Up close and personal on taxes

The Tale of Four Tax Returns, a short video documentary from PBS last week, really highlights many important aspects of our taxcode from the perspective of four very different real life  taxpayers.

Top left is Jennifer Rosado, a low-income single mother with children.  Two years ago, in 2010, she was making poverty level wages of $12,800 and the refundable tax credits she received made the difference for her family between living below the poverty line and above it.  It is important to stress the difference between those tax credits and traditional welfare--she had to EARN the income through work in order to receive those credits.   After two years she has worked her way into a higher paying job and she is currently on the phase-out portion of the Earned Income Credit.  Her tax scenario looks a lot like the Ashley Sawyer case study in the VITA test.

Lower left is Danny Rangel, a Navy veteran now working as electrian, whose income of about  $30,000 also qualifies for VITA tax preparation assistance.    Unlike Jennifer, Danny has no children, so he is paying a substantial amount of his income in federal taxes.  If we consider both income and payroll taxes, he paid a larger share of his income in federal tax in 2010 than Mitt Romney did.  The difference becomes even more stark if we consider the other taxes he pays (sales taxes, excise taxes on gas and other items, property taxes passed onto him in the form of high rent).  His tax scenario looks a lot like the Rose Hudson VITA case study.

The two taxpayers on the right are on the other end of the income spectrum.  Eric Schoenberg, the wealthy investor in the lower corner earns eight times as much as Seth Hahn at top right, but both taxpayers earn well above the median income.  Their financial positions are similar to those to which many Union College students aspire.   Their very different tax circumstances reveal a lot about the complexity of the unfairness built into our tax system.

The show's transcript is available here.  The video, which provides a Rashomon-style multifaceted perspective on our tax system, is embedded below.

Watch 1/11/2013: A Tale of Four Tax Returns on PBS. See more from Need To Know.

Under penalty of perjury!

Mathbabe (a mathematician, data scientist, and public policy blogger) wrote a blog post called I totally trust experts, actually in which she stated:

"I also hire an accountant and sign my tax forms without reading them."  

As a public finance economist specializing in tax policy, I know Mathbabe is far from alone in that practice, but in my opinion, an "expert" accountant is seriously remiss in professional responsibilities if s/he encourages you to sign your tax return without reading it.

Your tax pro should be taking special pains to let you know that signing a tax return is not like signing the ubiquitous terms of service to get access to some internet site.  I know there is a lot of confusing boilerplate (Cathy isn't the only mathematician who finds taxes annoying and tedious--see here another discussion about Berkeley math PhDs and taxes, and for a comic relief parody from another mathematician, see here), but part of a tax preparer's professional obligation is to help the client navigate through the gobbledigook and understand the critical essence of the information presented in the return before asking for a signature.

Signing a tax return is signing a statement that says--upfront, in the opening sentence--

"Under penalty of perjury, I  declare that I have examined this return and the accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete."

Who is the "I" in that sentence?  It is not your tax preparer.  It is YOU, the taxpayer.

You--not your accountant!--are the person ultimately accountable to the IRS for the accuracy of what is on your return. You are signing--under penalty of perjury--and submitting a document to a government agency with the power to pursue both civil and criminal charges against you, to seize assets, garnish wages, and generally create a great deal of hassle down the road.

Studies have shown that tax pros, even CPAs,  frequently make mistakes on tax returns. They may be experts in tax law, but they are not experts in knowing every twist and turn of your personal financial circumstances.  They admit as much when they sign the return.  Unlike you, the tax pro is not required to sign a sweeping statement that it is "true, correct, and complete."  The tax pro only signs that it is based on "all facts of which [the preparer] has any knowledge."  Reliance on a CPA is not going to be a defense against negligence penalties if you acknowledge that you did not even bother to read your return before signing it. Many Tax Court opinions make this clear.

As the supervising faculty member for a Volunteer Income Tax Assistance (VITA) site providing free tax help to low-income working families, I insist that my student volunteers walk their taxpayers line by line through the tax returns they prepare for them, confirming their understanding of the key statements and numbers on their tax returns and encouraging them to ask questions until they feel completely comfortable signing that statement on the return.

Our clients who have generally relied on paid preparers in the past say that no paid preparer has ever taken the trouble to do that before they came to us.  Most of the clients said their prior preparers just entered a bunch of numbers into the computer, printed out a bunch of documents they didn't understand, and told them "Here is the amount of your refund.  Sign here."  (Despite this cavalier attitude, such preparers often charge very high fees, even for very simple returns.)

Walking our clients line-by-line through the tax returns before asking them to sign is an essential part of our quality control process.   During the walk-through, some taxpayers recall important issues they might have forgotten to mention earlier as we walk them line-by-line through their returns or they catch misunderstandings our preparer might have gotten from the statements they had made during the interview.   The return walk-through also helps our clients to get a clearer handle on the big picture of their finances and the tax implications of the choices they have made and/or may be considering for the future, e.g., 401k enrollment, community college tuition, home ownership, self-employment, charitable giving.  (Interesting note though:  the poor give a larger share of their income to charity than the rich, despite the fact that there is minimal--frequently zero--tax benefit for charitable donations by low-income families.)

Another sad irony:  in many recent years, as my former classmate, National Taxpayer Advocate Nina Olson, has repeatedly pointed out, low-income working families have been far more likely to be audited than many folks with higher incomes.  And when they do get audited, they are at much higher risk of getting steamrolled by a process they do not understand.  The poor really can't afford to do what Mathbabe admits to doing!  Most of them can't afford the professional resources to dig themselves out of IRS trouble, so their best defense is (1) filing an accurate return and (2) understanding the information on their tax returns well enough to have the confidence to contest any audit claims made by the IRS.

But the tide is turning.  Thanks in part to Nina Olson's highlighting of the issue, the IRS is now increasingly redirecting its audit resources towards the higher income taxpayers.  So those folks are also well-advised to examine their returns carefully before signing.  Caveat taxpayer!

"Examining your return" does not literally have to mean reading every word of the obscure boilerplate on your return, but responsible tax preparers should be guiding all their clients (rich and poor) should take a thoughtful look at it, and make sure their clients understand the essence of the statements they are making to the IRS (and their state, if applicable) about the amounts and sources of income,  exclusions,  various types of deductions, tax credits, and why they are justified in claiming them.

Can I claim myself? FAQ#1

Rose Hudson, college student 

Frequently asked question #1:  My parents are NOT claiming me on their return, so can I claim myself on my own return?

Answer:  Whether you can claim yourself on your tax return does NOT depend on whether your parents actually claim you as their dependent.   It depends on whether they *could* have claimed you under the applicable tax laws.

If any other taxpayers qualify to claim you as their dependent, you may NOT claim an exemption for yourself on your own tax return, even if they choose not to exercise their right to claim you.

That is why our official IRS  Intake/Interview sheet asks:

Notice the wording.  It is quite deliberate.  We are not asking "Is anyone else claiming you?"  We are asking "Can anyone else claim you?"

You can see the same kind of wording right on the IRS Form 1040 tax return itself:

IRS Pub 17 (the definitive advice for laypeople) further reinforces the message by explicitly stating:

Your Own Exemption
You can take one exemption for yourself unless you can be claimed as a dependent by another taxpayer. If another taxpayer is entitled to claim you as a dependent, you cannot take an exemption for yourself even if the other taxpayer does not actually claim you as a dependent.

So, naturally enough, this leads to

Frequently Asked Question #2:  How do I know if another taxpayer can claim me on their return?

 That turns out to be a complicated question for many taxpayers, including many young people and some very low income disabled or elderly citizens who may not be providing all of their own support, so we will save it for the next post.

In the meantime, I will leave you with a case study from the VITA volunteer workbook.  Rose Hudson, the fictitious college student who also works as a restaurant manager, has checked the box on her Intake/Interview form to indicate that she does not believe that any other taxpayer can claim her.

However, experience shows that many taxpayers are confused about these matters, and given her age and student status and the fact she lived with her parents for at least part of the year raises questions about whether she can--in fact--claim herself.   Before going ahead and assuming that Rose can claim herself because she believes nobody else can claim her, we need to actually go through the information  she has given us and ask sufficient additional questions to be sure whether she is right in saying that nobody else can claim her.  

You can find Rose's tax documents and the notes taken by her interviewer at this link.   Feel free to take a look and see what you think.  You may find it helpful to use IRS Pub 4012 Tab C, IRS Pub 17, and/or IRS Pub 501 as references.

Do you need to file a return?

Who needs to file?  Who knows?  Who cares?

Updated Jan 2021 for 2020 tax year.

Who needs to file?  Who knows?

In general (unless special circumstances apply, which is frequently the case--see below), the following taxpayers will NOT be subject to a legal filing requirement:

• Single taxpayers with 2020 incomes below $12,400

• Married taxpayers with 2020 incomes below $24,800

• Head of Household taxpayers with 2020 incomes below $18,650

However, special circumstances CAN and DO apply to many taxpayers.  The applicable income limits can be higher or lower--even zero in some cases, so it is foolhardy to rely on the figures above without digging deeper.

On the one hand, many taxpayers can have income levels much higher than those above without being subject to a filing requirement.  For example, taxpayers whose income comes entirely (or almost entirely) from Social Security benefits may not have a filing requirement, even if their income is much higher than the amounts listed above.

In addition, taxpayers who are legally blind and/or over 65 have higher thresholds before they are require to file tax returns.  (Why just the blind and not those with other disabilities, some of which might arguably require far more expense to mitigate?  Who knows?  Apparently it historically had something to do with the relative strength of the lobbying efforts of their advocacy organizations.)

In many other cases, however, taxpayers can be required to file at much lower levels than above dollar figures might suggest.  Some examples:

• Taxpayers with self-employment income can be required to file a tax return once their self-employment income reaches $400.
  
• Taxpayers who can be claimed as a dependent by another taxpayer can be required to file a tax return if they have "investment income" over $2,200 and are subject to the "kiddie tax".   Note that the IRS deems "investment income" for this purpose to be anything other than wages and self-employment income, so investment income subject to kiddie tax could conceivably include prizes your child won or those on-line poker winnings.   Even taxpayers who *can't* be claimed as a dependent (e.g., self-supporting independent full-time students under 24 in some cases) may still be subject to the kiddie tax in some cases if a substantial part of their support comes from sources other than earned income.   (Note that kiddie tax is Out of Scope for VITA, so if your taxpayer has a dependent child with substantial amounts of UNearned income, please alert me.)
  
• If you are a taxpayer whose employer did not withhold and remit the correct amount of Social Security payroll tax on your wages for whatever reason (e.g., tax evasion by your employer or perhaps your employer is an international organization legally not required to withhold such taxes such as the International Monetary Fund (IMF) or the World Bank, even though you owe them) you can be required to file a tax return even if your income is very low because you still need to report and pay your payroll taxes.
  
• There is a laundry list of other obscure miscellaneous situations when you may need to file a return with the IRS even if your income fell below the usual thresholds.  A number of additional cases (including Alternative Minimum Tax, IRA and other retirement plan taxes, nanny taxes, first-time homebuyer credit repayments, and other situations) are listed on page A-3 of Pub 4012.
  
• Foreign students and visiting foreign scholars may be required to file US income tax returns even if their income was extremely minimal or possibly even zero.  (These situations are outside the scope of our VITA site, unfortunately.  The exact nature of each student's tax situation can depend on the bilateral tax treaty between the US and the student's home country, and so it is incumbent upon individual students to sort out their tax filing issues the best they can.  The IRS offers guidance here and here.)

As you can see, it can easily get complicated.  Many people who can be claimed as dependents may not even know they can be claimed as dependents, because the rules are so complex.  Some people who are technically "self-employed" or otherwise responsible for reporting and paying their own payroll tax apparently do not fully understand their situations (as infamously illustrated by Treasury Secretary Timothy Geithner on his own tax returns a few years ago!)  

Who cares?

To file or not to file?  For most people who are not required to file, the filing requirement threshold dollar value is beside the point because there are so many advantages to filing, even when it is not legally required.

Advantages of filing a tax return even when not required:

• To claim a refund:  If income taxes were withheld from your pay (check boxes 2 and 17 of your W-2 to determine this), you may be due a refund.   Also, you may be due to receive a refund if you are eligible for refundable tax credits (e.g., the Earned Income Credit, the Additional Child Tax Credit, the American Opportunity Credit, Recovery Rebate Credit,etc.)
• To create official record documents which may be useful later:  When you file a tax return, you are declaring--under penalty of perjury--that you have accurately collated and summarized all pertinent financial documents.  That contemporaneously created record could be very useful  down the road.  For example, if you later apply for financial aid for higher education, for a property tax abatement, for home heating assistance, for health care subsidies, for a mortgage or other loan, or in a variety of other situations (applications for naturalized citizenship, applications for professional licenses, divorce and child support hearings, bankruptcy, student loan hardship deferrals) you may find it very helpful to have copies of your old tax returns for those purposes.   In some cases, you may be asked to document your income (and/or your record of tax compliance) over several prior years, and that may be a challenge for many people who did not file tax returns, because they did not hold onto the old W-2s, etc. and they may find it hard to track down old employers, etc.  By contrast, if you filed a tax return--even if you lost your copy--you can order free transcripts from the IRS, which provide the key relevant information from your old returns.  
• To preempt a criminal from fraudulently filing a tax return using your name and SSN (or at least mitigate the damage as quickly as possible):  Sadly, this is a growing problem and my old classmate Nina Olson, the National Taxpayer Advocate, says that the IRS has been unable to deal with it adequately.   The IRS has made it way too easy for someone to use your name and Social Security number to file a completely fabricated return in order to get a large refund.  The IRS has operated under enormous political pressure to "get the tax refunds out quickly!" and their normal practice is to issue refunds very fast and only ask questions later--often much later!  Criminals have exploited this weakness in the system to get large refunds based on filing returns under other people's identities.  Unless you yourself file a return, the IRS may have no easy way even to contact you and notify you promptly that somebody else has already filed a return in your name and SSN.
• To set the record straight, establish a clear record of tax compliance, and start the statute of limitations running:  You may be absolutely *sure* that you are not subject to a filing requirement, but what if the IRS has records that disagree with yours (not necessarily due to criminal intent by others, but perhaps due to bad penmanship on another taxpayer's tax documents or incorrect W-2s or 1099s filed by employers and financial institutions.)  Or perhaps you work in a business where there is a lot of sketchily documented income (e.g., as a waitress with cash tips.)  If you don't file a tax return, the Internal Revenue Service could conceivably come after you many years down the road, at a time when it might be very hard for you to reconstruct your records accurately.  This may be especially important if you plan to apply for a professional license which requires a documented record of tax compliance (e.g., attorney, professional tax preparer, etc.)  If there is a disagreement between IRS records and your records, it is best for you to learn about that sooner rather than later, at a time when it is still relatively easy for you to obtain the documents that will support your side of the story.  Once you file a return, the IRS and state tax authorities generally have a statute of limitations which gives them three years to challenge the information--unless they can show a major omission on your part, which gives them additional time, or deliberate fraud, which gives them forever!  But the burden of proof is on them in those cases.  If you don't file a timely tax return, the burden of proof that you complied with tax law this year is on you--potentially for decades to come!

There are other benefits to filing a tax return even when you are not legally required to do so.  It can be educational and enlightening for a young person to work through the process in a thoughtful and observant way--and good practice for the future, when the stakes will be higher and your tax returns more complex.  Also, don't forget that in some cases you may have a state tax filing requirement even if you don't have enough income to require filing a federal return.  New York State tax filing requirements are available here.  

That said, I can think of a few categories of people who are not obligated to file who may reasonably decide not to go to the trouble of filing.  A conscientious senior citizen in poor health with very limited income, virtually all of it from Social Security, who brings *all* her relevant tax documents to AARP-Tax Counseling for the Elderly, where a trained and certified volunteer interviews her, asking a number of questions to make sure that all possible sources of income and tax liability have been assessed, and concludes she does not need to file, may quite reasonably decide to take that advice, because it is not worth the stress of dealing with so much fine print and jargon.  

After all, remember that filing a tax return is not a frivolous thing to be undertaken lightly.  Filing a tax return means you--the taxpayer!--are signing the following statement: 

"Under penalty of perjury, I declare that I have examined this return and its accompanying schedules, and to the best of my knowledge, they are true, correct, and complete."

Tax Planning for Hobbits?

A local attorney and CPA whose firm specializes in advising clients who have accumulated substantial assets will be giving a breakfast talk Thursday morning with an intriguing title 

Financial Planning Association of NENY: An Unexpected Journey: A Hobbit’s Guide to Income Taxes

Thursday, Dec 20, 2012 7:30aWolferts Roost Country ClubAlbany, NYJoin us as Marty Finn, Esq. gives a spirited review of expired and expiring income tax provisions; new taxes, credits and reporting rules on the horizon; fiscal cliffs and other competing tax proposals and, most importantly, what to tell your clients right now about 2012 year end tax moves and planning for 2013 and beyond.

I am intrigued--but I am not going.  Mr. Finn's hobbit clients are so different from typical VITA site clients that it's hard to imagine I'll find out anything useful or relevant.  In general, tax advice for wealthy taxpayers is irrelevant (at best) or actually unhelpful (at worst) to low-income working families.

So much irony here, it's hard to know where to begin.  

Wolfert's Roost is a very fancy Albany country club named after a Dutch settler, Wolfert Acker, who built a small cottage in 1690, a humble but comfortable abode where a hobbit might indeed feel rather at home.  

In 1802, Washington Irving acquired Wolfert's modest estate and wrote his brother that he intended to make it over into a "little nookery" that would be "quaint but unpretending."  The picture below shows how those plans actually worked out into the grand mansion known as Sunnyside.

Wolfert's Rest Redux:  Sunnyside (image credit Wikipedia/Currier & Ives 1860)

Suffice it to say that the modern-day Wolfert's Roost Country Club looks far more like the grandiose Sunnyside than like the original Wolfert's Roost.   Indeed, both the country club and Irving's grand estate are as different from the original cottage as today's labyrinthine and complex tax returns are from the original  1913 tax return with its single page of instructions.

It's hard to imagine a humble hobbit (known for love of simplicity, their lack of materialism, and their modest lifestyles) being at home in a fancy country club learning about the ins and outs of how to take best advantage of an uncertain tax code.

But the hobbit analogy is certainly apt in that we do not have any clear map for the tax policy that faces us in the future--the fiscal cliff affords us little inkling of the financial consequences of many decisions high-income taxpayers have traditionally made in December.

But VITA sites like ours serve a very different population from the wealthier taxpayers whose decisions are likely to be the focus on Thursday morning's breakfast.   Mr. Finn's bio on his firm's website says that he specializes in "structuring business transactions" and "asset preservation," so clearly his business caters to hobbits who have accumulated assets to preserve or business transactions to structure.   

However useful Mr. Finn's advice might be for his hobbit taxpayer clients, it is unlikely to be of much help for typical VITA site clients.

With or without a fiscal cliff, VITA site clients have long faced extremely uncertain effective marginal tax rates (due to the income phaseout provisions for the various credits,  as well as the myriad of social assistance programs serving the poor, everything from SSI and TANF, food stamps, Section 8 housing subsidies, school lunches, to Medicaid.)  A few thousand dollars change in income in one direction or another can create wild gyrations in their marginal tax rates.   The tax code can be turned on its head for low-income taxpayers.  It is hard to know whether to give advice to go with a Roth vs. a traditional 401(k) if a taxpayer is uncertain about whether his effective marginal tax rate will be positive 95% (the rate recently estimated by Bloomberg News for some low-income taxpayers) or negative 40% next year, simply because he does not know what his income is going to be because he is not sure whether he will be laid off or how many hours of work his employer will be able to offer him or whether his precarious health will allow him to work.   And tax returns filed by low-income working families are far more likely to be audited than those of higher income taxpayers.

Even if low-income working families did have a clear roadmap of the tax policy horizon, it would be of little help.  Many VITA clients are "unbanked" with too little in assets to attract interest from traditional mainstream financial institutions and with very little control over their financial lives, little flexibility to move income or deductions or credits across years in order to game the tax system.  Most VITA clients are not homeowners.   The few VITA site homeowners may well be in negative equity positions due to an upside-down mortgage, and--in any event--they rarely realize much in the way of tax benefits from itemizing deductions.   Short of accelerating the birth of a baby due in January 2013 to late December (a move with potentially serious health consequences), typical VITA clients have few "year-end tax planning" strategies available to them.  

Their greatest concerns of typical VITA clients are not with *preserving* assets from taxes, but rather with just building up some assets in the first place and finding a financial institution which will not charge them large, confusing, or unpredictable fees for holding the very modest financial assets they do somehow manage to accumulate.  

U

Miles, please do NOT blow up our taxpayers!

Dear Miles,

You may not remember me, but I definitely remember you sitting in the front row of the Ec 10 class I taught as a teaching fellow at Harvard in the late 1970s.  Seeing your name appear in the blogosphere conjured up a vivid memory of the jacket you wore, which had your name embroidered on it.

I enjoy reading your new blog--and feel a sense of kindred spirithood.  Although I am not now--nor have I ever been--a macroeconomist, there are not enough liberal eclectic economist bloggers running around.