How Far Can A Taxpayer Go? – (AAPL)

If you wonder why Apple (NASDAQ:AAPL) CEO Tim Cook had to appear before a Senate panel last week to justify his company’s tax strategies, I can crystallize the issue for you with two quotations.

The first: “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”

The second: “Apple is a great company, but they don’t have a right to decide in my book how much in taxes they are going to pay and to whom they are going to pay them.”

The first observation comes from the esteemed Judge Learned Hand in his 1934 opinion in Helvering v. Gregory. (The case is better known as Gregory v. Helvering, which was its name when the Supreme Court affirmed Hand’s decision for the Second U.S. Circuit Court of Appeals.) It is one of the most important tax cases in American history, and it established the principle – which every tax professional is taught early in his or her career – that a taxpayer may freely do anything the law allows to avoid triggering a tax liability.

The second comes from Sen. Carl Levin, D-Mich., who chairs the Senate Permanent Subcommittee on Investigations. Levin made it clear he views Apple as a corporate tax chiseler that is weaseling out of sending billions of dollars to Washington.

Levin drew at least a veneer of bipartisan support from Sen. John McCain, R-Ariz., but the debate falls along familiar ideological battle lines for the most part. Congressional Democrats generally argue that successful multinationals – and Apple is about as successful a multinational as they come – use what Levin called “tax gimmickry” to avoid their fair share of the U.S. tax burden. Most Republicans more or less agree with Sen. Rand Paul of Kentucky, who defended Apple’s managers at last week’s hearing for doing what they are paid to do, which is to generate the most value they can legally produce for their shareholders.

That’s pretty much where the discussion has stopped, except for the related question of whether corporate tax rates are too high to begin with. But the issues Levin raised about Apple’s activities are actually more nuanced than this party-line confrontation.

A fact about Helvering v. Gregory that is sometimes forgotten is that, despite Hand’s time-honored comments about a taxpayer’s right to arrange business affairs favorably, the taxpayer lost the case.

In 1928, Evelyn Gregory owned all the shares of the United Mortgage Company, which in turn owned all the stock in Monitor Securities Corp. Mrs. Gregory wanted to sell Monitor Securities and keep the proceeds for herself. She could have had United Mortgage distribute the Monitor shares to her, but that would have been treated as a taxable dividend from United Mortgage. She would have been obligated to pay tax on the entire value of the Monitor shares.

Instead, Gregory organized a new company, the Averill Corp. She had United Mortgage transfer the Monitor shares to Averill, in exchange for which Averill issued all of its new shares to Gregory. Three days later, Gregory dissolved Averill. That same day, she sold the Monitor shares she now owned for $133,333, but because the shares had a cost basis of around $57,000, she reported a taxable capital gain of only $76,000. United Mortgage’s distribution of Monitor shares to Averill appeared to qualify as a tax-free reorganization of United Mortgage’s business, which is the position Gregory took.

The tax authorities challenged Gregory. She won her case in the Board of Tax Appeals, but Internal Revenue Commissioner Guy T. Helvering took the case to the Second Circuit.

That is how Judge Hand came to write his famous words about tax planning. But Hand also looked at the substance of what Gregory had done. She claimed to have reorganized United Mortgage’s business by placing part of its holdings in the new company, Averill. However, Averill never conducted any business; it simply received the Monitor Securities shares and then promptly liquidated itself, distributing the Monitor shares to its sole stockholder, Gregory. “To dodge the shareholders’ taxes is not one of the transactions contemplated as corporate ‘reorganizations,’” Hand observed.

The Supreme Court agreed. Its opinion was authored by Justice George Sutherland, a former Republican senator who emerged as one of the New Deal’s strongest judicial opponents in the 1930s. But he showed little appreciation for the creativity of Mrs. Gregory and her tax advisers.

“The whole undertaking, though conducted according to the terms of [the tax law], was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else,” Sutherland wrote. “The rule which excludes from consideration the motive of tax avoidance is not pertinent to the situation, because the transaction, upon its face, lies outside the plain intent of the statute. To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.”

Sutherland wrote those words nearly 80 years ago, but we can plainly hear them echo in Levin’s complaint last week that Apple’s accountants and lawyers “created corporations that don’t exist anywhere for tax purposes. That is right at the epitome of creative tax gimmickry.”

This explains why Cook felt he had to appear before the panel and its TV cameras and endure the inevitable hectoring, though he proved masterful at charming the senators and deflecting many of their complaints. Cook argued that Apple’s international arrangements are legitimate business structures that serve corporate purposes besides merely avoiding taxes, an argument that strikes many observers as implausible. Yet it is an argument he must make, because the courts have left unclear, for the past 80 years, exactly how much credence they will give to taxpayer arrangements whose sole purpose is saving taxes.

Gregory followed the letter of the law and still lost her case, because judges concluded that her activities were not what the statute’s writers intended. Yet in many other cases, courts have accepted unanticipated outcomes that favor taxpayers. Congress is free to change any statute that it thinks is being abused. It often does. For example, we used to reduce gift and estate taxes using certain kinds of “freeze” techniques that are no longer available because lawmakers responded with new rules.

Even if you agree with Rand Paul that last week’s hearing was a “show trial,” staged for political purposes, and even if you think – as I do – that it is counterproductive to try to make global corporations (and their many foreign shareholders) pay American taxes on profits generated elsewhere, it is not intellectually honest to just dismiss Levin’s complaints. He is only the latest in a long line of people who have wondered how far a taxpayer is, or ought to be, allowed to go.

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About Larry M. Elkin 564 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

Visit: Palisades Hudson

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