On April 11, 2017, we discussed what constitutes Tax Reform. On April 24, 2017, we explored the process by which Tax Reform will likely be created by lawmakers. In our May 3, 2017 blog post, we focused on the likely timing for Tax Reform. In this blog post, we look at what Tax reform may look like.
Like one of my favorite things in this world, namely ice cream, Tax Reform also likely comes in different flavors. For starters, we have President Trump’s campaign comments on Tax Reform. Next, we have the Republican leaders’ from the U.S. House of Representatives initial draft of a Tax Reform package. Lastly, we have the White House’s April 26, 2017 one-page memorandum that broadly outlines the President’s current vision of Tax Reform.
Let’s break Tax Reform into three broad categories, namely:
- Estate & Gift Tax
- Individual Income Tax
- Corporate Income Tax
On April 11, 2017, we discussed what constitutes Tax Reform. On April 24, 2017, we explored the process by which Tax Reform will likely be created by lawmakers. In this blog post, we focus our attention on the likely timing for Tax Reform.
When will we see Tax Reform? At this point in time, it is anyone’s guess. There are lots of external factors that impact the timing and possibility that Tax Reform in any shape or form will become a reality.
New Administration Doubles Down on Tax Reform Efforts
President Trump made it clear, both during his campaign and shortly after he entered the White House, that Tax Reform is a top priority. In fact, in an address to both branches of Congress on February 28, 2017, he stated that his administration “is developing historic [Tax Reform] that will reduce the tax rate on our companies so they can compete and thrive anywhere and with anyone …. it will be a big, big cut.” In addition, he indicated that his administration will provide “massive” tax relief for the middle class.
On April 11, 2017, we discussed what constitutes Tax Reform. In this blog post, we will explore the process by which Tax Reform will likely be created. After reading this post, if it seems to you that the legislative process for making tax laws is an awful lot like “making sausage,” you are perceptively correct.
The legislative process starts with the selection of special ingredients by lawmakers, who generally keep a keen eye on the intended result. The ingredients are mixed together carefully during the legislative process. Spices and other ingredients are added from various sources (e.g., input from legislative staff, the Treasury and industry). The product that results from the process is not always what was exactly intended at the start. Consequently, it may be tweaked somewhat before it is finally packaged and presented to the public.
This is the first of a series of posts on Tax Reform. In this series, I will be covering: what Tax Reform means, the legislative process for enacting it, the likely timing of its arrival, the estate & gift tax and income tax proposals already presented by the Trump administration and the U.S. House of Representatives, and possible planning strategies that businesses and individuals may wish to consider.
What Tax Reform Is
As a starter, what exactly is “Tax Reform”? Is it something you will know if you see it? Are there objective standards as to what constitutes “Tax Reform”?
The late Senator Russell B. Long, a Democrat from Louisiana, served more than four decades in the U.S. Senate. He was Chairman of the U.S. Finance Committee from 1966 to 1981, and was very influential in shaping our tax laws during the ’60s, ’70s and ’80s. In fact, he was one of the major contributors to the Tax Reform Act of 1986.
As a footnote, the ’86 Act, enacted over thirty years ago, was the last major tax reform legislation passed by our lawmakers. So, it has been a long time since we have seen Tax Reform.
The proposed $3 billion per year tax-raising bill, Oregon Measure 97, was defeated yesterday by a 59% to 41% margin. The fight was long and bloody. Media reports that opponents and proponents together spent more than $42 million in their campaigns surrounding the tax bill.
So, What Now?
The defeat of Measure 97 eliminates the proposed 2.5% gross receipts alternative corporate tax applicable to C Corporations with annual Oregon gross receipts over $25 million. Oregon C Corporations, however, are still faced with a minimum tax based on Oregon gross receipts. The minimum tax applicable to Oregon’s C Corporations is based on gross revenues as follows:
C Corporations with Oregon annual revenues greater than $25 million may face a new minimum tax obligation – 2.5 percent of the excess – if Measure 97 passes. If a business falls within this category, there may be ways to mitigate its impact. The time to start planning, however, is now.
Oregon taxes corporations under an excise tax regime. The Oregon corporate excise tax regime was adopted in 1929. The original legislation included what is commonly called a “minimum tax” provision. In accordance with this provision, corporations subject to the Oregon excise tax are required to pay the greater of the tax computed under the regular corporate excise tax provision or the tax computed under the “minimum tax” provision. Accordingly, the “minimum tax” is an “alternative” tax; it is not an “additional” tax as many commentators have recently asserted.
Originally, the Oregon corporate “minimum tax” was a fixed amount – $25. As a result of the lobbying efforts of Oregon businesses, the “minimum tax” was eventually reduced to $10, where it remained for almost 80 years.
In 2010, Oregon voters dramatically changed the corporate “minimum tax” landscape with the passage of Measure 67. The corporate “minimum tax” (beginning with the 2009 tax year), is no longer a fixed amount. Rather, it is now based on Oregon sales (gross revenues). The “minimum tax” is now:
|Oregon Sales||Minimum Tax|
|$500,000 to $1 million||$500|
|$1 million to $2 million||$1,000|
|$2 million to $3 million||$1,500|
|$3 million to $5 million||$2,000|
|$5 million to $7 million||$4,000|
|$7 million to $10 million||$7,500|
|$10 million to $25 million||$15,000|
|$25 million to $50 million||$30,000|
|$50 million to $75 million||$50,000|
|$75 million to $100 million||$75,000|
|$100 million or more||$100,000|
S corporations are exempt from the alternative graduated tax system. Instead, they are still subject to a fixed amount “minimum tax,” which is currently $150.
As an example, under the current corporate “minimum tax” provision, a corporation with Oregon gross sales of $150 million, but which, after allowable deductions, has a net operating loss of $25,000, would be subject to a minimum tax of $100,000. Many corporations operating in Oregon, which traditionally have small profit margins (i.e., high gross sales, but low net income), found themselves (after Measure 67 was passed) with large tax bills and little or no money to pay the taxes. Three possible solutions for these businesses exist:
- Make an S corporation election (if eligible);
- Change the entity to a LLC taxed as a partnership (if the tax cost of conversion is palatable); or
- Move all business operations and sales outside of Oregon to a more tax-friendly jurisdiction.
Several corporations in this predicament have adopted one of these solutions.
Initiative Petition 28/ Measure 97
Measure 97 will be presented to Oregon voters this November. If it receives voter approval, it will amend the “minimum tax” in two major ways:
- The “minimum tax” will remain the same for corporations with Oregon sales of $25 million or less. For corporations with Oregon sales above $25 million, however, the “minimum tax” (rather than being fixed) will be $30,001, PLUS 2.5 percent of the excess over $25 million.
- The petition specifically provides that “legally formed and registered benefit companies” as defined in ORS 60.750 will not be subject to the higher “minimum tax.” Rather, they will continue to be subject to the pre-Measure 97 “minimum tax” regime (as discussed above). Caveat: The exception, as drafted, appears to only apply to Oregon benefit companies; it does not extend to foreign benefit companies authorized to do business in Oregon.
Measure 97 expressly provides that all increased tax revenues attributable to the new law will be used to fund education, healthcare and senior citizen programs. As a result, many commentators believe the initiative has great voter appeal and will likely be approved by voters. If Measure 97 is passed, it is slated to raise over $6 billion in additional tax revenue per biennium.
On November 2, 2015, the Bipartisan Budget Act (“Act”) was signed into law by President Barack Obama. One of the many provisions of the Act significantly impacts: (i) the manner in which entities taxed as partnerships will be audited by the Internal Revenue Service (“IRS”); and (ii) who is required to pay the tax resulting from any corresponding audit adjustments. These new rules generally are effective for tax years beginning after December 31, 2017. As discussed below, because of the nature of these rules, partnerships need to consider taking action now in anticipation of the new rules.
The Current Landscape
Entities taxed as partnerships generally do not pay income tax. Rather, they compute and report their taxable income and losses on IRS Form 1065. The partnership provides each of its partners with a Schedule K-1, which allows the partners to report to the IRS their share of the partnership’s income or loss on their own tax returns and pay the corresponding tax. Upon audit, pursuant to uniform audit procedures enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), examinations of partnerships are conducted generally under one of the following scenarios:
- For partnerships with ten (10) or fewer eligible partners, examinations are conducted by a separate audit of the partnership and then an audit of each of the partners;
- For partnerships with greater than ten (10) partners and/or partnerships with ineligible partners, examinations are conducted under uniform TEFRA audit procedures, whereby the examination, conducted at the partnership level, is binding on the taxpayers who were partners of the partnership during the year under examination; and
- For partnerships with 100 or more partners, at the election of the partnership, examinations may be conducted under uniform “Electing Large Partnership” audit procedures, whereby the examination, conducted at the partnership level, is binding on the partners of the partnership existing at the conclusion of the audit.
Lawmakers believed a change in TEFRA audit framework was necessary for the efficient administration of Subchapter K of the Code. If a C corporation is audited, the IRS can assess an additional tax owing against a single taxpayer—the very taxpayer under examination—the C corporation. In the partnership space, however, despite the possible application of the uniform audit procedures, the IRS is required to examine the partnership and then assess and collect tax from multiple taxpayers (i.e., the partners of the partnership). In fact, the Government Accountability Office (the “GAO”) reported in 2014 that, for tax year 2012, less than one percent (1%) of partnerships with more than $100 million in assets were audited. Whereas, for the same tax year, more than twenty-seven percent (27%) of similarly-sized corporations were audited. The GAO concluded the vast disparity is directly related to the increased administrative burden placed on the IRS under the existing partnership examination rules.
In general, the Oregon income tax laws are based on the federal income tax laws. In other words, Oregon is generally tied to the Internal Revenue Code for purposes of income taxation. As a consequence, we generally look to the federal definition of taxable income as a precursor for purposes of determining Oregon taxable income.
What does this mean to taxpayers in the trade or business of selling recreational or medical marijuana in Oregon?
Currently, it appears these taxpayers are stuck with the federal tax laws. Consequently, unless the Oregon legislature statutorily disconnects from IRC § 280E, for Oregon income tax purposes, all deductions relating to the trade or business of selling medical or recreational marijuana will be disallowed.
I suspect the result of IRC § 280E and its impact on Oregon income taxation will be that many taxpayers in this industry will go to lengthy efforts to capitalize expenses and add them to the cost of goods sold. Caution is advised. The taxing authorities will likely closely scrutinize this issue.
In addition to income taxes, retail marijuana sales in Oregon are subject to a sales tax. This is a tax that is paid by the customer, and collected and paid over to the taxing authorities by the retailer. Interestingly, the sales tax regime has been strenuously resisted by Oregon taxpayers for decades. The Oregon Legislature, however, passed HB 2041, introducing a state sales tax of 17% (with the possible add-on of up to 3% by local governments) on the retail sales of marijuana. Governor Kate Brown signed the bill into law on October 5, 2015. As a consequence, taking into consideration both income taxes and sales taxes, the marijuana industry and its customers may become a big contributor to the state’s tax revenues. I am not sure I could have ever predicted the current state of affairs.
As a general rule, in accordance with IRC § 162(a), taxpayers are allowed to deduct, for federal income tax purposes, all of the ordinary and necessary expenses they paid or incurred during the taxable year in carrying on a trade or business. There are, however, numerous exceptions to this general rule. One exception is found in IRC § 280E. It provides:
“No deduction or credit shall be allowed for any payment paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any state in which such trade or business is conducted.”
Congress enacted IRC § 280E as part of the Tax Equity and Fiscal Responsibility Act of 1982, in part, to support the government’s campaign to curb illegal drug trafficking. Even though several states have now legalized medical and/or recreational marijuana, IRC § 280E may come into play. The sale or distribution of marijuana is still a crime under federal law. The impact of IRC § 280E is to limit the taxpayer’s business deductions to the cost of goods sold.
On October 22, 2015, the U.S. Tax Court issued its opinion in Canna Care, Inc. v. Commissioner, T.C. Memo 2015-206. In that case, Judge Haines was presented with a California taxpayer that is in the business of selling medical marijuana, an activity that is legal under California law.
The facts of this case are interesting. Bryan and Lanette Davies, facing significant financial setbacks and hefty educational costs for their six (6) children, turned to faith for a solution. After “much prayer,” Mr. Davies concluded that God wanted him to start a medical marijuana business. Unfortunately, it does not appear that he consulted with God or a qualified tax advisor about the tax implications of this new business before he and his wife embarked upon the activity.
The good news for the Davies is that their business blossomed. In fact, they employ ten (10) people in the business and have enjoyed financial success. They timely filed state and federal income tax returns, reported income and paid, what they believed, was the proper amount of taxes. The bad news for the Davies is the fact that the IRS did not agree with their computation of the tax liability.
The IRS issued a notice of deficiency. Not able to resolve the matter at IRS appeals, the Davies found themselves in the U.S. Tax Court. The sole issue in the case was whether the taxpayers’ business deductions were properly disallowed by the Service under IRC § 280E.
To no avail, the Davies presented numerous arguments as to why marijuana should no longer be a controlled schedule I substance. They also asserted that their new business created employment opportunities for others, cured their family’s financial woes, and allowed them to participate in civic and charitable activities.
Judge Haines quickly dismissed the Davies’ arguments, concluding the sale of marijuana is prohibited under federal law—marijuana is a schedule I controlled substance. Accordingly, IRC § 280E prevents taxpayers from deducting the expenses incurred in connection with such activity (other than the cost of goods sold).
Faced with a tax assessment exceeding $800,000, the Davies argued that their business does more than sell marijuana. In fact, it sells books, shirts and other items related to medical marijuana. Citing other cases, they argued that their expenses should be apportioned among the various activities (i.e., the sale of medical marijuana and the sale of other items), and that they should be able to deduct the expenses related to the sale of the non-marijuana items.
The court explained that, where a taxpayer is involved in more than one distinct trade or business, it may be able to apportion its ordinary, necessary and reasonable expenses among the different trades or businesses. Unfortunately for the Davies, they could not show that they operated two (2) or more trades or businesses. In this case, the facts indicated that the sale of shirts, books and other items was merely incidental to the sale of medical marijuana. There was not more than one (1) trade or business.
PRACTICE ALERT: Whether more than one (1) trade or business exists is a question of facts and circumstances. Under CHAMP v. Commissioner, 128 T.C. 182 (2007), if a taxpayer operates more than one (1) distinct trade or business, it may be allowed to apportion its expenses among the trades or businesses. If only one (1) of the businesses is impacted by IRC § 280E, only the expenses relating thereto should be denied. The key is establishing that more than one (1) trade or business exists, and reasonably be able to apportion the expenses among those trades or businesses. Keeping separate books and records, and accounting for business expenses in a separate manner, is likely the best approach. The more separation and distinction among the businesses the better the chances of showing more than one (1) trade or business exists. Maintaining separate entities or business names for each activity may be warranted.
The Davies lost the case and are now faced with a hefty tax bill. Unless IRC § 280E is amended, taxpayers involved in the sale of medical and/or recreational marijuana, despite state legalization, will be presented with the same dilemma faced by the Davies in Canna Care, Inc. v. Commissioner.
Actual or constructive receipt of the exchange funds during a deferred exchange under IRC Section 1031 totally kills an exchange and any tax deferral opportunity. Treasury Regulation Section 1031(k)-1(f)(1) tells us that actual or constructive receipt of the exchange proceeds or other property (non-like-kind property) before receiving the like-kind replacement property causes the exchange to be treated as a taxable sale or exchange. This is the case even if the taxpayer later receives the like-kind replacement property. In accordance with Treasury Regulation 1.1031(k)-1(f)(2), a taxpayer is in constructive receipt of money or property if it is credited to his, her or its account; set apart for the taxpayer’s use; or otherwise made available to the taxpayer.
The treasury regulations specifically tell us that security (such as a third party guarantee, letter of credit or mortgage) put in place to ensure a transferee (including the Qualified Intermediary) actually transfers the replacement property to the taxpayer does not constitute actual or constructive receipt of the exchange funds.
Last, where the exchange funds are held in a “qualified escrow account,” no actual or constructive receipt exists by the mere fact that the escrow holds the funds. A qualified escrow account exists if two criteria are met:
Requirement #1: The Escrow may not be established so that the holder of the funds is the taxpayer or a “disqualified person.”
Under Treasury Regulation Section 1.1031(k)-1(k), a disqualified person is:
- Any person or firm that acted as the taxpayer’s employee, attorney, accountant, investment banker or business broker, or real estate agent within two (2) years prior to the transfer of the relinquished property (or when there are multiple relinquished properties, the time period starts at the transfer of the earliest relinquished property). For this purpose, some services are ignored such as services routinely provided by title insurance companies, escrow companies, and financial institutions.
- The attribution rules of IRC Sections 267(b) and 707(b) come into play, but we have to substitute 10% for 50% in applying these rules. So, for example, related persons include: the taxpayer’s spouse, siblings, ancestors, and lineal descendants; a corporation or a partnership owned more than 10% by the taxpayer or a related person; or a trust in which the taxpayer or a related person is a beneficiary or the fiduciary.
Requirement #2: The terms of the escrow must expressly provide that the taxpayer’s rights to the funds are limited.
The taxpayer cannot be allowed to receive, pledge, borrow against or otherwise obtain the benefits of the funds until after the exchange period expires, until after the 45 day identification period where the taxpayer failed the exchange by not identifying any replacement property, or after the time when the taxpayer has received all of the property identified within the 45 day identification period.
Chief Counsel Advice 201320511
Chief Counsel Advice 201320511 raises a not so obvious issue in the area of constructive receipt of exchange funds. An issue that likely occurs often.
In the CCA, Chief Counsel was presented with a taxpayer that was in the equipment rental business. It regularly engaged in Code Section 1031 deferred exchanges to dispose of its rental equipment and to obtain new rental equipment in a tax deferred environment. Machinery and equipment rental businesses, rental car businesses, trucking companies and airlines likely find themselves in this same predicament.
The taxpayer maintained various lines of credit that it used to assist in funding operations during parts of the year and to acquire new rental equipment. The lines of credit, as you may suspect, were secured by the equipment.
Under the exchange agreement, the two specific requirements of a qualified escrow were met, but the Qualified Intermediary was required to pay down the lines of credit with the exchange proceeds and then (through the taxpayer) use the same lines of credit to fund the purchase of the replacement property. Again, one would assume this often occurs in personal property exchanges by taxpayers in related or similar businesses.
The specific issue presented to Chief Counsel was whether the use of the exchange proceeds to pay down the taxpayer’s debt (which may or may not have been directly related to the relinquished property) constituted constructive receipt by the taxpayer of the exchange funds, thereby killing the taxpayer’s opportunity to obtain tax deferral. The taxpayer was getting the benefit of the exchange funds during the time the deferred exchange was ongoing.
Chief Counsel, citing the boot netting rules, concluded in favor of the taxpayer and held no actual or constructive receipt existed. The new debt secured by the replacement property equaled or exceeded the debt secured by the relinquished property which was paid off in the exchange.
Put this Chief Counsel Advice in your bag of tricks. The issue may come up when taxpayers undertake personal or real property exchanges where a line of credit serves as security.
Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.