Gregory v. Helvering & the Old Roots of Modern Financial Duplicity

Stock Shares Financial Accounting Tax Income Dividend

Creative Finance

I know we promised that the last article would be the final installment of Huddleston Tax Weekly before the return of our XVI Amendment series. Surprisingly, we fibbed a bit. We’d like to sneak in just one more – and now we really promise, just one more – article prior to our return to that series. If this frustrates you, that’s understandable, but hopefully whatever frustration comes to the surface will immediately dissolve after you know what topic to which this article will be devoted: the important case of Gregory v. Helvering (1935). Though not the most well-known financial case, this Great Depression-era piece of litigation is fascinating for a number of reasons. Perhaps the most notable reason for its appeal is its relevance to more modern financial scandals.

In 2017, we have become accustomed to seeing all sorts of financial scandals. Some of these scandals, like the Enron scandal, can be very elaborate and involve complex accounting fraud, insider trading and other kinds of high-brainpower underhandedness. Every trend, no matter its size or significance, can be traced to a single source, and the case of Gregory v. Helvering stands as a legitimate candidate for the forerunner to much of the financial trickery present in recent decades. And this is not necessarily because the taxpayer in Gregory v. Helvering aimed to abuse the law in a nefarious way; the facts of the case, as they’ve come down to us, do not allow for such a conclusion. But in this case we do see an attempt to transact in such a manner that the form of the law is obeyed but its spirit is ignored. And this creative maneuvering is something that we see again and again in the modern era.

Let’s look at the details of this case to get a better sense of why it foreshadows many recent financial scandals.

Facts

The taxpayer owned a company – United Mortgage Corporation – and this company held 1000 shares of another company’s stock (Monitor Securities Corporation). The taxpayer wished to sell this stock but also wished to minimize (or ideally eliminate) the potential tax liability of such a sale. Toward this end, the taxpayer established a new company, Averill Corporation, and then transferred the 1000 shares of Monitor to Averill. The taxpayer then transferred the 1000 shares of Monitor to herself, and then quickly dissolved Averill. The Averill entity clearly had no other function aside from acting as a conduit through which to distribute the shares to the taxpayer. The taxpayer contended that the series of actions which occurred fell under section 112 of the Revenue Act of 1928 as a corporate “reorganization.” If what occurred were in fact reorganization under section 112, the gain realized by the taxpayer would not be taxable.

Law

The relevant subsections of 112 were (g) and (i). Subsection (g) stated that distributions of stock on reorganization to a shareholder in a corporation which was a party to the reorganization will not result in gain (to the receiving shareholder). Subsection (i) lays out a definition of reorganization.

Ruling

The court (Supreme Court of the U.S.) ruled that a legitimate reorganization had not occurred and that the deficiency assessed by the IRS was correct. Even though the taxpayer had apparently satisfied every element of section 112, the court reasoned that section 112 did not apply because the Averill Corporation was clearly a “dummy company” in the sense that it served no other purpose than to eliminate the tax liability which would have normally followed the stock distribution. Hence, though the taxpayer took steps to fall under section 112, what had actually occurred was a dividend, because there was no substance underlying the creation of the Averill Corporation.

What we have here, therefore, is a fascinating early example of creative business maneuvering. The taxpayer either received expert counsel on section 112, or was familiar with section 112 by way of independent research, and the taxpayer established the dummy company for the specific purpose of falling within the meaning of this statute. And even though the steps taken by the taxpayer would seemingly bring the transaction under section 112, the court was not willing to let this type of trickery slide under the judicial radar. In some ways, Gregory v. Helvering represents the embryonic form of more heinous modern trickery, such as the kind perpetrated by Enron’s CFO, Andrew Fastow.

Although what happened here is dwarfed by comparison to modern scenarios, it’s still interesting to see the roots of what goes on around us today.

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Source

Readers who enjoyed this piece should consider viewing our presentation on business formation. This presentation was given by our principal and founder, John Huddleston

Tax Reduction Strategies for Small Law Firms by Steven Lok, CPA

Small Law Firms Tax Reduction Strategies

Small Law Firms

Huddleston Tax CPAs takes a particular interest in helping small businesses with their tax and accounting needs. Consistent with this interest is our focus on the tax strategies which may assist small law firms. Our CPA, Steven Lok, will be giving a presentation on December 7, 2016 which will discuss these tax strategies.

Among the topics covered by Mr. Lok will be entity selection, client trust funds, accounting methods, deductions and others as well.

The webcast is entirely free to view. Individuals who’d like to attend can sign up (for free) at www.smallbusinesswebcast.com.

The presentation will commence at 10:00 am PST and end no later than 11:00 am PST.

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Video introduction to our upcoming webcast

The Basics of Balance Sheets

Ledger Books Balance Sheets

Balance Sheets

The world of finance can be a bit complicated at times, in part because financial professionals often have an interest in portraying matters to be more complex than they actually are. However, one of the more straightforward items in finance is the balance sheet. Put simply, a balance sheet is a statement which gives a picture of the financial condition of an individual or company at a specific moment in time. Balance sheets can be difficult to read if the size of the entity is unusually large; however, all balance sheets share a number of common characteristics.

Balance sheets list the assets, liabilities and equity of an entity. Assets are listed on one side of the sheet and liabilities and equity are listed on the other and the two sides are made to balance out. Assets are typically subdivided by type – i.e. current (or short-term) and non-current (fixed). Examples of current assets include cash, cash equivalents, accounts receivable and inventory. Non-current assets include investment property, intangible assets, biological assets and so forth. Common types of liabilities include accounts payable, promissory notes, corporate bonds, current and deferred tax liabilities and others.

The difference between an entity’s total assets and total liabilities is its ownership equity (or shareholder’s equity). An entity’s equity, which can manifest in a variety of forms, essentially represents its “net worth” or value.

In the United States, balance sheets created by public business entities have to abide by structural guidelines outlined by the Generally Accepted Accounting Principles (GAAP). After balance sheets have been prepared, they undergo a process called Balance Sheet Substantiation in which the internal balances of a business are “reconciled” in order to ensure maximal accuracy.

In summary, balance sheets are an elementary – though exceptionally important – item of financial accounting and provide a valuable glimpse of the financial condition of an individual or company. Balance sheets only start to get tricky when very large companies are involved, and even then balance sheets should never be a source of intimidation.

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Readers who found this piece intriguing should consider viewing this presentation about QuickBooks

What is Mark-to-Market Accounting?

Mark to Market Accounting

Mark to Market Accounting

Mark-to-market accounting – also referred to as “fair value accounting” by some – is a type of accounting which attempts to reflect the market price of assets and liabilities. In mark-to-market, the value of assets and liabilities may change in tandem with market fluctuations. The rationale of mark-to-market accounting is to portray financial conditions with greater accuracy: because values change based on market fluctuations they are supposedly in greater agreement with reality. However, while mark-to-market may create a more accurate financial picture in certain cases, in other cases it can become problematic when market conditions are highly unstable. Mark-to-market can also become problematic in situations in which the market price of a given asset cannot be objectively determined.

The reputation of mark-to-market has taken a hit because of its association with the Enron scandal of 2001. However, if used properly, mark-to-market can be a valuable tool for accountants and businesspeople.

Beginnings

Mark-to-market accounting developed among traders on futures exchanges. Traders used mark-to-market as a means of staying informed about the current value of their accounts on the exchange. Traders often engage in deals which change the value of their accounts rapidly and dramatically; using mark-to-market enabled traders to conduct business with updated information.

In the 1980s, mark-to-market spread to major banks and corporations. In the 1990s, mark-to-market began to figure prominently in a number of accounting scandals. As mentioned prior, when no fixed or recognized market exists, assets are valued “marked to model” using complex financial models; marking assets in this manner creates opportunities for overly-optimistic projections and even outright distortion. In the Enron scandal, Enron executives used financial modeling to hide debts and liabilities in order to create an inaccurate financial picture of the company.

Easy Example

Suppose an investor buys 100 shares of stock at $5 per share. And then let’s suppose the stock begins to trade at $7 per share. With mark-to-market accounting, the stock now holds a value of $700 (100 shares multiplied by $7), whereas the “book value” of the stock might otherwise only be $500. Likewise, if the stock declined to $3 per share, the mark-to-market value of the account would drop to $300 and the investor would have an unrealized loss of $200.

As you’ll notice, the basic principles of mark-to-market are actually quite easy to understand. And by all indications this system of accounting developed with perfectly good intentions. Problems only begin to emerge when the market price of an asset cannot be objectively assessed. However, even then, whether an account is accurate depends greatly on the intentions of the financial professional involved.

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If you’re interested in learning more about accounting you may want to view this presentation on QuickBooks essentials by our CPA Jessica Chisholm

Huddleston Tax CPAs of Seattle & Bellevue
Certified Public Accountants Focused on Small Business

(800) 376-1785
40 Lake Bellevue Suite 100, Bellevue, WA 98005

Huddleston Tax CPAs & accountants provide tax preparation, tax planning, business coaching, Quickbooks consulting, bookkeeping, payroll and business valuation services for small business. We serve Seattle, Bellevue, Redmond, Tacoma, Everett, Kent, Kirkland, Bothell, Lynnwood, Mill Creek, Shoreline, Kenmore, Lake Forest Park, Mountlake Terrace, Renton, Tukwila, Federal Way, Burien, Seatac, Mercer Island, West Seattle, Auburn, Snohomish and Mukilteo. We have a few meeting locations. Call to meet John Huddleston, J.D., LL.M., CPA, Tawni Berg, CPA, Jennifer Zhou, CPA, Jessica Chisholm, CPA or Chuck McClure, CPA. Member WSCPA.