P&G gets to buy back its stock (via the split-off) and divest itself of an asset/line of business that does not interest it anymore - without paying any tax.
Wednesday, November 19, 2014
You may have read that Warren Buffett (through Berkshire Hathaway) is acquiring the Duracell battery line of business from Procter & Gamble in a deal worth approximately $4.7 billion. The transaction will be stock-for-stock, although P&G is stuffing approximately $1.7 billion of cash into Duracell before Berkshire takes over. Berkshire will exchange all its P&G stock in the deal. Even better, there should be minimal or no income tax, either to P&G or to Berkshire Hathaway.
Do you wonder how?
The tax technique being used is called a “cash rich split off.” Believe it or not, it is fairly well-trod ground, which may seem amazing given the dollars at play.
Let’s talk about it.
To start off, there is virtually no way for a corporation to distribute money to an individual shareholder and yet keep it from being taxable. This deal is between corporations, not individuals, albeit the corporations contain cash. Lots of cash.
How is Buffett going to get the money out?
· Buffet has no intention of “getting the money out.” The money will stay inside a corporation. Of course, it helps to be as wealthy as Warren Buffett, as he truly does not need the money.
· What Buffett will do is use the money to operate and fund ongoing corporate activities. This likely means eventually buying another business.
Therefore we can restrict ourselves to corporate taxation when reviewing the tax consequences to P&G and Berkshire Hathaway.
How would P&G have a tax consequence?
P&G is distributing assets (the Duracell division) to a shareholder (Berkshire owns 1.9% of P&G stock). Duracell is worth a lot of money, much more money than P&G has invested in it. Another way of saying this is that Duracell has “appreciated,” the same way you would buy a stock and watch it go up (“appreciate”) in value.
And there is the trip wire. Since the repeal of General Utilities in 1986, a corporation recognizes gain when it distributes appreciated assets to a shareholder. P&G would have tax on its appreciation when it distributes Duracell. There are extremely few ways left to avoid this result.
But one way remaining is a corporate reorganization.
And the reorganization that P&G is using is a “split-off.” The idea is that a corporation distributes assets to a shareholder, who in turn returns corporate stock owned by that shareholder. After the deed, the shareholder owns no more stock in the corporation, hence the “split.” You go your way and I go mine.
Berkshire owns 1.9% of P&G. P&G is distributing Duracell, and Berkshire will in turn return all its stock in P&G. P&G has one less shareholder, and Berkshire walks away with Duracell under its arm.
When structured this way, P&G has no taxable gain on the transaction, although it transferred an appreciated asset – Duracell. The reason is that the Code sections addressing the corporate reorganization (Sections 368 and 355) trump the Code section (Section 311) that would otherwise force P&G to recognize gain.
P&G gets to buy back its stock (via the split-off) and divest itself of an asset/line of business that does not interest it anymore - without paying any tax.
What about Berkshire Hathaway?
The tax Code generally wants the shareholder to pay tax when it receives a redemption distribution from a corporation (Code section 302). The shareholder will have gain to the extent that the distribution received exceeds his/her “basis” in the stock.
Berkshire receives Duracell, estimated to have a value of approximately $4.7 billion. Berkshire’s tax basis in P&G stock is approximately $336 million. Now, $336 million is a big number, but $4.7 billion is much bigger. Can you imagine what the tax would be on that gain?
Which Berkshire has no intention of paying.
As long as the spin-off meets the necessary tax requirements, IRC Section 355 will override Section 302, shielding Berkshire from recognizing any gain.
Berkshire gets a successful business stuffed with cash – without paying any tax.
Buffett likes this type of deals. I believe he has made three of them over the last two or so years. I cannot blame him. I would too. Except I would take the cash. I would pay that tax with a smile.
There are limits to a cash-rich split off, by the way.
There can be only so much cash stuffed into a corporation and still get the tax magic to happen. How much? The cash and securities cannot equal or exceed two-thirds of the value of the company being distributed. In a $4.7 billion deal, that means a threshold of $3.1 billion. P&G and Berkshire are well within that limit.
As happens with so much of tax law, somebody somewhere pushed the envelope too far, and Congress pushed back. That somebody is a well-known mutual fund company from Denver. You may even own some of their funds in your 401(k). They brought us IRC Section 355(g), also known as the two-thirds rule. We will talk about them in another blog.
Thursday, November 13, 2014
I am reading a notice from the Department of Labor titled “FAQs about Affordable Care Act Implementation (Part XXII)."
This will never make it as summer reading while on a beach.
And the DOL pretty much says what many practitioners concluded last year when the IRS issued Notice 2013-54, addressing employer reimbursement arrangements and individual health insurance policies acquired on an exchange.
COMMENT: “Exchange” and “marketplace” are the same.
The government does NOT like them.
Let’s clarify what we are talking about. There used to be a very common arrangement whereby an employer would pay your health insurance, reimburse your medical expenses, or a combination of the two, with no tax to you. These plans had several names, including health reimbursement plans or Section 105 plans. The practice had been around since before I was born.
Introduce ObamaCare. Say that someone goes on the exchange and buys an individual policy. Let’s take one more step and say that someone qualifies for a government subsidy on that individual policy.
Step One: You have someone getting money (in the form of the subsidy) from the government.
Say that person’s employer has a health reimbursement plan. The plan reimburses medical expenses, including insurance, up to some dollar amount – say $2,500.
Step Two: That person submits his/her government-subsidized Obamacare policy to the employer for reimbursement, up to $2,500.
To the extent that person’s share of the policy cost was less than $2,500, that person has broken even on the deal. To the extent that his/her share was $2,500 or more, his/her share of the cost would be $2,500 less.
Step Three: The government did not like this, did not like this at all. They huffed and they puffed and they issued Notice 2013-54, which pretty much indicated that the government was not going to allow a mixture of Obamacare individual health policies and employer reimbursement plans. Many practitioners were shocked. Heck, I myself had a similar plan at one time.
But there were a select few companies who continued marketing these things. Introduce some painful and lawyerly reading of the rules, and the companies declared that “their” plan would somehow pass muster with Notice 2013-54.
If there was any legitimate question, there is none now.
Let’s review Q&A 3:
Q: A vendor markets a product to employers claiming that employers can cancel their group policies, set up a Code section 105 reimbursement plan that works with health insurance brokers or agents to help employees select individual insurance policies, and allow eligible employees to access the premium tax credits for marketplace coverage. Is this permissible?
A: No. … the arrangements described in this Q3 are themselves group health plans and, therefore, employees participating in such arrangements are ineligible for premium tax credits….
Second, as explained in …, such arrangements are subject to the market reform provisions of the Affordable Care Act …. Such employer health care arrangements cannot be integrated with individual market policies to satisfy the market reforms, and, therefore, will violate …., which can trigger penalties such as excise taxes under section 4980D of the Code.
There are extremely limited exceptions, such as a one-person employer, but the broad broom has swept. The government is not going to allow a tax-free employer reimbursement for an individual policy acquired on an exchange.
So what if the employer included the reimbursement on the employee’s W-2? It would not be tax-free then, by definition. My previous understanding was that an employer could reimburse the individual policy, as long as the reimbursement was included on the employee’s W-2.
COMMENT: Another way to say it is that the government doesn’t care, as long as it gets its tax.
Let’s take a look at Q&A 1:
Q: My employer offers cash to reimburse the purchase of an individual market policy. Does this arrangement comply with the market reforms?
A: No. If the employer uses an arrangement that provides cash reimbursement for the purchase of an individual market policy, the employer’s payment arrangement is part of a plan, fund, or other arrangement established or maintained for the purpose of providing medical care to employees, without regard to whether the employer treats the money as pre-tax or post-tax to the employee.
Huh? Wait a minute here.
I interpret this to mean that an employer cannot have employees submit their insurance bills for reimbursement in lieu of other compensation. To phrase it differently, the employer must give the employee a raise (or bonus) and the employee must decide whether he/she wants to use the raise (or bonus) toward the insurance. The employee may decide to take the money and go on vacation; the employer cannot decide this for the employee.
By the way, notice that we have been speaking about individual health policies. The above discussion does not apply to group health policies acquired through SHOP, which is the exchange for businesses with less than 50 full-time employees. Those polices are group policies, not individual policies, and do not qualify for the ObamaCare subsidy. No subsidy, different rules.
Saturday, November 8, 2014
Our story starts in 2005. Taxpayer (Lundy) received a Form 1099-R reporting approximately $42,000 of “retirement” income. The Lundys left it off their tax return. The IRS noticed and demanded payment. Off to Tax Court they went. Before there could be any hearing, the IRS settled, agreeing there was no tax due.
This action is referred to as a “stipulated” decision, and they tend to be about as terse as Bill Belichick at a press conference. We won’t read much there.
That said, I am thinking personal injury. We know that damages for personal injuries (think car accident) are tax-free. My hunch is that Lundy got injured, received a $42,000 settlement and a Form 1099-R to boot. Somebody messed up by issuing the 1099 in the first place. The IRS made a second mistake by not adequately investigating the facts before taking the matter to court.
Fast forward 6 years.
The Lundys file their tax return for 2011. Mr. Lundy has a W-2 from driving a school bus, and Mrs. Lundy has approximately $20,000 from a small business. There is some income tax, throw in some self-employment tax, and the Lundys owed about $3,500.
They send in the return. They do not send in any money, nor was there any withholding on Mr. Lundy’s W-2.
The IRS – of course – wants to know why. And they want their money.
The Lundy’s have no intention of sending money.
The Lundys file a request for a due process hearing.
The funds that you are attempting to collect from are indeed part of my total and permanently [sic] disability benefits which were subject of the UNITED STATES TAX COURT CASE # 2759-07S***. We filed a timely appeal to the U.S. TAX COURT and laid out all of our affirmative defenses to the Commissioner of the Internal Revenue Service claims at that time. The most important claim that we made at that time is that whatever we funded, financed, and paid for with my total and permanently [sic] disability funds which were determined by this order to be non-reportable, tax free, and tax exempt from the clutches of the IRS was also off limits from the IRS.”
Let’s think about their argument for a moment. The Lundys were arguing that any income earned from a tax-free source would – in turn – also be tax-free. Does this make sense? Let me give you a few situations:
· You sell your primary residence, excluding $500,000 of gain. You invest the $500,000 in the next hot IPO. It takes off, and next thing you know you are rubbing shoulders with Gates, Buffett and Zuckerberg.
· You take the interest from your municipal bond fund to fund the next great mobile app. You are subsequently acquired by Apple and you buy Ecuador.
· You work overseas for a number of years, always claiming the foreign earned income exclusion. You invest your tax savings in raw land. Two decades later you sell the land to someone developing an outdoor mall. You buy a county in Wyoming so you have somewhere to hunt.
Of course it doesn’t make sense. It is clear that we have to separate the cart from the groceries. The cart stays at the store while the groceries go home with you. They are two different things, and the fate of the cart is not the fate of the groceries. Income from a tax-free pile of money does not mean that the earnings are magically tax-free. If only it were so. Could you imagine the ads from Fidelity or Vanguard if it were that simple?
The Lundys lost, of course.
Of surprise to me, as a practitioner, was the IRS restraint on penalties. The IRS popped them for late payment penalties, of course, but not for the super-duper penalties, such as for substantial accuracy. Why?
Who knows, but I did notice the Tax Court case was “pro se,” meaning that the Lundys represented themselves. There is a way to have a tax practitioner involved in a “pro se,” but I do not think that is what happened here. I suspect they actually represented themselves, without an accountant or attorney.
Not that an accountant or attorney could have represented them in any event. A practitioner is prohibited from taking frivolous positions. The Lundy positon was as close to frivolous as I have heard in a while.
And the IRS gave them a break.
Not that the Lundys would see it that way, though.
Friday, October 31, 2014
For (very) closely-held service companies, it is common to “bonus” enough profit to bring taxable income down to zero (or very close). There are two reasons for this:
(1) The company is a personal services company (PSC), meaning that it will face a maximum corporate tax rate on whatever profit is left in the company. This is a tremendous impetus to not leave profit in the company.
(2) There is one owner (or very few owners) and the majority of the money is going to him/her/them anyway.
In many cases the company is also cash-basis taxpayer, and the accountant normally pays very close attention to cash in-and-out during the last few days of the tax year. With electronic bank transfers becoming more commonplace, I have seen carefully-monitored tax planning destabilized by sizeable electronic customer transfers on the last day or two. It happens, as the customer may be doing cash-basis planning themselves, and payment to my client is a tax deduction to them.
There are limitations on how far this can be pushed, though. It is not acceptable to delay depositing customer checks, for example, in order to avoid income recognition. In addition, one has to be careful about writing so many checks that it creates a bank overdraft. A common way to plan around an overdraft is to have a line of credit available. The bank would then sweep funds from the line as necessary to cover any overdraft. One might also run an overdraft if he/she knows that a deposit will arrive early the following month, as that deposit would occur during the float period of any outstanding checks. A business owner might “know” that check is coming because said check is already in the owner’s desk drawer, but we will not speak further of such absurd examples. It is not as though I have ever seen such a thing, of course.
Let’s talk about Vanney Associates, Inc. Robert Vanney is an architect with perilously close to 40 years experience. The firm has about 25 employees, and Robert is the sole shareholder. He is – without question – the key man. His wife, Karen, is a CPA with a retired license, and she takes care of the books and records.
In 2008 Mr. Vanney received $240,000 in monthly payroll. At the end of the year, he determined and paid employee bonuses, taking as a personal bonus whatever was left over. The leftover was $815,000. The withholdings on the leftover were approximately $350,000, leaving approximately $464,000 payable to Mr. Vanney.
Problem: there was only $389 thousand in the bank.
There was enough money to pay the withholding taxes, but there wasn’t enough to also pay Mr. Vanney. What to do? The Vanney’s did not need the money, so they decided not to borrow from the bank. Mr. Vanney instead endorsed the check back to the company, and that was the end of the matter.
But it wasn’t. The IRS looked at the business tax return and decided to disallow the $815,000 bonus and almost $12,000 in related employer payroll taxes.
Why? The government got their taxes, so why should they care?
There is a legal concept when paying with a check. A check is referred to as a “conditional payment,” because writing the check is subject to a condition subsequent. That subsequent condition is the check clearing the bank. We take it for granted, of course, so we overlook that technically there are two steps. When the check clears, the two steps unify and become as one. This is why you can send a check to a charity on December 31 and claim the deduction in the same tax year. There is no chance that the charity is receiving that check and depositing it by December 31. Still, if it clears in the normal course of business, all parties – including the IRS – consider the check as having been written on December 31.
That is not what happened here. The check never cleared the bank.
Which is unfortunate, as the IRS now could argue that the check remained conditional. Being conditional there was never payment in 2008. This was fatal, as Vanney Associates was a cash-basis taxpayer.
And the Court agreed.
Think about this for a moment. The corporation was disallowed a 2008 deduction for the $815,000. Whereas the Court did not address this point, that bonus was included on Mr. Vanney’s 2008 Form W-2. He would have reported that W-2 on his 2008 individual tax return.
There is something seriously wrong with this picture.
I suppose Vanney Associates could amend its 2008 payroll tax returns. It could reverse that bonus, as well as the related withholding taxes. It would get a refund, but it would be amending multiple federal and state (and possibly local) payroll returns.
Mr. Vanney would then amend his personal 2008 tax return.
But that is assuming we are within the statute of limitations to amend all those returns.
When then would Vanney Associates get its $815,000 bonus deduction?
Your first response might be the following year: in 2009. I believe you would be wrong. Why? Because Mr. Vanney did not cash his check in 2009. The check remained a conditional payment in 2009. Same answer for 2010, 2011, 2012 and 2013. This case was decided September, 2014. Seems to me the first time Mr. Vanney could “cash” his check is this year – 2014.
Let me ask you another question: why didn’t the Court allow the (approximately) $350,000 in withholdings as a tax deduction? That check cashed, right?
I think I know. If the company did not “pay” the $815,000 in 2008, then there is no “bonus” for that withholding to attach to. From a tax perspective, the company overpaid its withholding taxes in 2008. The tax problem is that the overpayment is not a "deduction," as no payroll taxes were actually due. Payroll taxes attach to payroll, and there was no payroll. It was a "prepayment," waiting on Vanney to request a refund.
What is our takeaway?
Over the years I have heard more than one practitioner declare a tax outcome as “making no sense.” An unfortunate consequence is that the practitioner may not pursue a line of reasoning to conclusion. There are reasons for this, of course. First, an accountant has probably been exposed somewhere to generally accepted accounting principles. GAAP is a financial statement concept (think auditors, not tax accountants) and GAAP generally has some symmetry to it. The practitioner forgets that the IRS not bound by GAAP. The purpose of the IRS is to collect and enforce, and it does not consider itself bound by any symmetry should GAAP get in its way. The second is human: we respond to an absurd result by assuming we must have made a mistake in our reasoning. Many times we are right. In Vanney’s case, we were not.
What could Vanney have done?
He could have had a line of credit in place. He could have cashed that check.
BTW I almost invariably recommend my cash-basis clients have a line of credit, even if they have no intention of using it. This costs them money, as the bank may charge a flat fee (say $100 or $250) annually for keeping the line of credit available. In addition, many a bank will require at least one draw over a month-end annually in order to keep the line open. This means there will be some interest expense.
Why do I recommend it? It is cheap insurance against nightmares like this.