Vince Nardone: Tax and Controversy

The IRS Warns Employers and Employees of the Tax Consequences of Retirement Plan Loans and Hardship Distributions

Guest Author: M. Pilar Honer, Esq., Columbus, Ohio

 

The Service has recognized that during these hard economic times, many taxpayers have had to tap into their retirement plans as a last resource.  Thus, in the Service’s latest edition of “Retirement News for Employers”, the Service advised employers and employees on the tax consequences of retirement plan loans and hardship distributions.

 

Retirement Loans

 

The Service reminded employers and employees of the various requirements for employees to take loans from their retirement plans.

 

1. Only qualified plans, such as profit-sharing, 401(k) and money purchase plans may allow participants to borrow money from their accounts.  IRA-based plans, such as SEPs (Simplified Employee Pension Individual Retirement Account), SIMPLE IRAs and SARSEPs (Salary Reduction Simplified Employee Pension Plan), and traditional and Roth IRAs cannot provide loans to participants.

 

2. The plan document itself must specifically permit these loans. 

 

3. The loan amount is limited to the lesser of $50,000 or 50% of the employee’s vested account balance. 

 

4. The borrower must repay the loan at least quarterly and over a period not exceeding five years, subject to the exception for a purchase of a principal residence.

 

5. Any loans over the permissible amount are treated as distributions when the loan is made and taxed accordingly.  Also, missing payments causes the loan to go into default and be taxed as a distribution.

 

The Service also addressed what it found to be the number one tax issue with loans, which is when a participant terminates their employment while having an outstanding loan balance.  When this happens, plans usually offset the distribution of the participant's account by the amount of the outstanding loan balance.  For tax purposes, the amount of the distribution includes the loan balance at the time of the offset.  If the participant wants to roll over his entire benefit, then he must come up with money that represents the loan offset as well as money to cover the 20% mandatory federal income tax withholding that applies to the full amount, including the loan offset.  The 10% additional tax on early distributions also applies if the participant is under age 59 1/2, unless an exception to the early withdrawal tax applies.  Thus, there can be some severe negative tax consequences if an employee terminates their employment without having repaid the loan from their retirement account.

 

On the side of the employer, the Service addressed several issues that it encounters. One issue is when an owner-employee borrows money from the company's plan, but fails to follow the same rules that apply to other participants.  Like any other participant, an owner-employee must have a loan meeting all of the loan formalities, otherwise it may be tagged as a prohibited transaction.  Another issue the Service encounters is when employers dip into plan assets to meet payroll or pay other bills.  This is never permissible.  Similarly, another issue that the Service frequently encounters is when employers withhold salary deferrals from an employee’s salary intending to deposit the money into the employee’s 401(k) or IRA account, but instead use the salary deferrals to cover other business debts.  The Service stressed that this is also never permissible.  The money must be deposited in the employee’s 401(k) or IRA account as soon as the money can be reasonably segregated from the employer's assets.

 

Hardship Distributions

 

The Service reminded employers that while defined contribution plans—for example, 401(k), 403(b), 457 plans—may allow participants to withdraw certain amounts from the plan because of a financial hardship, the treasury regulations provide detailed guidelines that must be followed to ensure the plan satisfies the law's requirements.

 

In general, a plan can make a hardship distribution only: if the plan permits such distribution when there is an immediate and heavy financial need of the employee—in certain cases, this includes financial needs of the employee's spouse, dependent or beneficiary—and the distribution is an amount necessary to meet the financial need.

 

The Service recommended employers follow this seven step checklist before making a hardship distribution:

 

1.      Review the terms of the plan, including: (i) whether it allows hardship distributions; (ii) the procedures an employee must follow to request a hardship distribution; (iii) the plan's definition of a hardship; (iv) and any limits on the amount and type of funds that can be distributed as a hardship distribution from an employee's account.

 

2.      Ensure that the employee complies with the plan's procedural requirements. For example, make sure employees have provided a statement or verification of their hardship in the form required by the plan.

 

3.      Verify that the employee's specific reason for hardship qualifies for a distribution using the plan's definition of what constitutes a hardship.  For instance, the plan may limit a hardship distribution to pay burial or funeral expenses and not for any other reason.

 

4.      If the plan, or any of the employer's other plans in which the employee is a participant, offers loans, document that the employee has exhausted them prior to receiving a hardship distribution.  Likewise, verify that the employee has taken any other available distributions, other than hardship distributions, from these plans. Under some plans, a hardship distribution is not considered necessary if the employee has other resources available, such as spousal and minor children's assets—excluding property held for the employee's child under an irrevocable trust or under the Uniform Gifts to Minors Act.

 

5.      Check that the amount of the hardship distribution does not exceed the amount necessary to satisfy the employee's financial need.  The amount required to satisfy the financial need, however, may include amounts necessary to pay any taxes or penalties that are due because of the hardship distribution.

 

6.      Make sure that the amount of the hardship distribution does not exceed any limits under the plan and is made only from the amounts eligible for a hardship distribution. For example, a plan may allow a hardship distribution of only 50% of an employee's salary reduction contributions.

 

7.      Most plans also specify that the employee may not contribute to the plan and all other plans that the employer maintains for at least six months after receiving a hardship distribution.  Inform the employee of this provision and enforce it.  Failure to do so is a common plan error but may be corrected through the Employee Plans Compliance Resolution System.

 

Finally, the Service reminds the employees that hardship distributions are not tax free. Generally, hardship distributions are subject to income tax in the year of distribution and, if the employee is under the age of 59 1/2, to the 10% additional tax on early distributions unless some exception applies.  Hardship distributions, however, are not subject to the mandatory 20% income tax withholding.

 

See the attached IRS newsletter Retirement News for Employers.

Download Retirement News for Employers

United States Tax Court to IRS - Basis overstatement is not omission of income.

In Kenneth Beard v. Commissioner, TC Memo 2009-184 the Tax Court held that an overstatement of basis is not an omission of gross income for purposes of Internal Revenue Code section 6501.  Why is that important?  Well, Section 6501 provides that, unless extended or suspended, the statute of limitations on assessment for income taxes is three years from the later of when the return was filed or the return's due date.  One exception, however, is where the original return as filed omitted gross income in an amount exceeding 25% of the gross income that was stated on the return, the three-year rule is replaced with a six-year rule.  Thus, the IRS can go back 6 years rather than 3 years if this exception applies.

In Beard,the IRS had determined that the taxpayer had overstated his basis in two S corporations sold during the taxable year 1999, thus causing an understatement of gross income by more than 25 percent of the amount stated in the taxpayer's return.  The issue for decision was whether, under those circumstances, the taxpayer's actually omitted income, giving rise to an an extended 6-year period of limitations.  The court recognized that the general definition of gross income in the context of a trade or business meant the total of the amounts received or accrued from the sale of goods or services.  The IRS tried to argue that the overstatement of basis in a context outside of the sale of goods or services should constitute an omission from gross income.  Rejecting that argument, the court held that the taxpayers did not omit income from their return.  Therefore, the taxpayers were not subject to the 6-year period of limitations.  Great result for the taxpayers.

See the full case attached.Download Basis and sol - as of August 19, 2009

IRS Proposes Regulations Clarifying When A Tax Practitioner May Charge Contingent Fees

Guest Author: M. Pilar Honer, Esq., Columbus, Ohio

 

On July 27, 2009, the Service published proposed regulations, which essentially expand the use of and clarify what constitutes a contingent fee under Circular 230 § 10.27.  Before these proposed regulations become final, the Service will be taking public comments for their review and consideration.

 

Currently, under Circular 230 § 10.27(b), a tax practitioner may not charge a contingent fee for services rendered in connection with any matter before the Service, including the preparation or filing of a tax return, amended tax return or claim for refund or credit.  There are, however, several exceptions to this rule.  One of those exceptions provides:

 

a practitioner may charge a contingent fee for services rendered in connection with the [Service's] examination of, or challenge to an original tax return; or an amended return or claim for refund or credit where the amended return or claim for refund or credit was filed within 120 days of the taxpayer receiving a written notice of the examination of, or a written challenge to the original tax return.

 

Treas. Reg. § 10.27(b)(2).  Hence, Circular 230 § 10.27(b) provides that a tax practitioner may charge a contingent fee only after the taxpayer receives written notice of an examination or challenge by the Service.  The proposed regulations, however, expand the use of contingent fees by providing that the tax practitioner may charge a contingent before or after the taxpayer receives written notice by the Service.  The proposed regulations also permit a tax practitioner to charge a contingent fee for whistleblower claims under Internal Revenue Code § 7623(b).  Finally, the proposed regulations clarify what constitutes a contingent fee.  Currently, Circular 230 § 10.27(c)(1) provides that a contingent fee depends on the specific results attained without directly providing that it is the specific tax result that is relevant to the definition of a contingent fee.  The proposed regulations then clarify that a contingent fee is a fee based on a percentage of the refund reported on a return, percentage of the taxes saved, or that otherwise depends on the specific tax result.  Thus, the proposed regulations clarify that a contingent fee includes, but is not limited to, any fee that depends on the specific tax result obtained in any given transaction.

 

The Treasury Department and the Service have specifically requested comments on the clarity of these proposed regulations and how they can be made easier to understand.  All comments will be available for public inspection and copying.  The public hearing is scheduled for November 20, 2009, at 10 a.m., and will be held in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

 

See the attached proposed regulations. Download Proposed Regulations 10.27

 

To submit comments online go to 

 http://www.regulations.gov/search/Regs/home.html#home

TAS Objectives for Fiscal Year 2010

  Guest Author: M. Pilar Honer, Esq., Columbus, Ohio 

On June 30, 2009, National Taxpayer Advocate, Nina E. Olson, submitted the Taxpayer Advocate Service’s (TAS) mid-year report to Congress that identified TAS’ objectives for fiscal year 2010. See the report attached below.  As background, TAS is an independent organization within the IRS that assists taxpayers who experience economic harm and are seeking help in resolving their tax problems, and whose problems have not been resolved through the normal channels of the IRS.  The mid-year report is one of two that TAS is required to submit to Congress each year.  This year’s mid-year report focused on the following objectives:

·         Improving taxpayer services,

·        Enhancing IRS oversight of federal tax-return preparers,

·        Improving the accessibility of the offer-in-compromise program, and

·        Working with the IRS to improve its ability to administer refundable tax credits effectively.

First, as to Taxpayer’s services, the report expressed concern about the IRS's sharp decline in telephone service and need for improvement.  TAS also suggested the IRS’ need to reinvigorate its efforts to pursue cross-functional, research-driven service improvements to implement the Taxpayer Assistance Blueprint­ (TAB).  TAB, originally initiated by Congress’ 2006 appropriations report, is a five-year strategic plan for taxpayer services that was formulated by the IRS and is administered by the IRS, the IRS Oversight Board, and TAS.  See page xi of TAS’ mid-year report for further detail.

Second, as to the oversight of tax-return preparers, the report notes the high percentage of tax-return preparers who fail to prepare accurate returns and the need for government to increase its efforts to protect taxpayers from those tax-return preparers. TAS recommended the following: (i) regulating unenrolled federal tax-return preparers by requiring initial testing and continuing professional education, (ii) increasing IRS enforcement actions against tax-return preparers who fail to perform due diligence or consciously facilitate noncompliance, and (iii) having return prepares use a unique Preparer Tax Identification Number (PTIN) on all returns, thereby making it easier to identify tax-return preparers submitting unreasonably high numbers of inaccurate returns.  

Third, the report addressed the need to improve the accessibility of the IRS's offer-in-compromise program.  TAS suggested that by making the OIC applications less cumbersome, taxpayers who legitimately qualify for OIC will not be deterred to apply.  The IRS has also recently announced the OIC Project Team, including TAS participation, that will examine the characteristics of qualified OIC applicants and increase the number of qualifying applicants. 

Finally, the report addressed the administrative problems presented by the credits that were either increased or introduced by the American Recovery and Reinvestment Act of 2009.  These include the earned income tax credit, the child tax credit, the “Making Work Pay” credit, the “American Opportunity” education tax credit, and the first-time home buyer credit.  The report notes that these refundable credits present an increased risk of fraud and therefore, the IRS will need to balance fraud prevention with the timely delivery of refunds.   As Olson stated

[i]f the IRS does not do enough to detect and prevent fraud, it may pay out billions of dollars as a result of false and fraudulent claims. On the other hand, if the IRS clamps down too tightly, hundreds of thousands and potentially millions of predominantly low income taxpayers will not receive timely refunds.

It will be interesting to see how these objectives will be executed during the 2010 tax year.  Whether the quality of taxpayer services will increase? Whether the number of tax-return preparers reprimanded will increase and then the number of inaccurate returns submitted decrease?  Whether the number of OIC’s accepted will increase?   Finally, whether the Service will properly handle the administration of the refundable tax credits?  TAS’ next report will be due on December 31, 2009.  This report will identify at least 20 of the most serious problems encountered by taxpayers, discuss the 10 tax issues most frequently litigated in the courts, and make administrative and legislative recommendations to resolve taxpayer problems.

See the attached Taxpayer Advocate Service’s mid-year report to Congress.

Download TAS Mid-year report