Podiatrist Has to Foot The Tax Bill: No Settlement and No Basis

A case earlier this week in Tax Court, Namen v Commissioner, presents two issues worthy of highlighting: one concerns when a settlement becomes binding, and the other concerns the taxpayer/podiatrist’s efforts to prove up his basis relating to his interest in an LLC that ran a surgery center.

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First on the settlement issue. The taxpayer’s lawyer argued on brief that he had accepted an IRS offer to settle the case that IRS counsel made after trial.

Counsel for the government disagreed:

[IRS counsel] states in her answering brief that she “made an oral offer of settlement to…[taxpayer’s counsel] based on the parties not writing briefs in this case, as well as on petitioner’s spouse’s consent to the assessment of tax and additions to tax against her.”

According to IRS counsel, taxpayer’s counsel “did not call to accept the offer until the day that briefs were due and after she had already filed her opening brief.” As a result, she claimed that by filing the brief she revoked her offer.

The opinion agreed with the IRS. It did so by first noting that a settlement is a contract subject to general principles of contract law. Citing Dorchester Industries v Commissioner the opinion notes that “contract requires ‘an objective manifestation of mutual assent to its essential terms’, and mutual assent is typically established through an offer and an acceptance.” Keith wrote a three part series on this issue last year, which you can read here, here and here.

A main issue in the case was there was no evidence in the record that would allow the court to find objective manifestation of mutual assent. The taxpayer’s counsel made his argument that the case was settled only on brief, and there was no evidence in the record “apart from the unsworn statements of counsel.” Unfortunately, counsel for the taxpayer did not move to reopen the record, though the opinion notes that counsel for the government failed to move to strike. Even without evidence in the record (and I guess accepting at face value the unsworn allegations), the opinion notes that the parties’ briefs failed to spell out the terms of the alleged settlement. As such, there was not enough for the court to find that the evidence before it proved that the parties’ counsel agreed on a settlement.

The merits issue essentially turned on the podiatrist’s inability to establish his basis in the LLC. The LLC was taxed as a partnership, and the podiatrist attempted to establish that he had a basis in the interest in the LLC to allow him to deduct the distributive share of the LLC’s losses. Losses are allowed to the extent of a member’s basis in the LLC; losses in excess of the basis can be carried forward. Basis can be established by contributions and are increased by the partner’s distributive share of partnership income, and decreased by all cash distributions and the partner’s distributive share of partnership losses. The taxpayer argued as well that he was personally liable for a share of loans that were made to the LLC; that is another way to juice basis in an LLC treated as a partnership.

As with the first issue, the taxpayer lost in part because the record did not support his allegations:

However, no corroborating documents supporting his testimony were admitted into the record. Petitioner also failed to provide any credible testimony or other evidence regarding the amount of his distributive share of partnership losses and the extent of any prior adjustments to his basis. Under these circumstances, we find petitioner’s generally uncorroborated testimony inadequate to establish his basis in RMSC; we also find his testimony inadequate to establish the extent to which he is entitled to a distributive share of any losses.

Parting Thoughts

Facts at trial are key. The record that counsel makes is crucial. If the facts exist outside the record the court will generally not be able to consider those facts in resolving the dispute. Counsel must carefully consider when it wishes to bring facts to the attention of the court and pay attention carefully to evidence beyond testimony, especially when one would expect there to exist corroborating documentation that could have perhaps surfaced. Testimonial evidence can win an issue. For certain issues the court knows that limited, or no, written evidence may exist. The residence test for dependency exemption provides a common example of a situation in which little or no direct evidence often exists. With an issue where the absence of written evidence is common, the court readily accepts testimonial evidence after weighing the credibility of the testimony. By contrast, with issues in which one would expect documentary evidence, testimonial evidence often carries little weight because the absence of the documents itself undercuts the credibility of the testimony. There is an old case the Tax Court sometimes cites in these situations (Wichita Terminal Elevator Co. v Commissioner) which holds that where a party has the ability to bring forward evidence and it does not the failure to bring forward the evidence creates a presumption that the evidence would be unfavorable.

When dealing with settlements, it is important to put offers and acceptances in writing. As Keith discussed in the prior posts dealing with settlements, holding the government to a settlement that did not involve a statement in open court is very difficult. The failure here to accept the settlement prior to the preparation of the briefs may itself prove fatal to the settlement because of the argument that timing was a condition of the settlement but even without that fact the proof here lacked the kind of proof that has formed the basis of binding settlements in earlier cases with this issue. If you want to bind the government, get the offer in writing and, if possible, get the terms before the Court in a manner that implicates the Court’s schedule. Remember that in addition to other considerations you face an argument that the attorney in the case did not have authority to settle the case without the permission of a manager. Here there was no proof of managerial consent to the settlement offer and that might have proved fatal had the issue moved further. The case also lacked the element of reliance. Petitioner showed little or no harm in reliance on the alleged settlement and no action taken in reliance.

Taxpayer Rights: Measuring IRS Performance

There is a lot to digest in the 2016 National Taxpayer Advocate Annual Report that was released earlier this month. One of the new parts of the 2016 report was the creation of a taxpayer rights assessment, which reviews IRS performance measures and data organized around the ten taxpayer rights embedded in the Taxpayer Bill of Rights. The general idea is to further cement the notions of taxpayer rights into the calculus of good tax administration.

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As the report discusses, this is a work in progress, both in identifying what are the appropriate ways to illustrate IRS performance relating to taxpayer rights and in ensuring that IRS or an outside group can observe and report on those tasks.

The initial assessment compares and reports on FY 2015 and 2016 metrics, including the following:

  • percentage of phone calls to IRS answered,
  • the no change, agreed and non response rate for correspondence, field and office exams,
  • the numbers of e-filed and paper filed returns by preparers and taxpayers directly,
  • numbers of returns submitted through the Free File consortium, by VITA and other volunteer groups,
  • the average days needed to resolve EITC and other correspondence examinations,
  • the numbers of submitted and accepted collection alternatives like offers and installment agreements,
  • and the number of tax clinics and volunteers hours at those clinics.

There are lots of items identified where there was no data available, such as numbers of math error adjustments that were abated, the percentage of taxpayers who felt their issues were resolved after contacting IRS by phone, and satisfaction relating to a variety of Appeals functions.

A taxpayer rights assessment is a great idea. One of the common critiques of taxpayer rights provisions is that in some cases an agency that violates a taxpayer’s rights may not lead to the taxpayer enjoying a specific remedy. No doubt when Congress wants to get an agency’s attention it can be specific in providing a consequence, such as monetary damages or a shift in the burden of proof if a dispute finds its way in court.

Yet the absence of a remedy does not mean that there are no other ways to encourage good agency practice. My research in the ways that agencies interact with regulated parties outside the tax system suggests that softer notions like employee training and mission statements that specifically address aspirational conduct and respect for the rights of those who are regulated can have an impact on rights that agencies should aspire to protect. In addition, transparency surrounding agency performance can influence agency conduct. An annual taxpayer rights assessment has the potential for  encouraging the IRS to do the right thing in the absence of a specific statutory consequence for failing to do so.

I am working on a paper discussing the role of taxpayer rights and compliance. Part of my paper focuses on how IRS metrics on its audits justifiably key in on revenue protected and on important metrics like the percentage of taxpayers who fail to respond to IRS correspondence audits and agree with IRS proposed adjustments. Absent from the equation has been the percentage of taxpayers who following an adjustment understand why in fact their return as filed was incorrect or whether the taxpayer felt that she had a fair shake in presenting information to justify a tax return position or explain why the taxpayer may have taken a position on a return.

To be sure, measuring taxpayer reaction is costly, and IRS has lots on its plate. It seems to me that good administration includes trying to assess more methodically how IRS is doing around the rights that are reflected in the 2014 Taxpayer Bill of Rights. I look forward to this hopefully becoming a regular part of the annual reports and more importantly it becoming inculcated in how IRS thinks it is doing in administering the tax laws.

For our prior post on the 2016 Report generally as well as links to the different volumes of the Report see NTA Releases Annual Report.

Sidebar: Taxpayer Rights Conference

The Institute for Austrian and International Tax Law at WU (Vienna University of Economics and Business) is hosting the second international taxpayer rights conference in Vienna on March 13 and 14. The conference is convened by the National Taxpayer Advocate and is sponsored in part by Tax Analysts. The conference promises to bring together an eclectic group of scholars and tax administrators. Details on the conference can be found here.

Brief Follow up to Today’s Post on Refund Loans

Today’s post noted that we are likely to hear from consumer groups regarding the return of refund loans. It turns out that yesterday the National Consumer Law Center issued a press release called Tax Time Kick-Off: Delays and Risks Await Many Taxpayers This Year, discussing some of this filing season’s challenges. In the release, the NCLC, which was a leading voice against the earlier use of refund loans, again warns consumers against their use:

Advocates recommend that taxpayers avoid no fee RALs if possible. One risk is that some unscrupulous tax preparers might charge more in their tax preparation fees to “no fee” RAL borrowers. Also, in the last tax season some lenders, such as EPS and River City Bank, appeared to actually impose a price for “no fee” RALs by charging a higher price for a refund anticipation check (RAC) if the preparer was offering these loans.

With RACs, the bank opens a temporary bank account into which the IRS direct deposits the refund. After the refund is deposited, the bank issues the consumer a check or prepaid card, minus tax preparation fees paid to the preparer, and closes the temporary account. RACs do not deliver refunds any faster than the IRS can, yet cost $25 to $60. Some preparers charge additional “add-on” junk fees for RACs, fees that can range from $25 to several hundred dollars.

The NCLC also discusses some of the other challenges this year, including the need for many taxpayers to get a renewed Taxpayer ID number (ITIN), the coming of private debt collectors and the need to select competent and honest preparers.

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Further note: I have updated the link to the IRS web page for this filing season.

Refund Loans on the Comeback, with a Twist

Tax filing season has kicked off. IRS has a web page dedicated to the filing season, and it includes a lot of helpful information, including information on ITIN changes and this year’s delay in releasing refunds relating to EITC and child tax credit.

The delay in the timing of the refunds is a major change.  New York Times reported last week on the resurrection in refund loans this filing season in Tax Refund Loans are Revamped and Resurrected, with the large tax prep chains offering up to $1300 within a day or so with no direct fees passed on to the individuals for the loan. The article discusses the history of refund loans, which in their earlier form carried heavy fees and attracted a lot of criticism from consumer advocates. They essentially disappeared a few years ago.

Here is why the loans have returned. As we have discussed, Congress in the PATH legislation mandated a delay in remitting refundable-credit-based refunds until mid-February. The start of filing season has traditionally been a time when millions of lower-income refund seeking individuals filed early to get the refunds. To offset the PATH delay, and as a way to stem the flow of individuals to DIY software, the large prep chains have stepped in and essentially offered access to the refund loans as a loss leader.

What happens if the refund never materializes come late February (say there is a set off or examination based refund freeze) and the loan cannot be repaid? The NYT article says the large prep chains are going to eat the loss, though I have not read the fine print on what the consumers are signing when getting the loans.

From a tax compliance perspective, this situation more closely aligns the prep companies with the government’s interest in ensuring that the claimants are in fact eligible when claiming a credit, or at least are able to get past the IRS filters on freezing a refund if there are eligibility concerns.

To be sure, the prep chains have other ways to make money on the transaction, and the prep companies are good at cross-selling. I suspect we will be hearing more from consumer groups on this practice.

 

 

Plastic Surgeon’s Share of LLC Income Not Subject to Self-Employment Tax

An earlier version of this post appeared in the Forbes PT site on January 20, 2017.

In Hardy v Commissioner the Tax Court considered the self-employment tax consequences of a plastic surgeon’s share of income earned through his investment in an LLC that owned and operated a surgery center. Whether a professional’s share of a pass through’s income is subject to self-employment (SE) tax is an important issue that affects many taxpayers. In Hardy, the taxpayer successfully argued that his share was more like passive income and was not subject to SE tax. In this post I will briefly discuss the issue and the reason for the Tax Court finding in favor of Dr. Hardy.

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Readers may recall our discussion of Fleischer v Commissioner, where the Tax Court treated the taxpayer individually, rather than his solely-held S Corp, as the rightful owner of income in Financial Consultant Fails To Avoid Self-Employment Tax With S Corp Structure, a post that generated some excellent comments.

I discussed in that post the contrasting self-employment tax consequences between using an S Corp and other pass through entities. Limited partners, like shareholders in an S Corp, are generally shielded from self-employment income on partnership profits. That is because Section 1402(a)(13) excludes from the definition of self-employment income the distributive share of limited partners’ income, other than a guaranteed payment for services. Section 1402(a)(13) predates the explosion of other pass through entities like LLCs that allow members, unlike limited partners, to actively participate in the business of the entity while also providing in some ways for liability protection.

There has been uncertainty regarding how that income should be characterized. Naturally, taxpayers have analogized members in these entities to limited partners for self-employment tax purposes; IRS, with some success, especially when the members were active in the business that generated the service income, treats the members’ share of the entity’s income as net business income subject to self-employment tax. The key, at least from the Tax Court’s perspective, is to determine whether the income that the member receives is more related to the capital investment in the entity or the services that the members perform in their capacity as individuals.

When the income seems more connected to the services that the members perform, it is treated as self-employment income. The 2011 Tax Court case Renkenmeyer v Commissioner, involving partners in a law firm is instructive. In that case the Tax Court concluded that because the “revenue was derived from legal services performed by the partners in their capacity as partners, they were not acting as investors in the law firm.”

In Hardy v Commissioner, decided this past week, the Tax Court distinguished Renkenmeyer. Hardy was a plastic surgeon specializing in pediatric reconstructive surgery. In 2006 he purchased for $163,974 a 12.5 per cent interest in a surgery center run through an LLC. The opinion held that he did not have self-employment income on his share of the surgery center’s income. To get to its conclusion the opinion walks through Hardy’s role with the surgery center and the ways that surgeons earn income. Hardy had no meaningful non-surgery related service responsibilities with the surgery center:

Dr. Hardy has never managed MBJ [the LLC/surgery center], and he has no day-to-day responsibilities there. Although he meets with the other members quarterly, he does not have any input into management decisions. He generally is not involved in hiring or firing decisions. His role and participation in MBJ have not changed since he became a member.

While Hardy performed some of his surgeries at the surgery center, he had no obligation to do so. The opinion discusses how patients pay surgeons directly for the surgery procedures. Patients separately pay a fee to the surgical facility for the use of facilities and associated services. What was a key fact was the nature of Hardy’s interest more closely resembled that of a passive investor, with his Hardy’s share of the LLC income related to the fees patients paid for the use of the centers. In essence his cut was not explicitly tied to surgeries that he performed. Those fees were due Hardy independent of any services or surgical procedures he chose to perform at the surgery center that generated the income in question:

Dr. Hardy receives a distribution from MBJ regardless of whether he performs any surgeries at the surgery center, and his distribution is not dependent on how many surgeries he performs at MBJ. MBJ does not have a minimum surgery requirement to receive a distribution.

With that as background, the opinion distinguished Renkenmeyer and held that the income was not subject to SE tax:

Dr. Hardy is an investor in MBJ, which is distinguishable from the limited liability partnership formed by the partners in the law firm in Renkemeyer, Campbell & Weaver, LLP v. Commissioner. MBJ owns and operates a surgical center. MBJ is equipped for doctors to perform surgeries that require local and general anesthesia. MBJ bills patients for the use of the facility. Although Dr. Hardy performs surgeries at MBJ, he is not involved in the operations of MBJ as a business. In contrast to the partners in Renkemeyer, Campbell & Weaver, LLP, who are lawyers practicing law and receiving distributive shares based on those fees from practicing law, Dr. Hardy is receiving a distribution based on the fees that patients pay to use the facility. The patients separately pay Dr. Hardy his fees as a surgeon, and they separately pay the surgical center for use of the facility in the same manner as with a hospital. Accordingly, Dr. Hardy’s distributive shares are not subject to self-employment tax because he received the income in his capacity as an investor. [notes and citations omitted]

Parting Thoughts

Hardy stands as useful precedent for members whose income is pegged to a capital investment rather than services those members perform.

It is interesting to note that the information returns Hardy received in fact treated the income as subject to self-employment tax. This is a good reminder (as Keith’s post Proving a Negative The Use of Section 6201(d) discussed) that preparers and taxpayers have to carefully consider the information returns starting to come in; understanding the nature of income, especially in a pass through environment, requires a bit of digging. In fact, in Hardy the parties raised this issue not in the pleadings but only on motion to conform the pleadings to the evidence under Tax Court Rule 41(b)(1). Hardy was fortunate on this issue that the Tax Court concluded that the IRS was not prejudiced or unfairly surprised, thereby letting him raise the issue that he did not flag in his petition.

Mixing a Pro Se Taxpayer and Confusing Innocent Spouse Deadlines Leads to Bad Result

In Vu v Commissioner, a summary case from late last year, the Tax Court held that a pro se taxpayer did not establish the Tax Court’s jurisdiction to hear an appeal of an IRS’s denial of a request for innocent spouse relief. What makes the case unusual is that the taxpayer Amanda Vu did file a petition requesting relief but she did so before the IRS issued what it styled as a notice of determination and just prior to 6 months elapsing after her request to the IRS for relief was made. In other words, her petition jumped the gun on the two separate avenues needed to confer the Tax Court’s jurisdiction.

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Before digging into the case I note that I came across the case and wrote a draft of this post without realizing that Carl and Keith are now representing the taxpayer Ms. Vu. As I discuss below, what intrigued me initially about the case was how the result was unfair. Carl and Keith and the Harvard Tax Clinic have filed a motion to set aside the dismissal and remove the case’s small case designation. I will discuss below why the Tax Court dismissed the case, and why I agree with the Tax Court judge that the outcome inequitable and hope that the legal argument Carl and Keith have advanced persuade the Tax Court to reconsider its approach.

I also note that we have discussed premature petitions before, albeit in the context of straight up deficiency cases. In Tax Court Order Finds Jurisdiction Even When Taxpayer Files a Petition Before the IRS Issues Notice of Deficiency a taxpayer filed a petition prior to the stat notice but in response to other correspondence IRS issued in its exam. I discussed how the Tax Court in Weiss v Commissioner went out of its way to confer jurisdiction, essentially allowing the taxpayer’s response to IRS motion to dismiss the case confer jurisdiction, so long as the taxpayer amended its petition and the IRS’s motion and the taxpayer’s response were issued prior to the actual 90-day period ran. I speculated that the problem of premature petitions filed in good faith was likely a common one, and that the Weisses were lucky in that the IRS motion, and their response, were within the 90-day period.

Vu was not nearly as fortunate as Weiss. I will simplify the facts to bring home the procedural conundrum Vu found herself in.

She, with a friend’s assistance, submitted a request for innocent spouse relief that she signed and dated February 28, 2014. IRS recorded it as received on March 24, 2014.

Vu testified that she received from IRS on June 12 an “Innocent Spouse Relief Lead Sheet” that was dated June 4, 2014. The document was designated Workpaper # 615 and reads in part:

Conclusion: (Reflects the final determination on the issue.)

Conclusion for 6015(b):

Note: A summary of your conclusion should go here. Ensure that reference is made as to what factors are met if allowing or granting partial relief, and what factors are not met

It was concluded that the Taxpayer does not meet innocent spouse relief under IRC 6015(b).

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Conclusion for 6015(c):

Note: A summary of your conclusion should go here. Ensure that reference is made as to what factors are met if allowing or denying partial relief, and what factors are not met if disallowing or granting partial relief.

It was concluded that the Taxpayer does not meet innocent spouse relief under IRC 6015(c).

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Conclusion for 6015(f):

Note: A summary of your conclusion should go here.

It was concluded that the Taxpayer does not meet innocent spouse relief under IRC 6015(f).

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Vu sent in a petition to Tax Court and it had a September 8, 2014 postmark, and Tax Court received it on September 12, 2014.

About one month after Vu filed her petition, on October 9, 2014 IRS mailed Vu a final determination denying her request for innocent spouse relief.

On November 3, 2014, IRS filed an answer. In the answer it denied issuing a notice of determination from New Mexico and indicated that it issued a notice of determination from Phoenix on October 9, 2014. IRS did not in the answer indicate that the petition Vu filed was premature; that was too bad because if it had flagged the issue, the taxpayer, like the early bird in Weiss, could have cured her defect and filed a petition that would have clearly been timely.

On January 27, 2015 Vu, more than 90 days after issuing what it called a final determination and over four months after Vu filed her petition, IRS filed a motion to dismiss Vu’s petition on the ground that she filed it prior to the time that the IRS issued its October 9 notice of determination.

Vu did not respond to the Tax Court’s order ordering a response to the motion. The motion was argued at a June 2015 calendar in New Mexico.

The Law

A petition to Tax Court is timely in innocent spouse cases if it is made (1) within 90 days of the mailing of a notice of final determination of relief, or (2) if the IRS has not yet mailed a notice of determination, at any point after six months has transpired since the taxpayer’s request for relief was made with the Commissioner.

Applying the above rules to Vu meant that the Tax Court would have had jurisdiction under two alternate theories:

  • if it considered the IRS’s Innocent Spouse Relief Lead Sheet IRS issued sometime in June a notice of determination and Vu filed a petition within 90 days of that determination, or
  • if at the time she filed her petition to Tax Court 6 months had elapsed following her request for relief and IRS had issued no determination in the case.

On both grounds the Tax Court held that Vu came up empty leaving the Tax Court to conclude that it had no jurisdiction in the case.

Both issues are interesting and walk us down some complicated procedural rules. First let’s look at issue 1. The opinion indicates that it likely would have been willing to conclude that the Workpaper #615 correspondence was a determination, noting cases such as Barnes v Commissioner that neither the statute or regs impose a specific form or spell out the content of what should be in a determination and the language of the workpaper led the taxpayer to conclude it was a final IRS determination. The problem for Vu was that there was no evidence in the record when IRS issued that correspondence, making it impossible to conclude that the petition she filed was within 90-days (and allowing the court to punt on concluding definitively that the Workpaper was a determination).

There were two possible dates: June 4, when the document was dated, or June 12, when Vu claimed to receive it. Determining which was correct was key, because if it were issued on June12th the petition she mailed on September 8 would have been filed within 90 days, using the mailbox rule that allows date of mailing to be the date of filing. If it were issued on June 4th the petition would have been filed outside the 90-days.

According to the Tax Court Vu did not offer any evidence as to why June12th was the correct date:

As for the June 12, 2014, date, petitioner however did not present any evidence whatsoever showing that any relevant action occurred on June 12, 2014, and has specifically failed to establish that respondent provided her the requisite final determination notice on that date.

What about issue 2, the 6-month rule? That issue turned on whether Vu’s request was considered made on February 28, when she signed, dated and testified that she mailed it, or March 24, when IRS records treated the request as received. If the operative date were February, then Vu’s petition would have conferred jurisdiction, as the petition she mailed on September 8 and which the Tax Court received on September 12 would have been filed after 6 months had elapsed from her administrative request for relief and prior to the IRS’s issuance of the October 9 final determination.

Vu came up empty here too. How it gets there requires a detour to Section 7502, the mailbox rule. The Vu opinion treats the statutory language “made” in the same manner as if it interpreted when the request were filed. The opinion treated the request for relief as having been filed or made in March (when IRS received it) and not when  mailed in late February. It does so because the mailbox rule under Section 7502 is actually an exception to the general rule that a document is filed when it is received by the IRS. Recall that the mailbox rule of Section 7502 only applies when documents are filed with and received after the expiration of a filing period. Here, the filing period limitation relates to the time period to bring an administrative request for innocent spouse relief, and that limitation was years in the future:

Because petitioner’s Form 8857…was filed before respondent initiated any collection action with respect to that year (indeed, before respondent even issued the joint notice of deficiency to petitioner and Mr. Nguyen with respect to that year), we find that respondent timely received the form on March 24, 2014; section 7502 therefore does not apply, and the relevant date for section 6015(e)(1)(A)(i)(II) is not six months after the alleged mailing date of the form but six months after the date of receipt of the form, or September 25, 2014.

The opinion made clear why Vu came up short:

Consequently, we can exercise jurisdiction over the petition herein only if it was filed “at any time after the earlier of” October 9, 2014 [the date of the formal notice of determination], or September 25, 2014 [six months after Vu’s request was made], see sec. 6015(e)(1)(A)(i), and “not later than” January 7, 2015, see sec. 6015(e)(1)(A)(ii). Because the petition was filed with the Court on September 12, 2014, it does not meet this requirement and we thus lack jurisdiction over it.

This opinion noted the unfairness of the outcome:

While we acknowledge that this is an inequitable result, as petitioner filed her petition believing in good faith that it was timely and her opportunity to file another petition has now expired, we are unfortunately constrained by the statute, and our role is to apply the tax laws as written.

Final Thoughts

This is a bad outcome. I do not understand why counsel for IRS did not alert Vu of the premature petition issue earlier in the process. It appears that counsel for the IRS did not appreciate the 90-day issue fully until it filed the motion; otherwise one would have hoped that counsel would have filed the motion in lieu of the answer. That would have given Vu time to file a petition within the 90-day window, as the taxpayer in Weiss did. I also note that the IRS only raised the 6-month issue at the hearing itself on the motion, which was many months after the IRS filed its motion to dismiss.

We have discussed before the difficulties associated with confusing IRS correspondence. When you add to the mix the reality that many taxpayers are pro se and not equipped to understand the nuances of differing IRS procedures you can get to a place where a taxpayer is denied her day in court despite efforts to have her case heard.

There is a possibility that the Tax Court will change its mind and the case will get heard. Keith and Carl in their motion to set aside the dismissal argue that the IRS forfeited the right to make an SOL argument by waiting too long in this case, as it should have been made in the answer. This is an argument similar to the way the Supreme Court in the 2004 case of Kontrick v. Ryan held that a bankruptcy debtor waited too long in his case to raise the untimeliness of a creditor’s filing because the time period was not jurisdictional, so had to be raised earlier in the case.  Kontrick is the Supreme Court opinion that first began the narrowing of the use of the word “jurisdictional”.

We have discussed the issue of jurisdictional deadlines repeatedly; the most recent was Carl’s discussion of Tilden earlier this week, an opinion that does not help the argument in Vu. Admittedly there is no direct precedent in support of Vu’s argument, and the Tax Court in Pollock v Commissioner has previously held that the deadline under Section 6015(e)(1)(A) was jurisdictional and not subject to equitable tolling. To be sure, there is no long line of Supreme Court precedent holding deadlines under Section 6015 jurisdictional, and the Tax Court’s opinion in Pollock was prior to the Supreme Court and other courts’ narrowing of the term jurisdictional. Moreover, the language in Section 6015(e) consists of a single sentence containing both jurisdictional grants and time periods to file a petition, a type of statute that the Supreme Court has previously held to be not jurisdictional.

Keith and Carl have a few cases other than Vu in the pipeline making this argument and I hope the courts at a minimum address the changing law and meaningfully apply those changes to these and other deadlines where IRS conduct has contributed to taxpayer confusion and the denial of a day in court.

NTA Releases Annual Report

The National Taxpayer Advocate released her Annual Report yesterday. The report is broken into three main volumes.

Volume 1 follows the general approach of past reports with a discussion of most serious problems, legislative recommendations and most litigated issues. Given the NTA’s laser-like focus on IRS plans to build the so-called Future State, much of the discussion touches on issues relating to IRS plans to modernize tax administration. In a Special Focus to Volume 1, the NTA “has attempted to identify and make recommendations to address the challenges the IRS faces to become a 21st century, taxpayer-centric tax administrator.” Volume 1 also has a discussion of IRS performance relating to taxpayer rights, a section I am looking forward to reading and a welcome addition to IRS performance metrics.

Volume 2 contains TAS research and related studies. There are five studies in the volume, including discussions of taxpayer service among differing ethnic groups, the impact of educational letters on potentially noncompliant individuals, IRS use of financial analysis in installment agreements, a call for IRS to better use internal data to determine collectability of taxpayers, a discussion of collection issues facing business taxpayers.

A new part of the report is in Volume 3, which contains literature reviews on taxpayer service in other countries, incorporating rights in tax administration, behavioral science, geographic considerations for tax administration, customer considerations for online accounts, alternative dispute resolution options and ways to reduce false positives in fraud detection.

For those looking for the Cliff Notes version there is an executive summary that summarizes the main issues.

I have previously expressed my admiration for the NTA’s reports. The reports are a major contribution to tax administration. I have not had time to work through materials but the Special Focus on Future State in Volume 1 is a good place to start for those interested in the prospects of tax administration reform. In the past year the NTA has convened a series of public forums to gain insights in taxpayer preferences and challenges. Applying her considerable experience with IRS and using insights from those forums, the NTA has attempted to provide a blueprint for best practices that Congress and IRS should keep handy as IRS crawls into the 21st century.

Financial Consultant Fails To Avoid Self-Employment Tax With S Corp Structure

This post originally appeared on the Forbes PT site on January 4, 2017

Late December’s Fleischer v Commissioner involves facts that are common among many small business service-providing taxpayers wishing to minimize self-employment liability by setting up S Corporations and funneling service income to those corporations. Unfortunately for Fleischer, the Tax Court found that he faced a sizable self-employment tax liability as it reallocated income that was reported on the S Corporation’s 1120-S to his Form 1040.

The case is in the category of who is the appropriate taxpayer, an issue that sometimes gets murky when taxpayers are dealing with closely or solely-held separate entities. I will summarize and simplify the facts somewhat and hone in on why the taxpayer lost despite the plans of both a CPA and lawyer advising on his tax structure.

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The Facts of Fleischer: Setting up an S Corp to Avoid Self-Employment Tax

Fleischer is a licensed financial consultant. Based on the advice of his CPA and lawyer, he set up an S Corporation. Fleischer was the president, secretary, treasurer and sole shareholder of the corporation. Fleischer entered into an employment agreement with the S Corporation, and pursuant to that agreement the S Corp paid him a salary in his capacity as financial advisor. In his individual capacity, Fleischer also entered into contracts with financial service companies Mass Mutual and LPL. Those contracts generated significant commissions, which Mass Mutual and LPL reported to the IRS and to Fleischer individually on various Form 1099’s over the years.

The key to the employment tax savings when all works well in this structure is that the S Corp pays a salary less than the gross receipts it receives. The shareholder/employee has employment tax liability to the extent only of the wages that the S Corp pays to the shareholder/employee. Fleischer paid employment tax on his wages from the S Corp. And while Fleischer’s status as sole shareholder meant that all of the S Corp’s income would flow through to him, the nature of the income matters. Individuals who earn service income directly have to pay Social Security and Medicare taxes, which are often referred to collectively as the self-employment tax. [Note that the tax rate for Social Security taxes is 12.4% and the rate for Medicare taxes is 2.9%; for 2017 Social Security taxes are levied only on the first $127,200 while the Medicare rate applies to all service income]. If the S corporation, rather than the individual, earns that income, then the S corporation does not have a separate employment tax liability and the shareholder does not have self-employment tax liability on his share of the S corporation’s income.

Fleischer’s S Corp paid him a salary of about $35,000. The net service income the S Corp earned varied over the years, going as high in one year as about $150,000. When, as was the case here, the S Corp’s wages paid are less than its net service income, the shareholder/employee can potentially avoid self-employment income tax if that income were earned directly by the shareholder/employee or employment tax if the S Corporation does not pay a salary commensurate with the corporation’s net business income.

Underlying this form, however, is the IRS’s ability to allocate the income to the party who truly earns the income. In addition, the compensation the S Corporation pays to its shareholder/employee must be reasonable; if too low IRS can argue that some of the distributive share should be characterized as compensation (Peter Reilly discusses one such situation in S Corporation SE Avoidance Still a Solid Strategy). The taxpayer’s reporting of the income and the mere creation of a separate entity do not give the taxpayer unlimited discretion to treat the income in the way most favorable to the taxpayer.

As an important aside, the consequences of an LLC earning service income differ from that of an S Corporation. When an LLC earns service income, the distributive share of partnership income allocated to members of an LLC is generally subject to self-employment tax. This is a key difference between S Corporations and LLCs in this context. For an excellent discussion of the issue, see our Forbes colleague Tony Nitti’s post from a few years ago, IRS: Partners’ Share of LLC Income is Subject to Self-Employment Tax.

Back to Fleischer. While he varied somewhat in the way that he reported the income in the years in question, Fleisher testified that he intended to “zero out” his possible self-employment income by reporting expenses on Schedule C to offset his reported income from MassMutual and LPL. In the years in question he paid employment taxes on his wages from the S Corp but would report the income from MassMutual and LPL on his 1040 as non-passive income that was not subject to self-employment tax.

In this case, recall that Fleischer was paid by Mass Mutual and LPL in his individual capacity pursuant to contracts that Fleischer and not the S corporation entered into. Fleischer testified that he individually entered into the contracts because it would have been costly and perhaps impermissible for his S corporation to become licensed and registered under federal securities laws.

On audit, IRS disregarded the S Corporation and treated Fleischer as individually earning the commission income, generating a sizable self-employment tax liability. Fleischer naturally disagreed and filed a petition with the Tax Court.

The Tax Court Agrees with the IRS

The lack of contracts between Fleischer’s S Corp and Mass Mutual and LPL proved to be Fleischer’s undoing. In describing the appropriate law, the Tax Court opinion notes a first principle of income tax, namely that “income must be taxed to him who earned it.” The opinion goes on to state that “for almost as long as this first principle of income taxation has been in place, the principle that a corporation is a separate taxable entity has been, too.”

The opinion goes on to discuss the key to reconciling these principles:

Because it is impractical to apply a simplistic “who earned the income” test when the Court’s choices are a corporation and its service-provider employee, the question has evolved to one of “who controls the earning of the income.”

To determine if the corporation and not the shareholder controls the earning the opinion notes that the case law looks to two requirements:

(1) the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense, and

(2) there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation’s controlling position.

While here Fleischer satisfied the first requirement he flunked the second due to the lack of a contractual relationship between the S Corp and the brokerage companies. In other words, there was no recognition from Mass Mutual or LPL that the S Corp had control over Fleischer even though the agreement that Fleischer and the S Corp signed had the bells and whistles that would satisfy the first requirement. Fleischer was an employee of the S corporation and it had the contractual power to control him, but there was not enough to show that Mass Mutual and LPL recognized the control that the S Corporation had the contractual power to exercise over Fleischer.

What about Fleischer’s argument concerning the practical difficulties associated with registering the S Corp under federal securities laws? According to the Tax Court, it did not matter:

Petitioner testified that it would be overly burdensome and “would cost millions and millions of dollars” for [the S Corp] to register under the Act, but he offered no other evidence to corroborate his testimony. The fact that [the S corp] was not registered, thus preventing it from engaging in the sale of securities, does not allow petitioner to assign the income he earned in his personal capacity to [his S Corp]. See Jones v. Commissioner, 64 T.C. 1066 (1975) (holding that a court reporter improperly assigned income to his personal service corporation because a court reporter was legally required to be an individual, and although the corporation was a valid entity, by law it could not perform such services).

Final Thoughts

Fleischer apparently followed his tax advisors’ advice in setting up his personal service S Corporation under state law. That is a necessary but not sufficient condition to have those entities be treated as the rightful earner of service income. As the Fleischer opinion shows, the party paying the service income must expressly recognize that the separate corporate entity has legal and actual authority over the individual. By failing to dot the i’s and then cross the t’s, the IRS, as here, can allocate income to the individual and leave the shareholder/employee with self-employment tax in the same manner as if there were no S corporation in the first instance. The opinion is a red flag for small business taxpayers who may not follow the exact letter of tax advice or for advisors who may not carefully detail all the steps needed to get the appropriate tax result.