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Archive for April, 2011

While perusing a New York Times blog post about the motivating factors behind taxpayer compliance, I stumbled upon this rather interesting chart prepared by Oscar Vela as part of a previous Ph.D. dissertation on “Tax Compliance and Social Values” (click to enlarge)

Integrity and Tax Compliance by Occupational Groups

 

Dr. Vela found that the occupations where integrity was particularly valued (like legal and education) were the same industries with the greatest degree of tax compliance, measured as the fraction of business income that went underrported in an IRS special compliance study. In simpler terms, those industries where the public demanded honesty tended to file the most honest tax returns. [Insert joke reflecting incredulous reaction to attorneys being honest here]

On the other end of the spectrum, the construction and building maintenance industries lived up to the public’s image of them as dishonest cheats by dishonestly cheating and misreporting nearly 40% of their taxable income.

Take what you will from this, since as Homer Simpson once said, “Facts are meaningless. You can use facts to prove anything that’s even remotely true.” But it would certainly appear that when it comes to determining who cheats on their taxes, perception dictates reality.

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From USA Today, the IRS issued a $4.5 million check to an accountant who tipped off the Service that his employer had avoided nearly $20 million in taxes.

The IRS has established a whistle-blower award program, offering tattletales squealers tipsters 15% to 30% of the amount recovered by the IRS.

According to the lucky accountant’s attorney, “It’s very difficult to be a whistleblower. Most people are inclined to turn a blind eye to it. The process can be time-consuming, arduous, and stressful, from both a personal and professional standpoint.”

Just for the record, as a CPA, tax season can also be time-consuming, arduous, and stressful, from both a personal and professional standpoint, and nobody is handing me a check for $4.5 million when it’s over. For that kind of money, I’d sing like a canary.

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For the second time in two weeks, the Tax Court denied a sizeable charitable contribution deduction ($6.5M) on the donation of an easement to the National Architectural Trust (“NAT”).

The NAT, a qualified organization for contribution purposes under Section 170(h)(3), runs a federal historic preservation tax incentive program that offers to “handle all the red tape and paperwork” necessary to earn the donor a contribution deduction of 10-15% of the value of a nationally registered historic building upon the donation of an easement.

Last week, in Kaufman v. Commissioner, 136 T.C. 13 (April 4, 2011), and today in Asser v. Commissioner, T.C. Memo 2011-84,  the court denied such contributions on the basis that the contributions failed to comply with the enforceability-in-perpetuity requirement of Treas. Reg. Section 1.170-14. 

In both donations, the building was mortgaged, and the lender agreement permitted the mortgagor to retain a prior claim to all condemnation proceeds in preference to NAT until they recovered the balance of the mortgage. This violates the requirement of Treas. Reg. Section 1.170-14(g)(6) that the contribution be protected in perpetuity because the NAT was not guaranteed a proportionate share of proceeds in the event of casualty or condemnation.

As pointed out by the court, if the donated property was destroyed and had no significant value remaining after the mortgage was satisfied , the right of NAT to a share in the future proceeds would not be guaranteed. As a result, no charitable contribution was permitted.

Now, I’m not one to point fingers, but I imagine there are currently at least two taxpayers a tad ticked off at NAT’s inability to “handle all the red tape.”

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Let’s say X Co. pays $10,000,000 to purchase the stock or assets of Y Co. Prior to closing on the transaction, X Co. utilizes attorneys to structure the deal, CPAs to advise on the tax implications, and an investment banking firm to help find Y Co.

Once the deal is consummated, X Co. pays a $500,000 fee to the investment bank as a success-based fee.

Why do you care about any of this?

Treasury Regulation S1.263(a)-5 provides that a taxpayer must capitalize any amount paid “to facilitate a business acquisition or reorganization transaction.” In general, an amount is paid to facilitate a transaction if the amount is paid in the process of investigating or otherwise pursuing the transaction.

These regulations also provide that an amount that is contingent on a successful transaction — such as X Co.’s $500,000 payment to the investment bank — is presumed to facilitate the transaction. X Co. is permitted to rebut this presumption and allocate a portion of the $500,000 fee to non-facilitative and potentially deductible expenses, but the regulations require that onerous documentation requirements be met to prove the costs were incurred for deductible purposes.

Last week, the IRS threw taxpayers a bone and greatly simplified the treatment of these success-based fees. Revenue Procedure 2011-29 provides a friendly safe harbor, allowing taxpayers to treat 70% of their success-based fee as deductible costs that do not facilitate the transaction, provided the remaining 30% is treated as facilitating the transaction and capitalized.

In our example above, rather than X Co. having to either 1) capitalize the entire $500,000 success-based fee, or 2) hope their documentation of the services performed by the investment bank is sufficient to support an allocation between deductible and non-deductible costs, X Co. can now simply elect to deduct $350,000 of the $500,000 fee and capitalize the remaining $150,000, with no onerous record-keeping necessary.

The safe harbor is effective for success-based fees paid or incurred in taxable years ending on or after April 8th, 2011. In order to elect the safe harbor, the taxpayer must attach a statement to its tax return for the year the success-based fee is paid or incurred, stating that the taxpayer is electing the safe harbor, identifying the transaction, and stating the success-based fee amounts that are deducted or capitalized.

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While not quite the prevalent practice it was during the internet boom of the late 1990’s, compensating employees through the issuance of stock options is still a popular tax planning technique. So what makes it so attractive?

Assume Employee A provides services for X Co. To reward A for his services, X Co. grants A 1,000 shares of stock options with a value and exercise price on the date of grant of $10. The options vest immediately, so A can exercise them at his leisure. Let’s assume these options  are non-qualified stock options.

Generally, the grant of an option is not a taxable event provided the stock did not have a readily ascertainable FMV on that date. Instead, A will not have a taxable event until he chooses to exercise the options and purchase the underlying 2,000 shares, at which point he will recognize compensation income equal to the excess of the FMV of the stock on the exercise date over the $10,000 exercise price. In summary, A controls the timing of his compensation income, and can plan accordingly. This is precisely why options can be a great form of compensation.

What happens, however, if upon exercise, A cannot sell the underlying shares due to a restriction on transferability?

Section 83 governs the treatment of restricted property, which includes options, warrants, and other restricted stock issued “in connection with the performance of services.” If restricted property received is 1) subject to a substantial risk of forfeiture, and 2) not freely transferable, Section 83 defers the taxation of the restricted property until the stock is no longer subject to a substantial risk of forfeiture and is freely transferable.

What’s the point? Here, Congress is doing the taxpayer a favor by attempting to match up the timing of the income recognition with the ability of the taxpayer to sell the stock, if necessary, to pay the resulting tax.

Pursuant to the regulations, one of the examples of stock that is not freely transferable is stock that cannot be sold within six months of purchase by a corporate insider, if that sale could subject the insider to suit under Section 16(b) of SEC law. The purpose of 16(b) is to prevent insiders from capitalizing on their access to information to turn a healthy profit on the sale of their stock. Since the stock cannot be sold within six months of its purchase, Section 83 defers the income recognition by A until the Section 16(b) restriction lapses, at which time A will recognize compensation equal to the FMV at that time less the exercise price.

Last week, the Ninth Circuit faced the uneviable task of interpreting the interplay between the Internal Revenue Code and securities law for one very important purpose, to determine when stock options are treated as having been purchased for purposes of Section 16(b),  upon grant or vesting. As discussed above, it is the purchase that will start the clock on the six month restriction window and the related income deferral period.

For the taxpayer in Strom v. U.S., 107 AFTR 2d 2011-684  (9th Cir., 2011) this purchase date meant the difference between deferral and the current recognition of income. Strom was granted stock options subject to a vesting schedule and Section 16(b) restrictions. If the purchase date was held to be the moment when the options vested, Strom could defer the income until six months after the last round of  shares vested, even if she had already exercised them. To the contrary, if the purchase date was held to be the grant date, Strom had to recognize the income immediately upon exercise, since it was outside the six-month window starting on the grant date. 

The Ninth Circuit, after delving into Section 16(b), determined that the SEC treated the purchase date of options as being the date of grant, not the date of exercise. As a result, Strom had to recognize the compensation income immediately upon exercise, since it was more than six months from the date of grant.

Strom was the first such case to take on this issue, so at least for those taxpayers whose appeal would lay in the Ninth Circuit, it provides the authority that the six-month Section 16(b) window will start upon the grant of stock options, not upon their vesting.

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Courtesy of Businessweek, How to Pay No Taxes, in which the author profiles “Eleven shelters, dodges, and rolls — all perfectly legal — used by America’s Wealthiest People.” 

It’s an interesting read, no doubt, but do note that it’s tempered with “caveat emptors” warning that some of the suggested transactions are currently or have previously been the subject of IRS scrutiny or litigation. 

Of particular interest is #7, “The Friendly Partner.” In this tip, the author extols the virtues of the so-called “leveraged partnership” which he describes as follows:

An investor owns a piece of income-producing real estate worth $100 million. It’s fully depreciated, so the tax basis is zero. That means a potential (and unacceptable) $15 million capital-gains tax.

1. Instead of an outright sale, the owner forms a partnership with a buyer.

2. The owner contributes the real estate to the partnership. The buyer contributes cash or other property.

3. The partnership borrows $95 million from a bank using the property as collateral. (The seller must retain some interest in the partnership, hence the extra $5 million.)

4. The partnership distributes the $95 million in cash to the seller.

Note: The $95 million is viewed as a loan secured by the property contributed by the seller instead of proceeds from a sale. For tax purposes, the seller is not technically a seller, and so any potential tax bill is deferred.

What the author fails to mention, however, is a little case called Canal Corp. v Commissioner, 135 T.C. No. 9 (August 5, 2010). In Canal, the Tax Court blew up a leveraged partnership transaction, resulting not only in the triggering of $524 million in capital gains, but also a rather hefty $36.7 milllion substantial underpayment penalty.

Without getting into too much detail, in Canal, the Tax Court held that even though the “seller,” technically indemnified the other partner’s borrowing on the loan (#3 in the steps above) — which was designed to give the seller basis in the partnership and allow for the tax-free distribution of the cash — the indemnity had no substance and was done simply to avoid the disguised sale rules of Section 707.

For $36.7 million reasons, I’d be rather careful before I entered into a leveraged partnership transaction, regardless of Newsweek’s recommendation.

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Unemployment is up. The stock market is down.

We know these things to be true, but the Statistics of Income Bulletin released today by the IRS — which compares 2009 individual income tax return data to 2008 — really drives home just how much Americans are struggling in the current economic climate. Some high low-lights include:

  • In 2009, 140.5 million tax returns were filed. While I have no empirical evidence to support this, based solely on the way the past month has felt, I”m fairly confident my firm prepares each and every last one of them.
  • Taxable interest was down 24.8 percent from 2008, a reflection that savings have been accessed to pay for living expenses.
  • As further support for this hypothesis, deductible penalties on the early withdrawal of savings increased by 302%!
  • Ordinary dividends were down 25%
  • Capital gains were down a remarkable 46%, while capital gain distributions decreased 89% from 2008 to 2009.
  • Rental income decreased 33.2% as reliable tenants became hard to find, and lessors were forced to lower their rental rates.
  • Taxable unemployment income increased 91.5%! Keep in mind, this is after accounting for the fact that in 2009, the first $2,400 of unemployment income was tax-free.

Not all components of income were down  from 2008 to 2009, however, but that doesn’t mean there was any good news to share. In 2009, taxable pension and annuity income increased by 3.1%, as many American’s were forced to access their retirement funds to weather the storm.

Scary data, certainly. What will be most telling, of course, is how 2010 ends up comparing to 2009.

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