Common Law Versus Statutory Employee

 

I am looking at a case concerning employee status and payroll taxes.

I see nothing remarkable, except for one question: why did the IRS bother?

Let’s talk about it.

There was a 501(c)(3) (The REDI Foundation) formed in 1980. Richard Abraham was its officer (a corporate entity must have an officer, whether one gives himself/herself a formal title or not). Mr A’s wife also served on the Board.

REDI did not do much from 1980 to 2010. In 2010 Mr A – who was a real estate developer for over 40 years – developed an online course on real estate development and began offering it to the public via REDI. Mr A was a one-man gang, and he regularly worked 60 hours or more per week on matters related to the online course, instruction, and student mentoring.

COMMENT: Got it. It gave Mr A something to do when he “retired,” if 60 hours per week can be called retirement. I have a client who did something similar, albeit in the field of periodontics.

So REDI went from near inactive to active with its online course. For its year ended May 2015 it reported revenues over $255 grand with expenses of almost $92 grand.

COMMENT: Had REDI been a regular corporation, it would have paid income taxes on profit of $163 grand. REDI may have been formed as a corporation, but it was a corporation that had applied for and received (c)(3) status. Absent other moving parts, a (c)(3) does not pay income taxes.

The IRS flagged REDI for an employment tax audit.

Why?

REDI had not issued Mr A a W-2. Instead, it issued a 1099, meaning that it was treating Mr A as an independent contractor.

Let’s pause here.

A W-2 employee pays FICA taxes on his/her payroll. You see it with every paycheck when the government lifts 7.65% for social security. Your employer matches it, meaning the government collects 15.3% of your pay.

A self-employed person also pays FICA, but it is instead called self-employment tax. Same thing, different name, except that a self-employed pays 15.3% rather than 7.65%.

My first thought was: Mr A paid self-employment tax on his 1099. The government wanted FICA. Fine, call it FICA, move the money from the self-employment bucket to the FICA bucket, and let’s just call … it … a … day.

In short: why did the IRS chase this?

I see nothing in the decision.

Technically the IRS was right. A corporate officer is a de facto statutory employee of his/her corporation.

§ 3121 Definitions.

 

(d)  Employee.

 

For purposes of this chapter, the term "employee" means-

 

(1)   any officer of a corporation; or

 

Yep, know it well. Been there and have the t-shirt.

Mind you, there are exceptions to 3121(d)(1). For example, if the officer duties are minimal, the Code does not require a W-2.

Mr A argued that very point.

Problem: there was only one person on the planet that generated revenues for REDI, and that person was Mr A. Revenues were significant enough to indicate that any services performed were also substantial.

There was another argument: REDI had reasonable basis under Section 530 for treating Mr A as a contractor.

COMMENT: Section 530 is an employment relief provision if three requirements are met:

·      Consistency in facts

·      Consistency in reporting

·      Reasonable basis

Section 530 was intended to provide some protection from employment tax assessments for payors acting in good faith. On first impression, 530 appears to be a decent argument. Continuing education instructors are commonly treated as contractors, for example. If REDI treated instructors with similar responsibilities the same way (easy, as there was only one instructor) and sent timely 1099s to the IRS, we seem to meet the three requisites.

Except …

Section 530 deals with common law workers.

Corporate officers are not common law workers. They instead are statutory employees because the statute – that is, Section 3121(d) – says they are.

Mr A was a statutory employee. REDI was therefore an employer. There should have been withholding, tax deposits and payroll return filings. There wasn’t, so now there are penalties and interest and yada yada yada.

I probably would have lost my mind had I represented REDI. Unless Mr A was claiming outsized expenses against 1099 income, any self-employment tax he paid would/should have approximated any FICA that REDI would remit as an employer. Loss to the fisc? Minimal. Let’s agree to switch Mr A to employee status going forward and both go home.

Why did this not happen? Don’t know. Sometimes the most interesting part of a case is not in the decision.

Our case this time was The REDI Foundation v Commissioner, T.C. Memo 2022-34.

Ohtani’s New Baseball Contract

I was reading about Shohei Ohtani’s new contract with the Las Angeles Dodgers. If the name rings a bell, that is because he both bats and pitches. He is today’s Babe Ruth. He played with the Los Angeles Angels in 2023, led the American League with 44 home runs and pitched over 130 innings with a 3.14 ERA.

I am more an NFL than an MLB fan these days, but it is hard to ignore this guy’s athletic chops. It is also hard to ignore his new contract.

•  Contract totals at $700 million
•  He will draw “only” $2 million for the first 10 years.
•  He will draw the deferral (that is, $68 million annually) beginning in 2034 and through 2043.

At $700 million, Ohtani’s is the largest MLB contract ever, but what caught my eye was deferring 98% of the contract for over a decade. Do not be concerned about his cash flow, however. $2 million a year is sweet (that is way over CPA bank), and I understand that his endorsements alone may exceed $50 million annually. Cash flow is not a problem.

Why would Ohtani do this?

For one, remember that athletes at his level are hyper-competitive. There is something about saying that you received the largest contract in MLB history.

Why would the Dodgers do this?

A big reason is the time value of money. $100 ten years from now is worth less than $100 today. Why? Because you can invest that $100 today. With minimal Google effort, I see a 10-year CD rate of 3.8%. Invest that $100 at 3.8% and you will have a smidgeon more than $145 in ten years. Invest in something with a higher yield and it will be worth even more.

Flip that around.

What is $100 ten years from now worth today?

Let’s make it easy and assume the same 3.8%. What would you have to invest today to have $100 in ten years, assuming a 3.8% return?

Around $70.

Let’s revisit the contract considering the above discussion.

Assuming 10 years, 3.8% and yada yada, Ohtani’s contract is worth about 70 cents on today’s dollar. So, $700 million times 70% = $490 million today.

My understanding is the experts considered Ohtani’s market value to be approximately $45 million annually, so our back-of-the-envelope math is in the ballpark.

Looks like the Dodgers did a good job.

And deferring all that money frees cash for the Dodgers to spend during the years Ohtani is on the team and playing. He may be today’s Ruth, but he cannot win games by himself.

There is one more thing …

This is a tax blog, so my mind immediately went to the tax angle – federal or state – of structuring Ohtani’s contract this way.

Take a look at this bad boy from California Publication 1005 Pension and Annuity Guidelines:

          Nonresidents of California Receiving a California Pension

In General

California does not impose tax on retirement income received by a nonresident after December 31, 1995. For this purpose, retirement income means any income from any of the following:

• A private deferred compensation plan program or arrangement described in IRC Section 3121(v)(2)(C) only if the income is either of the following:

1.    Part of a series of substantially equal periodic payments (not less frequently than annually) made over the life or life expectancy of the participant or those of the participant and the designated beneficiary or a period of not less than 10 years.

Hmmm. “Substantially equal periodic payments” … and “a period of not less than 10 years.”

Correlation is not causation, as we know. Still. Highly. Coincidental. Just. Saying.

Ohtani is 29 years old. 98% of his contract will commence payment when he is 40 years old. I doubt he will still be playing baseball then. I doubt, in fact, he will still be in California then. He might return to Japan, for example, upon retirement.

That is what nonresident means.

Let me check something. California’s top individual tax rate for 2024 is 14.4%.

COMMENT: Seriously??

Quick math: $680 million times 98% times 14.4% equals $95.96 million.

Yep, I’d be long gone from California.

 

Merry Christmas

 

Notice(s) Of Intent To Seize And Levy

 

I received the following notice under power of attorney for a client.  

Another accountant at Galactic Command works with the client. I am the tax nerd should problems arise.

Yeah, we have a problem.

For more than one year, too.

Combine the two and I can get cranky. Just because I know the route doesn’t mean I want to revisit the site.

But back to our topic.

The notice seems terrifying, doesn’t it? The IRS is talking about seizing and levying and all matters of unkindliness.

Let’s go through the sequence of these notices.

First, you owe the IRS. There is a sequence of four notices, sometimes referred to as the “500” sequence.

• CP501         You have unpaid taxes somewhere.
• CP502         We have not heard from you about unpaid taxes.
• CP503         Hey, dummy! Are you there?
• CP504         We intend to levy if you do not do something.

This is the fourth notice in the sequence for our client for tax year 2022. As you can see, he/she/they are moving through the IRS machinery rather quickly. Then again, almost $225,000 in taxes and penalties buys you a better spot in line.

The CP504 is however not the final:final notice.

Let’s talk IRS procedure.

Before the IRS can go after your stuff (bank account, car, John Cena collectibles), it must (almost always) allow you a hearing. This is called a Collection Due Process (CDP) hearing, and it entered the tax Code with the 1998 IRS Restructuring and Reform Act. The Act was Congress’ response to IRS horror stories, including aggressive collection actions.

The IRS is not allowed to go after you until you have been offered that CDP hearing. You can turn it down, blow it off or whatever, but the IRS must provide the opportunity before it can unleash the tender attention of Collections.

 Except …

There is a short list of stuff the IRS can levy before a CDP. The list is uncommon air, except for:

Your state tax refund

That’s it. For most of us, the IRS can only go after our state tax refund – at this stage.

Then you have the FINAL BIG BAD notice: either the 1058 or LT11.The difference depends on whether you have been assigned to a Revenue Officer (RO).

LIFE TIP: Avoid having your own Revenue Officer.

 

If you get to a 1058 or LT11, you are at the end of the line. You will be dealing with Collections, and it is unlikely you will like the experience.

You may want an attorney or CPA, depending upon.

Not that having a CPA seems to matter – because clearly not - to our client.

90 Days Means 90 Days

Let’s return to an IRS notice we have discussed in the past: the 90-Day letter or Notice of Deficiency. It is commonly referred to as a “NOD” or “SNOD.”

If you get one, you are neck-deep into IRS machinery. The IRS has already sent you a series of notices saying that you did not report this income or pay that tax, and they now want to formally transfer the matter to Collections. They do this by assessing the tax. Procedure however requires them (in most cases) to issue a SNOD before they can convert a “proposed” assessment to a “final” assessment.

It is not fun to deal with any unit or department at the IRS, but Collections is among the least fun. Those guys do not care whether you actually owe tax or have reasonable cause for abating a penalty. Granted, they might work with you on a payment plan or even interrupt collection activity for someone in severe distress, but they are unconcerned about the underlying story.

Unless you agree with the proposed IRS adjustment, you must respond to that SNOD.

That means you are in Tax Court.

Well, sort of.

The IRS will return the case to the IRS Appeals with instructions and the hope that both sides will work it out. The last thing the Tax Court wants is to hear your case.

This week I finally heard from Appeals concerning a filing back in March.

Here is a snip of the SNOD that triggered the filling.

Yeah, no. We are not getting rolled for almost $720 grand.

I mentioned above that this notice has several names, including 90-day letter.

Take the 90 days SERIOUSLY.

Let’s look at the Nutt case.

The IRS mailed the Nutts a SNOD on April 14, 2022 for their 2019 tax year. The 90 days were up July 18, 2022. The 18^th was a Monday, not a holiday in fantasy land or any of that. It was just a regular day.

The Nutts lived in Alabama.

They filed their Tax Court petition electronically at 11.05 p.m.

Alabama.

Central time.

90 days.

The Tax Court is in Washington, D.C.

The Tax Court received the electronic filing at 12.05 a.m. July 19^th.

Eastern time.

91 days.

The Tax Court bounced the petition. Since it had to be filed with the Tax Court - and the Tax Court is eastern time - the 90 days had expired.

A harsh result, but those are the rules.

Our case this time was Nutt v Commissioner, 160 T.C. No 10 (2023).

A Ponzi Scheme And Filing Late

I am reading a case involving a late tax return, a Ponzi scheme, and an IRS push for penalties.

It made me think of this form:

It is used for one of two reasons:

(1)  Someone is filing a tax return with numbers different from a Schedule K-1 received from a passthrough entity (such as a partnership).

(2)  Someone is amending a TEFRA partnership return.

That second one is a discussion for another day. Let’s focus instead on the first reason. How could it happen?

Easy. You are a partner in a partnership. You bring me your Schedule K-1 to prepare your personal return. I spot something wrong with the K-1, and the numbers are large enough to matter. We contact that partnership to amend the return and/or your K-1. The partnership refuses.

COMMENT: We would use Form 8082 to inform the IRS that we are not using numbers provided on your K-1.

This is a tough spot to be in. File the form and you are possibly waiving a flag at the IRS. Fail to file it and the IRS has procedural rights, and those include the right to change your numbers back to the original (and disputed) K-1.

There is another situation where you may want to file Form 8082.

Let’s look at the Rosselli case.

Mr. Roselli (Mr. R) was a housing appraiser. Mrs. Rosselli was primarily a homemaker. Together they have five children, three of whom have special needs.

Through his business, Mr. R came to know the founder of a solar energy company (DC Solar). Turns out that DC Solar was looking for additional capital, and Mr. R knew someone looking to invest. The two were introduced and – in gratitude – Mr R became a managing member in DC Solar via his company Halo Management Services LLC.

This part turned out well for the R’s. In 2017 DC Solar paid Halo approximately $300 grand. In 2018 DC Solar paid approximately $414 grand. Considering they had no money invested, this was all gravy for the R's.

COMMENT: Notice that Halo was paid for management services. Halo in turn was Mr. R, so Mr. R got paid over $700 grand over two years for services performed. This was a business, and Mr. R needed to report it on his tax return like any other business.

In late 2018 the FBI raided DC Solar’s offices investigating whether the company was a Ponzi scheme. The owners of DC Solar were eventually indicted and pled guilty, so I guess the company was.

Let’s roll into the next year. It was tax time (April 15, 2019) and there was not a K-1 from DC Solar in sight.

COMMENT: You think?

The accountant filed an extension until October 15. It did not matter, as the R’s did not file a tax return by then either.

The IRS ran a routine check on DC Solar and its partners. It did not take much for the IRS to flag that the R’s had not filed a 2018 return. The IRS contacted the R’s, who contacted their accountant, eventually filing their 2018 return in January 2022.

You know what was on that 2018 return? The $414 grand in management fees.

You know what was not on that 2018 return? A big loss from DC Solar.

Here is Mr. R:

Mr. Carpoff informed me that I was to receive Schedule K-1s showing large ordinary losses for 2018 from DC Solar, and as a result I would not have a tax liability for that year. However, before the K-1s could be issued … DC Solar’s offices were raided by the FBI.”

All of DC Solar’s documents and records were seized by federal authorities in the ensuing investigation. As a result, I was unable to determine any tax implications because I did not receive a K-1 or any other tax reporting information from DC Solar.”

Got it: Mr. R was expecting a big loss to go with that $414 grand. And why not? DC Solar had reported a big loss to him for 2017, the prior year.

But the IRS Collections machinery had started turning. By August 2022, the IRS was moving to levy, and the R’s filed for a Collection Due Process (CDP) hearing.

COMMENT: There is maddening procedure about arguing underlying tax liability in a CDP hearing, which details we will skip. Suffice to say, a taxpayer generally wants to fight any proposed tax liability like the third monkey boarding Noah’s ark BEFORE requesting a CDP hearing.

At the conclusion of the CDP hearing, the IRS decided that they had performed all the required procedural steps to collect the R’s 2018 tax. The R’s disagreed and filed with the Tax Court.

The R’s presented three arguments.

• They reasonably assumed that they would not be required to file or pay tax for 2018 because of an expected loss from the DC Solar K-1.

The Court was not buying this. Not owing any taxes is not the same as not being required to file. This was not a case where someone did not work, meaning they dd not have enough income to trigger a filing requirement. The Rs instead had a more complicated return, with income here and deductions or losses there. Granted, it might compress to no tax due, but they needed to file so one could follow how they got to that answer.

• The R’s reasonably relied on advice from their accountant and others.

The Court did not buy this either. For one thing, the Rs had never informed their accountant about the $414 grand in management fees. If one wants to rely on a professional’s advice, one must provide all available pertinent information to the professional. The Court was not amused that the R’s had not shared the LARGEST number on their return with their accountant.

• The R’s argued that they would experience “undue hardship” from paying the tax on its due date.

The R’s argued that their income died up when DC Solar was raided. Beyond that, though, they had not provided further information on what “drying up” meant. Without information about their assets, liabilities and remaining sources of income, the Court found the R’s argument to be self-serving.

Also, the Court did not ask – but I will – what the R's had done with the $700 grand in management fees they received in 2017 and 2018.

Yeah, no. The Court found for the IRS, penalties and all.

And here is what I am thinking:

What if they had timely filed their 2018 return, showing a loss from DC Solar equal to the management fees?

Problem: there was no K-1 from DC Solar.

Answer: attach the 8082.

I think the tax would eventually have turned out the same.

But I also think they would have had a persuasive case for abatement of penalties for late filing and late payment. The penalty for late file and pay is easily 25%, so that abatement is meaningful.

Our case this time was Rosselli v Commissioner, TC Bench Opinion, October 23, 2023.

IRS Collection Alternatives: Pay Attention To Details

 

I was glancing over recent Tax Court cases when I noticed one that involved a rapper.

I’ll be honest: I do not know who this is. I am told that he used to date Kylie Jenner. There was something in the opinion, however, that caught my eye because it is so common.

Michael Stevenson filed his 2019 tax return showing federal tax liability over $2.1 million.

COMMENT: His stage name is Tyga, and the Court referred to him as “very successful.” Yep, with tax at $2.1-plus million for one year, I would say that he is very successful.

Stevenson had requested a Collection Due Process (CDP) hearing. It must have gone south, as he was now in Tax Court.

Why a CDP hearing, though?

Stevenson had a prior payment plan of $65 grand per month.

COMMENT: You and I could both live well on that.

His income had gone down, and he now needed to decrease his monthly payment.

COMMENT: I have had several of these over the years. Not impossible but not easy.

The Settlement Officer (SO) requested several things:

·      Form 433-A (think the IRS equivalent of personal financial statements)

·      Copies of bank statements

·      Copies of other relevant financial documents

·      Proof of current year estimated tax payments

Standard stuff.

The SO wanted the information on or by November 4, 2021.

Which came and went, but Stevenson had not submitted anything.

Strike One.

The SO was helpful, it appeared, and extended the due date to November 19.

Still nothing.

Strike Two.

Stevenson did send a letter to the SO on December 1.

He proposed payments of $13,000 per month. He also included Form 433-A and copies of bank statements and other documents.

COMMENT: Doing well. There is one more thing ….

The SO called Stevenson’s tax representative. She had researched and learned that Stevenson had not made estimated tax payments for the preceding nine years. She wanted an estimated tax payment for 2021, and she wanted it now.

COMMENT: Well, yes. After nine years people stop believing you.

Stevenson made an estimated tax payment on December 21. It was sizeable enough to cover his first three quarters.

COMMENT: He was learning.

The SO sent the paperwork off to a compliance unit. She requested Stevenson to continue his estimated payments into 2022 while the file was being worked. She also requested that he send her proof of payments.

The compliance unit did not work the file, and in July 2022 the SO restarted the case. She calculated a monthly payment MUCH higher than Stevenson had earlier proposed.

COMMENT: The SO estimated Stevenson’s future gross income by averaging his 2020 and (known) 2021 income. Granted, she needed a number, but this methodology may not work well with inconsistent (or declining) income. She also estimated his expenses, using his numbers when documented and tables or other sources when not.

The SO spoke with the tax representative, explaining her numbers and requesting any additional information or documentation for consideration.

COMMENT: This is code for “give me something to justify getting closer to your number than mine.”

Oh, she also wanted proof of 2022 estimated tax payments by August 22, 2022.

Yeah, you know what happened.

Strike Three.

So, Stevenson was in Tax Court charging the SO with abusing her discretion by rejecting his proposed collection alternatives.

Remember the something that caught my eye?

It is someone not understanding the weight the IRS gives to estimated tax payments while working collection alternatives.   

Hey, I get it: one is seeking collection alternatives because cash is tight. Still, within those limits, you must prioritize sending the IRS … something. I would rather argue that my client sent all he/she could than argue that he/she could not send anything at all.

And the amount of tax debt can be a factor.

How much did Stevenson owe?

$8 million.

The Court decided against Stevenson.

Here is the door closing:

The Commissioner has moved for summary judgement, contending that the undisputed facts establish that Mr. Stevenson was not in compliance with his estimated tax payment obligations and the settlement officer thus was justified in sustaining the notice of intent to levy.”

Our case this time was Stevenson v Commissioner, TC Memo 2023-115.