The Abbott Laboratories 401(k)

Something caught my eye recently about student loans. A 401(k) is involved, so there is a tax angle.

Abbott Laboratories is using their “Freedom 2 Save” program to:

… enable full-time and part-time employees who qualify for the company's 401(k) – and who are also contributing 2 percent of their eligible pay toward student loans – to receive an amount equivalent to the company's traditional 5 percent "match" deposited into their 401(k) plans. Program recipients will receive the match without requiring any 401(k) contribution of their own.”

Abbott will put money into an employee’s 401(k), even if the employee is not himself/herself contributing.

As I understand it, the easiest way to substantiate that one’s student loan is 2% or more of one’s eligible pay is to allow Abbott to withhold and remit the monthly loan amount. For that modest disclosure of personal information, one receives a 5% employer “match” contribution.

I get it. It can be difficult to simultaneously service one’s student loan and save for retirement.

Let’s take this moment to discuss the three main ways to fund a 401(k) account.

(1)  What you contribute. Let’s say that you set aside 6% of your pay.

(2)  What your employer is committed to contributing. In this example, say that the company matches the first 4% and then ½ of the next 2%. This is called the “match,” and in this example it would be 5%.

(3)  A discretionary company contribution. Perhaps your employer had an excellent year and wants to throw a few extra dollars into the kitty. Do not be skeptical: I have seen it happen. Not with my own 401(k), mind you (I am a career CPA, and CPA firms are notorious), but by a client. 

Abbott is not the first, by the way. Prudential Retirement did something similar in 2016.

The reason we are talking about this is that the IRS recently blessed one of these plans in a Private Letter Ruling. A PLR is an IRS opinion requested by, and issued to, a specific taxpayer. One generally has to write a check (the amount varies depending upon the issue), but in return one receives some assurance from the IRS on how a transaction is going to work-out taxwise. Depending upon, a PLR is virtually required tax procedure. Consider certain corporate mergers or reorganizations. There may be billions of dollars and millions of shareholders involved. One gets a PLR – period – as the downside might be career-ending.

Tax and retirement pros were (and are) concerned how plans like Abbott’s will pass the “contingent benefits” prohibition. Under this rule, a company cannot make other employee benefits – say health insurance – contingent on an employee making elective deferrals into the company’s 401(k) plan.

The IRS decided that the prohibition did not apply as the employees were not contributing to the 401(k) plan. The employer was. The employees were just paying their student loans.

By the way, Abbott Laboratories has subsequently confirmed that it was they who requested and received the PLR.

Technically, a PLR is issued to a specific taxpayer and this one is good only for Abbott Laboratories. Not surprisingly there are already calls to codify this tax result. Once in the Code or Regulations, the result would be standardized and a conservative employer would not feel compelled to obtain its own PLR.

I doubt you and I will see this in our 401(k)s.  This strikes me as a “big company” thing, and a big company with a lot of younger employees to boot.

Great recruitment feature, though.

Oh Henry!

It is a classic tax case.

Let’s travel back to the 1950s.

Let us introduce Robert Lee Henry, both an attorney and a CPA.  He was a tax expert, but he did not restrict his practice solely to tax.

He was also an accomplished competitive horse rider. After he returned from military service, the Army discontinued its horse show team. In response, he organized the United States horse show civilian team.

He met the wealthy and influential, benefiting his practice considerably.

Then he had to give up riding. Heart issues, I believe.

But he was quite interested in continuing to meet the to-do’s and well-connected.

He bought a boat.

He traded it in for a bigger boat.

He bought a flag for the boat. It was red, white and blue and had the numbers “1040.”

People would ask. He would present his background as a tax expert. He was meeting and greeting.

His doctor told him to relax and take time off. Robert Lee called his son, and together they took the boat from New York to Florida. They then decided to spend the winter, as they were already there.

Robert Lee deducted 100% of the boat expenses.

QUESTION: Can Robert Lee deduct the expenses?

NERDY DETAIL: The tax law changed after this case was decided, so the decision today would be easier than it was back in the 1950s. Still, could he deduct the boat expenses in the 1950s?

The key issue was whether the boat expenses were “ordinary and necessary.” That standard is fundamental to tax law and has been around since the beginning. Just because a business activity pays for something does not mean that it is deductible. It has to strain through the “ordinary and necessary” colander.

In truth, this is not a difficult standard in most cases. It can however catch one in an oddball or perhaps (overly) aggressive situation.

Robert Lee was an accomplished rider, and he had developed a book of business because of his equestrian accomplishments. He monetized his equestrian contacts. He now saw an opportunity to meet the same crowd of folk by means of a boat.

Problem: Robert Lee did not use the boat to entertain or transport existing clients or prospective contacts.

And there is the hook. Had he used the boat to entertain, he could more easily show an immediate and proximate relationship between the boat, its expenses and his legal and accounting practice.

He instead had to argue that the boat was a promotional scheme, akin to advertising. It was not as concrete as saying that he schmoozed rich people in the Atlantic on his boat.

He had to run the “ordinary and necessary” gauntlet.

Let’s start.

He continued to have a sizeable equestrian clientele after he left competitive riding.

Good.

He was however unable to provide the Court a single example of a client who came to him because of the boat, at least until years later. Even then, there still wasn’t much in the way of fees.

Bad.

So what, argued Robert Lee. How is this different from buying a full-page ad in an upscale magazine?

Quite a bit, said the Court. You gave up riding for health reasons. There is no question that you derived tremendous personal enjoyment from riding. You have now substituted boating for riding. Enjoyment does not mean that there is no business deduction, but it does mean that the Court may look with a more skeptical eye. It would have been an easier decision for us if you had bought a full-page ad. There is no personal joy in advertising.

As a professional, I have to develop and cultivate many contacts – business, social, personal, political – retorted Robert Lee. One never knows who one will meet, and it takes money to meet money. That is my business reason.

Could not agree with you more, replied the Court. Problem is, that does not make every expenditure deductible. What you are doing is not ordinary. Let’s be frank, Robert Lee, the average attorney/CPA does not keep a yacht.

They would if they could, muttered Robert Lee.

Even if we agreed the expenses were “ordinary,” continued the Court, we have to address whether they are “necessary.” This test is heightened when expenses may have been incurred primarily for personal reasons. You did sail from New York to Florida, by the way. With your son. And you deducted 100% of it.

I am meeting rich people, countered Robert Lee.

Perhaps, answered the Court, but there must be a proximate relationship between the expense and the activity. What you are talking about is remote and incidental. It is difficult to clear the “necessary” hurdle with your “someday I’ll” argument.

Robert Lee shot back: my point should be self-evident to any professional person.

COMMENT: Folks, do not say this when you are trying to persuade a Court.

The Court decided that Robert Lee could not prove either “ordinary” or “necessary.”

The conclusion that the expenditures here involved were primarily related to petitioner’s pleasure and only incidentally related to his business seems inescapable.”

The Court denied his boat deductions.

Our case this time for the home-gamers and riders was Henry v Commissioner.

Issuing 1099s As Retaliation

I continue to be surprised when people use IRS forms as retaliation.

The form of choice tends to be a 1099. The intent – of course – is to provoke an IRS audit.

There was an incessant legal battle several years back at a Cincinnati CPA firm that detonated. I happen to know the parties involved, and I was interested in the use of 1099s as weapons of war. The senior partner in the imbroglio however was not amused with my interest, seemed surprised that so much of the combat was available to one who could search legal records, and told me where to take a long walk. Quite the charmer.

I am reading a case involving doctors in Illinois. There was an anesthesiologist (Nicholas Angelopoulos - “Nick”) who went into business with an orthopedist (Hall).  Hall owned a company (Keystone) which employed Nick and two other doctors.

There was a cost-sharing arrangement among the doctors, which is common enough but which seemed to change without much explanation.

There was question whether Nick and the other two doctors were ever owners of Keystone (an S corporation). There were e-mails, draft shareholder agreements and meeting agendas, and the doctors were charged for equipment purchased by the practice.  Dr Hall, however, maintained that he was the only shareholder.

OK.

There was an LLC called WACHN, comprised of our four doctors plus another and which purchased medical condominiums. Each of the doctors kicked-in $110,000 and the LLC borrowed the rest, although the doctors had to personally guarantee the debt. Nick said that he never signed the operating agreement and that his signature was forged by use of a signature stamp.

Odd.

Each of the four doctors was required to contribute $100,000 towards a “cash reserve” in Keystone’s bank account. Hall argued that it was necessary to avoid paying checking fees, and that – eventually – there would be more money to distribute to everyone. Nick thought that he was paying for his ownership in Keystone.

COMMENT: Folks, if your bank requires hundreds of thousands of dollars to avoid fees, you really need to consider another bank.

There were questions about how the numbers were calculated and allocated among the doctors in Keystone, but Hall assured the doctors that the practice manager (Hall’s brother in law, by the way) had assured him everything was in order.

I feel better.

In 2007 two of the doctors left.

Later in 2007, Nick told Hall that he too was leaving.

In March, 2008 Hall gave Nick a hand-written sheet stating that Nick owed $151,769. Hall, being a good sport, said that he would offset the $110,000 that Nick had put into WACHN, but Nick had to transfer his interest to Hall. Hall would then – back to that good sport thing – “forgive” the remaining $40,769. Hall did not address removing Nick as a guarantor for WACHN’s debt, though.

Nick told Hall where to go.

Keystone issued Nick a 1099 for $159,577.

Hall said that Nick still owed $100,000 toward the Keystone cash reserves and $28,000 towards the WACHN buy-in. There was also a $38,010 bonus that Hall was paying Nick on the way out, being a good sport and all. Nick responded that he had paid everything he was supposed to pay, and – by the way – what bonus?

Sure enough, in 2011 the IRS swooped in on Nick.

Mission accomplished.

Turns out the $38,010 bonus was right. That however left a bogus $121,567 on the 1099.

Let’s fast forward through the rest.

Nick sued Hall and Keystone. There were several lawsuits, but we are concerned here with the tax-related lawsuit.

The Court decided that Keystone and Hall filed a fraudulent 1099 because of “spite arising out of the larger disputes between the parties.” Code Section 7434 allows for damages in this circumstance, and the Court gets to decide.

The Court awarded Nick damages of $178,954.

Our case this time was Angelopoulos v Keystone Orthopedic Specialists.

Yet Another Preparer Penalty Starting In 2018

We have spoken before of social-worker duties the tax Code expects of a professional preparing a return with an earned income credit, a refundable child credit or the American Opportunity (that is, the college) credit.

Take the earned income credit, for example. If you have two children, that credit can be $5,616; have three and the credit can reach $6,318. Remember that the credit is refundable – meaning the IRS will write you a check – and no wonder this provision is rife with fraud.  

If the IRS wanted to push-back on the fraud, it could require a preparer to review documentation that a child (or several) actually lives with the parent/taxpayer.

To be certain to get the preparer’s attention, the IRS could also impose a penalty if the preparer failed to do so.

Let’s have the IRS tighten this up a notch by also requiring a form or schedule with the return requiring the preparer to declare that he/she did all of this Sherlocking.

Which is why I will not prepare a return with these credits unless I have known (or, alternatively, my partner has known) the client for a while.

This rule is expanding in 2018 to include head of household filing status.

Oh boy.

Let’s go through a Tax Court case I was reviewing recently.

(1)  Joe and Cerice lived together and had a child in 2006.

(2)  The relationship went south either late 2014 or early 2015.

(3)  Cerise moved in with her mother.

(4)  Joe and Cerise started sharing custody, although Joe’s parents also took care of the child while he was working.

(5)  There was a custody proceeding in 2015, and the Court order gave each parent equal time. For some reason, the Court came back in 2016 and reduced Joe’s share of parental time.

(6)  The Court stated that Cerise could claim the child in 2015 and all odd-numbered years. Joe could claim the child in even-numbered years.

QUESTION: Who claims the child in 2014?

The technical detail here is that head-of-household status requires the child to spend more than one-half of the year with the claiming parent.

Let’s say that I have never met Joe or Cerise. I meet with either one, who asks me to prepare the 2014 return. Whoever I meet with wants to claim the child, of course, as it will power head of household status, an earned income credit and a child credit. I suspect either Joe or Cerise could present a formidable argument that the child was with him/her for more than one-half of the year.

What am I supposed to do?

I would of course look at the custody agreement, but that doesn’t start until the following year. No help there.

I could get assurance from the other parent that he/she is not claiming the child.

Let’s say that fails.

I could get a letter from the pediatrician, I suppose.

Or the school, if the child were old enough.

Or maybe the landlord where either Joe or Cerise lives.

Here I am social-working this situation. If I don’t, the IRS can penalize me $510. For each instance. Miss both the head of household and refundable child care credit and the penalty is $1,020.

Which might be more than I am charging to prepare the return.

How keen would you be to accept Joe or Cerise as a client?

That is my point.

The New Qualified Business Deduction

I spent a fair amount last week looking over the new IRS Regulations on the qualified business deduction. It was a breezy and compact 184 pages, although it reads longer than that.

I debated blogging on this topic. While one of the most significant tax changes in decades, the deduction is difficult to discuss without tear-invoking side riffs. 

But – if you are in business and you are not a “C” corporation (that is, the type that pays its own taxes) - you need to know about this new deduction.

Let’s swing the bat:

1.    This is a business deduction. It is 20% of something. We will get back to what that something is.

2.    There historically has been a spread between C-corporation tax rates and non-C-corporation tax rates. It is baked into the system, and tax advisors have gotten comfortable understanding its implications. The new tax law rattled the cage by reducing the C-corporation tax rate to 21%. Without some relief for non-C-corporation entities, lawyers and accountants would have had their clients folding their S corporation, partnership and LLC tents and moving them to C-corporation campgrounds.

3.    It is sometimes called a “passthrough” deduction, but that is a misnomer. It is more like a non-C-corporation deduction. A sole proprietorship can qualify, as well as rentals, farms and traditional passthroughs like S corporations, LLCs and partnerships. Heck even estates and trusts are in on the act.

4.    But not all businesses will qualify. There are two types of businesses that will not qualify:

a.     Believe it or not, in the tax world your W-2 job is considered a trade or business. It is the reason that you are allowed to deduct your business mileage (at least, before 2018 you were). Your W-2 however will not qualify for purposes of this deduction.

b.    Certain types of businesses are not invited to the party: think doctors, dentists, lawyers, accountants and similar. Think of them as the “not too cool” crowd.

                                                   i.There is however a HUGE exception.

5.   Congress wanted you to have skin in the game in order to get this 20% deduction. Skin initially meant employees, so to claim this deduction you needed Payroll. At the last moment Congress also allowed somebody with substantial Depreciable Property to qualify, as some businesses are simply not set-up with a substantial workforce in mind. If you do not have Payroll or Depreciable Property, however, you do not get to play.

a.     But just like (4)(b) above, there is a HUGE exception.

6.   Let’s set up the HUGE exception:

a.     If you do not have Payroll or Depreciable Property, you do not get to play.

b.    If you are one of “those businesses” - doctors, dentists, lawyers, accountants and similar - you do not get to play.

c.     Except …

                                                   i. … if your income is below certain limits, you still get to play.

                                                 ii. The limit is $157,500 for non-marrieds and $315,000 for marrieds.

                                              iii. Hit the limit and you provoke math:

1.    If you are non-married, there is a phase-out range of $50 grand. Get to $207,500 and you are asked to leave.

2.    If you are married, double the range to $100 grand; at $415,000 you too have to leave.

                                               iv. Let’s consider an easy example: A married dentist with household taxable income of less than $315,000 can claim the passthrough deduction, as long as the income is not from a W-2.

1.    At $415,000 that dentist cannot claim anything and has to leave.

                                                 v. Depending on the fact pattern, the mathematics are like time-travelling to a Led Zeppelin concert. The environment is familiar, but everything has a disorienting fog about it.

1.    Why?

a.     The not-too-cool crowd has to leave the party once they get to $207,500/$415,000.

b.    Simultaneously, the too-cool crowd has to ante-up either Payroll and/or Depreciable Property as they get to $207,500/$415,000. There is no more automatic invitation just because their income is below a certain level.

c.     And both (a) and (b) are going on at the same time.

                                                                                                               i.     While not Stairway to Heaven, the mathematics are … interesting.

7.    The $207,500/$415,000 entertainment finally shows up: Payroll and Depreciable Property. Queue the music.

a.     The deduction starts at 20% of the specific trade or business’s net profit.

b.    It can go down. Here is how:

                                                   i. You calculate half of your Payroll.

                                                 ii. You calculate one-quarter of your Payroll and add 2.5% of your Depreciable Assets.

                                              iii. You take the bigger number.

                                               iv. You are not done. You next take that number and compare it to the 20% number from (a).

                                                 v. Take the smaller number.

c.     You are not done yet.

                                                   i. Take your taxable income without the passthrough deduction, whatever that deduction may someday be. May we live long enough.

                                                 ii. If you have capital gains included in your taxable income, there is math. In short, take out the capital gain. Bad capital gain.

                                              iii. Take what’s left and multiply by 20%.

                                               iv. Compare that number to (7)(b)(v).

1.    Take the smaller number.

8.    Initially one was to do this calculation business by business.

a.     Tax advisors were not looking forward to this.

b.    The IRS last week issued Regulations allowing one to combine trades or businesses (within limits, of course).

                                                   i. And tax advisors breathed a collective sigh of relief.

c.     But not unsurprisingly, the IRS simultaneously took away some early planning ideas that tax advisors had come up with.

                                                   i. Like “cracking” a business between the too-cool and not-too-cool crowds.  

And there is a high-altitude look at the new qualified business deduction.

If you have a non-C-corporation business, hopefully you have heard from your tax advisor. If you have not, please call him/her. This new deduction really is a big deal.

Making A Comeback: Section 1202 Stock

We are going tax-geek for this post.

Let’s blame Daryl, a financial advisor with Wells Fargo. He has been studying and asking about a particular Code section.

Code Section 1202.

This section has been a dud since 1993, but last year’s changes to the tax Code have resurrected it. I suspect we will be reading more about Section 1202 in the future.

What sets up the tension is the ongoing debate whether it is better to do business as a “C” corporation (which pays its own tax) or an “S” corporation (whose income drops onto its owners’ individual returns, who pay tax on the business as well as their other personal income).

There are two compelling factors driving the debate:

(1) The difference between corporate and individual tax rates.

For most of my career, top-end individual tax rates have exceeded top-end corporate tax rates. Assuming one is pushing the pedal to the floor, this would be an argument to be a C corporation.

(2)  Prior to 1986, there was a way to liquidate (think “sell”) a C corporation and pay tax only once. The 1986 tax act did away with this option (except for highly specialized – and usually reorganization-type – transactions). Since 1986 a C corporation has to pay tax when it liquidates (because it sold or is considered to have sold its assets). Its assets then transfer to its shareholders, who again pay tax (because they are considered to have sold their stock).

Factor (2) has pretty much persuaded most non-Fortune-500 tax advisors to recommend S corporations, to the extent that most of the C corporations many tax practitioners have worked with since 1986 have been legacy C’s. LLC’s have also been competing keenly with S corporations, and advisors now debate which is preferable. I prefer the settled tax law of S corporations, whereas other advisors emphasize the flexibility that LLCs bring to the picture.

Section 1202 applies to C corporations, and it gives you a tax break when you sell the stock. There are hoops, of course:

(1)   It must be a domestic (that is, a U.S.) C corporation.

(2)   You must acquire the stock when initially issued.

a.     Meaning that you did not buy the stock from someone else.

b.    It does not mean only the first issuance of stock. It can be the second or third issuance, as long as one meets the $ threshold (discussed below) and you are the first owner.

(3)   Corporate assets did not exceed $50 million when the stock was issued.

a.     Section 1202 is more of a west-Coast than Midwest phenomenon. That $50 million makes sense when you consider Silicon Valley.

b.    If you get cute and use a series of related companies, none exceeding $50 million, the tax Code will combine you into one big company with assets over $50 million.

c.     By the way, the $50 million is tested when the stock is issued, not when you sell the stock. Sell to Google for a zillion dollars and you can still qualify for Section 1202.

(4)   You have owned the stock for at least five years.

(5)   Not every type of business will qualify.

a.     Generally speaking, professional service companies – think law, health, accounting and so on – will not qualify. There are other lines of businesses – like restaurants and motels - that are also disqualified.

(6)   Upon a qualifying sale, a shareholder can exclude the larger of (a) $10 million or (b) 10 times the shareholder’s adjusted basis in the stock.

Folks, a minimum $10 million exclusion? That is pretty sweet.

I mentioned earlier that Section 1202 has – for most of its existence – been a dud. How can $10 million be a dud?

Because it hasn’t always been $10 million. For a long time, the exclusion was 50% of the gain, and one was to use a 28% capital gains rate on the other 50%. Well, 50% of 28% is 14%. Consider that the long-term capital gains rate was 15%, and tax advisors were not exactly doing handstands over a 1% tax savings.

In 2010 the exclusion changed to 100%. Advisors became more interested.

But it takes five years to prime this pump, meaning that it was 2015 (and more likely 2016 or 2017) by the time one got to five years.

What did the 2017 tax bill do to resurrect Section 1202?

It lowered the “C” corporation tax rate to 21%.

Granted, it also added a “passthrough” deduction so that S corporations, LLCs and other non-C-corporation businesses remained competitive with C corporations. Not all passthrough businesses will qualify, however, and – in an instance of dark humor – the new law refers to (5)(a) above to identify those businesses not qualifying for the passthrough deduction.

COMMENT: And there is a second way that Section 1202 has become relevant. A tax advisor now has to consider Section 1202 – not only for the $10-million exclusion – but also in determining whether a non-C business will qualify for the new 20% passthrough deduction. Problem is, there is next to no guidance on Section 1202 because advisors for years DID NOT CARE about this provision. We were not going to plan a multiyear transaction for a mere 1% tax savings.

Nonetheless 21% is a pretty sweet rate, especially if one can avoid that second tax. Enter Section 1202.

If the deal is sweet enough I suppose the $10 million or 10-times-adjusted-basis might not cover it all.

Good problem to have.