TIGTA Report Highlights Major Compliance Issues When Businesses Fail to Pay Salaries to Sole Shareholder S Corporations

We mostly stick to procedure on this blog. So we do not often talk about the taxation of entities. But most of us, even true procedure folks know that S corporations generally do not pay federal income tax on their profits. Instead, the profits flow through to shareholders and are not subject to self-employment taxes. This creates the incentive for shareholders to minimize or even fail to pay any compensation for service-providing S Corps. The savings for S Corps who fail to pay reasonable or in some cases any compensation means that there is a hefty amount of owed Social Security and Medicare taxes that the fisc misses out on (and I leave aside any 199A issues that create further incentives for S corps and their service performing shareholders to avoid or minimize salaries).  

A recent TIGTA report highlights the problem. While IRS has made employment taxes a priority, TIGTA notes that IRS selects few S corporations for examination.  On top of that, “when the IRS does examine S corporations, nearly half of the revenue agents do not evaluate officer’s compensation during the examination even when single-shareholder owners may not have reported officer’s compensation and may have taken tax-free distributions in lieu of compensation.”

This is bad news.  The study looked at a few years of S Corp returns and noted that some really profitable S Corps with only one shareholder pay absolutely no compensation:

TIGTA’s analysis of all S corporation returns received between Processing Years 2016 through 2018 identified 266,095 returns with profits greater than $100,000, a single shareholder, and no officer’s compensation claimed that were not selected for a field examination. The analysis found that the single-shareholder owners had profits of $108 billion and took $69 billion in the form of a distribution, without reporting they received officer’s compensation for which they would have to pay Social Security and Medicare tax. TIGTA estimated 266,095 returns may not have reported nearly $25 billion in compensation and may have avoided paying approximately $3.3 billion in Federal Insurance Contributions Act tax.

As TIGTA notes, there are many cases that hold that shareholder-employees are subject to employment taxes even when shareholders take distributions, dividends, or other forms of compensation instead of wages. The substantive rules require that S Corp shareholders performing services are to take reasonable salaries.  For some of these cases, see Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. 141 (2001). Joly v. Commissioner, T.C. Memo. 1998-361, aff’d by unpub. Op., 211 F.3d 1269 (2002). Joseph M. Grey Public Accountant, P.C. vs. Commissioner, 119 T.C. 121 (2002). David E. Watson, PC vs. U.S., 668 F.3d 1008 (8th Cir. 2012).

Reasonable compensation cases have been around for many decades.  It used to be that the reason for the cases was the flip side because solely owned companies wanted to pay a high salary in order to avoid the problem with dividends.  So, companies with lots of assets would structure their compensation to the executives to avoid having any money left over for dividends and avoid the tax on leaving excess profits in the corporation.

To get to a court case is labor intensive, though for sure in any situation with zero compensation it would be fairly easy for the government to prove that there should be some deemed compensation. S Corp audits are handled in the field. For FY 2017-2019 there were about 5 million S corp returns filed. The audit coverage ranged from a high of 12,169 in FY 2017 to a low of 9,556 in FY 19, with coverage ranging from .2% to .3%.  TIGTA notes that many of the audits failed to even raise the issue of officer compensation. While IRS should audit more and do a better job targeting the issue, I wonder if there needs to be a statutory fix that requires or perhaps presumes some minimum salary that is pegged to earnings. Any legislative fix should consider how to minimize the burdens both to the IRS and taxpayers and remove the temptation for businesses to play the lottery.

As Keith notes, there is a long-term cost to not paying a salary which is that the owner is not building Social Security credits.  So, their social security upon retirement could be significantly less than it would have been otherwise if this goes on for a long time.  While there is a back end savings to the government that may not be reflected in the loss figures that may be much less than the costs to the government relating to the foregone employment taxes.

Designation of Payment in Payroll Tax Cases

We have not written about designation of payment in a long time.  Early in the life of the blog we had two posts on the topic which you can find here and here.  Designation of payment for any type of tax could have important consequences for the taxpayer and save lots of money.  For taxpayers who owe employment taxes, or any trust fund tax, or for responsible persons regarding those trust fund taxes, the issue of designation becomes more critical to a successful plan to limit liability.

The IRS allows taxpayers to designate the liability to which a payment is posted if the taxpayer or the person making the payment follows the correct steps.  Policy Statement 5-14 (found at IRM 1.2.1.6.3) sets out the basic policy governing designation of payments.  Essentially, the taxpayer, or the person making the payment, needs to clearly state the liability by tax type and period as well as describe what portion of the liability the person intends to pay, e.g., tax, penalty, or interest.  If properly designated, the IRS will take the funds and apply them in the manner requested by the taxpayer.

read more...

Why does it matter which taxes get paid and what happens if a taxpayer makes a payment and does not designate?

It matters because sometimes a taxpayer owes different types of taxes and sometimes the taxpayer owes for several periods. 

Different taxes – Payroll taxes provide a good example of different types of taxes.  While you might lump payroll taxes together as one tax, it has different components.  Some of the payroll tax is owed because of the trust relationship created by the taxpayer when it withheld taxes from a third party for purposes of paying that tax over to the IRS.  Another part of the payroll tax is the taxpayer’s liability as a party making payroll to pay for the employer’s portion of payroll taxes.  Generally speaking, a payroll tax return (Form 941) will have three separate bases for liability.  Two are based on the trust relationship and stem from the money withheld from the employee to pay 1) income taxes and 2) Social Security and Medicare taxes.  The third portion of the payroll tax liability stems from the direct liability of the taxpayer to pay the employer’s portion of Social Security and Medicare taxes.

Different tax years – A taxpayer might owe income taxes for 2020, 2018, 2016 and 2014.  Attached to each of the income tax liabilities will also likely be interest and penalties.

If the taxpayer owing payroll taxes is Acme, Inc. and Acme’s owner is John, John faces a trust fund recovery penalty for which he has personal liability with respect to the unpaid trust fund portion of Acme’s payroll tax liability.  John cares deeply that Acme satisfy the trust fund portion so that he does not face a personal assessment of that liability.  He may also care about the employer portion of the payroll tax liability if he wants to keep Acme going, but his main concern derives from fear of personal liability.  If Acme has limited funds with which to pay the taxes or John has limited funds to contribute to Acme to pay the payroll taxes, John wants to ensure that the payments apply to the unpaid trust fund portion for which he has personal liability.  Only after the taxpayer penalties and interest of that portion of Acme’s liability is satisfied can he breathe easy regarding his personal liability.

If Acme or John, on behalf of Acme, makes a payment on the payroll tax liability and says nothing, the IRS will apply the payment to the non-trust fund portion of Acme’s liability first until it satisfies that portion.  By doing so, the IRS preserves the greatest possibility for it to collect additional dollars since it can go after either Acme or John on the trust fund portion but can only go after Acme on the non-trust fund portion.  The failure to make the designation could have significant negative consequences for John.

If Bob is the taxpayer owing income taxes for different years, he too might care about which of the four years to which the IRS applies his payment.  In most situations, the IRS will have assessed the earlier tax periods first, which means the statute of limitations on those periods will run first.  If the taxes for these four years were reported on timely filed tax returns, Bob’s 10-year statute of collection would run from about April 15, 2015 for the 2014 liability to April 15, 2021 for the 2020 liability.  The 2014 has less than four years to run before it expires while the 2020 liability has almost 10 years left.  Additionally, should Bob go into bankruptcy, the 2014 and 2016 liabilities would be classified as general unsecured claims which might be dischargeable with no payments made while the 2018 and 2020 would be excepted from discharge if a bankruptcy petition were filed at this time.  So, Bob has an incentive to designate his payments to the more recent periods, allowing the older periods to disappear more quickly due to the statute of limitations on collection or due to the bankruptcy discharge.  If Bob sends money to the IRS and says nothing, the IRS will almost always apply the money to the oldest period, first to taxes, then to penalties and then to interest.  Once the oldest period is paid, the IRS will almost always move to the next oldest period and again apply the payment to taxes, then penalties and then interest and so on until the liability is paid in full.  By applying the payment to the oldest periods first the IRS generally preserves the longest period of collection on the remaining liabilities and reduces the liabilities susceptible to discharge in bankruptcy.

In CCA 2019110508593544, IRS Chief Counsel gives brief advice on the issue of designation.  It states:

[A] question was raised about whether a taxpayer can designate the payment allocation when the taxpayer makes a quarterly federal tax deposit, attributable to a specific payroll, or whether the payment must be applied in the best interests of the government. Please share the response below with your staff.

A taxpayer is permitted to designate a voluntary payment, but in order for such designation to be proper the request or designation for the application of the payment must be specific, in writing, and made at the time of the payment. A taxpayer has no right of designation of payments resulting from enforced collection measures.

If a taxpayer submits a voluntary partial payment when there are assessments for more than one taxable period, and does not provide specific written instructions as to the application of the partial payment, then the payments will be applied in a manner serving the best interests of the government. The payment will generally be applied to satisfy the liability for successive periods in descending order of priority until the payment is absorbed and is applied to non-trust fund taxes first.

Pursuant to Policy Statement 5-14 (found at IRM 1.2.1.6.3), to the extent partial payments exceed the non-trust fund portion of the tax liability, they are deemed to be applied against the trust fund portion of the tax liability (e.g., withheld income tax, employee’s share of FICA, collected excise taxes). Once the non-trust fund and trust fund taxes are paid, the remaining payments will be considered to be applied to assessed fees and collection costs, assessed penalty and interest, and accrued penalty and interest to the date of payment.

For more information, see the following resources:

Rev. Proc. 2002-26, 2002-1 C.B. 746
Salazar v. Comm’r, 338 Fed. Appx. 75, 79 (2d Cir. 2009) (and cases quoted therein)
IRM 5.7.4.3
IRM 8.25.2.4.4

If you represent a taxpayer in a situation in which paying one tax period or one type of tax provides an advantage over letting the IRS choose the application of payment that most benefits it, you should make a clear designation with your payment.  In addition to describing the designation in the cover letter forwarding the check, you might also consider making note of the designation on the check itself in the notes section.

Taxpayers can only make a designation when they make a voluntary payment.  Involuntary payments such as payments pursuant to a levy, pursuant to a sale, pursuant to a bankruptcy distribution, or other similar situations in which the money comes to the IRS from a source other than the taxpayer do not offer the benefit of the opportunity to designate.  This can provide a good reason for the taxpayer to make a payment rather than to wait for the IRS to take the money through some form of collection action.

SECA and the Limited Partner Exemption Again

Monte Jackel, Of Counsel at Leo Berwick, discusses the absence of guidance or a legislative solution concerning self employment tax for a partner’s income derived from services performed as a partner on behalf of the partnership. As Monte discusses, the issue prompted proposed regulations and a Congressional backlash over two decades ago. Since then, neither Congress or IRS has had the appetite to address this issue on a systemic basis.  Les

Section 1402(a) of the Internal Revenue Code defines the term “net earnings from self-employment” as including the taxpayer’s distributive share of income or loss under section 702(a) from any trade or business carried on by a partnership of which the taxpayer is a member. However, section 1402(a)(13) excludes the distributive share of a limited partner from self-employment tax other than guaranteed payments to the limited partner for services rendered. Neither the statute nor any final or temporary regulations defines the term “limited partner” for this purpose.

The situation has cried out for regulations with respect to who is a “limited partner” for SECA purposes for over two decades now. Proposed regulations were issued in 1994 and reissued in 1997. Both sets of regulations were never finalized and prompted adverse Congressional reaction. There was a Congressional moratorium on finalizing the 1997 proposed regulations until July 1, 1998. That date has come and passed with no further IRS regulation activity. The 1997 proposed regulations can, however, be relied upon by taxpayers but cannot be enforced by the IRS against them. 

read more...

In Renkemeyer (136 T.C. 137 (2011)), the taxpayers, lawyers in a Kansas limited liability partnership law firm, argued that their distributive share of law firm income [post 1997] was not subject to SECA because the taxpayers were limited partners who enjoyed limited liability under applicable state law despite actively performing legal services on behalf of the partnership. The Tax Court rejected this contention, noting that a limited liability partnership is merely a general partnership where the members have limited liability. The court summarized the situation this way:

As of 2005 Congress had not issued any other pronouncements [referencing the 1997 proposed regulations] with respect to the definition of a limited partner for purposes of the self-employment tax, nor had the Secretary. We therefore are left to interpret the statute without elaboration…. “Limited partner” is a technical term which has become obscured over time because of the increasing complexity of partnerships and other flowthrough entities as well as the history of section 1402(a)(13). We therefore must look to the legislative history for guidance…. [T]he intent of section 1402(a)(13) was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership’s business operations (which was the archetype of limited partners at the time) would not receive credits toward Social Security coverage. The legislative history of section 1402(a)(13) does not support a holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons), from liability for self-employment taxes….  [I]t is clear that the partners’ distributive shares of the law firm’s income did not arise as a return on the partners’ investment and were not “earnings which are basically of an investment nature.” Instead, the attorney partners’ distributive shares arose from legal services they performed on behalf of the law firm.”

It is true that Renkemeyer has expansive language in it, quoted above, to treat a partner as not being a limited partner for SECA purposes when his income is derived from services performed as a partner on behalf of the partnership. However, it is also true that unless the Congress finally acts on the SECA issue as part of the current administration’s priorities, the IRS will be either forced to litigate the issue until it is resolved by enough courts to conclude on this issue, or it will have to muster up the political courage and finalize the 1997 proposed regulations. 

Should the IRS be allowed to effectively enforce the 1997 proposed regulations through audit and litigation in the courts and never risk political outrage again by the Congress if it comes to it? Is that the way the IRS should be administering the tax law, playing political games with the tax system and expending government resources to litigate cases that would not have arisen if the 1997 proposed regulations had been finalized? I think the answer is a clear and resounding no. 

Offset – Whose Funds Does the IRS Hold

In the recent case of Laird v. United States,  (5th Cir. 2019) the court addressed the issue of whether the IRS could offset an overpayment resulting from an attempted designated payment.  The Fifth Circuit distinguished earlier circuit precedent that the IRS could offset extra money that a taxpayer sent by creating a rule that the IRS can only do so when it applies the extra money to the tax account of the person remitting the money.  The rule makes sense but here the facts get muddy.

read more...

If you have never represented someone who might have the trust fund recovery penalty (TFRP) assessed against them, you might wonder why one taxpayer would pay the taxes of another.  Sure, there are many good and generous people in the world and we are in the giving season, but still, the payment of someone else’s taxes is not a customary holiday gift nor an ordinary act at any time of the year.  The picture becomes clearer when the TFRP enters the picture.  Let’s look at a typical fact pattern.

Corporation A builds buildings.  It has 20 employees.  Business has been slow, but it expects a turnaround at any time.  Corporation A has a cash flow problem.  To get it through the lean times, it looks for ways to conserve cash.  One way it decides to do this is to pay its employees their salaries, otherwise they will walk, but to hold off on paying the IRS the withheld taxes and the employer’s share of FICA.  Corporation A anticipates that it will soon have a contract that will allow it to make the tax payments and has no intention of stiffing the IRS.  Unfortunately, the business downturn lasts longer than it anticipates, and some of its accounts do not pay on time.  The unpaid taxes build up for several months at which time a friendly revenue officer appears at the door of Corporation A to demand payment, or levies will occur and the responsible officers will have the TFRP assessed against them pursuant to IRC 6672.

An officer of Corporation A, Bob, decides that the best thing to do in order to avoid the consequences of non-payment of the taxes is to pay them himself.  He sends the IRS a check for the unpaid taxes and designates on the check how the funds should be applied.  Unfortunately, he miscalculates the amount of debt that brought the revenue officer to the door of Corporation A and he sends a check for too much.  While it does not happen too often that a corporate officer sends in too much in this situation, it does happen, and it did happen in the Laird case.

The IRS knew what to do with the extra money.  It applied the funds to another debt of Corporation A which had not yet reached the hands of the revenue officer or it applied the debt to the non-trust fund portion of Corporation A’s outstanding liability.  Bob did not intend to pay the non-trust fund portion of Corporation A’s debt because he had no personal liability for this debt.  He only sought to pay the trust fund portion.  He requests that the IRS return to him that portion of the check which overpaid the liability he sought to satisfy.  The IRS argued that it had the right to offset this money against other debts of Corporation A.

In the case of United States v. Ryan, (11th Cir. 1995), the Eleventh Circuit answered the question in this case by holding that the IRS could keep the extra amount of a check sent in with a specific designation; however, in Ryan the taxpayer sending the check was the same taxpayer who owed the money.  In Laird the person sending in the money, like Bob, is not the taxpayer.  The entity, like Corporation A, is the taxpayer.  The Fifth Circuit holds that this distinction makes a difference.  Here, it holds that the individual (Bob) may require the excess amount be returned to him.  In the case, however, these facts were unclear.  The Fifth Circuit could not tell the true source of the funds.  So, it remanded the case to the district court for a determination of the true payor of the funds.  If the IRS can show that the corporation really paid the funds instead of the individual, then the IRS will be allowed to offset the funds.  If the individual can show that the money was his, then the IRS must return the money to him.

Notes from the Fall 2019 ABA Tax Section Meeting

From October 3 to 5 Les, Christine and I attended the tax section meeting in San Francisco.  We were each on different panels and we each enjoyed a delightful dinner cruise on the bay Friday night courtesy of tax procedure guru, Frank Agostino.  During the cruise the three of us had an in depth discussion with Frank about his latest ground-breaking tax procedure initiatives which we hope to highlight in coming posts.

For this post I intend to provide some of the information passed out during the update sessions in the Administrative Practice and Court Procedure Committees.  For anyone interested in more depth or more precision, it is possible to purchase audio tapes of the committee meetings from the tax section.

read more...

Administrative Practice Committee

The discussion initially focused on Appeals and the Taxpayer First legislation seeking to create a more independent Appeals.  Apart from the legislation, Appeals issued a new conferencing initiative on September 19, 2019.  A request for comments on the new process went out. 

The presenter discussed the change to IRC 7803(e)(5)(A) and the right to a hearing in Appeals.  This change resulted from the Facebook case discussed here.  For those who do not remember the Facebook litigation, Chief Counsel denied Facebook the opportunity for a conference with Appeals after Facebook filed its Tax Court petition — even though Facebook had not met with Appeals prior to filing the petition.  The new provision will make it more difficult to deny a taxpayer the opportunity to meet with Appeals in this circumstance.

Another provision of the Taxpayer First Act, IRC 7803(e)(7)(A), grants taxpayers the right to their file 10 days in advance of a meeting with Appeals.  This provision has some income limitations but will generally benefit the vast majority of individual taxpayers.  It seems like a good step forward, though I would like the file much earlier than 10 days before the meeting, and I have had trouble getting it from Appeals in the past.  Some Appeals Officers (AOs) have denied my request for information in the administrative file, even though taxpayers have always had the right to this information.  If the case is in Tax Court, a Branerton letter to the Chief Counsel attorney will almost always result in that attorney calling the AO to tell the AO to send the material.  If you go to Appeals prior to Tax Court and have no Chief Counsel attorney to make this call, I wonder if the legislation will cause Appeals to take the position that a taxpayer cannot receive the material until 10 days prior to the meeting.  This would be a shame, because meetings are much more productive when parties can properly prepare.

The Taxpayer First Act also made changes to the ex parte provisions, set out in 7803(e)(6)(B), first enacted in 1998 as a means of insulating Appeals from the corrupting influence of other parts of the IRS.  The ex parte provisions were previously off-code but picked up by the IRS in a pair of Revenue Procedures describing how they would work.  The new provision allows Appeals to communicate with Chief Counsel’s office in order to obtain a legal opinion as it considers a matter, as long as the Chief Counsel attorney providing the advice was not previously involved in the case.  I don’t think this changes much.  Rev. Proc. 201218 already allowed attorneys in Chief Counsel to provide legal advice to Appeals.  Maybe this makes it clear that Appeals is not so independent that it cannot receive legal advice when it needs it, but it seemed that Chief Counsel and Appeals had already figured that out — even if some taxpayers criticized Appeals for obtaining legal advice.  Of course, when obtaining advice Appeals needs to seek out someone other than the attorney who was providing advice to Examination, in order to avoid having the attorney be the Trojan horse improperly influencing Appeals.

The panel mentioned Amazon v. Commissioner, 2019 U.S. App. Lexis 24453 (9th Cir. 2019). This is an important transfer pricing case clarifying what constitutes an “intangible” that must be valued and included in a buy-in payment to a cost-sharing arrangement between a parent company and its foreign subsidiary entity. The 9th Circuit panel affirmed the Tax Court, declining to apply Auer deference and holding that certain of Amazon’s abstract assets, like its goodwill, innovative culture, and valuable workforce, are not intangibles.

The committee also discussed Chief Counsel Notice CC-2019-006 “Policy Statement on Tax Regulatory Process” (9-17-2019).  A copy of the complete policy statement can be found here.   Each of the four points is important in its own way.  I find number three to be especially important.  We discussed the notice previously in a post here.

A few recent cases were mentioned as especially important to administrative practice:

Mayo Clinic v. United States, 124 AFTR2d 2019-5448 (D. Minn. 2019) provides the most recent interpretation of Mayo and what it means, in the context of whether Mayo Clinic was entitled to an exemption as an “educational organization” under Treas. Reg. § 1.170A-9(c).

Baldwin v. Commissioner, 921 F.3d 836 (9th Cir. 2019) is a mailbox rule case in which the taxpayer seeks to overrule National Cable & Telecommunications Association v. Brand X Internet Services, 545 U.S. 967 (2005).

Bullock v. IRS, 2019 U.S. Dist. LEXIS 126921 (D. Mont. 2019) is a pre-enforcement challenge to Rev. Proc. 2018-38 which relieves 501(c) organizations of the obligation to disclose the names and addresses of their donors.

Court Practice and Procedure Committee

Robin Greenhouse, who now heads Chief Counsel’s LB&I office, gave the report for Chief Counsel’s office.  She read from her notes and provided no PowerPoint presentation or handout material, so this time I cannot FOIA the PowerPoint presentation to provide the data.

She discussed two financial disability decisions which seems like an interesting place to begin.  First she mentioned Carter, as representative for Roper, v. United States, 2019 U.S. Dist. LEXIS 134035 at( N.D. Ala. 2019) in which the court determined that an estate cannot use 6511(h) to assert financial disability because an estate is not an individual.  I wrote a post on this case earlier in the fall.   Next she mentioned the case of Stauffer v. Internal Revenue Service, which I recently wrote about here.  I failed to make notes on the other cases she discussed and I cannot remember why.

Judge Marvel talked about the new Tax Court announcement on limited scope representation and the Chief Counsel Notice, CC-2020-001 on that issue.  During the first month of the fall Tax Court calendar four persons entered a limited appearance, including our own Christine Speidel.  The limited appearance ends when the calendar ends, making it not entirely clear what to do with a decision document.  Some suggested getting the decision document signed by the petitioner was the way to go.

So far the Tax Court has 18 pending passport cases.  Judge Marvel indicated that we might see the first opinion in a passport case soon.

Effective on September 30, 2019 the Tax Court has begun accepting electronic filing of stipulated decisions.  The practical effect of this is that because the IRS always signs the decision document last, it will be the party to submit the document.  I doubt this change will have a profound impact on Tax Court practice but, in general, more electronic filing is better.

Development of the Tax Court’s new case management system is moving quickly.  The court expects it to go online by Spring of 2020.  When implemented, this system will allow parties to file petitions electronically.  Judge Marvel expects that practitioners will like the new system.  The new system may allow changes to the public’s access to documents; however, whether and how that might happen is unclear.

Gil Rothenberg, the head of the Department of Justice Tax Division’s Appellate Section gave an update on things happening at DOJ.  He said there have been 75 FBAR cases filed since 2018 with over $85 million at issue.  Several FBAR cases are now on appeal – Norman (No. 18-02408) (oral argument held on October 4th) and Kimble (No. 19-1590) (oral argument to be scheduled) both in the Federal Circuit; Horowitz (No. 19-1280) (reply brief filed on July 18th) in the 4th Circuit and Boyd (No. 19-55585) (opening brief not yet filed) in the 9th Circuit.

Over 40 bankers and financial advisors have been charged with criminal activity in recent years and the government has collected over $10 billion in the past decade.  I credit a lot of the government’s success in this area to John McDougal discussed here but the Tax Division certainly deserves credit for this success as well.

DOJ has obtained numerous injunctions for unpaid employment taxes in the past decade.  It has brought over 60 injunction cases against tax preparers and obtained over 40 injunctions.  These cases take a fair amount of time and resource on the part of both the IRS and DOJ.  They provide an important bulwark against taxpayers who run businesses and repeatedly fail to pay their employment taxes.  Usually the IRS revenue officers turn to an injunction when the businesses have no assets from which to administratively collect.  We have discussed these cases here.  I applaud DOJ’s efforts to shut down the pyramiding of taxes.  Congress should look to provide a more efficient remedy, however, for addressing taxpayers who engage in this behavior.

He said that while tax shelter litigation was generally down, the Midco cases continued.  He mentioned Marshall v. Commissioner in the 9th Circuit (petition for rehearing en banc was denied on October 2nd) and Hawk v. Commissioner in the 6th Circuit (petition for certiorari was denied by the Supreme Court on October 7th).  We have discussed Midco cases in several posts written by Marilyn Ames.  These cases arise as transferee liability cases.  See our discussion of some past decisions here and here.  My hope is that the government will continue to prevail on these cases as the scheme generally serves as a way to avoid paying taxes in situations with large gains.  I wonder how many of these cases the IRS misses.

In Fiscal 2019 there were 200 appeals.  The government won 94% of the cases appealed by taxpayers and 56% of the cases appealed by the government.  I was naturally disappointed that he only talked about cases in which the government prevailed and did not discuss some of the larger losses such as the one in Myers v. Commissioner discussed here.

He briefly discussed the Supreme Court’s decision in Taggart v. Lorenzen, a bankruptcy case, in which the court held that the proper standard for holding the government in contempt for violating the discharge injunction required mens rea.  This followed the position of the amicus brief submitted by the Solicitor General. The Court declined to adopt the petitioner’s position, which would permit a finding of civil contempt against creditors who are aware of a discharge and intentionally take actions that violate the discharge order. The Court found this proposal to be administratively problematic for bankruptcy courts, distinguishing between the purpose and statutory language of bankruptcy discharge orders (which require mens rea) and automatic stays (which do not).

He ended by announcing that he will retire on November 1, 2019.

11th Circuit Reverses and Imposes an Injunction Against a Corporation for Failing to Pay

We have discussed before the increasing practice of the Department of Justice Tax Division to seek an injunction against an operating business that pyramids its tax liabilities.  Pyramiding is the term used for taxpayers who keep building higher and higher tax liabilities by failing to pay period after period.  Usually, it applies to a company that fails to pay employment taxes by failing to withhold the income and employment taxes from its employees and pay the taxes over to the IRS.  Pyramiding typically occurs when a company lacks sufficient cash flow but sometimes it results simply from greed and a belief that the IRS will not catch the person and make them pay.

If a company pyramids its employment taxes and the IRS has no practical means of collecting from the company, the IRS, many years ago, would shut the company down, or attempt to do so, by issuing levies or seizing property even though the company had no equity in seized assets or funds in the bank.  By seizing assets of the business the IRS could effectively close the business temporarily and that might cause it to close permanently.  Other levies would frequently stop suppliers from supplying or banks from lending even if they produced no dollar return.  The goal of these seizures and levies was not to get money but to keep from losing more money.  The practice of no equity seizures went away over 30 years ago.  After the demise of no equity seizures, revenue officers longed for a tool to shut down the taxpayers in situations in which the taxpayer continued to run up liabilities no matter what the revenue officer tried to do. 

Finally, the government, after many years of discussing the possibility, decided that it could bring an injunction action seeking to stop the pyramiding taxpayer from running up additional liabilities.  Doing this through an injunction takes longer and cost more money from the perspective of the time and effort of the Department of Justice trial attorney but can prove an effective method of shutting down a business that continues to ignore the requirement to pay payroll taxes.  In United States v. Askins and Miller Orthapedeatrics, D.C. Docket No. 8:17-cv-00092-JDW-MAP (11th Cir. 2019), the 11th Circuit agreed with the IRS that an injunction of the business was appropriate remedy to stop a business from continuing to incur employment taxes.  In ruling for the IRS, the 11th Circuit reversed the decision of the district court which had denied the IRS injunctive relief.  The case represents an important circuit level discussion of what the IRS needs in order to succeed in obtaining injunctive relief.

read more...

 The business at issue was run by two brothers.  The brothers had caused the business not to pay its employment taxes, both trust fund and non-trust fund, since 2010.  The brothers also created trust and other entity accounts in order to hide the assets of the business.  In many ways the case read as a textbook case for a criminal prosecution against the brothers. A high percentage of injunction cases seem to fit the bill for criminal prosecution and DOJ does prosecute people for failing to pay employment taxes – something it almost never did three decades ago.  I do not know what causes the decision to fall into the injunction box rather than the prosecution box, but here the government chose the civil route.

The court described the situation as follows:

“The IRS has tried several collection strategies over the years. It started with an effort to achieve voluntary compliance: IRS representatives have spoken with the Askins brothers “at least 34 times” since December 2010, including 27 in-person meetings. Twice they entered into installment agreements that set up monthly payments to bring Askins & Miller back into compliance, but the company defaulted both times. Two other times, they warned Askins & Miller that continued noncompliance could prompt the government to seek an injunction.

The IRS has employed more aggressive means as well. It served levies on “approximately two dozen entities,” but most “responded by indicating that there were no funds available to satisfy the levies.” Three entities paid some money, but not nearly enough to satisfy Askins & Miller’s debts or to keep pace with its accrual of new liabilities. Additionally, the IRS’s ability to collect payments through levies has been hampered by the defendants’attempts to hide Askins & Miller’s funds and to keep the balances in Askins & Miller’s accounts low. Between 2014 and 2016, the Askins brothers transferred money from Askins & Miller to “RVA Trust,” which operates a private hunting club for the brothers, and “RVA Investments,” an accounting business associated with their father. The IRS also discovered additional accounts at BankUnited and Stonegate Bank. It did not seek to levy RVA Trust, RVA Investments, or the bank accounts because it discovered them after this case had been referred to the Department of Justice and because the IRS believed that “there is a substantial risk that any new levy would result in opening new undisclosed accounts and moving the money there.”

When the IRS finally gave up on its administrative collection efforts and referred the case to the Department of Justice for the pursuit of an injunction, it met another obstacle.  The district court denied the motion without prejudice finding the declaration conclusory, and finding that the proposed injunction was “effectively an ‘obey-the-law’ injunction.”  The IRS filed a new declaration with the district court trying again to convince it to enjoin the taxpayer’s actions.  The district court again reached the conclusion that the requested injunction served as an order to obey the law.  After the second attempt at the district court, the IRS appealed.  While the case was pending in the district court, the taxpayer ran up even more liabilities.

To obtain a preliminary injunction under “the traditional factors,” the IRS must demonstrate 1) a substantial likelihood of success on the merits, 2) that it will suffer irreparable injury unless the injunction is issued, 3) that the threatened injury to the IRS outweighs whatever harm the proposed injunction might cause the defendants, and 4) that the injunction would not be adverse to the public interest.  The district court noted that the parties essentially agreed that three of the four traditional elements for an injunction case were met by the facts of the case, but felt that the IRS could obtain a judgment for damages and, therefore, did not face irreparable injury.  The IRS argued that such a judgment was meaningless under the circumstances since it had exhausted its administrative efforts with its powerful administrative tools in trying to collect the outstanding debt.

Taxpayers raised a question of whether the closure of their business rendered the case moot.  The court went through a thorough analysis of factors of mootness factors and determined that remanding the case to the district court for a determination of mootness would serve no purpose but delay stating:

“Given the undisputed facts before us, we do not believe that the defendants can satisfy their “heavy” and “formidable” burden of making it “absolutely clear” that their behavior will not recur. And “we are unpersuaded that a remand would further the expeditious resolution of the matter.” Sheely, 505 F.3d at 1188 n.15 (conducting mootness analysis without remanding for further fact finding). The district court already concluded that the defendants have “a proclivity for unlawful conduct” and are “likely to continue ignoring” their tax obligations. The record demonstrates a near-decade-long saga in which the IRS has pursued Askins & Miller time and again. Over that time span, the defendants have funneled money to new accounts and entities as the IRS closed in on the old ones. For at least the time between November 2015 and mid-2018, Askins & Miller continued as a going concern despite reporting “no investments, no accounts or notes receivable, no real estate, and no business equipment.” Against that backdrop — and in light of the defendants’ admissions that Askins & Miller “continues to exist” and that one of the brothers continues to practice medicine — “we can discern no reason for sending the question of mootness back to the district court for further review or fact finding.” Id.

Then the circuit court moved on to examine the issue of whether the IRS had an adequate remedy of law.  Addressing that issue, the court acknowledged that it had not addressed the issue in its past ruling.  It found that prospect of even more losses in the future made a compelling case for granting the injunction stating:

“The fact that the IRS is attempting to avoid future losses is key. As the IRS notes, it “is an involuntary creditor; it does not make a decision to extend credit.” In re Haas, 31 F.3d 1081, 1088 (11th Cir. 1994). As long as the brothers continue to accrue employment taxes, the IRS continues to lose money. This sets the IRS apart from the position of other creditors (who can cut their losses by refusing to extend additional credit), and — crucially — means that the injunction sought is not simply an attempt to provide security for past debts. Rather, the proposed injunction here would staunch the flow of ongoing future losses as the brothers continue to accumulate tax liabilities — unlike in cases where the loss has already been inflicted or would be attributable to a single event, where we have stated that injuries are irreparable only when they “cannot be undone through monetary remedies.” E.g., Scott, 612 F.3d at 1295 (quoting Cunningham v. Adams, 808 F.2d 815, 821 (11th Cir. 1987)).

Indeed, the record and the district court’s own findings demonstrate that the government’s proposed injunctive relief is “appropriate for the enforcement of the internal revenue laws,” 26 U.S.C. § 7402(a), and that the government will likely suffer irreparable injury absent an injunction. Among other things, the district court noted that Askins & Miller had “a proclivity for unlawful conduct,” had “diverted and misappropriated” the employment taxes it had withheld from its employees’ wages, and was “likely to continue ignoring” its employment tax obligations. The IRS’s declaration demonstrates that, over a period of several years, it expended considerable resources making numerous — and unsuccessful — attempts to collect Askins & Miller’s unpaid taxes. And in the face of all that, as the declaration explained, Askins & Miller is effectively judgment-proof. In short, the record amply demonstrates that, absent the requested injunction, the government will continue to suffer harm from Askins & Miller’s willful and continuing failure to comply with its employment tax obligations — including lost tax revenue and the expenditure of a disproportionate amount of its resources monitoring Askins & Miller and attempting to bring it into compliance — and that, in all likelihood, the government will never recoup these losses.”

Having determined that the IRS did not have an adequate remedy at law, the circuit court ended by addressing the district court’s concern that the IRS merely sought an obey the law injunction.  Here, it stated that:

“Finally, the proposed injunction goes well beyond merely requiring compliance with the employment tax laws. In fact, it lists numerous concrete actions for the defendants to take — to name only a few, segregating their funds, informing the IRS of any new business ventures, and filing various periodic affidavits — well beyond what a simple “obey-the-law” injunction would look like. In short, this case does not raise the sort of fair notice concerns that Rule 65(d) is designed to address.”

The Askins and Miller case represents a major victory for the IRS.  The problem with pyramiding business taxes needs a solution.  After many years of floundering to find a solution, the IRS has combined with the Tax Division of the Department of Justice over the past decade (or more) to pursue injunctions against the most egregious taxpayers engaged in pyramiding in situations in which the decision is made not to prosecute.  This is a great development for everyone except the taxpayers who pyramid.  The government needs to aggressively pursue these taxpayers.  Doing so requires significant resources, but success can stop taxpayers who fail to pay year after year.  The 11th Circuit provides a great discussion for how to stop this action.  The effort expended in succeeding here shows the difficulty the government encounters as it seeks to stop this type of taxpayer action and the amount of resources it must expend to do so.

Who Owes the Tax – Blue Lake Rancheria

In the case of Blue Lake Rancheria Economic Development Corp. v. Commissioner, 152 T.C. No. 5 (2019) the Tax Court determined that only one of the two corporations against whom the IRS was pursuing collection owed the tax. I hope that we will one day receive a guest post from petitioner’s counsel, Bob Rubin, who started two weeks before me at Chief Counsel’s office in March of 1977 and occupied the office adjacent to mine, but in the meantime I want to write a short post to provide the facts and outcome on a case featuring the unique legal issues presented by tribal entities.

read more...

The primary issue in this case focused on tribal law and the powers granted to corporations chartered under the federal statutes governing these entities. Blue Lake Rancheria Economic Development Corporation (BLREDC) is the real petitioner in this Collection Due Process (CDP) case and the parent corporation in the structure created by the tribe. The second corporation, Mainstay Business Solutions (MBS), presents as a subsidiary of BLREDC.

MBS ran an employment and temp agency. During and after the recession, it experienced significant business challenges and ultimately closed its doors. Before it closed up, it incurred huge 941 liabilities for failure to pay over employment taxes for numerous quarters. MBS agrees that it owes the money but that does the IRS little good since it has no assets. The IRS seeks to also hold BLREDC liable for the unpaid taxes and BLREDC has assets.

The IRS argues for the application of state law and under state law it would have a relatively easy time tagging BLREDC with the liability. BLREDC argues that state law does not apply. The court recites the relevant statutes and notes that although MBS is structured as a division of BLREDC the form of a division is a creature of federal, and not state law, created as a result of the issuance of a federal charter to the tribe by a federal agency in a dispute over federal taxes. Under the circumstances the court states that it fails to see why state law matters.

Next, the IRS argued that the power to create legally distinct corporate divisions is not an ordinary corporate power and, therefore, it follows that the granting of such a power is outside the scope of the federal statute. As with the first argument, the court disposes of this one noting that the federal statute at issue here grants broad authority. It rejects the narrow interpretation of the scope of authority available under the statute.

Additionally, the court notes that the canons of construction at play in this this situation favor the tribe. It cites to a couple of canons it deems applicable and points out that they call for interpreting statutes in a manor favorable to the interests of the tribe.

The court closes with the following quote:

The plain terms of IRA [the federal statute at issue here] sec. 17 clearly bestow broad discretionary power on DOI to issue Federal charters of incorporation to Indian Tribes. The powers that may be conferred on a tribal corporation under IRA sec. 17 are not limited to those held by State corporations nor are they limited by State law.

As a result the Tax Court determines that BLREDC does not share the employment tax liability with its former division. On the way to this result the court had also determined that BLREDC did not have a prior opportunity to contest the merits of the employment tax liability. The court also distinguished the case of First Rock Baptist Church Child Dev. v. Commissioner, 148 T.C. 380, 387 (2017), discussed in a prior post here, as it went through its analysis concerning its jurisdiction. The court also pointed out that this case involved employment taxes and not income taxes stating that a different analysis applied in the case of employment taxes.

The tribal law that underpins the court’s decision here will not come into play in most of the cases litigated regarding related corporations and their common liabilities for tax. For that reason this taxpayer favorable opinion here will not easily translate to more common situations. Tax practitioners who do represent tribal interests will find the opinion useful not only in the way the court approached its analysis of the statute but also because of the canons it applied. Congratulations to my friend Bob Rubin for winning an unusual case and providing PT with the opportunity to explore the intersection of tribal law and tax procedure.

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.”

read more...

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.