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AN OVERVIEW OF THE US TAX SYSTEM




This article was originally written for and published in The Business Bulletin.


Several questions were posed to me in an email recently. They were (1) When is the IRS going to quit making new rules? (2) How many new rules are there this year that I can hardly understand? And then followed the comment, “I hope my accountant will let me know.”


I’m going to try to answer his questions: (1) The IRS doesn’t make those “new rules,“ or at least not in the way that we are thinking of. Congress makes the tax law. The IRS is charged with collecting the tax. (2) Depending on your situation there could be quite a few new rules, plus all the old ones you hardly understand. And yes, I too hope your accountant will “let you know.” But he just might not understand all the new or old rules himself, or he might not know exactly which one applies to you in your unique situation, or, help us all, he might forget or miss something if he’s tired or low on coffee. Or maybe he isn’t competent or even motivated?


How about those Congressmen up there on Capitol Hill who make tax laws? Are they acquainted with “life in the trenches?” Sometimes I wonder. On the average, I think not. Let me make the disclaimer right here that I do not mean to be negative about the IRS, or politicians. I’m confident there are some pretty good people up there, in face I’ve met some. But if we understand what makes them tick, we’ll understand the system a little better. We all enjoy job security. So it’s logical that a Congressman would try to please the voters in his constituency in order to be re-elected, correct? But the Congressman representing Iowa corn farmers may not have the same interest as the Congressman supporting California exporters/importers or the one trying to get help for Hurricane Ravaged Louisiana. Mix that up with a President that supports giving tax refunds to lower income taxpayers with children because those people vote him into office. It’s called “Pork Belly Politics” and that makes for many complicated tax laws so that everybody gets his “piece of pie.” It stands to reason that nobody gets votes by raising taxes.


But there are rules about lawmakers passing tax breaks without funding them somehow. It’s called “fiscal responsibility.” With each tax break comes an explanation about where that money will come from, etc. This little numbers game makes for interesting reading if you ever feel up to it. (See my previous article Figures Don’t Lie, but Liars Figure.) One way that politicians raise taxes without making a public issue is by passing little fine print “phaseout rules.” Here’s an example:


Social Security Benefits are not taxable income. Oh wait a minute, a quirky little law says it is taxable at 50% if you are married and if ½ of your Social Security Benefits plus your other income add up to $32,000 or more. No, just a minute, another quirky little law says it is taxable at 85% if you made over $44,000 and so on. Oh, and another little law says now you need to include non-taxable interest income in that computation, plus three other kinds. Oh, and another little law says you need to take into consideration any IRA contributions you made or 401K contributions not included in your W2 form. The bottom line is, we get new complicated tax breaks and add complicated little quirks that are supposed to fund them, and that adds up to what old Judge Learned Hand quoted in 1947: The tax code is a fantastic labyrinth…whose words merely dance before my eyes in a meaningless procession…” Yes, I said 1947, 65 years ago!


Now who has job security? Accountants? Enough on that, we’re talking about how the system works, or doesn’t work, (you decide). My opinion is that if everybody were honest and unselfish it would work well, but are they? In a recent survey 15% of the respondents said they “were likely to cheat on their income tax returns” for the obvious reason – money. 42% of those said they were one paycheck away from financial disaster, mind you! The U.S. Tax System was designed to be a voluntary based system, with a little “checkin up” following. You are to voluntarily report what you made and pay what you owe. That’s all fine and good except for a few citizens that are plagued with their human nature. They might just not voluntarily report all their income and pay all their taxes.


So the Return Examination or “Audit” division was created to plant a little holy fear in taxpayer’s heart. Auditors were to verify that returns were being done correctly and tax was being reported and paid in correctly. If not, they were to educate that taxpayer, make him pay up plus penalty and sometimes even make him a public spectacle. To some extent, that system helped. However, due to inefficiency on the government’s part and agility on the part of dishonest taxpayers, that system is no longer serving the purpose well. By the time the IRS gets around to auditing a return It’s commonly 2-3 years after the fact. Systematic, by the books auditing takes lots of time, and auditors aren’t known for being understanding and realistic, since they’ve never been in business and leave the office at 5 with their paychecks hitting their accounts every Friday. The IRS reports to Congress annually that they were able to “find” $X million in missing taxes per year with return examinations but they omit the fact that the amount they actually collect is a vastly different sum.


So recently we heard about the “new rules” about sending 1099 forms out. They’re not new rules, they’ve been around for years and years. However, somebody up there in Washington showed a surprisingly good sense of judging human nature: You now have to check two boxes on your farm, business, or rental schedule: (1) Did you pay rent or services to people of more than $600? And (2) Did you send those people a 1099 form? Now I don’t know about the accounting firm down the street, but my clients aren’t going to tell me to just check no if they actually paid. They want to tell the truth. So there are probably many more 1099 forms being sent out now than in previous years. In turn, there will be much more income reported on tax returns than in previous years. Do you believe it? I do, and I think it’s a good idea.


Just look at this example of how many people are bold enough to cheat: The year that IRS began requiring Social Security numbers on tax returns SEVEN MILLION dependents were dropped. Who were all those children? Were they pets?


Now the big cheating is not in under-reporting of income, but in falsely claiming credits not due them. When the government came up with the First Time Homebuyer Credit, you could get as much as $8,000 for buying a home. Do you think there might have been just a few people that thought they might could slip in there and get away with it? The IRS caught on fairly quickly on that one, and just made it a point to deny and audit each one. It was a grievous process for some of my clients to prove they deserved their refund, but at least I know that many cheaters were denied. The same process was later applied to the Adoption Credit.


On the other hand, the IRS has been unsuccessful at curtailing fraud on the big one, the Earned Income Credit. Between $11 TO $13 BILLION per year are paid erroneously for this credit. THAT, my friends, is massive cheating. What is being done? Not much that I can see. As tax preparers, we are being threatened to snoop around these people and we have to send in an additional form that is supposed to prove that we asked the right questions. We are liable for a $500 per omission penalty if we don’t do our job. But the worst of it is, these people if and when they’re caught, have long since spent the money and it’s impossible to recover it. So there you are. We have an endless circle going. The fallout is that much money is being wasted, and far too many cheaters slip by.


And the worst of it is, many of you regard tax time and their visit to their accountant about equally painful as a visit to the dentist. So, we’re doing what we can to make it more pleasant. You can reach us by phone, email, fax or our web page if you can’t stand to see us. If you do come in there’s hot coffee awaiting you and a nice chair to sit in while you fill out your paperwork. By the way, are you allergic to anything, and are you in any pain?

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