The IRS And Bull

One thing with a blog by a practicing tax CPA: you get a feel for whatever is going across my desk at the moment.

Let’s get historical and look at a Supreme Court case from 1935.

The case is Bull v United States. I kid you not.

Mr. Bull died in 1920.

He was a partner in a partnership.

His share of the partnership profits through his date of death was $24,124. His share of the profits for the rest of the year was $212,719.

The executor filed an estate tax return (that is, the tax return on the net assets Mr. Bull died with). That return included both the $24,124 and the $212,719. The executor paid whatever the estate tax was.

The executor then filed an income tax return for the estate.

COMMENT: Mr. Bull would have had a personal income tax return up to the day of his death. His estate would also have an income tax return, starting the day after he died. The estate would pay income tax until the assets were distributed (by will, contract or whatever). Whoever received the assets would pick-up their income tax consequence from that point on.

The executor did not include the $212,719 representing Mr. Bull’s share of the profits after his death.

COMMENT: The quirky detail here is that the partnership agreement allowed Mr. Bull to participate in profits for the year even after he died. I interpret that to mean that his estate would participate, as Mr. Bull could not do so personally. After all, he died.

The IRS threw a conniption, arguing that the estate should have reported the $212,719 on its income tax return. The IRS assessed income taxes.

I think the IRS is right: the partnership income after Mr. Bull’s death is (income) taxable to his estate.

But I think the IRS was wrong to include that same income on the estate (that is, his net assets at death) tax return. Why? Simple: That income could not have been an asset to Mr. Bull at death as it did not exist as of the date of his death.

I say that the executor paid too much estate tax.

The executor agreed and wanted the taxes back.

Problem: too much time had elapsed. The refund was barred under the statute of limitations. The IRS had zero intention of refunding even a penny.

What to do?

There was nothing in the tax law per se for a situation like this. Folks, this was the 1930s.

But we had a tradition of English common law and equity. The Supreme Court acknowledged that what was happening here was unfair.

The Supreme Court reasoned:

·      There is one transaction underlying both tax situations.

·      The IRS claim for a deficiency allows for an argument of recoupment, since the overpayment and deficiency arose from the same transaction.

·      Recoupment as a defense is never barred by the statute of limitations. It cannot, as it is a doctrine of equity.

If the Supreme Court could not get to this result using the tax statutes available, it would get to the result by introducing what has come to be known as “equitable recoupment.”

The IRS had to allow the estate to offset one tax against the other. Allowing two bites at the same apple was inequitable. The key is that one transaction – the same transaction – is triggering two or more taxes

Bull was – from what I understand – the first time we see the equitable recoupment doctrine in tax law. In Bull it mitigated the otherwise severe absolutism of the statute of limitations.

OK, this was not a particularly thrilling day at my desk.

CTG University: Part One

Let's discuss a famous tax case, and then I will ask you how you would decide a second case based on the decision in the first.

We are going back to 1944, and Lewis received a $22 thousand bonus.  He reported it on his 1944 tax return. It turns out that the bonus had been calculated incorrectly, and he returned $11,000 in 1946. Lewis argued that the $11,000 was mistake, and as a mistake it should not have been taxed to him in 1944. He should be able to amend his 1944 return and get his taxes back. This had an extra meaning since his tax rate in 1946 was lower (remember: post-war), so if he could not amend 1944 he would never get all his taxes back.

The IRS took a very different stand. It pointed out that the tax Code measures income annually. While arbitrary, it is a necessary convention otherwise one could not calculate income or the tax thereon, as there would (almost) always be one or more transactions not resolving by the end of the year. Think for example of writing a check to the church on December 31 but the check not clearing until the following year. The Code therefore taxes income on a "period" concept and not a "transactional" concept. With that backdrop, Lewis would have a deduction in 1946, when he returned the excess bonus.

The case went to the Supreme Court, which found that the full bonus was taxable in 1944. The Court reasoned that Lewis had a "claim of right," a phrase which has now entered the tax literature. It means that income is taxable when received, if there are no restrictions on its disposition. This is true even if later one has to return the income. The reasoning is that there are no limits on one's ability to spend the money, and there is also no immediate belief that it has to be repaid. Lewis had a deduction in 1946.

Looks like the claim of right is a subset of "every tax year stands on its own."

Let's roll into the 1950s. There was a company by the name of Skelly Oil. During the years 1952 through 1957 it overcharged customers approximately $500 thousand. In 1958 it refunded the $500 thousand.

You can pretty much see the Lewis and claim-of-right issue.

But there was one more fact.

Skelly Oil had deducted depletion of 27.5%. Depletion is a concept similar to depreciation, but it does not have to be tied to cost. Say you bought a machine for $100,000. You would depreciate the machine by immediately expensing, allocating expense over time or whatever, but you would have to stop at $100,000. You cannot depreciate more than what you spent. Depletion is a similar concept, but without that limitation. One would deplete (not depreciate) an oil field, for example. One would continue depleting even if one had fully recovered the cost of the field. It is a nice tax gimmick.

Skelly Oil had claimed 27.5% depletion against its $500,000 thousand or so, meaning that it had paid tax on a net of $366,000.

Skelly Oil deducted the $505,000 thousand.

Skelly Oil had a leg up after the Burnet v. Sanford & Brooks and Lewis decisions, as every tax year was to stand on its own. It refunded $505,000, meaning it had a deduction of $505,000. Seemed a slam dunk.

The IRS said no way. The $505,000 had a trailer attached - that 27.5% depletion - and wherever it went that 27.5% went. The most Skelly Oil could deduct was the $366,000.

But the IRS had a problem: the tax Code was based on period reporting and not transactional reporting. The 27.5% trailer analogy was stunning on the big screen and all, but it was not tax law. There was no ball hitch on the $505,000 dragging depletion in its wake.

Here is the Supreme Court: 

[T]he Code should not be interpreted to allow respondent 'the practical equivalent of double deduction,' *** absent a clear declaration of intent by Congress."

The dissent argued (in my words):           

So what? Every year stands on its own. Since when is the Code concerned with the proper measurement of income?

Odd thing, though: the dissent was right. The Lewis decision does indicate that Skelly Oil had a $505,000 deduction, even though it might not have seemed fair. The Court reached instead for another concept - the Arrowsmith concept. 

[T]he annual accounting concept does not require us to close our eyes to what happened in prior years."

There is your ball hitch. The concept of "net items" would drag the 27.5% depletion into 1958. "Net items" would include revenues and deductions so closely related as to be inseparable. Like oil revenues and its related depletion deduction.

The Court gave us the following famous quote: 

In other situations when the taxes on a receipt do not equal the tax benefits of a repayment, either the taxpayer or the Government may, depending on circumstances, be the beneficiary. Here, the taxpayer always wins and the Government always loses."

And over time the Skelly Oil case has come to be interpreted as disallowing a tax treatment where "the taxpayer always wins and the Government always loses." The reverse, however, is and has always been acceptable to the Government.

But you can see something about the evolution of tax law: you don't really know the law until the Court decides the law. Both Lewis and Skelly Oil could have gone either way.

Now think of the tax law, rulings and Regulations being published every year. Do we really know what this law means, or are we just waiting our turn, like Lewis and Skelly Oil?

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.

TomatoCare And The Supreme Court

Let’s play make believe.

Late on a dark and stormy Saturday night, the Congressional Spartans - urged on by Poppa John's and the National Tomato Growers Association – passed a sweeping vegetable care bill by a vote of 220-215.

The bill went to the Senate, where its fate was sadly in doubt. The fearless majority leader Harry Leonidas negotiated agreements with several recalcitrant senators, including the slabjacking of New Orleans, an ongoing automatic bid for the Nebraska Cornhuskers to the college Bowl Championship Series and the relocation of Vermont to somewhere between North Carolina and Florida. After passage, the bill was signed by the president while on the back nine at Porcupine Creek in Rancho Mirage, California.

As a consequence of this visionary act, Americans now had access to affordable tomatoes, thanks to market reforms and consumer protections put into place by this law. The law had also begun to curb rising tomato prices across the system by cracking down on waste and fraud and creating powerful incentives for grocery chains to spend their resources more wisely. Americans were now protected from some of the worst industry abuses like out-of-season shortages that could cut off tomato supply when people needed them the most.

California, Vermont and Massachusetts established state exchanges to provide tomato subsidies to individuals whose household income levels were below the threshold triggering the maximum federal individual income tax rate (presently 39.6 percent). The remaining states had refused to establish their own exchanges, prompting the federal government to intervene. The Tax Exempt Organization Division at the IRS, recognized for their expertise in technology integration, data development and retention, was tasked to oversee the installation of federal exchanges in those backwater baronies. IRS Commissioner Koskinen stated that this would require a reallocation of existing budgetary funding and – as a consequence - the IRS would not be collecting taxes from anyone in the Central time zone during the forthcoming year.

The 54 states that did not establish their own exchanges filed a lawsuit (Bling v Ne’er-Do-Well) challenging a key part of the TomatoCare law, which read as follows:

The premium assistance amount determined under this subsection with respect to any vegetable coverage amount is the amount equal to the lesser of the greater…”

These benighted states pointed out that, botanically, a tomato was a fruit. A fruit was defined as a seed-bearing vessel developed from the ovary of a flowering plant. A vegetable, on the other hand, was any other part of the plant. By this standard, seedy growth such as bananas, apples and, yes, tomatoes, were all fruits.

There was great fear upon the land when the Supreme Court decided to hear the case.

Depending upon how the Supreme Court decided, there might be no tomato subsidies because tomatoes were not vegetables, a result clearly, unambiguously and irretrievably-beyond-dispute not the intent of Congress on that dark, hot, stormy, wintery Saturday night as they debated the merits of quitclaiming California to Mexico.

The case began under great susurration. The plaintiffs (the 54 moon landings) read into evidence definitions of the words “fruit” and “vegetables” from Webster’s Dictionary, Worcester’s Dictionary, the Imperial Dictionary and Snoop Dogg’s album “Paid tha Cost to Be da Bo$$.”

The Court acknowledged that the words “fruit” and “vegetable” were indeed words in the English language. As such, the Court was bound to take judicial notice, as it did in regard to all words in its own tongue, especially “oocephalus” and “bumfuzzle.” The Court agreed that a dictionary could be admitted in Court only as an aid to the memory and understanding of the Court and not as evidence of the meaning of words.

The Court went on:

Botanically speaking, tomatoes are the fruit of the vine. But in the common language of the 202 area code, all these are vegetables which are grown in kitchen gardens and, whether eaten cooked, steamed, boiled, roasted or raw, are like potatoes, carrots, turnips and cauliflower, usually served at dinner with, or after, the soup, fish, fowl or beef which constitutes the principal part of the repast.”

The Court decided:

            But it is not served, like fruits generally, as a dessert.”

With that, the Court decided that tomatoes were vegetables and not fruit. The challenge to TomatoCare was courageously halted, and the liberal wing of the Court – in a show of their fierce independence and tenacity of intellect – posed for a selfie and went to Georgetown to get matching tattoos.

Thus ends our make believe.

There was no TomatoCare law, of course, but there WAS an actual Supreme Court decision concerning tomatoes. Oh, you didn’t know?

Back in the 1880s the Port of New York was taxing tomatoes as vegetables. The Nix family, which imported tons of tomatoes, sued. They thought they had the law – and common sense – on their side. After all, science said that tomatoes were fruit. The only party who disagreed was the Collector of the Port of New York, hardly an objective juror.

The tax law in question was The Tariff of 1883, a historical curiosity now long gone, and the case was Nix v Hedden. 

And that is how we came to think of tomatoes as vegetables.

Brilliant legal minds, right?

Has Maryland Been Caught Reaching Into The Tax Cookie Jar?

There are several states that impose a county tax in addition to a state income tax. Maryland is one of those states, and it has attracted attention to itself with the Maryland v Wynne. This case will soon go before the Supreme Court, which will decide whether Maryland has run afoul of the Commerce Clause of the Constitution.

That sounds esoteric.

It is not that bad, though, as long as we stay out of the weeds.

Let’s start this tax tale with an S corporation shareholder. His name shall be Clark. You may remember that “S” corporations do not pay tax (except in rare circumstances). Instead the corporation “passes through” its income to its shareholders, who in turn report their proportionate share of the corporate income on their individual tax returns.

Let’s say that Clark and his wife live in Maryland.

Let’s say that the S corporation does business both inside and outside Maryland. This means that Clark gets to pay income tax to all the states where the S corporation does business. This happens all the time, much to the chagrin of the tax professional who gets to prepare the paperwork.

Clark's corporation does business in North Carolina,. Clark pays tax to North Carolina (remember: the shareholder pays the income tax for an S corporation). Clark then takes a tax credit on his Maryland income tax for the taxes paid North Carolina. As long as North Carolina is not more expensive than Maryland, there is no-harm-no-foul, except for the professional fees to sort all this out.

And there we encounter the rub.

You see, Maryland divides its tax between a “state” tax and a “county” tax. And it makes a difference.

Enter Brian and Karen Wynne (the Wynnes). They are shareholders in Maxim Healthcare Services, Inc., an S corporation that files returns in 39 states. They themselves live in Howard County, Maryland. When they filed their 2006 Maryland tax return, they claimed taxes that they paid the other 38 states as a credit against their Maryland tax.

And the Maryland State Comptroller changed their numbers and sent them a bill. This lead to Appeals, then Maryland Tax Court, followed by the Circuit Court and – now - the Supreme Court.

The Comptroller’s argument? The Wynnes could not claim a credit for taxes paid other states against the county portion of the Maryland tax. Maryland changed its law in 1975, which was like … a really, really long time ago. Why are we even going there? How can one reasonably offset a state tax against a county tax?

I have to disagree.

Take two people living in Maryland. Have one invest in an S corporation that does all its business inside Maryland. Have the other invest in an S that does all its business in Maine. Unless the other state’s income tax rate is less that the Maryland state income tax rate, the first investor will pay less tax than the second investor. Tell me, how is that fair? Is the state not burdening interstate commerce by taxing the second investor (who invested outside Maryland) more than the first (who invested exclusively within Maryland)? And there you have the core of the challenge under the Commerce Clause.

Let’s use some numbers to make this concrete.

Say that the S corporation income allocable to Maine is $1,000,000. 

(1) The top Maine income tax is 7.95%, so let’s say the Maine income tax will be $79,500.

(2) The top Maryland state income tax rate is 5.75%, so the state income tax will be $57,500.

(3) The Maryland county tax rate is 3.2%, so the county income tax will be $32,000.

(4) This makes the total tax to Maryland $89,500. This exceeds the Maine tax by $10,000.

One offsets the $79,500 paid Maine against the $89,500 otherwise paid Maryland, and it all works out, right?

This is where you get hosed. According to Maryland, you cannot take the excess $22,000 (that is, $79,500 – 57,500) and claim it against the county tax. After all, it is a …. county tax. It does not make sense to offset Maine’s state tax against Maryland’s county tax.

Uhhh, yes it does.

Let us play games with this, shall we? I live in Kentucky, for example. Kentucky has 120 counties. Only Texas and Georgia have more counties, and I wonder why anybody would want more. I understand this goes back to rural times, when travel was more arduous. Nowadays it doesn't make much sense. How much money is wasted on duplication of facilities, county commissions, staff and services that accompanies all these counties?

Let’s say that Frankfort finds itself in a financial bind. Some hotshot realizes that disallowing a resident credit to Kentuckians with income outside the state would help to bridge that financial bind. Said hotshot proposes to carve the Kentucky state income tax into two parts: the state part and the county part. When the county part arrives, Frankfort will just pass it along to the appropriate county. Considering that Frankfort is shuttling monies to the counties already, all one has done is rearrange the furniture.

Except that Frankfort now keeps more money by disallowing a resident credit against all those county taxes. After all, it does not make sense to allow a state tax credit against county tax, right? Pay no attention that Frankfort itself would have created the distinction between state and county income tax. Why that was ... a really, really long time ago. Why are we even going there?

Could Maryland possibly, just possibly, be cynical enough to be playing out my scenario?

I’ll bet you a box of donuts that they are.

So Maryland v Wynne is before the Supreme Court, which will review whether Maryland has violated the “dormant” Commerce Clause. The Maryland Association of Counties has joined in (I will let you guess on which side), and the case has attracted considerable attention from tax practitioners and government policy wonks. There is, for example, some interesting tension in there between the Due Process and Commerce Clauses, for those who follow such things.

The case is scheduled for hearing the second week of November.