An Accounting Firm Gets Sued

I just saw that Baker Tilly has acquired Seiler LLP, a CPA firm located in San Francisco and practicing for well over half a century.

There is nothing unusual here. Many older CPAs are looking to retire. In some cases, the firm may have planned for transition and brought in, developed, and retained a pipeline of ownership-interested younger CPAs.  The older CPAs retire, the younger CPAs step up and the firm continues.

In other cases, there is no such pipeline, and the older CPA’s exit plan is a sale to another firm.

The matter caught my eye because a client is suing Seiler for negligence. The matter is still in court. I thought the grounds for negligence was … different.

It is not our usual brew of java, but let’s talk about it.

It starts with a married couple: Eric Freidenrich and Amy Macartney. They hired Seiler to prepare their 2019 joint tax return. The return was filed in December 2020.

COMMENT: You may be thinking that the return was filed late (that is, after October 15) and penalties and interest would be due. That is not true here, as the return showed an overpayment of almost $450 grand. There normally will be no interest and penalties on refund-due returns, as penalties and refunds normally apply only when balances are due the IRS. The risk to a refund return is waiting too long to file a return. Remember, the statute of limitations on filing is three years. Wait past those three years and you will lose your refund.

For some reason, Eric and Amy did not use a home address on their return. They instead used their financial advisor’s address, a practice they had followed for years.

Now, a couple of things happened after 2019 and during 2020 before Seiler filed the return:

·       Eric and Amy divorced.

·       The financial advisor moved.

On first blush, I would be concerned about the divorce. A CPA (or his/her firm) should think long and hard about representing a divorcing couple. The reason is simple: which one of the two is the client? Representing both can create a conflict of interest, and a CPA is supposed to maintain independence and avoid such conflicts. Failure to do so can result in a hearing before a State Board of Accountancy.

The refund arrived in April 2022.

The two had signed their separation agreement in June 2021.

The separation agreement included language that Eric would be responsible for additional taxes due during the term of marriage, but - to be fair - he would also be entitled to any refunds.

Amy did not know that the IRS refund got held up. The couple’s routine was to deposit in the couple’s Fidelity account, and the separation agreement had Amy receiving 60% of the Fidelity account.

The refund was almost $450 grand, and 60% of that – approximately $270 grand – would have gone to Amy.

She was not amused.

I would not be either.

She sued Seiler for negligence.

Notice that she did not sue her ex-husband.

Where is the negligence?

Seiler – as a firm – knew that that advisor had moved. It should have used the new address.

Did the tax team – a subset of Seiler – also know that the advisor had moved? Information moves well enough in a CPA firm, but it would be false to say that it moves flawlessly. It is possible that the tax department did not know, but Amy is suing Seiler, not the tax department.

Seiler (or rather, their attorney) tried to get the motion dismissed.

And there is a quick lesson here about torts. Torts are civil law. Think of torts as suing someone. You bring suit, not the government. It is conduct between private parties.

The idea behind a tort is to restore the injured party (as much as possible in the circumstance) to where he/she would have been had the other party not acted or failed to act. A goal of tort law is to see the world as it could have been, not as the world is now.

Well, under that description Amy would have received 60% of the IRS refund. Seiler injured her. Her ex did not injure her, as he stated in the divorce decree that he would keep any tax refunds relating to the marriage term.

The Court therefore saw reason for tort action and would not grant summary motion for dismissal.

What does this mean? It means that the Court will hear the case against Seiler for negligence.

As a tax CPA, it bothers me that I could get my firm sued for something I did not even know. That said, I get it. The firm knew. However, Eric and Amy saw the address on the return. Their attorneys would also have seen the address. Do we know if the financial advisor timely filed a change of address with the IRS? Seiler might not be the only party with some measure of fault. 

Getting A Carr Out Of New York

Did you know that New York is likely to audit you if you move away from the state? These “residency audits” are infamous, as the outcome is rarely in doubt. They are the state tax equivalent of World Wrestling Entertainment.

I have never lived in a state that would not allow me to leave. There is something about such behavior that is highly disturbing.

I am reading Patrick Carr’s request for redetermination with the New York Division of Tax Appeals.

Carr is an attorney who was admitted to the New York Bar in 1964. He was later admitted to the New Jersey Bar. He followed the traditional New York migration pattern, and by 2007 he was living in Sarasota. He was retired, so he did not bother to move his law license to Florida.

He got involved with a case. Since he didn’t have a Florida license, the court allowed him “pro hac vice” status, literally meaning “this time only.” The court allowed him – as an out-of-state lawyer – to appear in court for a specific trial.

The case went on for a while, and he had legal fee income for 2007, 2008 and 2009. 

He reported the income on his federal return as self-employment income. There is no Florida individual income tax.

Wouldn’t you know that he got pulled for a residency audit?

New York conceded that he had successfully left New York.

That should have been the end of the matter, but …

New York still wanted its taxes.

The taxpayer received a large amount of money in tax year 2007 from a case he litigated in Florida. Schedule C income for 2008 and 2009 were relatively smaller compared to 2007. The taxpayer stated that all of his schedule C income from legal services was sourced to the state of Florida.”

Let a tax pro translate the above:

We want the money.

Back to New York: 

However, the taxpayer is not licensed to practice law in the State of Florida.”

Tax pro:                  

Sounds like a Florida problem.

New York:

It was determined that he was admitted as counsel pro hac vice in the Circuit Court of the 12^th Judicial Circuit in Sarasota County, Florida. This means that he was given special permission to help litigate this particular case even though you are not licensed to practice law in the state of Florida.”

Tax pro:

He received permission from the Court. Are there any other issues?

New York:

Therefore, all of your income is subject to New York income tax, since your income was attributable to a profession carried out in New York State….”

Tax pro:

By "carried out in New York State," do you mean Sarasota?

New York admitted he never did any of the work in New York, and also admitted that he was not a resident of New York.

Tax pro:

This was productive. Stay in touch.

New York nonetheless sent him a tax bill for $68 thousand, plus interest. They reasoned that his New York law license was enough to make him taxable in New York.

Tax pro:

Why is New York dissing New Jersey? Carr had a New Jersey license as well as a New York license. Why don’t you make it 50% to keep it fair?

New York:

He used to live in New York.

Tax pro: 

He used to go to college. Why don't you bill him for tuition also?

You already know this wound up in Court.

And the Court pointed out the obvious:

·        Carr did not have an office in New York

·        Carr did not practice in New York

·        Carr had an office or other place of practice outside New York

·        Carr had a license outside New York

·        He was authorized to practice in Florida. In fact, that is what pro hac vice means

·        Holding a New York license is not the same as carrying on a profession in New York

The Court told New York to go away.

What upsets me about state tax behavior like this is the cost and stress imposed upon the individual. I can see that Carr represented himself (“pro se”) in this matter, but he is an attorney. Most people do not have the training and likely would not represent themselves. They would have to hire a tax pro to fend-off a reckless challenge by New York or another state. Even if they win, they lose – after they pay the professional fees.

Why Would a 100+ Year-Old Ohio Company Move To Ireland?

Consider the following statements:

• Eaton Corp acquired Cooper Industries for $13 billion, the largest acquisition in the Cleveland manufacturer's 101-year history.
• Cooper Industries is based in Houston and incorporated in Ireland.
• Eaton Corp incorporated a new company in Ireland - Eaton Corp., plc.
• Eaton Corp will wind up as a subsidiary of Eaton Corp. plc.
• The new company will have about 100,000 employees in 150 countries. It will have annual sales in excess of $20 billion.

This transaction is called an inversion. Visualize it this way: the top of the ladder (Eaton Corp) now becomes a subsidiary – that is, it moved down the ladder. It inverted.

 

To a tax planner this is an “outbound” transaction, and it brings onto the pitch one of the most near-incomprehensible areas of the tax code – Section 367. This construct entered the Code in the 1930s in response to the following little trick:

1. A U.S. taxpayer would transfer appreciated assets to a foreign corporation in a tax haven country. Many times these assets were stocks and bonds, as they were easy to sell. Believe it or not, Canada was a popular destination for this.
2. The corporation would sell the assets at little or no tax.
3. The corporation, flush with cash, would merge back into a U.S. company.
4. The U.S. taxpayer thus had cash and had deftly sidestepped U.S. corporate tax.

OBSERVATION: It sounds like it was much easier to be a tax planner back in the 1930s.

The initial concept of Section 367 was relatively easy to follow: what drove the above transactions was the tax planner’s ability to make most or all the transactions tax-free.  To do this, planners primarily used corporations. This in turn allowed the planner to use incorporations, mergers, reorganizations and divisives to peel assets away from the U.S.  Congress in turn passed this little beauty:

            367(a)(1)General rule.—

If, in connection with any exchange described in section 332, 351, 354, 356, or 361, a United States person transfers property to a foreign corporation, such foreign corporation shall not, for purposes of determining the extent to which gain shall be recognized on such transfer, be considered to be a corporation.

Congress said that – if one wanted to play that appreciated-stock-to-a-Canadian-company game again - it would not permit the Canadian company to be treated as a corporation. As the tax-free status required both parties to be corporations, the game was halted. There were exceptions, of course, otherwise legitimate business transactions would grind to a halt. Then there were exceptions to exceptions, which the planners exploited, to which the IRS responded, and so on to the present day.

By 2004 the planners had gotten very good. Congress passed another law – Section 7874 – to address inversions. It introduced the term “surrogate foreign corporation,” which – as initially drafted – could have pulled a foreign corporation owned by foreign investors with no U.S. operations or U.S. history into the orbit of U.S. taxation. How?

Let’s look at this horror show:

7874(a)(2)(B)Surrogate foreign corporation.—

A foreign corporation shall be treated as a surrogate foreign corporation if, pursuant to a plan (or a series of related transactions)—

7874(a)(2)(B)(i) 

the entity completes … the direct or indirect acquisition of substantially all of the properties … held directly or indirectly by a domestic corporation or substantially all of the properties … of a domestic partnership,

7874(a)(2)(B)(ii) 

after the acquisition at least 60 percent of the stock … is held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation,

7874(a)(2)(B)(iii) 

after the acquisition the …entity does not have substantial business activities in the foreign country … when compared to the total business activities of such expanded affiliated group.

How can this blow up? Let me give you an example:

• Foreign individuals form a domestic U.S. corporation (Hamilton U.S.) under the laws of Delaware.
• Hamilton U.S. makes a ton of money (not relevant but it makes me happy).
• All shareholders of Hamilton U.S. are either nonresident aliens or a foreign corporation (Hamilton International) also owned by the same shareholders.
• The shareholders have never resided nor have any other business interest in the U.S.
• Hamilton International was formed outside the U.S. and has no other business interest in the U.S.
• The shareholders decide to make Hamilton U.S. a subsidiary of Hamilton International.
• The shareholders have a Board meeting in Leeds and transfer their shares in Hamilton U.S. to Hamilton International. They then head to the pub for a pint.

Let’s pace this out:

• Hamilton U.S. would be subject to U.S. taxation on its operations, as the operations occur exclusively within the U.S. This result is not affected by who owns Hamilton U.S.
• We will meet the threshold of 7874(a)(2)(B)(i) as a foreign corporation acquired substantially all (heck, it acquired all) the properties of a domestic corporation.
• We will meet the threshold of 7874(a)(2)(B)(ii) as more than 60% of the shareholders remain the same. In fact, 100% of the shareholders remain the same.
• We will meet the threshold of 7874(a)(2)(B)(iii) as the business activities are in the U.S., not in the foreign country.

We now have the possibility – and absurdity – that Hamilton International is a “surrogate foreign corporation” and taxable in the U.S. Granted, in our example this doesn’t mean much, as Hamilton International’s only asset is stock in Hamilton U.S., which has to pay U.S. tax anyway. Still, it is an example of the swamp of U.S. tax law.

Let’s get back to Eaton.

Why would Eaton make itself a subsidiary of an Irish parent?

It is not moving to Ireland. Eaton will retain its presence in northern Ohio, and Cooper will remain in Houston. Remember that business activities in the United States will be taxable to the U.S., irrespective of the international parent. What then is the point of the inversion? The point is that more than one-half the new company will be outside the U.S., and the international parent keeps that portion away from the IRS. Remember also that Ireland has a 12.5% tax rate, as opposed to the U.S. 35% rate.

There is another consideration. Placing Eaton in Ireland allows the tax planners to move the treasury function outside the U.S. What is a treasury function? It is lingo for the budgeting, management and investment of cash. Considering that this is a $20 billion company, there is a lot of cash flow. Treasury is a candidate for what has been called “stateless” income.

           

There is more. Now the development of patents and intellectual property can now be sitused outside the United States. By the way, this is a key reason why virtually all (if not all) pharmaceutical and technology companies have presence outside of the United States. It is very difficult to create intellectual property in the U.S. and then move it offshore. How does a tax advisor plan for that? By never placing the intellectual property in the U.S.

           

And the point of all this: Eaton has estimated that the combined companies would realize annual tax savings of about $160 million by 2016.

In 2002, Senator Charles Grassley, then the top Republican on the Finance Committee, called inversion transactions “immoral.”  That ironically was also the year that Cooper Industries inverted to Bermuda, and it later moved to Ireland. The Obama administration has proposed disallowing tax deductions for companies moving outside the United States. Nothing has come of that proposal.

The U.S. policy of worldwide taxation goes back to the League of Nations, when the U.S. thought that advanced nations would eventually move to its side. That did not happen, and with time, many nations moved instead to a territorial system. The U.S. is now the outlier. Our tax policy now presumes irrational economics. I am not going to advise a client to pay more tax just because Senator Grassley thinks they should. 

I will take this step further: many tax planners believe that it may be malpractice NOT to consider placing as much activity offshore as reasonably possible. There is more than a snowball’s chance that I could be sued for advising a client as the Senator wants.

I am glad that Eaton kept its jobs in Ohio. It is unfortunate that it had to go through these gymnastics, though.