As the calendar flipped over to 2018, the frenzy of prepaying property tax is finally over. As I observed in emails and Internet postings it occurred to me there are two opposite camps when it comes to paying taxes.
The first camp, where I belong, goes by the book. They research the issues and they go by what the rules say. The second camp also researches the issues but they take calculated risks. They ask what are the chances they will get caught if they don’t go by the book and what the possible downside would be if they do get caught. They’re basically saying “Catch me.”
Even after the IRS published the advisory telling people that prepayments of property taxes not yet assessed are not deductible in 2017, someone asked:
If I deduct the payments for 2018 property taxes even though they haven’t been assessed, what are the chances I’ll be audited? And if I am audited and the deductions are not allowed, what will the consequences be?
The answer is they probably won’t be audited. Even if they are audited, they will just play dumb and say their local government was accepting prepayments and they thought it was deductible if they paid in 2017. When you have plausible deniability, the penalty is usually just the taxes owed plus interest. If they go by this approach item after item, year after year, even if they lose sometimes, they will probably still gain way more than they lose over time. The “catch me” approach “works.”
When you ask them why they would go against explicit rules, they say the IRS rules aren’t necessarily the final words and the rules can be challenged in court, even though they never really challenge the rules themselves. This way they justify to themselves it’s OK to ignore the rules. They won’t blatantly make up numbers on their tax return but they are willing to “not know” some rules when “not knowing” goes in their favor.
Apparently enough people want to make up their own rules that it has become a running joke in the tax professionals circles, as evidenced by this tweet from a tax lawyer:
Pro tip: If your #tax query starts with "Can't I just lie and say that…" you already know the answer.#TheMoreYouKnow
— Kelly Phillips Erb (@taxgirl) December 29, 2017
Our tax system is in a way an honor system. The IRS publishes rules and they expect everyone to follow those rules. You are not required to submit evidence to support every number on your tax return. The enforcement is by the possibility of an audit, but everyone knows the rate of audits is very low. Most people have never been audited. When you are audited you are not audited for all the years. If someone is willing to take calculated risks, there’s a lot of room to do so.
For example, you are allowed to contribute to an HSA and take a tax deduction only when you are in an HSA-eligible high deductible health plan. But you are not required to show any proof you are indeed in a high deductible health plan. How do they know what type of health plan you were in? They don’t. Some high deductible health plans aren’t HSA-eligible. How do they know your plan wasn’t eligible even though it had a high deductible? They don’t. You aren’t eligible to contribute to an HSA when your spouse contributes to a general-purpose health care FSA. How do they know your spouse had an FSA? They don’t. Would you get audited only because you contributed to an HSA? Probably not, when millions of others also legitimately contribute to an HSA.
Another example. When you had a wash sale you are supposed to exclude the loss. If you did it in the same brokerage account, the brokerage account will flag it as a wash sale. If you did it across two accounts at two different firms, neither firm knows to flag it. If you just take the loss, how do they know you had a wash sale? They don’t. Would you get audited only because you took a loss? Probably not, when millions of others also legitimately took a loss.
Opportunities like these for “not knowing” the rules are numerous. I would never take them myself. That’s not right, no matter what justifications people make up for their own conscience, or how likely and profitable they would get away with it. However, some people see it as a situation of offer and counter-offer, as in “I make an offer to pay this amount. If you don’t come back with a counter-offer that means you accepted my offer.”
It comes down to our attitude toward taxes. There’s a weird culture in that money paid in taxes is seen as just wasted. People feel good about donating to charities while justifying super-aggressive or downright illegal moves to lower their taxes.
It’s especially ironic against a backdrop of a controversial new tax law. The day before, some people were vehemently against the new tax law saying it will add a huge amount to the deficit and it will take away the necessary revenue for the social safety net. The day after, some of the same people were lining up at the local tax offices prepaying their 2018 property tax and thus adding even more to the deficit and depriving even more revenue from the social safety net. Some engage in mental gymnastics in finding excuses against the explicit notice from the IRS, telling themselves it’s not all black and white. Even elected officials who supposedly care about the social safety net went out of their way in their official capacity to make sure the revenue for the social safety net is deprived some more.
I’m firmly in the camp of doing it by the book and not pushing the envelope on your taxes. It would be very sad to say “I’m able to retire because I made up my own tax rules and they never questioned me.” or “I built my wealth on the backs of the elderly and the poor.” Save money by other means. Your financial success does not depend on your ability to pay the least amount of taxes you can get away with. If that means I pay more taxes than otherwise, I don’t see the taxes I paid as wasted. I see it as supporting the necessary social safety net and social services. Paying lower taxes isn’t always a worthy pursuit.
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Erik says
It’s nice going to bed knowing you don’t have to worry about potentially being caught for cheating, stealing, etc. That has value.
Kevin says
Exactly. I need to be able to look at an auditor if I’m unlucky enough to be selected for an audit and know that if the auditor finds something, its the result of a mistake on my part and not a deliberate act.
Wendy Hunter says
Harry, this is the finest thing I have read in a long time about finance or any other subject. Thank you for taking the high road. Doing the right thing because it is the right thing can be cast as old-fashioned, but you have helped us remember that doing the right thing isn’t about being a sucker but about being a part of a community/society.
Kevin says
THIS right here is awesome. Doing the right thing is under rated but in the case of taxes, they are part of the necessary fabric of the civilization within which we all live. If you’re making money, you’re paying taxes and vice versa is also important….if you’re paying taxes, you’re making money.
I don’t have an issue with taking advantage of recognized legal loop holes in the tax system but I do have a problem with tax evasion via feigned ignorance. We all end up paying for that at some point whether we realize it or not.
Brian says
I was with you right up to the very end – regarding “not pushing the envelope on your taxes.”
There’s a difference between tax evasion and tax avoidance. The examples you mentioned above fall in the realm of the former. One reason (of the many) that we were able to retire early was because we paid the least amount of taxes that we were legally obligated to pay. (Full disclosure: my wife does take the view that I spend too much effort avoiding taxes, yet she benefits from my efforts and is quite pleased with our low tax bills.)
Even in retirement. I take advantage of every opportunity to pay the least amount taxes that we are legally obligated to pay.
Even so, I don’t consider the taxes we pay as wasted in supporting the necessary social safety net and social services; but, I do consider them to be excessive.
But, tax law is the law. And the law must be followed. If I can use that law to our benefit to lower our tax liability, that’s always a worthy pursuit.(IMO)
Larry says
I agree with Brian: no excuse to break the law, or knowingly cheat, but tax avoidance is fine in my book.
“Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” – judge Learned Hand in Gregory v. Helvering
abc says
I avoid people that are not honest in doing their taxes or cheat on their wife.
MikeG says
Well said Harry. Agree 100% with you.
GMShedd says
I used to do taxes for free as part of a service that tried to assure that lower income people got the earned-income tax credits and child tax credits they were entitled to. Then I began to see how many upper income people came in because the service was free (not illegal, but taking advantage of my time). And to see how some people played the “mentally-disabled child” game (they can recite the code words that fit the diagnosis in the DSM), and how many more played the “disabled” game (while riding a Harley). If you have labeled your apparently-normal child as mentally-disabled for most of her childhood, what is the chance that child will ever live a normal life in adulthood? Ruining a child’s life so you can live off their benefits should get a parent sent to hell, but the SSA, like the IRS, doesn’t have the resources to investigate (thanks to having their budgets slashed by lawmakers of a certain stripe).
Anyway, the final straw came when I realized that the standard practice of crediting a child’s higher education expenses to the parents when claiming refundable educational credits (American Opportunity and Lifetime Learning) was often not justified, that I finally dropped out of the program. If a child borrows more than half of their total expenses for the year, then the parents don’t qualify for the credit, but it is taken more often than not–usually given to them by tax preparers. Let me say that I’d be ok with subsidizing students of higher education in some way (universities have become self-perpetuating money-making schemes, paying themselves with freely-dispensed student loans that saddle their young graduates with long-term debt), but claiming undeserved tax credits wouldn’t be my choice for how to do it.
Ryan says
I am sorry that you were so displeased by your experience. I am a long-time volunteer for a similar program. I have come across some clients that wanted their return prepared in a dishonest manner. However, I have come across many other clients that present themselves in an honest fashion and have been truly needy. These clients, often poorly educated, would almost certainly not be able to navigate the complexities of accurately claiming these valuable credits on their own.
The program that I volunteer with advises the volunteers that we are not deputy IRS auditors, that the clients are responsible for what is reported on their returns, and that it is appropriate for us to advise them of this. We are also empowered to decline to participate in preparing a return that appears to be fraudulent. My program also imposes an income cap on potential clients so that volunteers spend their time on serving the needy. I’m sorry that your experience was apparently different.
It is unfortunate that our tax code is so complex that the intended recipients of credits targeting the working class can’t, in many cases, reasonably prepare their returns on their own.
Dave says
I am with Ryan on this!
GMShedd says
Ryan, thanks for your response, and I’m glad that your experience has been a good one. Can I ask how you handle educational expenses at your site? Does a parent ever not get to claim the American Opportunity Credit when the child has student loans? Is the 50% of support value calculated before giving the credit to the parent?
Rick Van Ness says
Thank you for this. **Well said!**
Rules matter. Truth matters.
Paying-forward and giving-back matters.
Character matters.
Scott R says
Another great post, Harry. My mindset is different than yours, in that I equate tax as theft. But I have no desire to be thrown in jail or go through an audit, so while I’ve spent a good deal of time looking to maximize my tax avoidance options, I don’t take any deductions that I’m not able to take legally, and in good conscience.
AnonJoe says
I’m guessing you’ve either never experienced theft or never benefited from a government (e.g. driven on a road)?
Scott R says
Ha! The “Who will build the roads?” argument. In case you’re serious, here’s one of many articles that attempt to answer this question:
https://libertarianmoney.wordpress.com/2013/07/12/the-definitive-guide-to-who-will-build-the-roads/
GOPboy says
If you believe a single word of the drivel in this article then I have a bridge to sell you. It’s not surprising that libertarians can never get elected, the crap they espouse has exposed them for the fools they are.
OS says
I have a libertarian view of taxes too like Scott. When `pushing the envelope’ I try to evaluate the reward vs the risk by ratcheting how aggressive I am on a given topic and see what tax saving I net. It’s easier with some tax software packages than others. Even you follow rules by the book, you can still get audited and punished if your documentation is not perfect or you misunderstood the tax law so the boundary with `tax evasion’ is not clear cut.
JDC says
I am a tax lawyer and CPA. Believe it or not, I have never cheated on taxes even though I know how to do it. But, you are wrong in your approach.
Did it ever occur to you that the tax law is not black and white, as you suggest? There are many, many instances where the law is unclear. That is why there are tax lawyers and CPAs. When the IRS makes an advisory opinion, do you believe that becomes law? Tax laws are enacted by Congress and decided by courts, not by the IRS.
Do you ever consider probabilities? If a specific position taken by the IRS is challenged, what are the probabilities that position would be successfully overturned by the courts? That is the question you and everyone else should be asking. IMO, your skewed lecture on morality is misplaced, though I applaud your attempt at doing so.
Harry Sit says
Based on your advanced training and your reading of the law, every time you took a different position from the position of the IRS, the results by coincidence just happened to have benefited you. They never came back with a challenge because they didn’t know you took a different road. What difference does it make whether you think you ever cheated or you just genuinely disagreed? The results are exactly the same. Someone said something about a duck: If it looks like a duck, swims like a duck, and quacks like a duck, … …
It would make a difference if every time you take a different position, you point out exactly where you disagreed and you give your reasons. That way it’s out in the open. If they agreed after reading your arguments, you are clear. If they disagreed and the court rules in your favor, you are clear. Just throwing out a number without calling it out your different position doesn’t cut it.
Jdc says
Huh?
Harry Sit says
No necessarily you personally but whoever takes the approach “Their rules are not the final words so I’m going to do it my own way.”
JDC says
The advice that should have been given by this blog regarding prepayment of property tax was “Check with your tax advisor”. It was inappropriate to give tax advice. It is fine if you want to lecture against tax cheats, but your characterizations were, in some cases, way off base.
AnonJoe says
I applaud you for taking the high road. I found it easier to do that before the president said, of avoiding taxes, “That makes me smart.” As you say, the honor system helps make our country great, avoiding an awful lot of corruption.
That said, there are gray or ill-defined areas, where even the best intentioned person can’t know what the law “requires.” I’m struggling with the new law in that I made plans based around (then) current law, which was changed through a process I view having diminished moral standing (a majority of Americans voted for House Democrats).
Moral foundations of politics + tax law = furrowed brow.
But you’re right about the poor, so maybe it’s that simple. Elderly = more complex IMHO. Not that there aren’t huge numbers of elderly who desperately need a safety net, which I think we should provide. But there are broad questions of intergenerational wealth transfers as we look to Baby Boomer retirement …
Scott R says
One random thought I think is worth posting…
A lot of deductions, “loopholes”, etc. are in place because people with influence have helped to put them in place. Some of these are intentionally complex to ensure that the average person can’t take advantage of it.
Some are intentionally vague so that the average person avoids taking advantage of it for fear that they’ll be audited, while others (the ones who helped put these things in place, along with their friends) take advantage of them, banking on the fact that the vagueness of it can be used to their advantage (worst case, if audited and challenged, they pay the tax shortfall later).
Ron Manuel says
I’m a retired CPA and thought your post was outstanding. But I also agreed with what JDC said.
When you’re driving on an uncrowned Interstate with a posted speed limit of 70, I’m wondering what speed you drive.
DES says
I don’t cheat on my taxes either, but I can assure you I don’t drive the speed limit. Ever. : )
Thank God for radar detectors and laser jammers (in states where they’re legal).
Dave says
Amazed by the number of folks commenting who seem to want to justify cheating, by wiggling their words “the courts decide”. Thats like saying its ok to steal unless you are found guilty by a judge!
On the issue of prepaying taxes, the author would have been well suited to simply state when it is allowed which is when
– the taxes are actually paid and
– the taxes are assessed
Both have to be true. The latter is true if your property was assed a value and a rate you are obligted to pay is also set for any date in 2018 ( for example, my 2018 taxes arent due til march and sept, but the tax year starts in october and the assessment and rate are set. So prepay for me was ok)
Nothing immoral about strategizing to pay the minimum. Very immoral to take a catch me if you can strategy.
Many prepayments were legit this year, some were not. And playing dumb is not ok.
Good blog post!
JDC says
I agree that taking an illegal position and playing the “audit lottery” is wrong. However it is also wrong for unqualified people to be giving tax advice. Are you suggesting that you are more knowledgeable than Professor Herzig who is quoted in this squib from a NY Times article:
And in some states, homeowners may have received estimated assessments or taxes due in 2018 based partly on assessments from earlier years. Similarly, Mr. Cuomo’s executive order allowed local governments to levy taxes ahead of schedule. How the I.R.S. will treat such cases remains uncertain.
“It’s an open question right now,” said David Herzig, a professor of tax law at Valparaiso University. “It depends on your state. There’s going to be no uniform answer.”
Mr. Herzig said the I.R.S. guidance was also based on limited precedents and could be overturned by a legal challenge. As a result, he said, many taxpayers might prepay and hope that the courts rule in their favor.
Dave says
What i am saying is people who are prepaying when there has been “no” assessment are clearly not allowed to take it.
Your post reflects the wishful thinking of the “let a court say i really owe it” group.
Yes there will always be a grey area for a few where an estimate went out (does that count as an assessment?). But the wishful thinking. / catch me if you can crowd will use the uncertainty for specific cases and try to drive their tax deduction truck right thru it.
90 some percent chance you wont get caught and the irs will let this all go, so why not take it is what i am sure many people are thinking.
JDC says
We do not disagree on the ethical issues. You have now doubled down on your tax advice, so it seems you do believe that you are more knowledgeable than Professor Herzig. To you the law is clear, but to Professor Herzig the law is uncertain.
Harry Sit says
You will never find 100% agreement among academics. We don’t know whether Professor Herzig represents the mainstream or a climate change denier type of fringe opinion. Governor Cuomo is also not a disinterested party. From his recent speech, now we know a big part of this drama was fanned by Governor Cuomo for political gains.
JDC says
So take a poll of tax law academics, tax lawyers, and CPAs. The question is simple: Is the tax law regarding prepayment of property tax certain, as you and Dave state, or is it uncertain as explained by Professor Herzig? Hopefully, when the results all come back as uncertain, you will not claim that all were ideologically or politically biased.
JDC says
We do not disagree on the ethical issues. You have now doubled down on your tax advice, so it seems you do believe that you are more knowledgeable than Professor Herzig. To you the law is clear, but to Professor Herzig the law is uncertain.
Angie says
What a great post, just wanted to send kudos to you. “There’s a weird culture in that money paid in taxes is seen as just wasted” especially resonated with me. I found your blog years ago because you described how to do a back door with IRA contribution so comprehensively and I’ve enjoyed your posts ever since. Thanks for giving back to the internet reading public!!!
afan says
Picking up on this late.
I am neither an account nor a lawyer. I thought that the IRS did require one to state in the return that they were taking a position at odds with the IRS interpretation.
I drive the speed limit or more slowly, always. It is not a matter of getting caught. It is a matter of obeying the law. If I really thought the speed limit was too slow I would try to get it changed. Speeding is a major cause of accidents and death. All those speed related accidents and deaths are caused by drivers who are convinced they are so “good” that it will never happen to them.
I am not sold by the argument that taxes support the social safety net. A huge share of taxes go to things that have nothing to do with helping the poor. Consider fancy junkets for Congress, food and alcohol for receptions and dinners, bombs, bullets, guns and a massive regulatory industry that slows economic growth. Don’t collect more in taxes, cut spending.