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How to Challenge an Invalid IRS Notice of Deficiency

The IRS is required to send taxpayers a notice of deficiency before it can assess additional tax. The notice itself has to put the taxpayer on notice that the IRS made a determination that there was a tax deficiency (i.e., an amount owed), the tax year, and the amount. A notice that does not include one or more of these items may be invalid and, if enough time has passed, can prevent the IRS from lawfully assessing the tax. The U.S. Tax Court set out a two-prong test in Dee v. Commissioner, 148 T.C. No. 1 (2017), that may make it more difficult for taxpayers to challenge invalid notices.

The Facts and Procedural History

The facts and procedural history are as follows:

  • The taxpayer filed his 2014 tax return.
  • The IRS disallowed the premium tax credit reported on the return in 2015 by mailing a notice of deficiency to the taxpayer.
  • The notice of deficiency reflected $0.00 as the deficiency amount.
  • The notice also included tax calculations and indicated that “[a] decrease to refundable credit results in a tax increase.”
  • The taxpayer filed a petition with the U.S. Tax Court to challenge the disallowance of the premium tax credit.

The court asked the IRS to explain how the court had jurisdiction over the case if there was a tax deficiency in the amount of $0.00. The IRS responded that this was a clerical error and that it did not invalidate the notice of deficiency.

The Majority Opinion

The court said this two-prong test is to be used to determine whether a notice of deficiency is valid:

We have often addressed questions regarding the validity of notices of deficiency. We have at times characterized our review of the sufficiency of a notice as an objective test. But our caselaw shows that an objective review is used to establish prima facie validity of a notice of deficiency. When that objective review has led us to conclude that a notice was ambiguous, we have looked beyond the notice to determine whether the Commissioner made a determination and whether the taxpayer knew or should have known that the Commissioner determined a deficiency.

The court viewed the objective test as a “should have known” test and the subjective test as a “knew” test.

The court explained the objective test as follows:

we look to see whether the notice objectively put a reasonable taxpayer on notice that the Commissioner determined a deficiency in tax for a particular year and amount. If the notice, viewed objectively, sets forth this information, then it is a valid notice. … Accordingly, if the notice is sufficient to inform a reasonable taxpayer that the Commissioner has determined a deficiency, our inquiry ends there; the notice is valid.

The court explained the subjective test in light of a prior court case where the taxpayer asserted that he was not mislead by the error in the notice of deficiency. The taxpayer in this prior court case made this admission to allow the court to have jurisdiction. The court also cited another prior court case in which the court concluded that the taxpayer was not misled by the error given the taxpayer had filed a petition with the court contesting the deficiency.

In this case, the court determined that the taxpayer was not misled by the error given the taxpayer had filed a petition with the tax court contesting the deficiency. As such the court concluded that the notice of deficiency was valid and it had jurisdiction over the case.

The Concurring Opinions

One justice issued a concurring opinion to agree with the court’s conclusion, but not its two-prong test for reaching the conclusion:

I disagree that our caselaw supports a test that looks, in part, to whether the taxpayer knew or should have known that the Commissioner determined a deficiency or was misled. The references to a taxpayer’s knowledge or intent and/or to whether a taxpayer was misled in the cases on which the opinion of the Court relies are dicta reinforcing the Court’s conclusion in each case that the Commissioner made a determination in the notice of deficiency that passes jurisdictional muster. We should not elevate those references into a test that has no place in resolving the real jurisdictional issue—whether the Commissioner in the notice of deficiency made a determination with respect to the taxpayer that confers jurisdiction on this Court.

A second justice also issued a concurring option to agree with the court’s conclusion, but not its two-prong test for reaching the conclusion:

The opinion of the Court delineates a two-prong approach (with both objective and subjective elements) to determining our deficiency jurisdiction that is, at best, unnecessary, and is, at worst, improper.

The Dissenting Opinion

A third justice issued a dissent to disagree with the court’s conclusion:

The existence of a deficiency is a notice’s most fundamental requirement. The Commissioner is not required to give the correct deficiency amount, but he is required to determine an amount, and $0 is not a deficiency. The opinion of the Court cites a myriad of cases referencing notices dating back to 1919, see op. Ct. pp. 6-13, yet none of those cases hold valid a notice which informs the taxpayer that he does not have a deficiency.

The Problem with the Result

In a footnote in the dissenting opinion, the justice explained the problem with the court’s two-prong test:

While the notice in this case related to a refundable tax credit, the precedent here will extend to notices issued to increase tax liabilities. Some taxpayers receiving those notices will petition the Court. Their ticket to the Tax Court will also be a ticket to the gallows. Other taxpayers will not file petitions and may ultimately seek relief (i.e., pursuant to sec. 6320 or 6330) when the IRS attempts to collect. If we invalidate $0 deficiency notices, taxpayers would typically prevail in collection proceedings. Instead, our determination of whether the taxpayers were misled will now determine their fate.

The second justice who issued a concurring opinion (as described above), explained it this way:

Even in cases in which the Commissioner sends an inadequate notice of deficiency, the taxpayer does not petition us for redetermination, and tax is subsequently assessed, the taxpayer is not completely out of luck. The taxpayer has the option to pay the assessed tax and pursue a refund claim, after which he or she is entitled to file a suit for refund in a U.S. District Court or the U.S. Court of Federal Claims. Or, if the taxpayer does not become aware of the assessment until receiving a collection notice, the taxpayer can seek relief in a collections due process hearing, after which he or she is entitled to petition this Court for review. Although our caselaw probably would not allow us to find that a taxpayer who receives an inadequate notice of deficiency was not issued a notice of deficiency and thus is entitled to challenge his or her underlying liability under section 6330(c)(2)(B) (as Judge Foley correctly notes in his dissent, see Foley op. note 2, but which is true regardless of the outcome of this case), we could instead find that the Commissioner, in issuing an inadequate notice, failed to fulfill the necessary administrative procedures, including those in the Internal Revenue Manual, under section 6330(c)(1).

What this means is that by filing a petition in tax court, the taxpayer may lose the ability to contest the notice of deficiency in tax court. Even if the case was brought as part of a collection due process hearing, all the taxpayer would get was the case remanded to appeals for further consideration by a settlement officer. To have their day in court, the taxpayer may have to file a refund claim, pay the tax first, sue for a refund and contend with the higher burden imposed on taxpayers in refund litigation.

Bankruptcy Court Says Withholding on Wages Converts the Wages to a Tax

The U.S. Bankruptcy Court recently considered whether amounts withheld from wages in excess of the amount of the income tax liability owed is a refund of tax or a refund of wages. The case is In re Crutch, No. 15-44523-cec. (E.D.N.Y. 2017). The case is a reminder to those taxpayers who are considering bankruptcy that they may need to take steps to ensure that they do not receive tax refunds during their bankruptcy case.

The facts and procedural history are as follows:

  • The dispute relates to a Chapter 7 bankruptcy.
  • The taxpayer’s only income during 2015 was from Social Security and their pension.
  • New York law exempts Social Security and pension income from the bankruptcy.
  • The taxpayers wanted to exempt their 2015 state and IRS tax refunds from the bankruptcy.
  • The bankruptcy trustee asked the court to order the taxpayers to turn over the tax refunds.

The taxpayers argued that the “tax refunds” were not tax refunds; they were a return of Social Security and pension income. If the taxpayers were correct, the income would retain its exempt status under New York and bankruptcy law. This would allow them to keep the tax refunds. If the bankruptcy trustee was right, the “tax refunds” would belong to and have to be turned over to the bankruptcy trustee.

The bankruptcy court considered New York law and a prior court case from the Tenth Circuit Court of Appeals. In considering these laws, the bankruptcy court concluded that the status as wages is lost once the wages were withheld as a tax. The key is withholding.

The case does not address whether the withholding was made in error or in an amount that was excessive.

The case does also not address tax refunds that stem from estimated payments made to the IRS for exempt income that is received. These payments do not have taxes withheld from them. It is up to the taxpayer to pay estimated payments to the IRS. One is left wondering whether the act of remitting the payment to the IRS in an amount in excess of the amount of income tax owed would convert the overpayment to a tax refund in bankruptcy.

Regardless, the message for taxpayers who are considering whether to file bankruptcy is that they need take steps to ensure that they do not generate a “tax refund” during the course of their bankruptcy case. This may mean adjusting withholding amounts (and possibly estimated payments) or looking for ways to defer tax benefits to later years. This may include electing to capitalize and depreciate or amortize property rather than deduct the expenses for the property immediately, foregoing loss carrybacks, or even paying some expenses after the close of the tax year. It may also involve accelerating the receipt of income or gains to earlier years.

Taxpayer May Deduct Taxes for Defunct S Corp Paid in Current Year

In Brown v. Commissioner, T.C. Memo. 2017-18, the court addresses whether taxpayers can claim a deduction for taxes paid by a defunct S corporation in the current year when the taxes are owed by the corporation for prior tax years. Many taxpayers do not realize they can claim a deduction for taxes in this situation. The case also highlights the importance of clearly designating how voluntary payments are to be applied by the IRS.

The facts and procedural history are as follows:

  • The Browns owned an S corporation.
  • The S corporation:
    • incurred payroll tax liabilities for 2000 – 2002.
    • filed income tax returns for 2000 – 2002.
    • was administratively dissolved by the state in 2007.
    • did not have any business activities or assets in 2012.
  • The IRS assessed trust fund recovery penalties against the Browns for the trust fund portion of the S corporation’s payroll taxes.
  • The attorney representing the Browns remitted a check for $215,000 to the IRS with a letter indicating that the funds were to be applied the trust fund penalty.
  • The IRS applied the funds to the trust fund penalty.
  • The S corporation claimed a deduction for the payroll taxes paid in 2012 on a final tax return remitted for 2012 (The S corproation had not remitted income tax returns from 2003 through 2011).
  • The Browns then reported the flow through loss on their indivdiual income tax returns in 2012.

The IRS disallowed the deduction on the Browns’ individual income tax return. It made a number of arguments in support of disallowing the deduction.

Cash Basis Taxpayers Can Deduct Prior Taxes for Then Defunct Business

The IRS argued that the Browns could not deduct the expense as the S corporation was not a trade or business in 2012. While the business had ceased operations in 2002 and was dissolved in 2007, the court noted that the taxpayers, who were cash basis taxpayers, were able to deduct expenses in 2012 that were incurred in prior years in which the business was active. Taxpayers who pay their taxes late should take note of this rule, as this is a tax deduction many taxpayers do not know they can take.

Taxes Must be Paid by the Correct Legal Entity

The IRS also argued that the Browns could not deduct the tax payments as they were not paid by the S corporation. It isn’t described in the facts above, but the Browns had another S corporation and it remitted the funds to the attorney, who in turn remitted the funds to the IRS to pay the taxes. The Browns no doubt paid the taxes this way because the defunct S corporation at issue here did not have its own checking account. The Browns argued that this was intended to be a contribution to the defunct S corporation. The court agreed with the IRS on this issue, nothing that the payment did not originate from the correct S corporation and therefore no flow through deduction was allowed from that S corporation. The court disallowed the deduction on this basis.

Taxes are Deductible, Trust Fund Penalties are Not Deductible

The IRS also argued that the Browns could not deduct the tax payments as payments for penalties are not deductible. The Browns countered by citing the letter from their attorney that accompanied the payment to the IRS, which did not make it clear whether the payment was for the S corporation’s liability or the Browns’ personal liability for the trust fund penalties. The law says that the taxpayer is able to designate how the IRS is to apply voluntary payments like the payment at issue here. If the taxpayer had clearly designated the payment to the S corporation’s employment tax liabilities, the taxpayer may have been able to deduct the taxes (ignoring the payment originating from the wrong legal entity, described above). The court read the letter to say that the funds were to pay the penalties, not the S corporation’s liability. Since penalties are not deductible, the court did not allow the deduction.

Court Says No Reasonable Cause Defense for Trust Fund Penalty

Court Says No Reasonable Cause Defense for Trust Fund Penalty

In United States v. Liddle, Case No. 14-cv-04761-BLF (N.D. Cali. 2017), the court considered a trust fund recovery penalty case. The penalty was imposed on a CEO who admitted that his company failed to pay its employment taxes. The only question was whether reasonable cause is a defense to trust fund recovery penalties.

Businesses must withhold employment taxes from wages paid to their employees. If they do not pay the withholdings over to the IRS, the IRS may assess a trust fund recovery penalty against the responsible persons. The responsible persons include anyone who has authority or power to determine who the businesses pay. The trust fund recovery penalty is a individual obligation owed by the responsible person, not the business.

To be responsible, the responsible person must have acted willfully. The term willfulness has been defined as a voluntary, conscious and intentional act to prefer other creditors over the United States. As noted by the court, courts in other Circuits have concluded that reasonable cause can show that the person did not act willfully and, as such, reasonable cause can be a defense to trust fund recovery penalties. The court cited opinions from the Fifth, Tenth and Second Circuit Courts for this. The court went on to note that the Ninth Circuit, whose law applied in this case, did not provide for such a defense.

Because the taxpayer agreed that the other elements were satisfied in this case, the court concluded that he was liable for the trust fund recovery penalties.

The Ninth Circuit law applies to taxpayers located in California, Arizona, New Mexico, Nevada, Idaho, Washington, Oregon, and Montana. The Fifth Circuit includes Texas, Louisiana, and Mississippi. The Tenth Circuit includes Colorado, Kansas, New Mexico, Oklahoma, Utah and Wyoming. The Second Circuit includes New York, Connecticut, and Vermont.

Post Office Tracking Data Can Result in Tax Disputes

Post Office Tracking Data Can Result in Tax Disputes

There have been a number of tax cases involving disputes as to when tax documents are mailed to the government. In Tildon v. Commissioner, No. 15-3838 (7th Cir. 2017), the court considered a dispute that turned on whether U.S. Postal Service tracking data is a “postmark made by the U.S. Postal Service.”

The Facts and Procedural History

In Tildon, the taxpayer hired a tax law firm to prepare and file a petition with the U.S. Tax Court. The law firm prepared the petition, but did not obtain a postmark from the U.S. Postal Service when it mailed the petition to the U.S. Tax Court. Instead, the law firm put a self-printed stamps.com label on the envelope and hand-delivered the envelope to the post office. It did so on the last day for filing the petition with the U.S. Tax Court. Two days later, at a facility that was 10 miles away from the post office, the U.S. Postal Service entered the tracking information for the envelope into its computer system. The U.S. Tax Court received the envelope several days later and deemed the petition to be filed late. The taxpayer appealed the decision to the Seventh Circuit Court of Appeals.

The Timely-Mailing, Timely-Filed Rule

In the U.S. Tax Court litigation, the IRS cited the general timely-mailing, timely-filed rule. The timely-mailing, timely-filing rule is found in Sec. 7502. It says tax returns and, as in this case, tax court petitions, are timely filed even if they are received by the IRS after the due date as long as they were mailed on or before the due date. This rule only applies when there is a postmark made by the United States Postal Service (the regulations include similar rules for certain private delivery carriers, such as UPS and FedEx).

To be more specific, the timely-mailing, timely-filed rule says that the tax return or tax court petition is considered timely filed if the IRS actually receives the envelope either by the due date or “the time when a document or payment contained in an envelope that is properly addressed, mailed, and sent by the same class of mail would ordinarily be received if it were postmarked at the same point of origin by the U.S. Postal Service on the last date.” The IRS concluded the language in quotes was not satisfied, as it took the U.S. Postal Service seven days to deliver the envelope from Utah to Washington D.C., which was longer than it would ordinarily take.

The Exception Where There Are Two Postmarks

The U.S. Tax Court did not agree. It applied a different rule, which says that where there is a postmark by a U.S. Postal Service and another postmark that was not made by the U.S. Postal Service, only the postmark by the U.S. Postal Service is to be considered. The U.S. Tax Court treated the U.S. Postal Service tracking information as equivalent to a postmark for purposes of this rule. Because the tracking information was not entered into the U.S. Postal Service’s system for two days after the U.S. Postal Service received the envelope, the U.S. Tax Court concluded that the tax court petition was not timely mailed.

On appeal, the Seventh Circuit Court of Appeals concluded that the rule cited by the U.S. Tax Court did not apply. It noted that the U.S. Postal Service certified mail tracking information was not a postmark and not equivalent to a postmark. The IRS agreed that the general timely-mailing, timely-filed rule applied and was satisfied.

Avoiding these Disputes by Using Certified Mail

The Seventh Circuit had some harsh words for the tax law firm, which serves as a reminder why, even in this day and age of high technology, we take the time to mail correspondence to the IRS via U.S. Postal Service certified mail and retain the hand-stamped postmark as proof of mailing:

Although the taxpayer thus prevails on this appeal, we have to express astonishment that a law firm would wait until the last possible day and then mail an envelope without an official postmark. A petition for review is not a complicated document; it could have been mailed with time to spare. And if the last day turned out to be the only possible day (perhaps the firm was not engaged by the client until the time had almost run), why use a private postmark when an official one would have prevented any controversy? A member of the firm’s staff could have walked the envelope to a post office and asked for hand cancellation. … [The law firm] … was taking an unnecessary risk with Tilden’s money (and its own, in the malpractice claim sure to follow if we had agreed with the Tax Court) by waiting until the last day and then not getting an official postmark or using a delivery service.

The Code even confirms that the certified mail is “deemed the postmark date,” which means that it is equivalent to a postmark.

Transferring Property Owned by Taxpayer With Unpaid Taxes

Transferring Property Owned by Taxpayer With Unpaid Taxes

In United States v. Urioste, No. 4:15-CV-1787-VEH (N.D. Ala 2017), the court considered the situation where a business purchased and improved real estate that was encumbered by an IRS tax lien. The case highlights why it can be more advantageous to structure a transaction as a loan rather than a purchase when dealing with property owned by a taxpayer who has unpaid taxes.

Facts & Procedural History

The facts and procedural history are as follows:

  • The case relates to the tax liabilities of Mr. Urioste (the “Taxpayer”), who was deceased, and his single member LLC.
  • On April 21, 2006, the Taxpayer purchased real property that was the subject of the court case. The property was purchased using proceeds from a bank mortgage and the bank filed its mortgage the same day the real estate was purchased.
  • On April 25, 2006, the Taxpayer’s son formed an LLC.
  • On May 22, 2006, the IRS filed a notice of Federal tax lien against the Taxpayer.
  • On November 8, 2006, the Taxpayer requested an installment agreement with the IRS.
  • On November 13, 2006, the Taxpayer transferred the property to his son’s newly-formed LLC. The deed transferring the property excepted the IRS’s lien. The only consideration for the transfer was the son’s LLC assumed the bank’s mortgage on the property.
  • On November 2, 2007, the IRS rejected the Taxpayer’s installment agreement request.
  • On May 19, 2011, the son’s LLC paid off the bank’s mortgage on the property.
  • The son’s LLC had made $140,000 of improvements to the property.
  • On October 13, 2015, the government brought suit against the Taxpayer’s personal representatives and the son’s LLC to seize the property.
  • Neither the son nor the son’s LLC were aware of the IRS lien notice prior to the time the government brought suit.

In the case, the court looked to state law (i.e., Alabama law) to determine what rights the parties had to the property. The Taxpayer cited several judicial doctrines to argue that it had a superior right to the property than the IRS did.

Equitable Subrogation

The doctrine of equitable subrogation applies where one party advances funds to pays off the debt secured by another lien. This doctrine allows the new lender to step into the shoes of the prior lender and avoid another lien that would have priority. The doctrine does not apply if the new lender is aware of or should be aware of the other lien that would have priority.

So in this case, the Taxpayer argued that the son’s LLC stepped into the shoes of the bank, whose mortgage had priority over the IRS’s tax lien, and the IRS was not entitled to enforce its inferior lien.

The court did not agree, as it concluded that the son’s LLC was not a lender but rather a purchaser.

Unjust Enrichment

Unjust enrichment is an equitable argument whereby one party asserts that it is unfair for another party to benefit given the facts. In this case, the Taxpayer argued that it would be unfair for the government to benefit from the expenses the son’s LLC incurred in improving the property. The Taxpayer asked the court to find that there was an equitable lien, with priority, in the son’s LLC’s favor equal to the amount of the improvements.

The court considered Alabama law, which essentially says that unjust enrichment can only be invoked where there was some wrongdoing by the other party or some mistake. The court concluded that the government did not do anything wrong and that the expenditures were not made by mistake, but rather, they were made in furtherance of the son’s LLC’s business operations.

Marshaling of the Assets

The marshaling of the assets is another equitable argument. It applies where a debtor has two or more creditors and assets, and says that the creditor with priority cannot choose the asset that will result in the other creditor not being entitled to anything.

In this case, the Taxpayer argued that the government should foreclose on the Taxpayer’s other property first, before it forecloses on the property at issue in the case.

The court concluded that the son’s LLC was not a creditor, but rather a party that acquired the property. The Taxpayer argued that it was an equitable creditor because it paid off the bank mortgage. The court did not agree, and noted that prior courts have refused to require the government to marshall the assets when satisfying IRS tax liens.

Conclusion

While the Taxpayer was not successful in this case, the arguments show the distinction between being a lender and a purchaser when it comes to IRS liens. The parties are free to structure their affairs as they see fit (absent fraudulent transfers or other transfers for less than fair market value), which should be considered when dealing with property that could be subject to an IRS tax lien.

Deducting Pre-Acquisition Stock Compensation

Deducting Pre-Acquisition Stock Compensation

In Qinetiq US Holdings, Inc. v. Commissioner, No. 15-2192 (4th Cir. 2017), the court addresses the situation where a taxpayer acquired a target corporation and then claimed a substantial tax deduction for expenses the target corporation had paid prior to the acquisition. There are rules intended to prevent taxpayers from being able to deduct pre-acquisition expenses. The stock compensation rules can be an exception to these rules, which is addressed in the case.

Facts & Procedural History

The facts and procedural history of the case are as follows:

  • Thomas Hume (“Hume”) formed a corporation in 2002 and elected to have it treated as a Subchapter S corporation.
  • He admitted Julian Chin (“Chin”) as a shareholder of the corporation later in 2002.
  • As part of this, the corporation issued two shares of stock–Class A voting stock and Class B non-voting stock.
  • The corporate records included a consent that authorized the corporation to offer to sell the shares of the Class A voting stock to Hume and Chin.
  • The consent also authorized the corporation to enter into shareholder and employment agreements with Hume and Chin.
  • The consent did not authorize the corporation to enter into restrictive stock agreements with Hume and Chin.
  • The shareholder agreement with Hume and Chin included terms restricting the sale or transfer of stock and for returning stock to the corporation in the event of either Hume’s or Chin’s death, disability, or termination of employment with the corporation.
  • The employment agreements with Hume and Chin did not have any reference to stock issued as compensation.
  • Hume and Chin purchased the Class A voting stock.
  • In 2008, the corporation was acquired by the Taxpayer.
  • In 2009, the Taxpayer reported a $117,777,501 deduction for the stock Hume and Chin received in 2002.
  • The tax court ruled that the Taxpayer had not demonstrated entitlement to the deduction on two independent bases, namely, that the stock was not property “transferred in connection with the performance of services” and was not “subject to a substantial risk of forfeiture” at the time Chin acquired the shares.
  • The Taxpayer appealed the decision, which brings us to the current case.

The question for the appeals court was whether the Taxpayer was entitled to a deduction in 2009 for the stock Hume and Chin received in 2002.

Substantial Risk of Forfeiture

Compensation for services is usually deductible to the employer in the year it is paid and reported as income to the recipient in the same year. There is an exception for compensation for services that are subject to a substantial risk of forfeiture. This compensation is deductible and taxable in the year that it is no longer subject to forfeiture. The regulations include a number of rules that explain when compensation is subject to a substantial risk of forfeiture.

The appeals court cited two of these rules, namely, that there is no substantial risk of forfeiture if (1) the employer is required to pay the fair market value of such property to the employee upon the return of such property and, (2) at the time of the transfer, the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced.

Restrictions that are Not Substantial

The appeals court noted that the shareholder agreement obligated the corporation to pay the fair market value of such property to the employee upon the return of such property upon Chin’s death, disability, or termination without cause. These restrictions failed the fair market value rule cited by the court.

The other restrictions in the shareholder agreement showed that the only circumstances in which Chin would be required to forfeit his stock at a below-market price would be if he voluntarily resigned before 20 years of employment, if he voluntarily resigned and entered into competition with the Taxpayer, or if he was terminated for cause.

The regulations say that termination for cause does not apply, so the court focused on the restriction imposed if Chin voluntarily resigned. This is the crux of the case. The tax court concluded that this risk was not “substantial” given its conclusion that Hume would have been unlikely to enforce the shareholder restrictions on the stock in the event Chin voluntary resigned. The tax court based this decision on Chin’s early role in the company and the close relationship between Hume and Chin. The appeals court accepted this conclusion.

Structuring Stock Compensation

The takeaway is that stock restrictions have to be carefully considered in determining whether it is subject to a substantial risk of forfeiture. The regulations should be reviewed as they contain detailed rules that help clarify these rules. But the regulations (and case law) cannot be relied on in isolation. For restrictions such as voluntary resignation terms, facts, such as the close relationship identified in this case, should be considered in determining whether the risk is substantial.

It should also be noted that the appeals court did not have to address the investor vs. employee compensation issue in this case. This is yet another hurdle that taxpayers seeking to deduct this type of expense from a prior year have to overcome. This is especially true where the employees pay for their stock rather than being awarded stock pursuant to an established plan or arrangement based on some pre-defined criteria.

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