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.

Is Paying Cards A Sport?

What is a sport?

You and I have probably encountered that shiny-sparkly when discussing NASCAR.

But can it have a tax angle?

Oh, grasshopper. Even circles take on angles when you tax them.

Let’s travel to the UK. Their 2011 Charities Act defined sports as “activities which promote health involving physical or mental health or exertion.”

Introduce Sport England. They distribute National Lottery funding to encourage people to be more physically active. Seems a desirable cause.

It helps to be a sport if you want to tap-into that pot of Lottery gold.

Enter the English Bridge Union.

They want in.

The EBU has battling HMRC (that is, the British version of the IRS), arguing that entry fees to bridge tournaments should be exempt from VAT (“value added tax,” a sort of super sales tax). HRMC in turn looks to Sport England when developing its regulations. The EBU argued that the “physical or mental health or exertion” wording in the 2011 Act does not require physical activity.

But that is not Sport England’s position. They argue that the goal of sports is to increase physical activity and decrease inactivity.  That is not to argue that activities such as bridge do not help with mental acuity and the relief of social isolation; it just means that it is not a sport.

The EBU brought a refund suit against HMRC for VAT paid between 2008 and 2011. The amount is not insignificant: for 2012/13 alone it was over $800,000. The case went before the High Court of Justice of England and Wales.

The Court ruled that Sport England was within its rights to emphasize physical activities over mental and that Sport England could deny bridge status as a sport. Extrapolating, HMRC does not have to refund VAT paid on bridge tournament fees.

But the Court simultaneously added that it had not been asked to answer the “broad, somewhat philosophical question” as to whether bridge was actually a sport.

Seems both sides have a drum to beat following this decision.

By the way, the British courts have a different way than American courts. The lawsuit cost the EBU approximately $150,000. But they lost. They have also been ordered to pay approximately $75,000 to Sport England as reimbursement of their legal expenses.

COMMENT: I like this idea.

The EBU went to the Court of Appeal in London, where they lost earlier this year. They then appealed to the EU courts.

Here is Advocate General Maciej Szpunar of The European Court of Justice determining that bridge is a sport because it requires

… a certain effort to overcome a challenge or an obstacle” and “trains a certain physical or mental skill.”

The Advocate General’s decision will in turn be reviewed by the full Court en banc.

Soon an EU court will review a British tax decision. My understanding is that the British would not have to observe an adverse EU decision, but such a decision should nonetheless carry considerable persuasion.

And the Brits argue what constitutes a sport … because they have decided to tax something unless it is a sport. Well heck, all one has to do is remove “sport,” replace with another word, and we can continue this angels-on-a-head-of-a-pin nonsense until the end of time.

I do sympathize with the EBU. The HRMC, for example, recognizes both darts and snooker as sports, whereas you and I would recognize them as activities played in a bar. Several European countries – Austria, France, Denmark and others – already recognize bridge as a sport. To be fair, there are other countries – Ireland and Sweden, for example – that do not.

Did you know that the International Olympic Committee classified bridge as a sport back in 1998?  

But still…

I have difficulty with the concept of a “mental sport.”

By that definition tax practice – that is, what I do professionally – is a sport. 

Trust me, this is no sport.

Vanguard's Whistleblower Tax Case

Can the IRS go after you for not making enough profit?

There is a whistleblower case against Vanguard, the mutual fund giant. Even though there is a tax angle, I had previously sidestepped the matter. Surely it must involve some mind-numbing arcana, and –anyway- why enable some ex-employee with a grudge? 

And then I saw a well-known University of Michigan tax professor supporting the tax issues in the whistleblower case.

Now I had to look into the matter.

My first reaction is that this case represents tax law gone wild. It happens. Sometimes tax law is like the person looking down at his/her cell phone and running into you in the hall. They are too self-absorbed to look up and get a clue.

What sets this up is the management company: Vanguard Group, Inc. (VGI). Take a look at other mutual fund companies and you will see that the management company is separately and independently owned from the mutual funds themselves.  The management company provides investment, financial and other services, and in turn it receives fees from the mutual funds.  

The management company receives fees irrespective of whether the funds are doing well or poorly. In addition, the ownership of the management company is likely different from the ownership of the funds. You can invest in the management company for T. Rowe Price (TROW), for example, even if you do not own any T. Rowe Price funds.

Vanguard however has a unique structure. Its management company – VGI – is owned by the funds themselves. Why? It goes back to Jack Bogle and the founding of Vanguard: he believed there was an inherent conflict of interest when a mutual fund is advised by a manager not motivated by the same financial interests as fund shareholders.  Since the management company and the funds are essentially one-and-the-same, there is little motivation for the management company to maximize its fees. This in turn has allowed Vanguard funds to provide some of the lowest internal costs in the industry

My first thought is that every mutual fund family should be run this way.

VGI and all the funds are C corporations under the tax Code. The funds themselves are more specialized and are “registered investment companies” under Subchapter M. Because the funds own VGI, the “transfer pricing” rules of IRC Section 482 apply.

COMMENT: The intent of Section 482 is to limit the ability of related companies to manipulate the prices they charge each other. Generally speaking, this Code section has not been an issue for practitioners like me, as we primarily serve entrepreneurs and their closely-held companies. This market tends to be heavily domestic and unlikely to include software development, patent or other activity which can easily be moved overseas and trigger transfer pricing concerns. 

Practitioners are however starting to see states pursue transfer pricing issues. Take Iowa, with its 12% corporate tax rate as an example. Let’s presume a multistate client with significant Iowa operations. Be assured that I would be looking to move profitability from Iowa to a lower taxed state. From Iowa’s perspective, this would be a transfer pricing issue. From my perspective it is common sense.

Section 482 wants to be sure that related entities are charging arm’s-length prices to each other. There are selected exceptions for less-than-arm’s-length prices, such as for providing routine, ministerial and administrative services. I suppose one could argue that the maintenance and preparation of investor statements might fit under this exception, but it is doubtful that the provision of investment advisory services would.  Those services involve highly skilled money managers, and are arguably far from routine and ministerial.

So VGI must arguably show a profit, at least for its advisory services. How much profit?

Now starts the nerds running into you in the hall while looking down at their cell phones.

We have to look at what other fund families are doing: Janus, Fidelity, Eaton Vance and so on. We know that Vanguard is unique, so we can anticipate that their management fees are going to be higher, potentially much higher. An analysis of Morningstar data indicates as much as 0.5 percent higher. It doesn’t sound like much, until you consider that Vanguard has approximately $3 trillion under management. Multiply any non-zero number by $3 trillion and you are talking real money.

It is an interesting argument, although it also appears that the IRS was not considering Vanguard’s fact pattern when it issued Regulations. Vanguard has been doing this for 40 years and the IRS has not concerned itself, so one could presume that there is a détente of sorts. Perhaps the IRS realized how absurd it would be to force the management company to charge more to millions of Vanguard investors.

That might attract the attention of Congress, for example, which already is not the biggest fan of the IRS as currently administrated.

Not to mention that since the IRS issued the Regulations, the IRS can change the Regulations.

And all that presumes that we are correctly interpreting an arcane area of tax law.

The whistleblower is a previous tax attorney with Vanguard, and he argues that Vanguard has been underpaying its income taxes by not charging its fund investors enough.

Think about that for a moment. Who is the winner in this Alice-in-Wonderland scenario?

The whistleblower says that he brought his concerns to the attention of his superiors (presumably tax attorneys themselves), arguing that the tax structure was illegal. They disagreed with him. He persisted until he was fired.

He did however attract the attention of the SEC, IRS and state of New York.

I had previously dismissed the whistleblower argument as a fevered interpretation of the transfer pricing rules and the tantrum of an ex-employee bent on retribution.  I must now reevaluate after tax law Professor Reuven S. Avi-Yonah has argued in favor of this case.

I am however reminded of my own experience. There is a trust tax provision that entered the Code in 1986. In the aughts I had a client with that tax issue. The IRS had not issued Regulations, 20 years later. The IRS had informally disclosed its internal position, however, and it was (of course) contrary to what my client wanted. I in turn disagreed with the IRS and believed they would lose if the position were litigated. I advised the client that taking the position was a concurrent decision to litigate and should be addressed as such.

I became extremely unpopular with the client. Even my partner was stressed to defend me. I was basing professional tax advice on chewing gum and candy wrappers, as there was nothing else to go on.

And eventually someone litigated the issue. The case was decided in 2014, twenty eight years after the law was passed. The taxpayer won.

Who is to say that Vanguard’s situation isn’t similar?

What does this tax guy think?

I preface by saying that I respect Professor Avi-Yonah, but I am having a very difficult time accepting the whistleblower argument. Vanguard investors own the Vanguard funds, and the funds in turn own the management company. I may not teach law at the University of Michigan, but I can extrapolate that Vanguard investors own the management company – albeit indirectly – and should be able to charge themselves whatever they want, subject to customary business-purpose principles. Since tax avoidance is not a principal purpose, Section 482 should not be sticking its nose under the tent.

Do you wonder why the IRS would even care? Any income not reported by the management company would be reported by fund investors. The Treasury gets its pound of flesh - except to the extent that the funds belong to retirement plans. Retirement plans do not pay taxes. On the other hand, retirement plan beneficiaries pay taxes when the plan finally distributes.  Treasury is not out any money; it just has to wait. Oh well.

It speaks volumes that someone can parse through the tax Code and arrive at a different conclusion. If fault exists, it lies with the tax Code, not with Vanguard.

Then why bring a whistleblower case? The IRS will pay a whistleblower up to 30% of any recovery, and there are analyses that the Vanguard management company could be on the hook for approximately $30 billion in taxes. Color me cynical, but I suspect that is the real reason.

Lawsuits, Attorney Fees and What Is A “Relator” Anyway?

I have a friend who was considering employment litigation earlier this year. His job has sufficient visibility that it attracts people – some unpleasant and others unhinged. Couple that with a political-correctness-terrified employer and you have a combustible mix.

The taxation of litigation damages leaves room for improvement. Certain types of litigation – say personal injury or employment – are commonly done on a contingency basis. This means that the attorney does not receive fees unless the case is successful or settled. A common contingency fee is one-third. A rational tax system would recognize that the litigant received 67 cents on the dollar and assess tax accordingly. Our system does not do that.

Our tax Code wants to tax the litigant on the full proceeds, although one-third or more went to the attorney. The Code does allow one to deduct that one-third as a miscellaneous itemized deduction. It sounds great but many – if not most – times it amounts to nothing. Why? 

·        Miscellaneous itemized deductions are deductible only to the extent that they exceed 2% of your adjusted gross income (AGI). Swell that AGI to unrepresentative levels - say by the receipt of damages – and that 2% can amount to a high hurdle.

·        Even that result can be overridden by the alternative minimum tax (AMT). The AMT does not allow miscellaneous deductions at all. Forget about deducting that contingency fee if you are an AMT taxpayer, which you likely will be.

·        Then you have states, such as Ohio, which do not allow itemized deductions. The damages are sitting in your AGI, though. It stinks to be you.

How did we get to this place?

We know that the tax Code allows one to deduct business expenses against related business income. There may be restrictions – entertainment expenses, for example, or limitations on depreciation – but overall the concept holds. The result of this accounting exercise enters one’s tax return as net profit or loss.

But not always.

For example, I am in the trade or business of being an employee of my accounting firm. My salary enters my individual tax return as gross income. What if I have business expenses relating to the practice?  The IRS allows me to deduct those, but not directly against my salary. The IRS instead wants me first to itemize and then claim my accounting-practice expenses therein as a miscellaneous deduction. Miscellaneous deductions are the redheaded stepchild of itemized deductions. They are never deductible in full, and depending on one’s situation, they may not be deductible at all.

Extrapolate this discussion to the recipient of a legal settlement and you have the issue I have with accounting-practice expenses – but greatly magnified, as the dollars are likely more substantive.

So I was pleased to review the case of Bagley v United States.

Richard Bagley had an MBA and a M.S. in accounting. He worked for TRW Inc, and from 1987 to 1992, he was the Chief Financial Manager for their space and technology group. TRW did a lot of work for the government, meaning they had to follow certain accounting procedures when requesting payment from the government. Remember that Bagley was in charge of the accounting, and you have a good idea of where the story is going.

Bagley became aware of bad accounting. He nonetheless signed certifications to the government, mostly because he needed the job. He did the good soldier thing and reported his concerns to his superiors. TRW in turn notified him that he was going to be laid off because of a corporate reorganization, rising tides, Punxsutawney Phil not seeing his shadow and the Chicago Cubs missing the World Series.

He was laid off in 1993.

In 1994 he brought a wrongful termination lawsuit against TRW.  He lost that lawsuit.

In that same year, he filed a False Claims Act (FCA) on behalf of the United States against TRW.

There is a peculiarity about a FCA lawsuit that we should discuss. Although Bagley brought the FCA lawsuit, the action was technically brought by the United States against TRW for fraud. Bagley stood-in as an agent for the United States, and his status was that of “relator.”

Bagley took this matter seriously.

During the 1994 to 2003 time period, Bagley exclusively worked on his FSA prosecution activity, and was not otherwise employed.”

He maintained a contemporaneous log of hours he worked on the litigation. He attended meetings with his attorney and government counsel. He spent a lot of time looking through TRW documents. He stayed involved because the attorneys

… weren’t accountants and hadn’t spent 25 years working with TRW and didn’t have an in-depth understanding of TRW’s accounting system or the people or the products or anything about the company which was  necessary to understand how the frauds occurred and where the evidence was.”

He logged approximately 5,963 hours working on the FCA. He put in those hours 

… in order to successfully prosecute the claims so that [he] would receive an award.”

In 2003 TRW paid the government, which in turn paid Bagley $27,244,000. He in turn paid his attorney $8,990,520. TRW also paid Bagley’s attorneys $9,407,295 and issued the Form 1099 to Bagley.

NOTE: This is standard treatment. The payment to the attorney is imputed to the litigant.

He filed his 2003 Form 1040. There was some complexity on how to handle the attorney fees paid directly by TRW, so he amended the return. He went the usual route of deducting the attorney fees as a miscellaneous deduction. He amended a second time, this time showing the relator litigation as Schedule C self-employment income. He was now deducting the attorney fees directly – and fully - against the litigation proceeds.

The IRS bounced the seconded amended return.

There really was only one issue: did Bagley’s litigation activity rise to the level of Bagley being self-employed?

The Court went through the analysis:

·        Pursuing the activity in a business-like manner

·        Expertise

·        Time and effort expended

·        Success in carrying on similar activities

·        History of income and losses with respect to the activity

·        Financial status while pursuing the activity

·        Elements of personal pleasure or recreation

·        Regularity and continuity

The IRS argued along different lines. They reminded the Court of the origin and character of the activity giving rise to the FCA claim. Bagley’s claim was that of an informant, according to the IRS, not that of a relator prosecuting the case. According to them, it was Bagley’s status as an informant, not his activities as a relator – that drive the tax consequence.

The Court decided that an action under the FCA was different from a tort action, as the “gravamen” of a FCA action was fraud against the government. The relator stands in the shoes of the government in order to prosecute the claim. This consequently was not a personal claim that Bagley had undertaken. He had no personal stake in the damages sought – all of which, by definition, were suffered by the government.

The Court decided that Bagley did have a trade or business, and that the second amended return was correct. The government was to refund him approximately $3,874,000 plus interest for his 2003 tax year.

Note the tax year involved: 2003. This case was decided just this summer. Sometimes these matters take a while to resolve, but this was an especially slow boat on a lazy river.

OBSERVATION: The facts are too unique for this case to provide much precedence, but I am pleased that Bagley won. Frankly, a minor change to the tax law would make this case obsolete and remove the tax nightmare from future litigation settlements. Simply allowing the litigant to recognize the net damages as income would solve this matter. It would also reflect the equity of the transaction. Do not hold your breath, though.

Signing Up for Social Security?

Those applying for social security beginning Monday, May 2, will have to select an electronic payment option – either direct deposit or a debit card. The debit card can be reloaded every month. One has to be careful, though, as fees will apply. For example, there is a $1.50 charge for transferring from the card to a checking or savings account.

If you are already receiving social security, then you have two more years – until March, 2013 - to make this decision.