A number of changes have been made to the comments that I first
submitted to the panel on March 18, 2005. In a prior e-mail on March 20,
2005 a correction was provided to the original submittal.

A complete document is being provided with all changes through April 1,
2005 incorporated.

The really significant change that was made since March 20, 2005 is to a
sentence under the heading:

TAX TREATMENT OF STATE INCOME TAX OVERPAYMENTS AND REFUNDS WHEN THE
ALTERNATIVE MINIMUM TAX FOR INDIVIDUAL TAXPAYERS IS PAID IN ONE OR BOTH
YEARS

The sentence should read:

State income taxes are not allowed as deductions in determining
alternative minimum taxable income (AMTI).

The word \"refunds\" was included in error and has been removed from the
sentence.

Wm. David Kebschull

# SUBMITTAL OF COMMENTS TO THE PRESIDENT'S ADVISORY PANEL ON 

**FEDERAL TAX REFORM IN RESPONSE TO THE PANEL'S REQUEST**

**FOR COMMENTS #1 (POSTED FEBRUARY 16, 2005)**

##### "DOUBLE OR NOTHING"

### THE INTERNAL REVENUE SERVICE'S 

### 

### FRAUDULENT TAX TREATMENT OF

### 

### ITEMIZED DEDUCTION RECOVERIES

**SUBMITTED BY:**

**WILLIAM DAVID KEBSCHULL, INDIVIDUAL TAXPAYER**

## 216 GOUCHER WAY

**CHURCHVILLE, MARYLAND 21028**

**(410) 836-2922**

####### KEBSCHULLW@aol.com

######## 

######## DATE OF ORIGINAL SUBMITTAL: MARCH 18, 2005

SUBMITTAL OF LAST REVISION: APRIL 1, 2005

### "DOUBLE OR NOTHING"

### 

### THE INTERNAL REVENUE SERVICE'S FRAUDULENT TAX 

### TREATMENT OF ITEMIZED DEDUCTION RECOVERIES

**[Totally unacceptable burdens on taxpayers are Internal Revenue
Service forms and instructions that do not conform to the provisions of
the Internal Revenue Code.]{.underline}** To illustrate this problem I
will address IRS forms and instructions that produce "double or nothing"
taxation of state income tax refunds. In the spring of 1994, I
recognized that IRS instructions include state income tax refunds in the
calculation of medical expense deductions as well as miscellaneous and
casualty and theft loss deductions. By late 1994, I had discovered other
ways that tax refunds were used to impose illegal taxes on those paying
the regular tax and the problem with the instruction for (currently)
Line 7 on Form 6251 that has resulted in a multi-billion dollar fraud on
the United States Treasury. A few weeks after my initial discovery,
Professor Matthew J. Barrett's (Notre Dame Law School) law review
article, "Determining an Individual's Federal Income Tax Liability When
the Tax Benefit Rule Applies: A Fifty-Year Checkup Brings A New
Prescription for Calculating Gross, Adjusted Gross, and Taxable
Incomes", was published in the Brigham Young Law Review. For more than
ten years IRS has issued countless frivolous statements in attempting to
defend its bollixed instructions that result in "double taxation" of
itemized deduction recoveries under the regular tax. Similarly IRS has
attempted to defend the bollixed instructions that result in "double or
nothing taxation" of income used for a tax overpayment and the resulting
refund when the regular tax is paid in one year and the alternative
minimum tax (AMT) is paid in the other.

In general, for individual taxpayers the tax treatment of itemized
deduction recoveries is determined by the Tax Benefit Rule, section
111(a) of the Internal Revenue Code (IRC). Section 111(a) applies to
refunds of taxes and the recovery of other items that were allowed as
deductions on Form 1040 Schedule A. Under specific circumstances, the
treatment of certain tax refunds is determined by section 56(b)(1)(D) of
the Internal Revenue Code. Since state income tax refunds are the most
common kind of recovery and sections 111(a) and 56(b)(1)(D) apply to
state income tax refunds, my comments will focus on this these refunds.

# TAX OVERPAYMENTS AND REFUNDS WHEN THE REGULAR TAX

# FOR INDIVIDUAL TAXPAYERS IS PAID IN BOTH YEARS

The critical fact that must be remembered in the application of the Tax
Benefit Rule is that when a state income tax overpayment is allowed as a
deduction, it does not reduce gross income and can at most reduce
taxable income by no more than dollar for dollar.

Section 111(a) of the Internal Revenue Code states,

(a) Deductions. ^\_\_^ Gross income does not include income attributable
    to the recovery during the taxable year of any amount deducted in
    any prior taxable year to the extent such amount did not reduce the
    amount of tax imposed by this chapter.

Based on the critical fact and law cited above one would expect that
neither the gross nor the taxable income attributable to a state income
tax refund would exceed the amount of that portion of the overpayment
that reduced taxes in the prior year. Unfortunately IRS instructions do
not produce that result.

When the regular tax is paid, the amount of tax paid is not a simple
direct function of the amount of gross income reported by a taxpayer and
the tax rate. At the margin, gross income, or more particularly adjusted
gross income (AGI) or modified adjusted gross income (MAGI), can
increase the amount of tax paid by an amount that far exceeds the amount
determined by simply multiplying the marginal increase in income by the
tax rate. Using a state income tax refund as an example, here's why. To
the extent that a state income tax overpayment reduced taxable income in
the prior year, the refund of the overpayment is entered on Line 10 of
Form 1040. Form 1040 instructions and IRS Publication 525 describe how
to determine the portion of a tax refund that is to be included in gross
income. Since 1984, Internal Revenue Service instructions have ignored
the limitation imposed by section 111(a) of the IRC and included the
portion of a state income tax refund entered on Line 10 of Form 1040 in
the calculation of taxable Social Security benefits. Currently, when a
state income tax refund is included in this calculation, the refund can
increased the taxable portion of Social Security Benefits by up to 85
cents per dollar of refund. Thus, the gross income attributable to a
state income tax refund entered on Line 10 of Form 1040 can exceed the
refund by up to 85 percent.

Now precisely what is it about the language in section 111(a) of the
Internal Revenue Code that permits the Internal Revenue Service to issue
instructions that can result in the gross income attributable to an
itemized deduction recovery (state income tax refund) exceeding the
amount of the recovery? When confronted with this question, Internal
Revenue Service respondents have repeatedly refused to answer.

IRS inflicts additional abuse on taxpayers by including the state income
tax refund and the additional taxable Social Security benefit
attributable to the refund in the calculation of allowable medical,
miscellaneous, and casualty and theft loss deductions. The consequence
of this is that the taxable income attributable to the refund can exceed
the refund by more than 120 percent.

In addition, the taxable Social Security attributable to a state income
tax refund and/or the refund can reduce tax credits. Here are a few
examples: Credit for Child and\
Dependent Care Expenses, Credit for the Elderly and Disabled, Education
Credits, Credit for Qualified Retirement Savings Contributions, the
Child Tax Credit, the Adoption Credit, the Earned Income Credit.

State income tax refunds can also reduce the amount allowed for personal
exemptions and total itemized deductions.

A state income tax refund may also disqualify a taxpayer from taking the
student loan interest deduction or the tuition and fees deduction. This
results in an increase in adjusted gross income. The impact of the loss
of these deductions may be magnified by the impact of AGI on the various
items identified above.

# TAX TREATMENT OF STATE INCOME TAX OVERPAYMENTS 

# AND REFUNDS WHEN THE ALTERNATIVE MINIMUM TAX FOR INDIVIDUAL TAXPAYERS IS PAID IN ONE OR BOTH YEARS

Since 1997 there may or may not have been a tax benefit resulting from a
state income tax overpayment when the alternative minimum tax (AMT) was
paid. State income taxes are not allowed as deductions in determining
alternative minimum taxable income (AMTI). However, this does not mean
that a state income tax overpayment entered on Schedule A of Form 1040
cannot produce a tax benefit when the AMT is paid. The overpayment
entered on Schedule A can increase the portion of capital gains taxed at
5 percent and reduce the portion taxed at 15 percent by the same amount,
thereby creating a capital gains rate based tax benefit equal to 10
percent of the overpayment. The instruction for determining whether a
tax overpayment produced a tax benefit when the AMT was paid can be
found in IRS Publication 525.

**AMT PAID IN BOTH OVERPAYMENT AND REFUND YEARS**

Regardless of whether the overpayment produced a tax benefit in the
prior year when the AMT was paid, the refund is properly excluded from
AMTI by the instructions for Line 10 of Form 1040 or Line 7 of Form
6251. If capital gains are taxed at both the higher and lower rates, the
refund of a state income tax overpayment that produced a capital gains
rate based tax benefit will increase the capital gains portion of the
AMT. Unfortunately, IRS instructions use the income used for a tax
overpayment and the refund of that income to reduce medical expense
deductions when the AMT is paid in both years. Use of the refund to
reduce the medical expense deduction violates section 111(a) of the IRC.

###### **REGULAR TAX PAID IN OVERPAYMENT YEAR**

###### **AND AMT PAID IN REFUND YEAR**

The IRS instruction for Line 7 on Form 6251 that excludes from AMTI
state income tax refunds from overpayments that provided a tax benefit
in the prior year when the regular tax was paid violates section
56(b)(1)(D). Section 56(b)(D)(1) is limited to excluding refunds of tax
overpayments in years when the AMT was paid from AMTI.

**If a tax overpayment is allowed as a deduction when the regular tax is
paid and the refund of the overpayment is excluded from AMTI when the
AMT is paid, just when is the income or refund taxed directly?**

# 

# AMT PAID IN THE OVERPAYMENT YEAR 

# AND THE REGULAR TAX PAID IN REFUND YEAR

As a result of IRS instructions the income used for a state income tax
overpayment may ultimately be "double taxed". For this to occur the
state income tax overpayment would have had to have produced a limited
capital gains rate based tax benefit in a year the AMT was paid and the
refund received in a year that the regular tax was paid. First, the
income used for the tax overpayment is taxed at the AMT rate and then
the refund of the overpayment is taxed at the regular tax rate. In this
case the reduction in total tax is the result of the state income tax
overpayment entered on Schedule A of Form 1040 increasing the portion of
capital gains taxed at 5 percent and reducing the portion taxed at 15
percent by the same amount. Under section 111(a) of the IRC, the refund
should only be capable of producing a capital gains rate based increase
in the regular tax by shifting capital gains from being taxed at 5
percent to being taxed at 15 percent. If there were no capital gains or
they were only taxed at a one rate, the refund would produce no change
in taxes due under the law.

[THE BOTTOM LINE]{.underline}

In the final analysis, no tax system is any better than the integrity of
those responsible for administering it. I would be pleased to share with
the President's Advisory Panel on Federal Tax Reform copies of
correspondence to and from IRS and the Treasury Department since 1994 on
the issues discussed above.