Receiving An IRS Lock-In Letter

 

A client recently picked up his personal tax return. He asked to see me.

There was tax due with the return. I thought he had adjusted his withholding to increase his take-home pay, as he had spoken to me of financial stress. I am not a fan of doing this, as tax is due whether one withholds or not.   

He could not have tax due with his return, he explained, as he had received a lock-in letter from the IRS.

There is something I do not often see.

There are two versions of the lock-in letter: one sent to the employee and another to the employer. The IRS is telling both that it wants additional withholding from each paycheck, commonly meaning single withholding with no dependents.

The lock-in surprised me, as my client is not one to game the system. What he did was fall behind on his taxes due to a failed business. There are liens – IRS and private - that he is working through.

The IRS sends the employee a letter informing him/her that his/her withholdings are too low. The IRS wants the employee to self-adjust by increasing their withholding.

If that fails, the IRS sends the employer a letter. An employer has 60 days from the date of the letter to unilaterally adjust the employee’s withholdings.

The employee can quit, but the lock is good for 12 months. The employee will have to go somewhere else for a year before returning if he/she wishes to avoid the lock.

The 60 days has two purposes:

(1)  To allow the employer time to make the changes, and 

(2)  To prompt the employee to contact the IRS. If so – and if the employee can persuade the IRS – the IRS may modify the lock.

If the employee keeps his/her nose clean, he/she can request the IRS remove the lock-in. Figure that it will take about three years of tax returns, however, so it is best to avoid the lock altogether.

The employer is extremely unlikely to buck the IRS, as the employer might then draw surrogate liability. One might be a valued employee, but one is not that valued. 

Let’s look at a case.

Charles G worked for Volvo Trucks North America (VTNA). He submitted a W-4 to VTNA claiming that he was exempt from income tax withholding. He also requested VTNA to stop withholding social security taxes.

VTNA was surprisingly tolerant. It spotted Charles a 99-dependent W-4 (affecting income tax withholding), although it could not do anything about the social security.

Charles went a couple of years or so before the IRS contacted him. He blew it off, so the IRS sent VTNA a lock-in letter.

Charles went ballistic.

Charles accused the IRS and VTNA of “acting in violation of the Racketeer Influenced and Corrupt Organizations Act (RICO).”

Wow. I wonder how it went come employee review time.

The Court of course dismissed Charles’ claim against VTNA. In general, an employer must follow an employee’s request concerning withholding. If the employee asserts that he/she is exempt from withholding, then the employer must comply with such request unless certain situations occur. A lock-in letter is one of those situations.

It sounds rather self-evident, truthfully.

It also sounds like Charles was a bit of a tax protestor. A word of advice: don’t go there with Charles. Your chances of success are between zero and none, and the list of dead bodies on that hill stretches interminably. Several years ago, we represented a business having an officer the IRS considered a protestor. I did not agree with the IRS on this, but I admit that he was getting close to the line.  The audit was … unpleasant. There was no question that school was in session, and the IRS was looking to teach a lesson.

Our case this time was Giles v Volvo Trucks of North America, 551 F. Supp 2^nd 359.

Deducting Expenses Paid With Paycheck Protection Loans

There was a case in 1931 that is influencing a public controversy today.

Let’s talk about it.

The taxpayer (Slayton) was in the business of buying, holding and selling tax-exempt bonds. He would at times borrow money to buy or to carry tax-exempt bonds he already owned.

Slayton had tax-exempt interest income coming in. That amount was approximately $65 thousand.

Slayton was also paying interest. That amount was approximately $78 thousand.

COMMENT: On first read it does not appear that dear old Slayton was the Warren Buffett of his day.

Time came to file his tax return. He omitted the $65 grand in interest received because … well, it was tax-exempt.

He deducted the $78 grand that he was paying to carry those tax-exempt securities.

The IRS said no dice.

Off to Court they went.

Slayton was hot. He made several arguments:

(1)  The government was discriminating against owners of tax-exempt securities and – in effect – nullifying their exemption from taxation.

(2)  The government was discriminating against dealers in tax-exempt bonds that had to borrow money to carry an inventory of such bonds.

(3)  The government was discriminating in favor of dealers of tax-exempt bonds who did not have to borrow to carry an inventory of such bonds.

I admit: he had a point.

The government had a point too.

(1)  The income remained tax-exempt. The issue at hand was not the interest income; rather it was the interest expense.

(2)  Slayton borrowed money for the express purpose of carrying tax-exempt securities. This was not an instance where someone owned an insubstantial amount of tax-exempts within a larger portfolio or where a business owning tax-exempts borrowed money to meet normal business needs.

The link between the bonds and the loans to buy them was too strong in this case. The Court disallowed the interest expense. Since then, tax practitioners refer to the Slayton issue as the “double-dip.”  The dip even has its own Code section:

        § 265 Expenses and interest relating to tax-exempt income.

(a)  General rule.

No deduction shall be allowed for-

(1)  Expenses.

Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.

Over the years the dip has evolved to include income other than tax-exempt interest, but the core concept remains: one cannot deduct expenses with too strong a tie to nontaxable income.

Let’s fast forward almost 90 years and IRS Notice 2020-32.

To the extent that section 1106(i) of the CARES Act operates to exclude from gross income the amount of a covered loan forgiven under section 1106(b) of the CARES Act, the application of section 1106(i) results in a “class of exempt income” under §1.265- 1(b)(1) of the Regulations. Accordingly, section 265(a)(1) of the Code disallows any otherwise allowable deduction under any provision of the Code, including sections 162 and 163, for the amount of any payment of an eligible section 1106 expense to the extent of the resulting covered loan forgiveness (up to the aggregate amount forgiven) because such payment is allocable to tax-exempt income. Consistent with the purpose of section 265, this treatment prevents a double tax benefit.

I admit, it is not friendly reading.

The CARES Act is a reference to the Paycheck Protection loans. These are SBA loans created in response to COVID-19 to help businesses pay salaries and rent. If the business uses the monies for their intended purpose, the government will forgive the loan.

Generally speaking, forgiveness of a loan results in taxable income, with exceptions for extreme cases such as bankruptcy. The tax reasoning is that one is “wealthier” than before, and the government can tax that accession to wealth as income.

However, the CARES Act specifically stated that forgiveness of a Paycheck Protection loan would not result in taxable income.

So we have:

(1)  A loan that should be taxable – but isn’t - when it is forgiven.

(2)  A loan whose proceeds are used to pay salaries and rent, which are routine deductible expenses.

This sets up the question:

Are the salaries, rent and other qualified expenses paid with a Paycheck Protection loan deductible?

You see how we got to this question, with Section 265, Slayton and subsequent cases that expanded on the double dip.

The IRS said No.

This answer makes sense from a tax perspective.

This answer does not make sense from a political perspective, with Senators Wyden and Grassley and Representative Neal writing to Secretary Mnuchin that this result was not the intent of Congress.

I believe them.

I have a suggestion.

Change the tax law.

SBA Paycheck Protection Program

The last couple of weeks here at Command Center have been … unprecedented.

We have sent employees home, although we have not let anyone go.

Critical personnel (including me somehow) are still coming in, although we are instituting a policy of one-person-in-the-office-at-a-time.  

I understand working at home, but a typical accounting firm is not geared to work from home indefinitely. For one thing, it takes administrative staff to keep the information and document flow going to the at-homers, and there is no administrative staff.

Fortunately, the IRS and many (if not most) states have acknowledged the reality of the situation and are allowing extensions of time to file and pay. There was probably no choice: preparers were not going to be able to get the work done anyway. It is likely that your return will be extended this year, even if you have never extended before.

Some of our clients have shut down. One, for example, works with product promotion at Kroger’s. Have you been to a Kroger’s recently? The last problem they have is moving merchandise.

Let’s talk about something. There is a brand-new SBA program for emergency funding. It may be that you have never considered government assistance before, but these are extreme times.

We are talking about the “Paycheck Protection Program.” Congress took an existing SBA loan program and sweetened the pot. Its purpose is – flat out – to encourage employers to retain employees and – if the employer has already furloughed employees -to hire them back.

Here are the general features of the program:

(1)  It expires June 30, 2020.

(2)  Think businesses with less 500 employees, but there are exceptions.

(3)  In a bit of a surprise for the SBA, the program includes nonprofits (again, with less than 500 employees)

(4)  The maximum loan amount is 2.5 times average payroll during the one-year period before the date the loan is made.

a.    With adjustments for new businesses, of course.

(5)  That maximum caps out at $10 million.

(6)  The loan is principally to fund payroll (with some limitations), but it will also cover health insurance, rent, utilities and some interest expense.

(7)  Now think math:

A times B

A is the sum of those expenses described in (6) for the 8 weeks after you get the loan.

(8)  Let’s talk B.

B is a fraction. The government wants to know whether your workforce has gone up or down in number.

The numerator is going to be the number of employees between February 15 and June 30, 2020.

The denominator is the number of employees during the same period in 2019.

There are adjustments for real-life situations that do not fit the above periods.

There is also a test which substitutes payroll dollars for the number of employees. You fail the test if your payroll reduction (dollar-wise) exceeds 25%.

(9)  So what, you ask.

Let’s say you have 17 employees for the 2020 period.

Let’s say you had 16 employees for the 2019 period.

Fraction-wise, that is over 100%. Let’s round that down to 100%.

Let’s multiply that 100% by something.

What is the something?

The loan you took out.

Let’s say the loan was $125,000.

Multiply $125,000 by 100%.

You get $125,000.

The government will forgive 100 PERCENT of the loan! The entire $125,000 is gone, forgiven, paid-off, hasta luego, soyonara.

Wow.

(10)      Is there a follow-up to that?

Yep.

Generally, the forgiveness of debt results in income to the person whose debt was forgiven. It is why people get those 1099s in the mail from the credit card companies which have given up on collecting.

For purposes of this loan, the forgiveness will NOT count as income.

So let’s get this straight. You keep your employees on board. The government loans you money for your payroll. The government forgives the money. You walk away scot-free.

What happens if you don’t get to 100%? Then a portion of the loan remains. You pay interest not to exceed 4% and repay that portion of the loan over a period of up to 10 years. Still … not bad.

Folks, if this is you – please check it out before the deadline or the funding runs out.

You Receive A Wage Garnishment

I was minding my own business. My partner sweeps into my office and says we have to take care of something right away – hopefully that very afternoon.

Hey, I am a career CPA. Some level of ADD is almost requisite to longevity in this profession.

He drops an IRS Form 668-W on my desk.

There is something I had not seen in a while.

What is a 668-W?

A wage garnishment. The IRS refers to it as a “levy.” If you get to this point, you have almost gone through the belly of the whale. The IRS has sent notice after notice, giving you a chance to contest, request abatement, defer collection or set up a payment plan. You have ignored them all. They got angry. They are now garnishing your paycheck.

This notice goes to your employer, and your employer is charged with notifying you. Your employer is going to garnish your next paycheck. Your employer does not want to go resistance here, as an employer becomes liable should they just blow it off. And then there is a 50% “hi there” penalty on top of that.

The IRS publishes tables telling you how much you get to keep. Say that the you are married, have one kid and receive a weekly net check of $1,017.65. The table indicates that you can keep $541.35. The employer withholds and remits the $476.30 balance ($1,017.65 – 541.35) to the IRS.

On the upside, the IRS is not touching your health insurance or 401(k) withholding. On the down side, it is jonesing the rest of your paycheck.

Can you live on $541.35?

That is not the point.

The point is that the IRS wants you to reenter the grid and establish a payment plan. Once you do so, the IRS will release the levy. As far as they are concerned, you should have done so already. The levy is to slap you into reality.

And you have forfeited some (at this point) important procedural rights.

Say that there is a question whether you actually owe some or all of the tax. Had you paid attention to the increasingly strident string of IRS notices, you would have noticed one titled “Notice of Intent to Levy.”

That one is serious. Not as serious as the 668-W, of course, but serious.

At that time, you had the right to request an IRS appeals hearing, called a Collection Due Process hearing. That puts you in front of an Appeals officer to plead your case, including whether you actually owe some or all of what the IRS wants.

Say you ignored the Notice of Intent.

It is a year or two later and you receive the 668-W.

You bring it to me. You may note that I am not humored.

Guess what important right you forfeited by ignoring the earlier notice?

That’s right: being able to argue whether you actually owe some or all of the tax.

That is dandy if there is no question whether you owe the money.

Not my situation. The friend has a very good case that he does not owe (at least some) of the tax.

But we are past the point where I can force a collection hearing to talk about the matter.

Is it hopeless?

Nope. A proficient tax practitioner still has tricks.

Like?

Like an offer in compromise. You know, those middle of the night commercials to settle millions of dollars of tax debt for the change in your pocket.

Is the friend broke?

Not the point.

What is the point then?

There is more than one type of offer. The one I am considering has nothing to do with your ability to pay. It instead has to do with whether you actually owe the money. The first addresses doubt as to collectability. The second addresses doubt as to liability.

It is one way to get the IRS to review the file with an eye as to liability.

Is this what we are going to do?

Doubt it.

Why not?

Because an offer will stay that levy only so long. The IRS can still demand a weekly wage levy WHILE they are considering the offer. Will it happen? Maybe yes, maybe no, but why run the risk?

What is an alternative?

File an appeal.

An appeal shuts down all collections action, meaning that I do not have to bank on the IRS’ better nature to stay that levy. Appeals allows me to introduce evidence that the friend does not owe all the assessment. I am also hoping to get penalties abated, at least some, but that would be a bonus.

Should the friend’s situation have gotten to this point?

I am sympathetic. Those who have followed me know that I am generally pro-taxpayer, but that is not what we have here. There were notices, which were ignored. There was a statutory notice of deficiency, which was ignored. After the statutory notice, taxes and penalties were officially assessed, which was also ignored. There was a chance for reconsideration, which was ignored. 

During all this there was ALWAYS a chance for a payment plan.

As I said, you may note that I am not humored.