Kentucky, Bourbon and Tax Accounting

I came across a proposed tax bill that caught my eye.

It has to do with bourbon.

Bourbon is closely associated with Kentucky, as the state produces approximately 95% of the world supply. I have heard that there are more barrels of bourbon aging in Kentucky than there are residents (of which I am one). I do not know if that is true, but it does summarize the importance of the industry to the commonwealth.

So Kentucky senators and representatives have introduced a tax bill to exempt bourbon producers from the interest capitalization rules.

This is relatively old tax law, having entered the Code in 1986. It caused practitioners quite a bit of problem at start-up (I was a young CPA), but for the most part it has settled down since.

The explanation for the law was to bring consistency to inventory tax accounting. By itself that was laudable, but the law went further. Congress also decided that certain costs associated with a manufacturing or production process were not being appropriately captured by generally accepted accounting principles (GAAP). To correct that accounting oversight, the tax Code would henceforth require the capitalization of costs not previously capitalized on financial statements.

In accounting-speak, “capitalizing” means removing an expense from net income by putting it (that is, by “capitalizing” it) on the balance sheet as an asset. It can remain there for six months, fifteen years or until the end of time, depending upon. The common result is that it is not an expense on the income statement. Extrapolate that and it probably is not a deduction on the tax return.

You can see Congress’ fascination with becoming tax accounting experts.

This tax provision is referred to as uniform capitalization, or - for the hard core – Section 263A, which is the Code section that houses it. Most of the accountants I have worked with consider uniform capitalization little more than a slight-of-hand (and other earthier words) to increase taxes on inventory-intensive businesses.

Let’s be blunt: if there were issues with the inventories of Kimberley-Clark or Proctor & Gamble, the resulting lawsuits would have self-corrected the matter years ago.

Interest expense is one of the costs that have to be capitalized under Section 263A.

A perfect tax trap would be an expensive inventory which takes many, many years to get to market. One would have to capitalize interest every year. Granted, there would be a tax deduction down the line when the inventory was sold, but the wait to get there could get expensive.

What would be an example of such an inventory?

Well, bourbon.

Some high-end bourbons are aged for a long time. Take a personal favorite – Pappy Van Winkle Family Reserve 15 Year. It has a 20-year brother, but many aficionados consider the 15 a better product. There are bourbons aged even longer. That is a lot of years to carry an inventory.

The problem is that many bourbon competitors do not have this tax issue. Consider rum or vodka, for example, with a short ageing process.  Scotch whisky would be comparable, but the UK does not have an equivalent to Section 263A. This means that scotch producers do not have the tax problem of their US bourbon counterparts. Wine production would be comparable. Perhaps the Kentucky delegation could join forces with their California peers on this matter.

But why exempt bourbon producers but not others adversely affected by interest capitalization?

It is a fair question.

To which there is a fair answer: if international accounting firms are willing to be sued for the amount of inventory shown on audited financial statements, should we not presume that number is substantially correct? Why then does the Code require another calculation of inventory for the tax return?

We know why. It is the same as you losing a credit for your kid’s college tuition because you make enough money to send your kid to college. The tax Code is riddled with these things. Interest capitalization is a clever backdoor, however, as it dives into tax accounting itself. This area is arcane and boring and likely to keep someone from looking too closely. That is – of course – why it was done.

Will The IRS Ever Call You?

You have likely read or heard that the IRS will not contact you by telephone. If you receive a phone call claiming to be the IRS, hang up immediately. It is a fraud.

Then we read that some IRS offices were calling people.

Sigh.

I admit, it came as a surprise to me too.

Only a government agency could be this flat-footed.

Let’s talk about it.

To most of us, a call from the IRS is a call from the IRS. We are not particularly concerned whether it is examination, collections or Star Trek productions.

But to the IRS there is a difference. You see, Examination is the part of the IRS that audits you, disallowing all your deductions and assessing penalties for the presumption to deduct anything in the first place. Once you have served your time in the White Tower, your file is turned over to Collections. These kindly people will explain how you can easily pay $45,000 over 12 months when you only make $40,000 annually. It takes a little discipline and the elimination of frivolous expenses, like food, shelter and a car to get you to work .

Collections will never call you.

But it turns out that certain Examinations offices would.

The IRS explanation borders on a Zucker brothers comedy.

The IRS really, really thought that people would understand that Examinations is not Collections. How could there possibly be any confusion?

To be fair, they had a point. You see, Examinations will not ask for money. They may ask to set up a time for you to see them downtown, but the money part is later. They reasoned that fraudsters would not pretend to be Examinations, as that is not whether the money is. Fraudsters would pretend to be Collections.

Even though the average person could no more identify different IRS departments than identify different varieties of quinoa.

After all this went public, the IRS has NOW said that will not initiate contact by telephone, whether it be Examinations or Collections.

Good.

Mind you, this does not mean that they will never call. It does mean that their initial contact will be by mail. Once you are engaged with them – say you are in audit – then they may call. That seems reasonable. First contact does not.

LLC Members and W-2s

There is a tax issue that has dogged advisors for years. 

It has to do with limited liability companies.

What sets it up is tax law from general partnerships.

A general partnership is the Gunsmoke of partnerships. The “general” does not means everybody participates. It does mean that everyone is liable if the partnership gets sued.

Whoa. There is clearly a huge downside here.

Which leads us to limited partnerships. Here only a general partner takes on that liability thing. A limited partner put his/her capital account at risk, but nothing more. Forget about signing on that bank debt.

Let’s present the granddaddy of self-employment tax law:

·        A general partner is considered self-employed and pays self-employment tax on his/her distributable income, irrespective of his/her own involvement in the trade or business.

·        A limited partner is presumed to not be involved in the trade or business of the partnership; therefore, he/she does not pay self-employment (SE)  tax on his/her distributable income.

o   There is an exception for “guaranteed payments, which is akin to a salary. Those are subject to SE tax.

How can we differentiate a general partner from a limited partner?

It is that liability thing. The entity is likely being formed under state “limited partnership” law rather than “general partnership” law. In addition, the partnership agreement will normally include a section specifying in detail that the generals run the show and the limiteds are not to speak until spoken to.

Then came the limited liability companies (LLCs).

These caused tax planners to swoon because they allowed a member to actually participate in the business without forfeiting that liability protection.

COMMENT: BTW the banks are quite aware of this. That is why the bank will likely request the member to also sign personally. Still that is preferable to being a general, where receipt of the partnership interest immediately makes you liable.

Did you catch the use of the word “member?” Equity participants in an LLC are referred to as “members,” not “partners.”

So how are LLCs taxed?

Like a partnership. 

COMMENT: I know. All we did was take that car around the block.

Let’s return to that self-employment issue: is a “member” subject to self-employment tax because he/she participates (like a general) or not subject because he/she has limited liability (like a limited)?

It would help if the IRS had published guidance in this area since the days of the Rockford Files. Many advisors, including me, reason that once the LLC is income-taxable as a partnership then it is also self-employment taxable as a partnership. That is what “like a” means. If you work there, it is self-employment income to you.

But I do not have to go far to find another accountant who disagrees with me.

What to do?

Some advisors allow their LLC member-clients to draw W-2s.

Some do not.

There is a problem, however: a member is not considered an employee. And one has to be an employee to receive a W-2.

The fallback reasoning for a long time has been that a member “is like” an employee, in the same sense that I am “like” LeBron James.

It is not technically-vigorous reasoning, and I could not guard LeBron with a squad of Marines by my side.

Then the IRS said that it would respect a single-member LLC as the employer of record, rather than going up the ownership chain to whoever the sole owner is. The IRS would henceforth treat the single-member as a corporate employer for employment taxes, although the single-member would continue to be disregarded for income tax purposes (it is confusing, I know).  The IRS included exceptions, examples and what-nots, but they did not include one that addressed LLC members directly.

The members-want-W-2s school used this notice to further argue their position. You have the LLC set-up a single-member subsidiary LLC and have the subsidiary – now considered a corporate employer – issue W-2s to the members. Voila!    

Let’s be clear why people care about this issue: estimated taxes. People do not like paying estimated taxes. It requires a chunk of money every three months. Members pay estimated taxes. Members would prefer withholding. Withholding comes out of every check, which is less painful, and don’t even talk about that three-month thing.    

The IRS has backed-off the member/W-2 issue for a long time.

However the IRS recently issued guidance that the above “parent-subsidiary” structure will not work, and taxpayers have until August 1 to comply. The IRS did this by firing its big guns: it issued Regulations. There are enhanced disclosure requirements when one takes a position contrary to Regulations, and very few practitioners care to do that. It is considered a “call me to book the audit” disclosure.

The IRS has given these advisors little more than two whole months to rope-in their errant LLC clients. 

Although the window is tight, I agree with the IRS on this one, except for that two-month thing. They feel they have floated the change long enough to alert practitioners. I would have made it effective January 1, 2017, if only for administrative ease. 

Still this is an area that needs improvement. While the IRS is concerned that member W-2s may lead to members inappropriately participating in benefit plans, there is also mounting demand for member withholding. 

Perhaps the answer is to allow withholding but to use something other than a W-2. One could design yet another 1099, and the member would attach it to his/her tax return to document the withholding. Any additional paperwork is a bother at the LLC level, but it would just join the list of bothersome things. The members wanting withholding would have to employ their powers of persuasion.

Sounds like the beginning of a compromise.

Getting The IRS To Believe A College Student Paid For … College

We can argue whether it is a good thing that so many economically-related transactions are reported to the IRS.

It is not just the drag on the economy - which would include practitioners like me, I suppose. It has also allowed the IRS to increasingly delegate its compliance responsibilities to computer algorithms, often functioning without human eyes sparing a glance at the endless notices the IRS sends every year.

And that sets up the problem.  

You see, the notice assumes that you are wrong, and the IRS will likely revise your account – and bill you - should you not reply. That means that you are spending time resolving the matter, or you are sending the notice to me and I am spending time. You and I are being deputized as ad hoc IRS employees.

Personally I want a paycheck and retirement benefits.

This arrangement works fine as long as there is a balance. You agree not to send works of fiction to the IRS and they agree not to contact you like a kid in college wanting money.

That balance is increasingly a thing of the past. Perhaps as a consequence, I am reading or hearing more often that taxpayers should be able to sue the IRS for professional fees incurred with these notices. I am not certain if that means that my client would pay me and then sue, or whether I would sue to receive my fee, but you get the idea. It would be a “reverse penalty” on the IRS. 

I am looking at a pro se decision from the Tax Court. As we have discussed before, “pro se” means the taxpayer is representing himself/herself. It does not technically mean there is no tax practitioner present (for example, I can represent a client in a pro se case), but it probably does mean that there is not a lot of money at issue.

Angela Terrell was a college student. During 2010 and 2011 she was attending Hampton University in Virginia. In the fall of 2010 she registered for the 2011 spring semester. In November, 2010 the University billed her $2,460 for the upcoming semester. In January, 2011 they billed an additional $1,230.

She was borrowing to go through school. In January, after the add/drop period ended, her student loan released $10,199 directly to the university. She paid her tuition and used the rest for living expenses.

Let’s go to the end of the year. The university sent a 1099 for 2011 (technically, a Form 1098-T, but we are on a roll). It showed $1,180 (the $1,230 billed less fees of $50). It did not show what she actually paid.

COMMENT: This reporting was allowable that year.

Angela filed her 2011 tax return and claimed the American Opportunity credit, one of the education credits in the Code. She claimed $2,500.

Wouldn’t you know the IRS sent her a notice? They saw the $2,500. They also saw the 1099 for $1,180.  

The IRS disallowed her credit – in full. They did not even spot her the $1,180.

Surely someone at the IRS would recognize what happened and close the file.

Perhaps in a galaxy far away. In our galaxy Angela and the IRS went to Tax Court.

Did I mention that Angela was a COLLEGE student?

She submitted an account statement from the University – on official letterhead – detailing her tuition charges and payments.

The IRS argued that the 1099 said $1,180, she provided a different number and consequently they could not verify the credit. There was nothing more to see.

Does it sound to you like the IRS even listened to her? 

Here is the Court:

The only dollar amount appearing on that form … is in the box that shows the ‘amounts billed’ for tuition during calendar year 2011. The amount billed to petitioner during 2011 does not control the size of her credit; the relevant number is the qualified tuition that she actually paid during 2011. The Form 1098-T has no entry in box 1, which was supposed to show ‘payments received’ for qualified tuition.”

The Court decided in her favor.

Angela’s case looks very much like the IRS pursuing a frivolous argument, not to mention the inability of IRS machinery to resolve a “duh”-level tax issue at the earliest possible point of contact. Reverse the situation and the IRS would not hesitate to hit you with every penalty imaginable.