A Short Story About Connecticut Unemployment Reporting

I read that the Governor of Connecticut has signed a bill repealing certain additional payroll reporting requirements otherwise slated to start next year.

As background, all state quarterly unemployment returns include certain basic information, including:

·       Name

·       Social security number

·       Wages paid in the quarter

Prior to repeal, Connecticut employers were to report additional information with their quarterly unemployment returns. The reporting was to start in 2024, with the exact phase-in depending on the number of employees:

·       Gender identity

·       Age

·       Race

·       Ethnicity

·       Veteran status

·       Disability status

·       Highest education completed

·       Home address

·       Address of primary work site

·       Occupational code under the standard occupational classification (SOC) system of the federal Bureau of Labor Statistics

·       Hours worked

·       Days worked

·       Salary or hourly wage

·       Employment start date in the current job title

·       Employment end date (if applicable)

Ten of the above 15 data elements are not collected by any other state.

There was concern that the additional elements could negatively impact people filing for benefits – that is, the actual purpose of unemployment taxes.

“The Department of Labor would need to edit incoming reports against certain standards and reject employer wage/tax reports or suspend processing while seeking clarification of elements reported.   

“Rejected or suspended wage reports could make wage information unavailable when unemployment claimants apply for benefits.”

It appears a breath of sanity.

A Bad Idea

I am reading an abstract for an upcoming article in the Southern California Law Review.

When an electricity provider wants customers to pay their bills monthly, it sends them a bill each month. Yet this is not how the tax system works, at least for independent contractors. Their taxes are due quarterly, but they receive a tax statement (Form 1099) only one time a year. It is up to the individual, then, to know when their taxes are due and how to pay them, and it is on that individual to estimate how much they owe each quarter. As a result, compliance for independent contractors – particularly for online platform workers–tends to be lacking. Failure to pay their estimated taxes subjects these taxpayers to potential penalties and causes the government to collect less tax revenue.

Yep, quarterly taxes for the self-employed. I know a lot about the topic.

There is a simple, yet entirely overlooked, reform that could vastly improve compliance when it comes to paying estimated taxes: third-party information returns (Form 1099s) should be issued to taxpayers on a quarterly basis. The idea is straightforward and intuitive. If the government wants people to pay taxes four times per year, it needs to effectively “bill” them four times per year. This idea is supported by social science research showing that, the more taxpayers are reminded to pay their taxes, the more likely they are to do so.

Sigh.

If only it were so simple.

Unspoken is an arrogance that accounting is just pushing a button. Everything is automated, right, so what is the issue?

Much is automated. More so today than when I started, and it will be more so again when I eventually retire. But much is not all. Much is not necessarily even much.

The presumption that Fortune 500 accounting departments are the norm for businesses will lead to erroneous conclusions, including the one above. There are over 30 million companies in the United States. Less than 1 percent of those are publicly traded, and the Fortune 1000 constitutes a fraction of that fraction. There is an entire economic sector - the self-employeds, the small- and mid-market companies - that are unlikely to have an accountant - much less an accounting department - available to respond to the whims of nonserious minds. Most CPAs - including me – advise that market. When we meet with ownership, we meet with the owner or owners, not an assemblage at an annual shareholder meeting.  When decisions are required, the number of decision makers is few; in many cases, it is only one.

Somehow this overlooked sector represents roughly half of all economic activity and approximately two-thirds of all jobs created in the United States since the 1990s. This sector employs tens of millions, allowing them home ownership, EV purchases, private schools, higher education, smart phones, streaming services, and perhaps an occasional vacation to Disney World.

Can this sector push a button to generate quarterly 1099s because a professor thinks the idea has been “entirely overlooked?” Maybe, but probably not. More likely, they will call their CPA – assuming they have one.

That quarterly 1099 is somehow now in my court.

CPAs want to go home, too.

Then there is the issue of who will prepare these 1099s. I know that accounting literature is not a thing, but glance at the following:

Statistics from the AICPA suggest that 75 percent of current CPAs will retire in the next 15 years.

Does this seem like an appropriate time to further add to the problems of accounting? Many already see a profession facing future demands exceeding its ability to supply.

No, I don’t think that quarterly 1099s are a bright idea.

In fact, maybe the Congressional effort in 1986 to move almost all taxable year-ends to December 31, further compressing our work schedule was – in retrospect – not such a bright idea.  

Notices are the bane of tax practice. One may be a gifted practitioner but send enough penalty notices and even a loyal client begins to question. Maybe the decades of Congress “balancing” budget bills by increasing tax penalties on virtually anything that moves was not such a bright idea.

Maybe the relentless introduction of arbitrary, inconsistent if not preposterous – other than as blatant money grabs - tax laws was not such a bright idea.

Maybe passing tax laws late in the year when there is no time for advisors to react – or even better, passing those laws the following year but with retroactive effect – was not such a bright idea.

Maybe the hubris that just one more surtax, deduction or tax credit will somehow solve the enduring difficulties of the species and pave the highway to heaven was not such a bright idea. 

We are showered by sententious minds bringing bright ideas.

They should be entirely overlooked.

Change In The Kiddie Tax

Congress took a tax calculation that was already a headache and made it worse.

I am looking at a tax change included in the year-end budget resolution.

Let’s talk again about the kiddie tax.

Years ago a relatively routine tax technique was to transfer income-producing assets to children and young adults. The technique was used mainly by high-income types (of course, as it requires income), and the idea was to redirect income that would be taxed at a parent’s or grandparent’s (presumably maximum) tax rate and tax it instead at a child/young adult’s lower tax rate.

As a parent, I immediately see issues with this technique. What if one of my kids is responsible and another is not? What if I am not willing to just transfer assets to my kids – or anyone for that matter? What if I do not wish to maximally privilege my kids before they even reach maturity? Nonetheless, the technique was there.

Congress of course saw the latent destruction of the republic.

Enter the kiddie tax in 1986.

In a classroom setting, the idea was to slice a kid’s income into three layers:

(1)  The first $1,050

(2)  The second $1,050

(3)  The rest of the kid’s income

Having sliced the income, one next calculated the tax on the slices:

(1)  The first $1,050 was tax-free.

(2)  The second $1,050 was taxed at the kid’s own tax rate.

(3)  The rest was taxed at the parents’ tax rate.

Let’s use an example:

(1)  In 2017 the kid has $20,100 of income.

(2)  The parents are at a marginal 25% tax rate.

Here goes:

(1)  Tax on the first slice is zero (-0-).

(2)  Let’s say the tax on the second slice is $105 ($1,050 times 10%).

(3)  Tax on the third slice is $4,500 (($20,100 – 2,100) times 25%).

The kid’s total 2017 tax is $4,605.

Let’s take the same numbers but change the tax year to 2018.

The tax is now $5,152.

Almost 12% more.

What happened?

Congress changed the tax rate for slice (3). It used to be the parent’s tax rate, but starting in 2018 one is to use trust tax rates instead.

If you have never seen trust rates before, here you go:

          

Have over $12,500 of taxable income and pay the maximum tax rate. I get the reasoning (presumably anyone using trusts is already at a maximum tax rate), but I still consider these rates to be extortion. Sometimes trusts are just that: one is providing security, navigating government programs or just protecting someone from their darker spirits. There is no mention of maximum tax rates in that sentence.

Let’s add gas to the fire.

The kiddie tax is paid on unearned income. The easiest type to understand is dividends and interest.

You know what else Congress considered to be unearned income?

Government benefits paid children whose parent was killed in military service. These are the “Gold Star” families you may have read about.

Guess what else?

Room and board provided college students on scholarship.

Seriously? We are taking people unlikely to be racking Thurston Howell III-level bucks and subjecting them to maximum tax rates?

Fortunately, Congress – in one of its few accomplishments for 2019 – repealed this change to the kiddie tax.

We are back to the previous law. While a pain, it was less a pain than what we got for 2018.

One more thing.

Kids who got affected by the kiddie tax changes can go back and amend their 2018 return.

I intend to review kiddie-tax returns here at Galactic Command to determine whether amending is worthwhile.

It’s a bit late for those affected, but it is something.

Individual Changes In The New Tax Bill

We have a new tax bill, and it is considered the most significant single change to the tax Code over the last 30 years. Here are some changes that may affect you:

·     Your tax rate is likely going down. A single person making $150,000, for example, will see his/her rate dropping from 28% to 24%. A married couple making $250,000 will see their rate drop from 33% to 24%. Whether married or not, the top rate has gone from 39.6% to 37%.

·     You will lose your personal exemptions next year. For 2017 the exemption amount is $4,050 for you, your spouse and every tax dependent. 

·      To make up for the loss of the personal exemptions, your standard deduction is going up in 2018. A single taxpayer will increase from $6,350 to $12,000. A married taxpayer will go from $12,700 to 24,000.

·      Many of your itemized deductions will be limited or go away altogether next year:

o   For 2017 you can deduct interest on up to $1 million on a mortgage used to buy your home.  In 2018 that limit will drop to $750,000.

o   For 2017 you can deduct interest on (up to) $100,000 of home equity loans. In 2018 you will be unable to deduct any interest on home equity loans.

o   For 2017 you can deduct your state and local income and real estate taxes, without limit. In 2018 the maximum amount you can deduct is $10,000.

o   For 2017 you can deduct a personal casualty loss (such as a car flooding), subject to a $100-deductible-per-incident and-10%-of-income threshold. You will not be able to deduct such losses in 2018, unless you are in a Presidentially-declared disaster zone.

o   For 2017 you can deduct contributions up to 50% of your income. In 2018 that increases to 60%.

o   If your contribution provides the right to purchase seat tickets to an athletic event – say to Tennessee or Ole Miss – you can presently deduct a percentage of that contribution.  In 2018 you will not be able to deduct any portion.

o   In 2017 you can deduct employee business expenses, certain similar or investment expenses, subject to a 2% disallowance. Starting in 2018 no 2% miscellaneous deductions will be allowed.

·     Medical expenses – for some reason – go the other way. Congress reduced the threshold from 10% to 7.5%, and it made the change retroactive to January 1, 2017. It is one of the few retroactive changes in the bill, and it will exist for only two years – 2017 and 018.

·     Get divorced and you might pay alimony. For 2017 you can deduct alimony you pay, and your ex-spouse has to report the same amount as income. Get divorced in 2019 or later, however, and your alimony will not be deductible, and it will not be taxable to your ex-spouse.

·      Move in 2017 and you may be able to deduct your moving expenses. There is no deduction if you move in 2018 or later.

·      You still have the alternative minimum tax to worry about in 2018, but the exemption amounts have been increased.

·      If you own a business, chances are the new tax law will affect you. For example,

o   If you own a C corporation, you will now pay tax at one rate – 21%. It does not matter how big you are. You and Wells Fargo will pay the same tax rate.

o   If you are self-employed, a partner or a shareholder in an S corporation, you might be able to subtract 20% of that business income from your taxable income. There are hoops, however. The new law will limit your deduction if you do not have payroll or have no depreciable assets, although you can avoid that limit if your income is below a certain threshold.

·     Your kid will provide a larger child tax credit. The credit is $1,000 for 2017 but will go to $2,000 in 2018.

What can you do now to still affect your taxes?

·      Rates are going down. Delay your income if you can.

·      For the same reason, accelerate your expenses, especially if you are cash-basis.

·      Prepay your real estate taxes. Yes, that means pay your 2018 taxes by December 31.

·      Pay your 4^th quarter state (and city) estimated tax by December 31. You may even want to sweeten it a bit, although the tax bill does not permit one to prepay all of 2018’s state tax by December 31.

·      Remember that you are losing your 2% miscellaneous deductions next year. If you use your car for work and are not reimbursed, you will lose out. It is the same for an office-in-home. 

·   Congress is limiting or taking away many popular itemized deductions and replacing them with a larger standard deduction. This means your remaining deductions – mortgage interest, taxes (what’s left) and contributions are under pressure to exceed that standard deduction. If you do not think you will be able to itemize next year, you may want to accelerate your contributions to 2017. Remember that the check has to be in the mail by December 31 to claim the deduction in 2017.

There are some surprises to be had, folks. I was looking at an estimated 2018 workup for a routine-enough-CPA-firm client. The result? An over 16% tax increase. What caused it? The loss of the personal exemptions. It was simply too much weight for the increased standard deduction and slightly lower tax rates to pull back up. 

I hope that is not the norm. This is a hard-enough job without having that conversation. 

How Often Can The IRS Audit You For The Same Thing?

How often can the IRS audit you for the same thing?

I would have to ask two more questions before answering:

(1) Is the IRS auditing the same year?

(2) Is the IRS auditing the same issue?

Here is the relevant Code section:

            IRC Section 7605(b):

No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer's books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.

Focus in on the lawyered wording:

            “unnecessary examination or investigations”

            “an additional inspection is necessary”

If I were the IRS, I would argue that all examinations and inspections are “necessary” and be done with the matter.

Fortunately, it does not work that way.

Let say that you are self-employed and deducted a bad debt – a sizeable one – in 2014. The IRS takes a look at it and raises some questions, as bad debts are a notorious area of contention with the IRS. After some back and forth the IRS agrees to the deduction.

Question: Can the IRS audit your 2014 tax return again?

Answer: Of course it can, at least until the statute of limitations expires. What it cannot do is audit your 2014 bad debt again. It already looked at that issue and did not propose an audit adjustment. There is only one bite at the apple.

This does not mean that you are untouchable, however.

Let’s say that you incur a huge net operating loss in 2016. You decide, after meeting with your tax advisor, to carryback the loss to 2014 and get a tax refund. You could really use the cash, with that loss and all.

Question: Can the IRS audit your 2014 bad debt again?

The answer may surprise you: Yes.

Here is the Court:

This is not a case where the IRS is subjecting the Taxpayer to onerous and unnecessarily frequent examinations and investigations. The reexamination of Year 1 is not a unilateral action on the part of the IRS, but in response to the Taxpayer’s election to carry back net operating losses and claim a refund.”

In other words, you started it.

Let me give you a second scenario: 

You have a large donation in 2014 and another large donation in 2015. You were audited for 2014. The IRS made no change to your return.

Question: Can the IRS audit your 2015 for the donation? 

Here is Internal Revenue Manual 4.10.2.13:

(1) Repetitive audit procedures apply to individual tax returns without a Schedule C or Schedule F, when the following criteria are met:

·        a. An examination of one or both of the two preceding tax years resulted in a no change or a small tax change (deficiency or overassessment), and

·        b. The issues examined in either of the two preceding tax years are the same as the issues selected for examination in the current year.  

Answer: You should be able to stop this audit. The IRS looked at the same issue in the preceding year and found nothing.

BTW, note the references to Schedule “C” and “F” in para 1 above. Schedule C means that someone is self-employed, and Schedule F means that someone is a farmer. Those are two situations where a tax advisor would love to have this IRM protection. The IRS knows that too, which is why the IRS left out self-employeds and farmers.  

Question: What if the IRS audits you in 2014 for mileage and in 2015 for office-in-home expenses?  

Answer: You being are audited for two different things. What we are talking about is the IRS looking at the same thing, either more than once for the same year or more than once over a three-year period.

Let’s clarify a crucial point: what halts the second audit is NOT that you were previously audited on the same issue. What halts it is that you were audited and there was no change or an insignificant change. If you owed big bucks on the audit then you are fair game. 

A word of advice: you will have to let the examiner know. My experience is that he/she will be unaware until you bring it up. Address this issue early – for example, when the examiner is trying to schedule the visit – and you can stop the audit altogether. 

Tax Mulligans and Tennessee Walking Horses

Here is the Court:

While a taxpayer is fee to organize [her] affairs as [she] chooses, nevertheless once having done so, [she] must accept the tax consequences of her choice, whether contemplated or not, and may not enjoy the benefit of some other route [she] might have chosen to follow but did not.”

This is the tax equivalent of “you made your bed, now lie in it.” The IRS reserves the right to challenge how you structure a transaction, but – once decided – you yourself are bound by your decision. 

Let’s talk about Stuller v Commissioner.  They were appealing a District Court decision.

The Stullers lived in Illinois, and they owned several Steak ‘n Shake franchises. Apparently they did relatively well, as they raised Tennessee walking horses. In 1985 they decided to move their horses to warmer climes, so they bought a farm in Tennessee. They entered into an agreement with a horse trainer addressing prize monies, breeding, ownership of foals and so on.

In 1992 they put the horse activity into an S corporation.

They soon needed a larger farm, so they purchased a house and 332 acres (again in Tennessee) for $800,000. They did not put the farm into the S corporation but rather kept it personally and charged the farm rent.

So far this is routine tax planning.

Between 1994 and 2005, the S corporation lost money, except for 1997 when it reported a $1,500 profit. All in all, the Stullers invested around $1.5 million to keep the horse activity afloat.

Let’s brush up on S corporations. The “classic” corporations – like McDonald’s and Pfizer – are “C” corporations. These entities pay tax on their profits, and when they pay what is left over (that is, pay dividends) their shareholders are taxed again.  The government loves C corporations. It is the tax gift that keeps giving and giving.

However C corporations have lost favor among entrepreneurs for the same reason the government loves them. Generally speaking, entrepreneurs are wagering their own money – at least at the start. They are generally of different temperament from the professional managers that run the Fortune 500. Entrepreneurs have increasingly favored S corporations over the C, as the S allows one level of income tax rather than two. In fact, while S corporations file a tax return, they themselves do not pay federal income tax (except in unusual circumstances).  The S corporation income is instead reported by the shareholders, who combine it with their own W-2s and other personal income and then pay tax on their individual tax returns.

Back to the Stullers.

They put in $1.5 million over the years and took a tax deduction for the same $1.5 million.

Somewhere in there this caught the IRS’ attention.

The IRS wanted to know if the farm was a real business or just somebody’s version of collecting coins or baseball cards. The IRS doesn’t care if you have a hobby, but it gets testy when you try to deduct your hobby. The IRS wants your hobby to be paid for with after-tax money.

So the IRS went after the Stullers, arguing that their horse activity was a hobby. An expensive hobby, granted, but still a hobby.

There is a decision grid of sorts that the courts use to determine whether an activity is a business or a hobby. We won’t get into the nitty gritty of it here, other than to point out a few examples:

·        Has the activity ever shown a profit?

·        Is the profit anywhere near the amount of losses from the activity?

·        Have you sought professional advice, especially when the activity starting losing buckets of money?

·        Do you have big bucks somewhere else that benefits from a tax deduction from this activity?

It appears the Stullers were rocking high income, so they probably could use the deduction. Any profit from the activity was negligible, especially considering the cumulative losses. The Court was not amused when they argued that land appreciation might bail-out the activity.

The Court decided the Stullers had a hobby, meaning NO deduction for those losses. This also meant there was a big check going to the IRS.

Do you remember the Tennessee farm?

The Stullers rented the farm to the S corporation. The S corporation would have deducted the rent. The Stullers would have reported rental income. It was a wash.

Until the hobby loss.

The Stullers switched gears and argued that they should not be required to report the rental income. It was not fair. They did not get a deduction for it, so to tax it would be to tax phantom income. The IRS cannot tax phantom income, right?

And with that we have looped back to the Court’s quote from National Alfalfa Dehydrating & Milling Co. at the beginning of this blog.

Uh, yes, the Stullers had to report the rental income.

Why? An S corporation is different from its shareholders. Its income might ultimately be taxed on an individual return, but it is considered a separate tax entity. It can select accounting periods, for example, and choose and change accounting methods. A shareholder cannot override those decisions on his/her personal return. Granted, 99 times out of 100 a shareholder’s return will change if the S corporation itself changes. This however was that one time.

Perhaps had they used a single-member LLC, which the tax Code disregards and considers the same as its member, there might have been a different answer.

But that is not what the Stullers did. They now have to live with the consequences of that decision.