Now You Say You're Leaving California

I have stumbled into our next story of outrageous state tax behavior.

I was skimming (quickly, trust me) the Supreme Court decision in Franchise Tax Board v Hyatt. It involves a resident of Nevada who sued California. California invoked sovereign immunity, a legal doctrine arising from the era of royalty and asserting that the king can do no wrong and is therefore immune from legal action.

Handy, if you are the king  … or any of California’s countless government agencies.

This case goes back a long way. Gilbert Hyatt moved from California to Nevada in the early 1990s. More specifically, he said he moved in September, 1991. California says he moved in April, 1992.

COMMENT: Sounds like a “poe-tae-toe” versus “poe-taw-toe” moment, on first impression.

California said this meant he owed the state $10 million in taxes, interest and penalties from patent income.

            COMMENT: Of course.

Problem is that the California Franchise Tax Board took some … questionable steps in developing their case against Hyatt:

·        They went through his mail

·        They rifled through his garbage

·        They contacted third parties, including estranged family and people who did not have his best interests at heart

He brought suit … in Nevada courts. There was a previous Supreme Court decision (Nevada v Hall) that allowed a private citizen to bring legal action against a second state, without the second state's consent.

The jury verdict was almost $500 million in damages and fees.

Then California appealed, arguing that Nevada's law limited damages in similar suits against its own agencies to $50,000.  

California got the Nevada Supreme Court to reduce the verdict to $1 million. The Court reasoned that California went a bit further than Nevada would allow, so the $50,000 cap did not apply.

COMMENT: Folks, we need our own state. We could do whatever we want and then hide behind sovereign immunity, hakuna matata or whatever other multi-syllabic nonsense springs to mind.

California was still not happy, arguing that Nevada was exhibiting a “policy of hostility.”      

California appealed to the U.S. Supreme Court, arguing that the Full Faith and Credit Clause of the Constitution applied. The Supreme Court agreed, using words such as "comity" to reduce the damages to $50,000.

My thoughts?

I allow that there may have been a legitimate disagreement at the very beginning of this whole matter. Let’s say that you move most, but not all, of your possessions to another state. You leave some furniture there, as the realtor said that it would help to show and sell the house. You then have a California tell you that you had not really moved until the last chair and framed art had left the state. What are you going to do: sue? You are not moving back to California just to sue. That means that you are suing from another state and California is going to invoke the doctrine of the king’s pantaloons or whatever.

Still, doesn’t it feel … wrong … to have California going through your mail and trash, peering through your windows and contacting estranged relatives? This is behavior beyond the pale. We are not talking about homeland security, where some argument might possibly be made to excuse the king’s overreach. 

We are only talking about taxes.

Wal-Mart Sues Puerto Rico Over Tax Changes

I had seen the headline, but it was busy season and there were other priorities.

Now I have had time to look into the matter.

I am referring to the Wal-Mart v Zaragoza-Gomez decision. It has to do with Puerto Rican taxes.

You may know that Puerto Rico is a U.S. territory. I have bumped into it professionally only a couple of times over the last dozen or so years. It simply is not a component of my practice.

What you may not know is that Puerto Rico has its own taxes. It is similar to a state in that regard, but there are differences. For example, if you are a resident of Puerto Rico you do not have to file a U.S. tax return – unless you have income in the U.S. You then file a U.S. return, but only for the U.S. income.

Puerto Rico however is now on the precipice of bankruptcy. They decided to bring-in more money to the fisc by changing a tax rule or two:

·        Tripling the “tangible personal property” tax rate from 2.5% to 6.5% on purchases from vendors located off the island.

·        Eliminating the option for the Treasury Secretary to exempt, in whole or part, a 20% tax on services provided by related entities or by a home office upon proof that the price charged was equal or substantially similar to the price which would occur with an unrelated person.

There was a problem, however: the tax, as changed, applied to only one taxpayer: Wal-Mart.

Granted, Wal-Mart is also the island’s largest corporate taxpayer, but one would think the politicians would employ some … deniability … before they culled the Arkansan wildebeest from the herd. Shheessssh.

Now, 6.5% does not sound like a lot, but I suppose one has to specify what it is being multiplied against. 

·        If net profit, that would leave 93.5% of profit left over. That is pretty good.

·        If cost of sales, then we need one more piece of information.

We need to know the gross profit.

Say that you bought something for $93. You sold it for $100.  Your gross profit is $7. Now you have to pay tax. That tax is calculated as 6.5% times $93 or slightly over $6. Your profit was $7.

That is not so good.

Wal-Mart said that the effect of the changes was an effective tax rate of over 90%, so I am thinking we are not too far off with the above example.

Wal-Mart did what it had to do: it sued.

The District Court was sympathetic to Puerto Rico’s financial plight:

·        It gives us no pleasure, under these circumstances, to enjoin a revenue stream that flows directly into Puerto Rico’s general fisc.”

·        … we, too, are citizens of this island and we, too, must suffer the consequences….”

·         … we are here because … has left the plaintiff, Wal-Mart, with nowhere else to turn.”

The government argued that Wal-Mart would simply have to pay the tax and sue for refund. Wal-Mart’s argument was “not yet ripe,” as it had not been denied a refund of its taxes. Furthermore, Wal-Mart could “afford to pay” the tax.

The Court pointed out the obvious: it would likely take a generation for the case to resolve, at which point Puerto Rico might be as able to repay Wal-Mart as it is to have winter sports. 

This is not a remedy, but a cynical means of extracting more unconstitutional revenue from an innocent taxpayer without the deterrent effect of having to pay it back…,” said the Court.

The government said it would appeal.

The judge just took away $100 million from the people of Puerto Rico and gave it to Wal-Mart. Now I have to look for that money somewhere else,” said Governor Alejandro Garcia Padilla.

I have no particular sympathy for Wal-Mart, other than the deep belief that any government desirous of being perceived as legitimate is mandated to deal fairly with its citizenry. Taxation is especially sensitive, and this is the equivalent of having you pay for all the new sidewalks in the neighborhood because you have the nicest house.

Smart person moves out of the neighborhood.

The IRS Could Not Collect When Limitations Period Expired

Let’s talk a bit about the tax statute of limitations.

There are two limitations periods, and it is the second one that can lead to odd results.

(1) The first one is referred to as the limitations on assessments. This is the three-year period that we are familiar with. The IRS has three years to audit your return, for example. If they do not, then – in general – the opportunity is lost to them.

There are a number of ways to extend the three-year period. When I was young in the profession, for example, tax practitioners would “hold back” certain tax deductions until the client was closing-in on the three years. With a scant few and breathless days remaining before the period expired, they would file amended tax returns, thereby obtaining a refund for the client and simultaneously kneecapping the IRS’ ability to look at the return.

The rules have been revised allowing the IRS additional time when this happens. I have no problem with this change, as I consider the previous practice to be unacceptable. 

(2) The second one is the collections period, and this one runs ten years.

Say you filed your return on April 15, 2014. You got audited and the IRS assessed $15,000 on December 15, 2015. The IRS has ten years – until December 15, 2025 – to collect.

There are things that can extend (the technical term is “toll”) the collections period. Make an offer in compromise, for example, and the period gets tolled. 

Sometimes tax practice boils down to letting the ten-year period click-off, hoping that the IRS does not initiate action. It happens. A few years ago I had a client who had moved to Florida, remarried and had her new husband involve her in an unnecessary tax situation. It was extremely unfortunate and she was extraordinarily ill-advised. He passed away, leaving her as the remaining target for the IRS to pursue. She had a fairness argument, but that meant as much as a snowball in July to IRS Collections. They have a different mind frame over there.

So I am looking at a case where a taxpayer (Grauer) had an issue with his 1998 tax return. He filed it late (in 2000).  That was his first problem. He owed around $40 grand, which quickly became almost $58 grand when the IRS was done tacking-on interest and penalties. That was his second problem. He could pay that much money about as easily as I can fly.

In 2001 he signed a waiver, extending the ten-year collections period.

What makes this point interesting to a tax nerd is that someone would not (knowingly) sign a waiver without something else going on.  In fact, Congress disallowed this in the late nineties, responding to perceived IRS abuses - especially in Collections.

Sure enough, the IRS said that he signed an installment agreement in 2001 (around the time of that waiver), but that he broke it in 2006

Grauer said that he never signed an installment agreement.

It was now 2013, and off to Tax Court they went.

The Court looked at the account transcript, which showed that the IRS had issued an earlier Notice of Intent to Levy.  This was an immediate technical issue, as the Court would not have jurisdiction past the first Notice. The IRS persuaded the Court that the transcript was wrong. 

COMMENT: Your transactions with the IRS go to your “account.” That account is updated whenever a transaction occurs. The posting will include a date, a code, and sometimes a dollar amount and perhaps a meaningful description.  Some codes are straightforward, some are cryptic. 

The Court next observed that Grauer asserted that he had not signed a payment plan. In legal jargon, this was an “affirmative defense,” and the IRS had to prove otherwise. The IRS argued that its transcript was correct and that Grauer was incorrect.

The Court was a bit flummoxed by this response. The IRS was having it both ways.

The Court told the IRS to “show us the installment agreement.” 

The IRS could not.

The Court went on to describe the IRS account transcript as “indecipherable and unconvincingly explained.”

The Court decided for the taxpayer.

Remember: ten years had passed. The waiver needed to attach to something. In the absence of something, the waiver fizzled and had no effect.

The statute had expired.

Did the taxpayer get away with something?

I don’t know, but think about the alternative. Let’s say that the IRS could post whatever it wanted – to speak bluntly, to make things up – to your account. You then get into tax controversy. You are required to prove that the IRS did not do whatever it claimed it did. Good luck to you in that scenario. I find that result considerably more unacceptable than what happened here.

How To Lose A Tax Deduction For Wages Paid

This weeks’ tax puzzler involves a mom and her kids.

We again are talking about attorneys. Both mom and dad are attorneys, and mom is self-employed.

Sometimes she brought her children to the office, where they helped her with the following:

·        answering the telephone

·        mail

·        greeting clients

·        photocopying

·        shredding unneeded documents

·        moving files

Mom believed that having her children work would help them understand the value of money and lay the foundations for a lifelong work ethic.

She had three kids, and for 2006, 2007 and 2008 she deducted wages of $5,500, $10,953 and $12,273, respectively.

There are tax advantages to hiring a minor child. For example, if the child is age 17 or younger, there are no social security (that is, FICA) taxes. In addition, there is no federal unemployment tax for a child under age 21, but that savings pales in comparison to the FICA savings.

Then you have other options, such as having the child fund an IRA. All IRAs require income subject to social security tax. It doesn’t matter if one is an employee (FICA tax) or is self-employed (self-employment taxes), but social security is the price of admission.

Her children were all under the age of ten. Can you imagine what those IRAs would be worth 50 years from now?

The IRS disagreed with her deducting payroll, and they wound up in Tax Court.

Your puzzler question is: why?

(1) You: The Court did not believe that the kids really did anything. Maybe she was just trying to deduct their allowances.

Me: The tax law becomes skeptical when related parties are involved, and you cannot get much more related than a mother and her children.  It was heightened in this case as the children were so young. For the most part, though, the Court believed her when she described what the children did.

(2) You: Mom used the money she “paid” the kids for their support – like paying their school tuition, for example.

Me: The tax law disallows a deduction if the money is disguised support, which tax law expects to be provided a dependent child. In this case, the Court saw the children buying books, games and normal kid items; some money also went to Section 529 plans. The Court did not believe that mom was trying to deduct support expenses.

(3) You: She could not provide paperwork to back-up her deductions. What if she paid the kids in cash, for example?

Me: Good job. One reads that the Court wanted to believe her, but she presented no records. She did not provide bank statements showing the kids depositing their paychecks, presumably because the children did not have bank accounts.

She did not provide copies of the Section 529 plans. That was so easy to do that I found the failure odd.

At least she could show the Court a Form W-2.

Mom had not even issued W-2s.

The Court was exasperated.

It allowed her a deduction of $250 per child, as it believed that the kids worked. It could not do more in the absence of any documentation.

And there is the answer to the puzzler.

Too often it is not mind-numbing tax details that trip-up a taxpayer. Sometimes there is just a lapse of common sense.

Like issuing a W-2 if you want the IRS to believe you paid wages to somebody.