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The Structure of Tax Revolutions

The title of this post is based on Thomas Kuhn’s The Structure of Scientific Revolutions. Kuhn’s classic work explores scientific achievements to show how scientific knowledge has progressed over the years. Kuhn’s framework for examining the progression of scientific knowledge provides a useful way of viewing our tax laws, how they came about, and where they might go in the future.

In general, Kuhn proposes that scientific disciplines arise out of individual solutions to particular problems. Solutions to similarly situated problems are identified as being related and are grouped together. This grouping allows individuals to apply lessons learned from one problem to help solve other problems. Eventually enough of the problems and solutions are grouped together to form a body of knowledge worthy of academic study. At that point one or more all-encompassing textbooks appear. Students coming into the study of this new academic discipline are able to use the textbook’s paradigm to gain a quick in-depth knowledge of the subject. Not having to spend as much time figuring out the basics, the new students are quickly able to advance the new academic discipline. More and more problems are resolved as the discipline matures. The new problems and solutions are added to the textbook paradigm and are mastered by the newest students.

The students who came into being under the textbook paradigm spend their professional lives toiling under the framework provided by the paradigm. Eventually the professionals become committed to the paradigm for their survival. They reject major attempts to rewrite the textbook paradigm, preferring only to refine the paradigm. The professionals come to see the textbook paradigm as an end instead of a means to an end. Professionals believe that if a problem can not be solved it is not because a failure of the paradigm, it is because the paradigm just yet to be applied properly to the problem. At that point the academic paradigm becomes highly technical and not wholly useful. Refinements on top of refinements on top of refinements result a body of knowledge that even the most sophisticated computers can not fully manage. The textbook paradigm starts to break down. Specific problems arise that the textbook paradigm cannot adequately address. Newer practitioners and progressive thinkers start addressing the unresolved problems by applying pre-paradigm logic. The pre-paradigm logic gains in popularity and it becomes the subject of study. Eventually the old paradigm is discarded and the new one is put into place — a scientific revolution has occurred. The process then begins anew.

Kuhn’s paradigm very aptly describes the progression of our tax laws. Our tax laws have their history in the now humorous one page tax return and its accompanying pamphlet (that was the Internal Revenue Code). From that base the old code sections grew more verbose and new code sections were added as the government became aware of taxpayers circumventing the rules (i.e., problems were identified and solved). Simultaneously a body of administrative and judicial tax law developed (see tax laws for an overview of our tax laws). As this body of tax law developed, several seminal tax law textbooks appeared. Tax law became a well-established field of academic study. The students of this textbook paradigm became the practitioners who sought to continually refine the paradigm. Our tax laws were revised several times, with the Internal Revenue Code undergoing major revisions in 1939, 1954, and 1986. Enough problems were solved that it justified the creation of newer textbooks (tax practitioners recognize books by authors such as Bittker, Eustice, McKee, and others). The tax law began focusing on very technical and specialized problems. This is where our tax laws are today.

So what does today’s textbook paradigm look like? What paradigm are tax students being taught and under what paradigm are tax practitioners toiling? In general, the current paradigm is based on taxes being levied on earned income, income inherent in transferred property, and value inherent in transferred property. Tax practitioners today (myself included) view tax problems in terms of taxable gain. Thus tax practitioners spend their days looking for ways to:

  1. Avoid or defer recognition of income,
  2. Recognize and accelerate all permissible deductions,
  3. Characterize transactions as capital or ordinary for income and deduction purposes, and
  4. Recognize all applicable credits.

These four seemingly simple tenets make up today’s tax paradigm. They they consume almost all (if not all) of the tax practitioners talents and mental energy throughout his or her professional career.

But this paradigm has proven ineffective in addressing several problems. Some of these problems involve the inability to collect taxes and the inability for the paradigm to work effectively in an international economy (one only has to look at the problems with old Section 114 and new Section 199 to see how this has been playing out). As problems such as these increase in importance, newer and more progressive tax practitioners have begun discussing new tax regimes, such as consumption-based and value-added tax regimes. We are now at a point where these types of tax regimes are considered worthy of study (which they were not just two decades ago).

If Kuhn’s theory is correct, and it is applicable to our tax laws, then it appears that we might be nearing a tax revolution — a tax revolution that will result in a new consumption-based tax regime.

Fudge the Numbers on Your Tax Return? What if the Court Does the Same in Setting Criminal Sentences?

Fudging numbers, mystery math–it happens. Taxpayers are not allowed to do it. Should the federal courts be allowed to do it?

The federal sentencing guidelines assign points or levels to characteristics of individual crimes and individual criminal offenders. The higher the points or levels the higher the sentence imposed. It was hoped that this point system would result in uniform and rational criminal sentences being handed down by federal courts. Yet the sentencing guidelines do not specify what evidence the court may consider in applying the sentencing guidelines. As a result, the federal courts are in the position to apply the sentencing guidelines as they see fit — undermining the very reasons for having sentencing guidelines.

By way of example say a taxpayer fails to pay $500,000 of income taxes one year. The IRS discovers the omission, an investigation ensues, and the taxpayer is eventually taken into custody. The government asks a grand jury to indict the taxpayer for tax evasion. In the indictment the government alleges that the taxpayer evaded $250,000 of taxes, because that is all the government attorneys believe that they can prove in court. The government is deterred from asking the grand jury to indict based on the full $500,000 because (1) the government has to establish guilt as to that specific amount by proof beyond a reasonable doubt, which is a difficult burden to meet and (2) the government will probably not be able to get all of its evidence before the jury because the federal rules of evidence limit the admissibility of certain evidence.

So the grand jury indicts the taxpayer. A trial follows. The jury finds the taxpayer guilty of evading taxes to the tune of $250,000. The jury convicts. The jury goes home. The judge pulls out his or her sentencing guideline book. Before the judge opens the book, the government attorney says “Wait, Judge, we have evidence that this taxpayer owes an additional $250,000 of taxes. In addition, we have evidence that this taxpayer owes another $500,000 of taxes for a prior tax year.” The judge holds a hearing to see what this new evidence is all about. The hearing reveals that the government did not file a separate count against the taxpayer for the prior years taxes because the evidence was too weak to support a conviction. It also becomes apparent that the additional evidence for the extra $250,000 was not introduced because it was inadmissible under the federal rules of evidence.

Luckily (for the government) some of the federal rules of evidence do not apply at this hearing. Previously inadmissible evidence may now be admissible. Furthermore, the government’s burden of proof has been lowered to proof by a mere preponderance of the evidence.

The judge uses this additional evidence in applying the sentencing guidelines. Under the guidelines, without the additional evidence the taxpayer’s points or level would have been in the mid-twenty range and with the additional evidence it is in the low thirty range (forty-three is the highest points or level possible). So the additional evidence increases the taxpayer’s sentence by several years. The judge imposes the higher sentence. The taxpayer goes to jail.

Should the sentencing guidelines be applied based on evidence that was not heard by the jury? Or should the sentencing guidelines be applied based only on the evidence heard by the jury — the evidence that resulted in the criminal conviction? Has the sentencing guideline point system resulted in a more uniform and rational criminal sentence or is this just another example of fudged numbers or mystery math?

The Tax Collectors’ Chair

Having spent some time studying tax law and procedure and the efforts that taxpayers take to avoid paying taxes, I am often still surprised by the creativity of taxpayers – especially wealthy taxpayers. I came across this example in Galveston, Texas.

Galveston is an island in the Gulf of Mexico that is located a few miles off of the coast of Texas. Before the turn of the last century Galveston was considered the equivalent of modern day Wall Street. The wealthy citizens of Galveston erected mansions, most of which have since been destroyed by floods or hurricanes. This story comes from one of the surviving mansions. I think that the mansion is called the Ashton Villa. It is a historic home that is open to the public for tours.

The house is rather unspectacular by today’s standards. When you walk into the house you are greeted by the typical fare – a somewhat nice looking staircase, a chandelier, older looking pictures, etc. What is most interesting is the calling card basket and the chair that sits nearby.

The tour guide explains the calling card was the only way that one could gain the presence of the original inhabitants of the house. Southern society had rules of etiquette that spelled out how the cards were to be answered and rejected (apparently there was a modern-day “Etiquette for Dummies” book that was mass marketed to wealthy southerners). The process went somehting like this: servants would deliver these cards to the doormen and the doormen would place the cards in the basket by the door. The lady of the manor would review the cards every now and again, fold them in a way that specified whether the offer to visit was accepted or rejected and specify the date and time for the visit, and then the doorman would return the card to the appropriate would-be visitor. This process ensured that no one other than the house resident and the invited guest – not even the doormen – would know when and if the visit would take place. This procedure also ensured that no one would show up for an unscheduled appointment. Unsolicited guests were promptly turned away.

That brings us to the chair. The chair is the only real piece of furniture in the room. The chair is made of a beautiful polished wood. It has a nice dark brown stain. But there are some peculiarities about the chair. The seat of the chair has a sharp raised crevice running through the middle in the most obscene manner and the backrest is bent outward in the most unergonomic way. Further, the chair has only one small armrest. The whole contraption is polished and it slants forward at a steep angle. It is a very odd-looking piece of furniture.

I could not resist asking the tour guide why anyone would have such a contraption in his or her home. Could the original inhabitants not afford proper furniture? The tour guide explained that, given the calling card system, the only person who would show up without an appointment would be the tax collector. So the tax collector would be offered a seat in the chair and would be left waiting for several hours. The hope was that the tax collector would simply go away. So the chair was a tax savings measure – a tax savings measure that, according to the tour guide, was widely used in wealthy Southern homes before the turn of the last century.

Tax savings measures employed by the wealthy today are a little more sophisticated. Nonetheless, some of these sophisticated modern-day tax savings measures are premised on the very same principles underlying the tax collectors’ chair.

Congress Compromises Offers in Compromise

The Offer in Compromise (OIC) has proven to be an invaluable tool for taxpayers to resolve tax disputes with the IRS. OICs have allowed taxpayers to become compliant with our tax laws and they have also allowed the government to collect tax liabilities that would otherwise go uncollected. Yet, Congress has taken a notion to compromise the OIC program.

Both the House and Senate have now passed versions of the Safe Accountable, Flexible, and Efficient Transportation Act of 2005 (Act). This Act will be sent to a conference committee soon. If passed the Act will require taxpayers to:

  1. Submit non-refundable up-front lump-sum payments equal to twenty-percent of the offer if the offer proposes a payment schedule of five or fewer installments or
  2. Submit non-refundable installment payments equal to the installments that are proposed in the offer beginning when the offer is submitted and continuing until the IRS accepts the offer – no matter how long that may be.

This legislation will have two outcomes:

  1. It will result in fewer taxpayers coming forward to submit offers. To be eligible to submit an OIC a taxpayer has to either not owe the tax liability or have an economic hardship that prevents him or her from being able to pay the tax liability in full. I find it hard to believe that any taxpayer who does not owe a tax liability or who can not pay it will be willing or able to submit non-refundable tax payments. This is particularly true for poorer taxpayers. They will likely have to make smaller payments, which means that they will propose offers in excess of five installments which, under the new legislation, will require that they submit continuing installment payments until the IRS accepts or rejects their offer. IRS statistics indicate that on average it takes the IRS more than one year to accept or reject offers. I personally have handled cases where the IRS has taken more than two years to process the OIC. Moreover, the IRS admits that the number of OICs that have been rejected has increased each year. As a result poorer taxpayers will face the situation of having to make continuing payments on taxes that they do not owe and/or that they cannot pay with the real prospect of having their offer rejected more than one year later. This really is a heads-you-lose tails-I-win situation.
  2. It will result in the government collecting less tax revenues. A number of taxpayers who would have come forward and offered to settle with the IRS will now either refuse to pay anything or take other actions such as filing bankruptcy, exercising collection due process rights, and/or pursuing litigation. In the case of poorer taxpayers, if they opt to simply not pay their tax liabilities it is very probable that the IRS will end up collecting nothing or next to nothing on the tax debt. In the case where taxpayers pursue other remedies, IRS statistics indicate that when taxpayers pursue these remedies the chance that the government will collect nothing from the taxpayer increases substantially. Moreover, a number of taxpayers have paid tax revenues under compulsion of the OIC rule that once the OIC is accepted the taxpayer has to remain compliant with our tax laws for five years or face the prospect of having their OIC voided. With fewer taxpayers filing OICs there will be fewer taxpayers that are subject to this compulsion. The end result will be a reduction in the amount of tax revenues collected.

If all of that is not bad enough, Congress had the gall to title the Part of the Act in which these provisions are found “Improvements in Efficiency and Safeguards in Internal Revenue Service Collection.” When I see such titles, which are so contrary to the text of the underlying legislation, I often wonder if members of Congress (or their staff) actually read the text of the legislation or if they just voted based on the mislabeled title. In this case it appears to be the later rather than the former.

A Taxpayers’ Bill of Rights is Probably Coming to Your State – Lessons Learned from Colorado

Taxpayers; Bills of Rights (TABORs) prevent state governments from increasing taxes or spending revenue growth without first obtaining voter approval. Several states are poised to adopt state TABORs in the near future. The State of Colorado adopted a TABOR in 1992. There are a number of lessons that other states can learn from Colorado’s TABOR experiment.

Colorado’s TABOR was enacted as an amendment to the Colorado Constitution. Essentially the amendment prohibits the Colorado Legislature from increasing state or local taxes without first obtaining approval of the Colorado voters. Colorado’s TABOR also limits the amount of revenue growth that the state can retain and spend to the sum of inflation plus population growth. Revenue growth in excess of that sum must be refunded to taxpayers via tax refunds; however, the Legislature has the right to ask the voters to approve spending surplus revenues. Moreover, Colorado’s TABOR provides that when tax revenues decline the government’s spending limit must decline accordingly.

Generally the Colorado voters have not approved an increase in taxes or the spending of surplus revenues since the TABOR was enacted, although until recently they had never really needed to. Colorado’s economy performed fairly well from the time that the TABOR was enacted up until the technology bubble in the late 90’s and the national recession that began in late 2001. These economic downturns have reduced the state’s tax revenues, which has caused the state’s spending limit to decline. Simultaneously, the state has had to increase spending on state-mandated public education and federally-mandated Medicaid programs — both of which will continue to require increased spending in the future. The end result is that Colorado is now facing the perplexing situation of having an estimated $234 million budget deficit and at the same time, due to the TABOR, having to refund an estimated $345 million to taxpayers (too bad the State of Colorado can’t simply print more money!).

So where does this leave the State of Colorado? Basically it leaves the state government in the position of having to repeal or modify the TABOR. It is probably safe to say that Colorado’s politicians will not be able convince Coloradoans to repeal the TABOR. Colorado voters, like the voters in any other state, would be very unlikely to repeal any Constitutional amendment that grants them the right to write their own tax bill and to limit the amount of money that the government can spend. The fact that the TABOR is a Constitutional amendment, rather than just a state statute, makes it even more unlikely that the TABOR will be repealed. If that is not enough to secure the TABOR’s future, the fact that many of the politicians currently serving in Colorado, including the current governor, were integral to the enactment of Colorado’s TABOR should do the trick. So absent a miracle or a disaster, Colorado’s TABOR will likely remain on the books.

This leaves Colorado politicians in the position of having to modify the TABOR — a position that could end political careers. The governor has proposed the most widely cited modification. The governor’s proposal is to allow the government to keep the prior years spending level even though the year’s tax revenues have declined. Other proposals include various modifications that would allow the legislature to temporarily ignore the TABOR. The implication of the governor’s proposal and of most of the other proposed modifications is that the government will end up spending more money regardless of the TABOR. This process is strikingly similar to how the U.S. Congress set aside its own spending reform legislation.

So where do Coloradoans stand on this issue? It appears that most Coloradoans have not paid much attention to the issue. Others appear to only be concerned by the issue to the extent that the political talk has interrupted their favorite television programs. This apathy should be expected given the nature of the debate. Essentially the debate has been limited to Democrats citing how Colorado is in a state of decline as a result of the reduced government spending and the Republicans touting how the government will have to reign in its spending as a result of the TABOR. This limited debate may be partially attributable to Colorado politicians not wanting to remind voters that they designed and supported the TABOR. The resulting debate is just too predictable to draw any real interest from the citizenry.

There are a number of lessons that other states can learn from Colorado’s TABOR experiment, such as:

  1. Voters don’t seem to care how much money the government spends so long as the economy remains strong, their taxes remain low, the government benefits that they and their family receive are not affected.
  2. A Constitutional amendment for a TABOR will be irrevocable once enacted, forcing all future economic debates to be confined to proposing ideas to modify the TABOR. Considering that many citizens are not interested in state politics now, narrowing the scope of future debates in this manner would only serve to alienate citizens further. Even in the states in which the voters have historically been interested in state politics, such as California (remember Proposition 13?), a TABOR will narrow the debate so much that even most of those voters will lose interest (leaving only a small cadre of voters who are highly involved and highly upset).
  3. Any such legislation would not prevent state governments from exceeding their spending limit or from withholding taxpayer refunds. If your state government wants to spend more money or keep tax refunds then that is what it will do. The only impact of such legislation would be to doom voters to having to hear proposals to modify the TABOR in any year in which the state undergoes an economic recession or the state government decides it wants to spend more money.
  4. If Republicans have the majority control of your state and they enact such legislation it will signal that Republicans expect to lose majority control of your state government, because such a measure would probably represent a last ditch effort to impose spending limits on a Democrat controlled government.
  5. If Republicans hope to enact such legislation in your state then they should do so during an economic boom, rather than during or immediately following a recession. Moreover, if the legislation is enacted, the individual politicians who supported the legislation should keep alternative career options open just in case the state subsequently undergoes an economic recession and/or the state government decides to spend more money.

Offer-in-Compromise Rejected for Doubt as to Liability, Collectability, and Effective Tax Administration

In Eberhardt v. Commissioner, T.C. Summary 2004-147, the U.S. Tax Court concluded that an offer-in-compromise was not acceptable based on doubt as to liability, doubt as to collectibility, and it would not promote effective tax administration. The court case provides a good overview of how the IRS and the courts evaluate offers under each of these scenarios.

The facts and procedural history are as follows:

  • The Eberhardts 1995 Form 1040, U.S. Income Tax Return, was audited by the IRS.
  • The return reported medical expense deductions and the pension-related casualty or theft loss.
  • The IRS auditor proposed to disallow the medical expense deductions and the pension-related casualty or theft loss and closed the case to the IRS Office of Appeals.
  • Appeals disallowed the medical expense deductions and the pension-related casualty or theft loss and issued a statutory notice of deficiency.
  • The Eberhardts filed a petition with the U.S. Tax Court, which reached the same conclusion as the IRS agent and appeals officer.
  • The IRS began collections efforts following the court proceeding, which included issuing a final notice of intent to levy.
  • The Eberhardts requested a collection due process hearing and submitted an offer-in-compromise for $1,000 based on doubt as to collectibility and effective tax administration.
  • The IRS did not accept the offer-in-compromise and the Eberhardts asked the U.S. Tax Court to review the denial.

The IRS did not consider the offer-in-compromise based on doubt as to the tax liability, as the Eberhardts had previously had the tax liability considered in appeals and by the tax court. The tax court agreed with the IRS, noting that doubt as to liability does not exist where the liability has been established by a final court decision or judgment concerning the existence or amount of the liability.

The IRS did consider the offer-in-compromise based on doubt as to collectibility. The IRS evaluated the Eberhardts reasonable collection potential and concluded that they could pay the entire liability within a reasonable period of time. Both Mr. and Mrs. Eberhardt were employed and their monthly income exceeded their allowable monthly expenses. The court agreed with the IRS.

The IRS also considered the offer-in-compromise based on effective tax administration. The offer-in-compromise can be accepted based on effective tax administration if collection of the full liability would create economic hardship. The term “economic hardship” means the inability of the taxpayer to pay his or her reasonable living expenses. The IRS concluded that the Eberhardts could pay the full amount of the liability by making monthly payments and still pay for their reasonable living expenses.

The court considered the following factors in concluding that there was no economic hardship in this case:

  • Whether the taxpayers were capable of earning a living because of a long term illness, medical condition, or disability, and it is reasonably foreseeable that taxpayers’ financial resources would be exhausted providing care and support during the course of the condition;
  • Although taxpayers have certain monthly income, whether that income is exhausted each month in providing for the care of dependents with no other means of support; and
  • Although taxpayers have certain assets, whether the taxpayers are unable to borrow against the equity in those assets and liquidation of those assets to pay outstanding tax liabilities.

The Eberhardts claimed that they could not pay the tax in full because they had a substantial amount of short-term debt, the expenses of deferred maintenance on their home, and the need to fund their retirement savings over a limited number of years. The court concluded that this did not rise to the level of a financial hardship.

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