Suboptimal Tax Laws Are Still Valid Tax Laws

I have a family member who has accepted in position in, and will be moving to, Chicago. You can bet that we have discussed the compensation package, and I am to review the deferred compensation package when provided. His is a “C suite” position, so deferred compensation means more than just the 401(k) with which you and I are familiar.

I find myself reviewing a Federal Court of Claims decision on an airline pilot that got on the wrong side of FICA taxation of deferred compensation.

His name is Louis Balestra, and he was a pilot with United Airlines from 1979 until his retirement in 2004. There may have been no tax case, except that United Airlines filed for bankruptcy in 2002.

Let’s talk about the “general timing rule” for FICA taxation. It is easy: you pay FICA when you are paid. No pay, no tax. No fair to not cash your paycheck!

We also have deferred compensation, more specifically “nonqualified” deferred compensation, which means a retirement plan which deviates, either a little or a lot, from somewhat rigid IRS requirements in order to be “qualified.” There is then a ‘special timing rule” (I am not making this up, I swear), the purpose of which is to speed-up when the income is taxed for FICA. The Code section is 3121(v)(2):

   3121(v)(2) TREATMENT OF CERTAIN NONQUALIFIED DEFERRED COMPENSATION PLANS.—

3121(v)(2)(A) IN GENERAL.— Any amount deferred under a nonqualified deferred compensation plan shall be taken into account for purposes of this chapter as of the later of—

3121(v)(2)(A)(i)   when the services are performed, or

3121(v)(2)(A)(ii)   when there is no substantial risk of forfeiture of the rights to such amount.

We have a new shiny: “substantial risk of forfeiture.” If the company funds your benefit, for example, chances are that your FICA tax will be accelerated, perhaps many years before you actually receive any money.

Let’s work through this with an extremely simplified example. The company agrees to pay you $100,000 five years from now. Let’s also posit that you clear the second requirement of “no substantial risk of forfeiture.” Congratulations, you have FICA tax. Right now.

Being a tax accountant by training if not by temperament, I have to ask the question: how do I calculate the income to be taxed? Is it $100,000? That doesn’t make sense, as you will receive the money five years from now. A hundred grand then is not the same as a hundred grand now, if for no other reason than you could put it n a CD (if you received it now) and have more than a hundred grand five years hence. Is it the present value of the $100,000, discounted at some interest rate and for five years? That makes more sense, and that is the guidance provided by the Regulations.

Remember what I said about United Airlines filing for bankruptcy in 2002, two years before Balestra retired? Shouldn’t we take into consideration that United Airlines might not pay everything to which Balestra is entitled?

Makes sense to me. For example, Balestra paid FICA on approximately $289,000 of deferred compensation. United actually paid him approximately $63,000. He had paid FICA on that entire $289,000, and he wanted some of it back.

CLARIFICATION: It would be more correct to say that he paid the Medicare portion of FICA, as the social security side only applies up to an income limit.  Let’s continue. We are on a roll.

Balestra sued.  

And the Court was looking at the Shakespearean prose of Reg 31.3121(v)(2)-1(c):

(ii) Present value defined.— For purposes of this section, present value means the value as of a specified date of an amount or series of amounts due thereafter, where each amount is multiplied by the probability that the condition or conditions on which payment of the amount is contingent will be satisfied, and is discounted according to an assumed rate of interest to reflect the time value of money. For purposes of this section, the present value must be determined as of the date the amount deferred is required to be taken into account as wages under paragraph (e) of this section using actuarial assumptions and methods that are reasonable as of that date. For this purpose, a discount for the probability that an employee will die before commencement of benefit payments is permitted, but only to the extent that benefits will be forfeited upon death. In addition, the present value cannot be discounted for the probability that payments will not be made (or will be reduced) because of the unfunded status of the plan, the risk associated with any deemed or actual investment of amounts deferred under the plan, the risk that the employer, the trustee, or another party will be unwilling or unable to pay, the possibility of future plan amendments, the possibility of a future change in the law, or similar risks or contingencies.

Balestra tried, but he could not overcome the fact that the Regulations did not include “employer bankruptcy” as a possible reason to discount the amount of income accelerated for FICA tax – or, at least, to allow some of the FICA to be refunded once the actual payments are known.

Balestra lost his case.

The Court did realize the unfairness of the law, however.

It might have been wiser to have selected as a trigger something other than there being ‘no substantial risk of forfeiture’ … and instead considered the financial solvency of the employer – or to have deferred taxation while an employer is in bankruptcy, rather than until promised benefits are ‘reasonable ascertainable.”

You think?

But these are matters for law makers, not judges – suboptimal laws are still valid tax laws.”

I know. I would be more optimistic if I had any regard for the suboptimals in Congress.

Tile 26 of the United States Code would be a good deal shorter if the unwise tax laws could be purged by the judiciary.”

You must admit, it is easy to like this Court.

No Job Is Worth This Penalty

A few years ago someone asked me to “run their payroll.” This particular place had enough issues to fuel multiple seasons of Game of Thrones, among the least of which was an inability or unwillingness to pay their payroll on time.  It was just a matter of time until someone reported them to a government agency. I was to timely process the payroll, transfer funds, make tax deposits and so on.

My answer?

Not a chance.

I have no problem processing a payroll. The one thing I will not do however is involve myself with making payroll tax deposits.

Why?

There is an IRS penalty out there called the “responsible person” penalty, which we have previously referred to as the “big boy” penalty. This is gallows humor, and you want nothing to do with this boy. The IRS becomes very grim when one withholds payroll taxes and fails to remit them to the government. They consider it theft. The IRS roots around to learn who in the company had control over cash – that is, who decides who to pay, who can sign checks, that type of thing. If that person is you, you may be a “responsible person,” meaning that you are also liable for the payroll taxes. The IRS can chase the company, it can chase you, it can chase both of you. You have stepped into someone else’s problem.

Where have I seen this? Mostly it stems from severe cash flow pressures, such as after the 2008 business crash. My last responsible person penalty client was a contractor on the Kentucky side of Cincinnati. What made it frightening was the IRS interviewing the controller/office manager in addition to the owners. Why? Because, once in a blue moon, she would write a check, mostly if there was no one else available to sign. That woman was understandably terrified.

I am reading a District Court decision coming out of Virginia. From 1990 to 2000 Brenda Horne was the office manager for a medical practice. Her duties included:

·       Billing customers

·       Collecting accounts receivable

·       Making bank deposits

·       Writing checks

·       Preparing, signing and filing payroll tax returns

·       Decisions about hiring, firing and employee compensation

The company stopped making payroll tax deposits in 2006.  Brenda continued writing and signing checks to everyone but the IRS.

The IRS came in. The company owed over $2.8 million in back payroll taxes.

And now, so does Ms. Horne.

Perhaps she was part of this. Perhaps she was under-informed and went along in order to keep her job. She wouldn’t be the first. The fatal fact? That she could decide who to pay, who not to pay, and could sign checks accordingly. The IRS did not get paid, and they held her responsible.

Granted, the owners of the company are responsible long before an office manager is, but that is not the way the IRS approaches this. The IRS is happy to have several responsible persons. That increases the odds of collecting from someone. Theoretically, she could sue the medical practice and its owners for restitution if the IRS compelled her to pay. Considering that the company did not – or could not – pay the taxes when due, I am skeptical that it could pay Brenda Horne now.

It does not matter what she was paid for being an office manager. It cannot approach $2.8 million.

And the company’s loyalty to her?

She got fired at the end of 2010.

How Choosing The Correct Court Made The Difference

I am looking at a District Court case worth discussing, if only for the refresher on how to select a court of venue. Let’s set it up.

ABC Beverage Corporation (ABC) makes and distributes soft drinks and non-alcoholic beverages for the Dr Pepper Snapple Group Inc. Through a subsidiary it acquired a company in Missouri. Shortly afterwards it determined that the lease it acquired was noneconomic. An appraisal determined that the fair market rent for the facility was approximately $356,000 per year, but the lease required annual rent of $1.1 million. The lease had an unexpired term of 40 years, so the total dollars under discussion were considerable.

The first thing you may wonder is why the lease could be so disadvantageous. There are any number of reasons. If one is distributing a high-weight low-value product (such as soft drinks), proximity to customers could be paramount. If one owns a franchise territory, one may be willing to pay a premium for the right road access. Perhaps one’s needs are so specific that the decision process compares the lease cost to the replacement cost of building a facility, which in turn may be even more expensive. There are multiple ways to get into this situation.

ABC obtained three appraisals, each of which valued the property without the lease at $2.75 million. With the lease the property was worth considerably more.

NOTE: Worth more to the landlord, of course. 

ABC approached the landlord and offered to buy the facility for $9 million. The landlord wanted $14.8 million. Eventually they agreed on $11 million. ABC capitalized the property at $2.75 million and deducted the $6.25 million difference.

How? ABC was looking at the Cleveland Allerton Hotel decision, a Sixth Circuit decision from 1948. In that case, a hotel operator had a disastrous lease, which it bought out. The IRS argued that that the entire buyout price should be capitalized and depreciated. The Circuit Court decided that only the fair market value of the property could be capitalized, and the rest could be deducted immediately. Since 1948, other courts have decided differently, including the Tax Court. One of the advantages of taking a case to Tax Court is that one does not have to pay the tax and then sue for refund. A Tax Court filing suspends the IRS’ ability to collect. The Tax Court is therefore the preferred venue for many if not most tax cases.

However and unfortunately for ABC, the Tax Court had decided opposite of Cleveland Allerton (CA), so there was virtually no point in taking the case there. ABC was in Michigan, which is in the Sixth Circuit. CA had been decided in the Sixth Circuit. To get the case into the District Court (and thus the Circuit), ABC would have to pay the tax and sue for refund. It did so.

The IRS came out with guns blazing. It pointed to Code Section 167(c)(2), which reads:

            (2) Special rule for property subject to lease

If any property is acquired subject to a lease—

(A) no portion of the adjusted basis shall be allocated to the leasehold interest, and

(B) the entire adjusted basis shall be taken into account in determining the depreciation deduction (if any) with respect to the property subject to the lease.

The IRS argued that the Section meant what it said, and that ABC had to capitalize the entire buyout, not just the fair market value.  It trotted out several cases, including Millinery Center and Woodward v Commissioner. It argued that the CA decision had been modified – to the point of reversal – over time. CA was no longer good precedent.

The IRS had a second argument: Section 167(c)(2) entered the tax Code after CA, with the presumption that it was addressing – and overturning – the CA decision.

The Circuit Court took a look at the cases. In Millinery Center, the Second Circuit refused to allow a deduction for the excess over fair market value. The Sixth Circuit pointed out that the Second Circuit had decided that way because the taxpayer had failed its responsibility of proving that the lease was burdensome. In other words, the taxpayer had not gotten to the evidentiary point where ABC was.

In Woodward the IRS argued that professional fees pursuant to a stockholder buyout had to be capitalized, as the underlying transaction was capital in nature. Any ancillary costs to the transaction (such as attorneys and accountants) likewise had to be capitalized. The Sixth Circuit pointed out the obvious: ABC was not deducting ancillary costs. ABC was deducting the transaction itself, so Woodward did not come into play.

The Court then looked at Section 167(c)(2) – “if property is acquired subject to a lease.” That wording is key, and the question is: when do you look at the property? If the Court looked before ABC bought out the lease, then the property was subject to a lease. If it looked after, then the property was not. The IRS of course argued that the correct time to look was before. The Court agreed that the wording was ambiguous.

The Court reasoned that a third party purchaser looking to acquire a building with an extant lease is different from a lessee purchaser. The third party acquires a building with an income stream – two distinct assets - whereas the lessee purchaser is paying to eliminate a liability – the lease. Had the lessee left the property and bought-out the lease, the buy-out would be deductible.

The Court decided that the time to look was after. There was no lease, as ABC at that point had unified its fee simple interest. Section 167(c)(2) did not apply, and ABC could deduct the $6.25 million. The Court decided that its CA decision from 1948 was still precedent, at least in the Sixth Circuit.

ABC won the case, and kudos to its attorneys. Their decision to take the case to District Court rather than Tax Court made the case appealable to the Sixth Circuit, which venue made all the difference.

What Happens To Inherited IRAs in Bankruptcy?

Let us discuss IRAs.

You may be aware that there is bankruptcy protection for IRAs. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 exempts up to $1 million in IRAs created and funded by the debtor. Employer plans have even more favorable protection.

Why? The government has expressed interest that citizens be able to save for their retirement. This diminishes the odds of future government assistance and deemed in the public interest.

Fair enough. But I have one more question.

Let us say that you inherited the IRA. Does the above protection still apply to you?

Why wouldn’t it, you might ask. It is like an ice cream bar. It is still an ice cream bar whether you or I take it from the freezer, right?

This very question made it to the Supreme Court in the recent case of Clark v Rameker. While a bankruptcy case, it does have tax implications.

In 2001 Ruth Heffron established a traditional IRA and named her daughter as beneficiary.

NOTE:  “Traditional” means the classic IRA: contributions to it are deductible and withdrawals from it are taxable. Contrast this with a “nondeductible” IRA (contributions are nondeductible and withdrawals are taxable, according to a formula) and Roths (contributions are nondeductible and withdrawals are nontaxable).

Mrs Heffron passed away a year later – 2001 – and left approximately $400,000 to her daughter in the IRA account. Inherited IRAs have special rules on distributions, and one has to take distributions over a life expectancy or withdraw the entire balance within five years. Her daughter – Ms. Heffron-Clark - elected to use life expectancy with monthly distributions.

Fast forward to 2010 and Ms. Heffron-Clark and her husband file for Chapter 7 bankruptcy. The IRA has approximately $300,000 remaining, and you can bet that the couple considered the IRA to be an exempt asset. The unsecured creditors of the bankruptcy estate disagreed, thus beginning the litigation.

·       The Bankruptcy Court said that the IRA was not exempt and could be reached by creditors.

·       The District Court reversed, saying that the IRA was exempt and could not be reached by creditors.

·       The Appeals Court for the Seventh Circuit reversed, saying that the IRA was not exempt and could be reached by creditors.

This set up disagreement between the Fifth and Seventh Circuits, so the Supreme Court agreed to hear the case.

Believe it or not, the Bankruptcy Code does not define the term “retirement funds,” resulting in the above courts drawing such different conclusions. The Supreme Court declared that the term must be defined in order to arrive at a correct conclusion. The Court looked a dictionary and saw that “retirement” is defined as …

       … withdrawal from one’s occupation, business or office.”

The Court wanted to look at the legal characteristics of funds set aside for the day one stops working. It focused on three:

(1)  One can put additional monies into a retirement account.

POINT: One cannot put additional monies into an inherited account. In fact, if one inherits again, one cannot mingle the two accounts. Each is to remain separate and unique.

COUNTERPOINT: One cannot put additional monies into an IRA after age 70 ½.

(2)  Holders of an inherited account are required to begin distributions in the year following the death.

POINT: There are no age 59 ½ or 70 ½ minimum distribution requirements here. It does not matter whether the beneficiary is three years old or ninety-three; distributions must begin in the year following death, unless one fully depletes the account over 5 years.

OBSERVATION: The Court asked obvious question: how does this distribution requirement tie-in to the beneficiary’s retirement in any way?

(3)  The beneficiary can withdraw the entire balance at any time, without penalty.

POINT: You and I cannot do that with our own IRA until we are age 59 ½. 

OBSERVATION”: The Court noted that there is a ‘stick” if one wants to access a traditional IRA early – the 10% penalty. That expresses Congress’ intent to discourage use of traditional IRA s for day-to-day non-retirement purposes. The inherited IRA has no such prohibition. What does that say about Congress’ intent with inherited IRAs?

Rest assured that Ms Heffron-Clark was arguing furiously that the funds in that inherited IRA are “retirement funds” because, at some point, they were set aside for retirement.

The Court looked at the three criteria above and said that the inherited IRA certainly constitutes “funds,” but it cannot see how they rise to the level of “retirement funds.” They simply do not have the characteristics of normal retirement funds.

The Supreme Court unanimously decided that an inherited IRA do not constitute “retirement funds” and are not exempt from bankruptcy claims. Ms. Heffron-Clark’s creditors could in fact reach that $300 grand.

Granted, this is a bankruptcy case, but I see two immediate tax consequences from this decision:

(1) First, a surviving spouse (that is, the widow or widower) has a tax  option offered no other IRA beneficiary.

The surviving spouse can take the IRA as an inherited IRA (and be subject to bankruptcy claims) or he/she can rollover the IRA to his/her own personal name.

In the past, this decision was sometimes made based on the survivor’s age. For example, if the surviving spouse thought he/she might need the money before age 59 ½, the tax planner would lean towards an inherited IRA. Why? Because there is no 10% penalty for early withdrawals from an inherited IRA. There would be penalties on early withdrawals from a rollover IRA.

This decision now gives planners another reason to consider a spousal rollover.

(2) Second, there may be increased attention to IRA accumulation trusts.

A trust is allowed to be an IRA beneficiary, but at the cost of some highly specific tax rules. There are two types of permitted trusts. The first is the conduit trust. The trust receives the annual minimum required distributions (MRDs) but is required to immediately pay them out to the beneficiary.  While you may wonder what purpose this trust serves, consider that the trust – while unable to protect the annual income – can still protect the principal of the trust.

The second type is the accumulation trust. It is eponymous: it accumulates. There are no required distributions to the beneficiaries. The tax cost for this can be enormous, however. A trust reaches the maximum federal tax rate at the insanely low threshold of approximately $12,000. Obviously, this strategy works best when the beneficiaries are themselves at the maximum tax bracket.

The other point that occurred to me is the future of stretch IRAs. There has been considerable discussion about imposing a five-year distribution requirement (with very limited exceptions) on inherited IRAs. This of course is in response to the popular tax strategy of “stretch” IRAs. The stretch is easy to explain: I leave my IRA to my granddaughter. The IRA resets its mandatory distributions, using her life expectancy rather than mine (which is swell, as I am dead). Say that she is age 11. Whereas there are mandatory distributions, those distributions are spread out over the life expectancy of an eleven-year-old girl. That is the purpose and use of the “stretch.”

Consider that the Court just decided that an inherited IRA does not constitute “retirement funds.” This may make it easier for Congress to eventually do away with stretch IRAs.