Researching For Deductions

I was skimming a Tax Court case that almost made me laugh out loud.

It initially caught my attention because it involved a deduction for research costs.

The tax surrounding research costs come in two flavors:

·      What is deductible as research?

·      And – perhaps more importantly – can you get a tax credit for it?

Let’s talk this time about the first question, which may not be what you anticipate. Here is an example:

You build a garage to store your business equipment. The garage’s claim to fame is that it is built from natural fibers rather than bricks and lumber. It is the Kon-Tiki of garages. Can you deduct the cost of the garage as you build it?

At the end of the day, you will have a building. Granted, it may be unusual, but it is still a building. Can you deduct a building as you go along? Or do you have to accumulate (and defer) the cost until the building is ready for use? And then what - do you deduct the accumulated cost at that time or do you deduct the cost over a period of years?

You will be deducting the cost over a period of years, otherwise known as depreciation. You self-constructed a long-lived asset, and the tax Code (barring the unusual) will not let you deduct it immediately.

Let’s swing back to research costs.

What if the research costs result in a patent?

You have legal rights for a period of years to intellectual property, and the patent may be worth a fortune.

So we rephrase the question: can you immediately deduct the research costs resulting in that patent?

But CTG, you say, the two are not the same. Chances are that salaries make-up most of the research costs. It doesn’t seem right to capitalize and depreciate salaries. Sticks and bricks have staying power; they last for years. It makes more sense to depreciate those rather than salaries.

Hmmm. What about the wages of the tradesmen-and-women that constructed the building? Do we get to carve those out from the sticks-and-bricks and deduct them immediately?

Of course not.

You now get the issue with research costs.

To answer it the tax Code gives us Section 174:

        (a)  Treatment as expenses.

(1)  In general.

A taxpayer may treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account. The expenditures so treated shall be allowed as a deduction.

As long as the costs meet the definition of “research or experimental expenditures,” you have the option of deducting them immediately.

Problem solved.

Our case this time is Bradley and Hayes-Hunter v Commissioner.

Mr. Bradley was a litigation consultant. He reviewed evidence, provided expert testimony and conducted legal research. He was self-employed, and on his 2014 individual income tax return he deducted $25,000 as “Research.”

The IRS was curious what “research and experimental expenditures” a litigation coach could possibly have. It is well-trod ground that Section 174 addresses research in an “experimental” or “laboratory” sense. While one does not have to be in a Pfizer lab wearing a white coat, one likewise cannot be in a library shepardizing law cases.

What did he deduct?

I will give you a clue: his billing rate was $250 per hour.

He deducted $25,000.

And $25,000 divided by $250 is 100 hours.

Not only was he nowhere near a Section 174 research cost, he was also deducting his own time.

How I wish.

Who knows how much tax research I do over an average year. If I could only deduct my time, I would never pay income taxes again.

It won’t work for me, and it did not work for Mr. Bradley.

Patents, Capital Gains and Hogitude

I have an acquaintance who has developed several patents.  He works for a defense contractor, so I suspect he has more opportunity than a tax CPA.

COMMENT: Did you know that tax advisors have tried to “patent” their tax planning? I suppose I could develop a tax shelter that creates partnership basis out of thin air and then pop the shelter to release a gargantuan capital loss to offset a more humongous capital gain…. Wait, that one has already been done. Fortunately, Congress passed legislation in 2011 effectively prohibiting such nonsense.

Let’s say that you develop a patent someday. Let’s also say that you have not signed away your rights as part of your employment package. Someone is now interested in your patent and you have a chance to ride the Money Train. You call to ask how about taxes.

Fair enough. It is not everyday that one talks about patents, even in a CPA firm.

Think of a patent as a rental property. Say you have a duplex. Every month you receive two rental checks. What type of income do you have?

You have rental income, which is to say you have ordinary income. It will run the tax brackets if you have enough income to make the run.

Let’s say you sell the duplex. What type of income do you have?

Let’s set aside depreciation recapture and all that arcana. You will have capital gains.

People prefer capital gains to ordinary income. Capital gains have a lower tax rate.

Patents present the same tax issue as your duplex. Collect on the patent - call it royalties, licensing fees or a peanut butter sandwich – and you have ordinary income. You can collect once or over a period of time; you can collect a fixed amount, a set percentage or on a sliding rate scale. It is all ordinary income.

Or you can sell the patent and have capital gains.

But you have to part with it, same as you have to part with the duplex. 

Intellectual property however is squishier than real estate, which make sense when you consider that IP exists only by force of law. You cannot throw IP onto the bed of a pickup truck.

Congress even passed a Code section just for patents:

§ 1235 Sale or exchange of patents.

(a)  General.

A transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 1 year, regardless of whether or not payments in consideration of such transfer are-

(1)  payable periodically over a period generally coterminous with the transferee's use of the patent, or (2) contingent on the productivity, use, or disposition of the property transferred.

The tax Code wants to see you part with “substantial rights,” which basically means the right to use and sell the patent. Limit such use – say by geography, calendar or industry line – and you probably have not parted with all substantial rights.

Bummer.

What if you sell to yourself?

It’s been tried, but good thinking, tax Padawan.

What if you sell to yourself but make it look like you did not?

This has potential. Your training is starting to kick-in.

Time to repeat the standard tax mantra:

pigs get fat; hogs get slaughtered

Do not push the planning to absurd levels, unless you are Google or Apple and have teams of lawyers and accountants chomping on the bit to make the tax literature.

Let’s look at the Cooper case as an example of hogitude.

James Cooper was an engineer with more than 75 patents to his credit. He and his wife formed a company, which in turn entered into a patent commercialization deal with an independent third party.

So far, so good. The Coopers got capital gains.

But the deal went south.

The Coopers got their patents back.

Having been burned, Cooper was now leery of the next deal. Some sharp attorney advised him to set up a company, keep his ownership below 25% and bring in “independent” but trusted partners.

Makes sense.

Mrs. Cooper called her sister to if she wanted to help out. She did. In fact, she had a friend who could also help out.

Neither had any experience with patents, either creating or commercializing them.

Not fatal, methinks.

They both had full-time jobs.

So what, say I.

They signed checks and transferred funds as directed by the accountants and attorneys.

They did not pursue independent ways to monetize the patents, relying almost exclusively on Mr. Cooper.

This is slipping away a bit. There is a concept of “agency” in the tax Code. Do exactly what someone tells you and the Code may consider you to be a proxy for that someone.

Maybe the tax advisors should wrap this up and live to fight another day.

The sister and her friend transferred some of the patents back to Cooper.

Good.

For no money.

Bad.

The sister and her friend owned 76% of the company. They emptied the company of its income-producing assets, receiving nothing in return. Real business owners do not do that. They might have a career in the House of Representatives, though.

Meanwhile, Cooper quickly made a patent deal with someone and cleared six figures.

This mess wound up in Tax Court.

To his credit, Cooper argued that the Court should just look at the paperwork and not ask too many questions. Hopefully he did it with aplomb, and a tin man, scarecrow and cowardly lion by his side.

The Tax Court was having none of his nonsense about substantial rights and 25% and no-calorie donuts.

The Court decided he did not meet the requirements of Section 1235.

The Tax Court also sustained a “substantial understatement” penalty. They clearly were not amused. 

Cooper reached for hogitude. He got nothing.

When A Tax Shelter Blows Up

Can you image losing a tax case with the IRS and owing a billion dollars?

Who did this? We are talking about Dow Chemical Company (“Dow”). They lost in the District Court for the Middle District of Louisiana. I suppose they have no choice but to appeal. It is a billion dollars, after all.

What got them in this mess? 

A couple of tax shelters, one marketed by Goldman Sachs and both implemented by the law firm of King & Spalding. The IRS sued for tax years 1993 to 2003. 

Let’s talk about the first of the shelters – called a SLIP – which lasted from 1993 to 1997. Dow was not the only one that tried to SLIP the IRS. Merck and International Paper tried also.

SLIP stands for “Special Limited Investment Partnership.”  Its claim to fame was taking low-basis assets and turning them into tax deductions.  How would you do this? Well you could contribute them to a partnership, but that low basis would carryover. You would get no increased tax deduction by putting it a partnership.

Hmmm.

What if you put low-basis assets into a partnership and then leased them back?  Wait, the partnership would then have taxable income. Who would own the partnership? If you owned it, then the whole effort would be circular. 

What if there are other partners? Problem: you do not want other partners. 

What if you limit the other partners to a fixed return? It would be the same as paying interest to a bank, right? In partnership taxation we call this a priority or preference distribution. 

Problem: most of that income would be coming back to you. How can we solve this puzzle?

We delink the income distribution from the cash distribution. We bring in partners who will accept 6 or 7 percent priority, and we allocate virtually all the income to them.

Now why would someone agree to this?

If someone doesn’t pay U.S. tax, that’s why. Someone like a foreign bank.

Eureka!

You offer a foreign bank the deal, now referred to as a “structured financial transaction.” This means that it is complicated, and you will be paying top dollar for investment, legal and accounting advice. You explain to the bank that it would:

·        Receive a significant premium over a corporate bond

·        Take on less credit risk than a corporate bond

·        Escape any U.S. tax

Sure enough, Dow and Goldman Sachs rounded up five foreign banks willing to contribute $200 million. Dow set up a maze of subsidiaries, into which it dumped 73 patents. The interesting fact about these patents is that Dow had amortized them virtually to zero, Dow still used them in current operations and retained enough of the processes to make it unlikely anyone would want to buy the patents, though.  The patents appraised at $867 million.

One of those Dow subs contributed the patents into a partnership called Chemtech I, taking back an 81 percent ownership.

Dow paid Chemtech I around $143 million for use of the patents.

Chemtech I paid the foreign banks 7 percent as their priority return. Since the banks had invested $200 million, this was a cool $14 million in their pockets. Chemtech I paid a couple of other things, took the remaining cash and put in a subsidiary. That subsidiary loaned the money back to Dow. How much cash did it loan back, you ask? About $136 million. For one year.

On its tax return Chemtech I reported approximately $122 million in income. It allocated $115 million of that to the banks. Only $28 million in income went back to Dow itself.

What we have just talked about is known in tax lingo as a “strip.”

And there is the SLIP. All Dow did was move money around. It paid the foreign banks $14 million in interest but called it a priority, thereby dragging over $115 million of income with it. As the banks did not pay U.S. tax, they did not care. Dow however did.

In 1997 there was a change in U.S. tax law, and Dow had to switch to another tax strategy. Dow wanted to cash out the banks and start something else.

The banks wanted their share of the market value of those patents on the way out. Seems fair, as they were “partners” and all. Dow said “no way”. The partnership agreement stipulated how the patents were to be valued and how to calculate the banks’ share. Dow paid the banks approximately $8 million. The banks complained, but to no avail. Dow controlled the calculation of value.

Once the banks were out of the way, Dow created a second tax shelter using a fully-depreciated chemical plant in Louisiana. This strategy did not require banks, but it did employ a very clever maneuver to pump-up the basis of the plant, thereby creating depreciation deductions that Dow could use to offset real income from other sources.

Oh, there was a formidable tax issue that Dow resolved by ripping up a piece of paper and replacing it with another.

OBSERVATION: And there you see the IRS’ frustration: Dow is not dealing with independent parties. In Chemtech I, it was dealing with banks acting as banks. Dow called them partners, but it may as well have called them peanut –butter sandwiches for the difference it made. In the second deal (called Chemtech II), Dow did not even leave the ranch. It replaced a deal between its subsidiaries with another deal between its subsidiaries. Really?  No wonder the IRS was hot around the ears.

So the IRS gets into Dow’s tax returns. In 2005 it issued a Notice of Final Partnership Administrative Adjustment for tax years 1993 and 1994. Dow responds that the IRS did not give the notice to the properly designated person – the Tax Matters Partner – and the notice was therefore invalid.

OBSERVATION: The tax matters partner rule is to protect both the partnership and the IRS. It means something when you have big partnerships with hundreds if not thousands of partners. Dow however was setting up partnerships like they were jellybeans. I find it cheeky – to be polite – that Dow’s defense was “you sent the mail to the wrong cubicle.”

This thing goes back and forth like a tennis match. In the end, a court has to decide. The IRS had scooped up additional years – through 2003 – by the time this was resolved.

How would the IRS attack the shelters?

There are a couple of ways. The first is the “economic substance” doctrine. Think of it as the tax equivalent of “where’s the beef?” The court looks at the transactions and determines if there is any reality to what supposedly is going on. There are three prongs to this test:

(1) Does the transaction have economic substance compelled by business or regulatory realties;

(2) Does the transaction have tax-independent considerations; and

(3)  Is the transaction not designed in toto with tax avoidance intent?

The Court looks at the SLIPS and observes the obvious:

(1) The SLIPs did not change Dow’s financial position in any way. Chemtech I could not have licensed those patents to a third party if it wanted to, as it did not own all the rights. This means that Chemtech I could not produce independent revenue. That is a problem.

(2) The cash flow was circular. The little bit that left (to the banks) was the equivalent of interest. Big problem.

(3) Dow argued that it was preserving its credit rating and borrowing power, but it could not prove any increase in its credit rating or borrowing power. Dow also stumbled explaining why it structured the transaction this way rather than another way – like having domestic banks in Chemtech I.

The second way the IRS attacked was by arguing the partnership was a sham. This argument is slightly different from “economic substance,” as that argument looks at transactions. The sham partnership argument looks at the partnership itself and asks: is this a real partnership?

The Court notes the following:

·        The banks got a priority of 7%.

·        The only room left for the banks to profit was if the patents went up in value. The banks were only allocated 1% of that number, and Dow controlled how to calculate the number.

·        When the banks complained about their lousy 1%, a Dow executive called them “greedy.”

OBSERVATION: It was clear the Court was not impressed with this executive’s comment.

·        It was virtually impossible for the banks to lose money.

·        The one risk to the banks – IRS challenge – was indemnified by Dow.

The Court observed that true partners have the risk of loss and the hope of gain. The banks had virtually no risk of loss and sharply limited room for gain. There may have been a banking relationship, but there was no more a partnership here than in a Kardashian marriage.

The Court said the shelters were bogus and Dow owed the tax.

And a 20 percent penalty to boot.

MY TAKE:  Those who know me, or who follow this blog, know that I generally side with the taxpayer. After all, it is the taxpayer who sets an alarm clock, takes on a mortgage or builds a website that actually works, whereas the government is little more than weight in the trunk.

Still, at least pretend that there is some business reason for all the tax fireworks that are going off.

This court opinion is 74 pages long. While I am somewhat impressed with the tax wizardry that Dow brought to bear, I must admit that I am reading tax planning for its own sake. That may groove someone like me, but that is not enough to pass muster. There has to be a business purpose for moving all the pieces around the board, otherwise the IRS can challenge your best-laid plans.

The IRS challenged Dow. 

Dow lost.