Tax Charts for Sections 367 and 954(e)

So long as there is a tax law that continues to change, the TaxChartGuy, Andrew Mitchell, will continue to develop and share his tax charts. This time, we are invited to peruse 18 section 367 charts and 6 section 954(e) charts:

Section 367 Examples:
1. Outbound B Reorganization: CFC to Non-CFC (Sec. 367(a) & (b) Overlap)
2. Liquidation into 90% Corporate-Owned Partnership Does Not Qualify under Sec. 332
3. CFC Inbound Section 332 Liquidation With 100% Ownership
4. CFC Inbound Section 332 Liquidation With 100% Ownership
5. CFC Inbound Section 332 Liquidation With 80% Ownership
6. CFC Inbound D Reorganization
7. Lower Tier CFC Inbound Merger
8. Inbound C Reorganization: <10% Shareholder - All E&P Election
9. Inbound C Reorganization: <10% Shareholder - 50K De Minimis Exception
10. Foreign to Foreign C Reorganization: CFC to Non-CFC
11. Foreign to Foreign C Reorganization: CFC to CFC
12. Foreign to Foreign Triangular C Reorganization: Section 367(a) & (b) Overlap
13. Foreign to Foreign Reverse Triangular Merger: Section 367(a) & (b) Overlap
14. Foreign to Foreign Forward Triangular Merger: Acquiror U.S. Controlled
15. Outbound C Reorg Triggers Sec. 1248 Amount Inclusion
16. Foreign to Foreign B Reorganization: Sec. 1248 Amount Inclusion is Not FPHCI
17. Outbound Spin-Off: Gain to "Distributing"
18. Outbound 332 Liquidation: Overall Loss Limitation

Section 954(e) (Foreign Base Company Services) Examples:
1. Installation & Maintenance
2. Substantial Assistance for Oil Well Drilling
3. No Substantial Assistance for Dam Construction
4. Performance Guarantee for Superhighway Construction
5. Contract Assignment for Superhighway Construction
6. Contract Assignment as a Performance Guarantee

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, 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.

Your Confidential Tax and Financial Information for Sale?

Indeed, that could happen unless you are VERY careful. And even if you are careful, you might still fail to avoid such an outcome.

When I saw the news, my first thought was “They must be kidding. This makes no sense.” That’s what passed through my mind when I saw the headline in Tuesday’s Philadelphia Inquirer. The story, titled “IRS plans to allow preparers to sell data,” is as frightening as its lead-in.

There are three particularly upsetting aspects to this story. The first is the idea that a person’s tax data could be sold by his or her tax return preparer. The second is that this change in the tax regulations flew under the radar. The third is that even when I read through the proposed regulations, I did not see anything that specifically referred to the sale of tax data.

The third troubling aspect could be a simple matter of my inability to understand the proposed regulations. I doubt it, though, because I think one reason that the second troubling aspect exists is that very few people picked up on what was going on in these proposed regulations.

Section 301.7216-3 of the proposed regulations addresses "Disclosure or use permitted only with the taxpayer’s consent." Paragraph (d) states:

A tax return preparer may disclose tax return information to third parties as the taxpayer directs so long as the taxpayer provides a consent to disclose tax return information that satisfies the requirements of this paragraph and as prescribed by the Commissioner by revenue procedure.

It takes a bit of contemplation before realizing that this provision indeed permits tax return preparers to sell or give away their customers’ tax data. How many people would read that provision and understand that it what it does? The proposal was published on December 8, it is now mid-March, and this potentially dangerous proposal is only now getting a spotlight trained on it. When the proposed regulations were issued, the IRS announced the news with this headline: IRS Issues Proposed Regulations to Safeguard Taxpayer Information.

But it’s the first upsetting aspect to the story that deserves attention. Can someone explain to me why a tax return preparer needs to sell, or give away, customer tax data? What other incentive or purpose could there be other than money? Note that where there is a legitimate purpose for disclosure, the regulations permit the disclosure, but these are limited instances for which there is a logical explanation. These sorts of disclosures, such as sharing the data with another preparer who assists in doing the return, make sense. Sale of the tax information does not. At least not to me, to a few people who emailed me asking me to comment (which I already had planned to do), and to a few people quoted in the story.

Yet the plan has its defenders. They point to the consent requirement. The problem with using customer consent as the protective device is that many customers will not understand it, some may be asked to sign it without adequate disclosure, many will be caught up in the anxiety and frenetic pace of the preparation process, and I daresay some eager mercenaries will even forge a signature or obtain it under duress.

What are the folks at Treasury and the IRS thinking? Have they not read all the news reports in recent years about the inadvertent and deliberate release of individuals’ information that not only breaches privacy but increases the risk of identity theft? Have they not been following the news stories about identity theft?

What happens to the data once it is purchased by a third party? What’s to prevent that purchaser from selling it abroad, from selling it to criminals disguising themselves as legitimate businesses, from posting it on the Internet, or from using it for other nefarious purposes? Whether the purchaser acts knowingly or is duped, it makes no difference to the taxpayer whose financial and tax life has now been exposed to the world.

Treasury and the IRS refer to the changes as "housekeeping" intended to bring existing regulations into sync with the digital world. That may be true for much of the proposal, but the “consent to sale of tax data” portion ought not be cloaked by the seeming innocuousness of the rest of the proposed regulations. Think again about the misleading nature of the headline: IRS Issues Proposed Regulations to Safeguard Taxpayer Information.

One can imagine taxpayers concerned about the release of their tax and financial data to third parties, not fully understanding the situation, balking at filing tax returns. What the tax protest movement does not need is Treasury and IRS decision making that plays into their hands.

At this point, it would not hurt to send a message to one’s Senators and Representative, asking that Congress enact a statute prohibiting the marketing of tax information. It also would not hurt to understand that the process of publishing regulations in proposed form and allowing a period for public comments is a valuable procedure that reduces the chances of idiotic ideas becoming the law of the land.

There are times I wonder whether the brain cells of Washington decision makers are fully engaged. This is one of those times. It’s not the only time, but that’s for another day.

Special Low Rate = Higher Compliance? No.

Senator Evan Bayh of Indiana has introduced S. 2414, the "Simplification Through Additional Reporting Tax Act of 2006." This START Act of 2006 would require brokers who are otherwise required to file information returns under Code section 6045(a) to include in the Forms 1099 that they prepare some additional information. For each applicable security of a customer the broker must include the customer's adjusted basis in the security. An exception in the proposed legislation would permit the Treasury to waive the requirement if the broker does not have sufficient information to do the basis reporting. An example of such a situation arises when a customer transfers securities to a broker without providing the basis information. In contrast, if the securities are purchased through the broker, the broker should have the basis information. The new reporting rules would apply to tax returns due after 2008, for securities acquired after 2007. Nothing like letting the full impact wait until after elections.

Senators Obama, Carper, Kerry, and Levin are co-sponsoring the bill. The proposal is based on a recommendation made by the National Taxpayer Advocate. I mentioned this suggestion in passing when I reported on the National Taxpayer Advocate's report several weeks ago.

In his comments introducing the bill, Senator Bayh noted that the goal of the proposed legislation is to reduce the estimated $17 billion dollars of annually unreported capital gain income. That estimate is based on the IRS' 2001 estimate of $11 billion, increased in proportion to the increase in reported capital gains transactions. It represents approximately 3 percent of the tax gap, on which I last commented several weeks ago.

Here's what puzzles me. Even with a reduction of the income tax rate on capital gains to the special low 15% rate, there still are taxpayers unwilling to report capital gains. I can ask rhetorically, "how much lower must the rate be before these gains are properly reported?" I think the answer would be silence. If pressed, it would either be a request for a zero rate, or an explanation that the gains won't be reported no matter what is done with the rate.

Prof. Jay Soled of Rutgers-Newark Law School and Prof. Joe Dodge of Florida State School of Law have supported the legislative effort and have helped draft some of its terms. Jay points out:

While Senator Bayh's legislation, which would require mutual funds and brokerage firms to track and identify tax basis, may suffer from some minor blemishes, it is a crucial first step in having taxpayers accurately report the tax basis they have in their investments. Right now, when it comes to tax basis identification, it's the Wild West - where rough guesstimations substitute for accurate reporting. And, given the strength of the current opposition to tax increases, this measure would be one way in which legislation could be passed to decrease the tax gap (and also greatly simply the tax return filing process for those taxpayers who must prepare and submit Schedule Ds).

Jay continues:

Despite our work, the work of Senator Bayh's aides, and the critical contributions of Legislative Counsel and the Joint Committee on Taxation, the mutual fund and brokerage house lobbyists are already vehemently complaining about the (minor) administrative burdens associated with instituting this legislation. In the upcoming months it will be interesting to see who prevails: those of the American people or the well-entrenched lobbyists.

I think Jay makes some important points. I hasten to add: What happens if this bill is enacted and capital gains tax compliance fails to improve? Perhaps withholding income tax on broker transactions equal to five percent of the gross proceeds might be the compliance spark that some taxpayers appear to need.

Thanks to Mike McIntyre for alerting me to the fact that this proposal, which had come to my attention a few months ago when work was being done on the drafting and my input graciously had been solicited, had evolved into bill form. Now we can watch to see what happens. Yes, let's see if the lobbyists or the public interest prevails.

Bar Exam Failures: A Reprise

When I wrote the other day, in posting about the increase in bar examination failure rates, that "California's complex maze of legislation and regulations, almost matching the volume and depth of federal law, must be a contributing factor to its low 44 percent pass rate," I caught the attention of Greg Broiles, a tax attorney in San Jose. Greg shared some information that put the question into a more refined perspective:

The CA bar exam does not meaningfully test California law - a significant number of points needed to pass are from the same MBE taken by more or less every other aspiring attorney in the US, and the remainder of the points come from closed-universe "performance exams" where any needed precedents are supplied; and six essay questions, which are typically not California-specific, certainly not to the point that knowledege of administrative regs is needed.

In my reply to Greg I explained that my understanding of the California bar exam substantive content came from conversations with friends who had taken the examination, and whose experiences had been excellent performance on the multistate portion (MBE) and struggles with the essays because of the focus on California law.

Greg also suggested that the California pass rate takes on a different quality when the scores taken into account are limited to graduates of accredited law schools. Pointing me to the official California bar exam web site, he noted that graduates of accredited law schools typically put up pass rates closer to 70%. I had suspected as much (but hadn't looked at the official statistics), which is why I referred to state-specific examination content as ""a contributing factor" rather than as "the" reason. So I amend ""a contributing factor" to "a minor contributing factor."

Greg then shared an observation that I will quote, with his permission, in its entirety. Why? I told him that I wish I had said it myself. It's most instructive:

Ultimately, my impression is that there are three different bodies of law that one must learn in the transition from law student to practicing attorney - academic law (which puts a lot of emphasis on theory and history), bar exam law (which puts a lot of emphasis on memorization of oversimplified rules/doctrines), and real-world law, which has procedural and practical aspects previously glossed over, as well as tremendous depth within practice areas previously considered too esoteric or evanescent to consider seriously. It is possible for people to learn all three bodies of law, especially if they are willing to forget (or ignore) one in favor of the next; but people who want or need to believe that they can answer bar exam questions with academic law, or real world issues with bar exam questions are doomed to disappointment.

I think every law school should share Greg's observation with every incoming law student. And, by the way, with faculty.

Greg, a true tax lawyer, then added:

For better or for worse, I get the impression that tax may be an area where the disparity between academic law and real world law is comparatively minor - and since there are no tax questions on the multistate (nor on the CA bar exam), it's not necessary for tax practitioners to cope with that third, effectively useless, body of knowledge.

Ah, Greg, guess what? Tax is on the Pennsylvania bar exam. Fortunately, the bar examiners keep it restrained to basic concepts. Questions at the level of those principles that seem to have escaped the memories of some attorneys, including (gasp!) tax attorneys, as I noted earlier today.

Inventing Tax Deductions

One of my favorite aspects of tax filing season is that it generates all sorts of "new" deductions, such as the one for personal grooming, so that I have things to write about in this blog. OK, so I'm being a wee bit facetious. Seriously, what is it about tax filing season that makes people desperate for deductions? Sorry, still being sarcastic.

Here's another example. Someone I know asked about a taxpayer whose spouse is a physician. The physician has days on which he is on-call. A tax attorney told the physician that the costs of commuting to the hospital on days he is on-call are deductible. After hearing this seemingly great news, the physician's spouse decided to run it past me.

Perhaps to everyone's surprise, my response contained very few words of my own:

From Fillerup v. Commissioner, T.C. Memo 1988-103:

It is well established that a taxpayer's cost of commuting between his residence and his place of employment is a nondeductible personal expense. Sections 1.162-2(e),1.262-1(b)(5), Income Tax Regs.; see, e.g., Fausner v. Commissioner, 413 U.S. 838, 839 (1973); Commissioner v. Flowers, 326 U.S. 465, 473 (1946); McCabe v. Commissioner, 688 F.2d 102 (2d Cir. 1982), affg. 76 T.C. 876 (1981). This rule precludes the deduction by a physician of the cost of commuting to and from his residence when traveling to his medical office, a hospital or any other location integral to his business, even when the physician is required to travel from his residence on emergency calls. Sheldon v. Commissioner, 50 T.C. 24 (1968); Sapp v. Commissioner, 36 T.C. 852 (1961), affd. per curiam 309 F.2d 143 (5th Cir. 1962).

From Sheldon:

Amounts incurred in traveling to and from one's residence and regular place of employment are commuting expenses which are personal in nature and therefore not deductible as business expenses. Sec. 1.162-2(e), Income Tax Regs.; sec. 1.262-1(b)(5), Income Tax Regs.; and William L. Heuer, Jr., 32 T.C. 947, 951 (1959), affirmed per curiam 283 F. 2d 865 (C.A. 5, 1960), and the cases cited therein. Here the petitioner's automobile trips were between her home and her only place of employment. Her home was not used as an office and [**7] the hospital did not permit her to maintain an outside medical practice. Although the hospital allowed her to remain at home while on duty during weekdays because of her long hours, petitioner's decision to do so was purely for personal, not business, reasons. The sole concern of the hospital was that she be available on short notice; and it did not care whether she was at the hospital, her home or somewhere else when an emergency arose as long as she could be reached immediately.

In substance, the instant case is similar to Lenke Marot, 36 T.C. 238 (1961), where we rejected a claim by an electrocardiograph operator who was on 24-hour call and who sought to deduct expenses of getting to work from wherever she happened to be when called. Here, too, trips made by petitioner at night and on weekends when she was on call, whether for
scheduled operations or emergencies, do not qualify as ordinary and necessary business expenses.

In response came this observation:

I have to say, it is amazing to me how many people there are out there, who are "tax professionals" (like this attorney * * * ), but give the wrong advice. I understand that the tax law is complicated, but still, I think a little research never hurts.

Or, as I rejoined, research is good and so is having some knowledge of basic tax principles. The person also noted that an attorney had claimed that the cost of suits worn to work in a law office are deductible as an ordinary business expense. Hello? Are these attorneys taking the basic federal income tax course while in law school? Are they being taught basic principles of section 262? Are they paying attention? Are they "learning for the exam" and then dumping what they learned out of their memories? I believe in "learning for life" and not for an examination. I confess I don't remember all the twists and curls of the complex topics in the courses I took while in school and which covered areas to which I pay little attention, but I do remember the basic stuff. Why? Because it mattered to me, not for an examination, but because I have a relentless curiosity about so many things, including law, the primary area to which I devote professional efforts.

I think law is getting to be like medicine in this respect: It makes sense to get a second, and even a third, opinion. Even on the seemingly simple stuff.

Failing the Bar Exam: A Bad Thing?

A National Law Journal story reports that "Bar Exam Failures Are on the Rise." As a member of a law school faculty, I pay close attention to the question, because it is disappointing to learn that students who have graduated from the law school have failed the bar. According to the story, the national pass rate has fallen from 70 percent in 1995 to 65 percent in 2000, and to 64 percent in 2004. Perhaps it's not enough to be a trend, but it certainly warrants attention. Another perspective makes the situation more alarming. Despite an increase of only 6.4 percent between 1995 and 2004 in the number of people sitting for bar exams, there has been a 28 percent increase in the number of people who have failed. The situation is downright scary when one considers the reported suicide threats made by graduates who have failed the bar one or more times, the reports of nervous breakdowns, the conclusions that attending law school was a mistake,

The bar pass rate varies from state to state. In some states, the bar exam is more difficult than average. In other states, it is less challenging. That's not so much a matter of whim on the part of the examiners, but a reflection of the complexity of a state's law. California's complex maze of legislation and regulations, almost matching the volume and depth of federal law, must be a contributing factor to its low 44 percent pass rate.

The consequences of failing are severe. Jobs are on the line. When I was hired by the Chief Counsel to the Internal Revenue Service, I was told I had 14 months in which to pass a bar examination. At best, I would have had three tries. The National Law Journal reports that many employers are giving new hires only two tries, and if the graduate doesn't pass on the second try, he or she is shown the door. Considering the levels of debt carried by some graduates, this is more than a mere inconvenience.

Why is the percentage of failing scores increasing? Sometimes it's simply a bad day. I recall a very bright, accomplished graduate who failed the bar exam, to the surprise of everyone. When her story became known, it made sense. She and her husband attended law school at the same time. They had two young children. One became ill the night before the first day of the bar exam. Guess who stayed up with the baby? There's absolutely nothing that can be done about those sorts of situations. Fortunately, they're not too prevalent. But that means the explanation lies elsewhere.

Is it simply a matter of bar examiners raising the score required to pass? Is it caused by the switch from being required to score above a certain level for the exam as a whole to being required to score above a certain level on each part of the exam? The latter is more difficult to do, because it prevents a very high score on one part of the exam from offsetting low performance on another part. Perhaps this is a reason. But perhaps by raising the passing grade the bar examiners are making a statement about the need to reduced the number of ill-prepared lawyers hanging up their shingle and seeking clients.

Is the lower passing percentage caused by an increase in the number of students graduating from unaccredited law schools? During the past decade, several law schools have opened, and traditionally, new law schools attract students who can't get admitted to existing schools but who are willing to take the chance that the new law school will earn accreditation before they graduate. If this is the reason, surely statistics showing the pass rates for graduates of these schools would provide proof. The statistics do show that graduates of unaccredited law schools don't do as well on the bar exam as do graduates of accredited law schools, but it does not appear that removing all graduates of unaccredited law schools from the statistics would reverse the downward trend in the overall national pass rate.

There are some commentators who think that the reason bar pass rates are dropping is a deficiency in legal education. The fact that some law schools have added credit-earning bar review courses into their curricula is telling. But it ought not be necessary if the existing curriculum is properly taught and students are held to the appropriate performance standards.

My analysis is simple. Law schools are not holding students' feet to the fire when it comes to performance. Inflated grades send a message of inflated accomplishment. Students need to be held to the standards to which they will be held in practice. Can this be done?

Students get a taste of what practice (and the bar exam) demands when they are challenged in the same manner. Students claim that I am a very demanding teacher. I agree. Why am I that way? Because, as I tell my students, their employers, their clients, and the judges in front of whom they appear will be even more demanding. If students do the work that is required, they succeed. If they ignore their responsibilities, their grades will fall.

Fortunately, at least at this law school, there is a plan to assist students whose grades are low even in a grade-inflated environment. An excellent academic support program has been established. When students avail themselves of its services, they improve. The principal obstacle is that it is not possible to compel a student to accept the assistance or to follow the advice that is given.

There is no substitute for hard work. Students who "got by" with minimum effort in high school and college, even earning high grades, discover that law school is much more challenging, even if the faculty is less demanding than faculties were several decades ago. I tell my students that they are in graduate school, matriculated in a doctoral program, and preparing to enter professional practice. What is expected of them exceeds what was expected in college, by at least an order of magnitude. Some get the message. Some don't.

When the envelope arrives from the bar examiners, every recipient gets the message. But then, unfortunately, for some of them, it's too late. That is why I think it is better to dish out the bad news, namely, low grades, earlier in the process, if those low grades are deserved. Then, perhaps, more students will take advantage of academic support programs and take steps to change their study patterns and the priority to which they give their academic responsibilities.

So, aside from good students who have bad days, I'm not ready to lament increasing bar exam failure rates or to put blame on bar examiners. The clients-to-be of law school graduates in training deserve the best.

Phishing for a Tax Refund

It looks so inviting. To the untrained eye and uninformed mind, that is. What is it? It's one of those messages designed to appeal to human greed, sent by someone thoroughly bereft of integrity, fair play, and respect for law. Here's what it says:

After the last annual calculations of your fiscal activity we have determined that you are eligible to receive a tax refund of $63.80. Please submit the tax refund request and allow us 6-9 days in order to process it.

A refund can be delayed for a variety of reasons. For example submitting invalid records or applying after the deadline.

To access the form for your tax refund, please click here

Regards,
Internal Revenue Service

To someone not familiar with how the IRS operates and not attuned to the antics of phishers, this message, wrapped in imitation graphics and thus looking "official," surely will lure some people into its trap. Even if only one-half of one percent of the recipients falls for the deception, that's one-half of one percent of tens of millions of people. Under those circumstances, or any circumstances, that's one-half of one percent too much.

A person who knows how the IRS operates knows that it does not send these sorts of emails. A person who has the good sense to refer all tax correspondence to their tax advisor hopefully has retained a tax advisor who knows that this email is fraudulent. A person who does not know if the IRS sends these sorts of emails but who understands what phishing involves would look more closely, search the Internet for information and warnings on the specific message, and avoid problems. Someone with some fair amount of understanding with respect to sentence structure, grammar, and vocabulary would recognize the content of the email as something even a raw bureaucrat probably would not write.

Unfortunately, not everyone knows to do these things. Not everyone knows how to protect themselves. Not every tax advisor is up-to-speed with tax practice in the twenty-first century, which includes the ability to spot the digital version of con games.

What's particularly galling is that the criminals behind this particular scam are messing with tax. They have a history of impersonating banks, credit card companies, life insurance companies, utilities, hospitals, and just about every other sort of organization. Their chances aren't quite as high with those entities because not everyone banks at Bank X or buys water from Water Company Y. But almost everyone deals with the IRS. And at this time of the year, people are focused on taxes, distressed by taxes, worried about taxes, and eager to get good tax news. In step the criminals.

So what to do?

The first thing to do is to spread the word. Educate the public. Pass along the URL to this posting. Tell your friends and family to ignore this message that is NOT from the IRS.

The second thing to do is to improve the ability of people generally to spot and ignore these phishing attempts. It's popular to point the finger at software companies or some other "other" and expect them to protect people or design something that does so. Ultimately, though, the best protection is for each of us to be informed, educated, and alert.

The third thing to do is to act in ways consistent with the devaluation of human greed. Too many phishers and other digital crime perpetrators find their efforts easier to pursue and more likely to succeed because greedy people make easy marks.

This time, we can't blame the educational system, because phishing didn't exist when most people were in school. Yet for those now in school, it makes sense for them to have instruction in the recognition of digital fraud schemes, just as they presumably get instructions on rejecting offers of candy from strangers. Hmm. In some ways, the fraudulent IRS refund impersonation scheme isn't all that different from the offering of candy to someone the schemer hopes is gullible.

But what about all the people no longer in school? Some would propose huge government programs to deal with the problem. Others would suggest some sort of tax deduction or tax credit for doing things to prevent or avoid falling for the fraud. Nonsense. This situation is a wonderful example of how people can help themselves and each other. Simply spread the word, and put pressure on prosecutors to find and bring charges against the perpetrators.

Lest anyone fall for the "we can't find them" excuse, rest assured that most of these digital con artists can be found. The question is whether government is willing to invest time and money to do so. That issue involves a broader policy question of how the government should allocate resources devoted to protecting its citizens. Even though at least some of the perpetrators are physically beyond the United States, there is no reason that this nation does not have in place treaties that impose on the host nation an obligation to arrest, prosecute, and even hand over to the United States those of its citizens who are engaged in attempts to commit crimes in the United States against United States citizens. For all we know, the process of identifying and prosecuting phishing perpetrators, including those operating in foreign territory, would yield benefits in the planning and implementation of procedures to identify and neutralize the efforts of other criminals to perform other sorts of digital crimes, such as hacking, taking over computer systems, and bringing down the Internet.

Perhaps to get this started, each person who receives these Fake IRS Refund Phishing Scams (FIRPS?) should forward it, with the question, "Is this REALLY a fake as alleged by Jim Maule?" to their federal Senator and Representative, state governor, and state legislators. I wonder how long it would take legislatures to act, to direct executive branch officials to step up enforcement efforts, and to stiffen the penalties that courts can and should impose on those convicted of engaging in these scams.

Digital Security Practices for Tax Practitioners

Sometimes tax practitioners can learn from the experiences of people working in other industries who handle client financial information. Sometimes what appears to be good news for someone is more valuable as a warning than as a sigh of relief.

Last month, a federal district court in Minnesota dismissed with prejudice a complaint brought by a student loan borrower against a student loan servicing company. in Guin v. Brazos Higher Education Service Corporation, Inc., Civ. No. 05-668 (RHK/JSM) (D. Minn. 7 Feb 2006), the borrower sued after receiving notice from the company that the borrower's personal financial information might have been on a laptop computer stolen from the home of one of the company's employees. As I read the case, I kept thinking, "This could be about the theft of a laptop from the home of a tax practitioner's employee, an accounting firm's employee, or a law firm's employee." Thus, it is important to review the facts before exploring the court's reasoning and decision.

The loan servicing company, Brazos Higher Education Service Corporation, originates and services student loans. Among its 300-plus employees was a fellow named John Wright, who did financial analysis, principally analyzing loan portfolios, including the purchase of loans from other lenders and selling bonds financed by student loan interest payments. He worked out of his home, receiving financial data by electronic transmission from Brazos' finance department in Texas. Some of Wright's work requires him to have loan information such as the borrower's financial information. During a September 24, 2004, burglary at Wright’s home, the laptop on which he did his work was taken. Even though police were notified, neither the perpetrator(s) nor the laptop could be found. A private firm hired by Brazos also was unsuccessful in its efforts to recover the laptop.

Federal Trade Commission (FTC) guidelines regulating the student loan service industry recommend that when "deciding if notification [to customers of an identity theft threat] is warranted, [a company should] consider the nature of the compromise, the type of information taken, the likelihood of misuse, and the potential damage arising from misuse." California has a rule that requires such notification rather than leaving the decision to the discretion of the company.

Accordingly, Brazos tried to identify the borrower information that would have been on the hard drive of the stolen laptop and whether the thief or some other person could access it. Brazos determined that Wright had received seven data downloads before the laptop was stolen, but Wright did not track which databases were saved to the hard drive and which were not. Brazos concluded that it could not identify the borrowers whose data was on the laptop, so it sent a letter to all of its roughly 550,000 customers. The letter explained that "some personal information associated with your student loan, including your name, address, social security number and loan balance, may have been inappropriately accessed by the third party." and recommended borrowers put "a free 90-day security alert" on their credit bureau files and review consumer assistance materials published by the FTC. Brazos also set up a call center to answer borrowers' questions and to track reports of identity theft.

The plaintiff, Stacy Guin, who had taken out a student loan through Brazos several years earlier, received a copy of the letter. Guin contacted the Brazos call center to ask followup questions, and ordered and reviewed copies of his credit reports from the three credit agencies listed in the letter. Guin did not find any indication that a third party had accessed his personal information and, as of the time of the court's decision, had not experienced any identity theft or any other type of fraud involving his personal information. Brazos informed the court that to the best of its knowledge, none of its borrowers had experienced identify theft or other problems because of the laptop theft.

Guin sued Brazos, resting his case on three claims, breach of contract, breach of fiduciary duty, and negligence. Subsequently, Guin voluntarily dismissed his breach of contract and breach of fiduciary duty claims. Guin brought the negligence claim on behalf of "all other Brazos customers whose confidential information was inappropriately accessed by a third party."

Guin alleged that "[Brazos] owe[d] him a duty to secure [his] private personal information and not put it in peril of loss, theft, or tampering,” and that "[Brazos’s] delegation or release of [Guin’s] personal information to others over whom it lacked adequate control, supervision or authority was a result of [Brazos’s] negligence . . . ." Guin asserted that this conduct caused Guin to suffer "out-of-pocket loss, emotional distress, fear and anxiety, consequential and incidental damages."

After reviewing Minnesota law, which requires the plaintiff in a negligence action to prove the existence of a duty of care, a breach of that duty, an injury, and that the breach of the duty was the proximate cause of the injury, the court considered Brazos' response. Brazos argued that it did not breach any duty owed to Guin, that Guin did not sustain an injury, and that Guin could not establish proximate cause.

With respect to breach of duty, the court explained that the duty can be established by the traditional reasonable person of ordinary prudence standard or by statute. Guin's argument that the Gramm-Leach-Bliley Act (GLB Act), establishes a statutory-based duty for Brazos "to protect the security and confidentiality of customers’ nonpublic personal information" was rejected. The court pointed out that the GLB Act requires financial institutions to "[d]evelop, implement, and maintain a comprehensive written information security program that is written in one or more readily accessible parts and contains administrative, technical, and physical safeguards that are appropriate to your size and complexity, the nature and scope of your activities, and the sensitivity of any customer information at issue; [i]dentify reasonably foreseeable internal and external risks to the security, confidentiality, and integrity of customer information that could result in the unauthorized disclosure, misuse, alteration, destruction or other compromise of such information, and assess the sufficiency of any safeguards in place to control these risks; and [d]esign and implement information safeguards to control the risks you identify through risk assessment, and regularly test or otherwise monitor the effectiveness of the safeguards’ key controls, systems, and procedures. Guin's contention that Brazos violated the GLB Act by "providing Wright with [personal information] that he did not need for the task at hand," by "permitting Wright to continue keeping [personal information] in an unattended, insecure personal residence," and by "allowing Wright to keep [personal information] on his laptop unencrypted." was countered by Brazos with an assertion that Guin did not have sufficient evidence to prove Brazos breached a duty by violating the GLB Act. The court noted that nothing in the GLB Act addresses the FTC routine warning to businesses to provide secure data transmission through encryption, and that FTC regulations do not address, let alone require, encryption of data stored on a hard drive. The court concluded that at the time of the theft Brazos did have in place "written security policies, current risk assessment reports, and proper safeguards for its customers’ personal information as required by the GLB Act." Wright's access to the data, according to the court, was within the scope of the business duties that he had. Nothing in the GLB Act, according to the court, prohibits "someone from working with sensitive data on a laptop computer in a home office." Failure to encrypt the data, according to the court, does not violate the GLB Act.

Guin also argued that Brazos failed to comply with the self-imposed reasonable duty of care in its privacy policy, namely, that Brazos will “restrict access to nonpublic personal information to authorized persons who need to know such information.” Brazos conceded that under this policy, it owed Guin a duty of reasonable care, but argued that it acted with reasonable care in handling Guin’s personal information. The court concluded that because Brazos had policies in place, trained Wright about those policies, and followed those policies when transmitting data to Wright, it had complied with the policies. The court treated Wright's inability to foresee and deter the burglary and loss of the laptop as not a breach of duty.

With respect to injury, the court explained that "The threat of future harm, not yet realized, will not satisfy the damage requirement." Guin's assertion that he had been injured by identity theft was rejected because he could not prove anyone had stolen his identity. The court relied on an Arizona case (Stollenwerk v. Tri-West Healthcare Alliance, No. Civ. 03-0185, 2005 WL 2465906 (D. Ariz. Sept. 6, 2005). in which customers sued a corporation after computer hard drives containing customer financial information were stolen from the corporation's office. Testimony of an expert, who claimed that the plaintiffs' injury was "“an increased risk of experiencing identity fraud for the next seven years" was rejected because the expert did not quantify any increase in risk of identity theft because of the burglary. Guin had a similar expert's affidavit to offer, but the court treated it as similarly flawed.

With respect to causation, the court held that Guin could not show proximate cause because "the criminal act of a third party is 'an intervening efficient cause sufficient to break the chain of causation,' provided that the criminal act was not foreseeable and there was no special relationship between the parties." This question should go to a jury only if there is a reasonable difference of opinion, which the court decided did not exist. Even though Guin argued that leaving information unencrypted on a hard drive increases the risk that the information would be stolen, and even though Guin claimed that thefts of laptops and hard drives are occurring more frequently during an era of escalating identity theft problems, the court concluded that the theft of the laptop from Wright's home was not reasonably foreseeable by Brazos. According to the court, the facts that Wright lived in a relatively low-crime neighborhood, was unaware of any previous burglaries in his immediate neighborhood, and took reasonable precautions to secure his home made inapplicable the principle that high crime and a history of similar offenses can establish foreseeability.

So what does this have to do with tax practitioners, accountants, and law firms? Simple. These professionals maintain client information on their computer systems. Although they are not subject to the GLB Act, negligence can be proven in other ways if that information falls into the wrong hands. Even though the court analyzed all three defenses raised by Brazos, what made the case easy was the fact that Guin had not suffered identity theft. But Guin's good fortune in this respect is no assurance that a tax practitioner's client will similarly escape after his or her information is stolen or otherwise obtained from the tax practitioner's office.

It is not unreasonable to disagree with the court's analysis of the foreseeability and causation issues. Thefts of computers and digital information is common-place. Identity theft is an epidemic. Thieves who in pre-digital days could not be bothered with removing file cabinets of paper know that in a digital world a piece of equipment one-ten-thousandth the size of a file cabinet can hold thousands of file cabinets's worth of very valuable information.

Although some might read Guin, coupled with the inapplicability of the GLB Act to lawyers, as a comforting protection of tax practitioners against lawsuits brought by clients whose information is stolen, I read it as a word of warning. Guin illustrates the need for tax practitioners to understand what digital information is, how it is stored, how it can be accessed, why encryption is no less important than locking the office door, and why employees must not only be taught but required to follow data protection practices. It's not only theft of laptops from the practitioner's office or the employee's home that poses the risk. It's the data inadvertently sent in an email. It's the information hidden in a word processing or other file, as I discussed a little more than a month ago. It's the bad habit of leaving passwords written on post-it notes stuck onto the computer monitor. It's the employee who walks away from his or her desk without blocking access by logging out or locking the system. It's the lack of supervision of outsiders who enter into work areas. It pretty much is the failure to bring digital security experts in to analyze the operation, recommend a plan, and establish employee training programs for present and future use.

There are data protection failure cases waiting in the wings. Guin does not preclude a finding of liability in any of those cases if identity theft does occur. Do you want your client to be the named plaintiff in the case that proves Guin is not a blanket dispensation of tax practitioners from the ill effects of data protection mismanagement? I surely hope not.

Closing the Federal Tax Gap

Last month National Taxpayer Advocate Nina Olson presented a written statement addressing the federal tax gap. Considering that the tax gap, after taking into account IRS efforts to chase down unreported and unpaid taxes, is somewhere between $250 to $300 billion, the explanations and solutions provided by the report deserve careful attention. When the Taxpayer Advocate points out that an average of $2,000 per year is paid by compliant taxpayers to offset the tax gap, everyone should be listening. At least, I am.

The tax gap fascinates me and frustrates me. I discussed it several months ago when the data for 2003 was released. That data, computed from different sources, and two years more recent that what Nina Olson used, makes my fascination and frustration even sharper. I'm both fascinated and frustrated by the willingness of people to avoid their legal responsibilities. Of course, that fascination and frustration is not limited to tax avoidance devotees but also the behavior of those who violate a variety of rules and regulations.

I also visited the tax gap almost a year ago when the data used in Nina Olson's report was released. As I re-read my two posts I started to think that I had landed in a deja vu world, or perhaps a parallel universe. And that's without getting into a visit to the same topic about TWO years ago. If I were a magazine I might need to start publishing "The Annual Tax Gap Issue." Somehow I doubt it would get the attention Sports Illustrated gets with its "not quite on topic" annual issue.

Nina Olson's report points out that when taxable transactions are properly reported to the IRS, the rate of tax collection exceeds 90 percent, but when payments are not reported compliance drops to a range of 20 to 68 percent, depending on the type of transaction. Sometimes reporting does not occur because people are noncompliant. Sometimes reporting does not occur because it is not required. Though it may be a surprise to many, not all taxable transactions must be reported to the IRS. Olson estimates that about one-third of the tax gap arises from unreported transactions. What accounts for the rest of the tax gap? Olson doesn't get into this, but I would offer candidates such as improperly claimed deductions and credits, reported but unpaid tax liabilities, impermissible tax shelters, and similar devices that move transactions out of the reportable category.

Olson recommends expanding the list of transactions that must be reported. This is the sort of suggestion that makes one wonder why it wasn't done decades ago. The answer is easy. As Olson points out, tax revenues would climb if every taxable transaction was subject to reporting requirements. That, however, would be an onerous burden. Olson suggests that the nation could not tolerate reporting every payment to a cab driver, every payment to a lawn mowing neighborhood teen, and every payment to an independent contractor who comes to the home to make a repair.

I add that compliance is enhanced when withholding takes place, because withholding shifts the tax payment and not just information to the Treasury. A tale from the past explains why resistance to additional reporting requirements is likely to be no less strenuous as it was when additional withholding requirements were imposed. Some years ago, when the Congress enacted a law requiring banks and corporations to report interest and dividend payments, there was a huge outcry from banks and corporations, even though data processing made such reporting far easier than it would be for taxi riders to report their payments. Congress backed down after banks included flyers in their monthly statement mailings, accusing the IRS of enacting a new tax. The f word on this one for me wasn't frustrated or fascinated; it was furious. After all, compliance with respect to the reporting by RECIPIENTS of dividends and interests was, and to a great extent, still is, significantly less than compliance with respect to wages; in other words, mere reporting by the payor did not guarantee reporting by the payee though in recent years IRS computer matching has been digging out the recalcitrant taxpayers. Eventually, a "compromise" was adopted that installed a system of backup withholding, triggered with respect to specific taxpayers after they were identified as noncompliant. When filling out a form that asks, "Has the IRS notified you that you are subject to backup withholding?" is the noncompliant taxpayer likely to switch gears and be honest when answering?

Olson's report does not identify all of the candidates for admission to the reporting club. It suggests a process of studying each type of transaction to determine whether reporting for those types of transactions would be cost-beneficial. It provides, though, some examples, such as extending the reporting requirements applicable to payments to sole proprietors to payments to certain corporations. I ask, why not all corporations? The report also refers to the proposal to require brokers and dealers to report their customers' bases in stocks and other financial instruments.

An interesting idea floated in the report is encouraging taxpayers to schedule monthly estimated tax payments through automatic debits to their checking accounts. That idea flows from another one, quarterly reminders mailed by the IRS to taxpayers subject to estimated tax filing. Putting tax paying for self-employed individuals on a path similar to that applicable to employed individuals makes sense. My reaction to this proposal is "why not?" but my instinct is that it would not do much to bring the deliberately noncompliant into the fold. At best, it would reduce the risk that a taxpayer who made insufficient estimated tax payments and finds herself in a cash flow bind would try to escape the consequences by contributing to the tax gap.

The report proposes that the IRS be permitted to enter into voluntary withholding agreements under section 3402(p)(3) with industries or trades that have established payor-payee mechanisms, such as the travel industry, and hair stylists. The IRS, it is suggested, could provide safe-harbor worker classification if such an agreement is reached. The report suggests that self-employed individuals who establish a track record of noncompliance be compelled to have taxes withdrawn by automatic debit. My question is simply, "What about the noncompliant individuals who do not use banks?" Overall, this is the sort of process I figured already would have been in place. Backup withholding, even as enacted in the "compromise" that let corporations and banks off the withholding hook, is itself too limited.

The report recommends regulation of tax return preparers who are not subject to oversight under existing licensing of attorneys, CPAs, and enrolled agents. The report suggests that these unenrolled preparers be required to register, take a basic examination on substance and ethics, and participate in ongoing education. How, though, will the IRS identify the least compliant of these preparers if they are not signing the returns? The report admits that "The IRS does not know how many unenrolled return preparers are actively preparing returns for a fee in the United States." But it's worth a try, as much as I dislike government regulation. What I would like to see are tax courses in the nation's high schools and technical schools so that taxpayers are more likely to spot inept preparers (and more likely to demand tax reform).

Olson's report suggests that the IRS use more data from state and local governments. It appears that the IRS has access to this information but is using "very few" of the available resources. Why? Does it really require action by Congress to make this happen? No, but there is other information, such as gross receipts filings, that the IRS presently does not access, and perhaps the assistance or approval of Congress is required to open up these information exchanges. I say exchanges because state and local governments surely will seek data from the IRS for their efforts to increase compliance. Surely there are state and local tax gaps.

Finally, the report points out a need to research the reasons for noncompliance. Identifying approaches to reducing the tax gap would be enhanced if the reasons were understood. I'll get this started by sharing what I wrote several months ago:

One must wonder what motivates noncompliance. Perhaps some psychologists will conduct surveys to determine if it simply greed, or a growing rebellion in which people are "voting with their feet" by appropriating unto themselves their own special tax break that they cannot get through the Congress because they lack the clout of the lobbyists who have managed to reduce the tax on capital gains to extremely low levels. How much of the noncompliance is simple ignorance, stupidity, carelessness, or confusion? How much of the gap arises from people trying to hide information about the activities generating the income?

I provided one possible reason almost a year ago:

Most complexity in the tax law arises from the insane flurry of legislation enacted during the past 15 years that reflects the "I'm special" (or "my project is special") bleatings of the lobbyists and their clients. The "it would be nice/just/fair/smart/wise/sensible/good/ to create this special rule" argument too often is "it would be expedient to enact this special rule because it gets us votes" politics. Taxpayers know this, and thus feel justified in creating for themselves
the equivalent of the exception for which they did not have the money or connections to get for themselves directly.

Thus, I think that noncompliance increases in direct correlation to the extent taxpayers perceive the tax law as unfair. The more disproportionate a tax law's complexity is to the complexity of the context in which the law applies, the more unfairness will be perceived by more taxpayers.

And I agree, the answer is not simply a matter of changing the type of tax. It's a matter of changing the mentality that spawns the tax law.

I'm a tax teacher. I'm supposed to have the ability to change people's tax mentalities. I'm working on it.

I'm still working on it. Here's hoping that Nina Olson's report inspires more people to find themselves working on it.

The Dependency Exemption Deduction Issue That Won't Die

But perhaps it can be put to rest.

Two weeks ago I followed up on my previous analysis of the National Association of Enrolled Agents' letter in which it presented and analyzed several hypotheticals illustrating problems with the new rules concerning the dependency exemption deduction,
with a reformulation of my thoughts about one of the NAEA hypotheticals.

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 concluded that Alice is the qualifying child of Mom and Dad, because (1) she is their child, (2) she has the same principal place of abode as they do, (3) she is under 19, and (4) she does not provide more than half of her own support. I also concluded that Alice is the qualifying child of Joe because (1) she is his sibling, (2) she has the same principal place of abode as he does, (3) she is under 19, and (4) she does not provide more than half of her own support. Because a person can be claimed as a dependent by only one taxpayer, the question is whether Mom and Dad can choose to omit Alice from their return, letting Joe take the deduction. I had initially applied the tie-breaking rule in the Code that would have made Alice the dependent of her parents. The NAEA interpreted the phrase "and is claimed" in section 152(c)(4)(A) as permitting Mom and Dad to stay out of the tie-breaker, letting Joe win by default. After pondering the NAEA position and analyzing analogous situations in the tax law, I concluded that:

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.

But now news from the IRS, in the form of Volunteer Quality Alert 2006-04 – Guidance for Determining a Qualifying Child, Qualifying Relative, and Qualifying Person (March 2, 2006), the IRS makes it clear that the tie-breaking rules won't apply unless Alice is claimed on both the joint return of Mom and Dad and the return filed by Joe:

Sometimes a child meets the tests to be a qualifying child of more than one person. However, only one person can treat the child as a qualifying child. If the taxpayers have the same qualifying child, they may decide among themselves who will claim the child. If they cannot agree, and more than one taxpayer files a return using the same child, the IRS will use the tie-breaker rules...

Thus, as I explained in the reformulation post:

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.

And to my question "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?" the IRS has said, "Yes."

However, to my question "Why the difference?" which I asked after contrasting the rule that prohibits parental failure to claim an otherwise allowable dependency exemption for a child from letting that child claim a full personal exemption, the IRS gave no answer. How could it? How could it possible divine the presumed intent of a Congress that said nothing to reveal the inner workings of the minds of those drafting the provision. Of course, "Why the difference?" is a question of greater concern for the policy maker than for the tax return preparer trying to provide the best service to his or her clients.

It is just downright disappointing that something as simple as the dependency exemption deduction can be so confusing and trigger so much commentary. No wonder when the tax world turns to things such as partnership taxation or subpart F that the complexity becomes agonizing. The patient is screaming in pain, and Dr. Congress thinks a little more morphine is the cure.

Personal Grooming Expense Deduction? Dream On

If March roars in like a lion, which it did here, surely tax season debuts each year with the usual scavenger hunt for deductions. This year is no different. What is particularly annoying is that with the tax law so complicated, no one benefits when erroneous information further complicates taxpayer attempts to comply and tax return preparer attempts to be of service to their client. I confess to being easily annoyed when bad tax advice makes the rounds. The latest entry, or should I say re-entry, into the find-a-deduction sweepstakes is the "personal grooming expense deduction."

The February 2006 issue of "Costco Connection" has a tax-savings article in which the author, Howard Scott, in a paragraph headed "Seek out other expenses" writes: "Do you incur personal grooming expenses because image is important?" [To get to the page, after clicking on the URL, click on "Smart Tax Tips" at the bottom left, and then click on "15 Tax Talk" on the right-hand side.] My thanks to Greg Stewart of Spokane, Washington, for bringing this to the attention of the ABA-TAX listserve's subscribers.

There is no such deduction. There is a long list of cases denying deductions for personal grooming, no matter the connection it might have to the conduct of a trade or business. For example, in Thomas v. Comr., T.C. Memo 1981-348, the Tax Court wrote: "Whether or not petitioner was required as a condition to her employment to be neatly coiffed, the expenses she incurred for this purpose are inherently personal in nature and cannot be considered as business expenses."

Technically, Scott has done nothing more than to ask a question. But considering that it follows a list of other questions, all focusing on deductions that would be available if the answer is yes, the inference is that a "yes" to the question would trigger a deduction. The inference surely is intended, considering the litany of items covered by the list of questions. After all, if the intent simply is to get taxpayers thinking about anything, why not ask questions such as "Do you have a pet dog?" or "Did you go to the movies?" Answering "yes" to these questions would not generate a valid tax deduction.

Is it fair to suggest that the question claims a personal grooming expense deduction exists? In light of other advice in the article. yes. Scott explains that even if a taxpayer has an accountant, the taxpayer knows his or her business better than the accountant does. In most cases, that's true. Scott then writes that the accountant might be "conservative." Perhaps. I'm sure he means conservative in the cautious and not political sense. Being conservative, Scott concludes, "often translates into a reluctance to implement new stratagies." So does this mean claiming a deduction for personal grooming expenses is simply a new strategy? I don't think so. Claiming impermissible deductions is a strategy almost as old as the income tax law. Refraining from doing so is not my definition of conservative. It's my definition of sensible, law-abiding, and prudent.

It may appear that I'm "picking on" Howard Scott. That's not what I'm trying to do. I didn't seek him out. He put his article into the public spotlight, and many taxpayers have read or will read it. All I want to do is to alert people to two simple things. First, there is no deduction for personal grooming expenses. Second, beware of what you read about taxes and rely only on advice from people whose tax-advice-giving reputations you can and do trust. Before relying on advice from Scott, I'd want to know more about him.

One place to start is the Costco article. Someone pointed out an error in the article which I did not notice when I looked for the reference to personal grooming expenses. In another paragraph, discussing the benefits of hiring one's children, Scott uses $4,850 as the amount below which the children can use a standard deduction to shelter income from taxation. For 2005, however, the amount is $5,000. It's too late, however, to hire one's children for 2005. That year is past. So in giving advice for 2006, the amount to use would be $5,150.

Standing alone, the use of the wrong amount would generally be nothing more than an error. All tax practitioners make errors, though most are caught before damage is done. When an article contains an error, advice to push one's "conservative" accountant into new stratagies, and a suggestion that personal grooming expenses are deductible, red flags begin to flutter. The odds that the suggestion of a personal grooming expense deduction is the consequence of an editor's change unreviewed by the author fade to zero under these circumstances.

Following up on someone else's research, I looked around, and here is what has been found. The Costco article describes Scott as a "longtime writer and tax preparer specializing in small businesses" and explains he "has published more than 1,700 magazine articles and three books." Among those 1,700 articles must be the one appearing in Pizza Today and the two-paragraph "Avoiding an Audit" advice in Remodeling Online. According to this report, Scott not only is a free-lance writer and tax consultant, he also is a beekeeper.

Why have I invested my time in this story? Because umpteen million Costco customers will read the article. Tax practitioners are bracing themselves for clients arriving with a copy of the Costco article, along with grooming expense receipts, ready to argue that Costco's expert says that a deduction is available. No sooner had someone wondered aloud if people would take Scott's advice to heart than someone else answered affirmatively. A client arrived with a copy of the Costco article and announced she should be allowed to deduct the cost of her pedicures. Why? She often wears sandals and her toes need to look nice. The client's job? She sells carpets. Turned out the client was sufficiently informed about taxes and after a few minutes, let on that she was rattling her tax practitioner's cage. Most clients are not so savvy. Several years ago, another subscriber reported, clients asked about the "$5,000 vacation deduction." I wonder where that idea originated. Wherever it did, like the new ones that are popping up, they need to be discredited before innocent taxpayers get into trouble relying on them.

But for every client with some understanding of basic tax law, there are a dozen who grab onto the idea of a tax-savings deduction with the grip of a drowning person reaching for the life preserver. Add in the vanishing breed of people who do their own returns, some of whom surely will take the grooming expense question's intended inference to its logical conclusion, and there's real reason to worry about the impact of bad tax advice in an age when bad advice can circle the globe in minutes.

Speaking of circling the globe, there is a place where personal grooming expenses can be deducted. Where? In Australia, as explained on H&R Block's Tax Tips for Australian taxpayers. The Australian deduction, by the way, is permitted if it is "incidental" and "relevant to the taxpayer's occupation." So, want a deduction for personal grooming deductions that enhance your image? Move to Australia.

And here's hoping no one gets stung by claiming a deduction for personal grooming expenses.

ReadyReturn Not a Ready Answer

During the 2005 tax filing season, the California Franchise Tax Board (FTB) administered a pilot program for a project called ReadyReturn. A group of taxpayers was invited to join the pilot program. Under the pilot program, the FTB prepared the taxpayer's return, and then gave the taxpayer the opportunity to verify the information, make any necessary changes, and sign and submit the return. According to the FTB report, approximately 50,000 taxpayers were invited to join the pilot program, of whom nearly 9,400 filed the return prepared by the FTB (5,600 by e-file and 3,800 using traditional paper). The ReadyReturn site provides slightly higher numbers: 11,620 participants (5,610 by e-file and 6,010 by paper).

The FTB prepares the taxpayer's return by "using wage and withholding information that is already reported to the state by employers." Accordingly, the taxpayers invited to participate were those "who file the most simple returns."

FTB surveys of the participants revealed that almost all of them considered ReadyReturn easy to understand, almost all of them concluded they saved time using ReadyReturn, and more than 90% also concluded it was more convenient than how they filed the previous year. Roughly 80% reported that ReadyReturn made them "feel less anxious about filing their tax returns." The survey also discovered that 99% of the participants were “Very Satisfied” or “Satisfied” with ReadyReturn, roughly 97% would use it again, and about 90% thought ReadyReturn was a service that the government should provide. Only 5% indicated they believed their personal information was not secure with ReadyReturn. Many of the taxpayers invited to participate who chose not to do so turned down the opportunity because they had already filed their return, though others expressed doubt about the security of using the Internet, were not comfortable receiving a pre-filled-in return, or preferred a non-government e-filing company. The FTB reported that ReadyReturns were less likely to fall out of processing because of errors, that ReadyReturn users were less likely to receive error notices, and that ReadyReturn introduced "thousands" of paper filers to e-filing, with more than half of the ReadyReturn participants who used e-filing having used paper filing for the previous year.

Based on these results, the FTB requested that the program be fully implemented. However, it would be limited to taxpayers who are single, have no dependents, claim the standard deduction, and have income derived solely from wages.

The project, however, is not without its critics. For example, the National Taxpayers Union (NTU) produced an issue brief, California's ReadyReturn Program: Fool's Gold in the Golden State, in which it pointed out numerous concerns. First, the NTU wondered why the FTB should "get into the tax return preparation business," considering that there are more than adequate numbers of tax return preparers available. Second, the FTB provides a free e-file service, which should mitigate concerns about private industry charging taxpayers for that service. Third, there is no guarantee that the FTB would make fewer computational mistakes than other preparers. Fourth, the FTB is unlikely to "scour the tax code for ways to reduce the filer's prepared tax liability." Fifth, changes in the taxpayer's status could change eligibility, posing the risk that taxpayers would not understand the need to switch to a private preparer. Sixth, there is a cost in generating FTB-prepared returns that end up in the trash because the taxpayer became ineligible to participate or otherwise chose to pass up the chance. Seventh, ReadyReturn makes it less likely that taxpayers will understand how much of their income is being withheld or otherwise paid in taxes because they will not look at the return or have a preparer explain it. Eighth, some taxpayers may see ReadyReturn as a new approach to increasing tax collections. Ninth, the service would not be free because its costs are borne by taxpayers generally. Ninth, ReadyReturn could lead to FTB offering bookkeeping services or estimated tax computation advice, and, at the very least, would justify requests by the FTB for more employees and more funding. Concerns from other critics echo these arguments.

The California State Senate Republican caucus has prepared a briefing report on ReadyReturn that devotes far more space to objections than to the advantages touted by its supporters. The Howard Jarvis Taxpayers Association released a commentary in which it called ReadyReturn a "prime example of California's long line of information technology boondoggles," claimed that "[i]n addition to the conflict of interest in having the tax collector also serve as the tax preparer, the program presents a myriad of accountability problems, and suggested "ReadyReturn should be returned to sender with a cancellation notice."

The project also has its supporters. Joe Bankman, a member of the law faculty at Stanford, explains in "Simple Filing for Average Citizens: The California ReadyReturn" that ReadyReturn offers a solution to the trials and tribulations of fling tax returns. He rejects the arguments made by its critics, and rues the effectiveness of those lobbying on behalf of the tax return preparation industry. He concludes with a call for consideration of a similar program at the federal level. A lobbyists for the California Tax Reform Association explained that ReadyReturn was good for taxpayer privacy because taxpayers would "know what kind of information is there. It's simple and straightforward and demystifies the process of filing taxes."

Five months ago, I concluded that ReadyReturn wasn't ready for prime time. In my analysis I weighed the arguments in favor of its use against the arguments that it is not the answer to the problems it purports to ameliorate. Recently, as the FTB's request for full implementation came under attack in the California legislative process, the debate resurfaced. New arguments have been advanced, principally to paint ReadyReturn as a program to save low-income taxpayers from fee-paying and sometimes predatory tax return preparers. After considering these new arguments, my conclusion remains unchanged.

ReadyReturn has been hailed as a "move in the right direction" to deal with increasingly complex provisions that directly affect taxpayers least likely to have the ability to handle them, such as the additional wrinkles added to the earned income tax credit (EITC) by the legislation providing tax incentives for recovery from Hurricanes Katrina, Rita, and Wilma. The concern is that even more low-income taxpayers will be driven to use fee-charging preparers because volunteer preparers cannot compete with the likes of H&R Block. Aside from the fact that California's ReadyReturn cannot do anything for people in the Gulf Coast region filing 2005 federal income tax returns, justifying the implementation of government-prepared tax returns by pointing to government-generated complexity is a bootstrap argument. All that would be accomplished is to make more and more low-income taxpayers wards of the state when it comes to tax compliance. The notion that these taxpayers will review the return "proposed" by a government is impractical. Low-income taxpayers would either accept the government proposal, even if it was incorrect, or go to a fee-charging preparer for help in deciding whether to accept it.

ReadyReturn has been defended because the only "realistic alternative to ReadyReturn is commercial tax return preparation services, which have a vested interest in complexity." Yet ReadyReturn would cement the complexity, because by sheltering taxpayers from its impact, it removes an incentive for taxpayers to press for genuine simplification. What better way to guarantee complexity than to make taxpayers think it doesn't exist because taxpaying has allegedly been "demystified" by letting the government decide what the taxpayer should pay? Simplicity in the form of marching in lockstep to government-dictated tax returns is a dangerously misleading attribute of ReadyReturn, and the theoretical proposition that taxpayers can reject the government's proposed return flies in the face of reality. Low-income taxpayers already are at the mercy of the government, and ought not think they are being befriended by an entity that by law is not set up to be the low-income taxpayer advocate. Consider, for example, the difficulties faced by low-income individuals when dealing with government-controlled child support and custody matters. Incidentally, almost every tax return preparer with whom I communicate abhors the complexity that has turned the tax law into an impenetrable mess. The suggestion, as has been made, that tax return preparers might have been involved in creating the absurd complexities of the hurricane relief EITC, ignores the fact that most complexity arises either from special interests seeking to hide a narrowly focused tax benefit or from theoretical solutions proposed by folks with little or no practical experience in dealing with taxes. Tax return preparers are busy enough and coping with more tax nonsense than they wish than to have encouraged the addition of more mazes into the tax law.

Ready return has been described as a good idea being plowed under by the tax return preparation lobby. That lobby is perceived as inimical to a free market, and as joining forces to conspire against the public. Yet, all things considered, tax return preparers and tax return preparation software don't carry prices that smack of monopolistic or conspiratorial
behavior. Consumer choice when it comes to finding a tax return preparer is orders of magnitude broader than when it comes, for example, to choosing a computer operating system. There is genuine competition among preparers and tax return software developers. The problem with applying market analysis is that it presupposes the government should be a player in the market. How, then, can a government protect the market when it's playing in it? Unless there is a reason for the government to monopolize a market (e.g., national defense), it ought to stay out of it.

ReadyReturn has been characterized as a move toward simplicity on the premise that a government employee has a vested interest in simplicity because it means less work. I disagree. I translate a desire for less work into a temptation to cut corners. And we know whose corner will be cut when that happens. Most government employees have a sense of "protect the revenue" built into their mind set by their training. The folks programming the computer aren't working in algorithms to determine if the taxpayer is claiming the correct number of dependents. Although the FTB request for full implementation would not include taxpayers with dependents, legislators who support the project want to expand it so that it does. All that the FTB could do is to list the dependents claimed on the previous year's return, because it does not have access to information about support, living in the abode, etc. But I wonder if its need for that information would open the door to government collection of even more information about every aspect of the taxpayer's life that affects taxes. Trust me, most things in life affect tax liability.

ReadyReturn has also been characterized as a program that would eliminate the business incentive of tax return preparers to understate tax liability in order to generate refunds, especially if being compensated with a percentage of the refund. Tax return preparer misconduct is not a situation running out of control; in contrast, at least one study has found that a "clear majority" comply with the highest tax return preparation ethical standards. That is not surprising, because there are in place sufficient incentives for tax return preparers to be honest. Penalties, prison, professional disbarment, and similar adverse consequences face the unscrupulous preparer. The problem is that the government has a miserable track record enforcing existing penalties against unethical preparers. Perhaps the FTB could stop trying to play tax return preparer and funnel some resources into helping law enforcement police the tax return preparation industry. Making the government the tax return preparer for low-income, and eventually middle-income taxpayers, on account of the misdeeds of the small number of preparers who act illegally is overkill. One question not asked by the FTB was, "Who do you trust more, the revenue department or your tax return preparer?" Somewhere in here I have visions of people being treated by government doctors, having their tax returns prepared by government employees, having their music censored by government bureaucrats, having their hair length set by government barbers, and so on. The words, "I'm from the government and I'm here to help you, uh, take over your life, because, after all, there are some not very nice people out there doing bad things preparing tax returns,." ought to send chills down the spine of every citizen. ReadyReturn increases dependency on government. That simply is dangerous.

Ready Return has been defended as protection against tax return preparers who advance refunds to low-income taxpayers at a very high rate of interest. Isn't usury illegal? Ought it not be? Ought not our government schools teach people not to borrow money at a high rate of interest and to report such transactions to the appropriate law-enforcement agencies? And if we are to worry about protecting taxpayers as consumers, why should revenue departments be presumed any better at protecting their customers (taxpayers) than are businesses in the private sector subject to all sorts of constraints and requirements designed to ensure consumer protection? It is rather ironic that ReadyReturn would be defended as protection against high-interest loans when governments think nothing of paying zero interest on overwithheld taxes that are refunded months after they've been collected. Casting government tax return preparation as the taxpayer's friend in setting appropriate interest rates makes little sense.

ReadyReturn has been hailed as a remedy for the difficulties faced by taxpayers when the preparer is "long-gone when the IRS asks for more information" or disallows a credit or deduction fraudulently obtained by an unscrupulous tax return preparer, because ReadyReturn provides the low-income taxpayer with more information with which to evaluate the analysis of their returns. Yet aren't these taxpayers perceived as needing the assistance of a ReadyReturn program because they cannot read, cannot deal with numbers, and cannot understand taxes? How are they going to do anything with the information supposedly provided by the FTB? How could the FTB possibly have more information than the taxpayer has? Users of ReadyReturn are put in the position of having a tax return prepared by the government that is presumed to be correct, and the burden of fixing an error is shifted to the taxpayer.

ReadyReturn has been described as a cost-savings rejection of "outsourcing" tax return preparation to the private sector, because it takes overhead and profit out of the cost of return preparation. The notion that there are no overhead costs to government programs makes no sense to me. Surely, ReadyReturn and the staff running it use electricity, water, and health plan benefits.

ReadyReturn removes third-party protection from taxpayer-revenue department relationships. Will one branch of the FTB audit the work of another branch? Isn't there a conflict of interest when the auditor is preparing the return to be audited? Absolutely. Has not a lesson been learned from Enron about the importance of independence? Apparently not.

ReadyReturn masks the problem. As I concluded in my October commentary on ReadyReturn, the solution to complexity is genuine simplification. To achieve that goal, complexity must be revealed for the economic and social drag that it is. The legislative addiction to special interests, of which complexity is a major symptom, requires withdrawal. Withdrawal needs to be discomforting. Enablers of complexity need to be identified, and should not be permitted to cushion the consequences of addiction that lull its victims into a false sense of security. Low-income taxpayers have no incentive to learn why the tax law has become such an agony to taxpayers unless they experience some of that agony. Sheltering low-income taxpayers, and eventually the middle class taxpayers the FTB and ReadyReturn proponents want to bring into the project, dampens criticism of the tax system, weakens the tax reform movement, and trims the number of citizens considering the tax law to be a problem.

Yet the advocates of ReadyReturn have a noble purpose. I think they genuinely want to help low-income taxpayers. I think some of them, at least, genuinely think that ReadyReturn is the answer. They mean well, and they have done society a service by bringing much needed attention to the dangers posed to society by tax complexity and to the aggravations afflicting taxpayers when they try to comply with those laws. Yet when reading reports that the taxpayers using ReadyReturn are happy, I wonder how much of that happiness is blissful ignorance? An informed and educated citizenry is essential to a democracy, and so long as the tax law is as it is, keeping citizens insulated from the reality merely guarantees perpetuation of the mess.
The urge to protect low-income taxpayers is not unlike the urge to protect one's child from falling off the bicycle while learning to ride. In the long run, the child must be allowed to fall.

I, too, deplore the increase in the need for paid preparers. The answer, though, is to make independent tax return preparation services available to all taxpayers who cannot afford those services, at least until the true need for tax preparation assistance is removed.

After arguing on a listserve that "The goal of helping low-income taxpayers can be achieved in less risky, more informative, and more effective ways," I was challenged to elaborate, and that if I've "got something better to offer," I should show my hand. Fair enough.

If there is going to be the expenditure of government funds to assist low-income taxpayers comply with the tax law, I'd rather see government pay the bill, thus keeping the third-party intermediary in the picture and thus keeping government honest and unconflicted. My experience with most (not all) state revenue department officials (and some IRS employees) is that they do not have the training or mind-set to prepare tax returns for low-income and middle class taxpayers as an advocate of the taxpayer. Paying the bill for independent preparers to do the job would keep the spotlight on the national disgrace (and threat to economic survival) that the tax law has become over the past three decades.

Therefore, the money and resources being expended by the State of California to program, design, implement, and operate ReadyReturn should be used to finance a "tax return preparation credit" to be claimed by low-income taxpayers (however defined) who pay tax return preparers to prepare their return (and perhaps by those who prepare their own returns though that raises a gross income issue). In this manner, the tax return is prepared by someone or some entity outside of government, which makes it less risky because it puts a second set (or maybe even the only set) of knowledgeable eyes on the return (assuming the low-income taxpayer isn't knowledgeable and assuming, as I do, that the government employees
programming, designing, implementing, and operating the program are insufficiently knowledgeable about the specific tax situation of each taxpayer to know what is best for the taxpayer and in at least some instances are not up to speed on the law). This approach is more informative because it lets low-income taxpayers remain aware of the complexity imposed on them by state legislatures and revenue departments (and if implemented at the federal level, by the Congress and the IRS). This approach is more effective because it would generate fewer situations in which the taxpayer return shows a tax liability higher than (or refundable credit lower than) what an independent tax return preparer would generate. The credit could be disallowed to taxpayers who use a state-funded volunteer tax return preparation service, such as VITA programs that do state returns.

Francine Lipman of Chapman University School of Law considered the tax return preparation credit in her article, "The Working Poor are Paying for Government Benefits: Fixing the Hole in the Anti-Poverty Purse." She rejected the idea because she concluded it "would encourage rather than discourage the use of paid tax preparers with more even benefits being shifted away from working poor families and their communities to paid tax preparers." So stated, that seems true, but from a different perspective the question is whether the FTB should use tax revenue to pay its employees to prepare returns or transfer those dollars to low-income taxpayers so that they can hire independent tax return preparers to prepare their returns. So viewed, the credit removes the conflict of interest, preserves taxpayer choice in selecting a preparer, and decreases the risk that the FTB prepared return would be accepted blindly by taxpayers.

I have as much faith in things working out well for individual taxpayers under any sort of "we'll take over, thank you, sit back and relax" government-run program as I do in things working out for the folks trying to make sense of the Medicare mess. In both instances people theoretically can get third-party assistance, but if they cannot afford it, they don't get it. That's why I prefer the credit. If it means more tax return preparers get more business, that's simply another symptom of the tax complexity mess. The solution is to fix the problem, and not put a leaky band-aid on a symptom.

Will Congress Rescue the Definition of Qualified Child?

During the past two months I have described some of the issues arising from a careful reading of the definition of qualifying child enacted by the Working Families Tax Relief Act of 2004. The original post, reflecting a step-sibling hypothetical I had crafted for my basic tax class, was followed by a discussion of other problems identified by the National Association of Enrolled Agents and an elaboration of one particular NAEA hypothetical with respect to which I backtracked and conceded that even where I had tried to define away the problem there indeed was one.

Frank Degen of the NAEA has alerted me to the fact that in the Treasury Department's "Blue Book" for the proposed 2007 federal budget, there is a proposal to deal with the qualifying child definition problem. After setting forth existing law, and then pretty much using the existing hypotheticals to explain why corrective action is required, the Blue Book describes the specific changes under consideration:

The proposal clarifies the definition of a qualifying child and who is eligible to claim these children.

Definition of Qualifying Child. The proposal would stipulate that a taxpayer is not a qualifying child of another individual if the taxpayer is older than that individual. However, an individual could be a qualifying child of a younger sibling if that individual is permanently and totally disabled. In addition, an individual who is married and files a joint return (unless that return is filed only as a claim for a refund) would not be considered a qualifying child for the child-related tax benefits, including the child tax credit.

Eligibility of Taxpayer for Child-Related Tax Benefits. If a parent resides with his or her child for over half the year, only the parent would be eligible to claim the child as a qualifying child. However, the parent could waive the child-related tax benefits to another member of the household who has higher AGI and is otherwise eligible for the child tax benefits. In addition, dependent filers would not be eligible for child-related tax benefits.

The proposal would be effective for tax years beginning after December 31, 2006.

Four quick comments:

1. I haven't yet examined the proposal to determine if it resolves all of the problems.

2. I note that the changes are more than clarifying, because they add some wrinkles that don't exist in the law as enacted by the Working Families Tax Relief Act of 2004.

3. The proposed effective date pretty much makes the legislation non-binding for taxable years before 2007. Where does that leave people who are struggling to figure out the correct answer? They can treat the legislation as guidance on existing law. Perhaps they can be favored with an IRS ruling or announcement that interprets existing law in a manner consistent with the proposed legislation.

4. Perhaps the proposal will be enacted. Perhaps it will not. Perhaps it will be enacted in altered form, making reliance on it (see #3 above) somewhat of a gamble.