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.

Bill And The Gig Economy

I am inclined to title this post “Bill.”

I have known Bill for years. He lost his W-2 job and has made up for it by taking one or two (or three) “independent contractor” gigs.

However, Bills get into tax trouble fast. Chances are they burned through savings upon losing the W-2 job. They turned to that 1099 gig when things got tight. At that point, they needed all the cash they could muster, meaning that replenishing savings had to wait.

The calendar turns. They come to see me for their taxes.

And we talk about self-employment tax for the first time.

You and I have FICA taken from our paycheck. We pay half and our employer pays half. It becomes almost invisible, like being robbed while on vacation.

Go self-employed and you have to pay both sides of FICA – now called self-employment tax – and it is anything but invisible. You are paying approximately 15% of what you make – off the top - and we haven’t even talked about income taxes.

You find yourself in a situation where you probably cannot pay – in full, at least – the tax from your first contractor/self-employment year.

We need a payment plan.

But there is a hitch.

What about taxes on your second contractor/self-employment year?

We need quarterly estimated taxes.

You start to question if I have lost my mind. You cannot even pay the first year, so how are you going to pay quarterly taxes for the second year?

And there you have Bill. Bills are legion.

We arrange a payment plan with the IRS.

You know what will likely blow-up a payment plan?

Filing another tax return with a large balance payable.

All right, maybe we can get the first and second year combined and work something out.

You know what will probably blow-up that payment plan?

Filing yet another tax return with a large balance payable.

Depending upon, the IRS will insist that you make estimated tax payments, as they have seen this movie too.

A taxpayer named Allen ran into that situation.

Allen owed big bucks – approximately $93,000.

The IRS issued an Intent to Levy.

He requested a CDP (Collections Due Process) hearing.

COMMENT: The CDP process was created by Congress in 1998 as a means to slow down a wild west IRS. The idea was that the IRS should not be permitted to move from compliance and assessment (receive your tax return; change your tax return) to collection (lien, levy and clear out your bank account) without an opportunity for you to have your day.  

Allen submitted financial information to the IRS. He proposed paying $500 per month.

The IRS reviewed the same information. They thought he could pay $809 per month.

COMMENT: You would be surprised what the IRS disallows when they calculate how much you can repay. You can have a pet, for example, but they will not allow veterinarian bills.

There was a hitch. Monthly payments of $809 over the remaining statute of limitations period would not sum to $93,000. The IRS can authorize this, however, and it is referred to as a partial-pay installment agreement (PPIA).

EXPLANATION: Any payment plan that does not pay the government in full over the remaining statutory collection period is referred to as a “partial pay.” The IRS looks at it more closely, as they know – going in – that they are writing-off some of the balance due.

The IRS settlement officer (SO) read the Internal Revenue Manual to say that a taxpayer could not receive a partial pay if he/she was behind on their current year estimated taxes. Allen of course was behind.

Allen said that he could not pay the estimate.

The SO closed the file.

Allen filed with the Tax Court.

Mind you, Allen was challenging IRS procedure and not the tax law itself. 

He had to show that the IRS “abused” its discretion.

It would be easier to get a rhinoceros on a park swing.

I get it, I really do. Take two SO’s. One denies you a partial pay because you are behind on estimated taxes; the other SO does not. That however is the meaning of “discretion.”

Did Allen’s SO “abuse” discretion?

The Tax Court did not think so.

Allen lost.

But there is something here I do not understand.

Why didn’t Allen make the estimated tax payment, revise his financial information (to show the depletion of cash) and forward the revised financials to the SO?

I presume that he couldn’t: he must not have had enough cash on hand.

If so, then abuse of discretion makes more sense to me: someone in Allen’s situation could NEVER meet that SO’s requirement for a payment plan.

Why?

Because he/she could never make that estimated tax payment.

A Condo Association, Dogs Running Wild and An Office In Home

This time we are talking about an office-in-home. Many of us have one, but few of us can actually claim a tax deduction for it.

The office-in-home deduction has five main rules, two of which are highly specialized. The remaining three require one to:

1. Use the office exclusively and regularly as a principal place of business
2. Use the office exclusively and regularly as a place to meet or deal with patients, clients or customers in the normal course of business
3. Use the office in connection with a trade or business – but only if the office is a separate structure

If you are an employee, then you are in the trade or business of being an employee. If your office is in a separate structure, you are home-free under test (3). 

OBSERVATION: I suppose a converted, oversized shed could meet this test.   

I have a CPA friend who practices out of her basement. She would qualify under test (2), as she regularly meets with her clients there. I however almost always meet clients either at their office or mine, so I would not qualify.

That leaves us with test (1), which is an almost impossible standard to meet if one has an office elsewhere. Fortunately there was a Supreme Court decision a number of years ago (Soliman), which allowed one to consider administrative or management duties for purposes of this test.  

Soliman was an anesthesiologist, and the three hospitals where he worked did not provide him with an office. He used a spare bedroom for work-related activities, such as contacting patients and billing. The IRS had previously taken a very hard line with test (1) and denied the deduction. The IRS reasoned that Soliman’s job was to put people to sleep, and he did that job at the hospital. This meant that the hospital was his “principal” place of business.  The IRS was not going to be persuaded otherwise, at least until the Supreme Court told them to knock it off and allow Soliman his deduction.

Great. So I can do administrative work at home – such as scheduling or billing – and have my office qualify for a deduction, right?

Not so fast.

There are two more tests if one is an employee. The one that concerns us is the requirement that the office be for the convenience of the employer.

Those words sound innocuous, but they are not.

For most of us, having an office at home is for our convenience. In fact, the IRS takes this farther, arguing that – if your employer provides you with an office – then it is virtually impossible for the home office to be for the employer’s convenience.  The IRS reasons that the employer would not care if you showed up, as it had an office waiting. There are some exceptions, such as telecommuting or requiring work hours when the office is closed, but you get the idea. For the vast majority of employees, one cannot get past that convenience-of-employer test.

What if one is self-employed? Forget the convenience test. There is no employer.

Let’s look at McMillan v Commissioner. There will be a quiz at the end.

Denise McMillan had a couple of things going on, but what we are interested in is her home office. She was self-employed.

She claimed an office-in-home deduction on her 2009 return. I am not certain of her housing situation, but her office was 50% of her home. I cannot easily visualize how this is possible, especially given the requirement that the office space not be used for any other purpose. That is a lot of space that she is not using for another purpose – like living there.

She lived in a condo. She had gotten into it with the homeowners association over construction defects related to mold and noise, dogs running wild, dogs barking incessantly and leaving dog memorabilia as dogs will when running wild and barking nonstop.

The condo association would do nothing, so she sued them.

The condo association – highlighting the quality of its Board – sued her back.

Wow, send me a flyer so I can consider buying at this bus station to paradise.

All in all, she was out over $26 thousand in legal fees and expenses.

And she deducted 50% of them through her office-in-home deduction.

QUIZ: Is this a valid tax deduction?

She sued because of events which were interfering with her use and enjoyment of her property.  Had this property been exclusively her residence, the conversation would be over. But one-half of it was being used for business purposes.

She next had to show that the litigation also had an effect on her business activity.

 QUESTION: Have you decided yet?

The Court observed that she was suing over noise, animal waste and similar issues. She argued that they were affecting her ability to work. Makes sense to me.

The IRS did not challenge her argument. 

NOTE: My hunch is that the IRS was relying upon an origin-of-claim doctrine. The lawsuit originated from a personal asset – her residence – so the tax consequences therefrom should remain personal. In this case, personal means nondeductible.

Since the IRS did not challenge, the Court could not – or would not - conclude that there was no effect on her ability to work.

The IRS had not challenged the 50% percentage either.

So the Court decided that she was entitled to a tax deduction for 50% of her legal expenses.

By the way, how did you answer?