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If a Subchapter S corporation pays its shareholder’s personal expenses, can the payments be for the repayment of loans not subject to employment instead of wages subject to employment taxes? This is a common issue that has to be addressed when preparing S corp. tax returns. The IRS addressed this in AOD 2017-04, which was issued to note is disagreement with the U.S. Tax Court’s decision in Scott Singer Installations, Inc. v. Commissioner, T.C. Memo. 2016-161.
The S Corp Loan Case Facts
The facts in the Scott Singer Installations, Inc. v. Commissioner case are as follows: The taxpayer is a RV parts and servicing business and taxed as a Subchapter S corporation. Mr. Singer was the sole shareholder and actively involved in running the S corp. Mr. Singer advanced funds to the taxpayer in 2006-2011 and charged business expenses to his personal credit card. These advances were recorded as shareholder loans on the taxpayer’s books.
The taxpayer incurred losses in 2010 and 2011 and during these years it paid $181,872 of Mr. Singer’s personal expenses. These expenses were treated as repayments of the shareholder loans on the taxpayer’s books. The IRS determined that the taxpayer’s payments of Mr. Singer’s personal expenses were wages subject to tax.
The Court: Loan Repayments, Not Wages
The U.S. Tax Court concluded that Mr. Singer was an employee, but that the advances Mr. Singer made to the taxpayer were loans and that the payment of his personal expenses were repayments for those loans. The court reached this conclusion even though there was no promissory note or other documentation for the loans. Recording the transactions as loans on the taxpayer’s books was sufficient. The court also noted that the payment of personal expenses was recurring over time, which make it look like a loan repayment, and that the personal expenses continued to be paid even when the taxpayer was incurring losses.
The Importance of the Debtor-Creditor Relationship
The IRS does not agree with this holding. It concludes that the payment of a shareholder’s personal expenses by an S corp. are wages if the shareholder performs substantial services for the S corp. The IRS discounted the courts point that the recurring nature of the expenses and that the payments continued to be made when the taxpayer was incurring losses.
The IRS then notes the distinction between this case and the prior cases that reached the opposite conclusion, namely, the courts in the prior cases did not find a debtor-creditor relationship. If anything, the IRS’s AOD drives home the point that taxpayers should document the debtor-creditor relationship for loans.
It is not clear as to what level of conduct justifies the imposition of the $100,000+ foreign bank account reporting (“FBAR”) civil tax penalty. In Bedrosian v. United States, No. 15-5853 (E.D. Pa. 2017), the court considered whether reckless conduct is sufficient given the facts presented in the case.
The FBAR Civil Tax Penalty
The FBAR rules require U.S. citizens to report a financial interest in, or signature or other authority over, a bank, securities, or another financial account in a foreign country. If the account exceeds $10,000 in value, the penalty is $10,000 for non-willful violations and $100,000+ for willful violations. This begs the question as to what conduct is willful for the FBAR penalty.
Willful Includes Reckless Conduct
As noted by the court in Bedrosian, there is no clear guidance that answers this question (“Authorities ranging from various federal courts, the Internal Revenue Manual, and the Office of Chief Counsel for the Internal Revenue Service reach different conclusions about the level of intent necessary to satisfy the willfulness requirement”).
The taxpayer in Bedrosian cited the criminal penalty standard, which is a “voluntary, intentional violation of a known legal duty.” The court noted that the standard for the civil tax penalty is something less, suggesting that reckless conduct can satisfy the willful requirement for the FBAR civil penalty.
Is Following the Advice from a Tax Preparer Reckless?
There are several other cases that are very similar to this case. In those cases, the decision as to whether the conduct was reckless came down to whether the taxpayer was credible, his lack of knowledge genuine, and that he did not make other omissions or false statements in trying to report or resolve the FBAR penalties. It also helps if the taxpayer came forward to report the foreign account prior to the IRS finding out about the account.
The Bedrosian is somewhat unique in that the taxpayer claimed that his tax return preparer had advised him not to report the foreign account as the “damage had already been done.” This was a reference to the foreign account not previously having been reported. When the tax return preparer died and was replaced by a new tax return preparer, the taxpayer and his new tax return preparer reported one of the taxpayer’s two foreign accounts. The IRS then obtained information about the accounts from the foreign bank and notified the taxpayer of this. The taxpayer cooperated with the IRS in its investigation of the penalty and the IRS initially decided to close the case without imposing FBAR penalties. The IRS ended up imposing FBAR penalties when a new IRS agent was assigned to work the case.
The court did not decide whether this conduct was reckless as the case was presented on summary judgment. The court concluded that there were factual issues that did not warrant dismissing the case on summary judgment.
Cases like the Bedrosian case help define the conduct that is reckless for purposes of the FBAR penalty. Given that there is no clear definition of what conduct qualifies, this is a case that we will have to watch to see how the court or jury decides the issue.
When the IRS determines that independent contractors are taxed as employees, it is up to the employer to show that the IRS determination is incorrect. One way to do this is to show that the workers paid tax even though the employer did not withhold the tax. In Mescalero Apache Tribe v. Commissioner, 148 T.C. 11, the court addressed whether an employer has access to an employee’s IRS records to show that the employer is not liable for taxes it failed to withhold.
Employment Tax Audits
The IRS’s Small Business/Self-Employed Division has a small team of employment tax auditors whose job is to determine whether employment taxes are correctly determined, withheld and remitted to the IRS. These auditors conduct stand-alone employment tax audits and they are often brought into ongoing income tax audits when the income tax auditors uncover employment tax issues.
Employment tax auditors focus on worker classification cases. These are cases whereby the employer has paid workers as independent contractors rather than employees. There are a number of rules that apply in determining which classification is correct. There are also very generous settlement programs available to resolve these types of audits. These settlement programs require the employer to treat their workers as employees going forward. This affords little help if the workers really are independent contractors or if the other non-tax implications are too much to accept treating the workers as employees–such as entitlement to employee benefits, healthcare, etc.
There are also a number of options for employers who want to challenge the IRS’s worker classification determination. One option is to simply show that the worker paid the tax, as the law does not allow the IRS to collect the tax twice. So how does an employer show that the worker paid the tax? They usually do this by contacting the worker and asking them to fill out a form to indicate that the tax was paid. But what if the employer cannot locate the worker or if the worker refuses? The IRS has records showing whether the worker paid the tax. The IRS has always taken the position that it cannot disclose the worker’s IRS records to the employer given the confidentiality rules in the Code.
The Confidentiality Rules
This brings us to the Mescalero Apache Tribe case. The court analyzed the confidentiality rules and concluded that they do not prevent the employer from getting access to the worker’s records on audit or in court. This is limited to disclosure in judicial and administrative tax proceedings to persons other than government officials if the information directly relates to a transactional relationship between a person who is a party to the proceeding and the taxpayer (i.e., worker) which directly affects the resolution of an issue in the proceeding.
It is not clear whether the IRS will acquiesce to this decision or whether the U.S. Tax Court would reach the same conclusion when applying the law of a different circuit or if other courts will follow the decision. Nevertheless, the case provides employers with something to cite when requesting access to IRS records for their workers during and following employment tax audits.
The Section 6707A reportable transaction penalty can be difficult to work with given the more limited avenues for contesting the penalty. The court addressed this in Bitter v. Commissioner, T.C. Memo. 2017-46, in the context of a Section 412(i) plan. Tax advisors have been waiting for an answer to the very question about how to compute the penalty that is posed in the Bitter case. That question is whether the amount listed on the tax return must be used to compute the penalty or if the true decrease in tax is to be used.
The 6707A Reportable Transaction Penalty
The Section 6707A reportable transaction penalty applies if the taxpayer fails to report certain transactions to the IRS on a Form 8886, Reportable Transaction Disclosure Statement, with their tax return. The IRS determines which transactions are reportable by identifying transactions and designating them as listed transactions. Unlike most other tax penalties, the Section 707A reportable transaction penalty is an assessable penalty. This means that the IRS can assess the penalty without going through the statutory notice procedures. This also means that taxpayers generally cannot contest the penalty in U.S. Tax Court. So taxpayers have to pay the penalty, file a refund claim, wait for the refund claim to be denied, and then sue for a refund in U.S. District Court or the Federal Claims Court.
Section 412(i) Plans
Section 412(i) plans are a type of retirement plan where the plan purchases life insurance on the participants and the participants receive death benefits from the plan. Unlike traditional pensions, Section 412(i) plans have the advantage of not requiring the business to made additional contributions if the investments held by the plan lose money or do not perform well.
The IRS’s View of Section 412(i) Plans
Section 412(i) plans were popular in the late 1990s and early 2000s. Their popularity waned shortly thereafter given the IRS’s tough stance on these plans. The then new Section 6707A reportable transaction penalty all but killed Section 412(i) plans, as the IRS designated the plans as listed transactions that had to be reported to the IRS.
The IRS has taken the position that the full amount of the deductions taken for the plan are to be used to determine the amount of the Section 6707A penalty. Tax advisors have wondered whether the amount for the portion of the deductions for contributions that would be deductible under another Code section should be removed when calculating the Section 6707A penalty. The IRS takes the position that the penalty is computed based only on the amount listed on the tax return. So for example, if the taxpayer made an error and grossly overreported the amount of the Section 412(i) deduction, the IRS would say that the penalty is computed based on this amount–which would produce a larger penalty. The same would be true if the taxpayer grossly underreported the deduction on his return–which would produce a smaller penalty. This issue has not been considered by the courts, which is probably due in large part to the Section 6707A penalty not being subject to challenge in U.S. Tax Court.
Challenging the Section 6707A Penalty
This brings us to the Bitter case. The taxpayer in Bitter was asking the U.S. Tax Court to consider this question for the penalty as part of a challenge to a collection due process (“CDP”) hearing. As noted by the court, the U.S. Tax Court can consider whether a taxpayer is liable for this penalty, but it can only do so if the taxpayer has not previosly had an opportunity to contest his liablity for the penalty. The court noted that the taxpayer had challenged this penalty adminsitratively by having a conference with the IRS Office of Appeals. Since the taxpayer was afforded this opportunity, he was precluded from challenging the penalty in the U.S. Tax Court. So the question remains as to whether the Section 6707A penalty is to be computed using the full deduction amount under Section 412(i) (which has been re-numbered in the Code) or the difference between this amount and the amount of the deduction that would otherwise be allowable even though not reported on the taxpayer’s tax return.
The transfer pricing disputes often involve transfers of property offshore. Taxpayers make these transfers so that the post-transfer profits earned from the offshored property are not subject to tax in the U.S. or, in many cases, not subject to tax in the foreign countries either. The U.S. Tax Court recently decided Amazon Inc. v. Commissioner, 148 T.C. No. 8, which many corporate tax departments were watching closely to see how it would impact their own tax positions.
The facts in Amazon case involve a structure that has been widely used by U.S. Fortune 500 companies. The structure looks something like this:
- the company forms a legal entity in Europe and elects to have it treated as a controlled foreign corporation (“CFC”),
- the company transfers property (including intellectual property–such as trade names, know-how, computer software, contracts–and other intangibles) to the CFC,
- the company engages a valuation expert to value the assets that are transferred and reports and pays tax to the IRS on the sale of the assets to the CFC (the tax is paid for the CFC’s buy-in payment),
- the company enters into a cost sharing agreement (“CSA”) with the CFC so that each party contributes their assets to the CSA and is liable for the expenses they make to use/develop the assets in their respective jurisdictions,
- the CFC transfers or licenses the assets to an entity in another country that does not tax income from the assets or enters into service agreements to pull the profits to another country and obtains a favorable letter ruling from the foreign countries that allow the CFC to pay little to no tax on the income from the assets.
The IRS challenges this structure is by challenging the valuation and amount of the buy-in payment that is subject to tax in the U.S. and/or the expenses in the CSA payments. This is what the IRS did in the Amazon case.
The IRS determined the buy-in payment should have been $3.468 billion. The taxpayer’s valuation experts had determined the buy-in payment was $254.5 million. So there was more than a $3 billion difference in the valuations. This difference was attributable to the royalty rate, the useful life and decay curve, the revenue base, and discount rate each party used.
The court largely sided with the taxpayer on these issues. The case serves as yet another transfer pricing case that the IRS lost. Given the amounts at stake, the IRS will continue to make this type of challenge its top priority. Taxpayers who have buy-ins and CSAs should read the case and compare these variables to their own positions to see how they stack up.
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.