Taxpayer Fail On Discharging Taxes Through Bankruptcy

I have an IRS notice sitting on my desk. I meant to call the IRS about it on Friday, but it got away from me. I will call on Monday. It disgruntles me, as I have already called and considered the matter resolved.

There you have why practitioners get upset with the IRS about hair-trigger or bogus notices: one has only so much time.

My partner brought in this client. They were chronic nonfilers, and we prepared the better part of a decade’s worth of returns for them. I lost humor with them when the husband insulted one of my accountants. Granted, it is unlikely that a younger accountant would know what I know, but the incident was uncalled for. The husband and I had a very different and blunt conversation.

They spoke with my partner about discharging the taxes through bankruptcy, which is one reason I was brought in.

Short answer: forgetaboutit, at least for a while.

There are four basic requirements to discharging taxes in bankruptcy. I have not often seen the fourth reason, but I was recently reading a case involving that elusive fourth.

Here are the four requirements:

(1)  The taxes were due at least three years ago. Obtain an extension and you must include the extension period in the three years.

(2)  Fail to file and the taxes are not dischargeable until at least two years after filing.

(3)  The IRS must have assessed the taxes at least 240 days before filing for bankruptcy.

(4)  The return must not be fraudulent, and the taxpayer(s) cannot willfully have attempted to avoid the tax.

Let’s go through an example.

(1)  Let’s say we are talking about your 2016 tax return. If you filed on April 15, 2017, the first rule gives you a minimum date of April 15, 2020.

(2)  Let’s say you filed that 2016 return on July 21, 2018. The second rule gives you a minimum date of July 21, 2020.

(3)  Let’s say the IRS posted (that is, assessed) the 2016 return shortly after filing – perhaps July 31, 2018. There is no problem with the 240-day rule.

(4)  Let’s also say there was no attempt to evade tax. It was irresponsible not to file, but there is nothing there other than irresponsibility.

Seems to me that the earliest you can file for discharge via bankruptcy would be July 22, 2020 – the latest of the above dates.

Let’s talk about a case involving the fourth requirement.

There is a doctor. Her husband was a CPA – he lost his license after a conviction for tax evasion.

She let her husband prepare the returns for years 2004 through 2014.

I would not have done that, but - to me – a CPA losing his license for tax evasion is a HUGE dealbreaker, husband or not.

The entered into a payment plan. They missed some payments.

Like night follows day.

They were living the high life. They had an expensive house (Newport), but they wanted a more expensive house (Dwight). They bough Dwight on a land contract, hoping to sell Newport.

They then carried two houses, as Newport did not sell.

Now they were tight on cash, and they fell behind with the IRS.

Mind you, that did not stop them from sending their kids to a private school, racking up $325,000 in the process. They also took trips to Mexico and Puerto Rico, as well as parking a Jaguar and a Lexus in the driveway.

Newport was foreclosed.

In 2016 we have the bankruptcy.

The IRS moved to exercise its lien on the Dwight property.

Husband came up with a brilliant scheme.  He sold Dwight for a swan song to a former client.  He would pay the IRS the few dollars that came his way from the “sale,” and he and his wife would rent the Dwight property back from the former client.

Puuhleeeese, said the IRS.

The Court agreed with the IRS. It spotted a willful attempt to evade or avoid, thereby nixing any discharge of taxes although the couple had filed for bankruptcy.

Why? They failed the fourth requirement.

The case for the home gamers is re Harold 2020 PTC 58 (Bankr. E.D. Michigan 2020)

Getting ROBbed

I was skimming a Tax Court decision that leads with:

“… respondent issued a notice of deficiency … of $249,263.62, additions to tax … of $20,228.76 and $22,476.41, respectively and an enhanced accuracy-related penalty … of $63,918.33”

It was Roth IRA decision.

We have spoken before about putting a business in an IRA, and a Roth is just a type of IRA. This tax structure is sometimes referred to as a “ROBS” – roll-over as business start-up. 

Odds are the only one who is going to get robbed is you. I had earlier looked into and decided that I did not like the ROBS structure. There are too many ways that it can detonate. I do not practice high-wire tax.  

I have also noticed the IRS pursuing this area more aggressively. There often is complacency when a “new” tax idea takes, as the IRS may not respond immediately. That lag is not an imprimatur by the IRS, although self-interested parties may present it as such. I have been in practice long enough to have heard that sales pitch more than once.

Let’s discuss Polowniak v Commissioner.

Polowniak had over 35 years of marketing experience with Fortune 500 companies, including Proctor & Gamble, Johnson & Johnson and Kimberly Services. In 1997 he formed his own company – Solution Strategies, Inc. (Strategies). He was the sole shareholder and its only consultant.

In 2001 he received a nice contract - $680,000 – from Delphi Automotive Systems – which had him travel extensively to Europe, Asia and South America. 

Now the turn. His financial advisor recommended an attorney who pitched the idea of “privately owned Roth IRA corporations,” also known as PIRACs. These things are not rocket science. In most cases an individual already has an existing company, likely profitable or soon to be. Said individual sets up a Roth IRA. Said Roth purchases the stock of a new corporation (NewCo), which amazingly does exactly the same thing that the existing corporation did, and likely with the same customers, vendors, employee, office space and so on.

The idea of course is that NewCo is going to be very profitable, which allows the opportunity to stuff a lot of money into the Roth in a very short period of time.

So Polowniak sets up a NewCo, which he names Bevco Investments, Inc. (Bevco). There is a little flutter in the story as Bevco selects a January year-end, meaning that a sharp tax advisor may have the opportunity to move things back-and-forth between a calendar-year taxpayer and an entity that doesn’t file its tax return until a year later.

This is fairly routine tax work.

Polowniak owned 98 percent and his administrative assistant owned 2 percent.  His wife later purchased 6% of Bevco.

Strategies and Bevco entered into an agreement whereby it would receive 75% of Strategies revenues for 2002.

By the way, Delphi was never informed of Bevco. Neither was the administrative assistant.

The years passed. Polowniak let the subcontract with Bevco lapse.

And he started depositing all the Strategies revenue from Delphi into Bevco. There was no more pretense of 75 percent.

Bevco was finally dissolved in 2006.

And then came the IRS.

It went after Solutions, which did not report the $680,000 from Delhi. You remember, the same amount it was to share 75% with Bevco.

Sheesh.

It also came after Polowniak personally. The IRS wanted penalties for excess funding into a Roth.

Huh?

There are limits for funding a Roth. For example, the 2015 limit for someone age-50-and-over (ahem) is $6,500. If you go over, then there is a 6% penalty. Mind you, the 6% doesn’t sound like much, but it becomes pernicious, as it compounds on itself every year. Tax practitioners refer to this as “cascading,” and the math can be surprising.

How did he overfund?

Simple. He took existing money from Solutions and put it into Bevco. It is the equivalent of you depositing money at Key Bank rather than Fifth Third.

Polowniak’s job right now was to convince the Court that was a substantive reason for the Solutions –Bevco structure. If Bevco was just an alter ego, he was going to lose and lose big.

He trotted put Hellweg, a tax case featuring Roth IRAs and Domestic International Sales Corporations (DISCs). Whereas the taxpayer won that case, there was some arcane tax reasoning behind it, likely exacerbated by those DISCs.

The Court did not think Hellweg was on point. It thought that Repetto was much more applicable, pointing out:

·        All the services performed by Bevco had previously been performed by Polowniak through Strategies

·        Polowniak performed all the services under the contract with Delphi

·        Since he was the only person performing services, the transfer of payments between Strategies and Bevco had no substantive effect on the Delphi contract

·        Delphi did not know of the contract with Bevco; in fact, neither did the administrative assistant

·        The business dealing between Strategies and Bevco were not business-normative. For example, Bevco never kept time or accounting records of its services, nor did it ever invoice Strategies.

The Court decided against Polowniak. It did not respect the PIRAC, and as far as it was concerned all the Delphi money put into Bevco was an overfunding.

And that is how you blow through a third of a million dollars.

Is there something Polowniak could have done?

He could of course have respected business norms and treated both as separate companies with their own accounting systems, phone numbers, contracts and so forth. It would have helped had Strategies not been depositing and withdrawing monies from Bevco’s bank account.

Still, I do not think that would have been enough.

There are two major problems that I see:

(1) There was an existing contract in place with Delphi. This is not the same as starting Bevco and pounding the streets for work. There is a very strong assignment of income feel, and I suspect just about any Court would have been disquieted by it.

(2) There were not enough players on the field. If I own a company with 75 employees, I may be able to take a slice of its various activities and place it inside a PIRAC or ROBS or whatever, without the thing being seen as my alter ego. Polowniak however was a one-man show. This made it much easier for the IRS to argue substance over form, which the IRS successfully argued here.

 

My advice? Leave these things alone. There are a hundred ways that these IRA-owned companies can blow up, and the IRS has sounded the trumpet that it is pursuing them.

A Slice of Apple And A Double Irish, Please

Apple has been dragged before Congress for interrogation over its tax planning and practices. Let’s talk about some of them.

Apple’s headquarters are in Cupertino, California. It also has an office in Reno, Nevada, 200 miles away. California’s corporate tax rate is 8.8%. Nevada’s corporate tax rate is zero. Here is a pop quiz: what would you do if you were Apple’s state tax advisor?

You would try to move income otherwise reportable to California to Nevada, that’s what you would do. How would you do this? Would you move employees, lease an office, manufacture iPhones there? Nah. Think along other lines. Apple has cash. Boats and barges of it. It has to manage and invest that cash. Where are you going to advise them to manage it?

You got it: it’s going to happen in Nevada. Let’s set up a subsidiary called Braeburn Capital (get it?). Apple has earned approximately $2.5 billion in interest and dividends since opening Braeburn. What has Apple accomplished? It has saved 8.8% California state tax on that $2.5 billion, that is what it accomplished.

California has of course whined and sputtered and complained. What about their roads and schools and hospitals? Well, Nevada also has roads and schools and hospitals. There is a price point to everything. I may like an iPhone, but I am not going to pay thousands of dollars for it. Sounds to me like California priced itself out of the market.

Steve Jobs several years ago approached the city of Cupertino about a new headquarters for Apple. The city council, seeing an opportunity to get more than its fair share, inquired about Apple providing free wireless internet service. Maybe pony rides too. Steve Jobs responded that Apple paid taxes, and that the city should provide free internet service – and the pony rides. He continued:

“That’s why we pay taxes. Now, if we can get out of paying taxes, I’ll be glad to put up Wi-Fi.”

Jobs pressed on, noting that – if Cupertino did not want them – Apple could just move. Cupertino backed down. One council member complained, wondering what it would take to make Apple feel “more connected.”

COMMENT: I do not need to feel “more connected” to the government. Good grief. Has a flying saucer landed and disembarked these people?

Let’s talk next about Apple and international taxes. This has been the topic of recent Congressional hearings before the Senate Permanent Subcommittee on Investigations. Senator Levin, head of the committee, blasted Apple for using “offshore entities holding tens of billions of dollars, while claiming to be tax resident nowhere.”

One quick moment to explain – again – that the United States imposes a worldwide tax system. A U.S. person, including a domestic corporation, is supposed to pay U.S. tax, no matter where the sale occurred, whether the money was earned inside or outside the U.S. or whether the money returned – or will ever be returned – to the U.S. There are tax deferral provisions, fortunately; otherwise, no U.S. company would be able to compete internationally. Apple has aggressively used those deferral provisions, thereby provoking the senator’s wrath.

One of Apple’s subsidiaries - iTunes S.à r.l.’s – is located in Luxembourg. What does it do? It collects roughly a quarter of iTunes worldwide sales. If someone in Europe or the Middle East or Africa downloads from iTunes, the sale is recorded here. Remember: these are downloads, not an automobile or a wide-screen TV. Downloads can be located anywhere. Apple could download from a satellite circling the earth, if it wanted to. Luxembourg presents a low tax – and friendly - environment. With that, downloads are moved away from Germany, Britain - or the United States.

Senator Levin sees tax avoidance. Me? I see common sense.

BTW, note the market that iTunes S.à r.l.’s serves. We will come back to this.

Apple was one of the first to utilize a tax stratagem that has become known as the “double Irish.”  More specifically, they used a “double Irish” with a “Dutch sandwich.” This is esoteric stuff. Let’s review in general what the tax advisors did, other than think about ordering lunch.  

It takes two Irish companies to make this work (hence, the “double” Irish). The first company (Irish #1) enters into an intellectual property (“IP”) arrangement with Cupertino. Apple transferred its IP rights for Asia, African and the Middle East to Irish #1 back in 1980. At that time, Apple approached the IRS to have it review its advance pricing agreement with Irish #1, which established how the IRS would treat transactions between the two for tax purposes. The deal was favorable for Irish #1, which is to say that Irish #1 paid considerably less to Cupertino than it made selling the IP to other affiliates. 

NOTE: More income, lower expense to Irish #1. The purpose is to keep the income outside Cupertino – which is to say, outside the U.S. 

Someone has to sell the actual product: the iPods or iPhones. Enter Irish #2, which is owned by Irish #1. In fact, it is 100% owned, which allows Irish #1 to make a critical tax election with the IRS: a “check the box” election. While in place, this election means that the IRS will treat Irish #1 and Irish #2 as though they were one company. This is key, as the illusion will stop the IRS from claiming “foreign base company income.” It takes at least two companies to generate foreign base company income, and you do not want foreign base company income. It means that the U.S. will immediately tax you without waiting for you to send the money back to the U.S.  Ireland does not have an equivalent to the U.S. "check the box."

Irish #2 manufactures and/or sells the product. The product is high-tech, so Irish #2 has to pay for the IP. Who does it pay? It pays Irish #1, of course. Cupertino can “control” the amount of income left in Irish #2 by adjusting the amount it pays Irish #1. What profit remains in Irish #2 is taxable to Ireland at 12.5%.

Except it isn’t. Apple received a tax holiday for its first ten years in Ireland (this got them to 1990), and since then it appears to have negotiated its tax rate with Irish Tax & Customs.  This point is unclear, as the Irish government is prohibited from speaking on such matters. What has Ireland gotten in return? Apple now employs over 4,000 people in Ireland and is one of the country’s biggest employers.

Let’s go back to Irish #1. What does it pay Ireland? It pays nothing. Ireland looks and sees a nonresident company. Is Ireland blind? Well … Ireland will not tax nonresident operations of a nonresident company, and it considers a company to be nonresident if:

(1)            The company “controls” an Irish company that conducts a trade or business in Ireland, and

(2)            The company itself is “controlled” by one or more residents of a country with which Ireland has a double taxation treaty. 

OBSERVATION: Now you understand why this Irish has to be a “double.” One Irish company has to own another to put this plan into play.

To close the circle, let’s put the management and control of Irish #1 in the British Virgin Islands (BVI). The BVI does not levy a corporate income tax.

NOTE: Do you see what happened here? Profit is funneled to Irish #1, which does not pay tax to Ireland. The BVI has no tax. Irish #1 pays tax to nobody. Irish #2 pays tax to Ireland, but on greatly reduced profit.

And there you have a “double Irish!”

Let us step it up a notch. 

Let us introduce a third company. We will base this company in the Netherlands. We will call it “Dutch”. Why in the Netherlands? There are several reasons:

(1)            Both Ireland and the Netherlands are in the EU. EU members can move monies around with relative ease.

(2)            Holland’s corporate tax rate is 25%, not as attractive as Ireland’s 12.5%. Why would we send money there? The Netherlands will allow us to route profits through there if we agree to leave behind a small amount to be taxed.

(3)            The Netherlands will allow us to transfer money to tax havens on more favorable terms than Ireland. We intend to transfer the monies to the BVI.

We will place Dutch between Irish #1 and Irish #2. 

How do we get money into Dutch? Dutch will intercept sales bound for Irish #2. It’s not permanent: Dutch will forward those sales on to Irish #2. We will however leave some of Irish #2’s profit in Dutch for its trouble.

And Dutch will then move the profit – to the BVI.

You have just been served a double Irish with a Dutch sandwich. 

Congress blasted Apple because its subsidiaries reported approximately $30 billion in income from 2009 to 2012 but paid little to no tax. It is a fair point, but the following are also fair points:

(1)            Apple’ recent overseas sales have been approximately 60% of worldwide sales.

(2)            Apple keeps approximately $100 billion of its $150 billion cash war chest overseas. Its cash hoard seems – at first blush – in proportion to where it made sales.

(3)            Even with all this tax planning, Apple’s effective tax rate is roughly 14%. To put this in perspective, that is about the same as Samsung, Apple’s closest competitor. Where is Samsung headquartered? South Korea.

Could Apple have done even more? Yes, it could have. Remember my comment when we discussed iTunes S.à r.l.’s? This is the subsidiary that sells downloads to Europe, the Middle East and Africa. Whom does it not sell to? To the United States, Central and South America, that’s who. If Apple were truly concerned about eliminating its tax altogether, don’t you think it would have thought about this? It thought of near everything else.

It is difficult to consider the Apple hearings and not remember that Senator Levin was one of those who previously wrote the IRS demanding that it look into the tax exempt status of 501(c)(4)s, such as the  Club for Growth,  Americans for Tax Reform and Americans for Prosperity. In the summer of 2012, he demanded “why does the IRS allow 501(c)(4) organizations to self-declare?”

Uh, yeah. Thanks Carl. We know how well that turned out.

Ireland did not take well to Levin declaiming them as a “tax haven,” mentioning “Ireland” 37 times and “Irish” 29 times during Congressional hearings. The Irish Minister of State for European Affairs Lucinda Creighton travelled to Washington. She said:

“There is no doubt that some companies are taking advantage of the global legal and tax arrangements in a variety of jurisdictions.” 

“That is not something that Ireland can solve on its own. It is not something that the US or Ireland can solve together.”

Then she pointed out the obvious: the “extremely high corporate tax rate” in the U.S. is part of the problem. 

My take? 

Apple without a doubt pressed the pedal to the floor on its international tax planning. They are in good company, however, with Google, Yahoo, Dell, Pfizer and too many others to mention. Many tax advisors are concerned about this evolution of “stateless” income. “Stateless” means the income is not reported to or taxed by any country, and it is what Apple accomplished. It is one thing to arbitrage tax rates, as we did between California and Nevada. It is another to distill, filter and bottle the income to the extent it winds up being homeless.

I consider Apple to represent – to a great extent – the logical progression of our incoherent worldwide tax system. Congress thinks that multinationals will pay our highest-corporate-tax-rate -in-the-world just because… Well, why would they? Would you? The idiocy of this whole thing is thinking that Congress has a claim to money that someone – whether you, me or Apple - earned in Europe or Africa or Asia. The hubris and greed of Congress is stultifying.

Do you think that Irish Tax & Customs is wondering why Sen. Levin is thundering that Apple did not pay Ireland enough tax?