I tell my students you can often see how a court opinion will go by the opening line. In the recent case of Pacific Management Group, BSC Leasing, Inc., Tax Matters Partner, Et. al v. Commissioner, T.C. Memo. 2018-131 (Aug. 20, 2018), the first sentence signals that the opinion will not end well for the taxpayers. In that sentence Judge Lauber calls their carefully calibrated ballet-like choreographed set of structured transactions a “scheme.” Darn.
Explaining why this scheme did not work took Judge Lauber over 80 pages. And while blogging all the intricacies of the case is too much for one post, I do see one lesson in the case that I think you will find worth your time, a lesson about the common law of tax.
We often get so caught up in the intricacies of the various statutory provisions in the Internal Revenue Code that we lose sight of the fact that the U.S. legal system is based on a powerful idea: judges have the power to say what the law is and are not limited to the textual sources of law found in statutes and regulations. The traditional name for the kind of law not found in legislative pronouncements is “common law.” Judges write down their interpretations and understandings of the common law in opinions that later judges can consult. We call that precedent.
The common law tradition in the U.S. legal system influences even such a highly complex statutory and regulatory area of law as tax. In this case, Judge Lauber applied various common law doctrines to supplement and inform the relevant statutory provisions: the economic substance doctrine; the reasonable compensation doctrine; and the assignment of income doctrine. Again, it would be too much to cover all of these. So I will discuss only one: the common law of assignment of labor income. It’s an appropriate lesson for this Labor Day morning.
I structure my basic tax class around the study of four questions: (1) whether a taxpayer has an item of income or deduction; (2) who is the taxpayer who must report the income or take the deduction; (3) when must the taxpayer report the income or take the deduction; and (4) of what character (ordinary or capital) is the income or deduction.
When I get to the second question I tell my students to just leave their Codes at home because the question of “who” is the proper taxpayer to report an income item or take a deduction item is almost entirely common law (the grantor trust provisions being a notable exception).
The tax casebook I use (Freeland, Lathrope, Lind, Stephens) does a great job in presenting students with the most important cases on assignment of income and I generally give a lecture that attempts to synthesize those cases into various principles of the assignment of income doctrine. I caution students that while courts look to these principles, none is determinative. In true common law fashion one must study closely the facts of each case. So, for what it’s worth, here’s a typology I pull from the case law: I call it the four principles of assignment of income doctrine.
The first principle is the fruit and tree principle that Justice Holmes made famous in Lucas v. Earl, 281 U.S. 111 (1930). Courts distinguish between that which produces income (tree) and the income itself (fruit). Giving away the tree passes off the income fruit as well, but just giving away the fruit is not effective to shift tax liability. In Earl, Mr. Earl and his wife made a contract in 1901 to split all future earnings of either of them. Specifically, salary income would be “treated and considered and hereby is declared to be received, held, taken, and owned by us a joint tenants, and not otherwise, with the right of survivorship.” Notice that date of 1901. When Congress revived the income tax in 1913, the Earls followed the contract and each reported half of Mr. Earl’s earnings as income (this was long before there was a separate rate schedule for married couples filing jointly). Eventually, they got audited, for 1920 and 1921. The IRS concluded that Mr. Earl should have reported all the income those years. Justice Holmes agreed, on the principle that Congress had chosen to “tax salaries to those who earned them” and “the tax could not be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it.” Motive did not matter. Even though everyone knew the 1901 contract was not an attempt to avoid the income tax, it was still an “arrangement by which the fruits are attributed to a different tree from that on which they grew.”
In cases like Earl, the tree was labor and the fruit was the salary or earnings from that labor. In other cases, the tree might be property. For example, in Helvering v. Horst, 311 U.S. 112 (1940) the tree was a coupon bond. Mr. Horst tore off the coupons and gave them to his son. The majority said the coupons were the fruit of the bond tree. But three Justices (McReynolds, Jackson, and Hughes) dissented precisely because they disagreed with what was the relevant tree. They thought that the coupons themselves were property---saplings perhaps---and not fruit.
The second principle is about control. Horst is a great example. Although the fruit/tree principle was important to the majority, it was this control principal that the Court emphasized in reaching its conclusion. Here's my favorite quote from the case: “The power to dispose of income is the equivalent of ownership of it. The exercise of that power to procure the payment of income to another is the enjoyment, and hence the realization, of the income by him who exercises it.”
A third principle is about timing. Despite Justice Holmes’ assertion that “anticipatory assignments” will not work, it turns out they sometimes do. In the classic case of Commissioner v. Giannini, 129 F.2d 628 (1942), the taxpayer’s contract with a company entitled him to 5% of the corporate net profits, an amount which was decided twice a year by the Board of Directors (Mr. G. was not a member of the Board). When the Board met in June 1927, it decided the taxpayer was entitled to $445,000 for the first half of the year. The next month Mr. G. told the Board that he did not want any more money and so was renouncing his entitlement to any share of further profits for that year. He suggested that the Board do something else worthwhile with the money. The Board decided to use the money to establish a Foundation of Agricultural Economics at the University of California. It’s now called Giannini Foundation and is still around at U.C. Davis.
The IRS thought this was one of those anticipatory assignments of income because Mr. Giannini exercised too much control over the use of the money he ostensibly refused. The Ninth Circuit, however, thought that the timing of the refusal negated control. The Circuit Court placed great weight on the trial court’s finding of fact that Mr. G’s refusal was “definite” and “absolute.” “All that he did was to unqualifiedly refuse to accept any further compensation for his services... So far as the taxpayer was concerned, the corporation could have kept the money.” The Court emphasized that once one accepted the fact that Mr. G. truly had no hand in the actual use of the money that he was contractually entitled to receive then timing mattered because he had disclaimed long before the Board made a decision about the amount of his entitlement.
The fourth principle is one of relationship between the assignor and assignee. When transfers or assignments are gratuitous or between closely related parties, the courts will look very carefully at them and are not inclined to allow the assignment. But when the transfers are between parties at arms-length and especially when the assignee pays for the assignment, why that cuts the other way. So the type of relationship between the parties might make the assignment work or not. For example, notice the family relationships in Earl and Horst and the gratuitous nature of the assignment. Contrast that with the more arms-length relationship between Mr. Giannini and the Board.
An example of where this principle predominated is Estate of Stranahan v. Commissioner, F.2d 867 (6th Cir. 1973). This was a case where the assignment was for valuable consideration but was also between closely related parties. Mr. Stranahan and his brother had started a company called Champion Spark Plugs in 1908 (they apparently had to sue the original inventor---Albert Champion---to keep the name). By the 1950’s it was a Fortune 500 company. But Mr. Stranahan had gotten into some tax troubles and when he finally got straight in 1964 it cost him over $750k in interest. That interest was a deduction item but was also more than Mr. Stranahan had in income for 1964. So he needed to accelerate income to make use of the deduction. He did that by selling the right to receive dividend payments on his Champion stock to one of his sons, (the lawyer son Duane and not the golfing son Frank Richard). Duane paid $115k for the right to receive future dividend payments until they totaled $123k. Mr. Stranahan, however, still owned the stock.
When Champion paid out $40k of dividends to Duane in 1965, Duane reported and paid tax on those. The IRS audited Mr. Stranahan’s estate (he had died in late 1965) and determined that the fruit of the dividends should be taxed to the owner of the tree (the stock), just like in Horst. The Tax Court agreed.
Reversing, the Sixth Circuit distinguished Horst and other cases by holding that the arms-length nature of the sale trumped the fruit/tree principle. If first noted that the sale was bone fide: “We also note there are no claims that the transaction was a sham, the purchase price was inadequate or that decedent did not actually received the full payment of $155,000 in tax year 1964.” It then noted that Duane’s discounted price reflected risks that “however remote, did in fact exist.” “Accordingly, we conclude the transaction to economically realistic, with substance, and therefore should be recognized for tax purposes....”
Pacific Management Group basically involves five individuals: Johan Perslow, Cory Severson, Mark E. Krebs, Curtis S. Hartwell, and Richard Boultinghouse. Before 1999, these five individuals owned a group of five related companies that were engaged in various types of environmental water engineering activities. Judge Lauber calls them collectively the “Water Companies.” The Water Companies paid these individuals salaries and dividends. By 1999 the Water Companies were very successful but we all know money does not bring happiness. Quite the opposite. Rather than be happy with they rapidly increasing profits and take-home pay, the five individuals were unhappy that they were paying a “double tax” on the profits: once at a C Corp. level and once at the individual level.
Enter Ernest Scribner Ryder. He promised to show them how to avoid the double tax, sock away substantial amounts into retirement accounts without regard to the normal limitations on such contributions, and pay tax only on income needed to meet current living expenses. To make all that happen, Mr. Ryder's plan involved almost every tax entity known to practitioners: C Corps, S Corps, partnerships and---this is key---ESOPs.
Here’s the idea. In 1999, each of these five individuals formed an S Corporation, named after themselves! E.g. Mr. Boultinghouse’s corporation was Boultinghouse, Inc. Each S Corporation sponsored an ESOP and each ESOP owned 100% of the sponsoring corporation. Each of the five individuals was the sole participant in (and beneficiary of) the ESOP that owned the S Corp. that the individual had formed. Each individual then stopped being employed by the Water Companies and became a nominal employee of each S Corporation. E.g. Mr. Boultinghouse agreed to furnish unspecified services to Boultinghouse, Inc. for unspecified base salary amounts to be determined by the S Corporation. He even had a written contract.
Together, the five S Corporations formed a Partnership, Pacific Management Group (PMG). With that, the Water Companies stopped paying salary and dividends to the five individuals and started paying PMG “factoring fees” and “management fees.” PMG then transferred the payments to the five S Corporations, in rough proportion to each of the five individual’s former ownership position in the Water Companies. Then the S Corporation each paid a “base salary” equivalent to what each individual decided they needed to meet current living expenses. The rest of the money accumulated in the S Corp, supposedly tax free because each S Corp. was owned entirely by an ESOP. Can you just imagine the language in the nominal employment contract? "I agree to pay myself only whatever salary I ask myself for but I might deny myself the salary I ask for."
On audit, the IRS Revenue Agent was skeptical of these arrangements. The IRS issued an FPAA to PMG and NODs to each of the five individuals. All were consolidated into one trial and opinion that deals with a host of issues, including some gnarly jurisdictional issues. Identifying the correct tax treatment of this scheme is complex and Judge Lauber’s opinion give a very clear and detailed run-down on the issues, the facts, and the law. He has discussions about the common law of “reasonable compensation” and the common law of “economic substance.”
What I want to focus readers on here is Judge Lauber’s application of the assignment of income doctrine. That comes up in his redetermination of the five NODs. The IRS determined that the five individuals had unreported income in the amounts of income that had flowed from the Water Companies, through PMG, into the S Corps and that was not paid to them as base salary by the S Corps but was instead accumulated by the S Corps.
For four of the five individuals, Judge Lauber found for the IRS on a theory of constructive dividends. Judge Lauber found that the factoring fees and most of the management fees paid by the Water Companies were constructive dividends and, hence, were not deductible.
For four of the five individuals, the amount of constructive dividends Judge Lauber decided should be attributed to them exceeded the deficiencies the IRS had proposed. End of story for them. But for Mr. Boultinghouse, the IRS had determined $304k in unreported income for 2005 and under Judge Lauber’s analysis the constructive dividend theory accounted for only $147k of that proposed deficiency.
The IRS had an alternative theory: ineffective assignment of income. This theory applied to the $564k in management fees paid to PMG in 2005 that Judge Lauber decided the Water Companies could legitimately deduct. Judge Lauber determined that about $30,000 of these fees flowed through to Mr. Boultinghouse’s S corporation and were part of the monies held by his S Corporation, ostensibly owned by the ESOP.
Judge Lauber had no trouble using the fruit/tree principle and the control principle to find that this $30,000 paid to Boultinghouse, Inc. was reportable as income by Mr. Boultinghouse personally. See if you can spot those two principles at work in the following excerpt from the opinion:
“Under Mr. Ryder’s tax-minimization scheme, Mr. Boultinghouse remained the CFO of all four Water Companies, and he continued to provide them with exactly the same financial and accounting services he had supplied previously. But now he supplied those services as an “employee” of his S corporation, which allegedly supplied his services to PMG, which allegedly supplied his services as an “independent contractor” to the Water Companies. He signed a purported “agreement of employment” with his S corporation, but that document did not specify what position he was to hold or what duties he was to perform. Rather, it simply recited that he would “render and perform services under the direction and designation of” his S corporation. Because his S corporation was a paper entity and functionally his alter ego, that recitation was meaningless. In reality, he performed services for the Water Companies “under the direction and designation” of himself.
Mr. Ryder’s tax-minimization plan was a classic “assignment of income” scheme whereby Mr. Boultinghouse used a series of contractual arrangements to divert salary income that would otherwise have flowed directly to him. But no anticipatory arrangement can hide the fact that his share of the management fees was in substance earned by and owed to him.”
If you read the Tax Code you will search in vain for a statute that prohibits the scheme Mr. Ryder sold to Mr. Boultinghouse and his colleagues. But it is still a scheme that runs against the law: the common law of tax.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.