On Warren Buffett, Berkshire Hathaway and PFICs

We have spoken before about passive foreign investment companies, or PFICs (pronounced pea-fick). There was a time when I saw these on a regular basis, and I remember wondering why the IRS made the rules so complicated.

I am thinking about PFICs because yesterday I read a release for IRS Notice 2014-28. The IRS is amending Regulations concerning the tax consequences of U.S. persons owning a passive foreign investment company through an account or organization which is tax-exempt. Think a hospital, pension plan or IRA, for example. 

Granted, this is not as interesting as Game of Thrones or Sons of Anarchy.

Could you walk unknowingly into a PFIC? It is not likely for the average person, but it is not as difficult as you might think.

PFICs came into the tax Code in 1986. They were intended to address what Congress saw as a loophole. I agree that there was a loophole, but whether the tax fly required the sledgehammer response it received is debatable.

There were a couple of ways to get to the loophole. One way would be to form a foreign corporation and have the corporation invest in stocks and bonds. This means you are forming a foreign mutual fund. There are a couple of issues with this, the key one being that it would require a large number of investors in order to avoid the rules for a controlled foreign corporation. To the extent that 10%-or-more U.S. shareholders owned more than 50% of the foreign corporation, for example, one would have a controlled foreign corporation (CFC) and would be back into the orbit of U.S. taxation.

The second way is to invest in an existing foreign mutual fund. Say that you invested in a German fund sponsored by Deutsche Bank, for example.

And the average person would say: so what? You invested in mutual fund.

Here s what the IRS did not like: the mutual fund could skirt the taxman by not paying dividends or distributions.  The value of the fund would increase, as it would accumulate its earnings.  When you sold that foreign mutual fund, you would have capital gains and you would pay U.S. tax.

Well, the IRS was unhappy with that, as you did not pay tax on dividends every year and, when you did pay, you paid capital gains rather than ordinary income tax. How dare you?

Why the sarcasm? Because you can get the same tax result from owning Berkshire Hathaway. Warren Buffet does not pay a dividend, and never has. You hold onto your shares for a few years and pay capital gains tax when you sell. The IRS never receives its tax on annual dividends, and you pay capital gains rather than ordinary tax on the sale.

Why the difference between the Berkshire Hathaway and Deutsche Bank? Exactly my point. Why is there a difference?

So we have PFIC taxation. Its sole purpose is to deny the deferral of tax to Americans investing in foreign mutual funds.

There are three ways to tax a PFIC.

The default scheme is found in Code Section 1291. You are allowed to defer taxation on a PFIC until the PFIC makes an “excess” distribution. An excess distribution is defined as one of two events:

(1)   The PFIC distributes an amount in excess of 125% of the average distribution for its preceding three years; or

(2)   You sell the PFIC stock.

Let’s say that we use the default taxation on the PFIC. What does your preparer (say me) have to do next?

(1)   I have to calculate your additional tax per year had the distribution been equally paid over the period you owned it (this part is relatively easy: it is the highest tax rate for that year); and

(2)   I have to calculate interest on the above annual tax amounts.

You can imagine my thrill in anticipation of this magical, career-fulfilling tax opportunity. There are severe biases in this calculation, such as presuming that any income or gain was earned pro rata over your holding period. I have seen calculations where - using 15 to 20 year holding periods - the tax and interest charge can approach 100%. This is not taxation. This is theft.

The second option is to annually calculate a "mark to market" on the PFIC. This works if there is a published trading or exchange price. You subtract the beginning-of-year value from the end-of-year value and pay tax on it. I have never seen a tax professional use this option, and frankly it strikes me as tax madness. With extremely limited exceptions, the tax Code does not consider asset appreciation to be an adequate trigger to impose tax. There would be no 401(k) industry, for example, if the IRS taxed 401(k)s like they tax PFICs.

The third option is what almost everyone does, assuming they recognize they have a PFIC and make the necessary election to be taxed as a “qualified election fund,” or QEF for short.

   OBSERVATION: Tax practitioners like their acronyms, as you can see.

There are two very important factors to a QEF:

           

(1)   You have to elect.

a.     No election, no QEF.

(2)   The foreign fund has to agree to provide you numbers, made up special just for its American investors. The fund has to tell you what your interest and dividends and capital gains would have been had it actually distributed income rather than accumulate.

You can fast forward why: because you are going to pay tax on income you did not receive.

What happens in the future when you sell the fund? Remember, you have been paying tax while the fund was accumulating. Don’t you get credit for all those taxes when you finally sell?

Yes, you do, and I have to track whichever of three calculations we decide on in a permanent file. For every fund you own.

BTW there had better be a specific form attached to your tax return: Form 8621. If you were required to disclose a foreign financial account (which a PFIC would be) and did not do so, either on Form 8621 or on another form intended for that purpose, the IRS might be able to "toll" the statute of limitations. Tolling means "suspend" in tax talk. This means the IRS could assess taxes, penalties and interest many years after the tax year should normally have closed. 

This applies only to rich people, right? Not so much, folks. This tax pollution has a way of dissolving down to affect very ordinary Americans.

How? Here are a couple of common ways:

(1)   You live abroad.

You live abroad. You invest abroad.

I intend to retire abroad, so some day this may affect me. Me and all the other tax CPA billionaires high-stepping it out of Cincinnati. Yep, we are a gang of tax-avoiding desperados, all right.

(2)   You work/worked in Canada.

And you have a RSSP. The RRSP is invested in Canadian mutual funds. How likely is this to happen? How about “extremely likely.”

There you have two ordinary as rain ways that someone can walk into a PFIC.

Keep in mind that the IRS is convinced that anyone with a nickel overseas is hiding money. We have already gone through the FBAR and OVDI fiascos, and tax literature is thick with stories of ordinary people who were harassed if not near-bankrupted by obscure and never-before-enforced tax penalties. The IRS is unabashed and wonders why you – the average person – cannot possibly keep up with its increasingly frenetic schedule of publishing tax rules, required disclosures, Star Trek parodies, bonuses to deadbeat employees and Fifth Amendment-pleading crooks.

Beginning in 2014, FATCA legislation requires all “foreign financial institutions” to report to the IRS all assets held by U.S. citizens and permanent residents. The U.S. citizen and permanent resident in turn will disclose all this information on new forms the IRS has created for this purpose – assuming one can find a qualified U.S. tax practitioner in Thailand, Argentina or wherever else an American may work or retire. Shouldn’t be a problem for that overseas practitioner to spot your PFIC – and all the related tax baggage that it draws in its wake - right?

What happens if one doesn’t know to file the PFIC form, or files the form incorrectly? I think we have already seen the velvet fist of the IRS with FBARs and OVDI. Why is this going to be any different?

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.

Beer, Pepsi, A Cincinnati Family And The Estate Tax

I am reviewing a tax case involving estate taxes, generation-skipping taxes, a Cincinnati family, and a beer brand only recently brought back to the market. Let’s talk about it.

John F. Koons (Koons) owned shares that his father had bought during the 1930s in Burger Brewing Co., a Cincinnati brewer known for its Burger beer. The Cincinnati Reds broadcaster Waite Hoyt nicknamed a deck at Crosley Field (where the Reds then played) “Burgerville.” 

During the 1960s the company began bottling and distributing Pepsi soft drinks. In the 1970s it left the beer business altogether. The company changed its name to Central Investment Corp (CIC), and Koons was its largest shareholder.

In the late 1990s Koons got into litigation with PepsiCo. By 2004 PepsiCo suggested that the litigation could be resolved if CIC sold its soft drink business and left the Pepsi-Cola system. 

In July, 2004 Koons revised his will to leave the residue of his estate to a Revocable Trust.

In August, 2004 Koons set-up Central Investments LLC (CI LLC) to receive all the non-PepsiCo assets of CIC.   

In December, 2004 Koons and the Koons children executed a stock purchase agreement with PepsiCo. Koons owned 46.9% of the voting stock and 51.5% of the nonvoting stock of CIC.

The deal was sweet. PepsiCo paid $50 million to settle the lawsuit as well as $340 million, plus a working capital adjustment, for the shares of CIC.

There was a kicker in here though: the children’s agreement to sell their CIC shares was contingent on their also being redeemed from CI LLC. It appears that CI LLC was going to be professionally managed, and the children were being given an exit.

In January, 2005 CI LLC distributed approximately $100 million to Koons and the children.

By the end of January two of the four Koons children decided to accept the buyout offer.

In February, 2005 Koons amended the Revocable Trust. He removed the children, leaving only the grandchildren. He then contributed his interest in CI LLC to the Trust.

NOTE: A couple of things happened here. First, the trust is now a generation-skipping trust, as all the beneficiaries in the first generation have been removed. You may recall that there is a separate generation-skipping tax. Second, Koons’ interest in CI LLC went up when the two children agreed to the buyout. Why? Because he still owned the same number of shares, but the total shares outstanding would decrease pursuant to the redemption.      

Koons – who would soon own more than 50% of CI LLC - instructed the trustees to vote in favor of changes to CI LLC’s operating agreement. This prompted child number 2 – James B. Koons – to write a letter to his father. Son complained that the terms of the buyout “felt punitive” but thanked him for the “exit vehicle.” He told his dad that the children would “like to be gone.”

Sure enough, the remaining two children accepted the buyout.

On March 3, 2005 Koons died.

The buyouts were completed by April 30, 2005. The Trust now owned more than 70% of CI LLC.

And the Koons estate had taxes coming up.

CI LLC agreed to loan the Trust $10,750,000 to help pay the taxes. The note carried 9.5% interest, with the first payment deferred until 2024. The loan terms prohibited prepayment.

OBSERVATION: That’s odd.

The estate tax return showed a value over $117 million for the Trust.

The estate tax return also showed a liability for the CI LLC loan (including interest) of over $71 million.

And there you have the tax planning! This is known as a “Graegin” loan.

NOTE: Graegin was a 1988 case where the Court allowed an estate to borrow and pay interest to a corporation in which the decedent had been a significant shareholder.

Did it work for the Koons estate?

The IRS did not like a loan whose payments were delayed almost 20 years. The IRS also argued that administration expenses deductible against the estate are limited to expenses actually and necessarily incurred in the administration.  The key term here is “necessary.”

Expenditures not essential to the proper settlement of the estate, but incurred for the individual benefit of the heirs, legatees, or devisees, may not be taken as deductions.”

The estate argued that it had less than $20 million in cash to pay taxes totaling $26 million. It had to borrow.

You have to admit, the estate had a point.

The IRS fired back: the estate controlled the Trust. The Trust could force CI LLC to distribute cash. CI LLC was sitting on over $300 million.

The estate argued that it did not want to deplete CI LLC’s cash.

The Court wasn’t buying this argument. It pointed out that the estate depleted CI LLC’s cash by borrowing. What was the difference?

Oh, oh. There goes that $71 million deduction on the estate tax return.

It gets worse. The IRS challenged the value of the Trust on the estate tax return.  The Trust owned over 70% of CI LLC, so the real issue was how to value CI LLC.

The estate’s expert pointed out that the Trust owned 46.9% of CI LLC at the time of death. There would be no control premium, although there would be a marketability discount. The expert determined that CI LLC’s value for tax purposes should be discounted almost 32%.

The IRS expert came in at 7.5%. He pointed out that – at the time of death – it was reasonably possible that the redemptions of the four children would occur. This put the Trust’s ownership over 50%, the normal threshold for control.

Here is the Court:

The redemption offers were binding contracts by the time Koons died on March 3, 2005. CI LLC had made written offers to each of the children to redeem their interests in CI LLC by February 27, 2005. Once signed, the offer letters required the children to sell their interests ....

Any increase in the value of CI LLC would increase the generation-skipping tax to the Trust. 

Any increase in the value of the Trust would increase the estate tax to the estate.

The tax damage when all was said and done? Almost $59 million.

Given the dollars involved, the estate has almost no choice but to appeal. It does have difficult facts, however. From a tax planner’s perspective, it would have been preferable to keep the Trust from owning more than 50% of CI LLC. Too late for that however.