Not Filing A Return and Owing Tax

 

The question comes up periodically, even among accountants: 

Is there a penalty for filing a late return if the taxpayer has a refund?

In general, the answer is no. Mind you, this is not an excuse to skip filing. If anything, you have money due to you. Do not file for three years and you are losing that refund.

Let’s switch a variable:

Is there a penalty for filing a late return if the taxpayer owes taxes?

Uhhhh, yes.

As a rule of thumb, assume an automatic 25% penalty, and it can be more.

So what happens if someone cannot file by the extended due date?

I have a one of these clients. I called him recently to send me his 2020 information.

His comment?

         I thought you took care of it.”

Now, I have been at this a long time, but I cannot create someone’s return out of thin air. Contrast that with estimating a selected number or two on a tax return. That happens with some regularity, although - depending on the size and tax sensitivity of the numbers – I might flag the estimates to the IRS’ attention. It depends.

Let look at the Morris case.

James and Lori Morris were business owners in Illinois. In 2013 James expanded the business, creating a new company to house the same. They had a long-standing relationship with their CPA.

The IRS came in and looked at the 2013 return. It appears that there were issues with the start-up and expansion costs of the new business, but the case does not give us much detail on the matter.

The Morris’ held up filing a return for 2014. They also held up filing 2015 and 2016, supposedly from concern of repeating the issue the IRS was addressing on the 2013 return.

Seems heavy-handed to me.

Well, as long as they were fully paid-in:

They did not make any estimated tax payments during the year at issue and did not have tax withheld from their paychecks during 2015. Petitioner-husband had a minimal amount of tax withheld from his wages during 2016. Petitioner-wife had withholding credits of $10 and $11 during 2015 and 2016, respectively.”

Got it: next to nothing paid-in.

Maybe the businesses were losing money:

For 2015 and 2016 petitioners, respectively, had ordinary income from their S corporations of over $2.2 million and $3 million.”

What was going on here? I am seeing income over $5 million for two years with little more than $21 of tax paid-in.

The Morris’ argued that their long-standing CPA advised that filing a return while an audit for earlier years was happening could subject them to perjury charges.

COMMENT: Huh? There are areas all over the Code where a taxpayer and the IRS might disagree. If it comes to pass, one appeals within the IRS or files with a court. The system does not lock-down because the IRS disagrees with you.

Frankly, I am curious what was on that return that the issue of “perjury” even saw the light of day.

Oh, well. Let’s have the CPA testify. Hopefully the Morris’ will have reasonable cause for penalty abatement because of their reliance on a tax professional.

Mr Knobloch (that is, the CPA) did not testify at trial, and there is no evidence in the record except for petitioner-husband’s testimony of Mr. Knobloch’s alleged advice.”

The Court was not believing this for a moment. 

We need not accept a taxpayer’s testimony that is self-serving and uncorroborated by other evidence, and we do not do so here.”

I find myself wondering why the CPA did not testify, although I have suspicions.

I also do not understand why – even if there were substantive issues of tax law – the Morris’ did not pay-in more for 2015 and 2016.  Did they think they had losses? OK, they would be out the money for a time but they would get it back as a refund when they file the returns.

They instead racked-up big penalties.

Our case this time was Morris v Commissioner, T.C. Memo 2021-120.

P&G, Coty And A Unicorn Named Morris

You may know that P&G is streamlining, selling off non-core lines of business. It just concluded a deal to sell 43 beauty brands, including Clairol and Max Factor, to Coty, Inc. The deal appears to be good for Coty, as it will double sales and transform Coty into one of the largest cosmetic companies in the world. P&G in turn receives $12.5 billion.

What makes it interesting to the tax planners is the structure of the deal: P&G is using a “reverse-Morris” structure. It combines a carve-out of unwanted assets (unwanted, in this case, by P&G) with a prearranged merger. The carve-out is nontaxable, but if you err with the merger the carve-out becomes taxable. This is a high stakes game, and woe unto you if the IRS determines that the merger was prearranged. The reverse Morris is designed to directly address a prearranged merger.

Let’s walk through it.

First, what is a “regular” Morris?

Let’s say that you own a successful and publicly-traded company (say Jeb). You have a line of business, which we shall call Lindsey. Someone (“Donald”) wants to buy Lindsey. Jeb could flat-out sell Lindsey, but the corporate taxes might be outrageous. Jeb could alternatively spinoff Lindsey to you, and you in turn could sell to Donald. That would probably be preferable.

Why?

Front and center is the classic tax issue with C corporations: double taxation. If Jeb sells, then Jeb would have corporate taxes. Granted, Jeb would distribute the after-tax proceeds to you, but then you would have individual taxes. The government might wind up being the biggest winner on the deal.

Forget that. Let’s spinoff Lindsey tax-free to you, and you sell to Donald. There would be one tax hit (yours), which is a big improvement over where we were a moment ago.

But you cannot do that.

You see, under regular corporate tax rules a tax-free merger with Donald within two years of a spinoff would trigger BAD tax consequences. We are talking about the spinoff being retroactively taxable to Jeb. Jeb will have to amend its tax return and write a big check. That is BAD.

I suppose you could tell Donald to take a hike for a couple of years while you reset the clock. Good luck with that.

You talk to your accountant (“Hillary”). She recommends that you have Jeb borrow a lot of money. You then drop Lindsey into a new subsidiary and spinoff new Lindsey to you. You leave the debt in Jeb. You then sell Jeb to Donald. Donald takes over the debt. He doesn’t care. Donald just offsets whatever he was going to pay you by that debt.

This is a Morris deal and Congress did not like it. It looked very much like a payday.

• The cash is in Lindsey
• The debt is in Jeb
• You sell Jeb
• You keep Lindsey
• You keep the money that is in Lindsey
• The government doesn’t get any money from anybody

The government was not getting its vig. Congress in response wrote a new section into the tax Code (Section 355(e)) which triggers gain if more than 50% control of either the parent or subsidiary changes hands. 

Yep, that pretty much will shut down a Morris deal. Donald wants more than 50% control. Donald is like that.

Now, Section 355(e) presented a challenge to the tax attorneys and CPAs. Think of it as an epic confrontation between a chromatic Great Wyrm and your 28th level paladin at the weekly Saturday night D&D game. The players were not backing down. No way.

So someone said “the deal will work if the buyer will accept less than 50% control.”

Eureka!

Let’s take our example above and introduce a different buyer (let’s call him Bernie). Bernie wants to buy Lindsey. Bernie is willing to accept less than 50%, as contrasted to that meanie Donald. Same as before, let’s drop Lindsey into a new subsidiary. New Lindsey borrows a lot of money and ships it to Jeb. New Lindsey, now laden with debt, is sold to Bernie. Bernie takes over the debt as part of the deal. When the dust settles, Bernie will own less than 50% of new Lindsey, which gets us out of the Section 355(e) dilemma.

You in turn keep Jeb and the cash.

And that is the reverse Morris. We sidestep Section 355(e) by not allowing more than 50% of either Jeb or Lindsey to change hands.

Why do we not see reverse Morris deals more often? There are three key reasons:

1. It requires a buyer that is smaller than the target, but not so small that it cannot do the deal. 
2. There will be new debt, likely significant. This raises the business risk associated with the deal, as the bank is going to want its money back.
3. The new company’s management and board may be an issue. After all, the buyer BOUGHT the company. It is not unreasonable that Bernie wants to control what he just bought. I would want to drive the new car I just bought and paid for.

The Reimann family of Germany owns approximately two-thirds of Coty. Even though Coty is acquiring less than 50% of the P&G subsidiary, the Reimann’s will own a large enough block of stock to have effective control. That must have helped make the reverse Morris attractive to Coty.

Reverse Morris deals are not unicorns, but there have been less than 40 of them to-date. That makes them rare enough that the tax specialists look up from their shoes when one trots out. P&G by itself has had three of them over the last ten or so years. Someone at P&G likes this technique.