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The IRS Defense

The IRS Commissioner John Koskinen has spent a lot of time on Capitol Hill this past week answering questions about the Internal Revenue Service’s targeting ofirs certain political groups and the ongoing Congressional investigations.

Depending upon your political persuasion, you probably see this as a potential conspiracy deserving investigation, or you think this is nothing more than political grandstanding in an election year. Beyond the political theatrics, which are part of all Congressional hearings, there are some serious issues involved, not the least of them is the Service’s response to Congressional inquiries.

While you may disagree with the premise and conduct of the investigations and hearings, the IRS’s response is troubling, irrespective of political affiliations or leanings. As an American taxpayer, do you think you could handle an IRS audit the same way the IRS is responding to Congressional inquiries?

Documentation and Missing Information

The timeliness of providing documentation to Congress has been a point of contention. The investigation started over a year ago, yet some documents still have not been produced. The biggest bombshell hit last week, when the IRS informed Congress it could not provide some of the e-mails from Lois Lerner (the IRS official at the center of the controversy who has pled the 5th Amendment at two different Congressional hearings) due to a computer crash. They noted that six other employees also involved in the investigation experienced computer failures and lost e-mails during the same time period. Despite knowing about these computer issues in February, the IRS didn’t notify Congress until June, but notified the Treasury Department in April.

Everyone has probably encountered computer issues and lost information before. That’s understandable. However, the IRS has strict documentation requirements for taxpayers. You are required to retain your documents for at least three to seven years; sometimes longer. An IRS auditor can disallow a deduction if you don’t have the appropriate documentation.   Imagine telling an IRS agent you can’t produce the requested documents because of a computer crash and you destroyed the backups. Consider how skeptical the agent would be if you knew about it early in the audit process, but waited for months before disclosing it. Do you think the agent would take your word that all is okay and move on?

The IRS is also contending it doesn’t matter that some of the e-mails have been lost, as they cite the thousands of documents they have provided. This is analogous to providing boxes of receipts to substantiate your business expenses, but not providing the ones for your personal vacation you deducted as a travel expense. You can argue with the agent that the mounds of unrelated documents prove everything is legitimate, but it may not be. Furthermore, the agent is under no obligation to simply take your word for it.

The Law v. Common Sense

In a tense exchange between Commissioner Koskinen and South Carolina Congressman Trey Gowdy, the Commissioner stated there was no criminal wrongdoing by anyone at the IRS. Congressman Gowdy, a former federal prosecutor, asked what federal statutes Mr. Koskinen had reviewed to determine no criminal wrongdoing had occurred. The Commissioner responded that he hadn’t reviewed any laws. Instead, he was relying upon common sense that nothing inappropriate occurred.

Try using the common sense argument with the IRS. No Mr. IRS auditor, I don’t know what the law says about reporting that income or deducting those expenses, but relying upon common sense, it must be okay. Certainly the IRS agent will agree with your common sense approach and ignore the tax code.

Attitude

All of the IRS officials’ testimony seems to project an attitude that we’ve done nothing wrong; trust us; now leave us alone. In his recent testimony, Commissioner Koskinen’s demeanor appeared brash, indignant and borderline arrogant when responding to questions. Some of his supporters cheered his behavior, and thought he was standing his ground while being bullied by the Republican interrogators. While no one deserves to be disrespected or berated, the Commissioner showed no sense of remorse for anything and projected an aura of annoyance that he was being questioned.

Again, you should put this in context of an IRS audit. Imagine meeting with an IRS agent and displaying the same type of defiant attitude. Theoretically, IRS personnel should conduct themselves in the same manner no matter how you act or what you say, but do you honestly think that’s true? A basic understanding of human nature tells you that a contentious and condescending attitude will cause the auditor to be more suspect and less lenient in accepting anything that’s questionable.

The IRS Defense

Therefore, the next time you are audited by the IRS, consider employing the IRS defense strategy.

  • You don’t have to worry about missing documents if you inundate them with other information, and if can’t produce the documents, they should just trust you that everything is correct;
  • You don’t have to apply tax law, so long as your common sense tells you it’s correct;
  • You can be brash, indignant and uncooperative because you’ve done nothing wrong, and the IRS is responsible for wasting your time and taxpayers’ money.

On second thought, maybe this isn’t a very good defense and could cost you a lot of time and money in the long run. However, if it works for the IRS why shouldn’t it work for you? Furthermore, if this is how the IRS acts when it’s scrutinized, why should taxpayers be expected to act differently?

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The IRS and I Don’t Know

irsThe recent IRS scandal involving targeting of certain conservative groups applying for tax-exempt status is troubling on many levels. The more questions asked and the more information uncovered, the disconcerting it gets.

Aside from the potential abuse of governmental authority or violation of civil liberties, the lack of information, knowledge and candor by the IRS officials testifying before Congress is incredulous. Former acting IRS Commissioner Steven T. Miller could only muster a meek apology for not providing good customer service to the affected groups when he testified. In addition to Mr. Miller, multiple IRS officials have testified before Congress over the past three weeks. When questioned about who was responsible for this additional scrutiny, the same basic response is offered every time, “I don’t know. Without sounding overly critical, their response is lame.

The initial response from the IRS and White House blamed two rogue employees in the Cincinnati, OH Service Center. Doesn’t it make sense you might know the names of the individuals if you say its two people? Even if someone didn’t know their identity at the time, I think you could track them down in three weeks. Additionally, the Treasury Inspector General for Tax Administration (TIGTA) investigated this practice for nearly a year before the report was made public. Why wasn’t the TIGTA able to determine who was involved?

As some of the groups targeted by the IRS have come forth, it is obvious involvement went beyond two low-level employees in Cincinnati. IRS inquiry letters have been produced from multiple locations, signed by various individuals, including Lois Lerner, the head of the IRS Exempt Organizations Division responsible for approving these applications.

These are not low-level employees who are testifying. They are highly paid professionals responsible for the direction and operations of the IRS. It’s not realistic for them to know everything happening at the IRS, but it is their job to find out. Professing ignorance and blaming subordinates is not commensurate with they pay and position.

As someone who interacts with the IRS on a continual basis and has responded to countless IRS inquiries and audits, telling an IRS agent “I don’t know” isn’t sufficient. You may not know the answer at the moment, but you have to find out. When you meet or talk with an agent, you’re supposed to be prepared to answer their inquiries. Justifiably, IRS personnel get frustrated and annoyed if you can’t answer many of their questions and everything is delayed.

The IRS sends you a list of questions or inquiries ahead of time. While Congress may not provide a list of questions in advance, questions like “How did this happen?” or “Who is responsible?” seem rather obvious. To appear before Congress without any ability or intention of answering those questions is mystifying.

As some Members of Congress have already pointed out, the IRS should be held to the same standards of cooperation and responsiveness they expect from the U.S. taxpayers. If “I don’t know” won’t fly with the IRS, “I don’t know” shouldn’t fly for the IRS.

Targeted by the IRS

irsIf you have ever been audited by the Internal Revenue Service (IRS), it’s natural to feel like you have been singled out. It’s like getting pulled over for speeding. Regardless of your actions, you often feel like the authorities should be spending their time pursuing more important criminals. Despite your feelings, rarely are you being targeted by the IRS.

Shockingly, the IRS admitted last week that they had unfairly and inappropriately targeted certain nonprofit organizations because of their beliefs and affiliations. For over two years, IRS employees signaled out conservative groups with names or verbiage including “Tea Party,” “Patriot” and “Obamacare” for additional scrutiny. The IRS admitted this in advance of the pending release of a report by the Treasury Inspector General for Tax Administration (TIGTA) criticizing their behavior.

The IRS claimed the targets were nonpolitical and initiated by low-level employees in the Cincinnati, OH Service Center. The additional scrutiny may not have been ordered by a political appointee, but it seems obvious the additional attention and inquiries were politically motivated. Over the past few years “Tea Party” has as much a political connotation as Democrat or Republican. Additionally, it doesn’t appear any liberal-leaning groups received the same scrutiny. As a result, it seems hard to believe the IRS actions were not politically motivated.

It also appears the knowledge of this behavior went much higher than a few low-level staffers churning through documents in Cincinnati. Lois Lerner, the head of the IRS Exempt Organizations Division, found out about it in June 2011, and despite her instructions to change the review guidelines, the additional inquiries continued throughout 2012. In May 2012, Douglas Shulman, the IRS Commissioner at the time, and Steven T. Miller, his deputy and the current acting Commissioner, also learned of these targeted reviews. Both of these men failed to notify Congress, despite questions from several Senators and Representatives regarding the IRS scrutiny of these conservative groups.

No matter your political affiliation or beliefs, this acknowledgement by the IRS should be of grave concern for all Americans. It’s an extremely precarious position when government officials at any level, abuse their authority for political purposes. Those actions are characteristic of dictators and oppressive regimes; not what’s expected in a free, democratic republic.

You may not have much regard for the ideas and people affiliated with the Tea Party movement, but that should not matter. If the IRS has the ability to target them, they can also come after you.

The IRS claims no exemption was ultimately withheld from any applicant. This reassurance is also subtle claim of exoneration for their actions. The IRS is essentially trying to assert “No harm, no foul.” Even though no exemption was denied, it doesn’t mean these organizations didn’t suffer injury. Given the complexity of the rules, taxpayers often hire professional advisors. These organizations may have incurred substantial fees complying with the additional IRS inquiries, not to mention the delay in being able to pursue their stated mission.

The abuse seems limited to a certain group of employees handling a specific group of taxpayers and is not widespread throughout the IRS. If you receive an IRS notice, it’s probably not politically motivated. However, these actions, albeit limited, set a very dangerous precedent and deserve exceptional scrutiny by our leaders and the public at large.

No one likes to be examined or questioned by the IRS, but it’s part of dealing with a voluntary tax system. However, no one should ever be targeted for political purposes. Dealing with the IRS can be annoying, but being targeted for your political beliefs or affiliations is absolutely wrong, and should be criminal.

Paying Sales Taxes

online shoppingBypassing the Senate Finance Committee, the Senate passed a bill on Tuesday which would allow states to collect sales taxes from the certain out-of-state retailers.  Since the bill hasn’t passed the House, it’s not law yet, and although the bill passed by a 69-27 vote in the Senate, the future in the House is much less certain.

So what does this mean for you if this bill eventually becomes law?  In theory… nothing.  In reality… you’ll be paying more taxes.

Here are a few relevant facts about sales and use taxes.

  • 45 States and the District of Columbia collect sales taxes.
  • Although referred to as a sales tax, the tax is technically a tax on the use of purchased property and services.  That’s correct… states charge you a tax for the “right” to use something you bought.
  • Since states don’t trust you to pay the correct or full amount of tax, they impose an obligation upon the seller to collect the tax at the time of sale.  Since this is the mechanism for most people paying the tax, it is primarily known as a sales tax.
  • States would like to impose the collection requirement upon every entity selling merchandise to a resident.  However, a 1992 U.S. Supreme Court case restricted a state’s right to impose a collection requirement to those sellers who had a physical presence in the state.

The original clashes over sales tax collection were prior to the advent of the internet and primarily involved mail order sales companies (i.e., those companies that constantly mail you catalogs).  With the boom of the internet and online shopping, the issues have become more nuanced and pronounced, as the battles involve state tax authorities, local retailers (i.e., brick and mortar businesses), online merchants, and governments needing more revenues to balance their books.

States estimate the unpaid tax exceeds $20 billion annually.  Understandably, most state and local politicians are pushing hard to get this legislation passed.   Brick and mortar businesses see it as leveling the playing field.  By not collecting sales taxes, the total purchase price of an item is less expensive, thereby providing an advantage to retailers who don’t collect sales taxes.

Having lived in Vermont for many years, I know the advantage to retailers not collecting sales taxes.  Vermont has a sales tax, and New Hampshire doesn’t.  New Hampshire retailers have a distinct advantage.  Although they may not advertise the absence of sales taxes, people from all over Vermont travel to New Hampshire to make purchases with the sole intent of avoiding the sales tax.

If you buy something out-of-state without paying a sales tax, you’re supposed to remit the required tax to your state tax authorities.  Whether it’s intentional, an oversight or a misunderstanding of the law, few people ever self-assess the taxes owed on their out-of-state purchases.   In all likelihood, if the tax is not collected at the time of sale, it will never be paid.

If the tax is paid by the customer not the seller, why such resistance to collecting the tax?  For most businesses, it’s the cost of compliance.  Sales taxes are assessed and collected at the state level, which means there are 46 different sets of rules.  For instance, clothing may be taxable in one state, but not in another.  Many states also allow city, county and municipal governments to assess their own tax.  As a result, a business would need to keep up with constantly changing rules in each jurisdiction, collect the tax and potentially file hundreds of tax returns.  The cost may easily be absorbed by a billion-dollar national retailer, but could be way too much for a local business selling a few items a week over the internet.

The new legislation changes the rules of taxation.  It’s intended to supersede the U.S. Supreme Court case and eliminate the physical presence requirement.  Essentially, any business selling more than $1 million to out-of-state customers would be required to collect and remit the tax to the appropriate tax authority.

Unless you live in Alaska, Delaware, Montana, New Hampshire or Oregon (states without a sales tax), the legislation is good news and bad news.  The good news is that your state will likely raise some additional revenue by collecting sales tax on purchased items being shipped into your state.  The bad news is you’ll likely be paying some of that tax.  If you’re a business owner looking to create an online sales presence, be prepared.   If you cross the sales threshold, you’ll be required to collect the tax on any sale in the U.S. and be ready to pay large fees to the software providers and professionals you’ll need to help stay in compliance.

The bottom line on this legislation is this

  • You’re ecstatic if you’re a politician looking to raise revenues or if you’re a brick-and-mortar business feeling like your online competitors have an unfair advantage.
  • If you’re a small business whose tax compliance burdens have just multiplied exponentially, you’re probably concerned with how much it’s going to cost you to comply with this mandate.
  • As an average citizen, you’re probably torn between being glad your state and local government will have more money and being unhappy that some of that money is coming from you.

Arithmetic

A few weeks ago, former President Clinton scored political points while criticizing the economic plan of Gov. Mitt Romney.  He touted the Federal budget surpluses during the final years of his presidency.  He went on to say he was able to balance the budget by simple arithmetic.  He also invoked the simple arithmetic principle to argue that Gov. Romney’s plan didn’t add up and would result in a large tax increase on middle class Americans.

The truth is that neither Gov. Romney nor President Obama’s plans pass the arithmetic test.  A detailed analysis of their plans is far beyond the scope if this article, so I’ll briefly summarize.

The highlights of Gov. Romney’s plan:

  • Cut tax rates by 20% for individuals and lower the corporate rate to 25%
  • Have preferential rates for interest, dividends and capital gains
  • Eliminate loopholes and limit certain deductions for higher income taxpayers

The criticism of Romney’s arithmetic is there aren’t enough loopholes to close which will offset the reduced revenue from the lower tax rates.  Deductions would also have to be limited for lower income taxpayers to make the numbers work.

The main point of President Obama’s plan:

  • Increase the tax rates for people making over $250,000
  • Eliminate the preferential rate for dividends and increase the capital gains rate

These changes are estimated to raise an additional $70 billion in annual tax revenues.

The arithmetic doesn’t work for either of these plans to balance the budget.  For the 2012 budget year, the federal government overspent by $1.1 trillion, and the total national debt has exceeded $16 trillion.  Since the government spends approximately $3.5 trillion each year, it’s a monumental task to close a $1.1 trillion deficit.

The U.S. Treasury collects approximately $2.2 trillion in income tax revenue each year.  To balance the budget under the Romney plan, all current deductions would need to be cut in half to raise another $1 trillion.  Deductions would have to be limited even more if the tax rates are reduced.  The Obama plan is no better.  Even if his tax changes were implemented, he’s about $1 trillion short to balance the budget.  By simple arithmetic, the numbers don’t add up… for Romney or Obama.

We can’t tax our way out of the hole we are in.  We must cut spending in order to balance the budget.  This is not Washington semantics for cuts by reducing the rate of growth or cutting the amount you hoped to spend.  It means actually spending less than the $3.5 trillion we spent last year.

On this front, I give the edge to Gov. Romney.  You or I may not agree with his proposals or priorities, but at least he’s willing to talk about cutting federal expenditures.   He was criticized and ridiculed after the first Presidential debate for trying to kill Big Bird, because he advocated ending the federal subsidy to the Public Broadcasting Service.  He has also been willing to tackle the “third rail” of politics – Medicare and Social Security.

In contrast, I can’t think of one significant cut in federal spending proposed by President Obama.  Counting money which would have been spent for the war in Iraq but isn’t going to be spent doesn’t count in my book.  It’s like saying you cut your spending by $5,000 for the vacation you didn’t take.  Furthermore, the budget deficit for 2013 will still be over $1 trillion without any spending for Iraq.  Instead of talking about spending cuts, the President is pushing for more “investments” (aka spending) for teachers and infrastructure.  These may be good things, but it doesn’t address how to balance the budget, and taxing the rich more isn’t going to close the gap.

Politicians are very good at using sound bites and obscuring the truth.  President Clinton was right… balancing the budget is simply a matter of arithmetic.  In this case, both candidates (and most members of Congress) probably need a remedial math class.

The Buffett Rule

On Monday President Obama unveiled his deficit reduction plan.  In addition to reducing the deficit, he outlined his ideas to pay for the American Jobs Act he proposed two weeks ago.   No surprise his plan includes tax increases on more wealthy Americans.  Phrases such as “shared sacrifice” and people paying “their fair share” make for good sound bites.  However with Washington, the challenge is often deciphering what their pithy sayings mean.

He referenced the “Buffett Rule” as one of his proposals.  It’s named after Billionaire Warren Buffett who has been rather outspoken about the need to raise taxes on the super-wealthy.  Cueing off of a New York Times op-ed piece written by Mr. Buffett a few weeks ago, the Buffett Rule is supposed to make sure people who make over $1 million a year will pay a higher percentage of their income in taxes than someone who makes less than the $1 million threshold.

You may agree or disagree with the concept of the Buffett Rule.  Regardless if you think it’s a good idea, I have three primary issues with the proposed Buffett Rule.

  1. Additional Complexity.  As a tax professional, I can attest that the tax code is exceptionally complex and at times unwieldy.  With the myriad of deductions, exemptions and exceptions, it will be virtually impossible to make sure some making over $1 million will pay taxes at a higher rate than someone making less.  Everyone’s tax situation is unique, so it’s near impossible to offer such a guarantee.  It may sound simple, but it’s going to be very difficult to achieve.
  2. Increased Tax Avoidance.  While it may be good for those of us in the tax business, I can assure you that there will be a host of tax professionals looking for ways to minimize the tax liabilities of their clients under whatever new rules are enacted.  It’s simple economics.  The higher the tax rate, the more cost-effective it is to pay someone to find strategies which minimize your taxes.   You may have your opinions about what’s fair and right, but there is nothing illegal or immoral about structuring your affairs to pay less tax.  Tax evasion is illegal, but tax avoidance is not.  As I recently wrote, if you personally feel like you aren’t paying your fair share, then I would encourage you to make a voluntary contribution to the U.S. Treasury.  Trust me… they’ll take your money.  Political discourse and debate are fine, but it’s wrong to castigate someone who is abiding by the law because you don’t think the result is fair.
  3. Unintended Consequences.  Congress has a lousy track record of using the tax code to target certain persons.  The Law of Unintended Consequences often kicks in, and the negative ramifications are often much more detrimental than anyone anticipated.  Two great examples come to mind; one recent and one from decades ago.  The 1099 reporting provision included in the health care reform is the most recent Congressional bumbling.  As soon as it was passed, it became clear the administrative nightmare would far exceed any benefits obtained.  Fortunately, Congress repealed it before it became effective.  The Alternative Minimum Tax (AMT) is the classic example of unintended consequences.  The AMT was enacted in 1969 to tax 155 wealthy families who were viewed as not paying their fair share.  By 2008, 3.9 million taxpayers were subject to AMT, and 27% of them made less than $200,000. This probably isn’t what the 91st Congress had in mind.

The Buffett Rule may cause some wealthy people to pay more in taxes, but if history is a predictor of the future, the long-term results will be much different than expected.  Such targeted tax policy generally hasn’t yielded the desired results.  I’m not sure why they think the Buffett Rule will be any different.

Raising Taxes on the Super-Rich

Billionaire Warren Buffett made headlines last week with an opinion article he wrote for the New York Times.  His statement “My friends and I have been coddled enough by a billionaire-friendly Congress” attracted a lot of media attention and discussion.

In writing, “It’s time for our government to get serious about shared sacrifice” you can deduce his apparent attempt to sway public opinion and encourage Congress to increase the tax burden upon the wealthiest individuals in the country.  He generally described the targets for the additional sacrifice as those making over $1 million each year, but he didn’t offer specific proposals or suggestions of what additional sacrifice they should be required to make.

In the article, Mr. Buffett disclosed his 2010 tax liability of $6,938,744, which he said was 17.4% of his 2010 income.  It’s a hefty sum; not surprising for one of the world’s richest men.  Most of us would be happy to earn $6,938,744 in our lifetime, let alone pay that much in taxes in one year.

I have no qualms with Mr. Buffett sharing his opinion and participating in the debate over U.S. tax policy.  It’s part of his First Amendment rights to free speech.  Hypothetically, I would ask Mr. Buffett one question… if you believe your taxes are too low, what’s stopping you from paying more?

If Mr. Buffett thought $6,938,744 was insufficient or not his fair share, what prevented him from paying more?  I contend the only thing preventing him from paying a greater sum was himself.   If he chose, Mr. Buffett could have voluntarily added to his 2010 tax liability whatever additional amount he thought was fair.  The U.S. Treasury would have gladly accepted his additional contribution.

His tax liability of $6,938,744 is a rather exact number.  While not explicitly stated, it’s implied this was the statutory amount he was required to pay.  Thus, he paid the minimum amount he was legally obligated to pay, which is what everyone does, irrespective of their socio-economic status.

I may be cynical, but I know many wealthy people who advocate for government spending and programs, yet are constantly trying to minimize their personal tax liabilities.  There is nothing wrong with minimizing your tax liability.  It is part of what I do for people on a daily basis.  However, I see a tinge of hypocrisy when you think others should pay more tax, yet look for “loopholes” for yourself.

I think Mr. Buffett’s credibility in advocating for higher personal income taxes would be bolstered if he chose to make a voluntary contribution above and beyond the minimum required tax liability. His convictions would be demonstrated by his actions and not just his words.

That’s my opinion. What’s yours?