Vince Nardone: Tax and Controversy

Utilizing Bankruptcy to Reduce an Individual’s Outstanding Tax Debts

Utilizing Bankruptcy to Reduce an Individual’s Outstanding Tax Debts[1]

I. Introduction[2].

A. Introduction. Bankruptcy is a commonly overlooked tool of a tax practitioner when attempting to resolve his client’s tax liabilities. In fact, a taxpayer’s filing of a petition in bankruptcy may result in the elimination or significant reduction in taxes owed to federal, state, and local taxing authorities. It can also be used as leverage when negotiating offer-in-compromises and installment agreements with the IRS, as well as with state and local taxing authorities.

Collection Alternatives for Low Income Taxpayers

Disputing the Underlying Tax Liability

Amended Returns – if the liability has arose because of an error on an original filed return, a taxpayer may challenge the correctness of the summary assessment by filing an amended return and seeking a refund, if applicable, or at a minimum, reduce the assessed liability.

Audit Reconsideration – a taxpayer may request that a matter be sent back to examination for a redetermination of the liability even after receiving a collection notice. This can be done through the audit reconsideration process, which is more fully discussed under Internal Revenue Manual (“I.R.M.”) Section 4.13.1.2.

Offer in Compromise Based Upon Doubt as to Liability – regardless of whether there was an examination or a deficiency, or whether the tax assessed was attributable to a balance due return, the taxpayer may file an offer in compromise (which is more fully discussed below) on the basis of doubt as to liability. In these instances, the taxpayer must establish a genuine dispute as to the existence or amount of the correct tax liability under the law. See Treas. Reg. §301.7122-1(b)(1). [3]

Criminal Tax Fraud and Investigations

I. DEPARTMENT OF JUSTICE INVESTIGATIONS, PROSECUTIONS, AND POLICIES [1]

A. Department of Justice – Responsible for federal tax litigation, other than that occurring in the U.S. Tax Court. The Department of Justice, including the U.S. Attorneys, is responsible for the conduct of all federal tax litigation, both civil and criminal, in the federal courts. Title 28 C.F.R. §0.70.

B. The DOJ, Tax Division, has been delegated the responsibility of authorizing or declining investigation and prosecution in criminal tax matters. Cases are investigated by the IRS and recommended for prosecution to DOJ.

Alimony for Federal Income Tax Purposes

 I. Introduction. In the mid 1980s, Congress amended the Internal Revenue Code to make the alimony rules more flexible, simpler, and less dependent upon state law. According to commentators, the principal goal of the amendments was to provide a more equitable treatment to alimony without changing the fundamental intent of the alimony payment itself. This was accomplished by eliminating the requirement that alimony be paid in discharge of one’s legal obligation to support someone—arising out of a marital or family relationship—and also, by removing the requirement that the alimony payment be periodic. [3].

Indictment Upheld Against Senator for, among other things, conspiracy to filing false tax returns - Tax Fraud

In early 2007, a superseding indictment was filed in Pennsylvania charging Senator Vincent J. Fumo with multiple counts of federal violations.  Senator Fumo was charged in connection with four categories of wrongdoing: (1) fraud and conspiracy to commit fraud related to the Senate of Pennsylvania; (2) fraud and conspiracy to commit fraud, conspiracy to obstruct the Internal Revenue Service, and aiding and assisting in the filing of false tax returns related to Citizens Alliance for Better Neighborhoods; (3) fraud related to the Independence Seaport Museum; and (4) obstruction of justice and conspiracy to obstruct justice.

Recently, the Senator's motions to dismiss portions of multi-count indictment were denied. The case citation is (U.S. v. Fumo, DC, Eastern Dist. of PA, 100 AFTR 2d 2007-5532).  The indictment's allegations, including that senator knowingly and willfully aided preparation of exempt organizations Form 990 containing false representations about material matters/organization's expenditures, and that he otherwise encouraged or caused co-conspirator to make materially false statements, essentially tracked Internal Revenue Code section 7206(2)'s language and were sufficient to apprise him of section 7206 charges against him. And, allegations that he conspired to and destroyed e-mail and other electronic evidence in effort to prevent FBI, IRS, and grand jury from receiving or reviewing same were sufficient to establish viable obstruction charges under 18 USCS 1519 . Other arguments and motions to dismiss remaining/non-tax counts were also rejected.

This case in another example of an increased enforcement effort on the part of the IRS.  The IRS specifically seeks cases, such as these, because they are high profile and a more likely deterrent to others than say, Joe Smith the construction worker.  I will provide you updates on this case as they unfold.   

Fast Track Settlement Program - Audits

According to the Service's 2007-200 news release, the Service has expanded the number of test areas for its Fast Track Settlement program for taxpayers under examination by the Small Business/Self-Employed Division. The settlement program is now available for small businesses and self-employed taxpayers until Sept. 5, 2008, in five new areas, including Philadelphia, central New Jersey, San Diego, Laguna Nigel, Calif., and Riverside, Calif, as well as in the three original test cities of Chicago, Houston and St. Paul.

Under Fast Track, taxpayers under examination with issues in dispute work with IRS representatives from SB/SE's examination unit and the Appeals Division to resolve those issues.  Fast Track employs various techniques to facilitate case resolution. A taxpayer or IRS examination representative may initiate the Fast Track process after an issue is fully developed, and preferably before a 30-day letter is issued. The Fast Track process is designed to be completed within 60 days of acceptance of the application.  Taxpayers retain the right to request their issue be addressed through the traditional appeals process if Fast Track fails to yield a resolution.

This appears to be a good alternative for taxpayers, but until the test cases are completed by the Service and we begin to receive additional feedback from the Service as to the success of the program, we will have to rely upon our own experience in dealing with the Service to determine whether this is appropriate for a particular client.

Reporting Violations of the Federal Tax Laws

     On Dec. 19, the IRS announced new procedures for informants to report violations of the tax law to the agency's Whistleblower Office and possibly claim a reward. ( IR 2007-201 . Notice 2008-4, 2008-3 IRB ) The effective date for the new procedures will be Jan. 14, 2008. According to IRS, to make a claim, an informant must file the revised Form 211, Application for Award of Original Information. Informants must provide an estimate of the tax owed, the pertinent facts in the case and an explanation of how the informant obtained the information. The Whistleblower Office will make the final decision regarding the payment of an award and the amount of the payment, which in most cases will be at least 15% but no more than 30% of the collected proceeds. IRS must determine that the information submitted by the informant substantially contributed to the collection of tax. To be eligible for an award, the tax, penalties, interest, additions to tax, and additional amounts in dispute must exceed $2 million for any taxable year, and if the taxpayer is an individual, his or her gross income must be more than $200,000 for any taxable year in question. Form 211 can be found at http://www.irs.gov/pub/irs-pdf/f211.pdf.

     Ultimately, it will be very interesting to see how these new procedures impact the reporting of third parties to the IRS.  Is it a sufficient economic incentive for taxpayers to turn in other taxpayers, or has there always been another reason for doing so, such as revenge?  We will have to wait and see.

IRS Says Certain Companies May Pay Employment Taxes Twice

For several years the Internal Revenue Service ("IRS") has alerted businesses to its concerns regarding an employer’s failure to withhold and remit employment taxes to the IRS. One of those concerns involves abuses by certain third-party professional employer organizations ("PEOs"). PEOs offer an employee-leasing service, which means that, among other things, the PEOs handle administrative, personnel, and payroll accounting functions for employees who have been leased to other companies. As to the leased employees, the IRS reports that PEOs sometimes fail to remit the collected employment taxes to the IRS. In these instances, the IRS may require the client company (“Client”), even if they properly paid all employment taxes to the PEO, to cover any deficiency caused by the PEO’s failure to remit the employment taxes collected; thus causing the Client to pay twice.

This article briefly discusses (i) the background on employment taxes and PEOs, (ii) the IRS’ recent pronouncement regarding a Client’s potential liability for the PEO’s failure to remit collected employment taxes, and (iii) ways to minimize that liability.

Background on Employment Taxes and PEOs
>Employers must withhold and remit federal income taxes on the employee's compensation to the IRS; employers must also withhold from the employee's wages the tax imposed under the Federal Insurance Contribution Act (“FICA”) for social security and hospital insurance purposes. Employers and employees pay FICA taxes equally, but the employers have the responsibility of withholding FICA from an employee's wages and remitting both the employer and the employee's portion to the IRS. Employers must also pay unemployment taxes on the employee’s wages under the Federal Unemployment Tax Act (“FUTA”). The FUTA tax is not withheld from the employees’ wages; rather the Employer pays this amount directly. For purposes of this article, the income tax, FICA tax, and FUTA tax are collectively referred to as “employment taxes.”

Payment of the employment taxes must be made to an authorized bank or financial institution according to federal tax deposit requirements. In a typical employee-leasing arrangement, the PEO collects a fee from the Client for its employee-leasing services. The fee due typically includes the basic service charge and all required federal, state and local taxes, workers' compensation insurance premiums, health insurance coverage costs, and other employee and fringe benefit costs. Once the fee is received, the PEO then pays the wages of the leased employees, withholds the necessary employment taxes, and remits the required amounts to the IRS through the authorized bank or financial institution.

While employee leasing is a legal practice and cost effective way to conduct business[1],it is subject to abuse. That abuse occurs when a PEO collects the employment taxes from the Client but fails to remit the tax dollars to the IRS. According to IRS reports, this is a serious problem and an IRS tax enforcement priority. It also presents a problem for the Client. As discussed, the IRS’ current position is that a Client that engages the services of a PEO may still owe the tax; even if the Client does not realize that the appropriate taxes have not been remitted to the IRS until the PEO has filed bankruptcy, dissolved, or is otherwise uncollectible.

IRS’ Pronouncement Regarding a Client’s Potential Liability
>The IRS is currently looking at the way PEOs operate and are developing new tax reporting guidelines for PEOs and their Clients. The complicated hiring arrangement between PEOs and Clients can make it difficult to determine which company is ultimately responsible for withholding and reporting an employee's employment taxes. The IRS is generally not concerned with who pays the employment taxes, as long as they are in fact paid. The issue of what company is responsible for the payment only becomes an issue when the employment taxes go unpaid. If the taxes go unpaid in an employee-leasing arrangement, the IRS has concluded in Chief Counsel Advice 200415008 ("CCA") that it can assert liability against certain Clients for the unpaid employment taxes attributable to the particular workers leased by each Client. According to the IRS, this is true even though the Client pays the employment taxes to the PEO.

The IRS reasoned that to assert liability against a Client it has to establish that: (i) a common law employer-employee relationship exists between the Client and the leased employee and (ii) the PEO is not in control of the payment of wages. The IRS will determine on a case-by-case basis whether leased employees are common-law employees of a particular Client. Although the analysis of who may be a common-law employer is outside the scope of this article, facts such as the right to recruit, hire, train, discipline, evaluate, and terminate leased employees will weigh in favor of a common-law relationship. In making the determination of who the common-law employer is, the IRS will scrutinize the terms of the agreement between the PEO and Client, as well as the over all facts and circumstances surrounding the PEO-Client relationship.

Even if the IRS determines that the Client is the common-law employer, the Client may avoid liability if the PEO actually controls the payment of wages. Under the Internal Revenue Code, if the common-law employer does not have control of the payment of wages, the term “employer” for purposes of collecting and remitting the employment taxes means the person having control of the payment of wages. From the PEOs standpoint, however, if the PEO’s payment of wages is contingent upon or proximately related to the PEO having first received funds from its Client, the PEO is likely not in control of the payment of wages. In this instance, Clients may end up paying the employment taxes twice: once to the PEO and once to the IRS if that PEO fails to remit the collected employment taxes for the tax periods in question.

Ways to Minimize Liability
Although the IRS has stated that its decision to pursue a Client in the event a PEO fails to remit collected employment taxes is dependent upon policy and operational concerns, prudent Clients may take certain measures to avoid being exposed to double liability. In particular, Clients should:

• Avoid entering into a boilerplate employee-leasing agreement with a PEO. Rather, each Client should work closely with their legal advisor to draft an agreement particular to their needs.
• Avoid being labeled a common-law employer.
• Establish in the leasing agreement that the PEO is ultimately in control of the payment of wages.
• Investigate PEO references prior to entering into any agreement to ensure you are engaging the services of a reputable PEO.
• Draft an agreement that provides you adequate remedies in the event that employment taxes are not paid to the IRS.
• Obtain documentary proof after each reporting period that the PEO has actually timely paid the employment taxes. This may include an affirmative obligation of the PEO to provide quarterly copies of IRS Form 941 and copies of checks or other monetary instruments evidencing timely payment for each quarterly Form 941 presented.
• Reserve the right to audit the PEO’s books and records.

By taking these measures, Clients can avail themselves of the cost effective advantages of working with PEOs and at the same time be less concerned that the IRS may come knocking to collect employment taxes paid to the PEO but not remitted to the IRS[2].

---

[1] For example, PEOs may offer a service that allow other companies to pool their employees to get value discounts on health, disability, and workers' compensation insurance costs.

[2] In entering into an employee-leasing agreement it is also important not to overlook the impact of the sales tax, workers compensation, and unemployment compensation laws of a particular state.

IRS Provides Guidance On Physician Incentive Compensation Programs

To achieve the objectives of improving quality and reducing the cost of health care, the health care industry continues to seek ways to align hospital interests more closely with physician interests through incentive compensation. The IRS generally believes that incentive compensation plans have a potential for significant benefit to an exempt organization's functions by improving the quality of patient care and productivity, thereby reducing patient costs. Notwithstanding that general position, the IRS will closely scrutinize plans on a case-by-case basis to ensure that each plan complies with the prohibitions against private inurement and impermissible private benefit.

In a 2002 IRS information release, the IRS exempt organizations division advised that there is "no prohibition" or "per se rule" that prevents 501(c)(3) tax-exempt health care organizations from making incentive payments to physicians. As discussed below, the IRS generally reviews twelve factors in determining whether a health care organization utilizing an incentive compensation program for physicians complies with the prohibitions against private inurement and impermissible private benefit.

1. Independent Board of Directors and Conflicts of Interest Policy
Is the compensation arrangement established by an independent board of directors or by an independent compensation committee? Does the conflicts of interest policy bar the physician, who is a voting member of the board and who receives compensation from the organization, from discussing and voting on matters pertaining to that member's compensation? In General Counsel Memoranda ("G.C.M.") 38394, the IRS's General Counsel states that compensation arrangements with physicians result from arm's-length bargaining if they are established by independent compensation committees consisting of non-physician employees or independent boards of directors.

2. Reasonable Compensation
Does the compensation arrangement with the physician result in total compensation that is reasonable? An exempt organization may pay reasonable compensation for services without triggering the private inurement or impermissible private benefit provisions. Reasonable compensation is generally defined as the amount that would be paid for like-services by like-enterprises under like-circumstances.

3. Arm's-Length Relationship
Is there an arm's-length relationship between the health care organization and the physician or does the physician participate impermissibly in the management or control of the organization in a manner that affects the compensation? In G.C.M. 35638, the IRS's General Counsel approved a compensation plan in which participants shared savings generated by productivity improvements. The General Counsel allowed this plan because it was established at arm's-length, and it was a means of providing reasonable compensation to employees without any potential for reducing the charitable services provided by the tax exempt organization.

4. Ceiling
Does the compensation arrangement include a ceiling or reasonable maximum on the amount a physician may earn to protect against windfall benefits? In the FY 2000 CPE Text, the IRS emphasized the importance of a cap on total compensation. In one instance, while siding with the IRS, the tax court held that private inurement existed where a minister's compensation was 69-86% of gross contributions with no cap on total compensation.

5. Quality of Care and Patient Satisfaction
Does the compensation arrangement take into account data that measures quality of care and patient satisfaction? In G.C.M. 39674, the General Counsel approved two profit sharing incentive compensation plans based on the economic performance of the hospitals. Under these plans, all employees were eligible to participate, not just the physicians. The amounts that could be paid were subject to a minimum percentage of each employee's base compensation, and payments depended on standards designed to measure quality of patient care and patient satisfaction.

6. Reduction in Charitable Programs
Does the compensation arrangement have the potential for reducing the charitable services or benefits that the organization would otherwise provide? There is no bright line rule for this factor. However, the IRS may view the compensation arrangement negatively if it means a potential reduction in charitable activities.

7. Net Revenue Based
Does the physician compensation depend on net revenues? If so, does the arrangement accomplish the organization's charitable purposes? A defectively structured revenue-sharing arrangement could be one that allows the disqualified person to receive additional compensation without providing proportional benefits to the organization that contribute to its exempt purposes. Examples of defectively structured arrangements may include giving a disqualified person the equivalent of an equity interest in the exempt organization or allowing the disqualified person to manipulate expenses to increase his or her compensation.

8. Joint Venture
Does the compensation arrangement transform the principal activity of the organization into a joint venture between it and the physician? In one instance, a percentage compensation arrangement structured as a point system resulted in the loss of an organization's exempt status where it transformed the organization's principal activity into a joint venture with physicians. Under this arrangement, a sum of money was set aside as total salary, which would be divided among physicians in a ratio based on each physician's point score. Points were based on the amount of the physician's charges, the number of patient visits, the number of new patients, and the length of time the physician was associated with the clinic during which the physician had total charges above a certain minimum.

9. Distribution of Profits
Is the compensation arrangement merely a device to distribute all or a portion of the health care organization's profits to persons who are in control of the organization? In one case, a court denied an incorporated business college exempt status where the taxpayer's charter provided for payment of salaries to stockholders in proportion to their holdings and where the stockholders in fact treated the college as a commercial venture by operating it as a business and causing it to distribute large portions of its net earnings for their benefit.

10. Business Purpose
Does the compensation arrangement serve a real and discernible business purpose of the exempt organization? For example, the organization may want to achieve maximum efficiency and economy in operations by shifting away the principal risk of operating costs to the service provider to reduce the organization's need to carry large insurance-type reserves.

11. Abuse or Unwarranted Benefits
Does the compensation arrangement result in no abuse or unwarranted benefits? For example, prices and operating costs should compare favorably with those of similar organizations, and controls should be in place to avoid increases in compensation predicated on increases in fees charged to patients.

12. Services Personally Performed
Does the compensation arrangement reward the physician based on services the physician actually performs, or is it based on performance in an area where the physician performs no significant function? For example, the IRS found that a hospital was operated, to a considerable extent, for the private benefit of two founding doctors, rather than exclusively as a charitable organization. The doctors, who previously owned the hospital facilities and founded the hospital, shared in the fees from the privately operated laboratory and x-ray department, within the hospital, even though they performed no associated services.

In sum, when structuring an incentive compensation arrangement, these factors should be closely scrutinized to determine whether the plan adopted exposes the organization to any unwanted IRS scrutiny. Although complying with each factor will not guarantee that the IRS will approve of the arrangement, this information release provides guidance for health care organizations when considering physician incentive compensation programs.

Nonprofit Healthcare Joint Ventures Alive and Well After Redlands

On June 7, 2002, a federal district court rejected the Internal Revenue Service's ("IRS") finding that a Texas nonprofit healthcare system ("St. Davids") forfeited its tax-exempt status by entering into a joint venture with a for-profit entity.

In 1938, the IRS recognized St. Davids as a tax-exempt organization under 501(c)(3). In 1996, St. Davids entered into a limited partnership with HCA, Inc., a for-profit healthcare company. St. Davids' ownership interest in the partnership was 45.9%, leaving 54.1% ownership in the hands of HCA. The board overseeing the joint venture was evenly split between representatives of St. Davids and HCA. In October 2000, the IRS revoked St. Davids' tax-exempt status. The IRS argued that St. Davids' participation in the partnership did not permit it to act exclusively in furtherance of its charitable purposes and allowed for greater than incidental benefits to HCA.

The District Court narrowed the issues to two; stating that two factors caused the government to revoke St. Davids' tax-exempt status. First, the government claimed that St. Davids was not controlled by a community board and second, that HCA received an impermissible private benefit.

Community Board Standard
The district court ruled that St. Davids satisfied the requirement for community board control under 501(c)(3). The record reflected that the purpose of its board was to ensure the community's interests were given precedent over any private interest. The partnership agreement required that all hospitals owned by the partnership operate in accord with the community benefits standard. If the hospitals failed to meet that standard, St. Davids had the unilateral right to dissolve the partnership. Finally, the chairman's seat was reserved for a member appointed by St. Davids.

With regard to the community benefits standard, the district court found that "the presence of a community board is a point in favor of exemption but is not an absolute requirement for exemption." The district court reasoned that even if a community board is an absolute requirement, St. Davids' board satisfied that requirement. The district court stated, "[a]lthough exactly half of the members are appointed by a for-profit entity, the purpose of a community board is more complex than giving wealthy, self-styled philanthropists something to do on the rare occasions that they are not playing golf." The district court recognized that the purpose of a community board is to ensure that the community's interests are given precedence over private interest.

Private Benefit
The district court also rejected the IRS's position that the arrangement conferred an impermissible private benefit on HCA. The district court concluded that "it is difficult to imagine a corporate structure more protective of an organization's charitable purpose than the one at issue in this case." In addition to the protections discussed above, the district court noted that the partnership agreement gave the nonprofit partners substantially more control than the for-profit partners. The agreement made clear the partnership's purpose and that the voting rights and rules of the nonprofit partner prevent any usurpation of that purpose by HCA.

Effect on Redlands
The Redlands decision adopted a legal standard that ceding control immediately equates to impermissible private benefit. However, Redlands' control theory did not prevail in the St. Davids case. The district court criticized the government for arguing that the board did not satisfy the community board requirement based on the 50/50 split. The district court noted that voting strength is more than just looking at the number of votes, the law is more concerned with "control," which may emanate from majority control or the business structure. The determination of control requires a more in-depth analysis than counting how many votes a for-profit entity and a charity may have.

Conclusion
Although this decision should be seen as a step in the right direction and a significant blow to the IRS's control theory supported in Redlands, nonprofit joint ventures should proceed with caution. The government is likely to appeal this decision and other courts may not follow the decision of this court.