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Tuesday, April 15, 2014

Tax Day - April 15, 2014 - It Can Be Easier

The complexity of completing one's federal and state income tax returns is not necessarily tied to one's income level. One of the more complex federal tax rules is the Earned Income Tax Credit (EITC) for low-income workers. Could the individual income tax be simpler? Yes.  Here are some ideas.
  • Make all income you received subject to tax. What is income? Let's say it is anything that increases your wealth. So, it would be any payment from the government, debt forgiveness, gross wages, employer-provided health insurance, scholarships, gains from selling assets, etc. What would not be income? Borrowing money (it does not increase your wealth because you have an offsetting liability). Receipt of expense reimbursements from your employer (it makes you whole for what you, in essence loaned to your employer when you incurred the expense).  The simplification comes from not needed to determine if something you received is taxable; generally, it would be.
  • Allow very few non-business deductions.  It should just be personal and dependency exemptions that, in effect, remove from your income what it takes to live. The rationale is that you need some portion of your income to live and it should not be available for paying taxes. The amount should be tied to some multiple of the poverty level based on family size and your address to reflect that it costs more to live in some parts of the U.S. 
  • Allow business deductions including an inflation-adjusted expensing amount (Section 179) that would provide simplification and incentives to small to medium sized businesses. Expensing should apply to both tangible and intangible personal property.
  • Address equity issues with simple rules. For example, the state condemns your personal or business property resulting in you realizing a gain. But, you want to (or need to) buy replacement property. If you have to pay tax on the gain, you may not have enough for replacement property. So, keep a simplified Section 1033 on involuntary conversions that allows for gain deferral. Perhaps also allow for deferral of cancellation of debt income for insolvency or bankruptcy (to help with a fresh start for the person). The balance of the current, lengthy and complex cancellation of debt income exclusion rules could be removed. Others? There will be situations where someone has had some unusual, bad, expensive event, such as a casualty or large medical expense, that prevents them from having sufficient funds to pay their income tax. Some simple, limited rules for these types of events should be provided. We'd also need simple rules to ensure that income earned outside of the U.S. was not taxed by two countries. A foreign tax credit not to exceed what the U.S. tax on the income would be should work.
  • Retirement plans and savings - this is a bit more challenging. Individuals should be saving for their retirement.  The money you put into your retirement is money not available for paying taxes.  Also, if you pay tax on the income when earned and again when withdrawn, that doesn't seem fair (except for what you pay on the income earned while the money was in the retirement account). Also, lower income individuals will need an incentive to fund a retirement account due to limited funds. So, should they get a deduction for putting funds in a retirement account?  Retirement rules is an area of our tax law in need of significant reform. The current rules primarily benefit higher income individuals as they can take better advantage of the rules. The rules are also complex due to the number of different types of retirement plans.
  • Education incentives - today there are at multiple, duplicative, complex provisions offering various tax savings for higher education costs. I think that for the most part, this should all be taken care of outside of the tax law because there is already a system in place, such as for Pell Grants. When these rules are brought into the tax law, they primarily benefit those with enough income to owe tax - individuals who likely don't qualify for Pell Grants. But, what about my earlier point that the student receiving the scholarship will include it in income? Should they get some tax relief?  Or should we expect them to work to get the money to pay tax on the scholarship or seek a gift from family and friends?  Perhaps some version of the current American Opportunity Tax Credit (AOTC) should remain. It would also help the student without a scholarship or Pell Grant who is working to pay for tuition. It would not need to be refundable because once your tax is down to zero due to your personal exemption, you are not paying tax on the scholarship. Tax rules for higher education also need attention for simplification and equity issues. For example, the current AOTC is for the first 4 years of college, providing a maximum annual credit of $2,500.  That has differing results for these two students: (1) Ann who attends a private university for 4 years; gets a $10,000 benefit from the government. (2) Barbara who attends community college for 3 years where the annual tuition is less than the AOTC amount so she doesn't get full benefit of the credit and then she attends public university for 3 years to complete her degree and where the tuition is higher.  Her total benefit is less than $10,000.  This needs to get fixed.
  • Other changes?  
    • Lower tax rates to reflect that the tax base is larger with the above changes. With lower tax rates, capital gains should be taxed at those same rates. 
    • The net investment income tax (3.8% Medicare tax for high income individuals) should be repealed (an adequately progressive income tax rate structure would take care of it). 
    • AMT should be repealed because there should be only one minimum tax and removal of most of the special deductions, exclusions and credits would leave no need for it.
    • Some replacement should be made for the current income exclusion for state and local bond interest income. This exclusion benefits higher income individuals who buy the bonds and it helps state and local governments. Whatever the average annual "cost" to the government has been for the exclusion for the past five years should become a fund that the federal government would make available to state and local governments to replace the lost benefit of the exclusion.  And add the caveat that they can only get the funds if they conform their state income tax to the new, simplified federal income tax system (to better ensure true simplification for individuals).
    • More simplification such as fewer penalties and clearer rules on worker classification.
What do you think?

Thursday, April 10, 2014

The fate of expiring provisions for individuals

Senate Finance Committee hearing of 4/3/14 on extenders
Over 50 federal tax rules expired at the end of 2013 and a few more will expire in the next few years. This is not news - it is a recurring event.  Often the provisions are renewed a year or more later after expiration. That makes planning impossible and it removes the incentive effect that some of these provisions are intended to have.

I've got a short article in the 4/10/14 AICPA Tax Insider that lists all of the expired and expiring provisions relevant to individuals. An accompanying table shows:
  • When the provision was originally enacted.
  • How many times the rule has already been renewed.
  • How it would be addressed by proposals from Senator Wyden (although prior to some amendment by the Senate Finance Committee last week), Congressman Camp's reform proposals (of February 2014) and President Obama's FY2015 revenue proposals.
The table also includes my commentary on the particular items.

I hope you'll take a look and post a comment here on what you think of letting them all expire, renewing some, or something else and why. Thank you.

Saturday, April 5, 2014

SJSU MST's Contemporary Tax Journal publishes Spring 2014 issue

I'm proud to announce the publication of the 5th issue of the student-run, online journal of the San Jose State University MST Program. You can find the journal here (current and past issues): 
Here are the topics covered in the Spring 2014 issue:
  • Personal Services vs Royalty for Athletes

  • Summaries from the March 2013 Tax Policy Conference
  • Tax Credit for Qualified Plug-in Electric Drive Motor
  • Tax Incentives to Move Jobs Back to the U.S.

  • Pam Olson, Deputy Tax Leader and Washington National Tax Services Practice Leader, PwC
  • David Doerr, Chief Tax Consultant, California Taxpayers' Association
There are wonderful pieces here - I hope you'll take a look!  Thank you!! 

Wednesday, April 2, 2014

Filing season and rental activities

A regular area for Tax Court litigation for the past few years involves individuals with a few rental properties deducting the losses from them under the theory they are real estate professionals ( using a special rule of section 469(c)(7)).  These individuals usually have jobs outside of the real estate profession and do not devote more hours than in their other employment to the rentals.  They clearly do not qualify for the special rule.  Yet, they claim the loss (rate her than carrying it forward) and then after losing during the IRS audit, they go to Tax Court and lose. Why?  A better way to challenge would be to try to get Congress to change the law.  Perhaps trying to convince Congress to increase the income limit so they could use up to $25,000 of the loss currently (under a modified section 469(i)).

I've got a bit more here.

What do you think?

Saturday, March 29, 2014

Guidance on taxation of virtual currency

There are tax consequences of mining Bitcoin, investing in it or using it to buy or sell goods or services. Prior to the IRS release of Notice 2014-21 this week (3/25/14), we didn't know whether the IRS would treat a virtual currency as currency or property. The IRS has now said - treat it as property. [IRS Information Release IR-2014-36 and Notice 2014-21]

I think that is a good answer.  After all, Bitcoin and other virtual currencies are not used as the currency of any government and generally, are convertible to a currency of a government. For example, you can buy Bitcoin with U.S. dollars and convert it back to U.S. dollars.

So, what does it mean that Bitcoin and other convertible virtual currencies are property? Here are a few tax examples.  Note that these answers would be the same if you were instead using gold (or some other property people might take in exchange for transactions). In these examples, the affected taxpayer would need to use a currency converter.  Here is one example for Bitcoin.  I'm not sure if there is only one and we'll have to see if the IRS "endorses" one for Bitcoin and other virtual currencies.
  • If you mine Bitcoin, you generate income equal to the value of the Bitcoin when mined. And if you are doing this as a business, you'll also owe self-employment tax. [See Q&A 8 and 9 of Notice 2014-21]  If doing this as a business (and that might not always be easy to determine), how do you treat your related expenses? I believe expenses of mining (producing) the coin will have to be capitalized as part of the "goods" you are producing. Expenses related to "selling" the Bitcoin should be expensed when incurred.  The miner also needs to determine if they can use the cash method of accounting or instead need to use the accrual method.
  • If you buy Bitcoin so you can use it instead of dollars, you'll have some extra recordkeeping to handle. For example, you bought 1 Bitcoin (BTC) when it was worth $350. You later use half of that BTC to buy goods and at that time, 1 BTC is worth $400.  You have a $25 gain. A few months later, you use the remaining .5 BTC to buy goods and at the time, 1 BTC is worth $500, you will report a gain of $75.  One piece of good news though ... unless you are an investor in Bitcoin, this income should be capital gain income taxable at lower rates than ordinary income. The tax principle here is that if your wealth has increased and you cash out that wealth (realize it), you have income. When you can use something you paid $350 for to buy $450 of goods,  you have income of $100. This is the same result you'd have if you had converted the Bitcoin back to dollars right before making the purchase of the goods in dollars. [See Q&A 6 and 7 of Notice 2014-21]
  • Your employer pays you in Bitcoin. You'll have income equal to the value of the Bitcoin on the day you receive it. And, yes, the employer will include this income in your W-2. Same answer if you are instead a contractor; it will be included in the Form 1099 your employer gives you. [See Q&A 10-14 of Notice 2014-21]
This guidance has been long awaited. Likely so much attention on Bitcoin and the fact that thousands of vendors are taking it, led the IRS to finally issue guidance. Back in October 2006, the Joint Economic Committee of Congress issued a statement that it was studying taxation of virtual economies and currencies and would issue a report. The statement implied that taxes should not apply.  No report was issued. In May 2013, the Government Accountability Office (GAO) released a report on types of transactions involving virtual currency and the need for guidance on the tax issues (see my blog post of 8/29/13).  In 2014, the annual report to Congress issued by the IRS National Taxpayer Advocate (NTA) included a section on digital currency. Similar to the 2013 GAO report, it highlighted that tax considerations exist for some uses of virtual currencies and called for the IRS to issue guidance. 

The NTA report included data on the growth in the use of virtual currencies, thus increasing the need for guidance on the tax considerations. The report noted that in July 2013, there were 1,708 Bitcoin transactions per hour and the market value was $1.1 billion. By December 2013, there were just over 3,000 transactions per hour and the market value of the currency had grown to $12.6 billion.  The NTA's 2008 report to Congress included background on virtual economies and the need for guidance from the IRS.

There are still open issues for both the IRS and state tax agencies to address.  The IRS is seeking comments on additional issues.  Here are a few that come to mind for me:
  • Is mining of Bitcoin viewed as production of property or a service? That answer has a bearing on whether the related costs are added to the Bitcoin mined (as if part of the inventory) or expensed as paid or incurred (depending on your method of accounting). The issue here is that the property is intangible.
  • Will the IRS specify what exchange rate system it requires when there is more than one such converter?
  • When you buy Bitcoin or other virtual currency, will your state impose sale or use tax on it?
  • If a vendor sells services or digital goods to someone and accepts Bitcoin or other virtual currency as payment, will the vendor be required to report the transaction or ask for the customer's name and address?  These types of transactions can be concerns of tax agencies because they can go undetected.  The vendor needs to record it (using the Bitcoin value at the date of each transaction), but will the tax agency want more to help the customer with their Bitcoin gain/loss calculations and to help the tax agencies to even know that they occurred?
  • How will concerns of Treasury regarding illegal activities affect tax reporting? [see for example, remarks of David Cohen of Treasury on 3/18/14, and guidance issued 3/18/13]
What do you think? What other tax issues do you see?