Income Tax: A History

Benjamin Franklin once wrote, “In this world nothing can be said to be certain, except death and taxes” — something all taxpayers can attest to, particularly around April. Income tax, though, was not always quite so certain — in fact, for most of our nation’s history, income tax did not even exist.

Congress did not enact income tax in the United States until 1862, as a means to support the cost of the Civil War. Prior to that, the government had merely taxed imported goods to sustain itself. The Act of 1862 established the office of Commissioner of Internal Revenue, whose powers included the rights to assess, levy, and collect taxes, and to enforce the tax laws by seizing property or through prosecution, similar to the Internal Revenue Services’ powers today. At that time, a person earning between $600 and $10,000 per year (about $13,000 to $216,000 in today’s dollars) had to pay a three percent income tax, while those making more than $10,000 a year had to pay a higher rate.

Once the Civil War ended, Congress decided to focus its taxation efforts on tobacco and alcohol, and in 1872 it eliminated the income tax. The income tax did not reappear until 1894, when the growing Populist movement and the growing lobby to tax the rich influenced Congress to pass the Wilson-Gorman Tariff Act of 1894, which created a flat 2% income tax on all income over $4,000 (about $100,000 today).

Not everyone approved of this tax, however; a Massachusetts citizen named Charles Pollock, upon learning that the ten shares of stock he owned in the Farmers’ Loan & Trust Company made him liable to be taxed under the Act, sued the company to prevent them from paying the tax. The Supreme Court agreed to hear the case, and decided that certain taxes in the Wilson-Gorman Tariff Act were direct taxes, which, according to the Constitution, needed to be imposed in proportion to a states’ population. Since the act did not impose those taxes proportionally, the Supreme Court declared it unconstitutional, and Congress repealed the act in 1895.

The Supreme Court’s decision was unpopular, though, and in 1913, Congress and 42 states circumvented the Court’s decision by ratifying the 16^th Amendment to the Constitution, which unequivocally granted Congress the power to collect income tax “from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

When the income tax was created in 1913, the highest tax rate for married couples filing jointly was 7%, applicable to those making over $500,000 a year (over $10 million today). However, when the United States entered World War I in 1917, income tax rates rocketed up to 54% for those making over $500,000 a year; for those making the average income of $750 per year, though, the tax rate was only two percent.

Tax rates shot up again at the start of World War II, up to 77% for those making over $500,000 in 1941 and peaked at 94% for all making over $200,000 (about $2.4 million today) in 1945.

To take a look at a 1040 form from 1864, please click here.

Jim Walsh Named a Fellow of the Bar Foundation for Howard County

Jim Walsh was recently nominated and approved as a fellow of the Bar Foundation for Howard County, Maryland, Inc. The Bar Foundation is a non-profit charitable corporation founded in 2001 that works to improve the public’s knowledge of the law and to improve the administration of justice in Howard County.

In order to become a Fellow, a lawyer must be nominated by a current Fellow, then be endorsed by the Foundation’s Board of Directors. According to the Foundation’s Constitution,“Being a Fellow shall be  deemed a professional honor and distinction, and a recognition of outstanding dedication and contribution to maintaining the honor and integrity of the legal profession, the improvement and facilitation of the administration of justice, the work of The Howard County Bar Association, Inc. (the “Bar Association”) and/or the organized Bar of the State of Maryland and civic leadership.”

FACTA: More IRS Disclosure Requirements for Foreign Accounts

In recent years, ownership of foreign investments and financial accounts has become of increasing concern to U.S. taxpayers.  For a long time, bank secrecy laws in certain countries turned “offshore” financial institutions into tax havens, enabling U.S. taxpayers to avoid reporting foreign-based income or paying tax on that income.  As the result of far-reaching investigations and prosecutions (with the assistance of a whistleblower connected to UBS, a major Swiss bank), the IRS has begun to secure disclosure of formerly secret bank accounts, which enable them to uncover an untapped source of billions of dollars of previously unreported tax, plus interest and penalties.

One weapon that has been available to IRS for some years is the Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (the “FBAR”).  A U.S. taxpayer who owns or has “signature authority” over one or more foreign-based bank or investment accounts, with an aggregate value of more than $10,000 at any time during a year, must file a FBAR for that year, identifying all such foreign accounts and the maximum value during the year.  This, in turn, can be used by IRS to determine if income from the foreign account was reported on the taxpayer’s income tax return.  The penalties for failure to file the FBAR can be extreme, beginning at $10,000 per year and reaching the greater of $100,000 or 50% of the value of those foreign accounts, per year, if the failure to file was “willful,” as well as possible criminal penalties.

Now, Congress has enacted the Foreign Account Tax Compliance Act (FACTA), effective with the 2011 income tax returns.  Under FACTA, those taxpayers and foreign assets meeting the law’s criteria must file a new Form 8938, together with their tax return, that identifies those foreign assets, including the applicable value.  These rules apply to U.S. citizens, resident aliens, and certain nonresident aliens (such as bona fide residents of U.S. Possessions or those electing to be treated as resident aliens in order to file a joint return). The law also requires certain U.S.-based entities (such as closely-held corporations or partnerships) holding foreign assets to file the form 8938. However, the IRS has not yet formulated regulations to cover this, so, for 2011, only individuals have to file this disclosure form. However, if the foreign financial asset is owned by a disregarded entity, such as a single-member limited liability company, then that asset is deemed to be owned directly by the member and that asset must be reported on the 8938.

The types of “specified foreign financial assets” required to be reported on Form 8938 overlap those covered by the FBAR (basically, foreign bank and investment accounts), but also include many more, such as:

• stock issued by a foreign corporation (and not held through a brokerage account)
• interests in a foreign entity (partnership, limited liability company, trust, estate)
• bonds or promissory notes issued by a foreign person or entity
• interests in foreign pension or deferred compensation plans
• interests in foreign assets held by a child and generating unearned income subject to the “kiddie tax”

The applicable financial assets must be reported even if they do not generate any income, gains, or deductions to be reflected on the income tax return.

The threshold value of assets that triggers the requirement to file the Form 8938 depends on the circumstances. For a single taxpayer, the threshold is total value of $50,000 as of the last day of the tax year or $75,000 at any time during the year; for married taxpayers filing joint returns, the total value is $100,000 as of the end of the year or $150,000 during the year; and there are different thresholds for married taxpayers filing separate returns and for taxpayers living abroad.

The minimum penalty for failure to file the 8938 is $10,000, but that penalty can be increased by $10,000 per month (up to a maximum of $50,000) for continued failure to file after IRS gives notice that the 8938 was not filed (presumably, prompted by following up and matching against income disclosed by the foreign financial institutions). There also is a new 40% penalty for underpaying tax on income (derived from the undisclosed foreign asset) that was not reported, as well as fraud and criminal penalties.

It should be noted that the disclosure through filing the Form 8938 is separate from the FBAR reporting requirements, so a taxpayer still will have to file a FBAR, and be subject to FBAR penalties, in addition to the 8938 requirements.

The impact of FACTA on the taxpayer is increased by a second aspect of the law. Beginning in 2013, all foreign financial institutions well be required to report the accounts and items of income attributed to U.S. owners, regardless of bank secrecy laws.  Failure to comply could result in penalties and, in effect, denial of access to U.S. capital. This is likely to be a sufficient deterrent to financial institutions, ensuring that tax havens are a thing of the past and forcing all taxpayers to report and pay taxes on all foreign income.

All of this will impose an additional burden on the taxpayer, and additional cost of tax return preparation, because of the additional information that will have to be assembled, prepared, and reported.  Now, the taxpayer will have to be doubly aware of disclosure obligations relating to foreign assets, or face a greater certainty of stiff penalties.

Jim Walsh Re-Appointed to Board of Appeals

Jim Walsh was recently re-appointed by the Howard County Council to serve a second five-year term on the Howard County Board of Appeals.  The Board of Appeals is a five member citizen panel that hears appeals from decisions of various Howard County government agencies (primarily planning and zoning).   Jim served as chair of the Board for two of his first five years on the Board.  At the first Board meeting of 2012, Jim was re-elected as chair by his fellow Board members.

IRS Announces Third Offshore Disclosure Program

Citing a strong response to two previous disclosure programs, the IRS has just announced a third offshore voluntary disclosure program (OVDP). These disclosure programs are designed to seek taxpayers who are “hiding” offshore accounts that produce unreported taxable income, and bring them back within the U.S. tax system. The lure is the offer to achieve a controlled disclosure of these assets through the imposition of penalties that, while significant, still are less than the potential civil and criminal penalties that can only be described as draconian. The stepped-up efforts of IRS to both pursue significant prosecutions of taxpayers holding such accounts, and to force more and more foreign financial institutions to divulge the identities of such taxpayers, have led to a heightened awareness by taxpayers that they need to “come forward and come clean” before IRS catches them.

The basic premise of this problem is that the tax law of the United States, unlike most other countries, requires taxpayers to report and pay taxes on all income, including income earned outside of the United States. Even though that foreign income is reported to another country and taxes are paid there, that income also must be reported on the U.S. tax return. In most cases, the double tax is offset or reduced by a foreign tax credit. If the aggregate value of all foreign bank and investment accounts exceeds $10,000 at any time during the year, a Report of Foreign Bank and Financial Accounts (FBAR) must be filed (even if there is no tax due from those accounts). Failure to file this form carries a minimum penalty of $10,000 per year, which can increase if the taxpayer “wilfully” failed to file the form, and criminal penalties can apply as well. Many taxpayers could unknowingly be caught up in this difficulty. For example, an immigrant to the United States who still owns real estate or has bank or investment accounts in the original country would be subject to the disclosure requirements.

According to the IRS, some 33,000 taxpayers have responded to the previous disclosure programs, initiated in 2009 and 2011. Approximately $3.4 billion has been collected through the 2009 program, which is mostly completed, and another $1 billion of “up front” payments have been received so far in the 2011 program, which is only beginning to be processed. IRS reported that since the 2011 program closed in September, many individuals and tax advisors continue to express interest in the disclosure program.

The details of the new OVDP are still sketchy. It appears that the parameters and penalty framework will be similar to the 2011 program, except that the applicable disclosure penalty (which is in addition to other penalties such as underpayment of tax and a 20% accuracy-based penalty) will be 27.5% of the value of the foreign accounts and assets, up from 25% under the 2011 program. This still may be preferable to the potential penalties if the taxpayer holds out and is discovered by IRS. IRS is aggressively pursuing disclosure by offshore financial institutions in many countries, forcing an increasing number of “tax havens” to sidestep bank secrecy laws and divulge information on foreign accounts and income that previously was not taxed by IRS.

Given the increasing chance of being caught, taxpayers and their advisors are giving more consideration to voluntary disclosure. The penalties can be significant, but the alternative is having to constantly live under the shadow of potential discovery by IRS, which could result in extremely severe penalties and expenses, as well as criminal prosecution.

It should be noted, though, that this voluntary disclosure is not the remedy for everyone. For instance, the penalties under OVDP apply to the value of all foreign-based assets resulting in “tax noncompliance”, i.e., unreported income or unpaid tax. This can include foreign assets that do not have to be disclosed on the FBAR (the original basis for OVDP), such as income-producing real estate or valuable artwork sold at a profit. The value of such assets can significantly increase the amount of OVDP penalties. There is a procedure to “opt out” of the disclosure program, once accepted into it, if the penalties under the program are too severe and unwarranted under the facts, such as no unreported income or a lack of “wilfulness” in failing to report the foreign accounts.

We have dealt with these disclosures for our clients. If you or someone you know is in this situation, please give us a call so that we can help.

The Maryland “Medical Order for Life-Sustaining Treatment” Form: A Potential Trap for the Unwary

The Maryland Legislature, with a minimum fanfare, has enacted a new law that potentially could affect every senior citizen, as well as others who are admitted to health care facilities such as a nursing home, assisted living, a home health agency, a kidney dialysis center, or a hospice (but not, at this time, a hospital).  A new type of medical order, called a Medical Order for Life-Sustaining Treatment (MOLST) form, must be completed and maintained for every person admitted or transferred to one of those facilities.  This law became effective on October 1, 2011.

The MOLST form expands on the current “Do Not Resuscitate” (DNR) form, which instructs emergency responders and other health care providers regarding the use of life-saving treatments.  The MOLST form is intended to spell out choices regarding various life-sustaining treatments (especially in an emergency), and whether or under what circumstances they may or may not be attempted or continued.  These include:

• Cardiac or Pulmonary Resuscitation (CPR)
• Intubation (passing a breathing tube to assist in breathing) or artificial ventilation
• Blood transfusions
• Transfer to a hospital and performing medical tests
• Administering antibiotics and fluids and nutrition
• Dialysis

These MOLST orders are intended to be followed by emergency personnel and medical staff in case the person experiences a medical emergency, such as cardiac or pulmonary arrest, while a patient at the facility.

The MOLST order may only be prepared and signed by a physician or a nurse practitioner, and must be maintained with the patient’s medical records at all times.  The physician is required to complete the form in consultation with the patient, or if the patient lacks capacity then others, such as a health care agent appointed by an Advance Directive, may be consulted.

This appears to be a seemingly routine form that should bear close attention.  The physician preparing the order does not have to consult anyone other than the patient, even if the patient has an Advance Directive.  A patient, especially one who is elderly, may be fully lucid, yet may not be able to understand all of the medical choices and issues involved.  There is the possibility of choices being made and entered that actually are contrary to the patient’s true wishes, even if they are expressed otherwise in an Advance Directive.  Since this MOLST order now becomes a legal requirement, it is important to be aware of this.  It would be well for the family of an elderly patient to follow up with the staff at the facility and, after discussing the form with the patient, make sure that the form does, indeed, reflect the patient’s wishes.

Maryland Ground Rent Law Found Unconstitutional for a Second Time

About 15 months ago, we opined that the 2007 Maryland legislation reforming ground rents was constitutionally defective.  The courts agree.

To recap, the holder of a ground rent actually owns the property, and leases the property (in perpetuity) to the occupants commonly thought of as the owners of the property for what now seems to be a nominal amount. The typical ground rent in the Baltimore area calls for payments of less than $100 per year payable in semi-annual installments.  If the semi-annual rent was not paid, the ground rent owner could go through a legal process to eject the “tenants”, which made the ground rent safe because it operated as a kind of “super mortgage”, being even ahead of the “tenants’” mortgage lender.

In 2006 the Baltimore Sun ran a series of articles exposing abuses of the ground rent system, describing how some ground rent owners charged excessive fees for ground rent payments that were somewhat late, and ultimately even regained outright ownership of some properties when the “tenant” did not cure the defect in the mandated time.  The General Assembly responded to the Sun’s series by passing legislation that (1) prohibited the creation of new ground rents, (2) eliminated completely the ground rent owner’s right to eject a delinquent tenant, and (3) required that all existing ground rents in Maryland be registered in a central registry by 9/30/10 or be forever extinguished.  Although we perceive no problem with banning new ground rents, we did express doubts about the other two aspects of the law.

In October 2011, the Maryland Court of Appeals (Maryland’s highest state court) ruled that while a registry for ground-rent leases was legal, the penalty for failing to register was not.  The court ruled that the extinguishment of the unregistered ground rent was an unconstitutional taking of property without just compensation.

On Tuesday (12/20/11), Anne Arundel Circuit Court Judge Paul F. Harris Jr. ruled that the provision eliminating the ground rent owner’s right to a eject a delinquent tenant was also an unconstitutional taking without just compensation.  Because the latest case is a trial court ruling, the State could still appeal Judge Harris’ decision to the Court of Special Appeals (Maryland’s intermediate appellate court), or ultimately to the Court of Appeals.

It strikes us that the whole law is an example of politicians using a sledge hammer to solve a problem when a fly swatter would do the trick.

IRS Grants Second Amnesty Period For Unreported Foreign Investments

If you have a foreign bank or investment account, that may be a ticking tax bomb waiting to explode. If the aggregate balance of all foreign accounts exceeds $10,000 at any time during the year, a Report of Foreign Bank and Financial Accounts (FBAR) must be filed. Also, any income from those accounts must be reported on your income tax returns, even if you already reported the income on a foreign tax return and paid that country’s taxes on the income. The penalties for failure to do so can be draconian. In recent years, the IRS has stepped up efforts to discover the owners of such accounts, and has begun to target taxpayers and impose substantial civil and criminal penalties. Recently, IRS has announced agreements by a number of foreign institutions, long treated as “tax havens”, to disclose the information on all accounts owned by US citizens. Although recently publicized convictions dealt with large, multi-million dollar accounts, any account and unreported income is vulnerable to the same stiff penalties.

Currently, the IRS has an amnesty program that can limit the possible penalties and enable a delinquent taxpayer to “come clean” with a less onerous burden. The IRS 2011 Offshore Voluntary Disclosure Initiative enables the taxpayer to file all missing FBARs, report any unreported income, pay all taxes and some penalties and interest, but then the matter is finished and there is no need to continually worry whether your financial institution will be the next to deliver account information to the IRS.

This Initiative has certain rigid requirements and a considerable amount of documentation required to be accepted for the amnesty, including required FBARs and amended tax returns for 2003-2010, and the payment of a 20% penalty on unpaid taxes and a FBAR penalty of 25% of the highest amount disclosed on the FBARs. Also, all of the required documentation, plus payment of all taxes, interest and penalties (or at least acceptable arrangement of payment), must be submitted and accepted by August 31, 2011, with no possibility of extension. However, the potential penalties for failure to comply with FBAR reporting requirements can range from $10,000 to the greater of $100,000 or 50% of account value for each FBAR not filed, plus possible criminal penalties, which could make the Initiative requirements appear mild by comparison.

Various Fees and Taxes Increase Effective July 1

Assorted fees and taxes increased on July 1 here in Maryland, including:
(1) Increase of vehicle registration fees (up $26.50 for most vehicles over the two-year registration period),
(2) Doubling (to $40.00) of the land records surcharge assessed on deeds,
(3) Increase to 9% (from 6%) for the sales tax on alcohol,
(4) Increasing the cost to obtain a birth certificate, and
(5) Increasing the cost of vanity license plates.

Howard County bans smoking in public parks

Howard County Health Director Dr. Peter Beilenson announced today that Howard County will ban smoking in its parks effective tomorrow, July 13. The latest Howard County ban does not affect smoking in other public places nor on privately-owned yet publicly-accessible recreation areas (e.g., Columbia Association open spaces).