Substantially Disclosing A Gift To The IRS

Take a look at this memorable prose:

         Sec 6501(c) (9) Gift tax on certain gifts not shown on return.

If any gift of property the value of which (or any increase in taxable gifts required under section 2701(d) which) is required to be shown on a return of tax imposed by chapter 12 (without regard to section 2503(b) ), and is not shown on such return, any tax imposed by chapter 12 on such gift may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time. The preceding sentence shall not apply to any item which is disclosed in such return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature of such item.

I get it: if you never disclose the gift, the IRS can come after you until the end of time. The reverse is what concerns us today: if you disclose the gift “in a manner adequate,” then the IRS does not have until the end of time.

Gift tax cases can be … idiosyncratic, to be diplomatic. All tax is personal, but gift tax can be Addams Family idiosyncratic.

Ronald Schlapfer (RS) was a Swiss-born businessman. He had ties to both Switzerland and the United States. He owned a life insurance policy issued in 2006.The policy in turn owned all the stock in EMG, a Panamanian company previously owned by RS.

It was 2006 and RS was a nonresident of the U.S. He gifted his interest in EMG to his mother, aunt and uncle.

He obtained U.S. citizenship in 2008.

Got it: he gifted before he became subject to U.S. gift tax.

In 2013 – and after obtaining his citizenship – RS decided to play it safe and submitted an offshore voluntary disclosure filing with the IRS. It included a gift tax return for 2006, which informed the IRS of the gift to his family. The return included the following:

“A protective filing is being submitted. On July 6, 2006, taxpayer made a gift of controlled foreign company stock valued at $6,056,686 per U.S. Treasury Regulation 25.2501-1(B). The taxpayer is not subject to U.S. gift tax as he did not intend to reside permanently in the United States until citizenship was obtained in 2008.”

COMMENT: In this situation, a protective filing means that the taxpayer is unsure if a filing is even required but is submitting one, nonetheless. It is an attempt to backstop penalties and other bad things that could happen from a failure to file.

COMMENT: International practice has become increasingly paranoid for many years now. The IRS seems convinced that every UBER driver has unreported foreign accounts, and one’s failure to follow arbitrary and obscure rules are a per se admission of culpability. In this case, for example, there was technical doubt whether the gift was reportable as the transfer of a life insurance policy or as the transfer of a company owned by that policy. Why was there doubt? Well, the IRS itself created it. Rest assured, whichever way you chose the IRS would fall the other way.

The IRS disagreed that the gift occurred in 2006. There was a hitch in the transfer, and the attorney did not resolve the matter until 2007. RS in turn argued that 2007 was but a scrivener’s error. According to well-trod ground, a scrivener’s error is considered administrative, not substantive, and does not mark the actual date of the underlying transaction.

Sometime in here RS agreed to extend the limitations period.

In 2019 the IRS issued the statutory notice of deficiency (SNOD). That is also called a 90-day letter, and it meant that the next step was Tax Court - if RS wanted to further pursue the matter.

Off to Tax Court they went.

RS’ argument was simple: the statute of limitations had expired.

The IRS argued that the gift was not adequately disclosed.

The IRS argued that disclosure requires the following:

·       Description of the property gifted, and any consideration received by the donor.

·       The identity and relationship between the parties.

·       There is additional disclosure for property is transferred in trust.

·       A detailed explanation of how one arrived at the fair market value of the property gifted.

·       Whether one has taken a position contrary to any Regulations or rulings

The IRS was trying to catch RS in the first requirement above: a description of the property gifted.

Was it an insurance policy, ownership in a company, or something else?

Here is the Court:

While Schlapfer may have failed to describe the gift in the correct way, he provided enough information to identify the underlying property that was transferred.”

RS won his case. The IRS had blown the statute of limitations.

Our case this time was Schlapfer v Commissioner, T.C. Memo 2023-65.

Let's Talk Tax Inversions - Part Two

Last time we discussed the taxation of an inverting corporation.

There are three levels of tax severity to the corporation itself:

(1)   The IRS ignores the inversion completely and continues to tax the foreign company as if it were a U.S. company

(2)   The IRS will respect the foreign company as foreign, but woe to whoever tries to move certain assets out of the U.S. or otherwise use certain U.S. – based tax attributes for a period of 10 years.

(3)   The IRS will respect the transaction without reservation.

Then there is the toll-charge on the shareholders. If they own more than 50% of the new foreign company, the shareholders will pay tax on their shares AS IF they had sold them rather than exchanged them for stock in the new foreign parent.  The practical effect is that any inversion has to include cash to the U.S. shareholders, otherwise such shareholders would be reaching into their wallet to pay tax (and would likely vote to scuttle any inversion deal).

It was this toll charge that caught the attention of Congress. If you think about it, someone owning actual shares would be taxed, but someone having a future right to shares would not. Who would such a person be? How about corporate insiders: management and directors? Executives frequently receive stock options and other stock-based compensation. Congress felt that management and directors should also have “skin in the game,” thus the origin of Section 4985. 

One quickly realizes the parity Congress wanted:

(1)   First, Section 4985 applies only if gain is realized by any shareholder. If there is no toll charge on the shareholders, then there will be no toll charge on management and directors.

(2)   The Section 4985 tax will be the highest tax rate payable by the shareholders, which is the capital gains rate (15%)

There is some technical lingo in here. The tax Code dragnets all individuals “subject to the requirements of Section 16(a) of the Securities Exchange Act of 1934” – in short, the officers, directors and 10% shareholders. It also includes their families.

So Congress wanted insiders to also pay tax. That’s great. I wanted to play in the NFL.

Let’s take a look at another Congressional attempt to “rope in” executive pay: the golden parachute limitations of Section 280G. This tax applies to “excess” compensation payments upon a change in corporate control. The insider is allowed a base amount (defined as average annual compensation for the five years preceding the year of change in control). The excess is subject to an additional 20% excise tax – in addition to the payroll and income taxes already paid.

How does it work away from the fever swamp of Washington?

It doesn’t. Corporations routinely “gross-up” the executive compensation until the tax is shifted back to the corporation.

I suspect that every tax accountant has run into a compensation “gross up” exercise. I have done enough over the years to make my eyes cross.

Let’s return to our inversion discussion. What do you think companies are doing when their executives are subjected to the 15% Section 4985 excise tax?

Yep, the gross-up.

The mathematics of a gross-up are terrible. Let’s take the example of someone who is subject to the maximum federal tax rate (39.6%), add in the ObamaCare Medicare tax (0.9%), the Section 4985 tax itself (15%) and a state tax (say 6%), and 61.5% of every dollar is going to tax (I am leaving out the deductibility of the state tax). If I am to gross-up a payroll, I am saying that only 38.5 cents of every dollar will be available to satisfy the original Section 4985 tax liability. This means that the gross-up will have to be $2.60 (that is, 1 divided by 38.5%) for every dollar of the original Section 4985 tax.

But Congress, never willing to leave a bigger mess undone, added yet another twist to Section 4985: the corporation is not allowed to deduct the gross-up. Let’s say that the excise tax was $1 million. The gross-up would be $2.6 million, none of which is deductible by the company.

Yipes!

Medtronic is a medical device maker based in Minneapolis. It operates in more than 120 countries and employs approximately 50,000 people worldwide. It has agreed to acquire Covidien, an Irish medical device company. Since we are talking about inversions, you can surmise that the new parent will be based in Ireland. For its part, Medtronic says it will be leaving its Minneapolis-based employees in Minneapolis, which makes sense when you consider that they have employees located throughout the planet.

Medtronic will of course continue to pay U.S. tax on its U.S. income. What it won’t do is pay U.S. tax on income earned outside the U.S. This is not an unreasonable position. Think about your response if California tried to tax you because you drank Napa Valley wine.

Medtronic triggered the Section 4985 excise tax on its executive officers and directors. This tax is estimated to be approximately $24 million.

Remember the loop-the-loop involved with a gross-up. How much will it cost Medtronic to gross-up its insiders for the $24 million?

Around $63 million.

None of which Medtronic can deduct on its tax return.

Can you explain to me how this can possibly be good for the shareholders of Medtronic? It isn’t, of course.

Way to play masters of the universe, Congress.

Let's Talk Tax Inversions - Part One

You may have read recently that Burger King is acquiring Tim Hortons Inc, a Canadian coffee and donut chain. What has attracted attention is the deal is structured as an inversion, which means that the American company (Burger King) will be moving its tax residency to Canada. I suppose it was hypothetically possible that the deal could have moved Tim Hortons Inc to the U.S. (think of it as a reverse inversion), but that would not have drawn the attention of the politicians.

The combined company will be the world’s third-largest fast-food company, right behind McDonalds and Yum! Brands (think KFC and Taco Bell). While the U.S. will have by far the largest number of locations, the majority of the revenue – again by far – will be from Canada.

An issue at play is that U.S. companies face a very harsh tax system, one in which they are to pay U.S. tax on all profits, even if those profits originated overseas and may never be returned to the U.S. Combine that with the world’s highest corporate tax rate, and it becomes fairly easy to understand why companies pursue inversions. In certain industries (such as pharmaceuticals), it is virtually imperative that the some part of the company be organized overseas, as the default tax consequences would be so prohibitive as to likely render the company uncompetitive.

Let’s talk a bit about inversions.

Inversions first received significant Congressional scrutiny in the 1980s, when McDermott Inc did the following:

·        McDermott organized a foreign subsidiary, treated as a controlled foreign corporation for U.S. tax;

·        The subsidiary issued stock in exchange for all the outstanding stock of McDermott itself; and          

·        Thus McDermott and its subsidiary traded places, with the subsidiary becoming the parent.

In response Congress passed IRC Sec 1248(i), requiring any future McDermott to report dividend income – and pay tax – on all of its subsidiary’s earnings and profits (that is, its undistributed profits).

In the 1990s, Helen of Troy Corp had its shareholders exchange their stock for stock of a new foreign parent company.

In response the IRS issued Reg 1.367(a)-3(c), requiring the U.S. shareholders to be taxable on the exchange because they owned more than 50% of the foreign company after the deal was done.

In the aughts, Valeant Pharmaceuticals paid a special dividend to its shareholders immediately before being acquired by Biovail, a Canadian corporation. Valeant paid out so much money - thereby reducing its own value - that the Valeant shareholders owned less than 50% of the foreign company.

Interesting enough, this did not (to the best of my knowledge) draw a government response. There is a “stuffing” rule, which prohibits making the foreign corporation larger. There is no “thinning” rule, however, prohibiting making the U.S. company thinner.

Then there was a new breed of inversions. Cooper Industries, Nabors Industries, Weatherford International and Seagate Technologies did what are called “naked” inversions. The new foreign parent incorporated in the Cayman Islands or Bermuda, and there was no effort to pretend that the parent was going to conduct significant business there. The tax reason for the transaction was stripped for all to see – that is, “naked.”

That was a bridge too far.

Congress passed IRC Sec 7874, truly one of the most misbegotten sections in the tax Code. Individually the words make sense, but combine them and one is speaking gibberish.

Let’s break down Section 7874 into something workable. We will split it into three pieces:

(1)  The foreign company has to acquire substantially all the assets of a domestic company. We can understand that requirement.

(2)  The U.S. shareholders (referred to “legacy” shareholders) own 60% or more of the foreign parent. There are three sub-tiers:

a.     If the legacy shareholders own at least 80%, the IRS will simply declare that nothing occurred and will tax the foreign company as if it were a U.S. company;

b.     If the legacy shareholders own at least 60% but less than 80%, the IRS would continue to tax the foreign company on its “inversion gain” for 10 years.

                                                              i.      What is an “inversion gain?” It involves using assets (think licenses, for example) to allow pre-inversion U.S. tax attributes to reduce post-inversion U.S. tax. The classic tax attribute is a net operating loss carryover.

c.      If the legacy shareholders own less than 60%, then Section 7874 does not apply. The new foreign parent will generally be respected for U.S. tax purposes.

But wait! There is a trump card.

(3)  The IRS will back off altogether if the foreign company has “substantial business presence” in the new parent’s country of incorporation.

There is something about a trump card, whether one is playing bridge or euchre or structuring a business transaction. The tax planners wanted a definition. Initially the IRS said that “substantial business presence” meant 10% of assets, sales and employees. It later changed its mind and said that 10% was not enough. It did not say what would be enough, however. It said it would decide such issues on “facts and circumstances.” This sounds acceptable, but to a tax planner it is not. It is the equivalent of saying that one need not stop at a stop sign, as long as one is not “interfering” with traffic. What does that mean, especially when one has family in the car and is wondering if the other driver has any intention of stopping?

After three years the IRS said that it thought 25% was just about right. Oh, and forget about any “facts and circumstances,” as the IRS did not want to hear about it.

The 25% test was a cynical threshold, figuring that no one country – other than the U.S. – could possibly reach 25% by itself. Even the E.U. market – which could rival the U.S. – is comprised of many individual countries, making it unlikely (barring Germany, I suppose) that any one country could reach 25%.

Until Pfizer attempted to acquire AstraZeneca, a U.K. based company. The White House then proposed reducing the 80% test to a greater-than-50% test and eliminating the 60% test altogether. It also wanted to eliminate any threshold test if the foreign corporation is primarily managed from the United States.

The Pfizer deal fell through, however, and there no expectation that this White House proposal will find any traction in Congress.

And there is our short walk through the minefield of tax inversions.

There is one more thing, though. You may be wondering if the corporate officers and directors are impacted by the tax Code. Surely you jest- of course they are! There is a 15% excise tax on their stock-based compensation. How does this work out in the real world? We will talk about this in our next blog, when we will discuss the Medtronic – Covidien merger. 

Beany Baby Billionaire Caught With Secret Swiss Bank Account

I cannot understand people who go to great lengths to underreport income. I am not talking about tax planning – perhaps even aggressive tax planning – to reduce one’s tax under the law. Some actions are so routine one may not even see them as tax planning, such as moving from a higher-tax state (say Ohio) to a lower-tax state (say Florida or Nevada). 

What I am talking about is flat-out tax evasion. We have now crossed a line. The Supreme Court has acknowledged that no one is under compulsion to pay more tax than necessary, but likewise all are under compulsion to pay the appropriate tax.

Enter Ty Warner. He was responsible for the “beanie babies” from the 1990s and is the 100% owner of TY Inc and other business interests. There must be a LOT of money in beanie babies, as Forbes has ranked him as the 209th wealthiest American, with a net worth estimated at $2.6 billion.

He opens a secret bank account with UBS in 1996. In 2002 he transfers over $93 million from there to another Swiss Bank. He obfuscates the ownership of the account by tagging it with the name “Molani Foundation.” The UBS account threw off $3.2 million in income for 2002.  This income is not reported to the accountants and is not included on his tax return. Mind you, he had already reported $49.1 million on his income tax return.

QUESTION: Is it possible to have so much income that one forgets some of his/her income?

You can pretty much guess that there was no FBAR filed. How could there be? There apparently was no "foreign" account, at least to Warner.

Fast forward the conversation and UBS gets dragged into the IRS and Justice Department hunt for secret Swiss bank accounts.

Oh, oh, Warner realizes the jig is up. He tries to enter the IRS Offshore Voluntary Disclosure Program, but he was denied entry. A likely reason is that the IRS had already identified him as owner of one or more unreported accounts.

Now he has a serious problem. Could there be tax fraud? I cannot say. I can say that I recall sitting across a conference table from a client who could not tell you (or me) if his tax return – showing $33 million in gross income – included all his income for the year. Is it possible that $3.2 million got lost in Warner’s reported income of $49.1 million? It is possible, but the other actions – like fudging the name of the Swiss account or not telling the accountants – look bad.

What Warner did run into face-first is the FBAR reporting. This is the filing for foreign accounts over $10 thousand. It is mailed separately from the tax return, and it is due July 1. For decades no one paid much attention to these reports, but in the aughts the IRS decided that there was money to be found. They began the crackdown on foreign bank accounts, starting with UBS - eventually ensnaring Ty Warner. The penalties for an FBAR are confiscatorily insane, as the government somehow justifies that they can take up to half of whatever is in the account. For multiple years. Reflect for a moment that the government is saying that – should they press beyond two years - they can take from you more than you have – or ever had – in the account.

This has nothing to do with the earnings from the account. For example, for 2002 Warner’s secret account generated approximately $3.2 million in income. Did the government want taxes on the $3.2 million, which would be about $1 million? Nope. Did they want all of that $3.2 million? Nope.

What they wanted was one-half of the highest balance in the account. What was that amount for Warner? Try $53.6 million.

Warner doesn’t pay taxes on $3.2 million. Let’s be generous and say that it was $3.2 million for several years. It now costs him $53.6 million to cash-out?

Set aside whether this is confiscatory. I cannot understand why Warner –or anyone - would even go there. Let’s be honest: would he even have noticed the taxes had he correctly reported the $3.2 million to begin with?