Impact of Tax Cuts and Jobs Act: Part III – Changes to Employee Retirement Plans

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November 3, 2017

Yesterday, the House Ways and Means Committee released the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”), a bill that, if enacted, would represent the most substantial overhaul of the U.S. tax code in decades.  We are releasing a series of posts to highlight the provisions of the Bill affecting the topics pertinent to our readers, where each post will cover a different area of importance.  In Part I of this series, we covered potential changes to employer-provided benefits, and in Part II, we addressed entertainment expenses and other fringe benefits.  In this Part III, we will discuss the Bill’s potential impact on various retirement provisions.

Loosening of Hardship Withdrawal Rules.  Currently, participants in 401(k) plans may only receive hardship withdrawals under certain circumstances, and those withdrawals are limited to the amount of the participants’ elective deferrals.  In addition, participants are prohibited from making elective deferrals to their 401(k) plan for six months following receipt of a hardship distribution.  First, Section 1503 of the Bill would eliminate the six-month prohibition on making elective deferrals after receiving a hardship distribution contained in the current Treasury Regulations.  The provision would require Treasury to revise its regulations within one year of the Bill’s date of enactment to allow participants to continue contributing to their retirement accounts without interruption. Section 1504 of the Bill would add a new subsection 401(k)(14) to the Code expand the funds eligible for hardship withdrawal by permitting participants to make such withdrawals from account earnings and from employer contributions.   This provision, as well as the requisite revised regulations, would apply to tax years beginning after 2017.

Reduction in Minimum Age for In-Service Distributions.  Participants in profit-sharing (including 401(k) plans) and stock purchase plans currently may not take an in-service distribution before age 59½, and participants in other retirement plans (including defined benefit pension plans) are generally barred from taking in-service distributions until age 62.  Section 1502 of the Bill would lower the limit for in-service distributions from plans currently subject to the age 62 limit to age 59½ limit.  This provision would apply to tax years beginning after 2017.

Extension of Time Period for Rollover of Certain Outstanding Plan Loan.  Currently, under Code section 402(c)(3), a participant whose plan or employment terminates while he or she has an outstanding plan loan balance must contribute the loan balance to an individual retirement account (IRA) within 60 days of the termination, otherwise the loan is treated as an impermissible early withdrawal and is subject to a 10% penalty.  Section 1505 of the Bill would add a new subsection 402(c)(3)(C) to the Code to relax these rules by giving such employees until the due date for their individual tax return to contribute the outstanding loan balance to an IRA.  The 10% penalty would only apply after that date.  This provision would apply to tax years beginning after 2017.

Changes to Taxation of Non-qualified Deferred Compensation.  Currently, non-qualified deferred compensation that is subject to a substantial risk of forfeiture is not included in an employee’s income until the year received, and the employer’s deduction is postponed until that date.  By repealing Code section 409A and introducing a new section 409B, Section 3901 of the Bill would significantly restrict the conditions that qualify as a substantial risk of forfeiture, such that non-qualified deferred compensation would become taxable immediately unless it is subject to future performance of substantial services.  This provision would simplify the taxation of non-qualified deferred compensation to align it with the FICA tax timing rules that already applied under Code section 3121(v)(2).  This provision would be effective for amounts attributable to services performed after 2017, though the current rules would apply to existing non-qualified deferred compensation arrangements beginning with the last tax year before 2026.  Notably, the change is substantially identical to one introduced by former Ways & Means Chairman Camp in the past.  It is unclear how the provision in the Bill would apply to some forms of equity-based compensation, such as stock options, which the Bill includes within the definition of non-qualified deferred compensation.  If enacted, the change is likely to trigger a substantial reduction in the use of non-qualified deferred compensation because the resulting accelerated taxation would erode one of the primary purposes of deferring compensation.  Note: This provision was eliminated by the second amendment adopted by the Ways & Means Committee (discussed here).

Impact of Tax Cuts and Jobs Act: Part I – Exclusions for Certain Employer-Provided Benefits

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November 2, 2017

Today, the House Ways and Means Committee released the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”), a bill that, if enacted, would represent the most substantial overhaul of the U.S. tax code in decades.  We will release a series of posts to highlight the provisions of the Bill affecting the topics pertinent to our readers, where each post will cover a different area of importance.  In the first of this series of posts, we will discuss the Bill’s potential impact on the exclusions for several popular employer-provided benefits.

Limitation on Exclusion for Employer-Provided Meals and Lodging. Under Code section 119 as currently written, the value of employer-provided housing is excludable from an employee’s gross income and is not considered to be wages for purposes of employer withholding.  Section 1401 of the Bill would add a new subsection (e) to Code section 119 to limit the income exclusion for employer-provided housing to $50,000 ($25,000 for a married individual filing a joint return), and that amount would phase out for highly compensated individuals.  Presumably, this change would obligate employers to report the fair market value of employer-provided housing on an employee’s Form W-2 even if excludable under Code section 119, and the employee would take the exclusion on his or her individual income tax return.  In addition, the exclusion would be limited to a single residence for all employees, and the exclusion would be altogether eliminated for 5 percent owners of the employer.

Elimination of Exclusion for Dependent Care Assistance Programs. Under Code section 129, the value of employer-provided dependent care assistance programs (“DCAP”) is generally excluded from an employee’s income and wages up to $5,000 per year.  Employees typically take advantage of this exclusion through a dependent care flexible spending account that is part of a cafeteria plan under Code section 125.  Section 1404 of the Bill would repeal this exclusion in its entirety. Note: This provision was eliminated from the bill by an amendment adopted by the Ways and Means Committee (discussed here).

Educational Assistance Programs and Qualified Tuition Reductions. Two benefits primarily focused on assisting employees with educational expenses would be eliminated by the Bill.  First, under Code section 127, amounts paid to or on behalf of an employee under a qualified educational assistance program are excluded from an employee’s income and wages up to $5,250 per year.  Section 1204 of the Bill would repeal this exclusion in its entirety.  Second, the exclusion from income and wages for qualified tuition reductions provided by educational institutions would also be repealed by Section 1204.  Though this change would affect fewer employers, it would eliminate an often-significant benefit for employees who work for educational institutions, as they would be taxed on the full amount of tuition waived for them or their spouses or dependents to attend the educational institution.

Elimination of Exclusion for Adoption Assistance Programs. Currently, Code section 137 provides an exclusion from an employee’s income and wages for amounts provided by an employer to an employee for amounts paid or expenses incurred for the adoption of a child up a certain amount that is indexed for inflation ($13,570 in 2017).  Section 1406 of the Bill would repeal the exclusion.

Elimination of Exclusion for Employer-Paid Moving Expenses. Code section 132(a)(6) provides an exclusion from income and wages for a qualified moving expense reimbursement, which is an employer-provided benefit capped at the amount deductible by the individual if he or she directly paid or incurred the cost.  Section 1405 of the Bill would repeal this exclusion.

Exclusion for Employee Achievement Awards. Code section 74(c) excludes the value of certain employee achievement awards given in recognition of an employee’s length of service or safety achievement from the employee’s income. Section 274(j) limits an employer’s deduction for employee achievement awards for any employee in any year to $1,600 for qualified plan awards and $400 otherwise. A qualified plan award is an employee achievement award that is part of an established written program of the employer, which does not discriminate in favor of highly compensated employees, and under which the average award (not counting those of nominal value) does not exceed $400.  The exclusion under Code section 74(c) is limited to the amount that the employer is permitted to deduct for the award.  Section 1403 of the Bill would repeal this exclusion and the corresponding deduction limitation.

All of these changes would be effective for tax years beginning after 2017.  In addition to the employer-provided benefits discussed in this post, the Bill would affect a number of other topics covered by this Blog, so stay tuned for Part II in the series.

Graham-Cassidy Bill Eliminates Premium Tax Credit But Retains ACA Information Reporting Requirements

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September 21, 2017

With the September 30 budget reconciliation deadline looming, Senate Republican leaders recently released the Graham-Cassidy proposal, which would repeal and replace the Affordable Care Act, but retain most of its information reporting requirements.  A departure from previous GOP proposals (see discussions here and here), the Graham-Cassidy proposal would completely eliminate federal premium tax credits by January 2020, and not provide any other health insurance tax credits.  The legislation would instead put in place a system of block grants to the states which states could use to increase health coverage, but would not be required to use for that purpose.  The proposal would also zero out penalties for the individual and employer mandates beginning in 2016.

The information reporting rules under Code sections 6055 and 6056 would be retained under the proposal, but it is unclear what purpose the Form 1095-B would serve after 2019 when there is no penalty for failing to comply with the individual mandate and no premium tax credit or other health insurance tax credit.  The bill likely does not repeal the provisions because of limitations on the budget reconciliation process, which requires that changes have a budgetary impact.  The proposal would also keep in place the 3.8% net investment income tax, as well as the 0.9% additional Medicare tax on wages above a certain threshold that varies based on filing status and that employers are required to withhold and remit when paying wages to an employee over $250,000.

The Senate has until the end of this month to pass a bill with 51 Senate votes under the budget reconciliation process, before rules preventing a Democratic filibuster expire.  A vote is expected next week.

Tax Relief for Leave-Based Donation Programs and Qualified Plan Distribution Extended to Hurricane Irma Victims

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September 18, 2017

The IRS recently announced favorable tax relief for “leave-based donation programs” designed to aid victims of Hurricane Irma, as well as easier access to funds in qualified retirement plans for these victims.  These forms of relief were provided to victims of Hurricane Harvey last month (see prior coverage), and as expected, were promptly extended to victims of Hurricane Irma.

Specifically, under Notice 2017-52, employees may forgo paid vacation, sick, or personal leave in exchange for cash donation the employer makes, before January 1, 2019, to charitable organization providing relief for the Hurricane Irma victims.  The IRS will not treat the donated leave as income or wages to the employee, and will permit employers to deduct the donations as business expenses.  Similarly, in Announcement 2017-13, the IRS extended to employees affected by Hurricane Irma the relaxed distribution rules announced following Hurricane Harvey for plan loans and hardship distributions from qualified retirement plans.  The relief generally permits plan sponsors to adopt amendments permitting plan loans and hardship withdrawals later than would otherwise be required to provide such options, waives the six-month suspension of contributions for hardship withdrawals, and allows the disbursement of hardship withdrawals and plan loans before certain procedural requirements are satisfied.

As we discussed with respect to Hurricane Harvey, employers looking to provide further relief to their employees have other long-standing options, as well.  For example, Notice 2006-59 provides favorable tax treatment similar to that provided under Notice 2017-52 for “leave-sharing plans” that permit employees to deposit leave in an employer-sponsored leave bank for use by other employees who have been harmed by a major disaster.  Additionally, section 139 permits individuals to exclude from gross income and wages any “qualified disaster relief payment” for reasonable and necessary personal, family, living, or funeral expenses, among others; and the payments may be made through company-sponsored private foundations (see our recent Client Alert on section 139 disaster relief payments).

Hurricane Harvey Prompts IRS to Provide Tax Relief for Leave-Based Donation Programs

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September 7, 2017

The IRS recently released Notice 2017-48, providing favorable tax relief for “leave-based donation programs” designed to aid victims of Hurricane Harvey.  Under these programs, employees may elect to forgo vacation, sick, or personal leave in exchange for payments that the employer makes to charitable organizations described under section 170(c).  Under this notice, payments employees elect to forgo do not constitute income or wages of the employees for federal income and employment tax purposes if the employer makes the payments, before January 1, 2019, to charitable organizations for the relief of victims of Hurricane Harvey.  The IRS will not assert that an opportunity to make this election results in employees’ constructive receipt of the payments.  Thus, the employer would not need to include the payments in Box 1, 3 (if applicable), or 5 of the Forms W-2 for employees electing to forgo their vacation, sick, or personal leave.

With respect to employer deductions, the IRS will not assert that an employer is permitted to deduct these cash payments exclusively under the rules of section 170, applicable to deductions for charitable contributions, rather than the rules of section 162.  Accordingly, the deduction will not be limited by the percentage limitation under section 170(b)(2)(A) or subject to the procedural requirements of section 170(a).  Thus, payments made to charitable organizations pursuant to leave-based donation programs are deductible to the extent the payments would be deductible under section 162 if paid to the employees (i.e., the payments would have constituted reasonable compensation and met certain other requirements).

The requirements of Notice 2017-48 are straightforward, but if an employer fails to comply, the general tax doctrines of assignment of income and constructive receipt would apply.  Under these doctrines, if an employee can choose between receiving compensation or assigning the right to that compensation to someone else, the employee has constructive receipt of the compensation even though he or she never actually receives it.  (These concepts also create difficulties for paid-time off programs under which employees can choose to use PTO or receive cash.)  Thus, without special tax relief, an employee who assigns the right to compensation to a charitable organization would be taxed on that compensation, and the employer would have corresponding income and employment tax withholding and reporting obligations.  Although the employee would be entitled to take an itemized deduction for charitable contributions in that amount, this below-the-line deduction only affects income taxes (and not FICA taxes), and would not fully offset the amount of the income for non-itemizers who claim the standard deduction ($6,300 for single filers in 2016).

The devastation caused by Hurricane Harvey and the impending threat of Hurricane Irma, which is currently affecting islands in the Eastern Caribbean islands, have renewed interest in favorable charitable contribution tax rules that extend beyond the parameters of section 170.  Apart from Notice 2017-48, the IRS has also previously provided certain special tax treatment for disaster relief payments employers provide to their employees.  On August 30, the IRS provided for easier access to funds in qualified retirement plans in IRS Announcement 2017-11.  The rules generally permit plan sponsors to adopt amendments permitting plan loans and hardship withdrawals later than would otherwise be required to provide such options, waive the six-month suspension of contributions for hardship withdrawals, and allow the disbursement of hardship withdrawals and plan loans before certain procedural requirements are satisfied.  Although the relief provided in Announcement 2017-11 applies only to those affected by Hurricane Harvey (and Notice 2017-48 applies only to charitable contributions designed to aid such individuals), it is likely the IRS will provide similar relief to those affected by Hurricane Irma if it makes landfall in the United States, as appears likely at this time.

Employers looking to provide further relief to their employees have other long-standing options, as well.  For example, Notice 2006-59 provides favorable tax treatment similar to that provided under Notice 2017-48 for “leave-sharing plans” that permits employees to deposit leave in an employer-sponsored leave bank for use by other employees who have been harmed by a major disaster.  Additionally, section 139 permits individuals to exclude from gross income and wages any “qualified disaster relief payment” for reasonable and necessary personal, family, living, or funeral expenses, among others; and the payments may be made through company-sponsored private foundations (see our recent Client Alert on section 139 disaster relief payments).

Version III of Senate GOP Health Care Bill Retains Same Health Coverage Reporting Rules

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July 20, 2017

Senate Republicans have just released another update to the Better Care Reconciliation Act, which would repeal and replace the Affordable Care Act.  This updated bill preserves the same health coverage reporting rules under the prior version that was released a week ago on July 13 (discussed here).  Senate Republican leader Mitch McConnell stated that he expects a vote early next week on a motion to start the debate on either a repeal-and-replace bill or a standalone ACA-repeal bill.

Updated Senate GOP Health Care Bill Retains Additional Medicare Tax and Most Health Coverage Reporting Rules

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July 13, 2017

This morning, Senate Republican leaders released an updated Better Care Reconciliation Act that would largely retain the existing health coverage reporting regime enacted as part of the Affordable Care Act (ACA). In contrast to the prior Senate bill (see prior coverage), the updated bill would keep in place the 3.8% net investment income tax, as well as the 0.9% additional Medicare tax, which employers are required to withhold and remit when paying wages to an employee over a certain threshold (e.g., $200,000 for single filers and $250,000 for joint filers). The updated bill is otherwise similar to the prior bill from a health reporting standpoint, as it would keep the current premium tax credit (with new restrictions effective in 2020) and retain the information reporting rules under Code sections 6055 and 6056. (The House bill passed on May 4, 2017 (discussed here and here), by contrast, would introduce an age-based health insurance coverage credit along with new information reporting requirements.) The updated bill would also zero out penalties for the individual and employer mandates beginning in 2016.

In addition to the ACA repeal-and-replace efforts in the Senate bill, the House Committee on Appropriations included in its appropriation bill a provision that would stop the IRS from using its funding to enforce the individual mandate or the related information reporting rule under Code section 6055 for minimum essential coverage (on Form 1095-B or 1095-C). This provision would be effective on October 1 this year. Apart from significantly cutting IRS funding, however, the appropriation bill would not otherwise affect IRS enforcement of information reporting by applicable large employers regarding employer-provided health insurance coverage. Thus, even if both the Senate health care bill and the House appropriation bill were to become law as currently proposed, applicable large employers would still be required to file Forms 1094-C and 1095-C pursuant to Code section 6056 in the coming years.

Late Form W-2s Doubled, Penalties to Come

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July 12, 2017

The earlier filing deadline on January 31 for Forms W-2 resulted in more than double the number of late-filed returns, according to Tim McGarvey, Social Security Administration branch chief, who was speaking on an IRS payroll industry conference call.  He said that, to date, the SSA has received close to 50,000 late Form W-2 submissions, compared to an average of 25,000 late submissions annually in the past few years.  In response to an inquiry from the Tax Withholding & Reporting Blog, Mr. McGarvey indicated that the 50,000 submissions represent approximately 4 million late-filed 2016 Forms W-2.

In addition to the jump in the number of late-filed returns, Mr. McGarvey said that the number of Forms W-2c filed has also increased dramatically—up 30 percent from last year.  In response to an inquiry, Mr. McGarvey reported that the SSA has received approximately 2.7 million Forms W-2c in 2017, with some 2.2 million of those correcting 2016 returns.  That compares to a total of approximately 2 million Forms W-2c processed in 2015.

The January 31 deadline for filing and furnishing recipients with the Form W-2 and a Form 1099-MISC that reports nonemployee compensation (Box 7) became required under the Protecting Americans from Tax Hikes (PATH) Act to combat identity theft and fraudulent claims for refund (see prior coverage).

Late filers and those that struggled to provide accurate filings by the January 31 deadline should take steps now to prepare for the 2017 filing season.  Employers who provide taxable non-cash fringe benefits (such as the personal use of company cars) may want to consider imputing income for those benefits using the special accounting rule and flexibility in Announcement 85-113, if they are not already doing so.  Announcement 85-113 permits employers to treat non-cash fringe benefits as received on certain dates throughout the year (such as on the first of each month, each quarter, semi-annually, or annually).  It also allows employers to treat the value of non-cash fringe benefits actually received in the last two months of the calendar year as received in the following calendar year.  Making use of these rules can ease the year-end payroll crunch.  The earlier employers can provide copies of Forms W-2 to employees, the greater the chance there is for employees to identify errors and request corrections before the January 31 filing deadline.

Mobile Workforce Bill Passes House Again, Senate Fate Uncertain

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July 7, 2017

On June 20, 2017, the House of Representatives passed legislation to simplify state income tax rules for employees who temporarily work outside their home state.  Under the Mobile Workforce State Income Tax Simplification Act of 2017 (H.R. 1393), a state generally could tax a nonresident’s wages earned in the state only if he or she is working in the state for more than 30 days during the year.  Likewise, employers would have no corresponding duty to withhold and report the tax unless the 30-workday threshold is met.  Propelled by bipartisan support, similar measures have twice passed in the House in 2012 and 2015 but failed to gain traction in the Senate.  Currently, legislation similar to the House bill is awaiting Senate consideration, and once again, faces an uphill battle amidst concerns that the bill would cause significant revenue losses to certain states—including New York—with large employment centers close to state borders.

The bill is intended to reduce confusion and compliance costs stemming from inconsistent state income tax laws on nonresident employees and their employers.  Currently, forty-three states impose personal income tax on wages, including nonresidents’ wages earned in the state.  Thus, a traveling employee working on temporary projects in multiple states may be obligated to file and pay taxes in each of those states, and the employer would have corresponding withholding and reporting obligations.  Although states have three main measures that reduce compliance costs, the measures are largely piecemeal and inconsistent.  First, states generally provide an income tax credit for income taxes paid to other states, but the credit system does not eliminate the travelling employee’s obligation to file a nonresident return and the employer’s obligation to withhold and report the tax.  Second, some states waive the income tax obligations of nonresident employees and employers based on de minimis earnings and/or time spent in the state, but the waiver thresholds vary, and not all states have them.  Third, some bordering states have entered into reciprocity agreements under which each state agrees not to tax each other’s residents’ wages (see prior coverage of NY-NJ reciprocity agreement).  But these agreements only cover one-third of the states, and are geared toward regular commuters living near state borders, rather than employees traveling to multiple states for temporary work.

The bill would impose a 30-workday threshold on state income taxation of nonresidents, but would not prevent states from adopting higher or other types of thresholds.  Reciprocity agreements of bordering states, for instance, would still be effective.  Moreover, the bill allows an employer to avoid withholding and reporting penalties if they simply rely on their employees’ annual determination of days to be spent working in the nonresident state (barring actual knowledge of fraud, collusion, or use of a daily time and attendance system).  The bill also defines what constitutes a workday to minimize double counting.  The bill would not cover the wages of professional athletes, professional entertainers, certain production employees, and prominent public figures paid on a per-event basis.  Additionally, the bill does not specifically address equity or trailing compensation and employees who work for more than one related employer.

The bill likely faces an uphill battle in the Senate because the bill would cause significant revenue losses to certain states.  Generally, states that have large employment centers close to a state border (e.g., Illinois, Massachusetts, California, and New York) would lose the most revenue, while their neighboring states (e.g., New Jersey) from which employees travel would gain revenue.  Notably, New York would likely lose between $55 million and $120 million per year—an amount greater than the estimated revenue impact on all the other states combined (a $55 million to $100 million loss).  For these reasons, three members of the House Committee on the Judiciary opposed the bill and proposed to replace the 30-workday threshold with a 14‑workday threshold.  This is, not coincidentally, the threshold New York currently has in place for employer withholding obligations (but not for employee income tax liability or employer reporting obligations).  Although rejected, the effort to reduce the threshold may ultimately reshape the bill in the Senate or signal its continued lack of action.

With the Senate preoccupied with other legislative matters such as health reform (see prior coverage of health insurance reporting under the American Health Care Act) and opposition from some powerful Senators, it is unclear whether the Senate will consider the mobile workforce bill despite bipartisan interest.  In the meantime, employers with employees temporarily working in multiple states must continue to meet their nonresident state income tax withholding and reporting obligations.  We will continue to monitor further developments on the mobile workforce bill and its impact on state income tax filing, withholding, and reporting rules.

Tax Court Expands Section 119 Exclusion in Boston Bruins Decision

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June 27, 2017

In a much anticipated decision, the U.S. Tax Court ruled yesterday that “the business premises of the employer” can include an off-premises facility leased by the employer when its employees are on the road.  The decision in Jacobs v. Commissioner addressed whether the employer (in this case, the professional hockey team, the Boston Bruins) was entitled to a full deduction for the meals provided to the team and staff while on the road for away games.  The debate arose after the IRS challenged the full deduction and asserted that the employer should have applied the 50% deduction disallowance applicable to meals by section 274(n) of the Code.

Under section 162 of the Code, an employer may deduct all ordinary and necessary business expenses.  However, in recognition that the cost of meals is inherently personal, the Code limits the deductions for most business meal expenses to 50% of the actual expense under section 274(n), subject to certain exceptions.  The exception at issue in Jacobs allows an employer to deduct the full cost of meals that qualify as de minimis fringe benefits under section 132(e) of the Code.  In general, this includes occasional group meals, but would not typically include frequently scheduled meals for employees travelling away from home.  (For this purpose, home is the employee’s tax home, which is typically the general area around the employee’s principal place of employment.)  However, under Treasury Regulation § 1.132-7, an employer-operated eating facility may qualify as a de minimis fringe benefit if, on an annual basis, the revenue from the facility is at least as much as the direct operating cost of the facility.  In other words, an employer may subsidize the cost of food provided in a company cafeteria, provided the cafeteria covers its own direct costs on an annual basis and meets other criteria (owned or leased by the employer, operated by the employer, located on or near the business premises of the employer, and provides meals immediately before, during, or immediately after an employee’s workday).

The Bruins’ owners argued that they were entitled to a full deduction because the banquet rooms in which employees were provided free meals qualified as an employer-operated eating facility.  That may leave some of our readers wondering, “How can a facility that is free have revenue that covers its direct operating cost?”  The key to answering that question lies in the magic found in the interface of sections 132(e)(2)(B) and section 119(b)(4) of the Code.  Under section 132(e)(2)(B), an employee is deemed to have paid an amount for the meal equal to the direct operating cost attributable to the meal if the value of the meal is excludable from the employee’s income under section 119 (meals furnished for the “convenience of the employer”) for purposes of determining whether an employer-operated eating facility covers its direct operating cost.  In turn, section 119(b)(4) provides that if more than half of the employees who are furnished meals for the convenience of the employer, all of the employees are treated as having been provided for the convenience of the employer.  Working together, if more than half the employees are provided meals for the convenience of the employer at an employer-operated eating facility, the employer may treat the eating facility as a de minimis fringe benefit, and deduct the full cost of such facility.

The IRS objected to the owners’ treatment of the banquet rooms as their employer-operated eating facilities and disallowed 50% of the meal costs.  The Tax Court succinctly explained that the Bruins’ banquet contracts constituted a lease of the rooms provided for meals and that the contracts also meant that the Bruins operated the facilities under Treasury Regulation § 1.132-7(a)(3).  In doing so, the Tax Court summarily dismissed the IRS’s argument that the payment of sales taxes meant that the contracts were not contracts for the operation of an eating facility but instead the purchase of meals served in a private setting.

Having determined that the first two criteria were satisfied, the Tax Court turned to the question of whether the hotel banquet rooms constituted the “business premises of the employer.”  The court looked to a series of cases indicating that the question was one of function rather than space.  Relying on those cases, the court determined that the hotels were the business premises of the employer because the team’s employees conducted substantial business activities there.   The court seemed to put significant weight on the fact that the team was required to participate in away games, necessitating it travel and operation of its business away from Boston.  The Tax Court was unpersuaded by the IRS’s quantitative argument that the team spent more time working at its facility in Boston than at any individual hotel and its qualitative argument that the playing of the away game was more important than the preparation for the game that took place at the hotel.

Having determined that the hotel banquet rooms were an employer-operated eating facility, the Tax Court next addressed whether it qualified as a de minimis fringe benefit because more than half of the employees who were furnished meals in the banquet rooms were able to exclude the value of such meals from income under section 119 of the Code.  The court determined that this requirement was satisfied because the meals were provided to the team and staff for substantial noncompensatory business reasons.  The business reasons included: ensuring the employees’ nutritional needs were met so that they could perform at peak levels; ensuring that consistent meals were provided to avoid gastric issues during the game; and the limited time to prepare for a game in each city given the “hectic” hockey season schedule.  Relying on the Ninth Circuit’s decision in Boyd Gaming v. Commissioner from the late 1990s, the court declined, once again, to second guess the team’s business judgment by substituting the government’s own determination.

Although the decision focuses on the specific facts and the exigencies of a traveling hockey team, the decision is of interest for other taxpayers as well.  This is especially true given the IRS’s recent increased interest in both meal deductions and the imposition of payroll tax liabilities with respect to free or discounted meals provided to employees, particularly in company cafeteria settings.  The decision expands the scope of the section 119 exclusion to meals further than the IRS’s current limited view that it applies only to remote work sites, such as oil rigs, schooners,  and camps in Alaska.   To date, the most expansive application of the exclusion in the company cafeteria setting occurred in Boyd Gaming, where a casino successfully established that its policy requiring employees to eat lunch on-site was based on security concerns and the attendant screening procedures made it necessary to provide employees with meals during their shifts.

Jacobs seems to take the analysis one step further, because many of the business reasons for providing meals to Bruins employees could be echoed by other taxpayers.  No doubt, all employers are concerned with the performance of their employees.  To that end, it could be argued that ensuring that they eat well-balanced nutritionally appropriate meals can increase performance even if the employer is more concerned with brains rather than brawn.  Indeed, given the large health insurance costs borne by many employers, employers have a legitimate interest in providing healthy meals that may reduce the incidence of obesity, diabetes, heart disease, and other chronic ailments that raise their costs.  Moreover, many employees have hectic schedules during the work day with frequent appointments, meetings, and other activities that make it necessary to maximize the time available for work during the day.   Given the Tax Court’s implicit admonition of the IRS’s attempt to substitute its own judgment regarding the employer’s business reasoning in Jacobs and the court’s refusal to substitutes its own judgment as well, the IRS likely has a more difficult road ahead if it attempts to challenge the purported business reasons that an employer provides for furnishing meals to its employees.  It remains to be seen how the IRS will react to the decision and whether it will appeal the case, which seems likely.  For now, however, the case is a positive development for employers who have made a business decision to provide meals on a free or discounted basis to their employees to increase productivity and improve their health.

IRS Approves First Group of Certified PEOs under Voluntary Certification Program

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June 5, 2017

Last week, the IRS announced that it issued notices of certification to 84 organizations that applied for voluntary certification as a certified professional employer organization (CPEO), nearly a year after the IRS finished implementing this program (see prior coverage).  The IRS will publish the CPEO’s name, address, and effective date of certification, once it has received the surety bond.  Applicants that have yet to receive a notice of certification will receive a decision from the IRS in the coming weeks and months.

Congress enacted Code sections 3511 and 7705 in late 2014 to establish a voluntary certification program for professional employer organizations (PEOs), which generally provide employers (customers) with payroll and employment services.  Unlike a PEO, a CPEO is treated as the employer of any individual performing services for a customer with respect to wages and other compensation paid to the individual by the CPEO.  Thus, a CPEO is solely responsible for its customers’ payroll tax—i.e., FICA, FUTA, and RRTA taxes, and Federal income tax withholding—liabilities, and is a “successor employer” who may tack onto the wages it pays to the employees to those already paid by the customers earlier in the year.  The customers remain eligible for certain wage-related credits as if they were still the common law employers of the employees.  To become and remain certified, CPEOs must meet certain tax compliance, background, experience, business location, financial reporting, bonding, and other requirements.

The impact of the CPEO program outside the payroll-tax world has been limited thus far.  For instance, certification does not provide greater flexibility for PEO sponsorship of qualified employee benefit plans.  In the employer-provided health insurance context, the certification program leaves unresolved issues for how PEOs and their customers comply with the Affordable Care Act’s employer mandate (see prior coverage).  While the ACA’s employer mandate may become effectively repealed should the Senate pass the new American Health Care Act (AHCA) after the House of Representatives did so last month (see prior coverage here and here), the AHCA would impose its own information reporting requirements on employers with respect to offers of healthcare coverage or lack of eligible healthcare coverage for their employees.  It remains to be seen if the AHCA becomes law, what information reporting requirements will remain, and how PEOs and CPEOs can alleviate these obligations for their customers.

Information Reporting Provisions of AHCA Unchanged from Earlier Bill

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May 5, 2017

Yesterday, the House of Representatives narrowly passed the American Health Care Act (AHCA) on a near party-line vote, 217-213.  The legislation would repeal many provisions of the Affordable Care Act (ACA) but would retain and expand many of the ACA’s information reporting requirements.  After the House failed to pass the AHCA in late March, Republicans have worked to secure additional support for the legislation.

Although Republicans made changes to the legislation to enable it to pass the House, those changes do not substantively effect the information reporting provisions, including the new health insurance coverage credit reporting under section 6050X beginning in 2020, Form W-2 reporting of employer offers of coverage beginning in 2020, and the additional reporting required by providers of minimal essential coverage under Code section 6055.  (See earlier coverage here.)

The legislation faces an uncertain future in the Senate, where budget reconciliation rules and tepid support from some Republicans may make it difficult to secure passage.

IRS Provides Interim Guidance for Claiming Payroll Tax Credit for Research Activities

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April 19, 2017

The Treasury and the IRS recently released Notice 2017-23 providing interim guidance related to  the payroll tax credit for research expenditures by qualified small businesses under Code § 3111(f).  (See prior coverage.)  Specifically, the notice provides interim guidance on the time and manner of making the payroll tax credit election and claiming the credit, and on the definitions of “qualified small business” and “gross receipts.”  Comments are requested by July 17, 2017.

Code § 41(a) provides a research tax credit against federal income taxes.  Effective for tax years beginning after December 31, 2015, Code §§ 41(h) and 3111(f) allow a “qualified small business” to elect to apply a portion of the § 41(a) research credit against the employer portion of the social security tax under the Federal Insurance Contributions Act.  Generally, a corporation, partnership, or individual is a qualified small business if its “gross receipts” are less than $5 million and the entity did not have gross receipts more than 5 years ago.  The election must be made on or before the due date of the tax return for the taxable year (e.g., Form 1065 for a partnership, or Form 1120-S for an S corporation).  The amount elected shall not exceed $250,000, and each quarter, the amount that the employer may claim is capped by the employer portion of the social security tax imposed for that calendar quarter.

The notice provides that, to make a payroll tax credit election, a qualified small business must attach a completed Form 6765 to its timely filed (including extensions) return for the taxable year to which the election applies.  The notice provides interim relief for qualified small businesses that timely filed returns for taxable years on or after December 31, 2015, but failed to make the payroll tax credit election.  In this case, the entity may make the election on an amended return filed on or before December 31, 2017.  To do so, the business must either: (1) indicate on the top of its Form 6765 that the form is “FILED PURSUANT TO NOTICE 2017-23”; or (2) attach a statement to this effect to the Form 6765.

A qualified small business can claim the payroll tax credit on its Form 941 for the first calendar quarter beginning after it makes the election by filing the Form 6765.  Similarly, if the qualified small business files annual employment tax returns, it may claim the credit for the return that includes the first quarter beginning after the date on which the business files the election.  A qualified small business claiming the credit must attach a completed Form 8974 to the employment tax return.  On the Form 8974, the taxpayer filing the employment tax return claiming the credit provides the Employer Identification Number (EIN) used on the Form 6765.

For qualified small businesses filing quarterly employment tax returns, they must use the Form 8974 to apply the social security tax limit to the amount of the payroll tax credit it elected on Form 6765 and to determine the amount of the credit allowed on its quarterly employment tax return.  If the payroll tax credit elected exceeds the employer portion of the social security tax for that quarter, then the excess determined on the Form 8974 is carried over to the succeeding calendar quarter(s), subject to applicable social security tax limitation(s).

The notice also provides guidance for purposes of defining a “qualified small business.”  Specifically, the notice provides that the term “gross receipts” is determined under Code § 448(c)(3) (without regard to Code § 448(c)(3)(A)) and Treas. Reg. § 1.448-1T(f)(2)(iii) and (iv)), rather than Code § 41(c)(7) and Treas. Reg. § 1.41-3(c).  Therefore, gross receipts for purposes of the notice do not, as Treas. Reg. § 1.41- 3(c) does, exclude amounts representing returns or allowances, receipts from the sale or exchange of capital assets under Code § 1221, repayments of loans or similar instruments, returns from a sale or exchange not in the ordinary course of business, and certain other amounts.

IRS Guidance on Reporting W-2/SSN Data Breaches

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April 6, 2017

The IRS recently laid out reporting procedures for employers and payroll service providers that have fallen victim to various Form W-2 phishing scams.  In many of these scams, the perpetrator poses as an executive in the company and requests Form W-2 and Social Security Number (SSN) information from an employee in the company’s payroll or human resources departments (see prior coverage).  If successful, the perpetrator will immediately try to monetize the stolen information by filing fraudulent tax returns claiming a refund, selling the information on the black market, or using the names and SSNs to commit other crimes.  Thus, time is of the essence when responding to these data breaches.

According to the IRS’s instructions, an employer or payroll service provider that suffers a Form W-2 data loss should immediately notify the following parties:

  1. IRS. The entity should email dataloss@irs.gov, with “W2 Data Loss” in the subject line, and provide the following information: (a) business name; (b) business employer identification number (EIN) associated with the data loss; (c) contact name; (d) contact phone number; (e) summary of how the data loss occurred; and (f) volume of employees impacted.  This notification should not include any employee personally identifiable information data.  Moreover, the IRS does not initiate contact with taxpayers by email, text messages, or social media channels to request personal or financial information.  Thus, these types of requests should not be taken as IRS requests.
  2. State tax agencies. Since any data loss could affect the victim’s tax accounts with the states, the affected entity should email the Federal Tax Administrators at StateAlert@taxadmin.org for information on how to report the victim’s information to the applicable states.
  3. Other law enforcement officials. The entity should file a complaint with the FBI’s Internet Crime Complaint Center (IC3), and may be asked to file a report with their local law enforcement agency.
  4. Employees. The entity should ask its employees to review the IRS’s Taxpayer Guide to Identity Theft and IRS Publication 5027 (Identity Theft Information for Taxpayers).  The Federal Trade Commission (FTC) suggests that victims of identity theft take various immediately actions, including: (a) filing a complaint with the FTC at identitytheft.gov; (b) contacting one of the three major credit bureaus to place a “fraud alert” on the victim’s credit card records; and (c) closing any financial or credit accounts opened by identity thieves.

The IRS has also established technical reporting requirements for employers and payroll service providers that only received the phishing email without falling victim.  Tax professionals who experience a data loss also should promptly report the loss pursuant to the IRS’s procedures.

Poor Design and Poor Defense Sink Employee Discount Plan

A recent IRS Field Attorney Advice (FAA) memorandum highlights the risk of poorly designed employee discount plans.  In FAA 20171202F, the IRS Office of Chief Counsel determined that an employer was liable for failing to pay and withhold employment taxes on employee discounts provided under an employee discount plan that failed to satisfy the requirements for qualified employee discounts under Code section 132(c).  The FAA also suggests that had the employer either kept or provided better records of the prices at which it provided services to select groups of customers, the result may have been different.  In the FAA, the IRS applied the fringe benefit exclusion for qualified employee discounts to an employer whose business information was largely redacted.  Under the employee discount program considered, an employee and a set number of participants designated by each employee (including the employee’s family members and friends) were eligible for discounts on certain services provided by the employer.  The Treasury Regulations under section 132(c) permit employers to offer employees and their spouses and dependent children non-taxable discounts of 20 percent on services sold to customers.

The employer argued that, although the discounts provided under the program exceeded the 20 percent limit applicable to discounted services when compared to published rates, they were in most cases less than the discount rates the employer offered to its corporate customers and members of certain programs.   The Treasury Regulations provide that an employee discount is measured against the price at which goods or services are sold to the employer’s customers.  However, if a company sells a significant portion of its goods or services at a discount to discrete customers or consumer groups—at least 35 percent—the discounted price is used to determine the amount of the employee discount.  Despite the employer’s argument that the determination of the amount of the employee discounts should not be based on the published rates, the IRS refused to apply this special discount rule for lack of adequate substantiation.  Although the employer provided the IRS with bar graphs showing the discounts it gave to various customers, the employer did not substantiate the information on the graphs or provide the IRS with evidence showing what percentage of its total sales were made from each of the customers allegedly receiving discounted rates.  Had the employer shown that it sold at least 35 percent of its services at a discount, then at least some, if not most of the employee discounts in excess of the published rates less 20 percent, may not have been taxable.

Having determined that the discounts offered exceeded the 20 percent limit applicable to services, the IRS ruled that the employer must withhold and remit employment taxes on any employee discount to the extent it exceeded 20 percent of the published rate.  Correspondingly, the employer must report the taxable amount as additional wages on the employee’s Form W-2.  Perhaps even more costly for the employer, the IRS determined that the entire value of the discount (and not just the amount in excess of 20 percent) provided to someone designated by an employee constitutes taxable wages paid to the employee unless the person is the employee’s spouse or dependent child.  Accordingly, if an employee designates a friend under the program who uses the discount, the entire discount must be included in the employee’s wages and subjected to appropriate payroll taxation.

Offering employee discounts on property and services sold to customers can make for a valuable employee reward program, but the technical requirements to avoid tax consequences for these programs can be overlooked.  The FAA’s analysis is consistent with the regulations under Code sections 61 and 132, and should not be surprising to anyone familiar with the rules.  Given the recent interest in employee discount programs by IRS examiners conducting employment tax examinations, it would be prudent for employers to review their employee discount programs and consider whether the programs are properly designed to avoid the potentially expensive payroll tax consequences that could be triggered by discounts that do not qualify for the income exclusion under section 132(c).

Recent FAA Serves as Warning to Employers Using PEOs

A recent Internal Revenue Service Office of Chief Counsel field attorney advice memorandum (FAA 20171201F) sounds a cautionary note for employers making use of a professional employer organization (PEO).  The FAA holds a common law employer ultimately liable for employment taxes owed for workers it leased from the PEO.  Under the terms of the employer’s agreement with the PEO, the PEO was required to deposit employee withholdings with the IRS and pay the employer share of payroll taxes to the IRS.  Alas, that was not what happened.

The taxpayer did not dispute that it had the right to direct and control all aspects of the employment relationship and was thus was the common law employer with respect to the employees, but asserted that it was not liable for the unpaid employment taxes. Under the terms of the contracts between the taxpayer and the PEO, the taxpayer would pay an amount equal to the wages and salaries of the leased employees to the PEO prior to the payroll date, and the PEO would then pay all required employment taxes and file all employment tax returns (Forms 940 and 941) and information returns (Forms W-2) with respect to the employees.

After the PEO failed to pay and deposit the required taxes, the Examination Division of the IRS found the taxpayer liable for the employment tax of those workers, plus interest. The taxpayer appealed, making several arguments against its liability: (i) the PEO was liable for paying over the employment taxes under a state statute; (ii) the PEO was the statutory employer, making it liable for the employment taxes; and (iii) the workers were not employees of the taxpayer under Section 530 of the Revenue Act of 1978.

The Office of Chief Counsel first explained that the state law cited by the taxpayer was not relevant because it was superseded by the Internal Revenue Code. The FAA rejects the taxpayer’s second argument because the PEO lacked control over the payment of wages, and thus it was not a statutory employer. The PEO lacked the requisite control because the taxpayer was obligated to make payment sufficient to cover the employees’ pay before the PEO paid the workers.  Finally, the Office of Chief Counsel denied the taxpayer relief under Section 530 of the Revenue Act of 1978 because that provision only applies to questions involving employment status or worker classification, neither of which was at issue.  Although the FAA makes clear that the common law employer will be on-the-hook for the unpaid employment taxes, the FAA did indicate that it would be open to allowing an interest-free adjustment because the taxpayer’s reliance on the PEO to fulfill its employment tax obligations constituted an “error” under the interest-free adjustment rules.

The FAA serves as a reminder that the common law employer cannot easily offload its liability for employment taxes by using a contract. Indeed, it remains liable for such taxes and related penalties in the event that the party it has relied on to deposit them fails to do so timely.  Employers who choose to make use of a PEO should carefully monitor the PEO’s compliance with the payroll tax rules to ensure that it does not end up in this taxpayer’s position.  Alternatively, employers should consider whether to use a certified PEO under the new regime established by Congress (earlier coverage  available here and here).  When using a certified PEO, the common law employer can successfully shift its liability to the PEO and is not liable if the PEO fails to comply with the payroll tax requirements of the Code.

House Republicans Pull ACA Replacement Bill

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March 24, 2017

Facing likely defeat, Republicans have pulled the American Health Care Act, which would have made numerous changes to the information reporting provisions and employment tax provisions of the Affordable Care Act (ACA) (earlier coverage).   The legislation would have also created a new information reporting requirement by adding Section 6050X to the Code.  The House was scheduled to vote on the legislation this afternoon, but Republicans have struggled to appease both conservative Republicans, who wanted a more completed repeal of the ACA, and moderate Republicans, who were concerned about the potential loss of coverage that could result from the legislation. The decision to pull the bill increases the likelihood that the ACA’s information reporting regime under Sections 6055 and 6056 will remain in place, along with the additional Medicare tax and other provisions of the ACA.

Employers Likely Need to Update Their Processes Based on New Requirements for Employer Refund Claims of FICA and RRTA Taxes

On March 20, the IRS released Rev. Proc. 2017-28, providing guidance to employers on employee consents used to support a claim for credit or refund of overpaid taxes under the Federal Insurance Contributions Act (FICA) and the Railroad Retirement Tax Act (RRTA). The revenue procedure requires the employee consent to contain, among other information, the basis for the refund claim and a penalties of perjury statement. In addition, it permits employers to request, receive, and retain employee consent electronically, and clarifies the “reasonable efforts” an employer must make, if it fails to secure employee consent, to claim a refund of the employer’s share of overpaid FICA or RRTA taxes. Many of the requirements in the revenue procedure were included in a proposed revenue procedure contained in Notice 2015-15. Rev. Proc. 2017-28 also provides the circumstances under which an employee consent may use a truncated taxpayer identification number (TTIN).  Employers will need to review the new requirements and update their existing FICA refund process to ensure that process satisfies the new requirements.

Background

Treasury Regulation section 31.6402(a)-2 provides general rules for employers to claim refunds of overpaid FICA and RRTA taxes. An employer must file the refund claim on the form prescribed by the IRS (e.g., Form 941-X) and designate the return period to which the claim relates, explain the grounds and facts supporting the claim, and meet other requirements under the regulations and the form’s instructions. An employer that is granted a tax refund of FICA or RRTA taxes (including any applicable interest) must give the employee his or her share.

To protect an employee’s interests, the regulations prohibit the refund of the employer share unless the employer (a) has first repaid or reimbursed the employee, or (b) has included a claim for refund of the employee share of FICA or RRTA taxes, along with the employee’s consent. Similarly, to claim refund of the employee share, the employer must certify that the employer has repaid or reimbursed the employee share or has secured the employee’s written consent for the refund claim, except to the extent taxes were not withheld from the employee. But these requirements do not apply, and the employer may claim refund for the employer share, to the extent that either (a) the taxes were not withheld from the employee’s compensation; or (b) the employer cannot locate the employee or the employee will not provide consent after the employer has made reasonable efforts to either secure the employee’s consent or to repay or reimburse the employee.

New Rules on Requesting and Retaining Employee Consent

45-day consent period. A request for consent must give employees a reasonable period of time to respond, not less than 45 days. The request must clearly state: (a) the purpose of the employee consent; (b) that the employer will repay or reimburse the employee share (including allocable interest) to the extent refunded by the IRS; and (c) that an employee cannot authorize the employer to claim a refund on the employee’s behalf for any overpaid Additional Medicare Tax. A request for consent may include an express presumption that if an employee’s response has not been received by the employer during the specified time period, the employee will be considered as having refused to provide the employee consent. However, a failure to respond may not be deemed consent. A request for consent also may include a request that the employee keep the employer informed about any change in the employee’s mailing address or email address.

Electronic Consent. An employer may establish a system to request, furnish, and retain employee consent in an electronic format that ensures the authenticity and integrity of the electronic signature and record. Although an employer may use electronic consent, the employer must provide an employee, upon request, the option to review the consent request and to provide the consent in paper format.

Reasonable Efforts. An employer may claim a refund of the employer share of FICA and RRTA tax without obtaining employee consent only if the employer makes “reasonable efforts” to repay or reimburse the employee or secure the employee’s consent and the employer cannot locate the employee or the employee will not provide consent. The reasonable efforts rule is satisfied if an employer fulfills the following requirements.

  • Request for consent. The employer properly requests the employee’s consent.
  • Email receipt acknowledgement. Any electronic request for consent asks the employee to affirmatively acknowledge the request (e.g., by clicking on a voting button (YES) or by sending a reply message). A read-receipt message is not sufficient.
  • Record retention. The employer retains a record of sending the request for consent, including the mailing or personal delivery record, the email record (including any receipt acknowledgement), or the employee’s reply declining the request.
  • Second delivery attempt. If the employer’s initial request fails to be delivered, the employer must attempt to secure consent a second time, with a 21-day response period from the date of the second request. In particular, if a mailing is undeliverable, the employer must make a good faith attempt to determine the employee’s current address and if a new address is discovered, send the request again by mail or personal delivery. Alternatively, the employer can email the request to the employee. If an email is undeliverable (e.g., due to problems with the employee’s email address) or if the employee does not acknowledge receipt of the email, the employer must send a request in paper to the employee’s last known address by mail or personal delivery.

New Rules on Employee Consent

Required Items. Employee consents are subject to a list of requirements, two of which are noteworthy. First, the employee must identify the specific basis of the refund claim. The revenue procedure provides a detailed example: “request for refund of the social security and Medicare taxes withheld with regard to excess transit benefits provided in 2014 due to a retroactive legislative change.” It is unclear how detailed the basis provided must be to satisfy this requirement. Second, the consent must contain the employee’s signature under a penalties of perjury statement. The penalties of perjury requirement will complicate efforts to obtain employee consents and written statements as employees are often reluctant to sign documents under threat of perjury even when they are certifying true statements. This is particularly true with regard to former employees.

In addition to the two requirements described above, an employee consent must:

  • contain the employee’s name, address, and taxpayer identification number (TIN);
  • contain the employer’s name, address, and employer identification number (EIN);
  • contain the tax period(s), type of tax (e.g., social security and Medicare taxes), and the amount of tax for which the employee consent is provided;
  • state that the employee authorizes the employer to claim a refund for the overpayment of the employee share; and
  • with regard to refund claims for employee tax overcollected in prior years, include the employee’s written statement certifying that the employee has not made previous claims (or that the claims were rejected) and will not make any future claims for refund of the overcollected amount.

Use of TTIN. To address concerns regarding identity theft, the revenue procedure allows the use of a TTIN in place of the employee’s complete social security number (SSN) if the employer prepares the employee consent and prepopulates the TIN field with the TTIN. A TTIN may not be used, however, if the employer requests the SSN as the employee’s TIN or if the employee furnishes the TIN as part of the consent.

As a result of the new guidance, many employers will need to update their employee consent procedures to comply with the new rules, most of which are not specified in the Code or the implementing Treasury regulations. FICA tax overpayments frequently occur, and failure to obtain the proper employee consent, or failure to follow the procedures for requesting consent, can delay the employer’s refund claim. The new requirements apply to employee consents requested on or after June 5, 2017.

Revised House ACA Repeal Will Delay Repeal of AMT until 2023

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March 24, 2017

Last night, Republican leadership released a manager’s amendment to the American Health Care Act (AHCA) that would delay the repeal of the additional Medicare tax (AMT) of 0.9% imposed on certain high-income individuals from 2017 until 2023.  The move is an effort to shore up Republican support for the bill in advance of an expected vote late this afternoon or this evening.  The delay comes three days after an earlier manager’s amendment moved up the repeal of the AMT from 2018 to 2017, and added a transition rule related to employer withholding of the tax.  That change was also made in an effort to shore-up Republican support ahead of the House vote, which was originally expected to happen yesterday.  Our earlier analysis of the information reporting and employment tax provisions of the AHCA is available here.

42 Months Sentence Upheld For Business Owner’s Second Employment Tax Violation

A taxpayer who willfully failed to remit federal employment taxes while in the process of pleading guilty to a nearly identical crime could not escape his above-the-guidelines sentence of 42 months’ imprisonment, the D.C. Circuit recently held.  In United States v. Jackson, the taxpayer committed bankruptcy fraud in 2002 by diverting $373,000 from the company he ran to another one of his businesses, instead of remitting the federal tax withholdings from the wages of the company’s employees.  For this crime, the district court imposed five years’ probation rather than imprisonment.  But the taxpayer did not learn his lesson.  While pleading guilty to this crime and before being sentenced in 2006, the taxpayer, from 2005 through 2009, failed to pay almost $600,000 in federal employment taxes that his other business had withheld from employee wages.  He instead used this money to pay for jewelry, clothing, furniture, and rent.  Caught again, the taxpayer pleaded guilty, this time to willful failure of paying federal employment taxes in violation of Code § 7202, which carries a fine up to $10,000 and up to five years’ imprisonment.

The Department of Justice (DOJ) signed a plea agreement with the taxpayer recommending a U.S. Sentencing Guidelines range of 27 to 33 months.  This agreement was not, however, binding on the district court.  At sentencing, DOJ emphasized that the taxpayer was being sentenced for stealing employment taxes a second time.  Accordingly, the district court imposed 42 months’ imprisonment—9 months more than the top recommended range in the plea agreement.  On appeal, the D.C. Circuit affirmed, reasoning that the taxpayer’s repeat offenses not only demonstrated willful violation of the law, but also proved that a lenient sentence was not sufficient to deter him from committing similar crimes in the future.

As we noted in a prior post, DOJ has been ramping up criminal prosecutions of employment tax violations.  In Jackson, DOJ appears to have prosecuted the case very aggressively by recommending a sentencing range that functioned as an anchor, and then pushing for a harsher sentence.  The district court and the D.C. Circuit ultimately agreed, which reflects not only the seriousness and audacity of the taxpayer’s repeat offenses, but also the principle that using employment taxes held in trust for the government constitutes theft.  This principle is especially noteworthy for businesses that use trust fund taxes to pay other creditors when in dire financial straits, as this practice may now lead to not only civil liability, but also criminal prosecution for those making the decision to divert the funds.  Employers are well served to recognize that trust fund taxes are not their money.

W-2 Phishing Scam Targeting More Employers, Including Chain Restaurants and Staffing Companies

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February 3, 2017

Yesterday, the IRS and state tax agencies issued a joint warning to employers that the Form W-2 phishing scam that first affected large businesses last year has now expanded to other organizations, including chain restaurants, staffing companies, schools, tribal organizations, and nonprofits.  The scam involves emails sent to payroll or human resources employees that appear to be from organization executives and request a list of all employees and their Forms W-2.  Once the scammer receives the information, it can be used to file false tax returns and claim employee refunds.

According to IRS Commissioner John Koskinen, this is one of the most dangerous phishing scams the tax world has faced in a long time.  The IRS and its state and industry partners, known as the “Security Summit,” have enacted safeguards in 2016 and 2017 to identify and halt scams such as this, but cybercriminals simply evolve their methods to avoid those safeguards.  A 2016 Government Accountability Office report found that in 2014, the IRS paid an estimated $3.1 billion in fraudulent identify theft refunds.  The report also found that the IRS prevented the payment of or recovered another $22.5 billion in identify theft refunds in the same year.  Both numbers were down from the prior year, but it is somewhat unclear whether that is a result of a change in the methodology used to calculate the estimates.

To add insult to injury, some scammers are going back to the well, by following-up on the Form W-2 request with an email requesting a wire transfer.  As a result, some entities have not only exposed their employees’ personal information and made them vulnerable to potential identify theft but also lost thousands of dollars.  Employers should ensure that payroll, treasury, and accounts payable processes and procedures are in place to prevent the unauthorized sharing of Form W-2 information and unauthorized wire transfers.

Organizations that receive a scam email should forward the email to phishing@irs.gov, placing “W2 Scam” in the subject line.  In addition, organizations should file a complaint with the Internet Crime Complaint Center (IC3), which is operated by the FBI.  If an organization has already had Forms W-2 stolen, it should review the Federal Trade Commission and IRS’s recommended actions, available at www.identitytheft.gov and www.irs.gov/identitytheft, respectively.  Employees concerned about identity theft can consult Publication 4524 and Publication 5027 for information.  If an employee’s tax return gets rejected because of a duplicate social security number, he or she should file Form 14039, “Identity Theft Affidavit.”

Refusal to Allow Closing Agreements on FICA Timing May Lead to Challenge

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January 17, 2017

In an IRS Chief Counsel Advice Memorandum released on January 13, the IRS concluded that it should not enter into closing agreements with employers who failed to subject amounts of nonqualified deferred compensation to FICA taxes under the special timing rule in Section 3121(v)(2)(A).  In the past, some employers have been able to obtain a closing agreement in such circumstances.  In the CCA, the IRS concludes that, because the regulations apply the general timing rule in such situations, closing agreements that would allow the avoidance of the harsh result prescribed by the regulations are inappropriate.

The unwillingness of the IRS to issue closing agreements on the issue going forward may bring to a head arguments that the IRS’s regulations under Section 3121(v)(2) are not well supported by the language of the statute.  Under the statute, an amount deferred under a “nonqualified deferred compensation plan” is required to be “taken into account” as wages for FICA tax purposes when the services creating the right to that amount are performed, or, if later, the date on which the right to that amount is no longer subject to a substantial risk of forfeiture.  Under the “nonduplication rule,” an amount taken into account as wages under this mandatory timing rule (and any income attributable to such amount) are not treated as wages at any later time.  In other words, deferrals under a nonqualified deferred compensation plan and the related earnings are subjected to FICA taxation only once—at the time mandated by Section 3121(v)(2)(A).

Under the Treasury Regulations, the IRS goes a step further and creates out of whole cloth a second time for including in wages amounts deferred under a nonqualified deferred compensation plan—the time that the deferred amount and earnings would have been taken into account as wages under Section 3121(a) but for the application of Section 3121(v)(2).  The IRS’s regulatory approach is arguably contrary to the statutory language, which does not include a “backup” timing rule but instead provides the sole and exclusive rule regarding the time at which such amounts are wages as a matter of statutory law. There is no other Code provision that would override the clear and unambiguous mandate of Section 3121(v)(2)(A) to require, or event permit, amounts deferred under nonqualified deferred compensation plans to be treated as FICA wages in a later year.

In the absence of an explicit statutory command that would require the later inclusion in wages of deferred amounts that were not properly subjected to FICA taxation, the approach taken by Treasury and the IRS in the regulations may be vulnerable to attack.  With the IRS now refusing to enter into closing agreements on the issue, a cornered taxpayer might seek to do just that.

D.C. Council Passes Mandatory Paid Leave Bill

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December 22, 2016

The District of Columbia Council passed a generous paid family leave bill on Tuesday by a 9-4 margin.  The bill will provide eight weeks of paid leave to new mothers and fathers, six weeks for employees caring for sick family members, and two weeks for personal sick leave.  As we explained in a prior post, the District will fund the new benefit with a new 0.62 percent payroll tax on employers.  Large employers, some of whom already provide similar benefits to employees, have been increasingly outspoken against the bill, taking issue with what it views as a bill requiring them to fund paid leave for small employers who do not currently offer such benefits.  Despite large employers’ strong lobbying effort, which were joined by Mayor Muriel Bowser, the bill still passed by a comfortable margin.  Mayor Bowser has not indicated whether she will sign the bill, but the 9-4 vote is sufficient to override a veto.  Regardless of Mayor Bowser’s decision, the program will likely not get off the ground until 2019 due to the administrative hurdles required to implement the new system.

D.C. Council Moves Closer to Enacting Employer Payroll Tax to Create Nation’s Most Generous Family Leave Law

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December 7, 2016

On December 6, the District of Columbia Council advanced a bill known as the Universal Paid Leave Act of 2016.  The bill would impose an estimated $250 million in employer payroll taxes on local businesses to fund a paid leave benefit created by the bill.  The bill would raise the funds by creating a new employer payroll tax of 0.62%.  Self-employed individuals may also opt-in to the program by paying the tax.  Federal government employees and District residents who work outside of the District would not be covered by the bill.  However, Maryland and Virginia residents who work within the district would be covered and entitled to benefits from the government fund created by the bill.

If ultimately passed, the bill would require businesses to provide eight weeks of paid time-off for both full and part-time workers to care for newborn or adopted children.  The bill, which advanced on an 11-2 vote, will also guarantee six weeks of paid leave for workers to care for sick relatives, as well as two weeks of annual personal sick leave.  (Many employees would already qualify for unpaid leave under the Federal and District family and medical leave laws.)

A government insurance fund funded with the new employer payroll taxes would pay workers during their leaves. The bill provides for progressive payment rates, such that lower-income individuals receive a greater percentage of their normal salary during periods of time off covered by the program.  The fund created with the tax revenue would pay a base amount equal to 90% of a worker’s average weekly wage up to 150% of the District’s minimum wage.  (Based on the District’s current minimum wage laws, the base amount is expected to be calculated on up to $900 in weekly salary by the time the program would take effect based on a $15 per hour minimum wage rate that is currently being phased in.)  An employee whose average weekly wage exceeds 150% of the District’s minimum wage would receive the base amount plus 50% of the worker’s weekly wage above the District’s minimum wage.  Payments would be capped at $1,000 a week, with the cap being subject to increases for inflation beginning in 2021.

The bill must pass a final D.C. Council vote on December 20 and approval by District Mayor Muriel E. Bowser. A Bowser spokesman reported that the mayor was still undecided on the bill.  If the bill ultimately passes, benefits would likely not be available before 2019, as the District would need time to prepare and fund the program.

New Jersey and Pennsylvania Will Maintain Tax Reciprocal Agreement

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November 23, 2016

New Jersey Governor Chris Christie, who promised in September to revoke New Jersey’s 40-year-old tax reciprocal agreement with Pennsylvania, announced through a November 22 statement that he would continue the agreement.  Governor Christie had said he would eliminate the State of New Jersey and the Commonwealth of Pennsylvania Reciprocal Personal Income Tax Agreement unless the New Jersey legislature took steps to reduce public employee health insurance costs.

The stated impetus for scrapping the agreement was to make up for a budget deficit: cancelling the agreement was estimated to produce $180 million in revenue for New Jersey. Under the agreement, New Jersey and Pennsylvania residents who work in the other state are only required to file a tax return in their state of residence.  Pennsylvania residents working in New Jersey must file Form NJ-165, Employee’s Certificate of Nonresidence in New Jersey, and New Jersey residents working in Pennsylvania must file Form REV-419EX, Employee’s Nonwithholding Application Certificate, with their employers to avoid having New Jersey taxes withheld from compensation.

Without the agreement, residents of Pennsylvania and New Jersey who work in the other state would need to file two tax returns and claim a credit against taxes owed in their state of residence for taxes paid in their state of employment. Because Pennsylvania imposes a 3.07% flat tax and New Jersey imposes a graduated tax that is capped at 8.97%, New Jersey would greatly benefit from taxing the income of Pennsylvania residents working in New Jersey.  However, cancelling the agreement would have hurt many lower-income New Jersey residents who work in Pennsylvania (Philadelphia, in particular), as they would be forced to pay Pennsylvania’s 3.07% flat tax, instead of the lower New Jersey graduated rate.

However, Governor Christie stated that the agreement could continue due to the $200 million in savings caused by a public worker union-backed health care bill that was signed into law on November 21 (S2749).  The new legislation saves money by adjusting the process through which public workers receive their prescriptions.  Several major corporations that operate in New Jersey, including Subaru of America and Campbell Soup Co., have already praised the decision to maintain the agreement.

Change to Sentencing Guidelines Reflects DOJ’s Increased Employment Tax Enforcement Efforts

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November 21, 2016

Pursuant to amendments to the U.S. Sentencing Commission Guidelines Manual (Sentencing Guidelines), the background commentary to the Sentencing Guidelines no longer refers to violations of Code section 7202 as “infrequently prosecuted.” These amendments were passed by the Federal Sentencing Commission on May 5, 2016 and effective November 1, 2016.  Code section 7202 provides that any person who willfully fails to collect or truthfully account for and pay taxes when required shall be guilty of a felony and subject to a fine up to $10,000 and up to five years’ imprisonment. Defense attorneys had been using the “infrequently prosecuted” language to argue for more lenient sentences for Code section 7202 violations, and the Justice Department, citing the increase in prosecutions of Code section 7202 violations, had recommended that the language be removed because it is no longer true. For additional information on the change, please refer to our prior post.

According to Caroline Ciraolo, principal deputy assistant attorney general at the Justice Department’s Tax Division, the Tax Division was responsible for pushing the change through. Employment tax enforcement has been a top priority for the Tax Division in recent years, and Ciraolo noted that it should remain a priority even after she resigns when Obama leaves office.

Social Security Wage Base Will Increase 7.3% in 2017

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October 18, 2016

The Social Security Administration (SSA) announced that the maximum amount of annual earnings subject to Social Security taxes will increase to $127,200 in 2017, a 7.3% increase from the current $118,500 ceiling. This represents the largest single-year percentage increase since the wage base increased from $32,400 to $35,700 in 1983, an increase of 10.2%. SSA explained that the increase is due to the rise in average income and it estimates that the increase will affect roughly 12 million workers. Other cost-of-living increases released by SSA can be found here.

Court Decision Underscores Need for Due Diligence When Using Payroll Service Providers

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August 24, 2016

A recent decision of the U.S. District Court for the Central District of California should remind employers to regularly verify the actions of payroll service providers regardless of the provider’s reputation and the longevity of the relationship.  In particular, employers should open an e-Services account with the IRS and verify that all deposits are in fact hitting their payroll accounts timely.  This check should be performed weekly.  If deposits are not timely reflected on accounts, it is incumbent on employers to promptly determine the nature of the problem.  The IRS does not police payroll service companies, and the Department of Justice has prosecuted a number of people for embezzlement of payroll taxes over the years.

In Kimdun Inc. et al. v. United States, four McDonald’s franchises (the “Employer”) under common ownership used an outside payroll company for 30 years to process all aspects of their payroll, including the remittance of payroll taxes to the U.S. Treasury and the California Employment Development Department.  However, during the last several years of the relationship (2008-2011), the payroll company or its related bank embezzled the Employer’s payroll taxes.  To make matters worse, the Employer learned of the failure to deposit its taxes in 2009 but neglected to take any action until mid-2011 and continued to use the payroll company through 2012.  The IRS subsequently assessed approximately $425,000 in failure-to-pay penalties under Section 6651(a), failure-to-deposit penalties under Section 6656, and related interest.  Note that the penalties and interest were in addition to the payroll taxes that the Employer had to pay to the U.S. Treasury above and beyond the funds that were embezzled.

The Employer filed refund claims with respect to the penalties and related interest, which were denied by the IRS.  The Employer then sued for a refund in U.S. District Court arguing that the penalties should be abated on the grounds that the failures occurred due to reasonable cause and not due to willful neglect.  The District Court granted the government’s motion to dismiss, holding that the Employer failed to show that it had acted with ordinary business care and prudence.  In its analysis, the court considered the typical authorities that arise in reasonable cause determinations and concluded that the Employer’s reliance on the payroll company, an agent, did not establish reasonable cause.  The fact that the Employer seemed to wait passively for such a protracted period of time was a particularly bad fact.  The result may well have been different if the Employer had identified the theft within a matter of weeks, made good on the late taxes, and pursued legal action against the payroll company.

The key takeaway from this case, however, is that employers will not simply be absolved of their tax obligations based upon illegal acts committed by third-party agents.  With the tools available from the IRS through e-Services, employers should independently verify that their payroll service providers perform the tasks they agree to perform.

IRS Implements New Voluntary Certification Program for PEOs

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August 15, 2016

Through a flurry of guidance this summer, the IRS has finally implemented the long-anticipated voluntary certification program for professional employer organizations (PEOs).  In 2014, Congress enacted Code Sections 3511 and 7705, which brought about a sea-change in the payroll tax world by creating a new statutory employer: An IRS‑certified PEO (CPEO).  This change is significant because a common law employer (customer) who is otherwise liable for payroll taxes on wages that its PEO pays its employees may shift this payroll tax liability to a CPEO.  In May 2016, the IRS released temporary and proposed Treasury Regulations and Revenue Procedure 2016-33, providing tax and CPEO-certification rules under Sections 3511 and 7705.  After launching the online CPEO application in early July, the IRS proposed to create a new CPEO records system and last week, loosened certain certification rules by issuing interim guidance (Notice 2016-49), on which taxpayers may rely pending final regulations.  Importantly, Notice 2016-49 extended the application deadline from August 31, 2016, to September 30, 2016, for PEOs seeking to have the earliest possible effective certification date of January 1, 2017.

Although the CPEO program is welcomed by PEOs and their customers, applicants and CPEOs must carefully comply with numerous certification rules established under the recent IRS guidance.  Moreover, customers should be aware of limitations on their ability to shift payroll tax liabilities to their CPEOs.  Further, CPEOs and their customers should keep in mind that the CPEO program primarily assists payroll tax administration, and leaves difficult questions regarding CPEO sponsorship of qualified employee benefit plans and compliance with the Affordable Care Act (discussed in a separate blog post).

Background

PEOs provide customer-employers with payroll and employment services.  Before Congress enacted Sections 3511 and 7705 in late 2014, however, customers had remained liable for payroll taxes on wages paid to their employees.  Because there was no rule allowing the tacking of wages, PEOs would have to restart the applicable wage base limitations (e.g., FICA and FUTA limitations) upon moving the customers’ employees to the PEOs’ payrolls.  Under Section 3511, a CPEO is solely responsible for its customers’ payroll tax—i.e., FICA, FUTA, and RRTA taxes, and Federal income tax withholding—liabilities, and is a “successor employer” who may tack onto the wages it pays to the employees to those already paid by the customers earlier in the year.  The customers, on the other hand, remain eligible for certain wage-related credits as if they were still the common law employers of the employees.  Section 7705 called for the IRS to establish certification requirements.  It also provided a critical enforcement tool:  The IRS will publish every quarter a list of all CPEOs.

On May 5, 2016, the IRS released temporary Treasury regulations establishing certification rules under Section 7705 (temporary regulations).  These temporary regulations became effective on July 1, 2016 and will remain effective for three years thereafter.  Simultaneously, the IRS released proposed Treasury regulations under Section 3511 (proposed regulations) that establish rules on the payroll tax liabilities of CPEOs and their customers.  These rules are likely in proposed form because the IRS intends to revisit numerous issues, such as the treatment of specified tax credits.  Shortly after releasing these regulations, the IRS published Revenue Procedure 2016-33, which provides additional certification and application rules.  Although these rules do not affect an existing PEO’s established practices, a PEO must satisfy the requirements to become certified and thereby attract customers wishing to shift their payroll tax liabilities.

New Certification Requirements

The new IRS guidance establishes a robust set of certification requirements—e.g., proof of suitability, annual financial reporting and positive working capital, bonding requirements, etc.—aimed at ensuring the IRS’s collection of payroll taxes from CPEOs.

Suitability.  The temporary regulations add “suitability” requirements designed to ensure that the PEO has the capability, experience, and integrity to properly withhold and remit payroll taxes.  Showing that it has mulled over the PEO industry and its potential tax pitfalls, the IRS decided to apply many of these suitability requirements not only to the PEOs themselves, but also to certain “responsible individuals,” “related entities,” and “precursor entities” of the PEO.  Thus, for example, the IRS will not certify a PEO solely because its responsible individuals (e.g., certain owners, the CEO, or CFO) have failed to pay applicable Federal or state income taxes or have been professionally sanctioned for misconducts.  Nor can a PEO that is otherwise unsuitable for certification cleanse the taint of prior tax wrongdoings by transferring its assets to a new PEO that applies for certification.

Positive Working Capital & Transition Relief.  The temporary regulations add a positive-working capital rule—tweaked by Notice 2016-49—to ensure that the PEO is financially capable of fulfilling its tax obligations.  Under the temporary regulations, applicants and CPEOs must file annual audited financial statements accompanied by an independent CPA’s opinion that the financial statements (1) are fairly presented under GAAP, (2) reflect positive working capital, and (3) show that the PEO uses an accrual method of accounting.  Addressing comments that CPAs may be professionally prevented from including the last two items in a CPA opinion, Notice 2016-49 provides that, in lieu of doing so, a PEO must include in its annual filing a Note to the Financial Statements stating that the financial statements reflect positive working capital and providing detailed calculations.  Further, Notice 2016-49 provides transition relief for applicants required to submit a copy of its annual audited financial statements and CPA opinion for a fiscal year ending before September 30, 2016.

To allow reasonable fluctuation in working capital, an exception to the positive-working capital rule is available if: (1) the working capital of two consecutive fiscal quarters that year were positive; (2) the PEO explains the reason for the negative working capital; and (3) the negative working capital does not present a material risk to the IRS’s collection of payroll taxes.  The third element hinges on whether the PEO has identified facts and circumstances that will result in positive working capital in the near future.  A similar positive working-capital rule and a similar exception apply to quarterly financial statements.

Bond and Surety.  Under Section 7705(c)(2), an applicant or CPEO must post a bond (ranging from $50,000 to $1 million) with respect to its employment tax liabilities.  The temporary regulations clarified that the bond cannot be substituted with collateral, and that the bond must be issued by a qualified surety, i.e., one that holds a certificate of authority from the IRS.  Accordingly, a CPEO application must include a signed surety letter confirming that the surety agrees to issue a bond pursuant to terms set forth in Form 14751 and in the required amount to the applicant, if and when the applicant is certified.

Business Entity.  The temporary regulations provide that a CPEO must be a “business entity” organized in the United States, but may not be a disregarded entity.  Addressing concerns that PEOs may choose to be disregarded entities for legitimate business reasons, Notice 2016-49 provides that a CPEO may be a wholly domestic disregarded entity.  The Treasury and the IRS sought comments on whether they should allow partly or fully foreign disregarded entity to apply for certification.  Additionally, Notice 2016-49 provides that a sole proprietorship, which is not included in the definition of “business entity,” may apply for certification.

Consent to Disclosure.  Consistent with Section 7705(f), which requires the IRS to publish the names and addresses of all CPEOs, the temporary regulations add that the IRS will also publish the fact of the suspension or revocation of a PEO’s certification and may notify the PEO’s customers of this fact.  Accordingly, the temporary regulations also require an applicant or CPEO to provide the consents for the IRS to disclose confidential tax information to the customers and to other persons as necessary to carry out the purposes of the CPEO rules.

Functional Application of Rule.  The IRS will likely take a functional rather than a mechanical approach to applying the certification rules.  The temporary regulations permit the IRS to suspend or revoke a PEO’s certification if the PEO violates a certification requirement, but require the IRS to do so only if the violation presents a material risk to the IRS’s collection of Federal payroll taxes.  If the IRS suspends or revokes a PEO’s certification, the benefits—e.g., shifting of payroll tax liability and tacking of wages—under Section 3511 will not apply and the PEO must notify its customers of its suspension or revocation.

Employment Tax Treatment of CPEOs and Their Customers

The proposed regulations implement rules under Section 3511 pertaining to the employment tax treatment of CPEOs and their customers.

Work Site Employee.  Section 3511 shifts a customer’s payroll tax liability with respect to wages paid to a “work site employee,” and the proposed regulations apply a quarterly test.  Specifically, a covered employee is a work site employee for a calendar quarter, if at any time during that quarter, at least 85 percent of the service providers at the same work site are subject to one or more CPEO contracts between the CPEO and the customer.

Specified Tax Credits.  The proposed regulations also indicate that the IRS may change its treatment of specified tax credits under Section 3511(d)(1), for which the customer—not the CPEO—is eligible, provided that the wages at issue are paid to a work site employee.  In the preambles to the proposed regulations, the Treasury and the IRS sought comments as to whether they should expand the list of specified tax credits, and how the tax credits should apply with respect to non-work site covered employees.

Continuing Reporting Obligations.  Most significantly, the proposed regulations add three categories of reporting requirements that a CPEO must meet in order to remain certified: (1) reporting to the IRS by CPEOs, including any Form 940 (Employer’s Annual FUTA Tax Return) or Form 941 (Employer’s Quarterly Federal Tax Return) and their applicable schedules, periodic verification of compliance, notice of material changes to information provided, and independent financial review documents, such as the annual audited financial statements along with the CPA opinion; (2) reporting to customers by CPEOs, including notification of suspension or revocation of certification and notification regarding transfer of CPEO contract; and (3) inclusion of certain information in the CPEO contract.

CPEO System of Records

To ensure that an applicant or CPEO complies with the new certification rules, the Treasury and the IRS proposed to establish a records system that covers a myriad of groups of individuals involved in the certification process or administration of the applicant or CPEO.  The proposed records system keeps administrative, investigative, and tax records, which the IRS will only use and disclose consistent with the confidentiality rules under Code Section 6103.  Like the detailed certification rules, the proposed records system signals the IRS’s commitment to enforce the CPEO suitability requirements by weeding out PEOs managed by individuals with a history of tax wrongdoings.  The proposed system became effective on August 10, 2016.

Other Issues

Groundbreaking in the payroll tax world, the CPEO rulemaking project is still in its infancy, and the IRS will continue to issue new rules and clarifications as to a CPEO’s certification and reporting obligations, as well as the new CPEO records system.  Additionally, the IRS will likely address whether to expand the list of specified tax credits applicable to a customer with respect to its work site employees, and how these credits may apply in the case of non-work site covered employees.

One crucial issue the IRS has yet to address is the scope of the liability of CPEOs’ customers.  Although the new rules are intended to shift payroll tax liability to the CPEO, the customer, as the common law employer, may be liable if the IRS retroactively revokes or suspends a CPEO’s certification.  This liability may be significant, as it includes the payroll taxes that should have been but were not properly withheld and/or remitted, and may also include Trust Fund Recovery Penalties.  It is unclear if a customer can avoid this liability when its CPEO failed to withhold or remit payroll taxes properly, solely by showing that it relied on the IRS’s quarterly CPEO list.  Thus, it remains to be seen if the IRS clarifies whether customers must verify their CPEOs’ ongoing compliance with certification requirements.

IRS Releases New Form on Which Small Businesses Should Claim Payroll Tax Credit for R&D Expenditures

The IRS released draft Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, which qualified small business (i.e., start-up businesses) will use to claim the new payroll tax credit available to start-up businesses for qualified research and development (R&D) expenses up to $250,000.  As we explained in a prior post, the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) allowed start-up businesses to take advantage of the R&D tax credit by allowing them to offset the employer portion of the Social Security tax—the credit was previously only available to companies that could offset such expenditures against taxable income.  Also covered in that post were modifications to two existing forms to accommodate the reporting of the expanded R&D tax credit: Form 6765, Credit for Increasing Research Activities, and Form 941, Employer’s Quarterly Federal Tax Return.

The new form allows qualified small businesses to calculate the amount of the qualified small business payroll tax credit for the current quarter. Taxpayers will file Form 8974 quarterly by attaching it to Form 941.  Form 8974 calculates the amount of payroll tax credit available to the taxpayer based on Line 44 of the prior tax year’s Form 6765, and the amount of social security taxes reported for the quarter, which is pulled from Column 2 of Lines 5a and 5b of the Form 941 on which the credit is applied.  The amount reported on Line 12 of Form 8974 is the payroll tax credit that qualified small businesses should report on Line 11 of the Form 941 (generally, the amount of the total credit allowable based on the prior year’s Form 6765 or 50% of the reported Social Security tax reported on the Form 941 for the current quarter).

IRS Releases Drafts of Forms 941 and 6765 to Enable R&D Payroll Tax Credit Under Section 3111(f)

The IRS released drafts of Form 941 and Form 6765 to facilitate a new payroll tax credit intended to allow start-up businesses to take advantage of the research and development (R&D) credit in Section 41 of the Internal Revenue Code.  In the past, start-up businesses took issue with the R&D tax credit because the credit was an income tax credit.  Because start-up businesses may not have taxable income for several years, they were not able to take advantage of the credit.

The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) expanded the R&D credit by adding new Sections 41(h) and 3111(f) to the Code.  Those sections allow “qualified small businesses” to elect to claim the credit (up to a maximum of $250,000) as a payroll tax credit. Those employers may elect to use the credit to offset the employer portion of Social Security tax.  It may not be used to reduce the amount of Social Security tax withheld from employees’ wages, nor may it be used to offset the employer or employee share of Medicare tax.  For purposes of the credit, a “qualified small business” is an employer with gross receipts of less than $5 million in the current taxable year and no more than five taxable years with gross receipts.  Qualified small businesses may claim the R&D payroll tax credit in tax years beginning after December 31, 2015.

The IRS added two lines to Form 941 (Employer’s Quarterly Federal Tax Return). Qualified small businesses will report the amount of the credit on Line 11 and report the total applicable taxes after adjustments and credits on Line 12.  In addition, qualified small businesses will elect to take a portion of the R&D credit as a payroll tax credit by completing new Section D on Form 6765 (Credit for Increasing Research Activities).  Comments on the forms can be submitted on the IRS web site.

The IRS subsequently released a draft Form 8974 that is used to calculate the payroll tax credit.

Two District Courts Rule Stock Option Income Subject to RRTA Tax

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July 14, 2016

Two more railroad companies have failed in their efforts to obtain Railroad Retirement Tax Act (RRTA) tax refunds based on the application of RRTA’s definition of “compensation” as it relates to nonqualified stock option exercises by employees.  Just a week apart, the U.S. District Courts for Nebraska in Union Pac. R.R. Co. v. United States  and for the Northern District of Illinois in Wis. Central Ltd. v. United States, agreed with the government that the term “any form of money remuneration,” as compensation is defined by RRTA, is susceptible to a broad reading analogous to that of “wages” in the Federal Insurance Contributions Act (FICA).  Both courts, in detailed memorandum opinions, concluded that the income arising from the NQSO exercises had been properly subjected to Tier 1 RRTA taxes and, consequently, the refund claims were denied.  In so doing, both courts accepted the government’s position that the Treasury regulations defining RRTA compensation by reference to the definition of FICA wages in Section 3121(a) was a reasonable one.

In the first case on this issue, the U.S. Court of Appeals for the Fifth Circuit rejected BNSF Railway Company’s claims for refund of Tier 1 RRTA taxes that had been paid in conjunction with the exercise of nonqualified stock options.  In its refund claim, BNSF had argued that the term “any form of money remuneration” meant payment in cash or other medium of government authorized exchange and, consequently, NQSOs could not qualify as money.  Therefore, according to BNSF, income arising from the exercise of NQSOs did not constitute “compensation” subject to RRTA taxes.   In analyzing the definition of “compensation” under RRTA, the Fifth Circuit applied the two step framework set out in Chevron v. Natural Res. Def. Council, Inc. and concluded that Treasury was reasonable in interpreting RRTA coextensively with the FICA tax provisions, so that it was consistent with the broad reading of the term “wages” in FICA provisions.

IRS Reports Automatic Alerts for Missed Employment Tax Payments Already Improving Compliance

In a previous post, we discussed the improved automated system that the IRS implemented to issue more timely and accurate federal tax deposit (FTD) alerts to employers that may owe employment taxes at the end of a quarter.  FTD alerts are generated automatically by the Electronic Federal Tax Payment System (EFTPS) and notify employers of potential employment tax violations by comparing  employment tax deposits against those made during the same quarter in the previous year.  The IRS has improved the algorithm used to identify potential missed payments.   Previously, the system would not generate an FTD alert to the employer until the 13th week of the quarter.  The new algorithm allows the IRS to predict when an employer may owe employment taxes at quarter end, which will allow the agency to issue FTD three times during the quarter.  According to a director in the IRS Small Business/Self-Employed Division, Darren Gulliot, the IRS has been studying employers’ responses to certain types of IRS outreach, such as field visits, soft notices, and prerecorded messages, to determine the most effective types of outreach.  These combined efforts have resulted in a more than 50% decrease in the number of FTD alerts issued during the first three months of 2016 when compared to that same time period in 2015, and the alerts issued have become more accurate, meaning that fewer employers will receive FTD alerts, but the ones who do receive them will likely be liable for employment tax that quarter.

The IRS is modifying the system to notify the IRS of potential missed payments within 48-72 hours rather than 12-13 weeks under the current system.

 

U.S. District Court Finds Taxpayer Had Reasonable Basis for Classifying Workers as Independent Contractors

In an area IRS auditors are increasingly scrutinizing, a U.S. district court sided with the taxpayer in its claim for an employment tax refund on the grounds that the taxpayer had a reasonable basis for classifying its workers as independent contractors and thus was not liable for back employment taxes.  In Nelly Home Care, Inc. v. United States, the IRS asserted after an audit of a homecare services company that the company had misclassified its workers as independent contractors and assessed back employment taxes owed as a result of the misclassification.  Refund claims for employment taxes are within the jurisdiction of the U.S. district courts, so the taxpayer paid the taxes and filed a refund action in the U.S. District Court for the Eastern District of Pennsylvania.

The calculation of FICA and federal income tax withholding in reclassification cases is determined under the special rates of Section 3509 of the Internal Revenue Code when an employer incorrectly classifies an employee as an independent contractor but issues a Form 1099-MISC. The court noted that IRS auditors are increasingly relying on this section to scrutinize worker misclassifications.  However, Section 530 of the Revenue Act of 1978, which was never codified, provides a safe harbor for taxpayers that owe back employment taxes due to worker classification errors.  An employer may qualify for the safe harbor by showing that it had a “reasonable basis” to not classify workers as employees, provided the basis arose from reliance on one of four conditions: (i) judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer; (ii) a past IRS audit of the taxpayer in which there was no assessment attributable to the treatment of workers in substantially similar positions to the workers at issue; (iii) longstanding recognized practice of a significant segment of the industry in which the worker was engaged; or (iv) any other factors that a court considers sufficient to establish a “reasonable basis.”

The taxpayer in Nelly Home Care argued unsuccessfully that it satisfied the second and third conditions as a basis for its reasonable belief. However, the court found that the record demonstrated that the taxpayer satisfied the fourth condition for demonstrating that it had a reasonable basis and, therefore, was relieved of the employer’s responsibility to withhold income taxes on and apply FICA taxes to the payments.  Specifically, the court considered the inquiries made of other companies’ practices, the personal experience of the taxpayer in the industry, and the IRS’s silence regarding the taxpayer’s classification during its audits of the owner’s personal tax returns.  Notably, the court warned that its decision “in no way endorses” the taxpayer’s classification of its workers as independent contractors.

IRS Error Leads to Erroneous Penalty Notices

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May 9, 2016

The IRS announced that some taxpayers may have been erroneously assessed failure to deposit penalties after an IRS system error failed to account for the April 15, 2016, holiday in Washington, D.C.  The holiday moved the deadline for payroll tax deposit to April 18, 2016.  However, some taxpayers who timely deposited payroll taxes by the later date were assessed failure to deposit penalties.  The notice is titled “Your Federal Tax Deposit Wasn’t Submitted Correctly.” At the bottom, the date due is shown as April 15, 2016, and the date received is shown as April 18, 2016.  The IRS will contact affected taxpayers and no taxpayer action is required.

IRS Issues Regulations Relating to Employees of Disregarded Entities

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May 5, 2016

Yesterday, Treasury and the IRS released final and temporary regulations under Section 7701 meant to clarify issues related to the employment of owners of disregarded entities.  In 2009, the IRS issues regulations that required disregarded entities be treated as a corporation for purposes of employment taxes including federal income tax withholding and Federal Insurance Contribution Act (FICA) taxes for Social Security and Medicare.  The regulations provided that a disregarded entity was disregarded, however, for purposes of self-employment taxes and included an example that demonstrated the application of the rule to an individual who was the single owner of a disregarded entity.  In the example, the disregarded entity is treated as the employee of its employees but the owner remains subject to self-employment tax on the disregarded entity’s activities.  In other words, the owner is not treated as an employee.

Rev. Rul. 69-184 provides that partners are not employees of the partnership for purposes of FICA taxes, Federal Unemployment Tax Act (FUTA) tax, and federal income tax withholding.  This is true even if the partner would qualify as an employee under the common law test.  This made it difficult—if not impossible—for partnerships to allow employees to participate in the business with equity ownership such as options even if the employee owned only a very small portion of the partnership.  The 2009 regulations raised questions, however, provided some hope that a disregarded entity whose sole owner was a partnership could be used to as the employer of the partnership’s partners. Doing so would have allowed partners in the partnership to be treated as employees of the disregarded entity and participate in tax-favored employee benefit plans, such as cafeteria plans.  The final and temporary regulations clarify that that an individual who owns and portion of a partnership may not be treated as an employee of the partnership or of a disregarded entity owned by the partnership.

As a result, payments made to partners should not be reported on Form W-2, but should be reported on Schedule K-1.  Such payments are not subject to federal income tax withholding or FICA taxes, but will be subject to self-employment taxes when the partner files his or her individual income tax return.  In addition, if partners are currently participating in a disregarded entity’s employee benefit plans, such as a health plan or cafeteria plan, the plan has until the later of August 1, 2016, or the first day of the latest-starting plan year following May 4, 2016.

DOJ Repeatedly Signals Intent to Ramp Up Criminal Prosecutions for Employment Tax Failures

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April 14, 2016

The U.S. Department of Justice has recently proposed amendments to the U.S. Sentencing Commission Guidelines Manual (the “Guidelines”) to sharpen criminal prosecution of willful tax violations. Code section 7202 provides that any person who willfully fails to collect or truthfully account for and pay taxes when required shall be guilty of a felony and, if convicted, subject to a fine up to $10,000 and up to five years’ imprisonment. Since 1987, the background commentary in the sentencing guidelines has stated that Code section 7202 violations are “infrequently prosecuted.” In its annual letter to the Sentencing Commission, the Justice Department explained that defense attorneys have been citing this language to argue for more lenient sentences in Code section 7202 cases. The Justice Department recommended that the sentence be deleted because it is no longer true: Prosecutions have grown from three cases in 2002 to 46 cases in 2014. The Sentencing Commission subsequently recommended that the Guidelines be amended to delete the sentence as a requested.

At a Federal Bar Association Tax Law Conference on March 4, 2016, two attorneys from the Justice Department confirmed that the proposed change reflects the Justice Department’s commitment to employment tax enforcement and is dedicating additional resources to Code section 7202 cases. Employment tax withholdings represent 70 percent of all revenue collected by the Internal Revenue Service, and rampant violations are prompting the U.S. Department of Justice to prosecute employment tax violations more aggressively. Speaking at the Federal Bar Association Tax Law Conference on March 4, 2016, Caroline. D. Ciraolo, the Department of Justice Tax Division Acting Assistant Attorney General, said that the Justice Department will seek more civil injunctions in employment tax cases, which involve employers who fail to collect, account for, and deposit employment wage withholdings. Employers subject to a civil injunction must pay employment taxes on time, notify the IRS when the taxes have been paid, refrain from assigning property to or paying creditors until the taxpayers have paid employment tax obligations accruing after the date of the injunction, and inform the IRS if they establish a new business.

More recently, Noreene Stehlik, a recently appointed Senior Litigation Counsel at the Department of Justice Tax Division, also affirmed the Justice Department’s commitment to employment tax enforcement. At a D.C. Bar Taxation Section conference on April 13, 2016, Stehlik stated that the Justice Department has, in the first quarter of 2016, sought almost as many civil injunctions as it sought in all of 2015. She added that employers not complying with civil injunctions may be subject to criminal prosecution.

The Justice Department’s more aggressive approach seems to embrace the idea that when an employer, payor, or withholding agent makes the decision to use trust fund taxes (i.e., taxes withheld from employees, taxes withheld for backup withholding purposes, and taxes withheld under Chapters 3 and 4 of the Code) to pay other creditors, the use of such funds is tantamount to theft. Businesses that engage in this practice tend to be in dire straits financially and should not make matters worse by using funds held in trust for the government. Engaging in such practices often leads to personal liability for the individuals approving or making the decisions to improperly use the funds, but may also lead to criminal prosecution based upon recent comments from the Justice Department.

Court Allows Foreclosure of Delinquent Taxpayer’s Home and Business Property for Employment Tax Liability

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March 18, 2016

The U.S. District Court for the District of New Mexico recently held that the government is entitled to foreclose federal tax liens against a delinquent taxpayer’s home and business property, even though the taxpayer’s wife may be a joint owner. In United States v. Fields, Samuel Fields, the sole proprietor of a dry cleaner business, owed $211,855.80 in employment and unemployment taxes from 1993 to 2009. The IRS had made assessments against Fields starting in 1995. In 2005, for no consideration, Fields executed deeds to his two real properties – his home residence and business property – located in New Mexico, stating that he and his wife were joint owners. The U.S. Department of Justice sought partial summary judgment against Fields personally and to foreclose its federal tax liens against his home and business property.

The key issue was whether the federal tax liens were superior to the wife’s interests in the properties. Under Internal Revenue Code Sections 6321 and 6322, if a person fails to pay federal taxes owed, on the day the taxes are assessed a statutory tax lien arises and attaches to all property rights owned by the person. Further, the tax liens will also defeat a third party’s interest in the property unless that third party is a certain secured interest holder, a judgment lien creditor, or a purchaser. While priority of federal tax liens is determined by federal law, property interests are determined under state law – New Mexico law, in this case.

The court held that the tax liens arising from assessments made before Fields executed the deeds encumber and are superior to the property interests of both Fields and his wife. But the tax liens arising from assessments made after Fields executed the deeds, as a matter of law, only encumber and are superior to Fields’ interests in half of the value of each property. Although the United States may ultimately be entitled to the full value of each property if the deeds were a fraudulent transfer under New Mexico law, this issue may involve a factual determination as to Fields’ intent, and so the United States did not include it in its motion for partial summary judgment. Thus, the court permitted the foreclosure, as Section 7403(c) allows district courts to order the sale of property subject to a federal tax lien regardless of homestead exemptions or other ownership interests.

This case is part of the U.S. Department of Justice’s commitment to cracking down on employment tax violations.

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.