Helping Some Taxpayers But With Much Complexity - SECURE Act 2.0 Sec. 115 Emergency Withdrawals

SECURE Act 2,0 with over 60 provisions mostly all related to retirement plans, was enacted December 29, 2022 as part of the Consolidated Appropriations Act, 2023 (P.L. 117-238). I maintain a table of the provisions, summary from the Senate Finance Committee of each provision, effective date, and any guidance from the IRS.

SEC. 115 of the SECURE Act is called "Withdrawals for Certain Emergency Expenses." It is well-intended to allow individuals to withdraw up to $1,000 from their eligible retirement account every three years without the 10% additional tax of IRC §72(t), if the funds are for distributions used for certain emergency expenses, to meet “unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses.”  SEC. 115 is on pages 838-839 of P.L. 117-238.

IRC §72(t)(2)(I) covering this additional tax exception is 504 words long and in addition to defining emergency expenses, also provides:

• The individual may only make one distribution per year, and it may not exceed the lesser of $1,000 or “an amount equal to the excess of “(I) the individual’s total nonforfeitable accrued benefit under the plan (the individual’s total interest in the plan in the case of an individual retirement plan), determined as of the date of each such distribution, over ‘‘(II) $1,000.”
• The plan administrator may rely on employee’s written certification that the exception is met.
• The IRS can issue regulations where the employee statement doesn’t apply if the administrator “has actual knowledge” contrary to the certification, and procedures to address cases of employee misrepresentation.
• The taxpayer can repay the distribution within 3 years. 
• No further emergency distributions are allowed during the 3-year repayment period unless repayment occurs.
• Effective for distributions after 2023. See my table to see that there are a variety of effective dates for SECURE Act 2.0 provisions.

For more details, in addition to §72(t)(2)(I), see Notice 2024-03 (12/20/23) and Notice 2024-55 (6/20/24). Notice 2024-55 is 26 double-spaced pages but also covers another SECURE Act 2.0 exception to the 10% additional tax for domestic abuse victim distributions (SEC. 314). Also see IR-2024-170 (6/20/24).

Well, the idea sounds good. If someone has an emergency needing up to $1,000 of cash and the only source is a retirement plan, why not pull some funds out without the 10% penalty ("additional tax"). Now, the distribution will be taxed leaving less than $1,000 for the emergency. We might ask why only $1,000 which isn't enough to cover many emergencies. I think it is because the purpose of the account is for retirement.

Is this provision worth the 504 words in the Code, lengthy notice, future regulations and efforts by plan administrators to get the required statement that the withdrawal is for the right purpose (likely to be noted on the Form 1099-R)? It is also likely that similar to qualified charitable distributions (QCDs), it will not be noted on Form 1099-R because the administrator won't know if the individual pulled emergency withdrawals from other retirement accounts. While being able to return the funds to the account within three years (and getting a refund of taxes) is good, it adds complexity to recordkeeping for the owner and plan administrator.

I know this may seem harsh, but it would be simpler to not have this exception. But, there are often no other sources for someone in need to use this provision, unless family and friends or an employer can help. Could this be simpler?  Yes, just leave it as $1,000 over 3 years unless repaid (remove the alternative calculation). Trust the individuals declaration without the need for regulations to address when an individual might be lying. How many people are really going to lie to avoid the 10% penalty and harm their retirement funds?

Other simplifications?  What do you think?

Another note: I like the Cornell Law School Legal Information Institute website for accessing all laws. But, I remind students and practitioners that it is not always up to date. You will not find §72(t)(2)(I) at the Cornell Law School listing for §72 even though the  note at the bottom of the page lists P.L. 117-238 and SEC. 115 (their publication of §72(t)(2) goes from (H) to (L)). You can find the text in the public law or at the US Code webpage for the Office of the Law Revision Counsel at the House of Representatives website (enter Title 26, Section 72).

17th Anniversary of the 21st Century Taxation Blog

Today is the 17th anniversary of when I started this blog while I was a fellow with the New America Foundation. There is always plenty to write about regarding the topic of how taxes should reflect how we live and do business and follow principles of good tax policy. Time to regularly blog is not so plentiful.

Today the topic is taxation and coin-operated claw machines that are amusement games from which the player tries to pick up a toy with the claw and drop it in the chute. I'm not sure these are all coin-operated today as some likely only take folding money and some might take your credit or debit card.

A ruling from the Texas Comptroller of April 24, 2024 caught my attention. There are all types of taxes and one in Texas is the coin-operated machine tax! It defines the machine and like many taxes, has at least one exemption that then creates added complexity to define that exception. Here the exception is for "amusement machines designed exclusively for a child." This means a "machine that can only be used for skill or pleasure by a child under 12 years of age."

Well, what does exclusively mean and how does one really know if a machine is for ages 11 and below rather than ages 12 and more? Well, in a 2002 ruling, the comptroller defined "exclusively" as a machine "designed such that no person other than a child can use the machine." Also, "it doesn't matter if an immature adult or older child actually uses the machine" because it is the design that is relevant and the kind of prize a player can win is not relevant.  That seems odd, what if the prize is a pack of cigarettes? 

I'm sure the Texas comptroller must have better things to do than determine if a coin-operated machine is for kids age 11 and under rather than for immature adults or for anyone.

Ok, this is a bad way to draft a tax rule. At least two problems here. Coin-operated is too limiting if that means actual coins are dropped into a machine as these machines will certainly get converted to Apple Pay or debit/credit card tap as fewer people carry real money around. And there is no need for any exception here (I think that is true for most taxes - exceptions should be avoided).  If there is some need to provide relief to certain machine operators, find another way such as have them apply for a grant based on financial need (I'd say an income tax credit but Texas doesn't have a personal income tax).

And before leaving these claw machines, back in 2001, the IRS had a funny TAM on the topic. The issue was whether the items inside the machine such as stuffed animals or novelty toys or other prizes were inventory to which the unicap rules of §263A would apply. The conclusion was yes!

The taxpayer claimed that the prizes were supplies for tax purposes, but called them inventory on its balance sheet. The IRS also found that the taxpayer was selling these items and title transferred to the winner, making them merchandise!

I call this funny because either the drafter of TAM 200121006 was very skilled at using these claw machines or had never used one. I think most people put money in and don't get anything making it clear this is not the way a retailer sells goods. These should have been treated as supplies consumed in the process of providing entertainment services. The TAM does provide a good review of code, regs and cases on inventory for tax purposes.

One more relevant tax here is sales tax. As supplies, sales tax would be paid by the buyer (owner of the machine) when they buy the prizes.

Tax policy relevance here ... the Texas ruling is a reminder that just about anything can have a special tax on it, but if too special and with exceptions, it gets complicated quickly. It would be better to find a more simple and equitable way to generate revenues (equitable in that similar businesses might not have a special tax).

What do you think?

Earth Day and Taxes

Happy Earth Day!

Earth Day started in 1970 and one of the co-founders was Gaylord Nelson, who served as a senator from and governor of Wisconsin. He was also an alum of San Jose State University.

How about some individual tax credits to help reduce fossil fuel use? The Inflation Reduction Act of 2022 added a used clean vehicle tax credit and modified credits for new clean vehicles and residential improvements. See this 8/21/22 post for some information on the IRA and track changes to IRC Sections 25C, 25D, 25E, and 30D to learn more about these changes.

A helpful item I'll share here are some IRS publications on these credits that are difficult to find (they are not listed at the main IRS websites for each of these credits, which I have linked below).

Section 25C, Energy Efficient Home Improvement Credit AND Section 25D, Residential Clean Energy - Publication 5797.  This has a brief summary of each credit and a QR code to get more information. Also see main IRS website on these credits.

Section 30D, Clean Vehicle Credit - Publication 5866, which is a helpful checklist of qualifications. 

Section 25E, Previously-Owned Clean Vehicles - Publication 5866-A, also a helpful checklist of qualifications.

Also see the main IRS website on clean vehicle credits (new and used).

And a publication on each of the energy credits for individuals - Publication 5886-A.

Finally, an Earth Day reminder from the Social Security Administration - Opt Out of Paper Notices.

What tax suggestions do you have for Earth Day (or any day as we need to care about the Earth every day)?

Taxes and the Olympics

On March 1, the Commission on the State of U.S. Olympics & Paralympics issued a report: Passing the Torch - Modernizing Olympic, Paralympic, & Grassroots Sports in America. Per the announcement, this commission was directed by Congress to study recent reforms of the U.S. Olympic and Paralympic Committee to improve the organization's "ability to fulfill its mission."

The word "tax" appears 39 times in the report. Tax law changes suggested:

Page 17 - allow taxpayers to deduct the costs for their children to participate in youth sports.

Page 18 - allow taxpayers serving as volunteer coaches for youth sports to deduct out-of-pocket expenses.

Page 18 - to help support youth and grassroots sports, consider new revenue sources such as from an excise tax on legal sports betting and a voluntary checkbox on income tax forms for donations

The report notes the 2016 tax law change to add an exclusion from income for the value of the metal in gold and silver prize medals and bonuses winners receive (unless the taxpayer has AGI determined with the value of Olympic winnings above $1 million - IRC §74(d))

Well, that all sounds good - doesn't it?  But do these proposals meet any of the principles of good tax policy?  I don't think so.  Let's look at a few key principles regarding the deduction proposals.

Equity and fairness: For vertical equity, the deduction for children participating in sports will provide greater tax savings to higher income individuals because they are in a higher tax bracket and are likely to spend more on participation. Some leagues can cost thousands of dollars to join and often there are travel expenses too. If such a proposal were enacted, I suspect it would be an itemized deduction so would not help the majority of taxpayers and likely would have some type of cap.

If there is any money for new deductions, perhaps using that money to instead help fund sports programs at public K-12 schools would be a better way to go.

Convenience of Payment: For families who would most benefit from some assistance to enable their child to participate in local youth sports program, the deduction won't be enough and it won't provide any funds when it is time to sign up and get a uniform and equipment.

Simplicity: Any exception or special rule requires details on what qualifies and what does not. This is where complexity comes into play (see my post of 3/24/24). Principles of good tax policy are best met with a broad tax base and lower rates.

Neutrality: And why only subsidize youth sports via a tax deduction? Why not art and music, visiting museums, etc.? Also, some youth leagues, particularly the high fee ones, would likely increase fees because of the tax break to the payor. More parents might volunteer to coach (which is a good thing, but does violate the principle of neutrality if the tax deduction causes the behavior change). Volunteer coaches give up a lot of their time and some might even reduce work hours to coach - this really can't be compensated via the tax system (and isn't in the proposal) and I suspect most of the dedicated parent coaches don't expect to be compensated via the tax system. 

Minimum Tax Gap: Unfortunately, the deduction likely would be abused. Some individuals would deduct something even if their child did not participate or if they do, would add in some costs not directly related to the sports activity (perhaps more clothes or activities disguised as training). Similarly, some individuals might view themselves as coaches and deduct costs. 

What do you think?

Challenges of Tax Exemptions

One of several features that make tax systems complicated are the numerous exceptions that pull out from taxation something that is part of the tax base for a particular type of tax. It is probably almost impossible to find any federal, state or local tax that doesn't have some type of exception. A list of sales tax exemptions produced by the California Department of Tax and Fee Administration (CDTFA) lists 171 sales tax exemptions. All of them need a definition in the statute and often an explanation from the tax agency. This creates a lot of complexity because it is difficult to define most exemptions. For example, if a state wants to exempt food from sales tax but only healthy food, where does a "protein bar" full of sugar and not a natural item fall?

Our federal income tax law has Code sections 101 through 139I listing items of income, such as certain disaster relief payments, fringe benefits and gifts, that are income, but excluded from the measure of taxable income.

A 2023 ruling in Iowa caught my attention as an example of the complexities of defining exemptions (Sweat Iowa LLC, No. 346007, 11/14/23). Iowa imposes a 6% sales tax on "enumerated services" which includes "all commercial recreation." The term "enumerated services" signals that all potentially taxable services are not subject to sales tax. Generally, because a sales tax is imposed on personal consumption, everything that an individual purchases that is not for business use, should be subject to sales tax. If the law in any state worked that way, the rate would be lower and the tax base broader (and mostly easier to define).

For a sales tax (a tax on personal consumption), the only items that should be exempted medical services provided by a medical professional and tuition for a university or professional/job training.

In the Iowa ruling, the question was whether booking services for saunas with "science-backed technology of infrared (IR) and red light therapy(RLT) to optimize health and wellness" is "commercial recreation."

In the ruling, the Iowa Dept. of Revenue had to review the Code that defines "recreation" and then Black's Law Dictionary on the definition of "pleasure"! Because there was pleasure and promotion of physical fitness involved, the DOR found the sauna service to be taxable. It also noted that even if not recreation, it would fall under the taxable services of Turkish baths and reducing salons.

If the law instead stated that all personal consumption was taxable and only had very few exemptions, it would be a lot simpler for everyone and the rate could be lower.

And there are other reasons for a broader base, not only for sales tax, but often other taxes as well. Often the items that are left out of the base are ones where higher income individuals spend more money so they get the greater savings. This includes food which most states exempt (higher income individuals spend more on food that lower income individuals), entertainment, household services, and even a personal trainer.

A final note, of the 171 sales tax exemptions the CDTFA pub noted earlier, several only apply to businesses so should not even be part of the sales tax base and some major exemptions such as personal services and digital goods are not in the 171 because they are not part of California antiquated sales tax base of tangible personal property (been that way since 1932!).

What do you think?