Can a New Mexico worker escape state income tax with the 'Section 861' theory — that wages for U.S. labor aren't taxable income, that a private employee isn't an 'employee,' or that Form 1040 isn't really required?

Subject

Donald and Lori Breuer (D&O 99-22)

Plain-English summary

Donald Breuer worked as a technician for Intel in Rio Rancho, New Mexico. After his accountant suggested he needed more deductions, he researched taxes online, found a website called "Taxgate," and concluded that his Intel wages were not taxable income. For tax years 1996 and 1997 he filed New Mexico personal income tax returns reporting zero federal adjusted gross income and claiming full refunds of the state tax Intel had withheld. The Department paid the 1996 refund, then caught the problem, denied the 1997 refund, and in December 1998 issued estimated assessments of income tax, penalty, and interest for both years — including a 50% civil-fraud penalty for 1996.

The Hearing Officer denied the core protest: Mr. Breuer's compensation is income and is subject to both federal and New Mexico income tax. New Mexico "piggybacks" on the federal system, starting from federal adjusted gross income, so the case turned on federal definitions — and the Hearing Officer took apart each argument:

• The "Section 861" theory. Mr. Breuer argued that only income tied to the "sources" listed in Internal Revenue Code Section 861 (and regulation 1.861-8(f)(1)) is taxable, and that his wages weren't among them. The decision explains that Section 61 defines gross income as "all income from whatever source derived," which plainly includes "compensation for services." Sections 861–865 are source rules for nonresident aliens and foreign corporations, not a limit on what a U.S. worker owes; in fact Section 861(a)(3) treats pay for labor performed in the U.S. as U.S.-source income. Reading isolated phrases "out-of-context" does not override the whole statutory scheme.
• The "employee" argument. He claimed Section 3401(c) makes only government officials and corporate officers "employees." Courts have called this a "preposterous reading": the word "includes" is a term of enlargement, not limitation, so private wage earners are covered too.
• The Form 1040 / Paperwork Reduction Act argument. He claimed Form 1040 wasn't validly required. The form carries OMB control number 1545-0074 and is listed under the Code sections (6011–6013) that actually require returns, so it fully complies with the Paperwork Reduction Act.

The taxpayer did win on two points, so the result was granted in part and denied in part:

• No fraud penalty. The 50% penalty (Section 7-1-69(C)) requires the Department to prove willful intent to evade — and under Section 7-1-78 the burden is on the state. Because Mr. Breuer had done extensive research, bought the Code to check it, and had an accountant tell him the material "appeared to be accurate," the Hearing Officer was not convinced he lacked a genuine belief, so both years' fraud penalties were dropped.
• Assessments reduced to actual figures. The estimated assessments were adjusted to the real wages on his W-2 forms, with a $1,078.51 credit for 1997 withholding. (He could not swap in itemized deductions, because he had taken the standard deduction on his federal returns.)

What this means for you

• "Section 861" is a losing argument. Wages for services performed in the United States are gross income under Section 61. The Section 861 source rules are about nonresident aliens and foreign corporations, not a loophole for domestic workers.
• Your pay is taxable even though you're a private employee. Section 3401(c)'s list of "employees" is illustrative, not exclusive. Reading "includes" as a word of limitation has been rejected by the courts.
• A dropped fraud penalty depends on genuine belief — which expires once you're told you're wrong. The penalty fell here only because the Hearing Officer credited Mr. Breuer's sincere (if mistaken) research. Now that a decision has explained why the theory fails, continuing to file zero-income returns would look willful and invite the 50% penalty.
• Filing a zero-income return to grab a refund backfires. The Department can reverse a refund it paid, issue an estimated assessment, and add interest. Bringing your real W-2 numbers only reduces the estimate to what you actually owe.

Key questions answered

Does the Section 861 argument work in New Mexico?
No. New Mexico starts from federal adjusted gross income, and under Section 61 gross income means "all income from whatever source derived," including compensation for services. Sections 861–865 are source rules aimed at nonresident aliens and foreign corporations; Section 861(a)(3) actually treats U.S.-performed labor as U.S.-source income. The theory is a misreading of isolated phrases.

Isn't a private-sector worker not an "employee" under Section 3401(c)?
No. Courts hold the word "includes" in Section 3401(c) is a term of enlargement, so the definition covers private wage earners in addition to government officials and corporate officers. It does not limit taxation to those listed.

Why was the 50% fraud penalty removed if the arguments were meritless?
Because the penalty requires the Department to prove willful intent to evade (Section 7-1-69(C)), and the state carries that burden (Section 7-1-78). Mr. Breuer's extensive research and reliance on the Taxgate materials left the Hearing Officer unconvinced he lacked a genuine belief, so the penalty could not stand — for either year.

Did Mr. Breuer get anything out of the protest?
Yes — a partial win. The fraud penalties were dropped and the estimated assessments were reduced to his actual W-2 wages, with a $1,078.51 credit for 1997 withholding. He still owed the underlying income tax and interest, and could not substitute itemized deductions for the standard deduction he had claimed federally.

Verbatim citations

Gross income under the Internal Revenue Code:

Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items: (1) Compensation for services, including fees, commissions, fringe benefits and similar items....

Why the Section 861 argument fails:

When placed in context, it is clear that Section 861 and the regulations promulgated under that section apply to a determination of the tax liability of nonresident aliens and foreign corporations. These provisions have no application to United States citizens like Mr. Breuer, all of whose income is derived from wages for services performed within the United States.

Wages are income (quoting United States v. Koliboski):

[T]he defendant still insists that no case holds that wages are income. Let us now put that to rest: WAGES ARE INCOME.

Why the fraud penalty was not justified:

Although Mr. Breuer's arguments had no legal merit, I was not convinced that he did not, himself, believe them to be reasonable arguments.... Although the 50 percent penalty is not justified for the current assessments, Mr. Breuer now has reason to know the Taxgate arguments on which he relied do not have merit.

Source

• Listing: New Mexico Decisions & Orders
• Decision post: Donald and Lori Breuer
• Decision PDF: D&O 99-22

Original ruling text

BEFORE THE HEARING OFFICER
OF THE TAXATION AND REVENUE DEPARTMENT
OF THE STATE OF NEW MEXICO

IN THE MATTER OF THE PROTEST
OF DONALD AND LORI BREUER No. 99-22
ASSESSMENT NOs. 98047 & 98048

DECISION AND ORDER

A formal hearing on the above-referenced protest was held May 17, 1999, before Margaret

B. Alcock, Hearing Officer. Donald A. Breuer appeared on behalf of himself and his wife, Lori

Breuer. The Taxation and Revenue Department ("Department") was represented by Bruce J. Fort,

Special Assistant Attorney General. The record was left open for one week following the hearing to

allow Mr. Breuer to provide evidence of his income and the taxes withheld from his wages during tax

years 1996 and 1997. This evidence was received on May 20, 1999, at which time the matter was

submitted for decision. Based on the evidence and arguments presented, IT IS DECIDED AND

ORDERED AS FOLLOWS:

FINDINGS OF FACT

1. Donald and Lori Breuer are residents of Bernalillo County, New Mexico.

2. Since 1994, Mr. Breuer has been employed by Intel Corporation in Rio Rancho, New

Mexico, where he works as a technician.

3. In April 1996, the Breuers filed a 1995 New Mexico personal income tax ("PIT")

return reporting federal adjusted gross income of $47,218.00, New Mexico taxable income of

$30,606.00 and a net state tax liability of $1,204.00.

4. After filing his 1995 PIT return, Mr. Breuer's accountant told him he needed more

tax credits or deductions to reduce his income tax liability.

5. Mr. Breuer began to research tax issues on the Internet and came across a website

known as "Taxgate." Based on information on the website, Mr. Breuer came to the conclusion that

his wages from Intel did not qualify as taxable income under the Internal Revenue Code.

6. Mr. Breuer asked his accountant to review the Taxgate information. She told Mr.

Breuer the information appeared to be accurate but declined to advise Mr. Breuer as to whether he

should act on the theories set out on the Taxgate website.

7. Mr. Breuer purchased a copy of the Internal Revenue Code and regulations to check the

information on the website for himself and insure the accuracy of quotes taken from various sections of

the Internal Revenue Code and related regulations.

8. In April 1997, the Breuers filed a 1996 New Mexico PIT return reporting federal

adjusted gross income of zero, New Mexico taxable income of zero and a net state tax liability of

zero. The return showed a refund due of the $833.34, which was the amount of state taxes Intel

withheld from Mr. Breuer's wages during 1996.

9. The Department processed the Breuers' 1996 PIT return as filed and sent them a

check for $833.34.

10. In April 1998, the Breuers filed a 1997 New Mexico PIT return reporting federal

adjusted gross income of zero, New Mexico taxable income of zero and a net state tax liability of

zero. The return showed a refund due of $1,079.00, which was the amount of state taxes Intel

withheld from Mr. Breuer's wages during 1997.

11. On May 6, 1998, the Department sent the Breuers a letter denying their claim for

refund. The letter questioned why a taxpayer whose employer had withheld $1,079.00 of state taxes

from the taxpayer's income would have a federal adjusted gross income of zero and requested a copy

of the Breuers' federal income tax return.

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12. On May 8, 1998, Mr. Breuer sent the Department a copy of his 1997 federal income

tax return, on which he had also reported wages of zero, and a statement that he was not required to

report or pay federal income tax.

13. On December 4, 1998, the Department issued Assessment 98047 to the Breuers in

the total amount of $2,486.37, representing $1,431.00 in personal income tax due for 1996, $715.50

penalty and $339.87 interest. The Department also issued Assessment 98048 in the total amount of

$2,709.87, representing $1,707.00 in personal income tax due for 1997, $835.50 penalty and $149.37

interest.

14. The Department estimated the Breuers' 1996 and 1997 tax liability by using the

federal adjusted gross income reported on their 1995 PIT return, increasing that amount by 10% and

20% respectively, and then subtracting the standard federal exemption and deduction amounts.

15. The Department did not give the Breuers credit for taxes withheld by Intel during

1996 because these taxes had been refunded to the taxpayers. The Department did not give the

Breuers credit for taxes withheld by Intel during 1997 because the Department did not have a copy of

the W-2 to verify the amount of the 1997 withholding.

16. On December 10, 1998, Mr. Breuer filed a written protest to Assessments 98047 and

98048.

17. At the hearing on Mr. Breuer's protest, the Department conceded the evidence was

not sufficient to support assessment of the 50 percent fraud penalty for tax year 1997.

18. The Department also stated that if Mr. Breuer provided copies of this 1996 and 1997

W-2 forms, the Department would adjust the assessments to reflect the actual income and

withholding shown on those forms.

19. The record was left open for one week, during which Mr. Breuer submitted copies of

his W-2 forms for 1996 and 1997 and copies of mortgage interest statements showing mortgage

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interest and real estate taxes paid during those years. Mr. Breuer also submitted a copy of an opinion

letter he requested from a former Arizona assistant city magistrate concerning citizens' obligation to

report and pay income taxes.

DISCUSSION

There are two issues to be determined in this protest: (1) whether the Breuers are liable for

New Mexico income tax on Mr. Breuer's compensation from performing services in New Mexico

during 1996 and 1997; and (2) if the answer to the first issue is yes, whether Mr. Breuer is liable for

the 50 percent fraud penalty assessed against him for 1996. Before addressing the various arguments

raised by Mr. Breuer, a brief overview of New Mexico’s personal income tax statutes and their

operation will be useful.

New Mexico imposes income tax on the net income of "every resident individual". New

Mexico is among the majority of states that "piggy-back" or use the federal income tax system as the

basis for calculating state income taxes. The calculation of personal income taxes in New Mexico

begins with a determination of "base income" which is the taxpayer's "adjusted gross income" as

defined in § 62 of the Internal Revenue Code, plus certain net operating loss deductions which can be

deducted for federal purposes but which New Mexico does not allow to be deducted in the same

manner. See, § 7-2-2(B) NMSA 1978. New Mexico then allows certain deductions, such as the federal

standard or itemized deductions and deductions for income from federal obligations, to arrive at "net

income" upon which income tax is imposed. See, §§ 7-2-2(N) and 7-2-3 NMSA 1978. Given the

structure of the New Mexico income tax, most of Mr. Breuer's arguments—and this decision—are

based on an examination of provisions of the Internal Revenue Code relating to determination of

taxpayers' federal adjusted gross income.

I. COMPENSATION FOR SERVICES PERFORMED WITHIN THE UNITED STATES
IS GROSS INCOME UNDER 26 U.S.C. § 61.

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As noted above, New Mexico uses federal adjusted gross income as its starting point for

calculating New Mexico personal income taxes. The Internal Revenue Code, 26 U.S.C. § 1, et seq.

(1997), defines adjusted gross income as gross income, less certain deductions listed in § 62 of the

Code. Gross income is defined in § 61 as follows:

Except as otherwise provided in this subtitle, gross income means all
income from whatever source derived, including (but not limited to) the
following items:

(1) Compensation for services, including fees, commissions,
fringe benefits and similar items;
(2) Gross income derived from business;
(3) Gains derived from dealings in property;
(4) Interest;
(5) Rents;
(6) Royalties;
(7) Dividends;
(8) Alimony and separate maintenance payments;
(9) Annuities;
(10) Income from life insurance and endowments contracts;
(11) Pensions;
(12) Income from discharge of indebtedness;
(13) Distributive share of partnership gross income;
(14) Income in respect of a decedent; and,
(15) Income from an interest in an estate or trust.

This definition is quite broad, and certainly appears to include under the first listed category of

"compensation for services" the compensation Mr. Breuer received from performing services for his

employer in New Mexico. Mr. Breuer nonetheless disputes the applicability of § 61 to the

compensation he received from his work as a technician for Intel.

Mr. Breuer focuses first on the language in § 61 which refers to “items” of income. He

maintains that an item of income is not the same as a source of income—in order for an item of income

to be taxable, it must come from a taxable source. Mr. Breuer has determined that the only section of

the Internal Revenue Code dealing with the taxation of income from sources within the United States is

§ 861 in Part I, Subchapter N of the Code. He has further concluded that only income from sources

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under the "operative sections" of the Internal Revenue Code set out in the regulation at 26 CFR § 1.861-

8(f)(1) is subject to federal income tax. Because Mr. Breuer's wages from Intel do not come within the

purview of those sections of the Code, Mr. Breuer concludes that his wages are not subject to tax.

The problem with Mr. Breuer's analysis is that it relies on portions of federal statutes and

regulations taken completely out-of-context and without regard to the overall statutory scheme of which

they are a part. Mr. Breuer argues vehemently that the phrases he quotes from various sections of the

law are not subject to interpretation. In support of this position, he relies on the rule of statutory

construction that when the words of a statute are unambiguous, "courts must presume that a legislature

says in a statute what it means and means in a statute what it says there." Connecticut National Bank v.

Germain, 503 U.S. 249, 253-254 (1992). It is also a rule of statutory construction, however, that

statutes must be read in their entirety and each part must be construed in connection with every other

part to produce a harmonious whole. State ex rel. Klineline v. Blackhurst, 106 N.M. 732, 735, 749

P.2d 1111, 1114 (1988). See also, United States v. Morton, 467 U.S. 822, 828 (1984) ("we do not

construe statutory phrases in isolation; we read statutes as a whole"); Crandon v. United States, 494

U.S. 152, 158 (1990) ("in determining the meaning of the statute, we look not only to the particular

statutory language, but to the design of the statute as a whole and to its object and policy"). In

McCarthy v. Bronson, 500 U.S. 136, 139 (1991), a unanimous Supreme Court rejected what it

acknowledged was a "reasonable" construction of words in a federal statute dealing with prisoner

complaints because that construction was not in accord with the intent of the statute as a whole:

We do not quarrel with petitioner's claim that the most natural reading of the
phrase "challenging conditions of confinement," when viewed in isolation,
would not include suits seeking relief from isolated episodes of unconsti-
tutional conduct. However, statutory language must always be read in its
proper context. "In ascertaining the plain meaning of [a] statute, the court must
look to the particular statutory language at issue, as well as the language and
design of the statute as a whole." K Mart Corp. v. Cartier, Inc., 486 U.S. 281,
291, 108 S.Ct.1811, 1817, 100 L.Ed.2d 313 (1988). (emphasis added)

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A similar analysis was applied in the earlier case of Alexander v. Cosden Pipe Line Co., 290 U.S. 484,

496 (1934), in which the Supreme Court reversed a lower court decision construing two statutes taxing

the transportation of oil.

We cannot assent to the construction which the courts below placed on these
statutes. It must be conceded that the statutes are not happily phrased and that
some of their provisions separately considered give color to that construction.
But the statutes are to be considered, each in its entirety and not as if each of
its provisions was independent and unaffected by the others. (emphasis added)

In this case, Mr. Breuer's construction of isolated portions of the Internal Revenue Code and related

regulations may appear reasonable when taken at face value and without considering other provisions

of the Code. When placed in proper context, however, it is clear this construction does not reflect the

true meaning of the statutes and is directly contrary to the overall income tax scheme enacted by

Congress.

Section 61 of the Code defines "gross income" as "all income from whatever source derived."

The same language is found in the Sixteenth Amendment of the federal Constitution which gives

Congress the "power to lay and collect taxes on income, from whatever source derived...." The

Sixteenth Amendment was proposed and ratified in order to eliminate the distinction between taxes on

income from property, which had to be apportioned, and taxes on income from labor, which could be

taxed without apportionment. As the Supreme Court noted in Brushaber v. Union Pacific Railroad

Co., 240 U.S. 1 (1916): "the whole purpose of the Amendment was to relieve all income taxes when

imposed from apportionment from a consideration of the source whence the income was derived." Far

from requiring income to be traced to a specific source in order to determine whether it can be taxed,

the Sixteenth Amendment made the source of income irrelevant for all but a very few taxpayers. As

stated in Treasury Regulation § 1.1-1(b): "In general, all citizens of the United States, wherever

resident, and all resident alien individuals are liable for the income taxes imposed by the Code whether

the income is received from sources within or without the United States." The source of income is

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relevant only to nonresident aliens and foreign corporations, whose tax liability is limited to income

from sources within the United States. Congress enacted Subchapter N of the Internal Revenue Code,

titled "Tax Based on Income From Sources Within or Without the United States," in order to identify

the income on which this group of taxpayers must pay tax.

Sections 861 through 865 in Part I of Subchapter N of the Code address "Source Rules and

Other General Rules Relating to Foreign Income." Although Mr. Breuer maintains his tax liability is

limited to income from sources identified in § 861 and accompanying regulations, there is no indication

that Mr. Breuer has foreign income or that Subchapter N has any application to him. I note,

nonetheless, that § 861(a)(3) and regulation § 1.861-4 provide that compensation for labor or personal

services performed in the United States is treated as income from sources within the United States.

There is no rationale for Mr. Breuer's argument that the compensation he earned for personal services

performed in New Mexico was not income because it did not come from a "source" set out in

regulation § 1.861-8(f)(1). That regulation does not identify sources of income but simply lists other

sections of the Code to which the principles of Section 861 apply.

When placed in context, it is clear that § 861 and the regulations promulgated under that section

apply to a determination of the tax liability of nonresident aliens and foreign corporations. These

provisions have no application to United States citizens like Mr. Breuer, all of whose income is derived

from wages for services performed within the United States. The federal courts have held, on

numerous occasions, that such wages come within the definition of income under the Internal Revenue

Code and are subject to taxation. See, e.g., Funk v. Commissioner, 687 F.2d 264, 265 (8th Cir. 1982);

Grimes v. Commissioner, 806 F.2d 1451, 1453 (9th Cir. 1986). In United States v. Buras, 633 F.2d

1356, 1361 (9th Cir. 1980), the court specifically rejected the argument that wages are not income

because they are not derived from a taxable source:

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According to Buras, income must be derived from some source. Wages can-
not be taxed because the wage earner enjoys no gain from that source....
...

As for Buras' argument that he may not be taxed because he is a wage earner,
the Sixteenth Amendment is broad enough to grant Congress the power to
collect an income tax regardless of the source of the taxpayer's income.

In United States v. Koliboski, 732 F.2d 1328, 1329 n.1 (7th Cir. 1984), upholding Mr. Koliboski's

criminal convictions for failure to file federal income tax returns and filing false withholding

statements, the court addressed the argument that wages are not income as follows:

[T]he defendant still insists that no case holds that wages are income. Let us
now put that to rest: WAGES ARE INCOME. Any reading of tax cases by
would-be tax protesters now should preclude a claim of good-faith belief that
wages—or salaries—are not taxable. (emphasis in the original).

Mr. Breuer's compensation from performing services for his employer in New Mexico qualifies

as gross income under § 61 of the Code and is subject to both federal and New Mexico income tax.

II THE DEFINITION OF "EMPLOYEE" INCLUDES PRIVATE WAGE EARNERS.

Mr. Breuer next argues that only government officials and corporate officers are "employees"

subject to federal income tax. This argument is based on a misreading of § 3401 of the Internal

Revenue Code, which relates to the obligation of employers to withhold income tax from the wages of

their employees. Subparagraph (c) defines the term "employee" as follows:

For purposes of this chapter, the term "employee" includes an officer,
employee, or elected official of the United States, a State, or any political
subdivision thereof, or the District of Columbia, or any agency or
instrumentality of any one or more of the foregoing. The term "employee" also
includes an officer of a corporation.

Mr. Breuer interprets the word "includes" as a word of limitation. He asserts that only those persons

listed in the statute come within the definition of employees subject to withholding. Because he is not a

government official or corporate officer, Mr. Breuer concludes that his employer is not required to

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withhold tax from his wages and he is not required to report tax on his wages to the government. This

interpretation of § 3401(c) is incorrect and has been soundly rejected by the federal courts. As the court

stated in United States v. Latham, 754 F.2d 747, 750 (7th Cir. 1985):

Latham's instruction which indicated that under 26 U.S.C. § 3401(c) the
category of "employee" does not include privately employed wage earners is a
preposterous reading of the statute. It is obvious...the word "includes" is a term
of enlargement not of limitation, and the reference to certain entities or
categories is not intended to exclude all others.

See also, Sullivan v. United States, 788 F.2d 813, 815 (1st Cir. 1986): "Section 3401(c)...indicates that

the definition of 'employee' includes government officers and employees, elected officials, and

corporate officers. The statute does not purport to limit withholding to the persons listed therein."

(emphasis in the original).

The term "employee" as defined in § 3401(c) includes private wage earners like Mr. Breuer, as

well as government officials and corporate officers.

III FORM 1040 HAS BEEN ASSIGNED AN OMB NUMBER IN COMPLIANCE WITH
THE PAPERWORK REDUCTION ACT OF 1980.

Mr. Breuer maintains he is not required to file a federal income tax return because Form 1040

is not listed by the Office of Management and Budget as a form required to be filed under Treasury

Regulation § 1.1-1. Again, Mr. Breuer has interpreted the law by focusing on one small section of a

statute or regulation and blocking out the intent and meaning of the law as a whole.

Under the Paperwork Reduction Act of 1980 (44 U.S.C. §§ 3501-3520) and related regulations,

the Office of Management and Budget (OMB) must assign a number to each form required by an

agency of the federal government for the collection of information and identify the regulation that

requires the form to be filed. The individual income tax return, Form 1040, was assigned OMB control

number 1545-0074, and is listed as a form required by a number of different Treasury regulations,

including regulations under Code sections 6011 ("General Requirement of Return, Statement or List"),

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6012 (Persons Required to Make Returns of Income"), and 6013 ("Joint Returns of Income Tax by

Husband and Wife"). See, listing at 26 CFR § 601.9000. The 1997 Form 1040 Mr. Breuer filed with

the IRS, a copy of which is attached to Mr. Breuer's May 8, 1998 letter to the Department, clearly

displays OMB No. 1545-0074 in the upper right-hand corner.

Mr. Breuer's contention that Form 1040 also must be listed as a form required under Treasury

Regulation § 1.1-1 is without merit. Section 1.1-1 imposes a tax on taxable income and provides the

rates for calculating the tax. This regulation does not actually require the collection of any

information—the requirement for filing income tax returns is found in §§ 6011 through 6014 of the

Code and the regulations under those sections. The listing of Form 1040 as a form required to be filed

under these regulations fully complies with the Paperwork Reduction Act of 1980.

IV IMPOSITION OF THE FRAUD PENALTY IS NOT JUSTIFIED IN THIS CASE.

The Department's assessments of income tax to Mr. and Mrs. Breuer included the 50 percent

civil penalty authorized by Section 7-1-69(C) NMSA 1978 when a taxpayer's actions are based on a

willful intent to evade or defeat any tax. Although Section 7-1-17(C) NMSA 1978 creates a statutory

presumption that any assessment of tax by the Department is correct, the presumption does not apply to

fraud assessments. As stated in Section 7-1-78 NMSA 1978:

BURDEN OF PROOF IN FRAUD CASES. In any proceeding involving the
issue of whether any person has been guilty of fraud or corruption, the burden
of proof in respect of such issue shall be upon the director or the state.

At the hearing on Mr. Breuer's protest, Department counsel conceded there was insufficient

evidence to support the penalty imposed by Assessment No. 98048 for tax year 1997. Based on the

evidence presented, the Department also failed to meet its burden to establish the Breuers' liability for

the penalty imposed by Assessment No. 98047 for tax year 1996. Although Mr. Breuer's arguments

had no legal merit, I was not convinced that he did not, himself, believe them to be reasonable

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arguments. Mr. Breuer testified that he conducted extensive research on the Internet and provided

copies of some of the material he came across on the Taxgate website. He asked an accountant to

review this information. Although she declined to advise him as to what course of action to follow, she

did tell him that the information on the website appeared to be accurate. Mr. Breuer then purchased a

copy of the Internal Revenue Code and regulations to check the information on the website for himself

and insure the accuracy of quotes taken from various Code sections.

Although the 50 percent penalty is not justified for the current assessments, Mr. Breuer now has

reason to know the Taxgate arguments on which he relied do not have merit. Unless this decision is

appealed and overturned, he cannot continue to assert that he has no taxable income or that his income

is exempt without risking the imposition of a fraud penalty. As the court stated in Coleman v.

Commissioner of Internal Revenue, 791 F.2d 68, 69 (7th Cir. 1986):

Some people believe with great fervor preposterous things that just happen to
coincide with their self-interest. "Tax protesters" have convinced themselves
that wages are not income, that only gold is money, that the Sixteenth
Amendment is unconstitutional, and so on. These beliefs all lead—so tax
protesters think—to the elimination of their obligation to pay taxes. The
government may not prohibit the holding of these beliefs, but it may penalize
people who act on them. (emphasis added).

In this case, there is no question that Mr. Breuer's compensation from his employment in New Mexico

is income for federal and state tax purposes, and the Breuers have an affirmative duty to report and pay

tax on this income to both the federal government and the state of New Mexico.

V THE ASSESSMENTS SHOULD BE ADJUSTED TO REFLECT THE INCOME AND
WITHHOLDING INFORMATION ON MR. BREUER'S W-2 FORMS.

The assessments at issue were based on the Department's estimate of the Breuers' 1996 and

1997 income. The Department used the federal adjusted gross income reported on the Breuers' 1995

PIT return, increased that amount by 10% and 20% respectively, and then subtracted the standard

federal exemption and deduction amounts. At the hearing on Mr. Breuer's protest, Department

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counsel stated that if Mr. Breuer provided copies of his 1996 and 1997 W-2 forms, the Department

would adjust the assessments to reflect the actual income and withholding reflected on those forms

(except for the 1996 withholding amount previously refunded to the Breuers).

Mr. Breuer subsequently submitted copies of his W-2 forms for 1996 and 1997, as well as

copies of mortgage interest statements showing mortgage interest and real estate taxes paid during

those years. Based on the documentation submitted, Assessment No. 98047 for tax year 1996 should

be adjusted to reflect tax on income of $49,314.83; Assessment No. 98048 for tax year 1997 should be

adjusted to reflect tax on income of $53,251.14, with a credit for withholding of $1,078.51.

The Breuers are not entitled to claim itemized deductions for mortgage interest and real estate

taxes in lieu of the standard federal deduction. The deduction allowed in determining New Mexico

taxable income is based on the deduction taken on the taxpayer's federal income tax return, and

taxpayers who wish to claim the benefit of itemized deductions must complete Schedule A to their

Form 1040. In this case, there is no evidence the Breuers itemized their deductions on their 1996 and

1997 federal income tax returns. To the contrary, the 1997 federal income tax return introduced at the

hearing shows they claimed the standard deduction for that year. Their deduction for New Mexico

income tax purposes is limited to the amount shown on their federal return. If the Breuers wish to take

advantage of itemized deductions for 1998 and future years, they must first file a properly completed

federal income tax return listing those deductions on Schedule A to Form 1040.

CONCLUSIONS OF LAW

1. Mr. Breuer filed a timely, written protest to Assessment Nos. 98047 and 98048 pursuant to

§ 7-1-24 NMSA 1978, and jurisdiction lies over both the parties and the subject matter of this protest.

2. Mr. Breuer's compensation from performing services in New Mexico is included in

both "gross income" and "adjusted gross income" as those terms are defined in the Internal Revenue

Code.

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3. Mr. Breuer's compensation is included in both "base income" and "net income" as those

terms are defined in the Income Tax Act, Chapter 7, Article 2, NMSA 1978.

4. The Breuers are liable for payment of New Mexico income tax, plus accrued interest,

on the compensation Mr. Breuer received from Intel during 1996 and 1997, less the standard federal

deduction and exemption amounts. The Breuers are also entitled to a credit of $1,078.51 for tax

withheld by Intel during tax year 1997.

5. The Breuers are not liable for payment of the 50 percent civil penalty assessed by the

Department.

For the foregoing reasons, the Breuers' protest is GRANTED IN PART AND DENIED IN

PART. THE DEPARTMENT IS ORDERED TO ADJUST ASSESSMENTS 98047 AND 98048 IN

A MANNER CONSISTENT WITH THIS DECISION.

Dated May 28, 1999.

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