Friday, December 27, 2013
I have a friend who was considering employment litigation earlier this year. His job has sufficient visibility that it attracts people – some unpleasant and others unhinged. Couple that with a political-correctness-terrified employer and you have a combustible mix.
The taxation of litigation damages leaves room for improvement. Certain types of litigation – say personal injury or employment – are commonly done on a contingency basis. This means that the attorney does not receive fees unless the case is successful or settled. A common contingency fee is one-third. A rational tax system would recognize that the litigant received 67 cents on the dollar and assess tax accordingly. Our system does not do that.
Our tax Code wants to tax the litigant on the full proceeds, although one-third or more went to the attorney. The Code does allow one to deduct that one-third as a miscellaneous itemized deduction. It sounds great but many – if not most – times it amounts to nothing. Why?
· Miscellaneous itemized deductions are deductible only to the extent that they exceed 2% of your adjusted gross income (AGI). Swell that AGI to unrepresentative levels - say by the receipt of damages – and that 2% can amount to a high hurdle.
· Even that result can be overridden by the alternative minimum tax (AMT). The AMT does not allow miscellaneous deductions at all. Forget about deducting that contingency fee if you are an AMT taxpayer, which you likely will be.
· Then you have states, such as Ohio, which do not allow itemized deductions. The damages are sitting in your AGI, though. It stinks to be you.
How did we get to this place?
We know that the tax Code allows one to deduct business expenses against related business income. There may be restrictions – entertainment expenses, for example, or limitations on depreciation – but overall the concept holds. The result of this accounting exercise enters one’s tax return as net profit or loss.
But not always.
For example, I am in the trade or business of being an employee of my accounting firm. My salary enters my individual tax return as gross income. What if I have business expenses relating to the practice? The IRS allows me to deduct those, but not directly against my salary. The IRS instead wants me first to itemize and then claim my accounting-practice expenses therein as a miscellaneous deduction. Miscellaneous deductions are the redheaded stepchild of itemized deductions. They are never deductible in full, and depending on one’s situation, they may not be deductible at all.
Extrapolate this discussion to the recipient of a legal settlement and you have the issue I have with accounting-practice expenses – but greatly magnified, as the dollars are likely more substantive.
So I was pleased to review the case of Bagley v United States.
Richard Bagley had an MBA and a M.S. in accounting. He worked for TRW Inc, and from 1987 to 1992, he was the Chief Financial Manager for their space and technology group. TRW did a lot of work for the government, meaning they had to follow certain accounting procedures when requesting payment from the government. Remember that Bagley was in charge of the accounting, and you have a good idea of where the story is going.
Bagley became aware of bad accounting. He nonetheless signed certifications to the government, mostly because he needed the job. He did the good soldier thing and reported his concerns to his superiors. TRW in turn notified him that he was going to be laid off because of a corporate reorganization, rising tides, Punxsutawney Phil not seeing his shadow and the Chicago Cubs missing the World Series.
He was laid off in 1993.
In 1994 he brought a wrongful termination lawsuit against TRW. He lost that lawsuit.
In that same year, he filed a False Claims Act (FCA) on behalf of the United States against TRW.
There is a peculiarity about a FCA lawsuit that we should discuss. Although Bagley brought the FCA lawsuit, the action was technically brought by the United States against TRW for fraud. Bagley stood-in as an agent for the United States, and his status was that of “relator.”
Bagley took this matter seriously.
During the 1994 to 2003 time period, Bagley exclusively worked on his FSA prosecution activity, and was not otherwise employed.”
He maintained a contemporaneous log of hours he worked on the litigation. He attended meetings with his attorney and government counsel. He spent a lot of time looking through TRW documents. He stayed involved because the attorneys
… weren’t accountants and hadn’t spent 25 years working with TRW and didn’t have an in-depth understanding of TRW’s accounting system or the people or the products or anything about the company which was necessary to understand how the frauds occurred and where the evidence was.”
He logged approximately 5,963 hours working on the FCA. He put in those hours
… in order to successfully prosecute the claims so that [he] would receive an award.”
In 2003 TRW paid the government, which in turn paid Bagley $27,244,000. He in turn paid his attorney $8,990,520. TRW also paid Bagley’s attorneys $9,407,295 and issued the Form 1099 to Bagley.
NOTE: This is standard treatment. The payment to the attorney is imputed to the litigant.
He filed his 2003 Form 1040. There was some complexity on how to handle the attorney fees paid directly by TRW, so he amended the return. He went the usual route of deducting the attorney fees as a miscellaneous deduction. He amended a second time, this time showing the relator litigation as Schedule C self-employment income. He was now deducting the attorney fees directly – and fully - against the litigation proceeds.
The IRS bounced the seconded amended return.
There really was only one issue: did Bagley’s litigation activity rise to the level of Bagley being self-employed?
The Court went through the analysis:
· Pursuing the activity in a business-like manner
· Time and effort expended
· Success in carrying on similar activities
· History of income and losses with respect to the activity
· Financial status while pursuing the activity
· Elements of personal pleasure or recreation
· Regularity and continuity
The IRS argued along different lines. They reminded the Court of the origin and character of the activity giving rise to the FCA claim. Bagley’s claim was that of an informant, according to the IRS, not that of a relator prosecuting the case. According to them, it was Bagley’s status as an informant, not his activities as a relator – that drive the tax consequence.
The Court decided that an action under the FCA was different from a tort action, as the “gravamen” of a FCA action was fraud against the government. The relator stands in the shoes of the government in order to prosecute the claim. This consequently was not a personal claim that Bagley had undertaken. He had no personal stake in the damages sought – all of which, by definition, were suffered by the government.
The Court decided that Bagley did have a trade or business, and that the second amended return was correct. The government was to refund him approximately $3,874,000 plus interest for his 2003 tax year.
Note the tax year involved: 2003. This case was decided just this summer. Sometimes these matters take a while to resolve, but this was an especially slow boat on a lazy river.
OBSERVATION: The facts are too unique for this case to provide much precedence, but I am pleased that Bagley won. Frankly, a minor change to the tax law would make this case obsolete and remove the tax nightmare from future litigation settlements. Simply allowing the litigant to recognize the net damages as income would solve this matter. It would also reflect the equity of the transaction. Do not hold your breath, though.
Thursday, December 19, 2013
It wasn’t too long ago I was speaking with a friend who has a high-level position in the financial industry. The conversation included a reference to Bitcoins and how they might impact what he and his company do. We spent a moment on what Bitcoins are and how they are used.
I am still a bit confused. Bitcoins are a “virtual” currency. They are not issued or backed by any nation or government. They took off as a vehicle for wealthy Chinese to get money out of the mainland, and their market value over the last year has bordered on the stratospheric: from approximately $13 to over $1,000 and back down again. Understand: there is no company in which you can buy stock. To own Bitcoins, you have to own an actual “Bitcoin,” except that Bitcoins is a virtual currency. There is no crisp $20 bill in your wallet. You will have a virtual wallet, though, and your virtual currency will reside in that virtual wallet. I suppose some virtual pickpocket could steal your virtual wallet crammed with virtual currency.
You can own a gold miner stock, for example, although the decision to do that would have proved disastrous in 2013. Then there are Bitcoin “miners,” if you can believe it. Bitcoins presents near-unsolvable mathematical problems, and – if you answer them correctly – you might receive Bitcoins in return. That is how new Bitcoins are created. There a couple of caveats here, though: first, the problems are so complicated that you pretty much have to pool your computer with other people and their computers to even have a prayer of solving the problem. There is also a dark side: the computer security firm Malwarebytes discovered that there was malware that would conscript your computer and its processing power to aid others mine for Bitcoins. Second, only 21 million Bitcoins are supposedly going to be created. Call me a cynic, but look at our government’s fiscal death wish and tell me you believe that assertion.
Bitcoins are tailored made for illegal activities. The currency is virtual; there are no bank accounts or financial institutions to transfer information to the government - yet. China has banned their financial institutions from using Bitcoins, and Thailand has made it illegal altogether. Bitcoins was tied into Silk Road, which was an eBay (of sorts) for drugs and who knows what else. One apparently had to be a computer geniac to even get to it, as Silk Road resided in the dark web and required specialized access software (such as Tor) to access. Its founder was known as Dread Pirate Roberts (I admit, I like the pseudonym), and Silk Road accepted only Bitcoins as payment. The Pirate gave an interview to Forbes and was subsequently arrested by the FBI. You can draw your own conclusion on the cause and effect.
Did you know that there are merchants out there who will accept payment in Bitcoins, and in some cases only in Bitcoins? There is even a small town in Kentucky that agreed to pay its police chief in Bitcoins.
So how would Bitcoins be taxed? It depends. Let’s say you are trading the Bitcoins themselves, the same way you would trade stocks or baseball cards. You then need to know whether the IRS considers Bitcoins to be a currency or a capital asset.
There is a downside to treating Bitcoins as a currency: IRC Section 988 treats gains and losses from currency trading as ordinary gains and losses. This means that you run the tax rates, currently topping-out at 39.6% before including the effects of the PEP and Pease phase-outs and as well as the ObamaCare taxes.
What if Bitcoins are treated as a capital asset? We would then have company. Norway has decided that Bitcoins is not a currency and will charge capital gains taxes. Germany has said the same. Sweden wants to subject Bitcoins to their VAT. The advantage to being a capital asset is that the maximum U.S. capital gains tax is 20%. However, remember that capital losses are not tax-favored. Capital losses can offset capital gains without limit, but capital losses can offset only $3,000 of other income annually.
There is a capital asset subset known as commodities. Futures trades on a currency (as opposed to trading the actual currency itself) are taxed under Section 1256, which arbitrarily splits any gain into 60% long-term and 40% short-term. Now only 60% of your gain is subject to the favorable long-term capital gains tax. However, futures contracts on Bitcoins do not yet exist.
What if you are not trading Bitcoins but rather receiving them as payment for merchandise or services? This sounds like a barter transaction, and the IRS has long recognized barter transactions as taxable. What price do you use for Bitcoins? There are multiple exchanges – Mt. Gox or coinbase, for example – with different prices. One could take a sample of the prices and average, I suppose.
I also question what to do with the price swings. Say you received a Bitcoin when it was trading at $900. Under barter rules, you would have $900 in income. You spend the Bitcoin a week or month later when the Bitcoin is worth $700. You have lost $200 in value, have you not? Is there a tax consequence here?
If it were a capital asset, you would have “bought” it for $900 and “sold” it for $700. It appears you have a capital loss.
This doesn’t necessarily mean that that the loss is deductible. Your home, for example, is a capital asset. Gain from the sale of your home is taxable if it exceeds the exclusion, but loss from the sale of your home is never deductible.
If it were a currency AND the transaction was business-related, you would have a deduction, but in this case it would be a currency loss rather than a capital loss. A currency loss is an ordinary loss and would not be subject to the $3,000 annual capital loss restriction.
If it were a currency AND the transaction was NOT business-related, you are likely hosed. This would be the same as vacationing in Europe and losing money from converting into and out of Euros. The transaction is personal, and the tax Code disallows deductions for personal purposes.
What do you have if you “mined” one of those Bitcoins? When are you taxed: when you receive it or when you dispose of it?
Bitcoins are virtual currency. Do you have to include Bitcoins when you file your annual FBAR for financial accounts outside the U.S. with balances over $10,000? Where would a Bitcoin reside, exactly?
The IRS has not told us how handle the taxation of Bitcoins transactions. Until then, we are on our own.
Friday, December 13, 2013
I am reading Yung v Grant Thornton. This is a mammoth decision – it runs over 200 pages.
William Yung (Yung) owns a hotel and casino company (Columbia Sussex) based in northern Kentucky. I remember meeting with some of his tax people several years ago. I have watched fireworks from his Kentucky office location.
Then there is Grant Thornton (Grant), a national accounting firm, and its former partner, Jon Michel (Michel). Jon and I worked for the same accounting firm, although not at the same time. I remember having lunch with Jon a few years later and discussing joining Grant Thornton’s tax team. I also remember the unacceptable sales pressure that went with joining Grant. I passed on that, and I am glad I did.
Jon is in the tax literature, and not in a good way. It has a lot to do with that sales pressure.
Today we are talking about tax shelters.
CPA firms - especially the nationals - in the 1990s and aughts became almost pathologically obsessed with profitability. Accounting practice was changing, and the tradition of accountants being business advisors and confidantes was being replaced with a new, profit-driven model. We saw metrics like “write-ups” and “write-downs” by individual accountants. There were “individual” marketing plans for accountants two or three years into the profession and having another five or seven job changes ahead of them. I remember a CPA whose promotion to manager was delayed because she missed her “chargeable” budget by approximately 40 hours – over the course of an entire year.
And tax departments were leaned upon to come up with new “products” to market to clients.
COMMENT: Referring to tax advice as a “product” tells one a lot about the underlying motivation of whoever is promoting it. I for example do not sell a “product.” I provide business and tax advice. If you want a product, go to Amazon.
So what flavor of tax shelter are we talking about?
Yung and family and family entities (such as Columbia Sussex) own casinos and hotels. Some of them are in the Cayman Islands, which would make them controlled foreign corporations (CFCs). You may recall that the U.S. wants to tax all U.S. businesses on their worldwide income. Since doing so would almost guarantee that there would be no U.S. - based international businesses, the tax Code allows for tax deferrals, then exceptions to those deferrals, and then exceptions to the exceptions, and so on. It borders on lunacy, frankly, but this is what Yung and entities were caught in. Yung and entities had monies overseas, but it would have cost a fortune in taxes to bring the monies back to the U.S. Yung’s son Joe traveled regularly to the Caribbean, Central and South America seeking acquisition opportunities as a means to reinvest the Cayman monies. Grant was their accounting firm. Jon Michel even assisted in the acquisition of a Canadian hotel.
There was opportunity there for a sharp tax advisor.
Here is opportunity knocking:
· A partnership contributes cash to a foreign corporation (FC). It receives the common stock.
· Another party also contributes cash. In return it receives preferred stock.
· The FC borrows money from a bank.
· With the money, the FC buys marketable securities.
· FC then distributes the securities, with its attendant debt (sort of), to the partnership, liquidating the partnership’s investment in FC.
· There is a technical tax rule concerning a distribution with debt attached. The debt reduces the fair market value of the securities. If the debt were equal to the value of the securities, for example, the net distribution would be zero (-0- ).
· The partnership received a liquidating distribution worth zero (or near zero) but had an investment equal to the cash it put in FC. This leads to a big tax loss.
So far, so good. The partnership received marketable securities, but it also has to pay back the bank. Where is the tax shelter, then?
· The FC later pays off the debt.
The partnership is out no money but has a big tax loss.
The key to this was being able to reduce the liquidating distribution by the bank debt, even though the partnership never intended to pay the debt. Some tax CPAs and tax attorneys argued that this was fine, as tax Code Section 301(b)(2)(B) reduced the distribution…
“… by the amount of any liability to which the property received by the shareholder is subject immediately before, and immediately after, the distribution.”
We are talking the Bond and Optional Sales Strategy tax shelter sold by Price Waterhouse in the 1990s. The nickname was BOSS, and the IRS was determined to come down hard on the BOSS transactions and enablers. Frankly, I don’t blame them.
In 1999 the IRS published Notice 99-59, which warned that tax losses claimed in a BOSS transaction were not allowable for federal income tax purposes. The Service also warned of substantial and numerous penalties.
Congress followed this up with new tax Regulations to Section 301 in 2000.
So what did Grant Thornton do? It developed a new “product” which it called “Leveraged 301 Distributions” or Lev301. How did it work? Here is an internal Grant document:
The objective of the Leveraged 301 Distributions tax product is to structure distributions in order to permanently avoid taxability to shareholders. Either closely-held C corporations or S corporations can distribute assets subject to liabilities … and provide this benefit to shareholders.”
How similar is this thing to BOSS, which provoked Notice 99-59 and new tax Regulations? Back to that Grant internal document:
Further the IRS may assert arguments it used against the BOSS transaction in Notice 99-59 and against the subject-to language of former IRS Section 357”
This has to be a finalist for the “Worst Timing Ever” award.
Grant goes live with the product in June 2000. Jon Michel begins to promote the thing, including to Yung and Columbia Sussex.
You already know this thing went to trial, so let’s fast-forward to some language from the Court:
No one associated with Grant Thornton, even those intimately involved in the process who testified to the court, has stepped forward and taken credit for the idea and creation of Lev301.”
Hey, but Lev301 is substantially different from BOSS, right?
Here is the Court:
Grant Thornton believed that there was a 90% chance that the IRS would disallow the tax benefits on the Lev301 on audit.”
Good grief! Why would a self-respecting tax advisor be associated with this?
Yung and Columbia Sussex were not told about the 90% chance.
The court finds that Yung and associates brought income into the United States from his CFC’s on a routine basis. Yung and his associates looked for ways to accelerate this process but vetted possible means of doing so with a close concern for the risks involved, as evidenced by the decision not to participate in other tax strategies presented to them. Yung and his associates maintained a very conservative risk level about income tax reporting as evidenced by the IRS complimenting the consistent approach to paying taxes. The court finds the Yung’s testimony to be consistent with this approach to tax reporting and, therefore, to be credible.”
What did the Court say about Grant?
The evidence indicates everyone who participated was on high alert regarding this product. As a result, while this court certainly understands the fading of memory, the failure of some of Grant Thornton’s witnesses to recall anything about their participation in the research and development of this product is disingenuous and not credible.”
Let’s continue. Would Jon Michel have been permitted to meet and pitch Lev301 to Yung had Yung’s tax department been informed of the risk?
The likelihood that the IRS would view the Lev301 as an unlawful abusive tax shelter was a present risk that would have impacted … (Columbia Sussex’ CFO) decision to allow …. J(on) Michel to present Lev301 to Yung. Had the risk been disclosed … (Columbia Sussex’ CFO), (as he had done with the prior proposals) would have terminated discussions about Lev301 at that point.”
So Jon Michel and Yung meet. Yung wanted to know if other Grant clients had used this scheme.
J(on) Michel told Yung that, while he could not divulge the names of other Grant Thornton clients, he could disclose that a local jet-engine manufacturer and a local consumer products manufacturer had successfully used the Lev301 strategy to transfer foreign wealth to the U.S.”
For those of us who live in Cincinnati, the reference to GE and Proctor & Gamble is unmistakable. Still, if GE and P&G did use the strategy…
When Michel made this representation to Joe Yung, he had no knowledge as to whether GE and P&G had utilized a Lev301-like strategy.”
All right then.
In 2002 the IRS initiated an examination of Grant Thornton. The IRS issued a summons asking for documents relating to Grant’s promotion of Lev301 and the names of clients who participated in the product.
Grant Thornton did not notify the Yungs … about the summons, which further increased the likelihood that the Yungs … would be audited by the IRS on account of their participation in the Lev301.”
In November of 2002 the IRS audited Columbia Sussex for reasons unrelated to Lev301.
NOTE: This is fairly common for larger, higher-profile corporations. It does not necessarily mean anything.
Grant was hired to represent during the tax audit.
In 2003 Yung and Columbia Sussex received an Information Document Request from the IRS. The IRS wanted to know whether they had directly or indirectly participated in any transactions that were the same or substantially similar to a “listed” transaction.
NOTE: Like a BOSS or a BOSS-like transaction.
Jon Michel answered the question “No.”
The tax director at Columbia Sussex later read in a trade journal that the government was summoning Grant Thornton. He called Jon Michel. Jon informed Yung and associates that Grant was likely to comply with the summons and that client names would be turned over to the IRS.
And they were.
The IRS expanded its audit of Columbia Sussex to include more years, the Yung family, family entities and any unfortunate soul driving past corporate headquarters on I-275 in northern Kentucky. On the other hand, in 2004 Jon Michel wrote a nice letter to Yung and entities offering limited tax representation before the IRS.
Do we need to continue this story?
The Yung family and entities owed over $18 million in tax, interest and penalties to the IRS.
If this were you, what would you do next?
You would sue Grant Thornton.
COMMENT: Be honest: this is a Mr. Obvious moment.
A Kentucky circuit court has just ordered Grant Thornton to pay Yung and family and entities approximately $100 million, including $80 million in punitive damages. The judge described Grant’s actions as “reprehensible.”
Grant intends to appeal, saying:
We are disappointed in the Court’s ruling and believe we have strong grounds for an appeal, which we will pursue.”
Grant has to appeal the decision, of course.
Remember that Yung is in the hotel and casino business, an industry subject to higher financial and personal scrutiny. What is the collateral and reputational damage to him and his entities from an abusive tax shelter? Yung has said the ordeal has already cost him a casino license in Missouri.
I have little patience for this type of practice. What was motivating Grant with the Lev301 “product”- solving a client’s tax problem or generating a million dollar fee? Could it be both? Sure, but the smart money would bet the other way. This type of behavior is not “practice.” It is greed, it is an abuse of a professional relationship and it is disreputable to those of us who try to practice between the lines.