P&G, Coty And A Unicorn Named Morris

You may know that P&G is streamlining, selling off non-core lines of business. It just concluded a deal to sell 43 beauty brands, including Clairol and Max Factor, to Coty, Inc. The deal appears to be good for Coty, as it will double sales and transform Coty into one of the largest cosmetic companies in the world. P&G in turn receives $12.5 billion.

What makes it interesting to the tax planners is the structure of the deal: P&G is using a “reverse-Morris” structure. It combines a carve-out of unwanted assets (unwanted, in this case, by P&G) with a prearranged merger. The carve-out is nontaxable, but if you err with the merger the carve-out becomes taxable. This is a high stakes game, and woe unto you if the IRS determines that the merger was prearranged. The reverse Morris is designed to directly address a prearranged merger.

Let’s walk through it.

First, what is a “regular” Morris?

Let’s say that you own a successful and publicly-traded company (say Jeb). You have a line of business, which we shall call Lindsey. Someone (“Donald”) wants to buy Lindsey. Jeb could flat-out sell Lindsey, but the corporate taxes might be outrageous. Jeb could alternatively spinoff Lindsey to you, and you in turn could sell to Donald. That would probably be preferable.

Why?

Front and center is the classic tax issue with C corporations: double taxation. If Jeb sells, then Jeb would have corporate taxes. Granted, Jeb would distribute the after-tax proceeds to you, but then you would have individual taxes. The government might wind up being the biggest winner on the deal.

Forget that. Let’s spinoff Lindsey tax-free to you, and you sell to Donald. There would be one tax hit (yours), which is a big improvement over where we were a moment ago.

But you cannot do that.

You see, under regular corporate tax rules a tax-free merger with Donald within two years of a spinoff would trigger BAD tax consequences. We are talking about the spinoff being retroactively taxable to Jeb. Jeb will have to amend its tax return and write a big check. That is BAD.

I suppose you could tell Donald to take a hike for a couple of years while you reset the clock. Good luck with that.

You talk to your accountant (“Hillary”). She recommends that you have Jeb borrow a lot of money. You then drop Lindsey into a new subsidiary and spinoff new Lindsey to you. You leave the debt in Jeb. You then sell Jeb to Donald. Donald takes over the debt. He doesn’t care. Donald just offsets whatever he was going to pay you by that debt.

This is a Morris deal and Congress did not like it. It looked very much like a payday.

• The cash is in Lindsey
• The debt is in Jeb
• You sell Jeb
• You keep Lindsey
• You keep the money that is in Lindsey
• The government doesn’t get any money from anybody

The government was not getting its vig. Congress in response wrote a new section into the tax Code (Section 355(e)) which triggers gain if more than 50% control of either the parent or subsidiary changes hands. 

Yep, that pretty much will shut down a Morris deal. Donald wants more than 50% control. Donald is like that.

Now, Section 355(e) presented a challenge to the tax attorneys and CPAs. Think of it as an epic confrontation between a chromatic Great Wyrm and your 28th level paladin at the weekly Saturday night D&D game. The players were not backing down. No way.

So someone said “the deal will work if the buyer will accept less than 50% control.”

Eureka!

Let’s take our example above and introduce a different buyer (let’s call him Bernie). Bernie wants to buy Lindsey. Bernie is willing to accept less than 50%, as contrasted to that meanie Donald. Same as before, let’s drop Lindsey into a new subsidiary. New Lindsey borrows a lot of money and ships it to Jeb. New Lindsey, now laden with debt, is sold to Bernie. Bernie takes over the debt as part of the deal. When the dust settles, Bernie will own less than 50% of new Lindsey, which gets us out of the Section 355(e) dilemma.

You in turn keep Jeb and the cash.

And that is the reverse Morris. We sidestep Section 355(e) by not allowing more than 50% of either Jeb or Lindsey to change hands.

Why do we not see reverse Morris deals more often? There are three key reasons:

1. It requires a buyer that is smaller than the target, but not so small that it cannot do the deal. 
2. There will be new debt, likely significant. This raises the business risk associated with the deal, as the bank is going to want its money back.
3. The new company’s management and board may be an issue. After all, the buyer BOUGHT the company. It is not unreasonable that Bernie wants to control what he just bought. I would want to drive the new car I just bought and paid for.

The Reimann family of Germany owns approximately two-thirds of Coty. Even though Coty is acquiring less than 50% of the P&G subsidiary, the Reimann’s will own a large enough block of stock to have effective control. That must have helped make the reverse Morris attractive to Coty.

Reverse Morris deals are not unicorns, but there have been less than 40 of them to-date. That makes them rare enough that the tax specialists look up from their shoes when one trots out. P&G by itself has had three of them over the last ten or so years. Someone at P&G likes this technique.

TomatoCare And The Supreme Court

Let’s play make believe.

Late on a dark and stormy Saturday night, the Congressional Spartans - urged on by Poppa John's and the National Tomato Growers Association – passed a sweeping vegetable care bill by a vote of 220-215.

The bill went to the Senate, where its fate was sadly in doubt. The fearless majority leader Harry Leonidas negotiated agreements with several recalcitrant senators, including the slabjacking of New Orleans, an ongoing automatic bid for the Nebraska Cornhuskers to the college Bowl Championship Series and the relocation of Vermont to somewhere between North Carolina and Florida. After passage, the bill was signed by the president while on the back nine at Porcupine Creek in Rancho Mirage, California.

As a consequence of this visionary act, Americans now had access to affordable tomatoes, thanks to market reforms and consumer protections put into place by this law. The law had also begun to curb rising tomato prices across the system by cracking down on waste and fraud and creating powerful incentives for grocery chains to spend their resources more wisely. Americans were now protected from some of the worst industry abuses like out-of-season shortages that could cut off tomato supply when people needed them the most.

California, Vermont and Massachusetts established state exchanges to provide tomato subsidies to individuals whose household income levels were below the threshold triggering the maximum federal individual income tax rate (presently 39.6 percent). The remaining states had refused to establish their own exchanges, prompting the federal government to intervene. The Tax Exempt Organization Division at the IRS, recognized for their expertise in technology integration, data development and retention, was tasked to oversee the installation of federal exchanges in those backwater baronies. IRS Commissioner Koskinen stated that this would require a reallocation of existing budgetary funding and – as a consequence - the IRS would not be collecting taxes from anyone in the Central time zone during the forthcoming year.

The 54 states that did not establish their own exchanges filed a lawsuit (Bling v Ne’er-Do-Well) challenging a key part of the TomatoCare law, which read as follows:

The premium assistance amount determined under this subsection with respect to any vegetable coverage amount is the amount equal to the lesser of the greater…”

These benighted states pointed out that, botanically, a tomato was a fruit. A fruit was defined as a seed-bearing vessel developed from the ovary of a flowering plant. A vegetable, on the other hand, was any other part of the plant. By this standard, seedy growth such as bananas, apples and, yes, tomatoes, were all fruits.

There was great fear upon the land when the Supreme Court decided to hear the case.

Depending upon how the Supreme Court decided, there might be no tomato subsidies because tomatoes were not vegetables, a result clearly, unambiguously and irretrievably-beyond-dispute not the intent of Congress on that dark, hot, stormy, wintery Saturday night as they debated the merits of quitclaiming California to Mexico.

The case began under great susurration. The plaintiffs (the 54 moon landings) read into evidence definitions of the words “fruit” and “vegetables” from Webster’s Dictionary, Worcester’s Dictionary, the Imperial Dictionary and Snoop Dogg’s album “Paid tha Cost to Be da Bo$$.”

The Court acknowledged that the words “fruit” and “vegetable” were indeed words in the English language. As such, the Court was bound to take judicial notice, as it did in regard to all words in its own tongue, especially “oocephalus” and “bumfuzzle.” The Court agreed that a dictionary could be admitted in Court only as an aid to the memory and understanding of the Court and not as evidence of the meaning of words.

The Court went on:

Botanically speaking, tomatoes are the fruit of the vine. But in the common language of the 202 area code, all these are vegetables which are grown in kitchen gardens and, whether eaten cooked, steamed, boiled, roasted or raw, are like potatoes, carrots, turnips and cauliflower, usually served at dinner with, or after, the soup, fish, fowl or beef which constitutes the principal part of the repast.”

The Court decided:

            But it is not served, like fruits generally, as a dessert.”

With that, the Court decided that tomatoes were vegetables and not fruit. The challenge to TomatoCare was courageously halted, and the liberal wing of the Court – in a show of their fierce independence and tenacity of intellect – posed for a selfie and went to Georgetown to get matching tattoos.

Thus ends our make believe.

There was no TomatoCare law, of course, but there WAS an actual Supreme Court decision concerning tomatoes. Oh, you didn’t know?

Back in the 1880s the Port of New York was taxing tomatoes as vegetables. The Nix family, which imported tons of tomatoes, sued. They thought they had the law – and common sense – on their side. After all, science said that tomatoes were fruit. The only party who disagreed was the Collector of the Port of New York, hardly an objective juror.

The tax law in question was The Tariff of 1883, a historical curiosity now long gone, and the case was Nix v Hedden. 

And that is how we came to think of tomatoes as vegetables.

Brilliant legal minds, right?

Michael Jordan, The Grizzlies And The Jock Tax

I have been reading recently that the jock tax may be affecting where athletes decide to play. For example, Ndamukong Suh, an NFL defensive tackle formerly with the Detroit Lions, was wooed by the Oakland Raiders but opted instead to sign with the Miami Dolphins. I can understand a top-tier athlete not wanting to play for a team as dysfunctional as the Raiders, but one has to wonder whether that 13.3% top California tax rate was part of the decision. Florida of course has no income tax.

Let’s not feel sorry for Suh, however. His contract is worth approximately $114 million, with $60 million guaranteed.

So what is the jock tax?

Let’s say that you work in another state for a few days. You may ask whether that state will want to tax you for the days you work there. Some states tell you upfront that there is no tax unless you work there for a minimum number of days (say 10, for example). Other states say the same thing obliquely by not requiring withholding if you would not have a tax liability, requiring you (or your accountant) to reverse-engineer a tax return to figure out what that magic number is. And then there are … “those states,” the ones that will try to tax you just for landing at one of their airports.

Take the same concept, introduce a professional athlete, a stadium and a game and you have the jock tax.

It started in California. Travel back to 1991 when Michael Jordan led the Bulls to the NBA Finals. After the net was cut and the celebrations finished, Los Angeles contacted Jordan and informed him that he would have to pay taxes for the days that he spent there.

Illinois did not like the way California was treating their favorite son, so they in turn passed a law imposing income tax on athletes from other states if their state imposed a tax on an Illinois athlete. This law became known as “Michael Jordan’s Revenge.”

How do you allocate an athlete’s income to a given city or state? That is the essence of the jock tax and what makes it different from you or me working away from home for a week or so.

If we work a week in Illinois, our employer can carve-out 1/52 of our salary and tax it to Illinois. Granted, there may be issues with bonuses and so on, but the concept is workable.

But an athlete does not work that way. What are his/her work days: game days? Game and travel days? Game, travel, and practice days?

Let’s take football. There are the Sunday games, of course, but there are also team meetings, practice sessions, film study, promotional events, as well as minicamps and OTAs and so on. Let’s say that this works out to be 160 days. You are with Bengals and travel to Philadelphia for an away game. You spend two days there. Philadelphia would likely be eying 2/160 of your compensation.

This method is referred to as the “duty days” method.

Cleveland separated from the pack and wanted to tax players based on the number of games in the season. For example, the city tried to tax Chicago Bears linebacker Hunter Hillenmeyer based on the number of season games, which would be 20 (16 regular season and 4 preseason). Reducing the denominator makes Cleveland’s share larger (hence why Cleveland liked this method), but it ignores the fact that Hillenmeyer had duty days other than Sunday. What Cleveland wanted was a “games played” method, and it was shot down by the Ohio Supreme Court.

Cleveland also had an interesting twist on the “games played” method. It wanted to tax Indianapolis Colts center Jeff Saturday for a game in 2008.  However, Saturday was injured and did not play in that game, making Cleveland’s stance hard to understand. In fact, Saturday was injured enough that he stayed in Indianapolis and did not travel with the team, now making Cleveland’s position impossible to understand. Sometimes bad law surfaces when pushed to its logical absurdity, and the Ohio Supreme Court told Cleveland to stop its nonsense.

Tennessee wrote its jock tax a bit differently. Since the state does not have an income tax (more accurately, it has an income tax on dividends and interest only) it could not do what California, Illinois and Ohio had done before. Tennessee instead charged a visiting athlete a flat rate, irrespective of his/her income. For example, if you were a visiting NBA player, it would cost $2,500 to play against the Memphis Grizzlies.

Tennessee also taxed NHL players (think Nashville Predators) but not NFL players (think Tennessee Titans).

I guess the NFL bargains better than the NHL or NBA.

One can understand the need to fund stadiums, but this tax is arbitrary and capricious. What about a non-athlete traveling with the team? That $2,500 may be more than he/she earned for the game.

Tennessee has since abolished this tax for NHL players but has delayed abolishment until June 1, 2016 for NBA players.

In other news, NFL players remain untaxed.

We have talked about the denominator of the fraction to be multiplied against an athlete’s compensation. Are you curious what goes into that compensation bucket?

Let’s answer this with a question: why do so many athletes chose to live in Texas or Florida? The athlete may have an apartment in the city where he/she plays, but his/her main home (and family) is in Dallas, Nashville or Miami.

Let’s say the athlete receives a signing bonus. There is an extremely good argument that the bonus is not subject to the jock tax, as it is not contingent upon future performance by the athlete. The bonus is earned upon signing; hence its situs for state taxation should be tested at the moment of signing. Tax practitioners refer to this as “non-apportionable” income, and it generally defaults to taxation by the state of residence. Take residence in a state with no income tax (hello Florida), and the signing bonus escapes state tax.

Consider Suh and the Miami Dolphins. California’s cut of his $60 million signing bonus would have been almost $8 million. Florida’s cut is zero.

What would you do for $8 million?

The Sale of "American Pie"

Did you see where Don McLean sold his original manuscript for “American Pie” at Christie’s? He sold the work for $1.2 million, and it included his handwritten notes and deletions from the 1971-72 hit that – at 8 ½ minutes – was the longest song to ever top the U.S. charts.

The song of course is famous for its allusions. The “day the music died” refers to the death of Buddy Holly, whereas “the king” supposedly refers to Elvis Presley while “the jester on the sidelines” refers to Bob Dylan after his motorcycle accident. It became an anthem to disillusionment, to the sense of our best days being behind us and the ennui and hopelessness of a society being carted off in the wrong direction.

Sounds eerily contemporary.

He explained that he had forgotten he had the manuscript. He found it in the proverbial old box that had survived several moves. The sale allowed him to provide for his family, now and into the future.

Yes, $1.2 million will do that.

So what are the tax consequences from the sale of his manuscript?

We are talking about intellectual property and a subset we will call creative properties.

For the most part, self-created properties cannot be a capital asset in the hands of its creator. This causes a problem, as one requires a capital asset if one wants capital gains.

Take it a step further. If someone else owns the asset but its tax basis (that is, its cost for purposes of calculating gain or loss) is determined by reference to the creator’s basis, then it cannot be a capital asset.  How can this happen? Easy. You could gift the property, for example, or you could contribute the property to a family limited partnership. In either case the recipient will “take over” your basis in the creative property. Since the basis remains the same, it cannot be a capital asset.

The vocabulary gets tricky when discussing creative property. For example, an author (say Stephen King) may receive a “royalty.” Coincidently, find oil in your backyard and chances are an oil company will also pay you a royalty. Since the word “royalty” is the same, are the tax consequences the same?

The answer is no. If you write a book or score a movie soundtrack, that royalty is probably ordinary income to you. In fact, it is reported on Schedule C of your individual tax return, the same as your self-employment income from Uber. The oil royalty, on the other hand, is reported on Schedule E, along with rents. The Schedule C royalty will trigger self-employment tax. The Schedule E will not. 

OBSERVATION: We have discussed before that sometimes a word will have different meanings as it travels through the tax Code. Here is an example.

As always, there are exceptions. Let’s say you write one book and never write again. The IRS will likely consider that to be ordinary income but not self-employment income. Why? Supposedly it takes two or more books to establish that you are in the trade or business of writing books.

OBSERVATION: I am curious how the IRS would apply this standard to Harper Lee. She published, you will recall, To Kill a Mockingbird in 1960. It was only this year that she published her second work (Go Set a Watchman) – 55 years later. What do you think: is this self-employment income or not?

Remember when Michael Jackson bought the catalog of Beatles music? He bought it as a non-alternative investment, akin to stocks and bonds. Like a stock or bond, Michael Jackson would have had capital gains had he sold the catalog.

This created a fuss among songwriters. If they sold their own compositions, they would have ordinary and self-employment income. Introduce Michael Jackson and the tax result transmuted to capital gains.

So Congress passed Section 1221(b)(3), which incorporated a provision from the Songwriter’s Capital Gains Equity Act, promoted by the Nashville Songwriters Association International (NASI). It extended capital gains to self-created music owned for more than one year. It requires an election, and the songwriter/creative can elect for one musical composition and not for another. It does require the transfer of a musical composition or a copyright in the same; transfer something less and the result defaults to ordinary income.

NASI argued that the industry had changed. By the 1990s many music artists were acting as their own publishers or co-publishers, meaning they had some control over the exploitation of their songs. Gone were the days of Hank Williams and Bill Monroe, when songwriters sold their songs outright to music publishers with no right to ongoing income.

Congress listened.

Don McLean now has a tax option that he did not have years ago when he recorded “American Pie.” I suppose that there could be a scenario where it would be more advantageous to recognize the $1.2 million as ordinary income rather than as capital gains, but I cannot easily think of any that do not require low-probability tax considerations.

I would say he is making the election.