Wednesday, December 19, 2012

User Fees: When Users Should Pay 

In some areas of this country, the words “beach tag” can spark intense discussions and even arguments. For some people, the thought of being charged to use a beach is as repugnant as the thought of being charged to breathe. For others, the idea of requiring people to pay for the maintenance, repair, and security of what they are using makes all the sense in the world.

Last year, in Free, Freedom, Fees, and Taxes, I commented on a proposal by the town of Wildwood, New Jersey, to cut more than half of its police force and some of its firefighters because of budget shortfalls, even though Wildwood remained one of the few towns in New Jersey that did not charge a beach tag fee. During the summer, the population of the town increases from 5,000 to 300,000, and yet the opponents of beach tag fees somehow think that the 295,000 should enjoy themselves while letting the 5,000 bear the burden of the cost of maintaining the beaches, and providing security, rest rooms, clean-up, and other services. Though the anti-tax crowd often points to the inequity of asking a few to pay for the many, in this instance the anti-tax crowd asks for the few to pay for the many. Why? Because it has nothing to do with consistent and coherent tax policy, and everything to do with where people live. For the most part, the 295,000 visitors don’t want to pay beach tag fees.

Last June, in Limiting User Fee Use: Beach Tag Fees, I criticized the opposite situation, one in which towns were collecting more revenue from beach tag fees than was necessary to maintain the beaches and using the surplus to offset local taxes. In this situation, figuratively speaking, the 295,000 were being asked to pay for benefits accorded the 5,000.

Now, comes another story about beach tags. This time, two New Jersey legislators, one from each side of the aisle, are co-sponsoring a bill that requires elimination of beach tag fees by any town that accepts state or federal aid to rebuild its beaches. One of them claimed that a beach fee is just “another word for tax.” His argument is that if federal and state tax revenues are used to rebuild the beaches, it is unfair to charge him to use the beach because he has already paid for it. The absurdity of his argument is easily in this parallel proposition: “I bought my house for cash. It is unfair to make me pay for electricity and water for my house because I’ve already paid for the house.” Beach fees deal with annual operating costs of a beach. Disaster relief payments from the state and federal governments are capital investments, in contrast to annual expenses.

One of the legislators proposing the beach tag fee repeal defended the idea with a typical theoretical gloss that lacks practical sensibility. He explained that beach towns could be more efficient, pointing out that these towns have a police chief, an administrator, and a public works director. So what’s his idea? That one person do all three jobs? Perhaps he thinks that the 8-hour workday should be replaced by a 24-hour workday? Even aside from the fact that these individuals often work 16-hour days, especially in the summer, his comment indicates a total lack of understanding of what these people do and why few people would be qualified to do all three jobs.

The mayor of one beach town explained that if beach fees were eliminated, there would be less money for lifeguards and beach clean-up. So, those brilliant legislators ought to consider that if they succeed, they will be permitted free access to a filthy beach with no lifeguards. You get what you pay for.

The mayor of another beach town pointed out an interesting twist in the situation. Its agreement with the Army Corps of Engineers is that if the dunes were damaged, they would be replaced at no charge to the town. This mayor expressed a belief that the proposed legislation would not apply. I have a hunch that the legislators would take the opposite position.

As the mayor of yet another beach town explained, if beach fees are eliminated, the cost of maintaining the beaches will fall on the town’s taxpayers. If the federal and state governments want to pay for lifeguards, rest rooms, beach clean-up, and the other services provided by beach tag revenues, elimination of beach fees could be justified. Yet taxpayers who do not use the beach understandably would object. It’s one thing to use general taxes to repair dunes to preserve barrier islands that in turn protect the mainland, benefitting those who live there no matter whether they use the beach or not. It’s another thing to eliminate beach fees on the pretext that general funds were used to restore the capital, because it leaves the beach towns without revenue to pay for annual operating costs.

Monday, December 17, 2012

Go Ahead, Cut Taxes 

A little more than a year ago, in Infrastructure, Tolls, Barns, Jackasses, and Carpenters, I explained why the anti-tax and anti-toll forces have it all wrong. I pointed out that without taxes or tolls, highways would become, at best, rutted gravel roads. Five years ago, in Funding the Infrastructure: When Free Isn't Free, I pointed out that failure to repair and replace infrastructure will cause an economic collapse far worse than the supposed economic misery falsely offered by the anti-tax and anti-toll forces as the outcome of undoing the tax policy foolishness of the Bush tax cuts.

Last Friday came news that the Southeastern Pennsylvania Transportation Authority (SEPTA), a government agency that oversees public transit in the greater Philadelphia area, will close the bridge that carries Norristown High-Speed Line trains over the Schuylkill River. The reason is simple. The wooden ties on the bridge are rotted. The steel spikes holding the rails are coming loose. It is rusting. Its concrete piers are cracking. About the only good news is that SEPTA has had the sense to figure out there is a problem and to close the bridge before anyone is killed or injured, unlike what has happened in the past, continues to happen, and will happen with increasing frequency as the price society pays for the self-centeredness of the anti-tax crowd comes due.

It gets worse. The underfunded SEPTA expects more bridges and other infrastructure to be shut down, for the same reason. To get an idea of how bad the problem is, consider that the cost of fixing the bridge in question is $30 million. SEPTA estimates that it needs $5 billion to eliminate the backlog in infrastructure repair. That’s a lot of bridges and other things that will shut down if politicians fail to exercise their fiduciary responsibilities in a mature manner. Last year, the Congress blocked the Administration’s plan to infuse money into infrastructure repair, which, by the way, would create more jobs than have been created by the tax cuts that were guaranteed to create jobs.

It gets worse than worse. So how will SEPTA deal with its customers who need to cross the river, if there is no bridge? It will unload passengers from the trains, put them on busses, and drive the busses across the river. Three things will happen. First, passengers will waste time because of the longer commute, which in turn hurts the economy. Second, at least some, perhaps many, of those passengers will abandon public transportation and take to their vehicles, putting more stress on the highway infrastructure, and increasing commuting times for others, which in turn hurts the economy. Third, the busses that SEPTA adds to the highway bridge traffic also will have the same effect.

My prediction is that the anti-tax forces will rise up and yell for their favorite solution, the usurpation of government functions by their private sector heroes. The private sector does two things when it takes over government. First, it factors in a profit for themselves that government does not seek. Second, it uses bullying techniques to cut wages and drive the middle-class public servants into the ranks of the impoverished. Focused on the short-term instant profit effect, and oblivious to the long-term detriment to the economy, the private sector can engage in these tactics because it is immune from the ballot box. I have previously explained this problem in posts such as How Do Toll Road Lessees Make a Profit?, Are Private Tolls More Efficient Than Public Tolls?, More on Private Toll Roads, and When Privatization Fails: Yet Another Example.

One must wonder whether the attempt to shrink government by denying it the revenues necessary for it to do its job is part of a larger plan to privatize government and return society to the days of nobility and peasants, in which government was nothing more than the whim of the king and his elites. Perhaps they think that as the bridges close and collapse, the highways fall apart, the public education system continues to deteriorate, and the quality of life for all but the elites continues to decline, that frustrated and unhappy people will voluntarily dance to the tune of the privatized pied piper. Perhaps their confidence in their piper’s siren song is well-placed. Perhaps not. But if the people’s representatives in legislative bodies throughout the nation don’t step up and do what needs to be done, the consequences of collapsing infrastructure is not going to be pretty.

Friday, December 14, 2012

When a Tax Argument is Nonsense, Why Not Say So? 

The first-time homebuyer credit has again been litigated. Three weeks ago, in When the IRC Defines a Term, It Trumps Other Definitions, I explored a case in which the Tax Court rejected the taxpayer’s argument that the definition of a term found in the Internal Revenue Code should be set aside in favor of a definition from another federal agency. Proving that taxpayers will do almost anything to grab a social-policy tax credit, the taxpayers in the most recent first-time homebuyer credit case, Morales v. Comr. T.C. Memo. 2012-341, raised a rather bewildering argument.

On April 27, 2006, the taxpayers sold their principal residence. The title company filed a Form 1099-S, Proceeds from Real Estate Transactions, with the IRS. On March 17, 2009, the taxpayers purchased a property on which there were two separate houses. Each of the taxpayers moved into one of the houses and used it as his or her separate personal residence. Each taxpayer filed a 2008 income tax return, and each claimed an $8,000 first-time homebuyer credit.

The Tax Court easily determined that the taxpayers were not entitled to the credit. One of the requirements for a taxpayer to claim the credit is that the taxpayer must not have had a present ownership interest in a principal residence during the 3-year period ending on the date of the principal residence for which the credit is sought. The petitioners purchased the new principal residences on March 17, 2009, which meant that if they owned a present interest in a principal residence at any time between March 18, 2006 and March 17, 2009, they did not qualify for the credit. The taxpayers owned a principal residence from March 18, 2006 through April 27, 2006, and thus they were not entitled to the credit.

The taxpayers argued, however, that the IRS was estopped from asserting that they were not entitled to the credit because “an ordinary examination of the relevant tax documents,” presumably the Form 1099-S, would have indicated that the taxpayers did not qualify for the credit. The Court rejected the argument for two reasons. First, it would place an undue burden on the IRS. Second, it would undermine the effective administration of the tax laws. I would add a third reason. The argument is total nonsense. Examination of the Form 1099-S, together with the 2008 return, would indicate to the IRS that the taxpayers were not entitled to the credit. It is quite probable that the IRS did examine that form, and that’s how the taxpayers’ return was pulled for an audit. The taxpayers’ idea that if the IRS can determine there is an error on a return from looking at the relevant tax documents it is estopped form doing anything about it is absurd. Using the taxpayers’ argument, if a person failed to report wages that showed up on a W-2 filed with the IRS, the IRS would not be permitted to require that person to report the wages. Though it may have been a matter of judicial tact to state the reasons for rejecting the argument in the manner that the court did, there are times, I think, when calling nonsense what it is, nonsense, is valuable. Otherwise, the producers of the nonsense will generate even more nonsense. If one thing is clear, it is that the world doesn’t need more of this sort of nonsense.

Wednesday, December 12, 2012

Ohio as Role Model for Tax Policy 

High on my list of unacceptable revenue policies and practices is the diversion of revenue from the purpose for which it is collected to some other project or activity. Whether it is a designated tax, a user fee, or a toll, those who pay deserve to get what they are paying for and to be charged no more than is required for the designated purpose. As I explained in The Revenue Diversion Problem, “I take a dim view of governments diverting user fee revenue to purposes unrelated to the reason for imposing the user fee.” I have examined this growing trend of revenue diversion in posts such as User Fees and Costs, When User Fees Exceed Costs: What to Do?, Soccer Franchise Socks It to Bridge Users, Bridge Motorists Easy Mark for Inflated User Fees, Timing, Quantifying, and Allocating User Fees, Limiting User Fee Use: Beach Tag Fees, and Using Tolls to Fund Other Projects.

Now there is good news from Ohio. Technically, the news is old, and what is new is a recent case from the Supreme Court of Ohio that brought to my attention a provision in the Ohio Constitution, adopted in 1947, that specifically prohibits the use of motor fuels taxes for anything other than fixing roads, bridges, and other transportation infrastructure. In Beaver Excavating Co. v. Testa, (Dec. 7, 2012), the Court held that diversion of commercial-activity-tax (CAT) revenues derived from the gross receipts of motor vehicle fuel sales to non-highway purposes violates Article XII, Section 5a, of the Ohio Constitution. One of the interesting aspects of the case is that the plaintiffs included not only businesses paying the tax in question but also county engineers complaining that the diversion was impairing their budgets for transportation infrastructure projects.

The Court pointed out that the Constitutional provision in question was enacted specifically to limit the use of motor vehicle fuels taxes to transportation purposes. The provision was enacted to put an end to the then-existing practice of using motor vehicle fuels taxes for other purposes. The description of the Amendment is more proof that some things just don’t change: “This Amendment simply says you want your automobile license and gas tax money to go for better roads and streets. * * * Ohio originally promised that automobile license and gas tax funds would go for roads, streets, and related purposes. But
temptation was too great and millions of these special tax dollars have been and are being spent for other purposes.” One must wonder why, with the Amendment having been adopted by the voters, there was need for litigation in 2012.

In 2005, the Ohio General Assembly enacted the CAT to replace the corporate franchise and personal property taxes. The CAT is imposed on business gross receipts. Gross receipts do not include amounts paid by licensed motor-fuel dealers, licensed retail dealers, or licensed permissive motor-fuel dealers in state and federal motor fuel excise taxes with respect to motor-fuel receipts. CAT revenues are deposited in the state’s general fund. The Court concluded that the CAT is a tax that relates to motor vehicle fuel sales, and that to the extent that it does so, the revenue it generates from those sales must not be used for non-highway purposes.

The Court concluded that it was not improper for the state to collect the tax, but that it was a violation of the Ohio Constitution to spend it other than in accordance with the transportation-purposes-only requirement. The plaintiffs did not seek a refund, but an order requiring compliance with the expenditure limitation. Nor did they ask that revenues already improperly spent be restored to the transportation fund. Accordingly, the Court applied its decision prospectively.

The Ohio Constitution provides a model for provisions that protect those who pay taxes, user fees, and tolls from seeing their payments diverted to improper uses. Similar provisions might exist in other states; I haven’t looked because whether or not they do, they ought to exist in every state. I wonder how many state legislators and state employees making spending decisions have read the provision. If they haven’t, it’s time to do so and, while they’re at it, to look at this recent Ohio Supreme Court decision.

Monday, December 10, 2012

When Tax Revenues are Short-Changed, What Should Be Cut if Taxes Are Not Raised? 

A recent poll has reinforced the inescapable conclusion that Americans, as a group, are illogical when it comes to tax and spending policies. When asked whether budget deficits should be reduced by raising taxes or by cutting government spending, 46 percent chose spending cuts and 30 percent chose tax increases. As described in this summary of the poll, in February 2012 the spending cut option found favor with 56 percent, and in March 2011, 62 percent preferred spending cuts.

But when asked to choose which programs should be cut, poll respondents did a collective about face. Raising the eligibility age for Medicare found favor with only 40 percent, in contrast to 48 percent who opposed the idea. Slowing the growth of Social Security benefits was rejected by 70 percent of respondents. Military and defense budget cuts were opposed by the majority of those polled. Spending on those three programs constitutes a little more than one-half of total federal expenditures, although Social Security, standing alone as a separate trust fund, actually generates a surplus at the moment which is used to fund deficits in other areas of federal spending.

These poll results do not surprise me. More than three years ago, in Poll on Tax and Spending Illustrates Voter Inconsistency, I described the outcome of a similar poll in New Jersey:
According to the poll, 68% of the respondents favor cutting programs and services, whereas only 23% advocate increased taxes. Of those answering the poll questions, 75% support a wage freeze for state workers, and 61% advocate laying off state workers. Not one of several state programs nominated for reduced state funding gathered the support of a majority of the poll's respondents. Only 41% wanted to cut economic development spending, 30% would vote for reduced social services funding, a mere 11% favored cuts in education spending, and a scant 7% stood up for reduced health care expenditures.

This lack of unified focus shows up in how New Jersey residents dealt with specific questions. With respect to state spending for local government and schools, 60% want it to remain the same, 20% want an increase, and only 16% favor a reduction. Though 54% oppose school vouchers and 55% do not want to expand charter schools, 51% want increases in state spending on early childhood education.
These results prompted me to write:
The poll reinforces my contention that the underlying problem is the continued demand for government spending on programs that benefit state residents coupled with a continued resistance to the idea of paying taxes in order to fund those programs. The results of the poll suggest the extent to which various programs benefit residents. That explains the support for maintaining or increasing tax rebates even though it requires higher taxes on someone in order to do that. It also explains why so few favor cuts in health care, education, and social services funding, why gasoline tax increases aren't preferred, and why so many were quick to target state employees for pay freezes and furloughs.

This sort of entitlement mentality, a vision that grows out of the "I want, I got, I will continue to get" experience of too many people, suggests that finding a common ground to resolve the tax and spend debate in New Jersey, and elsewhere, will be difficult if not impossible. It's amusing to see that almost everyone understands there is a problem, almost half think it will get fixed, but fewer than half can rally around any specific solution to the fiscal mess.
A year later, in A Grander Delusion: Cut Taxes, Don’t Cut Spending, Cut the Deficit, I examined a poll taken in California:
When asked about ways to cut the state’s budget deficit, respondents preferred spending cuts to tax increases, but they also rejected spending cuts for programs constituting 85% of the state’s spending. The notion that “trimming waste,” as some suggested, can balance the budget when deficits are gargantuan is, as has often been demonstrated, nonsense.
This discrepancy between the desire to pay little or no taxes but yet to benefit from government programs is at the core of the current fiscal crisis in Washington. Things were working well until some geniuses decided, early in the last decade, to cut taxes and to increase federal spending at the same time. Is not the solution to un-do the behavior that caused the problem? What would be the status of the federal budget and the deficit if taxes had not been cut in 2001 and in 2003? What would be the status of the federal budget and the deficit if the increased spending during the past decade had been financed with taxes rather than debt? What would be the status of the federal budget and the deficit if the taxes had not been cut and the spending had been financed with taxes? The answer is obvious, but discussion tip-toes around it, because too many of those responsible for solving the problem had their hands in creating it, and lack the courage to admit their mistakes and to make amends. Political reputation and re-election appear to be more important to these folks than is the overall welfare of the nation.

Friday, December 07, 2012

Liquid Fuels Tax Increases on the Table 

According to this story, calls for increases in gasoline and other liquid fuels taxes are being put forth by those who understand the need for transportation infrastructure repair funding and who appreciate the declining value of existing fixed-amount taxes that do not reflect the impact of inflation since the taxes were last established. Support for, or at least willingness to consider, the increases is coming not only from the expected people and organizations but even from some who subscribe to anti-tax-increase philosophies. For example, Pennsylvania’s Governor Corbett, no fan of taxation, has admitted to “mulling an increase in one component of Pennsylvania’s gas tax.” New Jersey’s Governor Christie, another critic of taxation, is being pressured to increase gasoline taxes to fund restoration of highways and bridges damaged by Superstorm Sandy. The Republican chair of the House Transportation Committee expressed a “need to explore” the possibility of increasing the federal gasoline tax.

The gasoline tax is an inefficient way of funding the transportation infrastructure. Because it is set as a fixed number of pennies per gallon, decreases in sales – due to fewer miles being driven, more efficient vehicles, increases in the use of alternative fuels, or other causes – translates to a decrease in funding, even though there is not a concomitant decrease in the deterioration of roads and bridges. Add to that the impact of inflation, which increases the cost of repairs, but which is not reflected in adjustments to the fixed per-gallon tax amount. The federal gasoline tax was last adjusted 19 years ago. New Jersey adjusted its gasoline tax 24 years ago, and Pennsylvania’s last reset was 15 years ago.

Last year, in the Philadelphia area, only $1.4 billion was spent on a system that needs $2.5 billion a year to remain safe and functional. Which anti-tax advocate wants to be on the bridge that collapses because there was no money for repairs? One of the proposals being examined by Governor Corbett would increase the gasoline tax by 22 cents per gallon, though phased in over five years. At present, this tax is capped at a per-gallon price that is roughly half the current market price. In New Jersey, advocates of an increase are trying to sell a 10 cent increase, which would still leave New Jersey with one of the lowest gasoline taxes in the country.

Leaving gasoline taxes at their current levels guarantees more bridge collapses, and pothole-caused front-end alignment repair costs that will take more out of motorists’ pockets than the proposed tax increases. The best approach, of course, is to implement the mileage-based road fee, which I have discussed over an eight-year period, in Tax Meets Technology on the Road, Mileage-Based Road Fees, Again, Mileage-Based Road Fees, Yet Again, Change, Tax, Mileage-Based Road Fees, and Secrecy, Pennsylvania State Gasoline Tax Increase: The Last Hurrah?, Making Progress with Mileage-Based Road Fees, Mileage-Based Road Fees Gain More Traction, Looking More Closely at Mileage-Based Road Fees, The Mileage-Based Road Fee Lives On, Is the Mileage-Based Road Fee So Terrible?, and Defending the Mileage-Based Road Fee. If governors and legislators cannot bring themselves to step into the twenty-first century when it comes to maintaining the common weal, then they at least need to summon the courage required to raise the gasoline tax and prevent an ever-increasing parade of catastrophes.

Wednesday, December 05, 2012

The Hidden Government Spending Game 

The other day, a reader alerted me to a New York Times story that resonated with some positions I’ve taken with respect to federal, state, and local tax breaks for private companies, and Paul Caron picked it up in his Monday TaxProf blog items.

The point made by the story in its extensive analysis of private company tax breaks is a simple one. Governments give tax breaks to companies because the companies promise economic advantages to the government and the people within its jurisdiction, but far more often than not the companies renege on their part of the deal and the governments end up in a worse economic position than they be absent the tax breaks. A similar conclusion was reached in a Oregon Public Interest Research Group report on Oregon tax credits. The conclusion reached in these and similar reports is not a surprise, as it is something that I’ve been suggesting for quite some time. In posts such as Tax Breaks, Politician Takes, Using Taxes to Rescue a Non-Drowning Film Industry?, Do Profitable Companies Need Tax Breaks?, You’ve Gotta Give ‘Em (a Tax) Credit?, When Spending Exceeds Revenue, Hand Out Tax Credits? Really?, and Are State Tax Incentives Worth It?, I criticized special tax breaks because they are unwarranted government spending that benefits private companies and that provide an insufficient economic return on the expenditure. I argued that profitable companies do not need tax breaks, and unprofitable companies ought not be kept afloat with tax dollars because those companies either are engaging in activities rejected by the market or are engaging in de facto unprofitable but necessary activities that belong within the scope of government activity subject to public ownership rather than private inurement.

These tax breaks are nothing more than welfare payments to private enterprise. Opponents of social welfare spending defend these outlays with as much passion as they bring to their attempts to end government assistance for individuals in need of help. One of their favorite arguments is that these tax breaks do not constitute spending because they simply permit a taxpayer to keep the money that belongs to it. This argument is raised in commentary such as Education Tax Credits Are Not Government Subsidies. The reason the argument is wrong can be illustrated by an example. Assume that a government imposes an income tax equal to 20 percent of income, however defined. Taxpayers have income of $100,000,000 and pay $20,000,000 in income taxes. Along comes a special interest group that lobbies for an income tax credit equal to 10 percent of the cost of filming a movie within the jurisdiction of the government, and that the credit will bring $10,000,000 of movie making business into the jurisdiction. The group claims that the $1,000,000 credit will generate more than $1,000,000 of additional tax revenue for the government because of the economic activity triggered by the movie making activity. What the reports are telling us is that these predictions, not unlike those about trickle-down economics and job-creating tax cuts for the rich, are bogus. What the credit requires is one of three things, or some combination thereof. First, all taxpayers other than the movie company must collectively fork over $1,000,000 to make up for the lost revenue. Second, the government must borrow $1,000,000 and incur a deficit. Third, the government must cuts vital services to prevent a deficit from being incurred, thus depriving other taxpayers of $1,000,000 of services for which they have paid. As I explained in Using Taxes to Rescue a Non-Drowning Film Industry?:
In order for the tax burden of the film industry, for example, to be reduced, the tax burden of other taxpayers must be increased. Or, state tax expenditures on health, safety, education, and other essential and legitimate government services need to be cut, shifting the cost to the population generally, particularly through increases in local taxes. This puts upward pressure on the wage demands of workers in the state, it puts upward pressure on prices charged by other entrepreneurs in the state, and it puts upward pressure on interest rates as localities increase borrowing to cope with the impact of the state income tax incentive. Though the arrival of a production in the state brings a temporary boost to that state's economy, particularly that of the area in which the production exists, it isn't necessarily sufficient to offset the negative impact of the true cost of the specialized tax incentive. After all, the decision to bless one industry, thus shifting costs to another industry, may encourage those other industries to leave the state.
Even if one accepts the idea that this sort of government spending isn’t spending but a mere tax reduction, providing tax breaks to one group of taxpayers but not to another means that taxpayers not getting a special tax break are paying taxes at a higher rate that are those feeding at the tax break trough. One would expect the anti-tax crowd to express deep indignation about this sort of hidden tax burden, and although some who subscribe to the anti-tax philosophy do criticize this inequality, many, too many, say nothing. Why? Perhaps because a transparent direct subsidy to the special interest group would be seen for what it is, would be less defensible in terms of the deceptive “keeping their own money” nonsense, and would be more easily understood as an outlay that harms society both in the short-term and in the long-term when it comes to the promised, but unfulfilled, economic payback. For those who want to cut government spending, try starting with the hidden expenditures deceitfully tagged as tax breaks and providing an advantage to particular private sector entities while putting other taxpayers at an economic disadvantage.

Monday, December 03, 2012

Passing the Tax Responsibility Buck 

At the end of October, news stories, including this one, reported that hackers had managed to obtain millions of social security numbers, bank account data, credit card numbers, and business records by breaking in to South Carolina Department of Revenue computers. It isn’t difficult to imagine the far-reaching scope of the potential damage that has been done. A report released by investigators explained that the hacking was made possible by a Department of Revenue employee falling for a phishing email and providing username and password information.

Last week, the governor of South Carolina, according to this story, blamed the Internal Revenue Service. The governor’s reasoning is appalling. According to the governor, the IRS does not require South Carolina to encrypt social security numbers. So what? Is the South Carolina Department of Revenue incapable of figuring out on its own that sensitive taxpayer information should be encrypted? It’s not rocket science. Of course, South Carolina has now decided to encrypt social security numbers, but closing the barn door after the horses escape is too little, too late. According to another report, the Department had explored encryption on at least two previous occasions but for unknown reasons did not pursue the proposal.

According to this report, the intrusion would have been prevented had the South Carolina Department of Revenue installed a $25,000 dual password system. The IRS, on which the South Carolina governor is trying to put the blame, uses the dual password system. It’s interesting that the governor wants to blame the IRS for not requiring encryption, but does not explain why South Carolina did not imitate the IRS when it comes to dual password systems.

The Director of the Department resigned. There is no news as to the fate of the employee who responded to the phishing message.

It is a good guess that the failure to adopt the encryption proposals in the past was an attempt to save money. The same explanation probably accounts for the failure to purchase the dual password system. And to the extent that the Department’s use of forty-year-old equipment was a contributing cause of the problem, as mentioned in the official report, it’s also a good guess that failure to update the equipment was an attempt to save money. Just as Congress underfunds the IRS while heaping additional responsibilities on it while it tries to keep up with technological change, one must wonder whether the South Carolina legislature was adequately funding the Department of Revenue. So now the state is spending at least $14 million to fix the damage, including $12 million to purchase credit bureau protection for the affected taxpayers, is taking $5 million from other purposes to install encryption, and probably will spend much more before the entire mess is resolved. I wonder if the folks running the show, including those in other states and in Washington, D.C., ever heard the expression penny-wise, pound-foolish.

Friday, November 30, 2012

Tax Rates and Deduction Caps 

In the flurry of news reports about some members of Congress who made the Norquist anti-tax pledge backing away from that promise, such as this story, the discussion of how that may come to pass has received far less attention than it should, though it has received some attention in articles such as this report and this analysis. One avenue of escape from the pledge is the notion that the pledge requires opposition to rate increases but does not require opposition to revenue increases. The reason this distinction exists is because revenues can be increased without raising rates. One way of doing so is to eliminate or reduce exclusions from gross income. Another is to eliminate or reduce deductions. One way of reducing deductions is to subject them to a cap. As Senator Lindsey Graham explained, “I will not raise tax rates to do it. I will cap deductions.” Of course, imposing deduction caps to raise revenue constitutes a tax increase.

The idea of increasing revenue without raising rates is not new. It was implemented years ago when Congress placed a phase-out, which is a type of cap, on the personal and dependency exemption deduction and on select itemized deductions. The reason was an amazing bit of political manipulation. In Objections Raised to Elimination of Legislative Tax Deceit, I explained the background of this maneuver:
These two phaseouts [on itemized deductions and the deduction for personal and dependency exemptions] were enacted in 1990 as part of a Congressional subterfuge, or deceit, foisted upon the American citizenry. When public officials deceive citizens, problems arise. In this particular instance, Congress wanted to raise taxes without raising tax rates, because it concluded that it could tell Americans that it did not raise taxes by pointing to unchanged tax rates. However, "clever" minds figured out that if deductions, in this case itemized deductions and the deduction for personal and dependency exemptions, were reduced, the effect would be an increase in tax revenues. In other words, Congress "discovered" that it could raise taxes without raising tax rates and thus trumpet a self-serving proclamation that it had not raised taxes. The simple word for this is lying.
I revisited the issue in When is a 15% Tax Rate Not a 15% Tax Rate?, in which I noted:
I wrote about this problem 16 years ago, in Getting Hamr'd: Highest Applicable Marginal Rates That Nail Unsuspecting Taxpayers, 53 Tax Notes 1423 (1991). It has been cited and quoted almost a dozen times. I doubt, though, that anyone in Congress has read it. That's too bad, because repairs could be made if members of Congress understood the wool that was pulled over their eyes and the eyes of the citizenry by the folks who shoved phaseouts into the tax law as a way of raising taxes without raising rates.
When comparing the two approaches, I see only one advantage to the use of phase-outs, including deduction caps. Deduction caps permit legislators to claim that they have not raised tax rates, hoping that people interpret this claim as equivalent to not raising taxes. It is a misleading approach.

In contrast, I can identify more than a few disadvantages to using deduction caps. Each one by itself outweighs the seeming advantage. Because deduction caps are like phase-outs, the disadvantages of phase-outs that I examined in detail in Objections Raised to Elimination of Legislative Tax Deceit are no less applicable to deduction caps. I highlight these disadvantages, and others, in the following list.

First, deduction caps, like phase-outs, distort the progressivity of the income tax by creating higher average marginal tax rates for taxpayers not at the top of the income pyramid than apply to those at the top of the income pyramid. If nominal marginal tax rates have as much impact on economic decision making as tax-rate reduction advocates claim, average marginal tax rates have at least as much impact, and the skewing of those rates by the use of deduction caps is not beneficial.

Second, deduction caps, like phase-outs, complicate the tax law. The complication is unwarranted, detrimental, and cost-ineffective. The complication increases the chances of errors on tax returns.

Third, deduction caps, like phase-outs, do not increase tax revenue from all high-income taxpayers. Caps only affect those high-income taxpayers who claim the deductions that are subject to a cap.

Fourth, deduction caps, like phase-outs, do nothing to close the many loopholes used by high-income taxpayers to reduced their effective income tax rates, because most of those loopholes do not involve deductions.

Fifth, a deduction cap on the charitable contribution deduction probably will cause a reduction in charitable contributions by high-income taxpayers. In the long run, this outcome is much more harmful to the economy than raising tax rates.

Sixth, deduction caps, like phase-outs, exacerbate the marriage penalty. There are enough challenges with trying to eliminate that penalty without creating a penalty on unmarried individuals without making the task even more daunting.

Seventh, a deduction cap does absolutely nothing to stop the revenue losses arising from absurdly low tax rates on capital gains and qualified dividends. The current capital gains rates are much lower than they need to be to offset the inflation impact that serves as the justification for the lower rates.

About a year and a half ago, in A Foolish Tax Idea Resurfaces, I criticized the President for including a deduction phase-out in his fiscal year 2012 budget proposal. Apparently the President has seen the light, and according to this story, is rejecting deduction caps in favor of the much more transparent tax rate cut expiration. Two years earlier, in a Tax Change Ought Not Be Tax Redux, I criticized the President’s fiscal year 2010 budget proposal for suggesting that the itemized deduction and personal and dependency exemption phase-outs ought to be restored.

As explained in Objections Raised to Elimination of Legislative Tax Deceit, I successfully campaigned against the phase-outs and they were recently phased out of the tax law. It would be a step backwards to reinstate them, to let them be reinstated through inaction, or to adopt their deduction cap surrogates.

There are better solutions. Replacing deductions with credits is one. Repealing the special capital gains rates and indexing adjusted basis for inflation is another. Restoring progressivity to the tax law to undo a decade’s worth of economic damage caused by the discredited “trickle down” theory is yet another. Repealing special interest deductions is still another. It is time to start talking about genuine cures rather than playing around with attempts to hide the problems and mask the solutions. As I wrote in Tax Change Ought Not Be Tax Redux, “Let's face it. The days of using Pease and PEP to hide tax increases are long gone. Everyone knows the score. Aside from the impropriety of raising taxes using clandestine gimmicks, there's no need to do so. There's no genuine impediment to doing what needs to be done in the way it needs to be done. The bleating from the privileged few that taking away their capital gains break or their special dividend rate will destroy the economy should fall on deaf ears. The special interest groups have cried wolf too many times.”

Wednesday, November 28, 2012

Tithing and Taxing: What is (Gross) Income? 

Students in basic federal income tax courses throughout the country encounter the questions, what is income and what is gross income, early in those courses. By the time that topic has been explored, students have learned that the answer to the first question isn’t easy to define, and that the answer to the second question is complicated and not something that a computer program can resolve. This point is one that seems to sail by those who offer the flat tax or one of its many variants as a solution to income tax complexity.

Recently, Robert Smith of NPR, in a report brought to my attention by a faithful reader, explored how the Mormons define income for purposes of their church’s teaching that each member should tithe 10 percent of income. Though the 10 percent tithing principle is rock-solid, the church does not define income. It leaves that to individual members.

Two economists surveyed 1,200 Mormons. They learned that most would tithe on the amount of a cash gift. But few would tithe on the value of a gift of property. Most would tithe on money taken out of a retirement fund even though they had given 10 percent of the income from which the money was taken to put into the fund. In the tax world, this would be considered double taxation. Yet when asked about proceeds from a garage sale, it appears that no tithe is computed because the items sold “has already been tithed.” Most Mormons who find money would transfer 10 percent to the church. Though Mormons tithed on gain from the sale of stock, most did not offset gains with losses from stock sales. Most Mormons do not reduce income by deductions. Smith tells of a married couple who used different rules before they were married. The husband tithed on gross income, and the wife tithed on income net of taxes. Eventually the husband persuaded his wife to his definition of income.

It appears that Mormons react to cash. It does not appear they tithe on employer fringe benefits such as contributions to health care plans or the use of a company vehicle. One reason may be the lack of information sufficient to permit computation of a tithe. But the difference between the reactions to cash gifts and gifts in kind goes deeper than simply the availability of information.

When asked about the lack of an income definition, a Mormon bishop noted that “all this soul-searching about what you owe God is kind of the point.” Would this approach work with income taxes? I think the answer is no. The relationship between a faithful member of a church – and Mormons are not the only ones who require or recommend tithing – is very different from the relationship between a citizen and a government. People don’t soul-search what they owe to society. Churches can function even if members are not using the same definition of income, and even if members are not giving at uniform rates of contribution. Rarely, if ever, do members of a church get into a dispute with each other because someone contributes at 9.5 percent rather than 10 percent, or someone treats something as income that someone else does not. Surely they seek to enlighten each other, as the two spouses in the anecdote managed to do. In contrast, when it comes to financing society, people bring a very different agenda into the discussion. Unhappiness prevails when someone seeks to gain an advantage with respect to taxation.

Not only is soul-searching absent from tax law discussions, the seeming absence of complexity in a tithing system becomes an avenue for game playing in the tax world. Taxation of cash gifts but not in-kind gifts would trigger a rush to substitute property for cash in the gift-giving world. Would a gift card be treated as cash? Do Mormons tithe on the value of a gift card? I don’t know. What seems clear, though I may be wrong, is that Mormons generally do not rearrange their dealings in order to gain a tithing advantage. I can’t imagine someone saying, “Give me property and not cash so I can avoid tithing.” In the world of taxation, requests and planning along those lines is rampant.

The lack of a definition of income for tithing purposes does not appear to be an impediment. The lack of a definition of income for tax purposes would be fatal to any income tax system. The world of tithing and the world of taxation are two different places, as they ought to be. Though it would be nice if the generosity of tithing and the reluctance to, as one person put it, to get “petty with God,” spilled over into the world of government and taxation, it isn’t going to happen.

Monday, November 26, 2012

Is Grover Norquist Singing a New Tax Tune? 

Readers of MauledAgain know that I am not a fan of Grover Norquist’s anti-tax-increase pledge tactics nor of the influence this unelected, self-appointed anti-tax activist wields over federal and state legislators. In posts such as Food for Tax Thought?, Tax Semantics, Debunking Tax Myths, Tax Policy, Elections, and Money, If the Government Collects It, Is It Necessarily a Tax?, and When Privatization Fails: Yet Another Example, I have, as noted in Debunking Tax Myths, “explored the unwarranted and excessive influence that the unelected Grover Norquist holds over federal, state, and local tax policy and decision making,” and, “[b]ased on Norquist’s own words, . . . concluded that his anti-tax stance is simply part of his strategy to destroy government.”

Several days ago, in this Huffington Post opinion piece, Norquist offered two “protections available to the American people” to avoid previous experiences of watching legislators rush into adoption of economic or tax programs designed in private and put up for a vote without sufficient time for examination. Norquist suggests that negotiations on dealing with the impending fiscal cliff be aired on C-SPAN and not conducted in back rooms. He also proposes that once an agreement has been reached, it should be reduced to legislative language and then put online for 7 days for all Americans to read.

My first reaction to Norquist’s proposals was a positive one, which is rather surprising considering how adamantly I object to his dogma and tactics. Long before Norquist was pondering taxes, I was bemoaning the back-room approach to politics generally and to tax specifically. And long before Norquist turned his attention to legislative matters, I was also bemoaning the “last minute rush” process that generated legislation with flaws, omissions, and inconsistencies, and that raised more unanswered questions than good legislation ought to present. My students have been listening to these criticisms for all the years that I have guided them through the tax law that has emerged from this inefficient legislative process.

But the more I thought about Norquist’s proposals, I came to see two major concerns. Neither one causes me to object to Norquist’s proposals, but both cause me to look at them more closely.

The first is that the idea of requiring a 7-day period for examination of the legislation presumes that the legislation would be ready in time to permit that examination to take place, and enactment to occur, before the December 31, 2012, fiscal cliff event. The reason for the rush to enactment is that legislatures leave things go until the last minute. Though many people, including students, tend to do this is no excuse for public leaders to emulate bad practice. Instead, they need to learn and apply time management principles. Norquist does not address this underlying cause for the “rush to enact” problem that he seeks to remedy. Perhaps legislatures should be required to begin work on an issue a certain number of days before the deadline and should be prohibited from taking a break or doing anything else until the job has been completed. How that sort of solution can be implemented is not as easy to design as might first appear.

The second is that the idea of moving policy decisions out of the back rooms is not one I would have expected Norquist to make. Six years ago, in Food for Tax Thought?, I commented on a story, about the relationship between lobbyist Jack Abramoff and White House Political Director Ken Mehlman, who by 2006 was serving as chair of the Republican National Committee. One of the conversations in which Abramoff and Karl Rove addressed Abramoff’s efforts to obtain benefits for his clients took place at a "Tax Policy Dinner" hosted at Grover Norquist's home. To this, I reacted by writing, “So, wrapped up in this morass of favors, endorsements, deals, and other shadowy transactions is a thing called a ‘Tax Policy Dinner.’ Hosted, no less, by one of the staunchest opponents of taxation to come along in a long time.” I then added, “It is simply wrong for tax policy to be worked out at a private dinner to which only a select few are invited. When the deal is done before the vote is tabulated, what's the value of the vote?” I am confident that if I had requested this dinner to be broadcast on C-SPAN, Norquist and his cronies would have refused. Now, Norquist criticizes back-room dealing. Does this mean he would open his dinners to public view? Or stop doing public business in private? How does he reconcile his past practices with his most recent proposal? What he says, and how he says it, will be important, if he says anything at all. What he does, and how he does it, will be much more instructive.

Friday, November 23, 2012

When the IRC Defines a Term, It Trumps Other Definitions 

On Monday, the Tax Court released an opinion, Cheung v. Comr., T. C. Summary Op. 2012-114, in which it rejected a taxpayer’s argument that the definition of a term found in the Internal Revenue Code should be set aside in favor of a definition from another federal agency. Though it is readily apparent why the taxpayer wanted to take this approach, the Tax Court emphasized that when a term used in the Code is defined in the Code, it is improper to look elsewhere for the definition.

The taxpayer purchased property #1 on October 31, 2003, moved into the house on that property, and lived there until March 31, 2009. On July 26, 2004, the taxpayer married, and on January 18, 2006, his wife moved into the house on property #1, and lived there until March 31, 2009. On March 31, 2009, the taxpayer purchased property #2, and he and his wife moved into the house on that property.

The taxpayer and his wife filed a joint return for 2008, on which they claimed a first-time homebuyer credit. The IRS audited the return and asked for additional information to substantiate the credit. The taxpayer provided the IRS with a U.S. Department of Housing and Urban Development settlement statement showing the taxpayer as the purchaser of the house on property #2 with a settlement date of March 31, 2009. The IRS issued a notice of deficiency that, among other things, disallowed the credit.

The first-time homebuyer credit is not available unless, among other things, the taxpayer is a first-time homebuyer. Section 36(c)(1) defines a first-time homebuyer as “any individual if such individual (and if married, such individual’s spouse) had no present ownership interest in a principal residence during the 3-year period ending on the date of the purchase of the principal residence to which this section applies.” The taxpayer argued that he qualified under that definition, under the definition of first-time homebuyer appearing in statements on the HUD web site for HUD and FHA purposes, and under the definition of first-time homebuyer appearing in an article published in the Home Guides section of the San Francisco Chronicle. The definition appearing in the Chronicle matched the definition appearing on the HUD web site.

The taxpayer argued that section 36(c)(1) requires that only “one of the spouses has no present ownership interest in a principal residence during the three-year period ending on the date of the purchase of the principal residence for which the credit is claimed. Thus, if one spouse is eligible under I.R.C. § 36(c)(1), then both the spouses (the couple) are eligible.” Petitioners claimed that this interpretation was consistent with the definition found on the HUD web site. That definition provides that a first-time homebuyer is [a]n individual who has had no ownership in a principal residence during the 3-year period ending on the date of the purchase of the property. This includes a spouse (if either meets the above test, they are considered first-time homebuyers).”

The IRS argued that because the taxpayer, during the three-year period ending on March 31, 2009, owned property #1, he was not a first-time homebuyer within the meaning of section 36(c)(1). It did not matter, according to the IRS, that the taxpayer’s wife was a first-time homebuyer because she did not have an interest in a principal residence during that three-year period.

The Court held that the definition of first-time homebuyer appearing on the HUD web site is “not controlling for purposes of section 36.” The definition that is controlling is the one found in section 36(c)(1). The Court also held that the taxpayer’s interpretation of the section 36(c)(1) definition as requiring only one spouse to have lacked an ownership interest in a principal residence during the three-year period was incorrect. The Court pointed to the parenthetical language in the definition, which makes it clear that if a married couple purchases a principal residence and files a joint return, both spouses must meet the requirement that no interest in a principal residence be owned during the three-year period. This point had previously been made by the Court in Packard v. Comr., 139 T.C. No. 15 (Nov. 5, 2012).

It is a canon of statutory construction that when a statute uses a term and defines that term, the definition in that statute trumps definitions of that term found elsewhere. Looking to a definition not in the statute is an approach that makes sense only if the term is not defined in the statute. Though that happens more often that it should, it is not the case with the section 36 first-time homebuyer definition. As I tell my students, it’s not enough to read a newspaper description of a law, or to read a summary on a web site. The analysis should begin with the statute.

Thursday, November 22, 2012

A Thanksgiving Litany 

Like turkey, cranberry, and football, sharing a moment of thanks on the fourth Thursday of November has become a tradition on the MauledAgain blog. With the exception of 2008, an omission for which I don’t have or remember an explanation, I have consistently addressed the underlying purpose of Thanksgiving since 2004: In that year there was Giving Thanks, in 2005, A Tax Thanksgiving, in 2006, Giving Thanks, Again, in 2007, Actio Gratiarum, in 2009, Gratias Vectigalibus, in 2010, Being Thankful for User Fees and Taxes, and in 2011, Two Short Words, Thank You.

Last year, taking a lawyerly approach, I incorporated by reference all the people, events, and things for which I am grateful. I do that again, and I will make that list even longer:

I am thankful the sun comes up every morning and that I’m still around to notice. I am thankful that people rallied to help others during and after the hurricane superstorm. I am thankful that there is a chance intelligent discourse about the nation’s problems might trump the shrill voices of the disaffected extremists on both sides.

I am thankful for family, immediate and extended, of every imaginable degree of relationship. I am thankful for the help I receive as I dabble with family history research.

I am thankful for my friends, near and far, long-time and new. I am thankful for their stories, their attention, their advice, their jokes, and their laughter.

I am thankful for the readers of MauledAgain, including those who send me possible stories. I am thankful for my friends at the gym who also supply me with tax stories. I am thankful for the students who energize the classroom, the readers who take time to look at what I have written, the taxpayers and judges who give me things to discuss.

I am thankful that so many of my eighth grade graduating class found a way to get together in the spring at a “first time in 47 years” reunion. I am thankful that we have continued to gather informally during the intervening months. I am thankful for all that my classmates have accomplished, and for the memories that they safeguarded and then shared.

I am thankful that the members of the church to which I belong stepped up to support in many ways a renovation of the chancel that was much needed and that is now complete. I am thankful for the talents of my friend, the organ builder, who is producing a musical instrument which I am sure I will mention next Thanksgiving.

I am thankful people are reading this. Happy Thanksgiving.

Wednesday, November 21, 2012

A Not So Dopey Tax Question 

A recent news report highlights the confusion faced by Greenleaf Compassion Center when it has tried to determine whether the New Jersey sales tax applies to the legal medical marijuana it will be selling as the operator of New Jersey’s first legal marijuana dispensary. The Center has delayed opening its store until it gets an answer. The State Health Department wants the group to open even though the tax issue has not been decided. Hello? Should they collect the tax or not? The legislator who sponsored the legislation explains that he intended the sales tax to apply. But his legislation has no provision with respect to the issue. Hello? If you intend something, write it down.

A look at the New Jersey sales tax law is instructive. Under section 54:32B-3(a), a sales tax is imposed on “receipts from every retail sale of tangible personal property or a specified digital product for permanent use or less than permanent use, and regardless of whether continued payment is required, except as otherwise provided in this act.” I think marijuana is tangible personal property. That means it is time to continue reading. Section 54:32B-3(b) adds additional transactions to the list of taxable items, but none are relevant to the Center’s question. Section 54:32B-3(c) addresses the sale of prepared food and the sale of food and beverages from vending machines. Section 54:32B-3(d) imposes the sales tax on hotel rent, section 54:32B-3(e) addresses admission charges, and section 54:32B-3(f) focuses on telecommunication services. Sections 54:32B-3(f) and (g) have been deleted, section 54:32B-3(h) applies to dues, and section 54:32B-3(i) subjects parking and vehicle storage fees to the tax.

With the general provision appearing to make sales of medical marijuana subject to the New Jersey sales tax, the next step is to ascertain if there are any other provisions that set forth exceptions. Of those that exist, one appears relevant. Section 54:32B-8.1(a) provided exceptions for medical items, including “drugs sold pursuant to a doctor's prescription” and “over-the-counter drugs.” Section 54:32B-8.1(b) defines a drug as “a compound, substance or preparation, and any component of a compound, substance or preparation, other than food and food ingredients, dietary supplements or alcoholic beverages: (1) recognized in the official United States Pharmacopoeia, official Homeopathic Pharmacopoeia of the United States, or official National Formulary, and supplement to any of them; or (2) intended for use in the diagnosis, cure, mitigation, treatment, or prevention of disease; or (3) intended to affect the structure or any function of the body.” An over-the-counter drug is defined as “a drug that contains a label which identifies the product as a drug, required by 21 CFR 201.66. The label includes: (1) a "Drug Facts" panel or (2) a statement of the "active ingredient" or "active ingredients" with a list of those ingredients contained in the compound, substance or preparation.”

It appears from this explanation from the New Jersey Department of Health that a doctor’s prescription is required, and can be provided by having the physician register with the Department and then creating a patient record for the patient. Though the word “prescription” is not used, the process is the same, namely, an authorization by a licensed and registered physician for a patient to use a regulated product for health purposes.

Does medical marijuana fit within the definition of a drug? It appears so. It is a substance. It is not food, nor is it a legal food ingredient. It is not a dietary supplement. It is not an alcoholic beverage. It is intended for use in the mitigation of disease.

Unless there is some provision tucked away in some obscure place – and there could be, as I am not an expert in New Jersey sales tax law – the conclusion appears to be that medical marijuana is not subject to the New Jersey sales tax. So if the legislator who sponsored the legislation wanted the sales tax to apply, an amendment to the sales tax law would have been in order.

This question is going to pop up in an increasing number of states. Absent the insertion of specific language into a state’s legislation, tax practitioners across the nation will need to analyze existing provisions to construct advice for their clients. As I tell my students, you are in law school not so much to learn what the law is but to learn how to learn what the law is, because both law and the circumstances to which it applies keep changing.

Monday, November 19, 2012

Taxation of Medical Study Payments 

A recent Tax Court case, O’Connor v. Comr.,, T.C. Memo 2012-317, makes it clear that amounts received by a taxpayer for participating in a medical study must be included in gross income. O’Connor was paid $5,550 by Covance Clinical Research Unit, Inc., for participating in a medical study examining gout. O’Connor had suffered from gout for many years before participating in the study. In addition to the $5,550 cash payment, for 10 days and 9 nights, Covance provided O’Connor with meals and lodging, and subjected him to a variety of medical tests. O’Connor did not report the $5,550 on his return. While the IRS was auditing the return, O’Connor filed an amended return reporting the payment but the IRS did not process it. The IRS issued a notice of deficiency, and one of the items listed as a reason for the deficiency was the failure to report the $5,550 payment.

In holding that the payment must be included in gross income, the Tax Court rejected O’Connor’s argument that the payment was excluded under section 104 as a payment received on account of physical illness or physical sickness, and his argument that the payment was excluded under section 102 as a gift. The section 104 argument was rejected because O’Connor did not allege that he suffered physical injury or sickness on account of the gout study, and did not prove a causal link between the payment from Covance and the gout. Because O’Connor did not produce his contract with Covance, the Court was unable to conclude that the payment was for anything other than O’Connor’s participation in the study. The section 102 argument was rejected because O’Connor did not introduce any evidence demonstrating that Covance paid him out of detached and disinterested generosity. That Covance did not consider the payment to be a gift was reinforced by the fact it issued a Form 1099-MISC to O’Connor for the payment.

The result in the case is not surprising. The fact that a taxpayer sought to exclude such a payment is not surprising. What also is not surprising is that cases dealing with the determination of what constitutes gross income will continue to be with us no matter what is done with tax rates, no matter what sort of flat tax or similar arrangement is adopted, no matter the level of simplification applied to tax deductions and credits. Until and unless income taxes are repealed, the question “what is gross income?” will persist, in tax law courses and in tax practice. And if income taxes disappear, the inquiry will shift to questions such as “what is consumption?” or “what is value added?”

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