IRS New Fast Track Settlement Program (Or The Audit From Hell)

We very recently concluded the appeals of a tax audit that had dragged out for years. A CPA friend had begun the audit, and he eventually brought me in as a hired gun to represent on selected issues. He was facing a young examiner who – while bright enough – did not have the accounting background or tax experience to understand the waters he had waded into.

I will give you an example. My friend’s firm did the routine bookkeeping for this client. The routine pretty much consisted of tracking bank accounts and notes payable, with no monthly adjustments to Accounts Receivable or Accounts Payable. Those two accounts put the books on an “accrual basis,” so my friend was essentially maintaining the books on a “cash basis.”

At the end of a period (say year-end), he adjusted the books with the following entries:

            Accounts Receivable                              XXXX

                    Revenues                                                 XXXX

            Some Expense Account                         XXXX

                    Accounts Payable                                    XXXX

When I was a young accountant, I saw this bookkeeping more times than I can count.

The examiner came across one of those interim ledgers without revised Accounts Receivable and Accounts Payable, and he charged the client with maintaining two sets of books.

It was one of the few times I seriously considered running an examiner to ground. And yes, I did discuss the matter with the group manager. A charge like that borders on alleging fraud. The client hated (and hates) the IRS, but at no time was there fraud.

The examiner’s inability to comprehend routine bookkeeping alerted me that the audit was going to be rough. It was. Eventually I took over the audit, and my friend was glad to hand it off. To be fair, he is a general practitioner while I have specialized in tax for years. I guess I am more accustomed to beating my head against a wall.

It was a pain. We had complex tax issues, like methods of accounting and tax credits, and the examiner had already stumbled over prosaic stuff.

We tried to force issues away from the examiner and to the group manager. We appeared to have agreement from the manager, only to see issues reappear like some accounting knock-off of The Living Dead.

So now I am looking at the expanded IRS Fast Track Settlement Program. Fast Track has been around for years, but it has been limited to larger companies. The IRS has now expanded the program to smaller businesses and self-employed taxpayers. The program is an alternative to standard dispute resolution arising from an IRS audit.

There are requirements, of course. The issues must be fully developed, which is a fancy way of saying that both sides have presented their reasoning, with supporting authority and footnotes and all that. The taxpayer, the examiner or the group manager can initiate the request, which will go to IRS Appeals.

NOTE: What makes it “fast track” is the change in administrative procedure. Normally I have to wait for the examiner (that is, Examination) to write-up his/her adjustments and submit it in the form of a 30-day letter. I then appeal the 30-day letter. This program instead hauls one or more issues out of Examination and immediately puts it with Appeals. In effect, Examinations and Appeals are working simultaneously and before any of those 30-day or 90-day letters go out. 

If Appeals accepts the request, its goal is to resolve the matter within 60 days.

            COMMENT: Big improvement over the audit from hell.

To be able to respond so quickly, Appeals will not accept certain cases, such as correspondence audits or where Appeals believes the taxpayer has not worked fairly with the IRS.

If you change your mind, you can withdraw from Fast Track.

And, if Appeals decides against you, you still have the traditional Appeals rights you would have had anyway.

How did the audit from hell turn out? Examination wanted over $310 thousand. We went to Appeals. We just settled the case for around $5 thousand. Not bad, except for the tax fees the client had to pay for an audit that ran off the rails. 

How Early Can You File Your 2013 Tax Return?

How soon can you file your 2013 tax returns?

• If we are talking about your individual income tax return, you have to wait the entire month of January. The IRS will not open its electronic filing system until Friday, January 31.
• If we are talking about a business return (Form 1120, 1120S, 1065), you can file more than two weeks earlier – on Monday, January 13.

IRS Income Statistics For 2011 Are Out

IRS statistics are out.

• The top 1% of all filers paid approximately 35.1% of all federal income taxes. It takes adjusted gross income (AGI) of at least $388,905 to make the top 1%
• The top 5% paid 56.5%, with AGI of $167,728
• The top 10% paid 68.3%, with AGI of $120,136

The bottom 50%? They paid 2.9% of all federal income taxes. 

One should include the obligatory caveat that above statistics refer to federal income taxes and do not include social security taxes. It is questionable whether that adjustment would make any significant difference, though.

The Sysco Merger and the Double Dummy

Recently a financial advisor called me to discuss investments and, more specifically, Sysco’s acquisition of U.S. Foods.  I had to read up on what he was talking about.

The Sysco deal is a reverse triangular merger. It is not hard to understand, although the terms the tax attorneys and CPAs throw around can be intimidating. Let’s use an example with an acquiring company (let’s call it Big) and a target company (let’s call it Small).

·        Big creates a subsidiary (Less Big).

·        Less Big merges into Small.

·        Less Big ceases to exist after the merger.

·        Small survives.

·        Big now owns Small.

Voila!

This merger is addressed in the tax Code under Section 368, and the reverse triangular is technically a Section 368(a)(2)(E) merger. Publicly traded companies use Section 368 mergers extensively to mitigate the tax consequences to the companies and to both shareholder groups.

In an all-stock deal, for example, the shareholders of Small receive stock in Big. Granted, they do not receive cash, but then again they do not have tax to pay. They control the tax consequence by deciding whether or not to receive cash (up to a point).

Sysco used $3 billion of its stock to acquire U.S. Foods. It also used $500 million in cash.

And therein is the problem with the Section 368 mergers.

It has to do with the cash. Accountants and lawyers call it the “basis” issue. Let’s say that Sysco had acquired U.S. Foods solely for stock. Sysco would acquire U.S. Foods' “basis” in its depreciable assets (think equipment), amortizable assets (think patents) and so on. In short, Sysco would take over the tax deductions that U.S. Foods would have had if Sysco had left it alone.

Now add half a billion dollars.

Sysco still has the tax deductions that U.S. Foods would have had.

To phrase it differently, Sysco has no more tax deductions than it would have had had it not spent the $500 million.

Then why spend the money? Well… to close the deal, of course. Someone in the deal wanted to cash-out, and Sysco provided the means for them to do so. Without that means, there may have been no deal.

Still, spending $500 million and getting no tax-bang-for-the-buck bothers many, if not most, tax advisors.

Let’s say you and I were considering a similar deal. We would likely talk about a double dummy transaction.

The double dummy takes place away from Section 368. We instead are travelling to Section 351, normally considered the Code section for incorporations.  

 

Let’s go back to Big and Small. 

·        Big and Small together create a new holding company.

·        The holding company will in turn create two new subsidiaries.

·        Big will merge into one of the subsidiaries.

·        Small will merge into the other subsidiary.

In the end, the holding company will own both Big and Small.

How did Small shareholders get their money? When Big and Small created the new holding company, Small shareholders exchanged their shares for new holding company shares as well as cash. Was the cash taxable to them? You bet, but it would have been taxable under a Section 368 merger anyway. The difference is that – under Section 362 – the holding company increases its basis by any gain recognized by the Small shareholders.

And that is how we solve our basis problem.

The double dummy solves other problems. In a publicly traded environment, for example, a Section 368 merger has to include at least 40% stock in order to meet the continuity-of-interest requirement. That 40% could potentially dilute earnings per share beyond an acceptable level, thereby scuttling the deal. Since a double dummy operates under Section 351 rather than Section 368, the advisor can ignore the 40% requirement.

The double dummy creates a permanent holding company, though. There are tax advisors who simply do not like holding companies.

Sysco included $500 million cash in a Section 368 deal. Assuming a combined federal and state tax rate of 40%, that mix cost Sysco $200 million in taxes. We cannot speak for the financial “synergies” of the deal, but we now know a little more about its tax implications.