Tax Gross-Ups Make Parachutes More Golden
The battle to retain talent in a tight labor market and the consolidation trend that continues in many sectors of the economy are responsible for the popularity of "golden parachute" provisions for top executives.
A study of 350 corporations revealed that 64% of them provided financial protection for one or more key executives in 1997 in the event there was a change in company control. Golden parachutes, however, have significant tax implications for both the company and the executive.
If a parachute payment exceeds a certain threshold, the executive who receives the payment is subject to a 20% excise tax in addition to his or her regular income tax. Also, the portion of the parachute payment above the threshold amount is not deductible by the company as compensation to the employee.
Companies have several alternatives when it comes to providing the payments and dealing with the taxes thus generated, said Howard Golden of the New York office of William M. Mercer, which had conducted the study.
The two most popular tax approaches for golden parachutes are
- The cutback approach. The company pays the employee up to the threshold. In such cases, the company can deduct the full amount of the parachute payment and the employee is not subject to any excise taxes. The employee, however, may receive less additional compensation if this approach is used.
- The gross-up approach. The company absorbs the nondeductibility of the amount of the payment above the threshold. In addition, the company increases (grosses up) the payment to the employee to compensate for excise taxes.
"Gross-ups are moving forward as the design method of choice," Golden said. His observation was corroborated by the results of the study. It showed that nearly two-thirds of the companies that had golden parachutes used tax gross-up features to compe nsate executives for the additional tax exposure that resulted from the parachute payments.
How does Uncle Sam feel about these gross-ups? According to Golden, the IRS is neutral on the subject. "Either way, the IRS doesn't suffer a loss," he said.
AICPA Takes Stand on Tax Shelters
The AICPA entered the tax shelter debate when tax executive committee chairman David A. Lifson testified before the House Ways and Means Committee this spring. In his testimony, Lifson commented on the revenue provisions of President Clinton's fiscal year 2000 budget proposal.
"We oppose abuses of the tax system through improper activities," Lifson said, stating the AICPA's position. The restriction of such activities makes the tax system fairer for all taxpayers, he added.
Lifson, a CPA with Hays & Co. in New York City, said the AICPA supported the administration's efforts to curtail "tax avoidance transactions," but it also supported a taxpayer's right to legally minimize his or her taxes.
Lifson expressed concern over several of the provisions in the proposed budget. Most significant, he noted, the distinction between legitimate tax planning and improper tax activities was not clearly defined. As a consequence, taxpayers might be penalized for legitimate tax planning, he said.
In addition, Lifson voiced uncertainty about the level of authority granted to the IRS in the form of sanctions and penalties under the proposed budget.
"Anti-abuse legislation should be directed at transactions that are mere contrivances designed to subvert the tax law," Lifson said. "We see the proposals as an overbroad grant of power to the IRS to impose extremely severe sanctions on corporate taxpayers by applying standards that are far from clear."
Limits on Tax Court's Authority
In a recent case, the Sixth Circuit Court of Appeals affirmed the limited jurisdiction of the Tax Court. It held the Tax Court could not use the doctrine of equitable recoupment to allow a time-barred refund to a taxpayer's estate. Equitable recoupment is used to relieve an inequity resulting from the inconsistent tax treatment of a transaction. (An income tax refund, for example, can be used to offset a deficiency in estate taxes.)
At the time of her death in 1986, the estate of Bessie I. Mueller included 8,924 shares of Mueller Co. stock. The estate filed a timely estate tax return that reflected a $1,505 per share value for the stock. Shortly after Mueller's death, the estate sold the stock for $2,150 per share. It computed the capital gain on the sale using a basis of $1,500 (a $5 per share difference from the estate valuation) and paid income taxes for 1986 on the reported amount.
The IRS subsequently assessed a deficiency against the estate based on the valuation of the stock. The IRS valued the stock for estate tax purposes at the sale price of $2,150 per share. The IRS alleged that this increase in value and other adjustments (including an unclaimed credit for tax on prior transfers) resulted in a tax deficiency of nearly $2 million.
The estate challenged the deficiency in Tax Court (TC Memo 1992-284), and in Estate of Mueller v. Commissioner (Mueller case I), the Tax Court held the Mueller stock to be worth $1,700 per share. The increased basis ($1,700) resulted in a taxable estate that was less than the IRS's revaluation and--combined with the allowance for the prior unclaimed credit--an overpayment.
While the higher stock valuation increased the value of the estate for estate tax purposes, it also resulted in a higher basis in the stock, less the gain on its sale, and an overpayment of the income tax for 1986. By the time of the court's decision, however, the statute of limitations had expired on the 1986 income tax return.
The Mueller estate claimed it was entitled to equitable recoupment of the overpayment of the income tax. In Mueller case II (101 TC 551 ), the IRS challenged the Tax Court's jurisdiction to apply the doctrine. The court denied the IRS's motion.
In a third trial (107 TC 189 ), the Tax Court held that the doctrine of equitable recoupment is restricted to use as a defense against an otherwise valid claim. Since the IRS had no valid claim for additional tax, the defense of equitable recoupment did not apply. Equitable recoupment can be used by the Tax Court only to decrease a deficiency and not to create or increase a refund.
The Mueller estate then filed an appeal with the Sixth Circuit to determine whether a taxpayer could assert equitable recoupment to use a time-barred overpayment of income tax to offset a timely charged deficiency in estate tax. The appeals court held that the Tax Court is a court of limited jurisdiction that does not have general equitable powers. The court dismissed the Muellers' appeal without deciding the issue of equitable recoupment or giving a ruling on the overpayment of income tax issue.
Observation. Tax advisers should advise their clients that Tax Court is a court of limited jurisdiction, and it does not have general equitable powers. Although the doctrine of equitable recoupment can be a remedy against inequities, the Tax Court lacks the authority to apply the doctrine.
Tina Steward Quinn, CPA, PhD, , assistant professor of accountanc y, and Keith W. Smith, CPA, PhD, associate professor of accountancy, Arkansas State University, Jonesboro.
Involuntary Conversions With Multiple Payments
Under IRC section 1033, if a taxpayer's property is destroyed or condemned, he or she can exclude any gain on such involuntary conversions by acquiring similar property within a period that ends two years after the close of the first year gain is realized. However, when a taxpayer receives compensation for the property in two or more different tax years because of questions about its value, what is the time period for replacing the property to be eligible for a section 1033 deferral?
John Mahon and his wife operated a citrus tree business as a sole proprietorship. During 1985, the state of Florida destroyed their trees to prevent the spread of disease. In 1986, the state paid the Mahons approximately $42,000 in compensation for the destroyed trees. In 1992, following a lawsuit by other affected parties, they received an additional $1.3 million, of which approximately $573,000 was labeled interest. The Mahons omitted most of the proceeds from their 1992 tax return on the grounds that they were excludible under section 1033. On audit, the IRS determined that the full proceeds were taxableand should have been included on the Mahons' 1992 returnbecause no replacement property had been acquired during the required two-year period, which ended at the close of 1988. Following the audit, the Mahons filed a petition for bankruptcy. The IRS filed a claim for the taxes in U.S. Bankruptcy Court.
Result. For the IRS. The Bankruptcy Court rejected the Mahons' arguments for excluding the proceeds. They had claimed the proceeds were not taxable based on the doctrine of equitable recoupment, which allows taxpayers to recover taxes paid on related items, arising from the same transaction, that were treated inconsistently and now are barred by the statute of limitations. The court said that doctrine applies only when the IRS takes a different or inconsistent position on a return barred by the statute of limitations. In the Mahons' case, the IRS had not taken such a position on a prior return.
The Mahons also argued that the receipt of proceeds in two different years created two replacement periods. The Bankruptcy Court said the Tax Court had already rejected this position in Shipes , a case where the taxpayer was affected by the same citrus-tree-destruction program.
The Bankruptcy Court also found the two private letter rulings the Mahons cited as supporting multiple replacement periods to be irrelevant to their situation.
- In PLR 9028046, the taxpayer was permitted to exclude proceeds received after the close of the replacement period because the replacement property acquired during the period cost more than the sum of all the proceeds received. The exclusion was not the result of the IRS's having allowed two replacement periods.
- In PLR 8915013, the taxpayer's replacement period appeared to have been extended beyond the statutory period. However, receipt of the proceeds was in dispute and therefore not recognizable until later. A replacement period runs for two years after the year the first gain is realized; in this case, that period did not start until the dispute was settled, making the actual replacement within the statutory period.
Finally, the Bankruptcy Court said the fact the Mahons did not receive or even know about the second payment until after the replacement period closed was immaterial. The IRC provides for an extended replacement period if the taxpayer requests an extension before the period closes. Since the Mahons had not requested one, an extension was not granted. Future taxpayers who believe they might receive additional compensation must file for an extension in order to have time to reinvest subsequent recoveries.
- In re John Mahon , 1998 Bankr. Lexis 1056, 98-2 USTC 50,684.
What is a Capital Asset ?
Corporate stock generally is a capital asset unless it is owned by a company that is a dealer in corporate stock. For corporate taxpayers, classification of an asset as a capital asset is undesirable since it results in capital gains being taxed at normal corporate rates while capital losses can reduce only capital gains and not other income. As a result, corporate taxpayers generally attempt to have the stock they own classified as an ordinary, rather than a capital, asset.
Cenex, Inc., is an agricultural cooperative corporation that sells petroleum products to farmersamong other things. Along with eight other cooperatives, it created Energy Cooperative, Inc. (ECI), to operate an oil refinery. Only ECI shareholders were entitled to purchase oil from the company. When ECI went bankrupt, Cenex deducted the loss as an ordinary loss. On audit, the IRS reclassified the loss as capital on the grounds that the ECI stock was a capital asset. Cenex appealed.
Result. For the IRS. IRC section 1221 defines as capital assets all assets except those that meet any one of five limited exceptions. Cenex argued that its ownership of ECI met the first of these exceptionsthat stock in trade or other property of the kind a company would properly include in inventory is not a capital asset.
In the seminal Corn Products case, the U.S. Supreme Court held that corn futures were not a capital asset because they were an integral part of the company's inventory acquisition system. Following this decision, numerous courts accepted the argument that assets a company acquires for a corporate business purpose are not capital assets. However, in Arkansas Best, the Supreme Court rejected this expansion of its Corn Products decision and ruled that the exception is limited to inventory and items that are substitutes for inventory.
Cenex argued that it acquired the ECI stock to obtain inventory and thus it met the limited exception under Arkansas Best. Even if it did not qualify under this exception, Cenex said it qualified under several "source-of-supply" cases which the company said were unaffected by the Arkansas Best decision.
The Federal Circuit Court of Appeals rejected both arguments. It said that, to meet the Arkansas Best exception, an asset must be a surrogate or substitute for inventory. Although its ownership of ECI stock permitted Cenex to purchase inventory, the company was not guaranteed a particular quantity or price. Therefore, the ownership was not closely related to inventory and could not be considered a substitute for it. As for the source-of-supply cases Cenex cited, the Federal Circuit ruled that Arkansas Best had, in fact, overturned them.
The fact that a company purchases an asset for a business purpose does not automatically remove it from capital asset status. The asset must fit squarely within one of the five narrowly interpreted exceptions. Taxpayers attempting to argue that an asset is an inventory substitute must be able to show that ownership of the asset guarantees them the right to acquire a specific amount of inventory at a fixed price.
- U.S. v. Cenex, Inc. 156 F.3d 1377 (Fed.Cir.), 82 AFTR 2d 6645.
Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accountancy and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.
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Michael Lynch, CPA, Esq., professor of tax accounting at Bryant College, Smithfield, Rhode Island.