Wednesday, November 26, 2014

When Does A Grocery Store Get To Deduct the Fuel Points You Receive?

There is a grocery store chain that my wife uses on a regular basis. They have a gasoline-discount program, whereby amounts spent on purchasing groceries go toward price discounts on the purchase of gasoline. As the gas stations are adjacent to the grocery store, it is a convenient perk.

I admit I used the discount all the time. I purchased a luxury car this year, however, and my mechanic has advised me not to use their gasoline. It sounds a bit over the top, but until I learn otherwise I am purchasing gasoline elsewhere. My wife however continues as a regular customer.

Giant Eagle is a grocery store chain headquartered out of Pittsburgh. They have locations In Pennsylvania, Ohio, West Virginia and Maryland. They have a similar fuel perk program, except that their gasoline station is called “GetGo” and their fuel points are called “fuelperks!”

Their fuelperks! operate a bit differently, though. The perks expire after three months, and they reduce the price of the fuel to the extent possible. I suppose it is possible that they could reduce the price to zero. My fuel points reduce the price of a gallon by 10-cent increments, up to a ceiling. I am not going to get to zero.

Giant Eagle found itself in Tax Court over its 2006 and 2007 tax returns. The IRS was questioning a deduction on its consolidated tax return: the accrued liability for those fuelperks! at year-end. The liabilities were formidable, amounting to $6.1 million and $1.1 million for 2006 and 2007, respectively. Multiply that by a corporate tax rate of 34% and there are real dollars at stake.

What are they arguing over?

To answer that, let’s step back for a moment and talk about methods of accounting. There are two broad overall methods: the cash method and the accrual method. The cash method is easy to understand: one has income upon receiving money and has deductions upon spending money. There are tweaks for uncashed checks, credit cards and so forth, but the concept is intuitive.

The accrual method is not based on receiving or disbursing cash at all. Rather, one has income when monies are due from sale of product or for performance of services. That is, one has income when one has a “receivable” from a customer or client. Conversely one has a deduction when one owes someone for the provision of product or services. That is, one has a “payable” to a vendor, government agency or employee.

If one has inventories, one has to use the accrual method for tax purposes. Take a grocery store – which is nothing but inventory – and Giant Eagle is filing an accrual-basis tax return. There is no choice on that one.

There are additional and restrictive tax rules that are placed on “payables” before one is allowed to deduct them on a tax return. These are the “all events” rules, are found in IRC Section 461(h), and have three parts:

·        Liability must be fixed as of year end
·        Liability must be determined with reasonable accuracy
·        Economic performance must occur

Why all this?

Congress was concerned that accrual taxpayers could “make up” deductions willy-nilly absent more stringent rules. For example, a grocery store could argue that its coolers were continuously wearing out, so a deduction for a “reserve” to replace the coolers would be appropriate. Take the concept, multiply it by endless fact patterns and – unfortunately – Congress was probably right.

All parties would agree that Giant Eagle has a liability at year-end for those fuel points. Rest assured that the financials statement auditors are not have any qualms about showing the liability. The question becomes: does that liability on the financial statements rise to the level of a deduction on the tax return?

You ever wonder what people are talking about when they refer to a company’s financial statements and tax return and say that there are “two sets of books?” Here is but a small example of how that happens, and it happens because Congress made it happen. There are almost endless examples throughout the tax Code.

The IRS is adamant that Giant Eagle has not met the first requirement: the “liability must be fixed.”

To a non-tax person, that must sound like lunacy. Giant Eagle has tens of thousands of customers throughout multiple states, racking up tons of fuel discount points for the purchase of gasoline at – how convenient – gasoline stations right next to the store. What does the IRS think that people are going to do with those points? Put them on eBay? If that isn’t a liability then the pope is not Catholic.

But consider this…

The points expire after three months. There is no guarantee that they are going to be used.

OK, you say, but that does not mean that there isn’t a liability. It just means that we are discussing how much the liability is. The existence of the liability is given.

COMMENT: Say, you have potential as a tax person, you know that?

That is not what the IRS was arguing. Instead they were arguing that the liability was not “fixed,” meaning that all the facts to establish the liability were not in.

How could all the facts not be in? The auditors are going to put a liability on the year-end audited financial statements. What more do you want?

The IRS reminds you that it refuses to be bound by financial statement generally-accepted-accounting-principles accounting. Its mission is to raise and collect money, not necessarily to measure things the way the SEC would require in a set of audited financial statements in order for you not to go to jail. In fact, if you were to release financial statements using IRS-approved accounting you would probably have serious issues with the SEC.

OK, IRS, what “fact” is missing?

The customer has to return. To the gasoline station. And buy gasoline. And enough gasoline to zero-out the fuel points. Until then all the facts are not in.

Another way of saying it is that there is a condition precedent to the redemption of the fuel points: the purchase of gasoline. Test (1) of Sec 469(h) does not allow for any conditions subsequent to the liability in order to claim the tax deduction, and unfortunately Giant Eagle has a condition subsequent. No deduction for you!

Mind you the deduction is not lost forever. It is delayed until the following year, because (surely) by the following year all the facts are in to establish the liability. The effect is to put a one-year delay on the liability: in 2008 Giant Eagle would deduct the 12/31/2007 liability; in 2009 it would deduct the 12/31/2008 liability, and so on.

And the government gets its money a year early. It is a payday-lender mentality, but there you are.

BTW test (1) is not even the difficult part of Section 469(h). That honor is reserved for test (3): the economic performance test. Some day we will talk about it, but not today. That one does get bizarre.

Wednesday, November 19, 2014

Buffett's Berkshire Hathaway Is Buying Duracell From Procter & Gamble

You may have read that Warren Buffett (through Berkshire Hathaway) is acquiring the Duracell battery line of business from Procter & Gamble in a deal worth approximately $4.7 billion. The transaction will be stock-for-stock, although P&G is stuffing approximately $1.7 billion of cash into Duracell before Berkshire takes over. Berkshire will exchange all its P&G stock in the deal. Even better, there should be minimal or no income tax, either to P&G or to Berkshire Hathaway.

Do you wonder how?

The tax technique being used is called a “cash rich split off.” Believe it or not, it is fairly well-trod ground, which may seem amazing given the dollars at play.

Let’s talk about it.

To start off, there is virtually no way for a corporation to distribute money to an individual shareholder and yet keep it from being taxable. This deal is between corporations, not individuals, albeit the corporations contain cash. Lots of cash.

How is Buffett going to get the money out? 

·        Buffet has no intention of “getting the money out.” The money will stay inside a corporation. Of course, it helps to be as wealthy as Warren Buffett, as he truly does not need the money.
·        What Buffett will do is use the money to operate and fund ongoing corporate activities. This likely means eventually buying another business.

Therefore we can restrict ourselves to corporate taxation when reviewing the tax consequences to P&G and Berkshire Hathaway.

How would P&G have a tax consequence?

P&G is distributing assets (the Duracell division) to a shareholder (Berkshire owns 1.9% of P&G stock). Duracell is worth a lot of money, much more money than P&G has invested in it. Another way of saying this is that Duracell has “appreciated,” the same way you would buy a stock and watch it go up (“appreciate”) in value.

And there is the trip wire. Since the repeal of General Utilities in 1986, a corporation recognizes gain when it distributes appreciated assets to a shareholder. P&G would have tax on its appreciation when it distributes Duracell. There are extremely few ways left to avoid this result.

But one way remaining is a corporate reorganization.

And the reorganization that P&G is using is a “split-off.” The idea is that a corporation distributes assets to a shareholder, who in turn returns corporate stock owned by that shareholder. After the deed, the shareholder owns no more stock in the corporation, hence the “split.” You go your way and I go mine.

Berkshire owns 1.9% of P&G. P&G is distributing Duracell, and Berkshire will in turn return all its stock in P&G. P&G has one less shareholder, and Berkshire walks away with Duracell under its arm.

When structured this way, P&G has no taxable gain on the transaction, although it transferred an appreciated asset – Duracell. The reason is that the Code sections addressing the corporate reorganization (Sections 368 and 355) trump the Code section (Section 311) that would otherwise force P&G to recognize gain.

P&G gets to buy back its stock (via the split-off) and divest itself of an asset/line of business that does not interest it anymore - without paying any tax.

What about Berkshire Hathaway?

The tax Code generally wants the shareholder to pay tax when it receives a redemption distribution from a corporation (Code section 302).  The shareholder will have gain to the extent that the distribution received exceeds his/her “basis” in the stock.

Berkshire receives Duracell, estimated to have a value of approximately $4.7 billion. Berkshire’s tax basis in P&G stock is approximately $336 million. Now, $336 million is a big number, but $4.7 billion is much bigger.  Can you imagine what the tax would be on that gain?

Which Berkshire has no intention of paying.

As long as the spin-off meets the necessary tax requirements, IRC Section 355 will override Section 302, shielding Berkshire from recognizing any gain.

Berkshire gets a successful business stuffed with cash – without paying any tax.

Buffett likes this type of deals. I believe he has made three of them over the last two or so years. I cannot blame him. I would too. Except I would take the cash. I would pay that tax with a smile.

There are limits to a cash-rich split off, by the way.

There can be only so much cash stuffed into a corporation and still get the tax magic to happen. How much? The cash and securities cannot equal or exceed two-thirds of the value of the company being distributed. In a $4.7 billion deal, that means a threshold of $3.1 billion. P&G and Berkshire are well within that limit.

Why two-thirds?

As happens with so much of tax law, somebody somewhere pushed the envelope too far, and Congress pushed back. That somebody is a well-known mutual fund company from Denver. You may even own some of their funds in your 401(k). They brought us IRC Section 355(g), also known as the two-thirds rule. We will talk about them in another blog.

Thursday, November 13, 2014

Employers - Be Careful With Medical Reimbursement Plans

I am reading a notice from the Department of Labor titled “FAQs about Affordable Care Act Implementation (Part XXII)."

This will never make it as summer reading while on a beach.

And the DOL pretty much says what many practitioners concluded last year when the IRS issued Notice 2013-54, addressing employer reimbursement arrangements and individual health insurance policies acquired on an exchange.
COMMENT: “Exchange” and “marketplace” are the same.
The government does NOT like them.

Let’s clarify what we are talking about. There used to be a very common arrangement whereby an employer would pay your health insurance, reimburse your medical expenses, or a combination of the two, with no tax to you. These plans had several names, including health reimbursement plans or Section 105 plans. The practice had been around since before I was born.

Introduce ObamaCare. Say that someone goes on the exchange and buys an individual policy. Let’s take one more step and say that someone qualifies for a government subsidy on that individual policy.

Step One: You have someone getting money (in the form of the subsidy) from the government.

Say that person’s employer has a health reimbursement plan. The plan reimburses medical expenses, including insurance, up to some dollar amount – say $2,500.

Step Two: That person submits his/her government-subsidized Obamacare policy to the employer for reimbursement, up to $2,500.

To the extent that person’s share of the policy cost was less than $2,500, that person has broken even on the deal. To the extent that his/her share was $2,500 or more, his/her share of the cost would be $2,500 less.

Step Three: The government did not like this, did not like this at all. They huffed and they puffed and they issued Notice 2013-54, which pretty much indicated that the government was not going to allow a mixture of Obamacare individual health policies and employer reimbursement plans. Many practitioners were shocked. Heck, I myself had a similar plan at one time.

But there were a select few companies who continued marketing these things. Introduce some painful and lawyerly reading of the rules, and the companies declared that “their” plan would somehow pass muster with Notice 2013-54.

If there was any legitimate question, there is none now.

Let’s review Q&A 3:

Q: A vendor markets a product to employers claiming that employers can cancel their group policies, set up a Code section 105 reimbursement plan that works with health insurance brokers or agents to help employees select individual insurance policies, and allow eligible employees to access the premium tax credits for marketplace coverage. Is this permissible?

A: No. … the arrangements described in this Q3 are themselves group health plans and, therefore, employees participating in such arrangements are ineligible for premium tax credits….
Second, as explained in …, such arrangements are subject to the market reform provisions of the Affordable Care Act …. Such employer health care arrangements cannot be integrated with individual market policies to satisfy the market reforms, and, therefore, will violate …., which can trigger penalties such as excise taxes under section 4980D of the Code.

There are extremely limited exceptions, such as a one-person employer, but the broad broom has swept. The government is not going to allow a tax-free employer reimbursement for an individual policy acquired on an exchange.

So what if the employer included the reimbursement on the employee’s W-2? It would not be tax-free then, by definition. My previous understanding was that an employer could reimburse the individual policy, as long as the reimbursement was included on the employee’s W-2.

COMMENT: Another way to say it is that the government doesn’t care, as long as it gets its tax.

Let’s take a look at Q&A 1:

Q: My employer offers cash to reimburse the purchase of an individual market policy. Does this arrangement comply with the market reforms?

A: No. If the employer uses an arrangement that provides cash reimbursement for the purchase of an individual market policy, the employer’s payment arrangement is part of a plan, fund, or other arrangement established or maintained for the purpose of providing medical care to employees, without regard to whether the employer treats the money as pre-tax or post-tax to the employee.

Huh? Wait a minute here.

I interpret this to mean that an employer cannot have employees submit their insurance bills for reimbursement in lieu of other compensation. To phrase it differently, the employer must give the employee a raise (or bonus) and the employee must decide whether he/she wants to use the raise (or bonus) toward the insurance. The employee may decide to take the money and go on vacation; the employer cannot decide this for the employee.

By the way, notice that we have been speaking about individual health policies. The above discussion does not apply to group health policies acquired through SHOP, which is the exchange for businesses with less than 50 full-time employees. Those polices are group policies, not individual policies, and do not qualify for the ObamaCare subsidy. No subsidy, different rules.

Saturday, November 8, 2014

Is Income From Investing Tax-Exempt Income Also Tax-Exempt?

Our story starts in 2005. Taxpayer (Lundy) received a Form 1099-R reporting approximately $42,000 of “retirement” income. The Lundys left it off their tax return. The IRS noticed and demanded payment. Off to Tax Court they went. Before there could be any hearing, the IRS settled, agreeing there was no tax due.

This action is referred to as a “stipulated” decision, and they tend to be about as terse as Bill Belichick at a press conference. We won’t read much there.

That said, I am thinking personal injury. We know that damages for personal injuries (think car accident) are tax-free. My hunch is that Lundy got injured, received a $42,000 settlement and a Form 1099-R to boot. Somebody messed up by issuing the 1099 in the first place. The IRS made a second mistake by not adequately investigating the facts before taking the matter to court.

Fast forward 6 years.

The Lundys file their tax return for 2011. Mr. Lundy has a W-2 from driving a school bus, and Mrs. Lundy has approximately $20,000 from a small business. There is some income tax, throw in some self-employment tax, and the Lundys owed about $3,500.

They send in the return. They do not send in any money, nor was there any withholding on Mr. Lundy’s W-2.

The IRS – of course – wants to know why. And they want their money.

The Lundy’s have no intention of sending money. 

The Lundys file a request for a due process hearing.

Their argument?

The funds that you are attempting to collect from are indeed part of my total and permanently [sic] disability benefits which were subject of the UNITED STATES TAX COURT CASE # 2759-07S***. We filed a timely appeal to the U.S. TAX COURT and laid out all of our affirmative defenses to the Commissioner of the Internal Revenue Service claims at that time. The most important claim that we made at that time is that whatever we funded, financed, and paid for with my total and permanently [sic] disability funds which were determined by this order to be non-reportable, tax free, and tax exempt from the clutches of the IRS was also off limits from the IRS.”

Well then.

Let’s think about their argument for a moment. The Lundys were arguing that any income earned from a tax-free source would – in turn – also be tax-free. Does this make sense? Let me give you a few situations:

·        You sell your primary residence, excluding $500,000 of gain. You invest the $500,000 in the next hot IPO. It takes off, and next thing you know you are rubbing shoulders with Gates, Buffett and Zuckerberg.
·        You take the interest from your municipal bond fund to fund the next great mobile app. You are subsequently acquired by Apple and you buy Ecuador.
·        You work overseas for a number of years, always claiming the foreign earned income exclusion. You invest your tax savings in raw land. Two decades later you sell the land to someone developing an outdoor mall. You buy a county in Wyoming so you have somewhere to hunt.

Of course it doesn’t make sense. It is clear that we have to separate the cart from the groceries. The cart stays at the store while the groceries go home with you. They are two different things, and the fate of the cart is not the fate of the groceries. Income from a tax-free pile of money does not mean that the earnings are magically tax-free. If only it were so. Could you imagine the ads from Fidelity or Vanguard if it were that simple?

The Lundys lost, of course.

Of surprise to me, as a practitioner, was the IRS restraint on penalties. The IRS popped them for late payment penalties, of course, but not for the super-duper penalties, such as for substantial accuracy. Why?

Who knows, but I did notice the Tax Court case was “pro se,” meaning that the Lundys represented themselves. There is a way to have a tax practitioner involved in a “pro se,” but I do not think that is what happened here. I suspect they actually represented themselves, without an accountant or attorney.

Not that an accountant or attorney could have represented them in any event. A practitioner is prohibited from taking frivolous positions. The Lundy positon was as close to frivolous as I have heard in a while.

And the IRS gave them a break.

Not that the Lundys would see it that way, though.