Dude, Free Dragon! and the Earned Income Tax Credit

I am looking at a report from the Treasury Inspector General for Tax Administration (TIGTA) dated March 31, 2014 and carrying the non-hummable title of

The Internal Revenue Service Fiscal Year 2013 Improper Payment Reporting Continues to Not Comply With the Improper Payments Elimination and Recovery Act.”

We have reviewed a number of previous TIGTA’a publications, and this one concerns the earned income credit. The initial idea behind it was laudable enough: it was intended to provide a floor to the most economically disadvantaged, while simultaneously diluting the disincentive as someone weaned off welfare and went back into the workforce.

Sounds good, right?

There is a card game called Magic: The Gathering. I have a number of friends who play, and one in particular who is a Tournament judge. Think of Dungeons and Dragons, translate it into a card game and you have Magic: The Gathering. The reason I bring it up is that there is a Magic card that allows one to put a dragon onto the board at no cost to the player. Dragons are as formidable as you would expect, so this is not insignificant in game context. The friends refer to it colloquially as “Dude, free dragon”!

The earned credit is the tax Code version of “Dude, free dragon”!

This credit was virtually built to be abused, and abused it has always been and will always be. One cannot turn down free dragons.

What does it take to power the earned income tax credit? It takes two things: earned income and a dependent child.

·        Earned income means that you have paid social security or self-employment tax on it. Workers compensation or unemployment, for example, will not power the EITC as one does not pay social security on either.

·       The other thing you need is a kid. Two is better than one. Three is better than two. Four is no better than three, so there is a limit to this escalation.

NOTE: There is a very limited credit for someone with little income and no children, but we will set that category aside for this discussion.

You need to have a job. Makes sense, if you remember what I said earlier about removing disincentives to return to work. A W-2 job is the easiest to understand.

Self-employment income will also do it. I suspect that any tax practitioner who has been around the block a few times has had or heard of an EITC client reporting self-employment income, likely with few if any expenses. The taxpayer is incentivized to lowball his/her expenses, as the credit can outstrip any additional taxes due from overstating his/her actual income. Alternatively, one might simply “make up” income, just to power the EITC.

You also need a kid. This is where it gets problematic, especially nowadays.  It can take the discipline of a sociologist to follow the convoluted trail of who-did-what-and-then-moved-in-with…. The bottom line is that a kid is the key to this ride. Having a kid, especially a kid you can “lend” out, becomes a commodity, and, like any commodity, the kid has value.

Where does a tax pro see this? Easy. How about two unmarried people who have a child together. One brings a child from a prior marriage. The facts make more sense if they maintain two households, but they wouldn’t be the first to live together and have two EITCs sent to the same address.

OBSERVATION: I am giving the IRS this one for free: check for two EITCs sent to the same address. You are welcome.

So you come to see me. You tell me that you are taking care of your on-and-off-girlfriend’s second daughter, because her mother is irresponsible and you have taken a liking to the girl. You are thinking of adopting, immediately after that around-the-world flight on a paraglider you are planning.  Coincidentally the kid also gives you an earned income tax credit. How am I to know whether this is really taking place, whether that the child is living with you and not with her mother, yada yada yada?

I will tell you what the IRS has said I am to do. Then I will tell you what I actually do.

The IRS keeps expanding what a tax preparer is to do when faced with an earned income tax credit.  Let’s go back to the Improper Payments Information Act that TIGTA referenced. This law goes back to 2002. TIGTA goes on to explain:

… the IRS’s estimates of Fiscal Year 2012 improper EITC payments were understated. They were based on an assumption that a provision in the American Recovery and Reinvestment Act of 2009 … that increased the EITC for certain taxpayers would expire at the end of 2010. However, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 extended the provision through 2012.”

Did you get that? The IRS did not update its 2012 estimates for a law passed in 2010. Amazing. Let a tax CPA do that and he/she will soon have no clients.

Let’s continue:

It was later extended through December 2017 by the American Taxpayer Relief Act of 2012.”

There is my second freebie to the IRS.

The EITC remains the only revenue program fund to be considered at high risk for improper payments.”

How much money are we talking about?

The IRS estimates that 22% to 26% of EITC payments were issued improperly in Fiscal Year 2013. The dollar value … was estimated to be between $13.3 billion and $15.6 billion.”

This is real money, even by Washington standards. So what was the IRS plan to deal with this?

The IRS announced a plan in January 2010 to register, license and create enforcement tools that would impact the paid preparer community more broadly.

Paid preparers assisted in the preparation of approximately 66 percent of all EITC claims paid in Tax Year 2008.”

Let me see if I get this right:

·       The IRS has a “Dude, free dragon” tax credit

·       People abuse “Dude, free dragon”

·       A normal person can hardly prepare his/her own taxes anymore, so he/she uses a preparer, therefore

·       Abuse of the EITC is the preparer’s fault

Right….

Let’s continue.

However, in January 18, 2013, a Federal Court enjoined the IRS from enforcing the regulatory requirements for registered tax return preparers.”

We discussed this in an earlier blog. The IRS was arguing that they could regulate preparers because of a Treasury decision having to do with government payment for horses after the civil war. The Federal Court said no; the IRS did not have legal authority and could not arrogate such authority to itself.

NOTE: Seems quaint reasoning, especially after six years of the current Administration, doesn’t it?

The IRS is miffed, sticks out its lip and pouts:

The Court ruling materially affects the basis on which the IRS planned to establish a baseline for meaningful reduction targets as previously indicated.”

So IRS Commissioner Koskinen is placing blame on the tax preparer community. If only the IRS could regulate preparers!

There is some truth to this. There are many grades of preparers. There are the classically-trained, such as tax attorneys and tax CPAs. There are also Enrolled Agents (EAs), many of which are quite good. Then we drop to people who have taken an H&R Block course. Then you have those that never even took the course. It is that last category or two that the IRS wants to reach, but they have been stymied.

In the meanwhile, you come into my office with an EITC. What does the IRS expect me to do?

Remember that the key is the kid. The IRS wants me to:

·       Review school records

·       Review health care records

·       Review child care provider records

·       Review social services records

And so on. If I don’t do this, I have to indicate to the IRS that I did not do so. On a form included with your tax return. The IRS reserves the right to later come to my office and review my files.

As much as I appreciate the opportunity to soothe my inner social worker, it seems a lot to ask for the few hundred dollars I may charge for that tax return.

So what do I do?

Easy. I do not accept a client with an EITC. Furthermore, I would also consider releasing an existing client who slips into the EITC, unless I know them well and have very strong confidence in their tax numbers. I have to, as the risk to me from that tax return is disproportionate.

I cannot afford to play “Dude, free dragon”!

You Want Me To E-File Your Tax Return? Then Show Me Your ID.

There are times I wonder why I do what I do.

It is difficult enough to keep up with the barrage of tax developments, pronouncements, law changes, court decisions and what not. I do not practice in all areas, so there is some fence around this field, but it is still a fairly large field.

Then you have the IRS bureaucracy, which is becoming more unwieldy every year. It used to be that I could contact a local IRS person to help with a tax problem. After a while, one got to know the local IRS employees, and they got to know me. The IRS restructuring took away our local contacts. Practitioners now contact regional offices using an 866-telephone number. Wait times have been noticeably increasing over the last two or three years.  I gave up on a call this past Thursday as it approached an hour and a half.

Folks, this is a “back door” line for CPAs and attorneys. I can only imagine what the wait time is for the general line.

This past week I was reading Publication 1345 titled “Handbook for Authorized IRS e-file Providers of Individual Income Tax Returns.” I would not recommend it unless you are a serious insomniac.  I came across the following pearl:

In-Person Transaction

The ERO must inspect a valid government picture identification; compare picture to applicant; and record the name, social security number, address and date of birth. Verify that the name, social security number, address, date of birth and other personal information on record are consistent with the information provided through record checks with the applicable agency or institution or through credit bureaus or similar databases. For in-person transactions, the record checks with the applicable agency or institution or through credit bureaus or similar databases are optional.

Examples of government picture identification (ID) include a driver’s license, employer ID, school ID, state ID, military ID, national ID, voter ID, visa or passport. 

If there is a multi-year business relationship, you should identify and authenticate the taxpayer."

Huh?

Let’s translate. An ERO is an electronic return originator. That is fancy language for someone who is authorized to file returns electronically with the IRS. My firm for example is an ERO. That makes me an ERO.

The IRS is talking about me inspecting a “valid picture identification” and so on. And when am I supposed to do this?

The IRS starts off talking about electronic signatures on a tax return. Obviously if I file your return electronically, I cannot send your fresh-ink signature at the bottom of the form. I do require from you a release authorizing me to e-file your return. That release may have your fresh-ink signature, but that release stays with me. The IRS does not get a copy.

Is the IRS talking about the e-signature on the return I file for you? Or is the IRS talking about an electronic signature on the release I obtain from you before e-filing your return? There is a big difference, and I cannot tell what the IRS meant. I suspect the IRS is talking about electronic signatures on the release. For the most part most of my clients sign their release in ink, although many clients will either fax or PDF their release to me. I am presuming the fax or PDF does not constitute an electronic signature, but I do need the IRS to be more precise in its use of the language.

Then there are the few clients. You know the ones: the computer hyper-literate. These guys can write a ditty, put music and video to it and publish the whole thing on You Tube in the time you or I would draft an e-mail. These guys are going to cause me a problem, because they know enough to sign that release with an "electronic signature.”

Let’s say they do.

The IRS now wants me to:

(1)  Inspect a valid government picture identification.

I presume we are talking about a driver’s license. It is inconvenient, but it follows what the stockbrokers have done for years.

What am I supposed to do with the kids, though, if the kids are too young to drive? 

What if mom and/or dad live with the client? Where does this end?

(2)  Record the name, social security number, address and date of birth.

No problem. We already do that.

(3)  Verify that information through record checks with the applicable agency or institution or through credit bureaus or similar databases.

Are you kidding me?

That one angers me. There is a superstructure of self-serving – and obviously incompetent - government bureaucrats and they have to recruit a tax CPA in Cincinnati to do THEIR JOB? I tell you what I want in return: I want a government salary; government benefits; all the holidays, including the make-believe ones; 6 weeks of vacation; a retirement plan; union protection so that I cannot be fired, no matter how incompetent I am.

What if I have known you for years?

If there is a multi-year business relationship, you should identify and authenticate the taxpayer."

Seriously? And what does “authenticate” mean?

Good grief. It would be less work to let these people vote. Hire me to do your taxes, however, and I have to go all Kojak on you.

How have we gotten to this point?

It has to do with identity theft. It has become a top-tier issue for the IRS. They responded in turn with Publication 1345. I am trying to be fair, I truly am, but I see a few things the IRS could immediately do before making me their Barney Fife:

(1)  Review refunds to taxpayers with a different address from last year.

(2)  Review refunds to taxpayers with a different employer from last year.

(3)  Stop issuing multiple refund checks to the same address. For example, the IRS sent 655 refund checks to the same address in Lithuania.

And what tax crook in his/her right mind is going to hire a tax CPA to do their dirty work anyway? Somebody clue the IRS that is not how those people work.

Publication 1345 addresses only individual tax returns. Is the IRS going to extend this to business returns? Will I need to confirm corporate minutes to be certain that Tom N. Jerry is in fact the CEO of that corporation and authorized to sign the corporate return? Will I need in turn to background check Tom N. Jerry himself?

And where will the time come from to do all this? I am already swamped during busy season. Even if the above takes only 5 minutes per return, multiply the 5 minutes by hundreds of clients. The IRS could easily add at least another 40 or 50 hours to my individual tax practice, time that I do not have. How will I respond? I will extend more returns. I would have to. I will charge you more. I would have to.  I would not accept electronic signatures on tax forms.

That last one is obvious.

On Warren Buffett, Berkshire Hathaway and PFICs

We have spoken before about passive foreign investment companies, or PFICs (pronounced pea-fick). There was a time when I saw these on a regular basis, and I remember wondering why the IRS made the rules so complicated.

I am thinking about PFICs because yesterday I read a release for IRS Notice 2014-28. The IRS is amending Regulations concerning the tax consequences of U.S. persons owning a passive foreign investment company through an account or organization which is tax-exempt. Think a hospital, pension plan or IRA, for example. 

Granted, this is not as interesting as Game of Thrones or Sons of Anarchy.

Could you walk unknowingly into a PFIC? It is not likely for the average person, but it is not as difficult as you might think.

PFICs came into the tax Code in 1986. They were intended to address what Congress saw as a loophole. I agree that there was a loophole, but whether the tax fly required the sledgehammer response it received is debatable.

There were a couple of ways to get to the loophole. One way would be to form a foreign corporation and have the corporation invest in stocks and bonds. This means you are forming a foreign mutual fund. There are a couple of issues with this, the key one being that it would require a large number of investors in order to avoid the rules for a controlled foreign corporation. To the extent that 10%-or-more U.S. shareholders owned more than 50% of the foreign corporation, for example, one would have a controlled foreign corporation (CFC) and would be back into the orbit of U.S. taxation.

The second way is to invest in an existing foreign mutual fund. Say that you invested in a German fund sponsored by Deutsche Bank, for example.

And the average person would say: so what? You invested in mutual fund.

Here s what the IRS did not like: the mutual fund could skirt the taxman by not paying dividends or distributions.  The value of the fund would increase, as it would accumulate its earnings.  When you sold that foreign mutual fund, you would have capital gains and you would pay U.S. tax.

Well, the IRS was unhappy with that, as you did not pay tax on dividends every year and, when you did pay, you paid capital gains rather than ordinary income tax. How dare you?

Why the sarcasm? Because you can get the same tax result from owning Berkshire Hathaway. Warren Buffet does not pay a dividend, and never has. You hold onto your shares for a few years and pay capital gains tax when you sell. The IRS never receives its tax on annual dividends, and you pay capital gains rather than ordinary tax on the sale.

Why the difference between the Berkshire Hathaway and Deutsche Bank? Exactly my point. Why is there a difference?

So we have PFIC taxation. Its sole purpose is to deny the deferral of tax to Americans investing in foreign mutual funds.

There are three ways to tax a PFIC.

The default scheme is found in Code Section 1291. You are allowed to defer taxation on a PFIC until the PFIC makes an “excess” distribution. An excess distribution is defined as one of two events:

(1)   The PFIC distributes an amount in excess of 125% of the average distribution for its preceding three years; or

(2)   You sell the PFIC stock.

Let’s say that we use the default taxation on the PFIC. What does your preparer (say me) have to do next?

(1)   I have to calculate your additional tax per year had the distribution been equally paid over the period you owned it (this part is relatively easy: it is the highest tax rate for that year); and

(2)   I have to calculate interest on the above annual tax amounts.

You can imagine my thrill in anticipation of this magical, career-fulfilling tax opportunity. There are severe biases in this calculation, such as presuming that any income or gain was earned pro rata over your holding period. I have seen calculations where - using 15 to 20 year holding periods - the tax and interest charge can approach 100%. This is not taxation. This is theft.

The second option is to annually calculate a "mark to market" on the PFIC. This works if there is a published trading or exchange price. You subtract the beginning-of-year value from the end-of-year value and pay tax on it. I have never seen a tax professional use this option, and frankly it strikes me as tax madness. With extremely limited exceptions, the tax Code does not consider asset appreciation to be an adequate trigger to impose tax. There would be no 401(k) industry, for example, if the IRS taxed 401(k)s like they tax PFICs.

The third option is what almost everyone does, assuming they recognize they have a PFIC and make the necessary election to be taxed as a “qualified election fund,” or QEF for short.

   OBSERVATION: Tax practitioners like their acronyms, as you can see.

There are two very important factors to a QEF:

           

(1)   You have to elect.

a.     No election, no QEF.

(2)   The foreign fund has to agree to provide you numbers, made up special just for its American investors. The fund has to tell you what your interest and dividends and capital gains would have been had it actually distributed income rather than accumulate.

You can fast forward why: because you are going to pay tax on income you did not receive.

What happens in the future when you sell the fund? Remember, you have been paying tax while the fund was accumulating. Don’t you get credit for all those taxes when you finally sell?

Yes, you do, and I have to track whichever of three calculations we decide on in a permanent file. For every fund you own.

BTW there had better be a specific form attached to your tax return: Form 8621. If you were required to disclose a foreign financial account (which a PFIC would be) and did not do so, either on Form 8621 or on another form intended for that purpose, the IRS might be able to "toll" the statute of limitations. Tolling means "suspend" in tax talk. This means the IRS could assess taxes, penalties and interest many years after the tax year should normally have closed. 

This applies only to rich people, right? Not so much, folks. This tax pollution has a way of dissolving down to affect very ordinary Americans.

How? Here are a couple of common ways:

(1)   You live abroad.

You live abroad. You invest abroad.

I intend to retire abroad, so some day this may affect me. Me and all the other tax CPA billionaires high-stepping it out of Cincinnati. Yep, we are a gang of tax-avoiding desperados, all right.

(2)   You work/worked in Canada.

And you have a RSSP. The RRSP is invested in Canadian mutual funds. How likely is this to happen? How about “extremely likely.”

There you have two ordinary as rain ways that someone can walk into a PFIC.

Keep in mind that the IRS is convinced that anyone with a nickel overseas is hiding money. We have already gone through the FBAR and OVDI fiascos, and tax literature is thick with stories of ordinary people who were harassed if not near-bankrupted by obscure and never-before-enforced tax penalties. The IRS is unabashed and wonders why you – the average person – cannot possibly keep up with its increasingly frenetic schedule of publishing tax rules, required disclosures, Star Trek parodies, bonuses to deadbeat employees and Fifth Amendment-pleading crooks.

Beginning in 2014, FATCA legislation requires all “foreign financial institutions” to report to the IRS all assets held by U.S. citizens and permanent residents. The U.S. citizen and permanent resident in turn will disclose all this information on new forms the IRS has created for this purpose – assuming one can find a qualified U.S. tax practitioner in Thailand, Argentina or wherever else an American may work or retire. Shouldn’t be a problem for that overseas practitioner to spot your PFIC – and all the related tax baggage that it draws in its wake - right?

What happens if one doesn’t know to file the PFIC form, or files the form incorrectly? I think we have already seen the velvet fist of the IRS with FBARs and OVDI. Why is this going to be any different?

Pfizer Wants To Decrease Its Taxes By Moving To Britain

I am reading the following headline at Bloomberg Businessweek: “Pfizer’s $99 Billion Bid for AstraZeneca Is a Tax Shelter.”

No, it is not. This is a tax shelter the same way I am Floyd Mayweather Jr.’s next opponent.

It is sign of a problem, though.

Pfizer is based in New York City. AstraZeneca is based in London. Pfizer has proposed the deal, but AstraZeneca has not yet accepted. The deal may fall yet fall through. There are any number of reasons why a drug company would buy another drug company, but this one would move one of the largest U.S. multinationals to London. The term for this is “inversion.”

Mind you: the Pfizer executives are not moving. They will remain in New York, and Pfizer research facilities will remain in Connecticut. Pfizer will however go from being a U.S.-based multinational to a U.K.-based one. How? There will be a new parent company, and that parent will be based in London. Voila!

Inversions are more complicated than they used to be. In 2004 Congress passed IRC Section 7874, which denies tax benefits to an inversion unless certain thresholds are met. For example,

·       If the former shareholders of the former U.S. parent own 80% or more of the foreign corporation after the inversion, then the inverted company will continue to be considered – and taxed – as a U.S. company.

You can quickly assume that new – and non-U.S. shareholders – will own more than 20% of the new Pfizer parent.

What if you own Pfizer stock? In addition to owning less than 80% of the new parent, code Section 367 is going to tax you when Pfizer inverts. This is considered an “outbound” transaction, and there is a “toll” tax on the outbound. What does that tell you? It tells you that there has to be cash in the deal, otherwise you are voting against it. There has to be at least enough cash for the U.S. shareholders to pay the toll.

Let’s say the deal happens. Then what?

I cannot speak about the drug pipeline and clinical trials and so forth. I can speak about the tax part of the deal, however.

As a U.S. multinational, Pfizer has to pay taxes on its worldwide income. This means that that it pays U.S. taxes on profits earned in Kansas City, as well as in Bonn, Cairo, Mumbai and Sydney. To the extent that a competitor in Germany, Egypt, India or Australia has lower tax rates, Pfizer is at an immediate disadvantage. In the short term, Pfizer would be less profitable than its overseas competitor. In the long term, Pfizer would move overseas. Congress realized this and allowed tax breaks on these overseas profits. Pfizer doesn’t have to pay taxes until it brings the profits back to the United States, for example. Clever tax planners learned quickly how to bend, pull and stretch that requirement, so Congress passed additional rules saying that certain types of income (referred to as “Subpart F” income) would be immediately taxed, irrespective of whether the income was ever returned to the United States. The planners responded to that, and the IRS to them, and we now have an almost incomprehensible area of tax Code.

Take a moment, though, and consider what Congress did. If you made your bones overseas, you could delay paying taxes until you brought the money back to the U.S. Then you would have to pay tax – but at a higher rate than your competitor in Germany, Egypt, India or Australia. You delayed the pain, but you did not avert it. In the end, your competitor is still better off than you, as he/she got to keep more of his/her profit.

What do you do? Well, one thing you cannot do is ever return the profit to the United States. You will expand your overseas location, establish new markets, perhaps buy another – and foreign – company. What you will not do is ship the money home.

How much money has Pfizer stashed overseas? I have read different amounts, but $70 billion seems to be a common estimate.

When Pfizer inverts, it may be able to repatriate that money to the U.S. without paying the inbound toll. That is a lot of money to free up. I could use it.

The U.S. also has one of the highest – in truth, maybe the highest – corporate tax rate in the world. The U.K. taxes corporate profits at 20%, compared to the U.S. 35%. The U.K. also taxes profits on U.K. patents at 10%, an even lower rate. This is a pharmaceutical company, folks. They have more patents than Reese’s has pieces. And the U.K. taxes only the profits generated in the U.K., which is a 180 degree turn from Washington’s insistence that it can tax profits of an American company anywhere on the planet.

Now, Pfizer does not get to avoid U.S. taxes altogether. It will still pay U.S. tax on profits from its U.S. sales and activities. The difference is that it will not pay U.S. taxes on sales and activities occurring outside the United States.

Since 2012 approximately 15 large U.S. companies have moved or announced plans to move offshore. Granted, there are numerous reasons why, but a significant – and common – reason has to be the benighted policy of U.S. multinational taxation. What has the White House proposed to stem the tide? Increase the ownership threshold from 20% to 50% before the company will be deemed based outside the U.S.

Brilliant.  To think that Washington at one time pulled off the Manhattan Project, Hoover Dam and landing a man on the moon. How far the apple has fallen.

The issue of corporate inversion has been swept up as part of the larger discussion on tax reform. That discussion is all but dead, unfortunately, although perhaps it may resurrect after the Congressional elections. The Camp tax proposal wants to move the U.S. to a territorial tax system rather than the existing worldwide system, which is an acknowledgement of the problem and a very good first step. It will not stop Pfizer, but we may able to stop the next company to follow.