Myths Regarding the Flat Tax

A flat tax on income would tax all individual income at the same rate. At a 15% rate, a person making $10,000 would pay $1,500 in taxes and a person making $100,000 would pay $15,000. Current proposals would eliminate income taxes on capital gains and dividends (so it isn't really the same tax rate on ALL income).

It is more fair than the current system - only if you agree that tax burden should be shifted from the wealthiest 10% or so of taxpayers to everyone else. Of the taxpayers who paid tax in 2012, those with AGI under $50,000 (90,812,022 returns) had 1.8% of total net taxable gains while those with AGI of a $1,000,000 or more (392,850 returns) had 73.5% of those gains. The flat tax would have eliminated taxes on almost $455 billion of capital gains realized by the very wealthy (about $1,158 per tax return and on $11.4 billion of capital gains on the under $50,000 taxpayers (about 12 cents per return). The division of taxable dividends is not quite as extreme: About 7.8% were received by taxpayers with AGI between $1 and $50,000 while 52.0% were received by taxpayers with AGI of a $1,000,000 or more.

Here are some other comparisons. 28.9% of the educator expense deductions were taken on tax returns with AGI of under $50,000 while almost none were taken by those with AGI of $1,000,000 or more. 58.2% of the total student loan interest deductions were taken by taxpayers with AGI under $50,000 while those over $1,000,000 deducted nothing (due to the AGI related phase out).

It is simpler than the current system - because it eliminates tax breaks such as home mortgage interest and real estate tax deductions, charitable contribution deduction, education credits and deductions, dependent care and child credits, and more. I've seen no suggestion that businesses would lose all their deductions and credits therefore that part of the tax code, with all its complexities, would remain.

The overwhelming majority of the complexity affecting individual tax returns provide tax savings; because of phase outs based on AGI, much of that savings is enjoyed by taxpayers with AGI under $100,000 or so.

Anyone who thinks a flat tax would remain simple needs a reality check. Just look at what Congress has done with the current income tax law during the last 2 or 3 decades. A flat tax might not even begin very simple because of the lobbying efforts of those negatively affected by elimination of home mortgage interest and real estate tax deductions, charitable contribution deduction, education credits and deductions, dependent care and child credits, and more.

The IRS would be eliminated - not true. It might be renamed but a tax collection agency would continue to exist. Those parts of the IRS needed to enforce business related parts of the Internal Revenue Code would remain unchanged.

It would reduce fraud - Ha! Crooks are crooks. Crooks will still cheat on their taxes. Most of the dollar cost of income tax fraud today comes from failing to report taxable income. Phony deductions and credits pale in comparison.

A flat tax would stimulate the economy here like it did in Eastern Europe - Some former members of the Soviet Union, primarily Baltic countries, did adopt a flat tax and did enjoy initial economic growth. Whether that growth was a result of a flat tax regime or because of suddenly having a free more capitalistic economy is open to debate. In any event, those countries’ economies are now no better, perhaps worse, than other countries.

In short, the benefits claimed for a flat tax are unlikely to occur, certainly for no significant length of time. The costs include the significant economic dislocation (job migration and price fluctuations are two examples) that would accompany any significant change in a tax regime. All the costs of having a flat income tax easily outweigh the mostly non-existent benefits.

Income tax information came from the IRS at http://www.irs.gov/uac/SOI-Tax-Stats-Individual-Income-Tax-Return-Form-1040-Statistics.

Damages for Physical Injury or Illness

The general question is, "if I get compensation for damages someone else has done to me, is the money taxable?"
As with any tax question the answer is, it depends.  That money is usually taxable, however.

A more specific question is, "if I get compensation for physical injury or illness that someone else has inflicted upon me, is the money taxable."
The answer is still, it depends, but settlements like these are usually not taxable.

Here is the general rule.

1. The settlement has to be for a tort or tort-like action. "Tort" is one of those legal-babble terms that means you got damaged by someone else. You don't have to go to court for this requirement to be met.
2. The settlement has to be because of a physical injury or illness. Making you bleed is what we call a "good fact." Internal bleeding counts. So do bruises.

Next, the exceptions: If the payment, or part of it, is for medical bills that have already been deducted on a tax return, that part is taxable income. Also, if the payment, or part of it, is labeled "punitive damages," that part is taxable. That's it. Those are the exceptions. Everything else is excluded from taxable income.

"So what's the big deal," you might ask. "It doesn't seem like rocket science."

You would think. However, there are a lot of people running around out there who believe there are other exceptions. Here are some myths in descending order of pervasiveness.

• Myth #1: If you get physically injured by someone else and they compensate you for lost income, that part is taxable. Not so! It makes no difference how the dollar value of the physical injury is computed, the payment is still tax free.
• Myth #2: If the compensation includes an amount for emotional distress or something similar, that part is taxable. This one is trickier because another part of the tax code says compensation for emotional distress is taxable. However, that other part refers to emotional distress when that's the only damage done to the person. If the emotional distress (including pain and suffering) is a result of the physical injury, the payment is still tax free.
• Myth #3: Payments to anyone besides the injured party are taxable. Wrong again. If a person is banged up in an automobile accident and the spouse gets a payment for his/her suffering as a result of that accident, those payments are tax free. If a spouse is killed by someone else in an accident and the settlement results in the estate getting money, the estate does not have taxable income. If that settlement goes to the surviving spouse or other family member, the payment is still tax free.

If you meet the criteria under "general rule" and you're told by your tax return preparer that the lost wages part of your settlement is taxable, tell them to read IRC Section 104, Reg Section 1.104-1, and most importantly, Revenue Ruling 87-95. If they still don't understand, drop me a line. Our rates, in my opinion, are reasonable. (I have to say it's just my own opinion that our rates are reasonable because the AICPA has said that a general claim of charging "reasonable" rates is unethical.)

Do be sure to read the disclaimer at the top right of this page.