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.
Many of our readers have asked me about the likely controversy that will ensue following the death of Prince. In fact, two readers feel, since I have been reporting about some of the controversy surrounding the Estate of Michael Jackson, that I must write about Prince’s estate and the expected controversy surrounding it. So, here we go!
Prince Rogers Nelson, known to his fans as “Prince,” passed away on April 21, 2016 in Carver County, Minnesota at his estate, Paisley Park. He was 57 years old. The media reports that he left no spouse or children, but he is survived by a sister and five half siblings. In addition, the initial accounts are that he died without a Last Will and Testament. What is likely to follow is best summed up by the title to Prince’s 1981 hit song “Controversy.”
Controversy involving the pop star’s estate could arise on many fronts. Potential instigators of controversy include the taxing authorities and persons claiming to be legal heirs of Prince.
Probate and Estate Tax Laws in Minnesota
In Minnesota, like most states, if a person dies without a valid Last Will and Testament, his or her probate estate passes by the laws of intestate succession. Under the Minnesota Uniform Probate Code, if a decedent has no surviving spouse and no surviving descendants: (1) the estate passes to his or her parents or the survivor of the parents; (2) if there are no surviving parents, the estate passes to the descendants of the parents (i.e., the decedent’s siblings, half or whole, nieces and nephews etc.); and (3) if there are no surviving descendants of the parents, then a detailed statutory scheme kicks in, which includes paternal and maternal grandparents and their respective descendants. Ultimately, if there are no family survivors, the “no-taker” provision of the statute comes into play – the estate passes to the state.
A probate has been filed in Carver County, Minnesota. I suspect there will be controversy arising about who are the deceased pop singer’s lawful heirs and who is entitled to inherit his suspected massive estate under the Minnesota laws of intestate succession. Perhaps a Last Will and Testament will be presented to the probate court? Time will tell. In any event, it should be interesting.
A Controversy Coming to Pass?
The controversy that is of most interest to me and likely to you is the estate tax controversy that will likely occur. Some background is needed to set the stage.
This year, the federal estate tax exemption is $5.45 million. The federal estate tax rates are graduated, starting at 18% and quickly rising to 40% on taxable estates over $1 million. For a taxable estate over $1 million, the federal estate tax is $345,000, plus 40% of the amount exceeding $1 million. So, for an estate of $505,450,000 (after taking the $5,450,000 exemption), the federal estate tax is $199,945,000 ($499,000,000 X 40% plus $345,000 = $199,945,000).
The Minnesota estate tax exemption in 2016 is $1.6 million. Like the federal estate tax rates, the Minnesota estate tax rates are graduated, starting at 10%, but quickly rising to 16%. For taxable estates over $10,100,000, the estate tax is $1,082,000, plus 16% of the amount exceeding $10,100,000. So, in our example above, the Minnesota estate tax would be $80,082,000 ($505,450,000 - $1,600,000 = $503,850,000 – $10,100,000 x 16% = $79,000,000 + $1,082,000 = $80,082,000).
So, for purposes of illustration, if Prince’s estate was valued at $505,450,000, it could end up being exposed to more than $250 million in state and federal estate taxes. That amount is enough to set the stage for controversy. The issue is likely twofold: (i) what assets are included in the estate; and (ii) what is the value of those assets (on the date of Prince’s death or the alternative valuation date). I suspect the latter will be the most significant issue facing the estate.
The Artist’s Teeming Trove
Prince’s estate likely is comprised of real estate, financial assets (e.g., stocks and bonds), art, collectibles and other personal property. The “other personal property” may be where most of the valuation debate rests. This category of property consists of:
- Song royalties;
- Film rights;
- Intellectual rights to Prince’s likeness; and
- Unreleased song recordings.
Prince reportedly left over one thousand unreleased song recordings in what has been referred to as “the Vault.” What is the value of a musical artist’s unrecorded songs? This is an especially difficult question to answer, given the songs had not debuted prior to the artist’s death. Nobody knows how well the songs will be received by the public.
What is the value of a deceased musical artist’s likeness? It is hard to debate (or at least I think it is hard to debate) that Prince’s likeness is an asset of the deceased artist’s estate. Placing a value on it, however, will likely be the subject of a heated fight among the estate and the government.
Keep in mind, many artists, including Elvis Presley and Michael Jackson, arguably earn more money from their lifetime work after their deaths than they earned during their lifetimes. For example, it was recently reported that Elvis Presley’s heirs earned more than $55 million in 2012 alone from licensing and royalties relating to the late singer’s songs, theatrical works, likeness and sales of personal assets. This is clearly more than “The King” ever earned in any year during his life. So, the valuation of Prince’s future income stream should be a challenging debate. The focus should be the value of assets on the decedent’s death (or the alternate valuation date) rather than some other post-death date.
“Life” After Death
While Prince’s tangible personal property may appear to be less of a challenge from a valuation perspective than the intangible personal property, it certainly will not be left out of any valuation fight. When a star passes away, the value of his or her personal property can skyrocket. For example, just one of Prince’s many guitars sold at auction a few days ago. Indianapolis Colts owner Jim Irsay purchased the late artist’s guitar known as the “Yellow Cloud” for $137,500. It was reported that the auction house originally pegged the guitar’s value at $30,000, but the bidding frenzy concluded with a sales price of almost five times that amount. The guitar was custom made for Prince by Knut-Koupee in 1989. It is described as being in good condition, despite the fact that Prince broke its neck while performing in 1994 (it was professionally repaired). Arguably, the guitar’s value significantly increased on or after the artist’s death (as exemplified by the auction house’s original valuation). This assuredly makes valuation for estate tax purposes challenging as the focus should be on the value of the guitar at the date of death (or the alternate valuation date).
Prince understood and recognized that paying taxes is required. In fact, the following lyrics from his hit song “Paisley Park” support that hypothesis:
“See the man cry as the city
Condemns where he lives
Memories die but taxes
He’ll still have to give”
It will be fascinating to learn what is reported on the state and federal estate tax returns as the value of Prince’s estate. The value will presumably be huge, and the number of assets will likely be many. It should be an interesting battle of the valuation experts.
In March 2014, I reported on the all-out battle that was ensuing in the U.S. Tax Court between the IRS and the Estate of Michael Jackson over the value of the late pop singer’s estate. It began in 2013, when the estate petitioned the court, alleging that the Service’s assessment, based upon the assertion that the estate underreported its estate tax obligation by more than $500 million, was incorrect. In addition, the estate challenged the IRS’s additional assessment of almost $200 million in penalties. Keep in mind that although these numbers are staggering, they do not include the estate’s potential state of California estate tax obligations.
If Michael Jackson could instruct his estate lawyers about case strategy, I am sure he would be recounting the lyrics from his 1982 smash hit Beat It:
Just beat it, beat it, beat it, beat it
No one wants to be defeated
Showin’ how funky and strong is your fight
It doesn’t matter who’s wrong or right
Just beat it, beat it
Unfortunately, the case is not going the way Michael Jackson would have wanted it to go. Rather, victory appears to be nowhere in sight for either the taxpayer or the government.
It is now well over two years after the battle started. It continues to rage. Neither the IRS nor the estate is taking the tack from the title of the late pop singer’s 1991 hit song, Give In to Me.
In July 2014, the IRS added a little more pain to the estate’s already existing misery. It took a deeper look at the value of the estate’s ownership rights to the Jackson Five master recordings and the accrued royalties. As a result, the IRS increased the assessment by almost $29 million. Ouch! I am confident Michael Jackson would have responded to the IRS, quoting from his smash hit Leave Me Alone that appeared on the 1987 album Bad:
Leave me alone, stop it!
The IRS either isn’t hip enough to remember the late pop singer’s hit, Leave Me Alone, or it simply isn’t listening! Last week, it asked the court to add another $53 million in value to the estate.
The battle continues roaring strong. The IRS, in its quest to collect more taxes and penalties, appears to be leaving no stone unturned. I apologize in advance to my readers, but I have to quote Michael Jackson one more time; this time from his hit song Scream that appears on the 1995 album HIStory: Past, Present and Future, Book I:
Tired of injustice
Tired of the schemes
The lies are disgusting
So what does it mean
Kicking me down
I got to get up
As jacked as it sounds
The whole system sucks
Trial in this case is currently scheduled for February 2017. It continues to be interesting. Stay tuned! I will follow up if the case resolves or takes another interesting turn.
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.
Earlier this week, United States Tax Court Judge Richard T. Morrison ruled, in the case of Emmanuel A. Santos v. Commissioner, T.C. Memo 2016-100 (May 17, 2016), that the government will not pay the cost of a taxpayer obtaining a law degree.
This is a pro se case. While the record was not very clear, the taxpayer, Emmanuel A. Santos, claimed he earned a degree in accounting from Indiana University in 1988. Thereafter, he began a career as a tax return preparer. In 1996, he obtained a master’s degree in taxation. Eventually, Mr. Santos expanded his tax return preparer practice to include accounting and financial planning services.
Mr. Santos attended a law school in California, graduating in 2011. He was admitted to the California Bar Association and the United States Tax Court in 2014. In 2015, Mr. Santos and his father started Santos & Santos Law Offices LLP, a law firm offering attorney, tax planning, accounting and financial planning services.
On his 2010 federal income tax return, Mr. Santos deducted, in addition to various expenses, including laundry costs, $20,275 for law school tuition and fees. On audit, many of these deductions were denied.
After likely losing at the IRS Office of Appeals, Mr. Santos headed to the United States Tax Court. The sole issue in dispute was whether the deduction of $20,275 for law school tuition and fees was allowable under Code § 162 as an ordinary and necessary business expense.
When Educational Expenses Are Considered Deductible (and When They Are Nondeductible)
Treas. Reg. § 1.162-5(a) is clear—educational expenses that either: (i) maintain or improve skills required by the taxpayer in his or her current employment; or (ii) are required by the taxpayer’s employer (or applicable law) as a condition to continued employment or rate of compensation, are deductible. On the other hand, certain types of educational expenses are expressly nondeductible, including expenses for education that qualify the taxpayer for a new trade or business. Treas. Reg. § 1.162-5(b)(1) provides examples of these nondeductible educational expenses. One of the examples set forth in the regulations specifically references a taxpayer practicing accounting who pursues a law degree. The costs of attending law school are nondeductible because the course of study qualifies the taxpayer for a new trade or business. The law degree is not required to continue practicing accounting.
Previous Tax Court Holdings
Judge Morrison cited numerous cases where the courts have held, consistent with the Treasury Regulations, a law degree qualifies a taxpayer for a new trade or business, and thus the cost of the degree is a nondeductible educational expense. This is true, even if the degree improves the taxpayer’s accounting and tax skills, and the taxpayer remains practicing accounting (i.e., never practices law). See e.g., Taubman v. Commissioner, 60 T.C. 814 (1973).
Despite the clear language of the Treasury Regulations and the numerous cases supporting the government’s position, Mr. Santos brought his case to the United States Tax Court. He appears to have argued that the holdings in the cases where the court relied upon the Treasury Regulations are incorrect because the regulations are invalid. Mr. Santos’s argument, at first blush, appeared intriguing to me. By gosh, I recently won an Oregon Tax Court case invalidating a long-existing administrative rule (which is akin to Treasury Regulations).
Shortly after Treasury promulgated Treasury Regulation § 1.162-5, the United States Tax Court ruled that it was valid. The Ninth Circuit Court of Appeals affirmed the tax court’s conclusion. See Weiszmann v. Commissioner, 52 T.C. 1106 (1969), aff’d 443 F.2d 29 (9th Cir. 1971).
Giving It the Old College Try
Mr. Santos argued that the court in Weiszmann employed the wrong standard to examine the validity of the regulation at issue. Unfortunately for him, the tax court quickly dismissed the argument without much discussion. Then, Mr. Santos asserted that Treasury failed to adequately respond to public comments before finalizing the regulations at issue, thus making the regulations invalid. Unfortunately, Mr. Santos did not raise that issue until after the trial had concluded. Consequently, the trial court record contained no evidence upon which the tax court could even evaluate his assertion. While his argument was creative and certainly intriguing, it never gained any traction. If he had offered evidence on the issue at trial, the tax court’s opinion would have been a much more interesting read. Who knows if any evidence exists to support his assertion of invalidity – Mr. Santos lost!
The clear take-away from this case is that: educational expenses are generally only deductible if they are incurred to maintain or improve the skills required for current employment or to retain current employment or current compensation. The costs of education required to prepare for a new trade or business are generally nondeductible.
The outcome of these cases is generally dependent upon the facts and circumstances. For example, if Mr. Santos had been a practicing tax lawyer (i.e., had already obtained his J.D. degree, had already passed the bar examination and was practicing as a tax lawyer), the costs of obtaining his LL.M. (taxation) may have been deductible.
Many nuances exist in this area of tax law. Consequently, careful analysis is required.
Late this afternoon, President Obama signed into law the tax extenders legislation referenced in my blog earlier today. Hopefully, we can now complete our client year-end tax planning.
The Protecting Americans from Tax Hikes Act of 2015 Passes Both the U.S. House of Representatives and the U.S. Senate
Late in the day on December 15, 2015, the U.S. House of Representatives passed the Protecting Americans from Tax Hikes Act of 2015 (the “Act”). The Act, which represents a $622 billion tax package, revives many taxpayer-friendly provisions of the Code that expired a year ago.
The Act passed the House with a vote of 318 to 109. Voting in favor of the Act were 77 Democrats and 241 Republicans.
The Act moved to the U.S. Senate, where it was presented along with a comprehensive spending bill. As expected, the Senate voted in favor of the legislation today by a vote of 65 to 33. Consequently, the Act moves from Congress to the desk of President Obama. Most commentators expect that he will promptly sign the Act into law, as his administration has shown strong support.
In anticipation of President Obama signing the Act into law, the following is a brief overview of some of the most important provisions:
Business Provisions of the Act
The Act includes several business taxpayer provisions, including:
- Built-In Gains Tax Recognition Period Reduced. The Act retroactively and permanently sets the recognition period under Code Section 1374(d)(7) at five years.
- S-Corporation Charitable Contributions. The Act retroactively and permanently extends Code Section 1367(a)(2) that had expired on December 31, 2014. Consequently, if an S-Corporation contributes money or property to a charity, each shareholder may take into account his or her pro-rata share of the fair market value of the contributed property in determining his or her income tax liability. In other words, the contribution flows through to the shareholders. Likewise, the shareholder gets to reduce the basis in his or her stock by his or her pro-rata share of the corporation’s adjusted basis in the contributed property (rather than by the amount of the charitable deduction that flowed through to him or her). This provision should be a benefit to charities.
- Research Credit. The research credit allowed under Code Section 41(h) was retroactively and permanently extended. It had already expired as of December 31, 2014.
- RIC Interest and Related Dividends and Short-Term Capital Gain Dividends. The Act retroactively and permanently extends the rules contained in Code Section 871(k), exempting from gross income and the withholding tax the interest-related dividends and short-term capital gain dividends received from a regulated investment company. These provisions had expired as of December 31, 2014.
- Small Business Stock. Under Code Section 1202(a)(4), assuming certain requirements were met, a taxpayer prior to this year was allowed to exclude all gain from the disposition of qualified small business stock acquired after September 27, 2010, but before January 1, 2015. The exclusion applied for both regular income tax and alternative minimum tax purposes. The Act permanently and retroactively extended this provision for stock acquired after December 31, 2014.
- New Markets Tax Credit. The Act retroactively extends the new markets tax credit under Code Section 45D(f) through the end of 2019. Unless extended or made permanent, it will expire on December 31, 2019.
- 15-Year Straight-Line Cost Recovery for Qualified Leasehold Improvements. The Act permanently extends the 15-year recovery period for qualified leasehold improvements, qualified restaurant property and qualified retail improvement property.
- Section 179 Expensing. The Act permanently and retroactively extends the small business expensing limitation and phase-out amounts that were in effect from 2010 to 2014. Consequently, for 2015 forward, the Code Section 179 deduction limit is $500,000. Likewise, the deduction phase-out commences at $2 million. Both the limitation and the phase-out threshold will be indexed for inflation beginning next year. This provision of the Act also extends 50% bonus depreciation through the end of 2019.
Individual Provisions of the Act
The Act includes several individual taxpayer provisions, including:
- Enhanced child tax credit. The Act makes the child tax credit, with a $3,000 un-indexed threshold, permanent. The threshold was scheduled to rise to $10,000 and be indexed for inflation. The Act eliminates the threshold increase and the index for inflation.
- American Opportunity Tax Credit. The Act makes the American Opportunity Tax Credit permanent.
- Mass Transit. The Act permanently extends the employee exclusion for employer-provided mass transit. Now, the exclusion ceiling is equivalent to the employer-provided parking exclusion (i.e., $250 per month).
- State and Local Sales Tax Deduction. The Act permanently extends the life of Code Section 164(b)(5) so that a taxpayer who itemizes his or her deductions may elect to deduct state and local general sales and use taxes in lieu of state and local income taxes. Under Code Section 164(b)(5)(I), this provision, absent the Act, expired on December 31, 2014.
- Nontaxable IRA Transfers to Eligible Charities. The Act makes Code Section 408(d)(8)(F) permanent. Consequently, individuals who are at least 70½ years of age may exclude from gross income qualified charitable distributions from IRA’s, subject to an annual cap of $100,000.
- Home Mortgage Debt Discharge Exclusion. Under Code Section 108(a)(1)(E), prior to this year, an individual taxpayer could exclude from gross income the discharge of indebtedness from a qualified personal residence, up to $2 million for married taxpayers filing jointly, and $1 million for single taxpayers or married taxpayers filing separately. This provision of the Code expired on December 31, 2014. The Act, however, gives it new life, albeit for a brief period of time. The provision will now expire on December 31, 2016, unless extended or made permanent.
Many taxpayers and tax advisors feared that no extenders act would not be passed by the end of 2015. Fortunately, lawmakers were able to reach a compromise. We expect President Obama will sign the Act into law well before the end of the year. Stay tuned!
The Chief Financial Officer’s Act of 1990 (“1990 Act”) was signed into law by President George H.W. Bush on November 15, 1990. One of the major goals of the 1990 Act was to improve the financial management and to gain better control over the financial aspects of government operations. One provision of the 1990 Act in this regard established a requirement that the government’s financial statements be audited. Interestingly, we had not seen comprehensive legislation with this focus since the Budget and Accounting Procedures Act of 1950 was enacted by lawmakers.
As a result of the 1990 Act, the Government Accountability Office (“GAO”) annually audits the financial statements of the Internal Revenue Service (“IRS”). The general objectives of the audit are two-fold: (i) to determine whether the IRS’s financial statements are fairly presented; and (ii) to determine whether the IRS is maintaining effective internal controls over financial reporting.
As you may suspect, the success of the tax collection efforts of the IRS directly impacts federal receipts. Accordingly, the effectiveness of the financial management of its operations is critically important to both lawmakers and taxpayers.
On November 12, 2015, the GAO issued its audit report for fiscal years 2014 and 2015. The report spans, with attachments, over 150 pages, and contains some interesting information. Some may characterize the information as downright scary!
The GAO concludes that the Service’s financial statements are “fairly presented in all material respects.” That is the good news. With good news, however, there is sometimes bad news. This happens to be one of those cases.
The bad news is that the “IRS did not maintain effective internal control over financial reporting as of September 30, 2015, because of a continuing material weakness in internal controls over unpaid tax assessments.” Weaknesses in the IRS systems and errors in taxpayer accounts apparently rendered its systems incapable of readily distinguishing between taxes receivable, compliance assessments, and tax write-offs. Consequently, the IRS, in its financial reporting, had to make over $9 billion in adjustments to the numbers computed by its financial systems. One has to assume this work was both laborious and costly. YIKES!
If that is not bad enough, the GAO noted some continuing and some new deficiencies in the IRS’s financial reporting systems, including:
- Missing security updates;
- Insufficient audit trails;
- Insufficient monitoring of key systems; and
- Use of weak passwords
Together, these problems, according to the GAO, constitute a significant deficiency in the Service’s internal controls over its financial reporting systems. Unless these matters are fully addressed, the GAO concludes that the IRS’s financial data and taxpayer data will be at “increased risk of inappropriate and undetected use, modification, or disclosure.”
The Service already faces enormous challenges relating to safeguarding taxpayer information, warding off invalid tax refund claims arising out of cases of identity theft, and implementing the tax provisions of the Patient Protection & Affordable Care Act. Unfortunately, these are not the only challenges confronting the IRS. As reported in previous blog posts (see "Strong Commentary from Washington Regarding IRS Budget Cuts" and "The IRS Continues to Face Severe Budget Cuts—What Does this Mean to Tax Advisors and Their Clients?"), the IRS continues to face significant budget cuts. Together, these challenges appear to be a recipe for disaster. The GAO report issued on November 12, 2015 supports this scary conclusion. As taxpayers and tax practitioners, we should be concerned about all of these matters.
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.
As reported in previous blog posts (January 17, 2014, January 21, 2014, and January 20, 2015), federal budget setbacks continue to severely impact the Internal Revenue Service (“IRS”) and its ability to carry out its lofty mission:
“[T]o provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all.”
Senator Ron Wyden (D-OR), Ranking Member of the United States Senate Committee on Finance, understands the critical role the IRS plays in maintaining our tax system. In a letter to IRS Commissioner John Koskinen, dated September 2, 2015, Senator Wyden professionally, but directly, questions the agency’s reallocation of IRS limited resources away from information technology (“IT”), enforcement and collection.
As reported in my January 20, 2015 blog post, IRS Commissioner Koskinen pronounced that, as a result of the budget cuts facing the IRS, in addition to several other expense cutting measures, (i) the IRS would not update and/or replace IT systems as previously scheduled; and (ii) the IRS would implement staff reductions and furloughs, resulting in 280,000 fewer collection matters being pursued and 46,000 fewer audits being conducted this fiscal year.
In his letter, Senator Wyden points out some interesting facts that call into question Commissioner Koskinen’s expense cutting decisions. Foremost, Senator Wyden raises the fact that about $5.10 of taxes owed are collected for every dollar spent on enforcement efforts. Consequently, it is troubling that the Service is curtailing collection efforts, the very function that creates revenue. Isn’t there a better place to reduce expenses within the agency?
Senator Wyden predicts that as a result of Commissioner Koskinen’s expense cuts, in addition to reduced tax collections, the number of tax cheats will rise. This is especially true if the IRS does not use its available resources to improve IT systems.
It is difficult to disagree with Senator Wyden’s predictions or his criticism of the cost cutting measures being implemented within the IRS. In fact, Senator Wyden concludes the combination of reduced enforcement activity and funding cuts for IT systems is a “dangerous cycle” that will likely lead to increased tax fraud in this country. He states:
“Shouldn’t the American public view diminished enforcement and reduced IT spending for what they really are: tax cuts for tax cheats and kickbacks to crime syndicates?”
The facts are the facts. The budget cuts facing the IRS are significant. Commissioner Koskinen is presented with a very difficult dilemma. One thing is clear – cutting the funding for collection, enforcement, and IT systems will not serve our tax system well. That said, where should the cuts be made?
Budget cuts that negatively impact taxpayer service will also likely result in a reduction in tax collections. With the Code as complex as it is, taxpayer service is paramount to maintaining tax revenues. The Service plays an important role in providing guidance to taxpayers about their tax obligations. Numerous empirical studies reveal good taxpayer service improves taxpayer voluntary compliance, leading to increased collections. Consequently, there may be no good place for Commissioner Koskinen to cut the agency’s expenses going forward without negatively impacting collections and compliance.
Maybe the best answer for our country is to have lawmakers rethink which government agencies should take the brunt of expense reductions. Logic would tell us that the IRS, the very agency that collects revenues, should probably be last on the list.
Senator Wyden asked Commissioner Koskinen to respond to his letter by October 2, 2015. I suspect the response will be an interesting read. Stay tuned!
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.
Upcoming Speaking Engagements
- "Subchapter S After the Tax Cuts and Jobs Act – the Good, the Bad and the Ugly," New York University 77th Institute on Federal TaxationNew York, NY, 10.25.18
- "Developments in the World of IRC Section 1031 Exchanges, including the Impact of the Tax Cuts and Jobs Act," IRS Tax Practitioners ForumPortland, OR, 10.31.18
- "Navigating the Built In Gains Tax for C to S Conversions After the Tax Cuts and Jobs Act," 2018 Oregon Society of Certified Public Accountants (OSCPA) Northwest Federal Tax ConferencePortland, OR, 11.5.18
- "The Tax Cuts and Jobs Act – What It May Mean to Your Clients," Estate Planning Council of Portland Mini-SeminarPortland, OR, 11.7.18
- "What a Family Law Practitioner Needs to Know About the Tax Cuts and Jobs Act," Clackamas County Bar Association Fall ConferenceOregon City, OR, 11.8.18
- "Subchapter S After the Tax Cuts and Jobs Act – the Good, the Bad and the Ugly," New York University 77th Institute on Federal TaxationSan Diego, CA, 11.15.18