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.

Are Minimum Required Distribution Rules Changing Again?

I wonder what is going on at the IRS when it comes to IRA minimum required distributions.

You may recall that prior law allowed for something called a “stretch” IRA.  The idea was simple, but planners and advisors pushed on it so long and so hard that Congress changed the law.

An IRA (set aside Roth IRAs for this discussion) must start distributing at some point in time. The tax Code tells you the minimum you must distribute. If you want more, well, that is up to you and the tax Code has nothing further to say.  The minimum distribution uses actuarial life expectancies in its calculation. Here is an example:

                   Age of IRA Owner            Life Expectancy

                            72                                    27.4

                            73                                    26.5

                            74                                    25.5

                            75                                    24.6                                        

Let’s say that you are 75 years old, and you have a million dollars in your IRA. Your minimum required distribution (MRD) would be:

                  $1,000,000 divided by 24.6 = $40,650

There are all kinds of ancillary rules, but let’s stay with the big picture. You have to take out at least $40,650 from your IRA.

President Trump signed the SECURE Act in late 2019 and upset the apple cart. The new law changed the minimum distribution rules for everyone, except for special types of beneficiaries (such as a surviving spouse or a disabled person).

How did the rules change?

Everybody other than the specials has to empty the IRA in or by the 10^th year following the death.

OK.

Practitioners and advisors presumed that the 10-year rule meant that one could skip MRDs for years 1 through 9 and then drain the account in year 10. It might not be the most tax-efficient thing to do, but one could.

The IRS has a publication (Publication 590-B) that addresses IRA distributions. In March, 2021 it included an example of the new 10-year rule. The example had the beneficiary pulling MRDs in years 1 through 9 (just like before) and emptying the account in year 10.

Whoa! exclaimed the planners and advisors. It appeared that the IRS went a different direction than they expected. There was confusion, tension and likely some anger.

The IRS realized the firestorm it had created and revised Publication 590-B in May with a new example. Here is what it said:

For example, if the owner dies in 2020, the beneficiary would have to fully distribute the plan by December 31, 2030. The beneficiary is allowed, but not required, to take distributions prior to that date.”

The IRS, planners and advisors were back in accord.

Now I am skimming the new Proposed Regulations. Looks like the IRS is changing the rules again.

The Regs require one to separate the beneficiaries as before into two classes: those exempt from the 10-year rule (the surviving spouse, disabled individuals and so forth) and those subject to the 10-year rule.

Add a new step: for the subject-to group and divide them further by whether the deceased had started taking MRDs prior to death. If the decedent had, then there is one answer. If the decedent had not, then there is a different answer.

Let’s use an example to walk through this.

Clark (age 74) and Lois (age 69) are killed in an accident. Their only child (Jon) inherits their IRA accounts.

Jon is not a disabled individual or any of the other exceptions, so he will be subject to the 10-year rule.

One parent (Clark) was old enough to have started MRDs.

The other parent (Lois) was not old enough to have started MRDs.

Jon is going to see the effect of the proposed new rules.

Since Lois had not started MRDs, Jon can wait until the 10^th year before withdrawing any money. There is no need for MRDS because Lois herself had not started MRDs.

OK.

However, Clark had started MRDs. This means that Jon must take MRDs beginning the year following Clark’s death (the same rule as before the SECURE Act). The calculation is also the same as the old stretch IRA: Jon can use his life expectancy to slow down the required distributions – well, until year 10, of course.

Jon gets two layers of rules for Clark’s IRA:

·      He has to take MRDs every year, and

·      He has to empty the account on or by the 10^th year following death

There is a part of me that gets it: there is some underlying rhyme or reason to the proposed rules.

However, arbitrarily changing rules that affect literally millions of people is not effective tax administration.

Perhaps there is something technical in the statute or Code that mandates this result. As a tax practitioner in mid-March, this is not my time to investigate the issue.  

The IRS is accepting comments on the proposed Regulations until May 25.

I suspect they will hear some.

If I Had A Pony, I Would Ride It On My (Tug) Boat

If you have a business, and especially if that business has real estate, odds are very good that your tax advisor will talk to you about the “repair regulations” this filing season.

The IRS and taxpayers have spent decades arguing and going to court over whether an expenditure is a repair (and immediately deductible) or a capital improvement (which cannot be deducted immediately but rather must be depreciated over time). Eventually the IRS decided to pull back, review the existing court cases and develop some rhyme or reason for tax practice in this area. They were at it for years and years.

And now we have the “repair regulations.”

I debated whether to write on this topic, as one can leave the pavement and get lost in the weeds very quickly. It is like a romper room for tax nerds. Still, we have to at least discuss the high points.

Let’s set this up. Say that you have a tug boat. The boat is expected to last you approximately 40 years, if you maintain and keep it up. Every 4 or so years, you anchor the tug and give it a good overhaul, replace what needs replacing and rebuild the engine. This is going to cost you well over $100 grand.

Question: is this a repair (hence deductible) or a capital improvement (not immediately deductible but depreciable over time)?

It is not immediately clear. This costs a lot of money, so one’s first response is that it has to be capitalized and depreciated. However, regular use of a tug presumes heavy maintenance of this kind over its life. That sounds more like a repair expense.

The IRS has introduced the concept of a unit of property. We have to base the repair versus capitalization decision on the unit of property. Is the engine the unit of property (UOP) or is it the overall boat?

The main test for UOP is “functional interdependence.” The placing in service of one thing depends on the placing in service of something else.

Well, a tug boat engine without a tug boat to put it in is not of much use to anybody, so we would say that the overall boat is the unit of property.

Progress. Do we now know whether to capitalize or deduct the engine?

Nope.

Onward.

We next climb through a fence we will call the “BAR,” which stands for

·        Betterment

·        Adaptation

·        Restoration

If you get stuck on any rung of the “BAR,” you have to capitalize the cost. Sorry.

Let’s have a quick peek at which each term means:

·        Betterment

o   You made the thing larger, stronger, more efficient.

We did not turn the thing into a “monster” tug. Let’s move on.

·        Adaptation

o   You tweaked the thing for a different use or purpose.

Nope. It’s still a tug. Can’t fly it or drive it on a highway.

·        Restoration

o   Returning the thing to a usable condition after you have run it into the ground, either because you neglected it (and it fell apart) or it just got too old.      

Doesn’t sound like it. We are not neglecting the tug in any way, and it still has many years of use left.

This is looking pretty good for our tug.

Let’s go through a few more rules, just in case.

If your CPA prepares audited financial statements for you, the IRS will not challenge your deducting something up to $5,000 as a repair as long as you did the same thing on your financial statements.  

That tug thing costs way more than $5,000. Let’s continue. 

NOTE: BTW, if you do not have an audit, the IRS drops that dollar limit down to $500.

If we are talking about “materials and supplies,” the IRS will not challenge your deducting something as long as it costs $200 or less. Fuel for that tug would be considered “materials and supplies.” 

That tug work blew past $200 like it was standing still. Let’s proceed.

If you capitalize the thing on your books and records, the IRS will not argue that you should have deducted it instead.

            Downright charitable of them. Let’s move on.

If a repair is expected to be done more than once over the life of the UOP, then the IRS will not challenge your deducting it as a repair.

Whoa. We have something here. That boat is expected to last somewhere around four decades. The heavy maintenance has to be done every so many service hours, generally meaning every three or four years. Looks like we can deduct the repairs to our tug.

Let’s dock the tugboat and briefly discuss a building. Perhaps we can see our tug from our building.

The IRS is taking the position that a building is both one unit of property and more than one unit of property.

I do not make this up, folks.

The IRS wants certain systems of a building – like its HVAC or its elevators – to also be considered a separate UOP. Let’s take an example. Let’s say that you are replacing a bunch of windows on that building. You would then evaluate whether it is a repair or an improvement by reference to the building as a whole. This is a good thing, as it would take a lot to “improve” the building as a whole. This makes it more likely that the answer will be a deductible repair.

However, say that you replace an elevator. The IRS says that you have to look at elevators separately from the overall building. We’ll, it does not take much to improve an elevator if you are just comparing it to an elevator. This is a bad thing, as it makes it more likely that the result will be a capital improvement.

BTW there is a separate test if your building costs less than a $1 million when you bought it. The IRS will “spot” you a certain amount before it will challenge whether something is a repair or not. It’s for the smaller landlords, but it is something.

And there you have the highlights of the repair regulations.

Depending on your fact patterns, there may be elections and forms that you have to attach to your tax return. Your tax advisor may even request that you change your underlying bookkeeping – like expensing stuff under $5000/$500 on your general ledger, for example. Some of these will require extra work, and hence additional fees, by and from your advisor.

And there is one more thing.

Let’s go back to the tugboat.

Let’s say that you did the major overhaul four years ago and capitalized the cost. You are now deducting those repairs over time as depreciation. The new rules now allow you to deduct the cost immediately as a repair. Had we only known!

Is it too late for us? Four years back is one more year than the statute of limitations permits, so we cannot go back and amend your return.

The IRS – to their credit – realized the unfairness of this situation, and it will let you go back and apply these new rules to that old tax year. The IRS calls it a “partial disposition,” and you can deduct what’s left of that capitalized tugboat repair on your 2014 tax return. It is called a “Change in Accounting Method” and is yet another multi-page form with your return, but at least you can get the deduction. But only on 2014. Let it slip a year and you can forget about it.

If any of the above rings a bell, please discuss the “repair regulations” with your tax advisor. Seriously, after 2014 you may be stuck. Tax does not have to be fair.

Lyle Lovett - If I Had A Boat 

Civil War Horses, Con Men and Lois Lerner

I think I have been insulted.

I am reading this morning that the Court of Appeals for the D.C. Circuit is hearing the IRS appeal of the Loving decision.  That decision concerned the recent effort by the IRS to regulate tax preparers, and the IRS lost the case. There were three parts to the IRS effort:

• a unique preparer identification number, called a PTIN (“pea tin”). The PTIN would allow – in theory - the IRS to track which individuals prepared which returns. I say “in theory” because it is not uncommon for larger returns to have two or more preparers and one or more reviewers. Traditionally the highest-ranking last person in the chain is considered the official preparer, but the IRS did not write its regulations that way.

• a competency test. CPAs, enrolled actuaries, attorneys and enrolled agents were exempt, as their credentialing already includes a competency test.

• a continuing education requirement. Tax laws change frequently, so the IRS thought that continuing education would be a good idea. It is.

Here is the rub: where does the IRS get the authority to make these proclamations? I know it sounds a bit quaint to talk about “government of laws rather than of men” in the current political environment, but there are a few sticklers out there who still believe in the concept. One of them was Judge Boasberg in the Loving decision.

Yesterday the IRS trotted out its attorneys, arguing that they have the right to regulate whatever they want under the “Horse Act of 1884.” Folks, that is “18” 84. 

Do you remember the following words?

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

This is the 16^th amendment, creating the income tax and ratified in February 1913. That is “19”13. Which comes after “18”84, for most people. Let’s be blunt here: how can a law from the 1800’s give the IRS any authority over income tax preparers when the income tax was not even created until 1913?

I have to admit, I had to look up the Horse Act of 1884. We must have missed that bright shiny in high school American History. After the Civil War, people brought claims against the U.S. for dead or missing horses. Makes sense, as horses were required to work the farm or for transportation, and their loss would have been keenly felt. Always seeking a vacuum, fraudsters soon appeared to help people press horse claims against the government. Soon all horses were thoroughbreds, and the government was facing more actions than there were horses lost in the Civil War. The government realized they were being scammed by con men and, in defense, starting regulating those people. The government even used the term “enrolled agent,” a term still used today for a class of preparer who has passed a competency examination given by the IRS itself.

So the IRS attorneys are arguing that tax CPAs like me are akin to fraudsters who inflated the value of dead or missing horses in action against the government following the Civil War?

As I said, I think I have been insulted.

I am also reading that Lois Lerner, the former head of the IRS Exempt Organizations Division, is retiring. You may remember that she invoked the Fifth Amendment when appearing before Congress on May 22, 2013. She was the political hack from the Federal Elections Commission who somehow wound up at the IRS reviewing and delaying applications from conservative groups, especially Tea Party organizations, seeking 504(c)(4) status in time for the 2012 presidential election. Good thing she was there too or the election may have gone a different way. She was quite happy to initially throw a few Cincinnati IRS employees under the bus, saying they had gone “rogue.” Later investigation, including e-mails, put a rest to that lie. Congress could have instead spoken with a few practicing tax CPAs, and we could have told them the same thing.  

She has been on “administrative” leave since then, drawing an approximate $170,000 salary. Now she gets to retire. It’s a nice retirement too, as she able to look for another government position and still collect her retirement pay, estimated over $50,000 annually. 

I would love a deal like that. Unfortunately, the IRS thinks of me as a con man.

Smackdown On IRS Regulation of Tax Preparers

In 2009 the IRS commissioned a study of the tax preparation industry. Some of the findings were obvious: as the tax law becomes more complex, taxpayers are increasingly relying upon tax preparers or tax software (think TurboTax) in preparing accurate returns. The study then went on to look at the preparers themselves, from attorneys and CPAs to big-block preparers (such as H&R Block) to someone who prepares a few returns for compensation from their kitchen table.

It was on that last point that the IRS had an issue. It noted that anyone could enter the tax preparation business and that that ill-equipped preparers were making numerous errors that were costly to the Treasury. The IRS was unsure even of the number of tax preparers out there, guessing there were between 900,000 and 1.2 million preparers.

The IRS observed that:

...the American public overwhelmingly supports efforts to increase the oversight of paid tax return preparers.”

Sorry, that one sounds like self-serving flourish. I doubt the American public is barely aware of this issue.

The IRS, then under Commissioner Shulman, instituted a three-part program to oversee individual income tax preparers:

(1) A specific identification number for each preparer

           

This is called the “preparer tax identification number” (PTIN), and every preparer is required to obtain one and use it on every return he/she signs. Before January 1, 2011, use of a PTIN was optional.

(2) The competency test

The IRS mandated that preparers had to take an exam and then went on to exempt categories of preparers, such as attorneys, CPAs and EAs. There were reasonable grounds for these exceptions, as each of these groups has its own licensing system. 

After much wrangling, the IRS also exempted preparers supervised by an  attorney, CPA or EA. If you worked for me, for example, you could be exempt by working under my supervision.

(3) Continuing education

           

Preparers had to complete 15 hours of continuing education each year. Again, attorneys, CPAs and EAs were exempt because of their own education requirements.

The government being what it is, a new unit was created within the IRS – the Return Preparer Office – to administrate all this activity. The government also created a new designation, the "registered tax return preparer," for those passing the competency exam.

So far, this sounds reasonable (or, at least, not unreasonable), right?

There was deep cynicism right away about what the IRS was actually up to. For example, the PTIN cost $63. Every year. Many practitioners, including some I have worked with, believe this to be a back-door effort by the IRS to pad its own budget. The facts seem to bear this out, as the IRS has collected more than $106 million from the preparer registration and testing system. It has spent approximately $50 million and assigned 167 employees to the program.

What about the testing? No one is truly certain how many tax preparers have to go through the testing, given that so many (like me) are exempted. The number I have seen most often is 350,000.

Let’s go with 350,000. As of December 31, 2012, only 48,000 of 350,000 had finished the certification process. Sheeeshh. No one is knocking down that door.

That leaves continuing education. The cost of those 15 hours could vary significantly. For many preparers, the number of returns prepared might not justify the cost of the education. Preparers were required to obtain their first 15 hours in 2012. After complaints, the IRS wound-up allowing preparers to make-up their 2012 hours in 2013.

Fueling the cynicism was the program’s open support by H&R Block and Jackson Hewitt. Those big guys are better positioned to comply with these new rules. The former CEO of H&R Block – Mark Ernst – was made deputy commissioner of the IRS and drafted many of the new rules for tax preparers. No conflict there, it appears. The investment firm UBS advised "the new regulations should help (H&R) Block" to put their smaller competitors out of business.

This is the United States, so you know someone sued. Three independent tax preparers did, with the assistance of the Institute for Justice.

The case is Loving v Internal Revenue Service, decided on January 23, 2013 by the District Court for the District of Columbia. Judge Boasberg wrote the opinion and he is – given that tax can be boring – quite the hoot. Let’s summarize what he said.

The Court immediately observed that the IRS was interpreting an 1884 statute as giving it authority for its actions. That statute gives the Treasury Secretary authority to regulate preparers who “practice” before it. The Court immediately noted that:

... attorneys, CPAs, enrolled agents or enrolled actuaries are otherwise regulated by the IRS and thus have no bone to pick with the new regulations.”

That leaves the other hundreds of thousands of preparers who are not attorneys, CPAs, EAs or enrolled actuaries. They comprise the 350,000 preparers we discussed previously. Sabina Loving, of the eponymous case, is a bookkeeper and tax preparer from Chicago. She is one of those 350,000.

So, is Sabina Loving “practicing” before the IRS?

Here is the Court:

Under ..., originally enacted in 1884, the Treasury Secretary has authority to regulate people who practice before the Treasury Department. This is so even though the casual student of history knows that the Sixteenth Amendment authorizing the modern federal income tax was not ratified until 1913.”

COMMENT: Heh.

           

Section 330(a) authorizes the Treasury Secretary to ‘regulate the practice of representatives.... In dispute is the IRS’s interpretation that tax-return  preparers are ‘representatives’ who ‘practice’ before the IRS.”

The IRS hurries through..., arguing that the statute is ambiguous because it defined neither ‘representative’ nor ‘practice’.... That simplistic approach will not fly, however.”

The Court goes on to observe that the statute refers to a “representative” advising and assisting persons in presenting their cases. Here is the Court again:

           

Filing a tax return would never, in normal usage, be described as ‘presenting a case.’ At the time of filing, the taxpayer has no dispute with the IRS; there is no ‘case’ to present.”

COMMENT: I like this judge. He likely has blown his chance to be on the Supreme Court, though.

With an invalid regulatory regime on the IRS’s side of the scale and a threat to the plaintiff’s livelihood on the other, the balance of hardship tips strongly in favor of plaintiffs.”

The Court permanently enjoined the IRS from enforcing its tax preparer program.

Yes, the little guy won, at least for the moment. In a motion filed January 24 with the Court, the IRS argued that it has a “reasonable likelihood” of winning its appeal and that the public will suffer “irreparable harm.” The IRS argued that it would incur “substantial costs” to restart the preparer program if the injunction is not lifted. The IRS also noted that that “thousands of return preparers who have already submitted their users fees would demand refunds, and the United States would likely face numerous lawsuits—including class action lawsuits.”

My Take: I am both happy and uncomfortable with the decision. I agree that the IRS went a bridge too far. I also understand that a rapidly-changing tax code requires ongoing education and that unscrupulous preparers fueling fraudulent deductions and tax credits have become a cottage industry.

I point out how much of this trouble has been caused by Congress introducing what most parties agree are welfare or transfer payments into the tax code. Congress could remove a lot of steam from unscrupulous preparers just by eliminating refundable tax credits, such as the earned income credit, for example. Here is a currently out-of-vogue idea:  why not have a national debate on whether the purpose of a tax system is to – you know – collect taxes?

The District Court will either lift its injunction or not. If not, expect an appeal from the IRS to the Circuit Court. It seems to me a tremendous expenditure of talent and resources by an over-tasked agency.