In 2015, the U.S. Tax Court issued its ruling in the case of David W. Laudon v. Commissioner, TC Summary Option 2015-54 (2015). The case may not raise or even resolve any novel tax issues, but it reminds us of what is hopefully the obvious relative to the deductibility of business expenses. The Court’s opinion and its recitation of the underlying facts, however, make for an extremely interesting and entertaining read.
For more than a year, I have been discussing the potential that Oregon lawmakers will pass a corporate gross receipts tax. On May 26, 2017, we discussed recent events that would lead a reasonable person to believe that the dream of a corporate gross receipts tax was definitely alive and well in Oregon. In fact, the passage of it certainly appeared to be gaining steam in the legislature. Maybe that is not the case – at least for now.
Late yesterday, Oregon Democrats announced that they are abandoning any efforts to enact a corporate gross receipts tax this year as they have been unable to garner adequate legislative support to pass such a measure. Article IV, Section 25 of the Oregon Constitution requires a three-fifths majority of all members elected to each house of the legislative assembly to pass bills for raising revenue and that the presiding officer of each respective house sign the bill or resolution. So, it appears a three-fifths vote in favor of a corporate receipts tax in each the house and the senate is not currently attainable.
After Oregon Measure 97’s drubbing at the polls in November 2016, for many, it suggested the quashing of any notion of a gross receipts tax in the state. For Oregon Senator Mark Hass (D) and Representative Mark Johnson (R), it got them thinking creatively about alternatives to such an approach, spawning Legislative Concept 3548, and subsequently, the births of Senate Joint Resolution 41 and House Bill 2230. Both resemble the now defunct Measure 97—and in the same way can be viewed as a hidden sales tax, essentially. While finding a palatable path to reform is certainly a tall order, the new tax proposals could pose a serious threat to the Oregon business community and present a thorny solution to addressing the state’s budgetary needs.
In an April 2017 State Tax Notes article, titled “The Idea That Would Not Die: Beyond Oregon’s Measure 97,” my colleague Michelle DeLappe and I discuss these new Oregon tax proposals and their key differences with Measure 97, the benefits and shortcomings of a gross receipts tax, and the likelihood of a gross receipts tax in Oregon becoming a reality.
As I reported previously, Oregon Measure 97 was overwhelmingly defeated by voters in the state’s general election this past November. It certainly appeared that the voters spoke loudly and clearly on November 8, 2016, when they voted to defeat the ill-designed amendments to the Oregon corporate minimum tax regime contained in Measure 97. Flaws in the legislation included:
- Measure 97 contained a corporate alternative tax based on Oregon gross receipts – a tax that has no relationship to profits.
- Measure 97 proposed a corporate alternative tax applicable only to C corporations. S corporations, entities taxed as partnerships and Oregon benefit companies would have escaped the proposed tax altogether.
- While Oregon benefit companies would have escaped the proposed tax, non-Oregon benefit companies were to be subject to the tax. As a result, Measure 97 was clearly in conflict with the Interstate Commerce Clause.
Enter Legislative Concept 3548
On February 13, 2017, Oregon Senate Finance Committee Chairman Mark Hass (D) requested that Legislative Concept 3548 (“LC 3548”) be released. LC 3548 is a legislative referendum to amend the Oregon Constitution in order to create a “Business Privilege Tax” based on gross receipts. It looks a lot like Measure 97. There are, however, some key differences, including:
The proposed $3 billion per year tax-raising bill, Oregon Measure 97, was defeated yesterday by a 59% to 41% margin. The fight was long and bloody. Media reports that opponents and proponents together spent more than $42 million in their campaigns surrounding the tax bill.
So, What Now?
The defeat of Measure 97 eliminates the proposed 2.5% gross receipts alternative corporate tax applicable to C Corporations with annual Oregon gross receipts over $25 million. Oregon C Corporations, however, are still faced with a minimum tax based on Oregon gross receipts. The minimum tax applicable to Oregon’s C Corporations is based on gross revenues as follows:
C Corporations with Oregon annual revenues greater than $25 million may face a new minimum tax obligation – 2.5 percent of the excess – if Measure 97 passes. If a business falls within this category, there may be ways to mitigate its impact. The time to start planning, however, is now.
Oregon taxes corporations under an excise tax regime. The Oregon corporate excise tax regime was adopted in 1929. The original legislation included what is commonly called a “minimum tax” provision. In accordance with this provision, corporations subject to the Oregon excise tax are required to pay the greater of the tax computed under the regular corporate excise tax provision or the tax computed under the “minimum tax” provision. Accordingly, the “minimum tax” is an “alternative” tax; it is not an “additional” tax as many commentators have recently asserted.
Originally, the Oregon corporate “minimum tax” was a fixed amount – $25. As a result of the lobbying efforts of Oregon businesses, the “minimum tax” was eventually reduced to $10, where it remained for almost 80 years.
In 2010, Oregon voters dramatically changed the corporate “minimum tax” landscape with the passage of Measure 67. The corporate “minimum tax” (beginning with the 2009 tax year), is no longer a fixed amount. Rather, it is now based on Oregon sales (gross revenues). The “minimum tax” is now:
|Oregon Sales||Minimum Tax|
|$500,000 to $1 million||$500|
|$1 million to $2 million||$1,000|
|$2 million to $3 million||$1,500|
|$3 million to $5 million||$2,000|
|$5 million to $7 million||$4,000|
|$7 million to $10 million||$7,500|
|$10 million to $25 million||$15,000|
|$25 million to $50 million||$30,000|
|$50 million to $75 million||$50,000|
|$75 million to $100 million||$75,000|
|$100 million or more||$100,000|
S corporations are exempt from the alternative graduated tax system. Instead, they are still subject to a fixed amount “minimum tax,” which is currently $150.
As an example, under the current corporate “minimum tax” provision, a corporation with Oregon gross sales of $150 million, but which, after allowable deductions, has a net operating loss of $25,000, would be subject to a minimum tax of $100,000. Many corporations operating in Oregon, which traditionally have small profit margins (i.e., high gross sales, but low net income), found themselves (after Measure 67 was passed) with large tax bills and little or no money to pay the taxes. Three possible solutions for these businesses exist:
- Make an S corporation election (if eligible);
- Change the entity to a LLC taxed as a partnership (if the tax cost of conversion is palatable); or
- Move all business operations and sales outside of Oregon to a more tax-friendly jurisdiction.
Several corporations in this predicament have adopted one of these solutions.
Initiative Petition 28/ Measure 97
Measure 97 will be presented to Oregon voters this November. If it receives voter approval, it will amend the “minimum tax” in two major ways:
- The “minimum tax” will remain the same for corporations with Oregon sales of $25 million or less. For corporations with Oregon sales above $25 million, however, the “minimum tax” (rather than being fixed) will be $30,001, PLUS 2.5 percent of the excess over $25 million.
- The petition specifically provides that “legally formed and registered benefit companies” as defined in ORS 60.750 will not be subject to the higher “minimum tax.” Rather, they will continue to be subject to the pre-Measure 97 “minimum tax” regime (as discussed above). Caveat: The exception, as drafted, appears to only apply to Oregon benefit companies; it does not extend to foreign benefit companies authorized to do business in Oregon.
Measure 97 expressly provides that all increased tax revenues attributable to the new law will be used to fund education, healthcare and senior citizen programs. As a result, many commentators believe the initiative has great voter appeal and will likely be approved by voters. If Measure 97 is passed, it is slated to raise over $6 billion in additional tax revenue per biennium.
In general, the Oregon income tax laws are based on the federal income tax laws. In other words, Oregon is generally tied to the Internal Revenue Code for purposes of income taxation. As a consequence, we generally look to the federal definition of taxable income as a precursor for purposes of determining Oregon taxable income.
What does this mean to taxpayers in the trade or business of selling recreational or medical marijuana in Oregon?
Currently, it appears these taxpayers are stuck with the federal tax laws. Consequently, unless the Oregon legislature statutorily disconnects from IRC § 280E, for Oregon income tax purposes, all deductions relating to the trade or business of selling medical or recreational marijuana will be disallowed.
I suspect the result of IRC § 280E and its impact on Oregon income taxation will be that many taxpayers in this industry will go to lengthy efforts to capitalize expenses and add them to the cost of goods sold. Caution is advised. The taxing authorities will likely closely scrutinize this issue.
In addition to income taxes, retail marijuana sales in Oregon are subject to a sales tax. This is a tax that is paid by the customer, and collected and paid over to the taxing authorities by the retailer. Interestingly, the sales tax regime has been strenuously resisted by Oregon taxpayers for decades. The Oregon Legislature, however, passed HB 2041, introducing a state sales tax of 17% (with the possible add-on of up to 3% by local governments) on the retail sales of marijuana. Governor Kate Brown signed the bill into law on October 5, 2015. As a consequence, taking into consideration both income taxes and sales taxes, the marijuana industry and its customers may become a big contributor to the state’s tax revenues. I am not sure I could have ever predicted the current state of affairs.
As a general rule, in accordance with IRC § 162(a), taxpayers are allowed to deduct, for federal income tax purposes, all of the ordinary and necessary expenses they paid or incurred during the taxable year in carrying on a trade or business. There are, however, numerous exceptions to this general rule. One exception is found in IRC § 280E. It provides:
“No deduction or credit shall be allowed for any payment paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any state in which such trade or business is conducted.”
Congress enacted IRC § 280E as part of the Tax Equity and Fiscal Responsibility Act of 1982, in part, to support the government’s campaign to curb illegal drug trafficking. Even though several states have now legalized medical and/or recreational marijuana, IRC § 280E may come into play. The sale or distribution of marijuana is still a crime under federal law. The impact of IRC § 280E is to limit the taxpayer’s business deductions to the cost of goods sold.
On October 22, 2015, the U.S. Tax Court issued its opinion in Canna Care, Inc. v. Commissioner, T.C. Memo 2015-206. In that case, Judge Haines was presented with a California taxpayer that is in the business of selling medical marijuana, an activity that is legal under California law.
The facts of this case are interesting. Bryan and Lanette Davies, facing significant financial setbacks and hefty educational costs for their six (6) children, turned to faith for a solution. After “much prayer,” Mr. Davies concluded that God wanted him to start a medical marijuana business. Unfortunately, it does not appear that he consulted with God or a qualified tax advisor about the tax implications of this new business before he and his wife embarked upon the activity.
The good news for the Davies is that their business blossomed. In fact, they employ ten (10) people in the business and have enjoyed financial success. They timely filed state and federal income tax returns, reported income and paid, what they believed, was the proper amount of taxes. The bad news for the Davies is the fact that the IRS did not agree with their computation of the tax liability.
The IRS issued a notice of deficiency. Not able to resolve the matter at IRS appeals, the Davies found themselves in the U.S. Tax Court. The sole issue in the case was whether the taxpayers’ business deductions were properly disallowed by the Service under IRC § 280E.
To no avail, the Davies presented numerous arguments as to why marijuana should no longer be a controlled schedule I substance. They also asserted that their new business created employment opportunities for others, cured their family’s financial woes, and allowed them to participate in civic and charitable activities.
Judge Haines quickly dismissed the Davies’ arguments, concluding the sale of marijuana is prohibited under federal law—marijuana is a schedule I controlled substance. Accordingly, IRC § 280E prevents taxpayers from deducting the expenses incurred in connection with such activity (other than the cost of goods sold).
Faced with a tax assessment exceeding $800,000, the Davies argued that their business does more than sell marijuana. In fact, it sells books, shirts and other items related to medical marijuana. Citing other cases, they argued that their expenses should be apportioned among the various activities (i.e., the sale of medical marijuana and the sale of other items), and that they should be able to deduct the expenses related to the sale of the non-marijuana items.
The court explained that, where a taxpayer is involved in more than one distinct trade or business, it may be able to apportion its ordinary, necessary and reasonable expenses among the different trades or businesses. Unfortunately for the Davies, they could not show that they operated two (2) or more trades or businesses. In this case, the facts indicated that the sale of shirts, books and other items was merely incidental to the sale of medical marijuana. There was not more than one (1) trade or business.
PRACTICE ALERT: Whether more than one (1) trade or business exists is a question of facts and circumstances. Under CHAMP v. Commissioner, 128 T.C. 182 (2007), if a taxpayer operates more than one (1) distinct trade or business, it may be allowed to apportion its expenses among the trades or businesses. If only one (1) of the businesses is impacted by IRC § 280E, only the expenses relating thereto should be denied. The key is establishing that more than one (1) trade or business exists, and reasonably be able to apportion the expenses among those trades or businesses. Keeping separate books and records, and accounting for business expenses in a separate manner, is likely the best approach. The more separation and distinction among the businesses the better the chances of showing more than one (1) trade or business exists. Maintaining separate entities or business names for each activity may be warranted.
The Davies lost the case and are now faced with a hefty tax bill. Unless IRC § 280E is amended, taxpayers involved in the sale of medical and/or recreational marijuana, despite state legalization, will be presented with the same dilemma faced by the Davies in Canna Care, Inc. v. Commissioner.
Please join me for the NYU 73RD Institute on Federal Taxation. This year’s Institute will be held in San Diego at the Hotel Del Coronado November 16 – 21, and in New York City at the Grand Hyatt New York October 19 – 24. Please see the attached brochure. The coverage of tax topics is both timely and broad. This year’s presentations will cover topics in the areas of: executive compensation and employee benefits; partnerships and LLCs; corporate tax; closely held businesses; and trusts and estates. What is so terrific about the Institute, in addition to a wonderful faculty and the interesting current presentation topics, you can choose the presentations you want to attend. In other words, you can pick and choose the topics that relate to your tax practice.
This is my second time speaking at the Institute. My topic this year is: "Developments In The World Of S Corporations." I plan to deliver a White Paper that will provide attendees with an historic overview of Subchapter S and a look through a crystal ball at the future of Subchapter S, including a review of the recent cases, rulings and legislative proposals impacting Subchapter S.
I hope to see you in either San Diego or New York.
The IRS will strike down transactions among related parties that lack economic outlay. At least two recent US Tax Court cases are illustrative of the issue.
Kerzner v. Commissioner, T.C. Memo 2009-76 (April 6, 2009). The Service beat the taxpayers in this case by a nose. Mr. and Mrs. Kerzner were equal partners in a partnership that owned a building. The partnership leased the building to an S corporation which was owned equally by two shareholders, Mr. and Mrs. Kerzner. Over the years, the partnership loaned the Kerzners money. In turn, they loaned the money to their S corporation, which used the money to pay rent to the partnership.
At the end of each year, promissory notes were drafted to document the loans; some of the notes stated an interest rate, some did not. Even though the notes required payment of principal, virtually no payments were ever made because the notes each year were replaced with new notes before any payment was due.
The S corporation had large losses. The Kerzners claimed basis in the loans to the corporation and took the losses on their individual tax returns. Upon audit, the Service claimed the loans lacked economic substance and did not give the Kerzners basis to absorb the losses.
Two points of law need to be understood:
- First, in accordance with Code Section 1366(d)(1), the losses taken by the Kerzners cannot exceed their adjusted basis in the stock, plus their adjusted basis in any loans from them to the corporation; and
- Second, basis is only obtained in loans if: (i) the corporation owes the debt directly to the shareholders; and (ii) the shareholders really made an economic outlay that rendered them poorer. There must be economic substance—the loans must be real.
In this case, the money started with the partnership and ended with the partnership. Because it is likely no cash ever actually exchanged hands and only a mere after-the-fact paper trail was created, there was no economic substance. Consequently, the US Tax Court disallowed the losses.
The Kerzners could have changed the result!
- They could have taken a real distribution from the partnership and loaned it to the S corporation, and required the corporation to make monthly payments of principal and interest;
- They could have borrowed money from a bank and loaned it to the S corporation, and required it to make monthly payments of principal and interest; or
- They could have used their own resources and loaned money to the S corporation and required it to make monthly payments.
The 2012 tax court memo case of Maguire v. Commissioner sounds a lot like the saga of the Kerzners.
Like the Kerzner case, this is also a Tax Court Memorandum case. A Memorandum Opinion is generally only issued in a case that does not involve a novel legal issue. Like Kerzner, this case definitely did not involve a novel legal issue. Its outcome, however, is debatable.
While the facts and legal issues in this case are much like the Kerzner case, the outcomes are opposite.
Maguire v. Commissioner, T.C.M. 2012-160 (June 6, 2012). The Maguires, husband and wife, owned two S corporations. The businesses of the corporations were related. One corporation operated an automobile dealership. The other corporation operated a finance company that purchased customer notes from the dealership. The finance company operated at a profit while the automobile dealership operated at a loss. The Maguires did not have sufficient basis in the dealership to deduct the losses. They had substantial basis, however, in the finance company.
The Maguires could have fixed the problem. In a reorganization, they could have formed a parent holding company, an S corporation, and put the two corporations downstream as wholly-owned subsidiaries, and made QSub elections. This would have totally resolved the problem. Unfortunately, they had a minority owner in each entity that would not agree to the reorganization.
The Maguires came up with what they thought was the next best solution. At the end of each year, the finance company owned substantial A/R from the dealership. So, the Maguires caused the finance company to distribute the A/R to them; they had substantial basis to absorb the distribution without tax. Then, they contributed the A/R to the dealership, freeing up the losses with their newly found basis. The transactions were allegedly contemporaneously documented in minutes and the books of both corporations. The underlying customer notes were real and legally binding.
The Service disallowed the losses, arguing the actions between the related entities and the Maguires lacked any economic outlay. This was the same argument the government asserted in Kerzner. Although the transactions were documented by journal entries and corporate resolutions, the parties’ economic positions were not altered.
Losses deductible by a shareholder are limited to his or her basis in the corporation under Code Section §1366(d). A shareholder’s basis in the corporation is increased by capital contributions. To qualify as a capital contribution, the shareholder must make an actual economic outlay. The US Tax Court disagreed with the IRS. Judge Ruwe found the “distributions and contributions did have real consequences that altered the positions of petitioners individually and those of their businesses.” There was an economic outlay.
The court’s decision hinged on several key facts, including:
- The transactions were properly memorialized in minutes of both corporations;
- The transactions were properly recorded in the books of both corporations;
- The underlying customer notes were real; and
- The accounts receivable were legally enforceable, and thus had value.
The facts in Maguire are strikingly similar to the facts presented to the court in Kerzner. The only real difference is that, in Maguire, there was credible evidence that the documentation was done contemporaneously with the transactions each year. Whether economic outlay exists is a question of fact. A few takeaways from Maguire and Kerzner relative to transactions among related parties include:
- Documentation is king. Transactions must be properly documented in the records of the related entities;
- The documentation should be contemporaneous with the transactions; after the fact documentation should be avoided;
- An actual transfer of funds should occur;
- The agreements need to have real consideration and be legally binding; and
- Caution is always required when transactions occur among related parties.
Kerzner and Maguire should serve as lessons for tax advisors. Transactions among related entities will be closely scrutinized. Economic substance must exist to withstand the attack.
Larry J. Brant
Larry J. Brant is a Shareholder in Foster Garvey, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; Washington, D.C.; New York, New York, Spokane, Washington; 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.