The Taxation of Kidney Swaps

Reader James Butler has brought to my attention a story about two women, each of whom is donating a kidney to the other's husband. They are not donating to their own husbands because of blood type mismatches.

The two women connected through the Paired Donation Consortium, which facilitates matching between living donors. So far, the Consortium has registered 80 pairs of donors and recipients, leading to 12 kidney swaps already in place.

James, who is a tax lawyer, reacted to the story as tax lawyers do. He immediately saw the tax issues. He wrote:

It would seem each women is "donating" a kidney to the
other's husband in exchange for a like donation. While the IRS may never dare raise the issue, could this create taxable income to each couple? They aren't gifts since something is expected in return. There isn't a like kind exchange since this isn't a business or investment type activity. Selling a kidney is illegal but swapping them seems ok.

Is it taxable? If it is taxable, would it be income to the wife or the husband? The husband gets something of value in exchange for something given up by the wife. Maybe they are constructive gifts to the husbands followed by an exchange?

I think James gets an A for describing the black letter law. The exchange is not a gift because they each get something in return. Each has a basis of zero in the exchanged kidney. Each has an amount realized equal to the fair market value of a kidney. The like-kind nonrecognition rules do not apply because it's not a trade, business, or investment activity. No other non-recognition provisions are relevant. There's no exclusion applicable to the transaction. The lack of cash is not an obstacle to the taxation of bartered exchanges. Though James didn't mention it, IRS rulings with respect to the sale of blood and blood products suggest that the income would be ordinary income and perhaps personal services compensation income. There's no charitable contribution deduction because no charity receives the kidneys. The substance over form doctrine treats the exchange as a swap of kidneys between the two women, each then making a gift to her husband. My guess is that there are medical expenses, which ought to be deductible to the extent they exceed the 7.5 percent adjusted gross income floor.

That's the easy part. The tough question is whether the IRS would require taxation. What a heartless (ouch) approach to take. The IRS does have a track record in this area. So, too, does the Justice Department.

The first case is that of United States v. Garber, 607 F.2d 92 (5th Cir. 1979). Dorothy Garber learned, after the birth of her third child, that her blood contained a rare antibody useful in producing blood group typing serum. At the time she was one of only two or three people in the entire world with the antibody. A manufacturer of diagnostic reagents, Dade Reagents, persuaded her to sell to them blood plasma. The process involved withdrawing a pint of her blood, putting it through plasmapheresis to extract plasma by centrifuge, and returning the red blood cells to her body. Each appointment lasted from 90 to 150 minutes, generated a pint of plasma from two pints of blood, required injection of an incompatible blood type to increase the antibodies, caused pain and discomfort, and posed the risk of blood clots and hepatitis. Garber was paid on a sliding scale reflecting the strength of the plasma obtained in the particular appointment.

Eventually, other reagent manufacturers lured her away from Dade Reagents by offering higher prices for her plasma. She began selling both to Associated Biologicals and to Biomedical Industries. Both paid money for each extraction, and Biomedical also provided a salary, a leased automobile, and a bonus. At one point Garber was doing six extractions a month.

Although she reported the salary, Garber did not report the other payments as income, even though she received a Form 1099 from Biomedical. She did not receive such forms from Associated Biologicals. Consequently, she was INDICTED for willfully and knowingly attempting to evade a portion of her income tax liability by filing false and fraudulent income tax returns. She was convicted with respect to one of the years in issue, and sentenced to 18 months in prison, all but 60 days of which was suspended, placed on probation, and fined $5,000 in addition to her civil liabilities and penalties.

On appeal, the Fifth Circuit held that the trial court's refusal to admit the expert testimony of a CPA retained by Garber, after permitting the government's witness, an IRS agent, to testify that the transactions generated unreported income, was reversible error and remanded the case. The appellate court noted that besides the disagreement over the characterization of the transactions as performance of services or sale of products, there was disagreement in the latter instance over the valuation of the plasma. The court then made a total mess of its explanation by confusing basis and value and making some rather bizarre assertions:

The cost of Garber's blood plasma, containing its rare antibody, cannot be mathematically computed by aggregating the market cost of its components such as salt and water. That would be equivalent to calculating the basis in a master artist's portrait by costing the canvas and paints. No evidence of any original cost exists in the case of Garber's unusual natural body fluid.

In such a situation it may well be that its value should be deemed equal to the price a willing buyer would pay a willing seller on the open market. [citations omitted] If this were the proper basis, the exchange would be a wash resulting in no tax consequences.

Sorry, but the basis in a master artist's portrait IS the cost of the canvas and paints. Moreover, setting basis equal to value makes no sense in the absence of taxation. Nor does setting value equal to the price at which something would exchange on the open market establish basis. And they wonder why I continue to insist that basic federal income taxation should be a required course. We're talking some very core concepts.

The concurring judge, though agreeing that the trial court's evidentiary decision was reversible error, stated, sensibly:

Because I conclude that the transactions under investigation constituted services and the income derived therefrom taxable under 61(a)(1), I should have preferred that the court say so in positive terms. The question would thus cease to be a novel one for those considering it in the future.

The dissent, in which three other judges joined, concluded that there was gross income, pointed out that Garber had spent for personal purposes the portion of her fees that the payor had put into a savings account earmarked for tax payments, had not been told by the IRS that the payments were not income, and had not sought professional advice. The dissent agreed, though, with the concurring judge that the majority opinion did not provide appropriate guidance on the legal question of whether the payments were gross income. It pointed out, accurately, that if the payments were not gross income, the case should be reversed and the indictment dismissed, but that by remanding the case, the majority implied that the payments were gross income.

The good news: After the remand, the government dropped the prosecution. There's no record of whether Garber paid the unreported tax.

A year later, the Tax Court addressed the deductibility of various expenses by another plasma donor, Margaret Cramer Green. Green v. Commissioner, 754 T.C. 1229 (1980). In this case, Green was paid by Serologicals, Inc. for generating plasma through plasmapheresis. Green reported the amounts she received as gross income, offset by claimed business expense deductions. The court's analysis is most interesting, especially in light of the Garber opinions issued a year earlier:

Both parties to this case base their respective arguments upon the implied assumptions that petitioner realized income upon receiving payment for her plasma and that this income should be characterized as ordinary. Although these assumptions may seem obvious, since this case presents some novel legal questions, we feel compelled to lay a firmer foundation for our conclusions herein.

Clearly, petitioner realized income. Section 61 states that "gross income means all income from whatever source derived.4 Such sweeping language must be broadly interpreted to fulfill the intent of Congress to implement a comprehensive income tax. [citations omitted] Congress intended "to use the full measure of its taxing power." [citations omitted] Fulfilling this intent, the well-settled test for income is that enunciated in Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955), which looks for "undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." The Fifth Circuit, to which appeal in this case would go, has followed this test as a search for lasting economic gain realized primarily by the taxpayer personally, [citations omitted] See also the Fifth Circuit's general discussions of this and other matters as they specifically relate to blood plasma sales in United States v. Garber, 607 F.2d 92 (5th Cir. 1979), revg. and remanding, on rehearing en banc, 589 F.2d 843 (1979), a criminal fraud case. All of these gains are taxable, unless specifically excluded. [citations omitted] Petitioner received the payments for her plasma directly, without any conditions subsequent which might require repayment of the funds or might control her use of the funds. The payments were not subject to any exclusion from income. [footnote omitted] The payments were gross income to petitioner under section 61.

Next, we must determine the character of the income realized by petitioner for her plasma. This income was not capital gain. Capital gain involves the sale or exchange of a capital asset. Section 1222(1) and (3). If petitioner's activity is viewed as the sale of property held for sale to customers in the ordinary course of business, petitioner's blood plasma, the property held for sale, is not a capital asset. Sec. 1221(1). On the other hand, if her activity is viewed as a service, her blood plasma is an integral part of that service and is not part of a sale or exchange. [citations omitted] Therefore, regardless of how the activity is viewed, it is not the sale or exchange of a capital asset and the income realized therefrom is not capital gain.

Nevertheless, the identification of the activity as either the sale of a product or the performance of a service is important in determining gross income and the deductibility of certain items in the calculation of adjusted gross income and taxable income, which is the general issue before us. Under the facts of this case, we find that petitioner's activity was the sale of a tangible product. From petitioner, who did little more than release the valuable fluid from her body, the plasma was withdrawn in a complex process by the equipment of the lab. Petitioner performed no substantial service. She was paid for the item extracted by the lab. Except for the unusual nature of the product involved, the contact between petitioner and the lab was the usual sale of a product by a manufacturer to a distributor or of raw materials by a producer to a processor. A tangible product changed hands at a price, paid by the pint.

The rarity of petitioner's blood made the processing and packaging of her blood plasma a profitable undertaking, just as it is profitable for other entrepreneurs to purchase hen's eggs, bee's honey, cow's milk, or sheep's wool for processing and distribution. Although we recognize the traditional sanctity of the human body, we can find no reason to legally distinguish the sale of these raw products of nature from the sale of petitioner's blood plasma. Even human hair, if of sufficient length and quality, may be sold for the production of hairpieces. The main thrust of the relationship between petitioner and the lab was the sale of a tangible raw material to be processed and eventually resold by the lab.

So is there any difference between the extraction of plasma and the extraction of a kidney? In both instances, the taxpayer "performed no substantial service."

Not only do these cases affirm what James Butler and I think is the black letter law result, they suggest, at least to me, that the IRS probably would require reporting of the gross income by the kidney-swapping women. Are the cases different? If one tries to distinguish Garber and Green by characterizing them as motivated by economic gain, one can treat each kidney-yielding woman as motivated by economic gain, namely a kidney for her husband. If one tries to distinguish the kidney-swapping women by portraying them as altruistic and generous despite the kidney being received in turn, one can note that Garber and Green endured discomfort, pain, and risk in order to help all those unidentified individuals who benefit from medical science's use of the rare plasma.

If the IRS does so proceed, the outcry might be overwhelming. In that case, Congress can amend the Code if it so chooses, to provide an exclusion. The IRS should not arbitrarily add an exclusion to the tax law simply because it might be a good idea.

It is doubtful that the kidney-swapping women would be permitted to claim trade or business deductions. Unlike Garber and Green, who had been undergoing plasma extraction for years on a continual basis, the kidney-swapping women were engaged in a one-time transaction. It is highly unlikely the one-time transaction would rise to the level of a trade or business.

I wonder if the kidney-swapping women have consulted their tax advisors. If they did, I wonder what the tax advisors told them. I am most curious. If you were their tax advisor, what would you tell them?

Student Email: Problem or Opportunity?

When a story comes at me from three directions, in three different forms, it tends to get my attention. In this case, it happened to be a story that resonated with one of my very many favorite topics.

Within the space of hours, three things crossed my path.

1. An email from a colleague pointing the faculty to this story about student emails.

2. A print copy of the same story left on my desk by another colleague.

3. A TaxProf Blog post on the same story, with links to six other faculty blogs mentioning or commenting on the story.

It's one of those stories that I think takes the extreme and tries to paint it as the norm. The story collected some examples of what justifiably could be called outrageous, obnoxious, or simply unthinking emails sent by students to their professors. There's the student who cut class and requested the professor's class notes. There's the student dissatisfied with a grade who sends an unkind email. There's the future leader of America who notified her teacher that she was late for class because she was dealing with the consequences of heavy drinking at a "wild weekend party." There are emails from a student asking advice on buying school supplies, from a student explaining he would be cutting class so that he could play with his son, from students criticizing other students or faculty's attention to those perceived as undeserving of it, and more.

The article, however, jumps from the question of inappropriate content and tone to the claim that "At colleges and universities nationwide, e-mail has made professors much more approachable. But many say it has made them too accessible, erasing boundaries that traditionally kept students at a healthy distance." Mention is made of the demand, expressed directly or indirectly, for instantaneous response. The article suggests that the concept of students as consumers has left students feeling entitled to make demands and demonstrate rudeness. Faculty, concerned with student evaluations that increasingly are used in making retention, tenure, and compensation decisions, hesitate to reprimand students clearly in need of some admonition.

There are faculty who feel pressured to be available for student email responses on a 24/7 basis. Yet there are faculty who deal with some student emails simply by failing to respond. According to the article, a faculty member of the Harvard Graduate School of Education suggests that these sorts of email indicate students "no longer deferred to their professors, perhaps because they realized that professors' expertise could rapidly become outdated," and that the notion faculty were "infallible sources of deep knowledge," which may have underpinned student deference, has weakened.

Layered on top of these concerns is a general consensus that students are oblivious to the consequences of putting something in an email. Inappropriate emails can tag a student as unprofessional, immature, irresponsible, or even dangerous. When it comes time to seek recommendations, the negative impressions left by an email may still be lingering in the minds of the faculty.

Wow.

The article raises more than a few issues, but it also puts the situation in a misleading light. Nowhere, for example, does the article provide or refer to empirical evidence indicating whether these "it's all about me" emails constitute 2 percent, 20 percent, or 75 percent of student emails to faculty. Nowhere, for example, does the article focus on whether, as I and others speculate, the majority of these emails come from immature, inexperienced, and clueless undergraduates rather than from graduates. Nowhere does the article use one of my favorite techniques for analyzing the impact of technology, which is to disconnect the technology from the content and determine if the latter is a phenomenon created by the former or simply an existing characteristic repackaged in the new technology.

My experience, and that of other law faculty with whom I've spoken, with whom I've communicated, or whose comments I've read, is essentially uniform. The overwhelming majority, perhaps almost all of our student emails, are polite, appropriate in terms of content, and deferential. For me, the emails fall into three major categories. There are the emails in which a student apologizes for having to miss or having missed class, asking for nothing and almost certainly intended to prevent me from getting the idea that the absence suggests a deeper problem. There are emails dealing with what I call the "administrative management" of the course, with questions and information about enrollment, "clickers," seating chart photos, and other details that are numerous early in the semester. There are emails in which students ask substantive questions, some requesting clarification and others pushing the discussion beyond what class time permitted us to explore. Other emails include requests for recommendations, advice about getting jobs in tax or estate practice, and similar exchanges well within typical student-faculty communication boundaries.

Of course, my colleagues and I could be in for a surprise. Perhaps what is happening today in undergraduate school will be transpiring several years from now in law school, medical school, and other graduate programs. We won't know for a while. But before concluding that rude or inappropriateness in emails is a monopoly held by college students, consider something a teacher friend mentioned to me last night. Emails from the parents of K-6 students sometimes manifest a disrespect that is no less unsettling than the rudeness displayed by students in their emails. Perhaps that tells us something about why youngsters aren't learning manners: perhaps they are being taught, overtly or by example, how to be expert in acting badly.

It is important to remember that email does not cause disrespect. I remain unconvinced that non-anonymous email somehow lures people into turning wicked on their recipients. I understand how email tends to be written at speeds that defy application of the rules of spelling, grammar, and pronunciation. I understand that email, when not carefully written, can lose something in tone. I do not think that email somehow turns otherwise polite students into seekers of a professor's class notes.

I started teaching before there were emails. In the days before email, there were rude students. There was the student who walked into my office at 5:30 the afternoon before an exam, with dozens of pages of questions reaching back to the beginning of the semester and that would take several hours to answer. I turned him away. Email had nothing to do with his lack of judgment, his failure to heed my warnings about the need to assimilate throughout the semester, and his obvious disregard of my advice to avoid studying during the evening before the exam because at that point sleep is far more important to improved accomplishment. Email had nothing to do with the student who rudely made clear she deserved special treatment to accommodate the classes she missed because she was working in a family member's political campaign. Email had nothing to do with the student who arrived late for a class, tried to make an announcement as a representative of a student organization, and then turned to leave the room after having done so (though stopped by my inquiry, "You're in this class, aren't you? So why aren't you staying?" —- he stayed.)

Blaming email for student rudeness, immaturity, inability to exercise discretion over email content, or selfishness is like blaming guns for homicides, dollar bills for tax fraud, and trash for littered highways. Somewhere along the line, post-modern culture needs to reshape itself and pull the notion of individual responsibility back from the island to which it has been exiled.

It also is important to recognize the improvements that email has brought to education. When my students have a question at 2 in the morning, they can send it to me. My students know they won't get an instantaneous response. I tell them that. They're sensible enough to understand why. In the days before email, the student either would try to remember the question or would write it down. They would come to my office, and puzzle over their handwriting, or try to remember the question. It was inefficient. Now it's much more efficient.

In the days before email, the days before the exam were characterized by lines of students outside my office door waiting to ask questions. Sometimes I used an appointment arrangement but that didn't stop unscheduled students from dropping in. I would answer a question for student A, and twenty minutes later student B would ask the same question. I would repeat the answer. By the time student F asked the question I knew I needed a new approach. That conclusion was reinforced by the incidents of students in the hall overhearing the discussion and asking to join in, but who then needed to be brought up to speed. So I tried the group review session. That failed. Not only did it become increasingly difficult to find a suitable time and a room, it also frustrated students who wanted their questions answered first so they could leave and resume studying. See? More proof that "it's all about me" originated other than in the technology. What the technology has done is to permit a student to email a question, which I answer. I then post the question and answer to the discussion board section of the Blackboard Classroom for the course. Now all other students can read the question, and, if interested, the answer. There is no need for a student to ask the question of me again. Often, another student will spin another question off the one that is posted. The system is fairer, because it gives everyone in the class an equal opportunity to learn from the posted question and answer.

Email has also proved useful when supervising directed research projects. The number of visits to my office has dropped significantly. The student can email drafts, I can mark them up and add comments, and I can email the edited draft back to the student. Office visits are appropriate when the analysis or discussion is too complex or voluminous for email.

Only once have I seen a rude email, and it was from a student to another professor; I was copied. An Associate Dean who was copied on the email responded so brilliantly I was ready to stand up and bow. This episode causes me to wonder if students are rude because they get away with it. As several faculty in the article mentioned, they set down ground rules for the use of email. One has gone so far as to require a thank you, something I think the student should have learned LONG before arriving in college. Nonetheless, it is an unfortunate obligation of university faculty to do remedial work on account of the failings of those previously charged with the stewardship of our nation's children.

What I don't understand in the article is the notion that email makes faculty too accessible. Faculty can control the degree to which they are accessible. In many instances, the long-standing complaint was that faculty were NOT accessible. If the impact of email on the attempts by some faculty to insulate themselves from students is to drag hermit faculty out of their research labs and away from their research projects, I applaud that consequence. Faculty are paid to teach. Research institutions exist for those who wish to research without what they see as the "inconvenience" of interacting with novice students.

Nor do I understand the claim that student email goes "too far" when it involves comments such as "I think you're covering the material too fast, or I don't think we're using the reading as much as we could in class, or I think it would be helpful if you would summarize what we've covered at the end of class in case we missed anything." Perhaps the professor is going too fast. I've been known to slip into doing that. If a student thinks the readings aren't being used sufficiently, the email provides an opportunity for the faculty member to explain why the readings are intended for pre-class consumption and preparation. A student who wants an end-of-class summary has provided the faculty member with the opportunity to explain why a student learns more when a student does the work than when the student is handed something that has sharpened the mind of the professor. In other words, the student has demonstrated he or she needs to realize that a person does not lose weight and get into shape by watching someone else ride the bicycle.

I'm glad the article drew people's attention to the topic. I hope that my elaboration has put the matter into a more realistic perspective.

Sometimes, Following Instructions Can Be Bad for One's Taxes

One of the principal hallmarks of dealing with the tax law is the continual struggle to keep up to date. No sooner has Congress amended the law than it amends it again. And again.

Here is an example of how confusion is generated by the inability of the current legislative and political systems to implement a tax law that remains stable so that people can learn what it requires. This example affects almost every divorced taxpayer who has a child. My thanks to Julian Block for suggesting I take a close look at this conundrum.

In 2004, the Working Families Tax Relief Act of 2004 amended the dependency exemption deduction rules. My description of these changes can be found in a previous MauledAgain post. Specifically, when the parents of a child are divorced, separated, or live apart during the last 6 months of the year, and the child is in the custody of one or both of his or her parents for more than half the year, the 2004 legislation provided that the child would be treated as the qualifying child of the noncustodial spouse, even if otherwise the child would be the qualifying child of the custodial spouse, if either of two tests were met. The first test is met if the divorce decree or separation agreement provides that the noncustodial parent is entitled to the dependency exemption deduction. The second test is met if the custodial parent signs a written declaration (Form 8332) in which the custodial parent agrees not to claim the dependency exemption deduction for the child. A "grandfather" provision was maintained that permits the noncustodial parent to treat the child as a qualifying child if the agreement was executed before January 1, 1985, and the noncustodial parent provides at least $600 for the child's support.

After the 2004 legislation was enacted, a glitch was discovered. Actually, several were discovered, but the one that matters in this discussion involved the provision permitting the parents to determine by agreement who takes the dependency exemption deduction. Essentially, the first test had been removed by legislation in 1984, thus the "grandfather" provision, and the 2004 legislation restored it even though it made no sense to restore it.

So when the Congress, or more accurately, Congressional staff, was drafting the Gulf Opportunity Zone Act of 2005, to provide tax relief and recovery incentives for areas afflicted by the Hurricanes Katrina, Rita, and Wilma, it once again amended section 152. In effect, it removed the first test. The change was made applicable as though it had been included in the 2004 legislation. Therefore, as it now stands, if the parents of a child are divorced, separated, or live apart during the last 6 months of the year, and the child is in the custody of one or both of his or her parents for more than half the year, the child is treated as the qualifying child of the noncustodial spouse, even if otherwise the child would be the qualifying child of the custodial spouse, if the custodial parent signs a written declaration (Form 8332) in which the custodial parent agrees not to claim the dependency exemption deduction for the child. The "grandfather" provision for pre-1985 agreements remains.

But all of that isn't the most confusing part of the explanation. It gets better. Or worse.

In order to have forms and instructions ready for the January-April filing season, the IRS must prepare those forms and instructions late in the preceding year. The hope is that by December of a particular year it is possible to state the rules that apply to that year. So, in December of 2005, the IRS prepared all sorts of forms and instructions, including the instructions to Form 1040. In those instructions, the IRS set forth the changes as made in the 2004 legislation. Why? Because that is what section 152 provided when the IRS revised the instructions. The instructions were revised because the 2004 legislation went into effect as of January 1, 2005, and thus the instructions for filing 2004 Forms 1040 reflected what had become old law.

But unfortunately, what the IRS drafters thought had become the new law for 2005 was itself turned into old law (or perhaps turned into "never quite was given a chance to be the law" law) when Congress passed, and the President signed, the Gulf Opportunity Zone Act of 2005. When did this happen? On December 21, 2005. By then, the instructions had been drafted. What fun to draft something that is correct, and then watch it become obsolete (and erroneous) days after its appearance.

What does this mean? It means that the instructions to Form 1040 concerning which divorced or separated parent can claim the dependency exemption deduction for the child are wrong. How many people know that? Will the IRS mail revision notes to persons who requested paper versions of the form? Will the IRS change the pdf file available on its web site? Will the typical taxpayer dealing with this issue be able to figure it out and get it right? Will tax return preparers catch on? The answers to those questions are probably not and maybe. How many resources of the IRS will be diverted from other tasks to dealing with correcting the mistakes that surely are going to be made? How many dollars? How many staff hours? The answer to those questions is that I have no clue. Perhaps the mistakes will go undetected and uncorrected.

How did this happen? I think it's easy to figure this out. The hurricanes hit in late August and in September. Why did it take so long for Congress to pass what was, by tax law standards, a relatively short bill? Why were things allowed to sit until the end of the year? Why do many people leave things go until the last minute? Why do many people not realize if they delay, others are put into a time squeeze? Or, as in this case, make decisions that are, from the perspective of hindsight, erroneous?

The underlying question is why our educational institutions and school systems do not teach time management skills. Of course, whether it would have made a difference if these sorts of courses had been required of people who are now in the Congress is another question I'd prefer not to answer. It's too depressing.

So, word of warning. The IRS instructions to Form 1040 with respect to the claiming of the dependency exemption deduction by divorced and separated parents are wrong. They were correct when written. They're now out of date. Spread the word. And the explanation.

Maybe There is A Dependency Exemption Problem After All

Frank Degen, who signed the NAEA letter to which I referred in last Wednesday's posting has written me share his insights into the hypothetical that I concluded was not a problem.

Recall the hypothetical:

Mom, dad, Alice (14), and Joe (22) live in the family house. Mom and dad file a joint return with an AGI of $400,000. Since Alice is a qualifying child of mom and dad, they could claim her as a dependent but would receive no tax benefit as their personal exemptions are phased out and the child tax credit would not be available to them. Joe is not a full-time student and his only income is a W-2 with $15,000 in wages. Under §152, Alice is a qualifying child of Joe, so he claims her as a dependent and thus gets the child tax credit and yes, even the earned income tax credit. Assuming Joe had no tax withheld, he goes from a balance due of $683 to a refund of $3,158.

I had analyzed the facts in this manner

I agree that Alice is the qualifying child of Mom and Dad. She is their child. She has the same principal place of abode as they do. She is under 19. She does not provide more than half of her own support. Alice also appears to be the qualifying child of Joe. She is his sibling. She has the same principal place of abode as he does. She is under 19. She does not provide more than half of her own support. But in this instance the Code provides a rule to break the impasse. Under section 152(c)(4)(A), an individual who may be claimed as a qualifying child by two or more taxpayers is treated as the qualifying child of the individual's parent if one of the taxpayers claiming the individual as a qualifying child is the individual's parent. The fact that the amount of the exemption for the parents is zero because their AGI is high enough to trigger total phase-out of the exemption amount does not change the definition of qualifying child.

Frank Degen explains that the NAEA considers phrase "and is claimed" in section 152(c)(4)(A) as precluding the parents from entering the tie-breaking competition. Literally, this would make sense. The parents, not needing a dependency exemption the amount for which has been phased down to zero, do not enter Alice on their return. Thus, as Frank concludes, the son is the only person claiming Alice and there is no tie to break under the tie-breaking rules.

What happens if the statute is interpreted in this manner? First, taxpayers in the situation that Alice's parents and brother find themselves are left to work out a suitable tax-favorable arrangement. Only one "claims" the child in question and the others fail to "claim" the child. Perhaps Congress intended this flexibility. Under this interpretation, the only time that the tie-breaker would be triggered is when two or more taxpayers both claim the dependency exemption, prompting the IRS, which most likely would notice the double dipping, to apply the tie-breaker. Is the tie-breaker intended only as a remedial tool for the IRS to use when multiple taxpayers with "claims" to the child fail to settle on one claimant? Althoug figuring out what Congress intends is more a guessing skill than an analytical one, it's safe to suggest that Congress intended for the tie-breaking rule to apply as soon as multiple taxpayers became eligible to claim the child.

Interpreting the "and is claimed" language so that it gives the taxpayers a planning option is inconsistent with how Congress treats failure to claim the dependency exemption when doing so opens up a personal exemption for the dependent. Persons for whom another taxpayer can claim a dependency exemption are not permitted to claim their own personal exemption. Technically, they have a personal exemption but its amount is zero. Taxpayers whose adjusted gross income is sufficiently high to trigger a phase-down of the dependency exemption amount to zero have nothing to lose by omitting the dependent from their tax return. The statute, however, eliminates the dependent's personal exemption even if the eligible taxpayer neglects the dependency exemption.

But it's not so simple. In several other provisions, Congress bases eligibility on whether a dependency exemption has in fact been taken rather than looking to see if one could have been taken. For example, the Hope and Lifetime Learning credits are disallowed to a person if a dependency deduction with respect to that person "is allowed to" another taxpayer. Thus, the other taxpayer can forego the dependency exemption and leave open the credit door for the person in question, which is something that the taxpayer would want to do if the dependency exemption was phased down to zero or close to zero.

Why the difference? No one has any idea. In fact, some have argued that the credit should be disallowed to the person if the other taxpayer is eligible to take the dependency deduction even if the other taxpayer fails to do so. But the language of the credit provision undercuts that argument.

Thus, although it makes no sense in terms of policy or practical application, there is something to be said for the NAEA's interpretation of the "and is claimed" language. After all, to reach the sensible policy and practical application result, Congress should, and could, have used the phrase "and could otherwise be claimed" in lieu of "and is claimed." Congress did not do so. Thus, to the extent the NAEA is asking for clarification, it is a problem that should be mentioned, even though I'd be reluctant to advise Alice's brother to take the dependency exemption deduction and would insist he make his decision after listening to, or reading, a full explanation of the issue and the risks involved in making a yes or no decision.

Legislation has been proposed to change the rules. In Senate Report 109-051, accompanying a bill that was reported to the Senate in March of 2005 but as to which no other action has been taken, the following language appears:

(4) Special rules for claiming qualifying child.

(A) Rules involving parents.

   (i) In general. A taxpayer other than a parent of an individual may not claim such individual as a qualifying child for any taxable year beginning in a calendar year if--

      (I) a parent is eligible to claim and claims such individual as a qualifying child for any taxable year beginning in such calendar year, or

      (II) the taxpayer has a lower adjusted gross income than any parent who may claim such individual as a qualifying child for any taxable year beginning in such calendar year.

   (ii) More than 1 parent claiming qualifying child. If the parents claiming any qualifying child do not file a joint return together, such child shall be treated as the qualifying child of--

      (I) the parent with whom the child resided for the longest period of time during the taxable year, or

      (II) if the child resides with both parents for the same amount of time during such taxable year, the parent with the highest adjusted gross income.

(B) Rule for 2 or more nonparents claiming qualifying child.

If an individual may be and is claimed as a qualifying child by 2 or more taxpayers, neither of whom is a parent of the individual, for a taxable year beginning in the same calendar year, such individual shall be treated as the qualifying child of the taxpayer with the highest adjusted gross income for such taxable year.

I am not confident that this language would fully resolve the issue. Notice that it uses "eligible to claim and claims" when it ought to use "eligible to claim" to be consistent with the approach taken with respect to the personal exemption amount of persons who can be claimed as dependents by other taxpayers.

It is, though, a wonderful lesson in how the Internal Revenue Code, and tax law generally, becomes more complicated as each year passes. And this is with respect to a fairly simple concept and rule, as tax law concepts and rules go. Imagine what it's like parsing the subchapter K partnership regulations.

Tax and Relationships: A Book to Read and Give

Every once in a while something crosses my path through the tax thicket that not only gets my attention but motivates me to share it. This time, it's a book by Julian Block. The book's title says a lot, but it doesn't say it all: "MARRIAGE AND DIVORCE: Savvy Ways For Persons Marrying, Married Or Divorcing To Trim Their Taxes - And They’re Legal." It might sound like another box of tax gimmicks, but it's not.

Julian Block is someone whose name should be recognized by those who read items about taxes in the New York Times, the Wall Street Journal, Business Week, Money, and the U.S. News and World Report, or who notice his nationally syndicated column, The Tax Advisor. And for those more interested in the visual, he shows up on a variety of television news programs. He has the usual list of credentials attached to folks who try to interpret tax law for the ordinary citizen. I'd say he's a lot like me except I haven't made it into all those publications and my television appearances have been slim in number. And Julian has another credential in the "I wonder what it was like category": he was a special agent for the Internal Revenue Service. My students surely remember that early in the basic tax course, while describing the audit process, I tell them that if someone shows up and identifies himself as a special agent, stop, and get an attorney. Once upon a time, Julian was one of those folks whose arrival, or more precisely, whose introduction, would raise blood pressure and accelerate heartbeats. Next best thing to being a rock star, I suppose.

So along comes a book with chapter titles like this one: “Having An Affair Can Be Taxing” sound like one of my in-class quips that gets the students' attention. Using the question and answer format, Julian shares the questions he wants clients to ask. Almost in time for Valentine's Day is this one: “Does the IRS
require a woman to pay taxes on engagement gifts if she breaks the engagement?” That'll keep some of them reading! Julian explains why December weddings often are more expensive than if postponed into January, and it has little to do with the cost of the reception hall. The marriage penalty and marriage bonus, two topics to which my students pay especially close attention, do not go unexplored. I must complain, however, that the chapter, "Unearthing Hubby's Hidden Assets" is too forgiving of the wives who are no less adept at hiding wealth. But the stories in it surely will prove to be better than any television reality show.

I haven't read the book. Yet. The reviews in Money and the New York Times suggest it would be make sense to do so as quickly as possible. Because tax season is upon us, I'm mentioning the book sooner rather than later. The book is of interest, of course, to just about everyone over the age of 18. I suggest picking it up as a gift for that newly-engaged couple who probably forgot to add it to their registry of desired gifts. Contact Julian at 3 Washington Sq., #1-G, Larchmont, NY 10538. Tell him MauledAgain sent you.

Edit: Julian contacted me today to invite persons interested in the book to email him: julianblock@yahoo.com which will bring it to your mailbox more quickly.

Special Low Capital Gains Tax Rates = More Tax Revenue? Hardly.

A report issued in January by the Treasury Department's Office of Tax Analysis has some interesting information relevant to the on-going debate about the alleged revenue-generating effects of special low tax rates for capital gains. The argument made by advocates of these low rates is that decreases in the rate will encourage taxpayers to sell capital assets that they are unwilling to sell when rates are higher, and that this "unlocking" effect would cause tax revenues to increase. See, for example, this report, which claims that capital gains revenues possibly would increase to as much as $77 billion pe year if the capital gains rates were cut.

Well, the capital gains rates were cut. What happened?

According to the Treasury report, total realized capital gains in 2000 were $655,285,000,000. In 2001 it dropped to $349,441,000,000. In 2002, it dropped further, to $268,615,000,000. And in 2003 it increased slightly, to $323,306,000,000.

Tax revenue, however, simply dropped over the same period, from $127,297,000,000 in 2000, to $65,668,000,000 in 2001, to $49,122,000 in 2002, and $45,108,000,000 in 2003. Adjusted for inflation, which was suggested by and computed by Mike McIntyre, in 2003 dollars the amounts are $142,048,000,000, $71,054,000,000, $51,508,000,000, and $45,108,000,000, respectively, making the decline even sharper than demonstrated by the raw dollar amounts. The effective rate, which had been dropping slowly from 2000 (19.8%) through 2002 (18.8%), fell to 14% in 2003.

There's a big difference between $77 billion on the one hand, and $49 billion or $45 billion on the other. It appears that once a large group of taxpayers did a one-time disposition of some capital assets, the one-time spike in revenue disappeared. At that point, revenue decreased because the rates had been decreased.

Gains as a percentage of gross domestic product fell from 6.56% in 2000, to 3.45% in 2001, fell again in 2002 to 2.57%, and increased slightly in 2003 to 2.95%. For all the talk about how important special low tax rates for capital gains are for the economy, considering the relatively insignificant portion of GDP represented by capital gains, one must wonder whose economy is replete with capital gains. And for all the talk about how special low tax rates for capital gains "unlock" capital assets and generate increased sales, the data puts that claim in a questionable status.

It would be interesting to see what would have happened had adjusted basis been indexed for inflation, and the same rate applied to capital gains as are applied to the wages of laborers. Of course, much of the required data does not exist, and no one knows what people would have done had the tax rules been different. It would be conjecture. But the failed promise of ever-increasing tax revenues from special low capital gains tax rates was pretty much conjecture. It was tried. Its advocates had their day. Now it's time to try the indexed basis regular rate approach. Yes, it's conjecture. But could it be any worse in terms of policy or outcome? I doubt it.

Defining Dependents: Is it Any Easier?

The National Association of Enrolled Agents (NAEA) has sent a letter to the Commissioner, asking for clarification of the new provisions affecting dependency exemption deductions. The NAEA raises some interesting questions through hypotheticals. One of these had been posed to me a few weeks ago, so these questions don't come as a surprise.

These are not the first interesting situations to be presented to the world. Two months ago I shared a step-sibling puzzle, after having explained the changes in a prophetically-named posting, Redefining Children (at least in the Tax World).

Here is one hypothetical presented by the NAEA:

Twin nine-year old children of deceased parents, who live with their adult cousin for the entire year and are fully supported and cared for by the cousin, cannot be claimed as dependents by the cousin. Under the new rules, this cousin cannot claim the two children as qualifying relatives because the children meet the definition of a qualifying child with respect to one another. The problem does not exist if there is only one such child living with a cousin, so if each twin were to be taken in by a different cousin, they could be claimed as qualifying relative dependents

Neither twin can be a qualifying child of the adult cousin. Why? Neither twin is a child, descendant, sibling, step-sibling, nephew, niece, or child of a step-sibling of the adult cousin. Thus, neither twin meets the relationship test for qualifying child status, even though the adult cousin meets the other three tests of abode, age, and support for each twin. Each twin has the same principal place of abode as the adult cousin, each meets the age requirements by being under 19, and each has not provided more than one-half of his or her own support.

Can each twin be a qualifying relative of the adult cousin? An individual is a qualifying relative if the individual satisfies four tests as to the taxpayer seeking the dependency exemption: relationship, gross income, support, and non-qualifying child. The relationship test is met because each twin is someone who is not the adult cousin's spouse and who has the same principal place of abode as does the adult cousin. The gross income test presumably is met because the facts of the hypothetical suggest that they have none, being fully supported by the adult cousin. The support test is met because the adult cousin provides more than half, in this instance all, of the support of each twin. What about the non-qualifying child test?

The non-qualifying child test requires that the individual for whom the taxpayer seeks a dependency exemption deduction not be the qualifying child of the taxpayer or of any other taxpayer. It already has been demonstrated that neither twin is the qualifying child of the adult cousin. Is either twin the qualifying child of another taxpayer? According to the statutory language, no. There are no other taxpayers in the picture aside from the adult cousin.

The problem, however, is that the IRS, in its publications, changes the language of the statute. To quote from the NAEA letter to the Commissioner: "In IRS publications this has been translated into language such as the qualifying child of anyone else or the qualifying child of another person." This is a HUGE difference. If the test is that the person not be the qualifying child of anyone else, the twins are not the qualifying relative of the adult cousin because they are qualifying children of each other. Each twin is a sibling of the other, thus satisfying the relationship test for qualifying child. Each twin meets the other three tests (abode, age, support) because each twin has the same principal place of abode as the other twin, each meets the age requirements by being under 19, and each has not provided more than one-half of his or her own support.

In effect, the NAEA letter is asking the Commissioner, "What happened? On what grounds did someone drafting a publication change the word taxpayer to "anyone else or another person"? Not every person is a taxpayer. Not every person who is an "anyone else" is a taxpayer. Under Code section 7701(a)14), a taxpayer is "any person subject to any internal revenue tax." In contrast, section 7701(a)(1) defines "person" as "construed to mean and include an individual, a trust, estate, partnership, association, company, or corporation." Person and taxpayer are two different concepts, and using one term to mean the other is unwise.

Not all the problems, though, are of IRS making. Consider this hypothetical from the NAEA:

Twin nineteen-year old brothers live together in their home and attend school full-time. Their parents are deceased. The brothers do not provide more than half of their own support. Although they have part time jobs and earn about $5,000 annually, their principal support comes from their aunts and uncles who together contribute about $25,000 per brother towards their household and college expenses. The aunts and uncles do not live with the brothers. Each brother meets the definition of a qualifying child with respect to the other. Putting the dependency rules together with this, if each twin is able to claim the other as a dependent, it means that the other one cannot because a dependent cannot have dependents. However, since neither can be claimed, it means they can have dependents. This loop continues endlessly – we now have the qualifying child paradox.

Let's call the brothers A and B. A is the qualifying child of B. Why? A is the brother of B, A has the same principal place of abode as does B, A meets the age test by being a full-time student under 24, and A does not provide more than half of his own support. B is the qualifying child of A. Why? B is the brother of A, B has the same principal place of abode as does A, B meets the age test by being a full-time student under 24, and B does not provide more than half of his own support. However, even though A is the qualifying child of B, A cannot be the dependent of B because B is a qualifying child of A, and thus would be the dependent of A but for the fact that because A is the qualifying child of B, B would be a dependent of A. It is a classic paradox. Though there are many special rules in section 152, none addresses this puzzle.

However, one of the problems described by the NAEA is not a problem. Consider the NAEA's hypothetical:

Mom, dad, Alice (14), and Joe (22) live in the family house. Mom and dad file a joint return with an AGI of $400,000. Since Alice is a qualifying child of mom and dad, they could claim her as a dependent but would receive no tax benefit as their personal exemptions are phased out and the child tax credit would not be available to them. Joe is not a full-time student and his only income is a W-2 with $15,000 in wages. Under §152, Alice is a qualifying child of Joe, so he claims her as a dependent and thus gets the child tax credit and yes, even the earned income tax credit. Assuming Joe had no tax withheld, he goes from a balance due of $683 to a refund of $3,158.

I agree that Alice is the qualifying child of Mom and Dad. She is their child. She has the same principal place of abode as they do. She is under 19. She does not provide more than half of her own support. Alice also appears to be the qualifying child of Joe. She is his sibling. She has the same principal place of abode as he does. She is under 19. She does not provide more than half of her own support. But in this instance the Code provides a rule to break the impasse. Under section 152(c)(4)(A), an individual who may be claimed as a qualifying child by two or more taxpayers is treated as the qualifying child of the individual's parent if one of the taxpayers claiming the individual as a qualifying child is the individual's parent. The fact that the amount of the exemption for the parents is zero because their AGI is high enough to trigger total phase-out of the exemption amount does not change the definition of qualifying child.

Technical amendments to the 2004 legislation that changed the dependency definitions are awaiting action by Congress, but these amendments do not address the problems raised by the NAEA. The ABA Section of Taxation has identified yet another problem for which it suggests additional technical amendments.

There are lessons to be learned from this analysis. As is the case with computer programs, the more complex the provision, the higher the chances for a crash. The faster the writing, the greater the chance of error. The more authors, the higher the number of inconsistencies and paradoxes. The less review and testing, the faster it is rushed to market, the larger the number of snags.

The underlying problem is that the definitions in section 152 are being used for too many purposes. It's not that there ought to be multiple definitions. It's that there should be far fewer purposes. Strip the tax law of the wide array of credits, deductions, special provisions, and other attempts to create a different tax law for each taxpayer, and the complexity is reduced. Rather than an earned income tax credit, why not eliminate income taxes on people with adjusted gross income under the poverty level? Rather than trying to figure out who claims who as a dependent, why not assign each person an exemption amount that the person can choose to use on his or her own return, or transfer or sell to one other person (presumably a taxpayer who could make use of it), similar to the manner in which pollution credits are traded? It surely would be easier than the current approach, which has generated thousands of cases and hundreds of thousands of audit adjustments over the years.

In the meantime, let's hope the IRS responds quickly and sensibly to the NAEA's letter. And I might ask those folks to write some exam questions for my students!

Love of Learning Trumps Buying a Degree?

Every day the messages show up in my e-mail inbox. Though using different articulations, they all offer the same deal. I am presented with the opportunity to purchase a degree. M.B.A., J.D., Ph.D., you name, "they" have it. For sale.

This sort of nonsense has been around long before there was an Internet and e-mail. Quack doctors with fake degrees hanging on their office walls were the subject of news stories, when they were caught, of course, decades ago.

What the Internet has done is to make "fake degree proliferation" a much more serious problem. About a year ago, the Chronicle of Higher Education did a report on educators with fake degrees who were selling fake degrees. When will this end? When every person on the planet has one of every kind of academic degree imaginable?

Most people, degreed or not, would agree that there is something not only inappropriate, but dangerous, in permitting someone to purchase a degree and then use that piece of paper to lure patients, clients, or customers into paying for services. Who wants to have surgery performed on his or her child by a person with a purchased M.D.? Who wants to get legal advice from someone with a fake J.D.? Who wants to drive across a bridge designed by someone with a sham engineering degree?

The deeper concern, though, is whether a degree obtained through conventional means is any more of a guarantee that the patient, client, or customer will receive due care. I've raised this question, though obliquely, in several previous posts. For example, a few weeks ago, in No Wonder Tax Law Seems So Difficult, I noted:

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.

Several days later, in commenting on a response to that commentary, in Students Fail When We Fail Students, I observed:

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.

Recent events have persuaded me that the problem is very real, and is no less a threat to the health and welfare of individuals than is the problem of fake degrees purchased on-line or through some other outlet.

Theoretically, someone who does business with a person who holds a degree from an accredited educational institution can rely on that institution's role as a gate keeper to whatever profession the degree permits its holder to enter. In theory, someone who does not understand the subject matter, or someone who does not perform to a specified minimum standard, does not earn the degree. In theory, a person who earns a degree in the conventional manner has engaged in the equivalent of the apprenticeship through which persons learning trade skills must pass before holding themselves out as masters of their trade.

In practice, however, it just isn't so. People emerge from educational institutions holding degrees and carrying brain cells stuffed, more or less, with knowledge. Some of these people also carry an understanding of the discipline, acquired through experiential and active learning, reflecting a devotion to the subject matter of the degree. They are immersed. But others, increasing in number, depart with a degree in one hand, an expecatation of salary in the other, and not much more than acquired but unapplied knowledge, to a greater or lesser extent, in their cerebral memory banks.

This is not a new phenomenon. For as long as there have been schools there have been folks who have tried to slide by, doing the minimum amount of work necessary to acquire the benefits associated with graduation from the school. What is new is the prevalence of this mindset among present-day students. This is in no way an indictment of the diligent students who bring a rigorous approach to their studies. It is, instead, a lamentation over the ever-growing attitude that the student is a customer who, having paid tuition, is entitled to set the terms and conditions of his or her participation in the education offered by the institution to which tuition has been paid.

In theory, students who fail to do what is required should fail to graduate. In theory, this should happen because they fail one or more courses. Or, as I like to put it, they "earn a grade of F." Unfortunately, the F grade has all but disappeared from American higher education, and it seems to be on its way out in the K-12 grades. Why? There are several reasons. There is pressure to move the student through the system as quickly as possible. Parents assume that their children deserve wonderful grades because they are wonderful people. Standards have eroded, viewed in light of post-modern culture as meaningless trappings of a by-gone era pervaded with injustice. In some instances, effort alone earns high grades, and if it does not, students squawk.

What is most disturbing to me is that I see more of the "I paid my tuition, now give me my diploma" attitude among post-graduate students than among graduate students. What troubles me is that the former, for the most part, are or have been participants in the practice world. They should know that clients are not well served by anything less than rigorously application of genuine understanding of the subject matter. The impression I get, however, at least from some, is that the degree becomes a wall decoration that brings more clients into the office. Call it strict, but I simply don't see how anyone in practice can view a degree as anything other than a marker of having climbed to an even higher understanding, and having become even more deeply immersed, in the subject matter.

Interestingly, there is a related phenomenon that gets far less attention in today's media than it did decades ago. Perhaps it is not as common an occurrence. There are people who read and study in a particular discipline without being enrolled in any sort of program, degree or otherwise. For all intents and purposes, they are teaching themselves, having learned to do so somewhere along the line in their previous education. They self-study for the enjoyment, the fulfillment, the growth and the understanding. They may end up doing more reading and thinking than someone enrolled in a formal degree program. Wait. Surely they end up doing more work than at least some people enrolled in a degree program but scraping by on the bare minimum.

The folks who have the desire to learn, the discipline to stay focused, the perseverance to keep reading and thinking, the motivation to write and explain, and the appreciation for genuine understanding make the best students. They also become the best practitioners, whether it is in an operating room, nuclear power plant control room, architect's office, or law firm. To them, the degree is a marker and not a stand-alone consumer purchase. For their teachers, they are what makes the classroom a fun place.

Fortunately, I have always encountered some people of this disposition in my classes. Their numbers, though, appear to be shrinking. They're being crowded out. They're being crowded out by the degree purchasers. It is an issue to which I intend to pay even more attention. The question is whether I can get anyone else to pay more attention.

Primary Goal of Tax Policy = Ever-Accelerating Growth? Hardly.

Yesterday the Heritage Foundation issued a report by Daniel J. Mitchell, Ph.D., with the fascinating title, "The President’s Tax Agenda: Pro-Growth Measures Jeopardized by Excessive Spending and Misguided Focus on Deficit." The theme of the report jumps out from the opening: "President George W. Bush’s tax agenda is largely focused on making the 2001 and 2003 tax cuts permanent. This is sound policy."

I disagree. It is not sound policy.

Dr. Mitchell argues that "The primary goal of tax policy should be faster growth. This is why permanent tax cuts are important, especially the tax rate reductions that increase incentives to work, save, and invest." I'm surprised, considering his perspective, that he thinks that government should use tax policy to stimulate private markets. There are two principal difficulties with this position. First, the primary goal of tax policy should be the collection of revenue sufficient for government to perform the services that only government can perform for its citizens, such as national defense, or to perform services most efficiently handled by government, such as national disease monitoring and quarantine implementation. Note that the question of whether a local, state or a national government should be the particular government entity performing an appropriate government-provided service is a secondary issue. Second, faster growth as a goal makes no sense. Accelerating growth would lead to, well, infinity. Economic growth should keep pace with the demographic changes in society, with an allowance for improvement in the standard of living of those not sharing in the growth because their opportunities are limited by the imbalance in growth sharing.

Dr. Mitchell argues for making the overall rate reductions permanent because "these rate reductions have increased incentives for productive activity." Not only is it difficult to imagine someone taking on a productive enterprise because the applicable income tax rate is 35% instead of 39%, it also makes no sense to assume that most people have a choice in the matter. What drives productivity is the need to eat, own or rent shelter, acquire medical care, and to have access to the goods and services that make survival possible. Not only does the current rate structure tax someone making a few hundred thousand dollars a year at the same rate as someone making millions, tens of millions or hundreds of millions of dollars a year, the current tax law also iimposes higher effective marginal tax rates on those earning from roughly one hundred to roughly two hundred thousand dollars a year than it does on those earning more, on those living on social security and seeking part-time employment to supplement their income, and on some low-income families eligible for the earned income tax credit.

Dr. Mitchell argues for "reduced double-taxation of ... capital gains." It comes as a surprise that capital gains represented double taxation. Why? Because they're not. Yes, taxation of dividends represents theoretical double taxation, but because most corporations pay little or no taxes, most dividends represent earnings taxed only upon payment to taxable shareholders. Dividends paid to tax-exempt shareholders are not taxed.

Dr. Mitchell rests part of his analysis on the proposition that "Higher taxes encourage additional spending." Though I agree that federal spending is replete with unjustifiable waste and misguided policies, the Congress manages to spend no matter the tax rate or the amount of revenue. Some financially disciplined individuals restrict spending to income, but even among individuals spending often exceeds income. In other words, restricting federal revenue is the wrong place to start. The process needs to begin with a discussion of proposed government spending consistent with the primary goal of tax policy being the collection of revenue sufficient for government to perform the services that only government can perform for its citizens and to perform services most efficiently handled by government. Once the cost is tallied, the appropriate revenue needs can be seen, presenting the opportunity to evaluate the cost of the desired programs and the burden of the taxation. That's how many private organizations and individuals handle their budgeting. Of course, those folks can't print money.

Dr. Mitchell then argues that "All tax increases cause economic harm because they encourage bigger government." This is total nonsense. The United States was compelled to increase tax revenue in the 1940s to pay for the cost of a war. Although the war caused harm, the spending ended the lingering unemployment from the Depression, and created a world in which the national economy could continue to function, free of the specific totalitarian threat it then faced. Taken to its extreme logic, Dr. Mitchell's analysis would support a tax rate of zero. The point is that although some government taxation-and-spending represents inefficient transfers of wealth, other instances of tax-and-spend do far more for the national benefit than would the absence of such situations.

In all fairness, Dr. Mitchell is not entirely off base. When he writes, "The bad news is that the President’s budget is silent on the issue of fundamental tax reform," he strikes a resonant chord with me. As I mentioned in my analysis of the tax portions of the State of the Union speech, I am bewildered by how quickly the President and his Administration has backed away from the recommendations of a Tax Reform Panel set up to generate the sort of report that the Administration could tolerate. I doubt Dr. Mitchell and I would agree on the details, but unless there is a full discussion, a thorough analysis, an opportunity for all to be heard, and a squelch on greed, there's no way any sort of tax reform will happen.

Trying to make the tax cuts permanent is not only a matter of good money chasing bad, it's pointless. What are the odds that permanent means beyond 2008?

EDIT 11 Feb 2006: The sentence "Note that the question of whether a local, state or a national government should be the particular government entity performing an appropriate government-provided service is a secondary issue." now appears as it does thanks to former student Nakul Krishnakumar pointing out that as originally written the sentence could be interpreted in a manner I did not intend.

Tax and Gambling: Worth the Risk?

When gambling meets tax law, a variety of interesting issues arise. One of the most interesting is the question of whether a taxpayer who borrows chips from a casino, gambles, loses, and gets a reprieve from the casino has gross income. In Zarin v. Commissioner, 92 T.C. 1084 (1989), the Tax Court held that the taxpayer had gross income, but the Third Circuit reversed (916 F.2d 110, 90 TNT 213-10 (3d Cir. 1990). This question, which continues to stir up debate among tax law academics and practitioners, is not the focus of today's post. There are other interesting questions. Those who are interested can get a good start to understanding the Zarin decision by reading Dan Shaviro's excellent analysis in "'The Man Who Lost Too Much: Zarin v. Commissioner and the Measurement of Taxable Consumption," 54 Tax L. Rev. 215 (1990).

The tax law limits the deduction of gambling losses to gambling winnings. For this reason, people gambling for the fun of it often try to persuade the IRS and the courts that they are carrying on a trade or business, which would permit deduction of gambling losses as business losses unimpeded by the limitation on the deduction of gambling losses. If they succeed, they also obtain deductions for the associated expenses of gambling, such as travel costs if they go to places such as Las Vegas or Atlantic City to pursue their goals.

In Commissioner v. Groetzinger, 480 U.S. 23 (1987), the Supreme Court held that the taxpayer had demonstrated his gambling activities rose to the level of a trade or business. The only salient fact making his situation special was that he devoted most of his time gambling and had no other source of earned income. Most gamblers need to hold regular jobs in order to make money, and thus it remains very difficult for a taxpayer in a specific situation to convince the IRS that he or she is carrying on a trade or business.

And if a gambler does make money, the income is taxed as ordinary income. If the taxpayer in Groetzinger had turned a profit, the profit would have been taxed at ordinary rates. It is also arguable that the income would be subject to self-employment taxes.

The question that gets my attention this morning is how should gambling be defined? In other words, what activities ought to be brought within the deduction limitation? Is it simply a matter of identifying the games available in a casino? Is it a matter of identifying those activities regulated by state gaming boards?

From a much broader tax policy perspective, the question is why should certain activities that involve gambling be taxed at special rates. For all intents and purposes, investing involves a gamble. There is no certainty in making an investment. The odds may differ, giving the investor a much better prospect of profit when investing in land than when investing in an obscure start-up company, but nonetheless, risk is risk. Even an agreement to perform services for a fee is a gamble, because there is a risk that the employer will go bankrupt.

Yet for some reason the Congress treats certain types of gambling, namely, investing in things called "capital assets" or engaging in activities "deemed" to be the same as investing in capital assets, as privileged and worthy of reduced taxation. Thus, the person who puts down a bet today on the 2008 Presidential election will be taxed at regular rates if she wins, but the person who puts down a bet today on the value of stock in Exxon-Mobil during November 2008 will be taxed at special low rates if he wins.

The argument that betting on stocks and other investments deserves a lower tax break because it creates jobs doesn't resolve the distinction even if the assertion is true. After all, there are hundreds of thousands of people holding jobs created to service those who gamble Las Vegas style.

Perhaps there is some sense that investing in land or a fly-by-night start-up is somehow more noble, more valuable, more dignified, or more moral than investing in the outcome of a Presidential election, next year's Superbowl, or oil to be delivered in 2010. But since when does the tax law care about the morality of income? Gross income from dignified jobs is taxed no more or less than gross income from undignified jobs. Gross income from illegal jobs is taxed no more or less than gross income from legal jobs. Gross income from investing in stock in a company manufacturing alcohol or tobacco products is taxed no more or no less than gross income from investing in stock in a company manufacturing cancer-curing pharmaceuticals or chicken soup, though both are taxed at special rates lower than those applied to gross income from any sort of job.

I do not see a difference between the person who devotes their time almost entirely to making casino and similar investments and the person who devotes their time almost entirely to making commodities futures and long-term option investments. Folks doing the latter try to distinguish themselves by arguing that they are using their intellectual skill and acquired knowledge, evaluating prospects, and otherwise doing something more than pulling a slot machine lever (or pressing a slot machine button). Yet that argument fails in two respects. Every person I know who gambles, whether at poker, the track, or using cards, claims that they are using their intellectual skill and acquired knowledge, evaluating prospects and otherwise doing something more than throwing some money at a stock on a hunch. Some folks study corporations and other study horses. The argument by the folks claiming capital gains low rates for their investment gambling, that they use intellectual skill and acquired knowledge and evaluate prospects, demonstrates that they are not very different from the lawyer, physician, or engineer who uses intellectual skill and acquired knowledge and evaluates prospects when deciding how to proceed with their professional endeavors. Yet the income they produce is taxed at the high rates imposed on labor income.

I wonder if the current Administration and its Congressional allies, in proposing to make permanent the special low rates applicable to those who gamble in commodities, options, and similar items, understands that gambling is gambling. Do they understand that making those rates permanent will generate even more incentive for tax shelter designers to find ways to package poker games as long-term investments the income from which would be taxable as capital gains?

Actually, I don't wonder. I'm certain that the thought has not crossed their minds. So I'm not even gambling when I make that observation.

A New Insult: Don't Like It? Call It Taxation.

It seems that taxes are so despised in this country that a great way to denounce an economic concept with which one disagrees is to call it taxation. I already can hear the insults. "You ... you .... you .... you tax person, you!" I've been called worse.

This latest observation comes from this CNN report about America OnLine's plan to require businesses to pay a fee to send commercial email messages. AOL, in conjunction with Yahoo!, has been testing an email system that permits the certification of email, which, theoretically at least, would curtail spam. The fee could be as much as $2 to $3 per 1,000 email messages.

Not surprisingly, there are marketers opposed to the idea. The CNN report quotes a USA Today report in which some marketers assert that the contemplated service fee is "a form of e-mail taxation." The CNN report also quotes the CEO of an e-mail services company as saying, "It's taxation of the good guys with cash, and it does nothing to help the good guys who can't afford the cost or to deter the bad guys who spam anyway."

News alert. A fee charged by a private company is not a tax. A tax is a financial imposition levied by a government or government entity, or a non-governmental organization acting on behalf of or under specific revenue-collecting authority of a government or government entity. To be more specific, this definition from Lectric Law Library's Lexicon will help a lot of people doing crossword puzzles: "This term in its most extended sense includes all contributions imposed by the government upon individuals for the service of the state, by whatever name they are called or known, whether by the name of tribute, tithe, talliage, impost, duty, gabel, custom, subsidy, aid, supply, excise, or other name."

The mis-use of the words "tax" and "taxation" by the people unhappy with AOL's plan could be deliberate. It surely makes the fee seem far more devious. Or it could be another case of ignorance, a pale imitation of the use of the term "tax" in the major league baseball collective bargaining agreement. The so-called "competitive balance tax" is simply a charge assessed against member clubs whose payrolls exceed a specified threshold. It has nothing to do with a tax other than the use of the term by lawyers and labor negotiators who decided to use the word "tax" to describe something that is not a tax.

And from such nonsense comes even more nonsense. Perhaps the next step is the exclamation of someone who walks up to a ticket window at a major league baseball stadium, asks for a ticket, and hears the words, "That will be $45, please." The exclamation? "Wow, what an outrageous tax you are sticking on me." Yes, indeed. They're taxing this person for entering the stadium.

Now let me go see if I can tax my employer for my services. Perhaps I'm onto something. Are taxes taxable?

Referring to AOL's plan as an email tax is going to do nothing but stir up that old urban legend about a federal email tax, which had seemed to fade away. Ah, old myths never die, they return in recycled form to haunt yet another generation.

New alert. AOL is NOT proposing to tax anyone. It couldn't even if it wanted to do so.

Super Bowl Taxes But No Super Tax Systems

Yes, even the Superbowl is not without tax overtones. Michigan, the state in which this year's showcase is being played, has an income tax, and imposes that tax on income earned by non-residents from sources within the state. Detroit, the city hosting the game, also has an income tax. Applying the state's 3.4 percent rate and the city's 1.275 percent rate to the income earned by employees of the Seattle Seahawks franchise while in Detroit, Michigan will generate roughly $500,000 of income taxes for Michigan and Detroit.

This is not news. The same general result, though with different rates and dollar amounts, would occur if the game were played in California, New York, or any of the many other states with income taxes that extend to non-residents. In California, where rates reach 9.3 percent, the amount involved could be as high as a million dollars of tax revenue for a few days of work.

What's news is that this is news to folks in Washington, one of the few states in the country without a state income tax. And some of these people, including state representative Christ Strow, think there is a problem. If Michigan and Detroit are going to take tax money from Washington residents, the state must "try and protect [its] athletes," according to Strow.

So Representative Strow has proposed a bill to tax Washington residents when they play professional games in Washington. The bill would not tax athletes from states that do not impose an income tax on Washington residents. Thus, it is "retaliatory" legislation, following the approach taken by Illinois when it enacted what has come to be known as "Michael Jordan's revenge." For more about the Illinois approach, and alternatives, see the student paper, STATE INCOME TAXATION OF NON-RESIDENT PROFESSIONAL ATHLETES, published by the Villanova University School of Law Tax Law Society's Tax Law Compendium.

But before Washington proceeds, its legislators ought to take a close look at the United States Constitution, and, more practically, at two important United States Supreme Court pronouncements on what the Constitution does and does not permit states to do when it comes to taxing non-residents. In Shaffer v. Carter, 252 U.S. 37, 52 (1920), the Court stated:

[W]e deem it clear, upon principle as well as authority, that just as a State may impose general income taxes upon its own citizens and residents whose persons are subject to its control, it may, as a necessary consequence, levy a duty of like character, and not more onerous in effect, upon incomes accruing to nonresidents from their property or business within the State, or their occupations carried on therein.emphasis added

In other words, Washington cannot subject non-resident athletes to a tax more onerous than the income tax it imposes on Washington resident athletes. For example, when New Hampshire, another state without an income tax imposed a commuter income tax on residents of surrounding states, the Supreme Court struck it down, in Austin v. New Hampshire, 420 U.S. 656 (1975), saying:

Against this background establishing a rule of substantial equality of treatment for the citizens of the taxing State and nonresident taxpayers, the New Hampshire Commuters Income Tax cannot be sustained. The overwhelming fact, as the State concedes, is that the tax falls exclusively on the income of nonresidents; and it is not offset even approximately by other taxes imposed upon residents alone. Rather, the argument advanced in favor of the tax is that the ultimate burden it imposes is "not more onerous in effect," Shaffer v. Carter, supra, on nonresidents because their total state tax liability is unchanged once the tax credit they receive from their State of residence is taken into account. * * * While this argument has an initial appeal, it cannot be squared with the underlying policy of comity to which the Privileges and Immunities Clause commits us.

According to the State's theory of the case, the only practical effect of the tax is to divert to New Hampshire tax revenues that would otherwise be paid to Maine, an effect entirely within Maine's power to terminate by repeal of its credit provision for income taxes paid to another State. The Maine Legislature could do this, presumably, by amending the provision so as to deny a credit for taxes paid to New Hampshire while retaining it for the other 48 States. Putting aside the acceptability of such a scheme, and the relevance of any increase in appellants' home state taxes that the diversionary effect is said to have, we do not think the possibility that Maine could shield its residents from New Hampshire's tax cures the constitutional defect of the discrimination in that tax. In fact, it compounds it. For New Hampshire in effect invites appellants to induce their representatives, if they can, to retaliate against it. * * *

Nor, we may add, can the constitutionality of one State's statutes affecting nonresidents depend upon the present configuration of the statutes of another State. Since we dispose of this case under Art. IV, 2, of the Constitution, we have no occasion to address the equal protection arguments directed at the disparate treatment of residents and nonresidents and at that feature of the statute that causes the rate of taxation imposed upon non-residents to vary among them depending upon the rate established by their State of residence. emphasis added; footnotes omitted

So there it is. Representative Strow's proposal guarantees litigation, and Supreme Court precedent guarantees a loss for Washington. Even though Strow is following the Illinois approach, the fact that Illinois has an income tax applicable to residents makes all the difference in the world. And in any upcoming litigation.

Another aspect of this situation deserves a bit of attention. That people who work in many states must file many tax returns is a fact of tax life. Until states and localities get together and agree on some sort of combined reporting, the professional athlete who plays games in multiple states must file multiple state and local income tax returns. Depending on how many games are played in states without an income tax, and on how deep into the playoffs the team advances, NFL players and team employees who travel need to file in as many as ten states and perhaps as many localities. For athletes in other professional sports, whose teams play many more games, in more states, the number of state income tax returns could reach several dozen.

The computations can be complicated. Records must be kept of the number of days played in each state. The paperwork burden is enormous, and athletes on the low-end of the salary scale, outside of the major sports, might not be able to afford professional tax return preparation assistance. According to a spokesperson for the Tax Foundation, quoted in this story, some very highly-paid athletes "travel with a coterie of accountants." This same person took the position that, "We consider it to be an outrageous administrative burden on anyone who travels and works for a few days out of state."

But before tears of sympathy are shed for the athletes, consider that anyone who works in more than one state or locality during the year faces the issue. Consider the barely-making it musical group or touring theater company making stops in all the states. Think about the traveling sales representative who criss-crosses the nation, spending several days in each state. Some of these folks are required to file state and local tax returns that can number as many as one hundred.

When people speak and write of tax reform, much, perhaps almost all, of the attention turns to the federal income tax. But for every federal income tax there are more than forty state income taxes. And for every state income tax there are dozens of local income taxes. Add this to the reason that a "flat tax rate" doesn't in and of itself simplify the tax law or tax return filing.

Today may be the day a Super game is being played, although I confess that because the Philadelphia NFL franchise isn't represented, it's just not quite as super as it could have been. But there is no question that the nation's tax systems, from Washington to the tiniest borough, is far from super. Perhaps it will be, aha, superseded by something better. Sorry. I'll take the 5-yard penalty for bad puns.

Taxes and the State of the Union

When my dentist yesterday afternoon asked me what I thought of the State of the Union speech, I wanted to reply, "I didn't hear much that wasn't recycled, and even the comments spoken by the President that were new for him, such as the addicted-to-oil comment, wasn't news to me." Of course, considering my mouth was full of equipment and he was poking around at a tooth, I wasn't able to say much. I couldn't say anything. Yes, the dentist is one of the few people who can get the edge on me in conversation time sharing.

But it reminded me I had intended to share some commentary on the tax and tax-related proposals mentioned by the President. Now that the crammed schedule of Wednesday (four hours of class, presentation, grading, etc.) and the tooth drilling of Thursday is behind me, I have a moment to present some brief notes.

From the President:

Yet the tax relief is set to expire in the next few years. If we do nothing, American families will face a massive tax increase they do not expect and will not welcome.

Because America needs more than a temporary expansion, we need more than temporary tax relief. I urge the Congress to act responsibly, and make the tax cuts permanent.

No, Mr. President, only a few American families will face massive tax increases if the special low rates expire, and though they will appear massive to most people, they won't be massive to the people who incur them, because the return of tax levels to where they had been will affect a very small fraction of these folks' income. Some Americans' tax liabilities would not change if the special low tax rates expire. On the other hand, Mr. President, the alternative minimum tax threatens to carve deeply into the economic well-being of the middle class. Why not fix that problem even if it means that the high rollers give up their special low tax rates? If you need to understand this, take a look at this blog. Scroll through, and you'll find more than enough explanations of why the "we deserve special low tax rates because we're so good for the economy" crowd is serving you about as well as has some sectors of the intelligence community.

From the President:

Keeping America competitive requires us to be good stewards of tax dollars. Every year of my presidency, we've reduced the growth of non-security discretionary spending, and last year you passed bills that cut this spending. This year my budget will cut it again, and reduce or eliminate more than 140 programs that are performing poorly or not fulfilling essential priorities. By passing these reforms, we will save the American taxpayer another $14 billion next year, and stay on track to cut the deficit in half by 2009.

I love that first sentence, Mr. President. It's a great soundbite. But cutting the budget deficit in half is like putting fillings in only half the cavity-afflicted teeth. Some of the deficit arises from those special low tax rates. Another significant portion is the cost of war. Trying to wage war while enabling most Americans to lead peacetime lives is oxymoronic. Wars aren't buildings that can be mortgaged.

From the President:

I am pleased that members of Congress are working on earmark reform, because the federal budget has too many special interest projects. And we can tackle this problem together, if you pass the line-item veto.

My expectations, Mr. President, is that you will live by these words, and just say no to the requests for special interest expenditures and special interest tax cuts. But I'm willing to predict that a discussion of the definition of special interest would be, ah, interesting.

From the President:

We must also confront the larger challenge of mandatory spending, or entitlements. This year, the first of about 78 million baby boomers turn 60, including two of my Dad's favorite people -- me and President Clinton. This milestone is more than a personal crisis -- it is a national challenge. The retirement of the baby boom generation will put unprecedented strains on the federal government. By 2030, spending for Social Security, Medicare and Medicaid alone will be almost 60 percent of the entire federal budget. And that will present future Congresses with impossible choices -- staggering tax increases, immense deficits, or deep cuts in every category of spending.

Congress did not act last year on my proposal to save Social Security -- yet the rising cost of entitlements is a problem that is not going away. And every year we fail to act, the situation gets worse.

So tonight, I ask you to join me in creating a commission to examine the full impact of baby boom retirements on Social Security, Medicare, and Medicaid. This commission should include members of Congress of both parties, and offer bipartisan solutions. We need to put aside partisan politics and work together and get this problem solved.

Well, Mr. President, you're right that entitlement growth threatens the nation's financial health. And it's not just retirement entitlements. Of course the question needs to be studied. Carefully. With input from people who are gifted with skills necessary for analyzing, explaining, and proposing remedies for the structural deficiencies in entitlements. But I fear that the nation will end up with a commission not unlike the one that looked at tax reform, omitted thorough analysis of many alternatives, and recommended changes, from some of which you turned and ran like a little child who hears the dentist's drill for the first time. Make me a promise. Promise you will appoint people because of their expertise, intellgence, willingness to listen, open-mindedness, creativity, and diligence. That disqualifies a lot of the people who might otherwise find their way onto the proposed commission. We don't need folks whose minds are already made up and whose political souls have already been sold to one or another particular devil of a detail.

From the President:

We will strengthen health savings accounts -- making sure individuals and small business employees can buy insurance with the same advantages that people working for big businesses now get. We will do more to make this coverage portable, so workers can switch jobs without having to worry about losing their health insurance.

Making health care affordable at the same price to all people must be balanced with the need to preserve the health of medical insurance companies by adjusting rates to reflect the bad health habits of some Americans. Designing accounts that put responsibility on people might just give people a chance to show themselves that they can be responsible. At the same time, remember it's tough for some people to put away money for future health issues when there are children in the house who are hungry. Tax deductions and tax exclusions work for those who have something to spend and deduct or who have income to exclude. Making coverage portable is a very good, but of course, not new, idea. Considering that part of the retirement entitlement concerns involve health care for retirees, perhaps it would make sense to wrap these issues together. Oh, I could live with a separate commission. But again, I want the experts on it. I want to know what should be done, not what politicians think needs to be done to ensure re-election.

From the President:

Second, I propose to make permanent the research and development tax credit -- (applause) -- to encourage bolder private-sector initiatives in technology.

If there is going to be an r&d credit, you're right, it ought to be permanent. It's tough to run a business that engages in r&d without knowing whether there will be a credit 2 or 3 years down the road. The same can be said, by the way, about other credits and tax provisions. It might be fun holding one's breath until reaching the last page of a great mystery novel, but American businesses need an environment of relative certainty, and not one in which it isn't know until May of a particular year that the Congress has retroactively renewed a tax credit back to the beginning of the year. Until entrepreneurs master time travel, they can't go back and grab "do overs" for their January through April business activities.

From the President:

Third, we need to encourage children to take more math and science, and to make sure those courses are rigorous enough to compete with other nations.

Of course this will make it easier for them to learn about the tax law, won't it? I'm doing my part, Mr. President, so if you need advice on how to make a course rigorous, send me an e-mail. Perhaps requiring high school sophomores to take a basic federal tax course would get their brains warmed up and ready for the math and science stuff? Rather than seeing those courses as "too hard" and impossible, they'll jump into those courses with a sigh of relief that they get to take "easier stuff" and they'll know that having succeeded in the tax course they can succeed in anything. Even quantum physics, Mr. President. After all, a little dash of subchapter K in one's high school sophomore year puts the entire cosmos into perspective.

Tax Charts for the Section 894 Regulations

Once again, Andrew Mitchell has created and now shares some more charts, the entire collection of which can be found at his tax charts web site. Here's the latest tax chart news:

Today we added to our website charts of the examples in the section 894 regulations dealing with domestic reverse hybrid entities. The charts include:

Example 1 - Dividend Paid by Unrelated Entity to DRHE

Example 2 - Interest Paid by DRHE to Related Foreign Interest Holder

Example 3 - Interest Paid by DRHE to Related Foreign Interest Holder

Example 4 - Reverse Hybrid for One Interest Holder But Not The Other

Example 5 - Recharacterization of Interest to Dividends Can Reduce U.S. Withholding Taxes

Example 6 - Payment to Related Tax-Consolidated Entity

Example 7 - Interest Paid to Unrelated Foreign Bank

Example 8 - Interest Paid to Foreign Bank Pursuant to a Financing Arrangement

Example 9 - Royalty to DRHE & Interest to Foreign Holder

The charts can be found at this link.

There are three ways to access the overall chart collection:

By Topic
Alpha-numeric order
Date uploaded

If you haven't read my previous accolades for Andrew's charts (see here, here, here, here, here, here, and here), take a look. As those who have followed my endorsement of Andrew's tax law visualization efforts know, I and others (e.g.,here) hold them in high regard.

Inadvertently Sharing Tax and Other Confidential Data

The Florida Bar Board of Governors has issued announcement in which it explains that it has asked its Professional Bar Committee to determine if "an ethics opinion or Bar Rule is needed to regulate the mining of metadata from electronic documents" by lawyers. The problem is one that affects not only lawyers, but also other professionals and pretty much every computer user. Although the Florida Professional Bar Committee will focus on a narrow question of what lawyers ought to do and not do when they receive documents filled with metadata, the ramifications of the problem extend far beyond that question.

First, what is metadata? According the to announcement, " metadata is information a word processing or document creation program keeps about the history of that document. This history includes changes, deletions, additions, which persons have accessed the document, and electronic notes that have been attached at various times. Such information is not visible on the screen, but it can be held in the background. And this information usually accompanies the document when it is electronically transmitted."

Here are some examples. Lawyer A prepares an estate tax return, using a spreadsheet to do certain computations not done by the return preparation software. In selecting particular values, the attorney makes certain decisions, and puts notes in the spreadsheet. Eventually the lawyer deletes those notes. A beneficiary sues Lawyer A, convinced that the estate tax was improperly computed, causing a diminution of the estate on account of allegedly overpaid estate taxes. The beneficiary retains Lawyer B. During discovery, the spreadsheet finds its way to Lawyer B. If Lawyer B "mines" the document, he or she will discover the notes that Lawyer A made and seemingly deleted.

Or consider an example from the Florida Bar Board of Governors. Lawyer C worked on a brief which was requested by law firm D for a case on which it was working. While working on the brief, C emailed her client with questions and received an email in reply. The email was attached to the brief as it was being prepared, and then was deleted. When C finished the brief, he offered to fax it, but D asked that it be e-mailed. D then mined the brief for metadata, and discovered a history showing every change that had been made to the document by C, information identifying the other persons, such as paralegals and legal secretaries, who had worked on it, and the content of the email sent by the client.

Or try this one that I shared with students in my Decedents' Estates and Trusts course, though I'm not certain I got the point across. Rest assured that to the best of my knowledge, no one other than myself and perhaps one of my colleagues brings this issue, and similar concerns, to the attention of our students. Lawyer A prepares a will for Client 1. Months later, while working on an estate plan for Client 4, Lawyer A decides that the will drafted for Client 1 is a good place to start. Even if Lawyer A is careful to change ALL the references to Client 1's name and gender-based references, a knowledgeable and curious Client 4 will be able to figure out the content of Client 1's will and the fact that it was used as a template for Client 4's will, unless Lawyer A removes the metadata.

Second, should lawyers who receive a document from another lawyer, a client, another party, or any other person, dig through the metadata in order to discover information that has been deleted? At least one member of the Florida Bar Board of Governors thinks so, calling it unethical and unprofessional. I agree. In many respects, the metadata's appearance in a document on the attorney's computer is not unlike the arrival of a misdirected facsimile on the attorney's facsimile machine. In both instances, the sender would not have sent the information had the sender been more careful and less ignorant.

Third, what should computer users, including attorneys, do to prevent other people from mining metadata? The Florida Bar Board of Governors also asked its Professional Ethics Committee to consider if lawyers have "an affirmative duty to take reasonable precautions to ensure that sensitive metadata is removed from an electronic document before it is transmitted."

There is no one answer, because software exists to mine metadata from documents created in Word, WordPerfect, Powerpoint, Excel, Adobe, and most other formats, and the steps that must be taken are not the same for all document formats.

In Word, Powerpoint, and Excel, users should turn off the Fast Saves feature, which isn't very important anymore because computers now run at fairly rapid speeds. In WordPerfect, turn off the "Save Undo/Redo Items with Document" option, but this will not remove all metadata. There is additional guidance at the Corel knowledge database.

Saving Adobe documents in PDF format removes most metadata, but this renders the document un-editable, so many attorneys are using this format if the recipients have no need to edit the document. But saving a Word document in PDF format doesn't necessarily remove the same data as does saving the file from within Adobe. However, a PDF document can be converted into TXT format, edited, and then converted back into PDF format, though doing so removes much of the formatting that makes PDF attractive. It is possible, though, when saving a file in PDF format from within Adobe Professional to make it impossible to convert the document into TXT format. For additional information, take a look at the National Security Agency's "Redacting with Confidence: How to Safely Publish Sanitized Reports Converted From Word to PDF". I suppose imitating the practices of the NSA should be sufficient for lawyers, other tax professionals, and computer users generally.

There also exist "metadata scrubbers" for certain formats, such as Metadata Assistant, ezClean, and Workshare Protect. I haven't found, though admittedly I haven't invested hours searching for, scrubbers that clean up tax return files generated by TurboTax, TaxCut, and similar programs.

So consider this post the sharing of an alert, and not a prepackaged solution. Attorneys and tax professionals need to study the problem, learn the solutions, establish office policies and procedures, and ensure that their employees understand and follow those rules. If a client is harmed by the release of data, a standard of "known or should have known" will leave no easy escape from liability for those who are not paying attention to this issue.

Thanks to the folks on the ABA-TAX listserv who shared their knowledge with the list's subscribers. After reading the questions and comments, I decided I could be of assistance by bringing these concerns to the attention of a different audience.