrases, it depends. Thereafter? Guess. Yes, it depends.

Another colleague who is retiring described the arrangement rather nicely when asking a question recently, “A bunch of us are heading out the door, though a couple are heading right back in.” It is a bit confusing, because it creates a relationship somewhere between full-time member of the faculty and fully retired no-longer-on-campus retiree. I’ve proposed a new designation but you’ll hear about that in the future only if it becomes official.

On the evening of May 12, the Villanova University Charles Widger School of Law hosted a retirement dinner for those of us who retired as of yesterday. When invited to speak, this is what I said:

Thank you.

Contrary to perception, my time here hasn’t been all about tax and numbers. So only a fraction of my remarks will involve integers.

I’ve been teaching or tutoring since I was in grade four. I have learned that it is true, the best way to learn is to be an effective teacher. Though that includes teaching one’s self, there is no good substitute for learning from and teaching others. That happens in this school, and I present four facets of how I experienced this.

First, when I joined the faculty, I was asked, “What’s it like now that you’re part of the faculty that taught you?” I answered, ‘They’re still teaching me.” I didn’t add that they were still admonishing me. Sometimes justifiably. Over the years, all but one of that group has departed, one way or another, and that colleague retires next year. As they left, others arrived, and I have learned from them as well. Though I have no time to describe what I learned, I appreciate the intellectual sharpening, the social banter, and the friendships. By my rough estimate, more than 100 teaching colleagues have shared this journey at one time or another. I thank my colleagues.

Second, faculty were not the only employees from whom I learned. Over the years, at least 200 administrators and staff taught me all sorts of lessons, from computer secrets to label printing, from library and research help to event planning tips. I thank the administrators and staff.

Third, the reason this institution exists, the students, taught me even more. I was told that when I graded exams, I would be astonished by what I would learn. I discovered the truth of that warning while grading 8.467 final exams in 21 different courses, taught over 87 semesters spanning 35 and a half years. I learned even more from those quizzes and exercises that I battled for permission to administer, and that have become a major component of the formative assessment process soon to be found throughout the curriculum. As I taught, I learned what my students were grasping and missing, in a process that had me read and grade, over the past 22 years, semester exercise and quiz responses totaling more than 52,000. I thank my students.

Fourth, even more learning came from colleagues who looked at manuscript drafts, student research assistants who dug up information, and staff who assisted in filling the mailboxes of lawyers and non-lawyers with 22 books and 33 revisions to 19 of those books, 22 chapters in books and 41 revision to 18 of those chapters, 33 articles, dozens of other publications, and 2,175 posts on the “will you ever tell us how it got its name” MauledAgain blog. The responses to those publications have been quite an education. I thank my helpers and my readers.

In closing, I have been asked, “So you’re retiring, why now?” The answer is in those numbers. Simply put, I do not want to burn out. Though Neil Young has claimed that it’s better to burn out than to fade away, I agree with John Lennon’s criticism of that advice. So I plan to fade away. Slowly, from 7 courses a year to 5 to 4 to 2, and now, yes, next year, 1 (or, maybe 2), I have tried to make retirement, for me, a gradual process and not an abrupt halt.

This evening has been a wonderful opportunity to pause, look around, share memories, and contemplate the future. It has been, and will continue to be, an extraordinary educational journey. Please understand, it’s not over. Though I am retiring, I am not leaving.

Some people have asked me what I will be doing now that I am “retired.” Others have noted that “your life will be so different.” I have explained why that will not be so. I will continue to teach, though only one course, or perhaps two. I will continue to write, though perhaps not as frequently. I will continue to share commentary on this MauledAgain blog. I will continue to research family history. I will continue the activities in which I engage at my church. I will continue to go to the gym. I will continue to visit family. I will continue to travel. I will continue to read. I will continue to do household and yard chores.

So to shift from visualizing doors to understanding the journey, I’m going down the same highway and perhaps spending a little more time in some lanes and a little less time in others. Perhaps I will slow down a bit, at first. But I will continue to learn. From that, I have no intention to retire.

Remembering All Who Served

Today is Memorial Day. It began as Decoration Day, intended to recognize those who died in war in service to their country, by placing flowers, wreaths, flags, and other “decorations” on gravesites. Purists will note that Veterans Day, in November, provides an opportunity to honor those who served and who are still with us.

Today, though, is a day to remember more than those who have died while serving our country in war. It is a day to remember those who served and suffered fates worse than death, those who served but who suffered physical and psychological injuries from which they have not fully recovered, those who served and fully recovered, and those who served though escaping death and injury. It is a day to remember that the horror of war extends far beyond gravesites and into the lives of millions of Americans, including the families and friends of those who have served.

Today is a day to remember the lessons that are taught by war, lessons that apparently are difficult to learn. War comes with a cost, and that cost must be paid. In recent years, this nation has short-changed its veterans, and Congress and individual politicians have trotted out all sorts of reasons for bringing corporate cost-cutting measures to bear on those who have paid a price too few appreciate. As I wrote ten years ago in A Memorial Day Essay on War and Taxation:

Wars consume resources. Wars divert resources. In other words, wars cost money. Wars destroy lives. A life lost is immeasurable, yet economists, lawyers, and juries put price tags on lives, however lost. It is not good for an economy, or for taxation, for lives to end prematurely.
. . .
War is such a collective expression of the ultimate essence of life and death that it ought not be undertaken half-heartedly, experimentally, impetuously, or foolishly. War requires commitment, and without it there ought not be war. War requires resources, and without a commitment to expend those resources, it ought not be undertaken.
. . .
Yet the current global war has not been managed in the same manner. Politicians have chosen to fight without increasing revenue, imposing rationing, or deferring projects and activities. In their defense, they argue that none of these things are necessary, that a nation can have its guns without giving up its butter. I disagree, and I happen to think that politicians are reluctant to do what needs to be done because they are more concerned about maintaining their position in office than in making the tough decisions that war requires. So our national leaders have chosen to put the cost of the current war on our children and grandchildren. Those who decry the huge deficits, triggered in part by war and in part by the almost insane concept of decreasing tax revenues (mostly for the wealthy) during wartime, pretty much focus on the economic impact. They ask if, or suggest that, our grandchildren will be facing income tax rates of 80 percent in order to reduce an unmanageable deficit. I think it will be worse. I think our children and their children and grandchildren will become subservient to our nation's creditors. The sovereignty of the United States of America is far from guaranteed, and is at risk. Were these considerations discussed when those in power decided that war can be done on the cheap?

War cannot be done on the cheap. War is not free. War ought not be purchased on a credit card. War is a national commitment. Hiding the true cost of war in order to influence a nation's willingness to engage in war is wrong. Ultimately, the price to be paid will be dangerously high. . . .

If I could travel back in time, I would amend that commentary to point out that our national leaders have chosen to put the cost of twenty-first century wars, declared or undeclared, as well as military actions, on our children, grandchildren, veterans, and military personnel. Those who benefit from the outcome of war have not been handed an adequate invoice.

Previous Memorial Day posts:

Gasoline and War

A Memorial Day Essay on War and Taxation

Memorial Day: How Important are Taxes Really?

Honoring Those That Serve

Memorial Day: Why a Holiday From Taxes?

Memorial Day, Taxes, and Remembering the Future

Free, Freedom, Fees, and Taxes

Paying Taxes: In Memoriam

Choose The Entity Carefully Because Tax Consequences Matter

A recent case, Aleamoni v. Comr., demonstrates the need for business owners to select carefully the entity through which the business will be conducted. In the mid 1980s, the taxpayer, a college professor, formed a C corporation through which he offered consulting and similar activities not part of his teaching and other university responsibilities. The taxpayer and his wife owned half of the shares, and their children owned the other half. Over the years, the taxpayer and his wife advanced money to the corporation, which the corporation recorded on its general ledger as loans from shareholders. In the mid-1990s, the taxpayer and his wife started attaching a Schedule C to their federal income tax return, deducting the money advanced to the corporation during the year as a business expense. No income was reported on the Schedules C. The corporation filed Form 1120 for each of its taxable years, reporting gross income and deductions exceeding the gross income. The balance sheets on those returns showed the advances from the taxpayers as loans from shareholders. The IRS disallowed the Schedule C deductions, and the taxpayers filed a petition for redetermination in the Tax Court.

The taxpayers argued that the advances were loans to the corporations, that the advances are deductible as business expenses, and that the failure of the IRS to disallow the deductions in audits of returns for earlier years precluded it from disallowing the deductions for the years in issue. The IRS argued that the advances are not deductible whether they are characterized as loans or as capital contributions.

The Tax Court concluded that the advances were not deductible under section 162 because they were not expenses. They represented investments by the taxpayers in the corporation and thus were not deductible. The court noted that if the advances were loans the taxpayers might be entitled to a bad debt deduction in the future to the extent the loans became worthless, and that if they were capital contributions the taxpayers might be entitled to a capital loss deduction in the future to the extent the stock became worthless. However, because the taxpayers explained that the corporation existed and doing business, because they expected the advances to be repaid in due course, and because they gave no suggestion that the stock was worthless, the bad debt and capital loss deduction possibilities were not in play.

The court suggested that the taxpayers might argue that the corporation was little more than the alter ego of the professor, but that a corporation formed for legitimate business purposes is an entity separate from its shareholders. Thus, the shareholders are not permitted to deduct the corporation’s expenses, even if financed by loans or capital contributions made by the shareholders.

The court pointed out that if the corporation were an S corporation the amounts advanced to the corporation would be deductible by the shareholders to the extent those amounts were used by the corporation to pay deductible expenses. That approach was rejected because the taxpayers had not formed an S corporation.

The court dismissed the taxpayers’ argument that the failure of the IRS to object to the Schedule C deductions in audits of returns for earlier years precluded it from doing so for the years in issue. It explained that the doctrine of equitable estoppel is not a bar to correction by the IRS of a mistake of law, even if the taxpayer relied on that mistake in filing returns for subsequent years.

When starting a business, selecting the form in which the enterprise is conducted is an essential consideration. There are advantages and disadvantages to each of the choices. Determining which form makes the most sense for a particular taxpayer depends on the particular characteristics of that taxpayer’s characteristics. It requires examination of the particular business, the market in which it operates, the long-term and short-term probability of success, the possibility of becoming a target for acquisition by another party, the tax situation of the taxpayer, the psychological and emotional constraints on the taxpayer’s business presented by third parties, the prospects of the taxpayer’s premature death, and dozens of other factors. Making the wrong decision, which is much easier to identify through hindsight, can have significant adverse consequences. It is worthwhile for the taxpayer to consult with a professional, to avoid relying on internet advice and sound bite bits of so-called wisdom, and to remain skeptical of decisions made by robots or other forms of artificial intelligence that disregard the factors not easily reduced to bits and bytes.

Taxation of Androids and Robots, and Similar Pressing Issues

A little more than three months ago, as I explained in “Can a Clone Qualify as a Qualifying Child or Qualifying Relative?”, a reader asked me, “Can a clone qualify as a qualifying child or qualifying relative?” After sharing my thoughts about how the analysis could begin, I concluded by admitting, “I don’t know. I can guess, and you can guess, and it’s fun to share our guesses. But in the end, it’s that classic response, ‘It depends.’ Until then, think about it from time to time.”

The same reader has now pointed my eyes in the direction of an almost two-year old commentary, Die, robot. From androids to zombies: taxation of the undead. However I had missed this, perhaps because it was based on a science fiction conference held in London, I had to read it. Of course.

The conference focused on how people would save tax in the future. The discussion started with the question, “who will the people be?” In a series of questions worthy of law school trying to prepare its students for practice in the late twenty-first century, the participants wondered if an android or robot into which someone’s consciousness had been downloaded would be taxable as a person.

The suggestion that taxing authorities would TRY to tax the android or robot is not surprising. Of course the authorities would try. But would they be correct? Would, or should, their decision be upheld or struck down?

One line of analysis contended that a person would not escape taxation simply because he or she had an artificial leg, or an artificial leg and an artificial heart, or a prosthetic voice. Logically, therefore, why would a person not exist if a combination of artificial everything, including an artificial brain, was cobbled together? These ideas have populated science fiction literature for decades. But unlike past generations, or even those alive today who as children or young adults passed these imaginations off as fantasy, the possibilities are very real, if not today, then next week or next year, or next decade, that human-like androids and robots will exist.

Eventually, the panelists at the conference decided that if the android or robot could own property, it should be treated as a person, and thus taxable. Similarly, if it incorporated itself the resulting entity would be taxable. The author of the commentary decided that the test should be, “if it moves, tax it, if it thinks, tax it, if it earns, tax it.” That approach would make animals obligated to file tax returns in those instances when the animal earned money, something that does happen. Animals certainly make money for their earners, as this article explains, so certainly the owner of an android or robot would be taxable on that income. But what happens if the android, or the robot, or the animal, is treated as having independent existence with a right to retain its earnings? Laugh not, because there are chimpanzees and capuchins who have been taught to handle money, as explained in an article that explains not only how they learned to use money and to understand it, but what they then ended up doing with it. It’s well worth the read.

The commentary addressed other tax issues involving androids and robots, such as domicile, cloning, zombies, sentient non-human aliens, and, perhaps alarmingly, time travel. If the question of “tax and time travel” is getting this sort of attention, I might need to find a better example for use in warning law students about drifting from the practical into the theoretical when doing so is inappropriate.

These questions are, at the moment, focused on theoretical concerns. But, one by one, sooner or later, they will become very real. Perhaps none of us will face them, other than in blog musings and dinner party chit-chat. But our children, grandchildren, or more remote descendants will grapple with these issues. Perhaps they will come back to fetch us. Will we be required to pay a transportation tax when that happens? If I find out, I’ll let you know.

Ascertaining a Taxpayer’s Motives

Usually, ascertaining a taxpayer’s motives is something on which practitioners and judges focus when the issue involves taxpayer intent with respect to a specific transaction. For example, in more than a few places, the Internal Revenue Code requires a determination of whether a taxpayer entered into a transaction with a purpose to avoid federal income tax. There is another set of situations, however, in which the focus on a taxpayer’s motives is a matter of understanding why a taxpayer chose to take a particular return position or to litigate an issue. A recent case, Santos v. Comr., T.C. Memo 2016-100, leaves me, and presumably others, wondering why the taxpayer contested a deficiency and advanced the arguments that he did.

The facts of the case are fairly simple. At an unspecified time in the past, the taxpayer earned a bachelor’s degree in accounting. In 1990, he began working as a tax return preparer. Five years later, he became an enrolled agent. In 1996, he earned a master’s degree in taxation. He expanded the scope of his services to his clients to include accounting and financial planning. At some point during or before 2010, the taxpayer enrolled in law school, and graduated in 2011. In that same year, he sat for the California bar examination. He was admitted to the California bar in 2014, and also was admitted to practice before the United States Tax Court. In 2015, he and his father opened law offices, offering legal representation, tax planning, accounting, and financial planning.

When the taxpayer filed his 2010 federal income tax return, he deducted $20,275 in law school tuition and fees. The IRS disallowed the deduction. The taxpayer filed a petition in the Tax Court. He lost. He lost because education expense deductions are not allowable if the education prepares an individual for a new trade or business, because the requirement that the taxpayer be carrying on the trade or business to which the deduction relates is not satisfied. This principle is set forth in the regulations under section 162. The regulations specifically include an example that explains why law school tuition is not deductible by someone who is practicing a profession other than law, such as accounting. Numerous judicial decisions have reached the same conclusion, and have upheld the regulations.

The taxpayer attempted to justify the claimed deduction by challenging the validity of the regulations. He argued that the Treasury Department failed to respond adequately to public comments received when the regulations were proposed in 1967, citing a 2015 decision involving regulations under a different Internal Revenue Code provision, and that analyzed the validity of the regulations based on empirical determinations and not statutory interpretation. The taxpayer also claimed the regulations violated the Regulatory Flexibility Act of 1980, but the court pointed out that the 1967 regulations were not subject to that Act because that Act, by its terms, applies only to regulations promulgated after 1980. The Tax Court also noted that the taxpayer did not raise his claim that the regulations are invalid until after trial, leaving the court bereft of any information about the comments offered in 1967 and without the ability to determine whether the Treasury Department responded adequately to those comments.

Apparently no additions to tax or penalties were asserted by the IRS. My guess is that the amount of tax liability in question was insufficient to trigger them, and that had the tax liability been sufficient, the taxpayer would have faced one or another addition to tax or penalty.

So, for me, the question is, why did the taxpayer challenge the regulations? Why did the taxpayer argue that a statute applicable after 1980 should be applied to regulations promulgated in 1967? Why did the taxpayer fail to raise the validity arguments until after trial? Several thoughts cross my mind:

Did the taxpayer make this argument because someone in his law school basic tax class suggest that the argument should be made?

Did the taxpayer make this argument because there were no other possible ways to defend the disallowable deduction?

Did the taxpayer make this argument because another practitioner, or an internet commentator, put the idea into his head?

Did the taxpayer make this argument because somewhere in his legal or tax education he was taught, or somehow learned, that creativity or cleverness is commendable no matter the circumstances?

What motivated the taxpayer?

The Soda Tax Flaw in Automotive Terms

The controversy over the latest soda tax proposals in Philadelphia continues without respite. If I were to publish a reaction to every comment and news development concerning soda taxes, this blog would become immense, quickly. So I am selective when I see or hear soda tax information and opinions. I have been sharing my views on the soda tax for almost a decade, starting with What Sort of Tax?, and continuing through The Return of the Soda Tax Proposal, Tax As a Hate Crime?, Yes for The Proposed User Fee, No for the Proposed Tax, Philadelphia Soda Tax Proposal Shelved, But Will It Return?, Taxing Symptoms Rather Than Problems, It’s Back! The Philadelphia Soda Tax Proposal Returns, The Broccoli and Brussel Sprouts of Taxation, The Realities of the Soda Tax Policy Debate, Soda Sales Shifting?, Taxes, Consumption, Soda, and Obesity, Is the Soda Tax a Revenue Grab or a Worthwhile Health Benefit?, Philadelphia’s Latest Soda Tax Proposal: Health or Revenue?, What Gets Taxed If the Goal Is Health Improvement?, The Russian Sugar and Fat Tax Proposal: Smarter, More Sensible, or Just a Need for More Revenue, Soda Tax Debate Bubbles Up, and Can Mischaracterizing an Undesired Tax Backfire?

Several days ago, Dr. George L. Spaeth of Philadelphia, sent a letter to the editor of the Philadelphia Inquirer, in support of the 3-cents-per-ounce soda tax proposal offered by the mayor, and in opposition to a one-cent-per-ounce counterproposal from the president of City Council. Dr. Spaeth justifies the soda tax as follows:

Many people do not understand the harmful effects of sugar, including weight gain and diabetes. There is an epidemic of obesity and diabetes in Philadelphia. People who are significantly overweight have a poorer quality of life, shorter life expectancy, and more illness. We all have needs and wants. Drinking beverages containing sugar is a want, not a need.

Though the doctor is correct in pointing out the disadvantages of being overweight, in asserting that sugary beverages are a want, not a need, and in identifying sugar as a cause of weight gain, he, like so many others, treats sugary beverages as though they are the only ingestible items containing sugar. Donuts contain sugar, donuts are a want, not a need, and yet donuts escape being a tax target of those promoting sugar-free health. The same can be said of cakes, cookies, pies, candy bars, and a long list of foods. The same can be said of coffee and tea to which a person adds sugar, because the tax would not apply to sugar sold in bags for use in adding to food and drink.

When, several months ago, another letter writer supported the revival of a soda tax proposal by the mayor of Philadelphia, I stressed the inequity of focusing on sugary beverages as one of the reasons the proposal was flawed. In Soda Tax Debate Bubbles Up, I wrote:

Another issue is whether a tax characterized as designed to improve health should be limited to just one of many allegedly unhealthy dietary items. The letter writer conceded this point by noting, “And evaluate your health status - and who will benefit from the tax.” The letter writer offered no proof that soda is more unhealthy than many of the other items, particularly those containing sugar, fats, and cancer-causing substances, that people ingest.

I’ve yet to see any explanation or justification for subjecting only certain sugar-containing items to a tax whose supporters claim is designed to reduce sugar ingestion. Reducing the consumption of sugary beverages is meaningless if those are replaced by other items containing sugar. If sugar is the problem, those craving it will seek it wherever they can find it.

Taxing only sugary beverages when trying to reduce sugar consumption is like requiring inspection of tire treads but not brake linings when trying to reduce automobile accidents caused by traction failures. Failing to look at all aspects of a problem is a major contributor to unwise legislative proposals and wacky legislation. If the problem is sugar, tax sugar. If the target of tax are beverages, what is the problem?

How to Share Costs, Or, Computing Tax Burden and Justifying User Fees

Sunday’s Parade Magazine included an interesting Ask Marilyn question. Randall Hancock wrote:

I once owned a house that was the second of 10 on a gravel road. The neighbor in the 10th house proposed buying new gravel, with each neighbor paying one-tenth of the cost. I disagreed as I used only two-tenths of the road, and he used the entire road. What should our shares have been?

Marilyn replied:

I think everyone should share the cost equally. The first neighbor needs to pay only for the first tenth of the road, but then the second neighbor needs to pay only for the second tenth (the first tenth is paid by the first neighbor), and so forth, with the last neighbor ultimately needing to pay only for the last tenth of the road.

Administrative issues aside, I disagree with the reasoning, and I question whether the result, though administratively simple, makes the most sense.

The person living in the first house uses one-tenth of the road. The person living in the tenth house used 100 percent of the road. The benefit accruing to the owner of the tenth house is ten times the benefit accruing to the owner of the first house. Put another way, the person living in the tenth house imposed ten times as much wear and tear on the road as does the person living in the first house.

Suppose, for example, that each homeowner was responsible to care for the portion of the road in front of the homeowner’s property. To keep things simple, assume that the houses are only on one side of the street, and that each has the same front footage on the road. The portion of the road in front of the first house will wear out more quickly than the portion in front of the tenth house. Over time, the owner of the first house will be paying ten times more for road maintenance than the owner of the tenth house. This, of course, ignores cost savings obtained by owners who get together to seek a “quantity discount” from the road repair vendor. Does it make sense to impose a disproportionately greater financial burden on the owner of the first house? Would that burden be reflected in the fair market value, and thus purchase price, of the house? Is the closer proximity of the house to the main road something that adds value to the house sufficient to offset any negative impact of the disparate road maintenance burden? Sharing the cost equally permits the owner of the tenth house to pay for one-tenth of the cost while contributing to roughly 18 percent of the wear and tear.

The preceding analysis assumes that the usage of the road is proportional to the distance to each house. Thus, it ignores the number of vehicles traveling to each house. Taking those into account presents a different alternative. In theory, the financial burden of maintaining the road should reflect volume of traffic generated by each house. That theory certainly falls apart in the face of practical reality, though I suppose someday we will hear that there is “an app for that.” A proxy for this measurement could be the number of vehicles registered to the address of each house. That alternative presents fewer practical problems of measurement, though it would still be difficult to measure because registration data doesn’t necessarily reflect the reality of vehicle ownership and garaging.

Consider, in comparison, the case of a shared driveway. Assume that one house is close to the street and the other house is behind the first house, further from the street. To reduce impermeable surfaces, the township refuses permission for a “flag lot” driveway for the house in the back, and instead requires builder to extend the driveway for the first house, so that it reaches the second house. Should the owner of the second house pay one-half of the cost of maintaining and repairing the entire driveway, while using the entire driveway and thus causing the front half of the driveway to deteriorate at a faster rate? Should the owner of the first house pay one-half of the cost of maintaining and repairing the entire driveway, though only generating one-third of the entire driveway’s use? Should the owner of the second house, who would have been saddled with the cost of a separate driveway as long as the extended driveway had the township permitted the usual “flag lot” driveway, reap a financial benefit that is, in fact, generated by the owner of the first house paying more than would have been paid had the driveway not been extended?

Generally, in these instances of shared private roads and shared driveways, the deeds, homeowner association documents, or similar contracts, specify the terms and conditions for maintaining common areas. So the question arises when the property is being developed, and the owners simply can live with the rules or choose not to purchase a home subject to those rules. When the question is transferred into the world of shared highways, police protection, and other public services, the analysis runs along the same lines but often generates different results. One of the hallmarks of society is that benefits and burdens end up being distributed in ways that do not match each other, and that do not match the specific benefits for, and burdens on, each taxpayer. Though, for example, a township might add a “street light fee” to the property tax bills of only those homeowners who live on streets with street lights, the cost of trash pickup might be imposed in proportion to property value, reflecting its funding through the real property tax, even though the amount of trash picked up at each home differs by orders of magnitude, one bag here, two bags there, and seven bags over there.

This simple example illustrates the challenges of designing taxes, and also demonstrates why user fees are easier to manage. Though not all public services can be funded through user fees because of administrative challenges or measurement obstacles, the user fee does present an opportunity to inject more fairness into public revenue determinations without unduly increasing complexity. If the costs of maintaining the gravel road or shared driveway are sufficiently small, equal division probably generates assessments for each owner that are not significantly different from what they otherwise would be. It’s not worth the effort to reduce one bill by $20 while increasing another by $20. But in the larger arena, with costs reaching tens and hundreds of millions, if not billions and trillions, user fees tied to benefit and burden are always worth at least full consideration and often deserve enactment.

If The Boss Makes You Buy It, Can You Deduct What You Pay?

It is not uncommon for an employee to be told by an employer that the employee must purchase and use particular items in the course of performing the employee’s duties. For many taxpayers, it is easy to consider the amounts paid by the employee to be deductible employee business expenses. That can be the outcome in some situations, but in many instances it’s not.

One prevalent example of employer-mandated employee expenses is the requirement that the employee wear particular clothing. The cost of that clothing is deductible only if the clothing is not suitable for everyday use. The classic examples of deductible expenses include the cost of welders’ gloves, surgical masks, and hard hats.

A recent case, Barnes v. Comr., T.C. Memo 2016-79, provides an example of clothing purchased at the employer’s direction by an employee whose attempt to deduct the cost was rejected by the IRS and the Tax Court. The taxpayer was hired as a salesman for Ralph Lauren Corp., and was required to wear Ralph Lauren apparel when representing the company. So the taxpayer purchased Ralph Lauren shirts, pants, ties, and suits, and deducted the cost as an unreimbursed employee business expense. The IRS denied the deduction, and issued a notice of deficiency. The taxpayer filed a petition in the Tax Court seeking a redetermination of the IRS deficiency claim.

The Tax Court explained the long-settled principle that the cost of clothing is not deductible as an ordinary and necessary business expense unless three conditions are satisfied. First, the clothing must be required or essential in the taxpayer’s employment. Second, it must not be suitable for general or personal wear. Third, it must not be worn for general or personal purposes. Though the taxpayer was required to purchase the clothing, thus satisfying the first condition, the court simply stated that “Ralph Lauren, however, is suitable for general or personal wear.” Accordingly, the IRS denial of the taxpayer’s deduction was upheld by the Tax Court.

The court did not discuss, presumably because the taxpayer did not raise, the question of whether the employer’s logo on the clothing would change the outcome. I’m not certain if the Ralph Lauren logo appears on all Ralph Lauren clothing, but presumably it does. Readers should know that I’m far from being a fashion guru. Commentators, for example, those at Bench, and Harvey and Caldwell suggest that so long as the employer’s logo is on the clothing, and is required apparel by the employer, the employee’s cost is deductible. As pointed out in this explanation, the question of whether a company logo on the clothing makes it unsuitable for general use has not been the subject of a judicial decision.

Had the taxpayer raised the issue, the Tax Court almost certainly would have considered it. My guess is that the conclusion would not have changed. The Ralph Lauren logo appears on shirts and other attire designed for sale to the public for general use. My guess also is that the court knows that the logo appears on the clothing, and by concluding that “Ralph Lauren clothing . . . is suitable for general or personal wear” indicated that the logo did not make a difference. In contrast, if the company logo appears only on clothing available for sale to employees required to wear the clothing, and prohibited from wearing the clothing outside of the work environment, the clothing might fit within the conditions for deduction. It will be in a future case when this question is squarely faced and answered.

So here’s another tax issue that doesn’t involve numbers. It also provides material for a basic federal income tax examination question. I would be more interested in the student’s reasoning than in the answer, which, of course, would be “It depends.”

Disregarded Entities Affect All Sorts of Tax Issues

Entities that are disregarded for federal income tax purposes almost always are discussed in the context of determining who is taxed on an entity’s income or who is permitted to deduct its losses. The most prevalent example of a disregarded entity is a limited liability company owned by an individual. In that case, the federal income tax law, and the income tax laws of most states, consider the individual to be the owner of the LLC’s assets and responsible for reporting its income and losses. A similar outcome applies to an LLC solely owned by a corporation. If the LLC elects to be treated as a corporation, then it is not disregarded, but that situation does not arise nearly as often.

But the impact of treating an entity as disregarded reaches beyond the question of income and loss allocation. A recent IRS private letter rulingPLR 201618008 illustrates the scope of the disregarded entity doctrine. An individual wholly owns two LLCs, both of which are disregarded entities for federal income tax purposes. One of the LLCs owned qualified Gulf Opportunity Zone property. On the individual’s federal income tax return for the year in which the LLC placed the property in service, the individual deducted the additional 50 percent first year depreciation deduction available for GOZone property. In a later year, the individual caused the ownership of the property to be transferred from the one LLC to the other, by distributing the property to the individual, who in turn contributed it to the other LLC. After the transaction was completed, the first LLC elected to be treated as a corporation and elected S corporation status.

The additional 50 percent first year depreciation deduction for GOZone property is recaptured if the property is no longer GOZone property in the hands of the same taxpayer before the end of the property’s recovery period. The IRS concluded that because both LLCs, at the time of the transaction, were disregarded entities owned by the same individual, the property was in the hands of the same taxpayer both before and after the transaction.

The conclusion reached by the IRS makes sense. The reasoning should apply to any instance in which the disposition of property, or any transaction that causes the property to be owned by another taxpayer, would otherwise trigger recapture or some other adverse tax consequence. Thus, for example, had one of the LLCs transferred property of any kind to the other LLC in exchange for cash or other property, the transaction should not be treated as a realization event, and thus not trigger gain or loss. Why? Because in this sort of transaction, the individual who owns both LLCs is simply moving property from one pocket to another, or from one room to another.

The reasoning in this PLR should provide helpful guidance for more than GOZone property transfers. It’s worth taking note and setting aside for future reference.

Lottery Tax Generalizations

A recent attempt to describe the impact of taxation on lottery winnings offers some inaccurate propositions. After explaining, correctly, that the IRS requires the lottery payor to withhold and pay to the IRS 25 percent of the winnings on behalf of the winner, the article then states that “The government taxes lotto winnings the same as income, but at the highest income tax rate, 39.6 percent.” First, lottery winnings are taxed the same as ordinary income, such as wages, and are not taxed in the same way long-term capital gains are taxed. Because lottery winnings are income, the better articulation would be to explain that lottery winnings are income, and are taxed in the same manner as is ordinary income. Second, lottery winnings are not necessarily taxed at the highest income tax rate. For example, an married couple with taxable income of $40,000 who wins a $5,000 lottery prize would face a $750 increase in their federal income tax liability, not a $1,830 increase. And if the couple decides to share some of the winnings with a charity, the increase in their federal income tax liability could be less than $750, depending on whether the couple itemizes deductions or claims the standard deduction.

The article then explains, “So if you win . . ., winners are then responsible for making the rest of the tax payment on the prize – another 14.6 percent – when they file their 2017 federal income taxes.” Aside from the possibility that a rate less than 14.6 percent could apply, if it turns out that the applicable effective rate exceeds 25 percent, the additional tax would be due when the taxpayers file their 2016 federal income taxes.

The article notes that winners can choose between thirty annual payments or a lump-sum that is less than the sum of the annual payments, describing the difference as a “loss of 35 percent of the total.” Actually, the lump-sum amount represents the present value of the thirty annual payments, because the lump-sum, if invested, generates additional income. What the article does not point out is that tp the extent the investments generate long-term capital gain and qualified dividends, the income produced by the invested lump-sum would be taxed at rates lower than those applicable to the thirty annual lottery payments treated as ordinary income.

Reducing tax information to sound bites or tweet-sized snippets is difficult, but if that path is chosen, words need to be selected carefully. Without words such as generally, roughly, usually, or approximately, specific situations end up viewed as universal rules applicable in all situations. A huge amount of tax law resides in the exceptions to general rules.

Making Headway on Financial Literacy Education?

A reader shared some links in response to my recent post, Is Basic Math Enough?. I had quoted a previous post, from 2005, in which I had shared statistics on the extent to which American school systems require high school students to take one or more courses in financial literacy. At that time, “only seven states require personal financial education as a high school graduation requirement, one requires high schools to offer a course in the subject though it is not a required course, and one state requires that it be taught in middle school.” According to this 2013 report, Financial education: Does your state make the grade?, progress has been made. Twenty-three states require either a financial literacy or personal finance course as a condition of graduation, or require that financial literacy be incorporated into a required course. But twenty-three is less than half of the states. So there’s still much to be accomplished.

That much more needs to be accomplished is evidenced by yet another report, from the Educational Testing Service. Testing literacy, numeracy, and problem-solving, the outcome was dismal. “In numeracy, U.S. millennials ranked last.”

Those who are curious can test themselves, though I suspect most people reading this blog will do quite well with this test. Administered globally, the test revealed that Americans scored worse than other major English-speaking economies.

My reaction? Wow. Just wow. So much for claims of American exceptionalism. Assuming that America no longer is “great” – whatever that means – and needs to be made “great again,” the foundational work needs to be done in the education space. Uneducated people cannot accomplish what educated people can do. By education, I don’t mean only formal classroom sessions, but also training and hands-on learning in all sorts of skills, trades, professions, and occupations. It’s not just the white-collar financial analysts, brokers, and tax professionals who need numeracy skills. Carpenters, roofers, mechanics, and cooks, to name just a few, also work with numbers. And everyone needs to understand cash, finances, investments, interest rates, present value, inflation, compounding, and the time value of money. I’ve yet to hear any of the candidates for President talk about these basic underpinnings of a successful economy. I wonder why.

Is the Cost of a Replacement Oven Deductible?

A question was posed by a tax practitioner that caught my eye, in part because it seemed to be an unusual situation, and in part because it could be used as an excellent examination question in a basic income tax course to measure students’ grasp of statutory interpretation and judicial opinions, and to argue by analogy. The facts are rather sad.

A man with Alzheimer’s disease lives at home. He receives help from an Alzheimer’s care specialist, is under a doctor’s care, and takes medications to alleviate and prevent other health problems. One day, he fainted. He fell back into the glass door of the oven. The glass shattered. The man’s head was injured but fortunately he only need medication for the headache and the lump on his head.

The oven was rendered useless. It cannot be fixed because the manufacturer no longer makes parts for the oven. Unfortunately, that part of the story is not unusual, because the “make no replacement parts, force purchase of a new item” approach to boosting profits is sweeping through the world. So the man needs to purchase a new oven.

The tax question is easily stated. Can the man claim a medical expense deduction or a casualty loss deduction for the cost of the new oven? Actually, those are two questions.

The first question is easy to answer. The cost of the oven does not qualify as medical care. Under Internal Revenue Code section 213(d)(1), medical care consists of “the diagnosis, cure, mitigation, or prevention of disease, or for the purpose of affecting any structure or function of the body, . . . transportation primarily for and essential to medical care, . . . qualified long-term care services, or . . . insurance . . . covering medical care. . . “ There’s simply no way the cost of the oven fits within that definition.

The second question is a bit more challenging. Under Internal Revenue Code section 165(c)(3), a casualty loss is a loss that arises “from fire, storm, shipwreck, or other casualty.” Because the incident did not involve fire, storm, or shipwreck, the question becomes one of determining if it fits within “other casualty.” The courts have defined a casualty as “an event due to a sudden, unexpected, or unusual cause.” The list of events that have been treated as casualties does not include destruction of an appliance on account of a fainting episode. However, arguing by analogy, the outcome should be the same as that reached when analyzing damage to property caused by an automobile accident triggered by a medical condition that causes loss of consciousness or control of the vehicle. If a person faints while driving and the vehicle consequently crashes, the event is a casualty. Now, whether the amount spent for the new oven would survive the $100 limitation and the ten-percent-of-adjusted-gross-income floor, and in turn be sufficient to permit disregard of the standard deduction, is a question that cannot be answered without having more information. What was the value of the old oven before the casualty? Is the value of the old oven after the casualty zero because it cannot be repaired? What is the taxpayer's adjusted basis in the old oven? That question must be answered because the amount of the casualty cannot exceed basis in the case of personal use property. Is the cost of the new oven an acceptable surrogate for cost of repairs in attempting to measure the decline in value? What is the cost of the new oven? What is the adjusted gross income? How much, if any, insurance reimbursement was available under the homeowner’s policy?

Note: On 10 May 2016, I added to the list of questions to be asked, in response to a reader's inquiry and suggestion that the original list of questions implied that the cost of the new oven would automatically be used to measure the deduction.

On the Mileage-Based Road Fee Highway: Young at (Tax) Heart?

Though I’ve never tried to calculate which topic has been the subject of the most MauledAgain commentaries, certainly my strong support for mileage-based road fees is a candidate for topping the list. If it doesn’t, it’s not far behind. Readers of this blog surely are aware of the arguments I have made in favor of this particular fee, and the rebuttals I have offered against criticism. The analysis began with Tax Meets Technology on the Road, and has continued through Mileage-Based Road Fees, Again, Mileage-Based Road Fees, Yet Again, Change, Tax, Mileage-Based Road Fees, and Secrecy, Pennsylvania State Gasoline Tax Increase: The Last Hurrah?, Making Progress with Mileage-Based Road Fees, Mileage-Based Road Fees Gain More Traction, Looking More Closely at Mileage-Based Road Fees, The Mileage-Based Road Fee Lives On, Is the Mileage-Based Road Fee So Terrible?, Defending the Mileage-Based Road Fee, Liquid Fuels Tax Increases on the Table, Searching For What Already Has Been Found, Tax Style, Highways Are Not Free, Mileage-Based Road Fees: Privatization and Privacy, Is the Mileage-Based Road Fee a Threat to Privacy?, So Who Should Pay for Roads?, Mileage-Based Road Fee Inching Ahead, and Rebutting Arguments Against Mileage-Based Road Fees

Now comes a report that, according to a survey by HNTB, an infrastructure solutions firm, “The majority of Americans would support road-usage fees to help fund transportation costs.” The survey revealed that 65 percent of Americans favor mileage-based fees and similar options to finance repairs to a crumbling infrastructure. An even higher number, 69 percent, favor “priced managed lanes.” There are a variety of priced managed lane formulations, but all involve some sort of fee for access to presumably less congested highway lanes.

What caught my attention was the difference in responses among Millennials, Gen-Xers, Baby Boomers, and “seniors” to the question of funding infrastructure. A higher proportion of Millennials and Gen-Xers preferred using higher property taxes to close the funding gap than was found among Baby Boomers and “seniors.” That makes sense, because property taxes are not well received by those on fixed incomes who cannot control what they are paying by altering their infrastructure-use choices.

Younger respondents were more in favor of mileage-based road fees than were older people. It is possible this reflects some combination of understanding technology, being less apprehensive about technology, and being accustomed to using technology of this sort. It also is possible that this reflects the proportionately lower use of highway infrastructure by younger people. Sometimes the future can be predicted, at least to some extent, by looking at what younger people are doing, and saying. If that is the case with this issue, the future, sooner or later, will see the implementation of mileage-based road fees. That I have something more in common with the younger generations than with my own is encouraging. Perhaps it ought not be, but it is. Am I young at (tax) heart?

Is Basic Math Enough?

One of my second cousins once removed shared on Facebook a meme apparently originating in a tweet by Sage Boggs and then posted by George Takei. The meme states “I’m glad I learned about parallelograms instead of how to do taxes. It’s really come in handy this parallelogram season.” One of the many people commenting on the original post stated, “If you cared about learning these things you would have taken a business studies unit in your final high school years. Don’t complain about a terrible education when you made the choice that some things were more important than learning things that might be useful.” In turn, this comment brought several reactions. Among them was the observation that it was “Easy to say unless your school doesn’t HAVE such courses.” Another asked and answered, “Did you school have basic math? That’s all that’s really necessary.” Another explained, “Actually, I did take all of the business classes in high school, including accounting. And taxes weren’t covered.”

Understanding basic arithmetic, which is the most elementary subset of mathematics, is helpful but not absolutely essential when it comes to doing tax returns. Why? Because tax preparation software handles the computations, and for portions not handled by the software, such as adding up receipts, there is other software, such as the Microsoft Windows Calculator, and physical calculators. I wonder if anyone still owns an adding machine with paper “tape”?

What matters most is the ability to read, to understand words, and to follow logic. What also matters is the ability, and willingness, to retain and sort a variety of documents representing financial information. Even so, it helps not only to be able to read, but also to acquire an appreciation for the language of tax rules and the way in which those rules are written. That is why it is most useful to enroll in a tax course of some sort.

Though some high schools provide students with an opportunity to become familiar with their tax obligations and how to comply with tax law requirements, too many schools fall short. Nine years ago, in Congress Invites My Ideas for Improving Tax Compliance and Of Course I Respond, I shared the letter I sent to Congress, and repeat here a portion of it:

Thank you for the invitation to suggest approaches for improving tax compliance. The tax gap is a concern that demands attention from the Congress.

There is no one “magic bullet” to solve the problem. Instead, I advocate a six-pronged strategy for improving compliance. Those six prongs are tax education in high schools, tax simplification, increased reporting, expansion of withholding, funding an improved tax audit process, and strengthening the ability of the Department of Justice to prosecute tax crime.

Making tax education a part of high school curricula throughout the nation would go a long way in reducing noncompliance. A significant portion of noncompliance is inadvertent, the result of taxpayers’ inability to understand the nature of the federal tax system and to recognize the flaws in the many inappropriate “tax savings” schemes offered to them by unscrupulous promoters of noncompliant tax reduction plans. The tax education I suggest is not a technical tax return preparation course, but one that blends an understanding of the rationale for taxation and the basic features of the tax system with advice on how to maximize compliance and minimize the aggravations that arise from noncompliance. Educating citizens before or as they enter the taxpaying world is much more efficient and effective than trying to remove their misperceptions after the fact during tax audits and tax litigation.

About a year later, in Does It Matter Who or What is to Blame?, I reiterated and expanded on a point I had made back in 2005:

And more than three years ago, in Economically Depressing?, I referred to "my expressed desire that K-12 education be revamped so that high school graduates enter society with the survival tools needed for life in the 21st century." According to the 2005 report of the National Council on Economic Education, the latest I could find, only seven states require personal financial education as a high school graduation requirement, one requires high schools to offer a course in the subject though it is not a required course, and one state requires that it be taught in middle school. There are 50 states in the union, plus the District of Columbia and some overseas possessions. Surely personal finance is no less important than other subjects being taught in middle school and high school.

Though comments on a facebook thread do not necessarily reflect national mood, I think it is a safe guess that most Americans would welcome high school courses that provide students with an awareness of the practical realities of financial responsibility, particularly tax obligations. I also think it is a safe guess that many Americans would react to these opportunities with comments along the lines of, “I wish they had something like that when I was in high school.” Politicians of the nation, federal, state, and local, it is time to step up and improve high school curricula by adding courses that prepare young people for life when tax reality hits home. Basic math courses aren’t enough, and provide very little of what is necessary.

Can Mischaracterizing an Undesired Tax Backfire?

A little more than a month ago, in Soda Tax Debate Bubbles Up, I noted that I had heard a radio spot on a local radio station seeking support in opposition to the soda tax proposed by Philadelphia’s mayor. I explained:

What had caught my ear was the characterization of the tax as a “grocery tax.” According to the organization’s web site, No Philly Grocery Tax, the tax would be a “3¢ per ounce tax on everyday grocery items.” Sure, the site then adds “like sodas, sports drinks, juice drinks and some teas” but the initial characterization will cause people to think that a proposal is underway that will tax everything in their shopping cart. Once that seed is planted in most people’s brains, it’s difficult to root it out. Even if the tax was imposed on all unhealthy food and drink items, it still would not be a tax on groceries, because it would not reach a long list of healthy items.

Though I oppose the soda tax as it is presently constructed, particularly because the concern is sugar, not beverages, I suggested that gross mischaracterization could work to the detriment of those overstating their case against the tax:

Simplistic reactions and mischaracterizations, no matter from which side of an argument, do not serve the public well. Though they can help advance the cause of those who toss them about, they also can backfire.

So it was no surprise to me when, a few days ago, I read a letter to the editor of the Philadelphia Inquirer by Dr. Barbara W. Gold, vice chair of Food Trust’s board. She pointed out that calling the soda tax a grocery tax is a scare tactic, is dishonest, and misleading. On those points she is correct. The soda tax will not cause a “large spike in grocery prices.” She describes other food items as “real groceries,” though that designation also is confusing, because soda is an ingestible item sold in, among other places, grocery stores.

Where I disagree with Dr. Gold is her support of a tax on “the beverage industry’s multibillion-dollar annual profits” to pay for desirable city programs. As I have continually pointed out, as unhealthy as soda can be, so too are other items, including some of the baked goods and frozen foods Dr. Gold includes within the category of “real groceries.” Medical research has demonstrated that one of the serious culprits in health issues is sugar. Limiting a sugar tax to sugary drinks is akin to limiting a tobacco tax to tiny cigars.

As I also pointed out in in Soda Tax Debate Bubbles Up:

The ease with which people not only fling such accusations but also readily accept and repeat them contributes to the sad state of this nation’s public and private political debate in the twenty-first century. It’s time for those involved in the soda tax debate, as well as any other political discussion, to focus on the facts and to stick with logic.

Dr. Gold’s letter is a step in the right direction, but it doesn’t go far enough, and it adds, perhaps inadvertently, another layer of confusion by introducing the confusing term “real groceries” into the discussion.

Ultimately, claiming that the proposed soda tax is a grocery tax will backfire. It distracts people from the central issues. Some people will look at that claim, consider it an overstatement, and decide that it reduces their confidence in the position being taken by those opposing a tax on, or limited to, certain beverages. To the extent these people end up supporting the tax proposal because of the overstatement by an opponent of the tax, the hyperbole will turn out to be counter-productive.

A Backwards Tax Argument

It isn’t unusual for a taxpayer to report less income on a federal income tax return than is shown on an information return such as a Form W-2 or Form 1099 if the taxpayer thinks that the amount on the information return is too high. And, sometimes, a taxpayer might report nothing, or even fail to file a return, as a reaction to an information return that reports more than what the taxpayer thinks should be reported.

A recent case, Chambers v. Comr., T.C. Memo 2016-72, presents an approach that was backwards to what one might expect to see. The taxpayer did not file a federal income tax return for 2011, so the IRS completed a substitute return, on which the IRS reported $35,257 of annuity income. According to records of the Office of Personnel Management, the taxpayer was entitled to a gross annuity of $46,392, of which $35,257 was paid to the taxpayer and $11,134 was paid to his former spouse.

The taxpayer did not dispute that he received annuity payments of $35,257. He argued that the Office of Personnel Management had miscalculated his annuity and that he should have received a higher amount. Thus, according to the taxpayer, the amount shown by the IRS on the notice of deficiency was incorrect.

The Tax Court concluded that it did not have jurisdiction to determine the proper amount of the taxpayer’s annuity for 2011. The Tax Court’s jurisdiction is limited to those matters over which Congress has authorize it to act. Determining the proper amount of the annuity is not one of those matters. Not surprisingly, the Tax Court held that the taxpayer had gross income in 2011 of $35,257, which was reduced by $3,152 on account of an IRS concession reflecting $3,152 that the taxpayer had contributed to the retirement plan under which the annuity was paid.

Even if the taxpayer was correct that he should have received additional annuity payments, logic prohibits concluding that the taxpayer’s gross income for 2011 was anything less than $35,257 reduced by the $3,152. Unlike an instance in which the taxpayer understandably does not want to be taxed on amounts erroneously reported on an information return but allegedly not received by the taxpayer, there is no sensible reason for concluding that tax is not due with respect to income that happens to be less than what the taxpayer thinks the income should have been.

The opinion in the case does not explain what the taxpayer thought was done incorrectly in computing the annuity. That makes sense, because those facts would be relevant to a decision over which the Tax Court has no jurisdiction. Thus, we do not have the benefit of what the taxpayer was attempting to do by not filing a return. My guess is that it was something along the lines of “the government paid me less than it should have paid me so I’ll get back at the government by not filing a tax return and not paying income tax on what I did get,” as though somehow the resulting tax reduction would offset the alleged annuity underpayment. As I pointed out in If This Happens, It Would Be a Tax Miracle:

It amuses me when people refer to “the government,” as though there is a monolithic, internally coordinated, and smoothly-functioning machine called “the government” that acts in a unilateral fashion to make decisions. Lumping all government offices, officials, employees, and agencies into one group makes it too easy to avoid placing responsibility where it belongs.

The practical reality of the situation is that the people who computed the taxpayer’s annuity payment would remain blissfully unaware of his failure to file a return and pay taxes until they read the opinion in the taxpayer’s case, which is something they are very unlikely to do.

The taxpayer paid a high cost for his decision to pay no tax on the annuity he received because he wanted a larger annuity payment. Not only does he end up paying the tax, plus interest, he was also held liable for the section 6651(a)(1) penalty for failure to file a tax return and the section 6651(a)(2) penalty for failure to timely pay the tax due. It can be expensive to go backwards.

A Tax End-Run That Didn’t Work

In a recent private letter ruling, PLR 201616002, the IRS concluded that a corporation’s matching contributions on account of employee political contributions are not deductible. This is one instance where the complications are not a product of tax law.

The taxpayer, a corporation, is barred by the Federal Election Campaign Act (FECA) from contributing to federal election campaigns. So the corporation set up a political action committee (PAC), funded by the taxpayer’s employees and by employees of the taxpayer’s subsidiary corporations. The PAC was established as a political organization exempt from federal income tax under section 527. It’s purpose is to “disburse funds to candidates” for public office, and the recipient candidates are selected by the PAC. The taxpayer encouraged its employees to contribute to the PAC. As an incentive, it promised that if an employee contributed at least an undisclosed amount, not in excess of another undisclosed amount, to the PAC, it would in turn make a contribution in the employee’s name to one or more charities selected by the employee.

The taxpayer sought a ruling from the IRS that the contributions to the charities were deductible as ordinary and necessary business expenses under section 162. The IRS concluded that they are not deductible.

The IRS explained that section 162(e)(1)(B) prohibits deduction of amounts paid or incurred in connection with a political campaign. The contributions to the charities, according to the IRS, ‘are inextricably linked” to the contributions to the PAC. The contributions to the PAC are a prerequisite for the contributions to the charities. The contributions to the charities are matched to the amounts contributed to the PAC. The reason for the contributions to the charities is to encourage contributions to the PAC.

So, in addition to creating a complicated arrangement designed as an end-run around FECA, the taxpayer tried to create a tax benefit from the arrangement. The attempt to create the tax benefit was also an end-run, around the restrictions of section 162(e). The tax attempt failed. Nothing in the PLR explains whether the FECA end-run works.

If This Happens, It Would Be a Tax Miracle

Once upon a time, Donald Rumsfeld, who finished his career in government as Secretary of Defense, served in Congress. He served as administrative assistant to a member of Congress from Ohio, then as staff assistant to a member of Congress from Michigan. In 1962 he was elected to Congress, and served until 1969 when he became Director of the Office of Economic Opportunity.

Now, though retired, he is back in the news. According to this report, Rumsfeld filed for an extension of time for filing his 2015 federal income tax return. He included a letter in which he explained that he remains “mystified as to whether our tax returns and tax payments estimates are accurate,” pointing out that although he has a college degree and retains an accounting firm, he is not confident that the returns he files with his wife are “properly completed.”

In the letter, he expresses the hope that “the U.S. government will radically simplify the tax code.” It amuses me when people refer to “the government,” as though there is a monolithic, internally coordinated, and smoothly-functioning machine called “the government” that acts in a unilateral fashion to make decisions. Lumping all government offices, officials, employees, and agencies into one group makes it too easy to avoid placing responsibility where it belongs. The Internal Revenue Code is a product of Congress. It is enacted by Congress. It is amended by Congress. Portions of it have been repealed by Congress. Why did Rumsfeld not express hope that “the Congress of the United States simplify the Code”? My guess is that facing the truth about the failures of Congress would hit too close to home. Rumsfeld served in Congress. He knows what it does. He knows better.

Worse, he told CNNMoney that although “his pleas are somewhat misdirected,” he thinks that the “IRS could do a whale of a lot to simplify the tax code.” No, it cannot. If the IRS tried to change the Internal Revenue Code, its actions would be null and void. It would be a miracle if someone in the IRS caused the language of the Internal Revenue Code to change.

Rumsfeld did admit that “the real burden in on Congress to take action.” Of course. But expecting the Congress of the United States to reform the tax law would be asking for yet another miracle. Beholden to special interest groups that in recent years have drafted many of the amendments to the Internal Revenue Code, the Congress lacks the courage, the incentive, and the determination to fix the mess that afflicts most people. Rumsfeld called the Internal Revenue Code “disgraceful.” He is correct. But who is to blame?

Rumsfeld has sent a similar letter to the IRS every April for as long as he can remember. Though he has never received a reply, he plans to continue sending the letter every April. It ought not surprise him that he will never receive a reply. That’s because the IRS is not to blame for the Internal Revenue Code, and cannot do anything to change it.

My question for Donald Rumsfeld is simple. Why not send the letter to every member of the Congress? Why not share the replies, if there are any? Why not share the names of those who do not reply? Why not shine the spotlight on those who are responsible? It’s too easy to focus on the IRS, which Congress has chosen to be the scapegoat for the sins of the legislature. Donald Rumsfeld, unlike most of the rest of us, is in a position to shift the focus of the spotlight. Will he?

Taxed When Receiving Nothing?

Sometimes basic tax principles are easy to state but difficult to understand. Recently, in Lamas-Richie v. Comr., T.C. Memo. 2016-63, the Tax Court had the opportunity to address a tax principle that defies common sense but that can be expressed in simple language. The taxpayer formed an LLC, taxed as a partnership, with an investor to continue and enlarge a web site that posted gossip. The taxpayer held 41 percent of the tax partnership and the investor and the investor’s affiliate owned 59 percent. The name of the web site was changed to thedirty.com, and the LLC was called Dirty World LLC. The taxpayer entered into an employment agreement with another of the investor’s affiliates, to compensate him for his services in managing the web site and editing its content.

The LLC filed a Form 1065 for 2011, which included a Schedule K-1 issued to the taxpayer. The Schedule K-1 reported a distributive share of the LLC’s income for the taxpayer, equal to 41 percent of its ordinary business income. However, the taxpayer did not receive the Schedule K-1, did not report the income, and learned of the Schedule K-1 when the IRS began to examine the taxpayer’s 2011 return. The taxpayer testified that there had been no Schedules K-1 in previous years because the LLC had not reported any profit in previous years, an assertion the Tax Court found credible. No distributions were made to the taxpayer.

The Tax Court held, not to the surprise of anyone who understands the taxation of partnerships and S corporations, that although no distributions had been made to the taxpayer, the taxpayer was subject to federal income tax on his share of the LLC’s income. This principle is well-settled. For many taxpayers, the idea of being taxed on something that they have not received makes no sense. One way of understanding the principle is to consider the taxpayer has having received his share of the profits and then having put them back into the LLC.

The Tax Court also held that the taxpayer was not absolved from reporting his share of the LLC’s income even though he had not received the Schedule K-1. That, too, is well-settled. Nor did the existence of losses in previous years help the taxpayer, because the taxpayer provided no evidence of the amount of those losses and thus did not demonstrate the existence of a loss carryforward.

When taxpayers form or join pass-through entities with the assistance of tax professionals, it is wise for the professional to explain to the taxpayer, both in spoken and written form, the tax consequences of doing so. Taxpayers should be cautioned to watch for Schedules K-1, and to forward them to their return preparer or, if they are doing their own taxes, to fill out Schedule E. Taxpayers also should be advised to contact the pass-through entity if and when an expected Schedule K-1 does not appear.

Timing Matters in the Tax World

One of the basic principles I try to help students understand is that in the tax world, as elsewhere, timing matters. That is a concept overlooked in many tax reform proposals, but having discussed that issue in the past, and surely with opportunities to discuss it again in the future, I’ll set it aside. Instead, it’s a good time to explore the impact of timing in a much more narrow situation.

Section 25A of the Internal Revenue Code permits taxpayers to claim the American Opportunity Tax Credit (AOTC) equal to the sum of two amounts. The first amount is 100 percent of the qualified tuition and related expenses paid by the taxpayer during the taxable year for education furnished during any academic period beginning in that taxable year, or $2,000, whichever is less. The second amount is 25 percent of those expenses that exceed $2,000 but that do not exceed $4,000. Thus, the maximum amount of the credit is $2,500. For a cash method taxpayer, the expenses are treated as paid in the taxable year in which they are actually paid. An exception in section 25A(g)(4) provides that if the expenses are paid during a taxable year for an academic period that begins during the first three months of the following taxable year, the academic period is treated as beginning during the taxable year in which the expenses are paid. The regulations explain this exception by pointing out that if the expenses are paid during one taxable year for an academic period that begins during the first three months of the following taxable year, the AOTC is allowed with respect to those expenses only in the taxable year in which they are paid.

The impact of this timing rule was the focus of the Tax Court’s decision in McCarville v. Comr., T.C. Summ. Op. 2016-14. The taxpayer, who used the cash method, attended college starting in 2008 and graduating in 2012. He worked to support himself and pay his tuition and other education expenses. He paid his tuition for the fall 2011 semester on August 6, 2011. He paid his tuition for the spring 2012 semester, which began in January 2012, on December 18, 2011, even though the due date was January 25, 2012. He paid early because, as he explained, he wanted it to be “in the bank.”

When the taxpayer filed his 2012 federal income tax return, he claimed an AOTC of $2,500. His college did not issue a Form 1098-T, Tuition Statement, for 2012, which generated an IRS examination of the 2012 return. The IRS denied the credit and issued a notice of deficiency. The taxpayer then filed a petition with the Tax Court.

The IRS conceded that the taxpayer was entitled to an AOTC for 2012 in the amount of $247.47, which is what the taxpayer paid for textbook rental in 2012. The IRS did not dispute that the taxpayer paid qualified tuition of $4,895 on December 18, 2011 for the semester beginning in January 2012. But the IRS argued that any credit for that amount, if allowed at all, would be in 2011, not 2012. Because of the $2,500 limit, the taxpayer could not use any additional AOTC in 2011. The taxpayer argued that “[i]t just seems kind of wrong” to be denied the AOTC credit in 2012 “essentially for paying [the tuition] early.” The Tax Court acknowledged that the statutory timing requirements “may very well seem to work a harsh result in a case such as this when a mere two-week delay in making the December 18, 2011 payment would have occasioned a different outcome.” But, the Court concluded, it was bound by the statute.

This case provides an example of why and how the income tax can frustrate taxpayers. It illustrates why planning is necessary. It illustrates the problems that arise when a statute is not drafted to take into account the very common practice of paying tuition in December for semesters that begin in January, especially when they begin early in January. It demonstrates why providing financial assistance for education ought not be in the income tax law and administered by the IRS but should be handled by the Department of Education. But accepting for a moment that a provision designed to assist and encourage people with education goals is in the tax law, it is unfortunate that the provision does not accomplish what it was designed to do, and applies in a haphazard manner.

As the taxpayer discovered, timing matters. Hopefully everyone discovers this principle before it is too late and time runs out on planning and other opportunities.