Cincyblogs.com
Showing posts with label depletion. Show all posts
Showing posts with label depletion. Show all posts

Friday, August 12, 2016

CTG University: Part One

Let's discuss a famous tax case, and then I will ask you how you would decide a second case based on the decision in the first.



We are going back to 1944, and Lewis received a $22 thousand bonus.  He reported it on his 1944 tax return. It turns out that the bonus had been calculated incorrectly, and he returned $11,000 in 1946. Lewis argued that the $11,000 was mistake, and as a mistake it should not have been taxed to him in 1944. He should be able to amend his 1944 return and get his taxes back. This had an extra meaning since his tax rate in 1946 was lower (remember: post-war), so if he could not amend 1944 he would never get all his taxes back.

The IRS took a very different stand. It pointed out that the tax Code measures income annually. While arbitrary, it is a necessary convention otherwise one could not calculate income or the tax thereon, as there would (almost) always be one or more transactions not resolving by the end of the year. Think for example of writing a check to the church on December 31 but the check not clearing until the following year. The Code therefore taxes income on a "period" concept and not a "transactional" concept. With that backdrop, Lewis would have a deduction in 1946, when he returned the excess bonus.

The case went to the Supreme Court, which found that the full bonus was taxable in 1944. The Court reasoned that Lewis had a "claim of right," a phrase which has now entered the tax literature. It means that income is taxable when received, if there are no restrictions on its disposition. This is true even if later one has to return the income. The reasoning is that there are no limits on one's ability to spend the money, and there is also no immediate belief that it has to be repaid. Lewis had a deduction in 1946.

Looks like the claim of right is a subset of "every tax year stands on its own."

Let's roll into the 1950s. There was a company by the name of Skelly Oil. During the years 1952 through 1957 it overcharged customers approximately $500 thousand. In 1958 it refunded the $500 thousand.

You can pretty much see the Lewis and claim-of-right issue.

But there was one more fact.

Skelly Oil had deducted depletion of 27.5%. Depletion is a concept similar to depreciation, but it does not have to be tied to cost. Say you bought a machine for $100,000. You would depreciate the machine by immediately expensing, allocating expense over time or whatever, but you would have to stop at $100,000. You cannot depreciate more than what you spent. Depletion is a similar concept, but without that limitation. One would deplete (not depreciate) an oil field, for example. One would continue depleting even if one had fully recovered the cost of the field. It is a nice tax gimmick.

Skelly Oil had claimed 27.5% depletion against its $500,000 thousand or so, meaning that it had paid tax on a net of $366,000.

Skelly Oil deducted the $505,000 thousand.

Skelly Oil had a leg up after the Burnet v. Sanford & Brooks and Lewis decisions, as every tax year was to stand on its own. It refunded $505,000, meaning it had a deduction of $505,000. Seemed a slam dunk.

The IRS said no way. The $505,000 had a trailer attached - that 27.5% depletion - and wherever it went that 27.5% went. The most Skelly Oil could deduct was the $366,000.

But the IRS had a problem: the tax Code was based on period reporting and not transactional reporting. The 27.5% trailer analogy was stunning on the big screen and all, but it was not tax law. There was no ball hitch on the $505,000 dragging depletion in its wake.

Here is the Supreme Court: 
[T]he Code should not be interpreted to allow respondent 'the practical equivalent of double deduction,' *** absent a clear declaration of intent by Congress."

The dissent argued (in my words):           
So what? Every year stands on its own. Since when is the Code concerned with the proper measurement of income?

Odd thing, though: the dissent was right. The Lewis decision does indicate that Skelly Oil had a $505,000 deduction, even though it might not have seemed fair. The Court reached instead for another concept - the Arrowsmith concept. 
[T]he annual accounting concept does not require us to close our eyes to what happened in prior years."

There is your ball hitch. The concept of "net items" would drag the 27.5% depletion into 1958. "Net items" would include revenues and deductions so closely related as to be inseparable. Like oil revenues and its related depletion deduction.

The Court gave us the following famous quote: 
In other situations when the taxes on a receipt do not equal the tax benefits of a repayment, either the taxpayer or the Government may, depending on circumstances, be the beneficiary. Here, the taxpayer always wins and the Government always loses."

And over time the Skelly Oil case has come to be interpreted as disallowing a tax treatment where "the taxpayer always wins and the Government always loses." The reverse, however, is and has always been acceptable to the Government.

But you can see something about the evolution of tax law: you don't really know the law until the Court decides the law. Both Lewis and Skelly Oil could have gone either way.

Now think of the tax law, rulings and Regulations being published every year. Do we really know what this law means, or are we just waiting our turn, like Lewis and Skelly Oil?

Thursday, September 22, 2011

President’s “Plan For Economic Growth and Deficit Reduction”


I was reviewing the tax provisions of the President’s “Plan for Economic Growth and Deficit Reduction.” It is possible that the “Super Committee” may adopt some of the tax provisions, so perhaps it is worthwhile to review the proposals.
(1)  Extend through 2012 the 100% bonus first-year depreciation.
(2)  Reduce the employer portion of the social security tax from 6.2% to 3.1%.
a.       This would cap-out at $5 million in payroll.
b.      Therefore the maximum cut would be $155,000 ($5,000,000 times 3.1%).
(3)  Create a tax credit for hiring employees who have been out-of-work for more than 6 months.
(4)  Create a tax credit to offset the increase in social security tax attributable to payroll increases over the corresponding period of the preceding year.
a.       So if your payroll was $1 million last year and $1.5 million this year, you would receive a credit for the social security taxes on the $0.5 million increase.
b.      There is a cap of $50 million.
c.       The credit would be good for the last quarter of this year and all of 2012.
(5)  The pre-EGTRAA tax rates would return for those making over $200,000 and $250,000.
OBSERVATION: Senator Schumer thinks these limits should be higher for New Yorkers. He is the senator from … New York.
(6)  Limit the tax rate at which high-incomes can reduce their tax to 28% for itemized deductions, excluded foreign income, health insurance and other selected deductions.
OBSERVATION: Right… make the calculation so complicated that even tax software won’t be able to get it right. Perhaps Congress and the WH should start with eliminating the phase-outs for personal exemptions, itemized deductions, student loan interest, education credits, child credit, AMT exemption and etc that would make this a circular calculation to stress even a mathematics graduate student.

(7)  Reduce the employee social security tax from 6.2% to 3.1%.
OBSERVATION:  Read this in conjunction with (2) above.
(8)  Repeal last-in first-out accounting (LIFO).
OBSERVATION: There is no accounting reason for this, as LIFO is considered to be a generally accepted accounting principle. It forms the tax accounting backbone of virtually every vehicle dealership in the nation.
(9)  Repeal the use of lower-of-cost –or-market inventory accounting.
OBSERVATION: Again, there is no accounting reason for this.
(10)  Increase the net FUTA tax from 0.6% to 0.8%.
OBSERVATION:  FUTA was increased on a “temporary” basis from 0.6% to 0.8% in 1976, although it went back to 0.6% this year. Does that sound “temporary” to you?
(11)  Eliminate the percentage depletion and intangible drilling cost provisions for oil and gas companies.
(12)  Eliminate coal activity expensing of exploration and development costs, as well as percentage depletion for hard mineral deposits and capital gains for royalties.
(13)  Modify the transfer-for-value exception on life insurance contracts.
OBSERVATION: Seems the viatical industry has drawn attention to itself.
(14)  Require business jets to be depreciated over 7 years rather than 5.
(15)  Revise the rules on transfers of intangibles to controlled foreign corporations.
OBSERVATION:  Think Google.
(16)  Revise the rules on the deductibility of interest paid to foreign persons.
I leave it to you to deem how serious you consider these proposals.