Making Sense of the Tax Maze

Los Angeles attorney Roman Melnik is used to sweating the details. But he may have met his match in the U.S. tax code.

Melnik, an attorney with the firm of Irell & Manella, had to file amended federal tax returns three years running. Among other things, he forgot to deduct state disability insurance premiums on his federal tax return and missed some itemized deduction phaseouts.

“I have never had a return where I didn’t catch an error later,” Melnik said. “I am now a firm believer in using [tax preparation] software to double-check.”

Count Melnik among the millions of Americans who are buffaloed by the nation’s byzantine tax laws--a system so complex that even the Internal Revenue Service thinks it has gotten out of hand. The agency’s taxpayer advocate, in listing the 20 biggest problems facing American taxpayers, puts complexity in the top two spots--once for individuals, once for businesses.

“Complexity remains the No. 1 problem facing taxpayers and is the root cause of many of the other problems on the Top 20 list,” the taxpayer advocate’s office wrote in its 2000 report. “Despite IRS restructuring to target services to taxpayer needs, the fact remains that the Internal Revenue Code is riddled with complexities that often defy explanation.”

And it’s likely to get worse before it gets better. Both President Bush’s tax plan and proposals from a tax-cut-happy Congress would further complicate the tax code by creating new deductions and credits. Moreover, despite the frustration over a tax system that forces even some low-income filers to seek help, many Americans wouldn’t have it any other way.

Robert Crockett, director of the Altadena Senior Center, said that when it comes to choosing between simplicity and deductions, he’ll take the deductions every time. Although his return is already so complex that he hires a professional preparer, he’d actually like to bring back some deductions that were eliminated in the Tax Reform Act of 1986--the last successful effort at simplifying the federal tax code.

“I think the economy would benefit if we could claim credit card interest deductions again,” he said, also casting a vote for reviving the old sales tax deduction.

Crockett’s viewpoint helps explain why demystifying the tax code makes a lot more sense in theory than in practice. Ever since tax reform, politicians have passed dozens of new tax provisions aimed at benefiting various interest groups.

The tactic was particularly popular during the Clinton administration, said Martin A. Sullivan, an economist with Tax Notes magazine in Arlington, Va. And the Republican-controlled Congress, happy that the White House was pushing tax breaks rather than new spending, went along. In the last five years alone, Congress has approved more than 2,000 tax changes, adding 5,000 pages of new provisions and explanatory text to the tax code.

The taxpayers who benefit from new and existing breaks include virtually anyone with a house, a life insurance policy, a child, an education or a medical issue, as well as all people who sell houses, insurance policies and provide day care.

More obscure groups get breaks as well: There’s a deduction for rural mail carriers covered by “certain collective-bargaining agreements.” There are special deductions for people who make last-ditch attempts to get oil out of seemingly dry wells. There’s even a tax break for farmers who are forced to sell livestock because of bad weather.

Needless to say, all of these money-saving provisions create a vast constituency for the current tax code. Corporations, unions, nonprofit groups and all of the people who work for them and provide them with services get some ancillary benefit from the tax code. And all of those registered voters who benefit from deductions and credits are loath to give them up.

“What we always try to do is give tax breaks to the most sympathetic characters in the public eye--whatever is in the news,” Sullivan said. “But nothing ever expires or gets taken away.”

As a result, new tax credits for retirement savings, education, child care, homeownership and medical expenses get piled onto old tax breaks for many of the same things. That leaves taxpayers trying to choose among competing tax breaks, such as whether to fund an education IRA now or claim a tax credit later or, perhaps, save through a state-sponsored, tax-favored tuition savings plan.

“Do you think middle-income taxpayers who need to save for their children’s college expenses have any idea of the best way to do it?” said Pam Pecarich, head of the American Institute of Certified Public Accountants’ tax committee. “I have friends who are tax professors who tell me that they can’t teach this stuff anymore.”

Retirement planning is another area in which the tax breaks tend to pile up. Tax-favored choices for retirement savings include traditional individual retirement accounts, Roth IRAs, 401(k)s, 403(b)s, 457 plans, Keoghs, SEP-IRAs and so-called Simple plans. Each comes with different rules and different income limitations. In some instances, you can use several retirement plans in concert. In other instances, you can’t.

Given this kind of complexity--and a tax code that now numbers 45,662 pages--even seasoned preparers acknowledge that they can no longer avoid mistakes.

Ron Mosier, a retired information systems manager who volunteers his time to help seniors with their taxes, says he messed up deductions for interest relating to home refinancing on his own return. He caught the mistake only after stumbling across an article on the subject.

Individual taxpayers, meanwhile, are more likely to think they’ve filed accurately, but only because they’re ignorant of all the possible pitfalls, experts contend.

“It’s like sliding down a tin roof,” said Charles Davenport, professor of tax law at Rutgers University in New Jersey. “As you make the system more complex, you steepen the roof a bit. You make it harder and harder for people to comply.”

And now for the really bad news: The momentum in Washington seems to favor laws that will make the tax code even more complex. Bush’s tax-cut plan would create complicated new deductions for dual-income married couples and for charitable contributions. Also, his proposals would be phased in, changing incrementally every year.

Simply put, simplifying the tax code is not on Bush’s agenda at the moment.

“The president’s priority is to allow people to keep more of what they earn,” said Ken Lesias, a White House spokesman. “That doesn’t disqualify this administration from going back later and looking at other priorities. But, at this time, we think things like eliminating the [estate] tax, reducing the marriage penalty and increasing the child tax credit are more pressing.”

Meanwhile, legislators are revving up with tax-cut bills of their own. Rep. Nancy L. Johnson (R-Conn.) just introduced a bill to provide a tax break for those who buy long-term-care insurance, as well as tax credits for families paying nursing-care expenses.

Rep. Ron Paul (R-Texas) has introduced bills that would provide tax credits to parents who pay education expenses. And Rep. James V. Hansen (R-Utah) plans to reintroduce a bill that that would create a $10,000 tax credit for people who “donate harvestable organs at death.”

The Hansen bill illustrates how seemingly minor changes in the tax code can open a Pandora’s box of questions, which usually require pages of tax law to answer.

“We would not want to increase the burden of filing,” said Justin Harding, Hansen’s legislative assistant. “But we recognize that some of the details to the bill have to be worked out.”

Such as? “For instance, how does a medical professional determine whether an organ is harvestable?” Harding said. “What forms would have to be filled out? When does the IRS play a role? We also haven’t set the number of organs that you’d have to donate to get the tax credit. We haven’t decided whether it’s two major organs or four major organs or what.”

Nor is it clear what sort of proof a donor’s heirs would have to produce to claim the tax credit, which would either offset estate taxes or provide heirs with a $10,000 check from Uncle Sam.

Entanglements like those lead to proposals for tax simplicity, such as the one favored by Grover Norquist, president of Americans for Tax Reform. He maintains that tax loopholes exist simply because rates are too high. If tax rates were lowered across the board, all deductions and credits could be jettisoned. Then taxes would be simple and everybody would be happy.

“At the end of the day, almost everybody who benefits from a deduction or a credit would be better off if all the deductions and credits were eliminated and you just lowered the rates,” Norquist said.

“The challenge is that no one wants to go first. They don’t want to say, ‘OK, I’ll give up my deduction or credit,’ because they fear that rates won’t be lowered and everyone else will hold onto theirs.”

How to end the standoff? So far, the rising chorus of complaints from businesses, academics and tax-simplification lobbyists has had little effect.

Perhaps, suggests Don Adamson, a retired engineer who volunteers to help Southland seniors file their tax returns, there’s a better way to get results.

“I keep hoping that legislators are going to come to their senses and simplify the code,” he said. “I figure that if legislators had to do their own tax forms themselves, we would have a much simpler system.”

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Cryptic Code

How complicated is the federal tax code? Here are a few “complexity indicators.”

Number of tax law changes since 1995: 2,116

Number of pages in the U.S. tax law:

1984: 19,500

2001: 45,662

Estimated time required to fill out:

*--*

Form 1990 2000 1040 9 hrs, 33 min 13 hrs, 1 min Schedule A 4 hrs, 13 min 5 hrs, 37 min Schedule B 1 hr, 20 min 1 hr, 26 min Schedule C 9 hrs, 39 min 10 hrs, 23 min Schedule D 3 hrs, 18 min 6 hrs, 58 min Total 28 hrs, 3 min 37 hrs, 25 min

*--*

Percentage of returns signed by paid preparers:

1987: 49%

1998*: 53.34%

*About 12 million additional taxpayers--10% of the total--use tax preparation software, which wasn’t widely available in 1987.

Source: CCH Inc.