Tax Reform: Close the Potholes


Posted by Bob Lord

Ever hear the one about the guy who walks into a casino? He hits a few jackpots playing the slots and pockets $5,000, but returns the next night and gives it all back, plus another $1,000.

So what's the punch line? Well, if you're a member of Congress, it's that he lost more in income tax then he did gambling. Because when the guy stepped into that casino, he also stepped into one of the "potholes" Congress has devised.

We've all heard of tax loopholes, rules under which taxpayers avoid tax through transactions cleverly structured to reduce taxable income artificially. Potholes are sort of inverted loopholes, rules cleverly structured by a revenue-hungry Congress to cheat taxpayers by inflating taxable income artificially. Potholes arise when a taxpayer's receipts are inextricably tied to offsetting items of loss or expense, in the same way the receipts of a business are tied to its expenses. Congress requires that taxpayer to separate the items of income from the offsetting items of expense or loss, rather than netting them out, as business owners do. Then, Congress cheats the taxpayer by requiring full recognition of the income items while limiting the deductibility of the associated expense or loss.

Although I'm a tax attorney, I never thought much about potholes until my sister, a horseplayer, alerted me to the absurd tax treatment of gamblers.  But Congress has carved out potholes for everyone. Our slot playing friend, for instance, steps in one not because he gambles, but because he is relatively low-income. This is the Standard Deduction Pothole.  Say he earns $45,000 per year, rents his Las Vegas home, and pays no state income tax. He is required to report his $5,000 first night winnings as income. Although he can take $5,000 of his losses as an itemized deduction, he would have to forego his $5,950 standard deduction to do so, which obviously makes no sense. The net-net is his losing year at the casino costs him $1,250 in additional tax.

For retired taxpayers, there's the Social Security Benefit Pothole. John, a retiree, loves gardening. His garden generates $2,000 in produce sales, but costs $3,000 per year to maintain. John's income and half his social security benefits total $25,000. John's unprofitable hobby subjects $2,000 of his social security benefits to tax.

For high-income taxpayers, there's the Pease Limitation Pothole. The Pease limitation reduces itemized deductions by 3% of adjusted gross income (AGI) above a threshold level, but not by more than 80%. Ordinarily, the Pease limitation is just a disguised rate increase. But when fictitious income is present, the Pease limitation becomes a pothole. Thurston breeds horses as a hobby. His horse breeding in 2013 generated $200,000 of receipts, but far greater expenses. Thurston had business income of $30,000,000 and $850,000 of itemized deductions. Thurston must report his $200,000 of receipts as income. He is allowed a $200,000 additional itemized deduction for his horse breeding expenses, but the Pease limitation cancels 80% of that deduction. Consequently, Thurston's unprofitable hobby costs him $64,000 in additional tax.

For middle-income taxpayers, there's the 2% Floor Pothole. Henry makes $80,000 as a CPA. He loves managing his investments, with the help of some newsletters and a technical analysis software program. His 2013 income includes $1,600 from investments, but he pays $1,600 for his various subscriptions. The 2% floor on certain itemized deductions eliminates the deduction for Henry's subscription expenses, leaving him with $400 of additional tax from his breakeven investment activity.

But it's those just underneath the top 1% who are Congress' prime pothole victim. First, there's the AMT Pothole. Frank and Louise live in Texas, a no income tax state. Frank's employer relocates him to California and increases Frank's pay by the $15,000 California state income tax on his $220,000 salary. Although Frank's $15,000 raise is offset by a $15,000 itemized deduction for California state tax, Frank and Louise's alternative minimum taxable income increases by $15,000. Frank and Louise's federal income tax liability increases almost $4,000, even though their real income hasn't budged.

If you avoid the AMT Pothole, there's the Exemption Phase-Out Pothole. Mike and Rebecca have five school-age children. Mike makes $360,000 annually as a dentist. In 2013, Mike hits the racetrack a few times, compiling $5,000 in winning bets and $7,000 in losing bets. Although he loses money overall, Mike’s winning bets reduce his and Rebecca’s exemptions by $1,092, costing them almost $400 in additional tax. (Rebecca is not pleased.)

Finally, there's my favorite, the Bad Timing Pothole. Jack, a California business owner, and his wife Sandy have five young children. 2013 was a good year for Jack's business until December, when it suffered an unexpected loss. Consequently, Jack overpaid his California income tax by $10,000. In 2014, Jack and Sandy's California tax refund increased their AGI by $10,000, and it was a bumpy road ahead: the Pease Limitation Pothole, the 2% Floor Pothole, and the Exemption Phase-Out Pothole. Total tax cost? Almost $1,000.

So, pretty much anyone can be a pothole victim.  Pothole victims either lack the clout or are insufficiently harmed to fight back. But all of us should demand Congress close the potholes. If we don't, Congress will continue to have the last laugh.