Incentives for Innovation - my oral testimony and the experience

I have a short article in the AICPA Corporate Taxation Insider this week (9/29/11) about my experience testifying before the Senate Finance Committee on 9/20/11; my oral testimony is included - here.

For more about the hearing and if you'd like to post your reactions to what I had to say or describe your ideas on incentives for innovation (including perhaps that there should be none) - here.

Thanks.

Buffett Rule - a New Tax Principle?

I think it is interesting to name a principle for tax reform after someone. That is what President Obama did in his recent tax reform proposal (9/19/11) that will help pay for some tax cuts intended to help with job creation and hiring. His 80-page plan lays out 5 principles for tax reform (page 46). These are:

1. "Lower tax rates. The tax system should be simplified and work for all Americans with lower individual and corporate tax rates and fewer brackets.
2. Cut Inefficient and Unfair Tax Breaks. Cut tax breaks that are inefficient, unfair, or both so that the American people and businesses spend less time and less money each year filing taxes and cannot avoid their responsibility by gaming the system.
3. Cut the deficit. Cut the deficit by $1.5 trillion over the next decade through tax reform, including the expiration of tax cuts for single taxpayers making over $200,000 and married couples making over $250,000.
4. Increase job creation and growth in the United States. Make America stronger at home and more competitive globally by increasing the incentive to work and invest in the United States.
5. Observe the Buffett Rule. No household making over $1 million annually should pay a smaller share of its income in taxes than middle-class families pay. As Warren Buffett has pointed out, his effective tax rate is lower than his secretary’s. No household making over $1 million annually should pay a smaller share of its income in taxes than middle-class families pay. This rule will be achieved as part of an overall reform that increases the progressivity of the tax code."

These are not exactly the "principles" I'd advocate for reform. I prefer the set that includes equity, simplicity, transparency, certainty, neutrality, economic efficiency and minimum tax gap. The "principles" President Obama outlines above should really be called "outcomes" for tax reform.

Some of his suggestions in the 80-page plan are specific, he lists some provisions he wants to remove such as tax preferences for oil, gas and coal companies. He is not specific on whether any of the existing 100+ special rules for individuals should be removed or cut back. To really reduce deficits though, these will need to be cut back since the majority of the $1.1 trillion of "tax expenditures" (special deductions, exclusions and credits) are for individuals.

The Buffett rule is vague. When tax cuts expire, the capital gains rate for most capital assets (such as stock investments) will go back to 20% (18% if held over 5 years). The rate on qualified dividends could be as high as 39.6% (in addition to the Medicare tax of Section 1411 that kicks in starting in 2013). Will the capital gains rate on high income individuals need to be raised beyond 18% to be sure their effective tax rate exceeds someone making $200,000 ($250K) if married? Will high income individuals be denied use of the 50% capital gains exclusion if they sell qualified small business stock held over 5 years (Section 1202)? Will a special surtax apply for incomes above $1 million (regardless of whether the income is ordinary or capital gain)?

How will lower corporate tax rates be paid for? The tax raisers in the president's plan cover the jobs provisions. They also cover some deficit reduction since his tax increases are permanent while the jobs provisions are temporary. Or will the Buffett rule be enough to cover a lower corporate tax rate? How low?

So, I won't be adding the Buffett rule to my list of principles of good tax policy (and I acknowledge that President Obama isn't suggesting it as a principle of good tax policy, but of his reform agenda). I would like to see more details on how it works to ensure that a wealthy person with only capital gains income, including from Section 1202 stock, does have a higher effective tax rate than an individual who keeps the lower tax rates promised for those under $200K and $250K of income.

I would like to see more about cutting back on overly generous and unnecessary deductions, such as for interest on a mortgage on a second home or a home equity loan, as well as mortgages over an amount tied to regional home values (which would be something less than the current $1.1 million limit).

For more on the Buffett rule and likely effect, see:

• Warren Buffett's 8/14/11 op ed in the New York Times
  
• "Obama's Tax Hikes Expected To Have Little Impact on the Rich" by Eichler, Huffington Post, 9/20/11.
• Citizens for Tax Justice fact sheet showing likely effective tax rates for millionaires + slightly longer report.
• Tax Policy Center - Howard Gleckman and William Gale and Samuel Brown

What do you think about the Buffett rule or any other part of the 80-page tax proposal?

More woes for state film credits

Yesterday's Wall Street Journal (9/23/11) had an entertaining article, "Snooki to Snookered: States' Film Tax Credits Produce Embarrassment" by Eric Felten, points out some of the many problems with state film credits. The article starts off noting that Governor Christie of New Jersey is concerned that his state's film credit is subsidizing Jersey Short that is rife with stereotypes that have offended some residents. According to the article, the governor has threatened to revoke the show's $420,000 subsidy from the state.

There's more including some states being concerned that their credits are producing films unlikely to be Academy Award winners with some featuring cannibals and others cold-blood killers. Per the article: "even the most casual perusal of the productions being funded by state governments finds a preponderance of low-budget gore fests."

For more, see my 3/21/11 post - here.

I think these film credits highlight the fight states are in with each other for any kind of business activity and their willingness to lower the tax bill to be business friendly. The film credits show how this gets out of hand as the subsidies are quite large and the type of activity engaged in might not lead to long-term jobs. That is, the film is made and the company and crew leave. It's not quite as good as getting a manufacturing plant or R&D facility that is likely to stay for a longer time period. Of course, some film credits might lead to creation or growth of film companies in the state, but not always.

The credits violate principles of simplicity, neutrality, equity and transparency too.

What do you think?

Incentives for Innovation - Senate Finance Committee Hearing

I was honored to have the opportunity to testify before the Senate Finance Committee this week (9/20) at a hearing on Tax Reform: Incentives for Innovation. A few comments I included in my oral and written testimony:

1. Tax reform should consider our country's economic, societal and environmental goals and be sure that that tax law is not hindering them, and perhaps even support them. Innovation is something that for economic reasons also warrants some support through the tax law.

2. Considerations should be given to modifying rules that potentially hinder innovation. For example, some MACRS lives, such as for computers, are too long. Also, while there is a desire to build cars with a higher mpg, Section 280F depreciation limits on cars makes them less attractive to business buyers. Why not remove or greatly reduce such limits for cars getting a certain mpg?

3. Modernize the Section 179 expensing election by also having it apply to intangible assets.

4. Look for ways to provide wider incentives for start-up innovators such as by broadening the Section 1202 gain exclusion to investments in partnerships and S corporations too.

5. Improve the research tax credit by making it permanent. Also review the exclusion for internal-use software as that term has a different meaning today than it did in 1981 when there were no web-based businesses.

6. In reform discussions about lowering the corporate tax rate, we'll need to consider the global economic reality that not only do other OECD countries have a lower statutory rate, many also have tax incentives for R&D.

For more information:

• Hearing website with links to written testimony of Senators Baucus and Hatch and the four witnesses.
• My website with links to other tax reform hearings held in 2011.

What do you think? Should there be incentives for innovation in the tax law or should they all be removed for simplification and rate reduction purposes? If any should be included, what should they be? Any other suggestions?

Registered Tax Return Preparer Exam Coming Soon

The exam that preparers who are not a CPA, attorney or Enrolled Agent (or supervised, non-signing preparer) will need to take to continue to prepare 1040 returns after 2013 is expected to be available in October. Once the tests are available, someone getting a PTIN for the first time who is required to take the test apparently must pass it before getting a PTIN. The fee to take the exam is expected to be between $100 and $125 (for each time a person needs to take it).

The IRS has laid out the topics to be covered - here.

The IRS suggests that a person get ready for the test by reviewing these materials:
2010 Form 1040
2010 Form 1040 Instructions
2010 Publication 17: Your Federal Income Tax*
Circular 230 (Rev. 8-2011): Regulations Governing Practice Before the Internal Revenue Service
2010 Publication 334: Tax Guide for Small Business
2010 Publication 970: Tax Benefits for Education
2010 Publication 1345: Handbook for Authorized IRS e-file Providers
2010 Form 6251: Alternative Minimum Tax – Individuals
2010 Form 6251 Instructions
2010 Form 8879: IRS e-File Signature Authorization
2010 Publication 596: Earned Income Credit

As I have noted in prior posts and articles, I think there is a disconnect in what the IRS is saying a preparer should know because sometimes they say they must know the substantive law (which should mean the Code, regs and court cases) other times, they say to look at pubs and form instructions which do not make reference to primary authority.

The questions will be multiple choice and true-false. There will likely be 120 questions with 2 - 3 hours to complete the exam.

Well, if an exam is prepared by using Pub 17 (which is 295 pages long!), what might some of the questions be? Might these by the questions? Do you know the answers?

1. Don is single and his girlfriend has been living with him for the past two years. She is a full-time college student who does not work. Don supports her. Don't filing status is:
A. Single
B. Head-of-household
C. Married filing joint (because he has lived with his girlfriend for over one year)
D. Married filing separately (because he and his girlfriend are not married)

2. Mr. and Mrs. Smith file jointly and itemize their deductions. Mrs. Smith volunteers for a local non-profit agency tutoring children about 5 hours per week. If Mrs. Smith provided these services for pay, she would get $50 per hour. She hires a babysitter to watch her children while she volunteers. The non-profit is about 10 miles from her home. In 2010, Mrs. Smith spent $65 on books to use with the kids she tutors. Which of the following constitute a charitable contribution deduction for the Smiths?
A. $250 per week for value of her contributed services
B. 14 cents per mile traveled
C. The $65 of books
D. The fee paid to the babysitter
E. None of the above.

Answers:
1. A. The girlfriend can't qualify Don for HH filing status because she is not a qualifying person. See page 23 of Pub 17.

2. B & C. There is no deduction allowed for the value of donated services or for the babysitting. 14 cents per mile + $65 for expenses are deductible as charitable contributions. See page2 158-159 of Pub 17.

What do you think? Were my sample questions too easy? too hard? not relevant? What do you think should be asked?

For more on who is subject to the tests - see this IRS page.
My articles on the IRS program to regulate return preparers - here.

New Perspectives on "Small" Business

The Treasury Department issued a study on how to better define "small" business. One purpose seems to be to get a better understanding on how many small businesses would face higher rates if President Obama is able to convince Congress to keep the lower rates for all but individuals with more than $200,000 of income ($250,000 if married). Only 2% of individuals have higher income than that. But some point out that a good portion of this 2% are small businesses and why should their rate be increased when President Obama and Congress want to lower the income tax rate for corporations.

Treasury uses two tests to better identify what is a true business (so tries to knock out those that may really be a hobby) and that operate as a traditional business (for example, have employees and depreciation, rather than just being an independent contractor). A business is small if gross receipts are $10 million or less. For sole proprietors, the Treasury approach finds that a little over 50% don't meet the "business" definition.

But once it identifies the small business, it matches it to the individual owner. Then it knows other characteristics of the individual. For example, does the individual have large sources of other income in addition to the small business income?

I have a short article in the AICPA Tax Insider explaining how Treasury defined "small" - "New Definitions of "Small" Business and Possible Relevance."

One finding from Treasury:

"For taxpayers reporting any flow-through income, eight percent of taxpayers reporting 75 percent of new flow-through income reported AGI over $200,000 (mean AGI of $760,000, median of $325,000). ... Taxpayers owning any business too big to meet the broad definition of small business ... are more concentrated in the upper income groups (49 percent reported AGI over $200,000, with mean AGI of $1.7 million an median over $500,000) and reported more than 100 percent of the net income from larger businesses (because of net losses and small amounts of positive income reported by lower AGI classes)."

It will be interesting to see how this data gets used.

For an analysis of the data, see Marty Sullivan's article, "Should We Raise Tax Rates on Wealthy Employers?" in Tax Notes and on his blog - here.Followed by his "The Myth of Mom-and-Pop Businesses" (9/12/11) - here.

It is a lot to sort through. I wonder if the fact that Treasury gave a "non-business" label to so many businesses if Congress will question if less favorable tax rules should apply. We'll see.

So Many Federal Tax Proposals

Len Burman has another great post in Forbes today with a graphic on the number of revenue estimate and other requests the Joint Committee on Taxation has received in the past several years (here). In several of the past ten years, there have been over 3,500 requests, reaching a high of almost 7,800 in 2007!

The revenue estimate requests means that a member of Congress had a tax proposal and needed to get a revenue estimate from the Joint Committee on Taxation (JCT). The requests are confidential. Of course, most of these proposals are never enacted, but this is a lot of time spent on something other than making the tax law simpler!

For more information from the JCT on its revenue estimating process and number of requests - see this JCT page - here.

There has been a growth in the number of special tax rules as explained in a JCT report on tax expenditures (JCX-15-11, March 2011, page 16). As you can see in the JCT chart from that report included at the end of this post, the number of special provisions increased from about 150 in 1999 to just over 200 in 2007. And many members of Congress keep thinking of even more as evidenced by the revenue estimate requests.
What do you think?

IRS Releases Information on What A Paid Preparer Should Know To Prepare 1040s

Another part of the IRS plan to regulate all paid return preparers was released this week - the specifications about the test that preparers must pass if they are not a CPA, Enrolled Agent, Attorney or supervised, non-signing preparer, or someone who never prepares or assists in preparing Forms 1040. These specifications were announced in IR-2011-89 (9/6/11) and a 5-page list of specifications was released as well.

The test is expected to be available in fall 2011. Preparers who are required to take it will have until the end of 2013 to pass it (if they have a provisional PTIN before the test is available). New preparers will have to pass it before they can get a PTIN and prepare Forms 1040.

The test will have 120 multiple choice and true-false questions. The testing center will provide the test-taker with Publication 17 and Form 1040 and its instructions. The time given to take the test seems to not yet been set; the IRS notice says between two and three hours. The test can be taken at a Prometric site (about 260 available throughout the country). The fee is expected to be $100 to $125 and must be paid for each attempt to pass the test.

No numerical score will be given to the test takers, just whether they passed or failed. "Diagnostic feedback" will be given to individuals who fail the test.

The IRS estimates that of the current 730,000 preparers with a PTIN, about 62% are not CPAs, Enrolled Agents or attorneys. But some of these preparers may be exempt from having to take this 1040 test (such as because they are a non-signing, supervised preparer). When IRS has people start renewing PTINs in October, they apparently will be asking if the person is required to take the test.

How to prepare for the test? Per the IRS announcement:

"To assist in test preparation, the following is a list of recommended study materials. This list is not all-encompassing, but a highlight of what the test candidates will need to know.

• Publication 17, Your Federal Income Tax
• Form 1040, U.S. Individual Income Tax Return
• Form 1040 Instructions
• Circular 230, Regulations Governing Practice before the Internal Revenue Service (rev. 8/2/11)
• Publication 334, Tax Guide for Small Business
• Publication 970, Tax Benefits for Education
• Publication 1345, Handbook for Authorized IRS e-file Providers
• Form 6251, Alternative Minimum Tax – Individuals
• Form 6251 Instructions
• Form 8879, IRS e-File Signature Authorization"

Comments:

1. 120 questions to be completed in two or even three hours? It seems then that these questions are not going to require making any calculations as there would not be enough time. (If the test is 2 hours, that is 1 minute per questions; if 3 hours then 1.5 minutes per question.)

2. I have blogged on this concern before and will repeat it. The IRS has said in letters to preparers and on their website that preparers are expected to know the substantive tax law. Per a website posted in January 2011 on "responsibilities of a tax return preparer", the IRS states the following (highlights added by me):

"Tax return preparers are expected to be knowledgeable in tax law and to prepare accurate returns. As a tax return preparer, you must take all necessary steps to prepare accurate Federal tax returns on behalf of your clients. These steps include reviewing the applicable tax law to ensure all income has been reported on the return, and only credits, expenses and deductions allowed under the Internal Revenue Code are taken. Tax return preparers are required to exercise due diligence in preparing or assisting in the preparation of tax returns and claims for refunds. As a general rule of thumb, that means knowing the underlying substantive law affecting an item of income or deduction."

So, why does the IRS recommend that to prepare for the test, individuals study IRS publications, forms and Circular 230, rather than also Internal Revenue Code Sections, regulations, IRS rulings and court cases? IRS publications and forms rarely ever mention an IRC section. In the test specifications, only a few Code sections are noted (Sections 121, 6694, 6695 and 7216). Also, why let test-takers have a copy of Pub 17 during the test rather than a copy of the IRC?

For more on this topic, please see my prior writings:

• "The Competent Tax-return Preparer" in the AICPA Tax Insider (3/10/11)
• 7/7/11 post with comments I submitted to IRS for the exam

3. Will all of this make for better preparers? I think it will help, but perhaps not as much as:

• Simplifying the law by reducing the number of special rules and temporary provisions.
• The IRS helping all preparers to understand the substantive law, such as by requiring greater knowledge than what is in the instructions to a tax form to be a preparer.
• Getting individuals to have a greater responsibility in getting competent tax prep help. While this may seem harsh, I think, for example, individuals should get a penalty if they file a return where they paid someone to prepare it, but that person did not sign it. And, greater penalties when they filed returns, even though prepared by someone else, that had items "too good to be true" such as omitted income and personal or bogus expenses.
• Move to a system where more individuals can have their return prepared by the IRS (after all, the IRS has all of the information from W-4s, W-2s and 1099s for many individuals (if they don't have gains/losses or a business)). There are a variety of proposals for this, such as in Senator Wyden's tax reform proposal (S. 727).

For more background and links, see "PTIN - The Continuing Sequels," AICPA Tax Insider, 6/9/11.

What do you think?

Tax Complexity - Is Wood Food?

One reason why the tax law is complicated is that many items are singled out for special treatment including often, to be non-taxed. For example, most states do not impose sales tax on groceries. Yet, some tax soda and other types of groceries or food. The complexity lies in trying to define the item(s) that gets the favorable tax treatment. If all items were taxed the same, there would be no need for special rules and the laws would be far less complicated (and the rates could be lower because the tax base would be larger).

The question of what is "food" is currently before the Streamlined Sales & Use Tax (SSUTA) group. The question is whether hickory wood that is purchased to be burned so that the scent can enter the food, is food (it is used to create "wood-grilled" food). The significance of it being food is that a state that has adopted the SSUTA, can either subject food to sales tax or exempt it. The benefit offered by the SSUTA is that all states that have adopted the SSUTA define "food" the same way.

Per the SSUTA website - "Pursuant to Governing Board Rule 902 this shall serve as official notice of the commencement of the public comment period for the interpretation request concerning whether or not wood used to create smoke is a food or food ingredient (RI11001)."

You will want to click on RI110001 to see the 73-page (!) analysis of this question by the taxpayer asking it.

My observations:

• Sales tax laws could be simplified by removing most exemptions applicable to individual consumers. All food should be subject to tax. Relief can be provided to low-income taxpayers through both refundable income tax credits and food stamps (or similar transfer, such as a debit card).
• For the immediate question on the wood for smoking, I would think most people would initially say it is not food because we don't eat wood. But the sole purpose is to flavor the food. Is this similar to lemons - they flavor the food but we throughout the rinds (usually).
• But what if the wood is also used to cook (heat) the food. That is a tougher situation because we don't eat heating supplies.

What do you think (about both the complexity angle of exemptions and the specific question asked of the SSUTA)?

Cities and the Income Tax

The 481 cities in California are not allowed to impose an income tax (per Revenue & Taxation Code Section 17041.5); neither may other local jurisdictions in California. However, they are allowed to assess a business license tax based on gross receipts. Not all states have such a restriction though.

Per a recent report from the Tax Foundation (Fiscal Fact No. 280), in 17 states, over 4,900 cities and counties impose a local income tax, affecting 23 million people. The taxing jurisdictions include school districts too. The report notes that San Francisco has an income tax imposed on employers (the payroll tax),* but as noted by California law (see above), this is not a local income tax as they are not allowed at the local level in California.**

Rationale for local income taxes:

• It will encourage local jurisdictions to favor high-paying jobs in its borders rather than minimum wage jobs at retail shopping outlets that generate sales tax (this is why many California cities seek big-box retailers - to get more sales tax revenue).
• It is another way to get non-residents (here, those who work in the taxing city but live in a different city) to contribute to the cost of services they use. Of course, these non-resident workers are likely paying sales tax while in the city each day. This is a question I've blogged on before - how much, if any, income tax should a jurisdiction take from a non-resident who is not entitled to many government services (see 6/19/11 post). For example, a person who lives in San Jose but works in San Francisco, is unlikely to be able to register their child in a SF public school.

I think California could benefit in a few ways if local jurisdictions had an income tax tied to the state income tax. These benefits include:

• An incentive that matches the state's incentive to have high-paying jobs in the state.
• A broader economic development perspective in that local governments would be interested in having more than just big box retailers. For example, they would want to have a law firm. (Note - as to whether the city should impose the income tax on the law firm's taxable income versus also that of all of the lawyers working in the city-located law office, is another issue - see 6/19/11 post).

SB 653 would allow counties to impose an income tax (see 4/24/11 post).

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* A 3/9/11 op ed in the San Francisco Examiner by former State Senator and SF Board of Supervisors member Quentin Kopp provides some background on R&T Section 17041.5 (he opposes the SF payroll tax). He says it was enacted in 1963 to prevent local jurisdictions from imposing income taxes. Apparently, at that time, San Francisco wanted to impose an income tax on those who lived or worked in the city to be sure they were contributing to the cost of city services they were using. The SF payroll tax applies to SF businesses with annual payroll over $250,000.

** The SF payroll tax was upheld as not being an improper local income tax in A.B.C. Distributing Co. v. City and County of San Francisco, 15 Cal. 3d 566 (CA S Ct, 1975). Per the court: "The short answer to plaintiffs' contention is that the payroll expense tax is not a tax on or measured by their income. Instead, the tax is imposed upon plaintiffs by reason of their employment of labor within the city and county, measured by the expense incurred by plaintiffs in conducting this aspect of their business. The fact that the tax is measured by wages paid to the employees would not convert the tax to an income tax. As this court explained in Gillum v. Johnson (1936) 7 Cal. 2d 744, 763, involving a federal social security payroll tax, such a tax may be an income tax to the employee, but "As affecting employers it is an excise tax, or a tax on the right to do certain things ....""

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Do you think California cities should be allowed to impose an income tax? If yes, should it be a percentage of the taxpayer's state income tax or some other calculation? Who should pay it?

More on Amazon, ABX 28, Ballot referendum ... and even Congress, jobs and Senator Bumpers' 1994 proposal

There is more in the news regarding Amazon's opposition to the affiliate nexus law (ABX 28, Chapter 7). Amazon is reported to have offered to build a distribution center in California creating 7,000 jobs if the legislature will postpone the effectiveness of the affiliate nexus law for at least two years while Congress has time to enact legislation (presumably the Main Street Fairness Act - S. 1452). See Reuters article - "Amazon offers California jobs if it drops tax."

Some thoughts:

1. Will Congress pass the Main Street Fairness Act? I think the first time it was introduced was by Senator Bumpers of Arkansas in 1994 as S. 1825 (103rd Congress). I don't know if was introduced in every session of Congress thereafter, but certainly in many. It was also S. 2153 (109th Congress) in 2005, called the Streamlined Sales Tax Simplification Act. There have been hearings over the years as well and modifications. Congress has a lot on its agenda, does it include this legislation?
2. If Amazon really wants the federal legislation, perhaps it hopes California will push Congress to pass it. But, the current legislation would only allow states that have adopted the Streamlined Sales & Use Tax (SSUTA) to collect tax from remote sellers. So, why would California push for federal legislation that won't help it collect sales tax (other than from Amazon when it establishes a physical presence by building a distribution center in the state). Also, Prop 26 which requires a 2/3 vote for any bill that might cause someone to have higher taxes, likely requires that adoption of SSUTA needs a 2/3 vote (even adopting the rounding convention of SSUTA might cause a tax increase for some taxpayer, for example). With many Republican legislators having signed a pledge not to vote for any tax increase, they cannot vote for any tax bill that requires a 2/3 bill making it harder for California to adopt SSUTA and thus pointless for California to spend time trying to get Congress to enact S. 1452 (other than to get Amazon to build a distribution center in the state). (This is all really a wacky way to design a tax system!)
   
3. If this gets Amazon to drop the ballot referendum, I think that is good. I expect that the ballot issue would be misinterpreted by those signing to get the measure on the ballot. I think many signers would think that there would be no sales tax on Internet purchases when it would just mean that Amazon would not have to collect the tax - the consumers still owe use tax.
4. So far as books, Amazon announced in May 2011 that sales of Kindle books (digital) were greater than physical books. California and many states don't subject sales tax to digital books because their outdated sales tax only apply to tangible consumption. Of course, Amazon sells a lot of physical books and other items, so a distribution plant in the state would still provide sales tax collection obligations, but there would still be a lot of transactions (Kindle downloads, cloud computing transactions including the music in the cloud that California's out-dated sales tax doesn't apply to).
   

What do you think?