Incompetent Employees And IRS Penalties

 

“Taxes are what we pay for civilized society.” Compania General De Tabacos de Filipinas v. Collector, 275 U.S. 87, 100 (1927) (Taft, C.J.). For good reason, there are few lawful justifications for failing to pay one's taxes. Plaintiff All Stacked Up Masonry, Inc. (“All Stacked Up”), a corporation, believes it has such an excuse. It brings this suit to challenge penalties and interest assessed by the Internal Revenue Service (“IRS”) following its failure to file the appropriate payroll tax documents and its failure to timely pay payroll tax liabilities for multiple tax periods.

The above is how the Court decision starts.

Here are the facts from 30,000 feet.

·      The company provides masonry services.

·      The company got into payroll tax issues from 2013 through 2015.

·      The company paid over $95 thousand in penalties and interest.

·      It now wanted that money back. To do so it had to present reasonable cause for how it got into this mess in the first place.

Proving reasonable cause is not easy, as the IRS keeps shrinking the universe of reasonable cause.  An example is an accountant missing a timely extension. There is a case out there called Boyle, and the case divides an accountant’s services into two broad camps:

·      Advice on technical issues, and

·      Stuff a monkey could do.

Let’s say that CTG Galactic Command is planning a corporate reorganization and we blow a step, causing significant tax due. Reliance on us as your advisors will probably constitute reasonable cause, as the transaction under consideration was complex and required specialized expertise. Let’s say however that we fail to extend the corporate return – or we file it two days after its extended due date. Boyle stands for the position that anyone can google when the return was due, meaning that relying on us as your tax advisors to comply with your filing deadline is not reasonable.

As a practitioner, I have very little patience with Boyle. We prepare well over a thousand individual tax returns, not to mention business, nonprofit, payroll, sales tax, paper airplanes and everything in between. Visit this office during the last few days before April 15th, for example, and you can feel the tension like the hum from an electrical transformer. What returns are finished? What returns are only missing an item or two and can hopefully be finished? What returns cannot possibly be finished? Do we have enough information to make an educated guess at tax due? Who is calling the client?  Who is tracking and recording all this to be sure that nothing is overlooked? Why do we do this to ourselves?

Yeah, mistakes happen in practice. Boyle just doesn’t care. Boyle holds practitioners to a standard that the IRS itself cannot rise to. I have several files in my office just waiting, because the IRS DOES NOT KNOW WHAT TO DO. I brought in the Taxpayer Advocate recently because IRS Kansas City botched a client. We filed an amended return in response to a Notice of Deficiency the client did not inform us about. The amended must have appeared as “too much work” to some IRS employee, and we were informed that Kansas City inexplicably closed the file. This act occurred well before but was fortuitously masked by subsequent COVID issues. The after-effects were breathtaking, with lien notices, our requests for releases, telephone calls with IRS attorneys, Collection’s laughable insistence on a payment plan, and – ultimately – a delay on the client’s refinancing. IRS incompetence cumulatively cost me the better part of a day’s work. Considering what I do for a living, that is time and money I cannot get back

I should be able to bill the IRS for wasting my time over stuff a monkey could do.

The Advocate did a good job, by the way.

Let’s get back to All Stacked Up, the company whose payroll issues we were discussing.

The owner fell on ice and suffered significant injuries. This led to the owner relying on an employee for tax compliance. That reliance was misplaced.

·      The first two quarterly payroll returns for 2013 were filed late.

·      The fourth quarter, 2013 return would have been due January 31, 2014. It was not filed until July 13, 2015.

·      None of the 2014 quarterly returns were filed until the summer of 2015.

·      To complete this sound track, the payroll tax deposits were no timelier than the filing of the returns themselves.

Frankly, the company should just have let its CPA firm take care of the matter. Had the firm botched the work this badly, at least the company would have a possible malpractice lawsuit.

The company pleaded reasonable cause. The owner was injured and tried to delegate the tax duties to someone during his absence. Granted, it did not go well, but that does mean that the owner did not try to behave as a prudent business person.

I get the argument. All Stacked Up is not Apple or Microsoft, with acres and acres of lawyers and accountants. They did the best they could with the (clearly limited) resources they had.

The company appealed the penalties. IRS Appeals was willing to compromise – but only a bit. Appeals would abate 16.66% of the penalties and related interest. This presented a tough call: accept the abatement or go for it all.

The company went for it all.

Here is the Court:

Applying Boyle to this case, it is clear as a matter of law that retention of an employee or software to prepare and remit tax filings, make required deposits, and tender payments cannot, in itself, constitute “reasonable cause” for All Stacked Up’s failure to satisfy those tax obligations. The employee’s failures are All Stacked Up’s failures, no matter how prudent the delegation of those duties may have been.”

And there is full Boyle: we don’t care about your problems and you doing your best with the resources available. Your standard is perfection, and do not ask whether we hold ourselves to the same standard.

I wonder if that employee is still there.

I mean the one at IRS Kansas City.

Our case this time was All Stacked Up v U.S., 2020 PTC 340 (Fed Cl 2020).

Using A Liquidating Trust

I am reading a case where the IRS wanted taxes of almost $1.5 million.

I am not surprised to read that it involved a real estate developer.

Part of tax practice is working within someone’s risk tolerance (including mine, by the way). Some clients are so risk adverse that an IRS notice – on any matter for any reason – can be interpreted as a mistake by the tax practitioner. Then you have the gunslingers at the other end of the spectrum. These are the clients you have to rope-in, for their own as well as your sake.

My experience has been that real estate developers seem to cluster around the gunslinger end of the spectrum. We have one who recently explained to me that “paying taxes means that the tax advisor made a mistake.” That, folks, is a lot of pressure … on my partner.

Jason Sage is a developer in Oregon. He represented several companies, including JLS Customs Homes. You may recall that 2008 – 2009 was a rough time for real estate, and JLS took it in the teeth. It had three projects, dragging behind approximately $18 million in debt.

Eventually the real estate market collapsed. Sage had to do something. He and his advisors decided to utilize liquidating trusts. The idea is that one transfers everything one has into a trust, which might be owned by one’s creditors; then again, it might not. The creditors might accept the settling of the trust (a fancy term for putting money and assets into a trust) as discharge of the underlying debt; then again, they might not. Each deal is its own story, and the tax consequences can vary depending on the telling.

Our story involves the transfer of three projects to three liquidating trusts. Since real estate had tanked, these transfers – treated for tax purposes as sales - threw off huge losses. These losses were so big they created overall losses - called “net operating losses” (NOLs). Tax law at the time allowed the net operating losses to travel back in time, meaning that Sage could recoup taxes previously paid.

COMMENT: I see nothing wrong with this. If the government wants to participate in one’s profits, then it can also participate in one’s losses. To do otherwise smacks more of robbery than taxation.

The IRS took a look at this arrangement and immediately called foul.

Trust taxation looks carefully at whether the trust is a separate tax entity from the person establishing the trust, funding the trust or benefiting from the trust.  There is a type called a “grantor trust” which is disregarded as a separate tax entity altogether. The most common type of grantor trust is probably the “living trust,” which has gained popularity as a probate-mitigating tool. The idea behind the grantor trust is that the grantor – say me, for example – is allowed to put money in, take money out, change beneficiaries, even terminate the trust altogether without anyone being able to gainsay my decision.

Tax law considers this to be too much control over the trust, so the trust and I are considered to be the same person for tax purposes. I would have a grantor trust. Its tax return is combined with mine.

How do I avoid this result? Well, I have to start with limiting my otherwise unrestricted control over the trust. Yield enough control and the IRS will respect the trust as separate from me.

The IRS argued that Sage’s liquidating trusts were grantor trusts. They were not separate tax entities, and one cannot sell and create a loss by selling to oneself. Without that loss, there was no NOL carryover and therefore no tax refund.

Sage had to persuade the Court that the trusts were in fact separate from him and his companies.

After all, the trusts were for the benefit of his creditors. One has to concede that creditors are an adverse party, and the existence of an adverse party is an indicator that the trust is a separate tax entity. Extrapolating, the existence of creditors means that someone with interests adverse to Sage’s own had sway over the trusts. It was that sway that made these non-grantor trusts.

Persuasive, except for one thing.

Sage had never involved the creditors when setting up the trusts.

It was hard for them to be adverse when they did not even know the trusts were there.

Our case this time was Sage v Commissioner.

Year-End Retirement Tax Changes

On Friday December 20, 2019 the President signed two spending bills, averting a government shutdown at midnight.

The reason we are talking about it is that there were several tax provisions included in the bills. Many if not most are as dry as sand, but there are a few that affect retirement accounts and are worth talking about.

Increase the Age for Minimum Required Distributions (MRDs)

We know that we are presently required to begin distributions from our IRAs when we reach age 70 ½. The same requirement applies to a 401(k), unless one continues working and is not an owner. Interestingly, Roths have no MRDs until they are inherited.

In a favorable change, the minimum age for MRDs has been increased to 72.

Repeal the Age Limitation for IRA Contributions

Presently you can contribute to your 401(k) or Roth past the age of 70 ½. You cannot, however, contribute to your IRA past age 70 ½.

In another favorable change, you will now be allowed to contribute to your IRA past age 70 ½.

COMMENT: Remember that you generally need income on which you paid social security taxes (either employee FICA or self-employment tax) in order to contribute to a retirement account, including an IRA. In short, this change applies if you are working past 70 ½.

New Exception to 10% Early Distribution Penalty

Beginning in 2020 you will be allowed to withdraw up to $5,000 from your 401(k) or IRA within one year after the birth or adoption of a child without incurring the early distribution penalty.

BTW, the exception applies to each spouse, so a married couple could withdraw up to $10,000 without penalty.

And the “within one year” language means you can withdraw in 2020 for a child born in 2019.

Remember however that the distribution will still be subject to regular income tax. The exception applies only to the penalty.

Limit the Ability to Stretch an IRA

Stretching begins with someone dying. That someone had a retirement account, and the account was transferred to a younger beneficiary.

Take someone in their 80s who passes away with $2 million in an IRA. They have 4 grandkids, none older than age 24. The IRA is divided into four parts, each going to one of the grandkids. The required distribution on the IRAs used to be based on the life expectancy of someone in their 80s; it is now based on someone in their 20s. That is the concept of “stretching” an IRA.

Die after December 31, 2019 and the maximum stretch (with some exceptions, such as for a surviving spouse) is now 10 years.

Folks, Congress had to “pay” for the other breaks somehow. Here is the somehow.

Annuity Information and Options Expanded

When you get your 401(k) statement presently, it shows your account balance. If the statement is snazzy, you might also get performance information over a period of years.

In the future, your 401(k) statements will provide “lifetime income disclosure requirements.”

Great. What does that mean?

It means that the statement will show how much money you could get if you used all the money in the 401(k) account to buy an annuity.

The IRS is being given some time to figure out what the above means, and then employers will have an extra year before having to provide the infinitely-better 401(k) statements to employees and participants.

By the way …

You will never guess this, but the law change also makes it easier for employers to offer annuities inside their 401(k) plans.

Here is the shocked face:

 Expand the Small Employer Retirement Plan Tax Credit

In case you work for a small employer who does not offer a retirement plan, you might want to mention the enhanced tax credit for establishing a retirement plan.

The old credit was a flat $500. It got almost no attention, as $500 just doesn’t move the needle.

The new credit is $250 per nonhighly-compensated employee, up to $5,000.

At $5 grand, maybe it is now worth looking at.

Can You Have A Mortgage Interest Deduction Without A Mortgage?

A new client comes in to meet with you. Let's call him Burley. Burley lives with his girlfriend, Julie, who purchased a house. The deed and mortgage is in her name, as Burley has lousy credit. He would have been no help with a mortgage approval.

Burley and Julie consider themselves domestic partners with equal ownership of the house.

Burley pays Julie $1,000 a month as "interest only" mortgage payments. Burley is not a big fan of bank accounts, preferring to conduct much of his activity in cash. This means he does not have cancelled checks to back-up his claim.

QUESTION: Does Burley have a tax deduction for mortgage interest?

The first problem is that Burley does not own the house.

This may seem fatal, but there is a loophole. Many states recognize the doctrine of equitable ownership, and their courts will enforce express or implied contracts between nonmarital partners. It is possible to have a tax deduction, even if you are not on the deed or mortgage, as long as your nonmarital partner is and you can prove such a contract.

But while a necessary first step, the tax Code goes further. It wants to see that the equitable owner has taken on the burdens of ownership as well as the benefits. Such burdens, for example, would include:

            (1) the right to use the property and enjoy its use

            (2) a duty to maintain the property

            (3) a responsibility to insure the property

            (4) the assumption of risk of loss

            (5) a responsibility to pay taxes and assessments

            (6) the right to improve the property

Burley pays $1,000 a month, which amount would cover his share of the mortgage payment, as well as (supposedly) his share of the insurance, taxes and other expenses of ownership. The amount does not vary for repairs, or for snow removal in the winter or lawn-mowing in the summer.

That sounds a lot like rent.

It would help if the arrangement between Burley and Julie were reduced to writing. After all, real estate is a significant purchase for most people, and it is not be unreasonable to want the agreement documented.

Burley and Julie of course have no such document.

Well, at least Julie could show up in person at the hearing and answer the judge's questions. Considering that Burley has little proof to provide on his own power, her testimony would be important.

Julie doesn't want to do that, however, but she is willing to send a letter instead.

The case is Jackson, and it is a pro se Tax Court case decided in July.

Jackson lost, which is about as surprising as daily summer showers in south Florida.

Here is the Court:

           

Because she held legal title to the residence and was the sole mortgagee, [Julie's] testimony would have been highly relevant to the question whether she and petitioner had agreed (expressly or impliedly) that he would hold an interest in the property.... Despite ample advance notice of the trial date and the Court's considerable flexibility in scheduling the trial in these cases, [Julie] did not appear as a witness."

What happens when you anger the Court?

Under the circumstances, we give no weight to [Julie's] ... letter to respondent's counsel related to petitioner's history of transferring funds to her."                              

This was the Court's polite way of saying "we do not believe you."

Small Business Health Care Tax Credit Redux

We’ve been looking again at the small business health care tax credit. Truthfully, I have been less than impressed with this credit, at least for our clients. It seems quite heavily engineered to accomplish so little.

There are three key steps to this credit:

(1)    How many employees do you have?

(2)    How much do you pay them?

(3)    Do you have a “qualifying” insurance arrangement?

Let’s go through them.

HOW MANY EMPLOYEES DO YOU HAVE?

To be fair, the credit does not address the number of employees. It instead addresses “full time equivalents.” This makes sense, as it may require two (or three) part-time employees to have one “full-time equivalent” employee.

The first thing to do is count the number of employees. This requires a definition of “employee” (remember, this is the tax code). The term “employee” does NOT include the following:

·         a sole proprietor

·         a partner in a partnership

·         a more-than-2% shareholder in an S corporation

·         a more-than-5% owner in any other business

Wait, there is more:

·         a family member of the above, including spouses, lineal family (ancestor/descendent) and in-laws.

So, you start with your year-end payroll summary. You eliminate the owners and their family. That leaves you with “employees’ for purposes of this credit.

Next you add-up the hours worked for those who remain. You stop counting at 2,080 hours per employee. After you adding-up all the hours, you divide by 2,080 to arrive at the number of FTEs. If this number is less than 25, you are still in the hunt.

The magic number is 10 or less FTEs. Above that number you will start to phase-out. By 25 you have phased-out completely.

HOW MUCH DO YOU PAY THEM?

We are talking Medicare wages, not income-taxable wages. The key difference will be contributions to 401(k)s, as those are Medicare-taxable but not income-taxable.

Fortunately you get to exclude the wages for the people left out above: the owners, their spouses and other family.

This can get you into an odd factual situation. You can have a workforce over 25 people – all full-time – and still qualify for this credit. The reason is that you have to eliminate the owners, their spouses and family. For some of our clients, that eliminates a sizeable part, if not the majority, of the workforce.

The key number here is $25,000 per FTE.  Above that amount you will start to phase-out.  By $50,000 you have completely phased-out. 

DO YOU HAVE A “QUALIFYING”INSURANCE ARRANGEMENT?

The insurance we are discussing is what you would anticipate: traditional insurance, HMO, PPO and hospital indemnity. It also includes specified illness (think cancer insurance) as well as some dental and vision insurance.

What it doesn’t include is an HSA.

The key requirement is that you – the employer - have to pay at least 50% of the cost of the insurance. There are some tweaks around the edges (such as if the insurance company does not charge the same premium for all employees in single coverage).

If you do not pay at least 50% of the health insurance, there is no point in even starting the calculation.

There is also a “ceiling” test: your insurance can only be so expensive for purposes of this calculation. The government will publish state-specific amounts for “small group market average premiums.” Your insurance cannot exceed that amount for your state.

AN INTERIM STEP

Add-up your cost of premiums for “qualifying” insurance for your “FTEs.”

WHAT IS THE AMOUNT OF THE CREDIT

If you are for-profit, the credit is 35% of the interim step.

ARE WE DONE?

Of course not. If you have too many employees – or the right number of employees but pay them too much – your credit gets phased-out, eventually to zero. No credit for you.

There are two phase-outs, which means that you cannot do this in your head.

(1)    If you have more than 10 FTE’s you start to phase-out. The phase-out is

(FTE – 10)

15

                                So, at 25 FTE’s you are completely phased-out.

(2)    If your average wage is more than $25,000, you start to phase-out.

(average annual wage - 25,000)

25,000

                                So, at $50,000 you are completely phased-out.

HOW ABOUT AN EXAMPLE?

Let’s say that you have 9 FTEs with an average wage of $23,000.

4 are single coverage and 5 are family coverage. You pay 50% of the single rate.

The premiums are $4,000 for singles and $10,000 for family. The state limits are $5,000 for singles and $12,000 for family.

Here is the calculation.

                                $2,000 times 9 equals                     18,000

The credit is 35% times 18,000 or $6,300.                      

LET’S CHANGE AN ASSUMPTION

What if the employer pays 50% whether of single or family coverage?

Here is the calculation:

                                $2,000 times 4 equals                     8,000

                                $5,000 times 5 equals                   25,000

                                                                                           33,000

The credit is 35% times 33,000 or $11,550.                    

HOW ABOUT ANOTHER EXAMPLE?

Let’s say you have 40 part-time employees. They total 20 FTEs. The average wage is $25,000. To keep this easy, let’s say that your cost of the health insurance is $240,000

(1)    First phase-out

20 FTE - 10                           equals 66.6% phase-out

15

(2)    Second phase-out

$25,000 - $25,000              equals 0% phase-out (that’s good!)

$25,000

The credit is (35% times $240,000) times (100% minus 66.6%) times (100% minus 0%) - or $28,000.

MISCELLANEOUS

The credit is part of the general business credit, which means that you get to carry it over if you cannot use it in a given tax year. In addition, the credit is allowed for AMT, which is good. You do have to reduce your deductible insurance by the amount of the credit.

As I said, we have been less than impressed. It is, however, a great way for Congress to increase someone’s tax preparation fees.