Thursday, January 19, 2012


The Tax Code is full of inequities.  Some are intentional, and some are a result of the evolution of the mucking fess that the Code has become.  The bottom line is that many taxpayers are slightly, or often royally, screwed.

Take, for example, the way gambling winnings and losses are treated.  Gross gambling winnings are taxed upfront on Page 1, increasing AGI, but losses are deductible only as a Miscellaneous itemized deduction on Schedule A.

A retired taxpayer playing $5.00 per day, six days a week, in the state lottery who wins $1,000 has actually lost $560 for the year, but could pay $150 or $250 more in federal income tax if he/she cannot itemize.  Plus, this $1000 gross win could add an additional $850 to his/her taxable Social Security benefits, adding another $125 to $213 in taxes.  So the $560 net loss could end up costing $463 in tax!

Since gross winnings increase AGI, but loss deductions do not, the winnings could cause the taxpayer to lose some or all of a multitude of other tax deductions and credits that are affected by AGI, so the tax on negative income could be even higher.

Larger winners are royally screwed.  While they can deduct their losses on Schedule A, if the win causes them to be a victim of the dreaded AMT the losses, as a Miscellaneous deduction, are “lost” in the AMT calculation.

There has been some relief offered in the new regulations for reporting casino winnings, but the basic inequity in the tax treatment of gambling winnings still exists.

Similarly unfair is the way “itemized deduction recoveries”, such as state tax refunds, are taxed.  A recovery is a return of an amount you deducted or took credit for in an earlier year.

Here is how the IRS explained the federal tax treatment of the former NJ Homestead Rebate check a while back -

In this case, it is the deduction you took for your property taxes in 1999. Taxpayers who itemized last year enjoyed the benefit of taking a deduction for the entire amount of their property tax payment. However, since they received part of that deduction back in the form of a property tax rebate, after they filed their return, these taxpayers will have to report that rebate as income on this year's return."

New Jersey taxpayers were told to report the rebate on Line 21 of Form 1040.  State tax refunds are reported on Line 10.  Like gross gambling winnings, this, too, increases AGI, and can therefore also increase taxable Social Security benefits and reduce various tax deductions and credits affected by AGI.

It is logical, and proper, that if you receive a tax benefit for a deduction in one year, if you receive a refund of all or part of that deduction in a subsequent year you must pay back the additional tax benefit that the original deduction provided.  However you deducted the item “below the line”, reducing taxable income, but you must report the recovery “above the line”, increasing AGI. 

A $500 state tax refund, which had provided a $125 tax benefit in 2010, could, when reported as gross income on Line 10, cause a married couple to lose a $2000 “above the line” deduction for tuition and fees paid for graduate school, resulting in “paying back” the IRS $500 more than the original tax benefit!  

While the so-called “Bush tax cuts”, which are set expire, did make some progress in bringing relief, there still exists a “marriage tax penalty”.  A married couple, especially where both spouses work, can pay substantially more federal income tax then if they remained single and just lived together, filing two separate Single returns.  Married taxpayers who file separately are even more screwed, as many deductions and credits are reduced or not allowed for those claiming this filing status. 

Self-employed taxpayers are royally screwed when it comes to the deduction for health insurance premiums.  The deduction is from gross income, and not from earnings from self-employment, causing a Schedule C filer, or a partner, to pay “self-employment tax” on the amount of premiums paid.

If the business was incorporated health insurance would be an employee benefit.  The amount of salary paid to the owner would reduce the amount of wages taken.  FICA tax would only be paid on the amount of salary.  So the owner-employee does not pay FICA tax on the amount of premiums paid.

The idiots in Congress fixed this inequity for one year only in 2010, but this fix was not extended.

And the list goes on.

Let us hope the many inequities in the Tax Code, like those I mentioned above, are addressed in the coming discussion of tax reform.


1 comment:

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