The Goose And Gander Tax Bill

Here is something that will catch your eye:

It is undisputed that the Debtor failed to file its tax returns for the years 2006 to 2008; and that for such failure, the Debtor incurred penalties totaling $3,662,000."

It is a bankruptcy case from Delaware.

COMMENT: You may wonder how a tax case wound up in bankruptcy court. Bankruptcy law keeps its own beat, and a bankruptcy court can have near-extraordinary powers. For example, the court can determine the amount or legality of any tax, any fine, or any penalty relating to a tax. That is what happened here. The IRS assessed a penalty, the taxpayer protested, the IRS decided it was right (surprise) and submitted the penalty as a claim to the bankruptcy court.

And I find the IRS position so extreme as to constitute bad faith. I further think the IRS should be required to reimburse the professional fees incurred defending against its reckless behavior. You miss a filing deadline by a day or two and one would think the Treasury underpinnings of the nation are in mortal throes. Have the IRS bankrupt you while enforcing some capricious tax argument, however, and you are expected to be a good sport.

I would like to someone (ahem, US Senator Paul) take up the cause. It could be called the Good For The Goose, Good For The Gander - Time For The IRS To Take Responsibility - Act. If the IRS can penalize you for unreasonable positions, then the IRS should also be subject to penalties for unreasonable conduct.  The penalty would be paid to the affected taxpayer.

Our protagonist (Refco Community Pool) formed in 2003 as a partnership. It was an investment group, and their thing was to track the S&P Managed Futures Index. To do this, they needed an investment advisor. They found one in the Cayman Islands (Sphinx Managed Futures Fund). The advisor (Sphinx) in turn used a clearinghouse (Refco, LLC) to execute trades and whatever.

OBSERVATION: Right off the bat, we have two Refco's going - "Pool" and "LLC." Set this aside, as it is not relevant to our story.

Here is what happened:

1. In 2005 Refco LLC filed for bankruptcy. This caused a run, meaning that ...
2. Sphinx yanked out $312 million. However, ...
3. Sphinx had to return $260 million as was deemed a "preference" action.
4. In 2006 Sphinx went into liquidation. As part of the process, the Court appointed two liquidators.  
5. The liquidators soon found very serious accounting issues. They in fact advised that they could not assure the accuracy of tax and accounting information provided investors.
6. Refco Pool wanted its money from Sphinx, but all they received was something called "special situation shares." They were special because no one knew what they were worth until the liquidation was complete, a process which stretched into 2013. 

The IRS noticed that Sphinx was not filing tax returns and issuing K-1s. The Sphinx liquidators explained that it would cost between $5 and $7 million to reconstruct records to even approach a tax return. The two sides came to an agreement, and Sphinx was absolved of filing K-1s from 2005 to 2007.

Let's back up a bit. Who invested in Sphinx? It was Refco Pool. The IRS next went after Refco Pool for not filing its tax return and issuing K-1s.

COMMENT: Here we have a conundrum. Refco Pool has one main asset - special situation shares (whatever that means) in a bankrupt entity with accounting problems severe enough that its liquidators advise against using any numbers. A tax return requires numbers. What to do?

           

Refco Pool argued reasonable cause for abatement of the penalty. You may as well have Refco Pool discover a new planet as get a tax return out of whatever information they could pry from Sphinx.

No, no, no, said the IRS. Refco Pool could have used selected files and summaries and reports and disbursement statements and a receipt from its last visit to Dairy Queen to reconstruct records that Sphinx should have provided but did not because the IRS said it was OK not to and then Refco Pool could have filed its own partnership tax return....

Well ... yes, Refco Pool could. However, the information was unreliable if not completely inaccurate. In fact, the matter went further than that. Even if Refco Pool could do some Harry Potter alchemy, it would not know how to separate the separate tranches, meaning it could not determine its share. And, since we are talking about it, Refco Pool would have no idea what to do with the "special" part of its share - which was certainly less than 100% but not certain to be more than 0%.

The Bankruptcy Court explained:           

As an accrual method taxpayer, the Debtor cannot recognize income until 'all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.'"

One could persuasively argue that Refco Pool could not meet this threshold.

The IRS persisted that Refco Pool could have assembled numbers - however fragile - and filed a tax return had it really wanted to.

ANALYSIS: The judicial standard however is not whether Refco Pool exhausted all possible alternatives. The standard is whether Refco Pool exercised the level of care that a reasonably prudent person would under the same circumstances. 

The Court pointed out the tax risk that Refco Pool would have assumed by filing a tax return:

By knowingly filing inaccurate returns, the Debtor had a reasonable cause for concern given the specter of accuracy-related penalties it might incur ...."

The IRS could have penalized Refco Pool if the numbers proved to be substantially inaccurate.

Wait, there is more.

Refco Pool had approximately 1,600 partners to whom it was obligated to issue K-1s. Had those K-1s gone south, the partners too could have gone after Refco Pool.

The Court was unconvinced whether Refco Pool could even sign a tax return:           

Based on this knowledge, a reasonable person would likely be concerned with signing the jurat clause at the bottom of Form 1065..." 

COMMENT: The jurat clause is the one at the bottom of the tax form that reads "... to the best of my knowledge and belief, it is true, correct, and complete."

The Court concluded: 

Based on the evidence presented, the Debtor proved that it carefully considered its filing obligations and undertook appropriate steps in an effort to avoid the failure. Accordingly, the Court holds that the debtor acted in a responsible manner both before and after the failure to file occurred."

The Bankruptcy Court disallowed the IRS penalties.

I grant you, this is an extreme case, but perhaps it takes the extreme case to spotlight outrageous government behavior.

Tax penalties can generally be abated for "reasonable" cause. The problem is that the IRS has redefined "reasonable" in a completely unreasonable way. Why? Many suspect that it wants to keep the penalties to supplement its Congressional funding. Is that really what we want: for the IRS to self-fund by automatically assessing penalties and then imperiously decreeing that any request for abatement of said penalties is not "reasonable"?

I propose a compromise if we cannot get the Goose & Gander bill passed: all IRS penalties are to be returned to Treasury. They are then to be re-budgeted as Congress determines, with no assurance that the monies would return to the IRS.  Perhaps that would cool the IRS jets a bit.

The President’s myRA

The President introduced something called a “myRA” at the State of the Union speech. He explained…

… while the stock market has doubled over the last five years, that doesn’t help folks who don’t have 401(k) s. That’s why, tomorrow, I will direct the Treasury to create a new way for working Americans to start their own retirement savings: myRA. It’s a savings bond that encourages folks to build a nest egg. myRA guarantees a decent return with no risk of losing what you put in.”

The idea here is to encourage small retirement savers. The concern is that routine bank or investment fees (for example, the annual “maintenance” fee for an IRA) may discourage some (or many) from saving for retirement. Under the myRA, the government picks up that tab. The concept makes sense.

The myRA would function as a Roth-type account. Monies going in would not be deductible for income taxes.

Contributions will be automatic, voluntary and small. Initial investments could be as low as $25 and ongoing contributions as low as $5. Contributions would be made through “automatic” payroll deductions.

COMMENT: “Automatic” meaning actual employers who pay people in actual payroll department to process these transactions. Automatic seems to mean “magical” inside the Washington beltway. 

The myRA big deal will be the savers account balance “will never go down.”

COMMENT: Somewhat like a savings account or certificate of deposit. There are – by the way – no annual fees for those accounts either. They are “magical.”

The myRA will earn the same interest rate as the federal employees Thrift Savings Plan Government Securities Investment Fund.

NOTE: Which returned 1.47% in 2012. Unfortunately, inflation for 2012 was 1.8%. The G Plan pays investors the investor the average return on long-term Treasury bonds.  

It will be available to households earning up to $191,000 annually.

Participants will be able to save up to $15,000, or for a maximum of 30 years. 

            COMMENT: Remember: this is a “starter” savings plan.

There would be a provision to transfer the account to a Roth IRA.

COMMENT: That part makes sense, as these accounts can be described as “Roth-lite.”

The President created this by executive action this past Wednesday.

            COMMENT: Really? 

Reflecting the crowd currently occupying it, this White House also wants to compel employers that do not offer myRA’s to offer automatic enrollment IRAs.

OBSERVATION: Approximately half of American workers are not covered by a retirement plan at work, propelling policy mandarins to talk about “mandatory” solutions to the retirement “problem.” I acknowledge the problem - two problems, in fact. First, that many people do not save enough. It might help if they had a job, though. Second, that these hacks and their “mandatory” solutions are themselves a problem.  

Call me completely underwhelmed. 

Why Is The IRS Looking At Restaurant Tips (Again)?

I recently visited one of our clients. He owns a restaurant/bar. That is a tough business under the best of circumstances.  It is a business where almost all your profit comes from paying attention to the nickels and dimes.

Is there anything new out there, he asked?

We talked about the IRS’ recent interest in employee tips and gratuities. What is the difference?

• A tip is an amount determined by the patron

• A service charge is an amount agreed upon by the restaurant and patron

The IRS has long defined a tip as:

1. Paid free from compulsion
2. Determinable by the customer
3. Not dictated by the restaurant/employer
4. The recipient of which is identified by the customer

You may know that restaurant employees are paid a lower minimum wage, as a substantial part of their income is expected to come from tips. The employees are supposed to report their tips to the restaurant, which in turn withholds the employee’s share of the taxes. The restaurant also pays employer FICA on the base wages and tips.

The IRS has long believed that there exists substantial noncompliance with tip reporting by restaurant employees, and it has rolled out a number of “programs” over the years with the intent of increasing compliance. I have been through several of these, and my conclusion is that the IRS just wants money, even if it takes a work of fiction to get there. For example, if the IRS feels that the cash tip rate is too low, they will simply propose a higher rate, and call upon the restaurant (which then means me) to prove otherwise. Failure to do so means the restaurant is writing a tidy check for those actual taxes on proposed tips.

It is unfortunately too common that a server will be under-tipped if he/she is serving a large party. As a defense mechanism, many restaurants have imposed a service charge policy (also known as an auto gratuity or “auto-grat”) on that table or tables. The policy has worked fine for years.

But not for the IRS. They have recently clarified that they don’t believe auto-grats count as a tips, as the customer does not have the option of changing the amount or directing who is to receive it. I have to admit, the IRS has a point. However, are they making things worse by pressing the point? Let’s go through a few issues:

• The auto-grat will be on the server’s paycheck, rather than cashed out at the end of the shift. This is not a big deal in the scheme of things – except perhaps to the server.

• Restaurants are allowed to claim a tax credit for employer FICA paid on tips in excess of the amount necessary to get a server to minimum wage.

a.     Reduce the amount considered to be tips and you reduce the credit available to the restaurant.

b.     Meaning more tax to the restaurant.

• An auto-grat is considered revenue to the restaurant. Tips are not. States with a gross revenue tax – such as Ohio with its CAT – will now tax those auto-grats.

a.     Meaning more tax to the restaurant.

• Following on the same vein as (3), the customer will pay more sales tax, as the auto-grat is included in sales.

a.     Meaning more tax to the customer.

• How does one (I don’t know: say my accounting firm) figure out what rate of pay to use if the employee works overtime?

a.     Remember, service charges are resetting the base rate of pay.

b.     What if they server works tips and auto-grat tables over the course of one shift? Do they have one rate of pay or two? How would you even calculate this?

• Let’s throw a little SALT (State And Local Tax) into the mix: some states do not follow the federal definitions. For example, New York will consider auto-grats to be considered tips if they are separately stated on the receipt or invoice. New Jersey and Connecticut follow this line also.

a.     The good thing is that auto-grats will not be subject to New York sales tax.

b.     The bad thing is the accounting required to figure this out.

How long do you think it will be before the attorneys eviscerate some restaurant chain for violations of FLSA and overtime regulations? Remember, a service charge can change a server’s base pay, something a tip cannot do. On the other hand, the odds of overtime under the current economy are pretty low.

What about discrimination? How long before someone sues for being scheduled insufficient/excessive service -charge/non-service-charge shifts?

You know what I would do? I would do away with service charges altogether. I am not bringing that tiger to the party. Tips only at my restaurant.

Is it good for the servers? Since when does any of this care whether it is good for the employee?

It is about one thing: more money to the IRS. There may have been a time when I would have been sympathetic to the government’s position, but in this day of credit and debit cards, I am cynical about how much “unreported” income there is left to squeeze out of this turnip. I am also concerned that some restaurants may impose a service charge and then keep a portion of it for themselves rather than pass it along in full to the servers and others.  I am unhumored by the IRS, but I would be beyond unhumored by a restaurant that did that to its employees.