Predictive Coding in the US Tax Court – The 21st Century Meets Tax

When business writers and commentators talk about future-focused and innovative industries, they don’t tend to put law on the list.  Maybe on the “slower to change” list (examples of why include wigs in court (outside of the US), lace-up wingtips as office attire (in the US), and the ongoing unresolved discussion of what to do about the billable hour system).  There are people and places looking to bring law into an efficient, tech savvy 21st century (such as the Michigan State University College of Law’s Reinvent Law Laboratory) but law, especially tax law, tends towards traditional processes and structures.

However, in true case of first impression (and 21st Century impression), the United States Tax Court has authorized the use of predictive coding in replying to an IRS request for taxpayers to produce electronically stored information (ESI) contained on backup storage tapes.    USTC Opinion for Dynamo Holdings LP v. Commissioner, 143 T.C. No. 9 (Sept. 17, 2014) is  here.

The Commissioner and taxpayer ran into disagreement over how ESI would be sorted and produced based on the taxpayer’s estimation that it would “take many months and cost at least $450,000 to fulfill [the IRS request] because they would need to review each document on the tapes to identify what is responsive and then withhold privileged or confidential information.”

Predictive coding is a computer-aided search and document review process that allows one or more parties to select search criteria (names, dates, other key words, etc.) from sample representative documents and then search larger data fields for patterns of potential relevance. The taxpayer in Dynamo Holdings believed that use of predictive coding would allow it to respond to the IRS at a cost substantially less than $450,000 and without inadvertent disclosure of confidential information.

The Tax Court, in light of its mandate to construe its Rules “to secure the just, speedy, and inexpensive determination of every case” considered the taxpayer’s request to use predictive coding “to efficiently and economically identify the non-privileged [responsive] information” and permitted it, finding a “potential happy medium” in the use of this new “form of computer-assisted review that allows parties in litigation to avoid the time and costs associated with the traditional, manual review of large volumes of documents.”

While this is one opinion, the USTC’s recognition of the technical and efficiency value of predictive coding is big news in and of itself.  Maybe not to tax law, but to efficient and modern practice of law in a time where clients want faster, cheaper, better service.

What May Qualify as a 501(c)(3) charity? A Medical Marijuana business?

While I generally work with mature companies in traditional fields (services, manufacturing, construction, pharmaceuticals), I occasionally receive phone calls from individuals I’ve not worked with before, referred to me by another professional, with fresh new questions.  A new question came last week – can a medical marijuana business that is legal under relevant state law qualify as a federally exempt charity under IRC Section 501(c)(3)?  I presume that the desire to operate as a nonprofit comes from the desire to avoid IRC Section 280E, which penalizes businesses “trafficking in controlled substances” by denying them deductions and credits.

I did not know the answer off-hand, but had two immediate thoughts – (1) isn’t pot still covered, federally, by the Controlled Substances Act? and (2) I don’t see the IRS getting behind granting the most valuable form of tax exempt status (valuable because (i) the nonprofit is exempt from tax and (ii) donors may take deductions from their taxes) to an activity that is not federally legal.

My hunch was correct – quick research produced several PLRs (IRS Private Letter Rulings) explaining why medical marijuana clinics could not qualify for IRC 501(c)(3) status due to the federal “illegal” status of the drug under the Controlled Substances Act and the public policy implications of permitting “charity” and donation deduction status to a disfavored activity.   My Walsh College colleague Professor Dan Hoops has written on the CSA and marijuana businesses in other contexts (again, the CSA is not “facilitating” the spread and profitability of this business).  Paper here.  A law professor at American University Washington College of Law suggests that IRC 501(c)(4) “social welfare organization” status may be available instead, or at least not barred under public policy grounds. I have not tested this concept. Paper here.

This is not an issue that is practically applicable to most taxpayers or clients, but it is a good example of what I like best about tax law – a novel question, a payoff for those who like deep dives into research, and a public policy angle.  It’s a living subject and an ever-changing body of law with some clear answers and thousands of gray areas.  And while the answer of “If you want to have your farm or clinic receive 501(c)(3) status you have a battle ahead of you that others have lost” may not have been the desired one, it’s better to ask first (or at least ask early).

Using Tax Law to Drive Behavior, and the “Inversion Fail” – Updated

Updated to add – as discussed below, whether for capital gains sale treatment upon a corporate inversion, or the excise tax on executives who authorize inversions, the “disadvantages” of an inversion may be eliminated for corporate insiders when the company grosses up compensation to cover penalties and other fees.  Medtronic is doing this for its CEO to the tune of $25 million dollars.  It’s legal, grossing up to cover insiders’ costs is not uncommon (only a problem if it isn’t reported is income to the recipient), and I’m not necessarily against it (just report that income and pay the tax) – but it’s another example of the “incentive fail” mentioned below.

I taught tax to accountants last semester and am starting a semester of tax law to law students at a Big 10 university about an hour from home.  I’m finding that the longer drive time is a welcome way to catch up on NPR, local news, and podcasts (something I do not do in my shorter home to office commute).  If I run out of those I can finally learn Japanese or tackle another item on the life list.

Every time I teach tax law, whether to accountants or lawyers (and let me digress to add that “tax” is always “tax law,” as the body of rules comes from statutes, regulations and case law – something that some do not acknowledge, thinking that tax belongs to accounting alone) I talk, when applicable, about how tax law and policy are frequently used to give incentives, or disincentives, to select behavior.  For example, the mortgage interest deduction makes buying a home more appealing.  Favorable capital gains and dividend tax rates make investment in business more appealing.  The “kiddie tax” rules, assignment of income doctrine and others (constructive dividends as well) limit gaming the system by pushing income to lower tax brackets in the family or making personal expenses deductible, and limit attempts to have a more appealing 1040 liability by pushing some income onto another family member.

NPR had an interesting story yesterday on (to use the internet “fail” meme) the “Inversion Fail.”  Corporate inversions are a frequent news topic these days – an unpopular but lawful move of company tax HQ offshore to change how the entity presently realizes and pays tax.  Under the Code, US persons pay tax on worldwide income, but foreign persons only pay tax to the IRS on US-sourced income under certain conditions.  The US shareholders of a wholly foreign corporation still pay tax, though, on their foreign as well as domestic income (one source of the offshore bank account issue – yes the account is offshore, yes you are a US taxpayer, yes, you still have to report and pay tax on that offshore income – thought you didn’t, eh?).

There is tremendous condemnation from many along a wide political spectrum for the corporation’s ability to pay less tax, or less present tax, but in all of this anger a big point is being missed – while an inversion may benefit the corporation, it does not necessarily benefit the shareholders – they may pay capital gains tax on sale of their existing shares to effect the inversion, and remain liable for tax on distributions and dividends.  Some useful, basic analysis here and here.  Worse for shareholders, if the inversion creates a taxable deemed sale, and post-inversion the new stock received performs worse, the tax bill (and liquidation of other assets to pay the tax bill) will be followed by a disappointing investment.

Per the NPR story, the immediate deemed sale on shareholders was an intentional disincentive to keep US companies from “inverting” overseas.  Possibly on the theory of “who would elect to walk into a taxable sale just to avoid US corporation tax?”  Answer – the executives and other insiders who can afford the deemed sale tax (may even have their compensation grossed up to cover it) and are taking a longer view.  Not the little guys, who would have little to no vote on corporate transactions anyway.  Disincentive fail.

Nonresident Pass-Through Taxation and the Sundance Kid: Redford Sues NY

The legendary Robert Redford, actor, director, founder of the Sundance Film Festival and former owner of Sundance Channel LLC, filed suit seeking cancellation of a $1.6 million dollar tax assessment from the State of New York on July 30, 2014 in the case Redford v New York State Department of Finance et al, New York State Supreme Court, Albany County, No. 003974/2014.  In this suit, Redford requests a declaratory judgement regarding whether New York State may constitutionally assess tax against him for indirect sale of a portion of equity in the Sundance Channel, and the assessment cancellation mentioned above.

Why is Redford’s suit newsworthy, other than as a celebrity tidbit?  Amount of assessment aside, it is a good reminder to the business community of how many states have become much more aggressive in attempting to collect tax from nonresident persons and companies.

Under the concept of “nexus,” states may tax persons and entities who have “sufficient” contacts with the state.  How much is enough to support taxation?  Typically, a taxpayer has nexus to be taxed – in very general terms – if the taxpayer is physically present in the state  or purposefully or actively solicits more than a minimal amount of sales in a state.  These tests for finding nexus to tax are limited by federal law P.L. 86-272, which exempts sales of tangible goods where orders are placed and shipping  originates out of state.

However, in recent years, with state revenues strained nationwide, a number of states have begun to go beyond traditional “nexus” and around P.L. 86-272 to attempt to tax individuals and companies only indirectly connected to the state – often through ownership in a flow-through or pass-through entity like a partnership, LLC taxed as a partnership, or Subchapter S corporation. New York has succeeded in collecting tax from nonresident shareholders upon IRC Section 338(h)(10) sales of Subchapter S corporations, and Michigan’s new Corporate Income Tax creates nexus in owners of pass-through entities taxable in Michigan, or the entire unitary group of companies if one is taxable in Michigan (each an attempt to reach out of state to tax persons who are not physically present with Michigan or conducting business in state).

So back to our Celebrity Tax News.  Redford is a Utah resident, and according to the complaint filed above, owns 100% of Sundance TV, Inc., a Subchapter S corporation (not domiciled in NY) (“Inc”), which owns 85.5% of Sundance Television Limited (a limited partnership not domiciled in NY) (“Limited”).  Limited owned 20% of the Sundance Channel LLC, a New York entity that operated a cable channel (“LLC”).  Redford’s complain characterizes Inc.’s and Limited’s investments (in Limited and LLC, respectively) as passive and managed from out of state.

In 2005 Limited sold a portion of its ownership in LLC, the New York entity, and recognized gain.  Any gain would be passed to the partners of Limited and shareholders of Inc and, to the extend that Redford was an end recipient of pass-through gain, to an individual who is not a resident of New York.  Redford’s attorneys argue that the gain on sale of LLC was not New York “source income ” and thus should not be taxable in New York.  If Redford were to pay nonresident tax on New York source income to New York, in addition to Utah resident income tax in his domicile of Utah, he would be subject to double taxation on the gain amount – a result that tax laws intend to avoid as excessive.

What’s next?  We’ll see – the Redford complaint was just filed and we have to wait, just as we in Michigan must wait for further Michigan Department of Treasury guidance on Michigan’s extension of nexus to out of state owners of pass-through entities in Michigan.    These aren’t the first, and won’t be the last, attempts by states to tax nonresidents who directly or indirectly own pass-through entities – if such a tax assessment comes to you or a client, don’t sit on your rights, get knowledge and guidance ASAP.

Business and Tax Planning Thoughts from the EAA Oshkosh Airventure Airshow

I escaped the office last week for a few days at the Experimental Aircraft Association’s annual Airventure in Oshkosh, Wisconsin, watching the air show and wandering through the avionics and engine component vendor booths.  A few business and tax planning thoughts came to mind as I wandered among the vintage sport plans, war birds and vendor displays.

1) Many corporate aviation services, and makers of nice, sizable twin prop and small jet craft were at the show.  Are these ultimately owned directly by individuals, heavily insured, or by LLCs, also insured?  In either case, insurance is key – there was a fatality at the show the day before we arrived, and I’ve known of a few pilots who ended up in fatal misadventures (some due to weather, some to weight and balance miscalculations in homebuilt aircraft).  Insurance can provide for surviving spouses and children, as well as compensate injured or deceased passengers and their families.

* If an aircraft is shared by multiple owners in LLC ownership, a problem similar to the Cottage LLC arises – are the owners going to contribute towards maintenance?  Is everyone “on board” with this or are hard feelings (“you use it more so I pay too much”) simmering?  Is there an aircraft LLC Operating Agreement (and was it custom drafted or generic)?  Was the aircraft title transferred to the LLC properly?

* If the aircraft is owned by a business, are records of business use, expenses and costs being kept for annual accounting and in case of IRS audit?  Contemporaneous records are key – the client who has to “recreate” at the time of audit is at a disadvantage, and a risk of fraud if the recreation becomes “creative.”

 * If the aircraft is used by one or more business owners, is a buy/sell agreement in place in case of the death or disability of a business owner?  If the buy/sell was intended to be funded with insurance, was this actually done (often the answer is “not yet”)?

* If the aircraft is held in a LLC, is it “wet leased” (with crew, fuel, oil and services) or “dry leased” (plane only, users hire crew and pay expenses) to its users?  There could be Federal Aviation Regulation and Internal Revenue Code 7.5% federal excise tax implications to wet lease transportation services – and call that insurance agent and read the policy well to make sure that what you actually do is covered as you think it will be.

2) Many vendors are on the Oshkosh airfield selling electronics, avionics, engine components, black steel brake rotors, seat and interior coverings and miscellaneous hardware.  One day at lunch I overheard an experienced A&P (aircraft and powerplant) mechanic talk about past and present air show sales trends – sales at the show were down under the prior 7% sales tax, up in 2014 with a lower applicable rate.  However, past and present, some pilots and mechanics chose to window shop, talk to manufacturer’s reps and order components from online retailers once home – if the cost of shipping is less than the cost of Wisconsin sales tax.

 * However, my compliant taxpayer friends, don’t make the unschooled Amazon and Ebay shopper’s error and assume that no state sales tax is a discount – your state (check your state, but this applies to Michigan and most) will expect reporting and payment of use tax on orders from out-of-state sellers – and if there is no proof of payment of either sales or use tax on audit, the unlucky taxpayer will very likely be in for a sizable sales/use assessment, with penalties and interest (and if there is no use tax return filing, the statute of limitations on assessment and collections remains open).

Legal and tax planning considerations are probably low on the list of the aircraft enthusiast or business craft shopper – the right plane or helicopter and an (adequate to optimal) insurance policy probably come first.  However, the business owner or aviation professional may benefit from planning to optimize enjoyment, and reduce risk and liability, for future adventures in the air.

Risks, Rewards and Creativity (?) for Startups and Other Ventures

I’ve been working on LLC Operating Agreements for a variety of client types recently.  Each poses its own challenges with risk and potential financial reward – sometimes connecting maximum flexibility with maximum uncertainty (in ways that established business clients might not appreciate).

Two Client Types, Two LLC Operating Agreement Needs:

1) The experienced business people, perhaps starting a new partnership in a familiar business field or leaving an employer to have their own small firm again. They may be happy with “the usual” buy-sell terms (redemption or cross-purchase on death, disability, termination of employment, certain other events) and allocation of profits and losses in accordance with percentage interests.  Maybe, if they really want to be “equals” and choose one of the lawyer’s least favorite things – 50/50 voting, they’ll need a deadlock provision or a “shotgun” clause (layperson translation – I don’t like you anymore, buy me out or I’ll buy you out).

In some cases, while the mature business person presents more opportunities for tax, succession and estate planning due to the income they generate from their line of work, these clients may wish for more streamlined LLC tax treatment – just allocate that profit and loss ratably, make distributions for tax payments, and let us run with the business.  They can turn to onshore and offshore investments and to their estate plans for tax savings or deferrals – or to attorney-structured small business or professional practice retirement and benefit plans –  and may desire much more creativity in structuring a future transition of the business. Their risks may be less in the LLC’s day to day governance than in their field of expertise or market.

2) The startup, founded on technology or other idea capital, some cash, and high hopes for grant funding or later investors or market success.  These founders may be much more interested (especially if they read startup and venture advice) in controlling near term equity vesting under something like the “4 years + cliff” concept (equity starts vesting after a 1 year wait, then 25% year) to avoid founders departing early and expecting to be paid for their equity.  Though in all honesty, in a startup, what is that vested equity worth in years 2-4?  It depends on book value, assets, EBITDA or another objective measure and it may not be as much as insiders think or hope.

These founders, if only one or two are cash contributors, may wish for more customized and technical partnership tax allocations, such as targeted allocations for early repayment to investors, or allocation of losses in accordance with capital contributions.  Or maybe the higher income bracket parter wants losses first, and then profits to repay the losses, or something else custom-drafted. Their potential reward (starting from zero, or close to it) may be huge, and with it the risks of failing to launch, or scale.  Different risks from the established going concern, and different desires for structural planning.

I spent some quality time with the 704 Regs yesterday (an activity that can lead one to wonder what cosmetic dentists and investment bankers do during the day), looking into evaluation of “substantial economic effect” of certain types of loss allocations to cash contributing founders. In layperson’s terms, looking at substantial economic effect asks “can we do this and not be in trouble with the IRS?”

The 704 Regs, or that part of federal Partnership Taxation that is to “simple LLC planning” what fugu is to sushi, govern how much creativity a tax planner may have in allocating items of profit and loss in (non-standard ways.  The density of the Regs and difficulty of the material give attorneys and accountants just enough ability to be creative to open up audit land mines.  No easy answers here, everything is fact and circumstance dependent.

What caught my eye, from one of the 704 Regs and the IRS audit techniques manual, was the discussion of transitory allocations (the IRS example is all losses to the higher income tax bracket partner, then all profits, in a highly speculative new startup with no guarantee of any profit).  The winning fact and circumstance that gave the custom-crafted transitory allocation “substance” was the presence of sufficient levels of risk so that no prediction could be made on profits offsetting losses in the first 5 years. There might be nothing but losses.  The business might not make it to year 5.  There is a certain irony to offering the greatest ability to creatively plan for profit and loss allocation to the business that might benefit from it less (profits? what profits?).  There is also a philosophical consistency with the Code’s and IRS’s desires to disallow tax avoidance.

In any case… each business is different and each stage is different.  What flies for the founder putting $25,000 into a startup, and hoping not to lose it all (at least without getting some deduction or offset) may not fly for the experienced professional starting a new LLC, but not a new line of work.  It’s all facts and circumstances, no easy answers here, but specialist know where to find the few answers or guideposts that exist.

Commercial Contracts – That’s Not Boilerplate!

In Part Two of this week’s posts on “That’s Not Boilerplate!” we have commercial contracts, or purchase order terms and conditions.  Yes, sometimes they are long, or tedious, or printed on the back of an order form in painfully tiny font, but as in my previous post regarding LLC Agreement terms, they can impact real money and rights – these are not boilerplate to be skimmed or ignored.

While it may be tempting to skim a contract or PO to focus on the goods, quantity and price, the material that can impact rights and money – big money – in the future may be located in the warranties (or “no warranties”) section, any limitation of liability section and, most important, the indemnification section.

The Indemnification, or “hold harmless” section, contains promises by one party – or both – to pay certain costs, losses, expenses and claims.  Here is where things get interesting – the section is almost infinitely customizable.  The payor – Indemnifying Party – may promise to cover costs for as little as personal injury, property damage or death due to willful misconduct, or as much as any claim or expense due to any action or inaction.   Attorney’s fees incurred by the aggrieved party may be paid (or not) as well.

You don’t have to be experienced in contract review to see how much of an economic impact indemnification section drafting can have on the party promising to hold the other harmless (i.e., pick up the tab).   And in a contract for sale of goods, a promise to pay for any claims or any losses may just be so broad that it overrides a well-crafted, limited product warranty and disclaimer of other liabilities.

The moral of this Monday post is – read the “boilerplate” carefully, because it really isn’t boilerplate, and be extremely careful in drafting or agreeing to another party’s drafts.  The money spent on experienced commercial contract attorney review may be miniscule in comparison to potential future liability.