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Having had the opportunity to review President Obama’s newly released 2011 tax return for Bloomberg news this morning, one thing is immediately obvious: the President’s tax return stands in stark contrast to the 2010 return previously released by his Republican counterpart, Mitt Romney. One look at the candidates’ tax filings makes it clear why tax policy will likely play an integral role in the upcoming election, as the dramatic differences evident in the determination of each man’s tax liability are mirrored in their respective tax proposals. 

Based purely on their respective tax filings, President Obama will be sure to portray himself as the “every man” in the upcoming election, despite being among the top 1% of earners in America. To the contrary, Mitt Romney, through no fault of his own, is likely to be painted as the embodiment of a broken tax system. This difference in perception will be due to a number of factors evidenced in their respective tax returns:

Sources of Income

The overwhelming majority of President Obama’s taxable income in 2011 was of the ordinary variety — wages of $395,000, self-employment income from book sales of $441,000, and taxable interest of $11,000. The President had no investment income in the form of qualified dividends or long term capital gains during 2011. In fact, Obama does not appear to be invested in the stock market to any material degree. As a result, the President derives no benefit from the 15% preferential tax rate afforded to these classes of income by the Bush tax cuts.  

To the contrary, on his 2010 tax return, Mitt Romney reported no wages and relatively minimal self-employment income. Instead, of his $21,600,000 of adjusted gross income, $5,000,000 was in the form of qualified dividends and $12,500,000 was generated as long-term capital gains. Courtesy of the Bush tax cuts, all of this income was taxed at the preferential 15% tax rate.

Level of Transparency

President Obama owns no rental properties, holds no interests in partnerships, S corporations, or trusts, and he fully maximizes his retirement plan contributions.  Even the President’s itemized deductions give the appearance of relative “normalcy;” he has a mortgage on his home and  his real estate taxes are a “reasonable” $22,000.

In contrast to the President, sophistication and complexity permeate Romney’s return. He holds interests in multiple trusts and rental properties, and his return is littered with informational filings related to numerous offshore investments. He owns no mortgage on his home, but paid over $226,000 in real estate taxes during 2010.

Effective Tax Rate

Due to his combination of considerable ordinary income, the absence of qualified dividends and long-term capital gain, and a moderate amount of itemized deductions, the President’s effective tax rate in 2011 was 20.5%. This is a number many American’s are likely to find more palatable than the 13.9% paid by Mitt Romney in 2010, particularly in light of the fact that President Obama’s adjusted gross income was $789,000, compared to the $21,600,000 Romney reported.  

Industry-Specific Tax Breaks

Perhaps most egregious in the eyes of observers, a substantial portion of Romney’s income is subject to one of the more hotly debated tax breaks currently available in the Code: the 15% tax rate afforded “carried interest.” This break allows private equity fund managers such as Romney to pay tax on the allocable share of fund income they receive in exchange for management services at a rate of 15% if the allocable income is in the form of long-term capital gains or qualified dividends, despite the fact that compensation for services rendered is typically taxed at ordinary rates.

 To the contrary, President Obama receives no industry-specific breaks.

Reflections in Tax Policy

Perhaps more so than in any election in recent memory, the tax returns filed by President Obama and Mitt Romney provide a window into their tax policies.

President Obama has built his platform on what he calls “fairness.” It is time, he insists, for the wealthy to pay their share. To do so, he proposes changes that would impact his tax situation minimally, but would drastically change that of his opposition and many of the nation’s wealthy.  

The President has vowed to repeal the Bush tax cuts, which would increase the top rate on ordinary income from 35% to 39.6%. While this would increase the tax imposed on Obama’s wages and self-employment income, it alone would do little to effect those of Romney’s ilk who earn their income predominately from qualified dividends and long-term capital gains.

To that end, the President has proposed returning the tax rate on qualified dividends to the top ordinary rate of 39.6%, while the tax on long-term capital gains would increase from 15% to 25% for those with adjusted gross income in excess of $250,000. These changes, if implemented, would have virtually no impact on the President’s tax liability, courtesy of his lack of investment income.

Romney, on the other hand, would feel a significant pinch, as the tax on his $5,000,000 of qualified dividends would increase by 24.6%, with the tax on his long-term capital gains of $12,000,000 jumping by 10%.

The President’s war on the perceived inequities doesn’t end there, however. He proposes two more law changes that would ensure Romney and other wealthy taxpayers pay there “fair share.” First, Obama would put an end to the tax break on carried interest, meaning much of Romney’s long-term capital gains would be taxed as ordinary income, at a maximum rate of 39.6%. In addition, the President proposes to institute the much-discussed “Buffett Rule” — named after the billionaire business magnate who stirred the hornet’s nest by famously claiming that he paid a lower tax rate than his secretary — which would guarantee that taxpayers earning over $1,000,000 in AGI paid a minimum effective tax rate of 30%.

Given that President Obama’s adjusted gross income did not exceed $1,000,000 in 2011, the Buffett Rule would not affect his tax liability. For Mitt Romney, on the other hand, the Buffett Rule would more than double his effective tax rate and his resulting tax liability.

It is this difference in their current and potential tax liabilities that the President will play up in his ensuing campaign. In order to chip away at the deficit, the President will insist, the nation’s wealthy must no longer be able to take advantage of industry-specific tax breaks and preferential tax rates and start pulling their weight, in the name of both fiscal responsibility and social equitability.

In direct contrast, Mitt Romney has built his tax platform on an array of tax cuts that could easily be dismissed as self-serving, but in fact may well do more to stimulate the economy and reduce the deficit than the increases proposed by the President.

Romney proposes to cut the tax rates for all Americans, with the maximum tax rate on ordinary income dropping to 28%. This would result in a 7% reduction on the President’s wages, but would have little effect on Romney’s return, with its absence of wages and self-employment income.

Where Romney would benefit greatly, however, is his proposal to keep the tax rate on long-term capital gain and qualified dividends at 15%. While this would preserve the preferential tax rate applied to the overwhelming majority of his income, Romney does not hoard the benefits all for the super wealthy. Instead, he proposes that taxpayers earning less than $250,000 in AGI be able to earn interest, dividends, and long-term capital gains tax free, a law change that would certainly motivate the middle class to save and invest.

Romney would keep the current preference on “carried interest” in place and also attempt to repeal the estate tax, two policies that are likely to be perceived as his catering to the super wealthy. As the majority of Americans will never have to concern themselves with carried interest or be subject to the estate tax, they may well see this as Romney aiming to protect his fortune and those of his Republican constituents, further alienating him in the eyes of many.

It’s rare that the tax world takes over the front pages, but judging by the immediate and widespread reactions to the President’s release of his tax return this morning, it appears the tax policies of Obama and Romney have become the focal point of the upcoming election.

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While F. Lee Bailey is widely considered one of the greatest defense attorneys to ever grace the inside of a courtroom, his body of work has more in common with that of  Lionel Hutz — the dimwitted lawyer from The Simpsons — than Bailey would ever care to admit. Think about it:

High profile victories:

Bailey: A successful defense of accused murderer Sam Sheppard, and of course, the O.J. debacle;

Hutz: Earned redemption for Homer in his false advertising suit against the all-you-can-eat seafood buffet, The Frying Dutchman.

Devastating defeats:

Bailey: Unable to free Patty Hearst from charges of armed robbery;

Hutz: Couldn’t garner justice for Marge in her sexual harassment suit against Mr. Burns.

 Questionable ethics:

 Bailey: Jailed for contempt (see below) and disbarred in Florida and Massachusetts;

Hutz: Set fire to all his records; changed his name to Miguel Sanchez.

Memorable quote:

Bailey: I use the rules to frustrate the law. But I didn’t set up the ground rules.

Hutz: Judge Snyder has had it in for me ever since I kinda ran over his dog… Well, replace the word ‘kinda’ with ‘repeatedly’ and the word ‘dog’ with ‘son’.

Despite this less than flattering comparison, it’s a must-read opinion when a lawyer of  Bailey’s caliber defends himself in front of the Tax Court, particularly when the transactions at issue are the very same that gave rise to Bailey’s incarceration and disbarment.

Facts in Bailey:

While there were other tax issues decided — the court held that Bailey’s yacht refurbishing activity was a “hobby” under the meaning of I.R.C. § 183, while his airplane manufacturing activity was a trade or business — the majority of the case was devoted to whether Bailey recognized taxable income during various stages of a rather unique relationship he entered into with a client at the behest of the government, so that’s where we’ll spend our time.

In 1994 Claude Duboc, who was accused of importing copious amounts of marijuana into the U.S., retained Bailey to negotiate a plea arrangement. As part of the agreement, Bailey would assist Duboc in cooperating with the federal government’s seizure of his many foreign assets, including multiple pieces of high-value residential real estate.

To facilitate restitution from Duboc, the government entered into a vague and unusual agreement with Bailey, under which Bailey would perform services to facilitate Duboc’s forfeiture of his assets, and Duboc would transfer 602,000 shares of Biochem stock to Bailey. This stock would provide funds that Bailey could use to maintain and transfer Duboc’s foreign assets, as well as to cover both Bailey’s fees and the other expenses generated by his work.

For receiving and holding the Biochem stock, Bailey did not open a new account. Rather, the government attorneys understood that Bailey possessed a Swiss bank account, and by agreement it was Bailey’s own account at Credit Suisse that was used. In 1994, 602,000 shares of Biochem stock, then worth $5,891,352, were transferred to Bailey’s Credit Suisse account. Bailey did not report income from his receipt of that stock on any income tax return for any year.

In 1994 and 1995, funds came into Bailey’s Credit Suisse account from three sources–(1) sales of Biochem stock for $2,400,855, (2) loans collateralized by Biochem stock of $3,013,463, and (3) sales of other stock owned by Duboc of $700,000.

From these proceeds, Bailey made further transfers to his personal money market account of stock sale and loan proceeds totaling $3,475,327, of which $425,056 represented stock sale proceeds and $3,013,463 constituted loan proceeds.

In late 1995 or early 1996, Duboc replaced Bailey with another lawyer. At the government’s request, the District Court ordered Bailey to transfer the 400,000 unsold Biochem shares to the federal government. At that time, however, Bailey owed $2,332,743 for loans that had been made against the unsold shares (and he had spent the proceeds); and Credit Suisse would not make any transfer of the shares until the loans were repaid. Bailey therefore did not immediately comply with the District Court’s order, and the court found him in contempt in March 1996 and ordered him incarcerated.

Bailey eventually repaid the full amount of the Credit Suisse loans.

Issue 1:Value of Biochem Stock Transferred to Bailey’s Credit Suisse Account Was Taxable Income:

Tax Court Position: The stock was not taxable income. The stock was not Baileys and was held merely in trust, and in light of the fact that the government persuaded the District Court to stick Bailey in jail until he lived up to the terms of that trust and turn the stock over, the value of the stock was not taxable income when received.

Issue 2: Stock Sale Proceeds and Loan Proceeds Received By Bailey’s Credit Suisse Account Represented Taxable Income:  

Tax Court Position: The stock sale and loan proceeds did not constitute taxable income:

Bailey’s agreement with the Government explicitly contemplated that he would use his existing Credit Suisse account for the Biochem stock. Consequently, the transfer of the shares to his Credit Suisse investment account and of the loan and sale proceeds to his Credit Suisse advance account did not constitute an appropriation of those proceeds.

Issue 3: Loan Proceeds Further Transferred From Bailey’s Credit Suisse Account to His Personal Money Market Represented Taxable Income:  

Tax Court Position: The loan proceeds were not income:

Bailey denied that the loans he received in his Credit Suisse account that were collateralized by the Biochem stock constituted income. He personally guaranteed the loans, and with great difficulty he borrowed from others and repaid the loans in 1996. He therefore invokes a basic tax principle: “[I]t is settled that receipt of a loan is not income to the borrower.” The receipt of a loan is not income to the borrower where the borrower uses another person’s property as collateral to obtain that loan–even where the collateral is obtained under false pretenses or is otherwise misappropriated–as long as there is a “consensual recognition” that the borrower will repay the loan.

Issue 4: Stock Sale Proceeds Further Transferred From Bailey’s Credit Suisse Account to His Personal Money Market Represented Taxable Income:  

Tax Court Position : Since Bailey was not required to repay the stock sale proceeds he appropriated, they represented taxable income.

Bailey bore the burden to prove that in transferring the funds to his money market  account he did not depart from his fiduciary role, and he did not carry that burden. The record does not show that he regarded the funds in the money market account as subject to restrictions on their use. We therefore hold that Bailey wrongly appropriated Biochem stock sale proceeds when he made transfers thereof to his Barnett money market account in the amounts of $175,037 in 1994 and $250,019 in 1995 (totaling $425,056) and that he received income for those amounts in those years.

Joe Kristan at Roth & Company has much more on the hobby loss aspects of the case.

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The opening day of the Supreme Court’s hearings on the Patient Protection and Affordable Care Act went pretty much as expected, with 90 minutes spent arguing semantics; specifically, whether the tax penalty imposed by I.R.C. § 5000A on individuals who fail to procure health insurance is more “tax” than “penalty.”  

As a reminder, today’s debate could have ended the highly anticipated hearing on the constitutionality of the individual insurance mandate before it began. If the I.R.C. § 5000A penalty was found to be a “tax,” then the Supreme Court would be barred from ruling on the  constitutionality of the insurance requirement by the Anti-Injunction Act — a 145-year old law — until after the tax has been imposed and collected — 2015 at the earliest. If the penalty is truly a “penalty,” however, then the Court can move forward with the argument everyone is longing to hear and determine the fate of Obamacare.

Well, we’ve perused the transcript from today, and while this is nothing more than our opinion, it appears that the majority of justices are in favor of settling the constitutionality debate sooner rather than later. If you’re scoring at home — and if you are, your loneliness saddens me — it would appear from the transcript that Justices Ginsburg, Scalia, Breyer, Kagan and Sotomayor are in favor of addressing whether Obamacare is constitutional now, while Justices Roberts and Alito would prefer to apply the Anti-Injunction Act and table any constitutionality discussion until 2015. It should be noted that it doesn’t appear that politics were the overriding motivation for any of the justice’s positions, as both conservative (Scalia) and liberal (Kagan) seemed to agree that the Anti-Injunction Act did not apply to I.R.C. § 5000A.

Perhaps the most fascinating aspect of the day was the unenviable position in which the government’s attorney -U.S. Solicitor General Donald Verrilli — found himself. Today, Verrilli vehemently argued that the I.R.C. § 5000A charge was not a tax but a penalty, and thus the Supreme Court was not prohibited from ruling on the provision’s constitutionality prior to the date the tax is collected. Verilli’s argument was made all the more difficult by the fact that everyone in attendance was keenly aware that tomorrow, when justifying the insurance mandate as constitutional, Verrilli would be back in the very same court room arguing that the I.R.C. § 5000A charge is in fact a tax, and is imposed as part of Congress’s taxing authority. Verrilli articulated his dueling positions thusly:  

Congress has authority under the taxing power to enact a measure not labeled as a tax, and it did so when it put section 5000A into the Internal Revenue Code. But for purposes of the Anti-Injunction Act, the precise language Congress used [calling it a penalty, rather than a tax] is determinative.

Verrilli wasn’t the only one in a tough spot on Monday. While the various states challenging the law are chomping at the bit to challenge the constitutionality of the insurance mandate, because both sides would prefer to determine the fate of Obamacare soon, no one was jumping at the chance to argue that the I.R.C. § 5000A tax penalty is in fact a tax, and thus subject to the Anti-Injunction Act. So to facilitate debate, the Supreme Court brought in their own attorney to do so, Robert Long.

Mr. Long — likely longing for his care-free days as a member of the popular rap group Black Sheep[i] — was stuck spending 30 minutes trying to convince some of the brightest people on the planet of something they appeared to have already decided they wouldn’t be convinced of. To be fair, the justices went easy on him., but there can’t be anything fun about getting hired to engage in an argument you know you can’t win.

Up today is the main event: the discussion of whether Congress has overstepped its taxing authority in requiring all American’s to obtain health insurance or suffer a tax…penalty…whatever. We’ll let you know how it goes.


[i] Not verified. May be an entirely different Mr. Long.

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A few things you may have missed this weekend while relentlessly bragging about how you predicted Lehigh’s upset of Duke in one of your brackets (while ignoring the seven other brackets where you picked Duke).

Kelly Erb over at Forbes is halfway through the process of covering key tax issues from A-Z, and as usual, she does an awesome job. Of course, if W doesn’t end up standing for Wesley Snipes, I reserve the right to change my opinion.

The Wall Street Journal published a list of Ten Common Tax Filing Mistakes People Make. Narrowly missing the cut? Paying a friend ten grand to torch your house for the insurance proceeds, then deducting the arson payment on your return.

National income gained overall in 2010, with the 15,600 most wealthy taxpayers pocketing an astonishing 37% of the gain. The bottom 90%, on the other hand, actually went backwards, as inflation wiped out any increase in pay. I wish there were a joke in here somewhere, but sadly, there isn’t.

I don’t know who this Tom Nitti is whose blog they’re citing over at Forbes, but I dig his style.

Lastly, a number of people reached out to me after I posted this video to ask if that was my son eating snow at the tail end of a horribly botched ski lesson. It was not, as 1) I’m not that bad of a father, and 2) Referring to your son as “bro” is a level of obnoxiousness even I’m not comfortable with. 

My boy did make his triumphant on-mountain ski debut yesterday, however, and daddy hasn’t stopped smiling since:

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While New Jersey residents wait with breathless anticipation for the Snooki-LaValle lovechild to arrive and lead them to a new age of prosperity, the State’s leadership is left to try and salvage the present by enacting sweeping tax cuts.

What remains to be determined, however, is what shape the cuts will take. On Wednesday, Governor Christie announced that he was “pretty close” to a deal on a tax-cut plan with Senate President Stephen Sweeney. To recap, here were the proposals by each side:

Christie: A 10% across-the-board reduction in the individual income tax rates to be phased in over a three-year period beginning in 2013. The plan would cost the state $183 million in 2013 and $1.1 billion by the fourth year.

Sweeny: Senate Democratic leaders, criticizing Christie’s plan as favoring the wealthy, have called for a 10% tax credit on the first $10,000 of property taxes paid. The credit would only be permitted for residents with income below $250,000, shifting the benefit of the tax cuts to the lower and middle class. The plan would cost the state $175 million in 2013 and $1.4 billion by the fourth year.

A third proposal had been pitched by state Assembly Democrats that would have doubled the tax credit to 20% of the first $10,000 of taxes paid while using the same income limits. As opposed to the Senate’s plan, the Assembly tax credits would have been paid for by implementing a “millionaires tax;” raising the top personal rate from 8.97% to 10.75%. Christie, as expected, rejected this idea as “dead.”

The sticking point will likely continue to be where to focus the tax cuts: Democrats don’t want the state’s millionaires to receive any additional benefit, while Governor Christie has been adamant about not raising taxes on the wealthy, having twice vetoed measures that would previously implemented a “millionaire’s tax.”

From Christie:

We’re pretty close, so now let’s see if we can find an area of compromise,” Christie said of Sweeney’s proposal. “I think everyone should get tax relief and he limits it at $250,000 — there’s a boulevard there between them. Lets see if we can get the car onto that boulevard and move it down the road.”

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Covering President Obama’s recent tax proposals has given me a firm appreciation for what it must have been like to be a sports reporter during the latter stages of Brett Favre’s career, when journalists breathlessly covered whether he would retire or continue playing, despite the fact that everyone knew damn well Favre would show up to camp a week late and start another 16 games. And what I’ve learned is this: it’s a rather empty feeling to spend day after day analyzing a story the ending to which was preordained before it even began.

But that’s where we are with tax reform in this country. Everything is happening, but nothing’s happening. Last week the president unveiled his plans for individual tax reform, and today it’s corporate tax reform, but regardless of what’s said or written, we all know nothing will be passed unless the president wins re-election, and even then these proposals — as currently constructed — are a long-shot to ever become law.

Anyhoo, what follows is a summary of President Obama’s appeal for corporate tax reform, released today. And while the headlining proposal — the promise to reduce the maximum corporate tax rate to 28% —  is likely to win some appreciation from the Republican party, there are enough high-profile revenue raisers in the plan, such as the elimination of tax preferences for the oil and gas industry and the imposition of a “minimum tax” on a U.S. corporation’s worldwide profits, to guarantee that the president’s corporate proposals will be shelved right along with his plan for individual tax reform until after the election.

The president’s plan can be separated into three distinct categories: general corporate reform, manufacturing industry reform, and international reform.  

General Corporate Reform

While the president’s pitch to lower the maximum corporate tax rate from 35% to 28% is sure to get the most publicity, understand that the intention is for this lost revenue to be paid for by broadening the tax base, i.e.., eliminating deductions. The president (correctly) points out that our current tax system — replete with innumerable deductions, exclusions and preferences — benefits certain industries over others. Take a gander at the following table, which illustrates the effective tax rate paid by different industries in 2007 and 2008, even though they were all subject to the same 35% marginal rate:

 

The president believes that while eliminating deductions and preferences, care should be taken to equalize the benefits of the code across all industries.  To that end, he has placed a number of provisions on the chopping block, calling for the following changes:

  •  Elimination of “Last in first out” accounting. Under the “last-in, first-out” (LIFO) method of accounting for inventories, it is assumed that the cost of the items of inventory that are sold is equal to the cost of the items of inventory that were most recently purchased or produced. This allows some businesses to artificially lower their tax liability.
  • Elimination of oil and gas tax preferences. The president’s framework would repeal the expensing of intangible drilling costs, and percentage depletion for oil and natural gas wells. .
  • Reform treatment of insurance industry and products The president’s framework would close this loophole and not allow interest deductions allocable to life insurance policies unless the contract is on an officer, director, or employee who is at least a 20 percent owner of the business.  
  • Taxing carried (profits) interests as ordinary income. The framework would eliminate the loophole for managers in investment services partnerships and tax carried interest at ordinary income rates.
  • Eliminate special depreciation rules for corporate purchases of aircraft. This would eliminate the special depreciation rules that allow owners of non-commercial aircraft to depreciate their aircraft more quickly (over five years) than commercial aircraft (seven years).
  • Addressing depreciation schedules. Current depreciation schedules generally overstate the true economic depreciation of assets.
  • Reducing the bias toward debt financing. Reducing the deductibility of interest for corporations should be considered as part of a reform plan. This is because a tax system that is more neutral towards debt and equity will reduce incentives to overleverage and produce more stable business finances, especially in times of economic stress.

 Manufacturing Industry Reform

 While the president asserts that all industries should be treated equally, the plan then goes on to bestow certain preferences specifically on the manufacturers by proposing the following:

  •  Effectively cutting the top corporate tax rate on manufacturing income to 25 percent and to an even lower rate for income from advanced manufacturing activities by reforming the domestic production activities deduction. The president’s framework would focus the current I.R.C. § 199  deduction more on manufacturing activity, expand the deduction to 10.7 percent, and increase it even more for advanced manufacturing. This would effectively cut the top corporate tax rate for manufacturing income to 25 percent and even lower for advanced manufacturing.
  •   Expand, simplify and make permanent the R&D Tax Credit. The president’s framework would increase the rate of the alternative simplified  credit to 17 percent.  
  •  Extend, consolidate, and enhance key tax incentives to encourage investment in clean energy.

International Reform

It is in the international arena that the president’s proposals most deviate from those of his Republican counterparts. While Mitt Romney and Newt Gingrich have loudly called for a move to a “territorial” tax system, whereby U.S. corporations would only pay tax on U.S. income, leaving other nations to trust foreign profits, President Obama wants to expand the current corporate tax regime to tax profits earned by foreign affiliates of U.S. corporations before they are repatriated to the U.S. This is sure to be a sticking point in any future negotiations, as some powerful lobbies will not take kindly to the idea of a minimum international tax rate.

 The president’s proposals include the following:

  •  Require companies to pay a minimum tax on overseas profits. Specifically, under the President’s proposal, income earned by subsidiaries of U.S. corporations operating abroad must be subject to a minimum rate of tax. This would stop our tax system from generously rewarding companies for moving profits offshore. Thus, foreign income deferred in a low-tax jurisdiction would be subject to immediate U.S. taxation up to the minimum tax rate with a foreign tax credit allowed for income taxes on that income paid to the host country. This minimum tax would be designed to balance the need to stop rewarding tax havens and to prevent a race to the bottom with the goal of keeping U.S. companies on a level playing field with competitors when engaged in activities which, by necessity, must occur in a foreign country.
  • Remove tax deductions for moving productions overseas and provide new incentives for bringing production back to the United States. The President is proposing that companies will no longer be allowed to claim tax deductions for moving their operations abroad. At the same time, to help bring jobs home, the President is proposing to give a 20 percent income tax credit for the expenses of moving operations back into the United States.
  •  Other reforms to reduce incentives to shift income and assets overseas. The Framework would strengthen the international tax rules by taxing currently the excess profits associated with shifting intangibles to low tax jurisdictions. In addition, under current law, U.S. businesses that borrow money and invest overseas can claim the interest they pay as a business expense and take an immediate deduction to reduce their U.S. taxes, even if they pay little or no U.S. taxes on their overseas investment. The Framework would eliminate this tax advantage by requiring that the deduction for the interest expense attributable to overseas investment be delayed until the related income is taxed in the United States.

Of course, the chess match continues. In response to the president’s plan for corporate reform, the rise of Rick Santorum, and his recent slip in the polls, Mitt Romney changed his stance on the maximum individual tax rate today, proposing to reduce it to 28% (as part of a 20% cut of all rates across the board) as opposed to simply extending the Bush tax cuts (which contain a 35% maximum tax rate), as he’d proposed earlier in his campaign. Romney also went on to promise a free Chalupa to anyone who votes for him.* Desperation, as they say, is a stinky cologne.

*this may not have happened

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Substantiation is a critical component of any tax deduction. In order to withstand an IRS challenge, it’s essential that a taxpayer maintain sufficient records to support their claimed deductions. And while the statute requires varying degrees of substantiation for different types of expenses, some simple universal truths apply to all deductions:

  • The burden falls on the taxpayer to substantiate the expenses; the IRS is not required to prove the expenses didn’t happen.
  • The fact that an expense was reported on a prior year return and created a net operating loss does not in itself substantiate those deductions. Tax returns are not substantiation.[i]
  • While the Cohan Rule[ii] permits the IRS to estimate a taxpayer’s deductions in the absence of the required substantiation, the IRS can’t do so if it has no reasonable way to approximate the expenses. In other words, you’ve got to be able to show the IRS something.

Failure to heed these rules can quickly lead to an adverse IRS exam or court decision, as one Maryland couple found out yesterday in a decision chock full of  perverted/litigious/murderous goodness:

Steven Esrig (Esrig) and his wife failed to timely file their tax returns from 1998 through 2003, and when they finally got around to it, they claimed significant deductions including net operating loss carryovers, business losses, and office expenses.   

Citing a lack of substantiation for all of the claimed losses and expenses, the IRS disallowed the deductions and assessed over $700,000 in additional tax for the six-year period, along with substantial late filing penalties.

In his defense, Esrig argued that he kept adequate records for his business expenses, though he never actually produced any of them at trial. Thus, it was left to the Tax Court to determine whether Esrig’s oral testimony constituted sufficient substantiation for his claimed deductions, and in order to do so, the court first had to gauge his credibility. As you’ll soon see, this is where things started to go bad for Steven Esrig:

Esrig liked to refer to himself as an “entrepreneur.” Now while normally, calling oneself an entrepreneur is simply a pleasant alternative to calling oneself  “unemployed,” in this case it appears Esrig truly was an innovative visionary along the lines of Steve Jobs. Behold:

Steven told us at trial that he got the idea for the company after an incident involving one of his children. Apparently, his then-five-year-old child asked to look at the Power Rangers website.  Steven logged on but inadvertently mistyped a character in the web address. Instead of getting the Power Rangers website, up popped a seriously pornographic one. This, he told us, was the reason he started Stelor, a company he claims invented a technology that protects children from predators and pornography and “shuts down identity theft.”

Esrig then also laid claim to inventing quotation fingers, the tankini, Jack and Cokes, and raccoons. [iii]

For obvious reasons, the court wasn’t buying Esrig’s story, its doubts prompting it to ask the logical question, “How could a company with such a multifaceted wonder product fail to achieve any level of success?”

Steven told us that the company failed because it “ran into some litigation” after it bought the domain name “googles.com” from someone who had it before Google. This, he said, led to five or six years of litigation with Google and ultimately bankrupted his company.

Now that’s a tough break. Who would have guessed that poaching a domain name from the world’s largest tech giant would lead to costly litigation? It almost makes me wonder if my recent decision to purchase the web address “Facebulk.com” to promote my Aspen Lip Collagen Clinic was not the best of ideas. 

With Esrig’s credibility irreparably tarnished, the Tax Court had no choice but to side with the IRS, denying the disputed expenses in full, including the $17,700 Section 179 deduction Esrig claimed for the cost of a fish tank and dining room furniture.

There was still the matter of $180,000 in penalties, however, which would be added to Esrig’s bill unless he could convince the court that the late returns and large underpayments were not his fault:

At trial, Steven blamed the couple’s return preparer. He said that he’d asked his accountant to request extensions for all the years at issue, but his accountant missed all the deadlines because she had to serve a very long prison sentence for murdering her husband, and the person in her office who took over their account made a slew of mistakes.

Call me a softie, but if your CPA going on a killing spree isn’t “reasonable cause” for late filings, then I’m not sure what is.  But the Tax Court — likely tired of listening to Esrig’s various yarns and unable to differentiate truth from fiction —  failed to share my sympathy, upholding the full amount of the penalties.  


[i] See Lawinger v. Commissioner, 103 T.C. 428 (1994).

[ii] Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).

[iii] May not have happened.

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