Federal Tax Bulletin - Issue 162 - January 12, 2018

IRS Issues Updated Withholding Tables; Taxpayers Could See Changes by February

The IRS issued updated income-tax withholding tables for 2018 which reflect changes made by the Tax Cuts and Jobs Act of 2017. According to the IRS, the new withholding tables are designed to work with the Forms W-4, Employee's Withholding Allowance Certificate, which workers have already filed with their employers, and employers should begin using the 2018 withholding tables as soon as possible, but no later than February 15, 2018. IR-2018-05; Notice 1036.

On January 11, the IRS issued new income tax withholding tables to reflect the changes in tax rates and tax brackets, increased standard deduction, and the repeal of personal exemptions that were included in the Tax Cuts and Jobs Act of 2017 (TCJA) that was signed into law on December 22. The withholding guidance is for employers to make changes to their payroll systems and is designed to work with existing W-4s that employees have on file.

According to the IRS, employees should begin to see withholding changes in their paychecks in February. However, the exact timing depends on when their employer makes the change and how often they are paid. The IRS noted that it typically takes payroll providers and employers about a month to update withholding changes on their systems. While employees do not need to take any action to get the new withholding rates, they should review their withholding to make sure that it is accurate. The IRS said it will be releasing a new calculator and Form W-4 soon, to help employees ensure withholding is accurate.

The IRS noted that employees will not need to fill out a new Form W-4, Employee's Withholding Allowance Certificate, because the new withholding tables are designed to minimize taxpayer burden as much as possible and will work with the Forms W-4 that workers have already filed with their employers to claim withholding allowances. The IRS said it is working on revising the Form W-4 to more fully reflect the new law and provide taxpayers information to determine whether they need to adjust their withholding. The IRS said it will soon be releasing a revised Publication 15, (Circular E), Employer's Tax Guide, and related publications.

In addition, the IRS said it is working on revising the Form W-4 to more fully reflect the new law and to provide taxpayers information to determine whether they need to adjust their withholdings. The IRS is also revising the withholding tax calculator on IRS.gov to help employees who wish to update their withholdings in response to the new law or other changes in their personal circumstances in 2018. The IRS anticipates this calculator should be available by the end of February.

The IRS cautioned that some people have more complicated tax situations and face the possibility of being under-withheld on their taxes with the changes to the withholding tables. For example, people who itemize their deductions, couples with multiple jobs or individuals with more than one job a year should review their tax situations. The IRS is encouraging taxpayers - particularly those with more than one income in their household - to check their withholding.

The IRS also advised that, in 2019, it anticipates making further changes involving withholding and will work with the business and payroll community to encourage workers to file new Forms W-4 in 2019 and share information on changes in the new tax law that impact withholding.

For a discussion of Form W-4, see Parker Tax ¶212,120.

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Form 1099 and Form W-2 Reporting Deadlines Fast Approaching

As the January 31 deadline for filing Forms W-2 and Forms 1099 bears down on businesses, practitioners may want to take a moment to remind clients of the deadline and the potential penalties for late filing (article includes link to sample client letter).

Practice Aid: See ¶320,690 for a client letter which explains the requirement to file Form 1099 and the significance of the Form 1099 question on various tax returns.

Penalties for Failing to File Correct 1099s

Information reporting penalties apply if a payer fails to timely file an information return, fails to include all information required to be shown on the return, or includes incorrect information on the return. The penalties apply to all variations of Form 1099.

The amount of the penalty is based on when the correct information return is filed. For returns required to be filed for the 2017 tax year, the penalty is:

• $50 per information return for returns filed correctly within 30 days after the due date, with a maximum penalty of $532,000 a year ($186,000 for certain small businesses);
• $100 per information return for returns filed more than 30 days after the due date but by August 1, with a maximum penalty of $1,596,500 a year ($532,000 for certain small businesses); and
•  $260 per information return for returns filed after August 1 or not filed at all, with a maximum penalty of $3,193,000 a year for most businesses, but $1,064,000 for certain small businesses.

For purposes of the lower penalty, a business is a small business for any calendar year if its average annual gross receipts for the three most recent tax years (or for the period it was in existence, if shorter) ending before the calendar year do not exceed $5 million.

Persons who are required to file information returns electronically but who fail to do so (without an approved waiver) are treated as having failed to file the return unless the person shows reasonable cause for the failure. However, they can file up to 250 returns on paper; those returns will not be subject to a penalty for failure to file electronically. The penalty applies separately to original returns and corrected returns.

The penalty also applies if a person reports an incorrect taxpayer identification number (TIN) or fails to report a TIN, or fails to file paper forms that are machine readable.

The penalty for failure to include the correct information on a return does not apply to a de minimis number of information returns with such failures if the failures are corrected by August 1 of the calendar year in which the due date occurs. The number of returns to which this exception applies cannot be more than the greater of 10 returns or 0.5 percent of the total number of information returns required to be filed for the year.

If a failure to file a correct information return is due to an intentional disregard of one of the requirements (i.e., it is a knowing or willing failure), the penalty is the greater of $530 per return or the statutory percentage of the aggregate dollar amount of the items required to be reported (the statutory percentage depends on the type of information return at issue). In addition, in the case of intentional disregard of the requirements, the $5,000,000 limitation does not apply.

A safe harbor from penalties has been established for failure to file correct information returns and failure to furnish correct payee statements for certain de minimis errors. Under the safe harbor, an error on an information return or payee statement is not required to be corrected, and no penalty is imposed, if the error relates to an incorrect dollar amount and the error differs from the correct amount by no more than $100 ($25 in the case of an error with respect to an amount of tax withheld). In Notice 2017-9, the IRS issued additional guidance on applying the de minimis error safe harbor relating to information reporting penalties.

Form 1099-MISC

Generally, any person, including a corporation, partnership, individual, estate, and trust that makes reportable transactions during the calendar year must file information returns to report those transactions to the IRS. However, a payer does not need to file Form 1099-MISC for payments not made in the course of the payer's trade or business. Thus, personal payments are not reportable. A payer is engaged in a trade or business if it operates for gain or profit. Nonprofit organizations are considered to be engaged in a trade or business and are subject to the reporting requirements. For other exceptions to filing a Form 1099-MISC, see ¶252,565.

The type of reportable transaction determines the Form 1099 that must be filed. Most of the issues revolving around the filing of Forms 1099, involve Form 1099-MISC and the reporting of non-employee compensation. In general, a payer must file Form 1099-MISC, Miscellaneous Income, for each person to whom the payer has paid during the year:

(1) at least $10 in royalties or broker payments in lieu of dividends or tax-exempt interest;

(2) at least $600 in rents, services (including parts and materials), prizes and awards, other income payments, medical and health care payments, crop insurance proceeds, cash payments for fish (or other aquatic life) purchased from anyone engaged in the trade or business of catching fish, or, generally, the cash paid from a notional principal contract to an individual, partnership, or estate;

(3) any fishing boat proceeds; or

(4) gross proceeds to an attorney.

In addition, Form 1099-MISC must be filed to report direct sales of at least $5,000 of consumer products made to a buyer for resale anywhere other than a permanent retail establishment. Form 1099-MISC must also be filed for each person from whom a taxpayer has withheld any federal income tax under the backup withholding requirement (discussed below), regardless of the amount of the payment.

Strategies to Avoid the Net Investment Income Tax May Trigger 1099 Filing Requirements

As previously mentioned, taxpayers not in a trade or business are not required to file Form 1099s. The characterization of an activity as a "trade or business" is important not only in deciding whether a business must file Forms 1099, but also in determining if income from an activity is subject to the net investment income tax (NIIT). Individuals are subject to a 3.8 percent tax on the lesser of net investment income or the excess of modified adjusted gross income over a threshold amount. Generally, income from a trade or business (with the exception of certain commodities trading income) is exempt from NIIT.

Taxpayers taking the position that their activity is not subject to NIIT because it rises to the level of a trade or business, need to be aware of Form 1099 filing requirements that come with an activity having trade or business status.

Tax Return Questions on Whether Reportable 1099 Payments Were Made

Similar to prior years, the 2017 Forms 1065, 1120, 1120S, and 1040, Schedules C, E, and F, all contain questions asking if the taxpayer made any payments in 2017 that would require the taxpayer to file Form(s) 1099. If the answer is "yes," then the IRS wants to know if the taxpayer did, or will, file the required Forms 1099.

Observation: The questions first showed up in 2011 and coincided with an increase in the penalties for failing to file correct information returns and payee statements. Practitioners immediately expressed concern that their clients may not be focused enough on the ramifications of not correctly reporting Form 1099 income and on their own liability for checking these boxes. If a client reports that all Form 1099s were filed when they were not, the client may be perjuring himself or herself. If the client reports that not all Form 1099s were filed, then that's a red flag for an audit.

Practice Aid: See ¶320,690 for a client letter which explains the requirement to file Form 1099 and the significance of the Form 1099 question on the various returns.

If a taxpayer has a business that uses sporadic labor, the Form 1099 questions can present a dilemma in certain situations. For example, how does a taxpayer who intermittently employs workers by picking them up at places where such workers congregate, answer the questions? If any of these workers are used several times during the year in the taxpayer's business, the amounts paid to that worker will most likely exceed $600 so that the contractor is responsible for issuing a Form 1099-MISC to that individual. What if the workers will accept only cash. Without proper documentation, how does the taxpayer prove that no one individual was paid more than $600?

Can IRS Limit Deductions to $600 Where No Form 1099 Is Filed?

Some practitioners have questioned whether or not the IRS can limit a compensation deduction to $599, the cutoff for not reporting nonemployee compensation, where a Form 1099-MISC is not filed. While there is nothing in the Code or regulations on this, nor is there any case law on point, some practitioners have reported IRS agents telling them that if they had not produced Form 1099s for compensation deductions taken on a return, the nonemployee compensation deduction would be limited to an amount not required to be reported on Form 1099-MISC.

What To Do If Form W-2 Is Undeliverable

A taxpayer should keep for four years any employee copies of Forms W-2 that the taxpayer tried to but could not deliver. However, if the undelivered Form W-2 can be produced electronically through April 15th of the fourth year after the year at issue, the taxpayer does not need to keep undeliverable employee copies. Undeliverable copies should not be sent to the SSA.

Conclusion

Practitioners should ensure that their business clients are on top of the January 31 filing deadline for Forms W-2 and Forms 1099-MISC. Moreover, they should also be advising their clients to have non-employee workers or contractors complete a Form W-9 if they believe payments to any individual might add up to $600 or more for the year. To the extent anyone is paid more than $600, a Form 1099-MISC should then be issued at the end of the year.

Practitioners should also document in their files that they've had these discussions with their clients and may want to consider having their engagement letter reflect the documentation a client will need to take certain deductions on the return. Similarly, practitioners may want to warn their clients about the trade-offs for claiming they are in a trade or business in an effort to escape the net investment income tax and their responsibility for filing Form 1099s when they are in a trade or business.

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IRS Finalizes Rules on Opting Out of Centralized Partnership Audit Rules

The IRS issued a final regulation on who can elect out of the centralized partnership audit regime and the manner in which such election must be made. In the final rule, the IRS declined to expand the types of taxpayers eligible to make the opt-out election even though Congress authorized it to do so, saying that such an expansion would increase the IRS's burden with respect to auditing such taxpayers. T.D. 9829.

Background

In 1982, Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). TEFRA included unified partnership audit procedures aimed at separating the determination of partnership items from the determination of nonpartnership items. For tax years beginning before 2018, the unified TEFRA audit procedures apply to most partnerships that have 10 or more partners. There is an exception to TEFRA for, and special audit procedures apply to, certain small partnerships and electing large partnerships (ELPs).

For tax years beginning after 2017, and earlier tax years if elected, the TEFRA and ELP audit procedures no longer apply. The Bipartisan Budget Act of 2015 repealed the TEFRA and ELP audit procedures and replaced them with a single set of rules for auditing partnerships and their partners at the partnership level.

Under this streamlined audit approach, the IRS examines the partnership's items of income, gain, loss, deduction, credit and partners' distributive shares for a particular year of the partnership (i.e., the "reviewed year"). Any adjustments are taken into account by the partnership, and not the individual partners, in the year that the audit or any judicial review is completed (i.e., the "adjustment year"). Partners are not subject to joint and several liability for any liability determined at the partnership level.

As an alternative to taking an adjustment into account at the partnership level, a partnership can issue adjusted information returns (i.e., adjusted Form K-1s) to the reviewed year partners, in which case those partners would take the adjustment into account on their individual returns in the adjustment year through a simplified amended-return process. The practical effect of this rule is that partnerships generally will no longer issue amended Form K-1s after the partnership return is filed, but instead will use the adjusted Form K-1 process for prior year adjustments.

Opting Out of the Post-2017 Partnership Audit Rules

Under Code Sec. 6221(b)(1), partnerships with 100 or fewer qualifying partners can opt out of the post-2017 partnership audit rules in which the partnership is responsible for underpayments of tax. In such cases, the partnership and partners will be audited under the general rules applicable to individual taxpayers. In order to qualify for this opt-out provision, Code Sec. 6221(b)(1)(C) provides that the partners must be either individuals, C corporations, a foreign entity that would be treated as a C corporation if it were a domestic entity, an S corporation, or an estate of a deceased partner. The election must be made with a timely filed return for the tax year for which it is to be effective and must disclose the name and taxpayer identification number of each partner in the partnership, and each partner must be notified of the election.

A number of situations were not addressed in the opt-out legislation, such as (1) the determination of the number of partners of the partnership for purposes of determining whether the partnership has 100 or fewer partners; (2) the determination of what partners constitute eligible partners for purposes of determining whether the partnership is eligible to make the election; and (3) the mechanics of making the election under Code Sec. 6221(b).

The IRS has now issued Reg. Sec. 301.6221(b)-1, which provides some guidance in these areas.

Determining the Number of Partners

In determining if a partnership has 100 or fewer partners for the tax year, the final regulation provides that a partnership has 100 or fewer partners for the tax year if it is required to furnish 100 or fewer statements under Code Sec. 6031(b). Thus, spouses count as two partners and not one. The IRS noted that, if two individuals are partners in a partnership, the partnership is required to furnish a statement under Code Sec. 6031(b) to each of those individuals, regardless of whether they are married to one another.

In addition, the IRS rejected a comment that the regulation expressly state that one spouse's community property interest is not taken into account for purposes of determining the number of statements the partnership is required to furnish under Code Sec. 6031(b). According to the IRS, creating a specific rule potentially at odds with the existing rules under Code Sec. 6031(b) could result in confusion regarding the proper operation of existing Code Sec. 6031(b) rules and such a rule was not necessary for implementation of Code Sec. 6221(b).

Observation: The IRS said that, as it gains experience with the centralized partnership audit regime, it may consider issuing sub-regulatory guidance covering elections under Code Sec. 6221(b) in the context of constructive and de facto partnerships.

Determining "Eligible" Partners

Under Code Sec. 6221(b)(2)(C), the IRS is authorized to prescribe rules similar to the rules for S corporation partners with respect to other types of persons not specifically described as eligible partners under Code Sec. 6221(b)(1)(C). Practitioners had asked the IRS to expand the rules in a number of ways, suggesting that partnerships, disregarded entities, trusts (including tax-exempt trusts, revocable trusts, charitable remainder trusts, grantor trusts, and nongrantor trusts), individual retirement accounts, nominees, qualified pension plans, profit-sharing plans, and stock bonus plans should be considered eligible partners for purposes of making an opt-out election under Code Sec. 6221(b).

The IRS rejected these comments because, it said, broadening the scope of the election out provisions to include additional types of partners or partnership structures would increase the administrative burden on the IRS since those structures and partners would need to be audited under the deficiency procedures. The IRS dismissed suggestions that the authority granted in Code Sec. 6221(b)(2)(C) signified a congressional expectation that the IRS would expand the list of eligible partners under Code Sec. 6221(b)(1)(C).

Making the Election to Opt-Out

The final regulation provides that the election to opt out of the centralized partnership audit regime must be made on an eligible partnership's timely filed return, including extensions, for the tax year to which the election applies, and, once made cannot be revoked without the consent of the IRS. Additionally, the election must include each partner's name, correct U.S. taxpayer identification number (TIN), and federal tax classification. If the election is being made by a partnership that has an S corporation as a partner, the regulation provides that the election must also include each S corporation shareholder's name, correct U.S. TIN, and federal tax classification.

The regulation also provides that the election must include an affirmative statement that the partner is an eligible partner and any other information required by the IRS in forms, instructions, or other guidance. If a partnership makes an election under Code Sec. 6221(b), the partnership must notify its partners of the election within 30 days of making the election. If the IRS determines that a purported election by a partnership is invalid, the IRS will notify the partnership in writing, and the provisions of the centralized partnership audit regime will apply to the partnership.

For a discussion of the election to opt out of the centralized partnership audit rules, see Parker Tax ¶28,710.

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District Court Holds That Settlement Proceeds Were Nontaxable, but Disallows Deduction of Legal Fees

A district court held that a taxpayer who settled a lawsuit against an accounting firm for failing to properly form an S corporation and an employee stock ownership plan, did not have to include $800,000 in settlement proceeds in income because the proceeds constituted a nontaxable return of capital. However, the taxpayer could not deduct the legal fees he incurred as business expenses because they were personal to him. The court also disallowed a deduction for the difference between the taxes paid as a result of the accounting firm's error and the settlement proceeds. McKenny v. U.S., 2018 PTC 2, (M.D. Fla. 2018).

In the late 1990s, Joseph McKenny hired accounting firm Grant Thornton (GT) to help him with the finances for his car dealership consulting business. GT advised him to form an S corporation, which would in turn form an employee stock ownership plan (ESOP). This structure would allow the income of the S corporation to flow through the ESOP, and under then-current law, the ESOP would pay no tax on the income. The law was later changed to eliminate the ESOP strategy, but at the time, the ESOP structure was not illegal.

GT failed to properly file the necessary documents to establish the S corporation and did not properly form the ESOP. GT also advised McKenny to form another S corporation to acquire a 25 percent interest in a car dealership and further advised the dealership to characterize its payments to the S corporation as management fees rather than partnership profits.

A 2005 IRS audit determined that the ESOP strategy was an abusive tax shelter and that the dealership's payments were improperly characterized for tax purposes. McKenny ultimately settled with the IRS and paid approximately $2.2 million in taxes, interest and penalties for 2000-2005. In 2007, McKenny and the IRS entered into a closing agreement in which McKenny agreed that he was not entitled to any other deductions and/or business losses relating to the ESOP transaction. The closing agreement specified that no amount would be allowed as an ordinary loss for the years at issue.

In 2008, McKenny sued GT for malpractice, breach of contract, and violations of state law, claiming damages in excess of $7.9 million. McKenny also sought to recover punitive damages, attorney's fees, and interest. McKenny and GT settled in 2009 with GT paying $800,000. McKenny claimed he incurred over $400,000 in legal fees in the lawsuit against GT.

On his 2009 tax return, McKenny excluded the $800,000 settlement proceeds as a recovery of capital and deducted the $400,000 legal fees as a business expense. He also deducted the $1.4 million difference between the settlement and the taxes he paid as an unreimbursed loss. The IRS disallowed all of these deductions and exclusions and McKenny paid an additional $813,000 in taxes, interest and penalties. When the IRS denied his refund claim, McKenny sued in a district court.

The IRS argued that the settlement proceeds could not be attributed solely to the amount McKenny paid in taxes because of GT's alleged malpractice because the lawsuit against GT included numerous claims including state law claims for punitive damages. It also said that any harm from the failed ESOP was too speculative because there was no guarantee that the IRS would have approved the ESOP strategy. Regarding McKenny's legal fees, the IRS pointed out that McKenny sued GT individually, not on behalf of his company, the settlement was paid to him personally, and he attempted to deduct the settlement amount from his personal income taxes, not the company's taxes. With respect to the $1.4 million deduction for the difference between the settlement and the taxes paid, the IRS made two arguments. First, it said that because the settlement payment was not a return of capital, the difference between that payment and the taxes McKenny paid was similarly not deductible. Second, the IRS asserted that because the ESOP strategy was an abusive tax shelter, it would be contrary to public policy to allow McKenny to deduct the taxes and penalties he paid because the strategy failed.

The district court held that McKenny could exclude his settlement proceeds from income but could not deduct his legal fees or the difference between the taxes he paid and the settlement proceeds. The court explained that lawsuit proceeds are not taxable income if they are payments by a person causing a loss that restore the taxpayer to the position he was in before the loss. The court pointed out that McKenny's compensatory damages claims against GT were for the taxes he paid because of GT's alleged malpractice. The fact that McKenny also sought punitive damages did not change the amount of his actual damages, which the court said were undisputedly over $2 million. Thus, in the court's view, the $800,000 settlement could be directly attributed to what McKenny paid in excess taxes and penalties because of GT's alleged malpractice. The district court did not agree with the IRS that McKenny's harm was too speculative; the court pointed out that the ESOP strategy was legal at the time and that the IRS provided no authority for its claim that it could have denied approval for the ESOP.

However, the district court agreed with the IRS that McKenny could not deduct his legal fees. The court found that the legal fees were personal to McKenny and not expenses of his business, and that McKenny attempted to deduct the settlement amount from his personal income tax, not the company's taxes. The court also disallowed the deduction for the difference between the taxes paid and the settlement as an unreimbursed loss, finding that McKenny had specifically promised in the 2007 closing agreement not to claim any other deductions or losses with respect to the ESOP strategy.

For a discussion of the taxability of income from lawsuits, see Parker Tax ¶74,130.

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Extended Limitations Period Did Not Apply to Omissions of Foreign Income

The Tax Court held that the IRS was barred by the three-year statute of limitations period from assessing deficiencies and accuracy-related penalties on a taxpayer's omission of income earned on foreign assets in years before the enactment of the foreign account reporting requirement in Code Sec. 6038D. The Tax Court found that the six year statute of limitations under Code Sec. 6051 for such omissions applies only to years for which there was a Code Sec. 6038D foreign asset reporting requirement. Rafizadeh v. Comm'r, 150 T.C. No. 1 (2018).

Mehrdad Rafizadeh filed tax returns for 2006-2008, the years at issue, but did not report income earned on a foreign account. In December 2014, the IRS issued a notice of deficiency determining deficiencies and accuracy-related penalties on underpayments for the years at issue. The IRS conceded that the notice was issued after the expiration of the general three year statute of limitations for each year.

Under Code Sec. 6501, the IRS generally has three years from either the date a return was due or the date it was filed to assess tax. An exception applies under Code Sec. 6501(e)(1)(A)(ii), which extends the period to six years if the taxpayer omits income attributable to an asset "with respect to which information is required to be reported under section 6038D."

Both the Code Sec. 6038D reporting requirement and the six year limitations period under Code Sec. 6501(e)(1)(A)(ii) were added by the Hiring Incentives to Restore Employment Act of 2010 (HIRE Act). The reporting requirement applies to tax years beginning after March 18, 2010, the date of enactment, and the six year limitations period applies to returns filed after March 18, 2010. Thus, the December 2014 notice of deficiency was timely only if the six year limitations period applied.

Rafizadeh argued that the plain language of Code Sec. 6038D provides that the six year period applies only if there was a Code Sec. 6038D reporting requirement at the time the income was omitted. The IRS countered by pointing out the addition of a cross reference to Code Sec. 6038D in Code Sec. 6501(c)(8). Under that provision, which applies to failures to comply with certain information reporting provisions, the limitations period does not expire until three years after the required information is provided. The HIRE Act added Code Sec. 6308D information reporting to the other information reporting provisions. According to the IRS, the incorporation of the Code Sec. 6038D reporting requirement into Code Sec. 6501(c)(8) showed Congress did not intend to make the six year statute of limitations in Code Sec. 6501(e)(1)(A)(ii) dependent on a taxpayer's failure to satisfy Code Sec. 6038D.

The Tax Court held that the wording of the effective date for Code Sec. 6501(e)(1)(A)(ii) limits its application to years for which the Code Sec. 6038D reporting requirement is effective. In the court's view, the most natural reading of the phrase "assets with respect to which information is required to be reported under section 6038D" in Code Sec. 6501(e)(1)(A)(ii) is that the six year period applies only when there is a Code Sec. 6038D reporting requirement. The court reasoned that Code Sec. 6501(e)(1)(A)(ii) does not simply incorporate the definition of assets in Code Sec. 6038D; it also specifies that it applies to assets that are subject to the reporting requirement. If Congress intended simply to incorporate the definition in Code Sec. 6038D of the assets to be covered, it could have said so in the statute, according to the court.

The Tax Court found that the cross reference in Code Sec. 6038D to Code Sec. 6501(c)(8) did not undercut its interpretation. The court explained that the trigger in Code Sec. 6501(c)(8) is the failure to report, and that failure results in a different limitations period. By contrast, the trigger for the six year period in Code Sec. 6501(e)(1)(A)(ii) is the omission of income from assets that are subject to the Code Sec. 6038D reporting requirement. In the court's view, the contrasting language in these two provisions did not shed any more light on how to read Code Sec. 6501(e)(1)(A)(ii) than the wording of the statute itself. Nor did the court agree that its decision rendered the March 18, 2010, effective date meaningless, because that date also applies to other statutory changes.

The court noted that it had addressed a similar issue with cross referencing to a Code section with a different effective date in Blak Invs. v. Comm'r, 133 T.C. 431 (2009). In that case, the Tax Court considered whether the effective date of Code Sec. 6707A precluded application of the extended limitations period in Code Sec. 6501(c)(10). The taxpayer argued that because Code Sec. 6501(c)(10) cross referenced Code Sec. 6707A, the effective date of Code Sec. 6707A controlled. However, the court concluded that applying the Code Sec. 6707A effective date to Code Sec. 6501(c)(10) would render the different effective date in Code Sec. 6501(c)(10) meaningless.

The Tax Court noted two key differences in Blak Invs. that required a different result. First, the wording of the two provisions differed; Code Sec. 6501(c)(10) includes the phrase "for any taxable year," while the application of Code Sec. 6501(e)(1)(A)(ii) is not so broadened. Second, the taxpayer in Blak Invs had a preexisting obligation to report certain information and failed to do so, resulting in the limitations period remaining open for the years at issue. In this case, Rafizadeh had no preexisting obligation to report the information required by Code Sec. 6038D. The differences between the statutory wording and the reporting regimes, in the court's view, required a different result in this case.

For a discussion of the foreign asset reporting requirements, see Parker Tax ¶203,175.

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Tax Court Upholds IRS Denial of Whistleblower Award

The Tax Court held that the IRS did not abuse its discretion in denying a whistleblower's claim for an award because the information provided by the whistleblower did not result in the collection of proceeds by the IRS. The court determined that the scope of its review of an IRS whistleblower award determination was limited to the administrative record but could be supplemented if the record was incomplete, and also determined that the applicable standard of review in such a case is abuse of discretion. Kasper v. Comm'r, 150 T.C. No. 2 (2018).

While working for his former employer, who was the target of the whistleblowing claim, Kenneth Kasper detected what he thought was a long term pattern of forced and uncompensated overtime. Kasper notified the IRS by filing a Form 211, Application for Award for Original Information, in January 2009. He claimed the target owed its employees millions of dollars in overtime pay and that the IRS would benefit by receiving the payroll taxes withheld on that compensation.

The Form 211 was received by the IRS Whistleblower Office (WBO) and eventually forwarded to Brett Roskelley in the Large Business and International Unit (LB&I). Roskelley decided that Kasper had identified a Department of Labor issue, not an IRS issue, and recommended that the IRS deny Kasper's claims. A rejection letter was sent to Kasper stating that the information he furnished did not meet its criteria for an award. The letter explained that, due to federal disclosure and privacy laws, the IRS could not give specific reasons for the rejection. Instead, a boilerplate list of common reasons for not allowing an award was provided. In response to the letter, Kasper filed a petition with the Tax Court.

The target entered bankruptcy in January 2009, around the time Kasper sent his Form 211 to the IRS. In February 2009, the IRS filed a proof of claim in the bankruptcy asserting that the target owed over $15 million in income and withholding taxes. The IRS's claim was amended In February 2010 to reduce the amount to about $170,000, all for unpaid corporate income tax, interest and penalties. A second amended claim increased the purported debt, again all for unpaid corporate income tax, interest and penalties. The IRS and the target eventually negotiated a closing agreement. The target agreed to pay the IRS $37.5 million in full satisfaction of its tax liabilities and agreed that those liabilities related to withholding tax under Code Sec. 1441.

Under Code Sec. 7623(b), a whistleblower may be awarded a percentage of the proceeds recovered from an action in which the IRS proceeded based on information provided by the whistleblower. Thus, Kasper had to show that the information he sent to the IRS about the target resulted in the collection of the proceeds the IRS received in the settlement in order to receive a whistleblower award.

Kasper acknowledged that the IRS did not independently act on his Form 211. However, he claimed that he submitted the same information to the IRS's Fresno office on a Form 3949-A, Information Referral, in late January 2009. Kasper believed the IRS used this information in preparing its proof of claim in the target's bankruptcy. He pointed out that the IRS's original proof of claim included employment taxes as a potential outstanding liability and inferred that the Fresno office must have reported his information to the IRS's solvency group. Kasper also noted that Roskelley was copied on an IRS email chain discussing the need for numbers for an amended proof of claim.

The IRS claimed that Kasper's information was never used and that the IRS merely followed its normal course of business in dealing the target's bankruptcy. The IRS claimed that the WBO's records showed Kasper's claim was denied because his tip was about unpaid wages, which was not an IRS issue because no tax is owed on unpaid wages.

The Tax Court noted that because so few whistleblower cases have been decided on the merits since the enactment of Code Sec. 7623(b) in 2006, it first had to analyze the proper scope and standard of review before considering the merits. The court noted that the default rule for review of an agency decision is that review is limited to the record. The court also found that when Congress provided for judicial review of whistleblower awards, it did not establish any rules about judicial review. Based on this lack of guidance, the Tax Court concluded that it should apply the default rule and limit its scope of review to the administrative record. With regard to the appropriate standard of review, the Tax Court determined that abuse of discretion applied because it was reviewing an agency decision where the scope of review is not de novo.

Turning to the merits, the Tax Court determined that the IRS did not abuse its discretion in rejecting Kasper's whistleblower claim. The Tax Court found that the boilerplate denial letter Kasper received did not explain why Kasper was ineligible for a whistleblower award. However, the court found a contemporaneous explanation in the WBO's records, which showed that the claim was denied because Roskelley's tip was about unpaid wages and no tax is owed on unpaid wages. This rationale, in the court's view, was neither arbitrary nor capricious nor an abuse of discretion.

The Tax Court rejected Kasper's theory that the information in his Forms 211 and 3949-A formed the basis of the IRS's proof of claim against the target in the bankruptcy. The court found that there was nothing unusual in the IRS's filing of its original proof of claim followed by two amendments later that year. According to the Tax Court, bankruptcy courts provide the IRS with notice of all chapter 11 petition filings regardless of whether the IRS is listed as a creditor. An IRS insolvency specialist then has 10 days to take action, which may include filing an estimated proof of claim before the bar date to protect the government's interest and provide more time to determine the exact liability. This unassessed claim is then followed as soon as possible by an amended proof of claim with the correct tax liability. The Tax Court determined that when the target filed for bankruptcy, the IRS was notified and an original proof of claim was filed by the insolvency department including unassessed claims for withholding taxes. An amended proof of claim was later filed that corrected these claims to zero. According to the Tax Court, none of the information provided by Kasper in his Form 3949-A would have changed this; the IRS could not have asserted a claim for employment taxes on the allegedly unpaid wages because unpaid wages are not taxed. Kasper's information therefore did not result in the collection of proceeds and he was not entitled to a whistleblower award.

For a discussion of whistleblower awards, see Parker Tax ¶262,301.

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Fifth Circuit Rejects Challenges to Conviction for Willful Failure to Collect and Pay Over Taxes

The Fifth Circuit, in a case of first impression, held that a district court correctly instructed a jury that an individual was guilty under Code Sec. 7202 if he failed either to account for or pay over tax, and it rejected the individual's argument that his failure to comply with both duties had to be proven to uphold a conviction. The court also rejected the individual's claim that the trial evidence was insufficient to support convictions for willfully attempting to evade or defeat a tax under Code Sec. 7201, as well as the willful failure to account for and pay over tax under Code Sec. 7202. U.S. v. Sertich, 2018 PTC 3 (5th Cir. 2018).

Anthony Sertich was a medical doctor and plastic surgeon who owned two medical entities: South Texas Otorhinolaryngology (STO) and Advanced Artistic Facial Plastic Surgery of Texas (Advanced). Sertich paid wages to, and withheld payroll taxes from, the employees of these entities. Between 2002 and 2011, Sertich accounted for, yet failed to pay over to the IRS, approximately $2.9 million in payroll taxes.

In 2014, Sertich was charged with ten counts of violating Code Sec. 7202 by willfully failing to account for, and pay over taxes withheld from, his employees during 2008-2010. He was also charged with one count of willfully attempting to evade and defeat the payment of more than $2.9 million in taxes owed by himself and his medical entities.

At trial, the jury heard evidence that Sertich had submitted wage and tax statements to the IRS showing that money had been withheld from his employees at STO and that he had claimed credit against his personal tax liabilities for the withheld amounts. There was evidence that Sertich repeatedly failed to pay over the withheld funds. In 2004, in part because of delinquent tax liabilities, STO went out of business and Sertich moved himself and his staff to Advanced. Later that year, Sertich filed for Chapter 11 bankruptcy, causing the IRS's collection efforts to cease until Sertich again failed to make scheduled payments.

IRS officers testified about repeated attempts to contact Sertich. In 2005, the IRS attempted to contact Sertich at his home and sent a letter encouraging him to file quarterly tax returns for STO. Sertich did not reply. In November 2006, the IRS tried to visit Sertich at his business address. Additional efforts to reach Sertich failed and in late 2007, the IRS issued a levy to Sertich's bank.

In January 2008, Advanced declared bankruptcy and collection efforts were once again halted. Sertich met with the IRS and agreed to make payments pending the bankruptcy, but he failed to make the payments. The bankruptcy case was dismissed in 2009. The IRS once again took steps to collect, making multiple attempts in 2009 and 2010 to contact Sertich and collect on his tax delinquency. Sertich was notified that if he did not sell or mortgage his house, forced collection would begin. The IRS eventually issued levies on Sertich's bank accounts and insurance reimbursements. Sertich again filed bankruptcy in 2010.

Throughout the relevant time period, Sertich's accountants and others told him regularly that he was obligated to timely file and pay the taxes he owed. Sertich testified at trial that he always intended to pay his taxes but had personal and family issues and lacked the financial ability to comply. He admitted to pursuing bankruptcy filings to develop a payment plan, but stressed that he always intended to make good on his debts. Sertich said that because his accountant told him he would owe interest on his tax delinquency, he assumed the delinquency was a loan from the government.

Sertich was convicted of violating Code Sec. 7202 for willfully failing to account for and pay over the taxes he withheld from employees from 2008 -2010. He was also convicted of violating Code Sec. 7201 for willfully attempting to evade and defeat payment of payroll taxes. The district court sentenced Sertich to 41 months in prison followed by three years of supervised release. Sertich appealed his conviction to the Fifth Circuit Court of Appeals.

Under Code Sec. 7201, a person who willfully attempts to evade or defeat a tax is guilty of a felony. Code Sec. 7202 provides that any person who (1) willfully fails to collect employees' taxes or (2) willfully fails truthfully account for and pay over withheld taxes is guilty of a felony. The second offense under Code Sec. 7202 applied to Sertich. The jury was instructed that, under Code Sec. 7202, the government had to prove Sertich failed to comply with one of the two duties -- either accounting for or paying over a tax. On appeal, Sertich argued that this instruction was incorrect because the second prong of Code Sec. 7202 requires proof that a person both failed to account for and pay over taxes. Sertich also challenged the sufficiency of the evidence of his willfulness in violating Code Secs. 7201 and 7202. He claimed that his willfulness under Code Sec. 7201 was not established because he had a good faith belief that he did not violate any criminal laws, did not know it was a crime to delay his payroll tax payments, and believed he was receiving a loan from the IRS which he intended to repay with interest. He also said he did not act willfully under Code Sec. 7202 because he had a good faith belief that he was not committing a crime, and was instead receiving a loan from the IRS.

The Code Sec. 7202 jury instruction issue was one of first impression in the Fifth Circuit. Agreeing with every other circuit to have considered it, the Fifth Circuit held that Code Sec. 7202 is violated if a person willfully fails either to truthfully account for taxes or to pay them over to the IRS. The court reasoned that the text of the statute creates a dual obligation to both truthfully account for and pay over taxes, an obligation that is satisfied only by fulfilling both separate requirements. The court also pointed out that Sertich's reading would lead to an absurd result where a greater punishment would apply to one who simply failed to collect taxes than someone who collected and used the taxes for his own purpose but notified the IRS that the taxes had been collected. Further, the Fifth Circuit noted that the Supreme Court had construed Code Sec. 6672, the similarly worded civil counterpart to Code Sec. 7202, to require the dual obligation to withhold and pay the sums withheld. Finally, the Fifth Circuit looked to the title of Code Sec. 7202, "willful failure to collect or pay over tax," and found that it suggested a violation when either duty has not been met.

The Fifth Circuit also held that the trial evidence was sufficient to support findings of Sertich's willfulness under Code Sec. 7201 and Code Sec. 7202. With respect to Code Sec. 7201, the court found that Sertich had repeated interactions with the IRS regarding the taxes he owed. Sertich also repeatedly filed for bankruptcy, causing the IRS to cease its collection attempts and release levies on his bank accounts. Based on this evidence, the Fifth Circuit saw a pattern of conduct from which the jury could infer that Sertich knew he had a duty to pay his taxes but voluntarily and intentionally evaded payment. Sertich's argument that he lacked the funds to meet his tax obligations was rejected because inability to pay is not a defense and, according to the Fifth Circuit, the record reflected Sertich used withheld funds for personal use. The Fifth Circuit found that willfulness under Code Sec. 7202 was also supported by the evidence because Sertich's accountants and IRS officers repeatedly advised him of his duties under the statute. According to the Fifth Circuit, Sertich's disregard for these warnings was evidence of his willful failure to comply. It was also reasonable for the jury, the Fifth Circuit found, to disbelieve Sertich's claim that he thought he had received a loan from the IRS.

For a discussion of the elements of tax evasion, see Parker Tax ¶265,100. For a discussion of willful failure to collect and pay over tax, see Parker Tax ¶265,113.