The IRS Should Apologize To This Taxpayer

In income tax land if …

•  You own a corporation, and

•  The corporation has property, and

•  The corporation gives you the property, and

•  You do not pay anything for it, …

… then the IRS will consider you as receiving distribution from the corporation. The classic distribution is a dividend, taxable to you and not deductible by the corporation. 

Perhaps the corporation distributes property and you pay some – but not all – of what the property is worth. A classic example is a corporation distributing a car to the owner’s child for a nominal amount. There is a distribution taxable as a dividend, and the dividend amount would be the value of the car over any amount paid. It would not be the full value of the car in this case.

The tax code views a C corporation (we are not discussing S corporations in this blog) as an entity distinct from its shareholders. That is how Congress justifies taxing the corporation on its income and then taxing the shareholders again when they receive dividends sourced to that income. Since there are two entities, there cannot be double taxation.  

But there is, of course, and it takes sleight of hand to maintain the illusion. Many if not most tax advisors – including me – have steered most of our closely-held business clients away from C corporations and to passthrough entities: perhaps S corporations, partnerships or limited liability companies. Sometimes the weight of the double taxation is unacceptable. 

The Tax Court decided the Welle case just last month. Sure enough, it involved a C corporation and a dividend. More specifically, it involved what the IRS saw as a new species of dividend. 

Let’s walk this through.

There is a construction company (TWC) in North Dakota. It is wholly-owned by Terry Welle (Welle). TWC primarily does multifamily construction, and its historical profit has been around 6 or 7 percent.

Welle decides he is going to build a lakefront property in Minnesota.

NOTE:  Excuse me here, but how about going south with that lakefront property? Is Minnesota that much warmer than North Dakota?

Back to our story. Welle has a company that builds things. He used TWC’s accounting system to track his costs, and he also used its workers to frame the Minnesota house. The company did a calculation of the costs, including overhead, and Welle reimbursed the company to the penny. 

The IRS comes in and finds fault. The IRS wants to know where the company’s profit is. Welle reimbursed the company at cost, including overhead, meaning that they made no profit from him. The IRS says that there should be and must be a profit. They calculate that profit to be around $48,000. Since he did not reimburse the company its erstwhile profit, the IRS assessed him with a $48,000 dividend. It wants $10,620 in income tax.

Oh, the IRS also wants an accuracy-related penalty of over $2,100.

Wow! The IRS is assessing a penalty on a tax theory it has never trotted out before? That is brazen.

This case goes to Court. The IRS argues that a corporate distribution must be measured at fair market value. Fair market value is the amount that would fully reimburse a company for its direct and indirect costs, as well as render a profit.  One cannot disagree with that summary of microeconomics 101.

The Court tells the IRS to back up. It wants the IRS to point to the distribution event before its gets to any issue of measuring and valuing. The Court reasons that a distribution requires assets to be “diverted to or for the benefit of a shareholder.” It must be a vehicle to “distribute available earnings and profits without the expectation of repayment.”

Show us the distribution, says the Court.

The IRS offers and the Court reviews a number of cases, but it cannot see how corporate assets were expended. Welle received services, but then again he paid for them. At most, he used the company as a conduit in maintaining records and paying subcontractors. The company was no better or worse for transacting with him. The event was a nullity.

In frustration, the Court writes:

Respondent does not explain how a corporation’s decision not to make a profit on services provided to a shareholder who fully reimburses the corporation for the cost of services (including overhead) constitutes a distribution of property that reduced the corporation’s earnings and profits under Section 316(a), nor does the respondent cite any cases supporting such a position.”

The Court decided for Welle and against the IRS.

My thoughts? This is one of the lamest tax theories I have come across, and I have near 30 years in the profession. What was the IRS up to? Are there that many North Dakota contractors building lakefront homes that the IRS decided to go where no serious tax practitioner had gone before? 

Let us segue for a moment. 

Do you remember Nina Olsen? She is the Taxpayer Advocate, and we have spoken of her before. The Advocate is supposed to sit outside the IRS and function as a watchdog. It is great idea, but I must admit the IRS for the last half-decade or so has seemed less than interested in the Advocate. Nonetheless, she is promoting an idea she calls the IRS “apology payment.”  The idea is to pay a taxpayer something when the behavior of the IRS causes excessive delay or expense or an undue burden resulting in significant hardship to the taxpayer.

This idea is being refloated in response to the 501(c)(4) scandal. Ms Olson argues that apology payment would: 

Serve as a symbolic gesture that the government recognizes its mistake and the taxpayer’s burden. These payments might enhance the public perception of the IRS and the tax system as just and fair.”

Great idea, although a $1,000 flat sum may be insufficient in some cases.

I would like to see Welle receive his apology payment for the IRS wasting his time.

Can The IRS Collect From You After 31 Years?

What were you doing 31 years ago? 

Me? I was living in South Florida. I probably had a nice tan. 

Let’s return to tax talk: do you think that the IRS can chase you down after 31 years?

One wouldn’t think so. There is a three-year statute of limitations on assessment, which generally means that the IRS has three years to audit you. If there is tax due, the IRS will then “assess” the tax, which means that they post the tax due to your master account. They have ten years (after assessment) to lien, levy or otherwise collect from you. The ten years is the statute of limitations on collection.  

NOTE: You can see there are two statutes at play: one on assessment and another on collection. The two can – and frequently – overlap, so that many times the effective statute of limitations is ten years.

There are specialized situations where tax representation involves exhausting the ten-year period. I had a client from Florida, for example, who inherited a nasty tax problem from her deceased husband.  Exhausting the collection period was part of our strategy.

Let’s talk about Beeler, which the Tax Court decided last month. 

There used to be a company called Equidyne Management, Inc, which failed to remit payroll taxes thirty-one years ago. That would be 1982.

Skipping out on payroll taxes is a bad idea. Somebody will not only be responsible for the taxes, interest and penalties but also for a 100 percent penalty to boot. This is the “responsible person” penalty, and this is one case where you do not want to be responsible.

NOTE: We have previously called this the “big-boy” penalty. It is one of the most gruesome penalties in the tax Code, as it imposes personal liability for a business debt.

Equidyne had three responsible persons: Beeler, Ross and Liebmann.

Ross filed for bankruptcy almost right away – in 1983. During his bankruptcy, he sent $80,860 as part of a “global settlement” with the IRS. “Global” means that he was paying off various taxes, not just the responsible person penalty.

Per the statute of limitations, the IRS had three years to assess. Right on schedule, in 1985 the IRS assessed the responsible person penalty against the three Equidyne officers. It could not assess against the company, as Equidyne itself had gone out of business.

Beeler lawyers up and contests the penalty. 

OBSERVATION: Litigation will “toll” the statute. This means that the ten-year period is suspended until the toll comes off.

The litigation is not resolved until 1995 - 10 years later. Beeler loses.   

Beeler contacts the IRS in 1997. The IRS fails to list the big boy penalty on his transcript.  

In 2001 the IRS releases liens on Beeler’s properties in New York and Sarasota. 

Even better, the IRS makes entry in Beeler’s master account that the statute of limitations on collections had expired.

Beeler wonders what is going on. More likely, Beeler’s tax CPA wonders what is going on. What the IRS did could be correct. The trust fund penalty is “joint and several.” The IRS could go against any of the three officers, but it does not have to go against the three proportionally. If the IRS had collected from one of the other two officers, then Beeler would be off the hook. The IRS cannot collect the penalty more than once, regardless of the number of responsible persons. 

In 2005 an IRS employee reviewing Beeler’s account notices that a “pending” code had been entered into the master file when Beeler litigated in 1986. This is standard procedure, and it indicates the “tolling” of the account. Problem is that the IRS failed to remove the code when the litigation ended in 1995. 

The IRS corrects the file. The judgment against Beeler is recorded. 

NOTE: One way to override the collection period is for the IRS to obtain a judgment, which requires the IRS to go to Court. Beeler was considerate enough to do this on his own power. 

Beeler is hopping mad. Wouldn’t you be? He sues the IRS - again. He has two arguments:

(1) The lien release discharged his trust fund obligation.

COMMENT: It did not. The lien secures a debt; it does not pay a debt. Relinquishment of a lien has nothing to do with the enforceability of the underlying debt.

(2) The big-boy penalty had been satisfied by payment.

COMMENT: This caught the Appeals Court’s attention, especially since the file went back to when some of the judges were probably entering law school. The Appeals Court sent the case back to the Tax Court to look into this matter.

The Tax Court determined the following:

(1)  Equidyne never paid anything.

(2)  Liebmann never paid anything.

(3)  Beeler never paid anything.

(4)  Ross paid $80,860 as part of a global settlement.

Beeler argues that Ross paid another $64,000. The Court finds record of a $64,000 but it believes that this was a bookkeeping entry reflecting a transfer among bankruptcy trustees and not a payment to the IRS.

But there was an IRS entry for $60,773. There was some dispute as to what it meant, as decades have gone by. The Court concluded that the IRS was correcting a prior entry, that this was not cash received and therefore not the $64,000 payment Beeler wanted.

Since there is no better information, the Court assumes that all of the $80,860 was paid toward the responsible person penalty and reduces Beeler’s liability accordingly. But Beeler is still on the hook for the balance.

Let us speculate. What if Beeler had not litigated the big-boy penalty? There would have been no judgment, and the statute of limitations would have eventually expired. Would the IRS have let that happen? Who knows? Sometimes the IRS will send a 90-day notice (called a “SNOD”) to get the case into Tax Court before the statute expires. You know what the IRS wants, of course: it wants the Court to transmute the assessment into a judgment. The IRS does not always send a SNOD, though. Perhaps it decides the likelihood of payment is low, or the amount due is inconsequential, or maybe the file just gets lost in the system. 

If he could go back, I wonder if Beeler would have litigated the penalty. It is the reason he is still on the hook, thirty- one years later.