The Anschutz Company v. Commissioner

So what do you do when you own a fortune in stock but do not want to pay the tax man?

Let’s look at Philip and Nancy Anschutz and The Anschutz Company (TAC). Philip Anschutz (PA) began acquiring oil and mineral companies during the 1960s. He expanded his activities to include railroad, real estate and entertainment companies. This meant he owned large blocks of various companies’ stock, and he housed them in TAC. TAC was an S corporation, a fact which is important and to which we will return later.

Well, if you keep buying companies, eventually you wind up having a lot of money invested in those companies. In the late 1990s and early 2000s, PA and TAC began looking for ways to free up some of that invested cash.

In 2000 and 2001 TAC received approximately $375 million from a series of variable prepaid forward contracts with Donaldson, Lufkin & Jenrette (DLJ). The contracts involved shares of Union Pacific and Andarko Petroleum. DLJ later became part of Credit Suisse.

Let’s get into eye-rolling territory and talk about a “forward contract.” Here is an example:

You want to unload $250 million worth of AJ stock but delay any tax consequence. Tony Soprano (TS) wants to help you. You hire a firm (BADA BING) who proposes a business deal involving TS. You loan the stock to TS. No, instead you loan the stock to BADA BING and you grant TS a security interest in the shares. TS then sells the stock. TS sells short, though.

QUESTION: By selling short, TS is saying that he does not own the stock. This is consistent with the story so far, as you lent the stock to TS. TS has a security interest in the stock, but that interest is not the same as owning the stock. Therefore TS has to sell short. He is protected however because – if ever called upon – he can deliver your shares to close-out the trade. Remember, your shares are in his possession.

                What do you get out of this? Nothing so far.

But let’s say that TS gives you 75% the money from the short sale. Ah, now you have something – you have cash in your pocket. The transaction as described is now a “prepaid” forward contract. The “prepaid” means that you got money.

There is more. You get a 5% prepaid lending fee because, by golly, you are lending the use of your shares to TS.

Somewhere down the line this story has to end, however. Say that 8 or 10 years down the road you are obligated to deliver to TS either:

·         a (variable) number of AJ shares, or

·         cash, or

·         equivalent but not identical stock 

The variable number of shares permitted to settle the contract makes this a variable prepaid forward contract.

There is also a way to do this with puts and calls and is referred to as a collar. It is interesting in a train-wreck sort of way, but let’s spare ourselves that discussion.

Let’s give TS some incentive to do the deal. We can add the following:

·         If the stock appreciates over the term of the deal, you get the first 50% in appreciation but TS gets ALL the appreciation after that.

·         TS kept 25% of the cash. He could invest it over the term of the deal and keep the earnings.

·         TS did sell the stock short, so if the stock goes down, the short sale would earn TS additional profit.

·         Upon the occurrence of certain events (bankruptcy, material change in economic position), TS could accelerate the settlement date of the deal.

How could TS lose money? TS already sold all the stock and paid you 75% of the proceeds. TS kept the remaining 25% for a period of time. Granted, TS did sell the shares short, so TS would have the risk of the stock going up in price over the term of the deal. This is how one loses money on a short sale, as it would make it more expensive for TS to close out his short position. But wait, TS has physical possession of your stock. If you do not make TS whole, he will simply take your stock to cover the short sale. What if the stock goes down? Then TS has a profit on the short sale. TS dealt a pretty good hand for himself.

How could you lose money? You really can’t. If the stock goes down, you buy it at the lower price and deliver it to TS. If the stock goes up you participate in the gain. Not all the gain, but still a gain. You lose by not making as much money as you could have by holding on to the stock. I can live with that kind of loss.

What was the underlying tax law that drove this transaction? Under long-standing tax law, a taxpayer did not have a sale - for tax purposes – of securities until the taxpayer delivered shares from his/her long position. In a forward contract, the delivery is delayed for years, possibly many years. So a forward contract, even a prepaid forward contract, of securities was not considered a "sale.” The IRS changed this in 1997 with Section 1259, which provided tax rules for constructive sales of financial positions. You may remember that you used to be able to protect an appreciated stock position at year-end by something called a “short sale against the box.” Then one day your accountant told you that you could not do that anymore because the law had changed. Tax law now requires you to have some level of risk in the position. The question is: how much risk?

Since TAC entered into these transactions in 2000 and 2001, it at least had the warning of Section 1259. TAC did not however have clarification of how far it could push the “link” between a variable contract and a stock loan. Tax law takes time to evolve. This is an innovative tax area involving financial instruments and derivatives, and tax clarification takes time. In 2006 the IRS finally gave warning that it did not like this structure. Too late for TAC to close the barn door, of course.

The IRS went after TAC.

What was the IRS position? We can hear the IRS saying:

“TAC did not keep enough risk to avoid a constructive sale of the Union Pacific and Andarko stock.”

What was TAC’s position? We can almost hear them saying:

“What are you talking about? We entered into two transactions - a prepaid variable and a stock loan, not one. The prepaid variable did not rise to the level of a constructive sale. The loan was to Wilmington Trust Company as collateral agent and trustee. Last time we checked, Donaldson, Lufkin & Jenrette was not Wilmington Trust Co.

In addition, is it fair to make tax law retroactive?”

In 2010 the Tax Court agreed with the IRS. TAC immediately appealed. The Appeals Court handed down its decision on Tuesday, December 27, 2011.

The 10^th Circuit Appeals Court noted that TAC effectively exchanged its shares for …

(1)    Upfront monies of 75% and 5%

(2)    the  potential to benefit to a limited degree if the pledged stock increased in value, and

(3)    the elimination of any risk of loss of value in the pledged stock

NOTE: Think about this for a moment. TAC transferred its shares to DLJ and DLJ relieved TAC of any risk of loss. What does this sound like?

The 10^th Circuit Appeals Court further reasoned that DLJ…

(1)    obtained all incidents of ownership in the shares, including the right to transfer them

(2)    acquired an interest in the property that it could not prudently abandon

(3)    had a present obligation to pay monies to TAC

(4)    had the right to sell or rehypothecate the shares

NOTE: DLJ had an immediate obligation to pay TAC and also had the right to sell the shares. What does that sound like?

Welcome to the new tax shelters. There was a time that shelters involved real estate or oil and gas and relied on nonrecourse loans or accelerated depreciation. Contemporary shelters use financial derivatives.

At the heart of this case is a metaphysical tax question: when is a sale a sale? The IRS did not challenge the substance of the deal. What it did challenge was this important detail: TAC lent its shares to DLJ to make the deal work. TAC argued that the stock loan and variable forwards were separate deals and that the stock was loaned to Wilmington Trust, not DLJ. The Tax Court in 2010 could not overcome the fact that, when TAC lent its shares, the shares were effectively gone and could not be recovered. A common factor of a sale is that the seller no longer has possession of the property sold.  

Why did TAC do this? TAC is an S corporation. S corporations can pay tax if they have a unique fact pattern called “built-in gains.” Sure enough, TAC had built-in gains in the Union Pacific and Andarko stock. The built-in gain had a clawback period of ten years. Sale of property with built-in gains within this period triggers the built-in gains tax. TAC was trying to avoid the double-taxation of built-in gains and then capital gains.

TAC lost big. The taxes were about $110 million. Oh, add on about another $30 million for penalties and taxes. Since TAC was an S corporation, all its income, deductions and credits flowed-through to PA and were reported on his individual income tax return. This means that PA lost big too.

The Payroll Tax Two-Month Holiday (Continued)

Here is the IRS announcement last Friday (December 23) about the two-month payroll tax holiday.

IR-2011-124, Dec. 23, 2011

WASHINGTON — Nearly 160 million workers will benefit from the extension of the educed payroll tax rate that has been in effect for 2011. The Temporary Payroll Tax Cut Continuation Act of 2011 temporarily extends the two percentage point payroll tax cut for employees, continuing the reduction of their Social Security tax withholding rate from 6.2 percent to 4.2 percent of wages paid through Feb. 29, 2012. This reduced Social Security withholding will have no effect on employees’ future Social Security benefits.

Employers should implement the new payroll tax rate as soon as possible in 2012 but not later than Jan. 31, 2012. For any Social Security tax over-withheld during January, employers should make an offsetting adjustment in workers’ pay as soon as possible but not later than March 31, 2012.

Employers and payroll companies will handle the withholding changes, so workers should not need to take any additional action.

OBSERVATION: Kruse & Crawford CPAs is one of the “employers and payroll companies” that will handle the withholding changes. So, we have a payroll tax holiday that does not last all the months in a quarter. Apparently Congress realized that the servicers may not have been prepared for this, so Congress decreed that we have an additional month to get it right.

Under the terms negotiated by Congress, the law also includes a new “recapture” provision, which applies only to those employees who receive more than $18,350 in wages during the two-month period (the Social Security wage base for 2012 is $110,100, and $18,350 represents two months of the full-year amount). This provision imposes an additional income tax on these higher-income employees in an amount equal to 2 percent of the amount of wages they receive during the two-month period in excess of $18,350 (and not greater than $110,100).    

This additional recapture tax is an add-on to income tax liability that the employee would otherwise pay for 2012 and is not subject to reduction by credits or deductions. The recapture tax would be payable in 2013 when the employee files his or her income tax return for the 2012 tax year. With the possibility of a full-year extension of the payroll tax cut being discussed for 2012, the IRS will closely monitor the situation in case future legislation changes the recapture provision.

OBSERVATION: If you think about this, there is a certain amount of sense. The FICA wage base for 2012 is $110,100. Since the holiday is for less than the entire year, Congress felt it necessary to prorate the wage base, as otherwise one could “game” the system. One would do that by taking his/her first $110,100 of payroll in the first two months of the year. That would require noncommon fact patterns, but it could and would happen. I know that we – as tax planners - would have taken advantage of it where possible for our clients.

OBSERVATION: How is the tax preparer to know if someone received more than $18,350 of payroll in the first two months? Will there be yet another “box” on the 2012 W-2 for this?

COMMENT: I suspect that Congress will extend the holiday for the full year, and the clawback provision will be deleted at that time.

Retirement and Health Plan Limits for 2012

Here are the 2012 contribution limits for the following retirement plans:

·         401(k) limits increase from $16,500 to $17,000. The same limit applies to 403(b) and  457 plans.

·         IRA limits remain the same at $5,000

·         SEP limits increase from $49,000 to $50,000

·         SIMPLE limits remain the same at $11,500

·         Catch-up contributions remain the same

o   $5,500 for 401(k), 403(b) and 457 plans

o   $2,500 for SIMPLEs

o   $1,000 for IRAs

Here are the new limits for high deductible health plans:

·         Health Savings Accounts

o   Individual contribution limits increase from $3,050 to $3,100

o   Family contribution limits increase from $6,150 to $6,250

·         High Deductible Health Plans

o   Minimum out-of-pocket limits remain the same at $1,200 and $2,400 for individuals and families, respectively

o   Maximum out-of-pocket limits increase from $5,950 to $6,050 for individuals and from $11,900 to $12,100 for families

·         Flexible Spending Accounts

o   No federal limits for 2012 but your employer may designate a limit

o   Federal limit of $2,500 beginning in 2013

The New 1099 For Credit Card Reporting

It’s been over a year since we talked about the new IRS Form 1099-K. This was part of the Housing Assistance Act of 2008, and it was to – at least partially - “offset” the cost of the first homebuyer’s credit.

This is Congress passing laws, mind you, so the reporting did not apply until sales made on or after January 1, 2011. This means you may be receiving this new 1099 during the 2012 tax filing season.

Let’s talk about the “why” for this form.

Say that you are a vendor on eBay or Amazon. It used to be that eBay or Amazon did not have to send you a tax reporting form. Why would they? They did not pay you; rather, a number of buyers using eBay or Amazon paid you. Let’s use another example. Let’s say that you use PayPal or Google Checkout on your website. As a third party payment network, they did not have to report the transaction. Why would they? They did not pay you; they just processed the transaction whereby some else paid you.

This caught the attention of a Congress that has all but gone through our sofa cushions for the next thing to tax.

So, let’s say that you are selling stuff on eBay or otherwise accepting payment through PayPal. Will you receive a 1099-K? It depends. If you have sales of less than $20,000 a year or fewer than 200 transactions per year, then 1099-K reporting will not be necessary.

The look and feel of Form 1099-K is very similar to Form 1099-INT used by banks to report interest and Form 1099-DIV used to report dividends.

Are we are expecting problems with the new 1099-Ks? Oh yes. The 1099-K will include sales tax and shipping charges, for example. The 1099-K will report the gross amount of payment card and third-party network payments, so one has to be careful with the reporting of refunds. The IRS is already talking about segregating receipts on different lines of the tax forms so that they can match to the 1099-Ks. When you consider that the IRS has a computer-matching program that generates notices without the intercession of human eyes, this may well be a disaster waiting to happen.

FATCA Filing Season

This past Saturday the IRS released the final version of Form 8938, Statement of Specified Foreign Financial Assets, and on Monday released the instructions. This form is in response to FATCA, and represents a further tightening of reporting requirements for foreign income and assets.

What do you have to report? The easy answer is overseas bank accounts and securities accounts. It gets a little trickier with hedge and private equity funds. It will also pick up your loan to Grandma Gretchen. This is reporting for foreign assets, not just foreign bank accounts.

Here are the dollar amounts if you live in the U.S.:

·         If single or married filing separately

o   $50,000 on the last day of the year or $75,000 at any time during the year

·         If married filing jointly

o   $100,000 on the last day of the year or $150,000 at any time during the year

Here are the dollar amounts if you live overseas:

·         If single or married filing separately

o   $200,000 on the last day of the year or $300,000 at any time during the year

·         If married filing jointly

o   $400,000 on the last day of the year or $600,000 at any time during the year

Are the dollar thresholds ridiculously low? Of course.

Form 8938 does not replace the FBAR (TD-F 90.22.1), which is filed separately from your income tax return and is due in Detroit by June 30^th every year.

Eventually the IRS intends for Form 8938 to also apply to domestic entities, but for right now the IRS is limiting its reach to only individuals.

My take?

We used to expect that the IRS would not assess penalties unless tax was due. That in turn meant that we did not overly fear information returns - that is, returns with numbers on them but no line that said “tax due.” There were some exceptions, such as W-2s and 1099s, of course; otherwise, this rule of thumb worked reasonably well.

No longer. There are penalties to these forms even if there are no taxes due or all taxes have been reported.  Congress has taken umbrage on Americans having assets overseas. I am at a loss why a married couple (say my wife and I) would draw Congress’ attention solely by having $100,000 overseas. That is not enough money to get a starring role next to Michael Douglas in Wall Street II. It is not enough money to get me invited to a White House dinner, and certainly not enough to join a presidential vacation.

If you are even close to the dollar limits, please see a professional. Do not fool around with this, as the penalties can be severe.

How Could I Live Without Filing Taxes?

Status of the Payroll Tax Cut

The Senate today approved a two-month extension of the employee Social Security tax cut.

You will recall that the employee FICA rate was cut from 7.65 to 5.65 percent, but only for 2011. The FICA tax is composed of two parts: a social security tax of 6.2 percent and a Medicare tax of 1.45 percent. Together they add-up to 7.65 percent and are referred to as FICA. The social security portion was reduced in 2011 by 2 points – from 6.2 to 4.2 percent. It is this portion that we are discussing.

A number of economic and financial commentators have pointed out that 2011 economic growth has been roughly equivalent to this payroll tax cut.  Add to the mix an upcoming election year and the issue of extending the cut has become quite electric.

The bill will next go to the House, where there has been some activism to cut the tax for all of 2012, not just two months.

The President has indicated his intention to sign the bill when it arrives.

My take?

Payroll is reported to the IRS on a quarterly basis. The first quarter is January through March. Accountants and payroll services now have to subdivide the quarter to determine which tax rate to apply to the payroll. Would it have been that difficult - especially since nothing has been accomplished anyway – to have the payroll tax cut run the full quarter?