Challenges of Tax Exemptions
One of several features that make tax systems complicated are the numerous exceptions that pull out from taxation something that is part of the tax base for a particular type of tax. It is probably almost impossible to find any federal, state or local tax that doesn’t have some type of exception. A list of sales tax exemptions produced by the California Department of Tax and Fee Administration (CDTFA) lists 171 sales tax exemptions. All of them need a definition in the statute and often an explanation from the tax agency. This creates a lot of complexity because it is difficult to define most exemptions. For example, if a state wants to exempt food from sales tax but only healthy food, where does a “protein bar” full of sugar and not a natural item fall?
Our federal income tax law has Code sections 101 through 139I listing items of income, such as certain disaster relief payments, fringe benefits and gifts, that are income, but excluded from the measure of taxable income.A 2023 ruling in Iowa caught my attention as an example of the complexities of defining exemptions (Sweat Iowa LLC, No. 346007, 11/14/23). Iowa imposes a 6% sales tax on “enumerated services” which includes “all commercial recreation.” The term “enumerated services” signals that all potentially taxable services are not subject to sales tax. Generally, because a sales tax is imposed on personal consumption, everything that an individual purchases that is not for business use, should be subject to sales tax.
If the law in any state worked that way, the rate would be lower and the tax base broader (and mostly easier to define).For a sales tax (a tax on personal consumption), the only items that should be exempted medical services provided by a medical professional and tuition for a university or professional/job training.

In the Iowa ruling, the question was whether booking services for saunas with “science-backed technology of infrared (IR) and red light therapy(RLT) to optimize health and wellness” is “commercial recreation.”

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American Opportunity Tax Credit Issues

Over the years, I have heard individuals and tax professionals raise various questions on the operation of the American Opportunity Tax Credit (AOTC at IRC 25A). This is the credit that for the past many years provides up to a $2,500 credit for each of the first four years of higher education at a college or university.  It started in the early 1990s as the Hope Scholarship credit for a lower amount and only the first two years of college.

There are numerous other tax breaks for higher education including an exclusion for scholarships, a limited above-the-line deduction for student loan interest, the Lifetime Learning Credit, an exclusion for interest on education savings bonds, 529 accounts, and more.

Some of the issues I have heard for the AOTC include:

  • Do years at a community college count as part of the four years? I believe they do, but what if the student isn’t, at least at first, pursuing a degree?
  • What are all of the expenses that qualify?
  • What if the 1098-T received (and required to claim the credit) is incorrect in terms of the year or amount?
  • Why does it only cover college or university programs rather than also trade schools and similar?
I’m working on a paper of these and a few other administrative and legislative issues about the AOTC. If you have questions or issues you’ve encountered or wondered about, I would greatly appreciate you posting them in a comment here.  Thank you!
Written by Annette Nellen, Professor San Jose State University
Important Effective Date Item In Preamble To Digital Asset Broker Reporting Prop. Regs
The proposed regulations on broker reporting of digital assets released August 29, 2023 (REG-122793-19) included more than guidance under IRC section 6045. They also included related proposed regulations under section 1001 on amount realized and section 1012 on basis. I think that generally, the 1001 and 1012 proposed regulations are fairly straightforward and tie to the general rules at these provisions.
One clarification they offer is that in a transaction where a taxpayer exchanges, for example, X coin for Y coin and pays a transaction fee, 50% of the transaction fee is treated as a reduction to the amount realized for the disposition of X coin and 50% is added to the basis of the Y coin acquired.
Unlike the virtual currency FAQs #39 – #41, Prop. Reg. 1.1012-1(j) provides that in applying the specific identification method to know which digital asset was disposed of (when the taxpayer has more than one unit or code representing their digital assets), the taxpayer must apply specific identification on a wallet by wallet or exchange by exchange system. In contrast, the FAQs allow (or at least do not disallow) use of a universal tracking approach where the taxpayer transferring, for example, 2 Xcoin out of wallet 1 to buy goods, could specifically identify to say they used the basis of 2 Xcoin in T’s wallet 2. This would not be allowed under the proposed regulations. The long list of questions in the proposed regulations include though, whether there are alternatives to this approach (questions 44 & 45 at page 59616 in the Fed. Register).
Prop. Reg. 1.1001-7(c) and 1.1012-1(j)(6) provide that these proposed regulations are effective on the January 1 following when final regulations are published. However, page 59616 in the Fed. Register states that the 1001/1012 proposed regulations are reliance regulations. That is, per the preamble, taxpayers “may rely on these proposed regulations under sections 1001 and 1012 for dispositions in taxable years ending on or after August 29, 2023, provided the taxpayer consistently follows the proposed regulations under sections 1001 and 1012 in their entirety and in a consistent manner for all taxable years through the applicability date of the final regulations.”

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Fewer Clean Vehicles Qualify For Federal Tax Credit In 2024

The §30D Clean Vehicle Credit that was greatly modified for 2023 through 2032 by the Inflation Reduction Act of 2022 has increasingly strict qualifications each year. Per the IRS and Dept. of Energy list of qualifying vehicles, there is a drop for 2024. For clean vehicles purchased from April 18, 2023 through December 31, 2023, 27 vehicles qualified an eligible buyer for a $7,500 credit and 16 for a $3,750 credit.

As of today (1/1/24), the list for 2024 includes just 10 vehicles for the $7,500 credit and 9 for the $3,750 credit. The drop is due to a combination of no longer meeting the higher critical minerals or battery component requirement or involving parts of assembly by a “foreign entity of concern” such as China.

I suspect that more vehicles will be added during the year, but this drop will likely continue annually for the next several years.  If you’re looking for a good deal on a clean vehicle, likely that happens the last week or so of the year when dealers are eager to sell eligible vehicles that won’t be eligible the next year.

And new starting in 2024 is the ability of buyers to transfer their credit to the dealer (if registered) so the customer/taxpayer can get the value up front rather than waiting to when they file their return.

There is more information at:

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Tax System Changes Can Help Reduce Poverty

I received information from the National Academies on their new report, Reducing Intergenerational Poverty, Sept 2023. It defines “intergenerational poverty,” provides demographics of this poverty, describes education and health issues associated with continual poverty, and makes recommendations.

The introduction reminds us of the relevance of this topic to us all (page 1):

“Capable and responsible adults are the foundation of any well-functioning and prosperous society. Yet low-income families struggle to offer their children the same advantages and necessities that better-off families can offer. As a result, throughout their childhoods children living in families with low incomes face an array of challenges that place them at much higher risk of experiencing poverty in adulthood as compared with other children.”

“The costs of perpetuating this cycle of economic disadvantage fall not only on low-income individuals and families themselves, but also on society as a whole. Poverty reduces overall economic output and places increased burdens on the educational, criminal justice, and health care systems. Understanding the causes of intergenerational poverty and implementing programs and policies to reduce it would yield a high payoff for children and for the entire nation.”

One of the recommendations is to increase and expand the Earned Income Tax Credit (EITC). Per the researchers: “The strongest direct evidence on the likely intergenerational effects for children is found for programs that increase both family income and parental employment during childhood and adolescence.” [page 133]
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Tax Reform Hearings Of The 118th Congress And Previous Congresses

In case it is of interest to you, something I started doing in 2007 (same year I started this blog) was maintaining a website of tax reform hearings of the 110th Congress and have done so through today finally getting a webpage for the 118th Congress (which started in January 2023) posted today. I use the term “tax reform” broadly here as just about any tax hearing, even the typical April ones to debrief about the filing season can lead to reforms.

The website for the 118th Congress with links back to 110th is here – https://www.sjsu.edu/people/annette.nellen/website/118th-hearings.htm

Unfortunately, some older links on some of the pages are broken because the URLs were changed perhaps due to website redesigns or change in controlling party of the committees. But if you do a web search using the name of the committee, hearing and year, you likely will find the information.

Of interest for the 118th Congress so far is one on the child tax credit which was created in 1997 and its expansion continues to be debated along with other possible tax changes, perhaps as part of appropriation bills. There are also a few on international tax reform.

I started doing this because in my teaching, research and writing on tax policy and reform, I often find interesting items and ideas in the testimony as well as just viewing the topics covered. Having the website with the tax hearings all in one place is helpful – and I’m glad to share.

What do you think? Professor Annette Nellen

Modernize 1970s Definition Of "Tax Shelter" To Help Small Businesses

Here is another suggestion from the testimony I submitted for the written record of a Senate Finance Committee and Small Business and Entrepreneurship Committee roundtable held 6/7/23 (see links at my 8/13/23 post).

This one has also been suggested by the AICPA including in letters I signed when chairing the AICPA Tax Executive Committee a few years ago, so it has been around for awhile. It would be a terrific simplification because I think that since the Tax Reform Act of 1986 stated that a tax shelter as defined under IRC Section 448 must use the accrual method regardless of gross receipts level, I think this is likely one of the most overlooked provisions in the law. The additional accounting method simplification added by the TCJA of 2017 further highlighted that a “tax shelter” can’t use the favorable methods.

The simplification recommendation:

One way an entity might be a “tax shelter” is meeting the definition of a syndicate as defined at IRC Section 1256(e). This definition pre-dates state law changes that allow the LLC business entity. A business that meets the definition of a “tax shelter” will not be allowed to use simpler accounting methods but instead will be required to use the accrual method, inventory accounting rules, and the uniform capitalization rules of IRC Section 263A.

Today, a small business might be formed as an LLC with financing provided by some owners who will not be involved in running the business. If over 35% of losses are allocated to limited entrepreneurs (inactive owners), the entity is a tax shelter even though it is running a real business (and might just have start-up losses or some bad years). The definition needs to be modernized such as to only be defined as a tax shelter per IRC Section 6662(d) (having a significant purpose of tax avoidance or evasion).

What do you think? Professor Annette Nellen, San Jose State University

Simplify And Modernize By Removing Exclusive Use For A Home Office Deduction

Yet more from the testimony I submitted for the written record of a Senate Finance Committee and Small Business and Entrepreneurship Committee roundtable held June 7, 2023 (see my posts of 7/9/23 and 7/2/23 and 6/25/23). Another way to simplify tax rules for small businesses (such as ones operating out of the owner’s home) and modernize tax rules is to remove the exclusive use requirement for the home office deduction.

Modern life makes it unlikely that anyone uses a home office only for business activities. Most people, for example, have a smartphone in their hands and might get a personal call or text message or use a weather app while in their home office.

An alternative would be to allow a home office deduction only if the space is used over 50% for business and to reduce the deduction based on the percentage of personal use of the space, such as based on time. Offering a standard home office deduction, such as allowed by Rev. Proc. 2013-13, would be helpful, with the amount adjusted annually for inflation (and no exclusive use requirement, but adjusting the standard deduction for the percent of personal versus business use of the space based on an average week of use).

What do you think? Professor Annette Nellen, San Jose State University.

Reminder On Resources For Tax Answers

A Tax Court Summary Opinion of June 26 on the mortgage interest deduction for 2019 when the taxpayer’s aggregate mortgage debt on their principal and second homes exceeded the debt limit included a subtle reminder about the role of IRS publications to support positions taken on tax returns. [McNamara, TC Summary Opinion 2023-22 (6/26/23)]

The taxpayer’s second home was only owned for 5 months of the year but in calculating the allowable mortgage interest deduction, performed the calculation as if owned 12 months. The taxpayer said they relied on IRS Publication 936, Home Mortgage Interest Deduction. The court relied on IRC Section 163(h) and related regulations, which it found “unambiguous” in determining the deduction as the IRS determined.

In noting that reliance on the IRS publication was “misguided,” the court added: See Miller, 114 TC 184, 195 (2000) which explains “that administrative guidance is not binding on the Court when the plain meaning of a statute is clear.” But the court did not include the quote on page 195 of that case. Here is is:
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Problem Of Earmarking Tax Revenues

When we pay taxes, we likely think they are funding government based on the spending recommendations of elected officials as informed by the government agencies, such as the Dept. of Education, that propose budgets for funding. But this is not true for all tax revenues because some are earmarked to go to certain funds. One that might come to mind are gasoline excise taxes that primarily fund the Highway Trust Fund to build and maintain roads.

States also have various taxes often earmarked for particular causes. For example, in 1998, California voters passed Prop 10 to add a 50 cent excise tax on a pack of cigarettes. This additional tobacco excise tax was earmarked for the newly created California Children and Families First Commission for various education, health and child care projects to help children.

On July 21, 2023, CalMatters, a nonpartisan, nonprofit news organization, reported: “Californians are smoking less: Why that’s a problem for these early childhood services.” They report that by 2026, First 5 Association of California expects 30% less revenue compared to 2021. The First 5 program in Kern County also notes the funding decline in its 2022-2023 report, resulting in less services for children 5 and under.

So, it’s good that fewer people are smoking, but important programs lose funding as a result. What an odd system!
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Help Individuals And Small Businesses By Promoting Tax Literacy

Continuing my current series of posts on addressing small business tax law complexity, here is another suggestion I included in what I submitted for the written record of a June 7, 2023 SFC and Small Business and Entrepreneurship Committee roundtable.

Promote Tax Literacy

We don’t teach about tax in K-12 or at universities other than accounting majors typically taking at least one taxation course and there might be some tax included in financial literacy curriculum available at some high schools and colleges. Given everyone’s role as a taxpayer, more is needed. To help small businesses, I suggest:

When a taxpayer requests an EIN for a new business, the IRS should at that time also send (electronically and/or by the U.S. Post Office) information about tax obligations of a business in a form understandable by a layperson.

Provide funding to the IRS and SBA to run live, online workshops for new business owners on specific topics relevant to helping the taxpayer understand their tax obligations and to ask questions.

While there are numerous publications at the IRS website that can help a new business owner understand their tax obligations, they can be overwhelming and sometimes not specific enough such as to explain estimated tax payments and information reporting obligations.
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What About Expanding The Qualified Joint Venture Election?

I think to generate simplification ideas, we need to look at every tax rule or calculation and ask at least two questions. First, should this rule even be part of this type of tax? After all, the federal income tax has over 160 “tax expenditures” which are special rules that are not part of the basic income tax structure (see OMB FY2024 report). Next, is there a different way to draft the rule or handle the computation? We get so used to certain rules, forms, and practices that we often act as if that is the only way something can be done.

I want to offer an example of an out of the box idea that does have some basis in an existing tax rule. I recently suggested this in comments I submitted for the written record of a June 7 joint hearing of the Senate Finance Committee and Small Business and Entrepreneurship Committee, on tackling tax complexity for small businesses. Among my suggestions, I offered this:

Allow co-owners of a start-up business to elect qualified joint venture status for the first few years.

IRC Section 761(f) allows a married couple to elect to treat a business they jointly own and operate as a “qualified joint venture” rather than as a partnership. The couple files two matching Schedules C rather than a Form 1065 partnership return. This is simpler for the couple and enables both spouses to pay into the Social Security system. [see IRS information]

Filing two Schedules C is much easier than filing a partnership return including a Schedule K-1 (as well as Schedule K-3) for each partner.
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