Why Audit Veterans Organizations?

I suppose that any examination of an exempt organization by the IRS nowadays is going to be viewed in harsh light.

What got me thinking about this is the controversy concerning IRS audits of veterans organizations. While it hasn’t garnered the attention of the 501(c)(4) imbroglio, there has nonetheless been harsh criticism. U.S. Senator Moran (Kansas) for example has stated:

On the heels of Americans' anger over revelations that the IRS intentionally targeted certain groups, it has been brought to my attention that the IRS is now turning their sights toward our nation's veterans. The IRS seems to be auditing veteran service organizations by requiring private member military service forms. If a post is unable or not willing to turn over this personal information, it is possible they could face a fine of $1,000 per day.

I am deeply concerned about this revelation and will insist on answers. This policy ... deserves, at a minimum, a thorough look to make certain the IRS is not overstepping bounds of privacy and respect for our nation's heroes."

For its part, the House Veterans Affairs committee has threated to investigate what the IRS is up to.

So why would the IRS – in a time of budget restraints – be auditing these groups?

A couple of reasons come to mind:

•  The IRS has to audit exempt groups occasionally, if only in the interest of enforcing tax compliance among all exempt groups.

• Veterans organizations have unique tax requirements that are relatively easy to run afoul of.

Reason (1) is easy to understand, even if we would rather have a root canal than undergo a tax audit. Reason (2) is a bit more involved.

Tax-exempt organizations come in multiple flavors, depending on what the organization does. For example, a veterans organization could qualify as a social welfare group – that is, a 501(c)(4) – given its purpose of promoting patriotism, championing the issues of veterans, assisting needy and disabled veterans and conducting social and recreational activities among its membership.   

Let’s go a step further, and you will understand how the sausage of tax law comes to be.

Let’s say the veterans organization buys a building. Let’s say it puts a kitchen and bar in said building. We may now have a social club under Sec 501(c)(7), the same as a college fraternity or private golf course. Had you and I gotten together and built our own golf course, our activity (of playing golf) would not be taxable. The tax Code acknowledges this and allows for larger groups to do what you and I could have done together if only we were multibillionaires. There could be tax consequences if we did other things, but let’s keep our discussion general.

In 1969 Congress expanded the reach of the unrelated business income tax (UBT). UBT by definition relates to tax-exempt organizations, and it means that the organization has to pay tax on profitable business activities that are not in furtherance of its tax-exempt purpose.

What does that mean? Let’s go back to that golf course you and I built. Let’s say that we rent out our course to the PGA annually for a major tournament. We of course charge the PGA big bucks for using our course. We apply as a (c)(7), albeit a small one, considering it is only you and me. The IRS is not going to let us pocket all that money and not pay tax. Why? Because it is not our exempt purpose to rent our course to the PGA.

The veterans organizations became upset with the UBT. It was not even the kitchen and bar, truthfully, as much as it was the insurances – life, health and so on – that they were offering to their members. That was a big deal, and their insurance activity was now being pulled into the orbit of the UBT because of that (c)(4) or (c)(7) status.

Congress, thinking that the answer to everything problem is yet another law, passed Code section 501(c)(19): 

(19)  A post or organization of past or present members of the Armed Forces of the United States, or an auxiliary unit or society of, or a trust or foundation for, any such post or organization—

(A)  organized in the United States or any of its possessions,

(B)  at least 75 percent of the members of which are past or present members of the Armed Forces of the United States and substantially all of the other members of which are individuals who are cadets or are spouses, widows, widowers, ancestors, or lineal descendants of past or present members of the Armed Forces of the United States or of cadets, and

(C)  no part of the net earnings of which inures to the benefit of any private shareholder or individual.

And veterans organizations now had an escape clause from the UBT – as long as they could fit into (c)(19).

It worked well enough for long enough. And now it is starting to work less well.

Why?

It’s the math. Code section (c)(19) states that at least 75% of the members must be veterans  and substantially all other members  (generally defined as 90% or more) must be spouses, widows and descendants. Let’s go through the math. To start, at least 75% of the members must be veterans. Of the remaining, 90% or more must be related to a veteran. Doing the math, only 2.5% of the total membership (25% times 10%) may consist of non-veterans or persons unelated to a veteran.

That is a tight window.

Statistics show over 19 million veterans in the United States. More than 9 million are age 65 or over. Veterans are aging, and every year there are fewer of them. Those demographics are pushing on the percentage tests of (c)(19).

Let’s point out another problem.

How do you prove the 75%? I suppose you could (and probably should) obtain documentation from the veterans. The same could be said for proving the other 90%.  It would be business- standard procedure to keep files and maintain a policy and post signs that only members and families are admitted. I suppose we could boost documentation even more by requiring sign-in books, but you get the idea.

Is it intrusive? You bet. We are talking about IDs and proof of military service, for example. The IRS aggravated the matter recently by asking for DD 214 forms, which is the paperwork accompanying military discharge. The IRS had not routinely asked for this before, so many organizations were caught flat-footed. To exacerbate the matter, the IRS then threatened $1,000 per day penalties.

Cue the resentment and anger of organizations like the American Legion. These generally are not organizations that can easily accommodate drastic changes in tax rules. Many are small, reliant on volunteers and operating on a tight budget.  One cannot approach them as though one were dealing with the tax department of an Apple or Pfizer.

What is the answer? I don’t know. The 501(c) area is a motley of tax grab-bag accreted over the years. Some (c)’s can receive tax-exempt contributions; others cannot. Some organizations are (c)’s just by existing; others have to formally apply and get approval. Some do not pay income tax unless they get carried away and flat-out run a for-profit business. Others pay tax on income “not sufficiently related” to their exempt purpose, a standard sometimes bordering on the mystical. Some are huge, own buildings and have tens of thousands of employees. Others are tiny, have space donated and do everything through volunteers.

It is maddening, but they all have to be (at least in theory) auditable by the IRS.

And there is the rub.

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.