Vince Nardone: Tax and Controversy

Domestic Case in Tax Court Highlights Importance of Consulting a Qaulified Tax Professional

The United States Tax Court decision of Tim Walker v. Commissioner, (2008) TC Memo 2008-194 highlights the importance of ensuring that taxpayers, who are going through a divorce, separation, or other domestic dispute, receive the necessary and proper guidance regarding the tax impact of their domestic matters.  In many instances, however, the domestic attorneys working with the taxpayers or the taxpayers representing themselves pro se, fail to obtain the necessary guidance. 

In the Walker case, the taxpayer had two daughters, both of whom lived with their mother for the tax year at issue.  An order of child support provided that the taxpayer was to claim one daughter for federal income tax purposes, and the mother was to claim the other.  The order also stated that the parents are to sign a federal income tax dependency exemption waiver; either a Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, or a written declaration conforming to the substance of Form 8332.  It is important to note that many of the domestic orders fail to provide for this additional language regarding the Form 8832.  Thus, the fact that this particular order did include it would have led me to believe that the taxpayer should have been able to claim the deduction or credit at issue in the case.  But, the taxpayer failed to acquire a signed dependency exemption waiver from the mother. Therefore, no Form 8332, or its equivalent, was attached to taxpayer's return.  Therefore, the Tax Court, after discussing the relevant law, held that the taxpayer was not entitled to the child tax credit claimed with respect to the daughter for the year in issue.  The way that this matter could have been avoided was to ensure at the time that the order came out that the order included the requirement that the taxpayer’s wife produce the signed waiver within X amount of days, rather than the taxpayer having to chase it down at a later date.  You do not want to be in a position that you have to rely upon another party, especially an ex-spouse, when it comes to your taxes.  Lesson to be learned from the case, please ensure you consult with a qualified tax expert.

See the case attached.

Download child_tax_credit_august_31_2008.pdf

Willfulness does not require proof of ability to pay, atleast in the Ninth Circuit

I initially chose note to discuss the case below because it starts out with the following: This case illustrates the enduring truth of Ben Franklin's sage observation that “nothing is certain but death and taxes.”  But, after considering it further and hearing this quote a million times, it still rings true for me and so I reconsidered my decision and actually wanted to include it for that same reason, so here it is.

In U.S. v. Easterday(2008, CA9) 102 AFTR 2d ¶ 2008-5218, the taxpayer appealed his conviction for willful failure to pay over employee payroll taxes, in violation of 26 U.S.C. §7202.  During the lower court trial, the taxpayer sought an “ability to pay instruction” in order to contend to the jury that his failure to pay over the taxes he owed was not “willful,” because he had spent the money on other business expenses and therefore could not pay it to the government when it was due.  The district court refused to give the instruction, and the jury subsequently convicted the taxpayer and sentenced the taxpayer to thirty months in prison.

According to the Ninth Circuit, which heard the taxpayer’s appeal, the requested instruction by the taxpayer in the lower court case was drawn from a portion of a 1975 decision of the Ninth Circuit court, in U.S. v. Poll, 521 F.2d 329 (9^th Cir. 1975).  The Ninth Circuit, however, stated that it had never subsequently cited the Poll case favorably in the context of a prosecution for failure to pay taxes.  The Court went onto to say that the Poll decision relied upon an earlier Ninth Circuit decision that two other circuits have expressly rejected.  And, most significantly, the holding of Poll that formed the basis for the proposed instruction was effectively eradicated by subsequent Supreme Court authority in U.S. v. Pompano, 429 U.S. 10, 12 (1976).

Nevertheless, the taxpayer contended that the Poll decision was controlling because the Ninth Circuit had never expressly overruled it.  The lower court had held that Poll was no longer good law.  The Ninth Circuit ultimately agreed.  The Ninth Circuit analyzing Poll, stated that the requirement in Poll that the government prove the taxpayer had sufficient funds to pay the tax was premised on a definition of willfulness that included some element of evil motive.  The Ninth Circuit went onto to say that the Supreme Court subsequently rejected any such definition of willfulness in the tax statutes.  See United States v. Pomponio, 429 U.S. 10, 12 (1976)(per curiam); see also United States v. Cheek, 498 U.S. 192, 201-02 (1991). “Willful” in the tax context means a voluntary, intentional violation of a known legal duty. See Cheek, 498 U.S. at 201-02; United States v. Powell,955 F.2d 1206, 1211 (9th Cir.1992). In other words, if you know that you owe taxes and you do not pay them, you have acted willfully. Poll has continued to be referred to occasionally in other contexts, principally in the child support area. See United States v. Ballek,170 F.3d 871, 874 (9th Cir.1999); H.R.Rep. No. 102-771, at 6 (1992). The Ninth Circuit, however, made it clear that it is not good tax law and should not be cited as such.

See the decision attached.

Download willfulness_withholding_tax.pdf

Spousal Support Payments included in Income

The case of Kim Reid v. Commissioner, (2008) TC Memo 2008-177 highlights the failure of the taxpayer, and in many instances the taxpayer’s domestic relations counsel, to take into consideration the tax implications of a domestic settlement.  The issue in the case was whether the taxpayer had to include in gross income spousal support payments she received from her ex-husband pursuant to a divorce decree.

In examining the facts, the court stated that nothing in the record showed whether the divorce decree designated each of the monthly payments at issue as a payment that is not includible in gross income under section 71(a) and not allowable as a deduction under section 215. See sec. 71(b)(1)(B). Thus, the court held that the taxpayer failed to establish that the taxpayer's divorce decree designated each of the monthly payments at issue as a payment that is not includible in gross income under section 71(a) and not allowable as a deduction under section 215.The court went onto say that nothing in the record showed whether taxpayer and Mr. Reid were members of the same household at the time Mr. Reid made each of the monthly payments at issue. See sec. 71(b)(1)(C). Thus, the court also held that the petitioner failed to establish that she and Mr. Reid were members of the same household at the time Mr. Reid made each of the monthly payments at issue.  In addition, the court stated that nothing in the record showed whether the taxpayer's divorce decree provided that Mr. Reid was obligated to make any spousal support payments after petitioner died and whether Mr. Reid had any obligation to make any payments as a substitute for spousal support payments after petitioner died. See sec. 71(b)(1)(D).  Under Ohio law, any award of spousal support payments is to terminate automatically upon the death of either party unless the order containing the award expressly provides otherwise.  See Ohio Revised Code 3105.18(B).  Again, the court held that the taxpayer failed to establish that the taxpayer’s divorce decree provided otherwise.

   

I am not sure why the taxpayer did not submit the actual divorce decree to the court, other than the likely fact that it did not support her position that the payments should not be taxable to her.  The case simply highlights the importance of taxpayers and their domestic relations attorneys need to consult with a qualified tax professional before finalizing a domestic relations matter.  The failure to do so can in some instances be very expensive for both the taxpayer and the domestic relations attorney.

See the Reid case below.

Download alimony_case.pdf

IRS Updates Procedures for Correcting Retirement Plan Errors

Recently, the Service updated its guidance on its voluntary correction program for employee retirement plans.  See Revenue Procedure 2008-50, which I have included below.  The update provides for an expansion of the correction programs and supposedly additional flexibility.  This will be helpful, if true.  As an example, one of the more common situations I see with closely-held businesses is the violation of the Plan when it comes to borrowing from the Plan.  That is, either borrowing the allowable amount and not paying it back, or borrowing to much from the beginning.  The question then comes up as to how do we deal with that violation under the Employee Plans Compliance Resolution System ("EPCRS"). 

According to the Service, under EPCRS, plan sponsors and plan professionals can correct certain errors in employee retirement plans, in some cases without having to notify the IRS.  Correcting plans in this way allows participants to continue receiving tax-favored retirement benefits and protects the retirement benefits of employees and retirees.

There are three levels of correction programs in EPCRS:

• The Self-Correction Program (SCP) permits a plan sponsor to correct insignificant operational failures in plans such as qualified plans, 403(b) plans, SEPs or SIMPLE IRA plans without having to notify the IRS and without paying any fee or sanction.  In many instances, a plan sponsor may correct significant operational failures without notifying the IRS and without paying a fee or sanction. 
  
• The Voluntary Correction Program (VCP) allows a plan sponsor, at any time before an audit, to pay a limited fee and receive the IRS’s approval for a correction of a qualified plan, a 403(b) plan, SEP or SIMPLE IRA plan.
  
• The Audit Closing Agreement Program (Audit CAP) allows a sponsor to correct a failure or an error that has been identified on audit and pay a sanction based on the nature, extent and severity of the failure being corrected.

In revising the EPCRS revenue procedure, the IRS incorporated comments from the retirement plans community by adding flexibility and increasing correction methods. The new guidance, which is a revenue procedure, makes the following improvements:

• Expands the availability of SCP in situations where operational mistakes have been partially corrected when the plan comes under examination.  Also, new examples relating to the exclusion of employees from 401(k) plans have been added to the standardized corrections. The new examples will benefit those who use SCP to correct the failures described in those examples.
  
• Establishes streamlined application procedures under VCP for numerous issues, including failure to amend plans for law changes, loan problems, failure to make minimum distributions to participants, excess elective deferrals made by participants to 401(k) plans and plans established by ineligible employers. In addition, streamlined application procedures have been developed for SEPs, SARSEPs and SIMPLE IRAs.
  
• Includes a sample application format that may be used for all other VCP applications.  “These revised application procedures should make the correction programs more accessible to small business employers,” said Joyce Kahn, who directs the voluntary compliance program. “Also, we anticipate that the new procedures will facilitate an expedited review of a significant number of VCP applications.”
  
• Makes it easier to correct loan failures under VCP.  Loans that violate section 72(p) of the Internal Revenue Code may still be corrected even if the loans do not violate the terms of the plan. Also, in many cases, the fee under VCP for correcting loan failures will be reduced by 50 percent.

See the Service's New Release 2008-96. 

Again, according to the Service, “The improved correction for participant loans should enable many more participants to bring delinquent loans from retirement plans back into compliance without incurring the tax consequences resulting from those loans being treated as taxable distributions under section 72(p).”  See News Release 2008-96.

See the entire Revenue Procedure directly below.

Download correcting_plan_errors_rev_proc_200850.pdf

IRS Loses another Case Dealing with Medical Residents and FICA Tax

In Center for Family Medicine v. U.S., 102 AFTR 2d ¶2008-5152 (DC SD 8/6/08), a district court ruled on summary judgment that stipends paid to medical residents were not subject to FICA tax under the Internal Revenue Code Section 3121(b)(10), which represents the FICA student exemption.  The district court also held, however, that head residents, who stayed on after completing their residency to administer the programs, were not eligible for the FICA student exemption.

It is important to note that the district court case does not impact the income tax aspects of medical residents' stipends, only the FICA taxes.  FICA refers to the Federal Insurance Contributions Act that imposes two taxes: (i) the Old Age, Survivors and Disability Insurance tax (OASDI) and (ii) the Medicare/Hospital Insurance tax (HI).  The taxes finance benefits under the Social Security Act.  The FICA taxes are based upon “wages” paid with respect to “employment,” OASDI is at 6.2% of wages with certain limitations and the HI is at 1.45%.  Section 3121(b)(10), however, provides an exemption from FICA taxes for services performed in the employ of a school, college, or university “if such service is performed by a student who is regularly enrolled and regularly attending classes at” such an institution.  For the years at issue in the Center for Family Medicine case, in a version of the regulations that have since been amended, treasury regulation section 31.3121(b)(10)-2(c) provided for an analysis of the facts and circumstances in a particular situation to determine whether an institution was a “school, college, or university” for purposes of the student FICA exemption.

For more detail, see the case below.  Download fica_tax_medical_resident_case.pdf

IRS issues Chief Counsel Advice impacting Professional Employer Organizations - Income Tax

The Internal Revenue Service (“Service”) recently issued a Chief Counsel Advice (“CCA”) memorandum whereby the Service denied a federal unemployment tax (FUTA) refund to a staffing company because—according to the Service—it was not the employer for FUTA purposes. See CCA 200827007 attached below.  For FUTA, the Service contends that the common law relationship of the parties determines whether an employment tax liability exists. Even though the company was treated as the employer for state unemployment tax purposes, for FUTA purposes, there was no evidence that the taxpayer was the common law employer.  Now, the Service wonders why so many taxpayers are noncompliant or have difficulty with complying with the tax laws.  It is because of administrative decisions such as these.  As we all know, if the shoe was on the other foot and the Service was trying to impose liability, rather than deny a refund, the Service would likely have argued that the Taxpayer was the common law employer and therefore liable.  For example, see CCA 200415008 discussed briefly below. 

In this CCA, the company conducted its operations in a manner similar to businesses commonly called referred to as employee leasing companies or professional employer organizations (“PEO”) as they are referred to in Ohio. The PEO offered client businesses multiple employee benefit and payroll services, including withholding, depositing, and reporting of all applicable federal and state employment-related taxes. The PEO filed Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return, and Form 941, Employer's Quarterly Federal Tax Return, for all of its clients on an aggregate basis, using its own name and employer identification number.

The PEO filed a claim for refund of FUTA taxes, based on its belief that it was eligible for the FUTA exemption under Internal Revenue Code §3306(c). The PEO argued that it was the employer of its clients' workers because it was considered to be the employer for state unemployment tax purposes and that it was the employer of the workers in question because it was the statutory employer of those workers under §3401(d)(1). The Service denied the PEO's refund claim because, according to the Service, there was no evidence that Taxpayer was the common law employer of the workers in question. The Service stated that how the PEO initiated its relationship with its clients, the range of businesses conducted by the clients, and the geographic dispersion of the clients, weighed against viewing Taxpayer as the common law employer.

The Service noted that: (1) the client company continued to control the daily performance of its workers' duties; and (2) Taxpayer did not provide the employees with any specific instructions as to when, where, or how the work would be performed. The Service further noted that the fact that Taxpayer was considered the employer of the workers for state unemployment tax purposes had no effect on the determination of who was the workers' employer for FUTA purposes. Similarly, its conclusion would not change even if Taxpayer was considered the statutory employer of the workers in question. According to the Service, the FUTA liability, including the exception from FUTA provided under §3306(c), is determined based on who is the common law employer.  See the CCA attached below. 

To better understand this decision, it is important to understand how FUTA tax is imposed on employers. The FUTA tax under §3301 is imposed on every employer equal to a certain percentage of the wages that it pays with respect to employment. Section 3306(b) provides that for FUTA purposes, the term “wages” means all remuneration for employment, with certain specified exceptions.  Section 3306(c) defines employment, in relevant part, as any service of whatever nature performed by an employee for the person employing him. Thus, unless amounts paid are excepted from “wages,” or the services performed are excepted from “employment,” FUTA tax applies. In Revenue Ruling 54-471, the Service contended that the common law relationship of the parties determined whether an employment tax liability exists, even when a third party is involved in the payment of wages. A common law employer/employee relationship exists between an entity and individuals when the entity has the right to direct and control the performance of services by the individuals. Factors considered in determining whether an entity has an employer/employee relationship with workers include the nature and degree of financial and behavioral control that the entity has, and the relationship of the parties, including the relationship the parties believe they are creating.  For additional information, please also see CCA 200415008 whereby the Service concluded that :

If each client company is the common law employer of the particular workers leased from the Taxpayer (i.e., the PEO), and the Taxpayer is not a section 3401(d)(1) employer, the Service could assert that each such client company is liable in the years at issue for the unpaid employment taxes related to these particular workers that cannot be collected from the Taxpayer. Whether the Service chooses to act on this legal conclusion is dependent upon a decision made by the operating division handling the case. The operating division's decision will include consideration of policy and operational concerns, including resource availability.

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