MauledAgain

The news of a few weeks ago (see, e.g., this report) that BP intended to claim deductions and credits arising from expenditures has caused quite a commotion. For example, according to this report, Senator Bill Nelson of Florida requested hearings on the issue and called BP’s intention to claim these deductions and credits “unacceptable.” Others stories, such as this one, suggest that public pressure will force BP to forego these tax breaks. A Tax Notes article, “BP, the Gulf, and Tax Deductions, 128 Tax Notes 569 (2010), reports that President Obama asked BP to give up its deduction for oil spill cleanup costs, whereas another article, “Cash on the Barrelhead: BP and Taxes, 128 Tax Notes 571 (2010), explained that it was the president’s press secretary, Robert Gibbs, who “called on BP to forgo the deductions, but conceded that the tax law permits them.”

There are three separate, though related, issues raised by these stories. They are too easily entangled in a manner that muddies up the analysis.

The first issue is whether BP is entitled to the deductions and credits in question. Assuming that the facts are as they have been reported, for example, that BP has in fact incurred the expenditures in question in the amounts in question, there is no question that BP is permitted to claim them. As explained in this opinion, “In short, it would likely take an act of Congress to keep BP from deducting its payments.” The word “likely” allows for the possibility that some other reason might persuade BP to give up on the tax breaks in question.

The second issue is whether BP should voluntarily give up the deductions and credits in question. On this question, reasonable minds can differ. On the one side is the notion that deductions are deductions, and barring application of public policy restrictions, which case law establishes don’t apply in this instance, taxpayers have claimed deductions for all sorts of things that might offend some other person’s sensibilities. On the other side is the notion that from a moral, philosophical, theological, political, or public relations perspective, BP has far more to lose by claiming the deductions and credits than it has to gain from doing what it is legally entitled to do. As noted in this report, Goldman-Sachs, as part of a settlement with the Securities and Exchange Commission, agreed that it would not deduct the penalties to be paid under the settlement. This is not the first time a taxpayer has made such a decision. The process that led to, and the consequences of, the decision at Boeing to do what Goldman-Sachs would do is discussed many paragraphs deep into this USA Today story.

The third issue is whether BP is permitted to give up the deductions and credits in question. The debate over the question of whether deductions and credits are mandatory became so intense that it inspired me to address the question in an article I wrote several years ago, “No Thanks, Uncle Sam, You Can Keep Your Tax Break,” 31 Seton Hall L. J. No. 1 (2007). Though the abstract will suffice for the casual reader, the serious researcher will want to read the entire article. So what’s the answer? As the abstract notes:

The article concludes that deductions are not mandatory other than in the computation of self-employment tax, as to which the IRS and courts have concluded deductions cannot be ignored, and other than the earned income tax credit which incorporates the self-employment tax computation concept. This conclusion is based on ample statutory evidence that allowable deductions will go unclaimed, on the failure of courts, aside from the self-employment tax situation, to compel taxpayers to claim all allowable deductions, and on the explicit and implicit approval by the IRS of disregarded deductions. The article suggests that aside from the two situations in which specific authority requires taxpayers to claim deductions, there is no reason for taxpayers who wish to forego deductions to hesitate in doing so.

But the more important question is “Why is that the answer?” I’m going to guess that some tax lawyer at BP or at a firm representing it is going to end up reading the article. If you do, let me know. It’s nice to see that an article is of value to practitioners.

The blogosphere is in a tizzy over the news from Philadelphia that the city is imposing its $300 business privilege license fee on bloggers who earn revenue from hosting ads on their blogs. In the referenced story, Robert Moran asks if there is a Tax on Phila. Bloggers? The answer is yes and no.

What has generated the uproar is the city’s insistence that the fee is due even if the blog generates less than $300 in revenue. According to this report, a blogger who raked in all of $11 over two years has been told to pay the fee, as was another blogger who collected $50 over a period of several years. The city’s response to the latter’s plea that she “makes pennies on her hobby” was to tell her to hire an accountant.

This issue came to my attention thanks to Andrew Oh-Willeke and Paul Caron. Andrew emailed me to ask if I had paid the tax. I pointed out to him that I don’t live or work in Philadelphia, but that I would not step away from the debate just because I’m not personally affected. At least for the moment, I’m not. Perhaps if I were raking in the cash, so to speak, I would have even more of a vested interest than I do, but that’s not a concern considering that aside from roughly a hundred people the 6-billion-plus people on the planet don’t think MauledAgain is worth visiting, even when it is free and unencumbered by ads.

Philadelphia contends that bloggers who collect revenue are conducting a business and must acquire a business privilege license. The catch in this analysis is not whether a business must acquire a business privilege license. That much is clear, and the city’s revenue officials are stuck with the statutory language. Those who think the imposition of a fixed fee makes little sense can look to Philadelphia City Council, the local equivalent of Congress, for an explanation of its decision to impose a flat fee rather than one based on a percentage computation. As pointed out Hot-Air, all sorts of taxes and fees apply to businesses that are making little, if any, money, whether due to start-up status, a down year thanks to a weak economy, or failure of customers and client to pay bills. In BPT Rears Its Ugly Head . . . Toward Bloggers, Doron Taussig notes that the tax applies not only to bloggers collecting revenue but to children who earn money babysitting or operating a lemonade stand. Compliance among the younger entrepreneurs probably is low because they fly under the radar, leaving little, if any, evidence of their activity or revenue collection on the internet as do bloggers.

In his post on the issue, Andrew Oh-Willeke notes that Philadelphia’s interpretation of its tax laws are “contrary to all common sense.” What lacks common sense is the law that is being interpreted. As often is the case with federal tax issues, the culprit isn’t the administrative agency but the legislature, in this case Philadelphia City Council. This is the same city council that also imposes a gross receipts tax, which can burden a business that loses money, and which I discussed in Don’t Like This Tax? How About That Tax?.

Is the fee is unconstitutional? This question was asked, for example, by The Conglomerate. Philadelphia explains that the fee is imposed on the conducting of a business and not on the content. It actually claims that the fee applies because the bloggers “made money,” though technically that is true only if “made money” means “collected revenue” in contrast to “generated a profit.” Newspapers and other publishers operating in Philadelphia pay the fee, and some of them have had years in which they did not make profits. Yet I doubt that the constitutional argument will get very far.

Instead, the issue is whether bloggers who collect revenue are necessarily conducting a business. For federal income tax purposes, a business does not exist simply because revenue is collected. If the taxpayer wants to deduct the expenses of a business, the taxpayer must demonstrate that a business exists, and the resolution depends on the facts and circumstances. The IRS and the courts apply a long list of factors to distinguish businesses from hobbies. Is a blogger who collects $11 or $50 over a two or three year period operating a business? Playing with a hobby? The answer is, “It depends.” Did the blogger set up operations in a manner consistent with an objective of making a profit? Does the blogger conduct operations in a manner consistent with good business practices? Does the blogger engage in efforts to increase revenue by marketing the blog? Does the blogger keep books and records? Does the blogger devote all, most, much, some, or a little bit of his or her time to the blogging activity? According to a spokesman for the mayor, a blog “is not a business unless it starts selling ads or otherwise generating revenue.” That conclusion sums up the problem. Collecting revenue does not create a business. Ask the taxpayers who try to take business deductions for vacation homes that they rent out on an occasional basis. They collect revenue, but that doesn’t elevate their situation to one of being in business. Is a person who wins a lottery, who surely is collecting revenue, conducting a business?

There’s a simple solution. City Council needs to define “business” so that the business taxes and fees apply only to those taxpayers who file a Schedule C or Schedule C-EZ with their federal income tax return. Would this be burdensome? No. In fact, according to Tax on Phila. Bloggers?, the city has been obtaining tax information from the IRS and has been going after bloggers “who reported blog income to the IRS, no matter how little.” Apparently the city has not limited itself to income reported on Schedule C, nor has it bothered to look at the bottom line. If City Council does not move on this issue quickly and appropriately, even more young, creative, tech-savvy entrepreneurs will leave the city for other places. Short-term thinking often blocks good long-term planning, which is how the city ended up in the mess in which it finds itself in 2010. Isn’t it time for City Council to put the brakes on the downward spiral? Otherwise, by 2020, there may not be anyone doing business in the city.

Several years ago, in Are State Gasoline Taxes the Best Source of Highway Revenue?, I pointed out that Pennsylvania faces a a $1.7 billion annual shortfall in road and bridge maintenance requirements. Last year, in Another Reason Why There Are, and Need to Be, Taxes and User Fees, I noted that New Jersey is in a similar predicament. The same is true of most, if not all, of the states. The nation’s transportation infrastructure is crumbling. How quickly people forget the bridge collapse in Minnesota. In Pennsylvania, an attempt to impose tolls on I-80 to fund highway and bridge projects elsewhere in the state was shot down by the Federal Highway Administration, as I explained in User Fee Philosophy Vindicated. Various proposals to grab short-term egg dollars by selling the long-term goose by turning the Pennsylvania Turnpike over to private sector investors whose primary goal would be to suck profits out of the public asset have failed, fortunately, to gather sufficient support. Calls to increase the gasoline tax frighten politicians who fear losing votes because they tell the voters the truth. The state’s governor and legislature have exchanged ideas, criticisms, and objections but have been unable to agree on a workable solution.

Now, according to this Philadelphia Inquirer report, the governor intends to make one last attempt to convince the legislature to deal with the crisis. To fix 5,000 failing bridges and 7,000 miles of deteriorating roads, the governor wants to impose a tax on oil-company profits, with a prohibition against passing the tax increase on to motorists. There are three problems with this idea. The pass-through prohibition might be unconstitutional. If enacted, the tax would be challenged and litigated, a process that would take years. Expecting oil companies to pay for the damage caused by motorists to roads and bridges is as wrong as expected motorists who pay tolls to cross the bridges between New Jersey and southeastern Pennsylvania to pay for soccer stadiums and football fields, on which I commented in Soccer Franchise Socks It to Bridge Users, Bridge Motorists Easy Mark for Inflated User Fees, and other posts dealing with the misadventures of the Delaware River Port Authority.

The chances of the legislature dealing with the problem in a sensible manner are slim to none. Several have admitted that with elections just two months away, they are not about to increase taxes, tolls, or any other fees that might jeopardize their ability to gather votes. They say this even though they confess that there is an “urgent need” to resolve the crisis. Proposals to increase the state gasoline tax to reflect inflation since its last increase 13 years ago again are circulating in Harrisburg. The governor claims that a recent poll financed by his campaign account shows that a majority of the state’s citizens “would be willing to pay a little extra for safer roads and bridges and better transit systems.”

Here’s the conundrum. So long as legislators continue to hold fast to the old ways, fearful of losing votes as a price of demonstrating and exercising leadership in a time of change, the crisis will not be resolved, bridges and roads will continue to fall apart, and eventually someone, or many, will die as an overpass, bridge, or road collapses. The resulting chorus of “I told you so” will do nothing to bring back the victims of political cowardice.

Those who read MauledAgain know that I oppose selling public assets so that private investors can milk them for short-term profits at the expense of the citizenry, as I have explained in posts such as Are Private Toll Roads More Efficient Than Public Tolls? and More on Private Toll Roads. Likewise, I oppose funneling tolls or user fees to projects unrelated to the toll or fee, as I explained in posts such as User Fee Philosophy Vindicated, Soccer Franchise Socks It to Bridge Users, and Bridge Motorists Easy Mark for Inflated User Fees.

What I support is the mileage-based road fee, a 21st century concept that seems to elude legislatures and politicians still living in the 19th and 20th centuries. It is time for them to sit down and read Tax Meets Technology on the Road, Mileage-Based Road Fees, Again, Mileage-Based Road Fees, Yet Again, and Change, Tax, Mileage-Based Road Fees, and Secrecy, and the articles and studies cited therein. During the transition period, while the technology is being adopted and installed, it is essential to raise the state – to say nothing of the federal – gasoline tax, for the reasons set forth in posts such as Is Gasoline Tax Increase in the Pipeline?, The Return of the Federal Gasoline Tax Increase Proposal, Raise, Don’t Lower, Fuel Taxes, Gasoline and Free Markets, Up, Up, and Away, Gasoline and War, and A Tax Trifecta: Gas, Enforcement, and Special Interests.

Though it is easy to paint tax increases as harsh, even if they are in the nature of user fees, the reality is, as explained in Funding the Infrastructure: When Free Isn’t Free, a mature population understands that it must pay for what it wants. In The Return of the Federal Gasoline Tax Increase Proposal, I noted that one hero of the anti-tax-increase crowd, Ron Paul, went so far, to use his words, to claim, while blasting a suggested increase in the federal gasoline tax, that the cost of gasoline should be adjusted to fit what people are able to pay rather than the economic burdens gasoline use imposes on society and the economy. Applied to all goods and services, this mentality would bring about more societal destruction than would the return of Attila the Hun and his hordes. As I also wrote in The Return of the Federal Gasoline Tax Increase Proposal:

It is human nature to want things for free, to seek preferential treatment, to get someone else to do one's work, to live on the backs of others. It takes intelligence, wisdom, and a sense of justice to understand that there is no such thing as a freeway, even if a select few find a way to make it free for themselves. Someone needs to pay. The mentality that brings the "I get to go straight out of the left turn lane because I am special" approach to driving surely dovetails with the "I get to use the highways without paying for them" mindset. The gasoline tax hasn't been increased for 15 years. The costs of repairing highways has increased during the same time period. That alone should close the door to the notion that the federal gasoline tax should be locked in forever at its current level.

Realists point out that increasing the federal gasoline tax is a politically difficult thing to do. For example, the Washington Post quotes Leon Panetta as explaining, "I don't think there's any question that as a matter of policy it makes a lot of sense to move in that direction, but politically it's a very high hurdle to get over." Of course it is. But if the nation doesn't clear that hurdle, the gasoline tax debate might become trivial in comparison to what awaits us if this situation isn't fixed, and fixed quickly.

Though it has been “only” 13 years in Pennsylvania, the same reasoning applies. If the Pennsylvania legislature doesn’t get it right this time, there may not be a next time. Or, if there is, it will be a crisis so dwarfing the current one that the sort of taxes and user fees required to repair the mess will make the proposals I offer today seem trivial in terms of ultimate taxpayer cost.

A recent decision, Foundation of Human Understanding v. U.S., No. 2009-5129 (Fed. Cir. Aug. 16, 2010), demonstrates the continuing difficulties encountered by tax administrators and judges schooled in pre-digital days and caught in a pre-digital mindset as the technological developments in the communications arena raise tax law issues. The case involves a Foundation incorporated in 1963, recognized as a tax-exempt entity by the IRS in 1965, and classified by the IRS as not a private foundation because it qualified as a publicly supported organization. The Foundation’s claim that it was not a private foundation because it was a church was rejected by the IRS, an conclusion that had no bearing on the outcome.

Two decades later, in 1983, the Foundation again requested that it be treated as a church, the IRS denied the request, the Foundation sought a declaratory judgment by the Tax Court, and the Tax Court held it was a church. The Tax Court relied on five facts: the Foundation owned a building where it conducted services several times a week, it operated a school for children where it taught its doctrines, it owned another property where it held seminars, meetings, and other activities, it purchased a second building for church services, and it provided “regular religious services for established congregations.” The Tax Court concluded that the Foundation’s radio broadcasting and pamphlet printing activities did not support its claim of being a church, but considered these factors to be insignificant compared to the Foundation’s other activities.

As the years progressed, the Foundation changed its operations. It moved its school into a separate corporation and operated it as a private non-denominational Christian school. It sold its church buildings. It continued to “disseminate its messages through broadcast and print media” and when the Internet became popular, began to use it for the same purposes. In 2001, the IRS determined that the Foundation no longer qualified for church status. The Foundation sought a declaratory judgment in its favor, this time in the Court of Federal Claims, where it lost.

The Court of Federal Claims noted that there are two approaches to determining church status. One is a bundle of 14 criteria invented by the IRS, about which the court expressed concern because it “appears to favor some forms of religious expression over others,” but the court examined the criteria and determined that the Foundation, though meeting some, had not proven that it “had a regular congregation or that it held regular services during the years at issue.” The other approach, a so-called associational test developed by the courts, was the basis for the decision by the Court of Federal Claims. That test defines a church as an organization that includes a body of believers who assemble regularly for communal worship. Accordingly, the court concluded that because the Foundation did not provide regular religious services to an established congregation, and because the extent to which the Foundation brought people together to worship was incidental to its main function of spreading its message, it was not a church. The court rejected the Foundation’s argument that a church exists if “there is a body of followers beyond the scope of a ‘family church’ . . . [who] seek the teachings of the organization and express or acknowledge an affiliation with its religious tenets” because, according to the court, “every religious organization has members who express an affiliation with the organization’s tenets.” Ultimately, the court held that the Foundation failed to establish that “it held regular services with a regular congregation during the years at issue and because its ‘electronic ministry’ did not satisfy the associational test.”

On appeal, the Federal Circuit affirmed. After noting that neither Congress nor the IRS has done much to explain the meaning of the term church in section 170, explaining that the definition of church is more limited than the definition for a religious organization, and agreeing that the 14 IRS criteria raise issues, the court decided to apply the associational test. It quoted other decisions that require “an associational role,” “a body of believers or communicants that assembles regularly in order to worship,” “a cohesive group of individuals who join together to accomplish the religious purpose of mutually held beliefs,” and “an organization [that] bring[s] people together as the principal means of accomplishing its purpose.” The court agreed with the trial court that holding occasional seminars in various locations did not constitute regular meetings, a regular congregation, or a regular assembly for worship, and that there was no proof that the seminars enabled participants to establish a community of worship. The court explained that while the associational test does not set a minimum frequency of gathering, it does require “gatherings that, by virtue of their nature and frequency, provide the opportunity for members to form a religious fellowship through communal worship.”

The Federal Circuit also rejected the Foundation’s argument that by listening to sermons broadcast over radio and the internet at set times, its members had established worship as a “virtual congregation.” The court noted, “The fact that all the listeners simultaneously received the Foundation’s message over the radio or the internet does not mean that those members associated with each other and worshiped communally.” The court decided that even though the Foundation permitted members to call in and to have their comments shared with those who were listening, it did not permit members to interact and associate with each other in worship. The Foundation’s reliance on a case holding that there can be a “church without walls” was rejected because in the cited case the church not only had a “street church” congregation, it also had a conventional bricks-and-mortar church building where worship services were held.

It is the rejection of the “virtual congregation” argument that poses problems. Even if, on a technical basis, the court’s decision is correct because it rests on the Foundation’s failure to meet its burden of proof, it merely postpones to another day a similar case where the organization brings in expert witnesses to explain how it is possible for people to interact without being physically proximate. Consider the various definitions provided for the associational test. One speaks of “an associational role,” but does not require physical proximity. Experiences by millions of individuals with social networking sites demonstrates that people can associate, sometimes quite intimately, without being physically proximate. Or consider the definition of “a body of believers or communicants that assembles regularly in order to worship.” Many denominations theologically propound the notion of “body of believers” as a bonding that transcends the physical limitations of a church building. Nothing in the definition requires that assembly cannot occur other than by physical proximity. Nor is there anything to suggest that worship requires interaction, particularly when one considers the many instances in which individuals arrive at a church, listen, and leave without speaking to anyone or at least without speaking to anyone concerning theological issues. For a court to decide that religious fellowship cannot be formed other than with physical proximity is for the court to intrude on the theological beliefs of the organization. In fact, religious fellowship can be established without physical proximity, and thus the court’s application of the associational test, if not the test itself, poses the same concerns as does the 14-criteria test of the IRS. Something called the First Amendment overshadows both tests.

Yet there is something of even wider import brewing in this decision. The terms “regular services” and “regular congregation” have their counterpart in the definition of an educational institution. Section 170(b)(1)(A)(ii) defines educational organizations eligible for tax-deductible charitable contributions as those “which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.” Aside from jokes about irregular faculty, irregular curriculum, and irregular students, I ask those in the basic federal income tax course who are trying to learn the parameters of the scholarship exclusion, which incorporates the section 170(b)(1)(A)(ii) definition, what happens to the on-line university? Are its students in attendance at the place where its educational activities are regularly carried on? Where is that place? Is it cyberspace? Is it the collective space formed by the aggregation of the various rooms scattered throughout the world where the students are sitting as they listen to, and in many instances respond to, the instructor and other students? Is physical proximity a prerequisite for “attendance at the place”?

The world has changed. People can interact without being in physical proximity in all sorts of ways that they could not accomplish before the advent of internet communications. Consider a class or a religious gathering taking place through video-conferencing. If the school or church relies solely on this technology, ought it be considered in some way “deficient” or “unqualified” as contrasted with their bricks-and-mortars predecessors? In many ways, reaching out, whether to students or congregants, in this manner opens the doors to people otherwise precluded, for mobility or other reasons, saves energy, eases pressure on the environment, and achieves a variety of other worthy goals.

True, the IRS and the courts can sit back and wait for Congress to amend the tax code to insert “whether or not in physical proximity” to bring the tax law into the 21st century. I am quite confident that this adjustment is thousands of pages deep in the pile of tax law changes that are on the Congressional desk. The words “regular,” “place,” “attendance,” “assembly,” and “association” are ambiguous in this context, and it is the obligation of the IRS and the courts to focus on these terms with 21st century eyes and minds. The next case will not be any less challenging. But it is “out there,” waiting.

According to Martin Regalia, chief economist of the U.S. Chamber of Commerce, “Uncertainty is the probably the biggest factor retarding economic growth.” He made this comment at an economic summit, at which, according to this report, other participants called for cuts in government spending, reduction of the federal budget deficit, a reduction in government regulation of business, and reform of the tax system, though Regalia, according to another report, also supports extension of the Bush tax cuts. As is the case with others who support reduction of the federal budget deficit and tax cut extensions, specifics on how to cut trillions of dollars in federal spending in order to reconcile those two inconsistent goals was not offered.

Yet aside from the inconsistencies with respect to budget deficits and tax cuts, Regalia is dead-on when he ascribes much of the nation’s ability to get its economy back on track to uncertainty. It is difficult to plan, whether for a business or individual decision making, when tomorrow’s tax climate is unknown. Though uncertainty cannot be eliminated in the business world, considering, for example, that no one can predict when and where the next earthquake will strike, it seems rather absurd for a nation to let its citizens dangle as they try to figure out what to do in their personal and business financial lives.

Decisions by businesses to purchase or to refrain from purchasing new equipment have been turned into a gambling game. It’s one thing to know what the tax consequences will be of making a purchase in August 2010, in December 2010, in 2011, or in 2012. That permits the decision-maker the opportunity to compare the various outcomes under each alternative. It’s another thing to wallow in uncertainty. So long as members of Congress continue to propose bigger and new tax breaks for equipment investment by businesses, it becomes difficult to make the purchase now when there is a chance that by doing so the opportunity to make the purchase next year, with a better tax break, will disappear. Indecision sets in, and business stagnates. A new tax break might be retroactive. It might not be. When this conundrum is extended to all of the tax components of business decision-making, such as rates, deduction limitations, foreign tax credit rules, and hundreds of other issues, the resulting matrix of confusion paralyzes America’s entrepreneurs.

The bottom line, no pun intended, is that it is easier for businesses to make decisions if they know what lies ahead, regardless of what lies ahead, than if they don’t know what lies ahead. Businesses can react to higher tax rates and to lower tax rates, if they know what the tax rates will be, but their decision modeling suffers when virtually everything in the tax law remains open to change, perhaps retroactively, sometimes at a moment’s notice.

Why is the Congress unwilling to provide America with a sufficiently certain tax law for the future? Notice that I did not ask why it is unable. Congress is capable of doing so, but chooses not to do so. The answer is that uncertainty provides members of Congress with the opportunity to use the promise or threat future tax law changes as bargaining chips in their continued pursuit of political power for the sake of power. Greed, it should be noted, isn’t restricted to the desire for money per se, although one significant consequence of holding political power is, as has too often been demonstrated, access to money. Perhaps, once business leaders realize that the very conditions of which they complain that are making business decisions so impossible to make are generated by a Congress grown addicted to campaign contributions and lobbying efforts with respect to specific tax provisions, they will turn their attention to fighting for more certainty, even at the expense of those who profit by pushing for continual changes in the tax rules.

As I pointed out in A Zero Tax, A Zero Congress, Congressed has betrayed America. I wrote:

What I can offer is my condemnation of the Congress for putting America into yet another economic mess. Several commentators have noted, cynically perhaps, that members of Congress benefit from having the estate tax issue held open because it encourages lobbyists for the various positions to rustle up more cash for the campaign coffers of members of Congress. Far be it for me to criticize a cynical observation. Truth be told, I think these commentators are making a valid point. It's not unlike members of Congress to put personal objectives, including raising re-election funds and grabbing power, ahead of what needs to be done for the national economic good. One look at the bribery involved in crafting a health care bill tells us quite a bit about the value system in play on Capitol Hill.

. . . .

There are a variety of words to describe the manner in which the Congress has handled the estate tax question. Irresponsible is my favorite. Short-sighted is another good one. Unwise, incompetent, and outrageous also come to mind. There also are some phrases that can be used. Derelict in its duty. A breach of its fiduciary obligation.

. . . .

There may not be any constitutional requirement that Congress do its job properly and in a timely manner, nor a provision that prohibits the Congress from creating the mess in the first place. Nor is there any statute that can be invoked to compel the Congress to live up to its responsibilities, particularly when the responsibility is one of its own making. But there is more to law than just a constitution and statutes, regulations and cases, rulings and decrees. There is a moral imperative, an overarching array of dedication to the national interest, respect for the citizens, decent treatment of the taxpayers, adherence to diligence, integrity, common sense, and fiduciary duty, and a deep understanding of the difference between the good and the expedient. Whether the Congress ever had or exercised this set of values is debatable, but what's not in dispute is the conclusion that the current Congress fails miserably in this regard. It is morally bankrupt. It earns a zero.

It ought to be crystal clear to the business leaders of America where the problem lies, and it ought to be crystal clear to them what needs to be done. Will they rise to meet the challenge? Or will they remain mired in the woeful world of tax politics, caught up in a spiral of economic degeneration?

Some time ago, I criticized the decision of the Delaware River Port Authority to use toll revenues for contributions to the construction of a major league soccer stadium. In Soccer Franchise Socks it to Bridge Users, I pointed out that tolls paid for the use of a bridge should be used for the maintenance and repair of the bridge and not for other purposes, as the DRPA had become accustomed to doing. In a follow-up, Bridge Motorists Easy Mark for Inflated User Fees, I noted the absurdity of the DRPA’s call for increased bridge tolls because it needed money to repair its bridges. Perhaps had money not been diverted to soccer stadium construction and other projects, there would have been funds for the DRPA to perform its stated functions. The criticisms that I, and a few others, offered fell on deaf ears, as a year later, I explained in Don’t They Ever Learn? They’re At It Again that the DRPA had announced plans to funnel more toll revenues into projects having nothing to do with the bridges and waterways it is charged with tending. Shortly thereafter, in A Failed Case for Bridge Toll Diversions, I lambasted the governor of Pennsylvania for his unwise attempt to justify using bridge tolls for other purposes.

A few days ago, I returned from some travels to discover that the DRPA had come under fire, again, for all sorts of mismanagement and misappropriation of its resources. Just take a look at some of the headlines in recent Philadelphia Inquirer articles and at some of the highlights:

Dougherty Furious at, Underwhelmed by, DRPA (local union leader serving as commissioner for DRPA unimpressed by response to his questions to the DRPA concerning continued salary payments to a dismissed DRPA employee, use by a DRPA official’s family member of a DRPA E-ZPass unit, and shifting car allowance payments into the DRPA general counsel’s salary in order to increase pension payments)

DRPA Safety Head Suspended for Improper E-ZPass Use, But More Questions Loom for Agency

Pa. Treasurer Demands Much Financial Data from DRPA (“The heat increased on the Delaware River Port Authority on Friday, as the Pennsylvania state treasurer demanded a broad accounting of car allowances, free E-ZPass transponders, hiring of family members, awards of contracts, conflicts of interest, and pension deals.”)

Facing Criticism, DRPA to End Free Bridge Passes, Car Allowances (top officials of DRPA to lose “free bridge passes and lavish car allowances” in response to “rising public and political criticism”)

Rendell Backs Changes at DRPA After Controversy (Pennsylvania governor demands state audits of DRPA, open meetings, public record access, public votes on DRPA contracts, limiting family hiring to one relative, prohibition on moonlighting by officials, elimination of private board meetings, and elimination of free E-ZPass units and car allowances)

DRPA Board Chairman Calls Criticisms Lots of Smoke, Little Fire (chairman of DRPA agrees to make changes requested by Pennsylvania and New Jersey governors)

DRPA Safety Chief Quits Amid Free E-ZPass Complaints

Investigation Sought Over DRPA Emails (allegations that agency email system used to solicit campaign contributions)

Pa. State Sen. to conduct hearings on DRPA (hearings to focus on DRPA “broad mandate to spend money freely” and "widespread allegations of mismanagement, fraud and political patronage")

Gov. Rendell Accepts “Lion’s Share of Blame” for DRPA Failures

Official Accused of E-ZPass Abuse Improperly Received Pension Credits

Despite Its Largesse, DRPA Should Stop Backing Non-transportation Projects, Pennsauken Board Member Says (but accepts $700,000 DRPA grant for building a football complex in the town of which he is a mayor)

Criticism of DRPA Management Decisions Continues

Pa. Treasurer Urges Major Changes to DRPA Rules

Ringside: DRPA’s Family Feud Exposes Waste, Abuse

Politically Connected Firms Reap Big DRPA Contracts

It is this sort of mismanagement, political cronyism, misuse of funds, and general failure to appreciate the “servant” portion of “public servant” that causes me to have sympathy for those who rail against government, and who call for cutting or eliminating taxes as a means of ending the corruption. The problem is that the service that the government or a government agency is supposed to be providing needs to be provided. The answer isn’t cutting taxes, or in this case, tolls, as the first step. The answer rests in some serious housekeeping, reform of the political system, implementation of oversight that is accountable to motorists who pay tolls and taxpayers who fund the agency, so that an accurate assessment can be made of what it costs to do what the agency should be doing. At that point, tolls can be adjusted downward if the numbers warrant. Merely cutting taxes or tolls doesn’t guarantee that the outcome won’t be continued funding of soccer stadiums and football complexes while necessary bridge maintenance and repairs are reduced or omitted.

The bottom line is that when government officials and employees engage in the sort of behavior manifested by the DRPA, they give a bad name to the many public servants who are doing their job, acting honestly, and avoiding political machinations. Granted, the DRPA is an egregious case and makes it easy for opponents of government to turn it into the poster child for underfunding government. The cause of the problem isn’t the existence of taxation or the imposition of tolls. It’s the existence of incompetent, corrupt, and unaccountable officials who rejoice when citizen anger is directed at the concept of taxation rather than at specific individuals misbehaving and making bad decisions while holding positions of trust. Imagine if the anger and energy of the anti-tax and tax reduction crowds could be channeled into genuine reform of government service.

It does amaze me when I read, in Gov. Rendell Accepts “Lion’s Share of Blame” for DRPA Failures, that Pennsylvania’s governor credited John Dougherty, a DRPA Commissioner and a long-time labor leader in Philadelphia “for bringing attention to possible abuses at the bistate agency.” It also bothers me to read, in The Bandwagon Gets Crowded in Calls for DRPA Reform, Monica Yant Kinney crediting Dougherty as having “filled a full-size bandwagon” on which former DRPA enablers are “piling on.” Dougherty certainly deserves credit for speaking up, but he didn’t build the wagon or form the band. It was lonely in the garage constructing that wagon as I complained about the use of bridge tolls for unrelated purposes. Granted, I didn’t see all of the abuses that Dougherty disclosed from his position as an insider, but what those were red flags flying from the wagon. Oh well, at least the governor of Pennsylvania has retreated from his almost-blind defense of the DRPA, even if it was a case of trying not to be run over as the DRPA reform bandwagon gathered momentum.

But wouldn’t it be nice if that $700,000 football complex grant was returned as an act of public servant leadership? It’s tough doing the right thing, but that’s what public service is all about.

The syllabus for Introduction to Taxation of Business Entities includes one last topic, namely, Introduction to Reorganizations. Only twice in the 18 times that I have taught the course has there been time to cover this topic, and even on those two occasions there were merely 10 or 20 minutes to present an extremely superficial overview of the most basic of basics. Needless to say, the students were told that there would not be any reorganization questions on the exam.

Experience taught me that it would make no sense to include death of a shareholder or death of a partner in the course. There simply isn’t the time, though both topics provide more opportunities to review previously covered material. For these interesting topics, students must wait until they are in another tax course.

When students leave the course, assuming they have been diligent and have learned what I intend for them to learn, they are capable not only of doing simple corporate and partnership tax returns but also of understanding basic planning questions, figuring out how to find answers to more advanced questions, and taking with them a solid foundation for more tax courses. It’s a difficult area of taxation, thanks to the Congress, it’s essential that students get a firm grip on the material, and it has always been my principal goal to put them in a position to succeed in practice even though that requires demanding assignments, intense concentration, and voluminous coverage. Does it work?

About two months ago, a former student shared these thoughts about the course on a professional networking site: “Professor Maule is one of the most captivating and brilliant professors I have ever encountered. His J.D. level, Taxation of Business Entities course is one of the most rigorous and intellectually stimulating courses I have ever taken. He is approachable, helpful, and makes a rather troublesome topic quite manageable.” It worked for this student, it has worked for others who have made similar comments, and hopefully by now it has worked for those who haven’t (yet) had anything to say about their experience in the course.

Three partnership liquidation patterns are considered. Only one gets extensive attention.

The first pattern is a so-called true liquidation, in which the partnership sells its assets and distributes the cash. The consequences follow principles with which the students are familiar, namely, the property disposition checklist, the passing through of gain or loss, the increase or decrease in partners’ adjusted bases in their partnership interests, and the 15-step distribution checklist. The latter has a simplified application, because the nature of the transaction obviates any need to consider sections 704(c)(1)(B), 737, 736, or 751(b). A brief example illustrates a burned-out tax shelter in which the sole asset disposition is a quitclaim of encumbered property to the creditor.

The second pattern is a proportionate distribution of all assets to the partners. Again, the consequences follow principles previously studied, namely, the by-now-shopworn 15-step distribution checklist. In this instance, although sections 736 and 751(b) remain irrelevant, sections 704(c)(1)(B) and 737 can come into play. There is no time to consider a problem based on this pattern.

The third pattern is a disproportionate distribtion of assets to the partners, a pattern that is far more likely to occur than the other two. Yet again, the consequences follow principles previously studied, namely, the by-now-shopworn 15-step distribution checklist. In this instance, although sections 736 remains irrelevant, sections 704(c)(1)(B) and 737 can come into play, and section 751(b) works its magic unless the transaction involves a proportionate distribution of the ordinary income assets. A problem involving two partners and four assets is used to demonstrate how to report this sort of partnership liquidation. At the end of the problem, discrepancies between potential ordinary income and capital gain and reported ordinary income and capital gain, caused by disappearing and created basis and the inability to make a basis adjustment, permits a preview of the basis adjustment issues waiting for discovery in a Partnership Taxation course.

Tucked in at the end of this topic is an examination of what happens when a partnership terminates by reason of sales of partnership interests. This discussion is deferred until this point because the consequences involve a deemed liquidating distribution, though the 1997 regulations created a conceptually bizarre momentary one-partner partnership in order to bail out the legislative mess created by having a limited time period in sections 704(c)(1)(B) and 737.

Next: Bringing It to an End

As the course winds down, the transactions that mark the end of an entity’s existence take center stage. The word liquidation presents almost as much ambiguity in the corporate liquidation context as it does with respect to partnership liquidating distributions.

There are several ways a corporation can structure its demise. If it sells all of its assets, it must recognize gain or loss, but this aspect of the situation requires students merely to review what they learned in the basic tax course.

For the shareholder’s tax consequences, the class takes a look at sections 331 and 334, giving a quick glance at section 332, because transactions involving subsidiaries aren’t within the scope of the course. From the corporation’s perspective, the operative provision is section 336. It would be a simple provision but for the overlapping provisions in paragraphs (1) and (2) of subsection (d) and the mostly redundant language of section 362(e), which the students encountered when learning about the tax consequences of corporate formations. Several examples, and some comparisons that students are expected to refine, help navigate this maze of bad drafting.

This topic closes with several problem sets. One focuses on the consequences to the shareholders. The other addresses the consequences to the corporation, principally the three loss limitations provisions of sections 336(d)(1), (2), and 362(e).

The S corporation liquidation topic is a 2-minute explanation that the same provisions apply, that any corporate gain or loss passes through to the shareholders, in turn affecting their adjusted basis and thus the gain or loss on the liquidating distribution. Fifteen seconds are expended mentioning the possibility of the built-in gains tax applying under certain circumstances.

Next: Partnership Liquidations

The partnership redemptions topic consists of two major subtopics. One deals with partial reductions in a partnership interest. The other deals with complete reductions of a partnership interest, in other words, partnership liquidating distributions.

The class returns to the 15-step distributions checklist that it first met when learning about partnership operating distributions. This time, notations in italics compares the application of the checklist to a partial reduction to its application in the case of operating distributions. With a few technical exceptions, all are the same, a consequence of the same statutory provisions applying to partial redemptions as apply to operating distributions. By this point in the semester, the students are beginning to understand why I predicted that the final few weeks would become increasingly a matter of review.

Because section 751(b) was avoided when doing operating distributions by keeping those distributions proportionate, this is the first time the class comes to grips with what was once the most difficult topic in the course until the section 704(b) regulations came along. The good news is that the definition of unrealized receivables is the same as it is for section 751(a) purposes, so they already know, or should know, this material. The bad news is that section 751(b) is not triggered by inventory items but only by substantially appreciated inventory items, so there’s another layer of complexity with which they must deal. I warn the students that there’s no sensible reason for the distinction but that it does provide good exam possibilities, aside from being a trap for the unwary tax practitioner. We then work through a problem involving a partial reduction in a partnership interest, including section 751(b) analysis. In fact, the section 751(b) portion of the problem solving is the only “new” black letter law being explored.

Having now arrived at liquidating distributions, it is necessary to deal with terminology issues arising from multiple definitions of the word “liquidation.” That having been accomplished, the students yet again see the 15-step distribution checklist show up on the projection screen, though not all at one time! This time, of the 15 steps, five require application of different principles than applied to operating distributions and partial redemptions. One of the differences requires extensive study, and that is the maze that constitutes section 736. Though it’s a simple sorting function, section 736 befuddles most students. So I use all sorts of methods to get the point across, including treating the paragraphs in that section as people engaged in a conversation, comparisons to marshalling yard (which fewer and fewer students recognize), and a more conventional flowchart. At this point the class is ready to take on two problem sets, one involving a simple application of section 736 that permits attention to be paid to section 731(a)(2), and the other letting the class dig into the finer points of section 736. The first problem set lets students discover that a taxpayer can realize gain yet recognize a loss. The second problem set is limited to cash distributions, because property distributions in a section 736 setting are far too complicated for this course.

This topic then concludes with what I call a review problem. It involves a lawyer retiring from a law firm, with the partners having several options as to how the deal will be structured. It’s a problem that could also be presented in a Business Planning course. By working through four alternatives, one a sale to the other partners, one a distribution with a provision for goodwill, one a distribution without a provision for goodwill, and one a sale to the other partners using partnership cash, the students are in a position to review a substantial portion of the partnership segment of the course. They also get a glimpse into drafting by focusing on the negotiations that would take place among the parties, particularly with respect to the danger of inconsistent tax reporting of the transaction, aand by identifying the language that would be needed to protect whichever of the parties is their client.

Next: Corporate Liquidations

Having explored sales of interests, the class turns to the tax consequences of corporate redemptions. Even though corporate redemptions resemble sales of stock, though to the corporation rather than a third party, the applicable rules are quite different.

The first set of issues involves the impact on the shareholder. This requires not only reading and understanding section 302, but also remembering what happens when section 301 applies. This happens because any redemption that fails to qualify as a distribution in exchange for stock is treated as a run-of-the-mill distribution. Again, student who have been assimilating previous topics are in much better position to learn the current material than are those who fall victim to the “the existence of reading periods suggests institutionalization of pre-exam cram time” mindset, one that makes learning not only more challenging but perhaps impossible in this course. The second set of issues involves the impact on the corporation. This is a much easier topic, for it requires another visit to section 311, a quick glimpse of section 162(k), and a few minutes of reading and interpreting section 312(n)(7).

Once the groundwork has been set out, it is time to pause so that the constructive ownership rules of section 318 can be digested. After this has been done, the focus can shift back to the application of section 302. Constructive ownership is one of those tax topics that most closely resembles a puzzle. Some students delight in its intricacies, while others begin to doubt their intellectual capacity. Attribution to entities meets attribution from entities, and the anti-sidewise-attribution limit shows up, demanding that the two not be conflated. After taking the students through some examples, I invite them to solve several problems, though none get as complicated as they could be. They are boggled by the lack of symmetry in rules that tell them they must attribute from granddaughter to grandfather but not from grandfather to granddaughter. If I have any misgivings about constructive ownership, it’s that we don’t have the several hours that I would like to dedicate to the topic.

Next on the list is complete termination, waiver of family attribution and the family hostility dilemma, disproportionate redemptions, the bizarre not-essentially-equivalent-to-a-dividend rule, and partial liquidations. Students learn why it sometimes makes more sense to try to avoid exchange treatment, because section 301 permits full use of basis whereas section 302 limits basis to a proportionate share of total basis. The existence and purpose of section 303 is mentioned but otherwise ignored. Constructive dividends get some attention, particularly the problems that arise in divorce situations as arose in cases such as Arnes and Read. We look at the regulations designed to alleviate the whipsaw, evaluate whether they truly solve the problem, and consider the dangers of not dealing with the issue in premarital agreements. The students learn why those among them who plan to be tax practitioners might be getting phone calls from their classmates who decided to practice domestic relations law and who, even if taking the basic tax class, usually are surprised when business tax gremlins appear. The class then deals with several problem sets focusing on one or another of these issues.

All of this having been done in the C corporation context, the shift to the S corporation world is rather simple. The rules are the same, and the application is much easier. If there are accumulated C corporation e&p, remembering what the accumulated adjustments account is will serve students well. Two short and simple problems conclude this topic.

Next: Partnership Redemptions

There are three topics dealing with sales of interests in the entity. Only one receives any significant amount of class time.

In the case of C corporations, the tax treatment of stock sales gets three minutes of class time, as I take the students through a quick review of the property disposition checklist they hopefully have saved from the basic course, and point out refinements they must make to that list on account of redemptions, section 306 stock, and two other transactions that the course does not cover. No problems are tackled.

In the case of S corporations, the tax treatment of interests in the entity consists of a reference to the just-completed C corporation stock sale topic, a reminder that sales to the wrong person can trigger termination of S status, a reminder that sales during the year require taking into account varying interests, and a quick comparison with the apportionment that occurs if S status is terminated. As is the case with C corporation stock sales, no problems are undertaken.

However, in the case of sales of partnership interests, the analysis becomes more demanding. It’s time for yet another professor-provided checklist. This one, however, consists of only nine steps, of which only three are complicated in any manner. The first step requires some discussion, because sales for federal income tax purposes are different from sales in the state law context, where they exist only under special circumstances. This step also requires a visit to section 707(b) and the disguised sale rules. Students need to learn that sales of partnership assets and sales of distributed assets, though in the family of sales, nonetheless are different transactions and ought not be confused with sales of partnership interests.

Though the second step essentially is a return to section 706(d) in the event the sale occurs other than at the end of the taxable year, the third step examines section 706(c), the phenomenon of bunching income, and the logistical difficulties of applying section 706(d) when the partner’s tax return is due many months before the partnership taxable year closes. This particular issue is an example of demonstrating why something that makes sense theoretically often breaks down when taken into the practice world.

The fourth through seventh steps are reflect typical disposition issues, though section 752(d) comes into play when dealing with amount realized. It’s the eighth step that consumes much of the class time devoted to the checklist. Students meet section 751, specifically, section 751(a), and the definition of section 751 assets. They discover that if they haven’t fully assimilated the allocations material, they will struggle when trying to apply the rule that ordinary income or loss equals the ordinary income or loss that would have been allocated to the selling partner had the partnership sold the section 715 assets for fair market value immediately before the sale of the partnership interest. The final step, whether the partnership terminates, poses much less of a challenge and is deferred until entity liquidations and terminations are discussed. The section 743(b) basis adjustment’s existence is mentioned but it is not studied, as it, too, was a subtopic removed when the course was packaged as a combined 3-credit course.

After dealing with a problem that takes the students through alternative facts, the topic closes with an example of why partnership taxation is so strange. Students are shown that a partner who sells a partnership interest for an amount realized equal to the partner’s adjusted basis in the partnership interest nonetheless may end up recognizing ordinary income and, of course, offsetting capital loss. This exercise has the effect of hammering home to the students the inadequacies of a basic tax course, which leads people to believe, as might clients with a smattering of tax knowledge, that there are no tax consequences when amount realized equals adjusted basis.

Next: Corporate Redemptions

After dealing with operating distributions of cash and property, the course advances to the topic of corporations distributing stock. There is no partnership analog in this area.

This topic begins with a brief review of the tax consequences of stock splits and stock dividends as learned in the basic tax course, and then embellishes those principles with the more refined principles found in sections 305 and 307. Distributions of stock by C corporations and by S corporations are covered, even though three of the exceptions in section 305(b) cannot apply in S corporation situations. Section 305(c) and section 304 are beyond the scope of the course. However, the impact on the corporation of the transaction, including the nonrecognition of gain or loss and the effect on e&p, is covered. Application of these principles to specific fact situations is worked out in a problem set involving variations in the type of stock held by the different shareholders.

At this point, it is time to consider section 306. This provision serves as a vivid example of how the tax law becomes complicated because of the need to shut down tax avoidance devices, in this case, the preferred stock bailout. The computation of ordinary income and capital gain or loss under section 306 is explored, as are the various exceptions to application of section 306. Yet another problem set gives students a glimpse into how section 306 works and why careful practitioners take steps to avoid it.

Next: Selling Interests in the Entity

The discussion of partnership operating distributions begins with clarification of terminology. Students learn that one set of rules applies to liquidating distributions and another set applies to distributions that are not liquidating distributions. They learn that distributions that are not liquidating distributions often are called operating distributions but that technically, they can be divided into distributions that reduce but do not eliminate a partner’s interest in the partnership and those that do not affect a partner’s interest. It is this last group that comprises the topic.

At this point, I take the students through a 15-step checklist that identifies the essential questions that must be addressed when analyzing a partnership distribution. I give this checklist to the students because if I leave them on their own to create it, the odds are that most of them will end up with something that hurts, rather than helps, their learning process. Even though two of the steps are not applicable, I leave them in place so that the same checklist can be used when we reach distributions that reduce a partner’s interest and when we reach liquidating distributions. Several of the steps are simple, but others contain sub-steps. Unless one works through the analysis in logical sequence, one will end up jumping around in ways that cause some steps to be omitted and some to be considered multiple times. I emphasize the need to work with the checklist because I’ve seen too many exam answers that demonstrate the mess that is generated when methodical analysis is forsaken, and I make that point as forcefully as I can. This is followed by working through a problem set involving distributions of cash and property, simultaneously and then in sequence, that touches upon partnership draws, but that leaves the partners with unvarying interests, no contributed property, and no 751(b) issues.

Omitted from this topic, other than taking their place in the checklist are the section 704(c)(1)(B) and section 737 contributed property rules, the 751(b) ordinary income asset rules, the section 731(c) marketable security rules, the section 732(c) basis allocation rules, and the section 734 basis adjustment rules. Of these, the first two will get attention in subsequent topics, whereas the others are simply omitted from the entire course.

The topic concludes with an analysis of section 735, including a comparison to its counterpart section 724, which is not quite identical. This is followed by a problem set that illustrates the tax treatment of a partner’s disposition of distributed property. Although the class does explore the puzzling case of gifted distributed property, it does not go into the ramifications of a partner’s disposition of distributed property that carries a depreciation recapture taint. That’s just too much for a course of this sort.

Next: Corporate Stock Distributions

In comparison to the tax treatment of C corporation operating distributions, the principles applicable to S corporation operating distributions are far less likely to leave students overlooking analytical steps. The world of S corporation distributions is divided into two parts, one involving S corporations that have no accumulated C corporation e&p and the other involving S corporations that do.

The rules for the former group that are covered in the course are about as simple as things can get in the tax law, and one short problem is sufficient to illustrate how they work. For the latter group, the concept of the accumulated adjustment account is introduced, and students are taken through a series of examples that illustrate many of the possibilities in terms of the size of the distribution and the size of AAA.

The class does not learn about the impact of tax-exempt income on AAA, the election to distribute earnings first, or restricted bank director stock. These are the sorts of issues that are among the first to go when shoehorning business entity taxation into a 3-credit course.

Next: Partnership Operating Distributions

From a pedagogical perspective it makes the most sense to deal with operating distributions before covering sales of entity interests, redemptions, liquidating distributions, or liquidations. Even though a shareholder might sell stock without ever having received a distribution, and even though a partner might reduced his or her interest in the partnership before any distributions are made, some of the principles that are learned with respect to operating distributions serve as a foundation for understanding those other topics.

Discussion of C corporation operating distributions begins with the necessity of distinguishing distributions from other transactions, such as disguised salary or interest, and the making and payment of loans. Transfers to third parties that can turn out to be constructive distributions to the shareholder also are examined.

Students are then taken through section 301, particularly subsection (c). For some reason, this provision has vexed students throughout the years and throughout class sessions, semester exercises, and final examinations. Section 301(c) resurfaces when redemptions are studied, and yet for some reason what appears to be a straight-forward pattern confuses far more students than one would expect. Consequently, I emphasize this particular provision and immerse the class into it. Section 311 also is emphasized, because students often overlook its existence.

Earnings and profits present far less trouble for students, perhaps because most of the law applicable to e&p does not get attention. Students learn how e&p differs from accumulated taxable income, but no attempt is made, for example, to work through computations of depreciation for regular tax purposes and for e&p purposes, to say nothing of depreciation for AMT purposes. Attention is focused on subsections (a) and (b) of section 312, dealing with the impact of distributions on e&p. In determining what remains in the course and what is jettisoned, e&p deficits ended up staying in the course, so students must deal with the oddities of Revenue Ruling 74-164. They get an opportunity to examine an IRS position that is wrong, but that favors taxpayers and thus is unlikely to be challenged.

This topic concludes with several problem sets. One involves cash distributions made under a variety of e&p conditions. The other involves property distributions, and the impact of section 311(b).

Next: S Corporation Operating Distributions

Having worked through section 704(b) special allocations, the class turns to section 704(c). The good news is that section 704(c) is much easier to understand, at least at the level studied in the course, than section 704(b). Students had encountered contributed property when dealing with partnership formations, and had a brief introduction to the section 704(c) contributed property allocation rules when learning how to compute partners’ shares of liabilities under the section 752 regulations. Though the initial encounter was limited to the traditional method, at this point discussion also includes the curative and remedial methods, illustrated through examples. It also makes sense to include at this point a look at section 724, because it applies when partnerships dispose of contributed property. This subtopic concludes with a problem set that deals with sales of contributed property. The course does not cover allocation of depreciation deductions arising from contributed propery, both because of time constraints and because that is a topic too complicated for an introductory course.

After dealing with section 704(c), discussion advances to the section 706(d) varying interest rule. To cope with the limitations of a 3-credit course, this subtopic is handled with a brief lecture and two examples. This approach works because the issues and the principles are not unlike those arising when interests in an S corporation change.

Following discussion of varying interests, the class turns to section 704(e). Misleadingly titled “family partnerships,” it reaches beyond family transactions to cover not only partnership interests created by gift no matter the relationship but also recognition of a person as a partner even if no gift is involved. Once students understand this incoherency in section 704(e), it becomes a bit easier to understand the reach of the provision and its limited scope. Two problem sets involving very simple fact patterns are used to demonstrate what section 704(e) does and does not do.

The partnership allocation topic closes with a discussion of section 707, which deals with transactions between partners and partnerships. Specifically, the focus is on transactions in which the partner acts other than in the capacity as a partner and on guaranteed payments. Because students should have learned in, and remembered from, the basic tax course how sections 267 and 1239 function, they are left on their own to learn section 707(b), which is the partnership equivalent of those two provisions. Several problems, dealing with subsections (a) and (c) of section 707, close out the partnership allocation topic.

At this point, I direct students to look at the summary that I provide to them in the course materials that overviews partnership allocations. I do this so that they can recover a sense of the big picture after having been immersed in five subtopics each of which is replete with details and technicalities even after being screened to simplify the discussion for the purposes of an introductory course.

Next: C Corporation Operating Distributions

The partnership allocation topic is, without a doubt, the most difficult portion of the Introduction to Taxation of Business Entities course. Specifically, the prize goes to special allocations, with the other four subtopics presenting much less of a challenge.

I explain to the class that the sequence in which we study the partnership allocation subtopics is in reverse order from the sequence in which one would work through a set of facts to determine how partnership items must be allocated. The reason for this strange decision is that learning the issues is easier if one begins with section 704(b) special allocations. I share with the class the experiment I tried some years ago, teaching the subtopics in application order, and how that made the learning process even more difficult.

The first subtopic is section 704(b) special allocations. I take out as many issues as I can. So we don’t look at depletion, we don’t dig deeply into the alternate test, we take a somewhat superficial look at fact-based issues such as economic effect equivalents and factors in accordance with interest in the partnership. Because the subtopic is so complicated, I take time to explain how to parse the regulations, how to identify things that unnecessarily contribute to the complexity, and how to work around them, such as giving names to things identified in the regulations only by long citations. I highlight the “(ii)(i)” problem, something that, like PIGs, involves a discussion I’ll leave to another day. I also suggest, and provide a partial template for, a flowchart sorting out the various prongs, tests, branches, and pathways that proliferate throughout the section 704(b) regulations.

Before getting to problems, I work the students through a lecture that is filled with examples that illustrate why the three-prong test exists. I do the same with substantiality, although that issue might be the most convoluted of all the issues that are covered in the course. When going over capital account accounting rules, I limit the scope to the effects of contributions and distributions of money and property and the effect of allocations of income and other items. At this point the class considers a very simple problem set that lets them focus on basic principles.

Coverage of the section 704(b) subtopic concludes with an exploration of nonrecourse deductions. Students return once again to the concept of partnership minimum gain, and then learn how deductions are characterized as nonrecourse. This aspect of the subtopic makes students aware of the danger in thinking that drafting partnership agreement allocation provisions is a simple task, demonstrated by the example of the unexpected nonrecourse deduction. After going through the safe harbor test and minimum gain chargebacks, we do a simple problem, and a variation, that illustrates nonrecourse deduction analysis without gettting overly complicated.

Next: Contributed Property, Varying Interest, and More Partnership Allocation Subtopics

The notion of allocations in the C corporation context isn’t so much a matter of allocation as it is a question of who is taxed on income that ostensibly is the income of a C corporation. Because of time constraints, I don’t do much other than to explain the general purpose and application of sections 482, 269, and 269A. Covering those provisions in five minutes as I do is a price that is paid for having a 3-credit course.

When it comes to S corporations, the allocation issue gets much more attention. The principles applicable to determining pro rata share, to complete termination of a shareholder’s interest during the year, and of reductions or increases in a shareholder’s interest during the year are carefully worked out. A problem is studied in which one of three shareholders sells part of her stock, and in a variation, all of her stock, to a fourth person. The projection screen fills with a flood of numbers, but it doesn’t seem to faze the students. That will happen soon enough.

Next: Allocations in the Partnership Context

It might appear that studying loss limitations before looking at allocations is backwards, but understanding how loss limitations work puts the allocation issues into perspective. It is easier to understand allocations once the consequences of an allocation are appreciated.

This topic begins with a categorical examination of each entity and an identification of the loss limitations that apply. For C corporations, it’s a matter of reminding students about section 1211, and pointing out the limited applicability of the at-risk and passive loss limitations. For S corporations and partnerships, it’s a matter again of refreshing students’ recollections of section 1211, describing the basis limitations, and noting that the at-risk and passive loss limitations are significant elements in computing the taxable income of many partners and S corporation shareholders.

A problem that deals with the section 704(d) basis limitation for partnerships illustrates the issues that arise both for partnerships and S corporations. The concept of multiple disallowed loss carry-forwards intrudes and illustrates the challenges of keeping track of more than a few facts at one time.

Then, because at-risk and passive loss limitations are not limited to business entity transactions, but aren’t given much, if any, attention in the basic tax course, I take the students through a short lecture in which I try to explain the basic principles of those limitations without getting mired in details. I do, however, take them far enough into the policy behind the limitations and the unexpected consequences of how section 469 operates so that they can understand what PIGs are. I’ll leave that discussion to another day.

Next: Allocations in the Corporate Context