The Houdini of Manufacturing

How would you define “manufacturing?”

There is a tax deduction tied-in with manufacturing activity. It is called the “domestic production activity deduction,” abbreviated “DPAD” and pronounced “Dee Pad.” 

An accountant calculates the DPAD by putting all revenues and expenses in one of two columns: domestic manufacturing and everything else. We want to know the profit from domestic manufacturing only. There is a bee’s nest of rules and sub-rules in here, but in general the deduction is 9% of the profit from domestic manufacturing. If your tax rate is 35%, then the DPAD translates into a 3.15% reduction in your tax rate.

Not bad for doing what you were going to do anyway.

The key thing is to define manufacturing. The IRS has provided the following:

·        The manufacture, production, growth or extraction of tangible personal property

·        Film production

·        Production of electricity, natural gas or water

·        Construction or renovation of real property

·        Engineering and architectural services in relation to the construction of real property

Many accountants have wondered about that last one. Good lobbying, I guess.

What is not manufacturing? The IRS did not consider food preparation at a retail establishment to be manufacturing, as one example. There actually is a “Starbucks Footnote” in the House-Senate conference committee report explaining that roasting the coffee beans would qualify but brewing and serving the coffee to customers would not.  

Let us introduce Houdini Inc. Here is some text from their website:

Since 1984, Houdini Inc. has been the leading supplier of upscale food and wine gifts to re-seller's throughout the U.S. Our trend-right gift assortments are found at America's foremost warehouse clubs, mass merchandisers, liquor retailers, specialty stores, catalog companies and internet sites.

We know you'll find these baskets represent a remarkable value: comparable products at these prices will not be found anywhere. Come in and shop around to find out why Houdini is the premier supplier of food gifts throughout the United States.

Houdini makes gift baskets. Odds are we have either given or received gift baskets over the years, so we have a grasp of the “activity” involved.

Houdini makes lots of baskets. They employ around 300 people, bring on approximately 4,000 temporaries during their busy period and can crank up to 80,000 baskets in a day. Most of their business is retail, and a good portion of that goes through their website using the business name Wine Country Gift Baskets. Houdini orders the baskets from China, and it fills the baskets with chocolate, cookies, candy, cheeses, crackers, wine or alcohol. They use inserts and spacers to make the baskets merry and festive.

What do you think? Does Houdini have a DPAD here?

Houdini filed its 2005 and 2006 tax returns without claiming the DPAD. They apparently met a smart tax practitioner and filed amended returns claiming a deduction. The numbers were as follows:

·        2005 DPAD of $206,987 and tax refund of $74,618

·        2006 DPAD of $394,770 and tax refund of $140,933 

The IRS issued the refunds.

Then the IRS wanted its money back. Houdini said no, and the IRS filed suit in December 2011. The case went to a District Court in California.

COMMENT: Tax cases from California can be entertaining to read.

The Court starts off addressing the Code section allowing the DPAD:

Section 199 … allows a taxpayer to deduct a specified percentage of ‘qualified production activities income’ for the taxable year.”

The IRS had published the following Regulation: 

If a taxpayer packages, repackages, labels or performs minor assembling … and the taxpayer engages in no other … activity …, the taxpayer’s packaging, repackaging, labeling or minor assembly does not qualify ….”

The IRS argued that Houdini merely packaged and repackaged the cookies, crackers, and wine. Per Regulation (which the IRS itself conveniently wrote), Houdini failed to have a manufacturing activity. No manufacturing activity means no deduction.

Houdini of course disagreed, arguing that the packaging and repackaging would disallow the deduction only if there is no other manufacturing activity. Houdini argued that there was other production activity.

How can Houdini show a manufacturing or production activity?

It helps to have a friendly judge.

The Court notes that Congress did not provide definitions. The IRS had not provided definitions either.  The Court explains that statutory interpretation “begins with the statutory text, and ends there as well if the text is unambiguous.”

The Court sees the following words and goes to the Merriam Webster Dictionary to determine what they mean:

·        Manufacture

o   To make into a product suitable for use

o   To make from raw materials by hand or by machinery

o   To produce according to an organized plan and with division of labor

·        Package

o   To make into a package

o   To present in such a way as to heighten appeal to the public

·        Produce

·        Repackage

The Court determines that Houdini makes products using machinery, according to an organized plan and with division of labor.

            SCORE: One for Houdini.

On the other hand, Houdini takes various items and puts them together in a more attractive form that appeals to the public.

            SCORE: One for the IRS.

We are tied. The Court must keep going.

Defendants [Houdini] argue that Houdini’s production process “changes the form of an article” within the meaning of Treasury Regulation 1.199-3(e)(1).

Houdini first selects various items – chocolates, cookies, candy, cheeses, crackers, wine or alcohol, packaging materials, and a basket or boxes – for its final products. Next the individual items are assembled in a gift basket or gift tower based on one of many detailed plans. This complex production process relies on both assembly line workers and machines. The final products, gift baskets and gift towers, are distinct in form and purpose from the individual items inside. The individual items would typically be purchased by consumers as ordinary groceries. But after Houdini’s production process, they are transformed into a gift that is usually given during the holiday season.”

SCORE: I see two for Houdini.

The IRS raises its hand and reminds the Court of the example in Regulation 1.199-3(e):

X purchases automobiles from unrelated persons and customizes them by adding ground effects, spoilers, custom wheels, specialized paint and decals, sunroofs, roof racks, and similar accessories. X does not manufacture any of the accessories. X’s activity is minor assembly …., which is not ….[a production] activity.

Houdini’s activity is not distinguishable from the example, argues the IRS. Its activity is a service – packaging and repackaging – that adds final value to a product but does not rise to the level of production. 

The Court then decides:

Unlike X, which does not change the form or function of the car by adding accessories to it, Houdini changes the form and function of the individual items by creating distinct gifts. Furthermore, the Court considers Houdini’s complex production process as more similar to purchasing various automobile parts from suppliers – such as the frame, engine, wheels, etc – and assembling them to create the car itself, which is undoubtedly manufacturing.

Can you believe it? Houdini won!

My thoughts? If you have read my posts, you know that I am usually pro-taxpayer. That said, I believe this is an ill-reasoned decision and lacking in common sense. A key concept to manufacturing is transformation. The final product is similar, but different. Whether we are discussing smelting ore to make engine blocks or planting seeds for a crop – what follows is different from what went before. Quite frankly, using the Court’s reasoning I would find a meal prepared by Iron Chef Morimoto to be closer to manufacturing than putting candy bars and wine bottles into baskets. 

Dealing With A Tax Levy

We recently spoke about IRS liens. Let’s continue the conversation and talk about levies.

A levy taps into our primal fear of the IRS. This is where they come and take your checking account, repossess your car and sell your house. You get behind on your taxes and you get to relive the Grapes of Wrath.

Rest assured that your fear of losing your car and your house are greatly overblown. Your fear of losing your checking account may not be, however.

How did you get to this point? 

Somewhere in the recent past, the IRS sent you a notice – actually, a series of escalating notices. An early one may have read something like:

According to our records, you have an amount due on your income tax.”

There will be several notices, increasing in intensity. It is likely that you ignored them. Perhaps you just knew that their numbers were wrong. Perhaps you were broke and had nothing to send. Whatever the case, the one thing you failed to do was talk to them. 

Eventually you will receive the CP 504 letter (“Intent to Seize Your Property or Rights to Property”), where the IRS says that they intend to intercept your state tax refund. The notice also allows IRS to increase your penalties, but it is the state refund that catches people’s attention. Not that much attention, though. I do not get too many calls on a 504. Chances are if you are behind on federal taxes, you are behind on state taxes too.

The 504 is the demarcation line when your account leaves Automated Collections. You are now moving to regular Collections. The 504 is also the last notice before the IRS sends Form CP 90 “Final Notice of Intent to Levy and Notice of Your Right to a Hearing.” 

If you have a CP 90, you have serious business. The IRS will send it certified mail to your last known address, so if you have moved – especially if you did not file returns – you may not even know that this notice went out. The IRS has to go through certain hoops before it can levy, and this notice is key. You have 30 days to claim a Collection Due Process Hearing. If the IRS moves against you without issuing a Final Notice, or before the 30 days are up, you can stop them. If you claim a CDP Hearing, you can present your side of the story.

What if the 30 days pass?

One thing the IRS can then do is levy your bank account. How do they know your bank account information? One way is pretty simple: you had your refunds electronically deposited to your bank account. They can still get to that information otherwise, but electronic transfer made things easier for them. A bank levy is a one-time shot. The IRS instructs the bank to turn over whatever you have in your account as of a given date. The bank has 21 days before they have to turn over the money. There are important points we should review:

·        It is 21 days from when the bank received the notice, not the date of the notice.

·        The levy amount is your balance when the bank received the notice. If you deposit money later, that later deposit will not go to the IRS.

·        If the IRS wants that later deposit, it will have to issue another levy.

My experience has been that banks may not be overly concerned with informing you about the levy. Odds are that you will have less than 21 days before you find out, unless you attempted to withdraw funds or some similar action shortly after the bank received the levy. I have had clients who learned about the levy after the 21 days ran off. Let me tell you, there is almost no chance of getting that money returned when that happens.

Another thing the IRS can do is a wage levy. The IRS contacts your employer and tells him/her to send money. IRS Publication 1494 has tables telling you and your employer how much of your money you get to keep. For example, if you are divorced with two kids and are paid monthly, you keep $1,720. The balance goes to the IRS. The upside is that the $1,720 is after taxes, health insurance and whatnot. The downside is that you and your two kids might not be able to live on $1,720 per month.

It gets worse. The wage levy is continuous. It need not be reissued like a bank levy. People have quit their jobs over a wage levy. There isn’t much an employer can do. If your employer refuses to remit the money from your paycheck, then he/she is personally liable to remit the money from his or her own funds. Good luck finding an employer who will do that for you.

Can the IRS levy monies you receive as an independent contractor? You bet. Can it levy your social security? Yes, up to 15 percent. Can it go after your PayPal? Surely, you jest. Of course they can.

What about your house and car? Not so much. Let’s go over some statistics to put your mind at ease. In 2011, the IRS issued almost 3.8 million third-party levies. The IRS seized less than 800 houses, cars and other personal property. The IRS does not want the hassle of taking and selling your property. It wants cash.  It does not want your car, unless your car is a late-model Ferrari or something of the sort. In fact, if you have minimal equity in the asset, the IRS is prohibited from taking the asset from you.

Alright, you have received a Final Notice. What do you do next?

First, be aware of time. Remember that you have 30 days. Use it.

File a collection appeal. This will temporarily pull you away from the part of the IRS that is trying to collect and puts you in another part that will hear your case. How long is temporary? Figure on about 4 to 6 months before your hearing. 

Be ready to talk about a payment at the hearing, though, because that is where Appeals will take the conversation. They will ask for full payment immediately, the same way my dog is always hopeful I have brought her home a hamburger or something similarly tasty. 

What if you are truly broke? Then the IRS may place your account on “cannot collect” status. This means that you are so broke that you cannot make a payment, any payment. How can that happen? Let’s say that you could not pay rent if the IRS wiped-out your checking account. Perhaps you could not pay for necessary prescriptions. The term is “hardship,” and they will consider this. 

What if the taxes belong to your ex-spouse from a year when you filed a joint tax return? An innocent spouse claim will get the IRS to stay collection.

What if you file an offer in compromise? An offer will get the IRS to stay collection.

What if the IRS assessed you without your knowledge? Let me give you an example. I represented a client whose wife passed away. He received IRS notices when she became gravely ill, and upon her death he retreated from the world for a year or more. The IRS – not hearing from him – made adjustments and assessed all kinds of taxes and penalties. What did we do? We requested a reconsideration, which is also a way to stay collection.

Then we get to a payment plan. The particular type of plan depends on how much you owe. If you owe less than $50 thousand, you can request a “streamlined” plan. You promise to pay the IRS over 6 years, which translates into a maximum of $694 per month ($50,000 divided by 72). It is called streamlined because you get to submit minimal information to the IRS. This is a big deal, as the normal paperwork can be a pain. 

Let’s say that you owe over $50 thousand. You will now be submitting financial information, including bank statements and copies of bills, to the IRS. The IRS will apply “standards” to your expenses, and if your expenses exceed those standards they may (and likely will) disallow the excess. I have been through this exercise many times, and I can assure you in advance that the IRS’ calculation of what you can pay is more than what you think you can pay. You likely will be saying goodbye to your I Phone data package, your satellite TV, the leased car you really cannot afford and so on. The IRS does not want to subsidize your lifestyle. 

There may be variations in your particular payment plan. A standard payment plan requires you to pay-off the IRS over time. What if you cannot? The IRS may agree to a “partial pay” plan, which means that the plan will not completely pay-off the IRS unless the plan payment or plan term is changed. In my experience, I have had to go to Appeals to get this plan, but I have gotten it. 

Another possibility is to file bankruptcy. Although a last resort, a bankruptcy results in a “stay” of all credit actions, including the IRS.

What if you miss the 30-day window on the Final Notice? Not all is lost. You can still request a hearing, now called an “equivalency” hearing. You still get Appeals involved, but the IRS does not have to delay collection action – including bank levy or wage garnishment - until the hearing.

Depending on your situation, consider a tax professional. You want an attorney or CPA who specializes in taxes. As a heads up, most CPAs and attorneys do not specialize in taxes. Another alternative is an Enrolled Agent, who – by definition – specializes in taxes. Be sure to clarify whether they have done tax representation before.  One can “do taxes” and have never represented. It really is two different things, and you do not need to pay someone while they learn the ropes.

Is Zwerner's 200% Penalty Excessive?

Let me ask you a hypothetical question.

Say you made a million dollars in 2013. Even in a worst-case, salt-the-fields scenario, what would be the most the government could take from you in taxes? 

I am thinking a million dollars. 

His facts are not attractive. There is a saying that “bad facts make bad law.” We have both in this case. 

His name is Carl Zwerner, is 86 years old and lives in the Miami area. For years 2004 through 2007, Zwerner maintained an account at ABN AMRO Bank in Switzerland. It is not (yet) illegal for an American to have a foreign bank account, but it is illegal not to report it. 

Somewhere in 2008 he had a change of heart. He filed a delinquent FBAR and amended his 2007 tax return to include the earnings from the account. In 2009 he decided to come clean on years 2004, 2005 and 2006 also.

There was a twist: Zwerner did not hold the bank account in his own name. The account was in the name of the “Bond Foundation” for a while, then in the name the “Livella Foundation.” At all times, though, Zwerner had control and was the beneficial owner of the funds. Those account names were just speed bumps.

Then he does the unbelievable. In a letter dated August 2010, he admitted to the IRS that he was aware that he should have reported both the existence of the account and the earnings from it.

Why, Carl, oh why?

The IRS, in yet another example of why people hate the IRS, decided that he “willfully” evaded his taxes, used regular gasoline in a high-octane-only car and failed to hold the door for an elderly woman at the grocery store. The IRS determined that the balances at the Swiss account were as follows over the years:

           

2004	$1,447,000
2005	$1,490,000
2006	$1,545,000
2007	$1,691,000

This did not take Sherlock-type powers by the IRS, by the way, as Zwerner had already reported the account.

The IRS then remembered that the penalty for willful failure to file an FBAR is 50% of the highest balance for each year.

NOTE: Did you pick-up on what the fifth-amendment-pleading crowd has done here? Two years worth of penalties and the account is depleted – essentially seized by the government. 

Well, Zwerner was facing 4 years. His penalty was almost $3.5 million, whereas his account had never exceeded $1.7 million.

Good thing he voluntarily filed amended returns! What would they have done to him had he not come clean? 

In the area of foreign accounts, Treasury and the IRS have decided that we are all guilty, and that the only way to salvation is through their disclosure program du jour. The fact that these programs may not be a fit for many (or most, in my opinion) is beside the point. Many tax practitioners, me included, have represented clients with foreign non-reporting issues. My clients have been “ordinary” – an expat who started a business in Scotland, another who had no idea what an “FBAR” was, much less that she had to file tax returns even though she had lived out of the U.S. for two decades. These are not tax desperados, and to lump them in with IRS programs designed to avoid criminal prosecution is bonkers.

And there is the rub. The IRS took Zwerner’s letter as an admission of “willfulness,” meaning that he is charged with tax fraud. This is a criminal charge, and Zwerner should have entered the Offshore Voluntary Disclosure Program if he wanted protection from criminal charges. The IRS would say this is not the same as my Aberdeen restaurateur. I in turn would ask the IRS: why don’t you have a program for people like my restaurateur? Do you think I enjoyed that phone call with an expat who is afraid to return to the United States to visit her mother? Why are you terrorizing ordinary people? We could probably put all the people with significant money hidden overseas into one hotel conference room. Why is it that attorneys and tax CPAs in 50 states have horror stories to tell? There cannot be that many overseas-money-hiding uber-wealthies to go around.

Zwerner amended his returns. He did not enter the disclosure program. The IRS calls this a “quiet disclosure,” and they do not like it. They assessed 200% penalties.

What choice did the IRS leave him? He filed a lawsuit against the government.  He has an interesting argument, as the Eighth Amendment prohibits “excessive fines.” 

What do you think? Is a penalty of more than 100% an “excessive fine?”

There is precedent. There is a 1998 case where someone tried to take $357 thousand overseas and got caught with the money in his luggage. The U.S. sought forfeiture of the entire amount. The Supreme Court ruled against the government, stating that forfeiture of all the money was “grossly disproportional to the gravity of the offense.” The Supreme Court ordered him to pay $20,000 instead.

We’ll be paying attention to Zwerner’s case as it goes through the courts.