Direct Democracy. FAIL. Prop 26 makes a mess of California tax law.

December 9, 2010

This one escaped my attention until recently.

On November 2, California voters narrowly approved Proposition 26. Skip to the next paragraph if you just want the take-away and not the lengthy explanation. This proposition amended the state Constitution to require a 2/3 vote to authorize ANY legislation that raises the tax liability of ANY taxpayer. So revenue-neutral bills–bills that increase funds from one source but reduce funds from another source–now require a 2/3 vote to pass. In addition, any bills that were passed after Jan 1, 2010 will become void on November 2, 2011 unless they are re-authorized by a 2/3 vote. One such bill is SB 401, which is very important to taxpayers because it brought California into conformity with Federal law for 2009 and forward. Conformity simply means California uses the same rules as the Federal government. Conformity means you don’t have to keep track of separate income and deductions on your state and federal tax returns. Keeping track of items that don’t conform is a huge burden on taxpayers (and tax preparers), and SB401 reduced the items that don’t conform to Federal law. Most importantly, SB401 allowed California taxpayers who had a foreclosure on a home with a mortgage balance higher than the value of the home to not recognize income from the value of the home. As an example, individuals with a $500k mortgage on a home that was foreclosed on and sold for $200k would have to recognize $300k of income without SB401. As a result of SB401, people who just went through foreclosure won’t have to pay tax on all that “income” that was not actually received. But without a 2/3 vote to reauthorize SB401–and frankly, no fiscal policy bill gets a 2/3 vote in the California legislature–the law will be nullified on November 2, 2011.

So, thanks to Prop 26,  many California taxpayers might have to amend their 2010 (and maybe 2009 as well) tax returns in November, 2011. Individuals who had a foreclosure in 2009 or 2010 may be facing tax bills of tens of thousands of dollars as a result. At this point, nobody knows if this will be the way the law is actually enforced, but that does seem to be what it says. It will certainly put the legislature in the awkward position of having to choose between enforcing a law that voters approved…even though it will be wildly unpopular once the effects are known…or doing the paternal thing of simply ignoring a law that voters approved because it’s “what’s best for them”.

One thing’s for sure: Unless by some miracle the legislature manages to re-authorize a fiscal policy bill by a 2/3 majority, the California public will be irate with Sacramento over a proposition passed directly by the California public.

I love the idea of democracy. But unfortunately, once again, when it comes to practical results…

Direct democracy. FAIL.


A realistic picture of taxes and the economy

October 15, 2010

I just ran across some blog posts from tax professor David Cay Johnston. He has a couple posts in particular that I find interesting because they highlight the disparity between perception and reality when it comes to taxes and the economy.

I find it odd that so many people believe that taxes are unusually high in this country.* From a global perspective, the US government takes in less revenue, as a percentage of total income, than nearly any other developed nation. From an historical perspective, the US government collected a smaller share of total income in 2009 than it has in 60 years. In fact, for 30 years now tax rates have been in fairly steady decline. As a tax professional who looks at tax numbers all the time, this isn’t at all surprising. But it’s amazing that people who aren’t informed about the reality have a very strong perception that things are exactly the opposite of the way they really are.

Anyway, here are a couple of articles I found very interesting…although I’ll warn you that if you’re dead set on believing the government has us on a steady path to socialism then you’ll probably just be really angered:

United in Our Delusion

US Tax Rates: A Bargain Hunter’s Dream?

*In the case of upper-middle income earners making about $80k-106k, I’ll concede they’re probably right to believe taxes are unusually high in this country. If you fall in this income category, you’d probably pay lower taxes overall moving to Canada or Western Europe (plus you’d get free health care thrown into the deal as well). The income tax, when combined with employment taxes that are very regressive, result in a tax code that hits these upper-middle-class earners harder than anybody, and then rates get dramatically lower for higher earners.

New tax provisions will help many small businesses

October 3, 2010

The recently passed Small Business Jobs Act offers a number of helpful changes to the tax law that will benefit small business owners. As with most bills, there are many provisions, and some of them are very complex. But I just wanted to point out two basic provisions that will be welcomed by many small business owners I work with:

1) Cell phones have been removed as “listed property.” OK, so if you’re not a tax professional, what on earth does that mean and why is it such great news? This means that deducting cell phone usage as a business expense will no longer be an enormous pain. When cell phones were listed property, the tax code required records to be kept of all calls that were made and their business purpose. This means that if you followed the letter of the law you’d have to get a detail bill and go through the bill call by call to determine how much of your bill was a deductible business expense.  No more. Now cell phone expenses can generally be deducted as simply as any other business expense. (Of course, this is bad news for those cell phone companies which annoyingly charged an extra monthly fee for detail billing. Sorry Verizon, etc…)

2) Health insurance for Self-Employed individuals can be deducted as a business expense. The self-employed have long been able to take a deduction for their health insurance. However, the deduction was only allowed against income tax, but not against the Self-Employment Tax, which is generally about 15% of net business income. In 2010 (and only 2010, unless this provision is extended later), the self-employed will be able to deduct their health insurance against income tax and the Self-Employment Tax, generally resulting in a tax savings of about 15% of your health insurance costs.

There are many, many more provisions to this bill. For more information, you can view this page at that provides a broader overview:

Of course, this is general information and it’s always good to consult with a qualified tax advisor to determine how these provisions apply to your specific situation.

Uncle Sam’s got the best annuity deal going

July 16, 2010

There’s a little known provision to Social Security that’s starting to get some attention (see here, here, and here, for examples). It’s commonly known that you can file for benefits beginning at age 62, but the longer you wait, up to age 70, the higher monthly benefit amount you’ll receive. So the little known provision is that you can apply for benefits at age 62, collect benefits for as long as you like, then re-apply later using Form 521 and get the higher rate. Of course, you do have to repay the benefits you’ve already received (it’s not a total free lunch!), but you don’t have to repay any interest on the benefits you’ve already received and you get to claim a credit for all taxes you previously paid on the Social Security benefits you’ve already received.

I won’t spend a lot of time re-hashing what’s already been said in the articles referenced above. Basically, if you’re 70, in good health, and have enough liquidity that you can pay back the SS benefits you’ve received to date, then essentially Social Security offers by far the best annuity deal going. Essentially, when you repay your SS benefits and start over at the higher rate, you’re buying the equivalent of an inflation-adjusted lifetime annuity with a pay-out equal to the increase in your monthly SS payment.

I did a little comparison shopping on what buying an equivalent lifetime annuity at age 70 would cost, and then (since no similar tool appears to exist anywhere else) I created a spreadsheet that takes your birthday and information about payments you’re currently receiving, and spits out what you’d have to repay and how much this would increase your monthly SS benefit (now available as an online calculator here). The results are pretty amazing.

Comparing the SS repayment option to the closest comparable annuities available commercially shows the SS repayment option will typically yield about a 25-50% monthly premium. As an example, here’s the spreadsheet calculating the repayment amount for a person born in the fall of 1940, who took SS at the earliest possible date, and is now repaying SS in order to collect at the maximum monthly rate upon reaching age 70:

In this example, the person is currently collecting ~$1400 monthly, but after starting over at the new payment level will receive almost $2400 monthly. This will require about $117,000 in prior payments to be paid back. Essentially, for under $120k, this person is receiving a $1000 monthly lifetime annuity that will adjust for inflation.

For comparison, I went to which offers annuity quotes of the best available rates being offered currently for commercial annuities. I got a quote for a lifetime annuity for a 70-year old based on a lump-sum initial investment of $120k. Here’s the result:

While they don’t offer an inflation-adjusted annuity choice, the 3% option closely approximates historical inflation of recent decades (2-3%). Here you see the same investment of $120k in a commercial annuity would yield a monthly payout of $681…not even close to the payout offered through Social Security!

By the way, the date and other figures in yellow in the spreadsheet were picked entirely at random to generate an example of somebody turning 70 soon. It was not picked to maximize the results…the result is fairly typical! Please visit the online calculator and compare the results with commercial annuity quotes yourself. You only have to enter the information in the yellow, highlighted boxes. Everything else will be calculated for you. There are basic instructions in the spreadsheet itself, although I’ll be posting again soon with more detailed instructions. Actually, I’ll probably have this tool available in a web-based format in the next couple weeks.

Find out if it’s worth it for you, and then contact me for details about the tax impact and how you claim credit for all the taxes you paid on SS benefits that you’ll be repaying.

UPDATE: If you downloaded the spreadsheet that was originally posted, it has been replaced with an online calculator. If you’d
like a copy of the original spreadsheet, please contact me.

Tax Preparation gets harder for same-sex domestic partners…but there’s probably an upside

June 29, 2010

A memo issued by the IRS earlier this month clears up some lingering questions about community property laws and same-sex partners. Since this blog is for individuals and not other tax preparers, I’ll spare the details here. The upshot is this: Same-sex registered domestic partners who live in community property states (i.e. California) must now use community property rules when preparing their federal tax returns…even though they continue to be prohibited from using Married filing status. And they have the option to amend previously filed returns to use community property rules if it’s more advantageous.

(One additional note: the memo addresses a case involving Registered Domestic Partners specifically, and not same-sex spouses who married during one of the periods when same-sex marriage was allowed. Since the community property rules are the same for RDPs and same-sex married partners, presumably the reasoning applies equally in both cases.)

The legal justification pretty much works out like this: Established case law has upheld the principal that state law trumps federal law in areas of property ownership. Community property laws in states that recognize same-sex marriage dictate that income must be treated as equally earned by both spouses (unless it is derived from “separate property”, but that’s another discussion). Since property laws of states trump federal law, the IRS has determined that same-sex married couples must use community property laws. However, the Defense of Marriage Act declared that under Federal law only marriages between opposite sex partners are recognized, and (so far) there is no legal basis for state marriage laws trumping federal marriage laws. Therefore, the federal rule prohibiting same sex marriages applies for purposes of determining filing status even though it doesn’t matter for purposes of determining property (and therefore income) ownership.

On that note, I’ll share a brief political commentary. Funny how the conservative, “states’ rights” people don’t seem to have any problem with the Federal government telling states who can and can not marry even though the authority to define marriage at the Federal level is found nowhere in the Constitution. Just how ridiculously complicated are things going to have to get before certain people decide it’s best for the government to just stay the hell out of individuals’ relationship decisions?? But I digress…

So what does this latest IRS ruling mean for same-sex couples in community property states? Well, good news and bad news.

First, the bad news–doing your taxes just got a little more complicated than it already was. All of your income and many deductions and credits will now have to be adjusted so that they are equally split between both spouses. Two negative issues (besides the basic matter of increased complexity) may arise from this. First, same-sex partners can expect a lot of IRS letters attempting to “adjust” their returns as they report income, deductions, and withholding that do not match what is on forms reported to the government such as W-2’s and 1099’s. This will be an annoyance as same-sex couples will have to deal with additional unnecessary correspondence with the IRS to explain their tax calculations. Second, and more troubling, is the possibility some deductions and credits may only be allowed at a 50% level. As an example, let’s say one spouse is a student who qualifies for the Lifetime Learning credit on $8,000 of school expenses, which would be a $1600 credit. Under the latest rules, the IRS may determine that only $4,000 was paid by the spouse in school, and $4,000 paid by the spouse not in school. The spouse in school can claim a credit on only $4,000 in expenses, while the spouse not in school is ineligible to claim a credit at all due to not being a student and the spouse not being a “spouse” on the Federal return. This would be grossly unjust if the IRS rules this way, but there’s certainly room within the rules as they’re now being applied for the IRS to take this stance.

Now, the good news. In most cases, the community property rules will probably result in tax savings, especially for spouses with significantly different levels of income. The simple reason is that if two spouses are in different tax brackets, the community property rules effectively move some of the income from the higher tax bracket spouse to the lower tax bracket spouse. Furthermore, because same-sex spouses have the option, but not the obligation, to amend prior year returns, they can amend their returns in order to get additional money back, or choose not to amend if there’s no savings to be found. Not often does the IRS allow you to follow the law only when it’s in your favor, but this is one of those cases.

In summary, tax preparation just got a little more complicated for same-sex spouses, but I expect in most cases same-sex couples will see some tax savings as a result. Same-sex spouses should only do their own return if they are very well-versed in community property rules. But given the complexities involved, I definitely recommend same-sex partners seek out a tax advisor who is very knowledgeable about the unique taxation issues faced by same-sex spouses.

The Paradox of Simplifying the Tax Code

April 26, 2010

It’s been a couple months since my last post as I’ve been busy helping people navigate the complicated mess that is our income tax code. And the last couple of years, I’ve noticed an interesting contrast between what people say they want, and what they actually want.

Over and over again I hear from the media and simply talking to people in public the common refrain that our tax code is way too complex. An unnecessarily complicated tax code creates an enormous burden on business and individuals, stifling productivity. Out in the open, you hear almost universal support of the idea of simplifying the tax code. So if we live in a democracy and nearly everybody says they want a simpler tax code, why don’t we have one?

Simple. People don’t tell the truth. Or they simply don’t think things through to the very next logical step.

Everybody says publicly they hate how complicated the tax code is. But privately things are very different. Privately, most people buy tax software or pay somebody like me to search for all the tax breaks they can possibly get. And what is a tax break? It’s simply an exception, a “complication,” to the straight-forward application of tax rates to income. And everybody wants as many as possible when it comes time to do their taxes.

If we want to simplify the tax code, we’ll have to start eliminating all these tax breaks. Who wants to vote for eliminating the deduction for mortgage interest? Who will vote for ending exemptions and credits for dependents? Any takers? Maybe a few, but overwhelmingly people tend to like tax breaks. Sure, most people aren’t big fans of “unfair” tax breaks for “others.” But it turns out when you try to eliminate any tax break, suddenly the “others” turn up to argue their tax breaks are just as “fair” as the tax breaks you receive.

I’m not saying our complicated tax code is a good system. But I am saying that “simplifying” the tax code is one of the most politically difficult things to accomplish in a democracy. Any politician who promises to simplify the tax code is probably blowing smoke.

And let’s consider just how much most people would like the alternative. It turns out our tax code already has built in to it a couple of flat taxes. First, there’s the FICA taxes that come out of people’s paychecks automatically and aren’t subject to deductions or credits. Because they’re almost invisible, most people don’t think much about them (plus only half the amount is shown on your paycheck, the other half truly is invisible to employees). However, self-employed people see this tax directly as it’s not withheld automatically from them. They have to cut a check. And most self-employed people howl about this one when they learn about it. Over and over I have to explain to self-employed people that their medical expenses, their mortgage, their kids…none of those personal deductions make any difference when determining self-employment tax. And self-employed people hate it.

The other flat tax in our system already is Alternative Minimum Tax. Like Self-Employment Taxes, this tax is pretty flat as well. (There’s a 2% higher tax rate at the higher end of the income spectrum, and they can still deduct mortgage interest and charity, but other than that it’s pretty close to a flat tax.) And what tax is universally loathed by upper-middle-income earners who sometimes find themselves subject to it? AMT, of course. Again, people are outraged that their kids, their state income tax, and countless other deductions they get under the normal tax system don’t make any difference for AMT purposes.

Turns out that–privately, at least–most Americans hate a flat tax even more than a ridiculously complicated tax.

Ah, irony…

February 6, 2010

I found parts of this Time article on a large Tea Party conference pretty interesting.

According to the article the attendees were “mostly white and older.” This probably wouldn’t surprise most people who’ve seen a TP rally. I’m not going to touch the race issue, but there’s no doubt the TP movement is popular with seniors. In the paragraph following the description of attendees, the article goes on to quote an attendee saying they “want to take back this country back those who are robbing it blind.” The paragraph after that indicates attendees “all support ‘first principles’ of small government”.

Looking at the most recent federal budgets, I wonder who exactly is robbing the country blind? About $1.2 Trillion, over 1/3 of the budget, is going directly to seniors in the form of SS payments and Medicare. Seniors represent the single largest recipient of federal government money. Do the seniors at this convention intend to take the country back from themselves? If they want smaller government, the most effective way to reduce the government’s size is lobbying for cuts to SS payments and Medicare benefits. Somehow I don’t see that happening.

But maybe somebody else is robbing the country blind in the rest of the budget. Let’s see, the next biggest recipient of government dollars is members of the defense community. Maybe the TPers think that our troops are robbing us blind? Haven’t seen that on any of their posters yet.

(Of course, a good argument could be made that defense contractors are getting rich off bad policy…but any time cuts to defense spending are proposed, it’s always politicized as a swipe at the troops.)

Then you’ve got those other nasty entitlement programs for children, the very poor, and the disabled. A lot of money goes there (not as much as to seniors or the defense community, but still it’s a lot). Maybe the TPers should start marching into the homes of the disabled and impoverished children and demand their money back.

And then there’s the interest on the national debt. That’s where those evil thieves are robbing us blind, right? Problem is, over half the national debt is held by Social Security, meaning that interest is going to SS recipients. So we’re right back at giving government money to seniors. And even though a large portion of that interest does indeed go to private and overseas investors, we’re talking about 2-3% of the entire federal budget. Not chump change, but hardly enough to say we’re being robbed blind.

And finally there’s the EVERYTHING ELSE category. Yep, everything else the government does besides what I mentioned above, when added together, comes to a total of about $500 billion. Highways, food inspections, environmental protection, national parks and public lands, payments to farmers (and ag corporations), education, NASA, judicial system, etc. etc. all added together comes to a grand total of significantly less than half of what seniors receive in direct support from the government.

So again I ask, *who* exactly is robbing the country blind??

I have no problem with seniors receiving substantial subsidies from the government. I believe one of the major roles of government is to protect society’s weakest members. And when people reach an age where they are no longer able to work, when their health may be failing, when biology and the demands of our modern society make it impossible for people to support themselves, then I think it’s important and admirable that society as whole, acting through government, is willing to offer support.

But what infuriates me to no end is when those who are receiving the lion’s share of government resources rail against “big government” and demand that government spending on everybody else be cut. I wonder when we’ll see seniors who claim to favor “smaller government” start rallying against their SS & Medicare benefits?