The Many Sizes of "Small"

It is amazing, and perhaps odd, that small businesses are defined in so many different ways in the federal tax law. The recently enacted Small Business Jobs Act illustrates this well. The special credit carryback rules apply to small businesses with average annual gross receipts of $50 million or less. The Section 1202 qualified small business stock gain exclusion refers to a C corporation with $50 million or less of assets. The allowance of a medical deduction in computing self-employment tax refers to small as being a sole proprietor (regardless of gross receipts or asset value).

I've got an article in the 10/28/10 AICPA Corporate Taxation Insider on this topic with several illustrations of "small" in the federal tax law. I contrast this non-systematic approach with that of the Small Business Administration that has a system and recognizes that "small" may vary from industry to industry.

In addition to relevance for federal tax incentive rules or rules to relieve small businesses from some burdensome rule, "small" is also under consideration for some multistate bill, such as H.R. 5660 and the MTC model sales tax notice proposal.

I've got more information and links in the article - "The Many Sizes of "Small"".

Tax Collection and the First Amendment

A ruling was handed down this week in the lawsuit between Amazon and North Carolina regarding the details of customer orders the state should be able to obtain from Amazon in order to assess sales tax on Amazon. The federal district court in Washington ruled that the First Amendment prevented North Carolina from obtaining the details is sought. The ACLU which also got involved has links to the ruling and other documents - here.

Here is a link to an Associated Press article "Judge: Free Speech Protects Amazon Buyers' Data" by Emery P. Dalesio (10/27/10) - (yes, I'm quoted at the end of it)

It seems unfortunate that tax compliance reached this point of becoming a First Amendment issue. I think the state should have been able to derive an assessment with the summary data that it received from Amazon without having to look at the details of every customer to see what county they lived in and if they were exempt.

It would also be helpful if the state could find ways to encourage its citizens to comply with the use tax laws. Have they tried a PR campaign? Do they ask those running for office and already serving if they have paid their use tax? Do state agencies pay their use tax? Is a table used so individuals don't have to keep records (except for purchases over $1,000) in computing their use tax? Is the state working with other states to get Congress to take action to try to get a workable system where remote vendors collect sales tax from all customers?

What do you think?

Deficit Commission and Tax Expenditures

There is talk that President Obams's Deficit Commission might recommend curtailing of some tax expenditures! This would certainly be progress in making the law more equitable, neutral and efficient as well as less complex.

Here is a CNNMoney article on the story - Bye-bye, tax breaks? (10/26/10)

Some of my prior posts and articles calling for reduction in tax expenditures at federal and California levels - here and here.

What do you think?

Idaho Pumpkin Stand Debacle - Lessons to be Learned

In case you missed it, there was a story in a few newspapers this week about the Idaho Tax Commission closing down a pumpkin stand operated by two children ages 4 and 6. While there might be more to the story than reported, the Associated Press story includes that the Tax Commission said that even roadside stands need a permit. (Washington Post, Tax collector tries to squash Idaho pumpkin stand, 10/22/10)

Well, this is a bad PR story, although apparently a self-inflicted one, for tax administrators.

But, I think there are lessons to be learned that would make tax administration simpler, less mysterious to taxpayers, and reflect the realities of today's business environment (whether that business is small and temporary or likely to be large and longstanding).

• Assume that people do want to properly comply with the tax law because the majority do. The reality is that people will try to make a little money by selling something on a short term basis. Yes, there are sales and income taxes to deal with. Why not just create a simple online and paper form where a family or school group can register for sales tax for a single event (and do so for all of their single events). The website tells them they need to either collect sales tax from customers or pay it themselves and the rate. Then after the event, they go back online and report and remit the payment or can print the form and mail a check. The seller doesn't need to register, get a resale certificate or file quarterly reports. If they do want to do all of that, they need to indicate that they are a business and follow the normal seller registration and filing procedures. Basically, tax administrators should recognize that there are individuals, families, school and non-profit groups that occasionally hold a sale, want to be compliant, but don't want to be stopped by paperwork and filing that is beyond what is necessary to collect the tax. (I realize that the answer could instead just be - exempt these small activities. But then it gets to an issue of what is small and it misses an opportunity for budding entrepreneurs to learn about the complete financial picture that also includes the reality of tax obligations.)
• Take opportunities to get some good PR. Why didn't the Idaho Tax Commission just explain about collecting sales tax and help the family do what they needed to do? Of course, they may have and it was so burdensome that the family realized that the answer was to shut down the stand. This is why the suggestion in the prior bullet point should be pursued by tax administrators.
• Be sure the income tax is simple for small activities. For income tax purposes, the family should be allowed to just report the sales as miscellaneous income. If they want to deduct expenses, they should be able to get the cost of sales but not other expenses unless they want to show they are in a trade or business (they would otherwise be miscellaneous itemized deductions subject to the 2% of AGI floor). BUT, even the income tax can and should be simplified by a law that just exempts up to $400 (or some other amount) from income tax (so no reporting of the income or expenses) for isolated sales activity (such as the annual garage sale or seasonal pumpkin sale by children). The tax law includes a far more generous exclusion- the Section 280A exclusion for rental of a residence for 14 days or less.

I hope the Idaho Tax Commission will re-evaluate its system in light of the bad press it got and set an example for how the tax system can be friendly and help people to easily comply with realistic rules and systems.

What do you think?

Various Tax Measures on November 2 Ballots in Several States

California is not the only state with tax-related ballot measures to be decided by voters on November 2, 2010. The National Conference of State Legislatures has compiled a list indicating tax and budget measures under consideration in 16 states. It is puzzling why voters are voting on most of these measures rather than having them decided by legislators who have the ability to improve the measures and determine how they fit within the bigger picture of balanced budgets and an appropriate tax system, and can deal with tax system improvements using something other than a piecemeal change approach.

I think a good example of a measure that really should be decided by legislators is Prop 24 in California. Part of the question here is whether the state should keep the change approved in 2009 by the legislators and the governor whereby multistate businesses can chose to determine the amount of income apportioned to California using either a 4-weighted formula or a single sales factor approach. This is a fairly complex calculation to understand. Also, it is part of a bigger business tax question that involves sourcing rules, combined versus separate reporting, the tax rates and economic development decisions.

The use of a single sales factor is really a decision to use the tax law for economic development purposes. The rationale typically offered for a single sales factor to determine how much of a multistate business' income is apportioned to a state is to encourage that business to place more property and payroll in the state because doing so, won't lead to a tax increase for them. The benefit to the state is hopefully getting businesses to place more payroll and property in the state.

But I think the theory isn't always easy to prove in fact and many factors come into play on what causes businesses to locate operations in one state or another. But, it is a complex tax rule and pulled out of the whole picture of business taxation in order to be determined by voters rather than legislators is not the ideal way to design a tax system. And it overlooks a question voters should have asked legislators (and they should have asked themselves back in 2009), why was this law change structured as a choice rather than changing the apportionment formula for all businesses as other states who adopted the single sales approach did?

Perhaps a better approach would be to use ballot measures for getting non-binding opinions of voters (like a survey) rather than having voters build parts of a tax system which typically really means that voters have placed some restriction in the law that then ties the hands of legislators such that they do not have access to the complete tax system in designing the best possible tax system for a state.

What do you think?

IRS Stats Group Posts Reports Dating Back to 1863

This week the IRS announced that it has posted some of its numerous historic statistical reports dating back to 1916 as well as the Commissioner's report of 1863!

Per the IRS:

"In 2009, SOI began digitizing nearly 500 print publications (and more than 50,000 pages) from its library. As a result of this effort, a wealth of historical tax data is now easily accessible in electronic format. The archive includes publications from 1916 through 1999. Publications for 2000 to present are available from the Tax Stats landing page here.


The oldest report available here was published in 1863. The Report of the Commissioner of Internal Revenue for 1863 contains information on the collection of revenue by source and district of collection. From 1863 to today, the Annual Report of the Commissioner of Internal Revenue, later called the IRS Data Book, presents an annual overview of IRS operations."

In 1916, 437,036 personal income tax returns were filed reporting an aggregate of $6.2 billion of income, an average tax of $396 and average tax rate of 2.15%. Exemptions for filing status reduced aggregate income by about 25%.

Today, about 142 million individual returns are filed annually.

Thanks to the IRS for posting the reports!

Cell Phone Pervasiveness and Tax Fairness - and Federalism Too

I think two actions of the past few weeks need to be linked in order to get a better sense of the tax policy issue and to determine whether there is even a problem to be solved.


The first item - H.R. 1521, the Cell Tax Fairness Act. This bill provides that"no State or local jurisdiction shall impose a new discriminatory tax on or with respect to mobile services, mobile service providers, or mobile service property, during the 5-year period beginning on the date of enactment of this Act." A House Judiciary Committee subcommittee held a hearing on the bill back in June 2009, but only voted on it (favorable) on September 15. 2010. The bill is sponsored by Congresswoman Lofgren (my representative) and has 197 co-sponsors.


Some of the reasons noted in the 2009 hearing as to why a moratorium is needed include:

• State telecom taxes are outdated and overly burdensome to providers and users.


• It would help low to middle-income taxpayers.


• It might better encourage broadband usage.

The second item - a report released October 14, 2010 by Pew Internet - Americans and their gadgets, notes that 85% of adults own a cell phone. Younger Americans do even better in cell phone ownership. About 95% of Americans age 18 to 29 own some type of cell phone.


So, this begs the question - if the existing quagmire of state and local telecom taxes has not adversely affected use of cell phones, why might the possibility of new state and local taxes be a problem?


Additional policy considerations:

1. Federalism and taking care of one's own fiscal problems: The federal and almost all state governments are having fiscal problems. How will Congress stepping in to tell state and local governments that there is a potential new revenue source they won't be able to consider in shaping (and perhaps reforming) their tax system help them? Also, wouldn't it be better for Congress to spend time figuring out how it will address the reality that the federal fiscal system is on an unsustainable path? Let state and local governments figure out their tax base and rates without shackles. Leaving them with more options lets them decide on the best structure.


2. How likely is it that state and local governments will enact policies that will harm growth of broadband and mobile services? Many of these governments have been helping to increase broadband access.


3. If the federal government wants to help grow broadband, they don't need to impose restrictions on state and local governments to do so. The feds have lots of other options that utilize their own funds. Congress could allocate grant monies to vendors or users, offer tax credits, or take other measures.

What do you think?

VAT - Economic Effects of More Investment and Less Consumption

The National Retail Federation released a study on October 14 on the likely effects of a VAT in the US. The VAT used in the study was modeled on the European VAT which is a credit invoice VAT with a narrow base that excludes rent paid by consumers and purchases of homes, groceries, medicine, health care, financial services and education. The rate used in the study was 10.3%.

The report, prepared by Ernst and Young and Tax Policy Advisers, concluded that such a VAT could result in the loss of 850,000 jobs in retail and other industries, reduce GDP for three years and cause retail spending to decline by $2.5 trillion over ten years. Per the NRF, the drop in jobs would be 850,000 in the first year and "would remain down by 700,000 jobs for decades to come."

The NRF plans to submit the report to President Obama's Deficit Commission which is to issue its report and recommendation in early December 2010.

I think this is an interesting report. Proponents of a consumption tax at the national level usually argue that it will increase investment - meaning that if spending on consumption drops from taxing it at a higher rate, people will instead save more money. I've often wondered when I hear of proposals for a 23% national sales tax or even a VAT of 5% or more, what does happen to our economy when people buy less goods? While as a whole, we are likely buying more goods than we need (do people really need to buy clothes for their pets? more clothes than they can wear in a week? gadgets?), what does happen to the economy when this and other spending drops? I would think the economy realigns. Is that an economy we can live with? I think a lot of that depends on where the lost jobs fall among various income groups.

I'm glad to see the study because I don't think there has been near enough discussion of what our economy with a VAT - even as an add on to the income tax rather than a replacement, looks like.

The report is 72 pages long, but certainly worth the read.

What do you think?

Tax System Equity and Tax Expenditures .. and Stanley Surrey Explanation

On October 11, 2010, the Washington Post ran an editorial entitled "The Current U.S. Tax System Is Tilted Toward the Haves." It addresses the issue of the growing number and amount of "tax expenditures" in our federal tax system and the inequities often inherent in them.

"Tax expenditures" refers to deductions, exclusions and tax credits that result in lowered tax bills for those using them. Generally, the term focuses on special rules that are designed for some purpose other than measuring income. Typically, the special rules are designed to encourage some type of behavior, such as charitable giving. For more on this - see the statement at the end of this blog post from Stanley Surrey who invented the phrase while serving as Assistant Secretary for Tax Policy at Treasury in 1967.

The editorial raises the question as to why about 50% of the $400 billion cost of the breaks benefit the "wealthiest 5 percent of Americans?" They note two problems with "tax expenditures" -

1. The lack of transparency and accountability.
2. Equity issues because "accomplishing social policy through tax expenditures tends to award the most help to those who need it least."

The editorial refers to a recently issued report by the Corporation for Enterprise Development and the Annie E. Casey Foundation entitled Upside Down. I encourage you to read the report and I applaud these entities and the Washington Post for highlighting this issue because more people need to understand that not only do these numerous special rules complicate the tax law, but they make the system inequitable.

We'd be better off with an income tax with a broader base and lower rate. Hopefully reports and articles like this will help spread the word to more people. (I had an op ed in the SF Chronicle on this topic in April 2008.)

And, here is a history lesson on "tax expenditures" - an excerpt from Pathways to Tax Reform by Stanley S. Surrey, 1973, page 6:

"The federal income tax system consists really of two parts: one part comprises the structural provisions necessary to implement the income tax on individual and corporate net income; the second part comprises a system of tax expenditure under which Governmental financial assistance programs are carried out through special tax provisions rather than through direct Government expenditures. This second system is grafted on to the structure of the income tax proper; it has no basic relation to that structure and is not necessary to its operation. Instead, the system of tax expenditures provides a vast subsidy apparatus and uses the mechanics of the income tax as the method of paying the subsidies. The special provisions under which this subsidy apparatus functions take a variety of forms, covering exclusions from income, exemptions, deductions, credits against tax, preferential rates of tax, and deferrals of tax."

Chicago Bottled Water Tax and Blog Action Day 2010

October 15 is Blog Action Day serving the purpose of trying to get bloggers to all blog on the same topic on this day. The 2010 topic is water. There is a lot of important information at the above link about global water problems and the shocking number of deaths every day due to unsafe water.

I'm using this day to comment on the recent case that upheld the Chicago 5 cent bottled water tax against challenges of it being an unconstitutional occupations tax and of violating the uniformity clause of the Illinois Constitution.

I wrote about this tax when it was enacted in 2007 - see 11/27/07 post and 3/20/08 and an April 2008 AICPA Tax Insider article. I noted that the tax is odd in that it is per bottle regardless of the size of the bottle; there is some reference to an environmental justification yet there is no tax on all bottled beverages; and there were non-tax alternatives to trying to get people to drink the city water rather than bottled water.

The tax was challenged by the American Beverage Corporation (Appellate Court, First District, 1-09-1511 (9/23/10)). Chicago won on the challenges because ...

1. Occupation tax - prior case law has held that "A tax on tangible personal property is not considered an occupation tax when the ordinance enacting it declares its legal incidence falls on the purchaser, rather than the seller." ABC argued that because collection falls upon the retailer/distributor, the practical effect was that it was an occupation tax. The court disagreed noting, among other things, that the tax was imposed on the transfer of the tangible object.
2. Uniformity clause - two factors were relevant here. First, there is a difference between taxed bottled water and other untaxed goods, such as carbonated or flavored water. Second, is the need for a reasonable relationship between the rule and its purpose. Per the court, "the City enacted the bottled water tax to raise revenue in a manner that discourages consumers from buying noncarbonated bottled water, both to conserve energy from nonrenewable sources and to reduce the discharge of toxic contaminants and litter. The classification is reasonably related to those purposes and therefore satisfies the second prong of the uniformity clause."

So, while upheld as valid on a legal challenge, I don't think it holds up under a tax policy analysis. Consider:

• Equity - the tax is regressive.
• Neutrality - is might encourage people to not buy bottled water, but I think it might instead make them want to buy it in larger bottles (tax is 5 cents per bottle) as a tax minimization plan.
• Simplicity - while the law is not too complicated, partly because it is per bottle rather than size of bottle, the Chicago tax system would be even simpler without the tax.

What do you think?

Taxpayer receipt or is there better information

I was intrigued by a September 2010 Idea Brief from The Third Way - A Taxpayer Receipt. This group would like to see the IRS add a feature to its website which would allow taxpayers to input their taxes paid (the amount shown on their 1040 + payroll taxes) and have a receipt created. The receipt would show their taxes paid broken down into the various ways it is used in the federal budget from Social Security to defense, the Smithsonian, EPA, the IRS and more.

The rationale is that people should know how their money is being spent and to understand "choices in the deficit debate."

The group notes that California's Franchise Tax Board offers an online receipt and federal legislation was proposed in 1997 to provide a similar tool at the federal level (H.R. 2827).

I think having more information about the federal budget is a great idea. I would like it to be more information though. A few observations:

1. The IRS is already required to provide a revenue and a spending pie chart in instructions to IRS forms. With most people not receiving the forms in the mail and probably not reading them page by page online, I suspect that few see these pie charts today. You can see them on page 100 of the 1040 instruction book. Congress needs to modernize this requirement to have this information posted on the IRS website. I think it should be readily available on the website of every senator and representative as well. It should also be more detailed, such as breaking down some of the general fund expenditure by agency.
2. The receipt will imply that only those who pay payroll taxes or federal income tax directly are contributing to government spending. This is not true because all individuals also pay some portion of business income taxes. This could be addressed by modifying the online receipt tool to include an estimate based on income level as to how much business and other taxes they are paying indirectly.
3. Also have individuals input their taxable income amount and have their marginal and effective tax rates printed on the receipt.
4. Show what income quintile they are in and its dollar size and percent of taxpayers in it.
5. Also provide a receipt for what the breakdown would have been based on the budget of five years ago. This will highlight some significant changes, particularly interest owed on the debt.
6. Include each person's share of the national debt and how much interest will be owed for the year on that amount.
7. Include explanations on the budget items and the budgeting process.
8. Include the names and email addresses of their elected officials so they can ask questions or seek additional information.

What do you think? Anything else you'd want on the receipt?

Trends and the Tax System - The Home Mortgage Interest Deduction

I think that a consideration of trends is helpful in reforming a tax system. For example, today's economy has become more global than in the 1960s when many of our international tax rules were put in place. Updating to reflect today's ways of living and doing business should be considered.

Today, USA Today reported on a trend of more people renting their homes than buying them, apparently due to both the economy and benefits of renting rather than owning. See Should you rent or buy your own home? by Christine Dugas. The article refers to a survey indicating that even some that can afford to buy a home are renting instead and fewer think it is part of the American dream to own a home.

There are tax policy reasons to reform the home mortgage deduction rules, perhaps this trend where more do not view home ownership as key to success, also helps drive success.

Earlier this year, the Tax Policy Center issued a report on the home mortgage deduction. They summarized the work of various studies that found that the deduction does not really increase home ownership. Instead, the bulk of the tax benefit goes to those in the top fifth of income levels and really just encourage them to buy a more expensive home. The report also notes that home ownership rates in countries without a mortgage interest deduction is similar to the US. (See Reforming the Mortgage Interest Deduction by Toder, et al (May 2010).)

In a report, Economic Survey of the United States, issued in September 2010 by the OECD, the value of the home mortgage interest deduction is questioned. The report notes that the deduction should be reduced or eliminated because it does not encourage home ownership, but only the ownership of more housing by higher income individuals. They suggest phasing out the deduction as Britain did over 12 years ending in 2000.

And, we should not forget that only about 1/3 of individuals even itemize and not all of these itemizers have mortgage interest.

And, the mortgage interest is not just on a loan to buy a home, but also allowed for home equity debt (up to $100,000 of debt) and on a second home! This deduction is one of the most costly in the tax law. Without it, or with a reduced deduction, the tax rate of renters and others could be lowered. The deduction also encourages over-investment in housing because its effective tax rate is zero compared to a much higher rate on corporate investment.

I think another trend is one caused by the home equity loan - borrowing too much!

The home mortgage interest deduction seems to viewed as an entitlement any suggestions to cut it back are maligned. But, it is used by less than 1/3 of individuals yet is one of the most costly provisions in the law - seems like a serious equity issue. And it does little to encourage home ownership.

Do you think it is time to reduce and improve the deduction as a way to keep lower rates or perhaps to help pay down the debt?

Lessons Learned - Tax Reform Act of 1986

What lessons do you think were learned from TRA'86? How might such lessons be relevant to tax reform efforts today? Please share your ideas with others by posting a comment here. Thank you.

My question ties to a September 23, 2010 Senate Finance hearing - Tax Reform: Lessons from the Tax Reform Act of 1986.

For a summary of the hearing, see my article in the AICPA Tax Insider for 10/14/10 - here.

Tax Reform Discussions in 2011?

A 9/29/10 article in The Hill - "Rep. Levin seeks early action on tax reform next year" reports that the House Ways & Means Committee chair wants to have lots of tax reform hearings in 2011. He says: "We're serious about looking at our tax code." The Hill also reports Congressman Levin saying that reform needs to happen in a non-election year.

Of course, it remains to be seen as to:

1. Will any such hearings include identifying the most significant problems in the federal tax law, why changes are needed (such as due to complexity, inequity, a high tax gap and bringing the tax law into the 21st century)?
2. Broadening the base and lowering the rate?
3. Ending campaign promises for special tax breaks?
4. Being honest with the public about the need to balance the budget and pay down the enormous national debt? (what I've referred to as the "tough love" talk)
5. Whether reforms will look at all federal taxes rather than only the income tax? I think it should all be looked at because it is the only way to really meet the principles of good tax policy and bring respect and sustainability to the system.

Also, President Obama's National Commission on Fiscal Responsibility and Reform is to issue its report in early December 2010. We'll also need to see if they can get the requisite 14 of 18 commissioners to agree on a plan and if they meet their deadline. If a consensus report is issued, will Congress take a look (12 of the 18 commissioners are current members of Congress).

What do you think?