Choose The Lesser Of IRS Grumpiness

 

Let’s talk about the failure to file (FTF) penalty.

Most of us must file an annual income tax return. Unless one is an expat (that is, an American living overseas), the return is due April 15. One can extend the return for six months (that is, until October 15), but the extension is for filing paperwork and not for payment of tax.

How is one supposed to estimate the tax if a significant amount of information is unavailable? Many times, there are estimates or informed guesses; the tax preparer will extend the return using those. Sometimes there are no estimates and no informed guesses; one then does their best. I doubt there isn’t a veteran tax preparer that hasn’t been blindsided by a Schedule K-1.

Let’s continue.

You extend your return. Your K-1 comes in heavier than expected. You owe $5,000 in tax with the return, which you file and pay on October 15.

You will have something called the Failure to Pay (FTP) penalty. The tax nerds know this as the Section 6651(a)(2) penalty. The penalty is as follows:

One-half of 1% for each month or part of a month

To a maximum of 25%

Let’s use our $5,000 example.

I count seven months from April through October (remember: a part of a month counts as a month).

The FTP penalty would be $5,000 times .005 times 7 = $175. It stings, but it is not crushing.

Let’s say the return was filed on October 30.

Has something changed?

Yep.

The IRS is strict about filing deadlines. If the return is extended to October 15, then you have until October 15 to file the return (or at least put it in the mail or submit the electronic file). The 15th is not a suggestion.

What happens if you miss the deadline?

You then filed your return late.

Back to our example. You file the return on October 30. You are just 15 days late. How bad can 15 days be?

It is not intuitive. If you file the return on October 30, you have blown the extension, meaning it is like you never submitted an extension at all. Any penalty calculation starts on April 16.

So what? The FTP penalty is still the same: $5,000 times .005 times 7, right?

The difference is that you have just provoked FTP’s big brother: the Failure to File (FTF) penalty. The FTF is the gym-visiting, MMA-training, creatine supplementing and aggressive sibling to the FTP.

Start with the FTP penalty. Multiply it by 10. The tax nerds know the FTF as the Section 6651(a)(1) penalty. 

Are we saying the FTF penalty is $5,000 times .05 times 7?

Nope, this is tax. There is a loop-the-loop to the FTF calculation.

• The maximum (a)(1) and (a)(2) penalty is 5% per month or part of a month.
• The math stops when you get to 25% in total.

The first loop means that the FTP penalty comes in at .005 and the FTF penalty comes in at .045 per month (or part thereof), as the maximum cannot exceed .050 per month.

The second loop means that the math stops when you get to 25%.

How does a tax pro handle this?

Easy: multiply by 25%.

Let’s go back to the math: $5,000 times 25% = $1,250.

This could have stopped at $175 had you just filed the return on October 15. Nah, you thought to yourself. What’s another couple of weeks?

$1,075, that’s what ($1,250 - $175). That is an expensive two weeks.

So, what got me fired up about this topic?

I saw the following on a tax return this past week:

Go to the bottom where it reads “Interest Penalties.” Go across to “Failure to File.” You will see $3,619.

Someone has just thrown away over three-and-a half grand by dragging their feet on filing. There goes a vacation, new electronics for the house, an IRA contribution - anything better than sending it to the government.

The client has two years of this, BTW.

But CTG, you say, maybe they did not have the money to pay.

The FTF does not mean that one is unable to pay. Granted, in real life the two issues often go together. One rationalizes. I do not have any money; if I delay filing maybe I can also delay IRS dunning letters and collection activity.

Maybe, but practice tells me it is rarely worth it. You have to go over four years with an FTP penalty before you equal just five months of FTF penalty. That money is just too expensive.

Let’s go back to our example.

Say the $5,000 is for tax year 2021. The taxpayer filed the return on or before October 15, 2022 and only now can pay the tax. What have we got?

First, the FTF penalty goes away, as the return was filed on time.

Second, the FTP penalty would be: $5,000 times .005 times 16 = $400. (I am running the penalty from April 2022 to July 2023)

Third, there will be interest, of course, but let’s ignore that for now.

$400 versus $1,075. Seems clear to me.

What can be done if one cannot get numbers together by October 15?

Here’s a thought.

I have a client who owns a successful drywalling company. We extended his return several years ago, and sure enough – closing in on October 15 – he was out-of-town, relaxed and unconcerned about any looming doom. However, I knew that he had a good year, and that any tax due was going to be significant. An FTF penalty on significant tax due was also going to be significant. We decided to file his return with the best numbers available, intending to amend whenever we obtained more precise numbers.

Did I like doing that?

That is a No.

Did he avoid the FTF?

That is a Yes, but he delayed getting us more accurate numbers. That delay created its own problems. Problems which were … completely … avoidable.

What is our takeaway?

File your return. Extend if you must, but file by the extension date. File even if you cannot pay. Yes, the IRS will penalize you. The IRS is grumpy about not getting its money. The IRS is grumpier, however, about not getting the tax return in the first place.

Remember: when given the option, choose the lesser of IRS grumpiness.

No Penalty Abatement When Taxes Not Paid For Years

 

I am looking at a case where the taxpayers wanted penalty abatement for reasonable cause.

I have been cynical for years about the IRS allowing reasonable cause, but let’s read on.

The Koncurats owed for years 2005, 2006 and 2010 through 2016.

CTG: There is a donut in there from 2007 through 2009. I wonder what happened?

For the years at issue Stephen Koncurat owned his own company in the insurance industry. Tamara Koncurat maintained their home and raised four children.

The interest and penalties added up, exceeding $670 grand. To their credit, the Koncurats did not argue the tax due. They did feel, however, that penalty abatement was warranted because “circumstances largely beyond his control” prevented them from meeting their tax obligations.

There were a lot of years involved, though. What were those circumstances?

·      Around 2007 or 2008 Stephen had six rental properties foreclosed.

COMMENT: Got it. That was the Lehman Brothers bankruptcy and the near implosion of the American housing market.

·      From 2010 to 2011 Stephen’s income dropped sharply from over $450K to about $96K.

·      There was a stretch where they could not even afford to make their house payment. Stephen’s father made the payments for them. 

OBSERVATION: This is years after 2005 and 2006, however. I can see going into a payment plan, then negotiating with the IRS to reduce or interrupt payments because of subsequent events cratering one’s income. It is not the easiest thing to do, but it can be done. 

·      Around 2014 or 2015 Stephen broke his back.

·      In 2018 he was diagnosed with cancer and a blocked artery.

·      He thereafter underwent three major surgeries and attended over 100 medical appointments.

He continued to work, as best he could., They reported the following income:

         2005          $274,359

         2006          $251,902

         2010          $462,455

         2011          $95,974

         2012          $71,847

         2013          $109,072

2014          $171,648

2015          $207,398

2016          $314,491                              

I get it. The 2011 through 2013 tax years were aberrant.

I am impressed how well he did during the broken back, cancer and surgery years, though.

Stephen voluntarily paid $1,500 a month to the IRS.

Good.

Starting January 2020.

What? Starting …??

I admit, this is going to be a problem. Unexpected circumstances can knock you off your feet. Maybe you don’t file or pay for a couple of years, but there is a beginning and end to the story. Somewhere in there the IRS – and reasonable cause – expects you to put on your big boy pants and try to comply. Hopefully you can file and pay, but maybe all you can do is file. Fine, then file and request a payment plan. Will the IRS be unreasonable? Of course. What if they want more than you can pay? Then request a Collections Due Process hearing.

The point is: get back into the system.

If you don’t, then reasonable cause – hard to obtain under regular circumstances – takes a step up the difficulty ladder. You now have to present “unavoidable obstacles” to your compliance.

Short of being in a coma or Marvel Universe superheroes destroying your city, that “unavoidable” threshold is going to be near-nigh impossible to meet.

Here is the Court:

·      They have alleged no details sufficient to support a finding that any of the hardships they experienced actually presented unavoidable obstacles.”

·      Further, the Koncurats have not alleged … that they ‘didn’t have [the money] or couldn’t keep [the installment plan] going…’”

·      While the family’s financial troubles were significant at times, the record reflects that they have had consistent access to financial resources throughout the years at issue.”

·      They were … contributing tuition, housing and wedding expenses to children….”

That last one doesn’t make sense for broke people.

·      Stephen Koncurat earned more than one million dollars in income in 2019, and again in 2021.”

So we are not talking about broke people. Broke people do not make a million dollars a year.

The Court wanted to know why – with that million dollars – they did not clean-up their tax debt – or at least a chunk of it – rather than delaying payment and tying up the Court’s time.

There was no reasonable cause for the Koncurats. Heck, one could have looked at the extended failure to pay and instead concluded that there was willful neglect.

Meaning no penalty abatement.

No surprise there.

The Koncurats dug themselves a hole by letting the matter go on long enough to attend high school. The likelihood of reasonable cause over that much time was minimal, but I do think that there was something they could have done to improve their odds.

What would that have been?

Take that $1 million dollars and pay the IRS.

They would then have gone before the Court and argued that they had a bad stretch, causing them to fail in their obligations and run afoul of the tax system. However, when their fortune improved, the first party they took care of was … the IRS.

Would this have allowed reasonable cause? Financial difficulties generally do not lead to eligibility for reasonable cause relief.

But it would not have hurt. It also would have lifted the needle off zero and given the Court something specific to support a taxpayer-favorable determination.  

Our case this time was United States v Koncurat, USDC MD, Case No 1:21-cv-00676.

Losing Deductions By Not Filing A Tax Return

I have become increasingly reluctant to accept a nonfiler as a client. That said, a partner somehow sneaks one or two a year into Command Center, and I – reluctant or not – become involved. It would not be so bad if it was just a matter of catching-up with the paperwork, but often one needs to stave off Collections, establish a payment plan, request penalty abatement (done after the taxes are paid, meaning I have to monitor it in my spare time) and on-and-on.

Try doing this during IRSCOVID202020212022. It is zero fun.

I am looking at a nonfiler that took a self-inflicted wound.

Let’s talk about Shawn Salter.

Salter was a loss prevention manager over 10 Home Depot stores in Arizona.  He worked from home but drove regularly to his stores. Home Depot offered to reimburse his mileage, but he turned it down. He thought that claiming the mileage on his return would give him a bigger refund.

COMMENT: Well, yes, as he was paying out-of-pocket for gasoline and wear-and-tear on his car. Clearly he is not a Warren Buffet successor.

Salter got laid off in 2013.

He took money out of his IRA to get through, but that is not the point of our discussion today.

He needed to file a 2013 return so he could get that tax refund, especially since he turned down the opportunity to be reimbursed.

What did he not do?

He did not file a 2013 return.

Eventually the IRS figured it out and asked for a tax return.

Salter blew it off.

The IRS prepared a “substitute for return.” You do not want the IRS to do this, by the way. The IRS will file you as single with no dependents (whether you are or not), include all your gross income and do its very best to not spot you any deductions. It is intentionally designed to maximize your tax liability.

The IRS wanted over $6 grand in tax, with all the assorted interest and penalty toppings.

Now Salter cared.

He told the IRS that he had used H&R Block software to file his return.

The IRS clarified that it had no 2013 tax return, either from H&R Block or from anyone else. Send us a copy, they said.

He did not have a copy to send. He did not have certified mail receipts or record of electronic filing. He had nothing.

Hard to persuade anyone with nothing.

Here is the Court:

We find that the petitioner did not file a return for 2013, ...”

This created a problem.

Salter wanted to claim that mileage, meaning that he needed to itemize his deductions.

OK.

Not OK. There is a tax issue.

Which is …?

Did you know that itemizing your deductions is considered a tax election?

And …?

You have to file a tax return to make the election.

Easy, you say, Salter should prepare and file a 2013 return claiming itemized deductions. Doing so is the election.

Too late. That window closed when the IRS prepared the substitute for return. The substitute is considered a return, and it did not itemize. Remember how a substitute works: income is reported at gross; deductions are grudgingly given, if given at all. 

No mileage. No deduction. No refund. Tax due.

As we said: self-inflicted wound.

Our case this time was Salter v Commissioner, T.C. Memo 2022-29.

Mean It When You Elect S Corporation Status

I am looking at an odd case.

I see that the case went to Tax Court as “pro se,” which surely has a great deal to do with its general incoherence. Pro se generally means that the taxpayer is representing himself/herself. Technically this is not correct, as I could represent someone in Tax Court and the case still be considered pro se. There was no accountant involved here, however, and it shows.

We are talking about Hong Jun Chan. 

He founded a restaurant named Younique Café Inc (YCI) in August, 2010.

In March, 2011 he filed an election with the IRS to be treated as an S corporation. All the owners have to agree to such an election, and we learned that Chan was a 40% shareholder of YCI.  

Let’s fast forward to 2016.

Chan and his wife filed a joint tax return for 2015, but they did not include any numbers from YCI. That does not make sense, as the purpose of an S corporation is to avoid corporate tax and instead report the entity’s tax numbers on the shareholder’s individual/separate return.

A year later the Chan’s did the same with their 2016 joint tax return.

This caught the attention of the IRS, which started an audit in 2019. The revenue agent (RA) found that no business returns had ever been filed.

Standard procedure for the IRS is to contact the taxpayer: perhaps the taxpayer is to visit an IRS office or perhaps the audit will be conducted via correspondence. The IRS did not hear from Chan. Chan later explained that they had moved to Illinois and received no IRS correspondence.

The RA went all Kojak and obtained YCI’s bank records. The RA added up all the deposits and determined that the Chan underreported his taxable income by $1,139,879 and $731,444 for 2015 and 2016 respectively.

Yep, almost $2 million.

Off to Tax Court they went.

Chan had a straightforward argument: YCI was not an S corporation. It was a C corporation, meaning it filed its own tax returns and paid its own taxes. Let’s be fair: the restaurant had gone out-of-business. It is unlikely it ever made money. Unless there was an agency issue, the business tax could not be attributed to Chan personally.

Got it.

ISSUE: YCI filed an S election. The IRS had record of receiving and approving the election. YCI was therefore an S corporation until it (1) was disqualified from being an S, (2) revoked its election, or (3) failed an obscure passive income test.

PROBLEM: YCI was not disqualified, had no passive income and never revoked its election.

But …

Chan presented C corporation tax returns for 2015 and 2016. They were prepared by a professional preparer but were not signed by the preparer.

COMMENT: That is odd, as a paid preparer is required to sign the taxpayer’s copy of the return. I have done so for years.

The IRS of course had no record of receiving these returns.

COMMENT: We already knew this when the RA could not find a copy of the business return. Any search would be based on YCI’s employer identification number (EIN) and would be insensitive to whether the return was filed as a C or S corporation.

Hopefully Chan mailed the business return using certified mail.

Chan had no proof of mailing.

Of course.

At this point in the case, I am supposed to believe that Chan went to the time and trouble of having a professional prepare C corporation returns for two years but never filed them. Righhhttt ….

But maybe Chan thought the preparer had filed them, and maybe the preparer thought that Chan filed them. It’s a low probability swing, but weird things happen in practice.

This is easy to resolve: have the preparer submit a letter or otherwise testify on what happened with the business returns.

Crickets.

The IRS in turn was not above criticism.

It added up deposits and said that the sum was taxable income.

Hello?? This is a RESTAURANT. There would be food costs, rent, utilities and so forth. Maybe the RA should have spent some time on the disbursement side of that bank statement.

Then the IRS charged 100% of the income to Chan.

Hold on here: didn’t Form 2553 show Chan as owning 40% - not 100% - of YCI?

We don’t believe that, said the IRS.

Both sides are bonkers.

Chan went into Tax Court without representation after the IRS tagged him with almost $2 million of unreported income. This appears a poor decision.  

The IRS - relying on a Form 2553 to treat Chan as a passthrough owner – could not keep reading and see that he owned 40% and not 100%.

Can you imagine being the judge listening to this soap opera?

The Court split its decision:

(1) Yep, Chan is an S corporation shareholder and has to report his ownership share of the restaurant’s profit or loss for 2015 and 2016.

(2)  Nope, both sides must go back and do something with expenses, as well as decide Chan’s ownership for the two years.

Our case this time was Hong Jun Chan and Suzhen Mei v Commissioner, T.C. Memo 2021-136.

A Tax Refund When The IRS Fails To Process A Return

I am looking at a case involving a tax refund. The IRS bounced it, and I am having a hard time figuring out what the IRS was thinking.

Let’s talk about it.

James Willetts filed an extension for his 2014 individual tax return. He sent a $8,000 payment and extended the return from April 15 to October 15, 2015.

Standard stuff.

He did not file the return by October 15, 2015.

Oh well.

He finally filed the 2014 return on April 14, 2018.

April 15, 2015 to April 14, 2018 is less than three years, and that is not even including the six-month extension on the 2014 return.

The IRS rejected the return because of potential identity theft.

I presume that the IRS sent a notice, but Willetts did not respond. The Court goes on to observe that it was unclear whether Willetts even knew there was an identity issue before bringing suit.

COMMENT: That struck me as odd, as one of the first things a tax professional would do is obtain a transcript of Willett’s tax account. I then noted that Willetts brought suit as “pro se,” generally interpreted as going to Court without professional representation. Technically, that is incorrect, as one can go to Court with a CPA and still be considered “pro se,” but, in Willetts’ case, I am inclined to believe he was truly pro se.

The issue before the Court was straight-forward: did Willetts file his return in time to get his refund?

Let’s go tax nerd for a moment:

(1)  A taxpayer may recoup a tax overpayment by filing a claim within a statutorily-prescribed period of time.

(2)  That period of time is:

a.    Three years from when the return was filed, if the return was filed within three years of when the return was due; otherwise

b.    … two years from when the tax was paid.

(3)  The three years in (2)(a) extends with a valid tax extension.

Let’s parse this.

(1) Willetts' 2014 tax return was due April 15, 2015.

(2) He had a valid extension until October 15, 2015.

(3) His three-year period for filing a refund claim would run – at a minimum - until April 15, 2018. Since he also had a valid extension, the extension period gets tacked-on. He therefore had until October 15, 2018 to file a refund claim within the three-year lookback period.

You can see where the IRS was coming from. It did not have a tax return in its system until after October 15, 2018.

However, Willetts filed - or at least attempted to file - a return on April 14, 2018. It wasn’t his fault that the IRS held up processing.

The Court made short work of this.

A tax return is deemed filed the day it is received by the IRS, regardless of whether it is accepted, processed, ignored or destroyed by the IRS. The IRS’ own records showed Willetts' return as received on May 2, 2018, well within the period ending October 15, 2018.

The return was filed timely. Willetts was due his refund.

I have a couple of observations:

(1)  I do not understand why the IRS pursued this. The rules here are bright-line. The IRS did not have a chance of winning; in fact, the case strikes me as borderline harassment. 

What concerns me is the mountain of paper returns – especially amended returns – waiting unopened and unprocessed at the IRS as I write this. Are we going to see Willetts-like foot-dragging by the IRS on those returns? Is the IRS going to force me to file with the Tax Court to get my clients their refunds?   

(2)  Let’s play what-if.  

Say that Willetts had filed his return on November 1, 2018, so that all parties would agree that he was outside the three-year lookback period. Once that happened, his refund would be limited to any taxes paid within the previous two years. His 2014 taxes would have been deemed paid on April 15, 2015, meaning that none, zero, zip of his 2014 taxes were paid within two years of November 1, 2018. There would be no refund. This, by the way, is the how-and-why people lose their tax refunds if they do not file their returns within three years.   

Our case this time was Willetts v Commissioner, Tax Court November 22, 2021.

Not Filing A Return and Owing Tax

 

The question comes up periodically, even among accountants: 

Is there a penalty for filing a late return if the taxpayer has a refund?

In general, the answer is no. Mind you, this is not an excuse to skip filing. If anything, you have money due to you. Do not file for three years and you are losing that refund.

Let’s switch a variable:

Is there a penalty for filing a late return if the taxpayer owes taxes?

Uhhhh, yes.

As a rule of thumb, assume an automatic 25% penalty, and it can be more.

So what happens if someone cannot file by the extended due date?

I have a one of these clients. I called him recently to send me his 2020 information.

His comment?

         I thought you took care of it.”

Now, I have been at this a long time, but I cannot create someone’s return out of thin air. Contrast that with estimating a selected number or two on a tax return. That happens with some regularity, although - depending on the size and tax sensitivity of the numbers – I might flag the estimates to the IRS’ attention. It depends.

Let look at the Morris case.

James and Lori Morris were business owners in Illinois. In 2013 James expanded the business, creating a new company to house the same. They had a long-standing relationship with their CPA.

The IRS came in and looked at the 2013 return. It appears that there were issues with the start-up and expansion costs of the new business, but the case does not give us much detail on the matter.

The Morris’ held up filing a return for 2014. They also held up filing 2015 and 2016, supposedly from concern of repeating the issue the IRS was addressing on the 2013 return.

Seems heavy-handed to me.

Well, as long as they were fully paid-in:

They did not make any estimated tax payments during the year at issue and did not have tax withheld from their paychecks during 2015. Petitioner-husband had a minimal amount of tax withheld from his wages during 2016. Petitioner-wife had withholding credits of $10 and $11 during 2015 and 2016, respectively.”

Got it: next to nothing paid-in.

Maybe the businesses were losing money:

For 2015 and 2016 petitioners, respectively, had ordinary income from their S corporations of over $2.2 million and $3 million.”

What was going on here? I am seeing income over $5 million for two years with little more than $21 of tax paid-in.

The Morris’ argued that their long-standing CPA advised that filing a return while an audit for earlier years was happening could subject them to perjury charges.

COMMENT: Huh? There are areas all over the Code where a taxpayer and the IRS might disagree. If it comes to pass, one appeals within the IRS or files with a court. The system does not lock-down because the IRS disagrees with you.

Frankly, I am curious what was on that return that the issue of “perjury” even saw the light of day.

Oh, well. Let’s have the CPA testify. Hopefully the Morris’ will have reasonable cause for penalty abatement because of their reliance on a tax professional.

Mr Knobloch (that is, the CPA) did not testify at trial, and there is no evidence in the record except for petitioner-husband’s testimony of Mr. Knobloch’s alleged advice.”

The Court was not believing this for a moment. 

We need not accept a taxpayer’s testimony that is self-serving and uncorroborated by other evidence, and we do not do so here.”

I find myself wondering why the CPA did not testify, although I have suspicions.

I also do not understand why – even if there were substantive issues of tax law – the Morris’ did not pay-in more for 2015 and 2016.  Did they think they had losses? OK, they would be out the money for a time but they would get it back as a refund when they file the returns.

They instead racked-up big penalties.

Our case this time was Morris v Commissioner, T.C. Memo 2021-120.

Downside Of Not Issuing 1099s

Let’s be honest: no one likes 1099s.

I get it. The government has conscripted us – business owners and their advisors – into unpaid volunteers for the IRS. Perhaps it started innocently enough, but with the passage of years and the accretion of reporting demands, information reporting has become a significant indirect tax on businesses.

It’s not going to get better. There is a proposal in the White House’s Green Book, for example, mandating banks to report gross deposit and disbursement account information to the Treasury.

Back to 1099s.

You see it all the time: one person pays another in cash with no intention – or ability – to issue a 1099 at year-end.

What can go wrong?

Plenty.

Let’s look at Adler v Commissioner as an example.

Peter Adler owned a consulting company. He had a significant client. He would travel for that client and be reimbursed for his expenses.

The accounting is simple: offset the travel expenses with the reimbursements. Common sense, as the travel expenses were passed-on to the client.

However, in one of the years Peter incurred expenses of approximately $44 thousand for construction work.

The Court wondered how a consultant could incur construction expenses.

Frankly, so do I.

For one reason or another Peter could not provide 1099s to the IRS.

One possible reason is that Peter made his checks out to a corporation. One is not required to issue 1099s to an incorporated business. Peter could present copies of the cancelled checks. He could then verify the corporate status of the payee on the secretary of state’s website.

Nah, I doubt that was the reason.

Another possibility is that Peter got caught deducting personal expenses. Let’s assume this was not the reason and continue our discussion.

A third possibility is that Peter went to the bank, got cash and paid whoever in cash. Paying someone in cash does not necessarily mean that you will not or cannot issue a 1099 at year-end, but the odds of this happening drop radically.

Peter had nothing he could give the Court. I suppose he could track down the person he paid cash and get a written statement to present the Court.

Rigghhhtttt ….

The Court did the short and sweet: they disallowed the deduction.

Could it get worse?

Fortunately for Peter, it ended there, but – yes – it can get worse.

What if the IRS said that you had an employee instead of a contractor? You are now responsible for withholdings, employer matching, W-2s and so on.

COMMENT: You can substitute “gig worker” for contractor, if you wish. The tax issues are the same.

Folks, depending upon the number of people and dollars involved, this could be a bankrupting experience.

Hold on CTG, say you. Isn’t there a relief provision when the IRS flips a contractor on you?

There are two.

I suspect you are referring to Section 530 relief.

It provides protection from an IRS flip (that is, contractor to employee) if three requirements are met:

1.    You filed the appropriate paperwork for the relationship you are claiming exists with the service provider.

2.    You must be consistent. If Joe and Harry do the same work, then you have to report Joe and Harry the same way.

3.    You have to have a reasonable basis for taking not treating the service provider as an employee. The construction industry is populated with contractors, for example.

You might be thinking that (3) above could have saved Peter.

Maybe.

But (1) above doomed him.

Why?

Because Peter should have issued a 1099. He had a business. A business is supposed to issue a 1099 to a service provider once payments exceed $600.

There was no Section 530 relief for Peter.

I will give you a second relief provision if the IRS flips a contractor on you. 

Think about the consequences of this for a second.

(1)  You were supposed to withhold federal income tax.

(2)  You were supposed to withhold social security.

(3)  You were supposed to match the social security.

(4)  You were supposed to remit those withholdings and your match to the IRS on a timely basis.

(5)  You were supposed to file quarterly employment reports accounting for the above.

(6)  You were supposed to issue W-2s to the employee at year-end.

(7)  You were supposed to send a copy of the W-2 to the Social Security Administration at year-end.

(8)  Payroll has some of the nastiest penalties in the tax Code.

This could be a business-shuttering event. I had a client several years ago who was faced with this scenario. The situation was complicated by fact that the IRS considered one of the owners to be a tax protestor. I personally did not think the owner merited protestor status, as he was not filing nonsense appeals with the IRS or filing delaying motions with the Tax Court. He was more …  not filing tax returns.  Nonetheless, I can vouch that the IRS was not humored.

Back to relief 2. Take a look at this bad boy:

§ 3509 Determination of employer's liability for certain employment taxes.

(a)  In general.

If any employer fails to deduct and withhold any tax under chapter 24 or subchapter A of chapter 21 with respect to any employee by reason of treating such employee as not being an employee for purposes of such chapter or subchapter, the amount of the employer's liability for-

(1)  Withholding taxes.

Tax under chapter 24 for such year with respect to such employee shall be determined as if the amount required to be deducted and withheld were equal to 1.5 percent of the wages (as defined in section 3401 ) paid to such employee.

(2)  Employee social security tax.

Taxes under subchapter A of chapter 21 with respect to such employee shall be determined as if the taxes imposed under such subchapter were 20 percent of the amount imposed under such subchapter without regard to this subparagraph .

Yes, you still owe federal income and social security, but it is a fraction of what it might have been. For example, you should have withheld 7.65% from the employee for social security. Section 3509(a)(2) gives you a break: the IRS will accept 20% of 7.65%, or 1.53%.

Is it great?

Well, no.

Might it be the difference between staying in business and closing your doors?

Well, yes.