Larry's Tax Law

This is the first of a series of posts on Tax Reform. In this series, I will be covering: what Tax Reform means, the legislative process for enacting it, the likely timing of its arrival, the estate & gift tax and income tax proposals already presented by the Trump administration and the U.S. House of Representatives, and possible planning strategies that businesses and individuals may wish to consider.

What Tax Reform Is 

As a starter, what exactly is “Tax Reform”? Is it something you will know if you see it? Are there objective standards as to what constitutes “Tax Reform”?

The late Senator Russell B. Long, a Democrat from Louisiana, served more than four decades in the U.S. Senate. He was Chairman of the U.S. Finance Committee from 1966 to 1981, and was very influential in shaping our tax laws during the ’60s, ’70s and ’80s. In fact, he was one of the major contributors to the Tax Reform Act of 1986.

As a footnote, the ’86 Act, enacted over thirty years ago, was the last major tax reform legislation passed by our lawmakers. So, it has been a long time since we have seen Tax Reform.

The proposed $3 billion per year tax-raising bill, Oregon Measure 97, was defeated yesterday by a 59% to 41% margin. The fight was long and bloody. Media reports that opponents and proponents together spent more than $42 million in their campaigns surrounding the tax bill.

So, What Now?

The defeat of Measure 97 eliminates the proposed 2.5% gross receipts alternative corporate tax applicable to C Corporations with annual Oregon gross receipts over $25 million. Oregon C Corporations, however, are still faced with a minimum tax based on Oregon gross receipts. The minimum tax applicable to Oregon’s C Corporations is based on gross revenues as follows:

C Corporations with Oregon annual revenues greater than $25 million may face a new minimum tax obligation – 2.5 percent of the excess – if Measure 97 passes. If a business falls within this category, there may be ways to mitigate its impact. The time to start planning, however, is now.

Background

Oregon taxes corporations under an excise tax regime.  The Oregon corporate excise tax regime was adopted in 1929.  The original legislation included what is commonly called a “minimum tax” provision.  In accordance with this provision, corporations subject to the Oregon excise tax are required to pay the greater of the tax computed under the regular corporate excise tax provision or the tax computed under the “minimum tax” provision.  Accordingly, the “minimum tax” is an “alternative” tax; it is not an “additional” tax as many commentators have recently asserted.

Originally, the Oregon corporate “minimum tax” was a fixed amount – $25.  As a result of the lobbying efforts of Oregon businesses, the “minimum tax” was eventually reduced to $10, where it remained for almost 80 years.

In 2010, Oregon voters dramatically changed the corporate “minimum tax” landscape with the passage of Measure 67.  The corporate “minimum tax” (beginning with the 2009 tax year), is no longer a fixed amount.  Rather, it is now based on Oregon sales (gross revenues).  The “minimum tax” is now:

Oregon Sales

Minimum Tax

< $500,000

$150

$500,000 to $1 million

$500

$1 million to $2 million

$1,000

$2 million to $3 million

$1,500

$3 million to $5 million

$2,000

$5 million to $7 million

$4,000

$7 million to $10 million

$7,500

$10 million to $25 million

$15,000

$25 million to $50 million

$30,000

$50 million to $75 million

$50,000

$75 million to $100 million

$75,000

$100 million or more

$100,000

S corporations are exempt from the alternative graduated tax system.  Instead, they are still subject to a fixed amount “minimum tax,” which is currently $150.

As an example, under the current corporate “minimum tax” provision, a corporation with Oregon gross sales of $150 million, but which, after allowable deductions, has a net operating loss of $25,000, would be subject to a minimum tax of $100,000.  Many corporations operating in Oregon, which traditionally have small profit margins (i.e., high gross sales, but low net income), found themselves (after Measure 67 was passed) with large tax bills and little or no money to pay the taxes.  Three possible solutions for these businesses exist:

• • Make an S corporation election (if eligible);

• • Change the entity to a LLC taxed as a partnership (if the tax cost of conversion is palatable); or

• • Move all business operations and sales outside of Oregon to a more tax-friendly jurisdiction.

Several corporations in this predicament have adopted one of these solutions.

Initiative Petition 28/ Measure 97

Measure 97 will be presented to Oregon voters this November.  If it receives voter approval, it will amend the “minimum tax” in two major ways:

• • The “minimum tax” will remain the same for corporations with Oregon sales of $25 million or less.  For corporations with Oregon sales above $25 million, however, the “minimum tax” (rather than being fixed) will be $30,001, PLUS 2.5 percent of the excess over $25 million.

• • The petition specifically provides that “legally formed and registered benefit companies” as defined in ORS 60.750 will not be subject to the higher “minimum tax.”  Rather, they will continue to be subject to the pre-Measure 97 “minimum tax” regime (as discussed above).  Caveat: The exception, as drafted, appears to only apply to Oregon benefit companies; it does not extend to foreign benefit companies authorized to do business in Oregon.

Measure 97 expressly provides that all increased tax revenues attributable to the new law will be used to fund education, healthcare and senior citizen programs.  As a result, many commentators believe the initiative has great voter appeal and will likely be approved by voters.  If Measure 97 is passed, it is slated to raise over $6 billion in additional tax revenue per biennium.

On November 2, 2015, the Bipartisan Budget Act (“Act”) was signed into law by President Barack Obama. One of the many provisions of the Act significantly impacts: (i) the manner in which entities taxed as partnerships[1] will be audited by the Internal Revenue Service (“IRS”); and (ii) who is required to pay the tax resulting from any corresponding audit adjustments. These new rules generally are effective for tax years beginning after December 31, 2017. As discussed below, because of the nature of these rules, partnerships need to consider taking action now in anticipation of the new rules.

The Current Landscape

Entities taxed as partnerships generally do not pay income tax. Rather, they compute and report their taxable income and losses on IRS Form 1065. The partnership provides each of its partners with a Schedule K-1, which allows the partners to report to the IRS their share of the partnership’s income or loss on their own tax returns and pay the corresponding tax. Upon audit, pursuant to uniform audit procedures enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), examinations of partnerships are conducted generally under one of the following scenarios:

• • For partnerships with ten (10) or fewer eligible partners,[2] examinations are conducted by a separate audit of the partnership and then an audit of each of the partners;

• • For partnerships with greater than ten (10) partners and/or partnerships with ineligible partners, examinations are conducted under uniform TEFRA audit procedures, whereby the examination, conducted at the partnership level, is binding on the taxpayers who were partners of the partnership during the year under examination; and

• • For partnerships with 100 or more partners, at the election of the partnership, examinations may be conducted under uniform “Electing Large Partnership” audit procedures, whereby the examination, conducted at the partnership level, is binding on the partners of the partnership existing at the conclusion of the audit.

Lawmakers believed a change in TEFRA audit framework was necessary for the efficient administration of Subchapter K of the Code. If a C corporation is audited, the IRS can assess an additional tax owing against a single taxpayer—the very taxpayer under examination—the C corporation. In the partnership space, however, despite the possible application of the uniform audit procedures, the IRS is required to examine the partnership and then assess and collect tax from multiple taxpayers (i.e., the partners of the partnership). In fact, the Government Accountability Office (the “GAO”) reported in 2014 that, for tax year 2012, less than one percent (1%) of partnerships with more than $100 million in assets were audited. Whereas, for the same tax year, more than twenty-seven percent (27%) of similarly-sized corporations were audited. The GAO concluded the vast disparity is directly related to the increased administrative burden placed on the IRS under the existing partnership examination rules.

In general, the Oregon income tax laws are based on the federal income tax laws. In other words, Oregon is generally tied to the Internal Revenue Code for purposes of income taxation. As a consequence, we generally look to the federal definition of taxable income as a precursor for purposes of determining Oregon taxable income.

What does this mean to taxpayers in the trade or business of selling recreational or medical marijuana in Oregon?

Currently, it appears these taxpayers are stuck with the federal tax laws. Consequently, unless the Oregon legislature statutorily disconnects from IRC § 280E, for Oregon income tax purposes, all deductions relating to the trade or business of selling medical or recreational marijuana will be disallowed.

I suspect the result of IRC § 280E and its impact on Oregon income taxation will be that many taxpayers in this industry will go to lengthy efforts to capitalize expenses and add them to the cost of goods sold. Caution is advised. The taxing authorities will likely closely scrutinize this issue.

As a general rule, in accordance with IRC § 162(a), taxpayers are allowed to deduct, for federal income tax purposes, all of the ordinary and necessary expenses they paid or incurred during the taxable year in carrying on a trade or business.  There are, however, numerous exceptions to this general rule.  One exception is found in IRC § 280E.  It provides:

“No deduction or credit shall be allowed for any payment paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any state in which such trade or business is conducted.”

Background

Actual or constructive receipt of the exchange funds during a deferred exchange under IRC Section 1031 totally kills an exchange and any tax deferral opportunity.  Treasury Regulation Section 1031(k)-1(f)(1) tells us that actual or constructive receipt of the exchange proceeds or other property (non-like-kind property) before receiving the like-kind replacement property causes the exchange to be treated as a taxable sale or exchange.  This is the case even if the taxpayer later receives the like-kind replacement property. In accordance with Treasury Regulation 1.1031(k)-1(f)(2), a taxpayer is in constructive receipt of money or property if it is credited to his, her or its account; set apart for the taxpayer’s use; or otherwise made available to the taxpayer.

In 2013, the Internal Revenue Service (“IRS”) announced that it would not issue Private Letter Rulings on “spin-off” transactions intended to qualify as tax-free under IRS § 355. As a result of the IRS no-ruling position, taxpayers have not been able to obtain certainty relative to the tax consequences of these types of transactions. Rather, the best they can do is obtain some comfort through an opinion of their tax advisors. The cost of tax opinions, however, can be significant.