AICPA Tax Insider

Closing Tax Gap

Cecille Isidro — Thu, 14 Aug 2008 16:26:00 -0400

Since the early 1980s, there has been a plethora of recommendations about how to reduce the tax gap. Many changes have been enacted, yet the gap grows. Proposals requiring additional information reporting or withholding are usually overlooked despite evidence that these techniques result in a low tax gap for wage earners. However, a significant information reporting rule was enacted in 2008. Its enactment though, seems to be more a result of its revenue potential than its role in a comprehensive tax gap reduction strategy.

Below, we'll review the tax gap and the recently enacted credit card information reporting provision, and explain reasons for the slow approach.

Tax Gap History

According to a 1994 GAO study, Tax Gap — Many Actions Taken, But a Cohesive Compliance Strategy Needed (GGD-94-123 (PDF)), the gross income tax gap for 1981 was $76 billion and $127 billion for 1992. By 2001, the tax gap had grown to $345 billion (IR-2006-28).

The 1994 GAO report noted: "Information returns are a proven way to promote compliance and help IRS find noncompliance." The GAO observed that Congress could do more to help improve compliance such as requiring: withholding on payments to independent contractors, 1099s for payments made to corporations, and basis reporting on 1099s for stock sales.

Many proposals have been made to reduce the tax gap. The 1994 GAO study lists 61 reports it issued from 1982 through 1993 on various aspects of the tax gap and compliance (Appendix II (PDF)). Proposals have also been made by the IRS, Treasury (PDF), the National Taxpayer Advocate, legislators, the AICPA and others.

The growing tax gap and need for revenue have led to greater focus on effective ways to reduce it. These activities include:

A conference by the AICPA, ABA, TEI, American Tax Policy Institute and American College of Tax Counsel held in June 2007 to discuss ideas to reduce the tax gap.

A tax compliance forum (PDF) held by the CBO, GAO and Joint Committee on Taxation in September 2007.

Sixteen tax compliance proposals are included in the President's 2009 revenue proposals (PDF). These measures include:

Proposal	10-Year Revenue Projection (millions)
1099s on payments to corporations	18.9
Basis reporting for security sales	16.9
Merchant payment card information reporting	13.8
Increase information return penalties	18.3

We have seen tax gap proposals included as revenue offsets to various tax bills. For example, Congressman Rangel's tax reform bill, HR 3970 (110th Congress) included basis reporting on 1099s for stock sales. This proposal was also included in a housing bill HR 5720 as well as a stand-alone bill, HR 878.

New Information Reporting Requirement

When a merchant allows a customer to pay with a credit or debit card, an entity, such as a bank, must process the transaction to enable the merchant to receive the funds. According to Treasury, the failure of some merchants to "accurately report their gross income, including income derived from payment card transactions, represents a significant part of the tax gap." (General Explanations of the Administration's Fiscal Year 2007 Revenue Proposals (PDF))

President Bush's budget proposals starting with FY2007 have included calling for regulations on information reporting of reimbursements made to merchants on credit cards, plus backup withholding. This information reporting idea finally made it into law via a statutory change. The Housing and Economic Recovery Act of 2008 (PL 110-289; July 2008) created IRC §6050W, Returns Relating to Payments Made in Settlement of Payment Card and Third Party Network Transactions. This rule requires payment settlement entities to file information returns with the IRS and the merchant. These returns are to include the merchant's name, address, taxpayer identification number (TIN), and the gross amount of the transactions the entity processed for the merchant. The provision covers credit and debit cards and third party payment networks, such as online payment systems.

As described in the Administration's FY2007 report (PDF), requiring the payment card issuers to file information returns should pose only a minimal burden because these issuers already provide the information to merchants. Backup withholding is viewed as leading to "material improvements in the compliance rates" of the merchants "without imposing a significant burden on the card issuers."

A de minimis exception provides that third party settlement organizations are only required to file returns regarding third party network transactions if the aggregate value of a merchant's transactions exceed $20,000 and the aggregate number of transactions exceeds 200.

Penalties are imposed for failure to file (IRC §6724). Backup withholding is required if a merchant does not provide a TIN (IRC §3406); effective for amounts paid after December 31, 2011. IRC §6050W is effective for calendar years beginning after December 31, 2010. For further details, see §6050W and the Joint Committee explanation (JCX-63-08 (PDF)).

Observations

Revenue reality: The Administration's FY2007 report (PDF) estimated that regulations calling for information reporting on payment cards would generate $225 million over 10 years. In the FY 2008 report (PDF), the estimate was up to $10.7 billion and for FY 2009 (PDF), $18.7 billion. The Joint Committee on Taxation (JCX-64-08 (PDF)) estimate for §6050W is $9.5 billion. This range of estimates likely reflects the challenges of measuring the tax gap, as well as the effect of a measure on compliance and enforcement.

Additional benefits: In testimony on the Administration's tax gap proposals, Treasury Assistant Secretary Eric Solomon made the following observations on additional benefits of credit card reporting (April 2007 testimony):

"[T]he proposed information reporting would assist the IRS by providing the merchant's overall volume of payment card sales in relation to expenses claimed and cash transactions reported. The reporting would also assist the IRS in analyzing the accuracy of reporting for payment card sales."

Complexities: In his 2007 testimony, Mr. Solomon also noted complexities in the credit card system due to the number of parties that can be involved in the reimbursement cycle. Refunds and cash back arrangements also pose problems. These issues should be addressed in regulations.

Small business concerns: In June 2008, the House Committee on Small Business held a hearing on electronic payment information reporting. Issues raised by those testifying included privacy, security, cost, the need for some entities to obtain new computer programming to comply, transaction complexity that will lead to inaccurate reporting or information that is not useful to verify gross receipts and not addressing unreported cash receipts instead.

Picking Up the Pace

Despite what appears to be increased concern over the tax gap, a comprehensive strategy for addressing it remains elusive. PAYGO (PDF) rules are the likely driver of piecemeal remedies. The information reporting provision that made it into the Housing Act had only weeks before being included as a revenue offset in an AMT relief bill (HR 6275).

A comprehensive approach to addressing the tax gap should yield a better result than the piecemeal, revenue targeting approach. Congress and Treasury could identify which measures would best address the most serious non-compliance problems. This approach likely would have led to enactment of measures to address non-reporting of cash transactions rather than credit card ones that already have audit trails. A comprehensive, strategic approach would likely have addressed causes of underreporting of payment card transactions. Many small businesses, particularly those that sometimes arise from online transactions, need guidance on recordkeeping and business reporting.

The piecemeal approach will likely remain for the 110th Congress as it works on AMT relief and extenders. The strategic approach will likely have to await tax reform activities in the 111th Congress.

Grabbing Remote Vendors

Cecille Isidro — Thu, 31 Jul 2008 10:56:00 -0400

As far back as 1872, when Montgomery Ward issued its first mail-order catalog, vendors have sold to customers without being physically present in the customer’s state. Although sales taxes have existed since the 1920s, we have no effective system for collecting sales-and-use tax on sales by remote sellers.

Today we’ll look closer at the history of the remote sales tax issue, clarify New York’s law change and note possible solutions.

Interstate Sales Tax History

As a 1965 congressional report noted: “The present system of State taxation as it affects interstate commerce works badly for both businesses and the States.” (State Taxation of Interstate Commerce Report No. 952, 9/2/65, Vol. 4, (the “Willis Commission” report))

While the 1965 congressional report made recommendations for administering state sales tax for interstate commerce, no action was taken. Litigation eventually led to our current sales tax nexus standard set by the U.S. Supreme Court in 1992 in Quill, 504 US 298. The Court ruled that physical presence was necessary for substantial nexus that would allow a state to impose sales tax collection obligations upon a vendor. A continuing issue is the amount and degree of physical presence needed. Many states provide some guidance on this question.

The Court also noted that per the Commerce Clause, Congress has the authority to “decide whether, when and to what extent the States may burden interstate mail order concerns with a duty to collect use taxes.”

E-Commerce Challenges

The e-commerce model makes it easy for a vendor to operate in one state and have customers in many other states. This increases the number of transactions in which states must look to their resident consumers to self-assess their use tax because remote sellers have no collection obligation.

Certainly, it is easier for states to have thousands of vendors collect and remit sales tax than to get millions of individuals to remit use tax. Auditing vendors is also more efficient than auditing individual buyers.

However, for a state to collect sales tax from a remote vendor, it must either convince the vendor to do so voluntarily or find a way for the vendor to have a physical presence in that state.

New York’s 2008 Legislative Change

Chapter 57 (April 08) broadens the definition of “vendor” at NY Tax Law §1101(b)(8). Under the new provision, sellers are presumed to be soliciting business and thus required to collect tax if, per an agreement, they compensate New York residents for directly or indirectly referring potential customers. Referrals may be made through a Web site or other means. The presumption only applies to sellers with over $10,000 of sales to New York customers made via the referrals in the prior four quarters. Sellers may rebut the presumption by showing that the residents did not solicit sales in New York for them (Bill Summary (PDF)).

The Governor’s budget estimated that this change would generate $47 million in 2008/2009 and $73 million in 2009/2010 — an indication that use tax compliance by New Yorkers is a problem. The New York State Department of Taxation and Finance has issued guidance on the vendor presumption (TSB-M-08(3)S (PDF)) and how to rebut it (TSB-M-08(3.1)S (PDF)). FAQs interpreting the new law also exist.

Vendor Reaction

In April 2008, Amazon filed a complaint challenging the constitutionality of the new provision. Amazon argues it has no physical presence in New York as required for sales tax collection. Per Amazon, the independent third-parties in its “Associates Program” perform advertising rather than solicit sales. Per Tyler Pipe, 483 US 232 (1987), such activity is not sufficient to find nexus. Amazon states that the associates are not its agents. Also, because membership in the program does not depend on residence, Amazon does not know which associates are legal residents of New York.

Amazon started collecting sales tax from its New York customers. As noted in its complaint, the new presumption “is effectively irrebuttable, even though it is not true.”

In contrast, Overstock.com, which also filed suit, terminated its relationships with its approximately 3,400 New York affiliate advertisers. (press releases of May 30, 2008 and May 15, 2008)

Counterpoint

A private ruling in Missouri issued in April 2008, found that a remote seller had no nexus in the state because goods were shipped by mail. The ruling also notes that under Missouri law, “advertising in the state through media” is not enough to establish nexus (LR 4702).

In a California Board of Equalization memo (PDF) (June 2008) on the New York law change, staff conclude that a link on an affiliate’s Web site does not by itself make the affiliate an authorized salesperson for the remote vendor.

Other Approaches

Arkansas (PDF), Minnesota (PDF), Idaho, and a few other states modified their sales tax laws to provide that a related party can create substantial nexus. For example, under Idaho’s rule (HB 320, Chapter 49), if a vendor and in-state business are related and use an identical or substantially similar name, trademark or goodwill to “develop, promote or maintain sales, or the in-state business provides services to, or that inure to the benefit of, the out-of-state business related to developing, promoting or maintaining the in-state market,” the vendor has substantial nexus.

These approaches also face constitutional challenges. Similar names or advertising alone is unlikely to meet the Quill nexus standard as it does not make the in-state entity an agent of the remote vendor and therefore does not create a physical presence for the seller. Several cases failed to find nexus in similar circumstances (for example, SFA Folio Collections, Inc., 585 A.2d 666 (Conn. 1991)).

In 2003, South Dakota enacted a rule prohibiting public corporations from doing business with vendors that do not collect sales and use tax (HB 1261, Chapter 34).

Solutions

As suggested in the 1960s, uniform rules would help both vendors and states. However, uniformity is difficult to achieve in the real world.

The closest recent attempt at uniformity is the Streamlined Sales and Use Tax Agreement (SSUTA) that at least 20 states have enacted. The SSUTA, offers simplification through uniform definitions, paperwork and registration. Adopting states must also offer amnesty to sellers who register to collect. It is unlikely that all states will adopt the SSUTA unless Congress provides an incentive or mandate. The SSUTA does not include rate simplification because local jurisdictions may set their own rates.

S. 34 and H.R. 3396 (110th Congress) propose that to the extent the SSUTA meets specified simplification standards, adopting states may collect sales tax from remote sellers. There is an exemption for small sellers with less than $5 million of remote taxable sales in the prior year.

The small seller exemption challenges the touted simplification. Also, unless states exempt purchases from small businesses from use tax, buyers still need to self-assess use tax.

Another solution to explore is better use of technology, such as at the time of sale having the buyer’s credit card charged sales tax by the state tax agency. This approach results in no filing obligations for vendors or buyers.

Looking Forward

The realities of e-commerce will continue to challenge states’ use tax collection efforts. Also, many buyers remain unaware of their use tax obligations. States will need to do more to improve their use tax self-assessment and must work together to convince Congress that sales tax can be collected from sellers without impeding interstate commerce. That’s more easily said than done.

Rethinking IRAs

Cecille Isidro — Thu, 17 Jul 2008 06:33:00 -0400

A Department of Labor retirement guide notes: “For many Americans, retiring in this new century is a mystery.” They’re living longer, they’re more personally responsible for their own retirement savings and they have many more savings options than previous generations did, which exacerbate the confusion. In June 2008, a House Ways and Means Subcommittee hearing explored options for expanding IRA participation. This article presents data about the mystery and IRA participation, highlights of the hearing and considerations for reform.

For general information about IRAs see IRS Publication 590 (PDF) and IRS FAQs.

Data

In 1974 when IRAs were created, life expectancy was 71.9 years (PDF) while in 2006 it was 78.1 years (Centers for Disease Control and Prevention).
People are working longer. About 70 percent of baby boomers (born 1946 to 1964) expect to keep working during normal retirement years (AARP, Reimagining America, 2005). From 1995 to 2006, the employment rate of individuals ages 55 to 64 increased 7.4 percentage points (California Budget Project, More Californians Are Working Later in Life (PDF), April 2007). Reasons for the change include greater longevity, insufficient retirement assets and personal desire.
In 2004, $3.5 trillion in assets was held in IRAs while defined contribution (DC) plans held $2.6 trillion and defined benefit plans (DB) held $1.9 trillion (GAO (PDF), June 2008).
Plan participation: (Labor Secretary Elaine L. Chao, June 2007)

Period	DB (private)	DC
1980	30 million	19 million
2005	22 million	57 million
Change	26.7% decrease	200% increase

In the same speech in which she provided this data, Secretary Chao noted:

Every year about one-third of workers change jobs.
Today’s workers are highly mobile.
From 1998 to 2004, less than 20 percent of IRA contributions were new retirement savings; over 80 percent of contributions were rollovers from other retirement accounts (GAO (PDF)).
From 1999 to 2002, 1.4 million individuals contributed to their traditional IRA each year while about 16 million individuals made annual contributions to their 401(k) plan (GAO (PDF)).
For 2004, 79 percent of all taxpayers were eligible to make an IRA contribution (about 145 million taxpayers), but only 10 percent (14.7 million taxpayers) actually did. Participation was highest among taxpayers with $200,000 or more of AGI and that group also made the largest average contribution. For eligible taxpayers with positive AGI, participation was greater among higher income taxpayers.

AGI	Number taxpayers	%	% of eligible	Contribution (000)	%	Avg.
$0	105,045	0.7	13.4	$339,361	0.7	$3,231
< $10,000	457,638	3.1	2.2	$878,336	1.8	$1,919
< $20,000	752,288	5.1	3.8	$1,286,603	2.6	$1,710
< $30,000	1,250,381	8.5	7.1	$2,498,356	5.1	$1,998
< $40,000	1,310,584	8.9	8.9	$3,052,654	6.3	$2,329
< $50,000	1,401,947	9.6	11.4	$3,677,978	7.5	$2,623
< $75,000	2,977,444	20.2	12.3	$7,932,144	16.3	$2,664
< $100,000	2,370,275	16.1	15.3	$7,503,213	15.4	$3,166
< $200,000	3,005,607	20.5	19.8	$12,982,307	26.7	$4,319
> $200,000	1,074,851	7.3	28.9	$8,577,702	17.6	$7,980
Total	14,706,060	100.0	10.1	$48,728,654	100.0	$3,314

Participation and contributions were also greater for older taxpayers. In 2004, 4.5 percent of eligible taxpayers under age 30 contributed an average of $1,875 while 16.8 percent of eligible taxpayers ages 60 to 69 contributed an average of $3,849 (Bryant, Accumulation and Distribution of IRAs (PDF), IRS, 2004).

A 2007 Department of Labor (DOL) compensation survey found variances in retirement benefits available to private industry workers based on the type of work and employer:

Category	Access	Participation	Take-up*
Full-time	70	60	85
Part-time	31	23	73
Goods producer	70	61	86
Service provider	58	48	83
< 100 workers	45	37	82
> 100 workers	78	66	85
Avg. wage < $15/hour	47	36	75
Avg. wage > $15/hour	76	69	90
All	61	51	84

* Percent of workers with access who participate.

Looking from the provider perspective, 46 percent of employers in the private sector offer retirement benefits. Just 44 percent of employers with less than 100 workers offer retirement benefits compared to 85 percent for those with 100 or more workers (DOL, National Compensation Survey (PDF)).

In 2005, only about one in four (27%) individuals with IRAs contributed the maximum allowable amount (Employee Benefit Research Institute, Notes (PDF), May 2008).
In 2001, 60 percent of taxpayers either had assets in, or income from an IRA or employer-sponsored plan. Thus, 40 percent of taxpayers have no retirement accounts although they may have other assets for retirement (Sailer & Holden, IRS, 2004 (PDF)).

Hearing

The June 2008 congressional hearing focused on a GAO (PDF) report on IRAs, the role IRAs play in the retirement system and proposals for improvements to employer-provided IRAs. One such proposal, H.R. 5160 (110th Congress), calls for various simplifications to employer-established IRAs as well as reduced restrictions and allowance of automatic enrollment.

The GAO report explains some of the barriers that prevent small employers from providing IRA options to employees — either ones that are employer-sponsored (Simplified Employee Pension plan (SEP) or Savings Incentive Match Plan for Employees (SIMPLE)) or a payroll-deduction IRA. These barriers include:

Costs
Confusion about the employer’s role in encouraging IRA contributions
Insufficient incentive for employers
Lack of awareness

The DOL (PDF) and Treasury (PDF) pointed out that they provide publications, seminars and model plans. The DOL’s Interpretive Bulletin 99-1 (PDF) provides guidance on the actions an employer can take with a payroll deduction IRA so as to avoid becoming subject to ERISA rules. Also, the employer may be reimbursed by the IRA sponsor for the reasonable costs of managing the program.

While those testifying tended to agree that automatic enrollment would help increase participation, additional problems were noted with the current system. These included complexity due to varying types of IRA plans, some contribution limits being too restrictive, tax benefits skewed to higher income individuals, high account management fees for individual accounts and risk.

Retirement Considerations for the 21^st Century

The 21^st century workforce will challenge traditional notions of retirement savings arrangements. Employer costs, business competition and employee turnover will continue to make DC plans the preferred retirement benefit. Worker mobility and turnover though will continue to challenge access and effective participation in employer-sponsored plans. Increased options and desire to work past the traditional retirement age will challenge individuals to know how much to save.

New thinking is needed given the number of workers without employer-provided access to retirement savings opportunities, low participation by those eligible to contribute to IRAs and greater retirement savings needs caused by greater longevity. The old models are not working effectively today. Minor changes may not be enough to adequately serve either employers or workers.

Consideration must be given to how existing tax breaks for retirement savings can be utilized to lead to broader coverage in a more equitable and simple manner. Individuals will need greater understanding of investments, savings strategies and budgeting as they take on greater responsibility for managing their own retirement assets.

The American workforce’s dearth or retirement saving knowledge and participation presents many opportunities for CPAs. Policymakers need help understanding where existing rules fail to generate adequate retirement savings and cause challenges for employers. The growing number of individuals managing their own retirement plan and savings decisions will require a higher level of financial literacy than most workers needed years ago. More individuals may turn to the CPA profession for help in creating and maintaining their retirement plans. Yet, the data indicate that many individuals may not know they need to take charge of their retirement planning or how to do it.

Goodbye State Tax Deduction

Ron Tang — Thu, 08 May 2008 00:52:00 -0400

The 1984 Treasury Department report (PDF) that laid the foundation for the base broadening and rate reductions of the Tax Reform Act of 1986, called for complete repeal of the itemized deduction for state and local taxes. Citing similar reasons, the 2005 final report of the President’s Advisory Panel on Federal Tax Reform also called for repeal. Yet, there are also proposals to make permanent the ability to deduct either state income or sales tax (for example, HR 3592, 110th Congress).

Below we’ll get some background on the state and local tax deduction and then look closer at arguments both for and against the deduction to understand why it will be part of broader tax reform discussions in years to come.

Brief History

The deduction for state and local taxes dates back to 1913 when the federal income tax was introduced. The Tax Reform Act of 1986 repealed the deduction for sales tax. The American Jobs Creation Act of 2004 allowed individuals to deduct either state income tax or sales tax starting in 2004; this provision expired after 2007 (Congressional Research Service, Federal Deductibility of State and Local Taxes (PDF), November 2007).

Data

The following data are from a 2008 Congressional Budget Office (CBO) report on the deduction.

About 35 percent of individuals itemize deductions.
For 2004, the average tax deduction per return that claimed the deduction was $6,767. The range was a high of $13,109 in New York to a low of $3,508 in Alaska.
For 2007, the deduction reduced federal tax collections by about $50 billion.
Distribution of the benefit of the tax deduction for 2004:

Adjusted Gross Income (AGI) Range ($) Percentage of tax benefits

0 - 40,000 3.7

40,000 - 75,000 15.7

75,000 - 100,000 14.2

100,000 - 200,000 29.5

200,000 - 500,000 13.6

500,000+ 23.3

Adjusted Gross Income (AGI) Range ($)	Percentage of tax benefits
0 - 40,000	3.7
40,000 - 75,000	15.7
75,000 - 100,000	14.2
100,000 - 200,000	29.5
200,000 - 500,000	13.6
500,000+	23.3

The Arguments

Strong arguments can be made to repeal, retain or expand the tax deduction. A summary of key arguments follows:

Ability to pay: Under an ability to pay perspective, mandatory tax payments represent funds not available for paying other taxes. Thus, a tax deduction is justified in order to measure ability to pay.

The counter-argument is that taxpayers derive both direct and indirect benefits from sub-national taxes. Direct benefits might include tree trimming while indirect benefits include a safer community due to police protection. These benefits are not included in income and thus, expenditures to produce the benefits should not be deductible.

Tax on a tax: When a portion of one’s income is used to pay taxes, inclusion of that income in the tax base results in a tax paid on a tax. Yet this concern appears to be somewhat unimportant because most states do not allow a deduction for federal taxes paid and the federal government does not allow a deduction for all taxes paid.

Spillover: While taxpayers benefit from taxes paid, others benefit as well, including sometimes, taxpayers in other jurisdictions. To the extent there are spillover benefits, a federal deduction is warranted.

The counter-argument is that taxpayers have control over their sub-national taxes through voting and decisions on where to live. Thus, if the taxes yield spillover benefits, the taxpayers should not be compensated by higher taxes on others.

President Bush’s Advisory Panel noted that the tax deduction provides a subsidy for public services that should be “treated like any other nondeductible personal expense, such as food or clothing” with the cost “borne by those who want them -- not by every taxpayer in the country.”

Lack of control/insufficient subsidy: Since the federal government does not control state and local tax systems, the tax deduction reduces the federal government’s control over its own revenues and what it chooses to subsidize.

The deduction can affect state and local tax system design. For example, criteria suggested by the California Legislative Analyst’s Office to evaluate tax proposals includes whether any new taxes are deductible for federal income tax purposes so that the state can “shift” tax burden to the federal government.

The burden is really shifted to other taxpayers. Also, the tax deduction yields greater benefits to itemizers in high tax states. The federal government is unable to shield taxpayers in low tax states from subsidizing taxpayers in high tax states. Some might argue that direct federal subsidies would be preferable over the indirect subsidies that result from the tax deduction.

Cost: The tax deduction is one of the largest federal “tax expenditures” in terms of revenues not collected due to the deduction. The 1984 Treasury report justified repeal by describing the deduction as “one of the most serious omissions from the Federal income tax base (PDF).” A counterargument ties back to ability to pay and the proper measure of the income tax base. Some would argue that a focus on “tax expenditures” leads to the view that all income belongs to the government (for example, see Joint Economic Committee, Tax Expenditures (PDF), 1999).

Fairness: Deductions provide a greater benefit to individuals in higher tax brackets relative to those in lower brackets. Also, the benefit of the tax deduction is greater for itemizers in high tax states (although reduced by the AMT). Some individuals pay higher federal taxes to offset the reduced revenues from the deduction.

Considering that taxpayers do get benefits from sub-national taxes, the 1984 Treasury report noted the following fairness concern (PDF): “Allowing a deduction for State and local taxes simply permits taxpayers to finance consumption expenditures with pre-tax dollars.”

On the other hand, fairness was the argument used to support the return of the sales tax deduction in 2004. Some would argue that the fairness of the deduction would be improved by broadening it to cover more types of taxes, rather than curtailing it. This approach might also lessen the importance of federal tax rules on decisions of sub-national governments over the types of taxes they impose (although taxes would still be favored over user fees).

Relevance in tax system reform: Due to the size of the tax deduction in terms of reduced federal revenues, repeal is often suggested in order to allow broadening of the income tax base and lowering of rates. Repeal would also reduce the number of itemizers, providing additional simplification. Federal reform proposals also include replacing the income tax with a consumption tax, which has no deduction for sub-national taxes.

Proposals

In addition to the proposals noted earlier, the 2008 CBO report on the deduction, prepared at the request of the Senate Budget Committee, analyzed five proposals for the tax deduction:

repeal
a two percent of AGI limit
a $5,000 cap, adjusted annually for inflation
replacement with a 15 percent non-refundable credit
repeal except for real estate taxes

Looking Forward

Itemizing and AMT have already eliminated the state and local tax deduction for many individuals. Will policymakers continue to chip away at it further?

The state and local tax deduction mostly survived the 1984 call for its repeal, yet its imperfections have once again been noted and it will be on the table in upcoming tax reform discussions. These discussions have begun as evidenced by Congressman Rangel’s reform proposal (H.R. 3970, 110th Congress) and a Senate Finance Committee hearing on April 15, 2008. Proposals will include base broadening with rate reductions, as well as a consumption tax to replace the income tax. These discussions, along with AMT reform considerations, will involve examination of the state and local tax deduction, as well as other tax preferences.

New Taxes And Tax Policy

Ron Tang — Thu, 10 Apr 2008 10:54:00 -0400

In recent years, there have been enactments and proposals for a variety of new taxes at both the U.S. state and local levels. A key impetus for these changes is the need for more revenue to fund state and local governments. While existing taxes could be increased to generate revenue, other sources have been considered for a variety of reasons. This article looks at a few recent examples and how they stack up under the principles of good tax policy.

Examples

Sources of new tax revenue are sometimes tied to activities that lawmakers believe may have some type of adverse social policy aspect. In 2005, Detroit's mayor considered a two percent tax on fast food restaurant purchases to help address a budget shortfall (CNNMoney.com, May 2005).

In 2007, Chicago enacted a bottled water tax of five cents per bottle starting January 1, 2008 (2008 tax ordinance (PDF)). Wholesalers collect the tax from retailers with the tax passed along to customers. The tax was originally proposed at 25 cents per bottle with the revenue to address a shortfall in water and sewer funds believed to be partially due to people drinking less tap water (CBS2, August 2007).

In 2008, a one percent excise tax on the sales price of televisions, video games and video game equipment was proposed in New Mexico. The revenues would go into the "leave no child inside fund" to be used for outdoor curriculum programs, "outdoor nature-oriented physical activity programs" for children and similar purposes. The bill, HB 583 (PDF), was estimated to raise about $1.85 million (PDF) annually. Beyond raising revenue, a goal of the proposal was to get children outside and away from TV and video games. The bill died in committee in March 2008.

Analysis

Both existing and proposed taxes can be evaluated using principles of good tax policy. The AICPA (PDF) has a set of principles for such purposes as does the National Conference of State Legislatures (NCSL). A new tax also raises some legal issues as well as the question of why policymakers need a new tax rather than using an existing one.

Rationale for a new tax: A new tax might be warranted if it eliminates flaws in an existing tax or addresses externalities. For example, as the fuel efficiency of passenger cars improves and some cars don't use gasoline, our existing gasoline excise tax which provides funds for highway maintenance and transit can be perceived as a "flawed" tax. A new tax would likely be warranted to replace (or supplement) the gasoline excise tax.

An example of a new tax that addresses externalities could include a carbon tax to enable prices to better reflect the true cost of activities that generate CO2 emissions. The funds could be used to address CO2 emissions or to reduce other taxes to improve overall efficiency of the tax system.

Principles	Bottled water tax	TV/ video game tax
Equity (similarly situated taxpayers treated similarly)	Bad: Consumers of bottled water are taxed while consumers of other bottled beverages are not (even if they include water).	*Bad:* Consumers of TV and video games are taxed while other indoor-type activities, such as bowling and sewing, are not taxed.
Equity (similarly situated taxpayers treated similarly)	Bad: Tax is regressive (greater impact to lower income individuals).
Certainty -- clear rules	Good: All size bottles taxed at same rate. Possible uncertainty if not pure water (for example, vitamins added).	*Bad:* Definitional issues likely.
Simplicity Economy in collection	*Bad:* New forms, procedures and rules needed.
Neutrality	*Bad:* Flat rate per bottle may lead to larger water bottles. Consumers may purchase water outside of city.	*Bad:* Consumers may enjoy TV and video games online or engage in other indoor activities.
Economic growth and efficiency	*Bad:* FLikely to make some Chicago businesses uncompetitive with those in other cities.	*Bad:* Earmarking generally not appropriate if there is a weak connection between the taxed activity and its use. Also, park funding becomes vulnerable to TV and video game sales.
Transparency	*Good & Bad:* Consumers will know of the tax when taxed item purchased. However, they may not be aware of whether alternatives to a tax were possible.
Minimum tax gap	Good: Likely difficult to evade assuming purchases from outside the jurisdiction are exempt.
Appropriate government revenues	Were alternatives explored? Could the city produce less tap water to meet reduced demand, thereby reducing its costs? Given the likely high fixed costs of producing clean water, this may not have been an option. Also, while the city might be able to increase the cost of tap water, that would put the cost on those who did not cause the problem and perhaps make the problem worse (more people may start buying bottled water).	Were alternatives explored? Parks and education are typical government functions and general fund revenues should be considered. In addition, what non-tax alternatives would help meet goal of getting children to spend more time outdoors? See earmarking issue noted earlier.
Appropriate government revenues	Good: A mix of taxes tends to provide better stability; however, these taxes are not significant revenue sources. These taxes likely produce revenues that are easy to estimate.

Legal issues of a new tax: A state's constitution and statute must be examined along with the proposed tax to be sure it is a legal tax. For example, if state law prohibits a sales tax on food, a tax on fast food or bottled water would have to be examined closely to determine if it is the equivalent of a sales tax on food. Similarly, if a state constitution prohibits local jurisdictions from imposing income taxes, any local tax based on gross receipts may be problematic.

Challenges to new taxes are not uncommon. For example, in 2007 the Ohio Grocers Association challenged Ohio's Commercial Activity Tax (a gross receipts tax) as an unconstitutional excise tax on food. It lost the case at the trial level, but an appeal is likely.

A lawsuit has been filed challenging Chicago's bottled water tax. Opponents to the tax argue that it violates state law because it is a tax on food and is not uniform because it does not tax other bottled beverages including ones consisting primarily of water. (See press release of International Bottled Water Association and complaint of four merchant associations.)

U.S. constitutional issues might also be relevant particularly where a tax applies to a subset of businesses, products or transactions. The First Amendment might also be a possible basis for a legal challenge to a tax on video games.

Policy analysis: The following chart applies relevant tax principles suggested by the AICPA and NCSL to the bottled water tax and proposed video game tax.

Conclusion

Chronic budget shortfalls and the unpopularity of rate hikes for existing taxes can lead state and local governments to consider new revenue sources. These sources may target activities potentially viewed as harmful or "easy targets," such as fast food, video games and adult entertainment. Regardless of the problem or revenue need, it is helpful to consider the principles of good tax policy to determine whether a new tax is appropriate and if so, that it is well-designed and fair.

What's Your Tax System IQ?

Ron Tang — Wed, 12 Mar 2008 02:00:00 -0400

While tax season tests our technical tax knowledge daily, here is an opportunity to take a break and test your knowledge about our federal tax system.

Answers to this quiz can be found at the bottom of this article.

Questions

IRS tax revenue collections for fiscal year 2006 were approximately $______ trillion.

The individual income tax was the largest portion of these tax collections, representing ___% of the total.

For 2005, _____ million individual tax returns were filed showing combined taxable income of $_____ trillion.
1. 108; 2.8
2. 124; 3.5
3. 134; 5.1
4. 149; 6.8

For 2005, ___% of individual returns claimed itemized deductions.

For 2005, ____% of individual returns reported AGI of $1 million or more.

For the 2004 tax return year, identify the following entity data as belonging to (i) corporations (non-S), (ii) S corporations, (iii) partnerships, and (iv) non-farm sole proprietorships:
1. 2,039,631 businesses; $18.0 trillion of total receipts
2. 2,546,877 businesses; $3.0 trillion of total receipts
3. 3,518,334 businesses; $4.7 trillion of total receipts
4. 20,590,691 businesses; $1.1 trillion of total receipts

For the 2005 tax return year, LLCs represented ___% of partnership returns filed.

Gas guzzler excise tax collections for fiscal year 2006 were:
1. $1 million
2. $50 million
3. $120 million
4. $200 million
5. $300 million

In fiscal year 2006, which category of Form 1040s had the highest IRS audit rate?
1. Non-business returns with total positive income (TPI) under $25,000
2. Non-business returns with TPI of $100,000 or more
3. Non-farm business returns with total gross receipts (TGR) under $25,000
4. Non-farm business returns with TGR of $100,000 or more
5. Farm business returns with TGR of $100,000 or more

Which category of tax return had the higher examination rate for fiscal year 2006?
1. Individuals (Form 1040)
2. Large corporations with assets of $250 million or more
3. Estates of $5 million or more

For fiscal year 2002 through 2004, corporations with assets of $250 million or more were more likely to be audited by the IRS if they were in which of the following industry sectors?
1. Financial services
2. Communications, technology and media
3. Retail
4. Heavy manufacturing
5. Natural resources

The largest federal "tax expenditure"* for fiscal year 2007 as estimated by the Joint Committee on Taxation was:
1. Mortgage interest deduction
2. Earned income tax credit (EITC)
3. Reduced tax rate on dividends and long-term capital gains
4. Tax credit for children under age 17
5. Exclusion for employer-provided health care benefits
6. Exclusion for employer pension contributions
  * Federal budget law defines "tax expenditures" as "revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability." Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2007-2011 (PDF), JCS-3-07 (9/07), p. 2.

For 2006, the percentage of the tax expenditure for mortgage interest deduction attributed to individuals with $100,000 or more of income was: (income for this purpose includes some non-taxable income)
1. 22%
2. 34%
3. 47%
4. 64%
5. 73%

For tax year 2005, how many taxpayers received assistance from the IRS via telephone?
1. 35 million
2. 42 million
3. 57 million
4. 63 million

For tax year 2005, how many returns were prepared at Volunteer Income Tax Assistance (VITA) and Tax Counseling for the Elderly (TCE) sites?
1. 1.2 million
2. 1.9 million
3. 2.3 million
4. 3.2 million

Answers

Per the IRS, gross collections for fiscal 2006 were $2,518,680,230,000.

Per the IRS, individual income tax collections for fiscal 2006 were $1,236,259,371,000 (49%). Corporate income taxes represented 15.1 percent of IRS collections, employment taxes 32.4 percent, excise taxes 2.3 percent and estate and gift taxes 1.1 percent.

C. Per the IRS (PDF) (p. 5), 134.4 million individual returns were filed in the 2005 tax year (2.2 million more than for 2004). These returns reported a total of $5.1 trillion of taxable income (10% increase from 2004).

Per the IRS (PDF) (p. 8), 35.5 percent of individual returns claimed itemized deductions.

Per the IRS (PDF) (p. 11), 0.23 percent of 2005 returns reported AGI of $1 million or more. The breakdown:

	    	 AGI	   	% of total returns
	Under $10,000                   18.9
	$10,000 to $19,999              16.9
	$20,000 to $29,999              13.8
	$30,000 to $49,999              18.3
	$50,000 to $99,999              21.4
	$100,000 to $199,999             8.0
	$200,000 to $499,999             2.0
	$500,000 - $999,999              0.4
	$1,000,000 and greater           0.2

Per IRS (PDF) data (pgs. 286, 289), A -- (i) corporations; B -- (iii) partnerships; C -- (ii) S corporations; and D -- (iv) non-farm sole proprietorships.

53 percent. Per IRS (PDF) data (p. 75), LLCs have represented the greatest percentage of partnership returns filed since 2002. Prior to 2002, general partnerships were predominant.

D. Per IRS data, $201,649,000 of gas guzzler excise tax (IRC §4064) was collected in fiscal year 2006, up from $79.7 million in 2002.

D. Per IRS data, 3.9 percent of Form 1040 business returns with TGR of $100,000 were examined. The percent examined for the other categories was 1.5 percent for nonbusiness returns with TPI under $25,000, 1.3 percent for non-business returns with TPI of $100,000 or more, 3.8 percent for non-farm business returns with TGR under $25,000, and 0.6 percent for farm business returns with TGR of $100,000 or more.

B. Per IRS data, 35.2 percent of large corporate returns with assets of $250 million or more were examined in fiscal year 2006. For these returns, the average recommended additional tax per return from a field audit was $6,151,813 and 11 percent of field audits resulted in no change. The percentage of returns examined in fiscal year 2006 was 1.0 percent for individuals, 23.4 percent for estates of $5 million or more, and 0.4 percent for partnerships and S corporations.

D and E. Per Transactional Records Access Clearinghouse (TRAC) data, large corporations in natural resources, construction, heavy manufacturing and transportation industries faced a 100 percent audit rate while large corporations in the financial services sector had a 15 percent audit rate, communications, technology and media a 64 percent audit rate, and retail, food, health care and pharmaceuticals businesses an 81 percent audit rate.

C. Per Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2007-2011 (PDF), JCS-3-07 (9/07). The estimated "cost" of each of the listed items for 2007:
- Reduced tax rate on dividends and long-term capital gains $127.1 billion
- Exclusion for employer pension contributions $108.6 billion
- Exclusion for employer-provided health care benefits $105.7
- Mortgage interest deduction $73.7 billion
- Tax credit for children under age 17 $45.0 billion
- Earned income tax credit $44.7 billion

E. Per Joint Committee on Taxation, JCS-3-07 (PDF) (p. 43); 10.4 percent of the benefit was attributable to individuals in the $50,000 to $75,000 income class and 12.8 percent to those in the $75,000 to $100,000 income class.

C. Per IRS data, 56,993,000 individuals received telephone support from the IRS, including recorded information.

C. Per IRS data, 2,268,000 returns were prepared at VITA and TCE sites, up from 2,111,000 for tax year 2004.

Tough Tax Questions for Presidential Candidates

Ron Tang — Thu, 14 Feb 2008 00:00:00 -0500

The current crop of Presidential candidates sound a lot like they did in prior years with promises of new targeted tax breaks, loophole closures, increased taxes on the rich and new spending programs. Have the candidates not read the doom and gloom budget reports from the Government Accountability Office (GAO), Congressional Budget Office (CBO) and others?

The fiscal agenda for the next President and Congress must include some very difficult decisions that go beyond just tweaking the tax system. Below, we’ll look closer at some key fiscal issues that have tax implications. Questions are posed that could help gauge how well candidates understand the fiscal quagmire the country is heading into and the remedies they would pursue.

What’s in Store

David M. Walker, head of the GAO, describes the current federal budget as being “on an imprudent and unsustainable path” (January 2008 testimony, GAO-08-411T (PDF)). CBO Director Peter L. Orszag observes that economic growth will not solve the impending budget problems. “A substantial reduction in the growth of spending, a significant increase in tax revenues relative to the size of the economy or some combination of the two will be necessary to maintain the nation’s long-term fiscal stability” (January 2008 testimony (PDF)).

The dire outlook stems from imploding healthcare costs and a population bulge of retiring baby boomers (born between 1946 and 1964). The likelihood of extending tax cuts that expire after 2010 and alleviating the alternative minimum tax (AMT) hit that millions will face, further aggravates the problems. The nagging tax gap dampens the outlook even more.

Healthcare Spending

Healthcare costs are a significant cause of impending budget problems.

In 2006, total healthcare spending represented 16 percent of GDP, almost double what it represented in 1976. And it is expected to represent almost 20 percent of GDP by 2016 (GAO testimony (PDF)).
Medicare and Medicaid costs represented one percent of GDP in 1970, four percent in 2007 and will continue to grow. Cost increases are not due solely to our aging population, but to increasing costs per beneficiary due to improved diagnosis and treatment techniques (CBO, The Long-Term Budget Outlook (PDF), December 2007).

Per Walker (GAO testimony (PDF) January 2008), increasing healthcare spending is “eroding the ability of employers to provide coverage to their workers and undercutting their ability to compete internationally.” Growing healthcare costs also impact the national debt, savings rates and economic growth adversely (for more information, see CBO, Growth in Health Care Costs (PDF)).

There are various tax implications of healthcare spending. The Hospital Insurance (HI) tax of 2.9 percent helps fund Medicare. One of the largest federal income tax expenditures is the exclusion for employer-provided health insurance that the Joint Committee on Taxation estimates as $628.5 billion from 2007 -- 2011 (JCS-3-07 (PDF)), not counting payroll taxes. This tax break can increase healthcare spending by reducing the relevance of cost in making healthcare decisions, which also leads to higher insurance costs for employers and others.

Question -- What are your plans for controlling rising healthcare costs and how will the HI tax and the income and payroll tax exclusions for employer-provided health insurance factor into solutions?

Baby Boomers Retiring

Retirement of baby boomers starting in 2008 as well as increasing longevity of the U.S. population will strain our Social Security system. Without changes, Social Security will grow from 4.3 percent of GDP in 2007 to 6.1 percent in 2030. Today there are 3.2 workers per Social Security beneficiary, but that ratio is expected to drop to 2.1 per beneficiary by 2030. (CBO, The Long-Term Budget Outlook, (PDF) December 2007)

Question -- What changes do you propose for Social Security taxes, retirement age, benefits and/or structure of the system to address the problems stemming from the decline in the ratio of workers to beneficiaries?

The Tax Gap

The annual federal tax gap is estimated at $345 billion. Congress and the IRS have increased their attention to this problem and possible solutions. Yet, little change has occurred. Numerous reports from the GAO (PDF), IRS and others offer specific suggestions for reducing the tax gap.

Questions -- What is your timeframe for implementing techniques to reduce the tax gap and will new information reporting be part of your plan? How do you think existing enforcement tools can address the problem?

AMT, Expiring Tax Cuts and Related Matters

Adjusting the alternative minimum tax for inflation and extending the 2001 and 2003 tax cuts would lead to a $617 billion deficit in 2018 rather than a $223 billion surplus (CBO, The Budget and Economic Outlook: Fiscal Years 2008 to 2018 (PDF), January 2008). The deficit scenario also increases the national debt and interest expense.

If the tax cuts are allowed to expire after 2010, AMT liabilities would drop by about two-thirds in 2011 (due to higher regular tax liabilities), but would continue to increase due to the lack of inflation adjustments in the AMT brackets. Over 31 million individuals would be subject to AMT in 2018 compared to less than seven million who were subject to it in 1987. Individuals subject to AMT are predominately in the $75,000 to $1 million adjusted gross income range (Joint Committee on Taxation, JCX-38-07 (PDF), June 2007).

In February 2007, the Center on Budget and Policy Priorities (CBPP) estimated that factoring in increased borrowing, extension of the tax cuts and indexing AMT for inflation would cost $4.3 trillion over 10 years (2009 through 2018).

A 2007 report of The Brookings Institute (Achieving Progressive Tax Reform in an Increasingly Global Economy (PDF)) notes that to alleviate budget problems including those arising from extension of tax cuts and adjusting AMT for inflation, would necessitate a 34 percent reduction of all government spending in order to attain “long-run fiscal balance.”

The GAO uses the following graph to emphasize the need to address fiscal issues earlier rather than later. The revenue line is based on extending the tax cuts, maintaining the 2006 AMT exemption amounts and keeping revenues at a historic level of 18.3 percent of GDP after 2017 (GAO-07-1261R (PDF)).

Dealing with expiring tax cuts and growing AMT will also involve consideration of the distribution of taxes, tax breaks and benefits. While Treasury (PDF) reminds us that expiration of the tax cuts will result in tax increases for millions of individuals, the distribution of the benefits varies among different income categories and filing units. For example, repeal of the estate tax skews the benefits to individuals in higher income groups. The CBPP and others note that the tax cuts made the tax law more regressive. These topics will surface in discussions on extending the tax cuts. For more information on distribution of the tax cuts, see reports by the Tax Policy Center (PDF), Congressional Research Service (PDF), and others.

Questions -- What are your plans for addressing the AMT and expiring tax cuts? Why? How will extension of the tax cuts, AMT relief or any new tax breaks be paid for? How progressive should the tax system be and how would you achieve that level?

There’s More

The next President and Congress also have various structural issues, such as complexity, as well as reform issues, such as ensuring that the tax system does not impede international competitiveness for U.S. businesses, to deal with. These tax reform matters cannot be addressed in isolation from the budget and distribution issues. These are all challenging issues that call for asking tough questions of candidates.

Internet Era Questions for Individual Clients

Ron Tang — Thu, 10 Jan 2008 00:00:00 -0500

The Internet has become ubiquitous for much of the population, but your clients may not be aware that their Web activities could produce tax liabilities and some may change in their individual tax status (for example, to sole proprietor). As a practitioner, you need to remind your clients to ensure that all of their Internet-related income is reported and that they are compliant with all relevant taxes. This article provides a set of questions to aid in this endeavor.

Worker Classification -- Is Congress Ready to Take Action?

Ron Tang — Thu, 13 Dec 2007 00:00:00 -0500

Proper classification of workers for tax purposes is important as different rules apply to employees versus independent contractors. Contractors may deduct expenses for adjusted gross income (AGI), owe self-employment tax and take advantage of tax-favored benefit plans for those who are self-employed. Employees have unemployment benefits, split payroll taxes with the employer and can be covered under employer-provided benefit plans.

Some employers misclassify workers to reduce employment tax liabilities. Tax compliance by contractors is not as high as it is for employees. In addition, misclassified workers may be deducting business expenses as a contractor that they would not be able to deduct as employees. And, less federal unemployment tax (FUTA) is collected when workers are misclassified as contractors.

Tax Classification Rules

Generally, for tax purposes, classification of a worker as an employee or a contractor depends on whether the employer has the right to control the worker performing the services with respect to the results to be achieved and the method of achieving the results. A set of 20 common law factors are analyzed to help determine if the right to control exists (Rev. Rul. 87-41, 1987-1 CB 296). There is no specific guidance on how the factors are to be weighted, which along with the nature of the factors, makes for a subjective determination and an increased likelihood of differing interpretations among the parties involved.

In addition, the Revenue Act of 1978 prohibited the IRS from issuing regulations or revenue rulings on worker classification until Congress enacted legislation (“Section 530”). The Act also provided some safe harbors where the IRS may not reclassify workers misclassified as employees for employment tax purposes (see IRS Publication 1976 (PDF) for the basics as well as an IRS Web site on worker classification).

Tax Gap Concerns

Both intentional and unintentional errors exist in the worker classification area. IRS data from 1984 found that about 15 percent of employers incorrectly classified workers as contractors. For workers classified as employees, over 99 percent of compensation was reported. However, when workers were misclassified as contactors, about 77 percent of income was reported if employers filed Form 1099, and only 29 percent if no Form 1099 was filed. (Sole Proprietors’ Tax Gap, GAO-07-1014, p. 64) The General Accountability Office (GAO) estimates that for 2006, this data would indicate an employment and income tax gap of $2.72 billion (GAO, Employee Misclassification (PDF)).

The worker classification issue generates gaps in federal and state income taxes, employment taxes and workers’ compensation payments. A study conducted in Illinois found that misclassification resulted in annual losses of about $39 million in unemployment insurance and $125 million in income taxes (Pinkham, et al., The Economic Costs of Employee Misclassification in the State of Illinois, 5/8/07 testimony).

Worker Classification Proposals

Various proposals have been offered over the years by the GAO, Treasury, the Small Business Administration, members of Congress and others. Such proposals include ones to reduce the number of factors to consider in classifying workers, elimination of Section 530, increased penalties for failure to file a Form 1099 and withholding on payments made to contractors. A 2006 report from the National Taxpayer Advocate included a proposal to not challenge the classification of workers who are a party to a voluntary withholding agreement (testimony of Nina E. Olson, The Causes and Solutions to the Federal Tax Gap (PDF)).

New Tax Form

In October 2007, the IRS released a new reporting form that may help in identifying situations where a worker has been misclassified. Form 8919 (PDF), Uncollected Social Security and Medicare Tax on Wages, must be filed by a worker if employment taxes were not withheld, the worker was not an independent contractor and one or more of seven specified reasons applies to the worker. These reasons include receiving a statement from the IRS that the worker is an employee and filing Form SS-8 (PDF), Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, but not yet hearing back from the IRS. For the following three reasons the individual must have filed a Form SS-8:

The individual was treated as an employee by the employer in the past and is performing substantially similar services with similar direction and control now.
Co-workers perform substantially similar services with similar direction and control and are treated as employees.
Co-workers performing substantially similar services with similar direction and control filed Form SS-8 regarding the employer and the determination was that they were employees.

Form 8919 calls for information on the employer and the wages paid so the taxpayer can compute the amount of Social Security and Medicare taxes owed. The form will be useful for an employee with an employer who is entitled to Section 530 relief. In such a situation, the worker as an employee, is subject to employment taxes (the employment tax relief is only for the employer and does not apply for income tax purposes).

The form may also encourage more workers concerned that they have been misclassified as contractors to file a Form SS-8 to get a determination from the IRS (and to bring the situation to the attention of the IRS). It may also help the IRS to find workers properly classified as contractors who prefer to be employees and are not paying self-employment tax.

The Future

While solutions to the problem have not been enacted, the issue has not been forgotten by Congress. On May 8, 2007, the House Subcommittee on Select Revenue Measures held a hearing on the “Effects of Misclassifying Workers as Independent Contractors.”

Among proposals for improving worker classification rules is S. 2044 introduced in September 2007 by Senator Obama and co-sponsored by Senator Clinton. S. 2044 includes various measures to reduce misclassification situations. Section 530 is cut back significantly by allowing the IRS to reclassify workers, repealing the ban on guidance and removing the safe harbor based on industry practice as a reason for treating a worker as a contractor. Senator Obama notes that S. 2044 will reduce the tax gap by bringing “billions of dollars in unpaid federal taxes... back into the system.”

Summary

Worker classification has been a confusing and abused area of the law for decades. Despite numerous proposals over the years, improvements have not been made. With increased focus on the tax gap and attention by Congress and presidential candidates, perhaps legislation will be enacted in the near future. Issues of health insurance and changes in the workforce (such as greater worker mobility, growth of knowledge workers, and fewer employer-provided pensions) may also drive the debate and solutions.

Strategy for Major Tax Reform

Ron Tang — Thu, 08 Nov 2007 00:00:00 -0500

On October 25, 2007, House Ways and Means Committee Chair Charles Rangel introduced H.R. 3970 (text, summary (PDF)), the Tax Reduction and Reform Act of 2007, a bill he informally calls the “mother of all tax reforms.” Based on what we have learned from the last major reform effort -- the Tax Reform Act of 1986, are we likely to see H.R. 3970 enacted?

Strategy

Briefly described below are actions and techniques that can improve the chances of a major income tax reform proposal becoming law. These features are also compared with TRA ’86 and H.R. 3970 to gauge the likelihood of H.R. 3970 becoming an enacted reform.

Studies: There must be thorough studies of how the tax law currently operates, its strengths and weaknesses and analysis of possible reforms that would remedy the problem areas.
Cooperation: Both the administrative and legislative branches must agree that existing tax law problems can only be remedied through major reform that will likely affect many parts of the existing tax law and most taxpayers. Both branches must be willing to work together to craft and support reform.
Purpose: In order to convince policymakers and taxpayers that reform is the right direction, the purpose of the effort must be clear. Leaders of the effort should be able to articulate the reasons why change is needed. Knowing the purpose enables legislators to identify appropriate changes and to verify if they address the problems. The purpose for making major changes must be perceived as meaningful to taxpayers. Legislators and taxpayers will not want to endure the change process and the results if they are not convinced it is all for a good cause.
Thoroughness: A thorough review of existing law should underlie the reform efforts in order for it to be major and justifiable.
Resoluteness: Every tax preference has a group that supports it. Thus, every change will have opposition. But, if the change is appropriate given the purpose of reform, legislators must be resolute in pursuing the change; otherwise, the goals for reform will not be achieved.
Policy: The principles of good tax policy (PDF) -- equity, transparency, simplicity, economic efficiency and others should be followed.
Transition: Taxpayers have made long-term decisions based on existing tax rules. The pain of new rules that alter past plans can be eased by transitioning in new rules if feasible.
Make everyone a winner: Taxpayers are more likely to accept the loss of favorable provisions if they see that there are also benefits for them, such as lower tax rates.

TRA ’86 vs. H.R. 3970

Strategy	TRA ’86	H.R. 3970
Studies	Several including Treasury’s Tax Reform for Fairness, Simplicity, and Economic Growth (PDF) (11/84).	Several from the Joint Committee on Taxation, GAO, and others, particularly on AMT, the tax gap, and international taxation.
Cooperation	The President and the tax-writing committees were in favor of reform.	The President created his own Panel on Federal Tax Reform that produced broad proposals but little discussion in Congress. AMT reform is a major goal for both the President and Congress.
Purpose	Improve fairness and efficiency and reduce complexity.	Primarily to repeal individual AMT, but also has a mix of other items, some of which are not reforms, such as one-year extensions of at least 30 temporary provisions.
Thoroughness	Per the General Explanation of the Tax Reform Act of 1986 (PDF) (5/4/87): “After extensive review of virtually the entire prior tax statute, Congress concluded that only a thorough reform could assure a fairer, more efficient, and simpler tax system.” Arguably, Congress was not thorough in all changes and subsequent changes were made, such as to long-term contract accounting and home mortgage interest.	While thorough studies of the Code have been made in recent years (such as the 2001 Joint Committee on Taxation’s simplicity study (PDF)), H.R. 3970 does not seem to be tied directly to any particular study. In addition, it extends many temporary provisions even though many have had no study performed as to their effectiveness. In addition, while at least one proposal — basis reporting by stock brokers, has been mentioned in tax gap reports, other tax gap remedies are omitted.
Resoluteness	Arguably, yes, given the number of favorable provisions eliminated and new limitations added.	Remains to be seen.
Policy	Arguably equity was achieved through passive activity loss rules, interest limitation rules and others. It is questionable whether simplicity was achieved due to the complexity of some of the new rules.	Repeal of AMT and §199 manufacturing deduction helps achieve simplicity and transparency, although offset somewhat by limitation on itemized deductions, phase-out of personal exemptions, and surtax on modified AGI. Tax gap partially addressed by basis reporting for stockbrokers. Economic growth and efficiency hurt by extension of life of §197 intangibles to 20 years, although helped by permanence of current §179 expensing deduction.
Transition	Many were included such as the phase-in of passive activity loss limitation and phase-out of the personal interest deduction.	Not apparent.
Winners	Individual tax rates were reduced and brought down to only two rates. This was likely perceived as a “win” by many despite the loss of some favored deductions, such as personal interest.	There are several “wins” such as repeal of the individual AMT and increase in the standard deduction. The new surtax for individuals with $200,000 of income will only affect a minority of taxpayers, but legislators will need to be able to show individuals that the bill is unlikely to increase their tax liability.

Conclusion

Change is never easy. Major tax law change is further burdened by the inherent complexity in the law and most taxpayers’ weak understanding of the tax law and related policies. Also, past efforts to do many things with the tax law besides raise revenue, as evidenced by the inclusion in H.R. 3970 of one-year extensions of 32 temporary tax preferences, adds to the challenge of tax reform. That is, the more preferential provisions there are, the harder it is to reach reform by broadening the base and lowering rates as was done by TRA ’86.

Congressman Rangel’s bill will be discussed in Congress. It includes proposals in several areas where studies have shown that reforms are needed, such as to reduce the tax gap and modernize international tax rules. However, H.R. 3970 does not completely address what is needed in these areas.

Along with the myriad tax reform proposals of presidential candidates, H.R. 3970 presents a good opportunity for evaluating reform strategy, particularly identifying the purpose for major reform.

AICPA Tax Insider

Closing Tax Gap

Tax Gap History

New Information Reporting Requirement

Observations

Picking Up the Pace

Grabbing Remote Vendors

Interstate Sales Tax History

E-Commerce Challenges

New York’s 2008 Legislative Change

Vendor Reaction

Counterpoint

Other Approaches

Solutions

Looking Forward

Rethinking IRAs

Data

Hearing

Retirement Considerations for the 21st Century

Goodbye State Tax Deduction

Brief History

Data

The Arguments

Proposals

Looking Forward

New Taxes And Tax Policy

Examples

Analysis

Conclusion

What's Your Tax System IQ?

Questions

Answers

Tough Tax Questions for Presidential Candidates

What’s in Store

Healthcare Spending

Baby Boomers Retiring

The Tax Gap

AMT, Expiring Tax Cuts and Related Matters

There’s More

Internet Era Questions for Individual Clients

Worker Classification -- Is Congress Ready to Take Action?

Tax Classification Rules

Tax Gap Concerns

Worker Classification Proposals

New Tax Form

The Future

Summary

Strategy for Major Tax Reform

Strategy

TRA ’86 vs. H.R. 3970

Conclusion

Retirement Considerations for the 21^st Century