The Nick Saban Tax

Have you heard about the “Nick Saban” tax?

Let’s set it up.

There has been a longstanding tax provision limiting the deduction for public company executive compensation to $1 million. Mind you, this is not a restriction on how much you can pay an executive; the restriction only applies to how much you can deduct on a tax return. The restriction does not apply to all executives, either; it applies to the CEO, CFO and three other most-highly-paids.

But there was an exception large enough for the Fortune 500 to drive through. The exception was for “performance.” Magically and almost overnight, virtually all executive compensation packages became based on “performance.” Options were considered performance-based, and eventually options came to be passed around like candy. Realistically, one had to refuse to do any tax planning for this provision to actually apply.

This changed with the Tax Cuts and Jobs Act passed in December, 2017. Congress tightened up this code Section (162(m)) by taking away the performance exception. The $1 million cap now has a real bite.

But Congress was still looking for money.

Congress decided to put the same $1 million compensation limit on nonprofits.

This creates a quandary, as nonprofits (generally) do not pay tax. If I were a nonprofit executive and Congress threatened to disallow my deduction, I would not be feeling the tremulous fear of my for-profit peers.

Congress thought of that. They decided that the nonprofit would pay a 21% tax on my behalf.

Whoa. Now you have my attention. Granted, the tax is not on me, but we all know how this works in the real world. Only small children and Congress believes in free. The rest of us have to pay.

Congress passed a tax provision applying the $1 million cap to the five highest- paid employees of a 501(a), which includes a 501(c)(3). Think nonprofits, certain hospitals, colleges and universities and the like.

BTW medical professors were excluded from this, so it appears clear that Congress was trying to reach the athletics programs and their coaches.

But there is a problem.

Here is Code section 4960 imposing the tax:

       (c)  Definitions and special rules.

For purposes of this section-

(1)  Applicable tax-exempt organization.

The term "applicable tax-exempt organization" means any organization which for the taxable year-

(A)  is exempt from taxation under section 501(a) ,

(B)  is a farmers' cooperative organization described in section 521(b)(1) ,

(C)  has income excluded from taxation under section 115(1) , or

(D)  is a political organization described in section 527(e)(1) .

What is that Section 115(1)?

         § 115 Income of states, municipalities, etc.

Gross income does not include-

(1)  income derived from any public utility or the exercise of any essential governmental function and accruing to a State or any political subdivision thereof, or the District of Columbia; or …

What does this mean?

Congress thought that – by extending Section 4960 to reference Section 115(1) – it would reach those entities exempt via Section 115(1).

Entities such as Alabama.

Or the University of Alabama.

Why?

Because the University of Alabama is an instrumentality of the state of Alabama.

And here the tax law goes wonky.

The Courts have looked at the interaction of Sections 115(1) and 511(which is the unrelated business income tax which applies to a nonprofit). Can a state instrumentality (say a university) run a business – say a farm-to-table restaurant chain – and avoid the unrelated business income tax because of Section 115(1)? If that were the case, then Illinois could start a chain called Outfront Steakhouse, make a zillion dollars and never pay tax because of Section 115(1).

The Courts have clarified that is not the case. There is a limit to Section 115(1).

According to that reasoning, it seems to me that Congress should be able to tax those university salaries.

But there is another argument – the doctrine of implied statutory immunity. This arises from our federalist system of government: the federal government has to respect the state government. Under this theory, if the federal government wants to tax a state, it has to say so in an unambiguous manner – that is, it cannot be “implied.”

Continuing our example, if the federal government wanted to tax Illinois for opening a steakhouse chain and locating them adjacent to every Outback Steakhouse location throughout the land, it would have to say something like:

… the [] tax will apply to an entity relying upon Section 115(1) for nontaxability of their [] business activity should that activity be the same or substantially similar to a business activity conducted by a for-profit restaurant chain.”

That is explicit. That breaches implied statutory immunity. The tax would then stick.

Is that what Congress did with the new Section 4960(c) tax?

Nowhere close, it appears.

Under that reasoning the University of Alabama will not pay the Nick Saban tax, as the tax does not reach the University of Alabama.

There are universities clearly affected by this new law: Duke, for example, or Northwestern. They have to pay up. Think of it as the difference between a “public” university and a “tax-exempt” university.

But having the state name in the university’s name, however, does not mean that the university is exempt as “public.” It depends on how the university was organized and chartered. Texas A&M will be affected by the new tax provision, but the University of Texas - Austin will not. It is enough to give one a headache.

What happens next?

The easiest path is for Congress to revise Code section 4960 and clean up the language. Without Congressional action, you can be certain the “public” universities will litigate this matter. They have to.

But the likelihood of the present Congress accomplishing anything seems unlikely, at best.

A Waitress, A Waffle House And A Lottery Ticket

It’s fun to think about winning the lottery

There is a (former) waitress in Grand Bay, Alabama who did. She worked at a Waffle House. Enter Edward Seward, a regular at the restaurant. Seward liked the lottery. As Alabama did not have a lottery, he would travel to Florida to buy tickets. He also liked giving away the lottery tickets to the waitresses at the Waffle House. Our protagonist – Tonda Lynn Dickerson – had an agreement with four other waitresses that – if they ever won – they would share the winnings equally.

Would you know that the lottery ship docked, and Tonda Lynn had the winning ticket? The winnings were more than $9 million if paid out over 30 years, and over $5 million if paid in lump sum. First thing Tonda did was quit her job.

Tonda Lynn took the matter to her dad – Bobby Reece. Turns out her family was quite close and had talked about sharing lottery winnings if ever anyone won. Bobby seemed the most invested in the lottery discussion. Johnny Reece - the brother - was not so much into it.   

Bobby contacted Louisa Warren, the general counsel for the Florida Lottery Commission. Bobby explained the family understanding about the lottery. She told Bobby:

Don’t sign that ticket, period.”

She recommended that they form an entity to claim the winnings.

Enter an attorney and an S Corporation named 9 Mill, Inc.

NOTE: Get it?

Bobby sat down at the table and decided the ownership percentages while Tonda Lynn and her husband went car shopping. Turns out that Tonda and James (the husband) owned 49% of 9 Mill, Inc.

OBSERVATION: Bobby seems to have an intuitive grasp of tax issues.

Bobby and Mrs. Reece and James went to Florida to claim the ticket. They decided to take a 30-year payout of $354,000 per year.

... and they were notified of a competing claim against the winnings.

Remember the other waitresses at the Waffle House? They lawyered up. Their attorney filed suit in the Circuit Court of Mobile County, claiming that his clients were entitled to 80% of the winnings. The waitresses had an agreement. They also had a witness – Mr. Seward – who started the whole thing by giving Tonda Lynn the lottery ticket.

Tonda seemed to have forgotten any agreement, any Waffle House, any other waitresses. She had bought the ticket herself, it seems. There was a small problem with that, however. The tickets were sequentially numbered at the bottom, and her ticket – number 18 – was missing

The Circuit Court entered an order saying that the other four waitresses were right and that Tonda Lynn had to part with 80%.

Well, 9 Mill, Inc was not going to stand for that. They countersued, and the case went to the Alabama Supreme Court. The Supreme Court overturned the Circuit Court.

Tonda Lynn was back in the money, but not for the reason that you may think. The Court agreed that there was an agreement between the five waitresses, but the Court also pointed out that it could not enforce that agreement on public policy grounds. Alabama could not enforce a contract based on gambling. Gambling was not allowed in Alabama.

I suspect that Tonda Lynn can never go back to that Waffle House.

Not too long after, the IRS contacted Tonda Lynn. The IRS wanted its gift tax – approximately $770,000.

Tonda Lynn had a lottery ticket.  The winnings went into an entity of which she and her husband owned 49%. What happened to the other 51%? According to the IRS, Tonda Lynn must have gifted it.

You have to admit, they have a point.

Now Tonda Lynn and the IRS go to Court. She presents two arguments:

(1)     No gift occurred because at the time of transfer there existed an enforceable contract under Alabama law.

(2)     Alternatively, she and her family were all members of an existing partnership that was the true owner of the lottery ticket.

Let’s address this in reverse order.

The Court noted that the partnership, if one existed, was an odd partnership because it did not observe the formalities of a business activity. Ownership had never been spelled out, for example. The members were not required to contribute to the partnership or to buy lottery tickets regularly. A family member did not even know if another member bought a lottery ticket. There may have been an understanding, but that understanding did not rise to the level of an”activity” which could be housed in an entity.

Additionally, Tonda did not buy the ticket. It was given to Tonda, who would still have to explain how the ticket got into the entity.

On the first argument the Court reminded Tonda that there could have been no enforceable contract.  Alabama did not recognize gambling.

NOTE: Odd that Tonda Lynn would forget this, as this is the same reason Tonda won her case against the other waitresses. Short memory, I suppose.

Tonda Lynn owed gift tax.

The story is not done, though. There was one more issue before the court.

It turns out that the delay in cashing the winning ticket was a tax boon to Tonda, as it allowed time for the other waitresses to submit their claim. Had they not, then Tonda would have owed gift tax of approximately $770,000. The claim introduced uncertainty about the value of the gift. What would an independent party pay for that ticket at that moment, knowing there was a cloud, the resolution of which could mean forfeiture of 80% of the winnings?

The Court discounted the gift by more than two-thirds.

It was Tonda Lynn’s only victory with the IRS.

How did it turn out for Tonda Lynn? Her husband divorced her. He then supposedly kidnapped her.  She later declared Chapter 13 bankruptcy.

Do you still want to win the lottery?