The 2014 Tax Act and Professional Employer Organizations (PEOs)

We know that Congress passed, and the President signed, the Tax Increase Prevention Act of 2014 at the end of last year. This is the tax bill that retroactively resurrected certain tax deductions that many taxpayers have become used to, such as deducting sales taxes (rather than state income taxes)  should one live in Tennessee, Florida or Texas or deducting (a certain amount of) tuition payments if one’s child is in college.

There is something else this bill did that was not as well publicized.

It has to do with professional employer organizations, known as PEO’s. These are companies that provide human resource (HR) functions, such as the paperwork involved in hiring, as well as running payroll and depositing payroll taxes and other withholdings.

There has long been a hitch with PEOs and payroll taxes: the IRS considered the underlying employer to still be liable for withholdings if the PEO failed to remit or failed to do so timely. The IRS took the position that an employer could not delegate its responsibility for those withholdings. To phrase it differently, the employer could delegate the task but could not delegate the responsibility.

You can guess what happened next. There were cases of PEO’s diverting withholdings for their own use, then going out of business and leaving their employer-clients in the lurch. If you were one of those employer-clients, the experience proved to be very expensive. You had paid payroll taxes a first time to the PEO and then a second time when the IRS held you responsible.

The answer was to watch over the PEO like a hawk. The IRS encouraged employer-clients to routinely go into the electronic payment system (EFTPS), for example, to be certain that payroll taxes were being deposited.

That unfortunately collided with many an employer’s reason to use a PEO in the first place: to have someone else “take care of it.”

Back to the tax bill. Stuck in with the tax extenders was something called the ABLE Act, which is a Section-529-like-plan, but for disabled individuals rather than for college expenses.

Stuck (in turn) onto the ABLE Act was a brand-new Code section just for PEOs. The provision requires the IRS to establish a PEO certification program by July 1, 2015. There will be a $1,000 annual fee to participate, but – once approved – the IRS will allow the PEO to be solely responsible for the employer-client’s payroll taxes.

You have to admit, this is a marketing bonanza if you own a PEO. It will separate you from a non-PEO who is bidding on the same prospective client.

The PEO will have to post a bond in order to participate in the program. In addition the PEO will have to be audited annually by a CPA. The PEO will have to submit that audited financial statement to the IRS.

I do not know the answer as of this writing, but I have a strong suspicion the AICPA was in the room when that audit requirement was included. Why do I say that? Because only CPAs are allowed to render an opinion that financial statements are “presented fairly in accordance with generally accepted accounting principles.” 

NOTE: That would be CPAs who practice as auditors. There are CPAS who do not. For example, I specialize in taxes.

There is – by the way – risk to the PEO. This is not a one way street. The PEO will be responsible for the payroll taxes, even if the employer-client does not pay the PEO.

Why Does Arkansas Think You Would Pay Taxes Voluntarily?

“This appeal arises from a dispute of ad valorem taxes.”

Thus begins the Arkansas Supreme Court decision in Outdoor Cap Co v Benton County.

Outdoor Cap Co (Outdoor Cap) makes – as you can guess – caps and other headwear. They are located in Bentonville, where Walmart is headquartered.

Ad valorem taxes are paid on the value of real or personal property. An example is property taxes assessed on business equipment; another example would be the annual property taxes a Kentucky resident pays on his/her car

Outdoor Cap has been paying property taxes since 1976. In 2011 it filed for a refund of its 2008 and 2009 taxes. It wanted a refund of over $247,000.

The reason for the refund? They made a mistake. They paid taxes on their inventory and (some of) that inventory was entitled to a “freeport” exemption.

This is a term we have not discussed before. The easiest way to understand the freeport is to think of port cities. Products arrive on very large ships, are unloaded, catalogued, organized and prepared for continued transit.  It would be bad practice to levy customs and duties simply because the products arrived at that particular port. It would make more sense to allow the products to pass through without assessment, to instead be taxed at their ultimate destination.

Substitute property taxes for customs and duties and you have the “freeport” exemption.

So Outdoor Cap made a mistake when it filed its personal property taxes and now wants some of its money back.

Benton County said “no.”

Outdoor Cap kept pursuing this until it wound up in the Arkansas Supreme Court.

The first thing that occurred to me is that perhaps Outdoor Cap was outside the refund period – you know: the “statute of limitations.” You have to get a refund claim in within a certain period of time, because to keep the claim period open indefinitely would impair the administration of the tax system

I was wrong. This was not about the statute of limitations. This was about whether Outdoor Cap paid something that the state was required to repay.

Outdoor Cap made three arguments:

            (1) The property was exempt from taxation.

The property is not taxable because of the freehold, but does that mean that the property is “exempt?’

And we now enter the legal swamp of wordsmithing. Technically, under Arkansas law (Ark Code Ann 26-26-1102) a freehold does not mean that the property is not taxable. There are two steps before property can be taxed: first, the property must be taxable; second, the property must be located in Arkansas.

The Court determined that the freehold addressed the second test only: Arkansas did not consider the property as being in Arkansas. Had it been, it would have been taxable.

This is a fine weaving of words, but there it is. Outdoor Cap lost argument one.

(2) The property was erroneously assessed.

Arkansas law (Ark Code Ann 26-35-91) allows refunds only for erroneously assessed property.

 
Outdoor Cap of course argued that the property was erroneously assessed.

On first impression, this seems solid ground. Outdoor Cap argued that the property was misclassified and taxes were erroneously paid on it. Taxes have to be assessed before they can be paid. Otherwise, the tax would be paid voluntarily, which is nonsensical.

The Court made a distinction between an excessive assessment and an erroneous assessment. Outdoor Cap reported its property without claiming the freeport. There cannot be an erroneous assessment under law because the company did not provide all the information that Arkansas would need to realize that there was an error. Yes, the assessment was “excessive,” but it was not “erroneous.”

Outdoor Cap lost argument two.

(3)  Since tax was not actually due, the payment was a voluntary payment and the company wants its payment refunded.

Arkansas apparently allows for voluntary payments. What it won’t do is give you the money back, unless you can show that you are otherwise entitled to a refund.

This gets us back to what we said in argument (2): to get money back, one has to show that the taxes are “recoverable.” Arkansas allows only one definition of “recoverable”: there must have been an error in assessment.

Surely taxes can be recoverable if there was a mistake?

“The principle is an ancient one in the common law, and is of general application. Every man is supposed to know the law, and if he voluntarily makes a payment which the law would not compel him to make, he cannot afterwards assign his ignorance of the law as a reason why the State should furnish him with legal remedies to recover it back.”

In desperation Outdoor Cap tried a “Hail Mary,” arguing that it paid it taxes under “coercion,” because, if taxes were not paid, the County had the authority to take and sell the property.

“… the argument is without merit because every taxpayer would have been ‘coerced’ according to Outdoor Cap’s argument because every taxpayer would be subject to penalties if its taxes weren’t paid.”

The “Hail Mary” fell to the ground.

The Court decides that Outdoor Cap …

“… voluntarily paid its taxes for the years 2008 and 2009, and did not claim a manufacturer’s exemption for those years. It is presumed to have known the law and its rights under the law. Accordingly, we do not find error in the circuit court’s application of the voluntary payment doctrine….” 

Outdoor Cap lost argument three.

The Court finally decided there was no refund for Outdoor Cap.

My thoughts?

Technically, the Court was correct. It was an affront to common sense, however. I have been at this for thirty years, and I have yet to meet the first person who paid taxes “voluntarily.” I guess I could put it on my bucket list, along with “play in the NFL.”

As I have gotten older, I have come to view the presumption that one “know the law” to be the drool of a political overclass.  An army of attorneys could not keep track of every mandate, ordinance, diktat or regulation these politicians strew upon society. It might be more honest if they simply said “I win and you lose, because I say so.”

I think Outdoor Cap Co got hosed.

Does An LLC Member Pay Self-Employment Tax?

There is an issue concerning LLCs that has existed for approximately as long as I have been in the profession. I am thinking about it because I recently finished a research memo which included this issue.

This time we are talking about limited liability companies (LLCs) and self-employment income. One pays self-employment tax on self-employment income, and the dollars can add up rather quickly.

The offending party is the following enchanting prose from Code section 1402(a)(13) addressing self-employment income:

           

… there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in … "

We do not need degrees in taxation to zero in on the term “limited partner” as being the key to this car. If you are a limited partner you get to exclude “the distributive share” of something. Since the IRS wants you to pay tax on something, the less of that something is probably a good thing.

So what is a limited partner in this conversation?

We don’t know.

The above wording came from an IRS proposed Regulation in 1977. The IRS stirred such a hornet’s nest that Congress put a hold on the Regulation. The hold has long since expired, but the IRS has not wanted to walk back onto that hill. It has been 37 years.

To be fair, the playing field changed on the IRS.

Have you ever heard of the Estate of Ellsasser? Don’t worry if you haven’t, as I suspect that many tax CPAs have not. Let’s time travel back to 1976. In addition to Bob Newhart and the Carol Burnett Show, people were buying tax shelters. The shelters worked pretty well back then, long before the passive activity rules entered the game. One of those shelters used to provide one with self-employment income, on which one would pay self-employment – also known as social security – tax.

Doesn’t sound like much of a shelter, doesn’t it?

The purpose was to get social security credits for someone who had not worked, had not earned enough credits, or had not earned enough to maximize their social security benefits.

The IRS did not like this at all, because at the time it was concerned with people taking advantage of social security. That was before our government decided to bankrupt us all, which act has now switched to the IRS demanding money from anyone foolish enough to make eye contact.

You see, in those days, there were entities known as “limited partnerships” in which a general partner made all the decisions and in return the limited partners got regular checks. A limited partner had little or no sway over the management of the place. It was an investment, like buying IBM or Xerox stock. There was no way the IRS was going to let a limited partner buy social security credits on the back of a limited partnership investment. No sir. Go get a job.

Fast forward about twenty years. There is a new sheriff in town, and that sheriff is the limited liability company (LLC). The states had created these new toys, and their claim to fame is that one could both work there and limit one’s liability at the same time. Unheard of! A limited partnership could not do that. In fact, if a limited partner started working at the place he/she would lose the protection from partnership liabilities. No limited partner was going to do that voluntarily.

And there you have a tax Regulation written in the 1970s referencing a “limited” partner. Twenty years later something new appears “limiting” one’s exposure to entity liabilities, but not being at all what the IRS had in mind two decades before.

And so the question became: does an LLC member have to pay self-employment tax?

And the issue has recently compounded, because there is also a new ObamaCare tax (the additional Medicare tax of 0.9%) which applies to …. wait on it… self-employment income. Yep, it applies to something the IRS cannot even define.

And then you have tax professionals trying to work with this nonsense. We do not have the option of putting the issue on the shelf until the baby is old enough to go to college. We have to prepare tax returns annually.

So I was looking at something titled “CCA 201436049.” It is nowhere as interesting as the final season of Sons of Anarchy, but it does touch upon our magic two words from the 1970s.

BTW, a “CCA” is a “Chief Counsel Advice” and represents an internal IRS document. It cannot be cited or used as precedence, but it gives you a VERY GOOD idea of what the IRS is thinking.

In our CCA, there is company that manages mutual funds. The management company used to be an S corporation and is now an LLC. The members of the management company pretty much do all the investment activity for the mutual funds, and the management company gets paid big bucks. The management company in turn pays its members via a W-2 and then “distributes” the remaining profit to them. The members pay social security on the W-2 (same as you or I) but not on the distributive share.

OBSERVATION: For the tax purist, a partnership is not allowed to pay its partner a W-2. The reason is that a partner in a partnership is considered to be self-employed, and self-employed people do not receive W-2s. LLCs have thrown a wrench into practice, however, and it is not uncommon to see an LLC member receive a W-2.

To get a CCA, the taxpayer has to be in examination. An IRS person in the field requests direction on how to handle an issue. The issue here is whether that distributive share should be subject to self-employment tax or not. A CCA is therefore like giving instructions to IRS examiners in the field.

The IRS goes through the same tax history we talked about above, and it is very skeptical that just “limiting” someone’s liability was the intent of the 1970s Regulation. It goes on to take a look at two recent cases.

In Renkemeyer, the Tax Court determined that lawyers within a law practice did not fit the “limited partner” exception, especially since they were actively working, something a 1970s “limited partner” could not do. They had to pay self-employment taxes on their distributive income.

In Reither the taxpayer issued W-2s and argued that that was sufficient to keep the rest of the distributive income from being subject to self-employment tax. The District Court made short work of the argument, primarily because there is no statutory support for it.

So … surprise, surprise… the CCA determined that the management company’s distributive share was subject to self-employment tax.

By itself, this is not surprising. What I did notice is that the IRS is paying more attention to this issue, and it is winning its cases. How much longer can it be before Congress finds this “new” source of tax revenue?

Granted, I think the odds of any meaningful tax legislation between Congress and this White House to be close to zero. There will be at least a couple of years.  That said, I suspect that tax planners have only so many years left to ramp this car onto the interstate before Congress takes our keys away.