How Banks and Hedge Funds Used Basket Options to Avoid Billions in Taxes

The U.S. Senate Permanent Subcommittee on Investigations held a hearing on tax avoidance by banks and hedge funds working together using basket options.

The concept is pretty simple, and was perfectly legal and commonplace until recently, when the IRS started challenging it.

Banks offer hedge funds basket options whose values fluctuate based on the performance of the underlying securities.

Hedge funds could then buy and sell stocks within the basket without subjecting the transactions to taxation as a short-term gain because it was technically owned by the bank.

The hedge funds only had to pay taxes on long-term gains, if and when they actually exercised their options.

This arrangement makes a huge difference because of the difference in the tax rates for short-term capital gains and long-term gains.   

Senator Carl Levin, who chairs the Senate Permanent Subcommittee on Investigations, said in his opening statement that “This structure worked well for the banks, which earned hundreds of millions of dollars in fees. It worked well for the hedge funds, which made billions of dollars in profits. But it didn’t work for average taxpayers, who had to shoulder the tax burden these hedge funds shrugged off with the aid of the banks.”

The hearing was focused on the basket options developed and sold by Deutsche Bank AG and Barclays Bank PLC to more than a dozen hedge funds.

These two banks together sold 199 basket options to hedge funds, which then made use of the arrangement to make more than $100 billion in trades.

One of the hedge funds singled out for attention in the hearing was Renaissance Technologies LLC aka RenTec, which used the basket options to rack up 100,000 trades per day on average, or about 30 million per year.

Around 60 options sold by the two banks to a RenTec fund called the Medallion fund, which generated profits of around $34.2 billion for investors, who saved $6.8 billion in taxes on these profits by avoiding taxes on short-term gains.

RenTec computers would send the order to the bank, which would then execute the trade. RenTec’s investment in a stock would often end in seconds or minutes, and was made to appear as a mere recommendation rather than being an actual trade.

Renaissance claims it was well within the law in doing this, and noted that it was the same as trading securities held by a brokerage.

However, the IRS challenged it and both banks have since discontinued the practice. Renaissance is currently engaged in a dispute with the IRS over the tax treatment of the trades that were conducted from within basket options.

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National Taxpayer Advocate’s FY2015 Objectives Report to Congress

The National Taxpayer Advocate had a hugely successful 2014, not least because the battered IRS has been actively seeking out ways to improve its image and soften the rough edges.

The announcement last month of the adoption of Taxpayer Bill of Rights by the IRS was a big win after a five-year campaign, but NTA Nina E. Olson is now focusing on other priorities, as outlined in the NTA’s FY2015 Objectives Report submitted to Congress last week.

The focus is now on tax preparer issues and the agency’s funding gap. To be more specific, these are areas of focus for FY 2015:-

- Implementation of the Taxpayer Bill of Rights;

- Preparer Standards and Helping Victims of Return Preparer Fraud;

- Tax Exempt Status Applications;

- IRS Funding Gap and TAS Technology; and

- Statutory Violations During Government Shutdown.

The section of the report on tax preparer standards discusses the recently announced voluntary continuing education (CE) program for unenrolled preparers as an interim solution while Congress considers giving the IRS the authority to establish a mandatory training and certification program for tax prepapers.

The NTA report stresses the need for competency testing to be an essential part of the voluntary education program, because its absence limits the program’s value and could mislead taxpayers during the 2015 filing season.

The report also takes the IRS to task for ignoring the legal authority granted to the agency to assist victims of prepaper fraud.

The NTA notes that the IRS has received four separate legal opinions on this issue since 2000 from its own Office of Chief Counsel, but has chosen to ignore things such as issuing refunds to victims of preparer fraud.

It has been 14 years since the first legal opinion was provided, but the IRS has still not developed procedures to fully unwind the harm done to the victims.

One section of the report is meant to wake up Congress to the impact of the IRs funding gap. One of the victims is the Taxpayer Advocate Service itself, which was informed earlier this year that their Taxpayer Advocate Service Integrated System (TASIS) could not be funded for the rest of this year.

TAS has been developing TASIS for a decade, and scrapping their funding is going to waste a huge amount of work that has already been done and will significantly diminish TAS’ capabilities.

Read the full NTA FY2015 Objectives Report to Congress – Download (pdf)

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Semper 4 Veterans Food Drive

I am honored to be working with Semper 4 Veterans, a not for profit organization that helps veterans in need.

Their primary goal is to provide assistance for veterans, military families in need of food, clothing, transportation fees, urgent rent assistance, and other necessary living expenses.

Since 2009, they have provided meals to thousands of veterans in need. 

We are having a food drive through the month of August to help as many families as we possibly can. Anything you can donate would be a great help to this amazing organization and all the people they help.

I urge you to check out their website to see all the good work they have done and the letters from veterans they have helped at

We will also be at the North Bellmore Stop & Shop this Saturday July 19 From 9:30 am - 3:30 pm collecting food.

Potato Salad Debate Over Kickstarter and Crowdfunding Taxes

There’s an ongoing debate about exactly how money raised on crowdfunding sites such as Kickstarter and Indiegogo will be taxed. It’s not so serious that the IRS needs to step in with guidance, but it is big enough a topic and prominent tax law experts have stepped in to offer their own two cents.

The whole thing began with an analysis of a Kickstarter crowdfunding campaign posted on the Tax Foundation By Scott Eastman.

The campaign was Zack Brown’s potato salad, who started the campaign as a sort of joke with a $10 goal for making potato salad. The more than 5,000 pledges quickly pushed the campaign up past $70,000.

Eastman’s calculations of the federal income tax, payroll tax and state and local taxes pegged Brown’s tax liability at around $21,000. The post was widely picked up and Zack Brown’s potato salad campaign and his potential tax bill even ended up on TIME.

Then Kickstarter brought down the pledged amount to about $48,000 because a lot of it were apparently fake pledges. Leaving that aside, let’s focus on the main issue – What is the tax treatment for funds raised on Kickstarter and other crowdfunding sites?

Kickstarter provides the following guidelines, while noting that they are not giving tax advice.      

“In general, in the US, funds raised on Kickstarter are considered income. In general, a creator can offset the income from their Kickstarter project with deductible expenses that are related to the project and accounted for in the same tax year. For example, if a creator receives $1,000 in funding and spends $1,000 on their project in the same tax year, then their expenses could fully offset their Kickstarter funding for federal income tax purposes. If a creator receives funding in one year and spends money on their project in a later year, consider whether their expenses can still offset their Kickstarter funding using the accrual method of accounting.”

Of course, not all funds raised on Kickstarter need be considered income. Some of it may be a non-taxable gift, depending on the type of campaign and what (if anything) has been promised by the creator to backers in return for their pledges.

The question that is being debated now is whether the money raised by Brown’s potato salad kind of campaign qualifies as income or a non-taxable gift. Backers who pledge $1 will get a thank you and have their name read aloud when Brown is making the potato salad.

Others pledging higher amounts get more swag (a photo, bite of the salad, chance to in Brown’s kitchen, hat, t-shirt, etc,). A lot of this could easily be ignored to make it a gift. He’s not actually selling anything to anyone through Kickstarter, and whatever the backers are getting doesn’t have value commensurate to the amount they paid. 

Eastman, however, classifies it all as income. Forbes’ Kelly Phillips Erb says she’s not so sure, noting that intent and value have a crucial role to play here.

Bottomline – don’t depend on Kickstarter or anyone else to decide whether the money you raise is income or a gift. Let your accountant take a look at it and decide how each pledge should be classified and taxed.

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Pot Shop’s Petition Against IRS Could Change Federal Law on Marijuana

The legal marijuana industry is stuck in a twilight zone between state and federal law, and they’re spoiling for a fight that will update federal laws.


This fight could very well take place in the U.S. Tax Court. To be specific, it could be settled through the petition filed against the IRS by Allgreens LLC, a medical marijuana dispensary in Denver.

The dispute arises from the fact that the IRS requires payroll tax to be paid in electronically by employers using the Electronic Federal Tax Payment System.

Marijuana dispensaries are unable to do this because they’re not legal under federal law, and as such find it hard to open bank accounts and use electronic banking services. So the IRS imposes a 10 percent penalty on them for paying the income withholding in cash.

Allgreens was actually making its payments electronically using EFTP until their bank account was closed half way in 2012.

After that, Allgreens started taking cash to the IRS office in Denver twice a month, and the agency started adding a 10 percent penalty on them every quarter.

That has added up to more than $20,000 as of the end of 2013, according to tax liens taken out by the IRS. Allgreens pays state and local taxes in cash, and no penalty is imposed on these taxes.

They asked the IRS to waive the penalty, claiming that they did not avoid using EFTP intentionally and the IRS shouldn’t be penalizing them for an option they do not have.

The IRS did not agree to waive the penalty, but did suggest alternative solutions to help avoid the penalty. The IRS apparently suggested that they should have a third-party pay the tax on their behalf.

Allgreens now claims in its petition in tax court that the IRS asked them to break the law, since a business that’s already illegal under federal law would be funneling payments via a third-party. It only adds to the felony charges the business opens itself up to.

Medical marijuana businesses are being made to jump through all these hoops and pay more than other businesses simply because of the disconnect between state and federal laws.

It’s not their fault that the business is legal in Colorado but not in America, silly as that sounds. The federal government can refuse to accept payments from what they consider to be an illegal business and shut it down. Alternatively, they can make it legal and allow the medical marijuana dispensaries to use banking services.

It’s pretty clear the federal government’s current position will become untenable if the Allgreens case starts winding its way up through the judicial system. If they don’t want this to turn into a landmark judgment on the legality of medical marijuana under federal law, the IRS is going to have to waive the penalty and let the rest of the status quo stand.    

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Was Mark-to-Market Accounting Rule to Blame for 2008-09 Economic Crisis?

Brian Wesbury, former chief economist for the U.S. Congress Joint Economic Committee (JEC), says the subprime mortgage crisis which popped the real estate bubble, lead to the credit crunch in the financial sector and subsequently a wider crash in the economy and a global recession, was actually sparked by a lowly accounting rule.

Wesbury, who is now at Illinois-based First Trust Advisors, spoke at a dinner meeting in Ireland.

He said the subprime market and its crash were too small to trigger such a massive response.

The real reason, he claims, was the acceptability of mark-to-market accounting as part of Generally Accepted Accounting Principles (GAAP) in the United States, and the lax guidelines for it.

The Mark-to-market or “fair value” accounting rule allows assets and liabilities to be assigned a fair value based on the current market price, objective assessments of the value, and comparisons to similar assets and liabilities.

It’s been a part of GAAP in the U.S. since 1990 or so, and was considered completely non-controversial and an integral part of the system until after the 2008-09 crash. If Mark-to-market accounting is used, values in the balance sheet may change along with market conditions.

It allows companies significant wiggle room both in pegging values to assets and liabilities, and for changing them later on. It makes forecasts of company performance rather difficult and relatively inaccurate, considering the many variables that could possibly change.

As the subprime crisis showed, the value of assets pegged to market conditions makes it really hard if the economy is down and the asset holder is in a tight spot. Institutional investors and banks had to write off billions of dollars because the paper they were holding was valued using mark-to-market and was worthless in the middle of the subprime crisis.

If this accounting rule had not been in place, the assets wouldn’t have been deemed worthless, and there would have been no Wall Street collapse or credit crunch. GM, AIG and the other big bailouts would never have been required, and the Great Recession would never have taken place at all.     

Mark-to-market is also an invitation to companies to indulge in manipulative accounting using estimated valuations that prove to be worthless later on. Before the subprime crash, the biggest example of Mark-to-market accounting gone bad was the Enron scandal.

After that, the Sarbanes–Oxley Act imposed much stricter restrictions on how mark-to-market accounting could be used. That didn’t solve the problem, but only bought some time.

When the subprime market crisis opened the floodgates, interventions (interest rate cuts, TARP, etc.) by the government and Federal Reserve didn’t stem the crisis. It was only brought under control after April 2009, when the Financial Accounting Standards Board (FASB) stepped in and changed the guidelines.

Mark-to-market accounting thereafter allowed valuations to be based only on the market price in a normal market, and forced liquidations could not be used any more as the basis for valuations.     

The lesson here is pretty obvious – Just because it’s generally accepted doesn’t necessarily make it the right thing to do.

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Flawed Payroll Tax Formula Costing $500M Per Year

Congress is quietly trying to fix a math error that is leaving half a billion dollars in annual payroll tax revenue uncollected due to differences in the computation formulae for FICA and SECA.

The recent tax reform proposal introduced by House Ways and Means Committee Chair Dave Camp seeks to rectify this costly mistake and raise an additional $5 billion in taxes over ten years that can be used to offset other tax breaks and essential programs.

The Tax Policy Center published a report on it that explains it in detail.  

The flaw arises from the mismatch in payroll taxes paid by workers under FICA and the taxes paid by sole proprietors and partners in partnerships under SECA.

Theoretically, a worker earning wages that are same as the earnings of a proprietor or partner should result in the same amount of tax to be paid under FICA and SECA.

Under FICA, the employer shells out 7.65 percent as withholding from the employee’s wages for Social Security (6.2 percent) and Medicare (1.45 percent). Workers likewise pay the same as their share, and those with earnings above $200,000 pay an additional 0.9 percent Medicare tax.

Under SECA, sole proprietors and partners in partnerships have to pony up the tax payable by both the employer and employee. Or at least they should have to…

Errors in the formula used for computing SECA end up lowering the tax paid by the self-employed. To be specific, the self-employed are getting a SECA deduction that’s too big, and consequently they end up paying less tax as compared to workers earning the same amount in wages.

For example, if a worker is earning $100,000 a year, the FICA tax including both the employer and employee’s shares comes to $15,300 (at 7.65 percent for each).

Under SECA, the comparable earnings are $107,650, which is $100,000 plus the employer’s share of payroll taxes. Applying the 7.65 percent SECA deduction on this amount brings it down to $99,415 in taxable earnings.

The actual SECA tax is then 15.3 percent of $99,415, which works out to $15,210, or $90 less than a worker with comparable earnings.

It’s a small amount, no doubt. But the difference grows wider as the income levels go higher up. For those earning $300,000, the difference is about $465.                

This difference is costing $500 million per year in lost tax revenue, and there really is no reason why it shouldn’t be collected.

Of course, that’s no reason for Congress to act on it either, as evidenced by the fact that the flaw has been allowed to survive for so long.

It may get knocked out of the tax code as part of the tax reform process, assuming they get around to taking that up sometime soon in the future.

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IRS Launches Voluntary Education Program for Tax Preparers

The IRS has launched a new voluntary tax preparer education program called the Annual Filing Season Program that aims to improve the tax know-how and filing season readiness of tax preparers.

The agency expects the voluntary education program for tax preparers to be in place and operational by the start of the 2015 filing season, as part of a broader effort to achieve a minimum level of competency among federal tax return preparers.

Around 60 percent of paid tax preparers are unregulated and do not have any professional credentials. As such, they are able to operate without any kind of oversight.

In order to bring this wild west of tax preparation under the bureaucracy’s yoke, the IRS had initiated a mandatory program of education and testing for all unregulated tax preparers.

But that didn’t go well, and the courts decided (see Sabina Loving vs. IRS) the IRS does not have the authority to go around dictating what kind of education and certification tax preparers need to have.

So now they have launched the voluntary Annual Filing Season Program as a temporary stop-gap arrangement while Congress gets its act together and pass a constitutional amendment that gives the IRS the authority it needs to make the program mandatory.

Preparers willing to participate in the voluntary program will have to register themselves with the IRS and get a Preparer Tax Identification Number (PTIN).

They will also be signing up for 18 hours of continuing education on an annual basis. This includes 10 hours of education on federal tax law topics, along with two hours on ethics.

The remaining six hours of classes will be a refresher course on the tax filing season, provided in the form of a test involving 100 questions.

Tax preparers who complete the course and pass the test get a record of completion and are good for that one filing season. In order to retain the qualification, preparers need to do it all over again every year thereafter.

Apart from the obvious benefits of education and being up-to-date on the latest regulations and changes in tax law for each filing season, tax preparers will also benefit from getting their names entered into the database of qualified tax return prepaprers.

Starting Jan 2015, taxpayers who need a tax preparer will be able to check this database to see if the preparer they are talking to is listed or not. It’s obvious that anyone not listed stands little chance of being hired once word gets around about this database.

If that’s not enough, the IRS plans to make sure everyone knows about it through a public awareness campaign that will be launched right in time for filing season next year.

For the record, this database includes CPAs, attorneys, enrolled agents, enrolled retirement plan agents and enrolled actuaries already registered with the IRS.

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The Dog Ate My Tax Receipts Act

It’s understandable if you think that The Dog Ate My Tax Receipts Act is something fictitious. Sad to say, it’s a very real change in the tax law being proposed by Rep. Steve Stockman, who represents the 36th Congressional District of Texas.

Stockman’s bill, called the “The Dog Ate My Tax Receipts Act,” would allow taxpayers who do not provide documents requested by the IRS to claim reasons like the dog ate my tax receipts, unexplained computer malfunction, burned for warmth while lost in the Yukon, forced to recycle by municipal green czar, and short on toilet paper while camping.

Stockman’s dog ate my tax receipts bill is admittedly a funny response to the ongoing controversy over the missing IRS emails.

Emails sent and received by former IRS Commissioner Lois Lerner were erased when her hard drive crashed in June 2011. The IRS has some 43,000 emails from Lerner’s account which were not lost in the hard drive crash, and has additionally managed to collect another 24,000 emails from people who received or sent the emails.

It’s not clear how many emails are still missing, and the hard drive that crashed has been destroyed because it was sent away to be recycled.

So there are no archives stored on backups? Apparently not, because the backups were on tape drives that get reused after six months. The emails for the period in question have long since been erased.        

Here’s the text of Stockman’s proposed law, which seeks to express the sense of the House of Representatives that they must allow taxpayers “the same lame excuses for missing documentation that the IRS itself is currently proffering.”

Whereas, the IRS claims that convenient, unexplained, miscellaneous computer malfunction is sufficient justification not to produce specific, critical documentation; and,

Whereas, fairness and Due Process demand that the American taxpayer be granted no less latitude than we afford the bureaucrats employed presently at the IRS;

Now, therefore, be it resolved that it is the sense of the House of Representatives that unless and until the Internal Revenue Service produces all documentation demanded by subpoena or otherwise by the House of Representatives, or produces an excuse that passes the red face test,

All taxpayers shall be given the benefit of the doubt when not producing critical documentation, so long as the taxpayer’s excuse therefore falls into one of the following categories:

1. The dog ate my tax receipts

2. Convenient, unexplained, miscellaneous computer malfunction

3. Traded documents for five terrorists

4. Burned for warmth while lost in the Yukon

5. Left on table in Hillary’s Book Room

6. Received water damage in the trunk of Ted Kennedy’s car

7. Forgot in gun case sold to Mexican drug lords

8. Forced to recycle by municipal Green Czar

9. Was short on toilet paper while camping

10. At this point, what difference does it make?

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Supreme Court Ruling Makes IRS Summons More Powerful

If you’re quaking in your boots after getting an IRS summons, well then… now you can quake some more.

In a unanimous opinion in United States v. Clarke, the Supreme Court quashed the possibility of those issued a summons being able to fight back by hauling the IRS agents concerned to court to grill them and find out if there was any ulterior motive for issuing the summons.                   

To be specific, the Supreme Court Justices wrote that taxpayers have a right to conduct an examination of IRS officials who issued them a summons only if said taxpayers are able to point to “specific facts or circumstances plausibly raising an inference of bad faith.”

The case began following a drawn out IRS investigation of Dynamo Holdings L. P., whose tax filings showed a pattern of high interest deductions. The statute of limitations on assessing tax liability was already in the rear view after several extensions, and Dynamo Holdings finally refused to let the investigation be extended yet again.

This led to the IRS issuing summonses to the partners of the firm. Respondents took the matter to court, seeking to question the agents involved in order to cast negative aspersions on the motives of the IRS in issuing the summonses.

The District Court denied their request, and respondents filed an appeal. The Eleventh Circuit Court reversed the district court verdict, noting that the court’s refusal to allow respondents to question agents was an abuse of discretion.

The Appeals Court ruled that respondents should be allowed to conduct such questioning of agents even if no factual evidence was presented to warrant claims of ulterior motives.

That ruling, had it been allowed to stand, would have caused the IRS a world of pain, because anyone who got a summons would contact a lawyer, and said lawyer would run to court and have the agents concerned hauled over and accuse them of all sorts of improprieties to try and get the summons revoked.

The Supreme Court’s unanimous opinion recognizes the Eleventh Circuit’s overreach and cuts the appeals court ruling down to size. What’s left is the ability to examine agents only if and when the respondent is able to convince the court with credible evidence that the summons was not issued in good faith.

Even circumstantial evidence will do as long as it makes a plausible case of bad faith on the part of the agency and the agents concerned.

The Supreme Court’s opinion makes it all look reasonable, but there’s another darker side to the issue. The agency knows now that there’s very little chance of being hauled to court if they issue a summons because the lower courts aren’t going to repeat the Eleventh Circuit’s mistake again.

Lawyers representing taxpayers who have been issued a summons will know it too, and they will be reluctant to make any allegations unless they have a solid case. It shuts the door on a valid and legal avenue for relief, and makes the IRS that much more powerful.

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