Wednesday, October 5, 2011

Cool, clear water

The story behind the Inaja Land case is almost as interesting as the tax issue it presents.  The City of Los Angeles gets a lot of its drinking water from runoff from the east side of the Sierra Mountains in the general vicinity of Yosemite National Park, quite a bit north and east of L.A.  The city started building an aqueduct to divert runoff water from the Owens Valley southward in the early 1900s.  Leading the effort was the city's famous (or infamous) utility commissioner, William Mulholland, after whom was named the Hollywood Hills drive on which so many show business celebrities have lived.

The loss of the water destroyed the farm economy and the ecosystem of the Owens Valley -- Owens Lake eventually went dry, for example -- but it enabled Los Angeles to become the booming metropolis it morphed into in the 20th Century.  The corruption and violence that surrounded water-related matters in the Mulholland days played an important role in the classic 1974 film "Chinatown," which is a must-see.

The first round of water diversion, which commenced with the completion of the aqueduct in 1913, was not the end of the story, however.  The headwaters of the Owens River, a natural spring, lie on the east side of a crest in the mountains called Deadman's Divide, not too far from Mammoth Mountain.  There was a lot of valuable water on the west side of the divide, sitting in bodies such as Mono Lake, Walker Lake and Grant Lake.  Los Angeles planned to get that water across the divide by means of an 11-mile-long tunnel, which would pass under Bald Mountain, come out on the east side at a place called Mono Craters, and spill into the Upper Owens.

In 1934, the Angelenos, led by Mulholland's successor, H.A. Van Norman, started blasting on both ends of the tunnel.  Here's a photo of the work camp on the west end:

Here's a view inside the tunnel while the work was in progress:

It was a nasty project, lasting five years, during which time about a dozen workers died.  Since the area is volcanic (as the name Mono Craters suggests), and there had been eruptions only around 600 years before, the construction crews encountered dangerous gases, unstable geological conditions, and lots of water.  The excavation and construction made quite a mess, and the mess floated downstream through the lands below, including the trout fishing club that had been established in 1928 by a group of Los Angeles outdoorsmen through their corporation, Inaja Land Company.  (Inaja Land had bought it from a Los Angeles furniture store family named the Barker Brothers, who had previously acquired it from locals in the Owens Valley community of Bishop.)  The Inaja folks threatened to sue the city, the case settled, and the rest is tax history.

Inaja Land Company is still there today, and apparently, the routing of all that extra water through its stretch of the Owens didn't hurt the trout much.  According to the full Tax Court opinion in case, the club restocked the stream with fish, constructed a diversion ditch, and made some other improvements that helped cope with the greater flows.  Nowadays a visit to the ranch, still a private club with just a couple of dozen members, tends to produce rave reviews among fly fishers.

Thursday, September 29, 2011

Stock dividends and other accounting mysteries

Eisner v. Macomber, that ancient Supreme Court case on realization of gross income for income tax purposes, gives us a chance to dabble in some corporate accounting matters.  It’s not necessary to understand the accounting completely in order to grasp the holding and rationale of the case –  Mrs. Macomber had no gross income because she owned the same thing after her receipt of the stock dividend as she did before.  But if the accounting intrigues you, as it did the Court to some extent, here’s a look at it.

The stock dividend is a maneuver that lowers the price per share of a company’s  stock by diluting the existing shares with new shares.  The transaction is recorded on the issuing corporation’s  balance sheet – one of its financial statements – but it has little economic significance.  No real assets leave the corporation, and the shareholders’ relationships with each other do not change.  The market senses the presence of the new shares, and adjusts accordingly; the price per share decreases, but since the shareholders have received new shares, the value of their holdings doesn’t change.

To understand the corporation’s accounting for the transaction, an introduction to  the balance sheet is helpful.  A balance sheet is a crude snapshot of the financial condition of a person or enterprise  at a given moment in time.  It’s divided into two sides – Assets and Liabilities.   The bottom line on one side will always match the bottom line on the other side -- hence, the name “balance sheet.”

The liabilities side is divided into two portions, Debt and Equity:




Total Assets

Total Liabilities (Debt + Equity)

On the Liabilities side, the  Debt plus the Equity equal the Total Liabilities.  And the Total Liabilities always equal the Total Assets (the bottom line on the other side).

The Equity portion of the Liabilities side of the balance sheet (also known as “net  worth”) represents who owns the corporation – namely, the shareholders.  Let’s say that two people form a corporation,  each contributing $10,000 cash to get it started.  Each receives 1,000 shares for his or her investment, or $10 per share.  The balance sheet just after the corporation is formed would look like this:


Equity: 2,000 shares, stated value $10 per share
Total Assets
Total Liabilities

Now let’s assume that the corporation borrows $30,000 from a bank.  The resulting balance sheet would look like this:

Debt: Bank

Equity: 2,000 shares, stated value $10 per share
Total Assets
Total Liabilities (Debt + Equity)

Next, let’s assume that the corporation uses half of its $50,000 cash to buy machinery and equipment:

Debt: Bank
Machinery and equipment
Equity: 2,000 shares, stated value $10 per share
Total Assets
Total Liabilities (Debt + Equity)

Note that the machinery and equipment are entered on the books at their historical cost, which is the same basic standard that’s used for determining basis for income tax purposes.  The value that an asset has on the balance sheet is called its “book value.” 

Next, let’s assume that the corporation has a successful year, bringing in a great deal of additional cash.  Its machinery and equipment wears out a little, which is reflected by a lowering of its “book  value,” but the increase in cash shows that it had a profitable year.  Here’s the asset side of the balance sheet at the end of the year:

Sunday, September 25, 2011

Justice Douglas, the tax code, and Portland summers

As I mentioned in talking about Glenshaw Glass the other night, in his later years Justice William O. Douglas dissented -- often without opinion -- in just about every tax case in which the IRS won.  Nobody knows for sure why this was, especially since at the start of his career on the Supreme Court he would vote for the government on a regular basis in tax cases.

There's a legend (reported by one of our casebook authors, no less) that while on the Court, Douglas had been audited by the IRS over questions about the taxability of expense reimbursements for taking his wife along on business trips, and he held a grudge.  Certainly those who have reviewed his tax opinions from a scholarly perspective can't explain his change of heart.  The late Penn and Harvard tax professor Bernard Wolfman, along with co-authors, spent many years studying Douglas's behavior in tax cases, which culminated in a law review article and later a book.  They were pretty much left scratching their heads.

Douglas was an enigma in every respect.  Hailed by many for his courageous and unwavering stances in favor of personal privacy, civil liberties, and concern for the environment, he's reviled by many for his unabashed judicial activism and the lack of discipline in his opinion writing. 

For his personal life, "Wild Bill" is universally condemned.  He was divorced three times while he sat on the High Court.  He abused his staff and law clerks.  He drank.  He was slow to pay his debts.  Judge Richard Posner of the Seventh Circuit has written:
Apart from being a flagrant liar, Douglas was a compulsive womanizer, a heavy drinker, a terrible husband to each of his four wives, a terrible father to his two children, and a bored, distracted, uncollegial, irresponsible, and at times unethical Supreme Court justice who regularly left the Court for his summer vacation weeks before the term ended.  Rude, ice-cold, hot-tempered, ungrateful, foul-mouthed, self-absorbed, and devoured by ambition, he was also financially reckless—at once a big spender, a tightwad, and a sponge—who, while he was serving as a justice, received a substantial salary from a foundation established and controlled by a shady Las Vegas businessman.
Other than that, he was a nice guy!

Douglas used to spend some of his summer vacations in Glenwood, Washington, at the foot of Mount Adams.  During those months, he used to show up in Portland to party.  Our city was a hotbed of vice for many decades, and Douglas took advantage of some of the illegal diversions that were freely available to wealthy and powerful people in those days.

Ace reporter Phil Stanford, who wrote a splendid book on the subject called Portland Confidential, includes several pages on Douglas, especially his connection with a local prostitute named "Little Rusty" Kronberg.  The Oregonian picked up on the story a while later, here.

Saturday, September 24, 2011

Phil has left the building

Phil LoBue, the taxpayer in the famous Supreme Court stock option case, was reportedly quite a character.  He was born in Sicily and lived in Leonia, New Jersey, across the river from the Big Apple, where he worked.  One of his proteges in the sales industry later wrote in a memoir that LoBue was "small, loud, and generous" and referred to himself as "the smallest Mafioso."  The colleague also wrote: "Before I left for my first trip to Europe, Phil had given me an envelope containing $100 with careful instructions where to spend it."  He didn't elaborate.

LoBue used to show up at various gatherings of chemical company executives, including a 1948 dinner put on by the New York Board of Trade (photo right).  He reportedly was a regular at the Chemists Club, a swanky industry hangout in midtown Manhattan.

Although employee stock options are often intended to engender company loyalty, it doesn't always work out that way.  Certainly it didn't with LoBue.  A February 3, 1947 story in the New York Times noted that Phil was leaving Michigan Chemical to start his own chemical sales firm.  As you may recall, LoBue exercised his options in 1946 and 1947, and so he wasn't an employee-stockholder of Michigan Chemical for long.

LoBue was born in 1901.  In 1931 he married Edna Reidel, who was five or six years younger than he.  The couple had two children, Bonnie Ann and Philip, both of whom are still alive and living in northern New Jersey.  They are 71 and 68, respectively.  Edna worked for 14 years as a secretary for the comptroller of AT&T.

The elder LoBue -- the taxpayer in the famous case -- died in 1970, at age 68.  Edna remarried and outlived her second husband as well.  She died in 2008 in New Jersey at the age of 101.

Thursday, September 15, 2011

In the back with the boxes, a tax issue

Commercial cargo jets, like the ones flown by FedEx, don't have windows on the sides.  The packages don't need to see the view.  But the aircraft do come equipped with a few "jumpseats" -- two in the cockpit and a few more in the cargo hold, often just behind the cockpit door.  These seats are reserved for unusual customers who have to accompany their freight to its destination -- when livestock is being transported, for example -- and they're also used by government aviation inspectors, maintenance personnel, and reportedly even Secret Service agents from time to time.

When no one is using the seats on official business, the cargo carriers reportedly allow some of their employees to occupy them for personal travel, without charge. It's not glamorous, and the routing is usually quite inconvenient (Portland to Seattle via Memphis, anyone?), but in some situations, it beats paying full fare or staying home. When employees take advantage of this perk, can they exclude its value from their gross income under section 132 of the Code?

This very question was presented to the IRS in the mid-1980s.  The agency audited a cargo carrier (believed to be FedEx), and the IRS agent conducting the audit asked the national office for a "technical advice memorandum," one of the nonprecedential types of IRS guidance I talked about the first night of class.  (Actually, it was the company's employees who would have to pay the income tax, but the company needed to know whether the flight values were wage income for tax withholding and Social Security tax purposes.)

The technical advice memo (8741007)  was issued on June 5, 1987.  In it, the national office ruled that the fair market value of the employees' personal travel was gross income to them, because it did not fit into the definition of a "no-additional-cost service" as defined in section 132(b).  As you will recall, that definition requires that the service be "offered for sale to customers in the ordinary course of the line of business of the employer in which the employee is performing services."  The IRS reasoned that the employer did not offer customers the same "service" that the employees were enjoying when they were sitting in the jumpseats.  "Because the jumpseats are not offered for sale to customers," the IRS reasoned, "their use by employees is not the result of unsold capacity."

To paraphrase the IRS ruling, FedEx was not in the business of passenger transportation, but rather in the business of freight transportation.  FedEx had argued, in effect, that the "service" it provided in its business was air transportation, period.  To the taxpayer, transportation of people and transportation of packages were the same thing -- transportation of matter, as it were.  That argument fell on deaf ears.

Taxpayers of means often don't take defeat at the hands of the IRS lying down, however.  Instead, they get on the phone with their lobbyists and friends in Congress.  Sometimes, they get special legislation passed to make their tax issues go away.  And so it was in this case.  Take a look at Code section 132(j)(7), which took effect Jan. 1, 1988.  Gong!  Problem solved, at least prospectively.

Thursday, September 8, 2011

"Surf riding" with Arthur B.

The Royal Hawaiian Hotel in Waikiki, where Arthur Benaglia worked (and ate and slept), has a rich history.  It's told in a nice book full of photos called "The Pink Palace," by Stan Cohen, published in 1986.

One of the many items that collectors covet from the heyday of the hotel are the dining room menus, whose covers were true works of art.  Nowadays, some of them, by an artist named John Melville Kelly, can run $50 or more.

Too cheap to spring for one of those, I did pick up a while back a matchbook of unknown vintage from the Royal Hawaiian-Moana complex:

When I look at it, I like to imagine myself lighting up a cigar on a beachfront veranda at the hotel and enjoying a mai tai and some laughs with my wife, and Arthur Benaglia with his wife Elise, and maybe a couple of celebrity guests, circa 1935.  Arthur served as the general manager of the Royal Hawaiian for nearly two decades from its opening in 1927.  (An older Royal Hawaiian Hotel, founded by real Hawaiian royalty in the 1800's, had been on a different site nearby.)

Research reveals that Arthur was an experienced hand at the hotel business when he got to Hawaii.  Born in Milan, Italy, he had grown up in a hotel family, and he worked at inns in Switzerland, Germany, England, and Scotland before moving to Canada at age 18.  In London, he was trained at the Hotel Carlton by someone named Escoffier, identified in one account as "founder of the modern French cuisine."

Young Arthur worked for a while in Montreal, but then he became a hotel manager, running the Vancouver (B.C.) Hotel and the wonderful Empress Hotel in Victoria.  He eventually took over management of the Banff Springs Hotel, which was then under construction.  From there he moved to New Orleans, where he managed two hotels, one of them being the New Roosevelt Hotel on Canal Street.  Then he boarded a cruise ship for the long trip from San Francisco to Hawaii, where he stayed for quite some time.

Hawaii historians remember Benaglia as a masterful manager of people, with exquisite taste, top skills as a promoter, and an intimate knowledge of every detail of the Royal Hawaiian, since he had been there since it was just a hole in the ground.  The guy really knew his stuff.

After leaving Hawaii during World War II, Arthur worked briefly in Los Angeles, and then he assumed management of the Plaza Hotel on Central Park in New York.  He died of a heart attack six months after arriving in Manhattan, in June 1944 -- in his apartment at the Plaza, of course.  He was 61 years old when he passed on.

UPDATE, 5/22: We ran into Arthur again in connection with a recent vacation to the 50th State.

Wednesday, September 7, 2011

Present value makes the world go 'round...

... the financial world, at least.

If you were with me as we calculated the present value of future receipts, consider the fact that one can compute the present value of even an infinite stream of future receipts.  As explained in Chirelstein's appendix, at 5%, the present value of $1 a year forever is $20.

How can one calculate the value of an infinite annuity?  If we do it manually, it's going take a long time.  We can take the present values of $1 every future year, and add them all up.  We'd start with year 1, then year 2, year 3, etc., and keep going until we drop or until we see that it's useless to continue.  Here are the first 10 years -- and let's use $100 annual receipts:

PV of $100, 1 year from now: $95.24
PV of $100, 2 years from now: $90.70
PV of $100, 3 years from now: $86.38
PV of $100, 4 years from now: $82.27
PV of $100, 5 years from now: $78.35
PV of $100, 6 years from now: $74.62
PV of $100, 7 years from now: $71.07
PV of $100, 8 years from now: $67.68
PV of $100, 9 years from now: $64.46
PV of $100, 10 years from now: $61.39

Adding those all up, we get to $772.16, with many more years to go.  But as you can see, the amounts get smaller as time marches on, and that trend will continue for as long as we want to play this game.  Here's year 15:

PV of $100, 15 years from now: $48.10

Here's year 30:    PV of $100, 30 years from now: $23.14

Here's year 50:    PV of $100, 50 years from now: $8.72

Here's year 100:    PV of $100, 100 years from now: $0.76

Eventually, the present values get so small that you can hardly see them, and as it turns out, they eventually disappear from the naked eye. For example, the present value of a $100 payment to come in 250 years from now is $0.0005.

In the end, the present value of the infinite stream is $2,000.  In other words, if one deposits $2,000 in a 5% account, one will get $100 a year to spend, every year, forever, leaving the original $2,000 in place to keep going.

When the annual payment is $100 and the present value is $2,000, it is sometimes said that the "multiplier" is 20.  That is, the present value is 20 times the annual payment.  The multiplier is just the inverse of the discount rate.  1 divided by .05 = 20.

Now here's where Wall Street comes into the picture.  When discussing the price of a stock that's traded on a national exchange, people often refer to the company's "price-earnings ratio."  And that's just another name for the multiplier.

For example, take a look at this entry on Yahoo! Finance for Dow Chemical:

Over on the right, do you see the line "P/E (ttm)"?  That stands for price/earnings (trailing 12 months).  What Yahoo! has done is compare the share price of the stock (P), $27.07, with the earnings per share of the company for the most recent 12 months (E), $2.18.  In this case, the stock price is 12.41 times annual earnings ($27.07/$2.18), and so the multiplier is 12.41.

Given that multiplier, the discount rate that the market is apparently applying to that stock -- the inverse of the multiplier -- is 1 divided by 12.41, or 8.06%.  The P/E ratio is a rough way of saying that the discount rate that investors are using in pricing that stock is 8.06% a year.

The P/E ratio shown there is crude in one respect -- it looks backward at the last 12 months of earnings, which is public knowledge because of the company's regular filings with the SEC.  In fact, a smart investor is looking to the future, not the past.  He or she is trying to predict, and then present-value, future receipts.  The past may be some indicator of future earnings, but there are certainly no guarantees.  And so it's not entirely certain what discount rate the market is actually using.  But P/E based on the last 12 months tells us something.

Most importantly, the fact that the P/E ratio is calculated and published for every public company, in real time, shows that investors are keenly interested in present value.  Present value is what that ratio is all about.

Monday, September 5, 2011

Cloak, dagger, and tax code

Wow, here's a unique gig for a tax type: tax attorney for the CIA.  But you'll need three years' practice experience, and you can't tell anyone you're applying.

More about that statute of limitations

At our first class meeting, I mentioned that taxpayers sometimes dig themselves a deep hole with their tax liabilities.  Sometimes they'll owe a decade or more of back taxes to the government.  When the IRS finally gets around to coming after them for it, the tax ruins them financially.

In response to a question, I added that there was a general three-year statute of limitations for the IRS assessing tax deficiencies -- extended to six years if the taxpayer omits a substantial amount of gross income from his or her tax return (as opposed to claiming improper deductions).  But how can the taxpayer be on the hook for more than six years' worth of income taxes?

It's easy to understand once you see how the statute of limitations (Code section 6501(a)) works.  The time for the IRS to assess income tax against the taxpayer generally runs for "3 years after the return was filed."  Therefore, if a taxpayer doesn't file a return, the statute doesn't even begin to run.  This is confirmed by Code section 6501(c)(3).

And as was also mentioned in class, if the taxpayer files a false or fraudulent return with the intent to evade tax, the tax due on that return may assessed against the taxpayer "at any time" -- that is, the statute never runs.  See Code section 6501(c)(1).

Thursday, September 1, 2011

Ted Drescher, the guy

A couple of years ago, an alert member of my Income Tax class prowled around on the internet and turned up some interesting information about Ted Drescher, the person.  And of course, that got me going, and I unearthed some other details about him.  They really have no significance from a substantive perspective, but some people just love the human stories behind tax cases, and if you're one of those, you might enjoy what we found.

It turns out that Ted was the grandson of Johann Jacob Bausch, one of the founders of (and the brains behind) Bausch & Lomb.  Ted's mom was Bausch's daughter, Anna Julia (~1869-1959); she married Willibald Drescher (1861-1937), who like Anna's dad was an immigrant from Germany.  (That may be Willie in the left foreground of this photo.)  Ted (named after his grandfather on his father's side) was Anna and Willie's only son; they also had two or three daughters.  When J.J. Bausch died in 1926, he left grandson Ted (then in his early 30's) 100 shares of the company in his will.

Here's an interesting story about Ted's childhood home in Brighton, New York, which is adjacent to Rochester.

At one point, the company got in trouble in a criminal antitrust case, and Ted was one of the officers hit with a civil suit over the same matter years later.  But the civil case was dismissed.

Ted was also a bit (scroll down) of an inventor.

Interestingly from our perspective, Ted never did live to collect on that annuity of his.  He died of a heart attack in 1953, at age 58, meaning that his beneficiaries (probably his widow, Rolena (d. 1986), and two daughters, Anna (d. 1993) and Marjorie (1926-2009)) would have gotten the death benefit specified in the policy.  Ted's mother was the last surviving child of J.J. Bausch; she died in 1959 at age 90.

Ted's buried with at least 15 other members of the Drescher clan in Mount Hope Cemetery in Rochester.  That's the same cemetery in which lie the remains of Susan B. Anthony and Frederick Douglass.

Wednesday, August 31, 2011

The Tax Court serves many masters

One thing we noted about the U.S. Tax Court is that cases from that court are appealable to federal courts of appeals all over the country.  Appeal from a Tax Court decision lies in the circuit in which the taxpayer lived when the taxpayer filed his, her, or its petition (complaint) in the Tax Court.  (The appeal venue can be changed by stipulation of the taxpayer and the IRS, but that's the general rule.)

This makes the life of a Tax Court judge a bit challenging.  If there is a conflict among the courts of appeals on a tax issue, the Tax Court needs to know to which circuit its decision is going to be appealable.  For that reason, one of the things the taxpayer has to include in the petition is a statement of the taxpayer's place of residence.

And that means that the Tax Court may have to rule one way or another depending on where the taxpayer lives, treating taxpayers from different parts of the country differently.  For example, let's say that on a particular tax issue, the Ninth Circuit favors the IRS but the Fifth Circuit favors the taxpayer.  And let's say that the Tax Court, if left to its own decision, agrees with the Ninth Circuit.  If a taxpayer comes in from the Fifth Circuit, the Tax Court will have to apply the Fifth Circuit rule, even though the Tax Court thinks it's wrong.  The Tax Court doesn't have much choice in the matter -- it will be reversed by the Fifth if it does what it thinks is right -- and so it has to buckle under.  If a taxpayer comes in with the same issue from the Ninth Circuit -- or a circuit in which the court of appeals has not yet spoken -- the Tax Court can and will do what it thinks is the right thing, and on these facts hold for the government.

There's a famous 1970 Tax Court case that lays out the rules of the road here.  It's Golsen v. Commissioner, 54 TC 742 (1970) (aff'd on other grounds), and for Pete's sake, it even has its own Facebook page!  I went ahead and gave it a "Like."

What this blog is about

Years ago, my colleague, the late, great Ed Belsheim, took me aside and revealed to me some of the secrets of his success as a law professor.  One of them was this: "We're here to teach the basics.  In class, by the time you say anything that's interesting to you, you've said too much."

Ed was a character.  At age 80-something, he'd cover huge swaths of material in every class session, and he had his syllabus memorized.  If a student asked an advanced question early on the semester, Ed would say something like, "We'll be covering that at 3:12 p.m. on October 14."  One evening, as I watched him slowly shuffling to his lecture, huffing and puffing a bit as he went, I kidded him: "Hey Ed, another 40 pages tonight?"  Without missing a beat, he replied: "At least."  The students loved him, and rewarded him with several best teacher awards.

As the years pass, I appreciate Ed's wisdom more and more.  I call it the Belsheim Rule.  There are so many interesting (at least to me) things that I'd like to say in the courses I teach -- the basic Income Tax class in particular -- but there isn't time for all of them.  And succumbing to the temptation to include too many can worsen the constant problem of trying to boil the entire income tax law into 52 hours.

This blog is an attempt to avoid that pitfall.  When I get out of a class session in which I've resisted the impulse to tell a good story, I'm going to reward myself by writing it down here.  I'll let the students know that this site exists, but I'll make their looking at it completely optional.  I hope I'll feel as though I satisfied my duty to share what I know, without gumming up the march through the syllabus with too many detours.