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Fools and Knaves, Wall Street Journal Edition

I have developed a simple rule of thumb in analysing conservative policy pronouncements, the Knaves and Fools Rule. The rule is simple: Conservative policy pronouncements are made by knaves and then the pronouncements are believed and repeated by fools. It is with some sadness that I have to report that someone who is no fool, Paul Caron, got fooled by the the knaves at the Wall Street Journal.

At his justifiably well-regarded TaxProf Blog, he notes what he feels is a "interesting editorial" in today's WSJ. The editorial is available online only to subscribers, but it's thesis is that "[e]ven the most ardent class warriors have no choice but to concede that the U.S. income tax code is steeply progressive -- that is, that it soaks the rich." The article goes on to quote from a study that purports to support this conclusion. Among other things, the study shows that since 1979, the proportion of the federal income tax burden borne by the wealthiest Americans has grown. (As is shown below, the "other things" that were reported in the study and which were critical to the ultimate conclusion reached by the study's authors were conveniently omitted in the WSJ editorial.)

Caron pulls a table from the study which shows that the percentage of total taxes paid by the really wealthy and the really, really wealthy increased dramatically from 1979 to 1999, and declined thereafter. He is fooled into believing that the chart illustrates that there was a dramatic increase in progressivity in the tax system in the 1979 to 1999 period and then a slight decrease thereafter. Had Caron thought about this proposition for a moment, he would have realized that the chart did not support either his or the WSJ's conclusions. Simply because X pays a higher percentage of all taxes in 1999 than he did in 1979 does not mean that the tax structure has become more progressive with respect to X. It may mean that X is making a whole lot more money in 1999 than he did in 1979. In fact, this is precisely what the study relied on by the WSJ reports.

The study, authored by Michael Strudler and Tom Petska of the IRS and Ryan Petska of Ernst and Young, can be found here. Among the points made in the study were the following:

• Between 1979 and 2002, the threshold for the top 0.1 percent grew from $321,679 for 1979 to $710,661 for 2002, an increase of 121 percent. Similarly, the threshold for taxpayers in the 1-percent group rose from $109,751 for 1979 to $175,618 for 2002, an increase of just over 60 percent. However, the thresholds for each lower percentile class show smaller increases in the period; the top 20-percentile threshold increased only 5.6 percent, and the 40-percent and all lower thresholds declined. In other words, over the period studied, the rich got a whole lot richer than everyone else and began to put real distance between themselves and the middle class.


• The share of income accounted for by the top 1 percent of the income distribution has climbed steadily from a low of 9.58 percent (3.28 for the top 0.1 percent) for 1979 to a high of 21.55 (10.49 for the top 0.1 percent) for 2000. To put it another way, the rich have become real hogs with respect to the portion of the total economic pie they consume.

What is the conclusion of the paper with respect to the increase or decrease of progressivity in the federal tax system? Rather than give you my slant on this, I will just quote the paper's conclusions verbatim:

So what does this all mean? First, the high marginal tax rates prior to 1982 appear to have had a significant redistributive effect. But, beginning with the tax rate reductions for 1982, this redistributive effect began to decline up to the period immediately prior to TRA 1986. Although TRA became effective for 1987, a surge in late 1986 capital gains realizations (to take advantage of the 60-percent long-term capital gains exclusion) effectively lowered the average tax rate for the highest income groups, thereby lessening the redistributive effect.

For the post-TRA period, the redistributive effect was relatively low, and it did not begin to increase until the initiation of the 39.6-percent tax bracket for 1993. But since 1997, with continuation of the 39.6-percent rate but with a lowering of the maximum tax rate on capital gains, the redistributive effect again declined. It appears that the new tax laws will continue this trend. Analysis of panel data shows that these trends are not quite as great as seen by looking at annual cross-section data, but the trends cited above are still apparent.

Contrary to the WSJ's conclusion, overall, the various changes in the tax code since 1982 have made the federal tax system less, not more, progressive. That is, the rich are paying a lower portion of the overall tax burden relative to their income now then they did in 1982 and the system's progressivity is headed for further declines.

The Moral of the Story: Only fools rely on "facts" bruited about by knaves.

Update

TaxProf links to the posting above and also to a previous posting of his that discussed an article, The Matthew Effect and Federal Taxation, 45 B.C. L. Rev. 993 (2004), by Martin J. McMahon, Jr., of the University of Florida, that illustrates that, over the last 25 years, the rich really are getting richer.

I would be remiss if I did not note that Brendan Nyhan was the first to call the WSJ's lie. Kevin Drum also covered the story. His posting includes a nifty illustrated chart.

One question: The WSJ editorial page lead the pack seeking to sack Dan Rather and other CBS editorial personnel when they relied on material they later discovered was false. Shouldn't the unnamed writer and his or her editor(s) responsible for yesterday's piece be cashiered? After all, the article plainly misrepresented (that is, lied about) the study that it discussed.

Just asking.

Timing Is Everything

11 U.S.C. Section 523(a)(1)(A) excepts from discharge under 11 U.S.C. Section 727 any tax liability that would be classified as a priority tax under 11 U.S.C. section 507(a)(8). Section 507(a)(8) states that a priority tax claim involves any tax liability for a tax year in which the tax return, "including extensions" is due within three years before the filing of the bankruptcy petition. The case of Dippel v. U.S, (Bankruptcy Ct. S.D.Fla., March 23, 2005), demonstrates that the early bird does not necessarily get the worm.

In 2001, the Dippels filed for an automatic extension to file their income tax return for 2000, extending the filing deadline within which they could file a timely return to August 15, 2001. They actually filed a return on April 22, 2001, but the Service marked it as being filed on or before April 15, 2001. They filed a Chapter 7 bankruptcy on June 15, 2004, more than 3 years after their 2000 return was filed, but less that 3 years after the due date, with extensions, for the filing of the return.

The court rejected the request for discharge, noting the unanimity of other courts that taxpayers cannot nullify their previously filed requests for extension. One cannot tell from the facts recited in the opinion whether the taxpayers had any ability to defer their bankruptcy filing by 61 days, but if they could have, they clearly should have.

I Stole this Article

Larry Ribstein makes a serious point in his post, Steal this Article, namely that he has "now awakened to the beauties of free dissemination of . . . academic writings." He refers explicitly to his articles, but I understand him to be in favor of free dissemination of a wide variety of academic writings.

While I strongly agree with Larry's position (some time ago I commented on the miracle of the freely available Public Library of Science jounals), I might not have posted about Larry's posting except for the fact that he provides a link to a free download of Abbie Hoffman's Steal This Book. Like Larry, I may be middle-aged (but, unlike Larry, not old), but there's still a little bit of Yippie left in me and it might be quite some time before I can work in a reference to Abbie on this blog, let alone link to a free download of his book.

Power to the People Larry.

Bad Idea for a Good Cause

Jane Galt suggests that one way to avoid the complications of the estate tax is to (i) have all inherited property receive a basis of $0.00, except for (ii) cash that is inherited, which would be taxed as income. Mark Kleiman thinks that this is a good idea. It's not.

I don't know whether there's been an economic analysis produced as to where the tax burden created by such a provision would fall, but I am aware that there have been analyses done with respect to proposals to do away with the estate tax, but which would also do away with the basis step-up rule. (That is, the basis of assets that are inherited are "stepped-up" to their fair market value as of the date of death.) Such a change would be less radical than the rule that Galt has proposed. The analyses that I'm aware of (I'll try to link to some this evening) show that net effect of the repeal of both the estate tax and the basis step-up rule would be to shift the burden of a tax triggered due to the death of the owner of property from families who are in the high end of familial wealth to those who are less wealthy. The reason is that only the very wealthy pay any estate tax when, as will be the case in a few years, the lifetime credit equivalency is $3M, whereas a good number of people, even people of modest means, receive some sort of inheritance. Almost all of these people would be paying additional tax if the basis step-up rule is eliminated.

My guess is that the Galt plan would, effectively, accentuate this downward shift in where the tax burden lands. For instance, in the 2 minutes since I read Galt's posting, I've already thought of a number of ways to minimize the tax bite where the asset is a family business. (I won't share my ideas with you---I consider them proprietary.) In other cases, families with significant wealth could defer the income tax for long periods of time by, for instance, borrowing against the assets. Families with less wealth who need to tap into inherited assets to buy homes, pay for college educations, etc., could not, since they will likely have to sell assets rather than merely borrow against them.

Like I said, a bad idea, unless you want to shift taxes from the wealthy to those less wealthy.

Update

In a research paper published in 2000, The Distributional Burden of Taxing Estates and Unrealized Capital Gains a the Time of Death, James M. Poterba and Scott Weisbenner conclude that:

[A]mong those with small estates ($1 million or less), taxing capital gains at death would collect more revenue than the current estate tax from roughly half of the decedents. For those with larger estates, replacing the estate tax with a tax on unrealized gains at death would result in a substantial reduction in total tax payments.

While the figures used in the report are from 1998, there is no reason to believe that the conclusion does not continue to apply today. In fact, since the unified credit amount has been dramatically increased, limiting the estate tax to taxable estates of over $4M, one would expect that the results today would be even more skewed in favor of the wealthy.

For an excellent primer on various policy questions pertaining to the estate tax, one should take a look at Estate and Gift Taxes: Economic Issues, by Jane G. Gravelle and Steven Maguire for the Congressional Research Service. They discuss a good number of the issues surrounding the estate tax, including how the tax works, whether the tax causes individuals to prematurely sell family businesses and farms (it doesn't, since "one can conclude that most farmers and business owners are unlikely to encounter estate tax liability"), and the claim that the costs of administering the tax eat up the revenue generated (they don't--the costs of administration are approximately 6-9% of the revenues generated).

Peanuts and Cracker Jacks

Via A Taxing Blog, I have come across the important academic paper, Identifying Moral Hazard: A Natural Experiment in Major League Baseball by Professors John Charles Bradbury and Douglas Drinen of the University of the South. The abstract of article is as follows:

In baseball, allowing a designated hitter (DH) to bat for the pitcher creates the potential for moral hazard among pitchers, who may then hit more batters without the fear of retaliation by the opposing team. The use of the DH in only one of Major League Baseball's two leagues provides a natural experiment to test for the existence moral hazard in a controlled setting. We develop a new micro-level dataset of individual plate appearances, which allows us to control for detailed cost-benefit attributes that affect the decision calculus of the pitcher. We find that moral hazard explains 60 to 80 percent of the difference in hit batsmen between leagues and find evidence of direct retaliation against plunking pitchers.

In other words, the DH rule not only does violence to the purity of the game, it also promotes violence on the field by removing disincentives to throwing pitches at batters.

The publication of the article raises once more the question of when that famous scholarly work, The Common Law Origins of the Infield Fly Rule, 123 U. Pa. L. Rev. 1474 (1975), will appear on the web.

Waiting for the Plumber, or Somebody Like Him

I am strongly in favor of the publication of greater numbers of judicial opinions. For instance, I see no reason that the Court of Special Appeals cannot publish all of its opinions on the web in the same way that the Fourth Circuit does, with opinions that the court feels should not constitute binding precedent being denominated as "unpublished.

I am also in favor of specialized courts to deal with serious business disputes. I believe that such specialized courts will lead to swifter and more certain resolution of business disputes, in the long run reducing the economic friction caused by disputes. A recent opinion by the Circuit Court for Baltimore City disappoints on both fronts.

The Circuit Court for Baltimore City publishes, on the web, a number of its decisions. The website is here. That's good. It allows businesses and their counsel insight into how nisi prius courts deal with business disputes and, theoretically at least, encourages settlements by reducing uncertainty. However, the opinion, in the case of Carnegie International Corp. v. Grant Thornton, LLP, is a disaster as a roadmap. It also reveals structural weaknesses in what, in Maryland, are termed Business and Technology Cases, that is, cases specially singled out for special treatment because of the complex business issues they present.

Carnegie is a 63 page opinion. (I read it while waiting for the sewer clearance people from Baltimore County to arrive to clear a sewer blockage at my home. It was a long wait. It is a long opinion.) One has to go at least 7 pages into the opinion to find what may be a concise statement as to the essential claims made by the plaintiff. Even then, it is not clear to me that this description applies to all of the claims, but that appears to be the case. The gist of Carnegie's claims seems to be that Grant Thornton caused Carnegie damage by taking actions or failing to act with the result that the trading of Carnegie stock on the American Stock Exchange was halted. The opinion, which probably reaches the correct legal result, fails as a cogent discussion of the case and the legal issues because it doesn't start with the type of opening that all good essays start with ("Once upon a time . . . .") and doesn't tell a story. As I tell my students, anyone who can tell a good dirty joke, and by this I mean a real joke, not merely a one-liner, can probably write a good brief, memorandum, or contract. Remember, a good joke starts with a factual premise, clearly stated ("A priest, a minister, and a rabbi walk into a bar . . . .") and moves logically forward from there.

What is even more disturbing is that the case reveals that the business and technology track may be certain, but it is hardly swift. The case was filed in May of 2000. The bench trial in the case began on November 5, 2001. It continued through April 4, 2003, and subsequent testimony was presented by depositions. Both parties submitted proposed findings of fact and conclusions of law on June 13, 2003. The opinion was not delivered until April 13, 2005, almost five years after the case was filed and almost two years after the Court had all of the evidence before it. By comparison, the Baltimore County sewer service acted with great dispatch.

Finally, the opinion fails to mention, even in a footnote, the bizarre activities of some of the players in the case, involving cults, alleged aliens, sexual slavery, and attempted contract murders. (If you want the salacious details, see here.) If you have to read a 62 page opinion, it ought to at least be well-written and have something to hold the reader's attention.

A Living Will for Our Times

Lawyers are constantly on the prowl for forms that they can incorporate into their practices. Via The Law Librarian Blog, I've found a great estate planning form designed for use in Florida which, with some tweaking, will probably work in Maryland as well. It can be found here.

Quick Pickup on Bankruptcy Reform Act

While President Bush has indicated that he will sign the bankruptcy bill, the exact date on which he signs the bill could be significant. BJ Haynes notes that:

[t]he bill has a 180 day delay in the effective date. If it is signed on or after April 19th, then October 15th would be within the 180 day period. October 15th is significant because it is three years from the extended due date of 2001 tax returns and thus the date on which 2001 tax liabilities would satisfy the three-year-from-due-date rule of Bankruptcy Code Section 507(a)(1).

He advises that:

[i]f you have clients who might benefit from using bankruptcy to discharge their unmanageable tax debts, time is now most definitely running out. It is strongly suggested that you go through your inventory of cases to see whether you have folks who owe large amounts of tax for tax years 2001 and prior. Discharging taxes under the new bill will be much more difficult, but to get the benefit of the existing law the petition must be filed within the 180 day effective date delay period.

Small Businesses and the Estate Tax

In a weblog comment opposing the repeal of the federal estate tax, Matt Yglesias argues that:

[t]he government ought, perhaps, to facilitate some kind of lending arrangement so that people who prefer to keep the store and pay the tax down over time out of operating revenues can do so.

Note to Matt: The tax code already has such a provision. Specifically, Section 6166 of the Internal Revenue Code allows the estate to elect to pay the estate tax attributable to an interest in a closely held business in installments over, at most, a 14-year period. If the election is made, the estate pays only interest for the first four years, followed by up to ten annual installments of principal and interest. Even better, a reduced interest rate of 2% per annum applies to the amount of deferred estate tax attributable to the first $1,000,000 in value (adjusted for inflation) of the closely held business. Even above that amount, the rate is fairly low: 45% of the annual rate applicable to underpayment of taxes. (The annual rate applicable to underpayment of taxes is currently 6%. That's right, even above the $1M threshold, the rate is only 45% of 6%, or 2.7%. Not a bad deal.)

Of course, the benefits of Section 6166 are not available to all estates. The value of the business must exceed 35% of the adjusted gross estate. By the way, farms can consitute a qualifying business.

This provision gives lie to the contention that the estate tax is devastating to small businesses. The fact that it is not widely publicized in policy debates in the mass media is due less to any political bias of the media than it is to the unfortunate tendency of the media to avoid examining technically complex issues. Stated another way, Section 6166 cannot be easily explained in a sound bite.

Sign of the Times

A change in administrative practice in Maryland shows the degree to which the internet has become woven into the fabric of business life.

In this state, businesses must file an annual tangible personal property tax return by April 15 of each year. In order to remain in good standing, certain entities, such as corporations and LLCs, must file annual returns and pay a $300 filing fee even if they have no tangible personal property. In previous years, extensions were routinely granted if a request for extension was mailed and postmarked by April 15 or faxed to the State Department of Assessments and Taxation by that date.

Beginning this year, in order to obtain an extension via a paper document, the document must be postmarked by March 15 and there is a $20 fee. Extension requests filed over the internet, however, are free and can be filed as late as April 15. Extension requests are no longer granted via fax or telephone. The change is explained here.

Of course, the number of personal and business income tax returns that are e-filed has grown geometrically in the past few years. But this is the first instance of which I am personally aware that the use of a traditional method of communication is discouraged by a governmental organization through the imposition of a transaction fee and the erection of other hurdles. It is a signal that the ownership of a computer and the use of the internet is coming to be viewed as being no more exceptional than the ownership and use of a telephone.

One Man's Loophole Is Another Man's . . .

The Washington Post has a summary of the results of the 2005 session of the Maryland General Assembly. One of the entries is a proposal that would have "[raised] money for construction by closing a corporate tax loophole." This alleged loophole closer died in a Senate committee.

The alleged loophole is the entity transfer tax bill. This bill would have imposed transfer and recordation taxes on the transfers of controlling interests in LLCs, partnerships, and corporations.

Let's be clear--the ability to freely transfer interests in entities that hold real property is not a "loophole." There are perfectly sound reasons not to impose a tax on such transfers, not the least of which is that such a tax would be difficult to enforce and, when applied to transactions that take place outside of Maryland between non-Maryland residents, unconstitutional as well.

Going one step further, the economic analysis of the revenue effect of the bill is suspect. That analysis depends solely on the estimated tax revenue that would be raised from the tax. The analysis does not factor into its conclusion the lost property tax revenue due to the depressive effect that the extension of the transfer and recordation tax would have on property valuations. The transfer and recordation tax is imposed on the entire value of the real property. Because real property is typically purchased using borrowed funds, the tax will reduce the amount that can be paid to purchase a property by about 4 or 5 times the amount of the tax itself. Since property taxes are annual levies, the tax loss from the reduced prices paid for commercial properties would recur year after year.

A friend of mine who was deeply involved in efforts to oppose the entity transfer tax bill bitterly complained about what he perceived to be left-wing bias on the part of the newspapers on the issue. While I thought that coverage was biased, the bias was that reporters like a simple story, e.g., rich, greedy developers attempt to preserve self-serving tax loophole.

There is no left-wing or right-wing bias. In fact, the actual systemic bias has worked to the benefit of the Bush Administration on numerous issues. (Think for a moment--does the President have a plan to reform Social Security? If so, would that plan resolve the current actuarial deficit with respect to the benefits due to current participants in the system? If one were to read the papers, one might conclude that there is an explicit plan (there's not) and that the plan will resolve the actuarial deficit (to the extent that any plan has been outlined by the Bush Administration, it does not address the actuarial deficit in any way, shape, or form).)

In fact, the bias is a dumb bias. That is, unless a story is simple, the press cannot digest it at all. The papers simply cannot seem to get their arms around anything that is even remotely complex, such as the concept of unintended consequences.

Stephanie Says

I just received a call from Stephanie of the Internal Revenue Service. Last week I filed for an employer identification number for a client for a newly formed LLC. The LLC in question will ultimately be classified as an S corporation. On line 8.a. of the Form SS-4, I had checked the box for the type of entity as "Corporation" with the form number to be filed as "1120S." In the box, "Other (specify)" I had stated "LLC electing corp", but did not check that box.

Stephanie informed me that this was incorrect and that the box "Other (specify)" should have been checked, with the description "single member" in the line provided. While I did not complain (after all, Stephanie corrected the form and the application will be processed in the ordinary course), it seems to me that my initial submission was correct. In the Q&A section of the web EIN application area, it is stated that LLCs "without type of entity" cannot obtain an EIN over the web. My interpretation of this is that one should check the box for the type of taxable entity (i.e., sole proprietorship, partnership, corporation) and put in a further description next to the "Other (specify)" box.

On the same day as the filing of the SS-4 that Stephanie called about, I filed another LLC that will be electing to be an S corporation. I have not yet received a call from the Service about that application. Given the lack of clarity in this area, I may not receive such a call.

Update

I did receive a call from "Jim" about the other filing. He asked but one question: Was the LLC a single-member LLC or a multi-member LLC? This leads me to suspect that the correct way to apply online for an EIN for an LLC that's an S corporation would be to check the box for a corporation filing a Form 1120S and then, in the line next to "Other (specify)" state either single member LLC or multi-member LLC.

Writer's Block

Last week, I was on the telephone with a stockbroker discussing a tax question one of her clients had raised. I told her that I had discussed a similar question on my weblog and gave her the URL. She tried to get to the weblog via the brokerage firm's internet connection and was told that the site was blocked and not accessible from that computer.

My guess is that I am neither so famous nor so notorious that the computer actually singled me out. Rather, I think that the brokerage house programmed its internet access to block all websites operated by Blogger not merely selected sites. It would not surprise me if the computer were somehow programmed to block weblogs that use any of the larger weblog hosting services (e.g., Blogger, Typepad, etc.).

If would appreciate it if anyone could send me information as to (i) whether this is a common practice among brokerage companies, (ii) whether the block is applied only to weblogs using the larger weblog hosting services, (iii) how the personnel of the brokerage company can get around the block, or (iv) any other pertinent information.

I understand that the People's Republic of China and Saudi Arabia block websites that they find offensive, but I would have thought that the stock brokerage houses, being champions of the free market, would not try to impede the free market of ideas.

Family (Dis)Harmony

On Friday, the Court of Appeals handed down decisions in two separate cases involving estate administration questions. I will not comment on one of these cases, Piper Rudnick v. Hartz, because another attorney in this firm was involved in the case. The question before the Court in that case was the grounds that would support the approval by the Orphans' Court of attorneys' fees incurred by a personal representative.

The other case decided by the Court, Brewer v. Brewer, deals with so-called "family settlement agreements" (also referred to by the Court as "redistribution agreements") whereby members of a family agree to divide an estate differently than is prescribed by the decedent's will. The Court held that:

(1) redistribution agreements are permissible and, so long as they comply with the requirements of basic contract law, neither the personal representative nor the court has any authority to disapprove or veto them, but (2) if they are to be implemented as part of the Orphans' Court proceeding, through a deed from the personal representative pursuant to an approved administration account, they must be attached to that account or otherwise made part of the Orphans' Court record. The account must not simply show the distribution in accordance with the agreement but must identify the agreement, incorporate it by reference, and clearly reflect that the distribution is being made pursuant to the agreement rather than pursuant to the Will.

There are two major practical questions that were not addressed by the Court.

First, what does it mean to "comply with the requirements of basic contract law"? In the course of the opinion, the Court noted that "the existence of a dispute is not ordinarily a prerequisite" to the enforcement of such an agreement. However, absent a dispute which a redistribution agreement purports to settle, what is the consideration that supports the contract? Presumably, in certain cases there could be property swaps that would provide consideration (e.g., the will provides that legatees John and Mary will each receive a one-half interest in both Blackacre and Whiteacre, but John and Mary agree that John will receive a 100% interest in Blackacre and Mary will receive a 100% interest in Whiteacre). However, in other cases (e.g., John is rich and Mary is not, so he agrees to forego some or all of his inheritance) this would not necessarily be the case.

Second, there are potential tax implications that must be considered. Of course, these tax issues were not before the Court in Brewer, but should be taken into account when weighing a redistribution agreement. Specifically, if the agreement is entered into after the nine month disclaimer period, it would seem likely that it could be argued the parties to the agreement have created either a taxable event for income tax purposes (as could be the case in a Blackacre/Whiteacre swap illustrated in the first example) or a taxable gift (as could be the case if one sibling waived part or all of his or her inheritance, as might be the case in the second example).

Oddly, the outcome of the case did not turn on the substantive issue concerning the enforcement of redistribution agreements, but rather on whether the plaintiff could reopen the estate after it had been closed for 20 months. Judge Raker dissented, contending that since this issue had never been raised either below or in the petition for certioari, it was not before the Court.

I Remember Momma?

When looking at reported decisions, I'm always reluctant to criticize arguments attorneys make in tough cases. For one thing, courts have been known to misunderstand or misconstrue perfectly reasonable, even if incorrect, arguments in order to fortify their own decisions and the reported opinion may actually make a plausible case appear to look preposterous. For another, the facts that are presented at trial may not be the facts upon which counsel based the decision to undertake representation. Every attorney who has been in practice for even a few years has horror stories about cases that looked great at the beginning, but which crumbled as "new" facts came to light. There are, however, a small class of cases that raise the question: "Why did they bother?" Maloof v. Commissioner decided today by the U.S. Tax Court is such a case.

In Maloof, the taxpayer was a sole shareholder of an S corporation that suffered a long succession of tax losses. Because his ability to use the losses of the corporation were limited to his basis in the corporation's stock, the taxpayer attempted to increase his basis in the stock by including in basis $4 Million in bank loans made to the corporation. Apparently, except for a pledge of his stock in the corporation, the taxpayer was not at risk with respect to the loans.

The opinion reads like the Children's Goldenbook of S Corporation Taxation with the Court walking through fairly basis principles of S corporation taxation. The taxpayer's positions were so adverse to established law that I'm surprised that there was no mention of possible sanctions for taking a frivolous position. (My favorite ludicrous position taken by the taxpayer is that he was a resident of Florida and thus the precedent of the 11th Circuit applied to the case. Why was he a resident of Florida: He lived with his mother, not his wife, who lives in Ohio. Note to Counsel: Your client's name is "Maloof" not "Oedipus.")

The case is instructive on one point: LLCs classified as partnerships or as disregarded entities have benefits over S corporations. Were the company an LLC classified as a partnership or a disregarded entity, the taxpayer would have obtained the benefits he sought. And, he wouldn't have had to run home to momma.

Tough to Breakup

In Renbaum v. Custom Holdings, Inc., the Court of Appeals made it clear shareholders must jump a high bar if they seek to force a judicial dissolution of a corporation on the grounds that the directors are deadlocked. In the Court's view, not any deadlock will do. The deadlock must be over an issue or issues that prevent the corporation from "perform[ing] its corporate powers."

In Renbaum, the corporation was a holding company, the sole business of which was to invest in publicly traded securities. The corporate stock was owned by two brothers and their wives. A serious dispute arose over the company's relationship with an attorney who simultaneously acted as the general counsel to the corporation and as the personal attorney for one of the brothers. Part of the dispute centered on the legal bills submitted to the corporation by the attorney. In addition to their inability to agree on who should serve as general counsel, the brothers also argued over whether and in what amount dividends should be paid. However, this dispute was resolved prior to the entry of a final judgment. Thus, by the time that the case was presented to the appellate courts, the only dispute extant between the parties was the general counsel issue. Curiously, however, the parties were in harmony concerning the management of the company's investment portfolio, agreeing to delegate that task to a specific third party investment manager.

Holding that, in order to justify a judicially ordered dissolution, there must be a deadlock concerning a "transcendant corporate function" which, if not broken, made "the object of corporate existence unobtainable." In order to make this determination the Court found that

[u]seful factors [that should be considered] . . . include: (a) whether the corporate function(s) have ceased; (b) the power in dispute is expressed as a discretionary or mandatory power in the corporation’s Articles of Incorporation, by-laws, or other corporate governing documents; (c) the role of that power in achieving the corporation’s primary function(s); and, (d) whether the corporation has exercised, as a matter of practice, that power routinely in its operations.

This case is significant because typical "canned" corporate forms (i.e., articles of incorporation, bylaws, etc.) often default to provisions that allow bare majorities of the shareholders to elect the majority of the members of the board of directors and allow a majority of directors to control the board. Absent fraud or some other basis upon which to demand a judicial dissolution, the minority shareholders can be frozen out. Thus, the ability of minority shareholders to pull the nuclear option of judicial dissolution is a power that the minority shareholders must bargain for at the inception of their relationship with the corporation.

It should be noted that the corporation in Renbaum is a general corporation, not a Maryland statutory close corporation. In the case of a close corporation, §4-602(a) of the Md. Corps. & Ass'ns Art. provides that a judicially ordered dissolution is available on the basis that "there is such internal dissension among the stockholders of the corporation that the business and affairs of the corporation can no longer be conducted to the advantage of the stockholders generally." That standard does not come into play outside of the context of a statutory close corporation. In the case of an LLC, it appears that the stricter standard applicable to general corporations applies, since LLCs can only be judicially dissolved if "it is not reasonably practicable to carry on the business [of the LLC] in conformity with the articles of organization or the operating agreement." See Md. Corps. & Ass'ns Art. §4A-903.

Stuffed and Mounted

The Washington Post reported today on an abusive tax avoidance scheme involving the donation of mounted big game animal trophies to various museums. Apparently, one particular appraiser has specialized in both valuing the trophies and arranging the donations. The valuations are often 5 to 10 times what the trophies will bring at established auctions. In one case, a museum sold mounts that had a total appraised value of $4.2 Million for only $67,000.

In addition to the tax abuse or, perhaps, tax fraud angle, the practice is in the sights of conservationists who content that "the trophies hunted are often endangered animals illegally brought into the United States." The question then is, Who Gnu?

Update

Senator Chuck Grasslely's office yesterday issued a press release where he said in part:

The phoniness of this kind of donation calls out for congressional action. It looks like it's time for these self-enriching hunters to become the hunted. Big-game trophies and other non-cash contributions that give more tax benefits to donors than help to the needy are in the Finance Committee's cross hairs. There's mounting evidence that some taxpayers are using these gifts to play big-money games for personal enrichment. This abuse is no different than what we saw with car donations. With car donations, someone cheated on his taxes to the tune of hundreds of dollars and the charity got $50 out of it. With taxidermy donations, the museum gets a pittance for a dusty boar's head that sits in a railway car until it sells, while the donor gets big tax breaks. This is completely unacceptable. We need to take the tax cheating out of taxidermy. We need to close loopholes in the tax laws intended to foster charitable donations, and Tuesday's hearing sets the stage for reform legislation.

"Take the tax cheating out of taxidermy"? Who writes this stuff?