Monday, September 03, 2007
There has never been a semester in which more than 10 or 15 minutes have been left for the assignment of income topic, despite the budgeted 50 minutes. What prevents this from becoming a major problem is that the students have dealt with the question of whose income is it and whose deduction is it throughout the course. Early in the course the students are given a problem in which an employer makes a transfer to an employee’s spouse as incentive for the employee to refrain from resigning, and thus early on they come to understand the concept of indirect transfers, the step transaction doctrine, and the principles that income is taxed to the person who earns it and to the person who owns the property that produces it. Of course, underneath those rules lurk all sorts of questions that arise when specific fact patterns are analyzed.
Students also encountered the assignment of income issue when they looked at the deduction of taxes paid by one person with respect to another person’s property and when they focused on the reasons for the existence of the provision taxing the unearned income of certain children at the parents’ marginal rates. They would have learned much more if the chapters in the text addressing the taxation of trusts and business entities were covered, but those matters have always been left to other courses, with the expectation that students would enter them possessing a knowledge and understanding gleaned in the basic course that would serve them well. Ultimately, whether that happens pretty much is in the student’s hands.
The course is not finished. There remains the final examination, the score on which at the moment counts for 2/3 of the course grade, the other 1/3 coming from the dreaded but necessary semester exercises that ultimately earn the respect and even gratitude of most students. Even when the students are finished with the examination, I continue to tend to the course, investing time in the very educational process of grading the examination. And then it’s off to find and learn the next batch of annual changes and to update the course for the next academic year. That process is one I will describe some day, because few people, even my colleagues, grasp the complexity and depth required to update a tax course.
Next: There is no nextin this series, though there are many planned "nexts" for MauledAgain, especially if the list of pending post topics holds up. Hopefully this series of posts about the basic federal tax course have been instructive not only to those who teach basic tax courses but also to the students who enroll in them, to practitioners who hire law graduates who have been in them, and to people who are curious about this particular law school course even though they are not lawyers or law students. There surely are other effective ways to structure a basic federal tax course and to select depth of coverage for its topics, but perhaps my explanation of why I do what I do with the course will give someone an idea or two for their own course. In some ways, this series of blog posts is inspired by the fact that during the upcoming semester two of my colleagues will be joining me in teaching the basic federal tax course when they step in to succeed two colleagues who no longer will be teaching it. I figured that my responses to their articulated and anticipated questions would be of interest to more than just the two of them. And I also figure that there will be more questions.
Friday, August 31, 2007
The basic rule is fairly simple. The amount received must be included in gross income to the extent it provided a tax benefit. In the case of a state income tax, the determination of whether a tax benefit occurs is accomplished by computing what the taxpayer’s taxable income would have been without the refunded tax having been deducted with what the taxpayer’s taxable income was with the refunded tax having been deductted.
There are two aspects of the topic that make a fitting next-to-last topic for the course. First, it requires the students to look again at the computation of taxable income and the big picture that illustrates the overall structure of the federal income tax. Second, it drives home the point made early in the semester and reiterated several times, namely, the tax law is dynamic. Students learn that in order to determine how much of a state income tax refund received in 2006 with respect to a tax paid and deducted in 2005, the preparation of the 2006 return requires a hypothetical reconstruction of the 2005 return, using 2005 law and inflation-adjusted amounts.
Next: So whose income is it?
Wednesday, August 29, 2007
So the students don’t explore what happens when there is debt secured by the property being sold. They don’t learn about the treatment of wrap-around mortgages, in part because of the time shortage and in part because few of them know what they are. They don’t examine dispositions to related parties or the acceleration of the depreciation recapture portion of the gain. They don’t delve into conditional payments. The list of what they don’t study is far longer than the list of what is assigned.
Next: The tax benefit rule
Monday, August 27, 2007
Students are told there are yet other methods of tax accounting but because they are used in relatively narrow situations their definitions and application are ignored. Instead, students are asked to consider issues such as constructive receipt, the “all events” test, and economic performance. The opportunity arises to have them again visit the concept of time value of money, and to consider whether it always makes sense to try postponing income and accelerating deductions. Usually someone in the class picks up on the possibility that the taxpayer will be subject to a much higher or lower rate in the following year, either because of changes in other income and deductions or through legislation.
Of course, all of this is compressed. The scheduled 50 minutes don’t exist, so coverage is limited to what fits into 25 or 30 minutes, at best. This means many of the assigned problems go unexamined.
Next: Installment sales
Friday, August 24, 2007
It would make no sense to discuss this aspect of gain characterization when teaching the gross income from property dispositions topic because at that point in the course few, if any, students have a clue with respect to the depreciation deduction. In contrast, by this point in the semester the students have had several encounters with the recapture concept.
I teach students the “short cut” method rather than the technical statutory method for computing depreciation recapture. Why? Because, yes indeed, there isn’t sufficient time to focus on the statutory construct. At least the students will leave the course with at least some sense of yet another concern that will affect decisions that they and their clients will be making.
Next: It’s time to discuss timing
Wednesday, August 22, 2007
There are all sorts of wrinkles in the provision. Before the gains and losses are compared, a subset of the gains and losses, those involving casualty events, are compared, and the net result is included in the basic comparison only if it is a gain. Special rules bring certain condemnation gains and losses into the picture. Some gains and losses with respect to property that is not business property enter the fray. A variety of gains and losses from certain types of business property are precluded from the computations. Special rules for certain animals exist. Overlaying this entire morass of definitions and exceptions is a recapture rule designed to prevent yet another game that taxpayers play in an attempt to steer gains into one year and losses into another in order to make the “best of both worlds” even better.
Again, pressed for time, the students end up with not much more than a conceptual explanation and one or two simple examples. The special inclusions, the exceptions, and the recapture rule fall by the wayside. Students are encouraged to do the assigned reading and to try solving the problems, but the time pressure problem is not a secret and students know, from the experiences of their predecessors, that they will not be taken as deeply into these topics as they are taken into the other topics. Students who take themselves into the Graduate Tax Program’s course on property dispositions, whether or not matriculated in the program, don’t suffer in the long run but the other students sadly are being shortchanged. What is truly disappointing is that many students are happy that the material is being abridged, when in fact it will disadvantage them when they reach the practice world.
Next: And then there’s that depreciation recapture thing
Sunday, August 19, 2007
Why is the discussion of capital gains delayed until near the end of the course? There are several reasons. First, the characterization issue affects both gains and losses and to delve into the issue when focusing on gross income would be premature. Second, understanding the impact of characterization as a double-edged sword that benefits those with net capital gains and disadvantages those with net capital losses is easier at this point in the semester. Third, some of the elements incorporated into the definitions reflect issues that weren’t covered until later in the course or that are more easily understood at this point.
My goal is to introduce students to the definitions and to illustrate the impact of the special treatment of capital gains and the disadvantageous treatment of capital losses. They need to understand why and how the “make ordinary income look like capital gain” and the “make capital losses look ordinary” games are played. They should understand the whipsaw situation that has given the tax law a variety of cases that treat the same transaction differently depending on whether it generated a gain or loss and which position the IRS took. What I do not try to do is to have the students compute tax liability when a portion of taxable income consists of capital gain. A quick peek at the form or the statute is enough to persuade anyone that putting J.D. law students enrolled in a basic course through that computational nonsense would be counter-productive.
As a practical matter, at this stage of the semester I’m so far behind that this topic receives 15 or 20 rather than the planned 50 minutes of class time. Some of the time savings comes from omitting some problems and taking students through others without asking them to contribute. In other words, with one or two classes remaining, I shift to lecture mode, not by desire but by dint of circumstances.
Next: Gains and losses from transactions involving business property
Thursday, August 16, 2007
The list of policy credits continues to grow at a rapid rate. There now are dozens. Many involve very narrow and specific transactions, and a few affect a significant number of taxpayers. All are structured on an arrangement of definitions, exceptions, computations, and limitations. In theory, if a student needed to learn about a specific credit, he or she should be able to read the provision and parse the language.
Unfortunately, there isn’t any class time available to explore the details of any specific credit. Thus, students are instructed to read several pages in the course text that describe the more important credits in general terms but they are not responsible for learning the details. Although many of the credits would not deserve attention even if time were available, there are several that should get a closer look, such as the earned income tax credit. There are good arguments for covering these credits but there simply isn’t anything that can be removed from the course to “make room.”
Next: Characterization of income and loss
Wednesday, August 15, 2007
The students do sit through illustrations because there are several important concepts that those examples provide. First, by showing how tax liability is computed I introduce students to the concept of progressivity in taxation. Second, by showing the impact of phase-outs I introduce students to the “bubble effect,” which generally causes the effective marginal rate of taxation on high income taxpayers to be less than the effective marginal rate of taxation on middle-income taxpayers, a phenomenon that begins to help those students who have not already done so to figure out where some of my undisguised disdain for the tax system originates. Third, by showing how tax liability differs depending on filing status, I introduce students to the joys and frustrations of the marriage penalty, and, yes, the marriage bonus. I provide the students with an illustration that involves a taxpayer who could easily be one of them in a few years. I show the tax consequences of this person marrying someone with similar income and, alternatively, someone with no or little income. It is one of the priceless moments in the course. Students who did not look at this illustration before class, and perhaps some who did but who didn’t quite figure out what was going on, become visibly shocked or even annoyed when they see how the tax law encourages and discourages different “types” of marriages. My warning early in the semester that tax law is everywhere and affects everything finally is hammered home.
If this wasn’t enough, the discussion then turns to the computation of tax liability for children who have not yet attained the age of 18. Once assured that they will not be required to do the calculations, students settle in for several illustrations of how this needlessly complicated provision operates. As a provision affecting all taxpayers under 18 and all taxpayers with children under 18, it is a provision with broad application. Although software exists that can handle the numbers, the concepts are much easier to comprehend when examples are presented. Those examples also illustrate the many practical problems arising when a theoretical solution was applied to a real concern.
Next: Tax credits
Monday, August 13, 2007
This topic, computation of taxable income, is mostly a one-class examination of how the pieces already studied fit together. To the array of gross income, deductions allowable in computing adjusted gross income, itemized deductions, and the deduction for personal and dependency exemptions are added two phase-outs and a study of the standard deduction.
One phase-out that requires attention is the one applicable to itemized deductions, and the other involves the deduction for personal and dependency deductions. The computation reflects adjusted gross income, which is why they are discussed at this point. Each is computed differently, in ways that appear, and are, arbitrary. When students discover that one of the phase-outs depends in part on how many $2,500 amounts are included in the excess of adjusted gross income over an inflation-adjusted amount dependent on filing status, they roll their eyes. I don’t blame them. Those who have read several of my articles know that I consider the phase-outs not only nonsense but fraudulent deception of taxpayers by manipulative politicians, few of whom remain in office but whose legacy continues to afflict taxpayers and law students. Making things worse is the phase-out of the phase-outs, which itself is scheduled for phase-out in 2011. Finding ways to help students comprehend these complexities without taking them into the depths of a numerical world is a significant challenge, because expressing the concept without using numbers and illustrations is counter-productive. The saving grace is that the students know that I will not ask them to do a tax return or these sorts of computations on the exam or in a semester exercise.
The standard deduction, an alternative to itemized deductions for taxpayers with itemized deductions less than the applicable standard deduction, consists of two elements, both consisting of dollar amounts set forth in the statute and adjusted for inflation. Students have visited inflation adjustments when dealing with some earlier topics so that aspect of the analysis is review. The standard deduction also reflects the taxpayer’s filing status, and that topic is examined briefly because students are not required to learn the niceties of the rules applicable to more complex marital transformations.
It is fitting that when dealing with this topic the students return to a point emphasized very early in the course. They see first-hand that the tax law is dynamic and not static. Two phenomena confuse them, even after I explain it to them. First, the dollar amount for the standard deduction that appears in the regulations does not match what is in the statute or the revenue procedure containing the inflation-adjusted amounts. The explanation is simple. The IRS and Treasury attorneys responsible for updating regulations are so swamped that they leave to the back burner the changes that people should be able to figure out for themselves. Students share my doubts and their facial expressions confirm their disappointment at how tax law administration leaves much to be desired. Second, the regulations interpreting the terms used in the definition of one of the standard deduction components are not found where one would expect to find them. They continue to exist as an interpretation of the personal exemption deduction even though this particular tax break for age and blindness long ago moved from the latter deduction to the standard deduction. Some students bemoan how confusing it is, especially because the situation is preventable. Such are the realities of law practice that I try to share with my students.
Next: With taxable income in hand, let’s compute tax liability
Friday, August 10, 2007
Students do need to learn why adjusted gross income is important. I tell them that a good mental exercise is to review their notes and to identify every instance in which adjusted gross income is a component of the analysis. I mention that it would make a good exam question. Does that qualify as motivation? Students also are told to think back to the beginning of the course, when they first met the overall structure of the taxable income computation and to ask themselves if corporations need to compute adjusted gross income. It’s a review question, I tell them. If they know the answer, I see a smile. If they don’t, I see frowns and sometimes worse.
Next: It’s time to compute taxable income
Wednesday, August 08, 2007
There are two major aspects of the topic. One reflects the definitions and the other is computational. I leave the computation issue, namely, the phase-out of the deduction, to the topic during which the students are taken through problems requiring the computation of taxable income.
The definitions are not, on the surface, particularly challenging. The elements are, for the most part, concepts with which the students are familiar. There are a few surprises, of course. Some students know that the spouse of a spouse’s sibling is not a brother-in-law or sister-in-law. Others learn this for the first time sitting in the tax classroom. The same phenomenon takes place in the decedents’ estates and trusts course that I teach, when some students learn that the spouse of their aunt or uncle is not their aunt or uncle, except under rather uncommon circumstances.
Another element in the definitions, namely, abode, causes special problems for students who are away at school and who otherwise qualify as a dependent. Because this particular issue is significant for most of their families, I let the students work through the analysis. If they learn anything, it’s that mundane decisions about driver licenses, voting registration, and selection of a permanent address to give to school officials end up affecting someone else’s tax return.
And, yes, they read about the disappearance of millions of dependents when taxpayers were required to provide social security numbers for dependents. They look at me, dumbfounded. There was that much cheating? Yes, and it simply has moved to other provisions. They laugh when I tell them that some people have claimed dependency deductions for pets. By this point, they know the outcome. Of course they laugh. Else they’d cry.
Next: It’s time to compute adjusted gross income
Monday, August 06, 2007
What makes this part of the course, and this aspect of the tax law, confounding is the existence of multiple restrictions that apply to clusters of deductions. In some instances a particular deduction may be subject to more than one of these overall deductions. I don’t push J.D. students too far in dealing with how multiple restrictions interact because it simply is too complicated. Even tax practitioners get frustrated at the chaotic nature of the computations that reflect the inability of unwillingness of Congress and the inventors of these limitations to coordinate them in sensible ways.
There are five overall deduction restrictions that I put before the students. These are the at-risk limitations, the so-called hobby loss limits, the limitations on deductions with respect to rental residences and offices in home, the passive loss limits, and the general policy restrictions. Because I can allocate only three 50-minute class sessions to overall deduction restrictions, I limit coverage and I direct the students to teach themselves the policy restriction. I made that decision because the policy restriction does not involve computations, and requires analysis more similar to what they did during their first year of law school than is most of the analysis applicable to other topics in the course.
Coverage of the at-risk limitation includes a very basic introduction to the concept, a streamlined definition of amount at risk, an explanation of why the limitation was enacted and how it failed, the wrinkle that considers taxpayers at risk for their share of nonrecourse debt secured by real estate, and a quick peek at the recapture concept. I assure the students that they are not expected to do at-risk limitation computations.
The hobby loss restrictions are much easier to understand, and therefore I take the students through several examples. I do expect them to understand how the limits are computed, because they are not particularly difficult, though some students struggle with translating the statutory language into application. I cannot resist pointing out to the students the special rules for horse-related activities, just as I do not resist pointing out similar special provisions when I teach the depreciation material. On several occasions, comments to the effect that I hate horses or dislike horse lovers make their way onto evaluations and even into classroom discussion. I always invite students who wish to do so to defend the special treatment of horse-related activities. No student has ever taken up the challenge.
The residence limitations consume at least half of the allocated time because they are important. They affect many taxpayers. Though it is a guess, I tell the students that I’m confident at least half of them, and probably many more, will encounter these limitations in their own lives. Of course, that’s not to say they will be happy with the outcome. Most lawyers, for example, who have home offices are subject to the limitations. Because the IRS continues to adhere to its losing position in Bolton, despite losing every case it has litigated, the time required to teach the computation of deductions allowable in any event allocable to rental activities is twice what it would and should be. This situation provides an opportunity to describe to students the practical realities of taking a return position that is inconsistent with an IRS position but that will almost certainly be approved by a court if the matter is litigated. The intersection of theory and practice is a fascinating boundary to take students through.
Then it gets worse. The students meet the passive loss limitations. A topic that could be made the subject of an entire 2-credit LL.M. (Taxation) course gets squeezed into 30 minutes. To say that the students get just the basics is an understatement. There simply is no time to explore in depth the definition of passive, or the application of the rules to multiple activities. The carryforward rules and those applicable to disposition of a passive activity are left to some other time and place.
At least by this point, students understand why so many taxpayers who do their own returns are frustrated, why tax return preparers have become increasingly disenchanted, why tax software has more errors than there should be, and why my bias against the mess that passes for our income tax system is so difficult for me to hide. True, I don’t make much effort to disguise my evaluation of the tax law. Not surprisingly, few if any students disagree with me. The struggle is the realization that they need to learn so much nonsense because, as I tell them, no matter what I think and no matter what they think, it’s waiting for them when they enter practice.
Next: What do you mean there is no deduction for my dog?
Saturday, August 04, 2007
Once upon a time, in a basic tax course long ago, I used classroom time to explore the first two deductions, the third not having yet been invented. As Congress added more and more provisions to the tax law, as it layered more exceptions and exceptions to exceptions onto the existing provisions, and as it piled more limitations onto the law, something had to be removed. First, it was the moving expense deduction. Ought not second and third year law students, at this point in the semester, be able to read and learn about these deductions without my in-class assistance? Is this not graduate school? My response, to the chagrin of most students, was yes to both questions. A few years later, the same treatment was accorded to medical expense deductions. In this instance, I limited the reading and carved away many of the peripheral issues. When Congress added te higher education expense deduction, my two thoughts were that students must become familiar with it and that there was nothing that could be removed from the course to create classroom time space for the topic.
My concern is that as each year passes, more and more topics will be added to the “learn on your own” list. It’s not that I think law students ought not be required at times to learn something by reading and thinking rather than listening. It’s a sense that over time the number of issues demanding attention will be more than double the number that can be handled adequately and sensibly during 42 50-minute class sessions. Is it any wonder I have no admiration for the Congress when it comes to taxation?
Next: Deduction restrictions
Thursday, August 02, 2007
For J.D. students, I break the topic into two pieces. One is the requirement that there be a gift to a qualified organization. The other is the concept of limitations.
For the first piece, I put to the students a series of questions that encourage them to focus on the concept of gift. Is the transfer of money to the local volunteer fire company a gift or should the payor’s desire for fire-extinguishing services in the event of a blaze negate the deduction? There is a long list of these sorts of questions, and usually student participation picks up. They understand the underlying transaction and they’ve heard about the deduction from family and news sources.
Because there’s no time to get into the qualification issue, I simply tell the students that most of the charities with which they are familiar, such as the American Red Cross and the National Multiple Sclerosis Society, are qualified. I let them know that most schools, including Villanova, religious organizations, and places of worship are qualified. If there is time I give them a two-sentence description of what being a qualified charity requires. The most important point I make is that they must verify the status of the donee organization before claiming a deduction.
The limitations piece gets a few minutes of class time. The 50-percent limitation is described. The other two may or may not be mentioned. The limitations applicable to the donation of inventory, partial interests in property, interests in trusts, conservation easements, and a variety of other restrictions simply must be left for an advanced course. That’s unfortunate, because it appears to me that more and more of our J.D. graduates are getting involved with charitable organizations, either as advisors or participants.
Next: The special deductions for individuals