Philadelphia Updates Wage Tax Return to Enable Reporting of Tip Income and Prevent Overassessment of Wage Tax Against Restaurant Employers

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June 17, 2016

A recent change to the Philadelphia Wage Tax Return addresses an issue that has plagued restaurants with tipped workers subject to the Philadelphia wage tax, yet the change to correct this issue has gone largely unnoticed by some restaurants.  Restaurants that operate within Pennsylvania and employ Philadelphia residents have historically been assessed for wage taxes they could not withhold and subjected to penalties and interest imposed by the City of Philadelphia for failing to withhold the Philadelphia wage tax on tip income earned by tipped workers.  These penalties were not only surprising, but also unjustified in many cases, given that restaurants often cannot withhold the full amount of the wage tax required by Philadelphia law.  Under the stacking rules that apply to wage withholding, employers must withhold taxes in a predetermined order prescribed by law, beginning with FICA taxes, then Federal income taxes, then state taxes, and lastly, local taxes.  Local taxes, such as the Philadelphia wage tax, often cannot be withheld because there is simply no money left after Federal and state taxes are taken out.  However, employers have been repeatedly punished with underpayment penalties imposed by the Philadelphia Department of Revenue with respect to the Philadelphia wage tax.

To rectify this situation, the City of Philadelphia has updated its Wage Tax Return, such that the 2015 version now provides on Line 3 an opportunity for employers to report the tip wages earned by employees on which the Philadelphia wage tax could not be withheld. The instructions to the 2015 Wage Tax Return explain that the employer should report the amount of tip income reported to the employer by the employee and any other tips allocated to the employee by the employer—the withholding liability is based only on wages under the employer’s control (other than tips) and amounts turned over voluntarily by the employee to the employer.  This is a welcome change by the Philadelphia Department of Revenue that addresses an issue that has caused significant headaches for many restaurants.

11th Circuit Decision Highlights the Disparity Between Regular IRS Appeals and Collection Appeals

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March 8, 2016

Although IRS Appeals personnel handle both traditional cases and collection due process (CDP) hearings, the two proceedings have vast practical differences for taxpayers. First, regular Appeals cases are conducted by Appeals Officers, who are well-versed in the law and legal authorities, whereas CDP hearings are conducted by Settlement Officers, who typically are former collection personnel that often lack the technical background of Appeals Officers. Although this difference is not critical in a case focusing solely on establishing a payment plan, it can be a significant issue if the case involves a dispute over substantive legal questions relating to the underlying tax dispute.

A recent opinion from the U.S. Court of Appeals for the Eleventh Circuit highlights the distinction between the two proceedings in a case of first impression in that circuit. In its opinion, the panel reversed the Tax Court on the issue of whether a preassessment hearing is required when a taxpayer timely protests a case involving trust fund recovery penalties but is subsequently afforded a CDP hearing. In Romano-Murphy v. Commissioner, the 11th Circuit reviewed the statute and regulations governing trust fund taxes, other applicable regulations, and the Internal Revenue Manual, and concluded that taxpayers who properly request preassessment hearings must be granted such hearings. This holding highlights the disparate opportunities available to a taxpayer in a traditional IRS Appeals hearing as compared to a CDP hearing.

Although the critical issue in Romano-Murphy is procedural in nature, the issue arose in the context of trust fund taxes. When an employer withholds federal income tax, Social Security tax, and Medicare tax on that income (known as “trust fund taxes”) but fails to deposit the withheld taxes, the Commissioner has several alternatives to collect those taxes. Section 6672(a) makes the responsible officers or employees personally liable for a penalty equal to the amount of the delinquent taxes, allowing the Commissioner to seek the tax from the individuals responsible for the collection and payment of withholding taxes on behalf of the organization, so long as the individuals willfully failed to properly pay.

The taxpayer in Romano-Murphy, Chief Operating Officer of a healthcare staffing company, was assessed nearly $350,000 in trust fund recovery penalties for her company’s failure to remit withheld taxes. The taxpayer timely and properly protested the assessment, providing all required information and identifying disputed issues, but the IRS failed to send her protest to IRS Appeals (no explanation for this failure was offered in the court’s opinion). Subsequently, the IRS served the taxpayer with a notice of intent to levy to collect the trust fund taxes, as well as a notice of federal tax lien filing. In response, the taxpayer challenged the levy and the lien in a request for a CDP hearing. At the CDP hearing, the Settlement Officer considered the taxpayer’s challenges and upheld the assessment in full. The taxpayer then challenged the CDP determination, including the legitimacy of the assessment in the Tax Court. In its decision, the Tax Court addressed the underlying liability and found the taxpayer liable for the taxes and essentially dismissed the taxpayer’s argument that she was entitled to a preassessment hearing before IRS Appeals before the assessment itself could be made.

The taxpayer’s sole argument in its appeal to the 11th Circuit was that the IRS denied her a preassessment hearing, which therefore invalidates the assessment. The IRS asserted that the absence of an explicit statutory requirement negated the need for a preassessment hearing, but the 11th Circuit panel looked to other statutory references, the regulations, the Internal Revenue Manual, and other relevant authorities to conclude that a regular IRS Appeals conference is indeed required on a preassessment basis when timely requested by the taxpayer. The court rejected the IRS’s argument that it may “simply ignore, disregard, or discard a taxpayer’s timely protest . . . if it so chooses” without establishing any rational criterion for doing so. The court went on to point out that were the IRS’s position correct, “the IRS could arbitrarily decide to shred one of every three . . . protests that arrive in the mail, or throw out all such protests received on Fridays, without any consequences whatsoever.”

In the alternative, and perhaps more importantly, the IRS argued harmless error on the grounds that the taxpayer’s challenges to the underlying tax were considered and rejected, just in the setting of a CDP hearing. Essentially, the IRS equated the opportunity afforded the taxpayer to present her case at the CDP hearing to the opportunity that she would have received at a preassessment Appeals hearing. The taxpayer argued that the denial of a preassessment conference prejudiced her because, for example, interest began accruing from the date of the assessment, the delay in hearing her claim kept her from being able to access for 18 months information that was only maintained on the IRS’s system, and the lien placed on her property harmed her credit. The court refused to rule on the issue of actual harm to the taxpayer but acknowledged that arguments exist on both sides. On one hand, it stated that the taxpayer was “not completely denied a right to be heard,” and thus her due process rights were not violated. But, the court also acknowledged the importance of enforcing procedures required by law that an agency failed to follow. The court vacated the judgment but remanded the case to the Tax Court to address whether the taxpayer was harmed by the error.

Although the 11th Circuit did not expressly address the vast differences between a taxpayer presenting its case in a preassessment Appeals hearing versus a CDP hearing, the differences in the qualifications between Appeals Officers and Settlement Officers cast a troubling shadow over the case due to the existence of substantive tax issues that require a higher degree of training, knowledge, and experience. As a result, whether a taxpayer presents its case at a preassessment Appeals hearing or a CDP hearing can significantly affect the outcome.

The court’s remand to the Tax Court will require the Tax Court to determine whether the IRS’s denial of a preassessment Appeals hearing that was ultimately held in a CDP hearing before a Settlement Officer years later caused sufficient harm to the taxpayer to warrant the invalidation of the assessment. If the taxpayer prevails, it appears that the statute of limitations may bar a reassessment by the IRS.

Tax Court Case Highlights Growing Problem of IRS Collection Activity before Taxes are Properly Assessed and Administrative Appeal Rights Exhausted

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March 5, 2016

A growing problem with the IRS’s administration of tax disputes involves the IRS initiating collection activity before it has either properly assessed the tax or before taxpayers have exhausted their administrative remedies. Generally, the IRS must observe certain procedural requirements before a tax or addition to tax is assessed against a taxpayer. Increasingly, however, the IRS has initiated collections against taxpayers before completing the assessment procedures or before the taxpayer has had the opportunity to exhaust its administrative remedies. This is particularly true with respect to certain employment tax liabilities and penalty assessments. It is important for taxpayers to avail themselves of their appeal rights timely to prevent erroneous and unsupportable assessments, which happen far more often than one would expect including against large employers.

The Tax Court recently addressed this issue in Hampton Software Development, LLC v. Commissioner. The Tax Court denied the Commissioner’s motion for summary judgment holding that a preassessment IRS Appeals conference held after the IRS issued a 30-day letter at the end of an employment tax audit did not constitute a “prior opportunity” for the taxpayer to dispute its underlying tax liability with respect to a Notice of Determination of Worker Classification (NDWC) that the taxpayer did not receive. Instead, the court held that a taxpayer will only be considered to have had a prior opportunity to dispute the underlying liability when the taxpayer actually receives the NWDC. Though this case arose in the context of worker classification, the procedures for challenging an NDWC apply in the same manner as if the NDWC were a notice of deficiency. Similar to a standard notice of deficiency in an income tax audit (as opposed to an employment tax audit, which are not within the jurisdiction of the Tax Court), section 7436 also provides for a 90-day period to file a petition in Tax Court challenging the IRS’s determination of worker classification during an IRS audit.

In this case, the taxpayer treated a maintenance worker as an independent contractor and issued Forms 1099-MISC. The IRS concluded on audit that the taxpayer should have treated the worker as an employee, thus underpaying its employment taxes for two tax years. The IRS issued a 30-day letter to the taxpayer advising the taxpayer of its right to request an IRS Appeals conference, and the taxpayer timely protested the audit findings and requested a conference with IRS Appeals. The taxpayer and the IRS Appeals Officer did not resolve the worker classification dispute, and the IRS subsequently sent an NWDC to the taxpayer by certified mail that the Postal Service was unable to deliver and returned to the IRS. Because the taxpayer was unaware of the NWDC, the taxpayer did not petition the Tax Court for redetermination of the worker classification dispute, and the IRS subsequently assessed the employment taxes and initiated collection activity by issuing a notice of levy.

Upon receiving the notice of levy, the taxpayer timely requested a collection due process (CDP) hearing before IRS Appeals. Although CDP hearings are conducted under the direction of IRS Appeals, they are not conducted by regular IRS Appeals Officers. Rather, Settlement Officers conduct CDP hearings. Generally, Settlement Officers are promoted from the ranks of Revenue Officers working for IRS Collections. Consequently, taxpayers seeking to make substantive legal challenges to an assessment in a CDP hearing can face an uphill battle. However, a taxpayer may seek judicial review of the Settlement Officer’s determination in the Tax Court if the taxpayer timely requests the CDP hearing within 30 days of the issuance of the CDP notice.

When the Settlement Officer conducted the CDP hearing in Hampton Software, the taxpayer disputed the underlying employment tax liabilities arising from the asserted misclassification of the worker, but the Settlement Officer refused to allow the taxpayer to dispute the underlying liabilities because it had previously disputed the same liabilities in a preassessment IRS Appeals conference. Soon thereafter, the Settlement Officer issued a notice of determination permitting collection activity to continue, and the taxpayer filed a Tax Court petition seeking review of the underlying employment tax liabilities.

In its motion for summary judgment, the Commissioner asserted that the taxpayer was precluded from disputing the underlying tax liabilities in the CDP hearing because it previously had an “opportunity to dispute” the underlying tax liabilities with IRS Appeals and because the IRS had issued an NWDC to the taxpayer. The Tax Court denied the Commissioner’s motion for summary judgment on both theories. With respect to the former, the court identified that the Commissioner’s argument deviated from its own regulations. In particular, the Section 6330 regulations regarding CDP hearings draw a distinction between taxes subject to the deficiency procedures and taxes not subject to the deficiency procedures. Taxes not subject to the deficiency procedures may not be challenged in a CDP hearing if the taxpayer had an opportunity to dispute the underlying liability either before or after the assessment of the tax. Conversely, the regulations provide that taxes subject to the deficiency procedures may be challenged in a CDP hearing if the taxpayer had an opportunity for a conference with IRS Appeals prior to assessment (but not a postassessment Appeals conference), meaning that in Hampton Software Development, the preassessment conference with IRS Appeals was not a “prior opportunity” for the taxpayer to be heard so the underlying liability could be raised in the Appeals conference.

Consequently, the court found that an NDWC is generally subject to the deficiency procedures, so the taxpayer was not precluded from later challenging the underlying liability in a CDP hearing, provided it did not have “actual receipt” of the NDWC. Had the taxpayer actually received the NDWC, it would have been able to petition the Tax Court within 90 days, so it would have been barred in any subsequent CDP hearing from contesting the substantive basis for the underlying liability. Because the taxpayer did not receive the NDWC and its Appeals conference was a preassessment conference, the taxpayer was not barred from raising substantive issues in its CDP hearing. The importance of actual receipt of the notice of deficiency is underscored by the requirement that the IRS send the notice by certified or registered mail. Absent evidence that the taxpayer deliberately refused delivery of the NDWC, the taxpayer’s claim that it did not receive the NDWC was sufficient to overcome the IRS’s motion for summary judgment. The Tax Court did not remand the case to the IRS Settlement Officer for further consideration. At this time, the taxpayer’s challenge has survived the Commissioner’s motion for summary judgment and presumably the Tax Court will review and rule upon the underlying worker classification dispute.

United States and Switzerland Amend FATCA Competent Authority Agreement to Exempt Certain Accounts Maintained by Lawyers and Notaries

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March 3, 2016

The Swiss competent authority released an announcement on March 1, 2016, that a new clause was added to the U.S.-Switzerland FATCA international governmental agreement (IGA) to exclude certain accounts maintained by lawyers and notaries licensed in Switzerland for their clients from FATCA coverage. Only accounts that are held in connection with certain activities protected by law under professional confidentiality fall under the exception (generally custodial and depository accounts), as the purpose of the new clause is to ensure that Swiss law protects the confidentiality of lawyers and notaries and their clients. The accounts will also only be protected if the underlying assets are directly related to a legal matter; a list of such items is set forth in the addition to the U.S.-Switzerland FATCA agreement. If the lawyer or notary certifies in writing to the bank maintaining the account that it falls within the exception, the bank is not required to identify the clients involved with the account. This addition is permitted under Annex II of the FATCA IGA, which allows additional accounts, entities, or products to be added pursuant to an agreement between the competent authorities of each country.

The announcement also reaffirmed that negotiations on a new FATCA IGA are ongoing, as required by a Swiss federal government mandate issued October 8, 2014. The new agreement will be a Model 1 IGA, which comes with reciprocal automatic information exchange obligations between the United States and Switzerland, unlike the current Model 2 IGA. Under the new IGA, Swiss financial institutions will report to Swiss authorities on U.S. account holders rather than reporting directly to the IRS.