Can Payroll Taxes Put You In Jail?

Can you go to jail for not remitting payroll taxes?

Let’s set this up:

• You have a temporary nursing staffing agency in Minnesota.
• You treat your nurses as independent contractors.
• You had a predecessor company which the IRS charged with willfully misclassifying workers and failing to remit payroll taxes.  You survived that occasion by settling with the IRS, but the settlement included language similar to the following:

 “... with respect to any other business similar to the ... entities that he might own, operate or control in the future, he would treat as employees for tax purposes all workers who performed functions or duties that were the same or similar as the function or duties performed by the nurses and nursing assistants who worked for the ... entities. In other words, defendant ... was obligated to withhold and pay over employment taxes for the nursing professionals who worked for any of his entities.”

• Minnesota has a law requiring nursing staffing agencies to certify that they are treating their nurses as employees and not as independent contractors. You have made this certification to Minnesota.

So, can you go to jail for not remitting the nurses’ payroll taxes?

A too-common problem is a cash-strapped business falling behind on depositing their payroll taxes. You can fall behind on many types of taxes and still be able to work something out. You fall behind with payroll taxes, however, and the IRS can be very harsh. The reason is that the IRS (and the states also) considers it stealing. You pay an employee $700 and withhold $200 for taxes. That $200 is not your money: it is the employee’s money that you now hold as agent for remittance to the IRS. The IRS reserves one of its most frightening penalties for this: it is called the trust fund recovery penalty. This penalty is 100% (you read that right), and it attaches to you as an individual. You cannot shed that penalty by leaving or bankrupting the business, because the penalty applies to you. It follows you like a bad haircut.

That penalty however is not what we have here. What we have here is Francis Leroy McLain (U.S. v McLain). The case was appealed to the Eight Circuit from the District Court of Minnesota.

The IRS looked at two entities owned by McLain, Kind Hearts and Kirpal Nurses, and came to the conclusion that the nurses were employees.

OBSERVATION: The IRS will almost always say that someone is an employee, whether they are or not. They want the payroll taxes, of course.

McLain owed about $340,000 in payroll taxes. He had been down this path before, and the IRS had not forgotten. They dusted off Section 7202, a very special tax gem for someone who pushes the sled too far:

Any person required ... to collect, account for, and pay over any tax imposes by this title who willfully fails to collect or truthfully account for and pay over such tax shall, in addition to the other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $10,000, or imprisoned not more than 5 years, or both, together with the cost of prosecution.”

McLain left the shores of the responsible person penalty far behind. He sailed into the deep waters of going to jail. He is now dealing with CID, the criminal side of the IRS.

NOTE: A word to the wise: you never want to deal with CID. These guys have badges. They have guns. And they will put you in jail. I know. I had a client who had gone to jail courtesy of CID, and I know a tax practitioner in northern Kentucky who will be going.

As a tax guy, I am hoping that McLain has some serious technical arguments to make in his defense. I am expecting a ferocious goal-line stand. Here comes his first play:

(1)   McLain referred to the two agencies, King Hearts and Kirpal Nurses, as “Kirpal.” He argued that Kirpal was the employer, and, as the employer, only Kirpal had a duty to account and pay over taxes on its employees.

COMMENT: McLain starts off by irritating me. There was a case on this issue before I even came out of school. The case is Slodov v United States. It was a Supreme Court case and included the following language:

“Sections 6672 and 7202 were designed to assure compliance by the employer with its obligation to withhold and pay the sums withheld, by subjecting the employer’s officials responsible for the employer’s decisions regarding withholding and payment to civil and criminal penalties ...”

            McLain was an officer. What part of this did he not get?

            SCORE: IRS (1) McLain (0)

(2)   McLain argues that he had a good faith belief that the nurses were not employees. The lawyers refer to this as “mens rea,” and he argued that his state of mind did not rise to “willful.” Without willfulness, McLain cannot come under Section 7202.

COMMENT: I like this argument. Unfortunately, he had a prior run-in with the IRS on this very same point, which greatly diluted the argument’s persuasiveness.

            SCORE: IRS (2) McLain (0)

(3)   McLain argues that the IRS has to pursue a civil penalty before it can pursue a criminal penalty, and the civil penalty requires a written notice. He received no written notice, so the IRS cannot proceed with criminal prosecution.

COMMENT: I noticed that the Court reminded McLain’s attorney that he “has an independent obligation, regardless of what his client may demand, to refrain from filing frivolous motions.”

            SCORE: IRS (3) McLain (0)

(4)   McLain moved to dismiss the charges because (1) he is a “natural human being” and the United States does not have authority over him.

COMMENT: McLain’s attorney blanched here, and McLain fired him. McLain represented himself from this point on.

A tax protest argument? Seriously?

SCORE: IRS (4) McLain (0)

McLain lost soundly.

This type of action by the IRS is rare. I can assure that – in almost all cases – the IRS does not want to put anyone in jail. They want your money, and being in jail impedes you getting the IRS any money. And all parties in the system – the IRS, the courts and judges, responsible practitioners – are tired of the tax protest siren song.

I am sympathetic to arguments that our tax system left the world of rational thought years ago, but that does not mean the income tax is illegal. It can be irrational, immoral, confiscatory, divisive and destimulative without being illegal.

McLain has taken what could have been a civil penalty – albeit a stiff one – and morphed it into a multi-year stay at Club Fed. There likely is a fairly impressive fine also. He did however enter the tax literature, primarily for being a blockhead.

Smackdown On IRS Regulation of Tax Preparers

In 2009 the IRS commissioned a study of the tax preparation industry. Some of the findings were obvious: as the tax law becomes more complex, taxpayers are increasingly relying upon tax preparers or tax software (think TurboTax) in preparing accurate returns. The study then went on to look at the preparers themselves, from attorneys and CPAs to big-block preparers (such as H&R Block) to someone who prepares a few returns for compensation from their kitchen table.

It was on that last point that the IRS had an issue. It noted that anyone could enter the tax preparation business and that that ill-equipped preparers were making numerous errors that were costly to the Treasury. The IRS was unsure even of the number of tax preparers out there, guessing there were between 900,000 and 1.2 million preparers.

The IRS observed that:

...the American public overwhelmingly supports efforts to increase the oversight of paid tax return preparers.”

Sorry, that one sounds like self-serving flourish. I doubt the American public is barely aware of this issue.

The IRS, then under Commissioner Shulman, instituted a three-part program to oversee individual income tax preparers:

(1) A specific identification number for each preparer

           

This is called the “preparer tax identification number” (PTIN), and every preparer is required to obtain one and use it on every return he/she signs. Before January 1, 2011, use of a PTIN was optional.

(2) The competency test

The IRS mandated that preparers had to take an exam and then went on to exempt categories of preparers, such as attorneys, CPAs and EAs. There were reasonable grounds for these exceptions, as each of these groups has its own licensing system. 

After much wrangling, the IRS also exempted preparers supervised by an  attorney, CPA or EA. If you worked for me, for example, you could be exempt by working under my supervision.

(3) Continuing education

           

Preparers had to complete 15 hours of continuing education each year. Again, attorneys, CPAs and EAs were exempt because of their own education requirements.

The government being what it is, a new unit was created within the IRS – the Return Preparer Office – to administrate all this activity. The government also created a new designation, the "registered tax return preparer," for those passing the competency exam.

So far, this sounds reasonable (or, at least, not unreasonable), right?

There was deep cynicism right away about what the IRS was actually up to. For example, the PTIN cost $63. Every year. Many practitioners, including some I have worked with, believe this to be a back-door effort by the IRS to pad its own budget. The facts seem to bear this out, as the IRS has collected more than $106 million from the preparer registration and testing system. It has spent approximately $50 million and assigned 167 employees to the program.

What about the testing? No one is truly certain how many tax preparers have to go through the testing, given that so many (like me) are exempted. The number I have seen most often is 350,000.

Let’s go with 350,000. As of December 31, 2012, only 48,000 of 350,000 had finished the certification process. Sheeeshh. No one is knocking down that door.

That leaves continuing education. The cost of those 15 hours could vary significantly. For many preparers, the number of returns prepared might not justify the cost of the education. Preparers were required to obtain their first 15 hours in 2012. After complaints, the IRS wound-up allowing preparers to make-up their 2012 hours in 2013.

Fueling the cynicism was the program’s open support by H&R Block and Jackson Hewitt. Those big guys are better positioned to comply with these new rules. The former CEO of H&R Block – Mark Ernst – was made deputy commissioner of the IRS and drafted many of the new rules for tax preparers. No conflict there, it appears. The investment firm UBS advised "the new regulations should help (H&R) Block" to put their smaller competitors out of business.

This is the United States, so you know someone sued. Three independent tax preparers did, with the assistance of the Institute for Justice.

The case is Loving v Internal Revenue Service, decided on January 23, 2013 by the District Court for the District of Columbia. Judge Boasberg wrote the opinion and he is – given that tax can be boring – quite the hoot. Let’s summarize what he said.

The Court immediately observed that the IRS was interpreting an 1884 statute as giving it authority for its actions. That statute gives the Treasury Secretary authority to regulate preparers who “practice” before it. The Court immediately noted that:

... attorneys, CPAs, enrolled agents or enrolled actuaries are otherwise regulated by the IRS and thus have no bone to pick with the new regulations.”

That leaves the other hundreds of thousands of preparers who are not attorneys, CPAs, EAs or enrolled actuaries. They comprise the 350,000 preparers we discussed previously. Sabina Loving, of the eponymous case, is a bookkeeper and tax preparer from Chicago. She is one of those 350,000.

So, is Sabina Loving “practicing” before the IRS?

Here is the Court:

Under ..., originally enacted in 1884, the Treasury Secretary has authority to regulate people who practice before the Treasury Department. This is so even though the casual student of history knows that the Sixteenth Amendment authorizing the modern federal income tax was not ratified until 1913.”

COMMENT: Heh.

           

Section 330(a) authorizes the Treasury Secretary to ‘regulate the practice of representatives.... In dispute is the IRS’s interpretation that tax-return  preparers are ‘representatives’ who ‘practice’ before the IRS.”

The IRS hurries through..., arguing that the statute is ambiguous because it defined neither ‘representative’ nor ‘practice’.... That simplistic approach will not fly, however.”

The Court goes on to observe that the statute refers to a “representative” advising and assisting persons in presenting their cases. Here is the Court again:

           

Filing a tax return would never, in normal usage, be described as ‘presenting a case.’ At the time of filing, the taxpayer has no dispute with the IRS; there is no ‘case’ to present.”

COMMENT: I like this judge. He likely has blown his chance to be on the Supreme Court, though.

With an invalid regulatory regime on the IRS’s side of the scale and a threat to the plaintiff’s livelihood on the other, the balance of hardship tips strongly in favor of plaintiffs.”

The Court permanently enjoined the IRS from enforcing its tax preparer program.

Yes, the little guy won, at least for the moment. In a motion filed January 24 with the Court, the IRS argued that it has a “reasonable likelihood” of winning its appeal and that the public will suffer “irreparable harm.” The IRS argued that it would incur “substantial costs” to restart the preparer program if the injunction is not lifted. The IRS also noted that that “thousands of return preparers who have already submitted their users fees would demand refunds, and the United States would likely face numerous lawsuits—including class action lawsuits.”

My Take: I am both happy and uncomfortable with the decision. I agree that the IRS went a bridge too far. I also understand that a rapidly-changing tax code requires ongoing education and that unscrupulous preparers fueling fraudulent deductions and tax credits have become a cottage industry.

I point out how much of this trouble has been caused by Congress introducing what most parties agree are welfare or transfer payments into the tax code. Congress could remove a lot of steam from unscrupulous preparers just by eliminating refundable tax credits, such as the earned income credit, for example. Here is a currently out-of-vogue idea:  why not have a national debate on whether the purpose of a tax system is to – you know – collect taxes?

The District Court will either lift its injunction or not. If not, expect an appeal from the IRS to the Circuit Court. It seems to me a tremendous expenditure of talent and resources by an over-tasked agency.