NOBODY EVER SAID TAXES WERE FAIR – PART II

Here are two more inequities in the US Tax Code, which have been made worse by the GOP Tax Act.

(1) Many employers have established an “accountable” plan for reimbursing employees for expenses.  If an employee incurs a legitimate job-related out-of-pocket expense he/she submits proof of payment to the employer and is reimbursed.  However, others, especially outside commission salesmen, are not reimbursed for the expenses incurred to generate sales.  The employer pays the employee a draw and a commission based on sales volume.  The employee is expected to “eat” his out of pocket expenses, which could be extensive in terms of business miles, meals and promotional expenses.

In the case of the reimbursed employee, his net salary is, in effect, all “in-pocket”.  In the case of the unreimbursed employee his net “in pocket” is his net salary less his unreimbursed expenses.  The salary of the unreimbursed employee is usually higher due to the “unreimbursementness”.  And there are employers without an accountable plan who simply provide their employees with a flat monthly “expense allowance”, or as was the case with municipal police officers and fire fighters an annual “uniform allowance”, without any documentation requirement.  This expense or uniform allowance is included in the gross taxable wages of the employee.   

Prior to the GOP Tax Act unreimbursed employee business expenses were allowed as a Miscellaneous Expense deduction on Schedule A, subject to the 2% of AGI limitation.  So, there was some relief.  But you had to itemize to be able to deduct expenses and had to reduce expenses by 2% of AGI, so the benefit was limited.  As Miscellaneous Expenses subject to the 2% of AGI exclusion were not deductible in calculating the dreaded Alternative Minimum Tax (AMT) many taxpayers lost the benefit of this deduction.  And as the gross wages before deducting any employee business expenses were included in AMT, a multitude of deductions and credits could be reduced, increasing the taxpayer’s effective tax.

And to add insult to injury, the increased amount of wages paid to unreimbursed employees, and the flat expense or uniform allowance included in gross taxable wages, are also subject to FICA tax.

Under the new law employee business expenses are no longer deductible.

So, both before and after the GOP Tax Act, employees who were not reimbursed for their legitimate out of pocket expenses via an accountable plan are effectively paying more tax on their net “in pocket” income than employees who were reimbursed. 

FYI – back when I started out in “the business”, in the early 1970s, outside salesmen could deduct their unreimbursed expenses “above the line” (remember – the “line” is Adjusted Gross Income) as an adjustment to income.

(2) Similarly, if a person receives a taxable legal award or settlement the gross amount of the award or settlement is reported as income on Page 1 of the Form 1040 – not the amount received by the beneficiary after legal fees are deducted.  If the award or settlement is from a claim of unlawful discrimination the legal fees are deducted “above the line” as an adjustment to income – so their Adjusted Gross Income includes only the amount they actually receive “in pocket” from the settlement. 

In all other cases the legal fees are, like employee business expenses, deducted as a Miscellaneous Expense on Schedule A, subject to the 2% of AGI exclusion.  Here the AGI includes the gross award or settlement, so the 2% exclusion is inflated.

And, also like with employee business expenses, since Miscellaneous Expenses subject to the 2% of AGI exclusion are not deductible in calculating the dreaded AMT, the taxpayer, in most cases, is taxed on the full amount of the award or settlement. 

Under the GOP Tax Act, the legal fees paid on taxable awards and settlements not related to unlawful discrimination are no longer deductible.

A taxpayer gets an award of $100,000.  His “contingent” legal fee is 1/3, or $33,333.  So, the taxpayer is only “in pocket” $66,667.  If in the new 24% bracket the taxpayer will pay $24,000 in federal income tax on net income of $66,667 – which is an effective 36% tax.     

TTFN