RERI-ng Its Ugly Head - Part One

Here is the Court:

The action involves RERI Holdings I, LLC (RERI). On its 2003 income tax return RERI reported a charitable contribution of property worth $33,019,000. Respondent determined that RERI overstated the value of the contribution by $29,119,000.”

That is considerably more than a rounding error.

The story involves California real estate, a billionaire and a university perhaps a bit too eager to receive a donation.

The story is confusing, so let’s use a dateline as a guide.

February 6, 2002 

Hawthorne bought California real estate for $42,350,000. Technically, that real estate is in an LLC named RS Hawthorne LLC (Hawthorne), which in turn is owned by RS Hawthorne Holdings LLC (Holdings).

Holdings in turn is owned by Red Sea Tech I (Red Sea). 

February 7, 2002 

Red Sea created two types of ownership:

First, ownership for a period of time (technically a “term of years,” abbreviated TOYS).

Second, a future and successor interest that would not even come into existence until 2021. Let’s call this a “successor” member interest, or SMI. 

QUESTION: Why a delayed ownership interest? There was a great lease on the California real estate, and 2021 had significance under that lease.

March 4, 2002     

RERI was formed.

March 25, 2002

RERI bought the SMI for $2,950,000.

August 27, 2003

RERI donated the SMI to the University of Michigan.

A key player here is Stephen Ross, a billionaire and the principal investor in RERI. He had pledged to donate $5 million to the University of Michigan. 

Ross had RERI donate the SMI. 

The University agreed to hold the SMI for two years, at least, before selling.

Do you see what they have done? Start with a valuable piece of leased real estate, stick it in an LLC owned by another LLC owned by another … ad nauseum, then create an LLC ownership stake that does not even exist (if it will ever exist) until 2021.

What did RERI donate to the University of Michigan?

You got it: the thing that doesn’t exist for 18 years.

I find this hard to swallow.

“Successor” LLC interests are sasquatches. You can spend a career and never see one. The concept of “successor” makes sense in a trust context (where they are called “remaindermen”), but not in a LLC context. This is a Mary Shelly fabrication by the attorneys.

So why do it?

Technically, the SMI will someday own real estate, and that real estate is not worth zero.

RERI hired a valuation expert who determined it was worth almost $33 million. This expert argued that the lease on the property – and its reliable series of payments – allowed him to use certain IRS actuarial tables in arriving at fair market value (the approximately $33 million).

Wait. It gets better.

The two years pass. The University sells the property … to an entity INDIRECTLY OWNED by Mr. Ross for $1,940,000.

This entity was named HRK Real Estate Holdings, LLC (HRK).

More.

HRK had already prearranged to sell the SMI to someone else for $3 million.

Still more.

That someone donated the same SMI and claimed yet another deduction of $29,930,000.

REALITY CHECK: This thing sells twice for a total of approximately $5 million but generates tax deductions of approximately $63 million.

Yet more.

Who did the valuation on that second donation? Yep, the same guy who did RERI’s valuation.

The IRS disallowed RERI’s donation to zero, zip, zilch, nada. The IRS was clear: this thing is a sham.

And there begins the litigation.

How something can simultaneously be worth $33 million and $2 million?

This is all about those IRS tables.

Generally speaking, the contribution of property is at fair market value, usually described as the price arrived at between independent buyers and sellers, neither under compulsion to sell or buy and both informed of all relevant facts.

Except …

For annuities, life estates, remainders, reversions, terms of years and similar partial interests in property. They are not full interests so they then have to be carved-out and adjusted to present value using IRS-provided tables.

OBSERVATION: Right there, folks, is why the attorneys created this Frankenstein. They needed to “separate” the interests so they could get to the tables.

RERI argued that it could value that real estate 18 years out and use the tables. Since the tables are concerned only with interest rates and years, the hard lifting is done before one gets to them.

Not so fast, said the IRS.

That real estate is in an LLC, so it is the LLC that has to be valued.  There are numerous cases where the value of an asset and the value of an ownership interest in the entity owning said asset can be different – sometimes substantially so. You cannot use the tables because you started with the wrong asset.

But the LLC is nothing but real estate, so we are back where we started, countered RERI.

Not quite, said the IRS. The SMI doesn’t even exist for 18 years. What if the term owner mortgages the property, or sells it, or mismanages it? That SMI could be near worthless by the time some profligate or incompetent is done with the underlying lease.

Nonsense, said RERI. There are contracts in place to prohibit this.

How pray tell is this “prohibited?” asked the IRS.

Someone has to compensate the SMI for damages, explained RERI.

“Compensate” how? persisted the IRS.

The term owner would forfeit ownership and the SMI would become an immediate owner, clarified RERI.

So you are making the owner of a wrecked car “whole” by giving him/her the wrecked car as recompense, analogized the IRS. Can the SMI at least sue for any unrecovered losses?

Uhhhh … no, not really, answered RERI. But it doesn’t matter: the odds of this happening are so remote as to not warrant consideration.

And so it drones on. The case goes into the weeds.

Who won: the government or the billionaire?

It was decided in a later case. We will talk about it in a second post.

Lawless In Seattle

Did you hear that Seattle has a new income tax?

Sort of. Eventually. But maybe not.

The tax rate is 2.25 percent and will tag you if you are (1) single and earn more than $250,000 per year or (2) married and earn more than $500,000.

This is big-bucks land, and we normally would not dwell on this except…

Washington state has no income tax.

Let us get this right: Seattle wants to have an income tax in a state that has no income tax. Washington state considered an income tax back in the 1930s, but the courts found it unconstitutional.

You or I would live within the Seattle city limits … why?

Surely there are nice suburbs we could call home. Heck, Bill Gates and Jeff Bezos do not live in Seattle; they live in the suburbs.

There appear to be legal issues with this tax.

The state constitution, for example, requires taxes to be uniform within a class of property. The pro-tax side questions whether income is “property.”

The anti-tax side provides the Power Inc v Huntley case (1951), wherein the Washington Supreme Court stated:

It is no longer subject to question in this court that income is property.”

Must be something cryptic about the wording.

Then there is a law that bans Washington cities from taxing net income.

The pro-tax side argues that they are not taxing “net” income. No sir, they are taxing “adjusted” or “modified” or “found-under-the-cushions” income instead.

The anti-tax side says: seriously?

Then you have the third issue that Washington cities must have state authority to enact taxes.

The pro-tax side says it can do this under their Licenses and Permits authority.

RCW 35A.82.020

Licenses and permits—Excises for regulation.

A code city may exercise the authority authorized by general law for any class of city to license and revoke the same for cause, to regulate, make inspections and to impose excises for regulation or revenue in regard to all places and kinds of business, production, commerce, entertainment, exhibition, and upon all occupations, trades and professions and any other lawful activity: PROVIDED, That no license or permit to engage in any such activity or place shall be granted to any who shall not first comply with the general laws of the state.

No such license shall be granted to continue for longer than a period of one year from the date thereof and no license or excise shall be required where the same shall have been preempted by the state, nor where exempted by the state, including, but not limited to, the provisions of RCW 36.71.090 and chapter 73.04 RCW relating to veterans.

I am not making this up, folks.

Here is the mayor:

This legislation will face a legal challenge.”

And green is a color.

But let me tell you something: we welcome that legal challenge. We welcome that fight.”

Then why pick a fight, Floyd?

… lowering the property tax burden …, addressing the homelessness crisis; providing affordable housing, education and transit; … creating green jobs … meeting carbon reduction goals.”

Got it: verbigeration, the new college major. It will get you to that $15 minimum wage. At least until those jobs go away because they are too expensive.

Speaking of expense: who is bankrolling this issue while it is decided in court? Has the city banked so much money that a guaranteed legal battle is worth it?

If we need to pack the courts, will you be there with me?” thundered a councilperson.

Pack the courts? Should we bring bats too?  

The pro-tax side wants to be sued, hoping that a judge will legislate from the bench.

Needless to say, the anti-tax side is resisting, with calls for “civil disobedience.”

With exhortations not to file returns.

The state chair of the Republican party is encouraging

“… non-compliance, non-violent and non-paying”

Sounds almost Gandhi-esque.

It appears that neither side has any intention to observe – heck, even acknowledge – any pretense of law.

I am at a loss to see how this is good for anybody.

Is Paying Cards A Sport?

What is a sport?

You and I have probably encountered that shiny-sparkly when discussing NASCAR.

But can it have a tax angle?

Oh, grasshopper. Even circles take on angles when you tax them.

Let’s travel to the UK. Their 2011 Charities Act defined sports as “activities which promote health involving physical or mental health or exertion.”

Introduce Sport England. They distribute National Lottery funding to encourage people to be more physically active. Seems a desirable cause.

It helps to be a sport if you want to tap-into that pot of Lottery gold.

Enter the English Bridge Union.

They want in.

The EBU has battling HMRC (that is, the British version of the IRS), arguing that entry fees to bridge tournaments should be exempt from VAT (“value added tax,” a sort of super sales tax). HRMC in turn looks to Sport England when developing its regulations. The EBU argued that the “physical or mental health or exertion” wording in the 2011 Act does not require physical activity.

But that is not Sport England’s position. They argue that the goal of sports is to increase physical activity and decrease inactivity.  That is not to argue that activities such as bridge do not help with mental acuity and the relief of social isolation; it just means that it is not a sport.

The EBU brought a refund suit against HMRC for VAT paid between 2008 and 2011. The amount is not insignificant: for 2012/13 alone it was over $800,000. The case went before the High Court of Justice of England and Wales.

The Court ruled that Sport England was within its rights to emphasize physical activities over mental and that Sport England could deny bridge status as a sport. Extrapolating, HMRC does not have to refund VAT paid on bridge tournament fees.

But the Court simultaneously added that it had not been asked to answer the “broad, somewhat philosophical question” as to whether bridge was actually a sport.

Seems both sides have a drum to beat following this decision.

By the way, the British courts have a different way than American courts. The lawsuit cost the EBU approximately $150,000. But they lost. They have also been ordered to pay approximately $75,000 to Sport England as reimbursement of their legal expenses.

COMMENT: I like this idea.

The EBU went to the Court of Appeal in London, where they lost earlier this year. They then appealed to the EU courts.

Here is Advocate General Maciej Szpunar of The European Court of Justice determining that bridge is a sport because it requires

… a certain effort to overcome a challenge or an obstacle” and “trains a certain physical or mental skill.”

The Advocate General’s decision will in turn be reviewed by the full Court en banc.

Soon an EU court will review a British tax decision. My understanding is that the British would not have to observe an adverse EU decision, but such a decision should nonetheless carry considerable persuasion.

And the Brits argue what constitutes a sport … because they have decided to tax something unless it is a sport. Well heck, all one has to do is remove “sport,” replace with another word, and we can continue this angels-on-a-head-of-a-pin nonsense until the end of time.

I do sympathize with the EBU. The HRMC, for example, recognizes both darts and snooker as sports, whereas you and I would recognize them as activities played in a bar. Several European countries – Austria, France, Denmark and others – already recognize bridge as a sport. To be fair, there are other countries – Ireland and Sweden, for example – that do not.

Did you know that the International Olympic Committee classified bridge as a sport back in 1998?  

But still…

I have difficulty with the concept of a “mental sport.”

By that definition tax practice – that is, what I do professionally – is a sport. 

Trust me, this is no sport.

Hockey Team Meals And Fairy Dust

Let’s say that you own a professional hockey team.

What is your biggest expense?

Your players, I would think.

You train them, coach them, house them, feed them, transport them.

Wait … did we say “feed them?”

Uh, yes. Here is an easy example: the team has an out-of-town game. I presume you are going to feed them while they are away from home and hearth.

We have walked into one of the tax Code’s nonsensicals.

Yes, I know: which one?

Are their on-the-road meals deductible?

Yes, but you may remember that only 50% of the meals and entertainment costs is deductible. The company has to eat the other 50%.

Why? Because of three-martini lunches and all that.

Fat cats. Write-offs. Loopholes. The Hallmark Channel.

Let’s say there is an uber-expensive – and secret - lunch in Georgetown between a media mouth and some cobbling bureaucrat. Why should you and I have to subsidize that behavior with a tax deduction?

But that is not your situation. You are feeding your players. Maybe you feed them because you want them present by a certain time, or you want your dietician to monitor their intake, or you want to minimize interruptions were they to go out for meals. Perhaps it gives everyone an opportunity to review game plans and prepare for media interviews.

But the tax Code lumps you in with those Georgetown pseudologists.

The Boston Bruins decided to push this issue. They deducted the full cost of their meals, not just 50%.

COMMENT: For the tax nerds, the issue before the Court was the “away” meals. The IRS was not concerned with “home” meals, for reasons we will not address here.

Two of their tax years – 2009 and 2010 – went to Court.

I had considered this is an uphill climb.

Code Section 274(n) waives the 50% axe.

(n)  Only 50 percent of meal and entertainment expenses allowed as deduction.

(1)  In general.

The amount allowable as a deduction under this chapter for-

(A)  any expense for food or beverages, and

(B)  any item with respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such activity,

shall not exceed 50 percent of the amount of such expense or item which would (but for this paragraph) be allowable as a deduction under this chapter.

But are there exceptions?

Yep.

For example, “de minimis” fringe benefits are not taxable to the employee.

Well, that is great for coffee and sodas at the office, but it seems that we are stretching the word too ….

Wait, a “employer-operated eating facility” can qualify as a de minimis fringe benefit.

Well, that is hay of a different barn. What does it take to be such a facility?

Here are two of several requirements:

(1) The facility has to cover its own direct costs on an annual basis.

(2)  The facility must be located on or near the employer’s business premises.

Hah, you say. There is no way that the Bruins can meet test one, as there is no “revenue” here. The whole thing is a “cost.”  

Would you believe me that there is a way – an obscure, head-scratching way – to string the tax Code together to spontaneously spark the required “revenue?”

There is and the Bruins made it. I will spare you the details.

On to test two.

Let’s say they are in Pittsburgh playing the Penguins.

Google tells me there is approximately 575 miles between Boston and Pittsburgh.

Seems a stretch that the Bruins are “on or near” their training facilities in Brighton, Massachusetts.

But have the Bruins rent-out a banquet room in a Pittsburgh hotel. Can one sprinkle fairy dust and argue that the rental transmogrifies the banquet room into Bruins “business premises” – at least for a while?

The Court really seemed to be in a favorable mood towards the Bruins. They emphasized the “function” of the banquet room rather than its actual location in space and time. Perhaps the banquet room identified as Bostonian.

We conclude that away city hotels were part of the Bruins’ business premises for the years in issue. In arriving at this conclusion we consider the traveling hockey employees’ performance of significant business duties at away city hotels along with the unique nature of the Bruins’ business (i.e., professional hockey).”

Having met that test, the Pittsburgh hotel in essence became “business premises” of the Bruins.

Bam! The Bruins have business premises in Pittsburgh.

The Court next considered whether the eating-facility-on-Bruins-business-premises-in-Pittsburgh qualified as a “de minimis” fringe benefit.

Well heck, I think the Court telegraphed its hand when it decided that a Pittsburgh hotel was “on or near” Brighton, Massachusetts.

To wrap this up, someone on the Court is a huge hockey fan and the Bruins got their 100% deduction.

I suspect that this type of meal expense is not what Congress was after with its Section 274(n) chop. It is nonsensical that the Code disallows a 50% deduction for employee meals when their job requires travel. This more resembles the histrionics of class envy than any rational tax argument.

However – and let’s be fair – that is what the tax Code says. 

Or said, more accurately.

All it takes is a court willing to sprinkle fairy dust.