Tuesday, October 29, 2013

Suit Against Subsidies Could Derail ObamaCare

Did you hear about the court decision in Halbig, et al v Sebelius? The suit was brought by six businesses against the employer mandate under ObamaCare. The federal District Judge, Paul Friedman, refused a preliminary injunction against the government, but he did say the case would be decided on an expedited basis.  That court joins Pruitt v. Sebelius, a case from Oklahoma. There is yet another suit to be heard by month-end in Richmond, Virginia.

What is going on?

They are suing over the employer penalty under ObamaCare - the $2,000 or $3,000 penalty, depending upon whether the employer offers insurance and whether the insurance meets politically correct criteria. The employer penalty triggers when an employee qualifies for a subsidy on the public exchange (the “Marketplace”). One qualifies if one’s income is below 400% of the federal poverty line and meets other criteria. The employer would then be required to subsidize some of the cost through that $2,000/$3,000 penalty.

What does it take to qualify for an individual subsidy?

Let’s do something that Congress apparently did not do when this passed this law: let’s read it:

Let’s start with Section 1311(b):


(1) IN GENERAL.—Each State shall, not later than January 1, 2014, establish an American Health Benefit Exchange (referred to in this title as an ‘‘Exchange’’) for the State that…

We read that each state is to establish an Exchange.

What if the state fails to establish an Exchange?


(A) a State is not an electing State under subsection (b); or
(B) the Secretary determines, on or before January 1, 2013, that an electing State—
(i) will not have any required Exchange operational by January 1, 2014; or
(ii) has not taken the actions the Secretary determines necessary to implement—
(I) the other requirements set forth in the standards under subsection (a); or
(II) the requirements set forth in subtitles A and C and the amendments made by such subtitles;
the Secretary shall (directly or through agreement with a not for profit entity) establish and operate such Exchange within the State and the Secretary shall take such actions as are necessary to implement such other requirements.

We read that the Secretary will establish the Exchange.

How does an individual get to a subsidy?


(a) IN GENERAL.—Subpart C of part IV of subchapter A of chapter 1 of the Internal Revenue Code of 1986 (relating to refundable credits) is amended by inserting after section 36A the following new section:


(a) IN GENERAL.—In the case of an applicable taxpayer, there shall be allowed as a credit against the tax imposed by this subtitle for any taxable year an amount equal to the premium assistance credit amount of the taxpayer for the taxable year.
(b) PREMIUM ASSISTANCE CREDIT AMOUNT.—For purposes of this section—
(1) IN GENERAL.—The term ‘premium assistance credit amount’ means, with respect to any taxable year, the sum of the premium assistance amounts determined under paragraph (2) with respect to all coverage months of the taxpayer occurring during the taxable year.
‘‘(2) PREMIUM ASSISTANCE AMOUNT.—The premium assistance amount determined under this subsection with respect to any coverage month is the amount equal to the lesser of
(A)   the monthly premiums for such month for 1 or more qualified health plans offered in the individual market within a State which cover the taxpayer, the taxpayer’s spouse, or any dependent (as defined in section 152) of the taxpayer and which were enrolled in through an Exchange established by the State under 1311 of the Patient Protection and Affordable Care Act, or
(B)    the excess (if any) of— ‘‘(i) the adjusted monthly premium for such month for the applicable second lowest cost silver plan with respect to the taxpayer, over ‘‘(ii) an amount equal to 1/12 of the product of the applicable percentage and the taxpayer’s household income for the taxable year

Whoa. If the nuns taught me how to read English, I see that the taxpayer has to be enrolled in an Exchange pursuant to Section 1311. Section 1311 requires “each state” to do something, otherwise Section 1321 kicks in.

Question: What if a state does nothing (thereby removing Section 1311) and the federal government steps in under Section 1321. Would someone in that state be receiving a subsidy as defined under Section 1401 or not?

Can the federal government be a “state?”

Let’s look at Section 1304(d):

Sec 1304(d) STATE.—In this title, the term ‘‘State’’ means each of the 50 States and the District of Columbia.

Looks like the answer is “no.”

Considering that there are approximately three dozen states that did not set-up their own Exchange, how does the federal government propose to get an employer to pay that $2,000/$3,000 penalty despite the language in Sections 1401 and 1311?

The IRS comes to the rescue by proposing the following Regulation:
a taxpayer is eligible for the credit for a taxable year if . . . the taxpayer or a member of the taxpayer’s family (1) is enrolled in one or more qualified health plans through an Exchange established under section 1311 or 1321 of the Affordable Care Act . . .”
Good grief! Well, one thing about Tony is that he could always count on Paulie and Christopher to back him up.

Does law mean nothing to this crowd? Perhaps the law is flawed, perhaps it was poorly drafted, but it still law. How many times have I read about unintended consequences of the alternative minimum tax or about some poor taxpayer being hung out to dry because he/she did not get that “special” piece of paper the IRS wanted in order to substantiate a transaction?  How did the IRS invariably defend its position? By arguing that the law is the law and that Congress should remedy any inequity.  

In a swell of self-importance, the Administration and its enablers refuse to accept that the same law that applies to you or me also applies to them. Instead they argue that:
(1) Justice Roberts decided that the penalties are a tax. The Anti-Injunction Act precludes plaintiffs from challenging the imposition of a tax before it is actually assessed.

(2) The plaintiffs lack standing due to the speculative nature of any claimed injuries.

(3) Following the White House announcement of the one-year delay of the employer mandate, the court should also delay its consideration.

(4) The language around subsidies represents but one of the ACA’s many drafting errors.

(5) Congress clearly intended to have tax credits available in all the states.

Let me get this straight: their argument is that Tony did not clearly intend for me to defend myself until after I was shot, because before then any self-defense would be speculative and contingent on the actions of someone for whom English is a second language. 


Let us review history to understand how we got into this mess. The House had a bill. The Senate had a bill. The bills were different. The Senate wanted to force the states to absorb the Exchanges, but it ran into a problem with Pritz v United States (1997):

[T]he Federal Government may not compel the states to implement, by legislation or executive action, federal regulatory programs.’’

The Senate instead added a provision for federally established exchanges as a backup option for states that refused to set up exchanges.

Remember that bill could not obtain bipartisan support, and it was passed on a Saturday night at late hour, after the Louisiana Purchase, the Cornhusker Kickback and who-knows-what-else. The Democrats had lost their Senate 60-vote majority in January 2010, meaning they could not override the expected filibuster.  To push the bill through the Senate, Reid forced a reconciliation vote - a tactic normally reserved to limit debate on budget bills. This tactic however did not allow for a normal Senate-House joint committee process to reconcile burrs in the law. How could it? It was designed for budget and debt ceiling items, not for something like this.

Let’s see what happens in Halbig and Pruitt. Judge Paul Friedman hopes to have his opinion out by February.

Thursday, October 24, 2013

When A Tax Shelter Blows Up

Can you image losing a tax case with the IRS and owing a billion dollars?

Who did this? We are talking about Dow Chemical Company (“Dow”). They lost in the District Court for the Middle District of Louisiana. I suppose they have no choice but to appeal. It is a billion dollars, after all.

What got them in this mess? 

A couple of tax shelters, one marketed by Goldman Sachs and both implemented by the law firm of King & Spalding. The IRS sued for tax years 1993 to 2003. 

Let’s talk about the first of the shelters – called a SLIP – which lasted from 1993 to 1997. Dow was not the only one that tried to SLIP the IRS. Merck and International Paper tried also.

SLIP stands for “Special Limited Investment Partnership.”  Its claim to fame was taking low-basis assets and turning them into tax deductions.  How would you do this? Well you could contribute them to a partnership, but that low basis would carryover. You would get no increased tax deduction by putting it a partnership.


What if you put low-basis assets into a partnership and then leased them back?  Wait, the partnership would then have taxable income. Who would own the partnership? If you owned it, then the whole effort would be circular. 

What if there are other partners? Problem: you do not want other partners. 

What if you limit the other partners to a fixed return? It would be the same as paying interest to a bank, right? In partnership taxation we call this a priority or preference distribution. 

Problem: most of that income would be coming back to you. How can we solve this puzzle?

We delink the income distribution from the cash distribution. We bring in partners who will accept 6 or 7 percent priority, and we allocate virtually all the income to them.

Now why would someone agree to this?

If someone doesn’t pay U.S. tax, that’s why. Someone like a foreign bank.


You offer a foreign bank the deal, now referred to as a “structured financial transaction.” This means that it is complicated, and you will be paying top dollar for investment, legal and accounting advice. You explain to the bank that it would:

·        Receive a significant premium over a corporate bond
·        Take on less credit risk than a corporate bond
·        Escape any U.S. tax

Sure enough, Dow and Goldman Sachs rounded up five foreign banks willing to contribute $200 million. Dow set up a maze of subsidiaries, into which it dumped 73 patents. The interesting fact about these patents is that Dow had amortized them virtually to zero, Dow still used them in current operations and retained enough of the processes to make it unlikely anyone would want to buy the patents, though.  The patents appraised at $867 million.

One of those Dow subs contributed the patents into a partnership called Chemtech I, taking back an 81 percent ownership.

Dow paid Chemtech I around $143 million for use of the patents.

Chemtech I paid the foreign banks 7 percent as their priority return. Since the banks had invested $200 million, this was a cool $14 million in their pockets. Chemtech I paid a couple of other things, took the remaining cash and put in a subsidiary. That subsidiary loaned the money back to Dow. How much cash did it loan back, you ask? About $136 million. For one year.

On its tax return Chemtech I reported approximately $122 million in income. It allocated $115 million of that to the banks. Only $28 million in income went back to Dow itself.

What we have just talked about is known in tax lingo as a “strip.”

And there is the SLIP. All Dow did was move money around. It paid the foreign banks $14 million in interest but called it a priority, thereby dragging over $115 million of income with it. As the banks did not pay U.S. tax, they did not care. Dow however did.

In 1997 there was a change in U.S. tax law, and Dow had to switch to another tax strategy. Dow wanted to cash out the banks and start something else.

The banks wanted their share of the market value of those patents on the way out. Seems fair, as they were “partners” and all. Dow said “no way”. The partnership agreement stipulated how the patents were to be valued and how to calculate the banks’ share. Dow paid the banks approximately $8 million. The banks complained, but to no avail. Dow controlled the calculation of value.

Once the banks were out of the way, Dow created a second tax shelter using a fully-depreciated chemical plant in Louisiana. This strategy did not require banks, but it did employ a very clever maneuver to pump-up the basis of the plant, thereby creating depreciation deductions that Dow could use to offset real income from other sources.

Oh, there was a formidable tax issue that Dow resolved by ripping up a piece of paper and replacing it with another.

OBSERVATION: And there you see the IRS’ frustration: Dow is not dealing with independent parties. In Chemtech I, it was dealing with banks acting as banks. Dow called them partners, but it may as well have called them peanut –butter sandwiches for the difference it made. In the second deal (called Chemtech II), Dow did not even leave the ranch. It replaced a deal between its subsidiaries with another deal between its subsidiaries. Really?  No wonder the IRS was hot around the ears.

So the IRS gets into Dow’s tax returns. In 2005 it issued a Notice of Final Partnership Administrative Adjustment for tax years 1993 and 1994. Dow responds that the IRS did not give the notice to the properly designated person – the Tax Matters Partner – and the notice was therefore invalid.

OBSERVATION: The tax matters partner rule is to protect both the partnership and the IRS. It means something when you have big partnerships with hundreds if not thousands of partners. Dow however was setting up partnerships like they were jellybeans. I find it cheeky – to be polite – that Dow’s defense was “you sent the mail to the wrong cubicle.”

This thing goes back and forth like a tennis match. In the end, a court has to decide. The IRS had scooped up additional years – through 2003 – by the time this was resolved.

How would the IRS attack the shelters?

There are a couple of ways. The first is the “economic substance” doctrine. Think of it as the tax equivalent of “where’s the beef?” The court looks at the transactions and determines if there is any reality to what supposedly is going on. There are three prongs to this test:

(1) Does the transaction have economic substance compelled by business or regulatory realties;
(2) Does the transaction have tax-independent considerations; and
(3)  Is the transaction not designed in toto with tax avoidance intent?

The Court looks at the SLIPS and observes the obvious:

(1) The SLIPs did not change Dow’s financial position in any way. Chemtech I could not have licensed those patents to a third party if it wanted to, as it did not own all the rights. This means that Chemtech I could not produce independent revenue. That is a problem.
(2) The cash flow was circular. The little bit that left (to the banks) was the equivalent of interest. Big problem.
(3) Dow argued that it was preserving its credit rating and borrowing power, but it could not prove any increase in its credit rating or borrowing power. Dow also stumbled explaining why it structured the transaction this way rather than another way – like having domestic banks in Chemtech I.

The second way the IRS attacked was by arguing the partnership was a sham. This argument is slightly different from “economic substance,” as that argument looks at transactions. The sham partnership argument looks at the partnership itself and asks: is this a real partnership?

The Court notes the following:

·        The banks got a priority of 7%.
·        The only room left for the banks to profit was if the patents went up in value. The banks were only allocated 1% of that number, and Dow controlled how to calculate the number.
·        When the banks complained about their lousy 1%, a Dow executive called them “greedy.”

OBSERVATION: It was clear the Court was not impressed with this executive’s comment.

·        It was virtually impossible for the banks to lose money.
·        The one risk to the banks – IRS challenge – was indemnified by Dow.

The Court observed that true partners have the risk of loss and the hope of gain. The banks had virtually no risk of loss and sharply limited room for gain. There may have been a banking relationship, but there was no more a partnership here than in a Kardashian marriage.

The Court said the shelters were bogus and Dow owed the tax.

And a 20 percent penalty to boot.

MY TAKE:  Those who know me, or who follow this blog, know that I generally side with the taxpayer. After all, it is the taxpayer who sets an alarm clock, takes on a mortgage or builds a website that actually works, whereas the government is little more than weight in the trunk.

Still, at least pretend that there is some business reason for all the tax fireworks that are going off.

This court opinion is 74 pages long. While I am somewhat impressed with the tax wizardry that Dow brought to bear, I must admit that I am reading tax planning for its own sake. That may groove someone like me, but that is not enough to pass muster. There has to be a business purpose for moving all the pieces around the board, otherwise the IRS can challenge your best-laid plans.

The IRS challenged Dow. 

Dow lost.