One thing is certain, paying more tax than the law requires will not improve your chances of surviving. Re-arranging client affairs & re-organizing client businesses opens doors to extensive tax avoidance. Every dollar saved drops straight to the bottom line as another dollar of cash, profit, working capital & competitive advantage, and improves your chance of surviving the 21st century.
Any business with a valid business purpose & economic substance can deduct any ordinary, necessary & reasonable expenses incurred in the pursuit of profits in a legitimate business.
The Decades Long Battle for the Soul of America.
Appeals Court Judge Learned Hand vs President Roosevelt
Anyone may arrange his affairs so that his taxes shall be as low as possible. He is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.” Judge Learned Hand.
The history of the tax code boils down into a massive fight for the soul of America between two men, President Franklin Roosevelt and Billings Learned Hand, an American judge and judicial philosopher. who was an avid supporter of free speech and noted for applying economic reason to American tort law. Their battle ground was the tax code. Roosevelt fought for an autocratic approach to tax, and Judge Learned Hand fought for a democratic approach to the code more in line with the 16th amendment itself.
The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
But in addition to the wording of the 16th amendment, above, there was another consideration which Roosevelt did not like. After Congress released the wording to be voted on by the nation, Congress became aware that the amendment would not pass. So they took out ads in newspapers all over the country saying,
“We will only tax profits.”
That did the trick; the 16th amendment passed; and the ad became part of the legislative intent requiring the courts consider that important limitation in any litigation.
Most of Learned Hand’s career he spent as a judge on the United States of Appeals for the Second Circuit. He was never nominated for the Supreme Court, despite being one of the most respected and accomplished jurists in American history, because Roosevelt hated him.
This fight between these two men is responsible for the evolution of tax law into the backbone of the philosophy of America. Without a liberal tax code, America would not be the same. The battle was fought over the meaning of the 16th Amendment. The stance each man took was completely opposite the other man’s Roosevelt favored ditching the democratic approach to taxation & the 16th amendment after 16th amendment was passed in 1913. Over the entire battle, Roosevelt made the IRS became extremely, inducing Congress to create powerful judicial safeguards against the government. Hand was responsible for much of those protections.
Roosevelt was born in 1883 and died in 1946. Learned Hand was born in 1872 and died in 1961. Their careers and their influence overlapped each other. Although Learned Hand won the argument, the eventual result wasn’t obvious for years. Their result of their long battle was decisive in determining the extent of Presidential and government power. Hand was one of the most influential jurists in American history, but he spent the entire apex of his career on the Court of Appeals. He was never nominated to the Supreme Court because Roosevelt hated him. Their battle was a fight to the death.
Roosevelt’s position on income tax was he could do what he wanted with it. His administration was very aggressive on income tax. For his entire presidency, the top tax rate was between 80% and 90%. From 1934 to 1937, during a time when the top tax rate was 90%, Roosevelt carried out a tax trial charging Andrew Mellon with tax fraud, The prosecutor didn’t think the evidence supported Roosevelt’s position, but he prosecuted the case for four years and won the case. Mellon had to pay $600,000 is back taxes. You can read about it here.
Roosevelt was also generally opposed to tax deductions, including business tax deductions. He & Learned Hand fought over taxes and other issues until Roosevelt died. The battle ended with his death in 1945, and the results came in, in 1954 with the Supreme Court Case now referred to as Glenshaw Glass. That case provided the basic framework of the American tax system when it made the case that tax deductions had to be ordinary, necessary in pursuit of profits by a legitimate business. Over time it evolved to …
“Tax deductions must be ordinary, necessary & reasonable in pursuit of profits by a legitimate business, and they must meet the additional tests of valid business purpose & economic substance”
Also in 1954, the issue was also dealt with by Congress in Section 162, Trade or Business Deductions, in much the same way the Supreme Court dealt with it.
Learned Hand is a legitimate American Hero. He saved the Republic. If the government could tax at high rates and no deductions, we would have a much different country today. Roosevelt’s tax policies were driving companies out of the U.S. for greener pastures overseas. But Learned Hand ended that. The same thing happened in the Obama administration, but tax reform is bringing U.S. dollars back from overseas.
Learned Hand is noted for applying economic reason to American tort law. Among his quotes are the following.
Top quotations about U.S. taxation.
First. A given result at the end of a straight path is not made a different result because reached by following a devious path. Minnesota Tea Co. v. Helvering, 302 U.S. 609 (1938).
Second. A transaction is to be given its tax effect in accord with what actually occurred and not in accord with what might have occurred. While a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not. Commissioner v. National Alfalfa Dehydrating, 417 U. S. 134 (1974).
Third. Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed. New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934)
Fourth. Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes. Judge Learned Hand.
Fifth. Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.
My favorite. “Anyone may arrange his affairs so that his taxes shall be as low as possible. He is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.” This is the essence of tax planning. Judge Learned Hand.
The IRS is shifting it’s emphasis from income taxes to employment taxes, starting in three states: Wisconsin this month; Texas & Arkansas next month. At that pace they will be auditing employment taxes in every state with a year.
That is going to hit like an atomic bomb.
Despite the tone of the article, this is a fundamental shift in IRS audit focus and it is going to be far more dangerous than the typical tax audit. Particularly in California. This is going to rattle through California like a runaway freight train. In fact, this is going to raise more money for California than the UBER case.
You can be legal in California and still break Federal law.
Read the third paragraph in the Accounting Today article. That spells it out. The IRS can no longer afford to audit tax returns with limited success. Very few cheat on their tax returns, because the risk is to high. The constant threat of audit worked. But in most states, the contractor / employment laws are widely ignored. And there is little consequence to pay. Consider the Uber decision. In some states, like California, they are relatively easy to get around.
For every contractor making $130,000 or more, the IRS will net nearly $30,000. Plus penalties & interest. A single employee shifted from contract to employment under federal law reaps more tax than any audit I have ever been involved in.
To better determine how to properly classify a worker, consider these three categories – Behavioral Control, Financial Control and Relationship of the Parties.
Behavioral Control: A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. Behavioral control categories are:
- Type of instructions given, such as when and where to work, what tools to use or where to purchase supplies and services. Receiving the types of instructions in these examples may indicate a worker is an employee.
- Degree of instruction, more detailed instructions may indicate that the worker is an employee. Less detailed instructions reflects less control, indicating that the worker is more likely an independent contractor.
- Evaluation systems to measure the details of how the work is done points to an employee. Evaluation systems measuring just the end result point to either an independent contractor or an employee.
- Training a worker on how to do the job — or periodic or on-going training about procedures and methods — is strong evidence that the worker is an employee. Independent contractors ordinarily use their own methods.
Financial Control: Does the business have a right to direct or control the financial and business aspects of the worker’s job? Consider:
- Significant investment in the equipment the worker uses in working for someone else.
- Unreimbursed expenses, independent contractors are more likely to incur unreimbursed expenses than employees.
- Opportunity for profit or loss is often an indicator of an independent contractor.
- Services available to the market. Independent contractors are generally free to seek out business opportunities.
- Method of payment. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time even when supplemented by a commission. However, independent contractors are most often paid for the job by a flat fee.
Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. This includes:
- Written contracts which describe the relationship the parties intend to create. Although a contract stating the worker is an employee or an independent contractor is not sufficient to determine the worker’s status.
- Benefits. Businesses providing employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay have employees. Businesses generally do not grant these benefits to independent contractors.
- The permanency of the relationship is important. An expectation that the relationship will continue indefinitely, rather than for a specific project or period, is generally seen as evidence that the intent was to create an employer-employee relationship.
- Services provided which are a key activity of the business. The extent to which services performed by the worker are seen as a key aspect of the regular business of the company.
Consequences of Misclassifying an Employee
Classifying an employee as an independent contractor with no reasonable basis for doing so makes employers liable for employment taxes. Certain employers that can provide a reasonable basis for not treating a worker as an employee may have the opportunity to avoid paying employment taxes. See Publication 1976, Section 530, Employment Tax Relief Requirements for more information.
It is regular practice in this practice & others to incorporate individuals who are paid 1099 income. This allows the contractor recognize part of the income as “earned income subject to FICA and Medicare employment taxes” and part as “unearned income not subject to employment taxes. This is a simple traditional tax savings technique that is recognized and utilized by probably 50% of tax professionals.
That practice requires the taxpayer make arrangements with the employer to treat the corporation as the contractor instead of the individual owner and pay the corporation directly. But in some industries, such the financial services industry, contracting with the individual is required. There’s no way around it. This practice requires the individual contractor to pay FICA & Medicare tax on 100% of the earnings instead of just the part of the earnings that represent the value of his time.
A 2016 tax court case, Fleischer v. Commissioner required the owner to pay employment taxes on the entire earnings paid to the owner in the owner’s name. Fleischer was the result of a Tax Audit.
This creates a problem for many contractors that we solved this years ago, before this audit or this court case even occurred. First the problem., then the solution we have developed.
However, in some cases the contractor does not have a proactive tax professional like Ellis that warn them about this up front, they don’t take precautions, they get caught on audit & ordered to pay a large shortfall in income tax plus penalties & interest. That creates a problem. We created the solution.
PROBLEM: The wage base for FICA tax is $132,900. The FICA tax rate is 6.2%. Maximum FICA tax is $8,603. This decision probably cost the taxpayer $4,300 for every year involved in the original audit. Plus penalties & interest.
SOLUTION:The likely solution to this problem is an employment contract. I have a template of such a contract if you’d like to see it, drop me a message and I’ll shoot you a copy. If you’d prefer to draft your own, here are some considerations. Neither are guaranteed and have never been challenged by the IRS. There are no guarantees.
- Require Mr. Fleischer to remit revenues he receives from xxx to Corp.
- Make the payor aware in an email that you are employed by your corporation, Individual PC.
- Have an employment contract between the individual providing the services and the corporation (Individual, pc.) who the corporation can direct and control in a meaningful sense.
- The employment contract should disclose & make corporation’s controlling position clear.
- When possible, enter into contracts in the name of your S-Corp, and consider revising those that were entered prior to its formation;
- Use a corporation named Individual, pc. Then get a dba to do business in another name. Try using the name Individual, pc. name.
- Prepare a written employment agreement between you and your S-Corp;
- If you work in an industry, such as the financial services industry, where contracting in the name of an individual is required (whether by rule or as a function of practical considerations), ensure that any contract between you and your S-Corp includes the relevant provisions cited in Fleischer (1&2);
- Work with trusted professional advisers who can help you navigate the complex statutes and regulatory rules applicable to your business.
If you have a contractor friend, call this problem to his/her attention. He, she & you can find my contact info on my LinkedIn profile page.
Here is an article on the court case itself.
Keep plugging. If we can help you by cutting your income tax, our specialty, get in touch.
IRS offers to settle with insurance tax scammers
Since 2014, the list of Dirty Dozen Tax Scams has included “captive” insurance companies. Although the law allows companies to create captive insurance companies to insure against legitimate risk. In that case, the insured company can deduct the premiums it pays for the insurance.
“However, in some “micro-captive” structures, promoters, accountants or wealth planners persuade business owners to participate in scams that lack many of the attributes of insurance.”
The IRS has pursued hundreds of cases against such schemes in Tax Court after auditing the taxpayer companies. After prevailing in three recent U.S. Tax Court cases, the IRS said it has decided to offer settlements to 200 taxpayers who are currently under exam. The IRS began mailing out time-limited settlement offers spell out specific settlement terms. Taxpayers who don’t receive a letter aren’t eligible for this resolution, the IRS pointed out.
“The IRS noted that it has consistently disallowed the tax benefits claimed by taxpayers in abusive micro-captive structures. While some taxpayers have challenged the IRS position in court, none have been successful to date. The IRS said it would continue to disallow the tax benefits claimed in abusive micro-captive transactions and continue to defend its position in court. The IRS has decided, though, to offer to resolve some of the cases.”
What this means is that there are probably 1000s of these situations out there, but that only a few of them have been audited. Still fewer have been taken to court.
The famous “Son of Boss” resulted in 1,165 tax cases. The IRS is apparently attempting to clear out the individual cases by offering deals. The real target of this effort is to find the advisrrs pushing the illegal schemes & prosecute them. In ‘Son of Boss’ tax fraud case, KPMG pled guilty to tax fraud.
Taxpayers are unlikely to go to prison, but their advisers are likely to.
Some tax scams:
Little Know Fact
Something very few people realize, the 16th amendment to the constitution created two tax systems, one for individuals and and one for businesses. And there’s a world of difference between them.
After proposing the new amendment, Congress began to worry that the amendment wouldn’t be ratified by the states. The issue was the way it was worded.
“The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.”
The specific language causing the concern was, “collect taxes on incomes from whatever source derived.” The concern was, the way it was written included money borrowed & the proceeds when selling at at loss in income subject to taxation. Obviously, Congress had a good reason to be worried. So at the last moment, Congress took out ads in newspapers all over the country promising to ‘tax only profits’.
That relieved an uneasy electorate and the amendment passed unanimously among all the states that voted. Voters weren’t opposed to income tax, they were opposed to an unreasonable tax.
The 16th amendment was subsequently ratified by the Supreme Court in ‘Glenshaw Glass’ and added to the tax code in section 162 of the 1954 tax code. In their deliberations, both the Supreme Court & Congress considered those ads as ‘legislative intent’. Courts have subsequently looked back at those ads to determine Congress’ intent. Intent is crucial to determining how the law will be interpreted and enforced.
In the final analysis, this created two tax systems, which I will explain in my next post.
Help them cheat, then turn them in?
I knew there was such a thing as an IRS whistle blower, but i didn’t know it was it’s own cottage industry. Which it apparently is. But I’m really having a hard time figuring out how it worked.
GINSBURG, Senior Circuit Judge.
“The Appellant asked to proceed anonymously before the Tax Court when challenging the decision of the Internal Revenue Service (IRS) to deny his application for a whistleblower award. The Tax Court denied his request, concluding the balance of interests weighed against anonymity because the Appellant is a “serial filer” of whistleblower claims, which he bases upon publicly available information. The Tax Court’s rationale was that if it does not “identify serial filers by name, the public will be unable to judge accurately the extent to which the serial filer phenomenon has affected the work of the Tax Court.” Whistleblower 14377-16W v. Comm’r, 148 T.C. 510, 518-19 (2017).
My experience with cheating clients
If you’ve ever had clients tell you how to do your job, you can probably relate to this. Of course when it comes to taxation, it involves criminal charges with jail sentences. So I don’t go there. This year, I had a fairly successful client in the cannabis industry that tried to talk me into cheating in three different ways.
- First, he wanted to deduct ah investment he made in a company that was still operating and paying taxes. He claimed, probably correctly, he paid more than it was worth and wanted to deduct the difference. That would work for GAAP, but not for taxes. For tax, that’s a violation of law.
- Second he found a tax preparer who was willing to play loosey-goosey with 280(e), which limits the deductions that a cannabis business can deduct. He told me top notch cannabis preparers were paying less attention to 280(e). I checked around and some of the top people in cannabis taxation said it was bullshit, as I expected. It ‘s against the law to ignore 280(e). Of course you can do all kinds of things with 280(e), but you can’t just ignore what it says.
- Third, he wanted us to deduct accrued interest in a cash basis company. Accruals can only be deducted in an accrual basis company.
In everyone of those situations, I could lose my ticket. All of them involved thousands or hundreds of thousands of dollars in tax.
I refused, he got angry, left and started bad mouthing me.
If an accredited tax preparer helps a client cheat, they are both liable. The taxpayer for preparing a false return, and the taxpayer for providing false information. If the client lies to the tax preparer and fails to product the documents, the tax preparer is still liable for not getting the documents. I see no way the tax preparer escapes unscathed.
How it should work
If someone goes to a tax preparer with the intention of cheating, it is the tax professional’s responsibility to tell the taxpayer(s) they could go to jail for cheating. If they persist, the tax preparers should resign from the engagement.
Something else that surprises me is this. The whistle blower bases his claims on “publicly available information. I’m not sure what that means. Apparently this guy was a tax preparer and used publicly available information to turn in his clients for a reward.
This does not sound like the entire story. i’m guessing there is more here than meets the eye.
And why would the preparer want anonymity?
I have no inkling what the underlying facts are in the court case that started this blog post off. It raised some interesting issues that I don’t understand how the preparer got around. Of course, I’m not going to turn my client in, but I wouldn’t feel bad if someone else did.
One other thing.
I know a person who was very high profile in American politics that was convicted of tax fraud 15 years ago, and he is still in prison. He is likely to die there.
Don’t go there.
A better approach that I suspect is used from time to time, is to simply not pay your taxes. Wait a few years and settle for pennies on the dollar. I don’t ever advise that, but I know it happens.
The U.S. Code is divided by broad subjects into 53 titles. Title 26 is the Internal Revenue Code, commonly referred to as the tax code.
The tax code is unique among all codes. The other 51 codes stand as they were written, one code is reserved and 50 of these codes are stable. The tax code is the exception. No other code is continually interpreted by government agencies (IRS) or court cases. Only the tax code. The tax code is unique in this respect. It’s a living, breathing body of law continually reinterpreted administratively and by the courts.
To a lesser extent, state tax codes are subject to the same phenomena.
That is not a bad thing. The constantly changing nature of tax codes opens the door for strategists like me to legally keep your taxes under control. But predatory practices sometimes make temporary advances. But so far, they have always been stopped.
Even if a tax professional would learn the entire 77,000 page to the tax code, in a year there would be so many subtle changes, they wouldn’t recognize it. That means everybody has to be very careful how they deal with federal & state tax authorities.
Predatory taxation happens from time to time. Here is an example of how the Supreme Court responds. Our republic is safe.
Every tax authority, at one time or another, takes a predatory stance. When that happens, people without hundreds of thousands of dollars to fight a hostile and predatory stance can be destroyed. This happens more than it should.
Personal animus for clients or professionals defending their clients causes predatory behavior more than you might expect. The IRS took a dislike to one of my clients for some unknown reason. I didn’t even let him talk to the IRS. Never-the-less, they disallowed a $100,000 deduction and wouldn’t back off. We pushed the issue all the way to the courthouse steps before the IRS relented. Finally, outside the tax court doors, ten minutes before the case was to be heard, the IRS attorney relented. Had it been the revenue agent, that never would have happened.
Our strategy was to drop the case rather than spend hundreds of thousands of dollars fighting to save $100,000 in tax. That’s the position predatory taxation puts you in. And believe me, every IRS revenue agent knows all about how the game is played.
Our only defense against that treatment, is the Supreme Court.
As far as I can tell, revenue agents aren’t subject to disciplinary action for being overly aggressive with taxpayers. They may claim they are, but I’ll never believe them. Your only recourse is court, and most taxpayers can’t afford that option.
A recent decision on predatory taxation reassures us the Supreme Court has our backs against predatory taxation.
States can be predatory just like the IRS. In my mind, the state of California is the most predatory. It is so bad that the CA tax authorities have been losing cases in the CA Supreme Court over CA’s attempt to push more & more into interstate taxation. This particular Supreme Court case does not involve CA, but it does close a loophole that predatory states were using to push more into predatory areas.
Everyone should read the article to understand the predatory nature of tax authorities when they are not kept reined in by close observation and regulation. Predatory taxing authorities are very powerful and very scary.
Here’s the link to Forbes. The Forbes article is well written, interesting and even brings Roman law into play as the originators of the NEXUS issue that interstate taxation is based on. As it turns out, NEXUS is a Roman word. Subsequent quotes are from the Forbes article.
“Typically, a state government will enact a statute that identifies who it will tax and what it will tax. When it comes to taxation of trusts, there are several moving parts. There is the person who created the trust. There is the beneficiary. There are the assets and income of the trust. And, there is the trustee. Each might be located in a different state. It would seem that four different jurisdictions are licking their chops for tax revenues. This is where “nexus” comes into play.’
There were several long standing Supreme Court rules the states were ignoring. I’m not going to repeat them here, but you can read the article. I am going to continue quoting from the article below.
“In spite of these long-standing rules — upon which there is about 150 years of US Supreme Court rulings — some states attempt to tax without sufficient NEXUS. Unless a taxpayer protests and asserts there is not sufficient NEXUS, the state gets away with it. And, often, the dollar amount in play is too little to fight for. But, occasionally, there is enough money in play and the taxpayer victim fights. (I use the harsh term “victim” because these states offend our cultural sense of fairness and equity when they pull this stuff in light of the US Supreme Court’s long standing position.)”
“In recent years, taxpayers who have asserted a lack of nexus and due process have won . . . with their own states’ supreme courts overturning the states’ offending statutes. But, this has occurred one state at a time. What taxpayers and tax planners have wanted was a newer US Supreme Court ruling that left no doubt . . . involving a state that had a ridiculously weak case . . . to finally put the issue to rest. North Carolina gave it to us.”
“And this is where predatory states got involved. Generally, trusts the taxes that were levied against trusts using inappropriate methods violating state NEXUS rules did not involve enough money to justify bringing expensive suits. And even when the tax justified a lawsuit, the case was brought in state court. So while this issue was working it’s way through state courts, other states were still being taxed in a predatory manner. ”
Finally two cases found their way into the Supreme Court and the issue was decisively decided unanimously. Sotomayer wrote the unanimous opinion.
Court of Appeals 9 (CA 9) upholds stock-based compensation cost-sharing reg again
The Court of Appeals for the Ninth Circuit, reversing a Tax Court decision, has upheld the validity of a reg under Code Sec. 482that requires controlled entities entering into qualified cost-sharing agreements (QCSAs) to share stock-based compensation (SBC) costs. A dissenting opinion rejected the reg, for similar reasons as those in the Tax Court decision.
Background-allocation of income and deductions among taxpayers. Code Sec. 482 authorizes IRS to allocate income and expenses among related entities to prevent tax evasion and to ensure that taxpayers clearly reflect income relating to transactions between related entities.
Under Code Sec. 482 in the case of any transfer or license of intangible property between controlled entities, IRS may allocate income, deductions, credits, or allowances between the entities to prevent the evasion of taxes or to clearly reflect income. Congress amended Code Sec. 482 in ’86 to provide that consideration for intangible property transferred in a controlled transaction must be commensurate with the income attributable to the intangible. Background-allocation of income and deductions among taxpayers. To achieve a clear reflection of each entity’s income, IRS considers what each entity’s income would be had the controlled entities been dealing with each other at arm’s length. (Reg. § 1.482-1(b)(1) ) In Xilinx Inc. and Subsidiaries, (2005) 125 TC 37, the Tax Court rejected IRS’s Code Sec. 482 treatment of employee stock options under a taxpayer’s cost-sharing arrangement with its subsidiary.
The Court determined that the then-applicable ’95 regs did not authorize IRS to require the taxpayers to share the spread or the grant date value relating to employee stock options under the agreement. The Ninth Circuit affirmed the Tax Court’s decision that controlled entities entering into QCSAs need not share SBC costs because parties operating at arm’s length would not do so. (Xilinx Inc. and Subsidiaries, (CA 9 3/22/2010) 105 AFTR 2d 2010-1490)
In 2003, IRS issued new final regs on cost sharing arrangements. Under the regs, controlled participants must share intangible development costs in proportion to their share of reasonably anticipated benefits. Reg. § 1.482-7A(d)(2)(ii) (the final rule) explicitly requires controlled parties entering into QCSAs to share SBC costs. SBC includes restricted stock, nonstatutory stock options, statutory stock options, stock appreciation rights, and phantom stock.
Background-determining validity of regs. In Chevron U.S.A. Inc. v. Natural Resources Defense Counsel, Inc., (Sup Ct 1984) 467 U.S. 837, the Supreme Court set out a two-step analysis for a court to apply in reviewing an agency’s construction of a statute that it administers: (1) if the intent of Congress is clear, IRS and the courts must give effect to the unambiguously expressed intent of Congress; (2) if the statute is silent or ambiguous as to a specific issue, the question for a court is whether the agency’s answer is based on a permissible construction of the statute. An agency’s regs are given controlling weight unless they are “arbitrary, capricious, and manifestly contrary to the statute.”
The Administrative Procedure Act (APA) requires courts to “hold unlawful and set aside agency action, findings, and conclusions” that are “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law” or “unsupported by substantial evidence.” (5 U.S.C. § 706(2)(A), 5 U.S.C. § 706(2)(E)) In Motor Vehicle Mfrs. Ass’n of United States, Inc. v. State Farm Mut. Auto. Ins. Co., (1983) 463 U.S. 29, the Supreme Court said that Treasury must provide a reasoned explanation for adopting a reg. Specifically, State Farm requires Treasury to articulate a satisfactory explanation for its action, including a rational connection between the facts found and the choice made.
2015 Tax Court decision. The Tax Court held that Reg. § 1.482-7A(d)(2) was invalid because it failed to satisfy State Farm ‘s reasoned decision-making standard. (Altera Corporation and Subsidiaries, (2015) 145 TC 91)
CA 9 reversed, upholds reg. The Court of Appeals for the Ninth Circuit, on July 24, 2018, reversed the Tax Court and upheld the reg. It said that IRS’s rule-making complied with the APA, and its reg is entitled to Chevron deference. A dissenting opinion would have rejected the reg, for reasons similar to those of the Tax Court. (Altera Corporation and Subsidiaries v. Comm., (CA 9 7/24/2018) 122 AFTR 2d ¶2018-5068)
One of the judges that was part of the majority in the case died after oral arguments in October 2017 but before the decisions were released in July 2018.
CA 9 withdrew its opinion. The Ninth Circuit withdrew both the majority and dissenting opinions filed on July 24th, allowing time for a “reconstituted panel” of judges to confer (i.e., with a new judge taking the place of the deceased judge).
CA 9 upholds the regs again – The court first held that the reg did not exceed the authority delegated to IRS under Code Sec. 482. The court also explained that Code Sec. 482 does not speak directly to whether the IRS may require parties to a QCSA to share employee stock compensation costs in order to receive the tax benefits associated with entering into a QCSA.
The panel held that the Treasury reasonably interpreted Code Sec. 482 as an authorization to require internal allocation methods in the QCSA context, provided that the costs and income allocated are proportionate to the economic activity of the related parties and concluded that the regulations are a reasonable method for achieving the results required by the statute. Accordingly, the regulations were entitled to deference under Chevron.
Finally, the reg at issue was not arbitrary and capricious under the Administrative Procedure Act (APA). The court found that while the rulemaking process was less than ideal, the APA does not require perfection. The court found that the IRS understood Code Sec. 482 to authorize it to employ a purely internal, commensurate with income, approach where comparable transactions are not comparable. In light of the statute’s plain text and the legislative history, the IRS also reasonably concluded that Congress intended to hone the definition of the arm’s length standard so that it could work to achieve an arm’s length standard so that it could work to achieve an arm’s length result, instead of forcing application of a particular comparability method. In addition, the court found the IRS understanding of its power to use methodologies other than a pure transactional comparability analysis was reasonable and, therefore, deferred to its interpretation under Chevron.
References: For qualified cost-sharing arrangements, see FTC 2d/FIN ¶D-1155; United States Tax Reporter ¶4824.05.