Z Street Decision Will Force IRS To Disclose How It Reviews – And Delays - Tax-Exempt Applications

I am reading things that make me wonder what is going on at the IRS. It repetitively appears that the agency – or at least influential partisan players – think that the job of the IRS is to take sides in political issues.

I am looking at Z Street v Shulman. It is a Court decision from the District of Columbia. There are some interesting points in here, embalmed in yawn-inducing legalese.

Let’s talk about this case.

Z Street is a non-profit corporation. It comes out of Pennsylvania, was organized in 2009 and immediately applied for tax-exempt status. Its purpose is to educate the public about Zionism; about facts on the formation of the Jewish state; and about Israel’s right to refuse to negotiate with terrorists.

We know about that the IRS instituted a policy of 501(c)(4) suppression prior to the 2012 presidential election. The 501(c)(4)s are a different animal from a (c)(3), the “traditional” charity. A (c)(4) may engage in an unlimited amount of lobbying, as long as it stays within the issues for which it was organized. If someone felt strongly about blue M&Ms, for example, I suppose that someone could organize a (c)(4) and lobby nonstop – as long as they stayed within the issues concerning blue M&Ms. A (c)(4) can also engage in some partisan political activity, as long as it does not become its primary activity. There is a price however for this freedom to till so close to political soil: deductions to a (c)(4) are not deductible.

Contrast that to a (c)(3), contributions to which are tax-deductible. As a trade-off, there are severe restrictions on lobbying activities of a (c)(3).

Anyway, Z Street applies for (c)(3) status. It wants that tax-deductible status, understandably. It is possible that – in the future – it will spin-off a (c)(4). 

Here are some quick dates:

·       12/29/09 - applies for exempt status with IRS

·       5/15/10 – IRS send a letter requesting additional information

·       6/7/10 – Z Street provides additional information to the IRS

·       7/10/10 – Z Street’s attorney tracks down the IRS person (Dianne Gentry) handling the file.  Agent Gentry tells the attorney that she has two reservations:

o   Z Street is engaged in “advocacy” activities that are not permitted under Section 501(c)(3)

o   The IRS has special procedures for applications from organizations whose activities relate to Israel, and whose positions with respect to Israel contradict the current policies of the U.S. government. She further stated, “these cases are being sent to a special unit in the D.C. office to determine whether the organization’s activities contradict the Administration’s public policies."

I am stunned.

I immediately pick up on the issue of a (c)(3) and advocacy. I expected that issue, and frankly, I wonder why Z Street didn’t organize a (c)(4) instead.

But “special procedures” and the “Administration’s” current policies? My tax-exempt application is to be judged on whether the Administration “likes” me and whether I say “politically correct” things? Good grief, bring on Kristallnacht.

Z Street brought a lawsuit. They alleged that the IRS maintains a special policy when it comes to Israel and to (c)(3)s whose stance does not agree with the Obama Administration, and that such applications are subject to special procedures not applied to other organizations. 

What does Z Street want?

·       A declaration that policy is unconstitutional, and

·       An injunction forcing the IRS to disclose the policy and barring the IRS from employing the same.

The IRS stalled this thing almost long enough to put your kid through college. I am disturbed that the IRS core argument seems to be “we can do whatever we want.” Here are their arguments:

(1)  The Anti-Injunction Act

The AIA was first enacted in 1867, and states that ”no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax is assessed.”

The IRS argued that the AIA barred the Court from granting injunctive relief.

(2)  Code Section 7428

Code Section 7428 already provides remedy for organizations that seek to challenge IRS determination of their (c)(3) status.

(3)  The IRS also argued that the case should be dismissed on “sovereign immunity” grounds.

The Court goes to work:

(1)  The D.C. Circuit had already decided a case (Cohen) rejecting  that the AIA’s “assessment and collection” language bars any and all lawsuits that might ultimately impact revenue to the Treasury. It has to be so, otherwise one could pass virtually any law and render it unreachable by calling it a “tax.”

(2)  By its terms, Section 7428 applies when there is controversy concerning qualification of an organization as a (c)(3). The only available remedy under Section 7428 is a “declaration with respect to … initial qualification or continuing qualification.”

The Courts points out that Z Street is not asking the Court for (c)(3) qualification. Rather it is asking the Court to force the IRS to follow a “constitutionally valid process” – nothing more and nothing less.

(3)  The Administrative Procedure Act expressly waived sovereign immunity for lawsuits such as this. The APA waives sovereign immunity for suits for nonmonetary damages that allege wrongful action by an agency or its officers or employees.

The Court points out the obvious: that is exactly what Z Street is doing.

Judge Ketanji Brown Jackson observed:

Defendant struggles mightily to transform a lawsuit that clearly challenges the constitutionality of the process that the IRS allegedly employs when it determines the tax-exempt status of certain organizations into a dispute over tax liability as a means of attempting to thwart this action’s advancement.”

In legalese, this is like being punched in the face.

The Court decided that the Z Street’s lawsuit could proceed. After the IRS files its response, the case will go to discovery. The IRS will have to pony up what it has been doing with tax-exempt applications these last few years. Anticipate that Z Street attorneys will seek depositions from other groups similarly treated by the IRS.  

Good.

If proven, this type of behavior by the IRS is thuggish and needs to be punished. People need to lose their jobs, if not their freedom for a while. Perhaps we could build a Lois Lerner wing at a prison somewhere. Perhaps somewhere near the District of Columbia so these people would not have to travel far.

Why do I say this? Our taxation system relies – to an overwhelming extent – on voluntary compliance. The function of the IRS is to administer and collect taxes and process records of the same. Whatever our political stance, we can have common ground on the assessment and collection of tax. We can all hate the IRS equally.

If we disagree on tax law, however, we take that disagreement into the legislative arena. Allow elected representatives to hash it out. At least the representatives have to run for reelection occasionally, so there is some chance for an accounting of their decisions and actions. This is greatly preferable – and healthier for our system of governance – than partisan berserkers bending whatever lever of government they can access to impose their dogma du jour.

Remember: there will be a future White House with very different attitudes and values than the present one. If this behavior goes unpunished, those now in power will then be out of power, and it will be their views and causes that will be handed to the tender mercies of the partisan berserkers then in power.

Don’t come crying then.

The IRS Will Begin Taxing Your Employer-Reimbursed Health Insurance

There was an article last week in the New York Times titled “IRS Bars Employers From Dumping Workers into Health Exchanges.” I scanned it quickly and made a note to return to the topic.

The IRS published Notice 2013-54 last year addressing, among other things, employer use of health reimbursement arrangements (HRAs). HRAs were popular for many years as a way to offer employees a tax-free fringe benefit. A common plan was employer reimbursement of qualifying medical expenses up to a limit (say $1,500 annually, for example). I used to be in one several years ago. Twice a year I would submit medical expenses for reimbursement. Shortly thereafter, I would receive a check, all without a nick to my W-2.

Then came ObamaCare.

There are questionable definitional rules under ObamaCare. For example, ObamaCare defines a coterie of health services to be “essential health benefits” (EHBs). You cannot have limits – either annual or lifetime – on EHBs. Why no limits?  It sounds great, like free ponies and summers off, but the government had to promise the insurance companies that it would subsidize them too if ObamaCare ran off the rails.

Think about the interaction of an HRA with the rule concerning EHBs. If an HRA is considered an EHB plan, then the plan will fail because there are annual limitations on the benefit. In our example, the limitation is $1,500, the maximum the plan would reimburse any one employee.

Notice 2013-54 considered HRAs to be just that, and now HRAs – with extremely limited carve-outs – are going the way of the dodo bird.

Let’s put a twist on the HRA example. Let’s say that you buy and your employer reimburses you for health insurance. Can that reimbursement be left off your W-2?

The New York Times was addressing that question.

Let’s go through the decision grid. I see three general ways an employer can approach health insurance:

(1)  The employer provides you with health insurance.

a.     In which case the rest of this discussion does not apply

(2)  The employer does not provide you with health insurance.

a.     Your employer may have issues depending on whether it has 50 employees or more.

                                                              i.     If no, there are no penalties.

                                                            ii.     If yes, your employer has penalties.

b.    You still have no insurance, though.

(3)  The employer does not provide you with health insurance but it does provide you with money to buy health insurance.

a.     Again, your employer may have penalties, depending on whether it has 50 or more employees.

b.    You have more money, but … do you have to pay tax on that money?

Since before Alaska and Hawaii became states, the answer to that question has been “No.”

With ObamaCare, the answer is now “Yes.”

The IRS has stated that any monies provided by your employer in scenario (3) above have to be included on your W-2. This means of course that you are paying taxes on it, and your employer is also paying taxes on it. You and your employer are unhappy with this. Retailers, homebuilders and car dealers are also unhappy with this, as you will have less after-tax money to spend with them. The only one who is happy with this is the government.

You know that there will be employers who are uninformed of these new rules - or informed but not care about any new rules. What will be their penalty for noncompliance?

That is what the IRS clarified last week. The penalty is $100 per day. Yes, that is $100 times 365 days = $36,500 per year. For each employee.

Let’s gain altitude and get some perspective on why the government is being so harsh. 

Remember that policies on the individual health exchanges are eligible for subsidy if one’s family income is less than 400% of the poverty line. The government does not want an employee to go the exchange and possibly receive a government subsidy at the same time that his/her employer is also providing a nontaxable employee benefit. That would be a double-dip.

You have to admit, it is a valid point.

It is also a valid point to question what the real government policy is here: for you to have health insurance or for the government to tax you? If the former, then the government could have reduced – or denied – health exchange subsidies to compensate for an employer reimbursement plan. If the latter, then the most recent IRS pronouncement makes perfect sense.

The IRS Will Be Looking At Deferred Compensation Plans

The IRS recently launched a limited audit effort to gauge how well nonqualified deferred compensation plans are complying with the tax Code. My understanding is that the number of companies to be contacted will be less than 100. The IRS will use this effort to refine its audit techniques in three areas of nonqualified deferred compensation:

1. Initial election to defer compensation
2. Subsequent election to defer compensation
3. Eventual payment of said compensation

Before proceeding further, let’s define the “nonqualified” part of this term. Someone is deferring compensation. Perhaps someone (say, Tom Brady) is earning $15 million this year, but some or all of it will not be paid until some future date. It happens all the time, and the IRS has limited “preapproved” ways to do so. The classic way is stock options, for example.

Deviate in any way from the IRS-preapproved road, however, and the plan is referred to as “nonqualified.” I use nonqualifieds on a common basis, as they allow more flexibility in their planning and implementation than qualifieds. There is no connation of good or bad to being “nonqualified.”

The IRS is looking at Section 409A, a particularly nasty Code section.

What was the purpose of Section 409A? Let’s go back to 2000 and 2001. We are now talking about Enron, an energy and commodities company headquartered in Houston and one of the most scandalous business frauds of all time. Enron executives pushed their way to the front of the line by accelerating the payout of their deferred compensation before the company went under. You may recall that the average employees were blocked-out of their 401(k)s, with the result that they saw their retirement dwindle if not evaporate while company fat cats, like Kenneth Lay and Jeffrey Skilling,  walked away with wheel barrels full of cash.

How did it evaporate? There were two primary drivers:

(1)  Enron made its 401(k) matching contribution with company stock. Then it put in a lockdown, preventing employees from selling that stock until age 50.

(2)  Enron decided to transfer the administration of its 401(k). Unfortunately, this occurred during the period the stock collapsed, and employees were preventing from selling their stock even if they could and wanted to.

The truth of the matter is that many companies, not just Enron, use their own stock to fund a 401(k). For example, Coca Cola employees keep more than 80% of their 401(k) assets in Coca Cola stock. At Proctor & Gamble, the percentage is over 90%.

So what we have is an issue of corporate 401(k) matching, as well as an issue of the interregnum between plan administrators. That was not sufficient for Congress, which loves nothing more than a good scandal (unless it is their own, of course). In response, Congress passed Sarbanes-Oxley in 2002. It then passed the American Jobs Creation Act – containing Section 409A – in 2004.

Congress was after deferred compensation.  

Section 409A starts off easy enough: it applies to any “plan” that provides for the “deferral of compensation” to “service providers.” A “plan” does not need to be reduced to writing, and “”service providers” can included independent contractors as well as employees. “Deferral” means any payment (to which a service provider has a legally binding right) that may be received in a future tax year.

            STEP ONE: Carpet bomb. Look for survivors later.

The IRS had to start excluding something, otherwise this thing was going to dragnet everything- think accrued sick leave or accrued vacation pay - into its wake. Remember: any compensation not paid IMMEDIATELY could potentially detonate this tax trap.

It didn’t matter how much money you made, either. This thing was not limited to the big wigs. Section 409A swept up the small and large alike.

How ridiculous does this go? A number of years ago the IRS decided that schoolteachers were violating Section 409A by deferring their salary over 12 months rather than being paid over the 9 months comprising a school year. Let that sink in: the IRS felt driven to protect Americans from the rapaciousness of schoolteachers wanting to budget their salary over 12 months.

NOTE: The IRS received so much bad press that it was forced to reverse its position. That was fine, but a more cogent question was whether the law was so deeply flawed that its logical progression inevitably led to absurd results.

Therefore, the IRS gave us a few exceptions, including:

·       “Short term deferrals”

o   This means being paid by March 15 of the following year

·       Qualified plans, which means pension and profit-sharing plans, including your 401(k)

o   Obvious

·       Certain welfare plans, such as vacation and sick leave plans

o   Obvious

·       Grants of incentive stock options (ISOs) and employee stock purchase plans (ESPPs)

o   Have their own rules

·       Options to buy the stock of the service recipient, but only if the exercise price is not less than the market value of the stock on the date of grant

o   This means that – if you work at P&G and can buy P&G stock through a plan, you had better pay full retail price. If P&G gives you a discount – say you buy for 90 cents on the dollar – the IRS sees this as a “feature for the deferral of compensation.”

What happens if you are pulled into this thing?

·       The plan better be in writing

·       You better make a timely election to defer

·       Distributions to you may only be made upon occurrence of six IRS-approved events

·        You better not be able to accelerate your deferred benefits

What is a timely election? It is not what you may think. Timely in this context means “before you earn it.” For example, if your 2014 bonus is payable in 2015, you had better have your election in place in 2013.

What if you want to make a change to an existing deferral?

·       The payment must be deferred for at least another five years

o   So if you were to start in 2017, you can now start no earlier than 2022

·       And you better make this change at least 12 months before the payment was scheduled to be paid

What do you have to do to get to your money?

·       Death

·       Disability

Good grief! What else have you got?

·       Separation from service

This means you have to be fired. 

·       Change in control

This means that there is a change in ownership or control of the company. I suppose you could sell the company AND get yourself fired, just to be certain.

·       Unforeseen emergency

Think illness or accident or property loss. Even then, you have to show that expenses could not otherwise be met by insurance or your liquidation of other assets. Goes without saying that amount of distribution is limited to the amount needed for the emergency, plus taxes.

·       Date certain or fixed schedule

Finally, here is the heart of the matter. The IRS wants you to select when the deferred monies are to be paid and how (lump sum, series of payments) and then stick to it. It wants you to decide this way ahead of time, and then severely penalize you if later life events cause you to change in your mind.

What happens if you botch it?  Well, Section 409A will kick-in. 

·       There is tax on the distribution

·       There is interest (called a “stinger”) equal to the regular underpayment rate plus 1%

·       There is a 20% penalty

What if you take a distribution early? Bam – you have tax, interest and penalty.

What if you do not do anything wrong, but the company flubs the paperwork? Bam – you have tax, interest and penalty.

Can you say lawsuit?

That 20% penalty is not calculated as you would expect, either. A reasonable person would anticipate the penalty to be 20% of the tax, or possibly 20% of the tax plus the stinger. It is not, however. The penalty is 20% of the deferred balance, whether received by you or not. 

            STEP TWO: Bayonet the survivors.

What if you are in several plans simultaneously and one goes south? Does one plan contaminate the other? 

Of course it does.

STEP THREE: Repeat steps one and two. 

So what did Congress really accomplish with Section 409A?

·       Inability to distinguish publicly-traded from privately-owned

I scratch my head why Congress thinks that my auto mechanic down the street can get himself in the same trouble as a Humana or a General Electric.

Publicly-traded stock is almost like cash. These companies can buy other companies with it. They can pay employees with it. They can fund retirement plans with it. They can … well, they can play Enron with it.  

A privately-owned company however cannot.  Privately-owned companies are playing with their own money. Even the most reckless take a pause when reaching into their own wallet. A publicly-traded executive is closer to a Washington politician than any of the business owners I am likely to represent.

·       Crippling tax bombs for the unadvised

Change your deferral payment date 363 days – rather than 366 - before scheduled payout and risk tax annihilation. 

Does Congress expect that every businessperson can keep a tax attorney on retainer?

·       Yet another tax “industry”

There are advisors out there specializing in Section 409A. There has to be. You could endanger a large company by implementing a faulty plan. 

However, this is not quite the same contribution to the economy as Steve Jobs introducing the iPhone, is it?   

·       Insinuation into routine business transactions

We have a client who recently hired a business development manager. Their intention is to grow the company for 7 or so years, then sell out. It is their retirement program of sorts, I guess. The deal with the development manager includes deferred compensation, driven off year-over-year business growth and eventual sale of the company. What should be a routine tax matter now requires a Section 409A specialist, to be sure the employment package doesn’t blow up.

You want an alternative to 409A? How about this: all accelerations of executive deferred compensation (remember: Enron was only about acceleration) have to go to a shareholder vote. While we are at it, let’s lock down the executives for the same period as the rank-and-file are locked out of their 401(k)s.

And if Enron was caused by acceleration, why does 409A penalize additional deferrals? What is the point?

So the IRS is going to be looking at 50 – to 100 large companies to check on their 409A compliance. I suspect these companies will be fine, as they have the people, resources and advisors to navigate Section 409A. I would give you a different answer were the IRS to train its attention on privately-owned companies, however.