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Archive for February, 2012

Earlier this week, I posted a link to an article detailing the desire of the IRS to hire a marketing firm to improve its image among the taxpaying public. Buried within the depths of the article was the reason for the Service’s PR push:

The IRS ranked last among 13 federal agencies in a 2010 survey by the Pew Research Center, which asked respondents if they had a favorable opinion of each agency.

This ranking should come as no surprise, as the IRS is the object of more scorn, derision and lazy Leno monologues than the entire Kardashian clan. But lest you start to think the public’s view of the IRS is unduly harsh, I encourage you to read this article authored by Janet Novack over at Forbes, which offers a stern reminder of just how illogical, oppressive and unyielding the Service can be.

As Novack explains:

After legendary modern art dealer Ileana Sonnabend died in 2007 at the age of 92, her heirs sold off some of her collection to pay a whopping estate tax bill: $331 million to Uncle Sam and $140 million to New York State….But they couldn’t sell Sonnabend’s most famous holding—Rauschenberg’s collage “Canyon”—because it includes a stuffed bald eagle, and two federal laws bar possessing or trafficking in the bird, dead or alive. [Ed note: Rauschenberg’s “Canyon” is widely considered to be the world’s second most sought-after piece of art, trailing only the Gummi Venus de Milo.]

Since “Canyon” couldn’t be sold without landing Sonnabend or her heirs in prison, the estate concluded that the work was worthless, and did not ascribe a value to it on the estate’s tax return. The IRS, however, had other ideas. After auditing the estate’s return, the Service set the value of  “Canyon” at $65 million, and assessed the estate a tax deficiency of $29 million, tacking on a $11.7 million gross valuation misstatement penalty under I.R.C. § 6662 just for giggles.

When estate attorney Ralph E. Lerner — who is suing the IRS on behalf of the Sonnabend estate — reached out to the IRS for their rationale, this is what he got:

When he called the chairman of the IRS art panel to complain, Lerner reports, “He told me there could be a market. For example, a recluse billionaire in China might want to buy it and hide it.” [Ed note: I’m looking at you, Chou Kuang Piu]

If that’s the approach the IRS is going to take with taxpayers, I’d advise them to go ahead and double that PR budget. Come to think of it, they may want to allocate some additional funds to smoothing things over with the Chinese while they’re at it.

It’s exactly this type of ridiculousness that makes the IRS the most reviled of all the government agencies. The Service is taxing  the estate on the hypothetical purchase price a piece of art could fetch on the black market, even though such a sale would constitute a federal crime. This basically leaves the estate with two options: 1) hold on to “Canyon” and risk having to pay the tax, or 2) sell the work of art in order to pay the tax and go to rich-white-people-prison.

Scarier still, the IRS has put the Sonnabend estate in this predicament based solely on the contrived notion that somewhere in the Far East exists a wealthy eccentric with $65 million burning a hole in his pocket who’s been longing for a stuffed bird to tie his den together. Illogical, yes. Egregious? Definitely. But, sadly, not unprecedented:

So just how creative is the IRS being here? California art law attorney Joy Berus says she’s not surprised by the IRS’ position in this case. The government has long asserted (with some support from case law) that contraband items in an estate (drugs, stolen art, stolen jewels or a purchased artwork that turns out to be a protected antiquity, say belonging to foreign government or a Native American tribe) can be valued for estate tax purposes at their  black or “illicit market” value.

Joy Berus speaks the truth. See PLR 9152005 (stolen War World II art included in estate at black market value) and PLR 9207004 (weed included in drug dealer’s estate at retail street value). Needless to say, we’ll be keeping an eye on this case and will provide updates on any future developments.

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CPAs are often their own worst enemies, and I say this not with regards to the long hours that stress our heart, the accompanying fast food that softens our midsections, and the prolonged exposure to fluorescent lighting that over time will leave the male portion of our population unable to get their soldiers to salute. Rather, we often sabotage ourselves and make things more difficult than they need to be by failing to search for an adequate authority when confronted with a problematic issue.

Consider the following alternative fact patterns:

Situation 1. A and B each own 50% of AB LLC. During 2011, AB LLC paid health insurance premiums for 2011 coverage on behalf of both A and B under AB LLC’s health plan.

Situation 2. C and D each own 50% of the stock of CD, Inc. an S corporation. C and D are also employees of CD, Inc. During 2011, CD, Inc. paid health insurance premiums for 2011 coverage on behalf of all of its employees, including C and D.

Question: How do AB, LLC, A and B, CD, Inc. and C and D account for the health insurance premiums paid by the partnership and S corporation, respectively?

In the absence of proper guidance, trying to determine the proper treatment of entity-paid health insurance premiums could easily send a CPA on a wild goose chase, leapfrogging from Section 401 to 106 to 1402 to 162(l) without ever finding a definitive answer. Such wayward wondering is responsible for many of the creative — albeit incorrect — tax return presentations of these items I’ve witnessed over the years.

But with a little digging, you’ll find that the IRS has wrapped these seemingly complicated issues up with a nice neat bow, eliminating any of the confusion that might otherwise exist. Revenue Ruling 91-26 covers the two situations posited above, and reaches the following conclusions:

Situation 1: The payment by AB, LLC of health insurance premiums on behalf of partners A and B are treated as guaranteed payments,[i] deductible by the partnership.[ii] A and B must then report the premiums paid on their behalf as guaranteed payment income on their individual tax returns.[iii] A and B can then deduct the premiums on Page 1 of their Form 1040 as self-employed health insurance.[iv]

Alternatively, Revenue Ruling 91-26 provides that AB, LLC may also treat the health insurance premiums paid on behalf of A and B as distributions. In this case, AB, LLC receives no deduction for the payments, but A and B may still deduct the cost of the premiums on Page 1 of their Form 1040 as self-employed health insurance.

Situation 2: Because Section 1372 provides that for purposes of the fringe benefit rules, any person who owns more than 2% of stock in an S corporation is treated as a partner in a partnership, the Ruling reaches the same conclusion as that found in Situation 1: CD, Inc. is entitled to deduct the cost of the health insurance premiums paid on behalf of C and D as part of the compensation paid to C and D. In turn, C and D, like partner A and B above, are required to include the value of the premiums in their respective wages.[v] C and D may then deduct the premiums paid on their behalf on Page 1 of their Form 1040 as self-employed health insurance.[vi]

As opposed to Situation 1, however, CD, Inc. may nottreat the premiums as distributions to C and D.


[i] I.R.C. § 707(c).
[ii] I.R.C. § 162(a). Note, the partnership level deduction should not be specially allocated to the partners on whose behalf the premiums were paid.
[iii] While I.R.C. § 106 generally excludes from the income of an employee any coverage provided by an employer under a health plan, the premiums paid on behalf of a partner is not excludible, because the benefit is treated as a distributive share of partnership income for purposes of the fringe benefit rules, and a partner is treated as self employed to the extent of his distributive share. Note, the guaranteed payment income should be specially allocated to A and B based on their respective share of premiums paid.
[iv] I.R.C. § 162(l). Subject to limitation.
[v] This is often where things go awry, as tax advisers don’t realize that in the S corporation setting, the health insurance premiums paid by the corporation must be included in a W-2.
[vi] See I.R.C. § 162(l)(5)(A), which provides that a 2% shareholders wages are treated as “earned income” for purposes of I.R.C. § 401(c), which qualifies them for the self-employed health insurance deduction.

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After the latest round of tax reform one-upmanship displayed by the presidential candidates — specifically President Obama revealing his plan to cut the corporate rate to 28% and Mitt Romney’s promise to chop individual rates by 20% across the board  — we can once again update our side by side comparison of the tax proposals floated by President Obama, Newt Gingrich, Mitt Romney, and Rick Santorum.

So with the caveat that these promises are subject to change every time a candidate gets tongue-tied during a debate, click here for a PDF of the comparison: 2012 Presidential Candidates – The Tax Proposals

Alternatively, below are JPEGs. Click to enlarge.

Page 1

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Covering President Obama’s recent tax proposals has given me a firm appreciation for what it must have been like to be a sports reporter during the latter stages of Brett Favre’s career, when journalists breathlessly covered whether he would retire or continue playing, despite the fact that everyone knew damn well Favre would show up to camp a week late and start another 16 games. And what I’ve learned is this: it’s a rather empty feeling to spend day after day analyzing a story the ending to which was preordained before it even began.

But that’s where we are with tax reform in this country. Everything is happening, but nothing’s happening. Last week the president unveiled his plans for individual tax reform, and today it’s corporate tax reform, but regardless of what’s said or written, we all know nothing will be passed unless the president wins re-election, and even then these proposals — as currently constructed — are a long-shot to ever become law.

Anyhoo, what follows is a summary of President Obama’s appeal for corporate tax reform, released today. And while the headlining proposal — the promise to reduce the maximum corporate tax rate to 28% —  is likely to win some appreciation from the Republican party, there are enough high-profile revenue raisers in the plan, such as the elimination of tax preferences for the oil and gas industry and the imposition of a “minimum tax” on a U.S. corporation’s worldwide profits, to guarantee that the president’s corporate proposals will be shelved right along with his plan for individual tax reform until after the election.

The president’s plan can be separated into three distinct categories: general corporate reform, manufacturing industry reform, and international reform.  

General Corporate Reform

While the president’s pitch to lower the maximum corporate tax rate from 35% to 28% is sure to get the most publicity, understand that the intention is for this lost revenue to be paid for by broadening the tax base, i.e.., eliminating deductions. The president (correctly) points out that our current tax system — replete with innumerable deductions, exclusions and preferences — benefits certain industries over others. Take a gander at the following table, which illustrates the effective tax rate paid by different industries in 2007 and 2008, even though they were all subject to the same 35% marginal rate:

 

The president believes that while eliminating deductions and preferences, care should be taken to equalize the benefits of the code across all industries.  To that end, he has placed a number of provisions on the chopping block, calling for the following changes:

  •  Elimination of “Last in first out” accounting. Under the “last-in, first-out” (LIFO) method of accounting for inventories, it is assumed that the cost of the items of inventory that are sold is equal to the cost of the items of inventory that were most recently purchased or produced. This allows some businesses to artificially lower their tax liability.
  • Elimination of oil and gas tax preferences. The president’s framework would repeal the expensing of intangible drilling costs, and percentage depletion for oil and natural gas wells. .
  • Reform treatment of insurance industry and products The president’s framework would close this loophole and not allow interest deductions allocable to life insurance policies unless the contract is on an officer, director, or employee who is at least a 20 percent owner of the business.  
  • Taxing carried (profits) interests as ordinary income. The framework would eliminate the loophole for managers in investment services partnerships and tax carried interest at ordinary income rates.
  • Eliminate special depreciation rules for corporate purchases of aircraft. This would eliminate the special depreciation rules that allow owners of non-commercial aircraft to depreciate their aircraft more quickly (over five years) than commercial aircraft (seven years).
  • Addressing depreciation schedules. Current depreciation schedules generally overstate the true economic depreciation of assets.
  • Reducing the bias toward debt financing. Reducing the deductibility of interest for corporations should be considered as part of a reform plan. This is because a tax system that is more neutral towards debt and equity will reduce incentives to overleverage and produce more stable business finances, especially in times of economic stress.

 Manufacturing Industry Reform

 While the president asserts that all industries should be treated equally, the plan then goes on to bestow certain preferences specifically on the manufacturers by proposing the following:

  •  Effectively cutting the top corporate tax rate on manufacturing income to 25 percent and to an even lower rate for income from advanced manufacturing activities by reforming the domestic production activities deduction. The president’s framework would focus the current I.R.C. § 199  deduction more on manufacturing activity, expand the deduction to 10.7 percent, and increase it even more for advanced manufacturing. This would effectively cut the top corporate tax rate for manufacturing income to 25 percent and even lower for advanced manufacturing.
  •   Expand, simplify and make permanent the R&D Tax Credit. The president’s framework would increase the rate of the alternative simplified  credit to 17 percent.  
  •  Extend, consolidate, and enhance key tax incentives to encourage investment in clean energy.

International Reform

It is in the international arena that the president’s proposals most deviate from those of his Republican counterparts. While Mitt Romney and Newt Gingrich have loudly called for a move to a “territorial” tax system, whereby U.S. corporations would only pay tax on U.S. income, leaving other nations to trust foreign profits, President Obama wants to expand the current corporate tax regime to tax profits earned by foreign affiliates of U.S. corporations before they are repatriated to the U.S. This is sure to be a sticking point in any future negotiations, as some powerful lobbies will not take kindly to the idea of a minimum international tax rate.

 The president’s proposals include the following:

  •  Require companies to pay a minimum tax on overseas profits. Specifically, under the President’s proposal, income earned by subsidiaries of U.S. corporations operating abroad must be subject to a minimum rate of tax. This would stop our tax system from generously rewarding companies for moving profits offshore. Thus, foreign income deferred in a low-tax jurisdiction would be subject to immediate U.S. taxation up to the minimum tax rate with a foreign tax credit allowed for income taxes on that income paid to the host country. This minimum tax would be designed to balance the need to stop rewarding tax havens and to prevent a race to the bottom with the goal of keeping U.S. companies on a level playing field with competitors when engaged in activities which, by necessity, must occur in a foreign country.
  • Remove tax deductions for moving productions overseas and provide new incentives for bringing production back to the United States. The President is proposing that companies will no longer be allowed to claim tax deductions for moving their operations abroad. At the same time, to help bring jobs home, the President is proposing to give a 20 percent income tax credit for the expenses of moving operations back into the United States.
  •  Other reforms to reduce incentives to shift income and assets overseas. The Framework would strengthen the international tax rules by taxing currently the excess profits associated with shifting intangibles to low tax jurisdictions. In addition, under current law, U.S. businesses that borrow money and invest overseas can claim the interest they pay as a business expense and take an immediate deduction to reduce their U.S. taxes, even if they pay little or no U.S. taxes on their overseas investment. The Framework would eliminate this tax advantage by requiring that the deduction for the interest expense attributable to overseas investment be delayed until the related income is taxed in the United States.

Of course, the chess match continues. In response to the president’s plan for corporate reform, the rise of Rick Santorum, and his recent slip in the polls, Mitt Romney changed his stance on the maximum individual tax rate today, proposing to reduce it to 28% (as part of a 20% cut of all rates across the board) as opposed to simply extending the Bush tax cuts (which contain a 35% maximum tax rate), as he’d proposed earlier in his campaign. Romney also went on to promise a free Chalupa to anyone who votes for him.* Desperation, as they say, is a stinky cologne.

*this may not have happened

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It’s going to be a busy day in the tax world, as President Obama will be unveiling  his long-awaited  proposal for corporate tax reform in a few hours. Expected to be included among the proposals are the following:

  • A reduction in the corporate tax rate from 35% to 28%;
  • A modification to Section 199 to ensure that U.S. manufacturers pay no more than a 25% effective tax rate;
  • Elimination of up to a dozen tax deductions currently available;
  • Renewal of the R&D credit under Section 41; and
  • The addition of a “worldwide minimum tax” to ensure that U.S. corporations that move operations offshore pay tax on its overseas profits.

It’s important to note, while the 7% reduction in the corporate tax rate may look universally appetizing, for those corporations that currently take advantage of many of the tax preferences on the chopping block, they may actually see their effective tax rate increase as a result of the lost deductions. Those corporations — typically in the technology and pharmaceutical fields — likely will not be on board with the proposed changes.

In general, however, corporate tax reform is one of the few areas where Republicans and Democrats may be able to find some common ground, as it is widely recognized that the current corporate tax regime is putting the U.S. at a competitive disadvantage with other nations.

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In December 2010, an Iowa district court decided Watson, a reasonable compensation case involving an S corporation shareholder-employee. For a primer on why reasonable compensation is a frequently litigated issue with regards to closely held S corporations, click here.

Watson, in many respects, was a precedent-setting case in the S corporation reasonable compensation arena, as it shed much-needed light on the methodology the IRS and the courts will employ to determine reasonable compensation, providing an analytical approach tax advisers could follow when guiding their clients.

Today, the Eighth Circuit affirmed the district court’s decision in Watson, holding that an S corporation shareholder-employee (Watson) who paid himself only $24,000 in salary during 2002 and 2003 while withdrawing over $375,000 in distributions was not reasonably compensated for his services. The court further upheld the district court’s determination of an annual reasonable compensation amount of $93,000, requiring Watson to recharacterize $69,000 of distributions in each year as salary. As a result, the corporation and Watson were held liable for over $23,000 in payroll taxes, penalties, and interest.

Facts in Watson:  

David Watson — like many of the subjects of reasonable compensation scrutiny — was a CPA.[1] He was also the sole shareholder and employee of an S corporation, which in turn was a 25% shareholder in a very successful accounting firm. Watson’s share of the revenue generated by the accounting firm was allocated to his S corporation, which would then pay Watson a salary and distributions. Any amounts not paid out in salary by the corporation were reported by Watson as his share of the S corporation’s income on his personal tax return, where it was not subject to payroll tax.[i]

In 2002 and 2003, Watson set his compensation from his wholly owned corporation at a mere $24,000 per year, an amount that was less than what first-year employees at his firm were earning.  In comparison, Watson received distributions of $203,651 and $175,470, respectively, in those years.

The IRS challenged Watson’s compensation as being unreasonably low; arguing that by foregoing salary in favor of distributions, Watson and the S corporation were avoiding payroll tax responsibilities.

Significance of Watson

In nearly all of the S corporation reasonable compensation cases that preceded Watson, the shareholder-employee failed to take any salary but withdrew distributions, leaving the IRS and the courts the simple task of reclassifying  the distributions as compensation for services.  

Because Watson actually reported compensation of $24,000 in each of the years in question, however, the Iowa District Court and the Eighth Circuit was faced with an issue of first impression: quantifying just what constituted “reasonable compensation” for Watson’s services. The resulting analysis provided the first court-approved roadmap for tax advisers to use in setting appropriate salary amounts for their S corporation shareholder-employee clients.

IRS Approach, District Court Decision

In setting Watson’s salary, the IRS engaged the services of a general engineer, who testified that based on the health of the accounting firm and the compensation of Watson’s peers in the industry, his compensation was unreasonably low.

To quantify the appropriate salary, the engineer utilized MAP surveys conducted by the AICPA, which indicated that the average non-owner director of a CPA firm the size of Watson’s would be paid $70,000. The engineer then grossed up this salary by 33% to account for Watson’s stake as a shareholder,[ii] resulting in “reasonable” compensation of $93,000 for each of 2002 and 2003.

The District Court agreed, citing Watson’s experience, expertise, and time devoted to his role as one of the primary earners at a well-established firm.

Eighth Circuit Decision

Today, the Eighth Circuit affirmed the holding of the district court. In reaching its decision, the court concluded that the characterization of funds distributed by an S corporation to its shareholder-employees turns on the analysis of whether the payments were made as compensation for services, not on the intent of the S corporation in making the payments. [iii]

The Eighth Circuit did briefly address Watson’s argument that his reasonable compensation should be capped at the revenue he personally generated for the CPA firm, less his allocable expenses. While the court admitted that evidence of shareholder billings may be probative on the issue of compensation, the Eight Circuit ultimately refrained from adjusting the previous calculation of Watson’s reasonable compensation performed by the IRS.  

What Can We Learn?

For tax advisers, the Eighth Circuit’s decision should reinforce the lessons taken home from the original Watson decision. The IRS is taking a formal, quantitative approach towards determining reasonable compensation, so to adequately advise our clients, we must be prepared to do the same thing.

At a minimum, in setting the compensation of our S corporation shareholder-employee clients, we must consider the following (note, all of these considerations are discussed in much greater detail in this PDF: Tax Adviser – S Corporation Shareholder-Employee Reasonable Compensation):

1. Nature of the S Corporation’s Business. It is no coincidence that the majority of reasonable compensation cases involve a professional services corporation, such as law, accounting, and consulting firms. It is the view of the IRS that in these businesses, profits are generated primarily by the personal efforts of the employees, and as a result, a significant portion of the profits should be paid out in compensation rather than distributions.

2. Employee Qualifications, Training and Experience, Duties and Responsibilities, and Time and Effort Devoted to Business. A full understanding of the nature, extent, and scope of the shareholder-employee’s services is essential in determining reasonable compensation. The greater the experience, responsibilities and effort of the shareholder-employee, the larger the salary that will be required.

3. Compensation Compared to That of Non-shareholder Employees or Amounts Paid in Prior Years.  Here, common sense rules the day. In Watson, a CPA with significant experience and expertise was  paid a smaller salary than recent college graduates. Clearly, this is not advisable.

4. What Comparable Businesses Pay for Similar Services. Tax advisors should review basic benchmarking tools such as monster.com, salary.com, Robert Half, and Bureau of Labor Statistics wage data to determine the relative reasonableness of the shareholder-employee’s compensation when compared to industry norms.

5. Compensation as a Percentage of Corporate Sales or Profits. Tax advisors should utilize industry specific publications such as the MAP to determine the overall profitability of the corporation and the shareholder-employee’s compensation as a percentage of sales or profits. Whenever possible, comparisons should be made to similarly sized companies within the same geographic region. If the resulting ratios indicate that the S corporation is more profitable than its peers but paying less salary to the shareholder-employee, tax advisors should determine if there are any differentiating factors that would justify this lower salary, such as the shareholder’s reduced role or the corporation’s need to retain capital for expansion. If these factors are not present, an increase in compensation to the industry and geographic norm provided for in the publications is likely necessary.

6. Compensation Compared With Distributions. While large distributions coupled with a small salary may increase the likelihood of IRS scrutiny, there is no requirement that all profits be paid out as compensation. Though the District court in Watson recharacterized significant distributions as salary, it permitted Watson to withdraw significant distributions in both 2002 and 2003. Perhaps the court was content to recharacterize just enough distributions to ensure that Watson’s compensation exceeded the Social Security wage base in place for the years at issue.[iv] In doing so, the payroll tax savings on Watson’s remaining distributions amounted only to the 2.9% Medicare tax.

[1] See Joseph M. Grey.
[i] See Rev. Rul. 59-221.

[ii] The MAP revealed that in general, shareholders billed at a rate 33% higher than non-owner directors.

[iii] Watson tried to argue that it was the intent of the S corporation to pay him only $24,000 for his services, with the remaining cash to be distributed based on the CPA firm’s success, a fact both courts found highly implausible given Watson’s experience and expertise.

[iv] $84,900 in 2002 and $87,000 in 2003.

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In a case decided earlier today, the Supreme Court held that a husband and wife who were Japanese citizens but lawful residents of the U.S. could be deported after pleading guilty to filing a false tax return.

Mr. and Mrs. Kawashima, seeking refuge from the repeated Godzilla attacks that plague their homeland, fled Japan and became legal permanent residents of the U.S. in 1984. Ten years later, Mr. Kawashima completed the process of assimilating into our society and becoming a “true” American by egregiously cheating on his taxes. He pled guilty to filing a false return under I.R.C. § 7206(1), while his wife pled guilty to aiding and assisting in the filing of a false return under I.R.C. § 7206(2).

I.R.C. §§ 7206  provides that willfully filing a false tax return is a felony. The issue at hand for the Supreme Court, however, was whether a conviction under these sections constituted an “aggravated felony” under the immigration laws, punishable by deportation.

An aggravated felony is one that either:

Clause #1: Involves fraud or deceit in which the loss to the victim or victims exceeds $10,000; or

Clause #2:  Is described in I.R.C. § 7201 (relating to tax evasion) in which the revenue loss to the government exceeds $10,000.

The Kawashimas argued that their conviction for filing a false return failed to meet the standard of an aggravated felony for three reasons:

1. Clause #1 did not apply to their crime, as I.R.C. § 7206 does not contain the words “fraud” or “deceit,”

2. Clause #1 was not intended to cover tax crimes, as that was solely the responsibility of Clause #2, and

3. Since Clause #2 was specific to tax evasion under I.R.C. § 7201, it did not cover their conviction under I.R.C. § 7206.

In its 6-3 decision, the Supreme Court shot down all three arguments, holding that the Kawashimas’ previous conviction qualified as an aggravated felony under Clause #1, as it involved fraud — even if fraud was not an express requirement of the statute — and the loss to the government exceeded $10,000. So sadly, it’s back to Japan for the Kawashimas.

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