ataxingmatter

TRAC on track

The IRS has been under court orders dating to 1976 to supply a wealth of information to TRAC, the Transactional Records Access Clearinghouse run by Susan Long at Syracuse University.  TRAC-IRS provides a wealth of information from the database it has access to, including news about IRS enforcement actions (new referrals for prosecution were up in March 2008 compared to a year ago, but still down significantly from the rates five years ago, according to a TRAC-IRS report) and audit rates (the 2007 audits of the nation's largest corporations was less than half of what it was in 1988,  according to TRAC-IRS's report).

On the corporate enforcement records, there seems to be a general pullback--field audits are down, auditor hours are down, additional recommended taxes are down.  This twenty-year low in audits appears little warranted from these corporations' records of engaging in various aggressive tax sheltering activities.  I have to admit to a somewhat cynical view--that the administration doesn't really believe that big corporations should have to pay tax so why should it focus on auditing them.  (This administration prefers no tax on income from capital, so that wages would bear all the burden.)  In its defense, the administration might argue that the new Schedule M-3 has made it easier to review book-tax differences and the reportable transaction regulations have required them to call attention to potentially questionable transactions, thus permitting IRS staff that would have been dedicated to ferreting out that information to focus on other issues (like overseeing the private contractors hired under lucrative contracts to do the easy tax collections).  That doesn't seem to explain it, however, once you notice that pass-through entity audits, though up, are nowhere near where they were a decade ago either.  And yet we suspect that pass-throughs have become an even more significant area for abuse (for both high net-worth individuals and big corporations.ee this story by Mike Carter in today's Seattle Times (and thanks to TaxProf for highlighting this).

One thing is certain, TRAC does a public service by gathering this data from the IRS and providing easily understandable analyses of it.  That public service has been made hard under the Bush administration, which has delayed, hemmed and hawed, and fought the release of information in court.  Recently, the IRS sought a court order modifying the court order requiring it to provide information to TRAC under the Freedom of Information Act.  District Court Judge Marsha Pechman, who ordered the IRS to comply with the long term order in response to a suit by TRAC back in 2006, responded to the government's request for a modification of the order with a clear statement that the government did not have standing to ask for modification of a standing order that it had still failed to comply with. S

IRS wins again on Kornman Son of Boss case

The Fifth Circuit affirmed the district court's summary judgment in favor of the IRS in the Kornman son-of-boss shelter case.  Download kornman. Son of Boss Shelter IRS win. 052208.doc . Kornman, a promoter of tax shelters, used the short-sale variant of the partnership tax shelter that sought to generate a large artificial (non-economic) loss by manipulating the partnership rules for inclusion of liabilities in basis.

The basis shelter involved Kornman entering into a short sale (in this case, a selling borrowed T-notes on December 27, in a short sale that would be closed out on December 30).  The brief turnaround period for a short-sale of T notes ensured de minimis risk of large gains or losses.  But Kornman purportedly transferred the short-sale brokerage account to a partnership, claiming a basis equal to the full amount of cash from the short-sale held in the account.  He claimed the cash was transferred to the partnership and disregarded the liability for closing out the short sale.  Then the brokerage account was purportedly sold for $1.8 million, again without the liability being considered so not treated as part of the amount realized.  Thus, Kornman claimed a loss of more than $100 million.

The IRS disputed the treatment of the obligation to close out the short sale, claiming that it was clearly a liability for purposes of the partnership rules, under various revenue rulings that had been issued before the transaction was undertaken.

The court sided with the IRS, noting that otherwise it would be forced to the absurd result of disregarding the liability and permitting a non-economic loss to reduce Kornman's tax liability.  Along the way, it considered the level of deference owed to revenue rulings and concluded that they were not entitled to the same Chevron deference that is given regulations that have undergone notice and comment.  Instead, revenue rulings are entitled to Skidmore deference--meaning that the fact that an agency with expertise has considered the issue is a persuasive factor in upholding agency interpretations.  (Congratulations to law prof Kristin Hickman, whose work on the administrative procedure act and IRS rulemaking was cited by the court.)

Tax Crimes: guilty verdict in Aegis tax shelter case (US v. Vallone)

A federal jury yesterday convicted six attorneys/promoters of sham tax trusts in United States v. Vallone, in what may have been the most broad-reaching illegal tax scam in U.S. history.  See the government's April 8 press release on the tax fraud indictment, here (noting that two CPAs connected with the scheme were indicted separately from the six attorney/managers) and the indictment (from fraudandscam.com) here and superceding indictment here. 

Most tax shelter schemes are limited to 30-40 taxpayers, because the promoters know that having too many taxpayers involved is likely to bring IRS attention.  Apparently that bit of wisdom had bypassed this group of tax scammers--the convicted sextet had marketed sham foreign and domestic trusts to hundreds of U.S. taxpayers using a network of promoters all over the country.  The six were officers and managers of Aegis, an Illinois-based outfit that purported to help wealthy U.S. taxpayers with investments and financial planning, but instead helped wealthy U.S. taxpayers rip off the federal government to the tune of more than $60 million over the ten years the conspiracy went on.  The trusts were used to conceal assets from the government and fraudulently reduce tax liabilities, even though the IRS had provided notice as early as 1997 that such trusts funnelling assets and income offshore did not prevent the income from being taxable in the United States.

The wealthy taxpayers involved in setting up these domestic or foreign trusts to hide their assets and income clearly must have known they were committing illegal tax fraud.  According to the indictment, in some cases, domestic trusts were backdated, to appear as though they had existed earlier.  In many cases, the Aegis defendants set up a domestic trust and then immediately transferred it to the taxpayer/client as new trustee, so the taxpayers knew that they still had control of the assets and income. The convicted group helped taxpayers file false returns, claiming deductions for ordinary expenses of maintaining their homes, which were claimed to be the "world headquarters" of the trusts! 

Foreign trust arrangements were more expensive and were reserved for the wealthiest clients--I suppose they thought it would be harder to trace the assets to Belize than to a U.S trust.  These are another version of the offshore credit card scams--taxpayers moved income around and ultimately located it in a bank account that was accessed by a credit card.  The money was never claimed on the tax return.

The indictment alleged that the defendants used the same methods to conceal their own lucrative fees from promoting the tax scams from the IRS.

Each count of tax fraud carries a maximum penalty of 5 years in prison and a $250,000 fine.  That should be enough to get such firms' potential taxpayer clients' attention, shouldn't it?  One can expect that there will be a number of wealthy clients of these convicted tax criminals who will face their own Waterloo soon.  Those cases should make the mainstream headlines and help counter the public's perception that tax crimes don't get punished.

Kentucky Tax Exemption for Home State Bonds: Supreme Court speaks

The Supreme Court has just released its decision in Davis, a case in which a couple claimed the State of Kentucky discriminated improperly under the Commerce Clause by providing a state tax exemption for its home state bonds while taxing all other bonds, including other state's bonds.  The Court concluded that Kentucky's tax scheme does not violate the Constitution.

BNA's summary of the decision includes the following paragraph:

The majority opinion, written by Justice David Souter, said the court's ruling in United Haulers Association Inc. v. Oneida-Herkimer Solid Waste Management Authority provided a firm basis for reversal. The logic that a government function is not susceptible to standard dormant Commerce Clause scrutiny because it is likely motivated by legitimate objectives distinct from simple economic protectionism applies with even greater force to laws favoring a state's municipal bonds, since issuing debt securities to pay for public projects is a quintessentially public function with a venerable history, he wrote.

Various documents connected with the decision are linked below:

• The opinion is here (described by BNA RealTime as a "highly fractured decision that produced four concurring and two dissenting opinions");
• Download davis. Kentucky Petition for SCt Review.brief.pdf ;
• Download davis. Kentucky Petition for SCt Review. Taxpayer response_cert_response.pdf ;
• Download davis. transcript of oral argument.06-666.pdf .

Last year, I wrote commentary for the ABA Tax Section stating that Kentucky's exemption for its home-state bond interest, though perhaps not the best idea for the state, should not be found to violate the Commerce Clause.  Linda M. Beale, The Tax Exemption for Home State Bonds, Misguided Though It May Be, Should Not Be Considered to Violate the Dormant Commerce Clause, ABA Tax Section NewsQuarterly, 2007.  I made the following key points in favor of permitting home-state bonds to enjoy tax exemption:

• states can apparently provide a direct cash subsidy to bondholders, so an equivalent tax exemption should be permitted;

• the core dormant commerce clause concept of "non-discrimination" is particularly indeterminate in the context of a state's use of its taxing powers;  if the scope of the market is defined as the bond market generally or as a single market for the particular state's bonds created by the state, then the home-state exemption is clearly non-discriminatory;

• the market participation exemption should cover the exemption of interest on home-state bonds, because the state is creating a new stream of commerce by issuing such bonds and that new stream is serving real needs in many ways in the modern, globalized financial environment, including creation of single-state municipal bond funds that would be in jeopardy if the exemption were disallowed;

• the friction between the states that is the hallmark of the rationale for the dormant Commerce Clause is absent on this issue; and

• upholding the home-state tax exemption would emphasize the importance of state sovereignty in this area, where the Constitution embodies the  Full Faith and Credit Clause (as evidenced in the earlier Bonaparte decision by the Court) and the Court has emphasized the importance of "Our Federalism."

In its opinion (written by Justice Souter), the Court echoed many of the arguments that I made in the 2007 piece.  It noted that the theme of modern Commerce Clause jurisprudence is economic protectionism, but that concept is limited by the doctrine of federalism.  It relied on the last term decision in United Haulers, which considered the interconnection of the market exception and a state's vital government functions to find lack of a Commerce Clause barrier to the waste hauling regulation at issue.  The Court noted that finding the exemption a violation of the Commerce Clause would interfere with long-term practices of state governments. And it applied the Bonaparte decision to support the view that a state was uniquely situated in its issuance of bonds, so that it really has no direct competitors.  "Kentucky, as a public entity, does not have to treat itself as being 'substantially similar' to the other bond issuers in the market."  Slip Op. at 13.  It noted the importance of the lack of other states' opposition to the scheme and the role that single-state mutual funds play in creating a market for what might be otherwise hard-to-sell bonds of small municipalities, showing that the exemption scheme is far different from the kinds of economic protectionism and worries about frictions between the states that underlie the dormant Commerce Clause jurisprudence.

Souter's opinion also further clarified the Court's "market participation" doctrine (and several earlier cases that had been relied on by the Davises to claim that no use of taxing authority could be analyzed under the market participant doctrine).  It noted that the state's dual roles as market participant and as taxing authority could not realistically be separated, with only the regulatory taxing authority role analysed. "[T]he differential tax scheme makes sense only because Kentucky is also a bond issuer"  so it would be foolhardy to view this as mere regulatory action, since the tax structure is "one of the tools of competition" in the bond market.  Slip Op. at 15.  Souter argued as I had about the possible ways to view the market: at its broadest, all private and public bonds are taxed other than the state's own bonds; the possibility for discrimination is at its greatest when you look only at the market for state bonds.  Slip op. at 20-21.

The dissent, authored by Justice Kennedy and joined by Justice Alito, calls the majority "wrong", states that the majority improperly disregards decisions dealing with discrimination, and harks back to the underlying concerns about frictions between the state.  It is essentially an argument for a national "free market" unfettered by any state regulation, including special taxation, and the view that state intervention will almost always create an "undue burden" under the Court's 1970 Pike v. Bruce Church decision.

Marriage and Tax: California action

What a wonderful happening for the afternoon of the day that I have almost finished grading corporate and partnership tax exams and can return to regular blogging and other important activities!  The California Supreme Court has just announced its opinion in "In re Marriage Cases" that marriage is a fundamental right that cannot be denied to same-sex unions. 

As New York Times coverage of the oral argument before the California Supreme Court in March indicated, the definition of marriage is at the heart of the case.  See Adam Liptak, Definition of Marriage is at Heart of California Case, New York Times, Mar. 5, 2008.  It has been four years since the Massachusetts high court reached a similar decision.   One hopes that eventually this great country will realize that this inclusionary approach is the right answer both morally and legally.  We need to recognize this right across the nation and repeal the "Defense of Marriage Act" that denies privileges under the federal income tax laws (and all other federal laws) to same sex couples that are enjoyed by opposite gender couples.

The past few years, however, have seen some states trending in the opposite direction, towards a religion-based notion of "traditional" marriage that seems based on ideologies not unlike the laws from an earlier time that prevented interracial marriages, an era finally brought to a close by the U.S. Supreme Court decision in Loving vs Virginia.  These states--like my new home in Michigan in 2004--have regretably enacted constitutional amendments that purport to "protect" marriage by declaring that marriage may only be between a man and a woman.  Now, anyone who knows anything about human nature knows perfectly well that these rules have nothing to do with "protecting" marriage and everything to do with discrimination that intends to prevent gay couples from enjoying various tax and other benefits (employment-related benefits like health insurance, legal benefits like adoption or inheritance rights, etc.) that accrue to a commited legal relationship recognized by state and federal governments.   They represent a regrettable tendency to let certain religious standards dictate rules restraining the modern concept of family. 

My view, stated before on this blog, is that the law has no business making distinctions among its citizens in terms of their decisions to enter into committed intimate relationships.  If a particular religious institution wishes to make such decisions, it may do so:   it may sanction and perform only those marriages that it supports, but it has no business dictating the possible status for committed relationships for people outside that religion.  Let the law deal reasonably with the types of relationships that are indeed customary in our society, and let the churches and synogogues and other religious institutions further commemorate whichever of those relationships they wish to recognize.

Recently, the highest court in Michigan purported to apply a "plain meaning" approach to the Michigan constitutional amendment to conclude that public employers in the state cannot even contract with their employees to provide health insurance benefits to domestic partners, because that would violate the marriage protection amendment.   As a lawyer who is a linguist by training, I have always found "plain meaning" arguments highly questionable.  They essentially permit judges to claim that they need not apply legal analysis but rather can rely on their mere understanding of language--often aided by selective use of dictionary definitions--to resolve the statutory or constitutional interpretative question at issue.   At its worst, in other words, plain meaning analysis is a way to bypass legal analysis and uphold what may well be an ideologically desired outcome based on a claim that anyone reading the legal text would conclude that the outcome is the only reasonable one, based solely on the reader's basic understanding and use of language. 

The Michigan supreme court applied that kind of dictionary-based, context-disregarding interpretative approach to the constitutional amendment.  It tossed off the fact that proponents of the amendment had marketed the amendment by specifically stating that passing the amendment would not affect the ability of public employers in the state to provide benefits to same-sex employee partners. 

Decisions such as those in Michigan undermine the fundamental policies of democratic egalitarianism, while the California outcome points the way towards a brighter future when our states and citizens can recognize the need for inclusionary rather than exclusionary approaches. I can only hope that eventually we will both remove the offending amendment from the state constitution and install judges who have a genuine respect for the diverse citizenry that they serve.

Democratic Leadership Council tax exemption case

The District Court ruled against the IRS on its withdrawal of 501(c)(4) tax exempt status from the Democratic Leadership Council.  You can read the court case on BNA at this link.  The Council was formed (by then-governor Bill Clinton) in 1985 and granted tax-exempt status under section 501(c)(4), which applies to "social welfare" organizations.  The organization claimed that it had an agenda of social betterment, pushing a "third way" that was based on "growing the economy" and "helping ordinary people benefit from that growth" rather than on redistribution.  It intended to develop that agenda through town meetings, public- affairs conferences, and other new fora that would engage the people in this "New Democrat" vision, but it would not intervene in political campaigns.  The IRS revoked the status in 2002, under the Bush Administration, claiming that the Council had provided private benefit to Democratic officials in 1997-1999. 

The court ruled that the IRS violated its own regulations by retroactively revoking the organization's tax-exempt status.  This is a narrow ruling, based on the fact that the Treasury's own regulations permit retroactive revocation of status only if the organization "omitted or misstated a material fact, or operated in a manner materially different from that represented".  The court said that "the IRS’s revocation of exempt status makes no mention of restrictions on its ability to revoke exempt status retroactively; [and]  the revocation relied on the DLC’s originally disclosed connections to the Democratic Party to conclude that DLC rendered an impermissible level of private benefit."

Hatch loses tax conviction appeal

After yesterday's posting regarding the Wesley Snipes verdict (he avoided the most severe charges of tax fraud, but was sentenced for failing to file a return; the promoters of the tax denial scam were convicted of tax fraud), it seems appropriate to note that Richard Hatch, the first season Survivor winner, lost his appeal of his conviction and four year jail term on tax charges.   See the AP story at Contracosta.com; bbc.uk.

Hatch failed to pay taxes on his Survivor winnings ($1 million).  He claimed that the show made a deal to pay his taxes when he caught food being smuggled to other contestants.  But on appeal, he provided no proof, not even cross examining the show's producer when on the stand about it.

The court found against him on all three claims in his appeal.  He'll get out of jail sometime in 2009.

State Tax Issues: Illinois Case Argued in Supreme Court Today

You might want to check out the Hull McGuire firm's discussion of the MeadWestvaco case to be argued in the Supreme Court on Wednesday, Jan. 16.  It's at this link:  http://www.whataboutclients.com/archives/2008/01/boundary_flareu_1.html

As the blog posting notes, this case involves the Court's interpretation of constitutional limitations on states' power to tax corporate income.  Precedent establishes two means by which states may tax corporations that have some activities within their boundaries--the "unitary business" approach and the "operational function" approach.  The blog posting argues that the Illinois court, in finding that Illinois could tax Mead's sale of Data Corporation (Lexis/Nexis), which it had sometimes treated as a separate subsidiary and sometimes as a corporate division, went beyond the permitted boundaries of the Court's existing interpretations. 

The company argued that the gain on the sale of Lexis/Nexis represented investment goodwill that was not within Illinois's power to tax.  The Illinois court concluded it was business income taxable by the state.

It will be interesting to see how the Court decides the case.

WalMart Loses in North Carolina Reit Case

WalMart intended to save itself a bundle in taxes with its captive REIT (real estate investment trust) program--North Carolina taxes, that is.  It created a number of REITs of which it was the 99% owner, and then rented its buildings from those REITs.  That meant it paid (deductible) rent to the REITS, which then were required (in order not to have to pay any corporate level taxes) to distribute the income (WalMart's rent payments) to the REIT owners (WalMart).  It just happened that the REITs were in other states (like Delaware) and not in the state where WalMart was earning all its income that it wanted to avoid state tax liabilities on (like North Carolina).  So WalMart paid rent to itself and got the rent back in a circular flow of cash, but claimed to avoid $33.5 million in taxes in North Carolina (or a total of $230 million in the several states it used this scheme in).

It isn't very hard to question this scheme.  Add to that the fact that REITs are not supposed to be "captive" in the first place.  They are a statutory regime that was designed to give little people the opportunity to invest in real estate the way big-monied investors can.  So any REIT is required to have at least 100 individual shareholders.   Clearly, the various conditions designed to let little guys enjoy the advantages of investments in real estate aren't working when WalMart can create its own captive REIT and own 99% of it.  The de minimis slippage to the 100 little people is a fairly small price to pay for the huge state tax savings that WalMart thought it was getting.

The North Carolina state judge, Clarence Horton, who handled the state's case against WalMart didn't seem to like it any better than I do.  He ruled in December against WalMart's tax shelter, saying the circular cashflow arrangement had "no real economic substance" other than saving the company state taxes.  Other states are also challenging the WalMart strategy.  You can find a good write-up of the case and links to the ruling and findings at Peter Lattman's law blog for the Wall Street Journal, here, and more about it at Bloomberg.com, here.

Wal-Mart can't hide its tax avoidance planning documents

In North Carolina, a case against Wal Mart has been going along for some time.  The state attorneyh general has posted a number of documents in the tax dispute, including many that reveal its use of Ernst & Young, its outside auditor, to design for it complex strategies to cut its state tax bills.  It ended up using one of them (at least)--the "captive REIT" strategy that purportedly allowed Wal-Mart to transfer ownership of its properties to a captive REIT (that's a real estate investment trust--supposed to be owned by many little investors, but various big corporations have figured out how to have a 100 very little guys but own the rest themselves) and then pay rent to the REIT and take a deduction for tax purposes even though the rent didn't leave the corporate till.

Wal Mart complained that having the E&Y documents public caused "unreasonable and undue annoyance and oppression".  The judge didn't buy it--he decided on Nov. 20th that the documents could stay public.

That's the right decision.  There is a public interest in knowing what kinds of schemes corporations are using to avoid taxes: public shaming can't happen unless the public knows.