TIGTA’s Report on the Growing Gig Economy

Today we welcome guest blogger Joseph C. Dugan. Joseph is a 2015 graduate of Indiana University Maurer School of Law. During law school, he coordinated IU’s IRS VITA program and worked part-time at a Low-Income Taxpayer Clinic. After graduating, Joseph clerked on the U.S. District Court for the District of Maryland and the U.S. Court of Appeals for the Seventh Circuit before assuming his present position as a trial attorney with the Federal Programs Branch of the Department of Justice, Civil Division. Joseph lives in Maryland with his wife and four-month-old son. Joseph writes in his individual capacity and does not purport to represent the views of the Department of Justice or any of its components.

 This post originally appeared here on the Surly Subgroup blog. We highly recommend adding it to your regular blog reads. Christine

On February 14, 2019, the Treasury Inspector General for Tax Administration (TIGTA) released a Valentine’s Day treat: a comprehensive report following a TIGTA audit concerning self-employment tax compliance by taxpayers in the emerging “gig economy.”

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As Forbes noted last year, over one-third of American workers participate in the gig economy, doing freelance or part-time work to supplement their regular incomes or stringing together a series of “gigs” to displace traditional employment. Popular gig services include ride-sharing giants Uber and Lyft; arts-and-crafts hub Etsy; food delivery services GrubHub and Postmates; and domestic support networks Care.com and TaskRabbit. Even Amazon.com, the second-largest retailer in the world and a traditional employer to many thousands of workers in Seattle and at Amazon distribution centers worldwide, has gotten in on the gig economy with its Amazon Flex service. And for those interested in more professional work experience to pad their resumes, Fiverr connects businesses with freelance copywriters, marketers, and graphic designers. The power of smartphones and social media, coupled with flat wage growth in recent years, makes the digital side hustle appealing and, for many households, necessary.

From a tax revenue perspective, the gig economy is great: it is creating billions of dollars of additional wealth and helping to replenish government coffers that the so-called Tax Cuts and Jobs Act (TCJA) has left a little emptier than usual. From a tax compliance perspective, however, the gig economy presents new challenges. Gig payers generally treat their workers as independent contractors, which means that the payers do not withhold income tax and do not pay the employer portion of FICA. Instead, the contractor is required to remit quarterly estimated income tax payments to the IRS and to pay the regressive self-employment tax, which works out to 15.3% on the first $128,400 in net earnings during TY2018, and 2.9% to 3.8% on additional net earnings. That self-employment tax applies even for low-income freelancers (i.e., it cannot be canceled out by the standard deduction or nonrefundable credits).

While the proper classification of gig workers is a legal question subject to some debate, platforms hiring these workers generally treat them as independent contractors. Taxpayers new to the gig economy and unfamiliar with Schedules C and SE may not be aware of their self-employment tax obligations. If they are aware, they may not be too eager to pay, especially if back-of-the-envelope planning during the tax year failed to account for this additional, costly tax.

In light of this emerging economic narrative and evidence that the portion of the Tax Gap attributable to self-employment tax underreporting is on the rise, TIGTA undertook an audit. TIGTA identified a population of 3,779,329 taxpayers who received a Form 1099-K (an information return commonly used by gig economy payers, as discussed below) from one of nine major payers between TY2012 and TY2016. The audit found that 25% of those taxpayers did not report income on either Schedule C (where self-employment income should be reported) or Form 1040 line 21 (where self-employment income is often incorrectly reported). The TIGTA audit further found that, after adjusting for taxpayers who filed Schedule C with a profit of less than $400 (who may not owe self-employment tax) and taxpayers who earned less than $400 on combined Forms 1099-K received by the IRS, 13% of taxpayers did not file a Schedule SE and did not pay self-employment taxes.

These TIGTA findings are revealing. As Leandra Lederman and I discuss in a forthcoming article, Information Matters in Tax Enforcement, there is a host of evidence that information reporting increases tax compliance. As a suggestive starting point, according to IRS statistics, the voluntary individual compliance rate for income subject to substantial information reporting is 93%, while the voluntary individual compliance rate for income subject to little or no reporting is under 37%. TIGTA’s report does not provide percentages that permit a direct comparison with overall IRS compliance estimates. However, the high rates of complete failure to report income tax and employment tax by gig workers receiving a 1099-K seem to suggest that the 1099-K requirement is not as effective as its drafters hoped. Given the transparency of the earnings to the IRS, a likely explanation for this failure is that some gig workers simply do not understand their tax obligations.

But there’s another problem: a substantial amount of gig income is not clearly subject to an information reporting requirement at all. Back in the day, if a payer hired an independent contractor and paid the contractor over $600 during the tax year, the payer was required under Code section 6041(a) and IRS guidance to file Form 1099-MISC, an information return that put both the IRS and the taxpayer on notice of the income. In 2008, however, Congress enacted Code section 6050W, which, upon its effective date in 2011, required “third-party settlement organizations” (TPSOs) to report payments on what is now Form 1099-K, subject to a generous $20,000/200 transaction threshold. A tiebreaker rule set forth in Treas. Reg. § 1.6041-1(a)(1)(iv) provides that a payer subject to reporting requirements under both Code section 6050W and Code section 6041(a) should comply with the former provision only. As a practical matter, this means that payers who consider themselves to be TPSOs (the definition of which is ambiguous and obviously drafted without reference to the emerging gig economy) can report payments for their higher-earning contractors while leaving contractors with under $20,000 or under 200 transactions invisible to the IRS. What are the chances that an Uber driver who earns a few hundred bucks a month in compensation for rides might genuinely, or conveniently, forget to report those receipts come tax time if she hasn’t received a 1099? Pretty good, if prior Tax Gap research is any indication.

My coauthor, Leandra Lederman, presaged some of the problems with Code section 6050W and Form 1099-K reporting in a 2010 article, in which she identified factors that inform the determination whether additional information reporting might be successful. As Leandra and I observe in Information Matters, Form 1099-K held little promise from the outset. And the problems inherent in the TPSO reporting regime have only worsened as the worker economy has transitioned more and more toward lean, diversified gigs.

As if all of this weren’t concerning enough, TIGTA also found serious problems with the way the IRS goes about assessing self-employment tax compliance. Due to resource constraints, the IRS’s Automated Underreporter (AUR) program, the first line of offense against noncompliant taxpayers subject to information reporting, only selects and works a fraction of returns flagged for discrepancies by the Information Reporting and Document Matching Case Inventory Selection and Analytics (IRDM CISA) system (an acronym that only a bureaucrat could love). The idea is for AUR examiners to focus on cases that may yield the highest assessments while also pursuing repeat offenders and providing balanced coverage across AUR inventories. Yet, even as the discrepancy rate involving Forms 1099-K issued by the nine gig economy companies at the center of the TIGTA study increased by 237% between 2012 and 2015, the AUR program selected just 41% of these cases for review.

That review is not necessarily robust. TIGTA found that, for TY2011 through TY2013, 57 percent of all self-employment cases selected to be worked by AUR examiners were screened out—that is, closed without further action. Yet for cases not screened out, 45% were assessed additional self-employment tax; and TIGTA estimates that about $44 million in further self-employment tax could have been assessed during TY2013 alone if the screened-out cases had been worked and resolved similarly to those that were not screened out.

TIGTA also found that, while the IRS has implemented several tiers of quality review within the AUR program, little action is being taken to identify and correct error trends, and the review processes themselves are prone to error and mismanagement due in part to a lack of centralized coordination. One unfortunate consequence of these shortcomings in the AUR program is that gig workers who are already confused about their obligations are receiving inaccurate CP 2000 notices (the standard notice that informs a taxpayer of an error detected through AUR). In fact, TIGTA estimates that the AUR program sent taxpayers 23,481 inaccurate CP 2000 notices about their self-employment taxes in FY2017. That error rate is not only bad for taxpayers, it is bad for the government: if self-employment tax is inadvertently omitted from a CP 2000 notice, as a matter of policy the IRS is generally unable to correct that omission even if the IRS later detects the mistake. That additional revenue is simply forfeited.

So, despite all its wonderful potential to increase both economic opportunity for hard-working Americans and access to valuable services for those willing to pay for them, the gig economy has created some new challenges for tax administration. Gig workers are unsure of (or noncompliant with) their self-employment tax obligations; gig payers are unsure of (or taking advantage of) their status as TPSOs; and the AUR program is not keeping up with the changing times. TIGTA proposes a host of corrective actions in the February 14 report, most of which the IRS has endorsed. Among these corrective actions, three that strike me as particularly important are Recommendation 3 (revise the Internal Revenue Manual to clarify those circumstances in which an AUR examiner should enter a note justifying a screen-out decision); Recommendation 10 (develop IRS guidance on how taxpayers should classify themselves under Code section 6050W); and Recommendation 11 (work with Treasury to pursue regulatory or legislative change regarding the Code section 6050W reporting thresholds). The IRS disagrees with Recommendation 10, asserting that the problem is better addressed through a Treasury Regulation than IRS guidance and complaining that the IRS is preoccupied with issuing guidance under the TCJA and reducing regulatory burdens pursuant to E.O. 13,789. That may well be the case, but revenues are being lost every year that gig payers and workers misunderstand, or misapply, their reporting and payment obligations. There is no reason to suppose that the gig economy will start contracting any time soon, so it would be prudent for the IRS and Treasury to allocate resources to address this problem expeditiously. (Yes, I appreciate that the IRS is chronically underfunded and forced to make very difficult choices about how to staff projects. This is a problem that Congress largely created and Congress alone can fix.)

Ultimately, the best course here might be for Congress either to tailor the definition of TPSOs to a narrower subset of payers for whom the higher thresholds actually make sense (e.g., platforms like eBay, whose casual sellers may not net any income through their online rummage sales) or to lower those thresholds to make gig earnings more transparent to the IRS. So long as we maintain the regressive self-employment tax, we ought to ensure that all taxpayers liable for the tax—even tech-savvy taxpayers Ubering their way through the emerging economy—pay their fare share.

Misclassified “Independent Contractor” Succeeds in Using Tax Code to Get Damages from Employer

We have nearly finished information return filing season. This is the time of year when Americans get their W-2s and 1099s, stuff them in folders and drawers, and hope that when it comes time to prepare their tax return they remember where the papers are. Information returns often lie forgotten until it’s time to answer questions from software prompts or from long-suffering preparers who play detective to ferret out a taxpayer’s economic life.  Some taxpayers can access their information returns seamlessly, but for most this is still a 20th century process that contributes to the huge costs of filing compliance. To be sure, information returns are the backbone of “voluntary” compliance—it is no surprise that when income is not subject to reporting taxpayers have a tendency to not include those items on their 1040s—and that will be true whether the 1040 is postcard size or in the form of a Hallmark Valentine’s Day card professing the IRS’s undying love for taxpayers who file and pay timely.

I digress—today’s post is about people who intentionally file incorrect information returns.

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We have discussed this issue before, and Stephen and I have just heavily tweaked this issue in the Saltzman and Book IRS Practice and Procedure treatise. The cases tend to crop up when someone seeks to make someone else’s life miserable by fling a phony return to generate IRS attention in the form of underreporting letters and possible tax assessments. What could be more middle-finger flipping then sending the IRS an information return showing a former partner or significant other with all kinds of income supposedly but not really earned?

To deal with this, Congress added Section 7434 which provides that

[i]f any person willfully files a fraudulent information return with respect to payments purported to be made to any other person, such other person may bring a civil action for damages against the person so filing such return.

There are a surprising number of interesting legal issues that spin off this provision. One of the issues concerns whether the statute provides a remedy for someone who is truly an employee but is treated as an independent contractor and who then receives a 1099-MISC rather than a W-2. The cases are split, some saying that the statute only provides a remedy when an improper amount is reported, and other courts holding that the statute provides a remedy for any fraudulent action in connection with the information return, including filing the wrong form. Another key issue that the courts are wrestling with is whether liability is limited to the person who was required to file the information return under federal law. For example, some courts have declined to find personal liability if the filer was not the party required to file the information return. See e.g., Vandenheede v. Vecchio, a 2013 case from a federal district court in Michigan declining to hold liable two co-trustees who prepared and caused a false information return to be filed on another’s behalf.

This takes us to a case from last year that I read as I prepare the updates for the next round of the treatise. The case is Czerw v Lafayette Moving and Storage. In the case, a federal district court in NY considered the claims of Joseph Czerw, who worked over twenty years as a mover for the same employer. In prior years, Czerw received W-2s and was treated as an employee, which was consistent with his actual arrangement with the employer. In 2015 his employer had major financial difficulties, with checks bouncing. Unlike in past years, when he got W-2s, for that year Czerw received a 1099-MISC for over $5,000. Not only was the information return the wrong type, but Czerw had only been paid about $4,000. Even though Czerw contacted his employer to get him to treat him as an employee and reflect the proper amount he was paid, his employer declined to fix things.

Czerw sued his corporate employer and Matthew Ferrentino, the corporation’s sole owner and president, alleging that his employer and Ferrentino had actual knowledge that a W-2 form was the correct form to submit and that the 1099-MISC reflected the wrong amount he received. Czerw alleged that the defendants willfully, purposely, and fraudulently filed the false Form 1099-MISC as part of a scheme “to defraud state and federal taxing authorities . . . by lessening [] Lafayette’s tax obligations and the amount of its worker’s compensation insurance premiums.” The complaint sought $5,000 in damages—the statutory amount provided in the absence of actual damages or discretionary legal fees.

The defendants defaulted, but before the court granted damages it had to explore whether the statute provided for relief in Mr. Czerw’s situation. The first issue the court considered was whether liability extended not only to the corporation but also to Ferrentino individually. The order briefly explores the split in cases on the issue, and lines up squarely with the cases that extend liability “on any person who willfully causes a fraudulent information return to be filed.” Thus it found that Ferrentino in his individual capacity was also potentially on the hook for damages.

As to whether section 7434 can be used in misclassification cases in the absence of an incorrect amount reported, the order notes that the law is developing on this issue. The court was able to avoid coming down on any side because the 1099-MISC that was filed overstated the amount that Czerw received:

As Plaintiff concedes, however, some courts have held that “§ 7434(a) creates a private cause of action only where an information return is fraudulent with respect to the amount purportedly paid to the plaintiff.” Liverett v. Torres Advanced Enter. Solutions LLC, 192 F. Supp. 3d 648, 653 (E.D. Va. 2016) (emphasis added). Under that interpretation, the statute “provides no remedy for a person incorrectly classified as an independent contractor.” Tran, 239 F. Supp. 3d at 1298. But because Plaintiff alleges that the Form 1099-MISC incorrectly states the amount paid to him, the second element is satisfied regardless, and the Court need not address whether the alleged misclassification supports a claim under § 7434.

Conclusion

Employee misclassification is a major issue. Employers who misclassify employees are failing to provide unemployment insurance and workers’ compensation. Those employers can also leave workers with large employment tax liabilities. Advocates who work in this field have Section 7434 as a possible mechanism to ensure fair treatment for workers and punish those who do the wrong thing. The Czerw order is helpful but as briefly reflected in this post there are some key legal issues that await further development.

 

 

 

 

 

 

Tax Court Judicial Conference Kicks Off Tonight: A Brief Take On Exotic Jurisdiction

Keith and I are both in Chicago to attend the Tax Court’s Judicial Conference. I am looking forward to seeing some old friends and colleagues, attending panels on a range of topics, and speaking on a panel with Keith, Nina Olson and Judge Peter Panuthos about the role that taxpayer rights play in representing taxpayers.

One of the panels I will attend is called “A Trip Through the Tax Court’s Exotic Jurisdiction.” I am especially looking forward to that, as I have been writing lately about the role that administrative law generally and the APA in particular plays in cases that are not traditional deficiency cases. Last week in updating the Saltzman Book treatise as part of our regular three times a year update I have revisited Kasper v Commissioner, a case we on PT discussed briefly when it came out and which is one of the more interesting procedure cases of the past year. As readers may recall, that case held that the standard of review in whistleblower cases is arbitrary and capricious and the scope of that review is limited to the administrative record.

In reaching its conclusion, Kasper revisits and places in context the Tax Court’s approach in other cases that are not traditional deficiency cases. Tax procedure can be complex enough when dealing with straightforward deficiency cases (consider for example the Borenstein case that PT discussed which Keith and Georgia State Tax Clinic Director Ted Afield have just filed an amicus brief that looks at an odd situation when a taxpayer filed an original return with a refund claim just prior to filing a petition). Congress over the past few decades has added to the Tax Court’s basket a number of other types of cases, including the whistleblower provisions Kasper addressed, CDP which 20 years on still presents a steady stream of tough issues (see Lavar Taylor’s latest guest posts on alter egos) and the rules relating to employment tax determinations under Section 7436.

All of this is preface for a recent Program Manager Technical Advice  that discusses the limits of Section 7436. Readers may recall that 7436 provides that the Tax Court has jurisdiction to determine in employment tax audits whether someone is properly classified as an employee or whether the employer is entitled to so-called 530 relief (essentially a safe harbor allowing escape from liability if certain conditions are satisfied). There have been a bunch of interesting procedural issues spinning off 7436; for example I discussed last year the Tax Court order that concluded that Section 7436 did not provide it jurisdiction to determine whether an S corp’s wages were artificially low:

Section 7436(a)(1) only confers jurisdiction upon this Court to determine the “correct and the proper amount of employment tax” when respondent makes a worker classification determination, not when respondent concludes that petitioner underreported reasonable wage compensation, as is the case here.

The PMTA involves a similar legal issue in a different context. In the PMTA, the IRS considered a non-US corporate taxpayer with a US Sub. The overseas parent sent its employees into the US to provide computer and engineering services to US clients. The overseas parent paid the employees for the engineering and computer work they did in the US. The overseas parent did not withhold on the payments it made to its employees for the work those employees performed in the US, essentially arguing that it was not engaged in business in the US and was able to rely on statutory and regulatory exceptions on overseas employers who have temporary employees working in the US and who earn limited salaries (while some treaties have specific rules on this the PMTA indicates that the parent resided in a jurisdiction that did not have a treaty with the US).

IRS examined and concluded that the parent should have withheld on the wages that were paid to its employees. The PMTA concludes that its conclusion regarding the withholding liability would not be a determination under 7436 and the parent was not entitled to go to Tax Court:

[T]here is no dispute that the [nonresident alien(NRA) parent corp] performing computer and engineering services on behalf of the foreign corporation are employees, that the services were performed within the United States, and that such NRAs received compensation from the foreign corporation for those services. Rather, the foreign corporation is asserting that it is not liable for income tax withholding because it was not engaged in a trade or business within the United States. This argument is not based on a position that the NRAs are not employees. Thus, there is no actual controversy over the worker classification of the NRAs. Rather, the foreign corporation’s disagreement is premised on the position that the NRAs are employees, but that because the employees worked for a foreign corporation while temporarily in the United States and were compensated less than a threshold amount the foreign corporation did not have a trade or business within the United States

Conclusion

Of course the IRS does not get to decide the contours of the Tax Court’s jurisdiction but as the PMTA discusses IRS employment tax audits can raise issues not squarely within the language of 7436. Absent Tax Court jurisdiction, taxpayers can get court review in the federal district courts or the Court of Federal Claims. That comes after assessment, and some payment of the tax, triggering other issues and perhaps more litigation costs.

NTA’s Reaction to Today’s Post on Misclassified Workers

Keith’s post this morning referenced the National Taxpayer Advocate Nina Olson’s blog post discussing the Mescalero case; her office reached out to us to provide some additional information that she had intended to share in a future blog post of her own.  Below is the latest, straight from the NTA:

After my blog posted, an analyst from TEGE contacted my senior research advisor, asking how we had come up with the estimate that it took only 1 or 2 hours to identify the workers and their tax payments.  My research advisor explained that there is a systemic way of searching and compiling the records.  Apparently the IRS had been searching each worker’s record manually, which took hours and hours…..This made me feel very sad, because clearly this analyst cared deeply and wanted to do the right thing.

It appears to me that the CCA may have been driven by the IRS’s concerns that is it “did not have the resources” to do these manual searches.  My office has committed to working with TEGE to show them how to do systemic searches, and then my office will go back to Chief Counsel and ask them to reconsider its CCA.

What is most disturbing about all this is that no one took seriously enough the taxpayer’s right to pay no more than the correct amount of tax, such that someone would think to explore whether there was a systemic way to pull this information.  This shows that there is still much work to do to embed the Taxpayer Bill of Rights in every aspect of IRS activity.

Thanks to the NTA for reaching out to Procedurally Taxing, and allowing us to publish her views.

For an index to all of the NTA’s blog posts see here

The NTA plays an important role in highlighting when tax administration neglects to take into account fundamental taxpayer rights, as well as highlighting ways that tax administrators can embrace and promote those rights.

Relatedly, the NTA is convening the third international taxpayer rights conference in the Netherlands on May 3rd and 4th. I attended the first two conferences, and I learned a great deal about tax administration generally and how other countries (and the US) are faring in incorporating taxpayer rights into all facets of tax administration. Information about the conference, including an agenda and registration, can be found here.

Misclassification of Workers and its Aftermath

Last spring we reported on the Tax Court decision in Mescalero Apache Tribe v. Commissioner, 148 T.C. No. 11 (2017), in which the Tax Court determined that the taxpayer could obtain information about tax reporting by its former employees. The tribe did not classify these individuals as employees during the period of employment; however, the IRS determined that the individuals who worked for the tribe were employees and not independent contractors. Where an employer has misclassified its employees, the employer is liable for certain taxes that would have been paid through proper withholding of employees unless the employer can show that the employees paid the taxes.

The tribe tried to track down the employees to determine if they properly reported the taxes. It could not reach most of them and sought through discovery in Tax Court to find out from the IRS whether the employees paid. The IRS resisted citing the disclosure provisions; however, the Tax Court ordered the IRS to turn over information which would allow the tribe to calculate its liability after taking into account the employee payments. This post is about the rest of the story because, not too long after the opinion came out, the IRS issued CCA 201723020 limiting the scope of the opinion in the view of Chief Counsel’s office. For those interested in this issue, you should also look at the blog post by the National Taxpayer Advocate on this subject.

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The CCA takes the position that a taxpayer that has misclassified employees cannot obtain information about the employees from Exam or Appeals but can only obtain the information through the discovery process in court. In a resource starved agency, it seems counterproductive to drive taxpayers into court just to obtain information that will allow the taxpayer to determine the correct liability. No one has this information other than the IRS and the individual employees who are typically scattered to the wind. If the misclassification only involves one or two employees, maybe the employer can readily find the misclassified employees; however, if the number of employees is substantial the employer will almost certainly encounter problems tracking down the all of the employees at the time of the misclassification. The CCA will cause employers in these larger cases to petition the Tax Court just to use discovery.

The opinion provides that:

“It is important to note that the court’s determination that the workers’ return information was discoverable was based largely on the representation by the Tribe that it has already made a significant effort to locate the workers and that it had failed only with respect to a relatively small number.  It is also important to note that IRC 6103(h)(4) authorizes disclosure, but does not require it; thus the court’s determination that the workers’ return information “is disclosable under section 6103(h)(4)(C)” does not create a requirement that the Service disclose the information.

Thus, Mescalero does not stand for the proposition that taxpayers and/or their representatives are entitled to workers’ return information during the conduct of an employment tax audit or at the Appeals consideration level. Instead, the Mescalero decision is limited to discovery requests made by a taxpayer during the pendency of a Tax Court proceeding, where the Tax Court has the ability to determine hether the requested information is disclosable pursuant to IRC 6103(h)(4), AND has balanced the relevancy of the requested information against the burden placed on the Service pursuant to Tax Court Rules 70(b) and 70(c).”

Since section 6103(h)(4) permits disclosure, it seems a better way may be to give the information to taxpayers at the examination level but charge them for the cost of obtaining the information so that the IRS is not the loser in this situation. Charging a reasonable search fee allows the taxpayers to obtain the information early in the process, saves resources of both parties inherent in the use of Appeals and the Tax Court. The decision expressed in the CCA makes a loser out of everyone when a much easier solution seems available. The National Taxpayer Advocate is rightfully critical of the decision in her blog post. Once the attorneys in Chief Counsel’s office opine that the decision to disclose is up to the IRS and not barred by section 6103, the door is open for the IRS to make a reasonable decision. The path suggested in the CCA should be ignored by those entrusted to administer the law.

 

 

Designated Orders: 10/30/17 to 11/3/2017

Kansas Legal Services Direcor William Schmidt summarizes the Tax Court’s designated orders for the week ending November 3. The meatiest of the orders considers the limits of Tax Court jurisdiction in cases that involve reasonable compensation audits of S Corporations, an issue that is getting a significant amount of Service attention. Les

In this light week of designated orders from the Tax Court, we have Respondent’s motion granted regarding their stipulation of facts pursuant to Rule 91(f) (Order Here) and a duplicative pretrial memorandum stricken from the record (Order Here). Two other orders have further analysis below.

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Continuance and a Remand

Docket # 16277-16 L, Kevin J. Mirch & Marie C. Mirch v. C.I.R. (Order Here).

This collection due process case was calendered for trial on November 13 in San Diego, California. Respondent filed both a motion for continuance and a motion for remand on October 26. The Court granted both motions.

In granting the first motion, the case was stricken from trial on the November 13 docket. In granting the second motion, the case is remanded to the IRS Office of Appeals for further consideration. The IRS is further ordered to offer Petitioner an administrative hearing at the Appeals Office located closest to Petitioner’s residence (or a mutually agreed location) at a mutually agreed date and time no later than January 30, 2018. It is further ordered that the parties shall file status reports no later than March 5, 2018.

I would speculate if there was cause for concern by the IRS to remand this collection due process case rather than go forward with litigation before the Tax Court.

No Determination – No Jurisdiction

Docket # 12528-17S, Mas Construction Service LLC v. C.I.R. (Order of Dismissal for Lack of Jurisdiction Here).

During tax years 2012 and 2013, the Petitioner was an S corporation operating as a construction company. Mark A. Sauerhoefer was the sole owner and sole officer of the S corporation. His treatment under the S corporation was as an employee with $4,500 as W-2 wages in 2012 and $8,550 in 2013. On December 22, 2014, Respondent sent Petitioner a letter informing it that the Employer’s Quarterly Federal Tax Return (Form 941) and Employer’s Annual Federal Unemployment Tax Return (Form 940 – FUTA) were selected for examination for the tax years in question. On May 22, 2015, Respondent sent initial examination results to Petitioner, focused on Mr. Sauerhoefer’s amount of reasonable wages. Petitioner responded with a letter contesting those findings. On July 2, 2015, Respondent sent a letter to Petitioner explaining the findings with an included Form 4668, Employment Tax Examination Changes Report. The report concluded Petitioner failed to report reasonable wage compensation for Mr. Sauerhoefer for the tax years at issue, proposed he should have reported $40,000 in annual wages during those years, and concluded that Petitioner was liable for proposed employment tax increases, additions to tax under IRC sections 6651(a)(1) and (2) and penalties under section 6656. In response, Petitioner sent several emails and a letter contesting the amount of reasonable compensation. On May 11, 2016, an informal Appeals hearing was held where Petitioner continued to raise the reasonable compensation issue. On February 8, 2017, the Appeals Office sent a settlement offer letter to Petitioner that Petitioner did not accept. Respondent did not issue to Petitioner a notice of determination of worker classification for the tax years. On June 5, 2017, Petitioner filed a petition with the Tax Court, stating the “taxpayer disagrees with wages determined for 2012-2013 by the IRS and employment taxes assessed.”

On September 15, 2017, Respondent filed a motion to dismiss for lack of jurisdiction on two grounds. The first count is that no notice of determination of worker classification, as authorized by IRC section 7436 to form the basis for a Tax Court petition, was sent to Petitioner. The other count is that no other determination was sent from the Respondent to Petitioner that would grant Tax Court jurisdiction. On October 6, 2017, Petitioner filed a notice of objection to the Petitioner’s motion.

In the discussion of this case, Judge Armen states that Petitioner consistently treated Mr. Sauerhoefer as an employee during the tax years at issue. As a result, Respondent did not make a determination that he was an employee, but rather concluded that Petitioner failed to report reasonable wage compensation. As IRC section 7436(a)(1) confers jurisdiction on the Court to determine the “correct and proper amount of employment tax” when making a worker classification determination, not when concluding that Petitioner underreported reasonable wage compensation as occurred. Footnotes 3 and 4 discussed 7436(a) and 7436(a)(2), respectively, and help bring Judge Armen to the conclusion that Respondent did not make any determinations under 7436(a)(1) or (2). The Court granted the motion to dismiss because the Tax Court lacked jurisdiction over the case as Respondent never made any determination of worker classification and did not make a determination regarding relief under section 530 of the Revenue Act of 1978.

Footnote 5, however, notes that this is not the end of the story. Mr. Sauerhoefer is also an individual petitioner of the Tax Court with docket number 12527-17S, on the Tax Court calendar for the Atlanta, Georgia trial session that begins February 26, 2018. The notice of deficiency attached to the petition in that case states Respondent “determined that your compensation from Mas Construction is $40,000 per year rather than the $4,500 and $8,500 as reported on your returns for the taxable years ending December 31, 2012 and December 31, 2013, respectively”. Mr. Sauerhoefer is thus able to make his arguments to the Tax Court in February 2018 about how reasonable the compensation truly was.

Takeaway: While the S corporation did not have a notice of determination, Mr. Sauerhoefer had a notice of deficiency. Since the notice is necessary for Tax Court to have jurisdiction under the petition, one case survives by having that essential element.

Tax Court Holds It Does Not Have Jurisdiction to Consider Reasonable Salary Determination in Exams of S Corps

Last month in Financial Consultant Fails To Avoid Self-Employment Tax With S Corp Structure we discussed the possible ways that service-performing employee/shareholders in S Corps can minimize employment taxes. IRS is aware of the abuses in this area and seems to be looking carefully at S Corps that are profitable and pay what it thinks are low wages to those key employee/shareholders.

In the last few weeks there have been some interesting Tax Court orders considering a jurisdictional issue spinning from IRS audits of S Corps and their shareholders.

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First some background.

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.

The scheme minimizes employment tax obligations by essentially paying below market wages to the S Corporation’s shareholder/employee; cash still comes out to the shareholder/employee in the form of other distributions.

As part of an IRS audit, IRS will examine the S Corp’s return and analyze the reasonableness of the salaries. If IRS thinks the wages are not high enough, it will send the S Corp a Form 4668, Employment Tax Examination Changes Report, which can propose what it thinks the reasonable salary is and thus propose employment tax increases (as well as penalties). Interestingly, this is the reverse of old reasonable compensation cases where C Corp shareholder/employees would pay themselves a salary that IRS argued was too high. As Keith notes and based on his experience in litigating a couple of those older reasonable compensation cases (see, e.g., Royal Crown v Comm’r) these are time-consuming to litigate and, as with many valuation cases, often involve expert testimony.

As a substantive matter, the key inquiry should be whether the payments that the shareholder received that were not labeled as compensation were remuneration for services. Not surprisingly, comparables are key, and IRS will look to industry and regional standards.

This brings us back to the procedural issues.

In response to the IRS issuing an Employment Tax Examination Changes Report (Form 4668) some S Corps have filed petitions to Tax Court to attempt to get the Tax Court to consider the reasonableness of the salaries.

Employment taxes are generally not subject to the deficiency procedures. The Tax Court has jurisdiction under Section 7436 to consider proceedings relating to determinations of an individual’s employment status. (Lavar Taylor has discussed this provision extensively in his series of posts considering the SECC v Commissioner case).

Even though the S Corps are not getting a notice of deficiency in a couple of recent cases they have essentially claimed that the IRS’s adjustments to the salaries that the corps paid to its shareholders are determinations for purposes of Section 7436.

The Tax Court has disagreed stating that the IRS adjustments have nothing to do with a determination of employee status but only relate to the amount of salary that should have been paid to someone who the parties already agree is an employee.

To that end, see the discussion in Azarian v Commissioner, involving a S Corp that operated a law firm and had a sole shareholder, where the Tax Court granted the IRS’s motion to dismiss on the grounds that it did not have jurisdiction:

Petitioner consistently treated Mr. Azarian as an employee for the taxable periods at issue. Therefore respondent did not make a determination that Mr. Azarian was an employee of petitioner, but rather concluded that petitioner failed to report reasonable wage compensation paid to Mr. Azarian for 2012-14. Section 7436(a)(1) only confers jurisdiction upon this Court to determine the “correct and the proper amount of employment tax” when respondent makes a worker classification determination, not when respondent concludes that petitioner underreported reasonable wage compensation, as is the case here.

The Tax Court took a similar approach in Arroyo Corp v Commissioner, also an S Corp exam looking at the reasonableness of salaries to shareholder/employees, where it stated that while the IRS made a determination with respect to the amount of the compensation, that was insufficient to generate jurisdiction under Section 7436.

Conclusion

S Corps wishing to challenge the IRS on these issues will likely have to go the refund route, though given the divisible nature of employment taxes those corporations need not fully pay any proposed liability. The Tax Court has closed one door though it is possible that a CDP proceeding could allow a taxpayer to challenge the liability, though that issue spins off other procedural issues, including whether the S Corp had a prior opportunity to challenge the liability. That issue is subject to considerable uncertainty, though last week’s Tenth Circuit opinion in Keller Tank v Commissioner sustained the Tax Court and IRS’s restrictive approach to the definition of prior opportunity (stay tuned as we will blog that case this week).

Tip of the hat to our hard-working blogging colleague Lew Taishoff, whose blog on the Tax Court brought these recent orders to my attention.

 

 

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.