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Posts Tagged ‘ceo’

In celebration of both 150 years of tax law and graphics crammed with too much information, enjoy this little number put together by Turbo Tax.  Noticeably absent from the listing: March 2, 1928: the date Tom and Mary Hardwick from Lake Oswego, Pennsylvania deducted $80 of charitable contributions they never actually made and got away with it.  A dark day for the U.S. tax regime, indeed.

            

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Last week, in our reactions to President Obama’s proposal for corporate tax reform, we took special note of the president’s continued push towards a  “worldwide” international tax system; one  that greatly expands the reach of the U.S. in taxing non-U.S. sourced income earned by foreign subsidiaries.

Most notably, we highlighted just how dramatically the president’s proposal deviates from those posited by the leading Republican candidates, who favor the “territorial” systems adopted by much of the developed world.

But what do “worldwide” and “territorial” international systems really mean? How do they compare to our current system? And more importantly, how would they change the way the U.S. currently taxes the icnome earned by foreign subsidiaries of domestic corporations?

To illustrate, let’s take a simple fact pattern:

X Co. is a U.S. corporation. X Co. owns 100% of Foreign Co., a foreign corporation that generates no revenue from U.S. sources.

How is Foreign Co.’s income taxed by the U.S. under either:

1) The current “deferral” international tax system?

2) The “territorial” tax system proposed by Mitt Romney and Newt Gingrich?

3) A more expansive “worldwide” tax system as proposed by President Obama.

Current  “Deferral” Tax System

Under the current system, there is generally no U.S. tax imposed upon the earnings of Foreign Co. until the earnings are repatriated to the U.S through a distribution to X Co. At that point, X Co. will pay U.S. tax on the dividend received from Foreign Co., subject to any tax treaty between X Co. and Foreign Co.’s resident nation.

Upon receiving the dividend, X Co. is permitted to utilize a foreign tax credit to reduce the U.S. tax applied to the dividend, preventing the same income from being taxed twice: once when earned by Foreign Co. and a second time when distributed to X Co.

Pros:

  • The current “foreign tax credit” system ensures that even where Foreign Co. enjoys a lower tax rate in its home nation, tax will ultimately be imposed on the earnings of Foreign Co. at the U.S. corporate rate;
  • U.S. tax is not imposed upon income earned by F Co. until the earnings are repatriated to the U.S.

 Cons:

  •  An administrative nightmare;
  • Encourages X Co. to leave Foreign Co.’s profits offshore to avoid the imposition of U.S. taxes upon repatriation;
  • Gives birth to a wide variety of accounting tricks and sophisticated tax planning measures employed to minimize the U.S. tax burden, which ultimately reduce U.S. tax revenue.

Territorial Tax System

Under a territorial tax system, U.S tax would never be imposed on income earned by Foreign Co. from non-U.S. sources. The U.S. would simply allow Foreign Co.’s home country to tax its earnings. When Foreign Co.’s earnings are subsequently repatriated to X Co., the dividends would not be subject to U.S taxation.  

Pros:

  • Greatly reduces the complexity of international taxation;
  • Eases the administrative burden on multinational corporations;
  • By eliminating the U.S. tax on repatriated foreign earnings, U.S. companies will no longer have to pay to bring overseas income “home,” thus encouraging investment in the U.S.

Cons:

  • Encourages U.S. corporations to shift activities to jurisdictions with lower corporate tax rates, taking jobs and revenue along with them and eroding the U.S. tax base.
  • Transition concerns; What do you do with the foreign income that was previously earned but not yet repatriated to the U.S.?  

A More Expansive Worldwide Tax System

President Obama is proposing a sea change in the way the U.S. taxes international operations; one which embodies the opposite characteristics of the system proposed by his Republican counterparts. The president would eliminate the current laws that permit domestic corporations to defer U.S. tax on Foreign Co.’s earnings until they are repatriated by instituting a worldwide minimum tax. This tax would be imposed on Foreign Co.’s income when earned, regardless of whether it was U.S. sourced or when it is repatriated.

Pros:

  • More tax revenue for us!
  • Does not distort the decision of where to invest.
  • Eliminates incentive to game the system, since the U.S. will tax Foreign Co.’s earnings, wherever they may be.

 Cons:

  • Makes the existing administrative nightmare even worse;
  • I’m not sure if this is a pro or con, but it is the opposite system that much of the developed world is adopting, potentially putting us at a competitive disadvantage.
  • Is sure to be highly opposed by powerful corporations that have successfully shifted much of their earnings overseas under the current regime.

Which system is the best? It’s nearly impossible to say at this point, because under no scenario would the U.S. adopt a pure territorial or worldwide international tax system. Any territorial system would have to adopt elements of a worldwide system to curb abuses, and vice versa. As indicated above, there are advantages and disadvantages to each of the options, and ultimately, the devil will be in the details.

This much is clear, however; the chasm that exists between the proposals fronted by President Obama and the Republican candidates is material and meaningful, and stands to garner more attention as November nears.

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Willie Moore (Moore) spent his 9-5 as a system support analyst for the city of Houston. On the side, Moore started a used car dealership, and for the first year the dealership was in existence, he attached a Schedule C to his tax return reflecting no revenue and $35,000 in expenses.  

The IRS disallowed the $35,000 loss incurred by the dealership, and the Tax Court upheld the disallowance. The court did so despite acknowledging that most of the expenses were legitimate, substantiated costs necessary to get the dealership off the ground.  

So then, why were the expenses disallowed?

Because in general, when a taxpayer incurs expenses in forming a Schedule C business or separate corporation (together, “a business,”)  those costs create an asset with a life longer than one year, i.e., the business. And as a basic tenet of tax law, those types of expenses must be capitalized. Making matters worse, because a business does not have a readily determinable lifespan, barring a statutory exception, these initial expenses would not be eligible for amortization.

And though Congress granted a reprieve with the enactment of Code Sections 248 (dealing with organizational costs) and 195 (dealing with start-up costs.) — which allow a new business to elect to expense or amortize costs that would otherwise go unamortized — each of these sibling sections contains a triggering date that signals the appropriate time to deduct the expense or begin the amortization. Attempt to deduct these costs prior to that triggering date — as Willie Moore did — and you face disallowance at the hands of the IRS.

Organizational Costs

Think of organizational costs as the expenses that give birth to a new business, such as legal services to draft corporate charters, by-laws, and articles of incorporation, accounting and consulting services incurred to choose the entity type, and expenses of initial meetings of directors and shareholders.

As discussed above, absent I.R.C. § 248, these expenses would be required to be capitalized and would not be eligible for amortization, as they create an asset with an indefinite life. Under I.R.C. § 248, however, up to $5,000 of organizational costs can be deducted in the year the taxpayer begins business. This deduction is reduced for every dollar the total organizational expenditures exceed $50,000, and any remaining expenses are amortized over a 15-year period beginning with the month in which the taxpayer begins business.[i]

As emphasized above, organizational costs cannot be deducted or amortized until the taxpayer “begins business;” a date that is separate and distinct from that on which the taxpayer comes into existence. For example, while a corporation comes into existence on its date of incorporation, it doesn’t “begin business” until it starts the operations for which it was organized. The regulations provide that in general, the acquisition of operating assets which are necessary to the type of business contemplated should constitute the beginning of business.

Start-Up Costs

Start-up costs, on the other hand, are the next expenses incurred as part of the business life cycle; they are incurred after a business is born, but before it begins its “active trade or business.” As with organizational costs, these expenses are considered to be part and parcel with creating the business, and thus would not be deductible or amortizable in the absence of I.R.C. § 195.

Typical start-up costs upon the creation of a new business include initial advertising and marketing costs, salaries and benefits prior to starting production or generating revenue, initial accounting and legal fees beyond those incurred as part of the organizational process, and rent and utilities in the pre-opening phase.

Given those examples, perhaps its best to simply default to treating all expenses incurred by a corporation prior to starting an “active trade or business” as falling within the gambit of Section 195.[ii]  

Like organizational costs, upon election a corporation my deduct up to $5,000 of start-up costs (phased out for each dollar total start-up costs exceed $50,000), and amortize the remaining costs over 15 years beginning with the first year in which the taxpayer beings an “active trade or business.”[iii]  .

Also similar to organizational costs, the real crux of applying I.R.C. § 195 is determining on what date to begin deducting or amortizing the expenses. The regulations offer little help in clarifying when an “active trade or business” begins,  and thus the determination of when to begin amortizing start-up costs has been frequently litigated.

In general, the courts have established that it is reasonable to mark the taxpayer’s start of its active trade or business in part based on the nature of its business. For example, the courts have held that for a manufacturing business, an active trade or business begins when the taxpayer acquires all necessary assets and places them in service, even if no income has been generated.[iv] To the contrary, the courts take a more stringent view of retail businesses; holding that an active trade or business begins only when the doors are open and revenues are flowing.[v]

What Can We Learn?

Willie Moore was deinied a $35,000 loss on his start-up car dealership not because the expenses incurred were fabricated or unsubstantiated, but rather because they were incurred prior to the date the dealership began its active trade or business, and thus were not yet eligible for deduction or amortization pursuant to Section 195. In denying the expenses, the Tax Court issued a reminder to all taxpayers that just because you’ve “started your business,” it doesn’t mean you’ve started your business. 

[i] No affirmative election is made; the taxpayer is deemed to have made the election by deducting/amortizing the organizational costs in the year business begins.

[ii] Except for interest, state taxes, and R&D expenses, which are excluded from I.R.C. § 195 by statute.

[iii] Also similar to I.R.C. § 248, the election to deduct/amortize is deemed to be made by the taxpayer by treating the costs accordingly on the first tax return on which the “active trade or business” begins.

[iv] Richmond Television v. U.S. 345 F.2d 901 (4th. Cir. 1965).

[v] Kennedy v. Commissioner, T.C. Memo 1973-15

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Certain things, while having the look, sound, and even feel of illegality, are actually within the confines of the law, like cock-fighting, marrying a step-sister, or killing a hobo for sport. Wait…what? OK, scratch that last one. But you get the idea. The law is complicated and convoluted, and what separates the guilty from the accused is often times attributable to puzzling semantics.

Consider this recent Tax Court case, in which an air conditioning technician, despite conducting a pattern of behavior that any reasonable person would coin corporate fraud, successfully avoided over $260,000 in penalties courtesy of the specific nuances of the tax law.  

Paul Avenell (Avenell) owned 96% of a corporation (Tacon). Tacon was sued, lost, and as a consequence, owed significant sums to a former subcontractor. Believing the verdict to be unjust, Avenell filed for bankruptcy and began to divert funds away from the corporation so they couldn’t be accessed by his creditor. As checks came in, he would exchange them for cashier’s checks, which were used to pay both corporate and personal expenses. As a result, the income was never recorded inside Tacon. The IRS assessed tax deficiencies, as well as substantial fraud penalties.

Despite his subversive behavior, the court found that Avenell had not committed tax fraud, because his concealment of income was done with the intent of avoiding judgment collection, rather than with the specific purpose of evading income tax.

Respondent infers that petitioner intended to evade taxes by exchanging general contractor’s checks for cashier’s checks and using those funds for personal purposes, including making a personal loan and opening a Cayman Islands bank account. Respondent further infers fraudulent intent from petitioner’s purchases of real estate in others’ names. Piling inference upon inference, however, does not qualify as clear and convincing evidence.  His inferences fall short of the required proof of fraud by clear and convincing evidence. We cannot conclude that petitioner’s delusive behavior was part of a deliberate scheme of fraudulent tax evasion. Petitioner credibly testified that he refused to deposit funds into Tacon’s account to avoid the judgment collection. The timing of petitioner’s delusive behavior involving cashier’s checks, the Cayman Islands bank account, real property purchases and the personal loan is consistent with that of Grant Metal’s judgment. We do not condone petitioner’s efforts to avoid judgment collection. We also do not find, however, that his actions were done with the intent to evade tax.

Because the underlying tax deficiencies were assessed more than three years from the date the tax returns were filed, the failure of the IRS to prove fraud — which would have extended the statute of limitations indefinitely — permitted Avenell to avoid the assessed tax in addition to the dismissed fraud penalties.

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A few things you may have missed this weekend while getting caught up in the Linsanity in New York:

Bad news for a lot of the country this week. Forbes reported that IRS agents are currently auditing one out of every eight millionaires. Things aren’t any better for the middle class, either, where 30 million taxpayers will pay alternative minimum tax (AMT) this year. The only winners were the very poor, who courtesy of Mitt Romney, learned that there’s a “safety net” in place to protect them. Romney wasn’t kind enough to disclose the location of said net, but I’m sure the poor appreciated the heads-up nonetheless.

IRS computers sent off a letter to a British Lord indicating he owed $13 million in taxes, penalties and interest. The Lord offered to ship Arsenal star Thierry Henry back to the U.S; “call it even.” [i]

You’re in Good Hands With Allstate. Unless Allstate is your employer, that is. In that case, you’re screwed.

The only thing standing between you and an extra $1,000 in  payroll tax savings is bipartisan agreement. Of course, since at this moment in our country’s history Republicans and Democrats can’t agree that water is wet, I wouldn’t go spending that money just yet.

Last week, I neglected to discuss the promulgation of proposed Foreign Account Tax Compliance Regulations (FATCA) regulations, largely because they’re longer than the Old Testament. To summarize, however, it’s another big step towards combating non-compliance by U.S. taxpayers using foreign accounts.

If you’re a product of the 80’s, as I am, then I dare you to find a better way to waste seven minutes of your life than this video. Long live Johnny Lawrence.


[i] Not an actual offer.

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If you’re nearing retirement age, I’m hoping you’ve spent your entire career socking away money into a 401(k) fueled by sound, cautious investment decisions, steering clear of the risky, get-rich-quick options favored by my generation.    

/Shakes fist at jar of magic beans on dresser

But while you’re kicking back and enjoying the fruits of your labor, be warned that your tax troubles aren’t over. Properly reporting the taxable portion of your retirement proceeds has become increasingly challenging, often causing taxpayers to unknowingly understate taxable income.

In a report issued this week by the Treasury Inspector General for Tax Administration (TIGTA), it was disclosed that the IRS has estimated that underreported retirement income added $4.2 billion to the tax gap in 2001.

There is tremendous motivation for the IRS to take steps to increase compliance, as the amount of retirement income reported annually is staggering. In 2008 and 2009, taxpayers filed approximately 21 million tax returns with taxable IRA income totaling $293 billion and approximately 52.2 million tax returns with taxable pension income totaling $1 trillion.

To catch underreporting with minimal manpower, the IRS uses its Automated Underreporter (AUR) Program to match amounts reported on Form 1040 to what was reported as paid to taxpayers from third parties such as employers, banks, brokers, and other financial institutions on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. If a mismatch is identified, the IRS issues a notice to inform the taxpayer that he may have underreported income. For  2007,  AUR Program examiners made tax assessments totaling approximately $607.5 million on 217,811 tax returns.

Despite the success of the AUR Program, the TIGTA report concluded that compliance could still stand to improve, citing the complexities taxpayers face in properly reporting the information disclosed on Form 1099-R:

We determined taxpayers receive Forms 1099-R from payers with the following contradictory or confusing information regarding the amount of taxable retirement income to put on their tax returns:

• A Form 1099-R with a taxable amount but also having the box checked indicating the “taxable amount could not be determined.” For some retirement income plans, the Form 1099-R instructions require the payer to complete the form in this manner. Our  analysis of 14.9 million Forms 1099-R with a distribution identified 11.5 million  (77.2 percent) that had taxable amounts totaling $107.5 billion, but the taxable amount not determined box was checked.

• A Form 1099-R with a gross distribution amount but the taxable amount was left blank. Our analysis of 14.9 million Forms 1099-R with a distribution identified 3.4 million (22.8 percent) had gross distributions totaling $67 billion, but the taxable amount was left blank.

To resolve these issues, the TIGTA report made the following recommendations:

1) Revise the Form 1099-R to clarify the meaning of the” taxable amount not determined” box in order to reduce taxpayer confusion, and

2) Include the dates needed to identify retirement savings program distributions that were not rolled over within the required 60 days.

The IRS agreed with the report’s first recommendation and plans to revise the instructions to Form 1099-R to clarify taxpayer responsibilities and the amounts to report. With regards to the second recommendation, the IRS plans to consider the feasibility and the benefits of including the dates of distributions and their respective contributions to identify distributions not rolled over within 60 days, but as of now, no changes are planned.

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Substantiation is a critical component of any tax deduction. In order to withstand an IRS challenge, it’s essential that a taxpayer maintain sufficient records to support their claimed deductions. And while the statute requires varying degrees of substantiation for different types of expenses, some simple universal truths apply to all deductions:

  • The burden falls on the taxpayer to substantiate the expenses; the IRS is not required to prove the expenses didn’t happen.
  • The fact that an expense was reported on a prior year return and created a net operating loss does not in itself substantiate those deductions. Tax returns are not substantiation.[i]
  • While the Cohan Rule[ii] permits the IRS to estimate a taxpayer’s deductions in the absence of the required substantiation, the IRS can’t do so if it has no reasonable way to approximate the expenses. In other words, you’ve got to be able to show the IRS something.

Failure to heed these rules can quickly lead to an adverse IRS exam or court decision, as one Maryland couple found out yesterday in a decision chock full of  perverted/litigious/murderous goodness:

Steven Esrig (Esrig) and his wife failed to timely file their tax returns from 1998 through 2003, and when they finally got around to it, they claimed significant deductions including net operating loss carryovers, business losses, and office expenses.   

Citing a lack of substantiation for all of the claimed losses and expenses, the IRS disallowed the deductions and assessed over $700,000 in additional tax for the six-year period, along with substantial late filing penalties.

In his defense, Esrig argued that he kept adequate records for his business expenses, though he never actually produced any of them at trial. Thus, it was left to the Tax Court to determine whether Esrig’s oral testimony constituted sufficient substantiation for his claimed deductions, and in order to do so, the court first had to gauge his credibility. As you’ll soon see, this is where things started to go bad for Steven Esrig:

Esrig liked to refer to himself as an “entrepreneur.” Now while normally, calling oneself an entrepreneur is simply a pleasant alternative to calling oneself  “unemployed,” in this case it appears Esrig truly was an innovative visionary along the lines of Steve Jobs. Behold:

Steven told us at trial that he got the idea for the company after an incident involving one of his children. Apparently, his then-five-year-old child asked to look at the Power Rangers website.  Steven logged on but inadvertently mistyped a character in the web address. Instead of getting the Power Rangers website, up popped a seriously pornographic one. This, he told us, was the reason he started Stelor, a company he claims invented a technology that protects children from predators and pornography and “shuts down identity theft.”

Esrig then also laid claim to inventing quotation fingers, the tankini, Jack and Cokes, and raccoons. [iii]

For obvious reasons, the court wasn’t buying Esrig’s story, its doubts prompting it to ask the logical question, “How could a company with such a multifaceted wonder product fail to achieve any level of success?”

Steven told us that the company failed because it “ran into some litigation” after it bought the domain name “googles.com” from someone who had it before Google. This, he said, led to five or six years of litigation with Google and ultimately bankrupted his company.

Now that’s a tough break. Who would have guessed that poaching a domain name from the world’s largest tech giant would lead to costly litigation? It almost makes me wonder if my recent decision to purchase the web address “Facebulk.com” to promote my Aspen Lip Collagen Clinic was not the best of ideas. 

With Esrig’s credibility irreparably tarnished, the Tax Court had no choice but to side with the IRS, denying the disputed expenses in full, including the $17,700 Section 179 deduction Esrig claimed for the cost of a fish tank and dining room furniture.

There was still the matter of $180,000 in penalties, however, which would be added to Esrig’s bill unless he could convince the court that the late returns and large underpayments were not his fault:

At trial, Steven blamed the couple’s return preparer. He said that he’d asked his accountant to request extensions for all the years at issue, but his accountant missed all the deadlines because she had to serve a very long prison sentence for murdering her husband, and the person in her office who took over their account made a slew of mistakes.

Call me a softie, but if your CPA going on a killing spree isn’t “reasonable cause” for late filings, then I’m not sure what is.  But the Tax Court — likely tired of listening to Esrig’s various yarns and unable to differentiate truth from fiction —  failed to share my sympathy, upholding the full amount of the penalties.  


[i] See Lawinger v. Commissioner, 103 T.C. 428 (1994).

[ii] Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).

[iii] May not have happened.

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