Why is this Topic Important to Wealth Managers? Provides an introduction into the Internal Revenue Code so that tomorrow’s blogticle about specific sections of the Code may be better understood, in particular the taxation of life insurance companies.

How are the laws related to tax organized or in other words, what’s the general process in finding an answer to a tax question?

All federal laws of the United States arise out of the Constitution.  The Constitution has granted Congress certain enumerated powers, such as the power to regulate commerce among the several states.  Congress also has the power to create laws that are necessary and proper in governing based on its listed powers.  All powers not granted to the Federal government are reserved by the States through the 10^th Amendment – meaning only the States may enact laws in those areas (al least this is how it is supposed to work).

Once Congress passes a necessary and proper law to carry out its enumerated powers, that law becomes a United States Statute, or a Statute already existing is either amended or deleted.  The Statutes of the United States are called the United States “Code”.

The United States Code is divided into 50 different titles.  Title 26 is perhaps the most infamous, being the “Internal Revenue Code”.  The Internal Revenue Code, or Title 26 of the United States Code is further delineated, into Subtitles, Chapters, Subchapters, Parts, and finally Sections and Subsections.

Congress has delegated the power of enforcement of these laws, which lies with the executive branch, of Title 26 to the Secretary of Treasury to create Regulations or Administrative Interpretations of the Statutes.  The regulations are not in and of themselves laws but rather, direction from the Secretary of interpretation of the laws.  The regulations have legal authority, which means they may be presented in court.  In almost all tax cases, there is some Statute, that is called into question, therefore the Court’s exclusive job is to rule on interpretation of the Statute as it applies to the situation before the court, not to overrule any statute, unless it found the law unconstitutional.  Therefore, additional law is generated by courts’ interpreting Statutes.  This is known as “case law”.

Let’s look at a simple example to illustrate the concept.  To determine how much tax an individual will pay on a certain transaction say, the receipt of life insurance payments as a beneficiary of a policy. Where do we start?  It is generally unquestioned that since the issue is about taxes we can look in Title 26 of the United States Code to find out what amounts paid to the taxpayer are taxable as income.

Moreover, Subtitle A of Title 26 is entitled “Income Taxes”, so that is a natural place to continue looking to see what taxes will be owed, if any on this payment.  Within Chapter 1 “Normal Taxes”, Subchapter A is called “Determination of Tax Liability”.  Determination of tax liability sounds on point in consideration of what we’re trying to accomplish.  In that Subchapter, Part 1 concerns “Tax on Individuals”.  Here is where we will start.  Section 1 is titled, “Tax Imposed”, and states “There is hereby imposed on the taxable income of” and lists the different filing statuses and applicable rates.

A question should then naturally arise, if there is a tax imposed, what is it imposed on?  The answer is nearby.  The wording of the statute says there will be imposition of tax on the “taxable income” of different filing statuses.  Well we might want to know then what taxable income means for federal legal purposes.  Looking in the index, or though a common search, one will find that Part I of  Subchapter B “Computation of Taxable Income”, is entitled “Definition of Gross Income, Adjusted Gross Income, Taxable Income, Ect.”.  So there it is, and if we look at the sections under Part 1 of Subchapter B, we will see Section 63’s title of “Taxable Income Defined.”

Section 63 (a) states, in part, “the term ‘taxable income’ means gross income minus the deductions allowed.”  Well it would certainly be helpful to know then what “gross income” means.  Not too far away, in the same Part, one can find in Section 61, which is entitled, “Gross income defined”.  Section 61(a) states in part, “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

…
(3) Gains derived from dealings in property.”  Life insurance contracts are property, generally.

Notwithstanding the meaning of “all income from whatever source derived” we know if some item is “otherwise” excepted in Subtitle A, “Income Taxes”, that such item would not be included in gross income.  Further, if the item is not included in gross income, it will not be included in taxable income, and even further, if the item is not included in taxable income, the imposition of a tax on such item does not apply.

We now must look in Subtitle A to see what, if any items are excepted.  Part III of Subchapter B, is conveniently enough titled “Items Specifically Excluded From Gross Income.”  The first Section of this Part is entitled “Certain Death Benefits”.  Payments from a life insurance contract to a beneficiary is on point with this Section, so it should be read.  Section 101 states, in pertinent part, “gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.” So if life insurance payments are not included in gross income, the life insurance payments are not taxable income, and therefore are not subject to an imposition of income tax, or in other words – no tax is due.

In this simple example, there was no need to examine the Regulations or any court cases, as our issue was straightforward.  However, most issues will involve additional questions which then the practitioner will look to further sources, i.e., regulations and case law, to determine the answer to the question presented.

For further explanatory discussion of the structure and sources of federal tax law, please see the AdvisorFX Main Library Section 50.6  Sources And Structure Of Federal Tax Law: A—Sources And Structure Of Federal Tax Law

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

Increased medical loss ratios (MLRs) are devastating health insurance producers’ balance sheets and pushing agents out of the health insurance business. Effective this past January, the Obama Administration’s Affordable Care Act increased the MLR requirement imposed on health insurance companies, forcing many carriers to reduce agent commissions by 25 percent or more.

The intent behind imposing MLRs is to ensure that consumers receive the full value of their premium dollars by requiring insurance carriers to spend premium dollars on direct medical services, rather than on administrative costs and profits. Under the new MLR requirement, insurers must spend 80 to 85 cents of every dollar on direct medical services. Insurers who fail to meet the MLR requirement must either adjust their premiums to account for any discrepancies or refund excess premiums to consumers.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of health care reform in Advisor’s Journal, see Long-term Care Insurance Reform Act of 2010 (CC 10-46), Changes Affecting Large Employers in the 2010 Health Reform Law (CC 10-17), Changes Affecting Business in the 2010 Health Reform Law (CC 10-16), & Changes Affecting Individuals in the 2010 Health Reform Law (CC 10-15).

Why is this Topic Important to Wealth Managers? This blogticle discusses a proposal to eliminate the Federal income, estate and gift and employment taxes. This is obviously not great news for wealth managers. However unlikely it may be that the proposed legislation will pass, it is important for those in the industry to be aware of potential legislation that would completely eradicate many uses for financial planning.

The somewhat radical Fair Tax Act of 2011, [1] a Bill introduced in the House earlier this year, intends to repeal the income tax, employment tax, and estate and gift tax.  It would also redesignate the Internal Revenue Code of 1986 as the Internal Revenue Code of 2011.

Since the income tax, under the proposed bill would be eliminated, a new source of tax revenue would have to be raised to support government operations.  Who is going to pay for all that interest after all? The House Bill supporter’s plans…impose a national sales tax.

The proposed legislation would impose a national sales tax on the use or consumption in the United States of taxable property or services. The sales tax rate determined by the drafters has been set at 23% in 2013, with adjustments to the rate in subsequent years. But the tax is only on consumers and the proposed bill would allow exemptions from the tax for property or services purchased for business, export, or investment purposes, and for state government functions.

How do the drafters of the legislation envision the collection process to work?  The states would have the primary authority for the collection of sales tax revenues with the responsibility of remittance of such revenues to the Treasury. The legislation also sets forth administrative provisions relating to: (1) the filing of monthly reports and payments of tax, (2) accounting methods, (3) registration of sellers of goods and services responsible for reporting sales, (4) penalties for noncompliance, and (5) collections, appeals, and taxpayer rights.

The legislation even addresses spending:  it directs the Secretary of the Treasury to allocate sales tax revenues among: (1) the general revenue, (2) the old-age and survivors insurance trust fund, (3) the disability insurance trust fund, (4) the hospital insurance trust fund, and (5) the federal supplementary medical insurance trust fund.

The proposed Bill goes one step further by prohibiting the funding of the Internal Revenue Service (IRS) after FY2015. In its stead the Bill would establish in the Department of the Treasury: (1) an Excise Tax Bureau to administer excise taxes not administered by the Bureau of Alcohol, Tobacco, Firearms, and Explosives (ATF), and (2) a Sales Tax Bureau to administer the national sales tax.

Interestingly enough the Bill self terminates the sales tax imposed by the Fair Tax Act if the Sixteenth Amendment to the U.S. Constitution (authorizing an income tax) is not repealed within seven years after the enactment of the proposed Act.

All this thanks to Rep. Rod Woodall from Georgia, the introducer of the proposed Bill. There are a number of arguments why a national sales tax is not the best approach to collect revenues.  The most striking is the underground economy and barter systems that would ensue would negate any real ability to tax consumer goods.

Tomorrow’s blogticles will discuss topics relating to insurance and financial planning.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] H.R. 25

We’re just two weeks into the new Congress and the Republican majority is already causing controversy as it tries to live up to what it perceives as its deficit reduction, tax cut mandate. Republicans promised to cut spending by $100 billion by the end of 2011, but critics say that recent Republican maneuvers will do just the opposite by reducing revenue through new tax cuts and a repeal of the health care reform law.  

The so-called “cut as you go” rules require that every new mandatory spending measure be offset by an equivalent spending cut. Tax cut legislation is exempt from the cut-go rules.  Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

Why is this Topic Important to Wealth Managers? Provides a brief discussion on the difference between tax avoidance versus evasion, the former earns wealth managers checks and the latter can send them to jail.  Knowing the difference, when to spot it, and how to “avoid evasion” is essential to any wealth manager’s tool kit.

Tax avoidance is “The act of taking advantage of legally available tax-planning opportunities in order to minimize one’s tax liability.” [1] On the other hand, tax evasion is the “willful attempt to defeat or circumvent the tax law in order to illegally reduce one’s tax liability. [2]

From the above definitions, and the function of the tax code itself, the line becomes blurred between taking advantage of legally available planning opportunities and a willful attempt to circumvent the tax law.  A well known quote often attributed to Will Rogers speaks to this point.  “The income tax has made more liars out of the American people than golf has. Even when you make a tax form out on the level, you don’t know when it’s through if you are a crook or a martyr.” [3]

Today’s advanced transactions are even more difficult to understand in regards to an ever expanding tax code.  Even over 50 years ago, (well before the Revised 1983 Code) it was said by one of the world’s most famous scientists, Albert Einstein, “The hardest thing in the world to understand is the income tax.” [4] So if Einstein had trouble with calculation of income tax liability, in the 30s-40s what can wealth managers do to not only keep their clients safe, but also maximize every opportunity?

• Stay Informed – A plan that may have been okay last year may be under attack currently.  Some forms of retirement plans were the classic example of this.
• Ask an Attorney and/or Accountant– If a wealth manager is planning a transaction that he/she is not absolutely sure of the consequences, in other words willing to risk licensing and professional liability, then it would be prudent to seek tax and/or legal advice for the client.  A small amount of billable time now can go a long way later, even if to just confirm initial conclusions.
• Don’t Stay too Limited – If a wealth manager hears of a beneficial concept for a client that makes sense, it may be worth exploring.  As we continue further into a global economic climate, many more international opportunities are becoming available.  Just with any other investment opportunity, risk levels vary based on various factors.
• Don’t Cheat – Know the rules of the game, and play the game the best it can be played within those rules.  Take for example, the recent “Father & Son” Cohen tax evasion case in South Florida.  The Times reported [5], “Prosecutors said the Cohens used offshore companies, friends and family posing as owners, and forged documents to cheat on their taxes. They said the Cohens should have declared income from their use of mansions and luxury cars that the father and son said were owned by corporations.”

Whomever was advising the Cohens, based on the information provided, was not doing a good job.  The Cohens were convicted at trial of “hiding a $33 million hotel sale from federal tax authorities while living a lavish lifestyle.”

It should be quite clear from the above example that forged documents are obviously illegal and wealth managers should make every attempt to avoid participating with anyone who has an intent to defraud.  There is always a line in the law, and although what the line is, or where it lies is not always clear, wealth managers should be able to distinguish clearly illicit activity.  With that in mind, it has long been the reasoning of the High Courts that for the reason and in favor of the “astuteness of taxpayers in ordering their affairs so as to minimize taxes we have said that ‘the very meaning of a line in the law is that you intentionally may go as close to it as you can if you do not pass it.’ ” [6]

Tomorrow’s blogiticle will discuss tax advantageous solutions such as bonds.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] Black’s Law Dictionary (8th ed. 2004), tax avoidance.

[2] Black’s Law Dictionary (8th ed. 2004), tax evasion.

[3] See generally, Charlie Kelliher, PhD.  Associate Professor, Dixon School of Accounting – University of Central Florida.   http://www.bus.ucf.edu/ckelliher/tax_5015/examples/tax_quotes.htm.  Last Accessed 10/6/10.

[4] Id.

[5] “Father and Son Found Guilty of Tax Evasion.” New York Times crediting Bloomberg News.   http://www.nytimes.com/2010/10/07/business/07tax.html?_r=1&src=busln.  Published: October 6, 2010.  Last Accessed 10/6/10.

[6] Atlantic Coast Line R. Co. v. Phillips 332 U.S. 168, 172-173, 67 S.Ct. 1584, 1587 (U.S. 1947) citing,  Superior Oil Co. v. State of Mississippi, 280 U.S. 390, 395, 396, 50 S.Ct. 169, 170, 74 L.Ed. 504.