Can A Severance Be A Gift?

I am looking at a case wondering why a tax practitioner would take it to Tax Court.

Then I noticed that it is a pro se case.

We have talked about this before: pro se means that the taxpayer is representing himself/herself. Technically that is not correct (for example, someone could drag me in and still be considered pro se), but it is close enough for our discussion.

Here is the issue:

Can an employer make a nontaxable gift to an employee?

Jennifer Fields thought so.

She worked at Paragon Canada from 2009 to 2017. Apparently, she was on good terms with her boss, as the company …

·      Wired her 35,000 Canadian dollars in 2012

·      Wired her $53,020 in 2014 to help with the down payment on a house in Washington state.

I am somewhat jealous. I am a career CPA, and CPA firms are not known for … well, doing what Paragon did for Jennifer.

She separated from Paragon in 2017.

They discussed a severance package.

Part of the package was forgiveness of the loan arising from those wires.

Forgiveness here does not mean what it means on Sunday. The company may forgive repayment, but the IRS will still consider the amount forgiven to be taxable income. The actual forgiveness is therefore the after-tax amount. If one’s tax rate is 25%, then the actual forgiveness would be 75% of the amount forgiven. It is still a good deal but not free.

Paragon requested and she provided a Form W-9 (the form requesting her social security number).

Well, we know that she will be getting a W-2 or a 1099 for that loan.

A W-2 would be nice. Paragon would pick-up half of the social security and Medicare taxes. If she is really lucky, they might even gross-up her bonus to include the taxes thereon, making the severance as financially painless as possible.

She received a 1099.

Oh well.

She left the 1099 off her tax return.

The IRS computers caught it.

Because … of course.

Off to Tax Court they went.

This is not highbrow tax law, folks. She worked somewhere. She received a paycheck. She left work. She received a final paycheck. What is different about that last one?

·      She tried to get Paragon to consider some of her severance as a gift.

The Court was curt on this point. You can try to be a bird, but you better not be jumping off tall buildings thinking you can fly.

·      She was good friends with her boss. She produced e-mails, text messages and what-not.

That’s nice, said the Court, but this is a job. There is an extremely high presumption in the tax Code that any payment to an employee is compensatory.

But my boss and I were good friends, she pressed. The law allows a gift when the relationship between employer and employee is personal and the payment is unrelated to work.

Huh, I wonder what that means.

Anyway, the Court was not buying:

Paragon’s inclusion of the disputed amount in the signed and executed severance agreement and the subsequent issuance of a Form 1099-MISC indicates that the payments were not intended to be a gift.”

She really did not have a chance.

The IRS also wanted penalties. Not just your average morning-drive-through penalties, no sir. They wanted the Section 6662(a) “accuracy related” penalty. Why? Well, because that penalty is 20%, and it is triggered if the taxpayer omits enough income to underpay tax by the greater of $5 grand or 10% of what the tax should have been.

Think biggie size.

The Court agreed on the penalty.

I was thinking what I would have done if Jennifer had been my client.

First, I would have explained that her chance of winning was almost nonexistent.

COMMENT: She would have fired me then, realistically.

Our best course would be to resolve the matter administratively.

I want the penalties dropped.

That means we are bound for Appeals. There is no chance of getting that penalty dropped before then.

I would argue reasonable cause. I would likely get slapped down, but I would argue. I might get something from the Appeals Officer.

Our case this time was Fields v Commissioner, T.C. Summary Opinion 2022-22.

 

Do You Have to Disclose That?

I was recently talking with another CPA. He had an issue with an estate income tax return, and he was wondering if a certain deduction was a dead loser. I looked into the issue as much as I could (that busy season thing), and it was not clear to me that the deduction was a loser, much less a dead loser.

He then asked: does he need to disclose if he takes the deduction?

Let’s take a small look into professional tax practice.

There are many areas and times when a tax advisor is not dealing with clear-cut tax law.

Depending upon the particular issue, I as a practitioner have varying levels of responsibility. For some I can take a position if I have a one-in-five (approximately) chance of winning an IRS challenge; for others it is closer to one-in-three.

There are also issues where one has to disclose to the IRS that one took a given position on a return. The concept of one-in-whatever doesn’t apply to these issues. It doesn’t have to be nefarious, however. It may just be a badly drafted Regulation and a taxpayer with enough dollars on the line.

Then there are “those” transactions.

They used to be called tax shelters, but the new term for them is “listed transactions.” There is even a subset of listed transactions that the IRS frowns upon, but not as frowny as listed transactions. Those are called “reportable transactions.”

This is an area of practice that I try to stay away from. I am willing to play aggressive ball, but the game stays within the chalk lines. Making tax law is for the big players – think Apple’s tax department – not for a small CPA firm in Cincinnati.

Staying up on this area is difficult, too. The IRS periodically revises a list of transactions that it is scrutinizing. The IRS then updates its website, and I – as a practitioner – am expected to repeatedly visit said website patiently awaiting said update. Fail to do so and the IRS automatically shifts blame to the practitioner.

No thanks.

I am looking at a case involving a guy who sells onions. His company is an S corporation, which means that he puts the business numbers on his personal return and pays tax on the conglomeration.

His name is Vee.

He got himself into a certain type of employee benefit plan.

A benefit plan provides benefits other than retirement. It could be health, for example, or disability or severance. The tax Code allows a business to prefund (and deduct) these benefits, as long as it follows certain rules. A general concept underlying the rules is risk-taking and cost-sharing – that is, there should be a feel of insurance to the thing.

This is relatively easy to do when you are Toyota or General Mills. Being large certainly makes it easier to work with the law of large numbers.

The rules however are problematic as the business gets smaller. Congress realized this and passed Code Section 419A(f)(6), allowing small employers to join with other small employers – in a minimum group of ten – and obtain tax advantages  otherwise limited to the bigger players.

Then came the promoters peddling these smaller plans. You could offer death and disability benefits to your employees, for example, and shift the risk to an insurance company. A reasonable employer would question the use of life insurance. If the employer needed money to pay benefits, wouldn’t a mutual fund make more sense than an illiquid life insurance policy? Ah, but the life insurance policy allows for inside buildup. You could overfund the policy and have all kinds of cash value. You would just borrow from the cash value – a nontaxable transaction, by the way – to pay the benefits. Isn’t that more efficient than a messy portfolio?

Then there were the games the promoters played to diminish the risk of joining a group with nine others.

Vee got himself into one of these plans.

He funded the thing with life insurance. He later cancelled the plan, keeping the life insurance policy for himself.

The twist on his plan was the use of experience-rated life insurance.

Experience-rated does not pay well with the idea of cost-and-risk sharing. If I am experience rated, then my insurance cost is based on my experience. My insurance company does not look at you or any of the other eight employers in our group. I am not feeling the insurance on this one.

Some of these plans were outrageous. The employer would keep the plan going for a few years, overpay for the insurance, then shut down the plan and pay “value” for the underlying insurance policy. The insurance company would keep the “value” artificially low, so it did not cost the employer much to buy the policy on the way out. Then a year or two later, the cash value would multiply ten, twenty, fifty, who-knows-how-many-fold. This technique was called “springing,” and it was like finding the proverbial pot of gold.

The IRS had previously said that plans similar to Vee’s were listed transactions.

This meant that Vee had to disclose his plan on his tax return.

He did not.

That is an automatic $10,000 penalty. No excuses.

He did it four times, so he was in for $40,000.

He went to Court. His argument was simple: the IRS had not said that his specific plan was one of those abusive plans. The IRS had said “plans similar to,” but what do those words really mean? Do you know what you have forgotten? What is the point of a spice rack? Does anybody really know what time it is?

Yea, the Court felt the same way. The plan was “similar to.” They were having none of it.

He owed $40,000.

He should have disclosed.

Even better, he should have left the whole thing alone.