Vince Nardone: Tax and Controversy

Cancellation of Indebtedness Income

We hear a lot today about debtors being subject to cancellation of indebtedness income, sometimes referred to as discharge of indebtedness, which I will refer to as COD income.  What you also hear about is debtors complaining that it is unfair.  But, in fact, it is not unfair.  Rather, it is necessary, and what the debtors and their advisors should be looking at is whether there are any exclusions available to the debtor to avoid the income legitimately, and stop worrying about what is fair or unfair.

So, why is it necessary and fair to subject debtors to COD income.  Well, when a borrower receives money in a loan transaction, such as purchasing a home, the borrower does not have to include that money in income.  As a fundamental principle of tax, borrowed monies are excluded from gross income because the obligation to repay borrowed monies offsets the economic increment even though borrowed funds increase a taxpayer's assets.  But, when the obligation is later discharged without requiring the borrower to pay it back, the borrower has realized an accession to wealth.  Again, the receipt of the proceeds of a loan is not income because the receipt is offset by an obligation to repay the borrowed monies.  If the obligation to repay is then eliminated, the borrower realizes an accession to wealth that should be included in gross income (i.e., the COD income).   Under basic tax theory, that is absolutely fair and not requiring them to include it in income is where it would be unfair as a matter of principle.

What debtors and their advisors should be focusing on is what theories under common law and statute, allow the the debtors to avoid the income.  As an example, a debtor that is insolvent immediately before the discharge will likely be able to exclude a portion of the amount discharged from income, both under common law and statute. Debtors and their advisors should seek out competent tax advisors to assist with this analysis.

Internal Revenue Service Announces New Format for Notices

Tax Attorney Vince Nardone discusses a recent Internal Revenue Service release:

Have you previously received an IRS notice that was dated two weeks after the date your received it?  Have you ever received an IRS notice that references a subject matter that does not pertain to you as a taxpayer or simply does not make any sense at all?  My point here is that the IRS has a lot of room for improvement when it comes to their notices.  Well, in Internal Revenue Service news release 2010-3, the IRS has announced new a format for certain notices.  I am skeptical at this point that there will be much improvement.  But, I hope for us tax professionals and our clients that I am wrong and hope that the revised notices are a step in the right direction.  See the newest notices by clicking on the link below or by copying and pasting the link into your web browser.  Also, the complete copy of the IRS news release is attached as a pdf for you to review.

http://www.irs.gov/individuals/article/0,,id=96199,00.html

Download Temp - IRS news release for new notice format

Deferred Payments by Husband, not Alimony - Income Tax

In Richard v. Commissioner, TC Memo 2008-207, the United States Tax Court ruled that the taxpayer's (husband's) payments were not alimony and therefore not deductible.  See full case below.  It is not surprising that another case has been decided where the parties in a domestic relation case have failed to properly plan for the tax implications of the payments or receipt there of.  But, in this instance,one of the parties was a lawyer, so maybe you would have thought that things would be different and thus somewhat surprising.  

To put this case into context, property settlements incident to a divorce generally are not a taxable event.  That is, the receipt of property does not give rise to taxable income and the transfer of property does not give rise to a deduction for the transferring party.  On the other hand, amounts received as alimony or separate maintenance payments are taxable to the recipient anddeductible by the payor in the year paid.  The phrase "alimony or separate maintenance payments" is defined as any cash payments meeting four criteria: 

(i)   such payment is received by or on behalf of a spouse under a divorceor seperation instrument;

(ii)  the divorce or separation instrument does not designate suchpayment as a payment, which is not includible in gross income and not allowable as a deduction;

(iii)in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made; and

(iv) there is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.

The parties, agreed that (i) and (iii) existed and therefore favored alimony treatment.  The parties, disagreed, however, that (ii) and (iv) existed.  The payments at issue dealt with certain deferred payments required to be made, which were evidenced by a promissory note and secured by an irrevocable letter of instruction requiring the husband's/taxpayer's law firm to make the payments in the event of the taxpayer's default.  The settlement further required that the taxpayer maintain a decreasing term life insurance policy on his life,of which the taxpayer's wife was to be the beneficiary and owner until the note was satisfied.  The court ultimately concluded that the payments constituted a marital asset division, as opposed to spousal support, and not to be included in the gross income of the taxpayer's wife or deductible by the taxpayer.  Again, another case where the taxpayer(s) failed to obtain the necessary tax advise prior to the settlement being finalized, and in this instance, at the very costly expense of the taxpayer. 

See the full case text below.  

Download alimony_tax_blog.pdf

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

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 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.

Download blog_2.pdf

IRS Notifies Delinquent Taxpayers to File their 2004 Tax Returns Before April 15, 2008 or Lose Out on $1.2 Billion Dollars

In Information Release 2008-46, the IRS notifies taxpayers that over $1.2 billion dollars are left on the table from non-filers. That is, taxpayers that should have filed returns, but failed to do so for 2004, will loss the opportunity to access those monies. The ability to obtain a refund is generally three years from the date the return was filed or should have been filed, with a number of exceptions. In this instance, a taxpayers 2004 return would have been filed on or before April 15, 2005. Thus, on April 15, 2008, those taxpayers that failed to file a return will lose the opportunity to claim the funds left with the IRS. See the full Information Release below:

Unclaimed refunds totaling approximately $1.2 billion are awaiting about 1.3 million people who failed to file a federal income tax return for 2004, the Internal Revenue Service announced today. However, to collect the money, a return for 2004 must be filed with an IRS office no later than Tuesday, April 15, 2008.

Those due a refund who did not file a 2004 tax return could collect even more money by also filing a 2007 tax return to claim the economic stimulus payment. To receive a payment, taxpayers must have a valid Social Security number, $3,000 of qualifying income and file a 2007 federal tax return. Millions of retirees, disabled veterans and low-wage workers who usually are exempt from filing a tax return must do so this year in order to receive the stimulus payment. Eligible people will receive up to $600 ($1,200 for married couples), and parents will receive an additional $300 for each eligible child younger than 17.

The IRS estimates that half of those who could claim refunds for tax year 2004 would receive more than $552. In some cases, individuals had taxes withheld from their wages, or made payments against their taxes out of self-employed earnings, but had too little income to require filing a tax return. Some taxpayers may also be eligible for the refundable Earned Income Tax Credit.

In cases where a return was not filed, the law provides most taxpayers with a three-year window of opportunity for claiming a refund. If no return is filed to claim the refund within three years, the money becomes property of the U.S. Treasury. For 2004 returns, the window closes on April 15, 2008. The law requires that the return be properly addressed, postmarked and mailed by that date. There is no penalty assessed by the IRS for filing a late return qualifying for a refund.

"Time is getting short for claiming the tax refund you may be entitled to," said acting IRS Commissioner Linda E. Stiff. "But you can’t get it unless you file the tax return. Don't take a chance on losing your tax refund. And this year, remember that you need to file a 2007 tax return in order to receive an economic stimulus payment."

The IRS reminds taxpayers seeking a 2004 refund that their checks will be held if they have not filed tax returns for 2005 or 2006. In addition, the refund will be applied to any amounts still owed to the IRS and may be used to satisfy unpaid child support or past due federal debts such as student loans.

By failing to file a return, individuals stand to lose more than refunds of taxes withheld or paid during 2004. Many low-income workers may not have claimed the Earned Income Tax Credit (EITC). Although eligible taxpayers may get a refund when their EITC is more than what they owe in tax, those who file returns more than three years late would be able only to apply it toward the taxes they owe (if any). They would not be able to receive a refund if the credit exceeded their tax.

Generally, unmarried individuals qualified for the EITC if in 2004 they earned less than $34,458 and had more than one qualifying child living with them, earned less than $30,338 with one qualifying child, or earned less than $11,490 and had no qualifying child. Limits are slightly higher for married individuals filing jointly.

Current and prior year tax forms and instructions are available on the Forms and Publications page of the IRS Web site at IRS.gov or by calling 1-800-TAX-FORM (1-800-829-3676). Information about the Earned Income Tax Credit and how to claim it is also available on the IRS Web site, IRS.gov. Taxpayers who need help also can call the toll-free IRS help line at 1-800-829-1040.

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]

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].

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].

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[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.