TAXES AIN'T FAIR!

Tax reform has become a hot political topic.  Reduce taxes on the middle class, or increase taxes on the “wealthy” simply because they can afford it.

 

I see a great need for substantive tax reform not to reduce, or for some taxpayers increase, the actual amount of taxes paid – but to simplify the Tax Code and make it more fair.

 

Nobody ever said taxes are fair.  There are many inequities in the US Tax Code, some purposeful and some unintended.

 

Among the biggest inequities concerns how the Code treats some aspects of “gross income” and expenses related to generating this income.  I speak specifically of the taxation of gambling winnings and legal settlements.

 

If you have gambling winnings you must report, in most cases (how to report some winnings is a topic for another post), the gross winnings as income on Page 1 of the Form 1040.  This is the amount that is reported on Form W-2G.  So gross winnings are included in Adjusted Gross Income (AGI).  But gambling losses, to the extent of winnings reported, are deducted as a Miscellaneous Deduction on Schedule A if you are able to itemize (although not subject to the 2% of AGI exclusion).

 

Similarly, the gross amount of legal settlements, except for settlements for physical injuries or sickness (any damages or settlement you receive to compensate you for your medical expenses, lost wages, and pain, suffering, and emotional distress is not included in income), is included as income on Page 1 of Form 1040.  The legal fees, often as much as 1/3 of the settlement, and other related are also deducted as a Miscellaneous Deduction on Schedule A if you are able to itemize (in this case the deduction is subject to the 2% of AGI exclusion).

 

A taxpayer can have $5,000 in gross winnings from gambling activities for the year, but $6,000 in gambling losses.  So, the taxpayer’s gambling activity for the year has resulted in a loss.  The taxpayer ended up with no money “in pocket’ from gambling. 

 

If the taxpayer is able to itemize without taking into effect the allowed gambling losses, the Schedule A deduction for $5,000 in gambling losses results in net taxable income of 0 – so, in effect but not necessarily in reality, he/she does not pay federal income tax on the winnings.  But if the taxpayer is not able to itemize, even with the gambling loss deduction, or if he/she is only able to itemize because of the gambling loss deduction (without the deduction his itemizable deductions do not exceed the applicable Standard Deduction), he/she will be paying federal income tax on up to $5,000 of income that was not actually received – in the 25% tax bracket $0 in net gambling income could cost the taxpayer at least $1,250.

 

Similarly, with a taxable legal settlement, the need to deduct legal fees as a miscellaneous itemized deduction subject to the 2% of AGI exclusion could result in federal income tax being paid on more than the actual “in pocket” amount.

 

Of course, a large portion of the inequity comes from the fact that various items of income are increased and deductions and credits are reduced or eliminated based on one’s AGI.  And the fact that most itemized miscellaneous deductions are not allowed in calculating the dreaded Alternative Minimum Tax (AMT).

 

While a taxpayer may be able to wipe out gambling winnings with fully deductible gambling losses, the fact that gross winnings are included in AGI could result in more of the taxpayer’s Social Security or Railroad Retirement benefits (the amount of benefits taxed is determined by a formula that is based on AGI) being taxed – many frequent gamblers in the casinos of Atlantic City for example are senior citizens – or could reduce or totally eliminate allowable tax deductions or credits.  So again, the taxpayer is in reality paying federal income tax on $0 in net income.

 

The same is possible with a taxable legal settlement – except for settlements for discrimination claims, the related legal fees allowed as an “adjustment to income” which reduces AGI.  And, while there may be no excess tax under “regular” income tax rules there may be AMT.  Allowable gambling losses from Schedule A are fully deductible in calculating the dreaded AMT – but because legal fees are a miscellaneous deduction subject to the 2% of AGI limitation they are not deductible in calculating AMT.  So, tax is paid on the full amount of the gross settlement at a flat 26% or 28%.  When adding the federal and state tax to the legal fees the taxpayer may end up with only 1/3 or less of the actual award “in pocket”.

 

And while in many cases net and not gross gambling winnings are taxed under AMT, the fact that gross winnings are included in AGI, and therefore Alternative Minimum Taxable Income (AMTI), could reduce the AMT exemption, resulting in AMT tax on gambling winnings even if the net is 0.  $5,000 in gross winnings can reduce the AMT exemption by $1,250 and result in an additional $325 or $350 in AMT.

 

The AMT issue would go away if tax legislation repeals this tax.  And changing the way Social Security and Railroad Retirement benefits are taxed and no longer allowing AMT to affect tax deductions and credits would also help to remove inequities.  But the best way to do away with the unfairness of the tax treatment of these two types of income would be allowing taxpayers to net gambling losses against gambling wins (still not allowing the deduction of more losses than wins) and net legal fees against gross settlements – either directly by entering the net amount on Page 1 or by allowing the deductions as an adjustment to income reducing AGI – would certainly fix the problem.

 

So, what do you think?

 

FYI – I will post on other inequities in the current Tax Code in future posts.

 

TTFN