Common Law Versus Statutory Employee

 

I am looking at a case concerning employee status and payroll taxes.

I see nothing remarkable, except for one question: why did the IRS bother?

Let’s talk about it.

There was a 501(c)(3) (The REDI Foundation) formed in 1980. Richard Abraham was its officer (a corporate entity must have an officer, whether one gives himself/herself a formal title or not). Mr A’s wife also served on the Board.

REDI did not do much from 1980 to 2010. In 2010 Mr A – who was a real estate developer for over 40 years – developed an online course on real estate development and began offering it to the public via REDI. Mr A was a one-man gang, and he regularly worked 60 hours or more per week on matters related to the online course, instruction, and student mentoring.

COMMENT: Got it. It gave Mr A something to do when he “retired,” if 60 hours per week can be called retirement. I have a client who did something similar, albeit in the field of periodontics.

So REDI went from near inactive to active with its online course. For its year ended May 2015 it reported revenues over $255 grand with expenses of almost $92 grand.

COMMENT: Had REDI been a regular corporation, it would have paid income taxes on profit of $163 grand. REDI may have been formed as a corporation, but it was a corporation that had applied for and received (c)(3) status. Absent other moving parts, a (c)(3) does not pay income taxes.

The IRS flagged REDI for an employment tax audit.

Why?

REDI had not issued Mr A a W-2. Instead, it issued a 1099, meaning that it was treating Mr A as an independent contractor.

Let’s pause here.

A W-2 employee pays FICA taxes on his/her payroll. You see it with every paycheck when the government lifts 7.65% for social security. Your employer matches it, meaning the government collects 15.3% of your pay.

A self-employed person also pays FICA, but it is instead called self-employment tax. Same thing, different name, except that a self-employed pays 15.3% rather than 7.65%.

My first thought was: Mr A paid self-employment tax on his 1099. The government wanted FICA. Fine, call it FICA, move the money from the self-employment bucket to the FICA bucket, and let’s just call … it … a … day.

In short: why did the IRS chase this?

I see nothing in the decision.

Technically the IRS was right. A corporate officer is a de facto statutory employee of his/her corporation.

§ 3121 Definitions.

 

(d)  Employee.

 

For purposes of this chapter, the term "employee" means-

 

(1)   any officer of a corporation; or

 

Yep, know it well. Been there and have the t-shirt.

Mind you, there are exceptions to 3121(d)(1). For example, if the officer duties are minimal, the Code does not require a W-2.

Mr A argued that very point.

Problem: there was only one person on the planet that generated revenues for REDI, and that person was Mr A. Revenues were significant enough to indicate that any services performed were also substantial.

There was another argument: REDI had reasonable basis under Section 530 for treating Mr A as a contractor.

COMMENT: Section 530 is an employment relief provision if three requirements are met:

·      Consistency in facts

·      Consistency in reporting

·      Reasonable basis

Section 530 was intended to provide some protection from employment tax assessments for payors acting in good faith. On first impression, 530 appears to be a decent argument. Continuing education instructors are commonly treated as contractors, for example. If REDI treated instructors with similar responsibilities the same way (easy, as there was only one instructor) and sent timely 1099s to the IRS, we seem to meet the three requisites.

Except …

Section 530 deals with common law workers.

Corporate officers are not common law workers. They instead are statutory employees because the statute – that is, Section 3121(d) – says they are.

Mr A was a statutory employee. REDI was therefore an employer. There should have been withholding, tax deposits and payroll return filings. There wasn’t, so now there are penalties and interest and yada yada yada.

I probably would have lost my mind had I represented REDI. Unless Mr A was claiming outsized expenses against 1099 income, any self-employment tax he paid would/should have approximated any FICA that REDI would remit as an employer. Loss to the fisc? Minimal. Let’s agree to switch Mr A to employee status going forward and both go home.

Why did this not happen? Don’t know. Sometimes the most interesting part of a case is not in the decision.

Our case this time was The REDI Foundation v Commissioner, T.C. Memo 2022-34.

The IRS Changes An In - Person Visit Policy

 

This afternoon I was reading the following:

As part of a larger transformation effort, the Internal Revenue Service today announced a major policy change that will end most unannounced visits to taxpayers by agency revenue officers to reduce public confusion and enhance overall safety measures for taxpayers and employees.”

One can spend a lifetime and never interact with a Revenue Officer. We are more familiar with Revenue Agents, who examine or audit tax returns and filings. Revenue Officers, on the other hand, are more specialized: they collect money.

I deal with ROs often enough, but – then again – consider what I do. I rarely meet with one in person, though. The last time I met an RO was one late afternoon at northern Galactic Command. I was the only person in the office, until I realized that I was not. I encountered someone who claimed to be an RO, which I immediately and expressly disbelieved. He presented identification, which gave me pause. He then asked about a specific client, giving me grounds to believe him. The IRS could not contact a taxpayer, so the next step was to contact the last preparer associated with that taxpayer.

I was – BTW – not amused.

I wonder if the above IRS policy change has something to do with an event that occurred recently in Marion, Ohio. The following is cited from a recent House Judiciary Committee letter to IRS Commissioner Danny Werfel:

On April 25, 2023, an IRS agent—who identified himself as 'Bill Haus' with the IRS’s Criminal Division—visited the home of a taxpayer in Marion, Ohio. Agent 'Haus' informed the taxpayer he was at her home to discuss issues concerning an estate for which the taxpayer was the fiduciary. After Agent 'Haus' shared details about the estate only the IRS would know, the taxpayer let him in. Agent 'Haus' told the taxpayer that she did not properly complete the filings for the estate and that she owed the IRS 'a substantial amount.' Prior to the visit, however, the taxpayer had not received any notice from the IRS of an outstanding balance on the estate.
 
"During the visit, the taxpayer told Agent 'Haus' that the estate was resolved in January 2023, and provided him with proof that she had paid all taxes for the decedent's estate. At this point, Agent 'Haus' revealed that the true purpose of his visit was not due to any issue with the decedent’s estate, but rather because the decedent allegedly had several delinquent tax return filings. Agent 'Haus' provided several documents to the taxpayer for her to fill out, which included sensitive information about the decedent.
 
"The taxpayer called her attorney who immediately and repeatedly asked Agent 'Haus' to leave the taxpayer's home. Agent 'Haus' responded aggressively, insisting: 'I am an IRS agent, I can be at and go into anyone's house at any time I want to be.' Before finally leaving the taxpayer’s property, Agent 'Haus' said he would mail paperwork to the taxpayer, and threatened that she had one week to satisfy the remaining balance or he would freeze all her assets and put a lean [sic] on her house.
 
"On May 4, 2023, the taxpayer spoke with the supervisor of Agent 'Haus,' who clarified nothing was owed on the estate. The supervisor even admitted to the taxpayer that 'things never should have gotten this far.' On May 5, 2023, however, the taxpayer received a letter from the IRS— the first and only written notice the taxpayer received of the decedent’s delinquent tax filings—addressed to the decedent, which stated the decedent was delinquent on several 1040 filings. On May 15, 2023, the taxpayer spoke again with supervisor of Agent 'Haus,' who told the taxpayer to disregard the May 5 letter because nothing was due. On May 30, 2023, the taxpayer received a letter from the IRS that the case had been closed.”

Yeah, someone needs to be fired.

The IRS did point out the following in today’s release:

For IRS revenue officers, these unannounced visits to homes and businesses presented risks.

No doubt, especially for those who think they can go into “anyone’s house at any time.”

What will the IRS do instead?

In place of the unannounced visits, revenue officers will instead make contact with taxpayers through an appointment letter, known as a 725-B, and schedule a follow-up meeting. This will help taxpayers feel more prepared when it is time to meet.

Taxpayers whose cases are assigned to a revenue officer will now be able to schedule face-to-face meetings at a set place and time, with the necessary information and documents in hand to reach resolution of their cases more quickly and eliminate the burden of multiple future meetings.

There will be situations where the IRS simply must appear in person, of course:

The IRS noted there will still be extremely limited situations where unannounced visits will occur. These rare instances include service of summonses and subpoenas; and also sensitive enforcement activities involving seizure of assets, especially those at risk of being placed beyond the reach of the government.

These situations should be a fraction of the number under the previous policy, however.

Failing To Take A Paycheck

I am looking at a case involving numerous issues. The one that caught my attention was imputed wage income from a controlled company in the following amounts:

2004                    $198,740

2005                    $209,200

2006                    $220,210

2007                    $231,800

2008                    $244,000

Imputed wage income means that someone should have received a paycheck but did not.

Perhaps they used the company to pay personal expenses, I think to myself, and the IRS is treating those expenses as additional W-2 income. Then I see that the IRS is also assessing constructive dividends in the following amounts:

2004                    $594,170

2005                    $446,782

2006                    $375,246

2007                    $327,503

2008                    $319,854 

The constructive dividends would be those personal expenses.

What happened here?

Let’s look at the Hacker case.

Barry and Celeste Hacker owned and were the sole shareholders of Blossom Day Care Centers, Inc., an Oklahoma corporation that operated daycare centers throughout Tulsa. Mr. Hacker also worked as an electrician, and the two were also the sole shareholders of another company - Hacker Corp (HC).

The Hackers were Blossom’s only corporate officers. Mrs. Hacker oversaw the workforce and directed the curriculum, for example, and Mr. Hacker was responsible for accounting and finance functions.

Got it. She sounds like the president of the company, and he sounds like the treasurer.

For the years at issue, the Hackers did not take a paycheck from Blossom.

COMMENT: In isolation, this does not have to be fatal.

Rather than pay the Hackers directly, Blossom made payments to HC, which in turn paid wages to the Hackers.

This strikes me as odd. Whereas it is not unusual to select one company out of several (related companies) to be a common paymaster, generally ALL payroll is paid through the paymaster. That is not what happened here. Blossom paid its employees directly, except for Mr. and Mrs. Hacker.

I am trying to put my finger on why I would do this. I see that Blossom is a C corporation (meaning it pays its own tax), whereas HC is an S corporation (meaning its income is included on its shareholders’ tax return). Maybe they were doing FICA arbitrage. Maybe they did not want anyone at Blossom to see how much they made.  Maybe they were misadvised.

Meanwhile, the audit was going south. Here are few issues the IRS identified:

(1)  The Hackers used Blossom credit cards to pay for personal expenses, including jewelry, vacations, and other luxury items. The kids got on board too, although they were not Blossom employees.

(2)  HC paid for vehicles it did not own used by employees it did not have. We saw a Lexus, Hummer, BMW, and Cadillac Escalade.

(3) Blossom hired a CPA in 2007 to prepare tax returns. The Hackers gave him access to the bank statements but failed to provide information about undeposited cash payments received from Blossom parents.

NOTE: Folks, you NEVER want to have “undeposited” business income. This is an indicium of fraud, and you do not want to be in that neighborhood.

(4)  The Hackers also gave the CPA the credit card statements, but they made no effort to identify what was business and what was family and personal. The CPA did what he could, separating the obvious into a “Note Receivable Officer” account. The Hackers – zero surprise at this point in the story - made no effort to repay the “Receivable” to Blossom.  

(5) Blossom paid for a family member’s wedding. Mr. Hacker called it a Blossom-oriented “celebration.”  

(6) In that vein, the various trips to the Bahamas, Europe, Hawaii, Las Vegas, and New Orleans were also business- related, as they allowed the family to “not be distracted” as they pursued the sacred work of Blossom.

There commonly is a certain amount of give and take during an audit. Not every expense may be perfectly documented. A disbursement might be coded to the wrong account. The company may not have charged someone for personal use of a company-owned vehicle. It happens. What you do not want to do, however, is keep piling on. If you do – and I have seen it happen – the IRS will stop believing you.

The IRS stopped believing the Hackers.

Frankly, so did I.

The difference is, the IRS can retaliate.

How?

Easy.

The Hackers were officers of Blossom.

Did you know that all corporate officers are deemed to be employees for payroll tax purposes? The IRS opened a worker classification audit, found them to be statutory employees, and then went looking for compensation.

COMMENT: Well, that big “Note Receivable Officer” is now low hanging fruit, isn’t it?

Whoa, said the Hackers. There is a management agreement. Blossom pays HC and HC pays us.

OK, said the IRS: show us the management agreement.

There was not one, of course.

These are related companies, the Hackers replied. This is not the same as P&G or Alphabet or Tesla. Our arrangements are more informal.

Remember what I said above?

The IRS will stop believing you.

Petitioner has submitted no evidence of a management agreement, either written or oral, with Hacker Corp. Likewise, petitioner has submitted no evidence, written or otherwise, as to a service agreement directing the Hackers to perform substantial services on behalf of Hacker Corp to benefit petitioner, or even a service or employment agreement between the Hackers and Hacker Corp.”

Bam! The IRS imputed wage income to the Hackers.

How bad could it be, you ask. The worst is the difference between what Blossom should have paid and what Hacker Corp actually paid, right?

Here is the Court:

Petitioner’s arguments are misguided in that wages paid by Hacker Corp do not offset reasonable compensation requirements for the services provided by petitioner’s corporate officers to petitioner.”

Can it go farther south?

Respondent also determined that petitioner is liable for employment taxes, penalties under section 6656 for failure to deposit tax, and accuracy-elated penalties under section 6662(a) for negligence.”

How much in penalties are we talking about?

2005                    $17,817

2006                    $18,707

2007                    $19,576

2008                    $20,553

I do not believe this is a case about tax law as much as it is a case about someone pushing the boundary too far. Could the IRS have accepted an informal management agreement and passed on the “statutory employee” thing? Of course, and I suspect that most times out of ten they would. But that is not what we have here. Somebody was walking much too close to the boundary - if not walking on the fence itself - and that somebody got punished.

Our case this time was Blossom Day Care Centers, Inc v Commissioner, T.C. Memo 2021-86.

An Attorney Learns Passthrough Taxation

 

I have worked with a number of brilliant attorneys over the years. It takes quite a bit for a tax attorney to awe me, but it has happened.

But that law degree by itself does not mean that one has mastered a subject area, much less that one is brilliant.

Let’s discuss a case involving an attorney.

Lateesa Ward graduated from law school in 1991. She went the big firm route for a while, but by 2006 she opened her own firm. For the years at issue, the firm was just her and another person.

She elected S corporation status.

We have discussed S status before. There is something referred to as “passthrough” taxation. The idea is that a business – an S corporation, a partnership, an LLC – skips paying its own tax. Rather the tax-causing numbers are pushed-out to the owners – shareholders, partners, members – who then include those numbers on their personal return and pay the taxes thereon personally.

Why would a rational human being do that?

Sometimes it makes sense. A lot of sense, in fact.

I will give you one example. Say that you have a regular corporation, one that the tax nerds call a “C.” Say that there is real estate in there that has appreciated insanely. It wouldn’t hurt your feelings to sell the real estate and pocket the money. There is a problem, though. If the real estate is inside a “C,” the gain will be taxed to the corporation upon sale.

That’s OK, you reason. You knew taxes were coming.

When you take the money out of the corporation, you pay taxes again.

Huh?

If you think about, what I just described is commonly referred to as a “dividend.”

That second round of income taxes hurts, unless one is a publicly-traded leviathan like Apple or Amazon. More accurately, it hurts even then, but ownership is so diluted that it is unlikely to greatly impact any one owner.

Scale down from the behemoths and that second round of tax probably locks-in the asset inside the C corporation. Not exactly an efficient use of resources, methinks.

Enter the passthrough.

With some exceptions (there are always exceptions), the passthrough allows one – and only one – round of tax when you sell the real estate.

Back to Lateesa.

In 2011 the S corporation deducted salary to her of $62,388.

She reported no salary on her personal return.,

In 2012 the S deducted salary to her of $73,448.

She reported salary of $47,171.

In 2011 her share (which was 100%, of course) of the firm’s profits was $1,373.

She reported that.

Then she reported the numbers again as though she was self-employed.

She reported the numbers twice, it seems.

The IRS could not figure out what she was doing, so they came in and audited several years.

There was the usual back-and-forth with documenting expenses, as well as quibbling over travel and related expenses. Standard stuff, but it can hurt if one is not keeping adequate records.

I was curious why she left her salary off her personal return. I have a salary. Maybe she knew something that has escaped me, and I too can run down my personal taxes.

She explained that only some of the officer compensation was salary or wages.

Go on.

The rest of the compensation was a distribution of “earnings and profits.” She continued that an S corporation shareholder is allowed to receive tax-free distributions to the extent she has basis.

Oh my. Missed the boat. Missed the harbor. Nowhere near water.  Never heard of water.

What we are talking about is a tax deduction, not a distribution. The S corporation took a tax deduction for salary paid her. To restore balance to the Force, she has to personally report the salary as income. One side has a deduction; the other side has income. Put them together and they net to zero. The Force is again in balance.

Here is the Court:

Ward also took an eccentric approach to the compensation that she paid herself as the firm’s officer.”

It did not turn out well for Ms. Ward. Remember that there are withholdings and employer-side payroll taxes required on salary and wages, and the IRS was already looking at other issues on those tax returns. This audit got messy.

There was no awe here.

Our case this time was Lateesa Ward v Commissioner and Ward & Ward Company v Commissioner, T.C. Memo 2021-32.

Keeping A Corporation Alive

Recently I received a call from a client requesting that certain records be sent to an attorney as soon as possible, hopefully before noon.

It was not a big request, just the QuickBooks files for two companies (those who know me will understand the inside joke in that sentence). Activity in recent years has been minimal, and the companies have been kept alive primarily because of a lawsuit. The companies previously experienced one of the most astounding thefts of intellectual property I have encountered. It sounds like the attorneys have now stopped playing flag and are now playing tackle, as legal discovery is turning up some rather unflattering information. We are talking retirement-level money here.

Notice what I said: the companies have been kept alive.

Why?

Because it is the companies that are suing.

Keeping the companies alive means filing tax returns, renewing annual reports with the secretary of state and whatever else one’s particular state of organization may require. It may also require the owners kicking-in money to pay those taxes, registrations and fees.

What if you do not do this? To use a rather memorable phrase: what difference does it make?

Let’s talk about the recent Timbron case.

There are two Timbrons: the parent (Timbron Holdings) and the operating company (Timbron Internation). For ease, we will call them both Timbron.

Timbron was organized in California.

Timbron did not pay state taxes.

By 2013 California has suspended corporate rights for both Timbrons.

In 2016 the IRS showed up and issued Notices of Deficiency for 2010 and 2011.

In October, 2016 Timbron filed a petition with the Tax Court.

In November, 2016 the IRS filed its response.

A couple of months later the IRS realized Timbron was no longer a corporation under California law. This is a problem, as corporations are legal entities, meaning they are created and sustained under force of law.

An attorney at the IRS earned one of the easiest paychecks he/she will ever receive.

The IRS moved to dismiss.

Timbron fought back. Someone must have invested in a legal dictionary, as we are introduced to “certificates of reviver.” Timbron continued on, arguing “vitality” and “mere irregularities.”

I am not an attorney, although I did a substantial portion of my Masters at the University of Missouri Law School. When I come across gloss and floss like “vitality” and so forth, I discern that an attorney is hard-pressed.

Here is the Court:

With respect to corporate taxpayers like petitioners, a proper filing requires taxpayers tendering petitions to the Court to have the capacity to engage in litigation before this Court.”

To no one’s surprise:

… we find that petitioners lacked capacity to timely file proper petitions.”

Timbron lost.

On the most basic of facts: it failed to maintain its corporate status under California law.

A Mom Taking Care Of A Disabled Child And Payroll Taxes

We have a responsible person payroll tax story to tell.

You may know that I sardonically refer to this penalty as the “big-boy” penalty. It applies when you have some authority and control over the deposit of payroll withholding taxes but do not remit them to the IRS. The IRS views this as theft, and they can be quite unforgiving. The penalty alone is equal to 100% of the tax; in addition, the IRS will come after you personally, if necessary.

You do not want this penalty – for any reason.

How do people get into this situation? In many – if not most cases – it is because the business is failing. There isn’t enough cash, and it is easier to “delay” paying the IRS rather than a vendor who has you on COD. You wind up using the IRS as a bank. Now, you might be able to survive this predicament if we were talking about personal or business income taxes. Introduce payroll – and payroll withholding – and you have a different answer altogether.

Our story involves Christina Fitzpatrick (Christina). Her husband made the decision to start a restaurant in Jacksonville with James Stamps (Stamps). They would be equal partners, and Stamps would run the show. Fitzpatrick would be the silent wallet.

They formed Dey Corp., Inc to hold the franchise. The franchise was, of course, the restaurant itself.  

Sure enough, shortly after formation and before opening, Stamps was pulled to Puerto Rico for business. This left Fitzpatrick, who in turn passed on some of the pre-opening duties to his wife, Christina.

Fortunately, Stamps got back in town before the place opened. He hired a general manager, a chef and other employees. He then went off to franchise training school. Meanwhile, the employees wanted to be paid, so Stamps had Christina contact Paychex and engage their services. They would run the payroll, cut checks and make the tax deposits.

            OBSERVATION: Let’s call this IRS point (1)

He also had Christina open a business bank account and include herself as a signatory.

            OBSERVATION: IRS point (2) and (3)

Stamps and the general manager (Chislett) pretty much ran the place. Whether he was in or out of town, Stamps was in daily contact with Chislett. Chislett managed, hired and fired, oversaw purchases and so on. He was also the main contact with Paychex.

Except that …

Paychex started off by delivering paychecks weekly to the restaurant. There was a problem, though: the restaurant wasn’t open when they went by. Paychex then starting going to Christina’s house. Chislett told her to sign and drop-off the paychecks at the restaurant. Chislett could not do it because it was his day off.

            OBSERVATION: IRS point (4) and (5).

You can anticipate how the story goes from here. The restaurant lost money. Chislett was spending like a wild man, to the extent that the vendors put him on COD. Somewhen in there Paychex drew on the bank account and the check bounced. Paychex stopped making tax deposits for the restaurants because – well, they were not going to make deposits with rubber checks.

By the way, neither Stamps nor Chislett bothered to tell the Fitzpatricks that Paychex was no longer making tax deposits.

Sure enough, the IRS Revenue Officer (RO) showed up. She clued the Fitzpatricks that the restaurant was over two years behind on tax deposits.

Remember that the restaurant was short on cash. Who could the IRS chase for its money in its stead?  Let me think ….

The RO decided Christina was a responsible person and assessed big bucks (approximately $140,000) against her personally.

Off to Tax Court they went.

The Court introduces us to Christina.

·       She spent her time taking care of her disabled son, who suffered from a rare metabolic disorder. As a consequence, he had severe autism, cerebral palsy and limited mobility. He needed assistance for many basic functions, such as eating and going to the bathroom. He could not be left alone for any significant amount of time.

·       Taking care of him took its toll on her. She developed spinal stenosis from constantly having to lift him. She herself took regular injections and epidurals.

·       She truly did not have a ton of time to put into her husband’s money-losing restaurant. At start-up she had a flurry of sorts, but after that she visited maybe once a week, and that for less than an hour.

·       She could not hire or fire. She was not the bookkeeper or accountant. She did not see the bank statements.

She did, unfortunately, sign a few of the checks.

The IRS looks very closely at who has signatory authority on the bank account. As far as they are concerned, one could write a check to them as easily as a check to a vendor. Christina appears to be behind the eight ball.

The Court noted that the IRS was relying heavily on the testimony of Stamps and Chislett.

The Court did not like them:

Petitioner’s cross-examination of Mr. Stamps and Mr. Chislett revealed that their testimony was unreliable and unbelievable."

That is Court-speak to say they lied.

Mr. Stamps evaded many of the petitioner’s questions during cross-examination by repeatedly responding ‘I don’t remember.’”

Sounds like a possible presidential run in there for Stamps.

The Court was not amused with the IRS Revenue Officer either:

However, we believe that RO Wells did not conduct a thorough investigation. For instance, RO Wells made her determination before she received and reviewed the relevant bank records. She also failed to interview (or summon) Mr. Stamps, the president of the corporation.”

The IRS is supposed to interview all the corporate officers. Sounds like this RO did not.

The Court continued:

We are in fact puzzled that Mr. Stamps, the president of the corporation and a hands-on owner, an Mr. Chislett, the day-to-day manager, successfully evaded in the administrative phase any personal liability for these TFRPs.”

My, that is curious, considering they RAN the place. The use of the word “evaded” clarifies what the Court thought of these two.

But there is more required to big-boy pants than just signing a check. The Court reminded the IRS that a responsible person must have some control:

The inquiry must focus on actual authority to control, not on trivial duties.”

Here is the hammer:

Notwithstanding petitioner’s signatory authority and her spousal relationship to one of the corporation’s owners, the substance of petitioner’s position was largely ministerial and she lacked actual authority.”

The Court liked Christina. The Court did not like Stamps and Chislett. They especially did not like the IRS wasting their time. She was a responsible person they way I am a deep-sea diver because I have previously been on a boat.

The Court dismissed the case.

But we see several points about this penalty:

(1)  The IRS will chase you like Khan chased Kirk.

(2)  Note that the IRS did not chase Stamps or Chislett. This tells me those two had no money, and the IRS was chasing the wallet.

(3)  Following on the heels of (2), do not count on the IRS being “fair.” They IRS can cull one person from the herd and assess the penalty in full. There is no requirement to assess everyone involved or keep the liability proportional among the responsible parties.

We have a success story, but look at the facts that it took.

Let's Talk Tax Inversions - Part Two

Last time we discussed the taxation of an inverting corporation.

There are three levels of tax severity to the corporation itself:

(1)   The IRS ignores the inversion completely and continues to tax the foreign company as if it were a U.S. company

(2)   The IRS will respect the foreign company as foreign, but woe to whoever tries to move certain assets out of the U.S. or otherwise use certain U.S. – based tax attributes for a period of 10 years.

(3)   The IRS will respect the transaction without reservation.

Then there is the toll-charge on the shareholders. If they own more than 50% of the new foreign company, the shareholders will pay tax on their shares AS IF they had sold them rather than exchanged them for stock in the new foreign parent.  The practical effect is that any inversion has to include cash to the U.S. shareholders, otherwise such shareholders would be reaching into their wallet to pay tax (and would likely vote to scuttle any inversion deal).

It was this toll charge that caught the attention of Congress. If you think about it, someone owning actual shares would be taxed, but someone having a future right to shares would not. Who would such a person be? How about corporate insiders: management and directors? Executives frequently receive stock options and other stock-based compensation. Congress felt that management and directors should also have “skin in the game,” thus the origin of Section 4985. 

One quickly realizes the parity Congress wanted:

(1)   First, Section 4985 applies only if gain is realized by any shareholder. If there is no toll charge on the shareholders, then there will be no toll charge on management and directors.

(2)   The Section 4985 tax will be the highest tax rate payable by the shareholders, which is the capital gains rate (15%)

There is some technical lingo in here. The tax Code dragnets all individuals “subject to the requirements of Section 16(a) of the Securities Exchange Act of 1934” – in short, the officers, directors and 10% shareholders. It also includes their families.

So Congress wanted insiders to also pay tax. That’s great. I wanted to play in the NFL.

Let’s take a look at another Congressional attempt to “rope in” executive pay: the golden parachute limitations of Section 280G. This tax applies to “excess” compensation payments upon a change in corporate control. The insider is allowed a base amount (defined as average annual compensation for the five years preceding the year of change in control). The excess is subject to an additional 20% excise tax – in addition to the payroll and income taxes already paid.

How does it work away from the fever swamp of Washington?

It doesn’t. Corporations routinely “gross-up” the executive compensation until the tax is shifted back to the corporation.

I suspect that every tax accountant has run into a compensation “gross up” exercise. I have done enough over the years to make my eyes cross.

Let’s return to our inversion discussion. What do you think companies are doing when their executives are subjected to the 15% Section 4985 excise tax?

Yep, the gross-up.

The mathematics of a gross-up are terrible. Let’s take the example of someone who is subject to the maximum federal tax rate (39.6%), add in the ObamaCare Medicare tax (0.9%), the Section 4985 tax itself (15%) and a state tax (say 6%), and 61.5% of every dollar is going to tax (I am leaving out the deductibility of the state tax). If I am to gross-up a payroll, I am saying that only 38.5 cents of every dollar will be available to satisfy the original Section 4985 tax liability. This means that the gross-up will have to be $2.60 (that is, 1 divided by 38.5%) for every dollar of the original Section 4985 tax.

But Congress, never willing to leave a bigger mess undone, added yet another twist to Section 4985: the corporation is not allowed to deduct the gross-up. Let’s say that the excise tax was $1 million. The gross-up would be $2.6 million, none of which is deductible by the company.

Yipes!

Medtronic is a medical device maker based in Minneapolis. It operates in more than 120 countries and employs approximately 50,000 people worldwide. It has agreed to acquire Covidien, an Irish medical device company. Since we are talking about inversions, you can surmise that the new parent will be based in Ireland. For its part, Medtronic says it will be leaving its Minneapolis-based employees in Minneapolis, which makes sense when you consider that they have employees located throughout the planet.

Medtronic will of course continue to pay U.S. tax on its U.S. income. What it won’t do is pay U.S. tax on income earned outside the U.S. This is not an unreasonable position. Think about your response if California tried to tax you because you drank Napa Valley wine.

Medtronic triggered the Section 4985 excise tax on its executive officers and directors. This tax is estimated to be approximately $24 million.

Remember the loop-the-loop involved with a gross-up. How much will it cost Medtronic to gross-up its insiders for the $24 million?

Around $63 million.

None of which Medtronic can deduct on its tax return.

Can you explain to me how this can possibly be good for the shareholders of Medtronic? It isn’t, of course.

Way to play masters of the universe, Congress.