Thursday, July 23, 2015

The Sale of "American Pie"

Did you see where Don McLean sold his original manuscript for “American Pie” at Christie’s? He sold the work for $1.2 million, and it included his handwritten notes and deletions from the 1971-72 hit that – at 8 ½ minutes – was the longest song to ever top the U.S. charts.

The song of course is famous for its allusions. The “day the music died” refers to the death of Buddy Holly, whereas “the king” supposedly refers to Elvis Presley while “the jester on the sidelines” refers to Bob Dylan after his motorcycle accident. It became an anthem to disillusionment, to the sense of our best days being behind us and the ennui and hopelessness of a society being carted off in the wrong direction.

Sounds eerily contemporary.

He explained that he had forgotten he had the manuscript. He found it in the proverbial old box that had survived several moves. The sale allowed him to provide for his family, now and into the future.

Yes, $1.2 million will do that.

So what are the tax consequences from the sale of his manuscript?

We are talking about intellectual property and a subset we will call creative properties.

For the most part, self-created properties cannot be a capital asset in the hands of its creator. This causes a problem, as one requires a capital asset if one wants capital gains.

Take it a step further. If someone else owns the asset but its tax basis (that is, its cost for purposes of calculating gain or loss) is determined by reference to the creator’s basis, then it cannot be a capital asset.  How can this happen? Easy. You could gift the property, for example, or you could contribute the property to a family limited partnership. In either case the recipient will “take over” your basis in the creative property. Since the basis remains the same, it cannot be a capital asset.

The vocabulary gets tricky when discussing creative property. For example, an author (say Stephen King) may receive a “royalty.” Coincidently, find oil in your backyard and chances are an oil company will also pay you a royalty. Since the word “royalty” is the same, are the tax consequences the same?

The answer is no. If you write a book or score a movie soundtrack, that royalty is probably ordinary income to you. In fact, it is reported on Schedule C of your individual tax return, the same as your self-employment income from Uber. The oil royalty, on the other hand, is reported on Schedule E, along with rents. The Schedule C royalty will trigger self-employment tax. The Schedule E will not. 

OBSERVATION: We have discussed before that sometimes a word will have different meanings as it travels through the tax Code. Here is an example.

As always, there are exceptions. Let’s say you write one book and never write again. The IRS will likely consider that to be ordinary income but not self-employment income. Why? Supposedly it takes two or more books to establish that you are in the trade or business of writing books.

OBSERVATION: I am curious how the IRS would apply this standard to Harper Lee. She published, you will recall, To Kill a Mockingbird in 1960. It was only this year that she published her second work (Go Set a Watchman) – 55 years later. What do you think: is this self-employment income or not?

Remember when Michael Jackson bought the catalog of Beatles music? He bought it as a non-alternative investment, akin to stocks and bonds. Like a stock or bond, Michael Jackson would have had capital gains had he sold the catalog.

This created a fuss among songwriters. If they sold their own compositions, they would have ordinary and self-employment income. Introduce Michael Jackson and the tax result transmuted to capital gains.

So Congress passed Section 1221(b)(3), which incorporated a provision from the Songwriter’s Capital Gains Equity Act, promoted by the Nashville Songwriters Association International (NASI). It extended capital gains to self-created music owned for more than one year. It requires an election, and the songwriter/creative can elect for one musical composition and not for another. It does require the transfer of a musical composition or a copyright in the same; transfer something less and the result defaults to ordinary income.

NASI argued that the industry had changed. By the 1990s many music artists were acting as their own publishers or co-publishers, meaning they had some control over the exploitation of their songs. Gone were the days of Hank Williams and Bill Monroe, when songwriters sold their songs outright to music publishers with no right to ongoing income.

Congress listened.

Don McLean now has a tax option that he did not have years ago when he recorded “American Pie.” I suppose that there could be a scenario where it would be more advantageous to recognize the $1.2 million as ordinary income rather than as capital gains, but I cannot easily think of any that do not require low-probability tax considerations.

I would say he is making the election.

Friday, July 17, 2015

National Taxpayer Advocate's June 30, 2015 Report To Congress

Twice a year the National Taxpayer Advocate submits a report to Congress. The Advocate is required to submit these without prior review by the Commissioner of the Internal Revenue Service, the Secretary of the Treasury or the Office of Management and Budget. A report was issued June 30, and it identified the objectives of the Advocate’s office for the upcoming fiscal year.

The National Taxpayer Advocate is Nina E. Olson. We have spoken of her before, and I am a fan.  

The following caught my eye:

The most serious problem facing U.S. taxpayers is the declining quality of service provided to them by the IRS when they seek to comply with their tax filing and payment obligations."

Given that this is a co-equal reason for the IRS to exist (the other being to collect revenue), this is a rather serious charge.

Consider the following:

·         The IRS hung up on approximately 8.8 million taxpayers during this year’s filing season. The IRS dryly refers to these as “courtesy disconnects,” ostensibly as proof that they too have read Orwell’s 1984.
o   This number was up from 544,000 hang-ups during the 2014 filing season.
·         Only 37% of people using toll-free lines were able to speak with a human being.
o   Down from 71% last year.
·          The IRS has announced that it will no longer answer any tax law questions at all.
·         The IRS will eliminate tax preparation altogether.
o   It used to maintain approximately 400 walk-in sites and helped taxpayers prepare around 500,000 tax returns annually.
·         The IRS answered only 17% of the calls from people whose account was blocked on suspicion of identity theft.
·         Don’t expect that hiring a tax professional will resolve the logjam. Professionals were able get through less than 50% of the time.

From the perspective of a practicing tax CPA, I found interacting with the IRS this filing season to be unpleasant, if not futile. I find myself with divided opinions: many of the examiners and officers I have met and worked with over the years are responsible and likeable enough. Gather them together however and you have an organization that has lost the trust and confidence of a sizeable number of taxpaying citizens.

Ms. Olson does point out that the IRS has been charged with additional tasks in recent years, such as pursuing foreign assets (FATCA) and "assisting" the American public with their health insurance (ObamaCare). There has simultaneously been a reduction in agency funding.The GAO has reported that IRS funding declined approximately $900 million since fiscal year 2010, for example, resulting in the elimination of approximately 10,000 full-time equivalent positions.

Let’s be frank: under this Congress there will not be – nor should there be – additional funding for an agency that has been weaponized for political purposes. Paul Caron, a Pepperdine tax law professor, maintains a count and compendium of IRS misbehavior at TaxProfBlog  ( He is perilously close to 800 days and will likely exceed that count by the time you read this. If smoke indicates fire, then someone must have burned down the warehouse district to generate that much smoke.

Is there a solution? Yes, but it will probably have to wait until November, 2016. But you already knew that.

Thursday, July 16, 2015

Magic Dragon, Pain Management and Taxation

I had lunch recently with a friend who has been diagnosed with Multiple Sclerosis.  I learned about MS primarily through him, and the disease is frightening. He went on to explain the neural degeneration and the pain that it can – and does – cause. His doctors have prescribed any number of pain medicines, but sometimes - many times - he does not need the full power of those prescriptions. He needs more than an aspirin but much less than an opioid.

It appears that marijuana does work for pain management.

Granted, this can be a problem where we live, as marijuana is not legal in either Kentucky or Ohio.

Over twenty states permit the medical use of marijuana, and four permit its recreational use. The problem arises from its status as a Schedule I controlled substance, meaning that it is illegal under federal law. I doubt too many tax CPAs get involved with businesses selling illegal products, and those that do are probably not in public practice.

The White House has encouraged the Justice Department not to prosecute marijuana distributors who comply with state law.  Granted, the next White House may change course on this matter, but for the moment there is temporary stability.

I have no idea how a state Board of Accountancy would react.

Remember that the tax Code is federal tax law. It also contains Code section 280E, which was passed in 1982, 14 years before California became the first state to legalize medical marijuana.

Let’s look at this polished pearl of prose.

Sec 280E Expenditures in connection with the illegal sale of drugs
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which the trade or business is conducted.

This section was created in response to the 1981 Edmonson case, in which the Tax Court allowed a seller of amphetamines, cocaine and marijuana to deduct expenses. The decision did not go over well.

So Congress responded with “no deduction or credit shall be allowed” on public policy grounds.

However that language does not mean what it first appears to say.  

Section 280E does allow a cost-of-goods-sold deduction. The reason goes back to accounting theory. Let’s say that you sell Supreme Court clown hats. You sell a million of them for $5 each. You have to have them manufactured, which you outsource and pay $3 each.  Let’s step into a tax accounting class and the professor asks you: what is your income?

·        Is it 1 million times $5 = $5 million
·        Or is it 1 million times ($5 - $3) = $2 million

The answer is $2 million, as you get to deduct the cost of a product when your business involves selling a product.

And the Tax Court agreed in the Olive case.

Following Olive, we know that we can deduct the cost of the marijuana from the revenues received from selling marijuana. What about everything else: payroll, rent, lights, cell phone, computers and software, stationary, and so forth?

Now we run full-face into Section 280E. There is no deduction.

That has to hurt come April 15th.

Surely the tax accountants can do something, right?

Yes, up to a point.

Remember that we said that you are allowed to deduct the cost of a product when your business involves selling a product? Another word for product is inventory, and there are things an accountant can do to tack some of those otherwise nondeductible expenses onto the inventory. You would then deduct those expenses as cost of goods sold when the product sells. I suspect you will still be leaving most of those expenses on the floor, but it is something.

More useful is to have another line of business that does not involve the sale of marijuana. Let’s say that one sets up a caregiving activity involving marijuana, providing support groups, lunches, counseling, social events and so on. As long as the primary business is not the sale of marijuana, the accountant could shift expenses (within reason; be fair) to that activity and sidestep the Section 280E disallowance. This was the Californians Helping to Alleviate Medical Problems (CHAMP) case, and it received the Tax Court’s approval. Introduce creative minds and I am certain there are a thousand variations on the theme.

There is a San Francisco marijuana business (Canna Care) that has taken Section 280E to Tax Court.  In their case it means a $2.6 million deduction. They do not have a CHAMP fact pattern but are instead arguing that the disallowance is punitive and hence unconstitutional.

There has been no decision as of this writing, but I would not be optimistic.

Why? The Ninth Circuit very recently decided on the appeal of Olive mentioned above. Martin Olive operates the Vapor Room, a medical marijuana dispensary in California. In addition to selling marijuana, it offers a number of services as well as food – both for free. It made a CHAMP argument, wanting to allocate expenses between the two lines of business.

The Ninth Circuit said no, basing its decision primarily on the “free” part of the food and services. To allocate expenses to two or more trades or businesses, one must in fact be in business. There is no hope of a profit when the activity is giving things away for free, so that activity cannot rise to the level of a trade or business.

But the Ninth Circuit also slapped down Olive’s direct challenge to Section 280E, saying the tax disallowance is not based on marijuana being legal or illegal. Rather the disallowance is based on marijuana being a controlled substance, which it is and continues to be.

And there you have the federal taxation of marijuana in a nutshell.

My thoughts?

It appears that the 1982 Section 280E addition to the tax Code is a bit out-of-step with contemporary society. Perhaps Congress could change one word: 

which is prohibited by Federal law AND the law of any State in which such trade or business is conducted”.

And no, I don’t want any credit for the suggestion. I am more of a bourbon fan myself.

Friday, July 10, 2015

Diabetes, Disability And A Penalty

I have a friend who damaged his back, leading to nerve complications which have greatly affected his ability to work. Granted, he can still work, but not with the same intensity as before and certainly not for as many continuous hours. Sometimes by midday he has to take pain medications, which tend to knock him out. It is an unfortunate cycle, and the impact on his earning power is significant.

Let’s talk about disability. Then let’s talk about a disability exception to a penalty.

First, is disability income taxable or nontaxable?

Let’s confine this discussion to a disability policy purchased from an insurance company, omitting coverage from workers compensation and social security. There is a rule of thumb that is very important when thinking about disability insurance:

If you deducted the insurance, then payments under the insurance are taxable.

Let’s say that you purchased a short-term disability policy through your cafeteria plan. Amounts run through a cafeteria plan are generally not taxable to you. That is the point of the cafeteria, after all. Collect on the policy, however, and you trigger the above rule.

As a consequence, just about any financial or tax advisor will tell you to pay for disability insurance with after-tax dollars. The issue becomes even more important when purchasing long-term disability, as you would be permanently disabled (however defined) should you collect. You do not need the tax burden at the same time that your earning power is compromised.

You may recall that there is a 10% penalty if you take monies out of your 401(k) or IRA early. Early has different meanings, depending upon whether it is an IRA (or IRA-based) plan or a qualified plan. You can take money from a 401(k) at age 55 without penalty, for example, if you no longer work for the employer. An IRA does not care about your employer, but it does make you wait instead to age 59 ½. Take a distribution before those ages and you are likely facing a penalty.

But there is an exception to the 10% penalty if you get disabled.

Let’s say that you are injured enough to collect disability. Will that count for purposes of avoiding the 10% penalty?

You would think so, right?

Let’s talk about the Trainito case.

Trainito worked with the Boston Department of Environmental Health (DEH).  He was diagnosed with type 2 diabetes in 2005. He unfortunately did not take good care of himself, and he had continuous and increasing issues with neuropathy. He worked for DEH until October 2010, when he resigned due to the diabetes. He did not pursue disability benefits from DEH. Perhaps they did not offer such benefits.

Then he stopped taking his meds.

Fast forward six months. Trainito took a retirement distribution of over $22 thousand in April 2011.

Two months later he was found at his home in a diabetic coma. He was taken to a hospital where he spent more than a month recuperating, leaving the hospital in late July 2011. Damage was done, and he had reduced use of an arm and leg. He then applied for disability benefits with the state.

When preparing his return for 2011 he claimed the disability exception to the 10% penalty on the retirement distribution. The IRS disagreed, and the two found themselves in Tax Court.

The Code section at play is Sec 72(m)(7):

            (7) Meaning of disabled
For purposes of this section, an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require.

On first reading, it seems to make sense. Introduce an attorney and a couple of non-immediate points appear:

(1) The disability must be “total.”

This is a rewording of “unable to engage in any substantial gainful…” This is not an insignificant requirement, as it does not look to one’s regular and primary employment.

Many private disability policies will find you disabled if you are unable to perform your own occupation. The IRS definition is much stricter, requiring one to be unable to reasonably perform almost any occupation. As a consequence, it is possible that someone may be considered disabled by his/her insurance company but not considered so by this section.

(2) The distribution must be attributable to the disability.

The clearest way to show this is to take the distribution after being medically adjudged as disabled. Trainito did not do that. It is extremely likely that he knew he was seriously compromised by his diabetes, but he had not obtained a medical signoff to that effect.

The question before the Court was whether the absence of that medical signoff was fatal. 

The Court acknowledged that “substantial gainful activity” can be impaired by progressive diseases, such as diabetes. The Court further clarified that the presence of an impairment (such as diabetes) does not necessarily mean that an individual is disabled as intended under Sec 72(m)(7).

COMMENT: Makes sense. Odds are we each know someone who is diabetic but has it under medical control.

Trainito provided the Court with the record of his six weeks in the hospital, from June through July, 2011.  He was in a coma for most of it.

The Court wanted records back to April, 2011, when Trainito took the distribution.

Trainito testified that he saw a primary care doctor twice a month after being diagnosed in 2005. He stopped that when he was no longer working at DEH.

The Court sniffed:

Thus the fact that petitioner suffered a diabetic coma on June 12, 2011 does not indicate whether he was disabled on April 22, 2011. Petitioner undoubtedly suffered from diabetes on April 22, 2011 but he has not provided sufficient evidence to show that his diabetes caused him to be disabled within the meaning of section 72(m)(7).”

This seems a bit harsh. There is a “duh” element considering that he has a progressive disease. Perhaps if Trainito had his doctor testify, perhaps if he introduced his earlier medical records …

But Trainito did not have his doctor testify nor did he provide his earlier medical records. Why? Who knows. I suspect there may have been a financial consideration, but the Court did not say. It is also possible that he thought his testimony, accompanied by his shortly-thereafter month-long coma, would be sufficient proof to the Court.

The Court concluded that Trainito did not meet test (2) above: he did not show that the distribution was attributable to the disability. Trainito owed the penalty.

What are my thoughts?

Sometimes tax is not just about Code sections and Regulations. Sometimes it is about facts and – more importantly – being able to prove those facts. I believe you when you tell me that you donated multiple rooms of furniture to charity when you moved, but you still need receipts and documentation. I believe you when you explain how you supported your children from a previous marriage, but I still need to review the divorce decree and related legal paperwork to determine whether you can claim the children as dependents.

The IRS told Trainito to “prove it.”

He didn’t.