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U.S. ANTI – BORDER TAX COALITION TO TARGET LAWMAKERS DURING CONGRESSIONAL RECESS
By Ginger Gibson
Opponents of a proposal to create a U.S. border tax on imported goods are targeting lawmakers in their home states for the next two weeks while Congress is in recess, according to organizers of the lobbying effort.
The anti-border tax coalition, known as Americans for Affordable Products, includes large corporations that require imports like automakers and retail giants like Target, Best Buy and Walmart. The tax opponents will target 40 members of Congress in 11 states, said coalition spokesman Joshua Baca.
“We’re talking to businesses, local associations, having a frank conversation with them about how dumb this idea is”, Baca said. His group argues the proposal will raise consumer prices.
As part of a total overhaul of the U.S. tax code, Republican House Speaker Paul Ryan has proposed lowering the corporate income tax to 20 percent from 35 percent, imposing a 20 percent tax on imports and excluding export revenue from taxable income.
The proposal has some strong corporate backers who say it will boost American jobs and not raise prices, including companies that do considerable amount of exporting, such as Boeing, Caterpillar and Pfizer.
The anti-border tax group is planning to host a town hall meeting next week in Nevada with Republican Senator Dean Heller, which will also be co-sponsored by local business groups and Americans For Prosperity, the conservative group funded by the Republican Koch brothers which also opposes the border tax.
Town hall meetings have gained more attention recently as events featuring Republican lawmakers have been targeted by activists to voice their opposition to several proposals, including repealing the Affordable Care Act which widened health insurance coverage for about 20 million Americans.
Additionally, the anti-tax group will hold a discussion in Ohio with Republican Representative David Joyce, where he will hear from local furniture store owners who would be affected by a border tax, Baca said.
Concurrently, members of the Retail Industry Leaders Association, which is comprised of large retailers like Autozone, Walgreens Boot Alliance, Inc. and J.C. Penny Company, are using the recess to give members of Congress behind-the-scenes tours of both their headquarters and stores in an effort to persuade them against the tax, spokesman Brian Dodge said.
Both groups are hoping to make more voters aware of their position and are armed with an opinion poll by a pollster who also works for several Republican members of Congress.
The poll, shared first with Reuters and which was conducted with funding from opponents of the tax, found 63 percent of voters are against the tax, including 70 percent of women.
Additionally, the poll makes the case that 56 percent of voters say they would be less likely to vote for a member of Congress who supports the tax proposal.
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» Federal Tax Highlights
CODE’S THIRD – PARTY SUMMONS RULES APPLY WHERE IRS SEEKS DATA ON TAXPAYER’S MARIJUANA BUSINESS
High Desert Relief Inc., (DC NM 3/31/2017) 119 AFTR 2d ¶ 2017-621
A district court has made several rulings regarding Code Sec. 280E, the Code section that disallows deductions in carrying on a trade or business that consists of trafficking in controlled substances. One such ruling was that Code Sec. 7609(c)(2)(E)(i), which provides an exception to the Code’s third-party summons rules where the summons is issued by an IRS criminal investigator, doesn’t apply when the summons is issued by a regular IRS agent to obtain information pertinent to enforcement of Code Sec. 280E.
Background—third party summonses. While IRS has authority to require the production of a taxpayer’s books and records that are in another party’s possession, it’s required to notify the taxpayer and certain others, who then may have the opportunity to intervene in a proceeding to enforce the third-party summons, or bring an action to quash the summons. (Code Sec. 7609(a)(1); Code Sec. 7609(b)) However, the requirement that the taxpayer receive notice of a third-party summons and the right of those persons to intervene in a summons enforcement proceeding or begin a proceeding to quash the summons don’t apply to any summons issued by an IRS criminal investigator in connection with the investigation of an offense connected with the administration or enforcement of the internal revenue laws. (Code Sec. 7609(c)(2)(E)(1))
The district courts have jurisdiction to hear motions to quash third-party summonses. (Code Sec. 7609(h)(1))
To have a summons enforced, IRS must make a prima facie showing that:
Once IRS makes its prima facie showing, the burden shifts to the party opposing the summons to either disprove one of the four elements of IRS’s prima facie case or convince the court that enforcement of the summons would constitute an abuse of the court’s process. The petitioner is only entitled to a hearing to examine an IRS agent if he or she points to specific facts or circumstances plausibly raising an inference of bad faith. (Clarke, (S Ct 2014) 113 AFTR 2d 2014-2483113 AFTR 2d 2014-2483)
IRS is not permitted to issue an administrative summons when a Justice Department referral is in effect. (Code Sec. 7602(d)(1))
Background—marijuana laws. Several state legislatures have passed laws legalizing the cultivation and sale of marijuana. These laws have created a conflict between federal law and state law.
Code Sec. 280E provides that a taxpayer may not deduct any amount for a trade or business where the trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (e.g., controlled substances within the meaning of schedule I of the Controlled Substances Act—such as marijuana) which are prohibited by Federal law.
Facts. The taxpayer, High Desert Relief (HDR), operated a medical marijuana business in New Mexico.
IRS’s auditor, Ms. Turk, on Feb. 2, 2016, notified HDR by letters that IRS had selected for examination HDR’s 2014 and 2015 tax returns. Ms. Turk attached Publication 1, “Your Rights as a Taxpayer”, to each letter. In May and June, 2016, Ms. Turk issued a summons to: HDR’s bank, My Bank; the New Mexico Department of Health – Medical Cannabis Program (NMDOH); and HDR’s utility company, Public Service Company of New Mexico (PNM), requesting documents pertaining to HDR. Ms. Turk stated that she issued these summonses in order to assess the correctness of HDR’s returns, determine if HDR has unreported taxable income, and substantiate the gross receipts reported in HDR’s tax returns. When Ms. Turk served the summonses on PNM, My Bank and NMDOH, she mailed, the same day, via certified mail, copies of the summonses to HDR, along with a notice explaining HDR’s rights to bring a proceeding to quash the summonses.
It was undisputed that no Justice Department referral, as defined by Code Sec. 7602(d), was in effect with respect to HDR for the 2014 or 2015 tax periods.
HDR filed petitions to quash the third-party summonses. Its primary argument in its petitions was that IRS was abusing its civil audit power to conduct a criminal investigation into whether HDR was violating the Controlled Substances Act (CSA). HDR also took the position that IRS cannot make any determination that an entity is illegally trafficking in drugs for purposes of Code Sec. 280E. HDR also argued that IRS cannot satisfy the requirements of Powell.
IRS filed a motion to dismiss HDR’s petition on several grounds including that the court did not have jurisdiction over the subject matter because IRS had not waived immunity.
The court had jurisdiction. IRS did not support its argument that it had not waived immunity, but the court assumed that IRS’s position was that Code Sec. 7609(c)(2)(E)(i) applied so as to prevent HDR’s ability to avail itself of Code Sec. 7602(b) relief. And, the Court rejected that argument.
More specifically, the court assumed that IRS’s position was that, if HDR’s argument was that IRS was conducting a criminal investigation was correct, the court lacked jurisdiction because Code Sec. 7609(c)(2)(E)(i) expressly excludes from its waiver of sovereign immunity any third-party summons “issued by a criminal investigator of IRS in connection with the investigation of an offense connected with the administration or enforcement of the internal revenue laws”.
The court said that, while Code Sec. 280E references a criminal statute, the CSA, it does not first require a determination by a government official conducting a criminal investigation that the party claiming a deduction is trafficking in controlled substances.
The court said that trafficking as used in Code Sec. 280E means to buy or sell regularly. As such, the real issue was whether IRS had authority to determine if, in the course of HDR’s business, it regularly bought or sold marijuana. The court saw no reason why not. Such a determination does not require “any great skill or knowledge, certainly not skill or knowledge of a criminal investigatory bent”. It cited Alpenglow Botanicals, LLC, (DC CO 2016) 118 AFTR 2d 2016-6968118 AFTR 2d 2016-6968.
Code Sec. 280E instructs that deductions should be disallowed if certain circumstances exist in a taxpayer’s business. As noted by the court in Alpenglow Botanicals, it “would certainly be strange” if IRS was not charged with enforcing that provision. The fact that selling marijuana may also constitute a violation of the CSA is simply a byproduct of Code Sec. 280E using the CSA’s definition of “controlled substances”. Code Sec. 280E does not require that a criminal investigation be pursued against a taxpayer, or even that Code Sec. 280E only applies if a criminal conviction under the CSA has been obtained. If Congress had wanted such an investigation to be carried out or conviction to be obtained, then it could easily have placed such language in Code Sec. 280E.
HDR asserted that Code Sec. 280E requires IRS to find that a crime has been committed and/or that a taxpayer has engaged in illegal activity. Even if these assertions were accurate, they do not transform IRS’ determination that Code Sec. 280E applies into a criminal investigation. An IRS agent conducting a civil investigation into tax liabilities may investigate whether a party is violating the CSA for the purposes of applying Code Sec. 280E without conducting a criminal investigation.
Therefore, under Code Sec. 7609(b)(2), IRS waived sovereign immunity for this proceeding to quash, and, accordingly, the court had jurisdiction over the proceeding pursuant to Code Sec. 7609(h)(1).
Taxpayer not entitled to examine IRS agent. The court then held that IRS made its prima facie case under Powell regarding the summonses and that HDR did not make the resulting case for bad faith.
Ms. Turk declared that the purpose of the investigation was to examine “the federal tax liabilities… of High Desert Relief, Inc. …for the tax periods ending June 30, 2014, and June 30, 2015”. The court said that this statement was enough to meet the first factor.
Ms. Turk also explained the summoned documents’ relevance to the inquiry. She stated that the records from NMDOH would be used to determine whether HDR was growing or selling marijuana and where its growing facilities were. The records from PNM would be used to determine, from how much electricity HDR used, how much marijuana HDR grew during the inquiry period to substantiate gross receipts. And the documents from My Bank would be used to substantiate gross receipts income for the inquiry period. This information satisfied the second Powell factor.
Ms. Turk declared that the information she sought was not already in her possession and that HDR had not provided any documents in response to the information document request she submitted to HDR. She also stated that, after issuing the summons to PNM, she received a package from PNM in response to the summons but “I have not and will not open the package until this litigation is resolved”. My Bank did not produce any records, but Ms. Turk obtained information from NMDOH through a public records request, and therefore she testified that IRS no longer sought to enforce that summons as it was moot. Through these statements, IRS met the third Powell factor.
The fourth Powell factor was satisfied by the mailings that IRS had made. Thus, IRS made its prima facie case.
HDR attempted to rebut IRS’s showing of good faith. Most of HDR’s arguments were premised on its position that IRS may not investigate or determine whether HDR violated the CSA. The court said that because it disagreed with this position, above, it need not revisit this issue here.
HDR also argued that it offered to provide IRS with the documents IRS sought and that, therefore, IRS could not meet the second Powell requirement that the information it sought was not in its possession. Prior to the issuance of the summonses, HDR offered to “furnish documentation to support income, costs of goods sold, and, ordinary and necessary business expenses, provided that we are given assurance from IRS, that IRS will use the information furnished for this civil audit, and not to support IRS’s determination that the Taxpayer’s business consists of illegal activities”. An IRS attorney responded that IRS did not have the authority to agree to the conditions, citing Code Sec. 6103(i) (“Disclosure to Federal officers or employees for administration of Federal laws not relating to tax administration”), which requires IRS to turn tax return documents over to other agencies in some circumstances. The record did not reflect that HDR ever provided the documents to IRS, either before or after the summonses were issued. The court concluded that IRS had demonstrated it met that “the information sought is not already within the Commissioner’s possession”, the third Powell factor. HDR’s response was insufficient to rebut IRS’s showing, given that HDR only offered to produce documents (and not necessarily the specific documents summoned) upon conditions with which IRS could not lawfully agree.
The court then concluded that HDR had not met the Clarke standard regarding an inference of bad faith and held that therefore HDR was not entitled to a hearing in which it could examine Turk.
Taxpayer also loses “dead letter” argument. Finally, the court rejected taxpayer’s argument that, because the Justice Department had issued memoranda in 2009 and 2013 that prosecution of marijuana related crimes committed by persons acting in compliance with state law was not a priority and was not to be pursued by the Department of Justice, the CSA was a “dead letter”—i.e., an unenforced law—and therefore it would be inequitable to enforce Code Sec. 280E.
HDR cited Sterling Distributors, Inc. v. Patterson, (DC AL 1964) 15 AFTR 2d 46115 AFTR 2d 461, where the issue was the deductibility of some business gifts that were illegal under a state law that was not enforced, and the court allowed the deduction. The Sterling court said that it didn’t make sense to say that the gifting frustrated state public policy when its authorized officers long ago determined that the rule should not be enforced. HDR also cited other similarly decided cases.
In disagreeing, the court first noted that, to be deductible under Code Sec. 162, an expense must be ordinary and necessary to carrying on the taxpayer’s business. A finding of “necessity” cannot be made, however, if allowance of the deduction would frustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof. Next, the court found that the cases that HDR cited all involved deductibility under Code Sec. 162; they did not involve Code Sec. 280E. Code Sec. 162 sets forth the general rule that ordinary and necessary business expenses are deductible, and then sets forth exceptions. One exception is for “other illegal payment under any law of IRS, or under any law of a State (but only if such State law is generally enforced)”. (Code Sec. 162(c)(2)) Code Sec. 280E contains no such exception for the lack of enforcement of the CSA by either state or federal authorities. “Where Congress includes particular language in one section of a statute but omits it in another section of the same Act, it is generally presumed that Congress acts intentionally and purposely in the disparate inclusion or exclusion.”
References: For statutory exceptions to the procedures for third-party summonses, see FTC 2d/FIN ¶ T-1255; United States Tax Reporter ¶ 76,094. For the disallowance of deductions or credits for illegal drug trafficking, see FTC 2d/FIN ¶ L-2632; United States Tax Reporter ¶ 280E4.
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SPRING CLIENT LETTER EXPLAINS RECENT DEVELOPMENTS THAT MAY AFFECT A CLIENT’S TAX SITUATION
There were a number of important tax developments in the first quarter of 2017. You can use the Client Letter that follows to keep your clients up-to-date on those key tax developments. For your convenience, we have included references in italics to issues of the Federal Taxes Weekly Alert where these developments were discussed in detail. These italicized references should be removed before you reproduce and send out the Client Letter to your clients.
Dear Client: The following is a summary of important tax developments that have occurred in the past three months that may affect you, your family, your investments, and your livelihood. Please call us for more information about any of these developments and what steps you should implement to take advantage of favorable developments and to minimize the impact of those that are unfavorable.
New guidance on how small businesses can use research credit to offset payroll tax.Businesses that increase certain research expenses may use a research credit to reduce their income tax liability. For tax years that begin after Dec. 31, 2015, eligible small businesses can take advantage of a new option enabling them to apply part or all of their research credit against their payroll tax liability, instead of their income tax liability. The option to elect the new payroll tax credit may be especially helpful for eligible startup businesses that have little or no income tax liability. To qualify for the new option for 2016, a business must have gross receipts of less than $5 million and may not have had gross receipts before 2012. Under the new rules, an eligible small business with qualifying research expenses can choose to apply up to $250,000 of its research credit against its payroll tax liability.
The IRS recently issued new guidance on this option for eligible small businesses to use the research credit to reduce payroll tax. Eligible small businesses choose this option by filling out Form 6765, Credit for Increasing Research Activities, and attaching it to a timely-filed business income tax return. The business claims the payroll tax credit on its employment tax return for the first quarter that begins after it files the return reflecting the election. For example, if a business files an income tax return on Apr. 10, 2017, with a Form 6765 attached reflecting the payroll tax credit election, it would claim the payroll tax credit on its Form 941, Employer’s Quarterly Federal Tax Return, for the third quarter of 2017. An eligible small business that files annual employment tax returns claims the payroll tax credit on its annual employment tax return that includes the first quarter beginning after the date on which the business files the return reflecting the election. The eligible small business also must file Form 8947, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, and attach it to the employment tax return. Under a special rule for tax year 2016, a small business that failed to choose the payroll tax option, but still wishes to do so, can still make the election by filing an amended return by Dec. 31, 2017.
For more information, see Weekly Alert ¶ 37 04/06/2017.
Fast track settlement program made permanent for small businesses and self-employeds.The IRS announced that it has made permanent a program that allows small business/self-employed taxpayers and the IRS to reach agreement on tax disputes more quickly. It’s called the Fast Track Settlement (FTS) program, and it’s designed to help certain small businesses and self-employed individuals who are under examination by the Small Business/Self Employed (SB/SE) Division of the IRS. The FTS uses alternative dispute resolution techniques to help taxpayers save time and avoid a formal administrative appeal or lengthy litigation. As a result, audit issues can usually be resolved within 60 days, rather than months or years. Plus, taxpayers choosing this option lose none of their rights because they still have the right to appeal even if the FTS process is unsuccessful.
For more information, see Weekly Alert ¶ 22 03/23/2017.
2017 luxury auto depreciation dollar limits and lease income add-backs released. Annual depreciation and expensing deductions for so-called luxury autos are limited to specific dollar amounts. These amounts are inflation-adjusted each year. The IRS has announced that for autos (not trucks or vans) first placed in service during 2017, the dollar limit for the first year an auto is in service is $3,160 ($11,160 if the bonus first-year depreciation allowance applies); for the second tax year, $5,100; for the third tax year, $3,050; and for each succeeding year, $1,875. These dollar limits are the same as those that applied for autos first placed in service in 2016.
For light trucks or vans (passenger autos built on a truck chassis, including minivan and sport-utility vehicles (SUVs) built on a truck chassis) first placed in service during 2017, the dollar limit for the first year the vehicle is in service is $3,560 ($11,560 if the bonus first-year depreciation allowance applies); for the second tax year, $5,700; for the third tax year, $3,450; and for each succeeding year, $2,075. For a light truck or van placed in service in 2017, the dollar figures are the same as for such vehicles first placed in service in 2016, except that the third-year amount is $100 higher.
A taxpayer that leases a business auto may deduct the part of the lease payment representing its business/investment use. If business/investment use is 100%, the full lease cost is deductible. So that auto lessees can’t avoid the effect of the luxury auto limits, however, taxpayers must include a certain amount in income during each year of the lease to partially offset the lease deduction. The amount varies with the initial fair market value of the leased auto and the year of the lease, and is adjusted for inflation each year. The IRS has released a new inclusion amount table for autos first leased during 2017.
For more information, see Weekly Alert ¶ 6 03/30/2017.
IRS delays employer deadline to provide small employer HRA notice to employees.Generally effective for years beginning after Dec. 31, 2016, an eligible employer—generally, an employer with fewer than 50 full-time employees, including full-time equivalent employees, that does not offer a group health plan to any of its employees—may provide a qualified small employer health reimbursement arragement (HRA) to its eligible employees, and such an HRA won’t be treated as a group health plan. Thus, a qualified small employer HRA isn’t subject to the tax law’s group health plan requirements, including the portability, access, and renewability requirements of the Affordable Care Act (ACA, also known as Obamacare). HRAs are arrangements under which an employer agrees to reimburse medical expenses including health insurance premiums up to a certain amount per year, with unused amounts available to reimburse medical expenses in future years. The reimbursement is excludable from the employee’s income.
The qualified small employer HRA rules generally require an eligible employer to furnish a written notice to its eligible employees at least 90 days before the beginning of a year for which the HRA is provided (or, in the case of an employee who is not eligible to participate in the arrangement as of the beginning of such year, the date on which the employee is first so eligible). However, under interim guidance from the IRS, an eligible employer that provides a qualified small employer HRA to its eligible employees for a year beginning in 2017 isn’t required to furnish the initial written notice to those employees until after further guidance has been issued by the IRS. That further guidance will specify a deadline for providing the initial written notice that is no earlier than 90 days following the issuance of that guidance.
For more information, see Weekly Alert ¶ 22 03/02/2017.
Revised list of boycott countries. A taxpayer who participates in or cooperates with an unsanctioned international boycott may suffer reduced foreign tax credits and have subpart F income in relation to taxes and income attributable to the country the government of which sponsors or supports an international boycott. The following countries are on the Treasury’s current list of countries which require or may require participation in, or cooperation with, an international boycott: Iraq; Kuwait; Lebanon; Libya; Qatar; Saudi Arabia; Syria; United Arab Emirates; and Yemen.
For more information, see Weekly Alert ¶ 39 04/06/2017.
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JUDGMENTS AND LIENS AGAINST SHAREHOLDER – GUARANTORS OF S CORP LOAN DIDN’T CREATE BASIS TO CLAIM LOSS
Phillips, TC Memo 2017-61TC Memo 2017-61
The Tax Court has held that a shareholder’s guarantee of a loan to her S corporation didn’t give her basis in the entity even where the lenders sued her on her guarantee and recovered deficiency judgments against her, resulting in liens against her real and personal property. As a result, she couldn’t deduct her distributive share of the entity’s losses.
Background. Deductions and losses of an S corporation are passed through to shareholders and (except as otherwise limited by the Code) claimed on their own returns. However, a shareholder may deduct his pro rata share of these passed-through items only to the extent of the sum of his adjusted basis in the S corporation stock—determined by taking into account the increases in basis for his share of the S corporation income during the year and the decreases in basis for nondividend distributions for the year (Code Sec. 1366(d)(1)(A)—plus his adjusted basis in any indebtedness of the S corporation to him. (Code Sec. 1366(d)(1)(B), Reg. § 1.1366-2)
Under regs that generally apply to transactions on or after July 23, 2014, an S corporation shareholder who merely acts as a guarantor or in a similar capacity (e.g., surety or accommodation party) hasn’t created basis of indebtedness unless the shareholder actually makes a payment, and then only to the extent of such payment. (Reg. § 1.1366-2(a)(2)(ii))
For transactions before July 23, 2014, the courts generally held that merely guaranteeing an S corporation’s debt wasn’t enough to generate a basis under Code Sec. 1366(d)(1)(B). To increase his basis in an S corporation, a shareholder had to make an “actual economic outlay”.
In Selfe v. U.S., (CA 11 1985) 57 AFTR 2d 86-46457 AFTR 2d 86-464, the Eleventh Circuit agreed that an economic outlay was required before a stockholder may increase her basis. But it did not believe that this test necessitated that the shareholder “must, in all cases, absolve a corporation’s debt before she may recognize an increased basis as a guarantor”. Rather, it concluded that a basis increase may be justified “where the facts demonstrate that, in substance, the shareholder has borrowed funds and subsequently advanced them to her corporation”. Establishment of this factual predicate would require proof that “the lender looks to the shareholder as the primary obligor”. The Court recognized that in practice this argument would usually meet with little success because the taxpayer would be unable to demonstrate that the substance of her transaction was different than its form.
In Sleiman v. Comm., (CA 11 1999) 84 AFTR 2d 99-598784 AFTR 2d 99-5987 (see Weekly Alert ¶ 3 09/16/1999), the Eleventh Circuit distinguished Selfe and held that a guaranty without payment didn’t create basis. In that case, the shareholder-guarantors had not previously been obligors on any S corporation loan and they pledged no collateral in support of their guaranties. Rather, the collateral was supplied by the S corporation, which was successful and well established. At the time they extended credit, the banks estimated that the collateral (chiefly real estate) was worth nearly twice the amount of the loans. A bank officer testified that the bank had requested guaranties from the taxpayers, not because it looked to them as the primary source for repayment, but because the bank’s general policy was to require personal guarantees on loans to closely held corporations. The Court concluded that the taxpayers had not established the unusual factual predicate inSelfe necessary to show that the loans, in form extended to the S corporation, had in substance been extended to the shareholders individually.
Facts. S corporation, Olson & Associates (Olson), which was owned 50% by Carl Olson, Jr., and 50% by Sandra Phillips, was engaged in developing and selling residential and commercial real estate. Like many such businesses, it relied heavily on debt financing. The only collateral to which the banks could look for repayment of their loans was the real estate and other assets held by Olson and its subsidiaries. Virtually all of the loans that the banks extended to Olson and its subsidiaries were guaranteed by Olson’s two shareholders and/or their spouses.
The nationwide downturn in the real estate market that began in late 2006 was especially severe in Olson’s region of operations. Starting in 2007, the company’s business experienced a spiraling decline in sales, revenue, and cash flow from which it never recovered. This precipitated a default on virtually every loan owed by the company. The lenders sued for repayment, typically foreclosing on the property that secured the indebtedness. Because the real estate had declined so precipitously in value, the collateral was usually insufficient to satisfy these judgments.
The lenders sued the guarantors, seeking enforcement of the personal guaranties to satisfy the deficiencies. Ten of these actions resulted during 2008 – 2009 in final judgments gating about $105 million against Mrs. Phillips and the coguarantors, including her husband.
The coguarantors bore joint and several liability for each of these judgments. As of the time the record in this case closed, neither Mrs. Phillips nor her husband had paid any amount toward these judgments. Nor had either made any direct payments to Olson’s lenders under his or her guaranties.
After receiving professional advice in 2010, including a formal opinion from tax counsel, Mrs. Phillips took the position that she was entitled to increase her basis in her Olson stock as a result of these judgments. She assigned $7,069,639 of the unpaid judgments to 2008 and the remaining $97,703,385 to 2009. For each year, she then allocated to each coguarantor a pro rata share of the unpaid judgment amounts exceeding all available collateral. After allocating her “proportionate share of the judgments less the fair market value (FMV) of the underlying property securing the liabilities”, she claimed that she had made deemed capital contributions to Olson, and so secured additional basis in her stock, of $1,553,360 in 2008 and $30,187,249 in 2009, allowing her to claim loss deductions.
On audit, IRS determined that for the years at issue Mrs. Phillips wasn’t entitled to any basis increase on account of her loan guaranties or the unpaid judgments against her.
Judgments didn’t create basis for shareholder. The Tax Court held Mrs. Phillips didn’t have enough basis in Olson to support the losses she claimed.
Although Mrs. Phillip claimed an increased basis in her Olson stock on her return, at trial she argued alternatively for additional basis in the company’s indebtedness to her. As the Tax Court noted, both arguments rested on a “substance vs. form” argument—on the theory that the guaranteeing shareholder had in substance borrowed funds directly from the lender, then transferred the loan proceeds to the S corporation either as a contribution to capital or a back-to-back loan. In either case, the question was whether Mrs. Phillips made the actual economic outlay requisite to securing a basis increase.
The Court concluded that the taxpayer’s situation resembled Sleiman more than it did Selfe.The facts here differed from those in Selfe on each of the important points identified by the Eleventh Circuit. There was no evidence that Olson’s lenders had a prior relationship with the taxpayer or that the taxpayer previously had been obligor on these loans. Mrs. Phillips did not pledge any of her personal assets as collateral for the loans; all the collateral (consisting primarily of real estate) was supplied by Olson (through its special purpose entities or their subsidiaries). Olson was a well established company with a good reputation, and the taxpayer conceded that the loans when made were clearly supported by the collateral that was pledged. Most importantly perhaps, the taxpayer produced no testimony or other evidence from any of the lending banks that any bank looked to the shareholder as the primary obligor on any loan. Further, the Tax Court noted that it was hard to see how a taxpayer could establish a bank’s intentions or expectations on this point without producing testimony from someone at the bank.
While Mrs. Phillips argued that the deficiency judgments against her gave rise to an “actual economic outlay” by (among other things) impairing her credit, the theory underlying Selfe—on which she relied—was that the bank, while nominally lending to the S corporation, may in substance have lent to the shareholder, who then contributed the loan proceeds to the corporation. In order to identify the “true obligor” in such circumstances, it was necessary to examine the lender’s intentions and other economic facts existing when the lender makes the loan. A court’s entry of a deficiency judgment against a guarantor many years later, after the corporation had defaulted and the corporation’s collateral had proven insufficient, was simply not relevant in determining whether the lender, when initially extending credit, looked to the shareholder as the primary source of repayment.
The Tax Court concluded that—that being so—Mrs. Phillips could make the required “economic outlay” in favor of Olson only by making a payment toward the judgments. This would create a debt from Olson to her and give her additional basis in that amount. But since she had made no payments either on the guaranties or on the judgments, she was not entitled to the basis increases that she claimed.
In addition, the Tax Court found that even if the taxpayer had shown that the deficiency judgments theoretically entitled her to some basis adjustment, she did not carry her burden of proving the size of the basis increase. Mrs. Phillips’ allocation of the unpaid deficiency judgments entered against her and the coguarantors rested on questionable assumptions that she neither addressed nor answered. Her estimates of the FMV of the collateral transferred to the judgment creditors were inadequately supported and internally inconsistent; there were unresolved questions as to whether certain collateral was returned and whether the taxpayer made associated downward adjustments to her claimed increase in basis. Further, for each loan in question, all coguarantors bore joint and several liability. Mrs. Phillips advanced no reason for believing that the judgment creditors would pursue all coguarantors pro rata rather than simply targeting the ones with the deepest pockets; allocating a pro rata portion of that judgment to Mrs. Phillips could generate a combined basis increase exceeding the amount owed to the judgment creditors in the first place.
References: For shareholder’s guarantee of loan to S corporation as debt to shareholder—pre-July 23, 2014 transactions, see FTC 2d/FIN ¶ D-1776; United States Tax Reporter ¶ 13,664.
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» Accounting Highlights
KPMG FIRES AUDIT CHIEF BECAUSE OF PCAOB DATA BREACH
KPMG LLP dismissed the chief of its U.S. audit practice, four other partners, and a sixth employee because they were given confidential information about the clients the PCAOB planned to inspect but failed to report the information on a timely basis through the appropriate channels. The firm named Frank Casal its new vice chairman and the chief of its U.S. audit practice.
KPMG LLP on April 11, 2017, said it fired the chief of its U.S. audit practice, four other partners, and a sixth employee because they were given confidential information about the clients the PCAOB planned to inspect but failed to report the information on a timely basis through the appropriate channels.
KPMG did not name the six employees but accused them of violating the firm’s Code of Conduct. It quickly named Frank Casal its new vice chairman and the chief of its U.S. audit practice to replace Scott Marcello. The firm also named Jackie Daylor as national managing partner for audit quality and professional practice.
“KPMG has zero tolerance for such unethical behavior”, Lynne Doughtie, the firm’s chairman and CEO, said in a statement. “We are taking additional steps to ensure that such a situation should not happen again.”
The dismissals centered around information a KPMG employee who had worked at the PCAOB until recently gained from another employee at the audit regulator about the upcoming annual inspection. KPMG is one of the Big Four accounting firms, and for the inspections of the large auditors, the PCAOB will assign teams as large as 50 employees to review the client audits. The individual inspections are planned in advance, but the identities of the clients being inspected are kept under tight wraps until a few weeks before the inspections when PCAOB officials begin to alert the firms about the clients that will be inspected, usually in groups of 10 to 15 at a time, to give them some time to prepare.
In this case, the names of the clients were leaked much earlier than planned.
A whistleblower within KPMG alerted the firm about the data breach, and the firm then notified the SEC and PCAOB about the incident. The accounting firm has hired a law firm to investigate how the breach happened.
KPMG said the breach does not affect the audit opinions it has rendered on any clients.
For its part, the PCAOB issued a brief statement that said the employee involved no longer works at the audit regulator and that it had taken actions to shore up its inspection process.
“The PCAOB takes the integrity of its oversight processes very seriously”, said the emailed statement from a spokesperson for the board.
The breach comes as the PCAOB is in transition. Chairman James Doty has headed the board for six years, but his term ended in October 2015. The SEC appoints all board members, including the chairman, and until the SEC has a new chairman, it will be unclear what the market regulator plans to do with the board’s leadership. President Trump’s nominee to run the SEC, Jay Clayton, is awaiting his confirmation vote by the full Senate.
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HOUSE BILL WOULD REQUIRE DISCLOSURE OF OFFSHORE TAX PAYMENTS
In a nod to civic and reform groups, Rep. Mark Pocan on April 6, 2017, introduced a bill that would require public companies to provide more information about their use of offshore tax havens.
H.R. 2057, The Tax Fairness and Transparency Act, would also close loopholes that allow companies to avoid taxes on profits earned overseas.
“Wall Street banks and big corporations rigged the system to dodge taxes and hide their profits overseas”, Rep. Pocan, a Democrat from Wisconsin, said in a statement. “These companies skirt their responsibilities, while small businesses and working families play by the rules and pay their fair share.”
The proposed legislation would amend Section 13 of the Securities Exchange Act of 1934 to require companies to disclose total corporate taxes paid.
In particular, companies must disclose the total pre-tax profit, the total taxes paid at the federal and state level, and the total amount paid in foreign taxes.
Foreign taxes must be reported country by country. The information should include revenues, pretax earnings, total income tax paid on a cash basis to all tax jurisdictions, and any taxes withheld on payments received by subsidiaries. Companies must also disclose total accrued tax expense recorded on taxable profits or losses, stated capital, total accumulated earnings, total number of employees on a full-time equivalent basis, and net book value of tangible assets.
The bill would also amend the Internal Revenue Code of 1986 to limit the interest deduction for excessive interest payments and terminate the deferral of active income of controlled foreign corporations. It is intended to dissuade U.S. companies from using inversions to avoid paying the 35 percent domestic tax rate by parking some of their money in locations overseas where the tax rates are much lower.
The measure comes as the Financial Accountability and Corporate Transparency (FACT) Coalition, a group of more than 100 organizations, has been calling for financial reforms. Offshore profits have significantly grown in the past several years, but investors face difficulty making investing decisions because they know little about multinational companies’ offshore tax strategies and the risk of potential tax liabilities.
According to an October 2016 report by the U.S. Public Interest Research Group (PIRG), 367 of Fortune 500 U.S. companies operated one or more subsidiaries in tax haven countries, and they had more than $2.5 trillion in profits in overseas subsidiaries that were subject to domestic taxes in 2015. But the report said only 58 companies disclosed that they would pay $212 billion in U.S. taxes if these profits were not booked offshore.
“The Tax Fairness and Transparency Act offers a pragmatic, enforceable response to the problem of offshore tax avoidance”, Clark Gascoigne, the deputy director of the FACT Coalition, said in a statement.
Despite the effort, the bill faces long odds given that Congress is in the hands of business-friendly Republicans.
In the meantime, the FACT Coalition—which includes the AFL-CIO, watchdog group Public Citizen, and the American Federation of State, County and Municipal Employees (AFSCME)—urged the SEC to take action as part of the Disclosure Effectiveness initiative.
The SEC in July 2016 issued Release No. 33-10110, Disclosure Update and Simplification, to solicit comments about cutting disclosure requirements that are unnecessary. The commission also published Release No. 33-10064, Business and Financial Disclosure Required by Regulation S-K, in April 2016 to seek comments about ways to improve disclosures under Regulation S-K, the set of rules that cover information outside the financial statements that companies must provide in their annual and quarterly reports.
In comment letters, the FACT Coalition said the SEC should amend Rule 4-08(h) of Reg S-X, which requires disclosure of the amount of domestic and foreign pre-tax income and income tax expense. The group said a more detailed country-by-country breakdown of tax payments is helpful to investors than the bundling together of total payments now permitted by the rule.
Moreover, the group said the SEC should revise Item 601(b)(21) of Reg S-K, which deals with information about subsidiaries, because some large companies in recent years have omitted information about subsidiaries if they are deemed not significant enough.
Reform groups believe some companies are avoiding revealing information about subsidiaries based in tax havens.
The initiative, which was started by former Chair Mary Jo White, is intended to cut redundant and outdated requirements and add information that would be useful to investors. It is unclear what direction Jay Clayton, President Donald Trump’s nominee to lead the agency, will take with the disclosure project. Clayton, a partner with the law firm Sullivan & Cromwell LLP, is awaiting a confirmation vote by the full Senate.
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