Taxing A Corvette

I came across an old case recently. It made me smile, as it reminded me of earlier – and skinnier – times.

Let’s set this up.

There are, broadly speaking, two accounting methods when deciding whether you have reportable income for a period: the cash method and the accrual method. There are a variety of sub, sorta- and who-actually-understands-this methods, but cash and accrual are enough for right now.

The cash method is easy: if you can deposit it at the bank you have income.  Maybe you decide not to deposit at the bank until next week, but it is still income today. Why? Because you can deposit it. The definition is “can” not “did.”

Accrual is trickier. Generally it means that you sent an invoice to someone. The act of invoicing means you have income, as someone owes you. What if you delay invoicing for a week or two? Well, then you have a variation on the above cash-basis reasoning: you could have but didn’t. Again, it is the “could,” not the “did,” that drives the test.

What if you are on the cash method and somebody pays you with property instead of cash? You have income. It makes sense when you remember that cash is a form of property. We have just gotten so used to it that we don’t think of cash that way. For tax purposes, though, someone paying you in asiago cheese and gluten-free crackers still represents income. Granted, we have to translate cheese-and-crackers into dollars, but income it is.

Let’s say that you played football. Not just any football, however. You were Vince Lombardi’s running back. It is December 31, and you and Lombardi and the Green Bay Packers are playing the New York Giants in the National Football League Championship.

COMMENT: NFL historians will immediately recognize that this was before the Super Bowl era. There was no game called the Super Bowl until the two leagues – the National Football League and the American Football League – merged in 1966. The first two Super Bowls were won tidily by Lombardi and the Packers. In Super Bowl 3 Joe Namath famously led the New York Jets over the Baltimore Colts.

So it is the championship game. You are the running back. It is December 31 and you are playing outside in Green Bay. I presume you are freezing. You run wild and score 19 points, establishing a league record. You are selected after the game by Sport Magazine as the most valuable player, which comes with the prize of a new Corvette. 

Sweet.

By the way, your Corvette is waiting for you in New York. It is now the evening of December 31, 1961.

Tax issue: Do you have income (the value of that Corvette) in 1961?

The IRS said you did.

But you throw the IRS a loop: the car is not income. No, siree. It was a gift. Alternatively, it is nontaxable to you as a prize or award.

I give you kudos, but the concept of a gift requires the presence of detached and disinterested generosity. While a creative argument, it could not be reasonably argued that a for-profit magazine was awarding an expensive car to the most valuable player of a televised sporting event out of a detached and disinterested generosity. It was much more likely that both Sport Magazine and General Motors were expecting publicity, advertising and social buzz from the award.

You still have your second argument, though.

Problem is, the prize or award exception requires you to receive it for an educational, artistic, scientific or civic achievement.

You argue your point: being a star football player “calls for a degree of artistry” requiring techniques based on “scientific” principles.

Seriously.

The Court decides:

We believe that petitioner should be caught behind the line of scrimmage on this particular offensive maneuver.”

You have income. And the Court gave us a great quote.

But when do you have income: 1961 or 1962?

The Court reasons through the obvious. You are in Green Bay. The car is in New York. You cannot get to that car - much less title it - unless you had Star Trek technology. However, it is 1961 and Star Trek is not on television yet. You have income in 1962, the following day.

Your tax case is seminal in developing the tax doctrine of constructive receipt. Normally constructive receipt accelerates when you have income, but it did not in your case.You could not have made it to the bank even if you wanted to.

So why did the IRS push the issue of 1961 versus 1962? They didn’t. Remember that you were arguing that the Corvette wasn’t taxable. The IRS had to fight back on that issue. The 1961 thing was a sidebar, albeit that is what the case is remembered for all these years later.

By the way, do you know which football player we have been talking about?

The IRS Should Apologize To This Taxpayer

In income tax land if …

•  You own a corporation, and

•  The corporation has property, and

•  The corporation gives you the property, and

•  You do not pay anything for it, …

… then the IRS will consider you as receiving distribution from the corporation. The classic distribution is a dividend, taxable to you and not deductible by the corporation. 

Perhaps the corporation distributes property and you pay some – but not all – of what the property is worth. A classic example is a corporation distributing a car to the owner’s child for a nominal amount. There is a distribution taxable as a dividend, and the dividend amount would be the value of the car over any amount paid. It would not be the full value of the car in this case.

The tax code views a C corporation (we are not discussing S corporations in this blog) as an entity distinct from its shareholders. That is how Congress justifies taxing the corporation on its income and then taxing the shareholders again when they receive dividends sourced to that income. Since there are two entities, there cannot be double taxation.  

But there is, of course, and it takes sleight of hand to maintain the illusion. Many if not most tax advisors – including me – have steered most of our closely-held business clients away from C corporations and to passthrough entities: perhaps S corporations, partnerships or limited liability companies. Sometimes the weight of the double taxation is unacceptable. 

The Tax Court decided the Welle case just last month. Sure enough, it involved a C corporation and a dividend. More specifically, it involved what the IRS saw as a new species of dividend. 

Let’s walk this through.

There is a construction company (TWC) in North Dakota. It is wholly-owned by Terry Welle (Welle). TWC primarily does multifamily construction, and its historical profit has been around 6 or 7 percent.

Welle decides he is going to build a lakefront property in Minnesota.

NOTE:  Excuse me here, but how about going south with that lakefront property? Is Minnesota that much warmer than North Dakota?

Back to our story. Welle has a company that builds things. He used TWC’s accounting system to track his costs, and he also used its workers to frame the Minnesota house. The company did a calculation of the costs, including overhead, and Welle reimbursed the company to the penny. 

The IRS comes in and finds fault. The IRS wants to know where the company’s profit is. Welle reimbursed the company at cost, including overhead, meaning that they made no profit from him. The IRS says that there should be and must be a profit. They calculate that profit to be around $48,000. Since he did not reimburse the company its erstwhile profit, the IRS assessed him with a $48,000 dividend. It wants $10,620 in income tax.

Oh, the IRS also wants an accuracy-related penalty of over $2,100.

Wow! The IRS is assessing a penalty on a tax theory it has never trotted out before? That is brazen.

This case goes to Court. The IRS argues that a corporate distribution must be measured at fair market value. Fair market value is the amount that would fully reimburse a company for its direct and indirect costs, as well as render a profit.  One cannot disagree with that summary of microeconomics 101.

The Court tells the IRS to back up. It wants the IRS to point to the distribution event before its gets to any issue of measuring and valuing. The Court reasons that a distribution requires assets to be “diverted to or for the benefit of a shareholder.” It must be a vehicle to “distribute available earnings and profits without the expectation of repayment.”

Show us the distribution, says the Court.

The IRS offers and the Court reviews a number of cases, but it cannot see how corporate assets were expended. Welle received services, but then again he paid for them. At most, he used the company as a conduit in maintaining records and paying subcontractors. The company was no better or worse for transacting with him. The event was a nullity.

In frustration, the Court writes:

Respondent does not explain how a corporation’s decision not to make a profit on services provided to a shareholder who fully reimburses the corporation for the cost of services (including overhead) constitutes a distribution of property that reduced the corporation’s earnings and profits under Section 316(a), nor does the respondent cite any cases supporting such a position.”

The Court decided for Welle and against the IRS.

My thoughts? This is one of the lamest tax theories I have come across, and I have near 30 years in the profession. What was the IRS up to? Are there that many North Dakota contractors building lakefront homes that the IRS decided to go where no serious tax practitioner had gone before? 

Let us segue for a moment. 

Do you remember Nina Olsen? She is the Taxpayer Advocate, and we have spoken of her before. The Advocate is supposed to sit outside the IRS and function as a watchdog. It is great idea, but I must admit the IRS for the last half-decade or so has seemed less than interested in the Advocate. Nonetheless, she is promoting an idea she calls the IRS “apology payment.”  The idea is to pay a taxpayer something when the behavior of the IRS causes excessive delay or expense or an undue burden resulting in significant hardship to the taxpayer.

This idea is being refloated in response to the 501(c)(4) scandal. Ms Olson argues that apology payment would: 

Serve as a symbolic gesture that the government recognizes its mistake and the taxpayer’s burden. These payments might enhance the public perception of the IRS and the tax system as just and fair.”

Great idea, although a $1,000 flat sum may be insufficient in some cases.

I would like to see Welle receive his apology payment for the IRS wasting his time.