Pouring Concrete In Phoenix

I read the tax literature differently than I did early in my career. There is certainly more of “been there, read that,” but there is also more consideration of why the IRS decided to pursue an issue.

I am convinced that sometimes the IRS just walks in face-first, as there is no upside for them. Our recent blog about the college student and her education credit was an example. Other times I can see them backfilling an area of tax law, perhaps signaling future scrutiny. I believe that is what the IRS is doing with IRAs-owning-businesses (ROBS).

A third category is when the IRS goes after an issue even though the field has been tilled for many years. They are signaling that they are still paying attention.

I am looking at a reasonable compensation case.  I believe it is type (3), although it sure looks a lot like type (1).

To set up the issue, a company deducts someone’s compensation – a sizeable bonus, for example. In almost all cases, that someone is going to be an owner of the company or a relation thereto. 

There are two primary reasons the IRS goes after reasonable compensation:

(1)  If the taxpayer is a C corporation (meaning it pays its own tax), the deduction means that the compensation is being taxed only once (deducted by the corporation; taxed once to the recipient). The IRS wants to tax it twice. In a C environment, the IRS will argue that you are paying too much compensation. It wants to move that bonus to dividends paid, as there is no tax deduction for paying dividends.

(2) If the taxpayer is an S corporation (and its one level of tax), the IRS will argue that you are paying too little compensation. There is no income tax here for the IRS to chase. What it is chasing instead is social security tax. And penalties. Some of the worst penalties in the tax Code revolve around payroll.

There is a world of literature on how to determine “reasonable.” The common judicial tests have you run a gauntlet of five factors:

(1) The employee’s role in the company

(2) Comparison to compensation paid others for similar services

(3) Character and condition of the company

(4) Potential conflict of interest

(5) Internal consistency of compensation

Let’s look at the Johnson case as an example.

Mom and dad started a concrete company way back when. They had two sons, each of which came into the business. They specialized in Arizona residential development. As time went on, the brothers wound up owning 49% of the stock; mom owned the remainder. The family was there at the right time to ride the Phoenix housing boom, and the company prospered.

A downside to the boom was periodic concrete shortages. The company did not produce its own concrete, and the brothers came to believe it to be a business necessity. They presented an investment opportunity in a concrete supplier to mom. Mom wanted nothing to do with it; she argued that the company was a contractor, not a supplier. This was how companies overextend and eventually fail, she reasoned.

The brothers went ahead and did it on their own. They invested personally, and mom stayed out. They even guaranteed some of the supplier’s bank debt.

Who would have thought that concrete had so many problems? For example, did you know that concrete becomes unusable after 

(1) 90 minutes or

(2) If it reaches 90 degrees.

I am not sure what to do with that second issue when you are in Phoenix. 

The brothers figured out how to do it. They developed a reputation for specialized work. They worked 10 or 12 hours a day, managed divisions of 100 employees each, were hands-on in the field and often ran job equipment themselves. Sometimes they even designed equipment for a given job, having their fabrication foreman put it together.

Not surprisingly, the developers and contractors loved them.

That concrete supplier decision paid off. They always had concrete when others would not. They could even charge themselves a “friendly” price now and then.

We get to tax years June 30, 2003 and 2004 and they paid themselves a nice bonus. The brothers pulled over $4 million in 2003 and over $7 million in 2004.

COMMENT: I really missed the boat back in college.

The brothers were well-advised. They maintained a cumulative bonus pool utilizing a long-time profit-sharing formula, and they had the company pay annual dividends.

The IRS disallowed a lot of the bonus. You know why: they were a C corporation and the government was smelling money.

The Court went through the five tests:

(1) The brothers ran the show and were instrumental in the business success. Give this one to the taxpayer.

(2) The IRS argued that compensation was above the average for the industry. Taxpayer responded that they were more profitable than the industry average. Each side had a point. Having nothing more to go on, however, the Court considered this one a push.

(3) Company sales and profitability were on a multi-year uptrend. This one went to the taxpayer.

(4) The IRS appears to have wagered all on this test. It brought in an expert who testified that an “independent investor” would not have paid so much compensation and bonus, because the result was to drop the company’s profitability below average.

Oh, oh. This was a good argument.

The idea is that someone – say Warren Buffett – wants to buy the company but not work there. That investor’s return would be limited to dividends and any increase in the stock price. Enough profitability has to be left in the company to make Warren happy.

This usually becomes a statistical fight between opposing experts.

It did here.

And the Court thought that the brothers’ expert did a better job than the government’s expert.

COMMENT: One can tell that the Court liked the brothers. It was not overly concerned that one or two years’ profitability was mildly compromised, especially when the company had been successful for a long time. The Court decided there was enough profitability over enough years that an independent investor would seriously consider the company. 

Give this one to the taxpayer.

(5) The company had a cumulative bonus program going back years and years. The formula did not change.

This one went to the taxpayers.

By my count the IRS won zero of the tests.

Why then did the IRS even pursue this?

They pursued it because for years they have been emphasizing test (4) – conflict of interest and its “independent investor.” They have had significant wins with it, too, although some wins came from taxpayers reaching too far. I have seen taxpayers draining all profit from the company, for example, or changing the bonus formula whimsically. There was one case where the taxpayer took so much money out of the company that he could not even cash the bonus check. That is silly stuff and low-hanging fruit for the IRS.

This time the IRS ran into someone who was on top of their game.

If Your Job Requires It, Can You Deduct It?

I was recently talking with a friend about job opportunities available to him.

Some locations – like New York and L.A. – he dismissed immediately.

Then he mentioned that another location would require him to “suit and tie” every day.

I could not help but laugh. We both worked together in a mandatory “tie” environment, and I have worked in a mandatory “coat and tie” one. I suspect the latter is because the firm was downtown, and the firm wanted to project a certain image as its employees walked about. 

Still, suiting up gets expensive.

Sure would be nice if you could get a tax deduction out of it.

It’s almost impossible.

There is a famous case that laid down three requirements for clothing to be deductible:

(1) The clothing is of a type specifically required as a condition of employment;

(2) It is not adaptable to ordinary day-to-day wear; and

(3)  It is not used for day-to-day wear.

All in all, that seems to cover almost all clothing, unless you wear uniforms or are an astronaut.

But let me give you a few odd situations, and you tell me if there is hope of a tax deduction:

(1) You are a painter and are requested by the union to wear the traditional white-on-white painter’s outfit.

(2) You are a television news anchor and have to dress the part.

(3)  You are a Swedish rock band and wear clothing that looks like it has been dragged and ripped by wild dingoes.

(4) You are a musician and dress like a gypsy (or Welsh witch) for your performances.

There is a fellow who works for Ralph Lauren Corp. The company requires him to wear Ralph Lauren apparel while representing the company. As a consequence he has quite the extensive collection (and investment), and he tried to deduct some of it as a miscellaneous deduction on his Schedule A.

The Tax Court just said no dice. The clothing could be used day-to-day and therefore did not rise to the level of a deduction. The cost and restrictions imposed upon him by his employer were not tax relevant.

In truth, I wonder why he even pursued this matter. There is a case from before I came out of school where an Yves Saint Laurent employee tried the same deduction and failed.

Back to our examples:

(1) No deduction. The clothing could still be worn, although one is unlikely to do so. There may be an argument if the union required you to dress that way. The tax trigger would be more the requirement and less the clothing.

(2) Almost impossible. There is a case involving a news anchor with a wardrobe she considered too conservative for everyday use. She segregated it and wore it only at work. Not only did the Tax Court disallow the deduction, they also assessed penalties.

(3) This was the band ABBA, and they got the deduction. If you google their photographs, it is clear you would not wear that clothing outside of a performance or on Halloween.

(4) This was Stevie Nicks of Fleetwood Mac. She deducted over $40 grand on her 1991 tax return for costumes and hair styling. The IRS disallowed these and selected other deductions on her return. While the matter was docketed for Tax Court, it was returned to IRS Appeals. It was there resolved, and unfortunately tax practitioners (other than Stevie’s tax advisor) do not know how it turned out.

Then for the extreme tax athletes there is the woman who was able to deduct her body makeup, and I freely admit I am not sure what that is. She did not deduct clothing, as she wore none. She was an actress for the Broadway performances of Oh! Calcutta!

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.