How to Fix the Prop 13 Loophole Without Harming CA Businesses

As of late, much has been written about Proposition 13—the 1978 ballot initiative that keeps property taxes low for landowners, whether they be residential homeowners or commercial landlords.   Under Proposition 13, real property is only to be reassessed when there is a “change of ownership”.  For residential homeowners, the rule is relatively simple to apply—if you sell or transfer your home, the property will likely be reassessed.  However, when property is owned by a business, the rules become extremely complex and contain a gaping loophole.     

This loophole recently gained widespread attention when computer billionaire Michael Dell restructured the purchase of the Fairmont Miramar hotel to avoid triggering a reassessment of the property—a move which saved him an estimated $1 million a year in property taxes.  His strategy involved buying the business that owned the hotel in such a manner so as to ensure that no single person or entity held more than a 50% interest in the business. And so, effectively, Michael Dell, Dell’s wife, and another entity took ownership in the entity, but none of them acquired more than a 50% stake.   This maneuver brought justified outrage—not only from the left, but even the head of the Howard Jarvis Taxpayer Association—the very group that helped ensure Proposition 13’s original passage said that Dell was “gaming the system”.     

Unfortunately, many long-time Proposition 13 critics are using this extreme circumstance to attempt to repeal, or effectively gut, the protections afforded by Proposition 13.  The most common “fix” offered by proponents is to only apply the generous rules of Proposition 13 to residential properties and to carve-out commercial properties, allowing commercial properties to be reassessed each year (a position apparently supported by most of the State's editorial board). 

While this approach may seem tempting to those who yearn for higher tax revenues, when one takes into account that California already has the highest income tax, the highest sales tax, the highest gasoline tax and one of the highest corporate taxes in the Nation, it is apparent that California’s budgetary ills are not wholly attributable to “low” revenues.    

Recently, Assemblyman Tom Ammiano (D-San Francisco) introduced a bill (AB 188) that sought to close the loophole and would require a reassessment if 100% of a business were sold or transferred within three years.   While this bill is a good start, the fatal flaw of this bill, however, is that it can easily be planned around (e.g., one can structure the business sale to take just over three years or acquire up to 99.9% of the business ownership without triggering reassessment).    

 There is, however, a way that the Proposition 13 loophole can be permanently closed so that the tax rules are applied fairly across the board while at the same time ensuring that businesses are not hit with increasing property taxes as property values increase.    

This can be accomplished by amending the applicable statutes to provide that when an original owner or owners of a property transfers, either in a single instance or cumulatively, more than 50% of his or her or their business, then all real property owned by that business will be reassessed.  From that point forward, those owners will then be considered the original owners and whenever more than 50% of the business interests are again transferred there will be another reassessment. 

Believe it or not, this “original owner” rule already exists in the Proposition 13 implementing statutes, but for some reason, it only applies if the property was originally transferred to the business by the owners (essentially as a capital contribution).  Thus, if a business buys the real property from a third party, then the “original owner” rule, as currently written does not apply (which is why it did not apply in the Dell transaction).  Thus, by slightly altering the existing “original owner” rule to capture all cumulative transfers of more than 50% of a business’s interests, it will ensure that businesses are given a break on property taxes and also ensure that reassessments do happen when it is clear there has been a change in a business’s ownership.  This slight change is something that the most ardent supporters and opponents of Proposition 13 should be able to agree on.    

The Darkside of IRS Automation

In early 2000, the IRS underwent a drastic overhaul in response to tremendous congressional pressures. They started to adopt the language and organization of business and management.  Taxpayers were no longer just taxpayers, they were "customers".  Part of this shift focused on "efficiencies" and introducing automated processes.  The thinking at the time was that this would make it easier and efficient for both the IRS and its "customers".

I recent lecture by the National Taxpayer Advocate, Nina Olson, however, is chilling and paints a gloomy picture of what lies ahead.  It presents what may be one of the greatest threats to the IRS, and its customers, to date.  Her most poignant comments were as follows:

I believe that the IRS is at a turning point, and for a number of reasons, we are beginning the slide to a radically different IRS from that which many of us in the room today practiced before or worked in just a decade or two ago. I believe that unless we act to change that trend, the IRS of tomorrow will have little personal interaction with taxpayers. . . . It will relentlessly drive forward on a path of more automation mostly to make its own work more convenient and rarely more helpful or tailored to the taxpayer. . . . It enables the IRS to ignore the humanity of taxpayers. [Emphasis in original.]

I can attest from personal experience that the average John Q. Taxpayer can be absolutely be trapped in the IRS "system" and find it difficult, it not impossible, to get answers or guidance.  Often cases languish waiting for agents to be assigned or for appeals case officers to be assigned.  Frequently, all a taxpayer can do is call up the IRS hot-line, sit on hold for 30 minutes, and then talk to an IRS agent over the phone who can't assist them, let alone provide them with any helpful suggestions. 

Vote For "La Wendy"--Worst Political Support Song Ever Written

Democratic LA mayoral candidate Wendy Greuel has received heavy union support compared to fellow democratic candidate Eric Garcetti.

In perhaps the worst demonstration of political support the LA hotel workers union wrote and sang a song urging citizens to vote for "la Wendy". Union officials translated the Spanish lyrics into English. Here's a portion of the words:

"If for la Wendy you want to vote

Get in the car and let's have fun.

And for la Wendy to win

All Latinos got to have her back.

If you want to earn $15 an hour

You have to march for la Wendy.

If the blond comes to your door

Open the door and let her in.

Wendy, la Wendy we're gonna vote.

$15 an hour we'll make.

Wendy, la Wendy we're gonna dance.

Eric Garcetti start crying.

From Montecito to Huntington Park

Passing El Sereno, eating tamales

And the voters for you will fight.

We'll have extra money to spend.

The people will support you.

That's why the blond will triumph.

In the truck we'll celebrate

With the mariachis we'll sing

Her last name is difficult to sing

That's why we're writing this rhyme.

La Wendy, Los Angeles you will change

And the Latino vote will crown you."

A Rational Explanation for the Targeting of Tea Party Groups by the IRS?

Although the inspector general of the U.S. Treasury is set to release a report on Wednesday detailing the increased scrutiny certain tea party groups received in their 501(c)(4) applications, a Duke tax law professor, Richard Schmalbeck, was at the ABA meeting where this was first disclosed and has shared his thoughts:

From the Tax Prof Blog: 

I was at the Exempt Organizations Committee meeting of the ABA Tax Section meeting when Lois Lerner, the director of the division that handles exempt organizations matters, dropped the bombshell that is in the papers today, and generating a lot of media outrage, especially but not exclusively on Fox News. I think her explanation in person was probably better than the statement that the IRS released, at least in terms of explaining why some exemption applications actually require more scrutiny than others.

The IRS position on 501(c)(4) organizations ("social welfare organizations")is that, while they can engage in campaign activities, they cannot do so as their primary activity—which they understand as more than 50% of the organization's activities. Many organizations that seek this status probably should be section 527 political organizations rather than social welfare organizations. So when the service center in Cincinnati, which handles exemption applications, was inundated with unusually large numbers of (c)(4) applications, they tried to find ways to triage them, so that the traditional social welfare organizations would not have their processing held up, but organizations that might be close to the 50% campaign activity zone would get the appropriate level of scrutiny. In developing ways to identify the applications requiring attention, one of the tests that somebody decided would work is whether the organization had "tea party" or "patriot" in its name. The IRS did also look at other organizations with potential for abuse of the social welfare organization status, but apparently did not come up with any shorthand ways of identifying any such organizations that did not have "tea party" or "patriot" in their names.

This was obviously a bad idea for a number of reasons, including its political asymmetry. But a) it didn't come from the top—Lois is herself a career employee, and it was a decision made somewhere below her level; and b) it did not involve scrutiny that was inappropriate under the circumstances. The content of some of the scrutiny may have been inappropriate, however, in seeking names of donors, which is not ordinarily done. (Even here, I can imagine some basis for thinking this was relevant to the inquiry: if all an organization's funds were coming from a party, or other 527 organizations, it would be a matter of some concern, and raise a somewhat higher suspicion that the organization was being used to finance campaign activities primarily. And while public disclosure of donors is not required, there is no absolute bar on the IRS seeking information about donors. They do it routinely in their efforts to determine private foundation status and compliance, since major donors are disqualified persons for purposes of the private foundation excise taxes. I should emphasize that Lois did not offer this explanation however—it is just my speculation on why IRS staff might have asked that question.)

I think the problem is that if you hear that tea party organizations were "targeted" for special scrutiny, it is hard to imagine an explanation that doesn't depend on partisan bias. But there is such an explanation: the need to draw the line between (c)(4) and 527 organizations. I'm not saying that this was the right way to go about this, and neither is Lois or anyone else in the IRS. But at the same time, it isn't the smoking gun that some in the media seem to think it is. It is nothing like Richard Nixon asking the IRS to audit his political enemies, though it is being compared to that.

Some additional headlines on this matter: 

American Thinker:  IRS Scandal Deepens: High Officials Knew of Tea Party Targeting in 2011

CNN:  IRS Abuses Power in Targeting Tea Party

Fox News:  Republicans Slam IRS Targeting of Tea Party as 'Chilling,' a Form of Intimidation

The Hill:  Rep. Issa: IRS apology to Tea Party Groups ‘Not an Honest One’

Legal Insurrection:  IRS Reaped Hatred of Tea Party Sown by Democrats and the Media, by William   Jacobson (Cornell)

Legal Insurrection:  The Washington Post leads on the #IRScandal ... Who Will Follow?

Mother Jones:  The IRS Shoots Itself in the Foot, Then Reloads

New York Post:  The Nixon Wing at the IRS

New York Times:  IRS Focus on Conservatives Gives G.O.P. an Issue to Seize On

Politico:  5 Questions on the IRS Debacle

Reuters:  IRS Kept Shifting Targets in Tax-Exempt Groups Scrutiny: Report

The Volokh Conspiracy:  IRS Scrutinized Teaching the Constitution, by Jonathan Adler (Case Western)

Wall Street Journal:  Wider Problems Found at IRS: Probe Says Tax Agency Used Sweeping Criteria to Scrutinize Conservative Groups

Washington Examiner:  Conservatives Want Congress to Audit IRS for Targeting Tea Party

Washington Post:  IRS Targeted Groups That Criticized the Government, IG Report Says 

Washington Tims:  IRS Scandal Grows to Include Debt Critics

Happy Mother's Day! Son Tries to Deduct Over $1MM in Legal Fees to Parents

So how much would you pay to have your child take care of you when you’re old and infirm?

According to one tax attorney, $1.2 million. At least that is the take away from Estate of Olivo v. Commissioner.

"The court considered whether mom’s estate could deduct $1,240,000 for son’s services before mom died. Tax lawyer Anthony Olivo worked in law firms from 1976 to 1988, then opened his own practice.

Yet by 1994, he was devoting so much time to his parents and their health problems that it was hard to maintain his practice. He lived with his parents and gave them round-the-clock care. That left little time to practice law, so from 1994 through 2003, he earned almost nothing from his practice.
So when they died he figured the estate should pay him all those lost wages. Hey, it’s deductible, he said. The court had to decide whether the estate could deduct the $1,240,000. On top of that was the $44,200 administrator’s commission Anthony received, not to mention $55,000 in accountant’s and attorney’s fees.
The court was careful to say that Anthony rendered extraordinary care. Hey, this was a doting son. His efforts were commendable. However, mom’s estate couldn’t prove that Anthony was entitled to any pay or how much his services were worth.
There was no contract, no invoice, and no evidence the family agreed to pay him anything. Sure, Anthony gave round-the-clock care. The family would have hired round-the-clock nurses if he hadn’t been there.
But he was, and the fact that a nurse would have been paid didn’t mean pay to Anthony was deductible. Anthony even considered billing the estate for his legal services.
After all, apart from his personal care and for administering the estate, he performed legal work too. He filed the estate tax return, handled an IRS audit and the estate’s Tax Court petition.
But here again, Anthony was out of luck. He didn’t keep time records, prepare invoices, or establish the value of what he did. He merely estimated his hours at a $150 hourly rate. That kind of loosey-goosey estimate wasn’t enough for a deduction.
The biggest lesson? Contracts, invoices, and good record-keeping are as important with family or related parties as anywhere else. In fact, perhaps there’s a bigger reason for being scrupulous with family and related parties: to save yourself headaches with the IRS. Happy Mother’s Day, Mom."

(Hat Tip:  Attorney Robert Wood of Forbes)

Proposition 13: Buying Property Without Reassessment of Property Taxes

Recently, Michael Dell has been in the news quite a bit as the result of his purchase of the Fairmont Miramar Hotel for $200 million.  In fact, the LA Times  reported to its chagrin that while Michael Dell had bought the hotel, he was able to exploit a "loophole" in Proposition 13 that allowed him to keep the property tax base as if the property was only worth $86 million.  By doing this, he was able to save over a million dollars a year in property taxes.  When the LA County Assessor's Office read the Times article they conducted a review of their own.  While LA County attorneys informed the assessor's office that Mr. Dell's transaction was not a change of ownership, the Assessor's Office challenged the transaction anyways.  Recently, an LA Superior Court judge ruled in Mr. Dell's favor, holding that under plain language of the law, there was no "change of ownership" and could be no reassessment.  

The Times, article, however, doesn't go into the details of how this was orchestrated and the law that applies.  Generally, when there is a change of ownership, property is reassessed for property taxes.  Now, when the property is owned by a legal entity, there are additional rules and complexities.  Under the law, the general rule is that the mere transfer of an ownership interest in a legal entity does not constitute a change of ownership of the property in the entity.  However, there are two main exceptions to this rule.  The first is the "change in control" exception which provides that if a single person (or entity) acquires more than 50% of the entity, then there will be a reassessment.  The second exception is called the "original co-owner" exception and provides that if the original owners of the entity cumulatively transfer more than 50% of their ownership interests in the entity to others, there will be a reassessment.  However, this second exception only applies if the entity acquired the property after March 1, 1975 in a transaction that was not considered a change of ownership because the property was used to capitalize an entity.  It was this curious requirement that worked in Dell's favor.

In particular, Dell's attorney's advised him that instead of buying the real property outright, he should instead by the LLC that owned the hotel.  In particular, they had Michael Dell form a limited partnership that bought 42% of the LLC, they had Michael's wife set up a trust for her to buy 49% of the LLC and then the remaining 8.5% was bought by an investment entity owned by Dell's investment managers.  Ordinarily, this transaction would easily fall under the "original co-owner" exception because you had the original owners of the LLC transfer 100% of there interests away.  However, because the hotel had been purchased by the LLC (or potentially was capitalized before 1975), this exception could not apply and so there could be no reassessment.  That left the Assessor's office relying on the first exception and so they argued that even though no single person owned more than 50% of the LLC, that there had been a change of ownership because Dell's interest and his wife's interest should be viewed as a single unit.  Dell's attorney's countered that this would violate the plain language of the law and that husband-wife transfers have never constituted a change of ownership.  The court ended up ruling in favor of Dell, which the Assessor's Office is expected to appeal.

The take-away is that if a buyer is interested in acquiring a property that has been owned by an entity since before 1975 (or purchased by the entitty thereafter), there are ways to structure the transaction so as to keep the low assessed value for property tax purposes.

How Apple Saved Billions By Issuing $17 Billion in Bonds

Recently, Apple made headlines by issuing a massive amount ($17 billion worth) of corporate bonds.  The main reason was to acquire sufficient funds to pay shareholders rather than having to bring back cash from Apple's overseas operations.  While Apple has around $45 billion in holdings in the U.S., it has $100 billion parked overseas.  Because it can be very expensive to repatriate these foreign funds, major corporations contort themselves to devise strategies to avoid paying this repatriation tax.

Below is a brief video highlighting the details of this strategy: