Improving the American Opportunity Tax Credit

Excerpt from Pub 970

In May 2024 I had the opportunity to participate in the California Lawyers Association Tax Section's DC Delegation. Participants identify a tax rule in need of reform and draft a paper explaining why change is needed and offer proposals for that reform.

My May paper was on modifying and clarifying the American Opportunity Tax Credit (AOTC) which offers up to $10,000 of tax credit (subsidy) to most families for a child (or themselves) in the first four years of college ($2,500 maximum credit for year for up to four years).

The phaseout income levels for the credit are quite high so at least 80% of families qualify.

But there is a bit of unneeded confusion and complexity in the provision including exactly how the "first four years of college" are determined. An example on the IRS website makes it sound like you can select which of the four years of college count which seems out of sync with Code Section 25A (Q&A 16).  But in sync if we are only required to ask if the student has reached "senior" status at the university. This basic issue should not be confusing, but is.

The IRS has an Interactive Tax Assistant tool on its website which can help but I found it might cause some users to give up such as asking if your spouse has an ITIN after answering "single" to the question about whether you are married.

There is also some complex planning possible if a student receives a scholarship, including a Pell Grant, that is partially taxable. One fix to help Pell Grant recipients has been proposed a few times but not enacted is to not require a Pell Grant recipient to reduce AOTC-eligible expenses by the amount of the grant.

For more background and my recommendations for both legislative and administrative improvements, see "Modify and Clarify the American Opportunity Tax Credit," Tax Notes Federal, 9/26/24.

What do you think?

Need for More Red Flags and Enforcement to Pursue Tax Cheaters

Every week, there are several news releases from the Tax Division of the Department of Justice and the IRS Criminal Investigation (CI) unit about people caught in tax evasion and sometimes not only stealing from all of their fellow taxpayers but also employer or others. I encourage you to scan recent headlines for the reports of catching some of these bad actors.

• Department of Justice Tax Division news - https://www.justice.gov/tax/tax-division-news
• IRS CI news - https://www.irs.gov/compliance/criminal-investigation/criminal-investigation-press-releases

But, of course, many are not caught and some are caught after the statute of limitations has closed for some years of taking deductions they were not entitled to. If civil fraud is involved, the statute of limitations remains open, but some cases have not involved fraud but instead negligently claiming, for example, unallowable hobby losses as allowable business losses (and not getting caught until after doing it for many years) or claiming large charitable contributions of grossly overvalued property with the deductions carrying forward (recent example - 4th Circuit case with conservation easement charitable deduction claimed at $5.1 million on property bought a year earlier for $652,000. The court noted that because the initial years of the deduction are closed and the IRS had not examined the initial year, the taxpayers "received the benefit of having deducted $1.75 million").

A 9/26/24 news release from IRS CI describes a person who over three years made over $1.2 million as a software engineering manager. So he would owe some taxes on this $400,000 of annual income. But he greatly reduced his taxes by claiming over $1.1 million of medical expenses which were actually under $100,000. A jury found him guilty on three counts of tax evasion. Per the news release, this high paid person "deducted nonexistent medical expenses from his taxes for multiple years because he had not been 'caught' the first time he did it."

But why wasn't this person's return flagged by the IRS as needing an audit? Why is an employee with wages well beyond the median U.S. income (about $64,000 for the years involved), allowed a very large medical expenses exceeding 7.5% of his AGI when it is extremely likely he has good health insurance from his employer who pays his high salary?  This should be a "red flag" to trigger an examination - high paid employee with medical expense deduction.

For the overvalued charitable contribution deduction, why didn't data on Form 8283 trigger an audit in the initial year of the donation? While the taxpayers overstated the basis making it look just a little bit less overvalued, how can a $5.1 million deduction of property purchased a year earlier for about $650,000 not be a "red flag". These taxpayers improperly listed the basis as $1.35 million but even this spread should have still been a red flag.

Well, likely more "red flags" to trigger audits are needed. And, of course, funding for IRS enforcement is needed. Examinations of high income individuals can be complex and human resource intensive. The IRS has reported that recent additional enforcement dollars bring in tax owed. For example, a September 2024 press release from the IRS notes that with better funding of enforcement, they "launched an initiative to pursue 125,000 high-income, high-wealth taxpayers who have not filed taxes since 2017"!!  Yes, go after these people. Also, Congress has noted that enforcement dollars bring in revenue because additional funding allocations are scored by government agencies as revenue raisers (the IRS will bring in more tax dollars than the budget allocation). Per a 2/29/24 CBO report: "A $20 billion rescission [of IRS funding] would reduce revenues by $44 billion and increase the cumulative deficit by $24 billion."

Congress cut $21 billion of the additional $80 billion provided to the IRS over 10 years by the Inflation Reduction Act of 2021 and the cut came from the enforcement dollars!  How odd. Doesn't Congress want to bring in tax dollars for which it already passed laws saying the taxes were owed?  Why should compliant taxpayers subsidize tax cheats who, like the person just found guilty of tax evasion by a jury, kept cheating because they got away with it (until now)?

Besides the medical expense and high valuations of donations on Form 8283, what additional red flags do you think would catch non-compliant filers?

40th Annual TEI-SJSU High Tech Tax Institute Nov 4 - 5

This is a wonderful milestone - 40 years of the collaboration of the Silicon Valley TEI Chapter, the IRS and the SJSU MST Program to reach our 40th Annual TEI-SJSU High Tech Tax Institute. We'll be back at the Crown Plaza Cabana in Palo Alto on November 4 & 5, 2024.

We have an outstanding group of experts in many hot tech areas including equity comp, M&A, IP location, Pillar 2, international developments, how generative AI is being used in the corporate tax department, federal controversy, ASC 740, the latest in R&D tax rules, and more.

AND ... IRS Commissioner Danny Werfel will be speaking on Monday November 4 and former Assistant Secretary for Tax Policy Dave Kautter, now with RSM, will provide a DC Tax Update on November 5 (Election Day!).  

This conference is known not only for fantastic, cutting edge topics, but also tax experts from throughout the US. Also, attendees have fun amidst the tax complexity and this is an outstanding networking event.

Please check out the complete agenda and list of speakers and register. 

Hope to see you there!

California AB 3289 and Greater Transparency for Our Tax Laws

California AB 3289 was enacted 7/15/24 (Chapter 124). It modifies Revenue & Taxation Section 41 which exists to improve accountability and transparency of the California tax system. Generally, any credit, deduction, exclusion, exemption of other tax benefit enacted is to state its goals, have detailed performance indicators to determine if the goal was met and call for appropriate data collection.

AB 3289 modifies this provision to exempt any new tax break that is a gross income exclusion if the lawmakers determine there is no available data to collect and report.

For example, picking a "hot" topic for summer 2024, if lawmakers added an exclusion for tips of certain employees, they would not have to include detailed performance indicators or data collection if lawmakers determine no available data can be collected and reported.

Per the Senate analysis (3/19/24) of AB 3289, the rationale for this change is that exclusions from gross income "often do not have available information to report, as the taxpayer does not list that excluded income on their return."

I don't think this change is needed. We should be able to find performance indicators for measuring if a tax break's goals and purposes are met and enable data collection for any tax change. AND, for equity, fairness, transparency and accountability purposes, we should have exclusions reported on an individual's tax return. Today, I think the only one reported is income on tax-exempt bonds. But that doesn't go a step further to highlight to the filer how much taxes they saved by using that exclusion.

Some exclusions are quite large such the exclusion for employer-provided health insurance, fringe benefits, gifts, life insurance proceeds, and gain from sale of a principal residence. The transparency problem of not reporting these items on a return is that taxpayers don't see the tax savings they obtain.

A schedule could be added to Form 1040 and modified by the states, that lists all tax breaks the taxpayer is using. Then their tax prep software can do a with and without tax calculation to show the savings from the tax breaks.

A fairness aspect of this is that for tax credits, the amount is on the return, but the tax savings of the exclusion for employer provided health insurance is not on the return. The average EITC at the federal level is $2,541 (per IRS 2022 stats) and that credit is clear on the return. Yet, many high income employees have a greater tax break just from their employer provided health insurance and that is not shown on the return. For example, someone in with a marginal tax rate of 32% where the employer covers $15,000 of their health insurance gets a tax break of $4,800 but likely is totally unaware of this.  The Affordable Care Act requires employers to report on Form W-2 the total cost of an employee's insurance and that should be changed to only report the amount the employer paid for the employee (not also any amount paid by the employee). This would provide this info right on the W-2.

Let's create a schedule of tax breaks to include with Form 1040 to create greater transparency of our tax systems. 

What do you think?

Budget Literacy for Form W-2

H.R. 8372, Debt Per Taxpayer Information Act, proposes to require the IRS to add this information to the bottom of Form W-2:

  1) Total revenue, outlays and deficit of the Federal government;

  2) Total gross Federal debt; and

  3) Estimate of the pro rate amount of Federal debt for taxpayers who will file 1040s for that year.

Sounds like a good idea to me.  There are many places where information about our tax and budget can be placed, including signs/posters in government buildings, lawmaker websites, and to better reach more individuals, rather than only the W-2, put the H.R. 8372 information on the bottom of Form 1099-NEC.

H.R. 8372 sponsor Congressman Arrington states that the Federal debt figure is $34 trillion or $200,000 per taxpayer!

In 1990, IRC Section 7523 was enacted to require the IRS to put 2 pie charts in the 1040 instruction booklet. One showing broad categories of revenues and the other expenditures. That may have reached people in the 1990s, but today, most people likely don't look at any pages of the Form 1040 instructions instead relying on tax prep software or a tax return preparer for answers to questions. That information also need to be moved to places where people will see it. [See my blog post on Section 7523 from 11/10/12]

And more is needed. I'd suggest a QR code with the proposed info to add to the W-2 so people can readily go for an explanation and more information. 

What do you think?