Tax Update Blog: June 2006 Archives

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SNOW FALLS IN JUNE

June 30, 2006

Treasury Secretary John Snow officially stepped down today. His successor, Henry Paulson, was confirmed by the Senate this week.

Oh, how I'm going to miss the headlines...

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IRS SHUTS DOWN!

June 30, 2006

Well, sort of.

The good news first, from an IRS press release (no link yet):

WASHINGTON -- The IRS Headquarters Building at 1111 Constitution Ave. NW in Washington is likely to remain closed for at least 30 days due to flooding and electrical outages.

The building sustained extensive damage to the infrastructure, office furniture and supplies.

The subbasement was submerged in more than 20 feet of water. The subbasement holds all of the building's electrical and maintenance equipment such as electrical transformers, electrical switchgears, and chillers. Although these systems require closer inspection, they appear to be 95 percent damaged or destroyed.

But all is not sweetness and light:

Repairs to the headquarters building will not impact the IRS's service and enforcement operations during this period.

All IRS business units have extensive business resumption plans that have been executed. The 2,400 employees who work at the headquarters building are being relocated to the other 12 buildings IRS occupies in the metro area or into temporary space, and some will telecommute as appropriate.

Oh, well. One can't have all that one would want...

I was in that building, I believe in 1988. It was a very spooky and weird place, with hallways that seemed to go on for ever. It looked like it was last decorated in 1946 with paint left over from the battleship program. If the Soviet Union were to take over, I thought, that's where they would have the U.S. KGB headquarters. At least now it gets a clean-up.

The TaxProf has more.

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IS IT A DIALOGUE WHEN I TALK TO MYSELF?

June 30, 2006

A St. Louis marketing firm that specializes in helping professional firms with their marketing asks "CPA Bloggers: Where Are The Accountants?"

Sadly, there are still far too few CPAs/CAs who blog. I read that about 20% of all business blogs are law related.

Where is the CPA profession? Folks, I think it's time to pay attention.

I have wondered why there are zillions of lawyer-bloggers and few accountant-bloggers. It may be that most of my colleagues, unlike me, know when to shut up. It may be that the people who are attracted to law just like to write and argue.

The marketeers put out a list of CPA blogs, including a nice note about our site:

Roth & Co CPA Blog Tax Update blog with frequent, interesting and varied dialogue

The "dialogue" part is interesting, given that we don't get many comments in our "comments" section. They must be on to my multiple-personality disorder...

Hat Tip: Tickmarks

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HOW SOFTWARE DEVELOPERS FIND THEMSELVES TAXED IN IOWA

June 29, 2006

The Iowa Department of Revenue this week released a letter responding to a software developer's questions about Iowa taxes. It shows how little contact a company needs in Iowa to be taxable here. It's also worth looking at because other states apply similar standards to drag companies into their income tax system. Public Law 86-272 is the federal statute that sets the bar for when you are subject to income tax in the state. The way Iowa applies the rules, taking care of your Iowa customers can have unpleasant tax side effects.

The facts:

Your scenarios assume that the software developer does not have an office in Iowa or a permanent sales staff in Iowa. The software is not sold, but the developer licenses the right to use software to an end user. As part of the transaction, the software developer may or may not send someone to the user�s office for installing the software and training the user on the software. The developer also contracts to provide continuous support and maintenance to each customer, and the contract typically breaks out a separate fee for each service.

So - does simply licensing software for use in Iowa make you taxable here? No:

The mere grant of the right to use the developer�s software does not, by itself, create Iowa corporation income tax nexus.

OK, what if you actually provide service to a customer? Bad news:

Sending an employee into Iowa to install and/or train the use does create Iowa corporation income tax nexus. As noted previously, the protection of Public Law 86-272 does not apply in this instance, so any physical presence in Iowa by an employee of the software developer is sufficient to create corporation income tax nexus.

Even if you only send them in for a day?

There is no minimum period of time needed to be in Iowa to create corporation income tax nexus. As noted previously, the de minimus exception in Public Law 86-272 does not apply in this instance, so any period of time spent in Iowa is sufficient to create nexus.

This can create unpleasant results. Iowa apportions taxable income here based solely on sales; most states also take property and payroll into account. That's a great formula for Iowa-based companies, but it can make non-Iowa companies taxable quickly at rates up to 12% - the highest in the nation.

The entire contract with an Iowa customer will be considered an Iowa receipt for corporation income tax purposes. Once nexus is established, the entire amount of income received from an Iowa customer will be considered Iowa receipts.

Well, Mr. Software Company won't ever make that blunder again; they'll avoid us forever. Do they ever get off the hook here?

Nexus for corporation income tax is determined on a year-to-year basis, and if a nexus activity occurs during the year, then the corporation has nexus for the entire year. For example, if on-going service and maintenance is performed by employees in Iowa, then the software developer has nexus in Iowa for that year. Also, if the service and maintenance occurred outside Iowa for a particular year, but nexus was created in that year due to installation, any income received from the on-going service and maintenance would be considered an Iowa receipt.

So if they steer clear of the land between the rivers from now on, they're off the hook. But it's not easy.

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DADDY MACK, MEET SENATOR GRASSLEY

June 29, 2006

The second oldest profession has laid down a challenge to the oldest; the politicians are taking on the pimps. The Senate Finance Committee yesterday approved Senator Grassley's tax crackdown on pimps.

I have no doubt that where hundreds of years and thousands of laws against white slavery have failed, this tax bill will succeed. And no doubt the bill will provide additional IRS funding so the bill doesn't weaken efforts to catch tax cheats and crack down on tax shelters. Oh, and did I tell you about those pills you can order on the internet that make you irresistible to the ladies?

The Tax Prof has a roundup; the Tax Policy Blog has more.

UPDATE: State 29 nails it (but don't go there if you're easily offended).

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SUMMER CARNIVALS

June 29, 2006

Summer is here, the pace slows, and the Carnivals move on. This week the Carnival of the Capitalists is up at Financial Methods. Good stuff as always; I like the post "College is Worth the Expense" from Free Money Finance. Our oldest boy is starting to think about college, and I weep at the tuition, so I appreciate the consolation.

The MightyBargainHunter.com hosts this week's "Carnival of Personal Finance." Among the many good articles there is one about the power of the Roth IRA.

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PATENTLY ABSURD

June 28, 2006

When browsing through this site's statistics recently I noticed a small flurry of visitors to a post about patenting "tax strategies." This got me to Googling, and it turns out that the Patent Office has a granted a bunch of tax patents. They even keep a list.

Many of these patents look like they're just marketing tools for insurance products. Here is a selection:

As a loyal resident of the Hartford of the prairie, I'm all for anything that will sell insurance policies. Yet if people get serious about enforcing tax patents, you have a real problem. What could be the public policy argument for allowing only royalty-paying taxpayers to use a given legal tax planning technique? For example, one patent is for "methods and investment instruments for perfoming tax deferred real estate exchanges." People do Section 1031 exchanges every day. Would like-kind exchange specialists be subject to subpoena to see whether they are using a "patented" method to do these relatively routine deals?

Absent ridiculous fishing-expedition subpoenas, tax privacy rules would make these things impossible to enforce. It seems only way a patent could ever be enforced would be when a case makes it to court and it becomes public record. That puts the patent-holder in a bind. The only reason they would be aware of the patent "violation" is because the IRS is attacking it - hardly a good advertisement. Would they continue to seek royalties if their strategy fails in court?

It's not like these tax scientists are curing a disease with a new medicine or stamping out hunger with a new miracle plant strain. It's likely these patents will just generate a bunch of rent-seeking patent jackals trying to extract royalties from routine transactions. I'd rather Senator Grassley pay more attention to this than to pimp taxes.

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OUR PIMPIN' SENATOR

June 28, 2006

I've said before that legislators look on the tax law as the Swiss Army Knife of public policy -- it can be used for anything. Senator Grassley now looks to use it to stamp out pimping:

Sen. Charles Grassley, chairman of the tax-writing Senate Finance Committee, wants the Internal Revenue Service to chase after pimps and sex traffickers with the same fervor it stalked gangster Al Capone for tax evasion.

Grassley, R-Iowa, would hit pimps with fines and lengthy prison sentences for failing to file employment forms and withhold taxes for the women and girls under their command.

I'm no fan of white slavery, but is this really where we need the IRS to spend its enforcement budget? The IRS has more than it can handle just dealing with the ordinary tax nonsense Senator Grassley and his colleagues pile onto the code every year.

Some problems just aren't really tax problems, but for each problem some legislator has a tax solution. That's why if the tax law were a Swiss Army Knife, it would be one that you would need a crew of engineers to operate and a railcar to move.

Hat tip: Instapundit.
Russ Fox has more.

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'YOU MIGHT BE A TAX GEEK...'

June 28, 2006

Tickmarks Blog does a Jeff Foxworthy on tax accountants. My favorite:

You MAY be a Tax Accountant if...you know the names of more judges on the U.S. Tax Court than you know the combined names of American Idol finalists and best actor and actress Oscar nominees for this past winter.

Heck, I know the names of more Tax Court special trial judges than I know American Idol finalists. I shouldn't admit that, I suppose.

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JUDGE: KPMG PROSECUTORS ACTED UNCONSTITUTIONALLY, BUT CHARGES AREN'T DROPPED

June 27, 2006

A U.S. Judge helped out the finances of the indicted former KPMG partners by opening the door for the international accounting firm to pay the parters' legal fees -- and then vigorously motioning the firm through that door. The judge declined to drop the charges, however. The Wall Street Journal reports ($link):

A federal judge in Manhattan found that government prosecutors violated the constitutional rights of 16 former KPMG LLP executives facing criminal charges for allegedly marketing fraudulent tax shelters by pressuring the firm to cut off their legal fees.

But U.S. District Judge Lewis A. Kaplan declined to dismiss the indictment against the former KPMG employees, saying they could file civil claims against the accounting firm to have the fees paid. He also suggested that KPMG could agree to advance the fees, and said the government could use its "leverage" to get the firm to pay the legal fees beyond its $400,000 cap.

In case somebody didn't get the hint:

Judge Kaplan left open the possibility the court could take further action if the fee issue isn't resolved. "The court declines to consider additional relief at this time, although it may do so in the future if KPMG does not, for one reason or another, advance defense costs," he wrote

The fees for the defense have to be enormous, so this must be a great relief to the defendants and their families. Given that long prison sentences are still a possiblity if the charges ultimately stick, the defendants can be excused if they aren't too happy just yet. Of course, being able to pay your lawyers can't hurt them on that score.

The TaxProf has a roundup.

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ANOTHER AMT ISO DEFEAT

June 27, 2006

If one door is locked, you try another. That one's locked, too?

That's the problem for taxpayers who exercised incentive stock options and then rode their new shares down to the basement. These taxpayers often owe large amounts of alternative minimum tax as a result of acquiring now-worthless stock.

James Pavlosky exercised ISOs in 2000, paying $96,120 for shares worth $1,612,500. While this generated no income in computing regular tax, the $1,516,380 difference was taxable in computing AMT. He apparently hoped to take advantage of the main ISO break - capital gain tax rates on the disposition of the shares one year after exercise.

Unforturnately, the stock collapsed. Mr. Pavlosky was unable to pay the $430,000 AMT bill and he ended up in bankruptcy.

The Tax Court has been unhelpful to ISO-AMT victims, like Iowan Ronald Speltz, so Mr. Pavlosky knocked at the Bankruptcy Court door for help. Earlier this month the Sourthern District of Texas U.S. Bankruptcy Court declined to open the door that the Tax Court left shut.

It doesn't seem like the courts are going to help the ISO-AMT victims. At this point they can only look to Congress.

The Moral: if you exercise incentive stock options, make sure you have enough resources to pay the AMT if the stock goes bad. If you don't, sell enough ISO stock to cover your taxes. You forfeit the regular tax breaks, but you may avoid a trip to bankruptcy court.

KNOW YOUR PAYROLL SERVICE

June 26, 2006

A frightening story out of New Jersey:

The owner of a New Jersey machinery manufacturing company is charging that New York-based TTS stole $47,000 of his payroll tax payments from the final three quarters of 2005. And he could be one of many potential victims in a case that has apparently drawn the attention of the Treasury Inspector General for Tax Administration.

The New Jersey company used TTS as their payroll service provider. TTS was supposed to remit payroll taxes on the company's behalf. TTS employees, according to a Tax Analysts story, may have made off with the funds. Apparently the IRS isn't being very sympathetic:

Documents provided to Tax Analysts show that Gaum Inc. owes the IRS roughly $47,000 in deficient withholding taxes. Kenny's client has also received notice of a federal tax lien. Kenny said that despite his client's involvement in the TIGTA investigation, the IRS has informed Kenny that the lien will not be released until payments are made.

If you are counting on a payroll provider to take care of your tax deposits, make sure its somebody you trust. If your payroll service provider doesn't remit your payroll taxes, the IRS will come after you. The IRS doesn't make it easy to check online whether your deposits are getting made, but if your tax advisor has your power of attorney, he may be able to check you account for you.

Permanent link to Tax Analysts article (Tax Analysts paid subscribers only).

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BEST?

June 26, 2006

Dan Meyer, proprietor of the Tickmarks blog, is kind enough to mention the tax update as one of the "Best of June Blogs" Thanks, Dr. Meyer!

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TROUBLE FOR TAX ACTIVIST NORQUIST?

June 26, 2006

Stuart Levine at Tax and Business Law Commentary says that Grover Norquist, the guiding hand behind Americans for Tax Reform and the dodgy disciple of estate tax repeal, may be in serious trouble. He notes a Washington Post article saying that Jack Abramoff funnelled cash for lobbying efforts through ATR:

According to an investigative report on Abramoff's lobbying released last week by the Senate Indian Affairs Committee, Americans for Tax Reform served as a "conduit" for funds that flowed from Abramoff's clients to surreptitiously finance grass-roots lobbying campaigns. As the money passed through, Norquist's organization kept a small cut, e-mails show.

That doesn't look good. Mr. Levine thinks that allowing ATR to be used as a conduit might make Mr. Norquist part of a criminal conspiracy. That may be wishful thinking by Mr. Levine, but even without criminal charges, ATR and Mr. Norquist may be vulnerable to some serious problems with the IRS.

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YOU DON'T SAY

June 23, 2006

From today's Des Moines Register:

Public distrust fueled by the CIETC salary scandal could be the biggest hurdle for a proposed $80 million per year sales-tax increase that central Iowa voters might be asked to approve this fall.

Imagine that.

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AICPA AND THE ESTATE TAX

June 23, 2006

The AICPA has made some recommendations for the estate tax. The recommendations are in a letter to to top congressional taxwriters reproduced by Tax Analysts ($link). The recommendations:

1. Make permanent the technical modifications to the generation-skipping transfer tax (GSTT) rules enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). These technical modifications provide relief from several GSTT "traps" that existed under previous law. However, as with other provisions of EGTRRA, these changes will sunset on December 31, 2010, unless action is taken to make them permanent.

2. Increase the applicable exclusion (exemption) amount in order to eliminate filing and tax burdens for 90 to 95 percent of estates. We also suggest indexing the exemption for inflation.

3. Retain the full step-up in basis to fair market value for inherited assets and avoid the complexities of carryover basis.

4. Create a uniform exemption amount for estate, gift, and generation-skipping transfer tax purposes. We emphasize the need for all three exemptions to be uniform in order to simplify planning for individuals.

5. Reinstate the full state estate tax credit, or provide another mechanism (such as a surtax) that would allow states to uniformly "piggyback" on the federal estate tax. To avoid diminishing tax revenues, many states have decoupled from the federal estate tax and enacted their own estate tax regimes, resulting in unnecessary complexity and uncertainty in both planning and administration.

6. Provide broad-based liquidity relief, rather than targeted relief provisions. Broad provisions that would apply to all illiquid estates would be both simpler and fairer to all taxpayers.

7. Make the top estate tax rate no higher than the maximum individual income tax rate. We note that if the rate structure has a large gap between brackets, there may be significant uncertainty in the planning process for married couples with significant estates. For example, taxpayers may have to consider if estate tax should be paid at the death of the first spouse at a 15% rate compared to an alternative of paying the tax in the future but at a higher rate.

Overall, these are pretty sensible. They would simplify planning, get rid of targeted provisions, increase the exemption, and lower the rate. I think "the highest individual rate" of 35% is too high, and I think uniform valuation rules would be helpful, but the AICPA recommendations are sensible and would improve the Thomas bill if they could be added to it. Unfortunately, it's probably too late.

The TaxProf rounds up coverage of yesterday's House passage of the Thomas estate tax bill.

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EXACTLY SO

June 23, 2006

From the Tax Policy Blog:

If a country desires a corporate income tax, it should have as broad a base and as low a rate as possible to ensure economic neutrality between industries. Unfortunately, the United States� corporate income tax has neither.

The U.S. statutory corporate income tax rate is as high as 35 percent. At the same time, the corporate tax code is riddled with exemptions, credits, deductions, and other special provisions�many of which have no economic rationale except to appease special interests and rent-seeking industries.

Rent seeking?

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HOUSE PASSES ESTATE TAX BILL; ON TO THE SENATE

June 22, 2006

The house has passed H.R. 5638, the Thomas estate tax compromise bill. The vote: 269-156.

(Note; I hade the wrong vote total and roll call link; I linked to a procedural vote. It's now corrected. Thanks, Professor!)

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BACKDATED OPTIONS: A GOOD THING?

June 22, 2006

The Wall Street Journal law blog calls my attention to a piece by WSJ columnist Holman Jenkins ($link) criticizing the coverage of the option backdating scandal. The blog entry says:

Jenkins writes that anyone �who waded through the literature on CEO compensation has long been aware of studies showing that executives reap non-random gains on their stock options.� He continues: �No surprise here: Options are meant to motivate executives to produce non-random gains, and the whole theory of corporate governance is that executives are self-interested and possess inside information, so you�d expect them to negotiate pay deals for themselves from which they�d benefit.�

Mr. Jenkins goes on:

Yet there is nothing categorically corrupt or improper about backdating to justify a conclusion that the boards here weren�t doing just that.

The scandal element, instead, arises because ever-shifting accounting, regulatory and tax standards were, by some readings, punitive during the years in question toward choosing a past date to make an options package effective.

That's cool: "by some readings" tax standards were "punitive." In fact, by any but the most willfully obtuse reading, backdated stock options are disqualified from the the exemption options otherwise enjoy from the $1 million tax deduction limit on executive compensation. By backdating options the executives have cost their companies, and their shareholders, millions of dollars in additional taxes. That by itself is a scandal. Even if you don't think that tax law is good policy - and I don't - that doesn't excuse executives who transfer millions of dollars of shareholder money to the IRS by flouting it.

UPDATE: In the comments IRS whistleblower Remy Welling notes the no-backdating rule for incentive stock options; that is independent of the $1 million compensation cap.

ANOTHER UPDATE: A more sympathetic view of the Jenkins piece from the barren icy wastes of southern Canada.

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FORD, MERCURY HYBRID SUVS CERTIFIED FOR TAX CREDIT

June 22, 2006

The IRS yesterday announced (IR-2006-98)that Ford Escape and Mercury Mariner Hybrid models qualify for the hybrid car tax credit as follows:

Ford Escape Front WD Hybrid Model Year 2007 � $2,600

Ford Escape 4 WD Hybrid Model Year 2007 � $1,950

Mercury Mariner 4 WD Hybrid Model Year 2007 � $1,950

Remember, this credit doesn't apply in computing alternative minimum tax, so be careful!

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HOUSE VOTE ON ESTATE TAX BILL TODAY

June 22, 2006

The House of Representatives is expected to pass Rep. Bill Thomas's H.R. 5638, "The Permanent Estate Tax Relief Act of 2006," today. The key vote comes next week when the Senate tries to gather the 60 votes needed to pass the bill. The bill now includes a provision indexing the $5 million exemption amount for inflation.

The TaxProf has a roundup of news and commentary. My own view: The Thomas bill has some of the features of a desirable estate tax - a low rate and a large exemption. It lacks other features that would make for good tax policy; these include repeal of special valuation and payment rules for small businesses and farmers (with a large exemption and low rate, these have no justification) and enactment of uniform valuation rules that would end the benefits of tax engineering like family limited partnerships to hold marketable securities.

Still, it's an improvement on the current system with its punitive rates, and it's a huge improvement over the one-year exemption in 2010 followed by 60% rates in 2011.

The most compelling argument against the Thomas bill is that it will cause the government to forsake a lot of revenue. That's poor justification for bad tax policy, and the current high-rate, loophole-ridden system is a model of bad policy. I think the opponents of the Thomas bill would have a much better argument if they laid out a better alternative to H.R. 5638 than simply keeping the current mess in place.

A more detailed discussion of my views can be found here.

Prior Tax Update coverage:

THOMAS INTRODUCES ESTATE TAX COMPROMISE

THOMAS COMPROMISE MAY BE SHORT OF 60 SENATE VOTES

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MICREL, AUDITOR DUKE OUT OPTION PRICE DISPUTE

June 21, 2006

The New York Times has an article up this week about Micrel's lawsuit against its former auditor over stock option repricing. The Micrel practice of repricing its stock options is back in the news now that other companies are under suspicion for backdating executive stock options.

From the story:

Instead of granting options at the market price on a new employee's hire date, Micrel proposed setting the price at the lowest point in the 30 days from when the grant was approved.

It seemed like an ideal solution. The 30-day window could help Micrel attract and reward new hires on a more equal footing, while helping to retain existing employees. And if it were extended up the corporate ladder, the prospect of built-in gains and tax breaks, worth millions of dollars, could enrich senior executives.

But the 30-day pricing method, which Micrel adopted in mid-1996, was an aggressive move legally and financially. In hindsight, it was also a major misstep.

Nearly five years later, Deloitte reversed its opinion and urged Micrel to restate its financial reports. The Internal Revenue Service came banging on its door. And today, Micrel and Deloitte are passing blame back and forth in court.

Of course, the IRS banged on the door, came in and looked around, and walked out empty-handed. I doubt it will be so gentle on the current crop of option backdaters.

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CARNIVALS AND CAVALCADES!

June 21, 2006

The second issue of Cavalcade of Risk is up at "It's Just Money." The Carnival of the Capitalists is at Blog Business World this week, and the Carnival of Persoanl Finance is at Consumerism Commentary. Check 'em out.

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WILL THIS ONLY INCREASE HIS THIRST FOR VENGEANCE?

June 21, 2006

Injustice happens. Maybe you got caught shoving back back the class bully, while the bully gets away with it. Maybe you got blamed for the spitball the kid behind you shot at the teacher. When you grew up, maybe you had to settle a bogus lawsuit because it was too expensive to defend. You grumble and get on with life.

Gene Haas, the owner of "the nation's largest computerized machine tool maker," apparently couldn't just let it go. According to court papers, Mr. Haas was angry at losing a patent lawsuit and decided to get even with the government by evading taxes. From the New York Times:

"The tax fraud schemes in this case stem from defendant Haas's dislike of the federal judicial system and anger towards a federal judge (Judge Leonie M. Brinkema) who presided over a patent infringement suit" that Mr. Haas lost in August 2000, according to the court papers. The indictment said that the primary purpose of the "tax fraud schemes was to recoup the patent infringement settlement payment by defrauding" the government.

This is turning out to be a really bad idea. The government has now accused Mr. Haas of evading nearly $20 million in taxes by a phony invoice scheme. According to the charges, a sham company sent invoices to Mr. Haas's company, Haas Automation:

Denis A. Dupuis, 51, of Newbury Park, Calif., a former general manager of Haas Automation, and Robert G. Cable, 73, of La Crescenta, Calif., a former salesman for the firm, were indicted, accused of helping fabricate the tax deductions. They were paid about 2 percent of the $23 million in face value of the sham invoices, the indictment said.

The other 98 percent of the money was funneled back to Mr. Haas, according to the indictment. It said Mr. Haas cheated the government out of $12.5 million on his personal tax returns and $7.7 million on Haas Automation's returns in 2000 and 2001.

The indictment also described two other invoicing schemes. One involved a Nascar race team sponsored by Haas Automotive and the other a land title company. The indictment gave few details other than stating that all the money paid in those two schemes was funneled back to Mr. Haas, suggesting that he may have operated them without confederates.

If I correctly read the federal sentencing guidelines, evading nearly $20 million in taxes using "sophisticated means" is worth 78 to 97 months of prison time for a first offender. Keep in mind that Mr. Haas has not been convicted of anything, and is presumed innocent by the courts. If he is convicted, however, he'll probably have over six years to ponder whether getting even with the government was a good idea.

(Hat tip: TaxProf Blog)

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THOMAS COMPROMISE MAY BE SHORT OF 60 SENATE VOTES

June 21, 2006

The estate tax fix we discussed yesterday may be struggling to get the 60 votes it needs to get through the Senate. The stumbling block appears to be projected lost revenues, according to Tax Analysts (viia the Tax News blog).

One important item that we should have mentioned yesterday: the proposed $5 million per taxpayer exemption could be inherited if not used. This would mean that a married couble would be able to pass $10 million tax-free even if the first to die didn't have $5 million to inherit. If he or she) only had $1 million of property in his own name, the spouse could use his remaining $4 million at her death. This is great from a policy standpoint, as it eliminated the need for trusts to keep couples from wasting their exemptions. Unfortunately it comes at a price:

Those provisions help push the cost of the bill about $5 billion higher than Kyls proposal, with the Joint Committee on Taxation estimating the 10-year cost of H.R. 5638 at $280 billion. The additional cost comes despite a provision permanently repealing the credit against and eliminating the deduction for state estate taxes and despite JCT assumptions that the capital gains tax rate will climb back to 20 percent in 2011, as scheduled under current law. According to the left-leaning Center on Budget and Policy Priorities, the cost of the legislation would climb to $800 billion between 2012 and 2021 if lawmakers were to extend the lower capital gains tax rate.

In an ideal world much of this lost revenue would be recovered as part of a comprehensive reform package (and by spending less, but that's not their way). Such a package would included standardized valuation rules that would eliminate the benefits family partnerships and other artificial vehicles to suppress estate values. It would also eliminate special valuation rules for farms and small businesses; these become unnecessary at a 15% or 20% rate with a large exemption. But it's not an ideal world; even though it has been clear for some time that there weren't 60 votes for repeal, they didn't get serious until this week about the fallback plan.

The TaxProf has a great roundup of stories on the estate tax saga.

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THOMAS INTRODUCES ESTATE TAX COMPROMISE

June 20, 2006

Now that the Senate has shown that it can't generate 60 votes to repeal the estate tax, lawmakers are finally getting serious about a long-term fix. As the law stands now, the estate tax will disappear in 2010, only to revive at much higher rates and with lower deductions one year later.

In an attempt to help the Senate put together the 60 votes needed for a fix, House Ways and Means Chairman Bill Thomas has proposed an estate tax with a $5 million per person exemption and a rate linked to the capital gains rate, currently 15%, for estates between $5 million and $25 million. Estates over $25 million would have a rate of twice the capital gain rate.

This makes sense under current law, but the linkage could get ugly if capital gain rates increase. In my 20 years of tax practice I've seen capital gains taxed at effective rates of 28% or more, and 56% strikes me as too high a rate for about any tax. Also, capital gains taxes tax only gains; the estate tax applies to 100% of the value of property held at death, whether it is appreciated or not.

The bill doesn't seem to have any provision to clean up the tax code by standardizing valuations or eliminating special provisions for small businesses. As the bill apparently does have a special income tax provision for tree growers, I don't think it's about cleaning up the tax code.

Links:

Center for Tax Studies crib of Tax Analysts report

Text of H.R. 5638

TaxProf Blog coverage

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IDED: THE MORE YOU SPEND, THE MORE YOU SAVE

June 20, 2006

Everyone has seen department store sale ads breathlessly intoning "the more you spend, the more you save!" The arithmetic seems almost plausible, until you think about it for a half-second. Then you realize the "savings" exist only if you assume away every possible use of your money other than buying things at that store.

The Iowa Department of Economic Development yesterday released a report trumpteting the successes of the Iowa Values Fund grants and incentives for small businesses. The report identifies the number of jobs "created and retained" by the IVF tax credits and incentives.

The math behind these claims is a lot like the math of the department store circular. The IDED assumes away other possible uses for the money spent on the funds. It also ignores the effects on other businesses whose competitors are subsidized by the IVF and who have to pay the higher taxes to fund it. The IDED also has no way to tell how many jobs would have been created in other ways absent the IVF funding, via banks or investors.

When all of the hidden costs are taken into account, there's no way that taxing Iowans and their businesses to lure and subsidize their competitors is a net gain to Iowa's economy.

Link: Des Moines Register Coverage

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MILLER S-CORP BASIS CASE - A WINDOW TO THE IRS EXAM PROCESS?

June 19, 2006

Tax Attorney Kreig Mitchell says last week's Miller Tax Court Case provides a window to the IRS approach to audits. The case involved an S corporation shareholder who deducted losses based on amounts he loaned to the corporation. Mr. Mitchell writes:

Based on the court opinion, it is apparent that the IRS agent undertook the tax audit with the sole aim of disallowing the losses. Ultimately the IRS logic is that Miller paid too little in tax in relation to other somewhat similar situated taxpayers - even though he was well within the law - therefore it is the IRS agent's job to collect tax revenues from Miller. I have seen this numerous times (so much so that I can almost see the look on the agents facial expressions as he or she is interviewing the taxpayer).

Mr. Miller won his tax case, but Mr. Mitchell says some taxpayers get buffaloed into conceding unwarranted tax adjustments.

This case presents such a common scenario, that it is worth pointing out to taxpayers. The Miller case highlights the IRS audit process and it shows that the IRS can and do take unsupportable positions and file frivolous lawsuits. It also shows some of the tactics IRS agents employ to encourage taxpayers to accept IRS determinations.

I've been fortunate (knock wood) in not having had to deal with many really bad IRS agents. They do exist, though, and the best way to fend them off is to be well-advised, as Mr. Miller was.

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SELL IT ON E-BAY

June 19, 2006

Technology evolves, but people stay pretty much the same. That means the march of progress creates new ways to get in trouble. For example, last week a defrocked San Diego policeman pleaded guilty to tax evasion via eBay:

SAN DIEGO � A former San Diego police officer, who failed to pay $63,000 in taxes on his salary and profits he made by selling stolen property on eBay, pleaded guilty Wednesday to federal income tax evasion charges.

James Estrella, 46, is scheduled to be sentenced Sept. 5 by U.S. District Judge Roger Benitez.

As part of his plea, Estrella admitted that he failed to file income tax returns for the calendar years 2001 through 2003, and failed to pay taxes for those years.

This is the first eBay tax conviction I have noticed, though I wouldn't be surprised if there have been others. With the IRS getting access to PayPal and offshore credit card records, I'm sure it won't be the last one.

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JULY 2006 APPLICABLE FEDERAL RATES (AFR) ISSUED

June 16, 2006

The IRS has issued (Rev. Rul. 2006-36) the minimum interest rates for loans made in JuLY 2006:

-Short Term (demand loans and loans with terms of up to 3 years): 5.05%
-Mid-Term (loans from 3-9 years): 5.05%
-Long-Term (over 9 years): 5:29%

Historical AFRs are available at the "links" page at www.rothcpa.com.

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S CORPORATION SHAREHOLDER WINS BASIS CASE IN TAX COURT

June 16, 2006

We have covered several cases where the IRS has shot down attempts by S corporation owners to deduct losses attributable to loans they made to S corporations. The IRS usually prevails when the taxpayer makes a loan to the S corporation using funds borrowed from a relative, or even (in effect) from the S corporation itself.

HOW IT'S DONE

In a Tax Court decision yesterday, a taxpayer demonstrated the right way to get loan money to an S corporation to get basis for pass-through losses. Timothy J. Miller owned Miller Medical Systems, Inc. (MMS), an S corporation "in the business of manufacturing mobile and modular medical diagnostic facilities."

The tax law only allows you to deduct S corporation losses to the extent you have basis in S corporation stock, or in debt you have loaned to the S corporation (click here for a more detailed explanation of these rules). Furthermore, you have to be "at-risk" for that basis - in crude terms, you have to be on the hook for it.

Continuing losses meant Mr. Miller was running out of basis by 1992. He had guaranteed a line of credit from Huntington Bank to MMS. The borrowings against the line didn't give Mr. Miller any basis for losses because guarantees of S corporation debt don't create basis. To get more basis, Mr. Miller replaced a line of credit from Huntington to MMS by entering into a personal line of credit with the bank under the same terms. He then entered into his own line of credit with MMS and took a security interest in the MMS property; the bank then took a secured interest in his security interest.

Four co-investors in the group signed guarantees of Mr. Miller's line of credit; in an unusual arrangement, they waived any right to go after Mr. Miller if the they had to make good on the guarantee.

And in due time, they had to.

IRS: NO SUBSTANCE, NO BASIS

The IRS tried to disallow Mr. Miller's deductions by arguing that "in substance" Mr. Miller was just guaranteeing the old loan, rather than borrowing personally:

Respondent [IRS] contends, however, that no substantive indebtedness was created between petitioner [Mr. Miller] and Huntington as a result of the restructuring because MMS remained in substance the borrower from Huntington. In respondent's view, petitioner was at best some kind of accommodation surety with respect to the indebtedness, a role insufficient to give him basis under section 1366(d)(1)(B).

The Tax Court rejected the IRS argument, noting that Mr. Miller was listed as the borrower on the bank records, and that the bank sought additional security from Mr. Miller when it later increased the line, including a second mortgage on his parents house.

AT-RISK

The IRS also said that the guarantees by his co-owners meant he was not "at-risk" for the guaranteed amounts. The Tax Court rejected the argument, saying that just because somebody else might be on the hook if he couldn't pay didn't mean he didn't have to pay if he could:

In short, there was no certainty that the guarantors would be called upon to satisfy the indebtedness. As a consequence, we conclude that petitioner had a realistic possibility of loss thereon.

This "realistic possibility of loss" standard is one of two ways the courts have enforced the at-risk rules. Some courts have used a different "worst-case scenario" view, which looks at who ends up holding the bag if everything goes bad. The Eighth Circuit, which includes Iowa, has used the "realistic possibilty" standard (See Moser, 914 F.2d 1040, no link available). If not overturned on appeal, this case will be helpful guidance for Iowans and other Eighth Circuit taxpayers.

The Moral? If you need to borrow money to fund your S corporation, visit your friendly banker. Don't borrow from your other businesses, or from your family, or from your co-owners. If you have to get a guarantee, make it clear that you are on the hook first.

Cite: Miller, T.C. Memo 2006-125

IOWA WILL CUT YOUR HOLDING PERIODS INTO LITTLE PIECES

June 16, 2006

Iowa has an unusual tax break for capital gains on business property held for a long time. You don't have to pay Iowa taxes on certain capital gains from the sale of business assets if you have both

1. Held the property for 10 years, and
2. "materially participated" in the business for 10 years.

This week the Iowa Department of Revenue ruled that if you buy your interest in the business in pieces, your holding period is also measured in pieces, and only the pieces held for 10 years qualify for the capital gains break.

THE COLOR CONVERTING SAGA

Chandrakant Shah began working for Color Converting Industries, an S corporation, in November 1978. He first acquired an ownership interest in the business in 1983. The S corporation later contributed the assets of the business to a limited liability company, Color Converting LLC; the S corporation continued in existence as an owner of the LLC.

He acquired additional interests in 2001 by setting up a new S corporation to buy additional interests in Color Converting LLC. At this point he had interests in two S corporations owning interests in the same LLC.

When the business sold its assets in 2003, the gain was taxed on the returns of its owners, including Mr. Shah. Mr. Shah claimed the Iowa exemption for all of the capital gain passing through to his 1040 through his two S corporations. The Department disagreed:

Because Protesters seek a deduction for capital gain resulting from the sale of their entire interest in the business, and not merely a portion of the interest, the period of time that Protesters held that interest is relevant. The Department does not dispute that the portion of the sale representing Protesters� interest in the business that was acquired in 1983 meets the requirements of 422.7(21). Protesters maintained an ownership interest in the business despite the fact that the business entity changed. At the time of the sale of the business, Protesters held this interest in the business for more than ten years and materially participated in the business for more than 10 years. Protesters contend however, that because the capital gain from the sale of their interest acquired in 1983 qualifies for the capital gain exclusion, that the property interest acquired in 2001 should also qualify for the exclusion.

Iowa enacted new holding period legislation this year that applies federal holding period rules to the capital gain exclusion. As federal law would treat the two interests acquired as having their own holding periods, the Iowa holding here likely would have been the same under the new law.

Link: Iowa Letter of Findings dated February 8, 2006

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NO MERCY FOR TAX CHEATS AROUND HERE

June 16, 2006

When a 68 year-old Minnesota businessman came up for sentencing on evading $240,000 in federal taxes, federal judge John Tunheim was kind and merciful. This week an appeals court told him to forget that mercy stuff.

Gerald Ture was convicted of dodging $240,000 of federal taxes by having companies he owned transfer funds to his personal bank account and treating the transfers and deductible business expenses. He never reported the transfers as income.

The federal sentencing guidelines indicated a prison sentence of 12-18 months for Mr. Ture, along with $3,000 to $30,000 in fines. Taking into account Mr. Ture's age, health, remorse, cooperation and lack of criminal history, the judge decided that two years probation and a community service requirement were punishment enough.

The Eighth Circuit Court of Appeals (which also covers Iowa) ruled that the mercy was misplaced. Tax evaders need to be imprisoned for the same reason armies shoot deserters - to encourage the others:

The District Court also failed to consider the importance of a term of imprisonment to deter others from stealing from the national purse. As the Guidelines explain, willful tax evaders often go undetected such that those who are caught -- especially those who are caught evading nearly a quarter-million dollars in tax -- must be given some term of imprisonment. The goal of deterrence rings hollow if a prison sentence is not imposed in this case.

The appeals court also said that it wouldn't be fair to other tax cheats who have had to serve time:

A review of Ture's offense and the factors the District Court considered almost begs the question of who gets prison if Ture does not.

The sentencing judge also said that paying back taxes, penalties and interest was enough of a financial burden that imprisonment was not needed. The appeals court didn't agree:

The second reason the District Court abused its discretion is because it wrongly accorded significant weight to an improper factor. In deciding against a term of imprisonment, the District Court placed a great deal of weight on the fact that Ture owes a substantial amount of back taxes, interest, and penalties. We deem this factor entirely improper and believe it results in bad public policy. If district courts were free to reduce prison sentences as the amount of tax loss rises, willful tax evaders would benefit as the amount of the government's tax loss rises, i.e., the lesson would be the more you cheat, the more lenient your sentence.

So the case goes back to the sentencing judge, presumably for a sentence including prison time.

The moral? Don't have your company pay your personal expenses to cheat on your taxes, and don't expect the federal courts here in the Eighth Circuit to cut you any slack if you get caught.

Links:

United States v. Ture, 8th Circuit No. 05-3142

Government Brief in appeal

Sentencing Law and Policy Blog coverage (not favorable to the decision).

St. Paul Pioneer Press coverage

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TAX POLICY QUOTE OF THE DAY

June 16, 2006

From a post at the Tax Policy Blog on a proposed presidential line-item veto on tax bills:

What is the difference between a direct subsidy on the spending side to a company that is poor spending policy and an equal tax deduction that is poor tax policy? Nothing, except that going through the tax code is often less transparent, and therefore easier for tax lobbyists to get inserted into law.

Indeed.

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YOU DON'T EXPECT THEM TO LOOK AT TAX RETURNS ALL DAY, DO YOU?

June 15, 2006

An employee of the Oregon Department of Revenue was having too much fun at his desk:

SALEM, Ore. - Electronic files containing personal data of up to 2,200 Oregon taxpayers may have been compromised by an ex-employee's unauthorized use of a computer, the Oregon Department of Revenue said Tuesday.

Amy McLaughlin, an information technology security officer with the state, said the incident apparently occurred when an employee downloaded a contaminated file from a porn site.

What, the tax returns weren't exciting enough?

Hat tip: TaxProf Blog.

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PEARLS OF TAX WISDOM

June 15, 2006

A bunch of current and former tax officials are convening at the 2006 IRS Research Conference Program at Georgetown University. After reading the Tax Analysts ($link) coverage, I almost wish I'd been there.

Mark Matthews, IRS deputy commissioner for services and enforecment, had a sharp observation on efforts to close the "tax gap," the difference between the amount of taxes imposed in theory and the amount collected:

Matthews acknowledged that the IRS will also have to get better at using the data it already has, but said that with significant help on the funding side and some legislative improvements, $50 billion to $100 billion could be shaved from the $345 billion tax gap.

"We'll never get it to zero. We'll never get close to zero," he said. "You wouldn't want to live in a country where it was close to zero".

On audit effectiveness:

A study released later in the day by three researchers, among them the IRS's Edward Emblom, asserted in its preliminary results that increased audits can have a significant effect on compliance for all taxpayers.

According to the study, doubling the audit rate from 1 percent to 2 percent on businesses with incomes between $25,000 and $100,000 reduces noncompliance by 7 percent, while doubling the audit rate for larger businesses had similar but less pronounced results.

Carrying out the math, if doubling the audit rate reduces noncompliance 7%, you'd have to increase audit coverage by over 14 times to eliminate non-compliance. Of course you would never do such a thing, but its worth noting how hard it is to close the tax gap. How much additional enforcement is worthwhile, and when do you see diminishing returns? Even if you increase the audit rate to 15% you would never eliminate non-compliance; at some point snuffing the last vestiges of non-compliance just costs too much.

On the stupidity of Section 199 and tax law drafting in general:

Later in the day, a panel of former Treasury officials agreed there is little hope lawmakers will take administrability into account in tax reform efforts or even in modest tax law changes.

"Unless it can be made into a sound bite, there are few lawmakers interested in simplicity and even fewer interested in administrability," said Pamela Olson, former Treasury assistant secretary for tax policy, now with Skadden, Arps, Slate, Meagher & Flom, Washington.

Olson said that President Bush called the section 199 deduction "ridiculous" while Congress was working on it, but lawmakers ignored the White House opposition. Section 199 was criticized by the panelists as an example of totally unadministrable tax law.

On our legislators' priorities:

Olson acknowledged that while some complexity is inherent in the code, she called "nonsensical" the lengths to which lawmakers have gone to funnel social, industrial, and energy policies through the tax code. Jane Gravelle of the Congressional Research Service said lawmakers seemed most concerned with raising the minimum amount of money necessary aided by budget gimmicks while still pandering to constituents.

Still, we must be sympathetic; it can be hard to pander while engaging in gimmickry without mussing your hair.

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TAX STUPIDITY

June 15, 2006

If Professor Maule's suggestion can be crafted into legislation, all of our government funding needs will be easily met: just tax stupid behavior:

Instead, let's stop taxing "sin" and activities classified as "sin" under certain dominant theologies. Instead, let's tax stupidity, or, more precisely, stupid behavior. I'm confident that the taxes on cigarettes would remain, because, with apologies to the people I know who smoke, smoking is stupid.

Heck, taxing stupid behavior would enable Congress to pay for itself!

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WORKERS V. INDEPENDENT CONTRACTORS: THE OBVIOUS

June 15, 2006

The IRS yesterday released a "Fact Sheet" on how to determine whether a worker is an employee or an independent contractor. The fact sheet begins by stating the obvious:

Most workers fall into two categories:

* Independent contractors
* Common-law employees

The main factor a business must use in determining how to classify its workers is the degree of control the business has over its worker. The more control the business has over a worker; the more likely it is that the worker is an employee rather than an independent contractor.

The sheet goes on:

It is critical that the business correctly determine whether the individuals providing services are employees or independent contractors. An employer must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. In addition, other tax issues, including the provision of certain employee benefits, depend upon the proper classification of workers.

A business generally does not have to withhold or pay any federal taxes on payments to independent contractors. However, independent contractors are subject to self-employment tax and should plan accordingly.

If a business incorrectly classifies a worker, the business could be subject to penalties.

OK, once the obvious is covered, what insight does the fact sheet give us as to making the distinction?

A business must base its determination as to whether a worker is an employee or an independent contractor on all facts and circumstances of its relationship with the worker.

Thanks for the help, guys!

In fairness, they do link to other resources; the TaxProf has more.

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FEELINGS... NOTHING MORE THAN FEELINGS...

June 15, 2006

Proving that Congress has the emotional stability of a junior high school, Max Baucus said "strong feelings" could delay a final estate tax compromise (TAFBLTL*):

"There are strong feelings all the way around," Baucus said later in the day. "Because of the strong feelings, I just don�t know" if an agreement can be reached by the recess.

Hmm. Max says Blanche and Chuck are mad at Jon and Bill, but he'll talk to Chuck, and maybe Olympia and Kent can make them friends again.

The current talk seems to involve a variation on a proposal by Jon Kyl:

The Kyl proposal, which would raise the estate tax exemption level to $5 million and lower the rate to 15 percent, has been modified to create an additional 30 percent rate on estates over $30 million. Finance Committee Chair Chuck Grassley, R-Iowa, has said the imposition of a 35 percent rate on estates over $35 million has also been discussed, but a Finance GOP aide said discussions are �very fluid� at this point.

Link: Tax Analysts $permanent link.

*Tax Analysts Free But Lame Temporary Link

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BACKDATED OPTIONS: IT'S LOOKING LIKE A NAIL

June 14, 2006

The old saying holds that when all you have is a hammer, everything looks like a nail. If your a lawmaker, your hammer is legislation. Case in point:

U.S. Senate Finance Committee Chairman Charles Grassley said executives who manipulated stock- option grants should be prosecuted, and he's willing push for changes in tax laws to make it happen.

"I've asked the Justice Department to let me know whether the tax laws on the books are adequate to rein in and prosecute stock-option backdating," Grassley, an Iowa Republican, said in a statement today. "I've asked the Justice Department to let me know. If the tax laws are inadequate, I want to beef them up."

But a new law isn't the answer to every bad thing. Backdating stock options already carries pretty serious tax consequences. With U.S. Attorneys investigating a raft of companies with backdated options, it's likely that the practice can constitute securities fraud or tax fraud. The Sarbanes-Oxley securities law probably put an end to the practice by requiring the reporting of options within two days of their grant.

Of course, you can pass all of the laws you want, but they don't work very well if they aren't enforced.

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RELIVING YOUTH THROUGH LITIGATION

June 14, 2006

The battle over Howard Hughes's estate was a fixture of my youth, like AMC Matadors and giant 2-door Chevys. If you look hard enough, you can find and drive old cars, but will contests come to an end.

Except for Mr. Hughes's estate, apparently. Joel Schoenmeyer explains how Melvin Dummar is taking another shot at claiming some of the estate using the "Mormon Will."

It almost makes me want to wear bellbottoms.

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ANOTHER INDIAN MASSACRE

June 14, 2006

The Tax Court handed down three decisions yesterday, all concerning members of Indian tribes claiming that they were exempt from the federal income tax.

How'd they do? About as well as some Indians did trying to reach Iowa in 1832. Russ Fox has the grim details.

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DES MOINES HOSTS HACKERFEST!

June 13, 2006

Actually, I hope not, but it's possible that the municipal fileservers are hosting a hacking event right now, based on this story from today's Des Moines Register:

Council hush on reasons for computer upgrade City pays $676,000 to fix unknown security 'loopholes'

Des Moines City Council members Monday approved a computer system upgrade � and kept secret the reasons they agreed to spend $676,000 of taxpayer money on it.

In addition, the city failed to obtain competitive bids on a portion of the project.

"I think this one, at least for me, is much more important to secure the network" in an expedited time frame, Mayor Frank Cownie said during the special meeting.

They're in a hurry, but it's obvious why they might be reluctant to say much:

Des Moines Police Chief Bill McCarthy last week told the council "there were some hideous problems" with the computer system that are "of the utmost urgency to resolve."

I can see the press conference:

"Chief McCarthy, I'm Ruslan Belarenko from the Leningrad Hacker Weekly. Could you tell us more about the nature of your security hole, the operating system, and the system administrator password? Oh, nevermind, the password is 'password,' I just figured that out."

Based on what I've seen from our computer guys, there are a lot of vulnerable networks out there. Part of their job is to test the security of client networks (only on request, of course), and it's scary to watch them penetrate systems that clients think are safe. I wouldn't be surprised at all to see a city or county network compromised big-time.

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DEATH AND TAXES ON DEATH TAXES

June 13, 2006

Joel Shoenmeyer has a thoughtful post on the proposed repeal of the estate tax. As I understand the post, he has philisophical problems with the estate tax:

I see no reason why the government should try to topple family dynasties when (1) such social engineering rarely if ever works, and (2) family dynasties (usually via incompetent and/or lazy members of following generations) do such a good job of toppling themselves.

Even so, he doesn't think the time is right for repeal:

...if you want to repeal the estate tax, you have to show either that (a) doing so will not result in a loss of revenues or (b) the loss in revenues will be made up elsewhere. I don't believe I've heard many people address either of these points.

Read the whole thing.

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SEC CHAIR ON OPTION BACKDATING

June 13, 2006

In a recent speech SEC Chairman Christopher Cox talked about option backdating:

While I can't comment on the SEC's ongoing investigations of specific companies, I can tell you what the Commission's position is. Back-dating must be fully disclosed. And the granting of back-dated options must be properly accounted for.

As one means of dealing with this problem, our proposed executive compensation rule will provide better and more useful disclosure of the backdating of options. It would require that a company clearly identify the portion of compensation that results from "in-the-money" option awards resulting from backdating.

Via BenefitsBlog.

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CRACKING THE CODE, OR SMOKING THE CRACK?

June 12, 2006

A reporter from Tax Analysts e-mailed me last week asking if I had ever dealt with clients who filed returns based on a book called "Cracking the Code." I hadn't heard of the book, so I googled the book title. After getting a page full of responses about the Catholic Church and Opus Dei, I refined the search by adding the name of the author, Alan Hendrickson.

Based on the Google results, Mr. Hendrickson's book looks like the usual delusional tax protestor stuff - wages aren't income unless their earned by government employees or on federal reservations or territories, etc. I said as much to the reporter, and said I was glad I had no clients who had filed based on Mr. Hendrickson's theories.

The reporter then asked why the IRS seems to issue refunds based on these returns. That is an interesting question. The IRS clearly does issue refunds based on bogus tax theories on occasion, and some people no doubt get it. Why?

ROLLING THE ACORNS PAST THE BLIND SQUIRRELS

Mr. Hendrickson would argue that the IRS issues refunds because he's "cracked the code," discovering the magic set of filings to get you out of paying taxes. That is, of course, absurd. And no, it's not a conspiracy to keep me doing what I'm doing for a living; if this stuff actually worked, I would take it to my highest-income clients, crack the code for them, and get them to pay me an annuity of 5% of their tax-free income for the rest of my life; they'd do it gladly, if it worked, and I'd spend my springs watching baseball games in Arizona instead of doing tax returns in Des Moines.

The refunds come through, when they come through, because of the ponderous nature of the IRS bureaucracy. I don't think the IRS has ever really figured out how to cope with tax protestors. It will inevitably fail to recognize some of the tax protest returns out of the 160 million or so annual 1040s, and some of the bogus filers will get their refunds. Any refund claim is likely to get paid if it isn't done in crayon, if it foots, if it doesn't use some obvious tax-protest trigger words (and maybe even then), and if the refunds are relatively small.

The Tax Analysts piece on Mr. Hendrickson's book came out today ($link). It quotes Dennis Parizek, "an IRS operations manager who heads the agency's "frivolous filer" unit based in Ogden, Utah." The piece says:

Parizek estimated that this year the IRS has stopped roughly 90 percent of zero wage refund claims, and he expressed confidence that more would be recovered after his agents start examining the returns filed this year. He speculated that most of the zero wage refunds that had been issued this year were for relatively small amounts -- less than $2,000.

The numbers are vague enough to make me suspicious. I wonder where they get the 90% figure? It's reassuring to know that the service centers do have teams dedicated to tax protest issues, but the words "estimated" and "speculated" sound like somebody guessing, rather than somebody with solid figures.

THE MAGICAL FORM 4852

Unfortunately for Mr. Hendrickson's readers, the method the book seems to advocate is one the IRS is likely to catch. Apparently Mr. Hendrickson's adherents file Form 4852, which is used by people who never get a W-2 from their employer, or who find errors on the W-2. The code-crackers file a 4852 showing no income.

This is likely to generate an IRS notice. The IRS does computer routines to match employer W-2 reports with the 1040s that are supposed to show the income. This routine will normally flag the code-crackers returns for further review. The IRS matching runs for 2004 filings are probably underway about now, and a lot of 2004 crackers who weren't identified on their initial filings can expect unhappy tidings from the IRS over the summer.

WHY SO SLOW?

Still, I have always thought the IRS response to tax protest arguments was puzzlingly slow. Tax protest promotors should be hit hard, and quickly, with maximum publicity to set an example. In fact, though, many continue to operate for months or years while the slow IRS injunction process grinds on - giving the gullible the impression that the promotors have really "cracked the code." And then they brag to their neighbors or on Mr. Hendrickson's website, making honest filers feel like chumps, at least for awhile.

I wonder whether the IRS has a central unit devoted full-time to tax-protest schemes? A few lawyers and agents devoted full-time to tax protestors and scam preparers should be able to pay for their keep by shutting down scams before they get traction.

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IRS SNITCH: A LESS THAN LUCRATIVE CAREER?

June 12, 2006

Tax lawyer Kreig Mitchell looks at the the new Treasury Inspector General's report on the IRS informant reward program.

There can be little doubt that most informant claims are rejected. Even if a claim is paid by the IRS, it is likely that the information provided will be deemed to "have no direct relationship to the determination of the tax liability" - which results in a mere 1% payment. Even then, the audit report indicates that it may take up to seven and one half years to receive payment. Given these constraints, potential informants should engage a tax lawyer to help them present their claim in a way that increases the chances that they will be compensated and be compensated sooner rather than later.

The informant program netted $340 million from 2001-2005 - a surprisingly small amount, it seems to me. In light of the paltry rewards, though, maybe I shouldn't be surprised.

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ZARQAWI: THE TAX ISSUES

June 09, 2006

Now that famous headchopper Zarqawi has moved on to his reward, Eugene Volokh raises the truly important question:

A reader asks:
[W]hen are US bounties, such as the kind on Abu Musab al-Zarqawi, subject to US income tax?

I love the question, a perfect example of the lawyer's gift for finding important legal issues in the unlikeliest contexts. I have no idea what the answer is, but I'm sure some of our commenters do.

The correct answer, I think, is here (from the Volokh comments).

UPDATE: More from the TaxProf.

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HEALTH SAVINGS ACCOUNTS: REPORTS FROM THE FRONT

June 09, 2006

The BenefitsBlog brings us a report of the difficulties in getting employees to go along with high-deductible health plans and HSAs. In one case,

Despite a communication strategy that began more than a year before the HDHP went into effect, only about 6% of the company's employees enrolled for the 2005 plan year. Enrollment for 2006, however, nearly doubled to 11%, and 96% of those who enrolled in 2005 stuck with the plan.

It is hard to change peoples attitudes towards health plans. Many folks find the possibility of higher out-of-pocket costs scary, even when weighed against the certainty of lower premiums and tax savings. The fact that people place such a large value on the mere chance that they may be slightly worse off with an HSA arrangement in a given year would be an interesting behavioral economics study. I think it is a baneful effect of years of conditioning that health costs are something that employers and insurance companies pay, even when in real life the patients pay one way or another.

Over time, though, people will figure it out if government policies don't get in the way.

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