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Monday, April 22, 2013

Sequestration And IRS Furloughs



Last Friday the IRS sent an e-mail alerting its employees that furlough notices are looming, beginning today.
           
Everyone is covered by this furlough, and that means everyone from the acting commissioner and executives to managers and employees,” said acting IRS Commissioner Steven Miller.

For your planning purposes, the first furlough days will be May 24, June 14, July 5, July 22 and August 30, with another two days possible in August or September.”

The National Treasury Employees Union President Colleen M. Kelley added her penetrating economic insight with the following:

Furloughing IRS employees is further evidence of the ongoing damage sequestration is causing across the country.”

Sure. It’s virtually post-apocalyptic out there.

You may remember that sequestration cuts kicked-in upon failure to arrive at a federal budget. Sequestration amounts to approximately 2 pennies per federal dollar – hardly an intimidating amount to almost anyone not drawing a government check. On the flip side, so may programs are excluded – social security, Medicare, Obama’s vacations – that the unprotected programs are facing much more than 2% average cuts.

Furlough means that IRS employees will be taking days off without pay. The financial effect will vary from family to family, of course, but it is unwelcome news.

Kudos to the IRS for not proceeding with furloughs during the filing season. It was already a difficult season, with a tax bill signed in January and a corresponding delay in the IRS accepting certain tax schedules and forms.



Saturday, April 20, 2013

Thursday, April 18, 2013

Beer, Pepsi, A Cincinnati Family And The Estate Tax



I am reviewing a tax case involving estate taxes, generation-skipping taxes, a Cincinnati family, and a beer brand only recently brought back to the market. Let’s talk about it.

John F. Koons (Koons) owned shares that his father had bought during the 1930s in Burger Brewing Co., a Cincinnati brewer known for its Burger beer. The Cincinnati Reds broadcaster Waite Hoyt nicknamed a deck at Crosley Field (where the Reds then played) “Burgerville.” 


During the 1960s the company began bottling and distributing Pepsi soft drinks. In the 1970s it left the beer business altogether. The company changed its name to Central Investment Corp (CIC), and Koons was its largest shareholder.

In the late 1990s Koons got into litigation with PepsiCo. By 2004 PepsiCo suggested that the litigation could be resolved if CIC sold its soft drink business and left the Pepsi-Cola system. 

In July, 2004 Koons revised his will to leave the residue of his estate to a Revocable Trust.

In August, 2004 Koons set-up Central Investments LLC (CI LLC) to receive all the non-PepsiCo assets of CIC.   

In December, 2004 Koons and the Koons children executed a stock purchase agreement with PepsiCo. Koons owned 46.9% of the voting stock and 51.5% of the nonvoting stock of CIC.

The deal was sweet. PepsiCo paid $50 million to settle the lawsuit as well as $340 million, plus a working capital adjustment, for the shares of CIC.

There was a kicker in here though: the children’s agreement to sell their CIC shares was contingent on their also being redeemed from CI LLC. It appears that CI LLC was going to be professionally managed, and the children were being given an exit.


In January, 2005 CI LLC distributed approximately $100 million to Koons and the children.

By the end of January two of the four Koons children decided to accept the buyout offer.

In February, 2005 Koons amended the Revocable Trust. He removed the children, leaving only the grandchildren. He then contributed his interest in CI LLC to the Trust.

NOTE: A couple of things happened here. First, the trust is now a generation-skipping trust, as all the beneficiaries in the first generation have been removed. You may recall that there is a separate generation-skipping tax. Second, Koons’ interest in CI LLC went up when the two children agreed to the buyout. Why? Because he still owned the same number of shares, but the total shares outstanding would decrease pursuant to the redemption.      

Koons – who would soon own more than 50% of CI LLC - instructed the trustees to vote in favor of changes to CI LLC’s operating agreement. This prompted child number 2 – James B. Koons – to write a letter to his father. Son complained that the terms of the buyout “felt punitive” but thanked him for the “exit vehicle.” He told his dad that the children would “like to be gone.”

Sure enough, the remaining two children accepted the buyout.

On March 3, 2005 Koons died.

The buyouts were completed by April 30, 2005. The Trust now owned more than 70% of CI LLC.

And the Koons estate had taxes coming up.

CI LLC agreed to loan the Trust $10,750,000 to help pay the taxes. The note carried 9.5% interest, with the first payment deferred until 2024. The loan terms prohibited prepayment.

OBSERVATION: That’s odd.

The estate tax return showed a value over $117 million for the Trust.

The estate tax return also showed a liability for the CI LLC loan (including interest) of over $71 million.

And there you have the tax planning! This is known as a “Graegin” loan.

NOTE: Graegin was a 1988 case where the Court allowed an estate to borrow and pay interest to a corporation in which the decedent had been a significant shareholder.

Did it work for the Koons estate?

The IRS did not like a loan whose payments were delayed almost 20 years. The IRS also argued that administration expenses deductible against the estate are limited to expenses actually and necessarily incurred in the administration.  The key term here is “necessary.”

Expenditures not essential to the proper settlement of the estate, but incurred for the individual benefit of the heirs, legatees, or devisees, may not be taken as deductions.”

The estate argued that it had less than $20 million in cash to pay taxes totaling $26 million. It had to borrow.

You have to admit, the estate had a point.

The IRS fired back: the estate controlled the Trust. The Trust could force CI LLC to distribute cash. CI LLC was sitting on over $300 million.

The estate argued that it did not want to deplete CI LLC’s cash.

The Court wasn’t buying this argument. It pointed out that the estate depleted CI LLC’s cash by borrowing. What was the difference?

Oh, oh. There goes that $71 million deduction on the estate tax return.

It gets worse. The IRS challenged the value of the Trust on the estate tax return.  The Trust owned over 70% of CI LLC, so the real issue was how to value CI LLC.

The estate’s expert pointed out that the Trust owned 46.9% of CI LLC at the time of death. There would be no control premium, although there would be a marketability discount. The expert determined that CI LLC’s value for tax purposes should be discounted almost 32%.

The IRS expert came in at 7.5%. He pointed out that – at the time of death – it was reasonably possible that the redemptions of the four children would occur. This put the Trust’s ownership over 50%, the normal threshold for control.

Here is the Court:

The redemption offers were binding contracts by the time Koons died on March 3, 2005. CI LLC had made written offers to each of the children to redeem their interests in CI LLC by February 27, 2005. Once signed, the offer letters required the children to sell their interests ....

Any increase in the value of CI LLC would increase the generation-skipping tax to the Trust. 

Any increase in the value of the Trust would increase the estate tax to the estate.

The tax damage when all was said and done? Almost $59 million.

Given the dollars involved, the estate has almost no choice but to appeal. It does have difficult facts, however. From a tax planner’s perspective, it would have been preferable to keep the Trust from owning more than 50% of CI LLC. Too late for that however.


Thursday, April 4, 2013

Does A Flight Attendant In Hong Kong Have Foreign Income?



I am going to put you on the spot. I will give you some facts and present a tax issue for you.

Yen-Ling is a U.S. citizen. She is an expat living in Hong Kong. She works international flights for an airline, and her flights include
  • Hong Kong to/from San Francisco
  • Hong Kong to/from Chicago
  • Hong Kong to/from Ho Chi Minh City
  • San Francisco to/from Nagoya
 What tax issues do you see?
·        Hong Kong is a red herring. As a U.S. citizen, she has to pay income taxes on her worldwide income.
·       She however does get some tax relief from the double taxation this would otherwise entail. She gets to offset her Hong Kong taxes against her otherwise payable U.S. income taxes. This is the “foreign tax credit.”
 You are doing well. Anything else?
·        I recall a “foreign income” exclusion in the tax code. I am a bit fuzzy on it, though.
Good catch. A U.S. citizen who both lives and works overseas can exclude a certain amount of his/her salary from U.S. tax. This amount is not chump-change. For 2013, for example, the maximum foreign income exclusion is $97,600.

Is all of her income foreign? She does live in Hong Kong.
·       Wait, she comes into and out of the U.S. on a regular basis. Some of her income has to be U.S. source.
You are right. How to do you propose to allocate it?
·        Hopefully the airline sent her something – maybe a breakdown of her flight and service hours.
Let’s say they do and it looks something like this:
  • Hours in U.S.
  • Hours in Vietnam
  • Hours in Japan
  • Hours in Hong Kong
  • Hours in international air space
 Her total hours are 1,960 hours. How do you propose to calculate this?
 ·        I propose to divide her hours in the U.S. into 1,960 total hours.
Seems reasonable. But ...

... you would be wrong. Not surprisingly, there has been litigation on this.

The Code defines "foreign earned income” as “the amount received by such individual from sources within a foreign country.”
·        So? She did not earn it within the U.S., so how can it be anything other than “foreign?”
Take a look at the wording in the following Regulation:
  • The term ‘foreign country’ when used in a geographical sense includes any territory under the sovereignty of a government other than that of the United States.”
Did you pick up on the tax hook?
 ·        You mean the word “sovereignty?”
That’s it. Under whose sovereignty is international airspace?
·        No one’s. That is why it is international.

Is her time in international airspace considered time in a “foreign country?”
·        That is ridiculous. According to this reasoning, an American on the moon would have all his/her income considered U.S. source.
You are right that this is ridiculous, but an American living (and working) on the moon would have U.S. source income. He/she would not have a foreign income exclusion, as he/she would not have foreign income.
·        Who dreamed this up?
To some extent, it is an unfortunate by-product of the U.S. worldwide tax system. It borders on the intellectually incoherent, which is why virtually all other advanced nations eschew it in favor of a territorial tax system.
·        How did it turn out for the flight attendant?
She got hosed. You can read about it at Rogers v Commissioner.
·        I could but I won’t.