Sole proprietors and partners who provide services to their partnership business have to pay self-employment taxes on the income they earn from the business. Self-employment taxes include Social Security and Medicare taxes. The owner of the sole proprietorship is then able to deduct one half of this amount in determining his federal income tax liability.
With a Subchapter S corporation, income earned by the owner from the business is generally not subject to self-employment taxes. Instead, the income may constitute taxable wages or a distribution of profits to the owner. The wages will be subject to payroll taxes that are the equivalent to self-employment taxes. The profits distributed to the owner will not be subject to this tax. This is one of the basic tax benefits of using a Subchapter S corporation.
The question presented in Jarrett v. Commissioner, T.C. Summary Opinion 2008-94, is whether a sole proprietorship running funds through a Subchapter S corporation as payment of an expense by a sole proprietorship can help reduce the taxpayer’s combined self-employment and payroll taxes.
Here are the facts in Jarrett. Jarrett operated a tax preparation business as a sole proprietor for over twenty years. Jarrett then formed a separate legal entity as a Subchapter S corporation. On his Schedule C for his sole proprietorship, Jarrett indicated that he received $17,444 of income and incurred $16,420 in expenses for his tax preparation services in 1999. This resulted in $1,024 of taxable income, which resulted in a $145 self-employment tax liability.
Of the $16,420 in expenses for his sole proprietorship, Jarrett included $7,000 for a payment made to his Subchapter S corporation. Jarrett included a Schedule E with his tax return showing the $7,000 payment as income from his Subchapter S corporation.
On audit, the IRS proposed its intention to disallow the $7,000 deduction and to include the $7,000 as income on Jarrett’s Schedule C for his sole proprietor business. This increased Jarrett’s self-employment tax liability by about $500. Jarrett contested the proposed adjustment. The U.S. Tax Court sided with the IRS, believing that the Subchapter S corporation did not provide any services to Jarrett’s sole proprietor business that justified the deduction and allocation of the income to that business.
Jarrett probably could not take advantage of the normal arrangement of operating his business using just a Subchapter S corporation in an effort to lower his payroll tax liability. The amount of money that he earned during the year does not appear to be sufficient for the Subchapter S corporation to pay a reasonable wage and then have some amount of profits left over to pay him a distribution of the profits. All of the $7,000 may have constituted wages to Jarrett.
Given the facts described in the court option, it appears that Jarrett may have tried to sidestep this problem by having his sole proprietorship pay the Subchapter S corporation and then claiming a deduction for the payment, thereby reducing his self-employment taxes for his sole proprietorship rather than reducing his payroll taxes using just a Subchapter S corporation.
Notwithstanding the nominal amounts involved, it seems as if this type of transaction would not result in any significant tax savings. The amounts paid to the Subchapter S corporation probably should have been paid as wages to Jarrett and they would have been subject to payroll taxes. This might be different if the payment was for an activity in which Jarrett did not have to perform services or where the services of the Subchapter S corporation were provided by an independent contractor engaged by the Subchapter S corporation to provide services to the sole proprietorship.
The IRS whistleblower program allows taxpayers to obtain payment from the IRS for providing information about alleged tax wrongdoing by other taxpayers. According to the new guidance issued by the IRS, there has been a significant increase in the number and quality of informant claims. The guidance sets out a three-step process for handling whistleblower claims.
First, according to the guidance, the IRS Whistleblower Office will review the claims. This will involve adding the claim to the IRS’s tracking system. This will also involve verifying that the claims meet the dollar thresholds set out in the Code. Smaller claims will be forwarded to the IRS’s Ogden Informant Claims Examiner Unit and sent directly to the field for possible audit. The larger claims will be scanned and forwarded to a subject matter expert for a particular Industry.
Second, according to the guidance, the subject matter experts, along with the IRS attorneys, will evaluate the claims and determine how the IRS will handle the claims. In this step, the focus is on reviewing the evidence submitted to determine whether the evidence can be considered or used by the IRS. The IRS is directed to limit contact between the persons reviewing the evidence and anyone that later conducts the IRS audit. This step will also involve screening the claim for fraud issues and the potential for referring the claim to the criminal investigation division.
Third, according to the guidance, the expert and IRS attorney will recommend a course of action to the IRS Industry Director. The Industry Director will then decide whether to proceed with the audit examination. When the case is sent to the field for audit, the IRS Whistleblower Office will continue to monitor the status of the audit.
The guidance does not provide a fourth step to explain how the Whistleblower Office will process payments to the informants. I am guessing that this missing fourth step is the one that many would-be informants have the most questions about.
Presumably, the Whistleblower Office will monitor the audits close enough so that they are able to make payments to informants in a timely manner. Just in case this doesn’t happen, it might be helpful if the guidance had required the IRS audit personnel to notify the IRS Whistleblower Office of the resolution of the audit for claims involving informants.
Tax penalties present taxpayers with unique issues to consider. Wilson v. Commissioner, T.C. Summary Opinion 2008-91, describes the situation where a tax attorney represents a taxpayer with a tax penalty that was imposed for a tax return prepared by the attorney’s firm. The issue that the case describes is the conflict of interest that the tax attorney has in representing taxpayers in this situation.
In Wilson, the taxpayers failed to report their Social Security income on their federal tax return. The taxpayers had their tax return prepared by Tax Help, Inc. The IRS sent the taxpayers a notice that it intended to increase the taxpayers’ tax liability to account for their Social Security income. The taxpayers submitted an amended tax return to reflect this income and the IRS assessed an accuracy related penalty. The taxpayers filed a petition to redetermine the tax, apparently, arguing that the penalty should be abated.
There are several defenses that taxpayers may assert to ward off accuracy related penalties. The most common defense is that there was no understatement of tax. If there was an understatement, another common defense is that the taxpayer acted in good faith in relying on a professional tax return preparer.
The U.S. Tax Court said that:
Petitioners failed to demonstrate reasonable and good faith reliance on their tax return preparer. In fact, at the trial petitioners’ attorney, who is also an accountant and employed at Tax Help, Inc., did not pursue this defense in any meaningful way but instead rested his case on [a] baseless contention…
The U.S. Tax Court also noted that:
Insofar as they might be indicative of the nature or quality of advice dispensed at Tax Help, Inc., petitioners’ attorney’s contentions tend to call into question whether the return preparer had sufficient expertise to justify petitioners’ reliance.
This is harsh language from the relatively reserved U.S. Tax Court. The issue that this raises is whether, given the facts described by the court, the tax attorney had an impermissible conflict of interest. As an employee of Tax Help, Inc., the attorney may have owed some duty of loyalty to his employer. As a tax attorney for the taxpayer, the attorney also owed a duty to the taxpayers as clients. The tax attorney’s duty to his clients is to be a zealous advocate for the taxpayers, which may have been muted by his duty to his employer. A tax attorney in this position may not be able to zealously argue that his employer was negligent. An outside tax attorney would be in a better position to make this type of argument.
In Orlock v. Commissioner, the Ninth Circuit Court of Appeals addressed the question of whether a spouse is entitled to a refund of payments to the IRS if she is granted innocent spouse relief. More specifically, the court considered whether the innocent spouse was entitled to a refund of payments made by the innocent spouse with her community property assets.
Married taxpayers who submit joint tax returns are both liable for the full amount of tax on the tax return. They are also jointly responsible for any understatement of tax on the return. The IRS has the authority to rule that one of the spouses is not personally liable for this type of joint understatement of tax. This is often referred to as innocent spouse relief.
In community property states, such as California, most property acquired by spouses during the marriage is subject to the creditors of either spouse. In common law or separate property states, such as Colorado, property acquired by spouses during the marriage may only be subject to the creditors of one of the spouses.
In Orlock, the IRS granted the wife innocent spouse relief. Prior to obtaining this relief, the wife had paid part of the joint tax liability. Part of the payment was made from the wife’s separate property and the rest was paid from the husband and wife’s community property.
The taxpayer petitioned the U.S. Tax Court to determine whether the IRS correctly handled her innocent spouse relief claim. The IRS agreed that the wife was entitled innocent spouse relief and a refund for the amount paid from her separate property, but it did not agree that she was entitled to a refund for the amount paid from her community property. The U.S. Tax Court agreed with the IRS. The Ninth Circuit Court of Appeals has now confirmed that a spouse is not entitled to a refund for the portion of tax paid from her community property after they are granted innocent spouse relief.
A qui tam claim involves a lawsuit where a private citizen helps the government prosecute fraud perpetrated against the government. These claims are often filed by employees or former employees who know of wrongdoing by an employer. These are often whistleblower claims. In exchange for helping to prosecute the claim, the private individuals are entitled to a portion of the government’s recovery.
Qui tam claims - and especially agreements to settle qui tam claims - raise a number of unique tax issues. One such issue is whether a taxpayer who pays to settle a qui tam claim can take advantage of the tax benefit rule. The IRS recently released a legal memorandum that addresses this issue.
The tax benefit rule allows a taxpayer to deduct or receive a tax credit for repaying income that the taxpayer paid tax on in a prior year. The idea is that the taxpayer who paid tax on income in a prior year and then had to repay the income, should be entitled to reduce their current year tax liability to offset the taxes that they paid in error in the prior year.
To qualify for the tax benefit rule, it must appear that the taxpayer had an unrestricted right to the payment in the year in which they received the payment. The courts have created a rule that says that taxpayers are not entitled to claim of right deductions or credits if the income was received on account of fraud or wrongdoing. The idea here is that the taxpayer who commits fraud knows or should know that it does not have an unrestricted right to the income.
A question arises where the taxpayer settles the claim without admitting or being found to have committed fraud - even though the taxpayer’s fraud is readily apparent. As the legal memorandum sets out, the IRS must scrutinize the settlement agreements and the intention of the parties to determine whether the settlement was for wrongdoing and whether there is sufficient nexus between the repayment and the income that was previously reported.
If an accrual method taxpayer issues a gift card, does the taxpayer have to recognize taxable income at the time that the card is sold or when the card is redeemed? The IRS Office of Chief Counsel recently issued a legal memorandum that addresses this question.
According to the IRS attorneys, taxpayers who issue gift cards are to recognize income for federal tax purposes when its gift cards are purchased. The IRS attorneys also conclude that taxpayers are not able to deduct the expense until the time that the gift cards are used.
Here is an example based on the conclusion reached by the IRS attorneys. Say that an accrual method business issues ten $10 gift cards in year one. The business would recognize $100 of income at the time that the gift cards were purchased. If five of the gift cards were used at participating stores in year one, the business would be required to pay $50 to the stores. The business would be able to deduct this expense in year one. If three of the gift cards were used at participating stores and the business paid the stores $30 in year two, the business would be able to deduct the $30 expense in year two. If the two remaining gift cards are not ever used, the business will not be entitled to a deduction for the remaining amount.
In analyzing the tax consequences of gift cards, the IRS attorneys compare payment for the gift cards to situations where a taxpayer receives a non-taxable deposit. With deposits, the recipient generally does not have to recognize income at the time of the payment because the recipient is, in most cases, required to refund the monies at some future time.
The recipient may have to recognize the payment as income when the recipient becomes entitled to retain the payment. This is often referred to as the “all events test.” This test provides that all the events that fix the right to receive income generally occur when (1) the payment is earned through performance, (2) payment is due to the taxpayer, or (3) payment is received by the taxpayer, whichever happens earliest. This often occurs at a subsequent date when the recipient does something to earn the money, such as when the recipient provides a product or service to the payee.
The IRS attorneys discounted the fact that the taxpayer who issued the gift cards may have to refund the monies at any time. The IRS attorneys argue that the payor has immediate control over the payments, given the uncertainties associated with the amount and timing of when the gift cards will be redeemed. In support of this position, the IRS attorneys noted that the taxpayer had not deposited the sale proceeds into a separate account.
The IRS attorneys do note that the result may be different if the payment is actually an advance payment for the sale of the payor’s own goods. If this is the case, the payment may fit within an exception in the Regulations.
The IRS has released proposed Regulations to implement the recent changes in Code Sec. 6039. These Regulations require corporations to report the transfer of stock upon the exercise of incentive stock options (ISOs) and by employee stock purchase plans (ESPPs).
Pursuant to the changes in Code Sec. 6039, corporations must provide this information to the employee and, now, to the IRS by the 31st of January in the year following the transfer. The Regulations indicate that Forms 3921 and 3922 will be used for this purpose.
These Regulations may make it easier to establish the employee’s tax basis in stock acquired from ISOs and ESPPs.The option period for ISOs can be up to ten years.The option period for ESPPs can be even longer.
Prior to the recent changes in the Code, corporations were only required to provide stock transfer information to employees in the year following the transfer.On audit for the year in which the stock was eventually sold, which could be many years or decades later, employees (and the IRS) often realize that the employee has not retained these old records.
Because corporations are not able to deduct the costs of ISOs or ESPPs compensation, many corporations put little effort into providing employees with this information or retaining this information for a long period of time.This is especially true for stock options granted by under-funded start-up companies and in cases where the company has gone out of business or has been acquired by another company.
Now that this information is to be reported to the IRS, the IRS may be able to use its computer matching program to help ensure that the employee’s taxable gain on the sale of the stock is reported correctly.As a result, this may mean that ISO and ESPP-related audits may increase.This also raises questions such as will the government retain this information, how long the government will retain this information, and can the employee rely on the government to retain this information.