Florida Tax Attorney Blog

The American Taxpayer Relief Act of 2012 ("2012 Taxpayer Relief Act") was signed into law by President Obama on January 2, 2013. The 2012 Taxpayer Relief Act overrides several tax increases that were scheduled to go into effect in 2013 and preserves several favorable tax provisions that were set to expire at the end of 2012. At the same time, the 2012 Taxpayer Relief Act increases income taxes for certain high income earners and slightly increases transfer tax rates.

Below is a summary of how the provisions of the 2012 Taxpayer Relief Act will impact individual taxpayers.

Preservation of Income Tax Rates for Most Individuals

Income tax rates for most individuals will remain at 10%, 15%, 25%, 28%, 33%, and 35% (as opposed to moving to 15%, 28%, 31%, 36%, and 39.6% as would have otherwise occurred). Note, however, that certain high-income individuals will be subject to an increased tax rate of 39.6% beginning in 2012.

Tax Rate Increases For High Income Individuals

Although the 2012 Taxpayer Relief Act preserved lower income tax brackets for the majority of Americans, tax rates will increase for certain high income individuals. Specifically, a 39.6% rate will apply to income that exceeds an "applicable threshold." The "applicable threshold" is $450,000 for joint filers, $425,000 for heads of household, $400,000 for single filers, and $225,000 for married taxpayers filing separately. These dollar amounts are subject to adjustments for inflation for tax years after 2013.

Capital Gain and Dividend Rate Increases for Higher-Income Taxpayers.

The 2012 Taxpayer Relief Act raised the maximum rate for capital gains and dividends to 20% (up from 15%) for taxpayers with incomes exceeding $400,000 ($450,000 for married filing jointly). In addition, these high-income taxpayers will be subject to the 3.8% surtax on investment income under Section1411 of the Internal Revenue Code, resulting in an aggregate tax rate of 23.8% for higher-income taxpayers.

Capital Gain and Dividend Rates for Other Taxpayers

For taxpayers who are taxed on ordinary income at a rate below 25%, capital gains and dividends will permanently be subject to a 0% rate. Thus, some lower-income taxpayers may actually realize tax savings as compared to the previous rates.

For taxpayers who are taxed on ordinary income at a rate of 25% or more (but whose income levels fall below the $400,000/$450,000"applicable threshold") will continue to be subject to a 15% rate on capital gains and dividends.

In addition, certain taxpayers will be subject to the 3.8% surtax (i.e. married taxpayers with modified adjusted income in excess of $250,000 ($125,000 if married filing separately), all other taxpayers with modified adjusted income in excess of $200,000). For these taxpayers, the maximum tax rate for capital gains and dividends will be 18.8% (15% + 3.8% surtax).

Alternative Minimum Tax ("AMT") Relief

In a nutshell, the AMT is the excess, if any, of the tentative minimum tax for the year over the regular tax for the year. The tentative minimum tax is calculated by adjusting the regularly computed tax liability for certain items. The resulting amount is the alternative minimum taxable income (AMTI), which is subject to an AMT rate of 26% or 28%. The purpose of the AMT is to ensure that higher income taxpayers who would otherwise be able to offset substantial income through the use of favorable deductions and tax credits are liable for a minimum amount of tax. This summary vastly oversimplifies the AMT and is only meant to provide general background information.

Without the 2012 Taxpayer Relief Act, the individual AMT exemption amounts for 2012 would have been $33,750 for single taxpayers, $45,000 for joint filers, and $22,500 for married taxpayers filing separately. Tthe 2012 Taxpayer Relief Act retroactively increased these exemption amounts to $50,600 for single taxpayers, $78,750 for joint filers and $39,375 for married taxpayers filing separately.

Also, without the 2012 Taxpayer Relief Act, many nonrefundable personal tax credits were allowed only to the extent that an individual taxpayer's regular income tax liability exceeded his tentative minimum tax. The 2012 Taxpayer Relief Act retroactively (for tax years beginning after 2011) allows an individual taxpayer to offset his entire regular tax liability and AMT liability by the nonrefundable personal credits.

Retention of Transfer Tax Exemption Amounts (Subject to Rate Increase)

The 2012 Taxpayer Relief Act thwarted a sharp increase in estate, gift and generation-skipping transfer taxes that were scheduled to occur for individuals dying and gifts made after 2012 by permanently preserving the $5 million exemption amount (subject to adjustment for inflation). Note, however, that the 2012 Taxpayer Relief Act also increases the maximum estate, gift and generation-skipping transfer rate from 35% to 40%. As a final note, the 2012 Taxpayer Relief Act maintains the portability feature that allows the estate of the first spouse to die to transfer his or her unused exclusion to the surviving spouse.

Extension of Certain Favorable Tax Provisions for Individuals

The 2012 Taxpayer Relief Act extends the following favorable tax items for individuals that were set to expire at the end of 2012:

American Opportunity Tax Credit extended for 5 years - permits eligible taxpayers to claim a tax credit equal to 100% of the first $2,000 of qualified tuition and related expenses, and 25% of the next $2,000 of qualified tuition and related expenses (for a maximum tax credit of $2,500 for the first four years of post-secondary education)

Deduction for Classroom Expenses of Elementary and Secondary School Teachers - originally expired at the end of 2011; has been revived for 2012 and 2013

Exclusion of Discharge of Qualified Principal Residence Indebtedness from Income - originally applicable to discharges before January 1, 2013; now extended to apply to discharges before January 1, 2014

Treatment of Mortgage Insurance Premiums as Qualified Residence Interest - expired at the end of 2011; has been revived for 2012 and 2013

Option to Deduct State and Local Sales Taxes - expired at the end of 2011; has been revived for 2012 and 2013

Special Rule for Contributions of Capital Gain Real Property made for Conservation Purposes - expired at the end of 2011; has been revived for 2012 and 2013

Above-the-line Deduction for Qualified Tuition Expenses - expired at the end of 2011; has been revived for 2012 and 2013

Tax-Free Distributions from Individual Retirement Plans for Charitable Purposes - expired at the end of 2011; has been revived for 2012 and 2013. (Note: Because 2012 has already passed, a special rule allows distributions taken in 2012 to be transferred to charities for a limited period in 2013. In addition, certain distributions made in 2013 can be treated as deemed made on December 31, 2012)

50% Bonus Depreciation - extended for 1 year so that bonus depreciation continues to be available for qualified property placed in service before 2014

The Supreme Court is set to review the Defense of Marriage Act ("DOMA") soon. In my opinion, DOMA violates at least three separate provisions of the U.S. Constitution. Most obviously, DOMA clearly violates the explicit guarantee of equality contained in the Equal Protection Clause. In addition, DOMA violates the Due Process Clause insofar as it deprives a significant minority of Americans of the constitutional right of marriage. Finally, DOMA arguably violates the First Amendment's guarantees of religious freedom insofar as primary opposition to same-sex marriage appears to be religiously based. In light of the foregoing, I expect the Supreme Court to invalidate DOMA. From a tax perspective, the invalidation of DOMA will trigger a right to tax refunds for prior year overpayments (because same-sex married couples have been denied the favorable tax treatment associated with being married). From a tax planning perspective, same-sex couples who may be entitled to a tax benefit should not wait for a final decision from the Supreme Court before filing a protective refund claim with the Internal Revenue Service. Rather, same-sex couples who are legally married should file claims now in order to protect their refund rights from expiring under the three-year statute of limitations that applies with respect to tax refund claims.

The Digital Goods and Services Tax Fairness Act (H.R. 1860) was introduced May 12, 2011 and would prohibit state and local governments from imposing taxes on certain sales of digital goods and services that are taxable under current law. The stated intention of H.R. 1860 is to promote neutrality, simplicity, and fairness in the taxation of electronic goods and services. But good intentions are not enough.

As a threshold matter, the proposed legislation arguably exceeds Congress' enumerated powers.

Commerce Clause. The Supreme Court has substantially narrowed its interpretation of the scope of the commerce power in recent years. In this regard, the Court has emphasized the importance of distinguishing between national matters and matters that are truly local. State and local taxation is a local matter insofar as revenue needs and tax issues vary among jurisdictions. The states are in the better position to identify issues with their tax systems and implement remedial measures.

14th Amendment. State action is a necessary prerequisite to the exercise of Congress' Section 5 power. It does not appear that Congress has made any factual findings of actual incidences of discriminatory taxation. To be sure, preventative rules are sometimes necessary, but even then, they must be appropriately tailored to reach the perceived threat in order to pass constitutional muster. The restrictions imposed on states' taxing rights by this legislation are too great in comparison to the threat of discriminatory taxation.

Even if Congress has authority to enact this legislation, the focus on tangible versus intangible is misplaced. A sales tax is best summarized as a tax on consumption. In this respect, there are two basic precepts to the sales tax: (1) all personal consumption should be taxed; and (2) all business inputs should be exempt. Yet, the inquiry as to whether the thing being conveyed is tangible or intangible says nothing about personal consumption or business inputs. Not only does this legislation focus on the wrong issue, but it also explicitly contravenes the established principle that business inputs should not be taxed. See Sec. 5(2)(B) (specifying business location as tax address for sourcing purposes when item is delivered to a business); Sec. 5(2)(F) (indicating that advertising services are sales taxable).

Moreover, although the proposed legislation apparently seeks to "promote neutrality, simplicity, and fairness in the taxation of digital goods and services," it will actually do the opposite. A "digital good" includes a variety of downloadable content - e.g., software, music albums, films, e-books, photography. Significantly, the downloaded content is no different than the content acquired through off-the-shelf software, CDs, DVDs, traditional books, or traditional photos. Yet, these items would be subject to a special federal tax regime under the proposed legislation. Such disparity is not neutral, simple, or fair. The substance of the transaction rather than the form of delivery should govern tax consequences. In this respect, the focus should be on consumption.

To be sure, risks of multiple taxation remain even when the focus is on consumption. However, States are competent to deal with these issues, and the drafters of this bill would agree according to Section 8 (expressing States' competency to deal with multiple taxation in international context). In the e-commerce environment, the issues of multiple taxation are similar domestically and internationally. So if Congress has faith in the States' ability to handle the issue on an international level, then the States are certainly competent to handle the issue domestically.

A federal court has held the denial of federal tax benefits to same-sex couples to be unconstitutional. More specifically, the Second Circuit held that the federal government unconstitutionally denied an estate tax marital deduction to a same-sex couple. See Windsor v. U.S., 2d. Cir., No. 12-2335-cv(L) (October 18, 2012).

But the implications of this case are far broader than the tax implications. Significantly, the Windsor Court treated sexual orientation as a quasi-suspect class, applying a heightened level of constitutional scrutiny. From an analytical perspective, this is a perceptible and welcomed improvement from many prior cases which have identified sexual orientation as a non-suspect class subject to an extremely low threshold of constitutional review. Moreover, the Court held that the denial of the federal tax benefit in this case was unconstitutional based on the broader holding that Section 3 of the Defense of Marriage Act ("DOMA")* was unconstitutional. This is another big step toward marriage equality.

*Section 3 of the Defense of Marriage Act ("DOMA") defines "marriage" as a relationship between a man and a woman and thereby legally codifies the non-recognition of same-sex marriages for all federal purposes, including federal tax benefits.

Tax policy is always a heavily discussed topic in election years. But before you blindly subscribe to either candidate's tax promises, you may want to consider that neither Romney's nor Obama's tax plan adds up mathematically.

Romney's Tax Plan:

Romney claims that he will reduce, or in some cases eliminate, most taxes. More specifically, Romney has claimed that he will:

- extend the Bush era tax cuts;
- reduce individual tax rates by some twenty percent;
- largely eliminate taxes on dividends and capital gains;
- repeal the estate tax;
- repeal the alternative minimum tax; and
- reverse Obama's healthcare reform tax.

Unbelievably, Romney claims that he can do all of this and yet still retain the progressivity of the current tax system. Of course, Romney has not yet revealed how he will implement these tax initiatives without adding to the existing deficit or converting the U.S. tax system to a regressive system. This is not surprising. After all, the sum cannot be greater than the parts that make it up. In this case, it would be literally impossible to implement all of these tax cuts while simultaneously retaining progressivity and reversing the national deficit.

Obama's Tax Plan:

Obama's signature tax proposal is the millionaire's tax, which would require Americans earning more than $1 million to pay some minimum tax rate. But while the millionaire's tax is good political speech, such a tax would affect less than 450,000 Americans in practice and generate a relatively small amount of revenue in relation to the national deficit. Yet, Obama claims that he will be able to raise some $206 billion over a ten year period in large part by eliminating the Bush era tax cuts and imposing a millionaire's tax. Of course, Obama has yet to reveal how these various tax initiatives will add up to $206 billion in the aggregate. This is not surprising. Again, the sum can only be as great as the parts that make it up. And in this case, $206 billion is literally not mathematically possible based on Obama's tax proposals.

A recent article published by Soundings Trade Only Today, a news source for marine industry professionals, touted the success of Florida's $18,000 sales and use tax cap on boats purchased or brought into Florida. According to the article, Florida generated some $13.4 million in direct sales tax revenue from sales of tax-capped boats during 2011.

According to a joint study conducted by the Florida Yacht Brokers Association (FYBA) and the Marine Industries Association of South Florida, the marine sales tax cap, which was enacted in 2010, has impacted the maritime industry in two significant respects. First, the average sale price for post- sales tax cap transactions was about $907,000. This figure represents nearly twice the average pre- sales tax cap. Second, out-of-state closings (presumptively to avoid sales tax) dropped from 21.5 percent to 12.8 percent.

In light of the success of the marine sales tax cap, a spokesman for FYBA stated that "setting a reasonable tax basis for high dollar purchases provides an incentive for more boats to be purchased, provisioned and kept plying the waters of Florida." Of course, this is a basic principle of tax policy in general. Unfortunately, however, this fundamental principle seems to have been forgotten in this new "occupy Wall Street" era of proposed "millionaire's taxes."
Aside from the inherently unresolvable policy issues associated with a millionaire's tax (e.g., class warfare, enhancing the social gap while only minimally closing the economic gap between the rich and the poor), raising taxes leads to decreased spending. While this may be less true with respect to inelastic items such as food, housing, and transportation, it cannot be debated with respect to more elastic luxury items . By contrast, reducing taxes stimulates the economy by boosting spending.

On the surface, one might be unsympathetic to the plight of the white-collar tax payer who is required to reduce his or her discretionary spending on luxury items such as boats, traveling, dining out, etc. But in the end, it all comes back to the middle-class because it is the middle class who will inevitably bear the incidence of a millionaire's tax. It is the middle-class who work in the shipyards where the boats are manufactured and the boat dealerships and brokerage houses where the boats are sold. It is the middle class who work and operate the upscale restaurants in which the wealthy dine. It is the middle class who repair and sell the Bentleys, Mercedes, and Porsches which the wealthy drive. The list goes on and on.

Moral of the Story: Love them or hate them, the spending habits of the wealthy keep many Americans employed. So don't kill the goose that lays the golden egg.

The Florida maritime sales tax cap is compelling evidence of the longstanding and well-established principle that reasonable levels of taxation stimulate economic growth. With that being said, other areas of government - both local and federal - would be well-advised to follow the Florida maritime industry's lead.

An allowance for costs of corporate equity financing has been proposed in the United Kingdom as a means of eliminating the distortions created by the debt-equity distinction in the corporate tax context. See Institute for Fiscal Studies, Tax By Design: The Mirrlees Review.This proposal comes after a comprehensive review of the British tax system (the "Mirrlees Review") by a prominent group of international tax experts. The study identified traits of a desirable modern tax system and assessed the U.K.'s tax system to determine the extent to which it conforms to these principles. Belgium enacted a similar allowance in 2005 which has substantially enhanced the efficiency of its corporate tax system.

Like the British tax system, the U.S. tax system encourages debt financing by permitting tax deductions for interest paid but not for dividends paid. A tax deduction for costs of equity financing would deincentivize extensive corporate leveraging and neutralize debt-to-equity ratios. In essence, tax considerations would be eliminated (as they should be) from the decision of whether to employ debt or equity financing. As a result, corporations would become more efficiently structured from a capital perspective and resources which are currently being allocated to tax planning could be reallocated to more value-added activities.

For instance, under current U.S. tax law, the determination of whether an instrument should be treated as debt or equity involves a balancing test, which is quite costly in terms of both time and money, to determine whether the instrument is more like debt or equity. See I.R.C. § 385(b). Under this balancing test, the following factors are considered:

• Whether there is a written unconditional promise to pay, on demand or on a fixed date, a sum certain in money in return for an adequate consideration, and to pay a fixed rate of interest;

• Whether there is subordination to or preference over any corporate indebtedness;

• The ratio of debt to equity;

• Whether there is convertibility into common stock; and

• The relationship between the holdings of stock in the corp and the holdings of the interest in question

A U.S. deduction for costs of equity financing would largely eliminate the need for corporations to engage in this type of fact-intensive analysis at the tax planning stage to create instruments that possess traditional indicia of debt. Moreover, it would cut down on the constant tension between corporate taxpayers and the IRS in the debt-equity context. Finally, it would substantially reduce litigation in this area and consequently relieve the overburdened federal court dockets to some degree.

In Healthpoint, Ltd. v. Commissioner, T.C. Memo 2011-24, the U.S. Tax Court addressed the frequently considered question of whether amounts received in settlement of litigation should be taxed as capital gain or ordinary income. The conclusion: it depends. This is because the character of the income for tax purposes is determined by the nature of the settlement award itself. Stated more simply, tax character depends on what the recipient of the award is being compensated for. For instance, punitive damages would be taxed as ordinary income. On the other hand, reputation damages would be taxed as capital gain. In the past, this has generally meant that settlement agreements determined tax consequences. That is, the parties to the settlement would include an allocation of the settlement award among various types of damages within the settlement agreement itself, and that allocation would determine the income tax consequences to the recipient. Significantly, however, the IRS successfully challenged the parties' allocation in Healthpoint.

Facts. Healthpoint Ltd. ("Healthpoint"), a specialty pharmaceutical company, owned the exclusive rights to a popular prescription cream used in the treatment of wounds. Ethex Corporation ("Ethex"), another pharmaceutical company, developed a competing cream which it marketed as comparable to Healthpoint's popular ointment. In reality, Ethex's cream was not comparable to Healthpoint's cream at all. To the contrary, it was formulated with different ingredients, and many users experienced side effects and otherwise adverse results.

Because Ethex marketed its cream as comparable to Healthpoint's cream, doctors and other healthcare practitioners stopped prescribing both creams as a result of the negative patient experiences with the Ethex cream. As a result, Healthpoint experienced lower-than-projected sales and brought suit against Ethex for its lost profits. Specifically, the lawsuit alleged false advertising, unfair competition, misappropriation, and trademark dilution. In the meantime, Ethex formulated an improved version of its cream and brought it to market while Healthpoint's lawsuit against it was pending. Healthpoint responded with a second lawsuit, raising the same allegations as in the first suit, plus trademark theft.

The first lawsuit ultimately awarded Healthpoint $16.5 million in damages, allocated as follows:

Actual Damges: $5 million

Lost Profits: $1.64 million

Punitive Damages: $3.2 million

Trademark Dilution: $6.3 million

Ethex appealed, and the parties entered into settlement negotiations while the appeal was pending. Ultimately, the parties agreed to settle both lawsuits for $15.8 million, allocated as follows:

Lawsuit #1:

Damage to Goodwill and Reputation: $10.45 million

Lost Profits: $1.35 million

Lawsuit #2:

Damage to Goodwill and Reputation: $4.05 million

Lost Profits: $450,000

As a result, Healthpoint reported $1.8 million of ordinary income and $14.5 million of capital gain. This character differential could have been inconsequential if Healthpoint were a corporation without substantial capital losses (because corporations are not entitled to the preferential capital gains rates). However, because Healthpoint was structured as a partnership, all tax attributes passed through to the individual partner level. Thus, there were substantial tax savings to be had here by characterizing the bulk of the settlement award as capital gain. Not surprisingly, the IRS challenged Healthpoint's characterization, and the issue was litigated before the Tax Court.

Holding. In the end, the Tax Court reallocated the settlement award in a way that reflected what it perceived to be the economic realities of the underlying claims. This included a partial allocation for punitive damages, which are taxable as ordinary income, despite explicit language in the settlement agreement stating that no portion of the settlement amount constituted a punitive damage award.

Practical Implications. Settlement agreements will be afforded less weight in determining tax consequences going forward. As a result, taxpayers must be able to substantiate any allocation of the settlement proceeds that the settlement agreement purports to make. In other words, it is no longer sufficient to simply set forth an allocation of damages in the settlement agreement.

How to avoid the Healthpoint result. In recharacterizing the allocation of the settlement award, the Tax Court emphasized that Healthpoint failed to provide any documentation to support or otherwise justify its allocations. Additionally, the Court pointed out that Healthpoint was cognizant of the tax consequences of its allocation. With that being said, I would urge taxpayers in settlement negotiations to do two things: (1) create a paper trail to support the allocation of the settlement award; and (2) deemphasize any tax motivation for certain allocations during settlement negotiations.

Buyer and Seller enter into a purchase and sale contract pursuant to which buyer places a deposit. Buyer breaches contract. Seller retains deposit. It happens more than you would think. And an interesting tax question is presented when it does: does the retained deposit constitute taxable income to the seller? And if so, is that income taxed as ordinary income rates? Or can the seller take advantage of the preferential capital gains rates?

As an initial matter, it should be noted that a "sale or other disposition of property" is a necessary precondition to a capital gain. See I.R.C. 1001(a). Obviously, there is no sale where a seller retains a deposit as a consequence of a contractual breach on the buyer's part. But is there a "disposition" within the meaning of I.R.C. 1001?

At the outset, the answer would appear to be an obvious no insofar as the seller continues to hold title to the property. After all, isn't disposal of the asset an essential component of an asset disposition?

One would think so. However, the U.S. Tax Court has analogized earnest money deposits to option payments. See e.g., Ahadpour v. Commissioner, TC Memo 1999-9. This is significant because there is language in the Internal Revenue Code which treats gain realized on the lapse of an option as capital gain.

Specifically, I.R.C. 1234(b)(1) provides:

In the case of the grantor of the option . . . gain on lapse of an option in property shall be treated as a gain . . . from the sale or exchange of a capital asset held not more than one year."

To be sure, "property" is narrowly defined for purposes of Section 1234 to include only stock, securities, commodities, and commodity futures. IRC § 1234(b)(2)(B). However, the Taxpayer Relief Act of 1997 extended sale or exchange treatment to "any property . . . [that] is a capital asset in the hands of the taxpayer." I.R.C. 1234A (emphasis added). In this regard, the legislative history of I.R.C. 1234A explicitly lists forfeiture of a down payment under a contract as an example of the type of property to which Section 1234A applies. See Staff of the Joint Comm. on Tax'n, General Explanation of Tax Legislation Enacted in 1997, 105th Cong., 1st Sess. 189.

But Section 1234(b)(1) treats a gain on lapse of an option as a short-term capital gain, and the preferential capital gains tax rates are only available for long-term capital gains. See I.R.C. 1234(b)(1) ("[G]ain on lapse of an option in property shall be treated as a gain . . . from the sale or exchange of a capital asset held not more than one year") (emphasis added); see generally I.R.C. 1(h).

Significantly, however, Section 1234A provides for treatment as "gain or loss from the sale of a capital asset." This is in contrast to Section 1234(b), which provides for treatment as "gain . . . from the sale or exchange of a capital asset held not more than one year." (emphasis added). Presumably, if Congress had intended to provide for short-term capital loss treatment in Section 1234A, it could have easily done so by including language similar to that which is found in 1234(b).

With that being said, the plain language of I.R.C. 1234A arguably supports long-term capital gain treatment of the retained deposit. (Of course, the counter-argument would be that I.R.C. 1234A was intended to extend I.R.C. 1234(b)'s sale or exchange treatment to a broader class of property, and as such, it should be construed consistently with that provision).

In any event, it should be emphasized that in Ahadpour (cited above for treatment of earnest money deposit as option to purchase), the Tax Court treated the forfeited deposit as ordinary income. Although this decision was issued in 1999, after the 1976 addition of 1234(b) and the 1997 addition of 1234A, the Court relied on pre-1234A case law in reaching that result. Thus, it is questionable whether this case was correctly reasoned.

The American Opportunity Tax Credit provides up to $ 2,500 per eligible student for qualified educational expenses (e.g., tuition, books, supplies) at the undergraduate level. Up to forty percent of the credit - or $1,000 - is refundable.

According to a recent Treasury report, the government has erroneously granted and taxpayers have wrongly received nearly $3.2 billion in American Opportunity Tax Credits. The report attributes this $3.2 billion error to ineffective IRS procedures for the review of education credits. To this end, the Treasury has forecasted that an additional $12.8 billion in wrongfully claimed education credits will be granted over the next four years under the current system of review.

In the wake of this report, the IRS has announced that it will closely scrutinize all tax returns that claim education tax credits going forward.

The good news is that the Treasury will save $12.8 billion over the next four years that it would have otherwise erroneously paid out in the form of wrongly claimed education credits. The bad news is that taxpayers claiming education credits will have their returns more closely scrutinized. In this regard, it is important not only to ensure that any education credits claimed are bona fide, but also that the tax return is accurate in all other respects since the return will be isolated for closer review.

Not only will the IRS more closely scrutinize tax returns that claim education credits, but it will also require taxpayers to provide more documentary support than in the past for any education credits claimed. The IRS is currently revising Form 8863, which is used to claim the Opportunity credit, and beginning in 2012, taxpayers claiming this credit must identify their educational institution on the Form 8863.

In addition, the IRS is considering a joint effort with the Department of Education whereby the Department would provide educational information to the IRS that could be used to verify taxpayers' eligibility for the credit.

Under current tax law, receipt of an insubstantial benefit in connection with a charitable contribution will not adversely affect or otherwise limit the deductibility of the contribution for tax purposes.

However, an interesting tax question is raised where a donor receives naming rights to a building or other capital facility in exchange for a contribution. Indeed, the fact that this type of charitable giving may be motivated by (or even conditioned on) receiving naming rights raises serious tax questions about the nature of the "gift."

Deductibility. In order to be deductible as a charitable gift, a contribution must be made without expectancy of any sort of return benefit. To this end, the U.S. Tax Court has stated, "[i]f a payment proceeds primarily from the incentive of anticipated benefit to the payor beyond the satisfaction which flows from the performance of a generous act, it is not a gift. DeJong v. Commissioner, 36 T.C. 896, 899 (1961). In this spirit, the IRS has limited deductibility where the donor receives a substantial benefit in connection with a contribution. E.g., Rev. Rul. 86-63 (emphasis added); see also I.R.C. 170(c). Thus, in situations where a donor makes a contribution with an expectation of receiving naming rights, the question becomes one of substantiality.

Are naming rights a substantial benefit? A 1986 Revenue Ruling issued by the IRS relating to contributions to collegiate athletic programs may provide some guidance in this area. See Rev. Rul. 86-63, 1986-1 C.B. 88. In this ruling, the IRS held that a charitable deduction is disallowed to the extent of any benefit received. However, a charitable deduction is still allowed to the extent that the contribution exceeds the value of the received benefit. Thus, if a taxpayer donates $500 to a college athletic program and receives football tickets valued at $300, a charitable deduction of $200 will be allowed. See Rev. Rul. 86-63. At the same time, the U.S. Supreme Court has clearly indicated that insubstantial benefits received in connection with a contribution are not necessarily considered. Specifically, the Supreme Court has stated that, "[w]here the size of the payment is clearly out of proportion to the benefit received, it would not serve the purposes of section 170 to deny a deduction." See U.S. v. American Bar Endowment, 477 U.S. 105, 117 (1986).

In the context of naming rights, then, the essential question is one of valuation. But how is the opportunity to name a building or other capital facility valued? The valuation issue is further complicated by the fact that different taxpayers may value naming rights differently. For instance, naming rights would likely be more valuable to a corporation than to an individual philanthropist due to the advertisement and exposure value that comes with it.

Minimum Donation Requirements.Where church members deducted a fixed amount paid to the Church of Scientology in exchange for some type of religious training, the U.S. Supreme Court held that there was no gift at all because the taxpayers received services with a measurable value. See Hernandez v. Commissioner, 490 U.S. 680, 691 (1989). As the Court explained, the value of the services was measurable because it was fixed by the church. Id. In this spirit, the Supreme Court disallowed the charitable deduction and held that only bona fide gifts are deductible. In this regard, the Court stated that a gift is not bona fide to the extent that the donor expects to receive a benefit in return.

Often, a university or other organization will fix a minimum donation as a prerequisite to receiving naming rights. It seems that the IRS could disallow a deduction to the extent of the dollar amount fixed by the organization based on the current law. The question is whether it should. And more importantly, whether it would.

In response to my recent article discussing the inappropriateness of value-added taxation in the United States, one reader has directed me to an article written by David Ignatius, which raises a compelling counter-argument. In essence, Mr. Ignatius argues that the U.S. is comparable to Greece in the sense that: (1) like Greece, the U.S. has spent more money than it has earned and borrowed to cover the resulting deficit for many years; and (2) like Greece (pre-EU/IMF bailout), the U.S. is one of the only nations without a system of a value-added taxation in place. Accordingly, he suggests that, unless the U.S. implements a value-added tax (VAT), it will experience a large-scale financial meltdown similar to the recent Greek fiscal crisis.

While I understand the logic of Mr. Ignatius' argument, I respectfully believe that his reasoning is flawed on 2 levels:

(1) A 21% VAT did not save the Greek government. To adopt a solution that failed for Greece in an effort to prevent what happened in Greece is counterintuitive.

As far as Greece's VAT goes, it should be noted that it was probably involuntary. The International Monetary Fund (IMF) routinely conditions loans on implementation of a VAT. In addition, European Union (EU) law requires that every member state adopt a VAT that conforms to EU standards. Thus, it is likely that Greece's enactment of a VAT was motivated by its need for financial bailout by the EU and the IMF.

(2) The root of the Greek fiscal crisis was rampant tax evasion, not proliferate government spending. Indeed, international comparisons reveal that tax evasion in Greece is among the worst in the developed world.

The high levels of tax evasion in Greece are largely attributable to the structure of its economy. Unlike the corporate-dominated landscape of American business, the Greek economy is comprised primarily of "mom and pop" operations, which can easily avoid reporting income. Thus, the conditions for underground business activity and tax evasion are optimal in Greece. The structural distinctions between the American and Greek economies in this sense really preclude any meaningful analogy of the U.S. economy to the Greek economy.

Continue reading "VALUE-ADDED TAXATION DID NOT WORK FOR GREECE, AND IT WILL NOT WORK FOR U.S. " »

Florida Republican Ileana Ros-Lehtinen became the 125th sponsor of a bill to repeal the Defense of Marriage Act (DOMA) last week.

Under DOMA, "the word 'marriage' means only a legal union between one man and one woman as husband and wife, and the word 'spouse' refers only to a person of the opposite sex who is a husband or a wife."

In this single sentence, our law unfairly deprives same-sex couples of countless federal benefits, including, without limitation:

• Social Security & Medicare Benefits;

• Veterans' Benefits;

• Employment Benefits;

• Military Service Benefits;

• Immigration and Naturalization Rights;

• Federal Tax Benefits

In the tax context, this means that same-sex couples who have been validly married under the laws of their states are explicitly denied the federal tax benefits associated with being married. At the most basic level, this precludes a married same-sex couple from filing a joint tax return. As a result, the couple cannot take advantage of the lower tax brackets available to married couples. Because same-sex couples must file separate tax returns, many couples lose thousands of dollars each year.

This result is constitutionally offensive in a Nation that claims to guarantee equal protection. Indeed, the men who founded our country must be rolling in their graves right now.

To be sure, this Nation was founded by Christians. But by Christians who were fleeing religious persecution and intolerance. By Christians who specifically intended to avoid establishment of a government religion. By Christians who created the First Amendment - which provides for a right to freely exercise any religion (or no religion) and prohibits an establishment of religion by the government - to avoid the religious strife and intolerance that plagued their homeland of England. By Christians who were committed to erecting a "wall of separation" between the government and all forms of religion.

The opposition to same-sex marriage is a predominantly religious one. Indeed, the vast majority of opponents cite bible verses as evidence of the immorality of same-sex marriage. Their reliance on the bible, however, is misplaced, for religion has no place in government, law, or politics. And our political system's preoccupation with this issue has seriously blurred the line between state and religion.

With that being said, I believe that opponents of same-sex marriage are operating under a fundamental misconception of the U.S. Constitution.

Continue reading "SEPARATE IS NOT EQUAL: SAME-SEX COUPLES SHOULD BE ENTITLED TO FEDERAL TAX BENEFITS " »

In its January 2011 report, the Congressional Budget Office (CBO) estimated that America's expanding spending policy will generate a combined deficit of nearly $8.5 trillion over the ten-year period from 2011 to 2021. Significantly, 30% of this projected overspending ($2.5 trillion) will be incurred in 2011 and 2012 alone. These projections are in spite of the CBO's warning last year that, "[t]o keep federal deficits and debt from reaching levels that would substantially harm the economy, lawmakers would have to significantly increase revenues, decrease projected spending, or enact some combination of the two." In light of this cautionary apprisal, a European-style value added tax (VAT) has emerged as a potential solution. Indeed, just this week, Jeffrey Owens, a director of the Organization for Economic Cooperation and Development (OECD), called for international agreement on a VAT structure at a lecture at NYU's School of Law.

Components of a good tax. There are four components of a good tax:

1. a tax should be fair and equitable;
2. a tax should be transparent;
3. the time and manner of tax collection should be convenient for the taxpayer; and
4. tax administration should be efficient.

With that being said, while it is true that the United States is the only major nation without a VAT, it does not necessarily follow that VAT is an appropriate or even viable solution for the United States. To the contrary, a U.S. VAT would be inequitable, hidden, inconvenient, and inefficient.

A U.S. VAT would be inequitable. A tax is considered to be equitable if citizens pay tax in proportion to their respective abilities. Under American tax policy, a taxpayer's ability to pay is measured in terms of available revenue for spending. In this regard, a U.S. VAT would be inconsistent with the ability to pay principle insofar as it measures taxpayers' ability to pay in terms of consumption rather than available revenue. In addition, a U.S. VAT would be inequitable in the sense that taxpayers would bear dissimilar tax burdens. A fair tax requires equal sacrifice from all taxpayers, but the incidence of a U.S. VAT would fall primarily upon lower income taxpayers because lower income taxpayers will spend higher percentages of their incomes on VAT.

A U.S. VAT would lack transparency. A value-added tax is a hidden form of taxation because those who ultimately pay it - i.e. consumers - are unaware of what they are paying. The hidden nature of a U.S. VAT would be particularly problematic because hidden taxes are easily increased by the government with little taxpayer resistance. Accordingly, once a value-added tax is introduced into the U.S. Tax Code, the rate of taxation is almost certain to increase. Indeed, there is a historical correlation between increased revenue and increased spending in the United States.

Continue reading "MORE MONEY, MORE PROBLEMS: A VALUE-ADDED TAX IS NOT THE ANSWER FOR THE U.S. " »

A bond swap is a tax and investment strategy whereby an investor sells a bond that has declined in value and simultaneously purchases a substantially similar bond with the proceeds from the sale.

Why?

If an investor plans to use the proceeds of the bond sale to purchase a substantially similar bond, why not just hold the existing bond? The reason is purely strategic. By engaging in this type of transaction, the investor generates a tax loss. This artificially generated tax loss can be used to offset capital gains and ordinary income without altering the general composition of the taxpayer's investment portfolio.

Here's How It Works:

Step 1: investor sells a bond that has declined in value.

Step 2: investor simultaneously purchases a bond with substantially similar attributes in terms of principal amount, yield, and recovery period.

Following this transaction, the investor continues to own a bond with substantially similar investment characteristics and also holds a tax loss that can be used to reduce his or her income tax liability. The tax loss realized on this transaction can be used to offset capital gains realized on other investments. In addition, to the extent the loss exceeds capital gains, it can be used to offset up to $3,000 of ordinary income. SeeInternal Revenue Code §1211(b). Any loss beyond that can be carried forward and used to offset capital gains and ordinary income in future tax years. SeeInternal Revenue Code §1212(b).

IRS May Challenge Bond Swap Transactions Under 2010 Legislation.

Investors have been engaging in bond swap transactions for years in order to trigger tax losses without altering their overall economic positions, and this practice has generally been accepted by the IRS. Moreover, the United States Supreme Court has seemingly endorsed this tactic. See Cottage Savings Association v. Commissioner (upholding mortgage loan swaps by banks to realize tax losses). But recent additions to the Internal Revenue Code have raised questions about the continued propriety of this tax and investment strategy.

In 2010, Congress codified the common law economic substance doctrine in Section 7701(o) of the Internal Revenue Code. Under the economic substance doctrine, tax benefits are denied if the transactions giving rise to the benefits lack economic substance apart from tax considerations. Pursuant to Section 7701(o)(1), in cases where the economic substance doctrine is relevant, a transaction shall be treated as having "economic substance" only if: (1) the transaction meaningfully changes the taxpayer's non-tax economic position; and (2) the taxpayer has a substantial non-tax purpose for entering into the transaction.

Because the bonds swapped are substantially similar and because the sole purpose of a bond swap is to create tax losses without changing the investor's overall financial position, this type of transaction is subject to challenge under this new legislation.

Bond Swaps Probably Remain Acceptable Despite 2010 Legislation.

Notwithstanding the 2010 codification of the economic substance doctrine, bond swaps probably remain safe tax and investment strategies.

First, in order for the IRS to invoke Section 7701(o) to challenge a bond swap transaction, the statute requires that the economic substance doctrine be "relevant" to the challenged transaction. Based on the pertinent case law, the economic substance doctrine is arguably irrelevant to a bond swap transaction. Indeed, in Cottage Savings, the Internal Revenue Service raised the economic substance doctrine in opposition to a bank's mortgage swap transaction, but the Supreme Court declined to apply the doctrine. Moreover, the Supreme Court seemingly rejected the relevance of the economic substance doctrine in swap transactions when it stated that, "a much less demanding and less complex test" is required.

Additionally, even if the economic substance doctrine is relevant to bond swap transactions, this type of transaction arguably possesses economic substance and business purpose apart from tax considerations in the sense that, although similar, the two debt instruments differ in the sense that they represent different debt obligations and have different issuers. Moreover, swap transactions have substance beyond the tax considerations in the sense that the swap itself is a mere component of a larger transaction of deriving a desired rate of return on the overall investment portfolio.

Continue reading "BOND SWAPS MAY BE SUBJECT TO CHALLENGE UNDER NEW TAX LAW" »