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How Far Can A Taxpayer Go?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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