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Ten Tax Rules Guaranteed to Drive You Crazy

Tax professionals are just about the only Americans who do not complain about the complexity of our tax laws. After all, if mere commoners could find their fiscal fortunes in the Internal Revenue Code, how would oracles like us ever command $400 an hour?

No, it is not complexity that rankles. Writing tax law is an art that requires Congress to balance the needs of the Treasury, the condition of the economy, the good of society and the wallets of the lobbyists who hang out with Ways and Means Committee members. The rules have to be complicated in order to do the least damage while extracting the most money from taxpayers and political hangers-on.

What gets my goat is the sheer silliness of rules that have either outlived their purpose, embody a long-discredited philosophy, or just do the opposite of what common sense demands. Here is my list of ten anti-taxpayer U.S. tax provisions that are guaranteed to drive you nuts if you think about them too much. For fairness’ sake, our next issue will contain a list of rules that are favorable to taxpayers but which make no more sense than these.

  1. Tax you once, tax you twice. We tax corporate profits when the corporation earns them, and we tax them again when the corporation pays dividends to shareholders. If a company earns a dollar from a customer, federal income taxes can eat up 60 cents before it ever reaches the owners. But the law leaves gaping loopholes that allow many businesses to escape the double tax. What remains is essentially a penalty against big business distributing profits to shareholders. Now you know why large companies pay such puny dividends. More sensible tax systems, such as England’s, provide tax credits to avoid or reduce the double-tax phenomenon. Then again, their tax systems are much less efficient than ours at separating political contributions from lobbyists.
  2. Don’t you dare play by our rules. Two decades ago newspapers wrote about high-income citizens who used legitimate deductions to reduce their taxes to virtually zero. An embarrassed Congress enacted a “minimum tax” that has evolved into today’s Alternative Minimum Tax, although there really is no alternative. AMT can ensure that if you don’t pay an oracle the proper sum of money for guidance, you’ll get walloped with a tax bill you never expected. You may get walloped even if you do pay an oracle the proper amount. The AMT system is rigged so that unlucky taxpayers may never get a federal deduction for common items such as state income and property tax payments. As state tax payments rise, vast numbers of taxpayers are expected to fall under AMT in the coming years unless Congress loosens the rules. Since these taxpayers vote, we can look forward to some changes.
  3. The myth of the worthy homeowner. The law was changed in 1986 to prohibit deductions for “personal” interest expense, such as interest on education loans and credit cards. Homeowners can still deduct generous amounts of interest on mortgage and home equity debt. So what happens? A lower-middle-class family, living in a rental, borrows money for a child’s college and pays full fare. An upper-middle-class family takes out a quadruple-subordinated-we-don’t-even-check-for-a-pulse home equity line of credit, and Uncle Sam picks up part of the tab. Sorry, was I dozing when someone explained the rationale for this?
  4. Gimme that. A long-standing principle of our tax law is that if you earn taxable income, you can deduct what it cost you to earn it. However, when today’s tax-writers need money, it’s principles, schminciples. That is why you can only deduct “miscellaneous” items, such as employee business expenses, to the extent they exceed 2% of your adjusted gross income. It is also why if your income is above a certain threshold, your deductions are arbitrarily reduced by $3 for every extra $100 you earn. This is how we raise tax rates these days without actually raising tax rates.
  5. Put it on top, please. Suppose you paid too much in state taxes in 1996. You deducted those taxes on your 1996 federal return, and you collected a refund in 1997. In 1997 Uncle Sam will expect you to include the refund in income, and count it toward the amount that reduces your 1997 itemized deductions. You wind up paying more federal tax this year than you saved last year. Nobody pretends this is fair.
  6. Give some, get more. Computing taxes is not an exact science, so sometimes the government and taxpayers find themselves owing money to the other party. They usually pay back what they owe, with interest. Trouble is, the government gets to make the rules, which is why taxpayers are required to pay more interest than the government for the same types of errors. Nobody pretends this is fair, either.
  7. Can’t win for losing. Economic losses incurred on personal assets are not deductible. This makes sense, or we’d all be deducting the normal depreciation of our cars, clothes, etc. But any gain on sale is fully taxable. This bothers the bejabbers out of homeowners who see the value of their homes go down and cannot stick the IRS with part of the cost. The recent real estate recession created so many misplaced bejabbers that Congress seems ready to do something, either exempting more of the gains on home sales from tax, or making the losses deductible. For all the logic they put in tax laws these days, Congress may very well do both. That ought to reunite homeowners with their bejabbers in a hurry.
  8. Roosevelt family values. With such a robustly irrational income tax system, you’d think we would be happy. Instead, we also have created a gift and estate tax system whose goal is to tax (yet again) any assets you have accumulated each time the assets pass to a younger generation. A $600,000 lifetime allowance targets this tax at the well-to-do, though you don’t have to be doing as well as you used to, since this level has been flat for eleven years. The gift and estate tax raises very little revenue for the government after the costs of collecting it are considered. However, it raises immense revenue for us oracles, who can help clients save millions by planning around it. You might think the government retains these taxes just to keep oracles from going on welfare. Not true. FDR once justified the estate tax as being necessary to avoid “the perpetuation of great and undesirable concentrations of control in a relatively few individuals over the employment and welfare of many, many others.” Somebody should tell Bill Gates.
  9. You can run, but leave the money. We let husbands and wives freely transfer assets to each other without paying estate or gift tax — as long as the recipient spouse is a U.S. citizen. If not, we require the money to be placed in a special trust or else the tax is due. If the recipient spouse withdraws principal from the trust, such as for her own support, the tax is still due, so it is next to impossible for a surviving noncitizen spouse to “spend down” otherwise taxable assets. Congress was worried that surviving spouses would simply take the money back to the Motherland, out of reach of the IRS. That may happen, but why does this risk justify the premature imposition of a tax that is supposed to be triggered when money moves across generational, rather than gender, lines?
  10. A Crummey rule, 30 years later. Taxpayers can give $10,000 per year to any beneficiary they choose without any gift tax consequence, as long as the gift is a “present interest.” This closes the door to many gifts that are made to trusts, which is often the most sensible way to make a gift. Taxpayers and the IRS have been battling since the Crummey case 30 years ago to define what types of gifts through trusts qualify as “present interests” eligible for the $10,000 exclusion. The bigger issue: Why limit the exclusion to present interests in the first place? Why not simply look to see if the gift is a bona fide, completed transaction that truly removes assets from the control of the giver? Then we could use trusts for sensible non-tax planning without a lot of legalistic lard and IRS-induced “gotchas.”