Windstream Holdings Put What Into a REIT?

Have you heard of Windstream Holdings?

They are a telecommunications company – that is, a phone company – out of Little Rock, Arkansas. They made the tax literature recently by getting IRS approval to put some of its assets in a real estate investment trust, abbreviated “REIT” and pronounced “reet.” 

So what is a REIT?

REITs entered the tax Code in 1960. For decades they have been rather prosaic tax vehicles, generally housing office buildings, apartment complexes and warehouses.

Yep, they invest in real estate.

REITS have several tax peculiarities, one of which has attracted planners in recent years. To qualify as a REIT, an entity must be organized as a corporation, have at least 100 shareholders, invest at least 75% of its assets in real estate and derive at least 75% of its income from the rental, use or sale of said real estate. Loans secured primarily by interests in real property will also qualify.

REITS must also distribute at least 90% of their taxable income in the form of shareholder dividends.

Think about this for a second. If a REIT did this, it would not have enough money left over to pay Uncle Sam its tax at the 35% corporate tax rate. What gives?

A REIT is allowed to deduct shareholder distributions from its taxable income.

Whoa.

The REIT can do away with its tax by distributing money. This is not quite as good as a partnership, which also a non tax-paying vehicle. A partnership divides its income and deductions into partner-sized slices. It reports these slices on a Schedule K-1, which amounts the partners in turn include on their personal tax returns. An advantage to a partner is that partnership income keeps its “flavor” when it passes to the partner. If a partnership passes capital gains income, then the partner reports capital gains income – and pays the capital gains rather than the ordinary tax rate.  

This is not how a REIT works. Generally speaking, REIT distributions are taxed at ordinary tax rates. They do not qualify for the lower “qualified dividend” tax rate.

Why would you invest in one, then? If you invested in Proctor & Gamble you would at least get the lower tax rate, right?

Well, yes, but REITs pay larger dividends than Proctor & Gamble. At the end of the day you have more money left in your pocket, even after paying that higher tax rate.

So what has changed in the world of REIT taxation?

The definition of “real estate.”

REITs have for a long time been the lazy river of taxation. The IRS has not updated its regulations for decades, during which time technological advances have proceeded apace. For example, American Tower Corp, a cellphone tower operator, converted to a REIT in 2012. Cell phones – and their towers – did not exist when these Regulations were issued. Tax planners thought those cell towers were “real estate” for purposes of REIT taxation, and the IRS agreed.

Now we have Windstream, which has obtained approval to place its copper and fiber optic lines into a REIT. The new Regulations provide that inherently permanent structures will qualify as REIT real estate. It turns out that that copper and fiber optic lines are considered “permanent” enough.  The IRS reasoned, for example, that the lines (1) are not designed to be moved, (2) serve a utility-like function, (3) serve a passive function, (4) produce income as consideration for the use of space, and (5) are owned by the owner of the real property.

I admit it bends my mind to understand how something without footers in soil (or the soil itself) can be defined as real estate. The technical issue here is that certain definitions in the REIT area of the tax Code migrated there years ago from the investment tax credit area of the tax Code. There is tension, however. The investment tax credit applied to personal property but not to real property. The IRS consequently had an interest in considering something to be real property rather than personal property. That was unfortunate if one wanted the investment tax credit, of course. However, let years go by … let technology advance… let a different tax environment develop … and – bam! -  the same wording gets you a favorable tax ruling in the REIT area of the Code.

Is this good or bad?

Consider that Windstream’s taxable income did not magically “disappear.” There is still taxable income, and someone is going to pay tax on it. Tax will be paid, not by Windstream, but by the shareholders in the Windstream REIT. I am quite skeptical about articles decrying this development as bad. Why - because a corporate tax has been replaced by an individual tax? What is inherently superior about a corporate tax? Remember, REIT dividends do not qualify for the lower dividends tax rate. That means that the REIT income can be taxed as high as 39.6%. In fact, it can be taxed as high as 43.4%, if one is also subject to the ObamaCare 3.8% tax on unearned income. Consider that the maximum corporate tax is 35%, and the net effect of the Windstream REIT spinoff could be to increase tax revenues to the Treasury.

This IRS decision has caught a number of tax planners by surprise. To the best of my knowledge, this is the first REIT comprised of this asset class. I doubt it will be the last.

Is It A Bad Thing To Be A Resident Of Two States At The Same Time?

A state tax issue came up with a client recently, and I was somewhat surprised by another CPA’s response.  The issue arises when someone has tons of interest and dividend income – that is, big bucks, laden with loot, banking the Benjamins.  Since I consider myself a future lottery winner, it also means something to me.

Here it is:

           

Can you be a resident of two states at the same time?

The other CPA did not think it possible.

There are a couple of terms in this area that we should review: domicile and place of abode. Granted in most cases they would mean the same thing. For the average person domicile is where you live. You are a resident of where your domicile is located. We future lottery winners however frequently will have multiple homes.   I intend to have a winter home (New Mexico comes to mind), a summer home (I am thinking Hawaii) and, of course, one or more homes overseas. Which one is my domicile? Now the issue is not so clear-cut.

OBSERVATION: Let’s be honest: this is a high-end tax problem.

Domicile is your permanent home. It is the place to which you intend to return when absent, to which your memories return when away, it is home and hearth, raising children, Christmas mornings and planting young trees There can be only one. A domicile exists until it is superseded, and there can never be two concurrent domiciles. It is Ithaca to Odysseus. It took Odysseus ten years to get home from Troy, but his domicile was always Ithaca. The concept borders on the mystical.

A place of abode can be an apartment, a cottage, a yacht, a detached single-family residence. There can be more than one. I intend to have abodes in New Mexico, Hawaii and possibly Ireland. My wife may pick out another one or two.

Most states (approximately 30, I believe) use the concept of “domicile” to determine whether you are or are not a “resident” of the state. You can generally plan for these states by pinning down someone’s “main” house.  A state can tax all the income of a resident, which is what sets up the tax issue we are talking about.

Then you have the “statutory” states, among the most aggressive of which is New York. New York will consider you a resident if:

(a)  Your domicile is New York, or

(b) Your domicile is not New York, but

a.     You maintain a permanent abode in New York for more than 11 months of the year, and

b.     You spend more than 183 days in New York during the year

That “or” is not there because New York wants to be your friend. That (b) is referred to as statutory residency. It is intentional, and its intent is to lift your wallet.

How? It has to do with all those interest and dividends we future lottery winners will someday have.

Let’s say that you live in Connecticut and work in White Plains. You are going to easily meet the “more than 183 days in New York” test. Unless you work at home. A lot. Let’s say you don’t.

We next have to review if you have a “permanent abode.” What if you have a vacation home in the Hamptons. What if you have an apartment in Brooklyn. What if you rent an apartment (in your name) for your daughter while she is attending Syracuse University. Do you have a permanent abode in New York? You bet you do. The “permanent” just means that it can be used over four seasons. We already discussed the meaning of “abode.”

Think about that for a moment. You may never stay at your daughter’s apartment. It will however be enough for New York to drag you in as a statutory resident because you “maintain” it.  New York doesn’t care if you ever actually stay there – or even step foot in it.

Great. You are a resident of both Connecticut and New York.

So what, you think. Connecticut will give you a credit for taxes paid New York. New York will give you a credit for taxes paid Connecticut. The accountants’ fee will be wicked, but you are not otherwise “out” anything, right?

Wrong. You may be “out” a lot, and it has to do with those interest and dividends and royalties and capital gains – that is, your “investment income.”

There is a state tax concept called “mobilia sequuntur personam.” It means “movables follow the person,” and in the tax universe it means that movable income (think investment income, which can be “moved” to anywhere on the planet) is taxed only by one’s state of residence. The system works well enough when there is only one state in the picture. It may not work so well when there are two states.

The reason is the common technical wording for the state resident tax credit. Let’s look at New York’s wording as our example:

A resident shall be allowed a credit …for any income tax imposed for the taxable year by another state …. upon income both derived therefrom and subject to tax under this article."

The trap here is the phrase “derived therefrom.” Let’s trudge through a New York tax Regulation to see this jargon in its natural environment:

           

The term income derived from sources within another state … is construed as ... compensation for personal services performed in the other jurisdiction, income from a trade, business or profession carried on in the other jurisdiction, and income from real or tangible personal property situated in the other jurisdiction."

Well, isn’t that a peach? New York wants my interest and dividend income to be from personal services I perform (that’s a “no”), from a trade, business or profession (another “no”) or from real or tangible property (again a “no”).

New York will not give me a resident credit for taxes paid Connecticut.

That means double state taxation. 

Yippee.

Can this be constitutional? Yes, unfortunately. The Supreme Court long ago decided that the constitution does not prohibit two states reaching the conclusion that each is the taxpayer’s state of residence. The Court stated:

“[n]either the Fourteenth Amendment nor the full faith and credit clause … requires uniformity of different States as to the place of domicile, where the exertion of state power is dependent upon domicile within its boundaries.” (Worcester County Trust Co v Riley)

What did we advise? The obvious advice: do NOT be in New York for more than 183 days in a calendar year NO MATTER WHAT. 

Our client’s apartment is in Manhattan, so she also gets to pay taxes to New York City on top of the taxes to New York State. I hope she really likes that apartment.

BTW New York is NOT on my list of states for when that future lottery comes in.

The IRS Should Apologize To This Taxpayer

In income tax land if …

•  You own a corporation, and

•  The corporation has property, and

•  The corporation gives you the property, and

•  You do not pay anything for it, …

… then the IRS will consider you as receiving distribution from the corporation. The classic distribution is a dividend, taxable to you and not deductible by the corporation. 

Perhaps the corporation distributes property and you pay some – but not all – of what the property is worth. A classic example is a corporation distributing a car to the owner’s child for a nominal amount. There is a distribution taxable as a dividend, and the dividend amount would be the value of the car over any amount paid. It would not be the full value of the car in this case.

The tax code views a C corporation (we are not discussing S corporations in this blog) as an entity distinct from its shareholders. That is how Congress justifies taxing the corporation on its income and then taxing the shareholders again when they receive dividends sourced to that income. Since there are two entities, there cannot be double taxation.  

But there is, of course, and it takes sleight of hand to maintain the illusion. Many if not most tax advisors – including me – have steered most of our closely-held business clients away from C corporations and to passthrough entities: perhaps S corporations, partnerships or limited liability companies. Sometimes the weight of the double taxation is unacceptable. 

The Tax Court decided the Welle case just last month. Sure enough, it involved a C corporation and a dividend. More specifically, it involved what the IRS saw as a new species of dividend. 

Let’s walk this through.

There is a construction company (TWC) in North Dakota. It is wholly-owned by Terry Welle (Welle). TWC primarily does multifamily construction, and its historical profit has been around 6 or 7 percent.

Welle decides he is going to build a lakefront property in Minnesota.

NOTE:  Excuse me here, but how about going south with that lakefront property? Is Minnesota that much warmer than North Dakota?

Back to our story. Welle has a company that builds things. He used TWC’s accounting system to track his costs, and he also used its workers to frame the Minnesota house. The company did a calculation of the costs, including overhead, and Welle reimbursed the company to the penny. 

The IRS comes in and finds fault. The IRS wants to know where the company’s profit is. Welle reimbursed the company at cost, including overhead, meaning that they made no profit from him. The IRS says that there should be and must be a profit. They calculate that profit to be around $48,000. Since he did not reimburse the company its erstwhile profit, the IRS assessed him with a $48,000 dividend. It wants $10,620 in income tax.

Oh, the IRS also wants an accuracy-related penalty of over $2,100.

Wow! The IRS is assessing a penalty on a tax theory it has never trotted out before? That is brazen.

This case goes to Court. The IRS argues that a corporate distribution must be measured at fair market value. Fair market value is the amount that would fully reimburse a company for its direct and indirect costs, as well as render a profit.  One cannot disagree with that summary of microeconomics 101.

The Court tells the IRS to back up. It wants the IRS to point to the distribution event before its gets to any issue of measuring and valuing. The Court reasons that a distribution requires assets to be “diverted to or for the benefit of a shareholder.” It must be a vehicle to “distribute available earnings and profits without the expectation of repayment.”

Show us the distribution, says the Court.

The IRS offers and the Court reviews a number of cases, but it cannot see how corporate assets were expended. Welle received services, but then again he paid for them. At most, he used the company as a conduit in maintaining records and paying subcontractors. The company was no better or worse for transacting with him. The event was a nullity.

In frustration, the Court writes:

Respondent does not explain how a corporation’s decision not to make a profit on services provided to a shareholder who fully reimburses the corporation for the cost of services (including overhead) constitutes a distribution of property that reduced the corporation’s earnings and profits under Section 316(a), nor does the respondent cite any cases supporting such a position.”

The Court decided for Welle and against the IRS.

My thoughts? This is one of the lamest tax theories I have come across, and I have near 30 years in the profession. What was the IRS up to? Are there that many North Dakota contractors building lakefront homes that the IRS decided to go where no serious tax practitioner had gone before? 

Let us segue for a moment. 

Do you remember Nina Olsen? She is the Taxpayer Advocate, and we have spoken of her before. The Advocate is supposed to sit outside the IRS and function as a watchdog. It is great idea, but I must admit the IRS for the last half-decade or so has seemed less than interested in the Advocate. Nonetheless, she is promoting an idea she calls the IRS “apology payment.”  The idea is to pay a taxpayer something when the behavior of the IRS causes excessive delay or expense or an undue burden resulting in significant hardship to the taxpayer.

This idea is being refloated in response to the 501(c)(4) scandal. Ms Olson argues that apology payment would: 

Serve as a symbolic gesture that the government recognizes its mistake and the taxpayer’s burden. These payments might enhance the public perception of the IRS and the tax system as just and fair.”

Great idea, although a $1,000 flat sum may be insufficient in some cases.

I would like to see Welle receive his apology payment for the IRS wasting his time.