Unforced Error on Short Stop

 I am reading a case concerning interest expense. While I have seen similar accounting, I do not recall seeing it done as aggressively.

Let’s talk about it.

Bob and Michelle Boyum lived in Minnesota and owned a company named Short Stop Electric. Bob was primarily responsible for running the company. Michelle had some administrative duties, but she was mostly responsible for raising the nine Boyum children.

Short Stop was a C corporation.

Odd, methinks. Apparently, the Court thought so also:

One might regard this as an eccentric choice for a small, privately owned business because income from C corporations is taxed twice.”

Let’s talk about this taxed-twice issue, as it is a significant one for tax advisors to entrepreneurial and closely held companies.

Let’s say that you start a company and capitalize it with a $100 grand. Taxwise, there are two things going on.

At the company level you have:

                   Cash                     100,000

                   Equity                 (100,000)                                 

The only thing the company has is the $100 grand you put in. If it were to liquidate right now, there would be no gain, loss, or other income to the company, as there is no appreciation (that is, deferred profit) in its sole asset – cash.

At a personal level, you would own stock with a basis of $100 grand. If the company liquidated and distributed its $100 grand, your gain, loss, or other income would be:

          $100 grand (cash) - $100 grand (basis in stock) = -0-

Make sense.

Let’s introduce a change: the company buys a piece of land for $100 grand.

At the company level you now have:

                   Land                     100,000

                   Equity                 (100,000)

Generally accepted accounting records the land at its acquisition cost, not its fair market value.

Now the change: the land skyrockets. It is now worth $5 million. You decide to sell because … well because $5 million is $5 million.

Is there tax to the company on the way out?

You betcha, and here it is:

          $5 million - $100 grand in basis = $4.9 million of gain

          Times 21% tax rate = $1,029,000 in federal tax

          $5 million - 1,029,000 tax = $3,971,000 distributed to you

Is there tax to you on the way out?

Yep, and here it is:

          $3,971,000 - 100,000 (basis in stock) = $3,871,000 gain

          $3,871,000 times 23.8% = $921,298 in federal tax

Let’s summarize.

How much money did the land sell for?

$5 million.

How much of it went to the IRS?

$1,950,298

What is that as a percentage?

39%

Is that high or low?

A lot of people - including me - think that is high. And that 39% does not include state tax.

What causes it is the same money being taxed twice – once to the corporation and again to the shareholder.

BTW there is a sibling to the above: payment of dividends by a C corporation. Either dividends or liquidation will get you to double taxation. It is expensive money.

Since the mid-80s tax advisors to entrepreneurial and closely held businesses have rarely advised use of a C corporation. We leave those to the Fortune 1000 and perhaps to buyout-oriented technology companies on the west coast. Most of our business clients are going to be S corporations or LLCs.

Why?

Because S corporations and LLCs allow us to adjust our basis in the company (in the example above, shareholder basis in stock was $100 grand) as the company makes or loses money. If it makes $40 grand, shareholder basis becomes $140 grand. If it then loses $15 grand, basis becomes $100 grand + $40 grand - $15 grand = $125 grand. 

The reason is that the shareholder includes business income on his/her individual return and pays taxes on the sum of business and personal income. The effect is to mitigate (or eliminate) the second tax – the tax to the shareholder – upon payment of a dividend or upon liquidation.

Back to our case: that is why the Court said that Short Stop being a C corporation was “an eccentric choice.”

However, Bob had a plan.

Bob lent money to Short Stop for use in its business operations.

Happens all the time. So what?

Bob would have Short Stop pay interest on the loan.

Again: so what?

The “what” is that no one – Short Stop, Bob, or the man on the moon – knew what interest rate Bob was going to charge Short Stop. After the company accounting was in, Bob would decide how much to reduce Short Stop’s profit. He would use that number as interest expense for the year. This also meant that the concept of an interest rate did not apply, as interest was just a plug to get the company profit where Bob wanted.   

What Bob was doing was clever.

There would be less retained business profit potentially subject to double taxation.

There were problems, though.

The first problem was that Bob had been audited on the loan and interest issue before. The agent had previously decided on a “no change” as Bob appeared receptive, eager to learn and aware that the government did not consider his accounting to be valid.

On second audit for the same issue, Bob had become a recidivist.

The second problem was: Short Stop never wrote a check which Bob deposited in his own bank account. Instead, Short Stop made an accounting entry “as if” the interest had been paid. Short Stop was a cash-basis taxpayer. Top of the line documentation for interest paid would be a cancelled check from Short Stop’s bank account. Fail to write that check and you just handed the IRS dry powder.

The third problem is that transactions between a company and its shareholder are subject to increased scrutiny. The IRS caught it, disallowed it, and wanted to penalize it. There are variable interest rates and what not, but that is not what Bob was doing. There was no real interest rate here. Bob was plugging interest expense, and the resulting interest rate was nonsensical arithmetic. If Bob wanted the transaction to be respected as a loan and interest thereon, Bob had to follow normal protocol: you know, the way Bank of America, Fifth Third or Truist loan money. Charge an interest rate, establish a payment schedule, perhaps obtain collateral. What Bob was doing was much closer to paying a dividend than paying interest. Fine, but dividends are not deductible.

To his credit, Bob had been picking up Short Stop’s interest expense as interest income on his personal return every year. This was not a case where numbers magically “disappeared” from one tax return to another. It was aggressive but not fraud.

Bob nonetheless lost. The Court disallowed the interest deductions and allowed the penalties.

My thoughts?

Why Bob, why? I get the accounting, but you were redlining a tax vehicle to get to your destination. You could have set it to cruise control (i.e., elect S status), relaxed and just …moved … on.

Our case this time was Short Stop Electric v Commissioner, T.C. Memo 2023-114.

Making A Comeback: Section 1202 Stock

We are going tax-geek for this post.

Let’s blame Daryl, a financial advisor with Wells Fargo. He has been studying and asking about a particular Code section.

Code Section 1202.

This section has been a dud since 1993, but last year’s changes to the tax Code have resurrected it. I suspect we will be reading more about Section 1202 in the future.

What sets up the tension is the ongoing debate whether it is better to do business as a “C” corporation (which pays its own tax) or an “S” corporation (whose income drops onto its owners’ individual returns, who pay tax on the business as well as their other personal income).

There are two compelling factors driving the debate:

(1) The difference between corporate and individual tax rates.

For most of my career, top-end individual tax rates have exceeded top-end corporate tax rates. Assuming one is pushing the pedal to the floor, this would be an argument to be a C corporation.

(2)  Prior to 1986, there was a way to liquidate (think “sell”) a C corporation and pay tax only once. The 1986 tax act did away with this option (except for highly specialized – and usually reorganization-type – transactions). Since 1986 a C corporation has to pay tax when it liquidates (because it sold or is considered to have sold its assets). Its assets then transfer to its shareholders, who again pay tax (because they are considered to have sold their stock).

Factor (2) has pretty much persuaded most non-Fortune-500 tax advisors to recommend S corporations, to the extent that most of the C corporations many tax practitioners have worked with since 1986 have been legacy C’s. LLC’s have also been competing keenly with S corporations, and advisors now debate which is preferable. I prefer the settled tax law of S corporations, whereas other advisors emphasize the flexibility that LLCs bring to the picture.

Section 1202 applies to C corporations, and it gives you a tax break when you sell the stock. There are hoops, of course:

(1)   It must be a domestic (that is, a U.S.) C corporation.

(2)   You must acquire the stock when initially issued.

a.     Meaning that you did not buy the stock from someone else.

b.    It does not mean only the first issuance of stock. It can be the second or third issuance, as long as one meets the $ threshold (discussed below) and you are the first owner.

(3)   Corporate assets did not exceed $50 million when the stock was issued.

a.     Section 1202 is more of a west-Coast than Midwest phenomenon. That $50 million makes sense when you consider Silicon Valley.

b.    If you get cute and use a series of related companies, none exceeding $50 million, the tax Code will combine you into one big company with assets over $50 million.

c.     By the way, the $50 million is tested when the stock is issued, not when you sell the stock. Sell to Google for a zillion dollars and you can still qualify for Section 1202.

(4)   You have owned the stock for at least five years.

(5)   Not every type of business will qualify.

a.     Generally speaking, professional service companies – think law, health, accounting and so on – will not qualify. There are other lines of businesses – like restaurants and motels - that are also disqualified.

(6)   Upon a qualifying sale, a shareholder can exclude the larger of (a) $10 million or (b) 10 times the shareholder’s adjusted basis in the stock.

Folks, a minimum $10 million exclusion? That is pretty sweet.

I mentioned earlier that Section 1202 has – for most of its existence – been a dud. How can $10 million be a dud?

Because it hasn’t always been $10 million. For a long time, the exclusion was 50% of the gain, and one was to use a 28% capital gains rate on the other 50%. Well, 50% of 28% is 14%. Consider that the long-term capital gains rate was 15%, and tax advisors were not exactly doing handstands over a 1% tax savings.

In 2010 the exclusion changed to 100%. Advisors became more interested.

But it takes five years to prime this pump, meaning that it was 2015 (and more likely 2016 or 2017) by the time one got to five years.

What did the 2017 tax bill do to resurrect Section 1202?

It lowered the “C” corporation tax rate to 21%.

Granted, it also added a “passthrough” deduction so that S corporations, LLCs and other non-C-corporation businesses remained competitive with C corporations. Not all passthrough businesses will qualify, however, and – in an instance of dark humor – the new law refers to (5)(a) above to identify those businesses not qualifying for the passthrough deduction.

COMMENT: And there is a second way that Section 1202 has become relevant. A tax advisor now has to consider Section 1202 – not only for the $10-million exclusion – but also in determining whether a non-C business will qualify for the new 20% passthrough deduction. Problem is, there is next to no guidance on Section 1202 because advisors for years DID NOT CARE about this provision. We were not going to plan a multiyear transaction for a mere 1% tax savings.

Nonetheless 21% is a pretty sweet rate, especially if one can avoid that second tax. Enter Section 1202.

If the deal is sweet enough I suppose the $10 million or 10-times-adjusted-basis might not cover it all.

Good problem to have.

Nails, REITs And Coffins

I am reading an article that includes the following sentence:

If these deals become widespread, they’d be another nail in the coffin of the corporate income tax.”

That sounds ominous.

It turns out that the author is writing about real estate investment trusts, more commonly known as REITs (pronounced “reets”).

I do not work with REITs. The last time I came near one was around 2000, and that was in a limited context. My background is entrepreneurial wealth and is unlikely to include REIT practice – unless said wealth is selling its real estate to said REIT.    

REITs have become popular as an investment alternative in an era of low interest rates, as they are required to pay dividends. Well, to be more accurate, they are required IF they want to remain REITS.

REITS are corporations, but they have access to a unique Code section – Section 857. Qualify and the corporation has an additional deduction not available to you or me – it can deduct dividends paid its shareholders from taxable income.

This is a big deal.

Regular corporations cannot do this. Say you and I own a corporation and it makes a million dollars. We want the money. How do we get it out of the corporation? We have the corporation pay us a million-dollar dividend, of course.

Let’s walk through the tax tao of this.

The corporation cannot deduct the dividend. This means it has to pay tax first. Let’s say the state tax is $60,000, which the corporation can deduct. It will then pay $320,000 in federal tax, leaving $620,000 it can pay us.

In a rational world, we would not have to pay tax again on the $620,000, as it has already been taxed.

That is not our world. The IRS looks around and say “the two are you are not the corporation, so we will tax you again.” The fact that you and I really are the corporation – and that the corporation would not exist except for you and me – is just a Jedi mind trick.

You and I are taxed again on the $620,000. Depending upon, we are likely to bump from the 15% dividend rate to the 20% rate, then on top of it we will also be subject to the 3.8% “net investment income” surtax. The state is going to want its share, which should be another 6% or so.

Odds are we have parted with another 29.8% (20% plus 3.8% plus 6%), which would be approximately $185,000. We now have $435,000 between us. Not a bad chunk of change, but the winner in this picture is the government.

Think how sweet it would be if we could deduct the million dollars. The corporation would not have any taxable income (because we paid it out in full as dividends). Yes, you and I would be taxable at 29.8%, but that is a whole lot better than a moment ago. We just saved ourselves over $260,000.

Congress did not like this. This is referred to as “erosion” of the corporate income tax base and is the issue our author was lamenting. Yes, you and I keeping our money is being decried as “erosion.” Words are funny like that.

Back to our topic.

Real estate has to represent at least 75% of REIT assets. In a similar vein, rental income must comprise at least 75% of REIT income. Get too cute or aggressive and you will lose REIT status – and with it that sweet dividends-paid deduction. For years and years these entities were stuffed with shopping malls, apartments and office complexes. They were boring.

Someone had to push the envelope. Maybe it was a tax planner pitching the next great idea. Maybe it was a corporate raider looking to make his or her next billion dollars. All one has to do is redefine “real estate” to include things that are not – you know – real estate.

For example, can you lease the rooftop of an office building and consider it real estate? What about pipelines, phone lines, billboards, data centers, boat slips?

In recent years the IRS said all were real estate.

Something that started as a real estate equivalent to mutual funds was getting out of hand. Pretty soon a Kardashian reality TV show was going to qualify as real estate and get stuffed into a REIT.

In the “Protecting Americans from Tax Hikes Act of 2015,” Congress put a chill on future REIT deals.

To a tax nerd, getting assets out of a corporation into another entity (say a REIT) is referred to as a “divisive.” These transactions take place under Section 355, and - if properly structured - result in no immediate taxation.

Let’s tweak Section 355 and change that no-immediate-taxation thing:

* Unless both (or neither) the distributing and the distributed are themselves REITs, the divisive will be taxable.

* If neither are REITS, then neither can elect REIT status for 10 years.

This tweak is intended to be a time-out, giving the IRS time. It is, frankly, an issue the IRS brought upon itself The IRS has issued multiple private letter rulings that seem to confound “immoveable” with “real estate.” The technical problem is that there are multiple Sections in the tax Code - Sections 168, 263A, 1031, and 1250 for example – that affect real estate. Each may be addressing different issues, and grafting definitions from one Section onto another can result in unintended consequences.

Again we have the great circle of taxation. Somebody stretches a Code section to the point of snapping. Eventually Congress pays attention and changes the law. There will be another Code section to start the process again. There always is.

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.

The Sysco Merger and the Double Dummy

Recently a financial advisor called me to discuss investments and, more specifically, Sysco’s acquisition of U.S. Foods.  I had to read up on what he was talking about.

The Sysco deal is a reverse triangular merger. It is not hard to understand, although the terms the tax attorneys and CPAs throw around can be intimidating. Let’s use an example with an acquiring company (let’s call it Big) and a target company (let’s call it Small).

·        Big creates a subsidiary (Less Big).

·        Less Big merges into Small.

·        Less Big ceases to exist after the merger.

·        Small survives.

·        Big now owns Small.

Voila!

This merger is addressed in the tax Code under Section 368, and the reverse triangular is technically a Section 368(a)(2)(E) merger. Publicly traded companies use Section 368 mergers extensively to mitigate the tax consequences to the companies and to both shareholder groups.

In an all-stock deal, for example, the shareholders of Small receive stock in Big. Granted, they do not receive cash, but then again they do not have tax to pay. They control the tax consequence by deciding whether or not to receive cash (up to a point).

Sysco used $3 billion of its stock to acquire U.S. Foods. It also used $500 million in cash.

And therein is the problem with the Section 368 mergers.

It has to do with the cash. Accountants and lawyers call it the “basis” issue. Let’s say that Sysco had acquired U.S. Foods solely for stock. Sysco would acquire U.S. Foods' “basis” in its depreciable assets (think equipment), amortizable assets (think patents) and so on. In short, Sysco would take over the tax deductions that U.S. Foods would have had if Sysco had left it alone.

Now add half a billion dollars.

Sysco still has the tax deductions that U.S. Foods would have had.

To phrase it differently, Sysco has no more tax deductions than it would have had had it not spent the $500 million.

Then why spend the money? Well… to close the deal, of course. Someone in the deal wanted to cash-out, and Sysco provided the means for them to do so. Without that means, there may have been no deal.

Still, spending $500 million and getting no tax-bang-for-the-buck bothers many, if not most, tax advisors.

Let’s say you and I were considering a similar deal. We would likely talk about a double dummy transaction.

The double dummy takes place away from Section 368. We instead are travelling to Section 351, normally considered the Code section for incorporations.  

 

Let’s go back to Big and Small. 

·        Big and Small together create a new holding company.

·        The holding company will in turn create two new subsidiaries.

·        Big will merge into one of the subsidiaries.

·        Small will merge into the other subsidiary.

In the end, the holding company will own both Big and Small.

How did Small shareholders get their money? When Big and Small created the new holding company, Small shareholders exchanged their shares for new holding company shares as well as cash. Was the cash taxable to them? You bet, but it would have been taxable under a Section 368 merger anyway. The difference is that – under Section 362 – the holding company increases its basis by any gain recognized by the Small shareholders.

And that is how we solve our basis problem.

The double dummy solves other problems. In a publicly traded environment, for example, a Section 368 merger has to include at least 40% stock in order to meet the continuity-of-interest requirement. That 40% could potentially dilute earnings per share beyond an acceptable level, thereby scuttling the deal. Since a double dummy operates under Section 351 rather than Section 368, the advisor can ignore the 40% requirement.

The double dummy creates a permanent holding company, though. There are tax advisors who simply do not like holding companies.

Sysco included $500 million cash in a Section 368 deal. Assuming a combined federal and state tax rate of 40%, that mix cost Sysco $200 million in taxes. We cannot speak for the financial “synergies” of the deal, but we now know a little more about its tax implications.