Federal Tax Bulletin - Issue 169 - May 1, 2018

Chief Counsel's Office Issues Guidance on Unreported Tip Income from "Tip Boxes"

The Office of Chief Counsel advised that cash amounts distributed to individuals from "tip boxes" are properly classified as tips under the rules of Rev. Rul. 2012-18 and are wages subject to FICA tax. In addition, the cash amounts distributed to individuals from "tip boxes" are subject to notice and demand procedures under Code Sec. 3121(q). CCA 201816010.

Background

In CCA 201816010, the Office of Chief Counsel was asked about the tax treatment of cash distributed from a "tip box." The scenario presented involved a taxpayer who engages individuals to perform services at the taxpayer's request and on the taxpayer's premises. The taxpayer treats the individuals as volunteers and does not directly pay the individuals any form of compensation or benefits for their services. The taxpayer acknowledged, however, that the individuals receive cash payments from amounts contributed by customers. The cash amounts are deposited by customers in "tip boxes" placed by the taxpayer in the vicinity of where the individuals perform services.

The taxpayer places the "tip boxes" to encourage customers to contribute cash amounts to the individuals, but does not require customers to make cash contributions. Customers have discretion on how much cash to contribute (including zero contribution).

The amount of cash in the "tip boxes" is distributed at the end of each shift. Individuals who performed services during a shift determine how to allocate the tip box amount between all of the individuals who performed services during that shift. Although the taxpayer is aware that customers place cash in the "tip boxes" and that the individuals working each shift distribute the cash among themselves, the taxpayer does not have a system in place for individuals to provide written statements reporting the cash amounts received to the taxpayer, and there is no evidence that the taxpayer has knowledge of the specific amount of cash received by each individual. The taxpayer does not issue Forms W-2, Wage and Tax Statement, to the individuals and has not included any wages or taxes in connection with their services on Form 941, Employer's Quarterly Federal Tax Return.

During the course of an audit, the IRS determined that the taxpayer has the right to direct and control the individuals as they perform services and that the individuals should be classified as employees of the taxpayer for purposes of FICA taxes. In addition to its worker classification determination, the IRS proposed a FICA tax liability related solely to the unreported cash amount received by the individuals. The IRS issued a Letter 3523 to the taxpayer at the conclusion of the audit, notifying the taxpayer of its worker classification determination.

The IRS asked the Office of Chief Counsel whether the cash amounts are "tips" subject to notice and demand procedures under Code Sec. 3121(q) or whether tax on the tip box amounts should be included in Table 3 of Letter 3523, which lists the proper amount of employment tax, additions to tax, and penalties with respect to payments made to individuals who are being reclassified as employees.

Analysis

Code Sec. 3102(a) requires employers to deduct from wages and pay over the employee portion of the FICA tax. However, Code Sec. 3102(c)(1) provides a special rule applicable to tips. The employer's obligation to deduct employee FICA tax from tips which constitute wages is applicable only to such tips as are included in a written statement furnished by the employee to the employer pursuant to Code Sec. 6053(a), and only to the extent that collection can be made by the employer by deducting the amount of the tax from wages of the employee (excluding tips) as are under control of the employer, or from other funds made available by the employee for this purpose.

Under Code Sec. 3121(q), tips received by an employee in the course of the employee's employment are considered remuneration for that employment (and are deemed to have been paid by the employer for purposes of the employer portion of the FICA taxes imposed by Code Sec. 3111(a) and (b)). For purposes of determining the timing of the employer's FICA tax liability, the remuneration is deemed to be paid when a written statement including the tips is furnished to the employer by the employee pursuant to Code Sec. 6053(a). However, if the employee does not furnish the statement, or if the statement furnished is inaccurate or incomplete, the remuneration is deemed to be paid on the date on which the IRS issues a notice and demand under Code Sec. 3121(q) for the taxes to the employer.

Tips are not defined in the Code or regulations; however, published guidance addresses how to determine whether a payment is a tip. Rev. Rul. 2012-18 reaffirms the factors first stated in Rev. Rul. 59-252 which are used to determine whether payments constitute tips. Rev. Rul. 2012-18 provides that the absence of any of the following factors creates a doubt as to whether a payment is a tip:

(1) payment must be made free from compulsion;

(2) the customer must have the unrestricted right to determine the amount;

(3) the payment should not be the subject of negotiation or dictated by employer policy; and

(4) generally, the customer has the right to determine who receives the payment.

The Office of Chief Counsel advised that, under the facts presented, the four factors set forth in Rev. Rul. 2012-18 are satisfied. The fact that the cash contributions are collected by the individuals who work during the shift and pooled for purposes of distribution among them satisfies the fourth factor, the Chief Counsel's Office said. The customers generally have the right to determine who receives the payment when the tipped amounts are pooled and the individuals working each shift distribute the cash among themselves.

According to the Chief Counsel's Office, once the amounts have been properly identified and characterized as tips, the timing of the FICA rules for employer tax liability purposes are applied. Because the tips have not been reported to the taxpayer under Code Sec. 6053(a), the Chief Counsel's Office said, they are deemed to be paid on the date on which the IRS issues a notice and demand under Code Sec. 3121(q) for the taxes to the taxpayer. Thus, the tips are not subject to the employer share of FICA tax until the IRS issues a notice and demand under section 3121(q).

The Chief Counsel's Office concluded that the IRS should issue Letter 3523 to the taxpayer based on the worker classification determination, and should identify in Table 1 of Letter 3523 the individuals the IRS determined should be reclassified as employees. However, tax on the cash amounts received by the individuals should not be included in Table 3 of Letter 3523 because the tips are deemed paid only after the IRS issues a notice and demand under Code Sec. 3121(q). According to the Chief Counsel's Office, the only issue that would be subject to Tax Court jurisdiction would be the proper worker classification of the individuals listed in Table 1.

The Chief Counsel's Office noted that, if an amount properly characterized by an employer as a tip was reported by the employee to the employer in accordance with Code Sec. 6053(a), it would be deemed to be paid at the time the written statement was made and tax on the amount should be included in Table 3 at the time Letter 3523 was issued. Similarly, if an amount characterized by an employer as a tip was determined not to be a tip (for example, it was a service charge) tax on the amount should be included in Table 3 at the time Letter 3523 was issued.

For a discussion of the payroll tax treatment of tips by an employer, see Parker Tax ¶124,120.

[Return to Table of Contents]

Engineer's Losses from Music Activities Partially Allowed as Business Expenses

The Tax Court held that a professional engineer, who recorded two full length albums of music and released them for sale, properly deducted most of the expenses related to the music activities as ordinary and necessary business expenses even though he had no income from his music activities for the years at issue. The court found that the taxpayer, who filed three Schedules C, Profit or Loss From Business, in one year and six the following year, had adequately substantiated most of the expenses he reported on his Schedules C even though some of his records were not maintained in an orderly fashion, were illegible, and required the court to cross reference multiple schedules and bank records. Nicholson v. Comm'r, T.C. Summary 2018-24.

Aaron Keith Nicholson is an engineer who found his work stressful. To reduce stress, he decided to develop his talents as a musician, and during 2013-2014, he produced two full length albums. Nicholson completed all the recordings in 2013, worked with a music producer, and released his music for sale on the internet as well as on CDs in 2014.

Nicholson has three daughters and one son, all of whom participated in various ways in his musical activities. Nicholson claimed that he was most creative and productive as a musician when he was happy and that he enhanced his artistic creativity and productivity by dining out with his children and engaging in recreational pursuits such as bowling, hiking and camping, and traveling.

Nicholson filed a Form 1040 for 2013 and attached three Schedules C, Profit or Loss From Business, identifying the underlying activities as Music Production/Record Company, Photographer, and Musician. Nicholson reported no gross receipts from these activities, but reported expenses of over $48,000. The expenses included contract labor expenses (comprising almost $26,000 paid to a recording studio with the balance apparently paid to his children); vehicle expenses of approximately $4,000, advertising expenses of $3,200; books, camera, and other equipment expenses of $2,900; audio and music equipment of over $3,000; repairs and maintenance expenses of over $1,000; and other miscellaneous expenses, including meals and entertainment, utilities, supplies, bank fees, and rental items.

Nicholson attached six Schedules C to his Form 1040 for 2014, identifying his business activities as Music Production/Record Company, Photographer, Musician, Business Administrative Support, Graphic Arts, and Writer. He reported no gross receipts for 2014 and expenses of over $21,000. The 2014 expenses included contract labor payments of $4,600 to a recording studio and $3,300, apparently paid to his daughter; vehicle expenses of almost $800; advertising expenses of almost $300, books, equipment, software, and business property expenses of over $6,000; repairs and maintenance expenses of $330, meals and entertainment expenses of $1,800, travel expenses of $3,600, and other miscellaneous expenses.

Nicholson kept comprehensive records, including a mileage log, receipts, and bank statements to substantiate the expenses he attributed to his music activities. His records included numerous receipts for meals that he shared with his children and their spouses or dates, hiking, camping and ski equipment, a rowing machine, books and magazine subscriptions, and travel expenses related to trips to various destinations in California and Nevada and to Japan, where his daughter and grandson lived. Nicholson said his hiking, camping and travel-related expenditures were properly attributable to his music activities because he took photos at the more picturesque locations for use as album art and for display on social media sites, and because traveling always inspired him to be more creative. He acknowledged that several receipts that he included in his business records, including those for a baby carrier, children's books, a stud finder, and a chain saw rental, were probably not related to his music activities.

Code Sec. 162(a) permits a deduction for ordinary and necessary business expenses paid during the year in carrying on any trade or business. No deduction is allowed for personal, living or family expenses. If a taxpayer establishes that a deductible expense was paid but fails to establish the amount of the deduction, the court may estimate the amount allowable as a deduction. Under Code Sec. 274(d), more stringent substantiation requirements apply for travel, meals and entertainment expenditures, as well as for expenses related to the use of certain listed property including passenger automobiles. For these expenses, the taxpayer's records must establish the amount, date and time, and business purpose for each expenditure for travel away from home or each expenditure or business use of listed property.

The IRS determined that Nicholson was not entitled to the loss deductions he claimed for the years at issue because he failed to substantiate the expenses reported on his Schedules C. In the alternative, the IRS determined that the expenses did not constitute ordinary and necessary business expenses, although the IRS did not dispute that Nicholson's music activities constituted a trade or business. The IRS also assessed accuracy-related penalties for both of the years at issue.

The Tax Court held that Nicholson adequately substantiated most of the expenses that he reported on his Schedules C. The court found that Nicholson's records were comprehensive, even though they were not maintained in an orderly fashion, some were illegible, and the court had to cross reference multiple schedules and bank records.

The court determined that Nicholson's ordinary and necessary business expenses were limited to his expenses for contract labor, web hosting, vehicle expenses, equipment and repairs, CD purchases, and certain other miscellaneous expenses. The court held that Nicholson had over $25,000 of deductible contract labor expenses in 2013 and approximately $4,600 in 2014. It also found that Nicholson had deductible vehicle expenses of over $1,300 and equipment and repair expenses of over $2,700 for the years at issue. Nondeductible personal expenses included Nicholson's payments to his children, expenses for travel, meals and entertainment, expenses for hiking and camping trips and related equipment, most vehicle expenses, and other nondeductible miscellaneous expenses.

With respect to penalties, the court found that the IRS had met its burden of production because Nicholson had claimed deductions for numerous nondeductible personal expenses. The court found that Nicholson did not offer a meaningful defense other than to assert that he relied on TurboTax to prepare his returns. The court found there was no objective evidence that Nicholson reasonably attempted to ascertain the correctness of the disallowed deductions or to comply with the Code, and therefore sustained the penalty determinations.

For a discussion of the deductibility of ordinary and necessary business expenses, see Parker Tax ¶90,110. For a discussion of travel expenses, see Parker Tax ¶91,105.

[Return to Table of Contents]

After Stakeholder Complaints, IRS Adjusts 2018 HSA Annual Limitation on Deductions

The IRS modified the 2018 annual limitation on deductions for contributions to health savings accounts for individuals with family coverage under a high deductible health plan (HDHP) to bring it back to the limitation amount in effect prior to the change in the limitation announced in Rev. Proc. 2018-18. The modification was the result of complaints from stakeholders that implementing the $50 reduction to the limitation on deductions for individuals with family coverage would impose numerous unanticipated administrative and financial burdens. Rev. Proc. 2018-27.

Background

On May 4, 2017, the IRS issued Rev. Proc. 2017-37, which provided the 2018 inflation adjusted amounts for health savings accounts (HSAs) as determined under Code Sec. 223. Under Rev. Proc. 2017-37, the annual limitation on deductions under Code Sec. 223(b)(2)(B) for an individual with family coverage under a high deductible health plan (HDHP) was $6,900.

Subsequently, the Tax Cuts and Jobs Act of 2017 (TCJA) modified the inflation adjustments for certain provisions of the Code, including the inflation adjustments under Code Sec. 223. On March 2, 2018, the IRS released Rev. Proc. 2018-18, which superseded Rev. Proc. 2017-37, to reflect the statutory changes to the inflation adjustments under TCJA. Under Section 4 of Rev. Proc. 2018-18, the annual limitation on deductions under Code Sec. 223(b)(2)(B) for an individual with family coverage under an HDHP was $6,850 for 2018 a $50 reduction from the limitation announced in Rev. Proc. 2017-37. Rev. Proc. 2018-18 did not change any other annual limitation or any other requirement under Code Sec. 223 for calendar year 2018.

In response to Rev. Proc. 2018-18, stakeholders complained that implementing the $50 reduction to the limitation on deductions for individuals with family coverage would impose numerous unanticipated administrative and financial burdens. Specifically, stakeholders noted that some individuals with family coverage under an HDHP made the maximum HSA contribution for the 2018 calendar year before the issuance of Rev. Proc. 2018-18 reducing the deduction limitation, and that many other individuals made annual salary reduction elections for HSA contributions through their employers' cafeteria plans based on the $6,900 limit for an individual with family coverage under an HDHP. Further, stakeholders informed the IRS that the costs of modifying the various systems to reflect the reduced maximum, as well as the costs associated with distributing a $50 excess contribution (and earnings), would be significantly greater than any tax benefit associated with an unreduced HSA contribution (and in some instances may exceed $50). Some stakeholders also pointed to Code Sec. 223(g)(1), which requires annual inflation adjustments for HSAs to be published by June 1 of the preceding calendar year, as another indication that a current year change would be unduly burdensome.

IRS Modifies Guidance

In response to these concerns, the IRS determined that it was in the best interest of sound and efficient tax administration to allow taxpayers to treat the $6,900 annual limitation originally published in Rev. Proc. 2017-37 as the 2018 inflation adjusted limitation on HSA contributions for eligible individuals with family coverage under an HDHP.

Rev. Proc. 2018-27 provides that, an individual who receives a distribution from an HSA of an excess contribution (with earnings) based on the $6,850 deduction limit published in Rev. Proc. 2018-18 may repay the distribution to the HSA and treat the distribution as the result of a mistake of fact due to reasonable cause under Q&A-37 of Notice 2004-50. Accordingly, the portion of a distribution (including earnings) that an individual repays to an HSA by April 15, 2019, is not included in the individual's gross income under Code Sec. 223(f)(2) or subject to the 20 percent additional tax under Code Sec. 223(f)(4), and the repayment is not subject to the excise tax on excess contributions under Code Sec. 4973(a)(5). Mistaken distributions that are repaid to an HSA are not required to be reported on Form 1099-SA or Form 8889 and are not required to be reported as additional HSA contributions. However, in accordance with Q&A-76 of Notice 2004-50, a trustee or custodian is not required to allow individuals to repay mistaken distributions.

Alternatively, an individual who receives a distribution from an HSA of an excess contribution (with earnings) based on the $6,850 deduction limit published in Rev. Proc. 2018-18 and does not repay the distribution to the HSA may treat the distribution in accordance with Code Sec. 223(f)(3), which describes the treatment of excess contributions returned before the due date of return. Thus, the excess contribution generally would not be included in gross income under Code Sec. 223(f)(2) or subject to the 20 percent additional tax under Code Sec. 223(f)(4), provided the distribution is received on or before the last day prescribed by law (including extensions of time) for filing the individual's 2018 tax return.

The tax treatment described above does not apply to distributions from an HSA that are attributable to employer contributions (pursuant to a cafeteria plan election or otherwise) if the employer does not include any portion of the contributions in the employee's wages because the employer treats $6,900 as the annual limitation on deductions under Code Sec. 223(b)(2)(B). In that case, unless the distribution from the HSA is used to pay qualified medical expenses, the distribution is includible in the employee's gross income under Code Sec. 223(f)(2) and subject to the 20 percent additional tax under Code Sec. 223(f)(4).

For a discussion of the limitation on deductions to HSAs, see Parker Tax ¶81,115

[Return to Table of Contents]

Son Fraudulently Induced Parents to Sell Company at a Discount by Not Disclosing Nonpayment of Payroll Taxes

The Fifth Circuit affirmed a district court's holding that an individual who managed a business owned by his parents fraudulently induced them to sell the company to him at a discount by not disclosing that the company had withheld but failed to deposit approximately $1 million in payroll taxes, a liability which was not transferred but remained with the parents after the sale. The court found that the omission constituted fraud because the son had a fiduciary duty to his parents to disclose the nonpayment, and the court rejected the son's argument that he was not aware of the nonpayment before the sale after finding that the son's awareness could be inferred from the evidence. Bailey v. Bailey, 2018 PTC 115 (5th Cir. 2018).

Shirley and Roger Bailey owned Rig-Up Electrical Services, Inc. (Electrical), an Arkansas corporation located in both Arkansas and Texas. Mrs. Bailey served as president, while her son, Jeffrey Bailey, was the executive vice president of the Texas location. In 2007, Mr. and Mrs. Bailey were considering retirement and left Jeffrey in charge of managing the company. Mrs. Bailey continued as president but assumed a smaller role.

Electrical's bookkeeper, Michelle Reed, was responsible for calculating the weekly payroll, tax deposits, and operating expenses. Once Jeffrey began managing the company, Mrs. Bailey's only remaining role was to make weekly draws on the company's line of credit at an Arkansas bank based on information provided by Reed for the amounts needed to cover expenses. Mrs. Bailey would transfer the funds from the Arkansas bank to a bank in Texas, and Reed would disburse funds from the Texas account.

Jeffrey started a new company in 2008 called Rig-Up Services, LLC (Services). He expressed interest in purchasing Electrical's assets. To help secure financing, Jeffrey hired Roy Johnson to serve as Electrical's chief financial officer. Jeffrey and Johnson then hired Harris Arthur, a CPA, to review Electrical's financial records and provide financial reports.

Electrical's payroll and tax deposits were computed on a weekly basis using accounting software. In April or May 2008, Arthur noticed that the software showed the payroll taxes as having been sent to the IRS while the bank records showed that they had not. Arthur tried to resolve the issue but was unsuccessful, so he sent a letter to Jeffrey asking for a power of attorney to request from the IRS information concerning Electrical's payroll tax payment history. Arthur confirmed a few days later that Electrical owed over $1 million in unpaid payroll taxes.

Meanwhile, Mr. and Mrs. Bailey began receiving letters from the IRS requesting Electrical's tax returns for unemployment and payroll taxes because they had not been timely filed. Mrs. Bailey faxed the second IRS notice to Jeffrey, who assured her that he had taken care of the problem.

In August 2008, Jeffrey and his parents executed an asset purchase agreement. Mrs. Bailey sold Electrical's assets to Jeffrey for $4 million when the market price was $12 million, resulting in an $8 million discount. She did so because of the family tie and her trust in him to run the business. Soon after the sale, Arthur sent a letter to Mrs. Bailey explaining that Electrical had been withholding funds from employees' paychecks but not transferring the money to the IRS. This information had been kept from Mrs. Bailey until after the deal closed. Six days before the closing, Johnson had instructed Arthur to focus on other issues and "leave the tax thing alone for now." Mrs. Bailey was thus surprised to learn of the tax liability, and a dispute arose as to who was responsible for it.

Jeffrey sued in a district court for a declaratory judgment that the obligation belonged to his parents and Electrical. Under the terms of the agreement, only certain preexisting liabilities of Electrical were transferred to Services, and those specified liabilities did not include payroll taxes. In an initial appeal, the Fifth Circuit held that Services and Jeffrey were not liable for the unpaid payroll taxes. The Fifth Circuit remanded for consideration of the parents' defense that they would not have sold the assets to Jeffrey at such a steep discount had they been told about the tax liability. On remand, the district court held that Jeffrey fraudulently induced the sale. The district court entered a judgment that Jeffrey and Services were responsible for Electrical's outstanding payroll taxes, plus interest and penalties.

Jeffrey appealed that decision to the Fifth Circuit. He argued that he did not have a duty to disclose Electrical's payroll tax liability before the execution of the agreement. He also argued that there was no evidence that he knew about the unpaid taxes before the sale. Jeffrey objected that Mrs. Bailey had an equal opportunity to learn of the nonpayment before the sale. Finally, Jeffrey argued that his parents had unclean hands because they increased Electrical's line of credit by approximately $500,000 days before the sale closed, and this liability did not transfer to Services.

The Fifth Circuit held that Jeffrey fraudulently induced the sale. It found that, as an officer of Electrical, Jeffrey had a fiduciary duty to disclose the tax liability to his parents as the owners of the company. Next, the court found that the evidence supported the conclusion that Jeffrey knew about the unpaid payroll taxes before the sale.

First, the court noted Arthur's testimony that before the sale, he twice discussed the problem with Jeffrey and Johnson and sent an email listing the unpaid amount. Although the email was not sent to Jeffrey, that fact did not undermine, in the court's view, Arthur's credible testimony that he discussed the problem (if not the exact amount) with Jeffrey before the sale.

The Fifth Circuit then laid out additional evidence that corroborated Arthur's testimony that he told Jeffrey about the tax problem. The court explained that Jeffrey knew the quarterly payroll tax returns had not been filed and told his mother he was taking care of it. Although a failure to file did not necessarily mean the payroll taxes had not been forwarded to the IRS, an inference could be drawn that there was also a problem with the payments themselves.

Arthur's request for a power of attorney also supported the conclusion that Jeffrey knew about the unpaid taxes. Arthur said he needed the power of attorney to determine all of the company's 2007 tax deposits. To the court, this suggested that Jeffrey knew not just about the failure to file but also that there was a problem with money being forwarded to the IRS, because there would be no reason to ask the IRS for payment information if Jeffrey believed that all 2007 tax deposits had been made. Moreover, it made little sense for Arthur to request the power of attorney but then hide from Jeffrey that the company had not paid the taxes it owed.

The court also found probative an email Johnson sent to Arthur, Reed and Jeffrey after the sale stating that the group needed to discuss how to handle the taxes owed from a financial reporting perspective. Although sent after the sale, the email's discussion of the $1 million owed and Jeffrey's inclusion on the distribution list supported the view that the group know about the liability before the sale. The court reasoned that nothing in the email suggested that Jeffrey was learning about the liability for the first time.

The Fifth Circuit found that Mrs. Bailey did not have an equal opportunity to learn of the nonpayment because it found that three days before the sale, Johnson directed Arthur not to tell her about the tax problem. The court also noted that Reed never advised Mrs. Bailey of the liability during their weekly phone calls.

Jeffrey's unclean hands argument was rejected because the transfer of funds was at issue in a separate lawsuit, and that case settled. In the settlement, the parties agreed to dismiss most of Jeffrey's claims against his mother in this case, including breach of contract, fraud and negligent misrepresentation. The Fifth Circuit reasoned that if Jeffrey achieved a settlement in the other lawsuit based on these same allegations arising out of the increased line of credit, it would be double dipping to use the same conduct as a defense in this case.

Finally, the Fifth Circuit discussed the consequence of Jeffrey's fraudulent inducement. The court found that the district court's remedy was effectively a reformation of the contract, and reformation is not a remedy for fraudulent inducement. The Fifth Circuit therefore remanded to allow Electrical and the Baileys to elect whether to rescind the contract or affirm it and recover damages.

For a discussion of the requirement to deposit employment taxes, see Parker Tax ¶217,000.

[Return to Table of Contents]

Insurers Can Bring Class Action for Unpaid ACA Cost Sharing Reduction Payments

The Court of Federal Claims allowed a lawsuit against the government by health insurers for unpaid cost sharing reduction (CSR) payments under the Affordable Care Act to go forward as a class action. The court found that the putative class representative satisfied all of the requirements for class certification and rejected the government's argument that a class action would be unmanageable due to the many individualized computations that it claimed would be required as a result of insurers offsetting the unpaid CSR payments by raising premiums in order to receive increased premium tax credit payments. Common Ground Healthcare Cooperative v. U.S., 2018 PTC 110 (Fed. Cl. 2018).

Background

The Affordable Care Act (ACA) includes a series of interlocking reforms designed to expand coverage in the individual health insurance market. To mitigate the risk to insurers resulting from such expanded coverage, the ACA included three premium stabilization programs: a temporary risk corridor program, premium tax credits for eligible individuals, and cost sharing reduction (CSR) payments to insurers.

The temporary risk corridor program required the Department of Health and Human Services (HHS) to make payments to insurers whose costs to provide benefits exceeded the premiums they received, and to collect payments from insurers whose costs were less than the premiums they received. The Code Sec. 36B premium tax credit was designed reduce the premiums for individuals with incomes between 100 percent and 400 percent of the poverty line by providing for periodic advance payments to insurers offering plans in which the eligible individuals are enrolled, and requiring insurers to use these payments to reduce premiums for these individuals. CSR payments were intended to reduce out-of-pocket expenses of eligible individuals by requiring insurers to reduce these individuals' cost sharing obligations and providing for reimbursements to insurers for the CSR payments they make. The overall effect of these reforms is that the tax credits help people obtain insurance and the CSR payments help people obtain treatment once they have insurance.

The government began making CSR payments to insurers in 2014. However, in October 2017, the government terminated these payments based on Attorney General Session's conclusion that Congress had not appropriated any funds for that purpose. Because insurers were still required to reduce eligible individuals' cost sharing obligations, the lack of reimbursement had the potential to cause serious financial strain on the insurers, who might then increase premiums to make up for the lost CSR payments or withdraw from the exchanges. Some insurers did, in fact, increase premiums.

In 2016, an insurer filed a putative class action in the Court of Federal Claims alleging the government had not fully paid the risk corridors payments to which insurers were entitled in 2014 and 2015. The government did not dispute that the insurers in that case satisfied the requirements for class certification under Rule 23 of the Rules of the Court of Federal Claims, and the court certified a class of insurers who were owed risk corridors payments. Common Ground Healthcare Cooperative opted in to the certified class in that case.

In 2017, Common Ground filed its own putative class action to recover, for itself and other insurers, unpaid risk corridors payments for 2016. Several months later, Common Ground amended its complaint to add a claim for the CSR payments that the government had not made since October 2017. Several other insurers then either filed suit or added claims to their existing complaints for the unpaid CSR payments. In December 2017, Common Ground moved to certify two classes: a risk corridors class and a CSR class. The government did not dispute the risk corridors class, and the court certified it. However, the government opposed Common Ground's motion to certify a CSR class.

Analysis

Rule 23 includes several requirements for maintaining a class action in the Court of Federal Claims. A putative class representative must demonstrate that (1) the proposed class is so large that joinder is impractical, (2) common questions of law or fact predominate over individual issues, (3) the representative's claims are typical of the proposed class, and (4) that a class action is the fairest and most efficient method of resolving the suit (the superiority requirement). The superiority requirement is met if a class action would achieve economies of time, effort and expense and promote uniformity of decision as to others similarly situated.

The government did not dispute that the first three requirements had been met, but contended that Common Ground had not established that a class action was superior to other methods of resolving the insurers' claims for unpaid CSR payments. According to the government, consolidation was superior to a class action because the court would need to make many individualized determinations due to the fact that some insurers would have made up for the unpaid CSR payments by increasing premiums, resulting in increased premium tax credit payments. To support the government's contention that such an offset was permitted under the ACA, the government cited California vs. Trump, 267 F. Supp. 3d 1119 (N.D. Cal. 2017), where a district court discussed how insurers were coping with the lost CSR payments by raising premiums to obtain larger premium tax credit payments.

The Court of Federal Claims rejected the government's arguments and certified the CSR class of insurers. First, the court found that there was no statutory support for permitting insurers to use premium tax credit payments to offset unpaid CSR obligations, even if insurers had intentionally increased premiums to obtain larger premium tax credit payments to make up for the lost CSR payments. The court found that the California vs. Trump decision did not support the availability of such an offset because nowhere did the district court hold that the government's liability for CSR payments was lessened or eliminated by the government making larger premium tax credit payments to insurers. In the view of the Court of Federal Claims, the district court had clearly emphasized that the tax credit and cost reduction provisions were separate and distinct. The district court found that by placing these provisions in separate Titles of the U.S. Code, Congress was aware of the different way in which each one fit into the ACA's statutory scheme. Moreover, the Court of Federal Claims found that the portion of the district court's opinion on which the government was relying was focused not on the government's obligation to make payments to insurers but on how the increase in premiums would affect the public.

The Court of Federal Claims recognized that the parties had not yet fully briefed the issue of whether the government's obligation to make CSR payments was mitigated by its increased premium tax credit payments. But given the lack of cited authority supporting the availability of such an offset, the court reasoned that the determination of the amount due to each potential class member appeared to consist of a straightforward calculation based on data obtained from the affected insurers. Thus, the court assumed for purposes of deciding the class certification issue that the individual damages determinations would be uncomplicated.

The court noted that the government had not argued that insurers had a strong interest in litigating their own separate actions, or that numerous individual class members had filed their own lawsuits regarding CSR payments. The government had challenged only the manageability of the proposed class action, and the court found that Common Ground had successfully rebutted that argument. In the court's view, each insurer was affected by the same government action in the same way. A class action would therefore be more efficient than consolidation because insurers could pursue their CSR claims without having to file separate complaints. Further, a class action would relieve both the government and the court of the burdens associated with managing potentially hundreds of new cases with virtually identical allegations. The court concluded that consolidation of CSR claims would be more cumbersome than allowing insurers to pursue their claims in a class action.

For a discussion of the health plan premium assistance credit, see Parker Tax ¶102,610.

[Return to Table of Contents]

Pizza Company Liable for Excise Taxes on Excess Contributions to Pension Plan

The Eighth Circuit affirmed the Tax Court and held that a business owed excise taxes and penalties because it made excessive contributions to its defined benefit pension plan. The court also held that the Tax Court correctly concluded that the taxpayer did not make a valid election regarding the excess contributions. Pizza Pro Equipment Leasing, Inc. v. Comm'r, 2018 PTC 116 (8th Cir. 2018).

Background

In 1995, Pizza Pro established a defined benefit pension plan (the Plan). The Plan's only participant was the corporation's president. The IRS determined that portions of the contributions to the plan were nondeductible, and thus subject to the 10 percent excise tax under Code Sec. 4972 because the plan's funding didn't fully account for reductions under Code Sec. 415(b)(2)(C) for benefits beginning before age 62, and those contributions were in excess of the Code Sec. 404 limitations. The IRS also imposed penalties for the failure to file an excise tax return and to timely pay the excise tax owed.

The Tax Court agreed and held that Pizza Pro was liable for the excise taxes and penalties and Pizza Pro appealed to the Eighth Circuit.

Limitation on Deductible Contributions to a Qualified Plan

Code Sec. 404(a) provides that an employer's contributions to a pension plan are deductible if they would otherwise be deductible, subject to certain limitations. In computing the amount of an allowable deduction, Code Sec. 404(j)(1)(A) provides that, in the case of a defined benefit plan, there cannot be taken into account any benefits for any year in excess of any limitation on such benefits under Code Sec. 415 for such year.

Code Sec. 415(a)(1)(A) provides that a defined benefit plan pension trust cannot be a qualified plan under Code Sec. 401 if it provides for the payment of benefits to a participant exceeding the limitations imposed by Code Sec. 415(b). A benefit exceeds the limitation if, when expressed as an annual benefit, that benefit is greater than the lesser of the annual inflation-adjusted limitation or 100 percent of the plan participant's average compensation for his highest three years. Under Code Sec. 415(b)(2)(A), an annual benefit is one that is "payable annually in the form of a straight life annuity (with no ancillary benefits)". If the benefit is in any other form, it must be adjusted so that it is equivalent to a benefit payable annually in the form of a straight life annuity. However, any ancillary benefit not directly related to retirement income benefits is not taken into account, nor is any qualified joint and survivor annuity as defined in Code Sec. 417. Code Sec. 417(b) defines a "qualified joint and survivor annuity" for purposes of Code Sec. 417 and 401(a)(11) (which requires joint and survivor annuities to be qualified) as an annuity "for the life of the participant with a survivor annuity for the life of the spouse which is not less than 50 percent of (and is not greater than 100 percent of) the amount of the annuity which is payable during the joint lives of the participant and the spouse," and "which is the actuarial equivalent of a single annuity for the life of the participant." Thus, even though certain joint and survivor annuities are not taken into account under Code Sec. 415(b)(2)(B), under Code Sec. 417(b) they nonetheless must be actuarially equivalent to straight life annuities.

Code Sec. 415(b)(2)(C) provides that if the retirement benefit under a plan begins before age 62, the annual inflation-adjusted limitation should be reduced so that such limitation (as so reduced) equals an annual benefit (beginning when such retirement income benefit begins) which is equivalent to a $160,000 annual benefit beginning at age 62.

Code Sec. 4972(c)(7) provides that in determining the amount of nondeductible contributions for any tax year, an employer may elect for such year not to take into account any contributions to a defined benefit plan except to the extent that such contributions exceed the full-funding limitation.

Arguments before the Eighth Circuit

The key question before the Eighth Circuit was whether the IRS applied mortality adjustments appropriately to reduce the maximum benefits under Code Sec. 415(b)(2)(C) for a retirement age before age 62 in the Pizza Pro's Plan, where the Plan did not provide for forfeiture of the participant's benefits at his death.

Pizza Pro contended that the Plan's annual benefit never exceeded the applicable limitation and that the Tax Court erred in holding that the word "equivalent" in Code Sec. 415(b)(2)(C) should be read as "actuarially equivalent." Relying on recommendations to the IRS from two actuarial groups, Pizza Pro also argued that failing to file the excise tax form should be considered sufficient evidence that Pizza Pro made an election under Code Sec. 4972(c)(7) and should thus not be penalized for failing to file the excise tax return.

Eighth Circuit's Decision

The Eighth Circuit affirmed the Tax Court and upheld the tax deficiency and penalties assessed against Pizza Pro. With respect to Pizza Pro's argument that the Tax Court erred in holding that the word "equivalent" in Code Sec. 415(b)(2)(C) should be read as "actuarially equivalent, the Eighth Circuit said that the court merely applied Reg. Sec. 1.415-3(e), which states that a plan benefit beginning before the normal retirement age is adjusted to "the actuarial equivalent" of a benefit beginning at the normal retirement age. The Eight Circuit noted that Pizza Pro had not challenged the regulation.

The Eighth Circuit said that, because Reg. Sec. 1.415-3(e) does not define "actuarial equivalence," the Tax Court was right to look to general practice within the field of actuarial science to ascertain the proper method for determining the limitation on the annual benefit. The Eighth Circuit found the IRS's report which was introduced in the Tax Court proceedings and which was prepared by an actuary employed by the IRS to be in line with actuarial practice. The court discounted Pizza Pro's report, saying it was not prepared by an actuary and did not accord with actuarial practice. Because the Tax Court did not clearly err in this finding, Pizza Pro's challenge to the deficiencies and additions failed.

With respect to Pizza Pro's argument regarding the election under Code Sec. 4972(c)(7), the court noted that the IRS did not adopt the suggestions made by the actuarial groups that filing no return was, in essence, the same as making the election. The court also noted that, in Young v. Comm'r, 783 F.2d 1201 (5th Cir. 1986), the Fifth Circuit had rejected a similar argument in another context. The Eighth Circuit noted that Pizza Pro's failure to file the requisite form stemmed from its belief that it made no excess contributions and owed no excises taxes, not its intent to make an election. Because it failed to inform the IRS in any manner, the court concluded that Pizza Pro did not make an election.

For a discussion of the limitation on contributions to a qualified plan, see Parker Tax ¶130,517.

[Return to Table of Contents]

Law Firm Can Equitably Recoup Employment Taxes Erroneously Paid by Related Entity

The Tax Court held that a law firm was permitted to offset an employment tax liability by the amount of employment taxes paid on the same wages for the same time period by a related firm due to an error by the firm's payroll services provider. The court held that the firm established the elements of equitable recoupment because an action for the overpayment was time barred, both the overpayment and the IRS's levy arose from the payment of wages to the same employees during the same time period, the payment of wages would otherwise be subject to tax twice on inconsistent theories, and there was sufficient identity of interest between the taxpayer and the related entity. Emery Celli Cuti Brinckerhoff & Abady, P.C. vs. Comm'r, T.C. Memo. 2018-55.

Background

In 1998, four attorneys practiced together in a firm called Emery, Celli, Brinckerhoff & Abady, LLP (Emery LLP). As of January 1, 1999, Andrew Celli ceased to be a partner and John Cuti was admitted as a partner. For the first 15 days of January, the firm continued as Emery LLP. On January 16, 1999, the firm began operating through a new entity, Emery Cuti Brinckerhoff & Abady, P.C. (Emery PC). The firm stopped conducting operations through Emery LLP as of January 16, 1999, but the LLP was maintained for the purpose of collecting revenues, satisfying liabilities, and distributing profits.

Emery LLP paid wages to employees totaling around $13,400 for the first quarter of 1999, and the balance of the employees' wages for that quarter were paid by Emery PC. Emery PC paid over $45,000 in wages and made employment tax deposits with the Electronic Federal Tax Payment System during the first quarter of 1999 (1Q 1999). However, the firm's payroll services provider erroneously made the deposits under Emery LLP's employer identification number (EIN). Emery PC's records showed six deposits totaling approximately $26,000, which were essentially identical the IRS's records for deposits by Emery LLP. The IRS's records showed no deposits by Emery PC for 1Q 1999.

Emery LLP timely filed a Form 941, Employer's Quarterly Federal Tax Return, reporting an employment tax liability for 1Q 1999 of approximately $26,000. Emery PC did not file a Form 941 for 1Q 1999 until 2006, after having been contacted by the IRS. For the three remaining quarters of 1999, Emery LLP filed no Forms 941 and reported no employment tax liabilities. For those quarters, Emery PC filed Forms 941 and made deposits exceeding $25,000 for each quarter.

In March 2006, the IRS notified Emery PC that it had no record of Emery PC having filed a Form 941 for 1Q 1999. Emery PC's accountant, David Grant, prepared a Form 941 for 1Q 1999, which he submitted on March 24, 2006. The Form 941 reported employment tax due of around $21,800 and claimed a credit for deposits of $21,700 by Emery PC. The IRS assessed the $21,800 in employment taxes, but did not credit Emery PC with the $21,700 of deposits claimed. The IRS also assessed additions to tax for failure to file a return, failure to pay, and failure to deposit tax due. The IRS began sending collection notices to Emery PC for these amounts.

Grant submitted to the IRS Taxpayer Advocate Service a Form 941c, Supporting Statement To Correct Information, for Emery LLP's 1Q 1999, claiming adjustments for Emery LLP's overpayment of employment taxes. The Form 941c reported that Emery LLP had previously reported wages of just over $80,000 for 1Q 1999, but that its correct wages and liability for that period were $13,400 and $3,800 respectively. Grant therefore requested that a $22,100 credit be applied to Emery PC's employment tax liability for 1Q 1999. The IRS responded that no credit could be applied because the three year statute of limitations period for a refund had expired.

The IRS then issued a Letter 1058, Final Notice - Notice of Intent to Levy and Notice of Your Right to a Hearing. Emery PC requested a hearing. It contended that the 1Q 1999 tax liability had previously been paid by Emery PC or a related entity and it was therefore entitled to either a credit, refund, setoff or equitable recoupment. Emery PC also argued that the penalties should be abated for reasonable cause. A settlement officer (SO) determined that, because Emery PC and Emery LLP were both still active entities, an offset would not be appropriate.

Emery PC explained to the SO its reasons for maintaining the active status of both entities and promised to provide a written explanation with supporting documentation within a week. Ten days after that deadline, with no explanation provided, the SO concluded that the proposed levy should be sustained. Emery PC's attorney eventually submitted two letters with extensive exhibits explaining the payroll services provider's error and the reasons for maintaining both Emery LLP and Emery PC as active entities. The SO did not review these letters and issued a notice of determination sustaining the levy.

The notice concluded that Emery PC had not shown that employment tax deposits had been misapplied to Emery LLP because Emery LLP was still active, and Emery PC failed to explain or provide supporting documentation for the continued active status of Emery LLP. The notice explained that Emery PC's claim for a credit for the time barred refund of Emery LLP's employment tax overpayment through equitable recoupment was not considered. The notice did not address penalty abatement. Emery PC petitioned the Tax Court for review.

Analysis

The doctrine of equitable recoupment allows a taxpayer to raise a time barred claim of a tax overpayment as an offset to reduce or eliminate an amount owed if certain elements are established. The taxpayer must show that (1) the overpayment is time barred, (2) the time barred overpayment arose out of the same taxable event as the deficiency before the court, (3) the taxable event has been inconsistently subjected to two taxes, and (4) if there is more than one taxpayer involved, there is sufficient identity of interest between them that they should be treated as one.

Emery PC argued that it was entitled through equitable recoupment to offset its employment tax liability with the overpayment by Emery LLP for the same period, the refund of which was now time barred. According to Emery PC, the IRS would otherwise be entitled to twice collect the employment taxes for 1Q 1999. The IRS argued that equitable recoupment did not apply because Emery LLP's overpayment and Emery PC's underpayment for 1Q 1999 did not arise out of the same taxable event. According to the IRS, the assessment of employment taxes in 1999 based on Emery LLP's payment and the assessment based on Emery PC's liability it reported on Form 941 in 2006 were two separate taxable events.

The Tax Court held that Emery PC was entitled to equitably recoup Emery LLP's employment tax overpayment for 1Q 1999 to offset Emery PC's unpaid employment taxes for that period. First, the court found that there was a time barred overpayment because Emery LLP paid $13,400 of wages and $26,000 of employment taxes for 1Q 1999, and the overpayment occurred more than three years ago.

Next, the court found that there was a single taxable event - the payment of wages. In the court's view, the taxable event in an employment tax case was not the assessment but rather the payment of wages because the payment of wages triggered the employment tax obligations. The court found that in this case the taxable event was the payment of wages to the firm's employees during the latter 75 days of 1Q 1999 (i.e., wages paid after January 15, 1999). In the absence of equitable recoupment, the IRS would have collected tax twice on the same wages, as all of the wages were paid to the same employees during the same period.

The Tax Court then found that the third and fourth elements were also satisfied. The payment of wages would be taxed twice on inconsistent theories because Emery LLP paid employment taxes as the payor of wages, and the IRS was seeking to collect employment taxes from Emery PC on the theory that it was the payor of those same wages during the same period. Identity of interest was also present because the court found that, although Emery LLP and Emery PC were separate legal entities with distinct EINs, each was owned by the same four individuals. Consequently, the burden of double taxation would be borne by the same individuals.

With respect to penalties, the Tax Court concluded that there was reasonable cause for abatement because Emery PC exercised ordinary business care and prudence to ensure that a Form 941 for 1Q 1999 was timely filed and its employment taxes were paid, albeit under an incorrect EIN.

For a discussion of the doctrine of equitable recoupment, see Parker Tax ¶261,180.50.