As Congress and the White House begin what has become their annual rite of trying to make the tax laws more complicated, Americans struggling to figure out their returns may be surprised to find themselves getting a bit of sympathy from . . . the IRS.
From inside the giant tax-collection agency, the national taxpayer advocate, Nina E. Olson, and the Taxpayer Advocate Service she heads are pressing lawmakers to wake up to the hardships they often inflict when they throw things into the code without a whole lot of thought about how they will work in practice.
Maybe, for example, a single mom with two children ought not to have to do the family tax returns six times to make sure she's not paying too much because of how she treats the "kiddie tax." And maybe the IRS shouldn't be able to disallow dependency exemptions for children without checking to see who's really supporting the kids.
Olson, in her annual report to Congress, offers half a dozen "key legislative recommendations" that she thinks ought to be enacted to make life easier for many taxpayers. Some of these may seem to border on policy, which is outside the advocate's purview, but Olson said recently that there should be ways to achieve the same policy goals without causing taxpayers such headaches.
A clear example is the kiddie tax.
Concerned that rich people were shifting assets to their children so that income from those assets would be taxed at the children's lower rates, Congress decreed back in the 1980s that if a child receives more than a small amount of investment income, this income is to be taxed at the parents' marginal rate.
That may sound simple, but the result is stunningly complex. A child's investment income is subject to a three-tiered tax structure. The first $750 is not taxed, the next $750 is taxed at the child's 10 percent rate, and the rest is taxed at the parents' rate. If the child has more than $1,500 in investment income (earned income is a different story), the parents have the option of having the child file a return or of adding the additional income to their own return.
Children who file pay at the parents' rate, but their income stays with them. If the parents add a child's income to their return, it is treated as if it were theirs. The choices have different consequences.
For example, adding the child's income to theirs boosts the parents' investment income, which would allow the parents to take a larger investment interest deduction, meaning interest on margin loans and the like. On the other hand, the parents' increased income may cause their personal exemptions to phase out and limitations on itemized deductions to kick in. They could also be pushed over certain limits, such as those for a Roth IRA. Then there is the alternative minimum tax, which could hit either the parents or the child.
If there is more than one child, their situations interact and the complications grow exponentially.
Olson, in a conversation the other day, recalled that when she was in private tax practice she had a recently widowed client whose husband had left life insurance for their two children, which the widow had invested in certificates of deposit and mutual funds.
"It was not like anybody was shifting assets," Olson said, but the kiddie tax turned their situation into "a nightmare. I literally did six different returns" to figure out what the proper tax was.
If the parents file separate returns, the law also requires the child's income be computed using the bracket of the parent with the higher taxable income. "But suppose the parents are separated but not divorced and are not sharing information," Olson said. The parent with custody of the child may have to go to the IRS to get the figures he or she needs, thus ending up with delays and possibly the need to file an amended return later on.
"There are all of these layers that this artificial construct [of the kiddie tax] triggers. You just think, this is not sane," Olson added.
In the advocate's report to Congress, "we are coming out and saying, just sever the linkage between the parents' rate and the child's rate. There are policy issues, but somebody could decide what's the right rate for the child. If you're worried about people transferring income to a child, set it at a high rate, but don't link it to parents," Olson said.
She noted that Congress enacted compressed brackets for trusts and estates years ago for somewhat the same purpose as the kiddie tax, and those brackets or something like them could be used for children's investment income.
Other areas ripe for repair include the treatment of awards for non-physical injuries in lawsuits.
"In such cases, contingent attorney's fees and attorney fee awards" -- money awarded to a successful plaintiff but earmarked and paid to the plaintiff's attorney -- "are treated differently depending on where the taxpayer lives," the report said. That's because over the years when the IRS has tried to assess tax on these fees, courts in different parts of country have come to different conclusions. The result is that some taxpayers can exclude attorney fees entirely, while others must include them in their own gross income. Some who must include them can deduct them as miscellaneous business expenses, but those deductions are subject to various limitations. Plus, there is the alternative minimum tax.
The report cited an extreme case in New York where a woman won $300,000 in damages and $950,000 in attorneys' fees and costs. She had to include both the $300,000 and the $950,000 in her income, resulting in a tax liability that not only ate up the entire $300,000 but left her owing an additional $99,000 in federal income tax. In certain other states, only the $300,000 would have been includable in her income, so that she would have owed $115,800 in taxes and been able to keep $184,200 -- a $283,200 tax swing based solely on where she lived.
The advocate's report recommends including legal fees in gross income but allowing an "above the line" deduction when calculating adjusted gross income. This kind of deduction is not affected by restrictions on itemized deductions and would not be subject to the alternative minimum tax, but it would allow the IRS to keep track of the amount of damages received by taxpayers and the amount received by their attorneys.
The report also recommends limiting the IRS's "math error authority" to fixing actual math errors, and requiring it to check out apparent errors that may in fact be correct.
The advocate's office is also seeking clarification of rules involving husband-and-wife business owners, more regulation of tax-return preparers and, not least, more authority for itself.
The entire report is available on the IRS's Web site, www.irs.gov. Click on "Taxpayer Advocate" at the bottom of the home page and scroll down to "Reports to Congress."
