501(c)(6): This Should Prove Interesting....

Most people are familiar with Section 501(c) of the tax law, which lists a number of kinds of organizations that are exempt from income tax.  Most recognized charities are exempt under Section 501(c)(3), and of course social welfare organizations - the subject of the IRS "scandal" involving conservative political groups - are exempt under Section 501(c)(4).  Less well known is the exemption under Section 501(c)(6), which covers:

(6) Business leagues, chambers of commerce, real-estate boards, boards of trade, or professional football leagues (whether or not administering a pension fund for football players), not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual.

This is the provision which results in the National Football League being exempt from federal income tax.  However, it's reach is far beyond the NFL.

Yesterday, Jason Chaffetz and Elijah Cummings, the chairman and ranking member of the House Oversight Committee, sent out letters to a number of sports organizations regarding their 501(c)(6) exemptions, including the National Football League, the National Hockey Leagem the US Tennis Association, the Women Tennis Association (WTA) Tour, the Association of Tennis Professionals (ATP) Tour, the National Lacrosse League, the PGA, the PGA Tour, the LPGA and the Professional Rodeo Cowboy's Association.  They specifically asked for "an analysis of what your organization's 2014 tax liability would be, if your organization were not exempt under 501(c)(6)."

I can't wait to see their answers.

A link to the letter to the NFL is here.

BTW, the NBA, Major League Baseball and Major League Soccer are not tax exempt organizations.

For more on the 501(c)(6) exemption, see this.

Sounds Like Retailers Have Taken Some Creative Tax Positions

The IRS came out with a directive last week on the Section 199 deduction.  Here's a link.  Section 199 provides a special deduction for ""Qualified Domestic Production Activities" equal to 9% of "Qualified Production Activities Income."  If your business is the "manufacture, production, growth or extraction" of tangible personal property (which includes computer software and sound recordings), you are eligible for this deduction.  Income from producing films, electricity, natural gas or potable water and from construction activities also qualifies for the deduction.

The purpose of the deduction is quite simple: to provide a lower effective tax rate on income from producing goods as distinct from income from services.  I won't go into a explication of the sordid history of this provision, except to say that its rationale was to reverse the migration of manufacturing activities from the United States to foreign countries.

Interestingly, architects and engineers who provide services with respect to the construction of property also get the deduction.  I guess the lawyers who draw up the construction contracts didn't have the heft to get the same benefit.  Of course, workers don't get the benefit, even though they are actually the ones doing the "producing."

Anyway, the IRS apparently saw a need to issue a notice to its auditors regarding what constitutes "production" for purposes of this rule.  The notice is a list of activities that are not production.  Apparently, some people were being quite creative:

(1) cutting blank keys to a customer’s specification;

(2) mixing base paint and a paint coloring agent;

(3) applying garnishments to cake that is not baked where sold;

(4) applying gas to agricultural products to slow or expedite fruit ripening;

(5) storing agricultural products in a controlled environment to extend shelf life; and

(6) maintaining plants and seedlings. 

Yes, some hardware store (can you guess which?) was taking the position that duplicating a key and adding color to a base paint was "production."  Little did I know that Congress wanted to encourage these kinds of activities by giving them a reduced tax rate!

Sometimes I hate the fact that I'm a tax lawyer, because so many of us are coming up with this sort of shit.

Tax Reform?

You know I'm starting to think this might happen.  The following update from Bloomberg BNA just crossed my desk:

"Members of the Senate Finance Committee's working group on overhauling international taxes say they are “making good progress,” though tax experts at a March 17 committee hearing on the issue said that much work still needs to be done.

Speaking at the hearing, Sens. Charles E. Schumer(D-N.Y.) and Rob Portman (R-Ohio), who co-chair the international-issues working group, sounded positive notes on their efforts to reach a bipartisan agreement.“We’ve reached a good deal of consensus here,” Portman said.

Witnesses ran down a litany of possible changes to international taxes meant to curb base erosion and profit shifting. Pamela Olson, U.S. deputy tax leader and Washington National Tax Services practice leader at PricewaterhouseCoopers LLP, said that the best way to stop BEPS is a lower corporate rate, though tax law should still contain anti-base erosion features."

I love this last quote by the PWC person.  Hey, if we cut the corporate tax rate to zero, there won't be any need for tax avoidance!

I guess I'm gonna have to start posting on this stuff again.

I'm Shocked - Shocked! - to Find There's Tax Avoidance Going On Here!

I must say I'm laughing my ass off.

Over the last week or so a controversy has been brewing involving Luxembourg and the tax games it has allowed multinational corporations to play by setting up paper subsidiaries in that country.
The background of this is that someone leaked Luxembourg tax rulings obtained by some 340 multinational companies to the International Consortium of Investigative Journalists, which has posted the rulings on its website.  The leak has created a storm of controversy, with officials from around the world vowing to take action to prevent tax avoidance through the use of Luxembourg as a tax haven.

Attention has focused on Jean-Claude Juncker, who is the current President of the European Commission and who, prior to assuming that post this year, had been either Prime Minister or Finance Minister of Luxembourg for over two decades.` Here is the latest from the Irish Times:

European Commission president, Luxembourg’s Jean-Claude Juncker, took political responsibility for his country’s tax practices on Wednesday, saying he would fight tax evasion with more automatic exchange of information between countries.

Juncker ( 59), who was the tiny Grand Duchy’s finance minister or prime minister for 24 years until the end of last year, has avoided the media since a network of investigative journalists reported last week that Luxembourg had granted sweetheart deals to some 340 multinationals allowing them to avoid billions of euros in tax.

The revelations put him under intense pressure to make clear his position on the tax deals and raised questions about whether they create a conflict of interest for him as commission chief.

“I am politically responsible for what happened in each and every corner and quarter (of Luxembourg),” he said, adding that while in line with Luxembourg and European laws, the tax practices may not have been ethical.

“It is true that sometimes when it comes to the application of different tax rules that are sometimes diametrically opposed that can lead to results that are not in line with ethical and moral standards that are generally applicable,” Mr Juncker said.

He explained that tax authorities in Luxembourg were independent of the government, but took political responsibility for the policies, which he said were a result of different tax regimes in EU countries.

“I am not the architect of what you could call the Luxembourgish problem,” Mr Juncker told reporters in a surprise appearance at a daily briefing of the European Commission.

“There is nothing in my past indicating that my ambition was to organise tax evasion in Europe,” he said.

The European Commission is investigating several tax schemes offered by Luxembourg to large multinational corporations to see if they broke EU laws on state aid.

“Everything that has been done has been in compliance with national legislation and international rules that apply in this matter,” Mr Juncker said.

“This state of affairs is due to the fact that we have to deal with the outcome of different standards. If there is no tax harmonisation throughout Europe ... then this can be the result.”

Please.

This kind of stuff has been going on for decades.  I know - I worked for years in the international tax group of one of the Big 4 firms (left there 10 years ago).  And it's not just Luxembourg.  The Netherlands is notorious for issuing these kinds of rulings.  So is Switzerland.  All of these countries engage in this sort of practice.  And the idea that they are doing it for reasons other than facilitating tax avoidance is just ludicrous.

As for the lack of tax harmonization in Europe, that is a feature, not a bug.

Everybody who is involved in tax administration, particularly when it involves multinationals, knows this kind of stuff is happening.  The idea that it is some big secret is hilarious.

Hahahahahahaha!  I'm having trouble getting myself up of the floor I'm laughing so hard.

As near as I can tell, this has nothing to do with countries being concerned about tax reduction schemes being carried out by multinationals.  It has everything to do with politics.  It's been clear from the outset that certain countries in the EU (namely the United Kingdom, but I'm sure there are others) were opposed to Juncker's elevation to EC president.  My guess is that this is a deliberate attempt to delegitimize him.

The real question is whether the fact that these kinds of arrangements are now becoming headlines will result in any real change in the way multinationals are taxed.

I seriously doubt it.

Qui Tam

Today's BNA Daily Tax Report has a story about a qui tam suit brought in NY against Vanguard.  The story is behind a firewall, but a related report at the Philadelphia Inquirer can be found here, and a post about it in the Tax Prof Blog is here.  A qui tam case is essentially a whistleblower case, where a person brings a lawsuit against someone for cheating the government.  Most states, and the federal government, have whistleblower laws that permit private parties to sue on behalf of the government if they discover wrongdoing.  The real party in interest is the government - it is entitled to the amounts recovered by the plaintiff - although the plaintiff is entitled to a percentage of the recovery.  While most such laws involve cheating in government government contracts (the first qui tam statute was passed by the federal government during the civil war to combat war profiteering), a few permit whistleblower claims that the party involved is cheating on their taxes.  The federal False Claims Act does not apply to tax obligations, but there is a separate statute that applies to tax cheating.  Here is a story about a tax whistleblower that received a nine-figure reward from the IRS.

Now I happen to personally know someone who filed a qui tam action in NY state court regarding what I would consider fairly egregious tax evasion by a private investment fund.  As in the Danon case described in the Inquirer article, the NY AG decided not to pursue the case.  Unlike the Danon case, the person decided to withdraw the complaint before it was unsealed.  I'll talk about why in a moment.

But first, the following passage from the BNA article is instructive:

Brian Mahany of Mahany & Ertl in Milwaukee, who represents Danon, told Bloomberg BNA that New York is the only jurisdiction in the U.S. that allows qui tam claims for unpaid corporate income taxes. Such actions are always filed under seal, he said, to allow the attorney general time to investigate or develop the case.

The fact that the attorney general has chosen not to intervene does not say anything about the merits of the case, Mahany said. Danon still can pursue the case on his own, though he could not settle with Vanguard without the state's stepping back in.

Goodman [of Horwood Marcus, a Chicago law firm, described by Bloomberg as a critic of tax qui tam actions] agreed that the attorney general's decision not to intervene does not necessarily say anything about the merits of the case. It often happens in qui tam actions that the AG decides to step in later, as the case progresses, he said.

And the calculation of whether to intervene is often political, Goodman said.

“They might think it's a great case, or they might back off because it's a contributor, a company involved in politics. Or they don't want to dismiss it because they don't want to be seen as soft on companies that are being aggressive in their tax positions.”

Goodman noted another factor the attorney general might consider: Many people in New York are Vanguard shareholders and if the case resolved in Danon's favor, it would mean their investments would be worth much less.

That is not an outcome that would endear any elected official to the voters.

As explained in the article, a qui tam case is usually filed under seal, with the AG and the state tax department given the opportunity to investigate the claim and take over the case if they feel it has merit.  In the case I am aware of, the investment firm involved was well-connected politically, and immediately upon learning of the suit pulled out all of the stops lobbying AG Schneiderman not to intervene in the suit.  The AG complied, notwithstanding the fact that he had trumpeted the creation of his Taxpayer Protection Bureau to crack down on what he described as "large-scale tax cheats."  Like I have stated numerous time, when a politically connected company has a tax problem, the first person they call is their lobbyist.  I am not at all surprised to hear in this instance that the AG has declined to intervene in the case.  In fact, to my knowledge, there has been only one case which has been unsealed that the AG has pursued - a case for sales tax evasion against Sprint.  My acquaintance's claim was filed before the AG announced his decision to take on the case against Sprint.  Obviously, Sprint hired the wrong lobbyist.

Now I am somewhat surprised that the plaintiff in this case, unlike the plaintiff in the case I am personally aware of, decided to pursue the action notwithstanding the AG's refusal to sign on.  The reason can be found in the comments to the Tax Prof Blog post, where the first commenter asked the following question:

Is lawyer whistle blowing a violation of professional ethics rules?

Now, my acquaintance had a background as a lawyer, but was not employed by the investment fund in that capacity.  Instead, he was part of the finance department.  As such, he was arguably not practicing law when he came upon the information regarding the tax evasion that was going on within the firm.  Nevertheless, there is clearly a reluctance to divulge confidential information when placed in that kind of position, particularly given the reputational issues.  As one person responding to this question stated:

At first glance, there does not seem to be any exception to the ethical obligation to maintain a client's confidences that would permit this lawyer to make these disclosures. Not that anyone with any sense would ever again trust him as their counsel.

In fact, as another commenter noted, it is not an ethics violation if the lawyer is seeking to stop an ongoing or future crime.  Nevertheless, anyone in a position of confidence who breaches that confidence, regardless of the justification, is probably destroying any chance he has of obtaining a similar position in the future.  My acquaintance decided the risk to his career was greater than the possible reward of pursuing the action, and therefor withdrew it.

Whatever else happens as a result of this case, Danon's career working as a high level tax attorney is undoubtedly toast.

The Well Fargo Case, in a Nutshell

This morning a number of news outlets, including Bloomberg, Reuters, and even Politico, are reporting on a tax case involving Wells Fargo, where the IRS denied a tax refund of about $148 million.  Wells Fargo lost at the lower court level, and had appealed to the U.S. Supreme Court.  Yesterday, in a victory for the IRS, the Court denied the appeal.

It just so happens that I had recently written a brief piece about this case.  So I thought I'd take the opportunity to explain in layman's terms exactly what Wells Fargo (WF) did, and why it lost.  It is also a lesson on how well-intentioned provisions of the tax law - in this case, Section 351 - can be taken advantage of by sophisticated tax planning.

Section 351

Section 351 is designed to permit the incorporation of a business without recognizing a taxable gain.  Assume, for example, that someone who owns and operates a retail store wants to incorporate his business.  He does so by transferring the property of the business - the building, furniture and fixtures, equipment, supplies, inventory, etc. - to the corporation.  In exchange for the property, the business-owner will get back stock in the corporation.  Usually, the corporation will assume obligations relating to the business, such as the mortgage on the building or a credit line from a bank.

Now a corporation is a separate person under the tax law.  Ordinarily, if I transfer property to another person and receive property back, I have to recognize gain equal to the difference between the value received and my cost for the property.  It's as though I sold my property for cash, and used the cash to acquire the property I received in the exchange.  In special circumstances, however, the tax law says I don't have to recognize the gain.  One of those is provided in Section 351, which says that if I transfer property to a corporation in exchange for its stock and after the transfer I control the corporation, I don't gain or loss on the exchange.  This Section allows people to incorporate their business without recognizing gain.

Now, when you incorporate a business like this, the corporation that acquires the business generally "steps into the shoes" of the person that transferred the business.  In other words, the corporation will compute income from the business in virtually exactly the same manner as the individual did before he incorporated.  For example, when the corporation sells inventory received in the exchange, its profit on the sale depends upon the cost of the inventory. The tax law says the corporation's cost is the same as it was for the transferor, so that the profit on the sale is the same as the individual owner of the business would have made if the business had not been incorporated.  If one of the assets transferred to the corporation is a lease (suppose the store was a leased building rather than an owned one), the corporation will generally be able to deduct rent on the lease in the same manner as the individual did prior to the transfer.

Oh, and one more thing.  What happens if the individual later sells his stock in the corporation?  When you sell stock, you have to report a gain or loss equal to the difference between your cost (basis) for the stock and the amount you receive on the sale - if you receive more than your basis you have a capital gain, and if you receive less than your basis you have a capital loss.  The tax law says that the individual's basis for the stock is the same as the basis of the assets transferred to the corporation.  If the corporation assumes obligations associated with the business, the basis is reduced by the amount of the obligations.  For example, if I transfer a building that cost me $100,000 with a mortgage of $80,000 (my equity is $20,000) to the corporation for its stock, my basis in the stock is $20,000 - my cost for the property minus the mortgage taken over by the corporation.

Now, Section 351 does not just apply to a transfer of a business.  It applies to a transfer of any property to a corporation in exchange for stock, even if the property is not part of a business.  As long as the person transferring the property controls the corporation immediately after the exchange, gain or loss is not recognized on the exchange of property for stock.

The Wells Fargo Case

Wells Fargo had engaged in several mergers with other banks, and after the mergers it consolidated a lot of the operations.  As a result, it ended up with a lot of real property that it didn't need for its business anymore.  Most of the property was not owned by WF, however.  It was leased from other owners.  WF had legal obligations to pay the rent on the leases but the properties were idle and, at most, they were able to sublease them for short periods of time at rentals that were not sufficient to cover the lease obligations.  In other words, the properties were losers.

If you have a lease on property that you no longer need, you can (assuming the landlord permits) transfer that lease to another person.  If the rent due under the lease is less than the rental value of the property, a transferee will ordinarily pay the transferor an amount which represents the future value of the difference.  For example, if the lease has 10 years left to go, the rent is  $1,000 per month but the rental value is $1,200, a transferee is getting the benefit of 120 months at $200 per month, and will pay the transferor an amount equal to the present value of that benefit.  In that case, the tax law says the transferee can deduct the amount paid over the term of the lease.

On the other hand, if the rental value of the property is less than the rent under the lease, then the transferor may pay the transferee to get rid of the lease.  In other words, if the numbers above were reversed, the transferor is getting a benefit of $200 per month by getting rid of the lease, and will pay the transferee for that benefit.  In that case, the transferor is making the payment, and gets to deduct the full amount when the lease transfer occurs.

However, Wells Fargo decided to get greedy, and use Section 351 as a way to get a double deduction.  Here's how it worked.  WF had 21 leases on properties at various locations in the United States on which it paid rents that were greater than the rental value of the property.  In fact , the rents were substantially greater - they calculated the amount it would have to pay to terminate the leases at $426 million.  They transferred these leases plus $430 million worth of government securities to a subsidiary corporation named Charter in exchange for stock.  As you can see from these numbers, the net value of the transfer was $ 4 million.

Now leases are funny animals under the tax law, because they represent a future obligation to pay for a future benefit.  This is different from, say, a loan, which is an obligation to pay in the future for a benefit provided in the past (like the mortgage on the building I discussed above).  So WF stated that the lease obligations weren't the kind of obligations that should reduce the basis (cost) of the stock.  It claimed that the basis for the stock was $430 million.

So, according to WF, the stock they received in the exchange had a "cost" of $430 million, even though it was worth only $4 million.  Naturally, they sold the stock for $4 million, and claimed a $426 million loss.

Now, some people may say, what's the big deal?  I said above that WF calculated it would cost them $426 million to terminate the leases and that if they paid that amount to somebody to take over the leases they would get a deduction for it.  So what's the big deal if they get the same loss by selling stock?

Well remember I said that the corporation "steps into the shoes" of the transferor?  In this case, Charter will be able to continue deducting rent on the leases.  And it does not take much in the way of tax planning for the buyer of Charter stock to be able to use those deductions to reduce its own taxable income.  Stated differently, the buyer paid WF $4 million in order to receive $426 million of tax deductions.

There's the double deduction - WF deducts the loss on the stock, and Charter deducts the loss on the leases.

Epilogue

Just a couple of additional notes about this.

First, the idea for getting this kind of double deduction was very popular in the 1990s.  WF paid a fee to a tax advisor of $3 million for assistance in putting this transaction together.

When Congress caught wind of it, they amended the tax law to stop it.  The amendment essentially provided that lease obligations like those transferred by WF to Charter would reduce the cost basis of the stock received in the exchange.  Under current law, then, WF would not be able to claim that its cost for the stock was $430 million - its cost would be $4 million.  But that was not the law in the year that WF sold the stock and tried to deduct the loss.

So how did the IRS win the case, if technically the law was on the side of WF?  Well, there's a long line of cases dating back to the early thirties that says that if a transaction has no economic substance and its only purpose is to generate a tax benefit, the transaction can be ignored as a sham and the benefit can be denied.

This concept, known as the "economic substance doctrine," drives a lot of people crazy.  They think that if they're bright enough to find technical loopholes, they ought to be able to take advantage of them.  Today I looked at the docket for the Supreme Court case and saw that there were about a dozen amicus curiae briefs filed, all on behalf of the bank.  Among those filing briefs were the American Bankers Association, the Chamber of Commerce and the Cato Institute.  Reading the brief of the Chamber is particularly fun.  They are apoplectic that the lower court found for the IRS.  They must be pulling their hair out that the Supreme Court - as business-friendly as it is - declined to take the case.

Kickstarting Tax Reform

So Senators Wyden and Hatch have decided that they want to kickstart the tax reform process by holding hearings this summer.  Thus far, they have identified three areas they want to explore:

1. Education Tax Incentives
2. Taxpayer Privacy
3. "Modernizing" corporate taxation.

I shudder to think what this last item is.

More thoughts as we get closer to the hearings.