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Failing to pay taxes to the government is a crime. This includes failing to pay employment taxes withheld by employers from employee wages. The Treasury Inspector General for Tax Administration (“TIGTA”) just released a report suggesting that the government has failed to enforce employment tax crimes. The report argues that the IRS’s lax enforcement results in non-compliance.
TIGTA’s lack of deterrence argument is as follows:
- As of December 2015, 1.4 million employers owed approximately $45.6 billion in unpaid
employment taxes, interest, and penalties.
- In FY 2015, the IRS assessed the TFRP [the trust fund recovery penalty, which is imposed on those who failed to pay the tax] against approximately 27,000 responsible persons—38 percent fewer than just five years before as a result of diminished revenue officer resources.
- In contrast, the number of employers with egregious employment tax noncompliance (20 or more quarters of delinquent employment taxes) is steadily growing—more than tripling in a 17-year period.
- Although the willful failure to remit employment taxes is a felony, there are fewer than 100 criminal convictions per year.
- Since the number of actual convictions is so minuscule there is likely little deterrent effect.
So basically TIGTA arguments that non-compliance is at an all time high, enforcement has waned, and criminal convictions are basically non-existent for employment tax crimes. TIGTA argues for criminal punishment as a form of deterrence to encourage voluntary compliance from other similarly-situated taxpayers.
Deterrence is generally defined as the action of discouraging an action or event through instilling doubt or fear of the consequences. With employment taxes, this assumes businesses are aware of the IRS’s lax enforcement and knowing this, they willfully fail to pay over the employment taxes withheld from their employee’s wages.
From our limited perspective, few taxpayers know how the IRS handles unpaid employment taxes and they only learn of the IRS’s processes when the IRS asks about the tax. Even then, they do not learn that the IRS’s enforcement is lax.
But if the government stepped up its enforcement of employment tax crimes, would this lead to increased employment tax compliance? It does not seem like it would. Again, from our limited perspective, these taxes are usually not paid over to the government due to circumstances beyond the taxpayer’s control–such as accounting personnel who take steps to hide the issue. Increased criminal enforcement would do little to change the outcome in these cases.
It other cases it does not seem like increased criminal enforcement to encourage compliance is appropriate in this area. In many of these types of cases, the taxes are not paid due to difficult financial situations that often come down to paying suppliers or paying wages to loyal and hard working employees so the employees can keep their jobs and feed their families, versus paying the employment taxes to the government. From a criminal prosecution perspective, the TIGTA report is correct in noting that the law says that willful failure to pay the tax is a crime and that evil motive or bad purpose is not necessary for a conviction. Maybe increased criminal enforcement could produce additional compliance in these cases, but should the government focus its limited resources on this type of non-compliance versus other areas where non-compliance is more visible and clearly willful?
The IRS largely disagreed with the TIGTA report for these very reasons. As noted in the report, the IRS indicated that cases should only be considered for criminal referral where a firm indication of fraud is present.
Taxpayers who own an interest in an S corporation but who are not familiar with the tax rules are often surprised to learn that they have to pay tax on the business profits even if they do not receive distributions from the business. The court recently addressed this fundamental concept in Dalton v. Commissioner, T.C. Memo. 2017-43. The case stands as a strong reminder that a tax advisor should be involved when shareholders sell or otherwise transfer their shares.
The facts and procedural history are as follows:
- The disputed involved a construction company that was taxed as an S corporation.
- The company was owned equally by two brothers.
- One of the brothers decided he wanted to resign and turn in his shares.
- The non-resigning brother took steps to lock his brother out of the business.
- Litigation ensued and the resigning brother ended up transferring his shares to his brother as part of a mediation agreement.
- The agreement provided the “transfer shall be effective no earlier than January 1, 2008, and no later than July 24, 2008, as determined by” the non-resigning brother.
- The company then issued a Schedule K-1 to the resigning brother for $451,531 of pass-through income through July 24, 2008.
- The resigning brother did not receive a distribution for this short tax year.
The issue in the tax court case was whether the resigning brother was liable for taxes on a distribution he did not receive.
S Corporation Rules
S corporations are not subject to Federal income tax. Rather, their items of income, deduction, credit, etc. flow through to the shareholder’s personal income tax returns. This is true regardless of whether any distributions are made to the shareholders. This often comes as a surprise to those who are not familiar with S corporations.
This aspect of S corporations often causes problems when there is a minority shareholder that cannot afford to pay taxes on the distributions and the S corporation retain earnings to invest in the business or uses the funds for other business expenses. The owners of S corporations will normally agree to make distributions to help the minority shareholders to address this problem.
Distributions That Are Not Made
In the Dalton case, the brother’s relationship had deteriorated. This may be why the company did not make distributions.
It might also be that the agreement between the brothers did not require a distribution or that one was needed for the retiring brother to be able to afford the taxes. The court opinion does not go into these details, but it would seem that the retiring brother would have received some sort of payout in exchange for his shares. This may have been pursuant to an installment agreement over a period of time, however. It could have also been treated as a guaranteed payment rather than a distribution. In either case, it would seem that the non-retiring brother had some funds from which to pay the resulting tax.
The unspecified closing date that could be determined by the non-retiring partner is also problematic. The agreement should have set a specific closing date, rather than leaving the closing date open for such a long period and allowing one party to decide what the actual date would be. This allowed time for the company to accrue profits that would be subject to tax. It could have also presented a situation where the non-retiring brother accelerated income and delayed deductions for the business in an effort to shift more of the Federal income tax liability to the retiring brother. The case does not indicate that this happened here, but it may very well have.
Suffice it to say that the agreement should have addressed these details and the resulting tax consequences. In reading the case, it seems like the retiring brother did not hire a tax advisor to help negotiate the agreement. One is left wondering if the non-retiring brother did have a tax advisor advising him.
One of the benefits of Subchapter S corporations is the ability to have losses flow through from the business’ tax return to the individual shareholder’s tax return. These flow-through losses are limited by the shareholder’s tax basis in the S corporation stock. The court recently addressed this limitation in Tinsley v. Commissioner, T.C. Summary Opinion 2017-9. This case is timely given that this issue is the focus of the IRS’s new audit campaigns.
The taxpayer in Tinsley was the sole shareholder of an S corporation. The corporation had borrowed approximately $100,000 from a bank. The S corporation then dissolved under state law and reported a loss on its 1120S tax return. The bank then renewed the loan, but it listed the old corporation as the borrower. It also had the taxpayer guarantee the loan. The taxpayer continued to operate the business under the old name. The taxpayer reported the loss on his personal tax returns. The IRS disallowed the flow-through loss.
The taxpayer did not have any tax basis in the S corporation stock due to capital contributions to the business. He argued that he had tax basis in the S corporation stock given his personal guarantee of the $100,000 bank loan:
he contends that upon the liquidation, he assumed the balance due on the note as guarantor, and because he was the sole remaining obligor, this assumption was a contribution to capital, allowing him to deduct the amount of Command Computers’ losses. Further, Mr. Tinsley asserts that following Command Computers’ liquidation, the Bank expected him, as guarantor, to repay the loan and that the Bank’s expectation was sufficient to generate a basis for Mr. Tinsley in Command Computers.
The court did not agree. The court noted that merely guaranteeing an S corporation’s debt is not sufficient to generate a basis under section 1366(d). The court noted that a shareholder may obtain an increase in basis in an S corporation only if there is an economic outlay on the part of the shareholder that leaves him or her “poorer in a material sense.” The taxpayer has to have an economic outlay. This can come about if the lender looks primarily to the taxpayer to repay the loan.
According to the court, there was no evidence that the lender in this case looked only to the taxpayer to repay the loan. The court seems to say that the lender looks to the non-existent corporation that is listed as the borrower. The court also said there was no evidence of an economic outlay by the taxpayer as the court record did not include evidence that the taxpayer was the party paying the loan.
These 1366(d) basis rules are in addition to the Sec. 465 at-risk and Sec. 469 passive activity loss rules. It should also be noted that this same fact pattern would satisfy the Sec. 465 at-risk rules as they do not require an economic outlay or the taxpayer to be the primary source of repayment.
To avoid this type of Sec. 1366(d) tax basis issue, taxpayers should document their economic outlays and/or that the borrower looks primarily to them to satisfy the loan.
Sometimes it is best to wait for the IRS’s collection statute to expire. This is a wait-and-see approach where the taxpayer waits to see if the IRS attempts to collect the tax debt. To succeed, it is important for the taxpayer to not extend the IRS’s collection statute. This issue came to a head in United States v. Kidwell, Civ. No. 2:16-433 WBS EFB (E.D. Cal. 2017).
The Kidwell case involved unpaid employment taxes. The taxes were reported on a Form 941 for the period ending September 30, 2004, which was filed on April 4, 2005, and a Form 941 for the period ending December 31, 2004, which was filed on January 31, 2005. The IRS assessed the taxes on March 28, 2005 and May 23, 2005. On March 1, 2016, the government sued the taxpayer to reduce the tax debt to a judgment. This would allow the government to continue to try to collect the unpaid taxes beyond the normal 10-year collection statute.
The IRS’s collection statute is generally 10 years from the day the tax is assessed. So it would seem that the 10 year period had lapsed by the time the government brought suit to collect the taxes. There are several actions that can extend the statute. The rules that extend the statue when the taxpayer submits an offer in compromise were considered in this case.
The offer in compromise is a formal administrative process for submitting a proposal to settle unpaid taxes. The statute of limitations rule for offers says that the IRS’s 10-year collection statute is suspended while an offer-in-compromise is pending and for thirty days after any rejection or appeal of the rejection.
In the Kidwell case, the IRS provided records showing that an offer in compromise was submitted, but it could not produce the offer or any other evidence about the offer having been submitted. The government conceded that the IRS destroyed the administrative records.
One would think that taxpayers who are trying to run out the statute of limitations would know whether they submitted an offer in compromise. That was not the case here. The taxpayer did not recall submitting an offer in compromise:
all of the deposition testimony that defendant points to states that defendant and his agents could not recall whether defendant submitted an offer-in-compromise. Defendant testified that he did not handle the taxes for the business, he “would only be guessing” whether an offer-in-compromise was filed, and it was “a possibility” that his accountant filed an offer for him. (Kidwell Dep. 64:17-65:21.) Defendant’s accountant, Ms. Kendall, stated that she “didn’t even remember [they] did an offer for [defendant].” (See Luoma Decl., Ex. B 52:5-8 (Docket No. 13-3).) Defendant’s business secretary, when asked whether she was aware that defendant made an offer-in-compromise, admitted that she was not the person who was corresponding with the IRS and was “not aware of an Offer in Compromise that [Ms. Kendall] would have made.” (Id., Ex. C 48:6-49:10.)
The Taxpayer argued that these facts created a triable issue and that it should get its day in court to prove these items. The court did not agree. The court concluded that this evidence did not create a triable issue of material fact as to the tolling or expiration of the statute of limitations. As such, it ruled in favor of the government.
It should also be noted that the Taxpayer argued that the tax liability was his wife’s, which means any offer would have been submitted for her and not for him. We have seen the IRS do this. It is a common practice. The IRS also does this with bankruptcy holds. The court was not presented with expert testimony explaining this and, as such, it did not find this argument persuasive.
In Scheurer v. Commissioner, T.C. Memo. 2017-36, the court denied a bad debt deduction for a loan that an unrelated third party would not have made given that the borrower had bad credit. This is one of the factors the courts consider in deciding whether a bad debt deduction is allowable. The case adds to the substantial body of law that helps clarify what facts are needed to support a bad debt deduction.
The IRS will often assert trust fund recovery penalties against anyone who signs checks written on the business checking account. The court addressed this in Shaffran v. Commissioner, T.C. Memo. 2017-35, concluding that some check signing activity alone is not sufficient to impose a trust fund recovery penalty. The case provides some insight as to how the IRS assesses these penalties.
The facts and procedural history are as follows:
- The case involved unpaid employment taxes for a restaurant.
- The restaurant had gone out of business before the IRS began its review of the unpaid employment taxes.
- The IRS revenue officer assigned the case spoke to the former landlord and was told that Mr. Shaffran was the bookkeeper for the restaurant.
- This was the sole information the IRS revenue officer used to determine that Mr. Shaffran was a responsible person and liable for the trust fund recovery penalty.
- The IRS mailed Mr. Shaffran a letter letting him know that the IRS was assessing the trust fund recovery penalty against him, but the letter was intercepted by the restaurant owner and not received by Mr. Shaffran.
- Mr. Shaffran was not the bookkeeper. The facts suggest that he was basically a friend of the individuals who owned the restaurant who assisted with the restaurant occasionally.
- This help included writing four checks from the business checking account when the owners were on vacation.
- The IRS issued an administrative summons to the bank to obtain the restaurant’s checking account records and confused the owner’s signature on the checks with Mr. Shaffran’s signature.
The issue for the court was whether these facts justify holding Mr. Shaffran liable for the trust fund recovery penalty. This turned on whether he had the ability to pay other creditors in lieu of the IRS. The court concluded that he did not:
The preponderance of the evidence establishes that petitioner lacked sufficient control over Restaurant Group’s affairs to avoid the nonpayment of its employment taxes during the tax periods in question. Petitioner was not an officer, director, employee or owner of Restaurant Group at any time. He was never an authorized signatory on Restaurant Group’s bank accounts. It is also clear from petitioner’s credible testimony and the administrative record that he: (1) did not have the authority to hire and fire Restaurant Group’s employees; (2) had no duty to, and did not, review or reconcile Restaurant Group’s bank statements; and (3) had no control over disbursements and decisions pertaining to Restaurant Group’s bank accounts, including the payroll account. Furthermore, there is no evidence that petitioner had any involvement in the preparation or filing of Restaurant Group’s employment tax returns or the payment of its employment taxes.
This case is an instance where the penalties should not have been imposed based on an unconfirmed statement that the person was a bookkeeper and corroborated by a mistaken belief that the person signed checks for the business. These are facts that a proper investigation would have disclosed. The IRS revenue officer assigned to the case did not do this investigation and their front line manager did not ensure that the revenue officer worked the case properly.
On appeal, the IRS settlement officer proposed to place the case in currently not collectible status and to abate the penalties for several of the tax periods. The settlement officer should have recorded these facts and proposal in an appeals memo or case closing record. Either this was not done (or the memo or closing record was vague) or the appeals team manager did not review the file properly before closing the case. The case may even have been sent to IRS review in collections or in appeals, which would mean that the reviewer or reviewers did not have enough information in the file to see the issue or they missed it. All-in-all, this means there were four to six IRS employees tasked with ensuring that the correct result was reached and, given the court decision, every one of them failed Mr. Shaffran.
The case serves as a reminder that the IRS is not perfect. IRS employees make a lot of decisions and they often do so with limited and flawed information. It is up to taxpayers to be vigilant and be willing to push back even when their case is reviewed by several different IRS employees at different levels within the IRS. With the trust fund recovery penalty, in particular, taxpayers should not accept that they are liable for the penalty just because they signed a few checks.
The Sixth Circuit Court of Appeals upheld the IC-DISC Roth IRA tax strategy in In Summa Holdings, Inc. v. Commissioner, No. 16-1712 (2017). This tax strategy allows business owners to sidestep the annual Roth IRA contribution limits, thereby allowing the taxpayers to amass sizable amounts in their Roth IRAs to grow tax-free. The case is noteworthy as it addresses the limits of the IRS’s ability to use the substance over form doctrine to recast otherwise legitimate tax strategies.
The Facts & Procedural History
The facts and procedural history of the case are as follows:
- The case involved a family-owned manufacturing business.
- Two of the owner’s children established Roth IRAs in 2001 and contributed $3,500 to each IRA.
- Each Roth IRA then purchased shares in a newly created legal entity (“DISC Entity”) in 2001 for $1,500.
- The family formed another legal entity that purchased the DISC Entity (“Holding Entity”).
- So the Roth IRAs each owned 50% of the Holding Entity and the Holding Entity owned 100% of the DISC Entity.
- The family business paid more than $5 million in commissions to the DISC Entity.
- The DISC Entity distributed this $5 million commissions as dividends to the Holding Entity.
- The Holding Entity paid a 33% income tax on the $5 million dividends and distributed the amounts to the Roth IRAs.
- The IRS issued notices of deficiency to the family business for 2008, arguing that the amounts paid to the DISC Entity were not commissions but rather dividends. This precluded the use of the IC-DISC rules. This also resulted in the family business not being entitled to the deductions it took for the commissions it paid.
- The IRS’s notice of deficiency was based on the substance over form doctrine.
- The U.S. Tax Court agreed with the IRS’s determination.
On appeal, the court was tasked with deciding whether the substance over form doctrine should be used when the actual transactions complied with the law and were consistent with the Congressional intent underlying the relevant tax statutes.
The IC-DISC Rules
The IC-DISC rules are intended to be an incentive for taxpayers to export U.S. products. It accomplishes this by allowing the business to deduct commissions paid to an entity set up to receive the commissions and the entity that receives the commissions may be able to pay tax on the income at the lower dividend tax rate. The resulting tax reduction can prove to be a significant monetary incentive for U.S. manufacturers. The tax reduction can be even greater when, as in this case, the IC-DISC is combined with a Roth IRA–assuming the arrangement is upheld by the courts.
The Importance of Tax Reduction Statutes
This brings us back to the case at hand. The IRS argued that it should be allowed to disregard the formalities of the Roth IRA-IC-DISC transaction, which satisfied the formalities of the law requirement as the transaction complied with the law, to look to the substance of the transactions. To the IRS, the substance of the transaction was to avoid the annual Roth IRA contribution limits.
The appeals court did not agree. The appeals court focused on the fact that the Roth IRA and IC-DISC rules are tax reduction statutes. Congress made it clear that these statutes were intended to be used by taxpayers to reduce their tax liabilities:
Congress designed DISCs to enable exporters to defer corporate income tax. The Code authorizes companies to create DISCs as shell corporations that can receive commissions and pay dividends that have no economic substance at all. See 26 C.F.R. § 1.994-1(a); Addison Int’l, Inc. v. Comm’r, 887 F.2d 660, 666 (6th Cir. 1989); Jet Research, Inc. v. Comm’r, 60 T.C.M. (CCH) 613 (1990). By congressional design, DISCs are all form and no substance, making it inappropriate to tag Summa Holdings with a substance-over-form complaint with respect to its use of DISCs. The same is true for the Roth IRAs. They, too, are designed for tax-reduction purposes.
When the Substance Over Form Doctrine Applies
According to the appeals court, the substance over form doctrine should only apply to transactions that are a labeling game sham (i.e., calling a dog a cow and seeking an incentive that applies to cows) and transactions that defy economic reality. The substance over form doctrine is not to apply when two potential options for structuring a transaction lead to the same end and the taxpayers choose the lower-tax path, when these types of tax reduction statues are in question.