What’s Fair Got To Do With It?

I am reading a tax case with an unfortunate result.

It does not seem that difficult to me to have planned for a better outcome.

I have to wonder: why didn’t they?

Let’s set it up.

We have a law firm in New York. There is a “heavy” partner and the other partners, which we will call “everybody else.” The firm faced hard times, and “everyone else” kept-up their bleed rate (the rate at which they withdraw cash), with the result that their capital accounts went negative.

COMMENT: A capital account is increased by the partner’s share of the income and reduced by cash withdrawn by said partner. When income goes down but the cash withdrawn does not, the capital account can (and eventually will) go negative. 

Let’s return to our heavy partner.

He was concerned about the viability of the firm. He was further concerned that New York law imposed on him a fiduciary responsibility to assure that the firm be able to pay its bills. I applaud his sense of responsibility, but I have to point out that any increased uncertainty over the firm’s capacity to pay its bills might have something to do with “everybody else” taking out too much cash.

Just sayin’.

Our partner’s share of firm income was almost $500 grand.

Problem is that the cash did not follow the income. His “share” of the income may have been $500 grand, but he left around $400 grand in the firm to make-up for the slack of his partners.

And you have one of those things about partnership taxation:   

·      The allocation of income does not have to follow the allocation of cash.

There are limits to how far one can push this, of course.

Sometimes the effect is beneficial to the partner:

·      A partner tales out more cash than his/her share of the income because the partnership owns something with big-time depreciation. Depreciation is a non-cash expense, so it doesn’t affect his/her distribution of cash.

Sometimes the effect is deleterious to the partner:

·      Our guy took out considerably less cash than the $500K income.

Our guy did not draw enough cash to even pay the taxes on his share of the income.

OBSERVATION: That’s cra-cra.

What did he do?

He reported $75K of income on his tax return. Seeing how did not receive the cash, he thought the reduction was “fair.”

Remember: his partnership K-1 reported almost half a million.

The number on his personal return did not match what the partnership reported.

COMMENT: By the way, there is yet one more form to your tax return when you do not use a number reported by a partnership. The IRS wants to know. He might as well just have booked the audit.

Sure enough, the IRS sent him a notice for over $140,000 tax and $28,000 in penalties.

Off to Tax Court they went.

And he had … absolutely … no … chance.

Partnerships have incredibly flexible tax law. There is a reason why the notorious tax shelters of days past were structured around partnerships. One could send income here, losses there, money somewhere else and muddy the waters so much that you could not see the bottom.

In response, Congress and the IRS tightened up, then tightened some more. This area is now one of the most horrifying, unintelligible stretches in the tax Code.  It can – with little exaggeration – be said that all the practitioners who truly understand partnership tax law can fit into your family room.

Back to our guy.

The Court did not have to decide about New York law and fiduciary responsibility to one’s law firm or any of that. It just looked at tax law and said:

Your income did not match your cash. You set this scheme up, and – if you did not like it – you could have changed it. Once decided, however, live with your decision.

Those are my words, by the way, and not a quote.

Our law partner owed the tax and penalties.

Ouch and ouch.

I must point out, however, that the law firm’s tax advisors warned our guy that his “fiduciary” theory carried no water and would be disregarded by the IRS, but he decided to proceed nonetheless. He brought much of this upon himself.

What would I have recommended?

For goodness’ sake, people, change the partnership agreement so that the “everybody else” partners reported more income and our guy reported less. It is fairly common in more complex partnerships to “tier” (think steps in a ladder or the cascade of a fountain) the distribution of income, with cash being the second – if not the first – step in the ladder. The IRS is familiar with this structure and less likely to challenge it, as the movement of income would make sense.

Another option of course would be to close down the law firm and allow “everybody else” to fend for themselves.

I would argue that my recommendation is less harsh.

Buffett's Berkshire Hathaway Is Buying Duracell From Procter & Gamble

You may have read that Warren Buffett (through Berkshire Hathaway) is acquiring the Duracell battery line of business from Procter & Gamble in a deal worth approximately $4.7 billion. The transaction will be stock-for-stock, although P&G is stuffing approximately $1.7 billion of cash into Duracell before Berkshire takes over. Berkshire will exchange all its P&G stock in the deal. Even better, there should be minimal or no income tax, either to P&G or to Berkshire Hathaway.

Do you wonder how?

The tax technique being used is called a “cash rich split off.” Believe it or not, it is fairly well-trod ground, which may seem amazing given the dollars at play.

Let’s talk about it.

To start off, there is virtually no way for a corporation to distribute money to an individual shareholder and yet keep it from being taxable. This deal is between corporations, not individuals, albeit the corporations contain cash. Lots of cash.

How is Buffett going to get the money out? 

·        Buffet has no intention of “getting the money out.” The money will stay inside a corporation. Of course, it helps to be as wealthy as Warren Buffett, as he truly does not need the money.

·        What Buffett will do is use the money to operate and fund ongoing corporate activities. This likely means eventually buying another business.

Therefore we can restrict ourselves to corporate taxation when reviewing the tax consequences to P&G and Berkshire Hathaway.

How would P&G have a tax consequence?

P&G is distributing assets (the Duracell division) to a shareholder (Berkshire owns 1.9% of P&G stock). Duracell is worth a lot of money, much more money than P&G has invested in it. Another way of saying this is that Duracell has “appreciated,” the same way you would buy a stock and watch it go up (“appreciate”) in value.

And there is the trip wire. Since the repeal of General Utilities in 1986, a corporation recognizes gain when it distributes appreciated assets to a shareholder. P&G would have tax on its appreciation when it distributes Duracell. There are extremely few ways left to avoid this result.

But one way remaining is a corporate reorganization.

And the reorganization that P&G is using is a “split-off.” The idea is that a corporation distributes assets to a shareholder, who in turn returns corporate stock owned by that shareholder. After the deed, the shareholder owns no more stock in the corporation, hence the “split.” You go your way and I go mine.

Berkshire owns 1.9% of P&G. P&G is distributing Duracell, and Berkshire will in turn return all its stock in P&G. P&G has one less shareholder, and Berkshire walks away with Duracell under its arm.

When structured this way, P&G has no taxable gain on the transaction, although it transferred an appreciated asset – Duracell. The reason is that the Code sections addressing the corporate reorganization (Sections 368 and 355) trump the Code section (Section 311) that would otherwise force P&G to recognize gain.

P&G gets to buy back its stock (via the split-off) and divest itself of an asset/line of business that does not interest it anymore - without paying any tax.

What about Berkshire Hathaway?

The tax Code generally wants the shareholder to pay tax when it receives a redemption distribution from a corporation (Code section 302).  The shareholder will have gain to the extent that the distribution received exceeds his/her “basis” in the stock.

Berkshire receives Duracell, estimated to have a value of approximately $4.7 billion. Berkshire’s tax basis in P&G stock is approximately $336 million. Now, $336 million is a big number, but $4.7 billion is much bigger.  Can you imagine what the tax would be on that gain?

Which Berkshire has no intention of paying.

As long as the spin-off meets the necessary tax requirements, IRC Section 355 will override Section 302, shielding Berkshire from recognizing any gain.

Berkshire gets a successful business stuffed with cash – without paying any tax.

Buffett likes this type of deals. I believe he has made three of them over the last two or so years. I cannot blame him. I would too. Except I would take the cash. I would pay that tax with a smile.

There are limits to a cash-rich split off, by the way.

There can be only so much cash stuffed into a corporation and still get the tax magic to happen. How much? The cash and securities cannot equal or exceed two-thirds of the value of the company being distributed. In a $4.7 billion deal, that means a threshold of $3.1 billion. P&G and Berkshire are well within that limit.

Why two-thirds?

As happens with so much of tax law, somebody somewhere pushed the envelope too far, and Congress pushed back. That somebody is a well-known mutual fund company from Denver. You may even own some of their funds in your 401(k). They brought us IRC Section 355(g), also known as the two-thirds rule. We will talk about them in another blog.

IRS Income Statistics For 2011 Are Out

IRS statistics are out.

• The top 1% of all filers paid approximately 35.1% of all federal income taxes. It takes adjusted gross income (AGI) of at least $388,905 to make the top 1%
• The top 5% paid 56.5%, with AGI of $167,728
• The top 10% paid 68.3%, with AGI of $120,136

The bottom 50%? They paid 2.9% of all federal income taxes. 

One should include the obligatory caveat that above statistics refer to federal income taxes and do not include social security taxes. It is questionable whether that adjustment would make any significant difference, though.

What Is A Quintile?

A quintile is one of five equal groups into which a population can be divided. If the top 20% of taxpayers pay 94% of the income tax, then isn't it fair that they receive 94% of any tax breaks? Isn't it unfair if they don't?