Federal Tax Bulletin - Issue 138 - April 17, 2017

Lawyers in Professional Limited Liability Company Subject to Self-Employment Tax

The Tax Court held that Lawyers who were members of a professional limited liability company were functionally the equivalent of general partners and thus could not avail themselves of the exception in Code Sec. 1402(a)(13) and exclude certain partnership distributions from self-employment income. However, the court also concluded that the lawyers were not subject to income tax on unidentified amounts in a trust account and were not liable for accuracy-related penalties. Castigliola v. Comm'r, T.C. Memo. 2017-62.

Vincent Castigliola, John Banahan, and Harry Mullen are attorneys licensed to practice law in Mississippi. Originally, they practiced law through a general partnership, but in 2001, they reorganized their law firm as a professional limited liability company (PLLC).[ named Bryan, Nelson, Schroeder, Castigliola & Banahan, PLLC (PLLC). In 2005, the PLLC's office and many of its records were destroyed in Hurricane Katrina, but the members recovered and continued their practice.

For 2008-2010, Castigliola, Banahan, and Mullen were engaged in the practice of law solely through the PLLC. They were members of the PLLC during those years, and the PLLC is, and has always been, member-managed. The PLLC has never had a written operating agreement. The PLLC timely filed Forms 1065, U.S. Return of Partnership Income, for 2008, 2009, and 2010. During these years, the members' compensation agreement required guaranteed payments to each member; the guaranteed payments were commensurate with local legal salaries as determined by a survey of legal salaries in the area. Any net profits of the PLLC in excess of amounts paid out as guaranteed payments were distributed among the members in accordance with the members' agreement.

Castigliola, Banahan, and Mullen shared the same CPA. The CPA was an accountant for many years and served in several positions in the National Association of State Boards of Accountancy. He also served eight years with the Alabama State Bar of Accountancy. Around the time the PLLC was formed in 2001, the members met with the CPA to discuss the new PLLC entity. The CPA had prepared federal income tax returns for Castigliola, Banahan, and Mullen (and for the general partnership that preceded the PLLC) for many years and was familiar with the history of their law firm as a result. On the basis of the CPA's advice, they reported all guaranteed payments from the PLLC as self-employment income subject to self-employment tax, but they did not remit self-employment tax on the amounts in excess of their distributive shares over the guaranteed payments.

As part of its legal practice, the PLLC handled subrogation payments for State Farm Mutual Automobile Insurance Co. (State Farm). The PLLC negotiated payment plans with uninsured individuals involved in automobile accidents with State Farm policyholders. When these uninsured individuals made payments to the PLLC, it deposited the payments into the trust account. Approximately twice per year the PLLC disbursed subrogation payments from its trust account to State Farm. When it disbursed a subrogation payment to State Farm, the PLLC also transferred the compensation due to the PLLC from its trust account to its operating account. At the end of 2010, the trust account held $15,167 of undistributed funds; the members do not know to whom this amount belongs.

Self-Employment Tax Exception for Certain Partnership Distributions

Code Sec. 1401 imposes a tax on the self-employment income of every individual for a tax year (self-employment tax). Self-employment income is defined as the net earnings from self-employment derived by an individual during any tax years excluding (1) the portion in excess of the social security wage base limitation for the year as well as (2) all earnings from self-employment if the total amount of the individual's net earnings from self-employment for the tax year is less than $400.

Code Sec. 1402 defines net earnings from self-employment as the gross income derived by an individual from any trade or business carried on by such individual, less applicable deductions, plus his or her distributive share (whether or not distributed) of income or loss described in Code Sec. 702(a)(8) from any trade or business carried on by a partnership of which he or she is a member.

Code Sec. 1402(a)(13) provides that self-employment income does not include the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Code Sec. 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.

In Renkemeyer, Campbell, & Weaver, LLP v. Comm'r, 136 T.C. 137 (2011), which involved a Kansas limited liabililty partnership engaged in the practice of law, the Tax Court noted that Code Sec. 1402(a)(13) was enacted before limited liability companies were widely used or generally treated as partnerships for federal tax purposes. The court said that the meaning of "limited partner" is not necessarily confined solely to the limited partnership context.

IRS Deficiency Notice

The IRS assessed self-employment tax deficiencies against Castigliola, Banahan, and Mullen because, it argued, the PLLC members were not limited partners for the purposes of Code Sec. 1402(a)(13) and therefore, the exclusion from self-employment tax did not apply. The members rejected this assessment, contending that the exclusion in Code Sec. 1402(a)(13) applied to the distributive shares of income in excess of their guaranteed payments.

Additionally, the IRS found that the PLLC members had additional income in 2010 in the form of undistributed funds held in the trust account and concluded they were liable for accuracy-related penalties under Code Sec. 6662(a) for 2008, 2009, and 2010 because they had underpayments due to substantial understatements of income tax or negligence.

Tax Court's Decision

With respect to whether the PLLC members were liable for the additional self-employment tax, the court said that the first inquiry to be made was whether the person claiming the Code Sec. 1402(a)(13) exemption held a position in an entity treated as a partnership that was functionally equivalent to that of a limited partner in a limited partnership. Because Castigliola, Banahan, and Mullen were all members of a member-managed PLLC, the court framed the issue as whether a member of such a PLLC is functionally equivalent to a limited partner in a limited partnership.

The exact meaning of "limited partner," the court observed, may vary slightly from state to state and so the court looked to documents drafted by The Uniform Law Commission: the Uniform Limited Partnership Act (ULPA (1916)) and the Revised Uniform Limited Partnership Act (RULPA (1976)). The court noted that amendments had been added to RULPA (1976) in 1985 (RULPA (1985)) and that versions of these uniform acts have been adopted in most states, sometimes with modifications. In particular, Mississippi adopted RULPA (1985) with some modifications in 1987. In terms almost identical to those of ULPA (1916) and RULPA (1976), the version of the limited partnership act that Mississippi adopted in 1987 and which was effective throughout the years at issue provided that a "limited partner" would lose limited liability protection if "in addition to the exercise of his rights and powers as a limited partner, he participates in the control of the business." Like RULPA (1976), Mississippi's version provides safe harbors for various activities a limited partner may perform without losing limited liability protection.

Common to each of the definitions of "limited partner," the court noted, were the primary characteristics of limited liability and lack of control of the business. In the instant case, the respective interests in the PLLC held by Castigliola, Banahan, and Mullen made each a member of the PLLC, which was member managed. Therefore, the court said, management power over the business of the PLLC was vested in each of them through the interest each held. The PLLC had no written operating agreement, nor was there any evidence to show that any member's management power was limited in any way. Furthermore, all members participated in control of the PLLC. For example, they all participated in collectively making decisions regarding their distributive shares, borrowing money, hiring, firing, and the rate of pay for employees. They each supervised associate attorneys and signed checks for the PLLC. On the basis of those facts, the court concluded that the respective interests held by Castigliola, Banahan, and Mullen could not have been limited partnership interests under any of the limited partnership acts. Therefore, the court held, they were not limited partners under Code Sec. 1402(a)(13) and their distributive shares in excess of the guaranteed payments were subject to self-employment tax.

Moreover, the court said, a limited partnership must have at least one general partner. The members had testified that all members participated equally in all decisions and had substantially identical relationships with the PLLC. Since by necessity at least one of the members must have occupied a role analogous to that of a general partner in a limited partnership, and because all of the members had the same rights and responsibilities, the court found that they all must all have had positions analogous to those of general partners in a limited partnership.

Trust Funds Aren't Taxable to PLLC Members

The Tax Court held that the funds remaining in the PLLC's trust account were not income to the PLLC members. The court noted that (1) the members testified credibly that the funds the IRS identified did not belong to the members; and (2) the IRS offered no evidence or arguments to support its contention that the members could withdraw these funds as fees.

Court Rejects Penalties Assessment

Finally, the Tax Court disagreed with the IRS that the PLLC members were liable for the penalties assessed by the IRS under Code Sec. 6662. The court noted that there is a substantial understatement of income tax for any tax year if the amount of the understatement for the tax year exceeds the greater of 10 percent of the tax required to be shown on the return for the tax year or $5,000. In looking at the calculations involving the various returns, the court found that the members' returns did not cross this threshold and thus the members did not substantially understate their income tax for any year at issue. Further, the court concluded that the members were not liable for the negligence penalty because they reasonably relied on the advice of their CPA and because there were no regulations or administrative or judicial guidance to assist the members at the time the returns were prepared.

For a discussion of partnership income and self-employment taxes, see Parker Tax ¶20,590.

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Individual Denied S Corporation Basis Increase for Unpaid Judgments on Real Estate Foreclosures

The Tax Court held that an S corporation shareholder could not increase her basis by the amount of judgments against her resulting from her guarantees on foreclosed real estate owned by the S corporation because she made no payments on the judgments. Her claims for passthrough loss deductions and net operating loss carrybacks resulting from the purported basis increases were denied, but she was not liable for an accuracy-related penalty. Phillips vs. Comm'r, T.C. Memo. 2017-61.

Sandra Phillips was a 50 percent owner of Olson & Associates (Olson), a Florida S corporation engaged in developing and selling real estate. Olson relied heavily on debt to finance its projects. Most of its $191 million in debt was secured by mortgages on its real estate properties. Almost all of the loans were guaranteed by Olson's two shareholders, including Mrs. Phillips, and/or their spouses.

In 2007, the nationwide downturn in the real estate market caused a decline in Olson's sales, revenue, and cash flow. Olson defaulted on almost every loan owed by it or its subsidiaries. Olson's lenders foreclosed on the properties pledged as collateral and, because of the decline in values, enforced the shareholders' guarantees to satisfy the deficiencies. The lenders obtained judgments in 2008 and 2009 of approximately $105 million against Phillips and her coguarantors, who were jointly and severally liable. Phillips made no payments toward any of the judgments, nor did she make any payments directly to the lenders under the guaranties.

In 2010, after receiving a formal tax counsel's opinion, Phillips took the position that she was entitled to increase the basis in her Olson stock as a result of the judgments entered against her. She claimed an additional capital contribution of approximately $1.5 million for 2008 and approximately $30 million for 2009. As a result of these purported basis increases, Phillips claimed net operating losses for 2008 through 2010 and carryback losses to her 2004 and 2005 tax liabilities.

The IRS audited Phillips and determined that she was not entitled to any basis increase resulting from her loan guarantees or the unpaid judgments against her. The IRS sent Phillips a notice of deficiency for the disallowed deductions plus a 20 percent accuracy-related penalty.

Before the Tax Court, Phillips argued alternately for an increase in her stock basis and in the debt of the S corporation, and said that her guaranties and the judgments against her constituted an economic outlay as required for basis increases in S corporation debt. Relying on the decision in Selfe vs. U.S., 778 F.2d 769 (11th Cir. 1985), Phillips argued that, even though no payments had been made, the judgments themselves demonstrated an actual economic outlay because the lenders looked to Phillips as a source of repayment. Phillips also argued that the deficiency judgments against her gave rise to an actual economic outlay because they impaired her credit.

Selfe involved a taxpayer who started a business and secured financing as a sole proprietor, pledging assets as collateral for the loans. The business was later incorporated and elected S corporation status. At that point, the corporation was substituted, at the bank's request, as the obligor on the loans, but the taxpayer's personal assets remained pledged as collateral. As sole shareholder, the taxpayer also personally guaranteed the loans. She never made any payment on her guaranty but claimed that the guaranty gave her additional basis. The Eleventh Circuit concluded that a basis increase may be justified where the facts show the shareholder has borrowed funds and then advanced them to the corporation.

The Tax Court rejected Phillips' arguments and held that she was not entitled to any basis increase. Phillips was not, however, liable for the accuracy-related penalty that the IRS had assessed against her.

With respect to her reliance on the decision in Selfe, the court noted that none of the factors that were present in Selfe applied. Unlike in Selfe, there was no evidence that Olson's lenders had a prior relationship with Phillips or that she had ever been an obligor on any loans. Phillips did not pledge any personal assets as collateral. The S corporation in Selfe, the court noted, was a fledgling enterprise and poorly capitalized, making it a poor credit risk, whereas Olson was a well-established company with a good reputation; further, Phillips admitted that when the loans were made, they were clearly supported by the pledged collateral. Most importantly, the Tax Court said, Phillips produced no evidence, by testimony or otherwise, that any lender looked to her as the primary obligor on any loan.

The court also rejected Phillips' credit impairment argument, saying a deficiency judgment entered against a guarantor many years after a default was irrelevant in deciding whether the lender looked to Phillips as the primary source of repayment when it made the loan.

The Tax Court also addressed the method Phillips used to calculate her purported basis increase. The court determined that, even if Phillips had shown she was entitled to a basis increase, the pro rata allocation reflecting her 50 percent ownership in Olson was incorrect. The co-guarantors were jointly and severally liable for the judgments and Phillips, the court said, gave no reason to believe that the judgment creditors would pursue all co-guarantors equally rather than targeting the deepest pocket. The speculative nature of the computation in the absence of an actual payment on the judgments, the court noted, provided further support for the rule that no basis increase is permitted without an actual economic outlay.

The Tax Court did note, however, that Phillips could have shown an economic outlay if she had made a payment toward the judgments. Such a payment would create a debt from Olson to her and give rise to additional basis in the amount of the payment.

Finally, the Tax Court found that the IRS should not have imposed the Code Sec. 6662 accuracy-related penalty on Phillips. The penalty applies to the portion of an underpayment attributable to negligence or any substantial understatement of income tax. The term "negligence," the court said, is defined as any failure to make a reasonable attempt to comply with the Code, and the term "substantial" is defined as an underpayment exceeding the greater of $5,000 or 10 percent of the tax required to be shown on the return. The IRS conceded most of the penalties, which were attributable to the passthrough losses for which Phillips had obtained an opinion from competent tax counsel. The Tax Court determined that the remaining underpayment was not due to negligence and did not exceed the $5,000/10 percent threshold.

For a discussion of the calculation of S corporation basis, see Parker Tax ¶32,840.

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Tax Organizations Call on Congress to Improve IRS Services to Tax Practitioners

Nine organizations representing various segments of the tax practitioner community, including the AICPA, called upon Congress to improve IRS services to tax practitioners. The group called for an improved governance and oversight structure for the IRS and proposed a new unit within the IRS that would centralize the agency's services to tax practitioners.

In a press release issued April 3, the AICPA announced that it and eight other organizations representing tax practitioners had presented federal law makers with a comprehensive set of recommendations designed to improve services provided by the IRS to taxpayers and tax practitioners. The group called the current degradation of the IRS taxpayer services unacceptable. In the report, called "Ensuring a Modern-Functioning IRS for the 21st Century" the group cites figures from the National Taxpayer Advocate's 2016 Annual Report to Congress that reported the percentage of taxpayer calls answered by the IRS between 2004 and 2016 had dropped from 87 percent to 53 percent.

In addition to the AICPA, the other organizations that participated in writing the report are: alliantgroup, LP; Crowe Horwath, LLP; National Association of Enrolled Agents; National Association of Tax Professionals; National Conference of CPA Practitioners; National Society of Accountants; National Society of Tax Professionals; and PADGETT BUSINESS SERVICES

In the report, the group noted that, as tax practitioners, it advises millions of taxpayers on tax matters, assists them with compliance responsibilities, and represents them before the IRS. Thus, the group said, it understands what is working and not working with tax administration from both taxpayer and practitioner perspectives.

With respect to IRS taxpayer service, the report advises that to instill trust in the tax administration system, taxpayer service goals should be based on the following two guiding principles:

(1) The IRS should only initiate contact with a taxpayer if the IRS is prepared to devote the resources necessary for a proper and timely resolution of the matter.

(2) Customer satisfaction must be a goal in every interaction the IRS has with taxpayers, including enforcement actions. Taxpayers expect quality service in all interactions with the IRS, including taxpayer assistance, filing tax returns, paying taxes, and examination and collection actions.

Resources Necessary. The report states that appropriate hiring, adequate training, skillful management, and the necessary technological tools are essential for the IRS to meet its responsibilities. The leaders of the IRS must have the experience and skills to motivate their workforce and lead them to the realization of the desired vision. Organizational alignment from Congress, the President, the IRS Commissioner, and through the ranks of the IRS, is necessary to delivering the promised goals. The report recommends that the legislative and executive branches determine the appropriate level of service and compliance they want the IRS accountable to provide and then dedicate appropriate resources for the agency to meet those goals. Furthermore, to enable the IRS to achieve the improvements required for a 21st century tax administration system, a modern technological infrastructure is necessary. Currently, the IRS has two of the oldest information systems in the federal government making the information technology functions one of the biggest constraints overall for the IRS. Without modern infrastructure, the report states, the IRS is unable to timely and efficiently meet the needs of taxpayers and practitioners.

Customer Satisfaction. The report notes that measurement tools are required to achieve customer satisfaction goals, including fairness in enforcement. The IRS made significant progress in measuring taxpayers' opinions in the years following the issuance of the 1997 Report of the National Commission on Restructuring the Internal Revenue Service. However, in recent years, the IRS has stopped reporting on customer satisfaction surveys and analysis. The report recommends that customer satisfaction surveys, gauging performance at all levels within the IRS, continue as an appropriate success measure. Congress, the report said, should utilize the survey results during the oversight and appropriations processes to ensure the agency is continually meeting the needs of taxpayers.

Finally, the report recommends that the IRS create a new dedicated "executive-level" practitioner services unit that would centralize and modernize its approach to all practitioners. Over time, the IRS has established a number of functional departments. The individuals in these departments are dispersed across the IRS and are not coordinated in a way that enables practitioners to timely access critical information (such as, their clients' account status or the availability of dispute resolution opportunities). Nor do the current teams or processes systematically solicit, gather or evaluate practitioner feedback. Enhancing the relationship between the IRS and practitioners, the report says, would benefit both the IRS and the millions of taxpayers served by the practitioner community.

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Individual's Claim of Exemption in Bankruptcy Did Not Shield EITC Refund from IRS Offset

After noting an apparent conflict in the Bankruptcy Code with respect to whether a tax credit can be shielded from the IRS in bankruptcy, a bankruptcy court held that the IRS could offset an individual's refund resulting from application of the earned income tax credit against the individual's tax liability for a prior year. The court also ruled that it had jurisdiction over the individual's action for a refund because sovereign immunity was waived. In re Benson vs. U.S., 2017 PTC 159 (Bankr. W.D. Va. 2017).

Background

Kerie Benson filed for bankruptcy under Chapter 7 of the Bankruptcy Code in March 2016. The IRS was a creditor with an unsecured claim for approximately $12,730 in unpaid taxes for the 2006 and 2011 tax years. Benson's 2006 tax liability was approximately $10,882. In her bankruptcy filings, Benson claimed her expected tax refund for 2015 as exempt from creditors. Benson filed her 2015 tax return in April 2016 and, after applying the earned income tax credit (EITC), she determined that she had overpaid $6,417 for the 2015 tax year. In May 2016, she amended her bankruptcy filings to claim an exemption for the expected refund. On May 19, 2016, Benson further amended her homestead deed to claim $5,993 of her expected refund as exempt.

When the IRS processed Benson's 2015 tax return, it offset her $6,417 overpayment against her 2006 tax liability of $10,882. The IRS notified her that she owed the difference of approximately $4,465 for 2006. Benson argued that the offset was improper because of her claimed exemption.

Before the bankruptcy court, the IRS made two arguments in support of its right to offset Benson's refund against her 2006 tax liability. First, it said that the court lacked jurisdiction because sovereign immunity had not been waived. Second, the IRS contended that its offset rights trumped Benson's claimed exemption. The bankruptcy court found that sovereign immunity was waived because the provisions directly implicated in this case, 11 U.S.C. Sections 522 and 553, were both specifically covered under the sovereign immunity waiver in 11 U.S.C. Section 106(a). The bankruptcy court also found that the IRS could offset Benson's 2015 EITC refund against her 2006 tax liability.

Exemption vs. Setoff Rights

The court observed an apparent conflict in the Bankruptcy Code between exemption and offset rights. Under 11 U.S.C. Section 553(a), a creditor has the right to set off a debt owed by the creditor to the debtor that arose before the filing of the bankruptcy. But 11 U.S.C. 522(c) says that property claimed as exempt is not liable for debts that arose before the bankruptcy was filed. The court noted that there was no controlling precedent in the Fourth Circuit, the circuit to which the case would be appealable, on this issue.

First, the court reviewed a line of cases where a debtor's exemption right trumped a creditor's offset and cited In re Alexander, 225 B.R. 145, 149 (Bankr. W.D. Ky. 1998) as the best representative of these decisions. Like Benson, the debtor in Alexander wanted to shield an EITC refund from being offset against a prior year tax liability. The Alexander court noted that the 11 U.S.C. Section 553(a) offset rule had previously been construed as permissive and that courts had discretion in applying it. The court also observed that in Kentucky, the EITC was considered a public assistance benefit. As no objection to the offset had been asserted by the IRS, the court found that the debtor's tax refund was exempt under 11 U.S.C. Section 522(a). Addressing the conflict between 11 U.S.C. Sections 553(a) and 522(c), the Alexander court found that the creditor's setoff right was subordinate to the debtor's exemption right because to rule otherwise would render 11 U.S.C. Section 522(c) meaningless. The Alexander court also found that this interpretation was consistent with the policy of the bankruptcy statute to give debtors a fresh start.

Next, the bankruptcy court considered In re Bourne, 262 B.R. 745 (Bankr. E.D. Tenn. 2001), a decision reaching the opposite result in holding that offset rights were not subordinate to a debtor's claimed exemption. In Bourne, the debtor defaulted on a loan which was guaranteed by the Department of Housing and Urban Development (HUD) and claimed an exemption for her tax refund. The IRS, without seeking relief from stay, intercepted the tax refund and applied it to the unpaid HUD liability. The Bourne court found that the federal intercept statute under which the IRS offset the refund made no allowance for state law personal property exemptions and that a state law exemption may not defeat the federal government's setoff rights. The Bourne court then responded to the arguments the Alexander court made in deciding that exemption rights trumped setoff rights. First, the court said that an equally logical interpretation that would give effect to both 11 U.S.C. Sections 522(c) and 553(a) was to hold that a debtor can claim an exemption which is valid as to all creditors except one having a right of offset. Second, the court found several examples of debts not dischargeable in bankruptcy and noted that the policy of a fresh start for the debtor is often subordinated to other societal goals and economic objectives. Finally, the court reviewed the legislative history of 11 U.S.C. Section 522 and found no mention of setoff rights or whether they could be defeated by an exemption. The Bourne court ultimately held that the debtor had no greater exemption rights with respect to her tax refund than she would have had if the bankruptcy case had not been filed.

The bankruptcy court also made note of the decision in In re Buttrill, 549 B.R. 197 (Bankr. E.D. Tenn. 2016), which expanded on Bourne in finding that the debtor's property interest in a tax refund is a contingent interest that can be defeated by a remedy acknowledged and preserved by bankruptcy rules.

Setoff Rights Trump Exemption Rights

In the instant case, the bankruptcy court ultimately reached a similar result as the decisions in Bourne and Buttrill, but took a different approach.

The court began by noting that under 11 U.S.C. Section 506(a), a creditor's claim that is subject to setoff under 11 U.S.C. Section 553 is a secured claim to the extent of the setoff amount. The court noted that to give adequate protection to this secured status, 11 U.S.C. Section 553(a) provides that "this title" does not affect any right of a creditor to offset a debt owing by the creditor to the debtor that arose before the filing of the bankruptcy. The court reasoned that "this title" means the entire U.S. Bankruptcy Code except for the enumerated exceptions, which do not include the debtor's exemption right under 11 U.S.C. Section 522(c). Thus, to give effect to 11 U.S.C. Section 506(a), preservation of a setoff right should, in the court's view, take precedence over the right to claim an exemption.

The court then reviewed the Supreme Court's decision in Taylor v. Freeland & Kronz, 503 U.S. 638 (1992), which held that if a debtor claims an exemption in a tax refund and no one objects, then the exemption claim prevails. In the bankruptcy court's view, the general rule in Taylor was that failing to timely object to the validity of an exemption is fatal to the objection. However, the bankruptcy court reasoned that a debtor cannot "bootstrap himself into" ownership of a property interest by claiming an exemption in something subject to a valid offset, and then claim the exemption invalidated the offset because no one objected. The debtor must, according the bankruptcy court, take affirmative action to challenge or void the offset.

Finally, the court reconciled its own ruling in a previous case, In re Addison, 2016 PTC 39 (Bankr. W.D. Va. 2015). In that case, the district court affirmed on appeal the bankruptcy court's finding of a stay violation under 11 U.S.C. Section 362 where the government set off the debtor's tax refund against a non-income tax liability without first obtaining relief from stay. First, the bankruptcy court noted that Addison did not address the interplay between 11 U.S.C. Sections 522(c) and 553. The bankruptcy court said that Addison was limited to the holding that if a bankruptcy stay is instituted before an offset, the overpaid funds are protected by the stay, and the government is treated like any other creditor. Because the present case involved the setoff of a tax refund against an income tax liability, the bankruptcy court found that 11 U.S.C. Section 362(b)(26) provided an express exception to the stay rule. That exception did not apply in Addison because the setoff in that case was against a non-tax debt. Thus, the holding in Addison that a stay under 11 U.S.C. Section 362(a) would prevent the setoff of a non-income tax liability was given full deference.

For a discussion of the IRS's right to offset a refund against a tax liability, see Parker Tax ¶16,180.

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Wife Escapes Liability for Fraud Penalties with Respect to Husband's Illicit Business

The Tax Court held that the wife of a taxpayer, who ran a business which specialized in the unauthorized duplication of copyrighted works and who significantly underreported his 2008 and 2009 business income, was not liable for the 75 percent fraud penalty for 2008 and 2009. Further, the court concluded that neither the husband nor the wife was liable for the fraud penalty for 2010 because the deficiency for that year was a run-of-the-mill deficiency arising from a failure to substantiate expenses underlying claimed deductions, and not the existence of fraud. Ballard v. Comm'r, T.C. Memo. 2017-57.

Facts

Bradley Ballard operated a sole proprietorship under the name Quik Copy. As Quik Copy, Mr. Ballard operated a print and copy business wherein he specialized in the unauthorized duplication of copyrighted works. To conceal his piracy, Mr. Ballard dealt mostly in cash, kept no financial or business records, and maintained numerous bank accounts.

Mr. Ballard and his wife filed separate tax returns for 2008. Ms. Ballard filed timely, reporting herself as a head of household, independently supporting her three children. Mr. Ballard filed as single with no dependents. Mr. Ballard, however, filed his return nearly five months late.

For 2009, Mr. Ballard filed as a head of household, claiming Ms. Ballard's children as dependents. Again Mr. Ballard failed to file timely, filing this return on May 3, 2010. Ms. Ballard neither signed this return nor filed separately.

For 2008 and 2009, Mr. Ballard reported portions of Quik Copy's receipts and expenses on his individual tax returns using Schedules C, Profit or Loss From Business. However, he did not report any gross receipts or expenses associated with his illicit activities.

IRS Audit

In 2010, the IRS audited Mr. Ballard's 2007 tax return. The IRS then expanded the audit to Mr. Ballard's 2008 and 2009 tax returns, for which an IRS revenue agent performed a bank deposits analysis. This analysis led the IRS to determine that Mr. Ballard had underreported Quick Copy's gross receipts by approximately $1,100,000 and $741,000 for 2008 and 2009, respectively.

During the audit, Mr. and Ms. Ballard provided the IRS with professionally prepared amended joint returns for 2008 and 2009 (amended returns) and their joint 2010 return, which at that time was approximately seven months late. They also consented to an extension of the statute of limitations on assessment. While the couple's amended returns purported to correct Mr. Ballard's reporting of Quik Copy's gross receipts for 2008 and 2009, the IRS found that the amended returns still exhibited significant underreporting when compared with the IRS's bank deposits analysis. Additionally, the couple failed to substantiate the business expenses and capital losses for which they claimed deductions in their amended 2008 and 2009 returns and in their newly filed 2010 return.

The IRS issued the Ballards a notice of deficiency for years 2008-2010 disallowing deductions for all unsubstantiated expenses and capital losses for years 2008-1010. On the basis of the bank deposits analysis, the IRS increased the couple's Schedule C gross receipts for 2008 and 2009. Finally, the IRS determined additions to tax, under Code Sec. 6651, for failure to file timely and fraud penalties, under Code Sec. 6663, for years 2008-2010 for both Mr. and Ms. Ballard.

Liability for Fraud Penalty

When any part of an underpayment of tax is attributable to fraud, Code Sec. 6663(a) imposes a penalty equal to 75 percent of that underpayment. To prove fraud, the IRS must establish that:  

(1) an underpayment of tax exists; and  

(2) a portion of the underpayment is attributable to the taxpayer's fraudulent intent to evade tax thereon.

Under Code Sec. 7454, the IRS bears the burden of proof and must prove fraud by clear and convincing evidence for each year. Various kinds of circumstantial evidence or "badges of fraud" may combine to support a finding of fraudulent intent, including:  

• a taxpayer's consistent pattern of understating income and filing false returns;
• failure to maintain adequate records;
• concealment of assets;
• dealing in cash;
• implausible or inconsistent explanations of behavior;
• and failure to cooperate with tax authorities.

While spouses are jointly and severally liable for the total tax due arising from their joint federal income tax return, Code Sec. 6663(c) provides that the fraud penalty does not apply with respect to a spouse unless some part of the underpayment is due to the fraud of such spouse.

Tax Court's Decision

The Tax Court upheld the tax deficiencies for 2008-2010, finding that undisputed facts showed that Mr. Ballard understated his Schedule C gross receipts for 2008 and 2009 and that he failed to maintain any business records. Additionally, the court said, the couple failed to substantiate their business expenses and capital losses in excess of the amounts that the IRS allowed for 2008-2010.

With respect to the fraud penalties, the court separately evaluated the actions of Mr. Ballard and Ms. Ballard for 2008 and 2009. The court noted that Mr. Ballard derived unreported gross receipts from his unauthorized duplication and sale of DVDs and CDs and conducted this portion of his business in cash and neglected to keep any books or records thereof. Further, the court said, Mr. Ballard trafficked these cash funds in and among multiple bank accounts and intermingled this cash with his personal assets. These actions indicated to the court that Mr. Ballard ultimately desired to conceal this income and the income's illicit sources by filing false returns with the IRS. Although Mr. Ballard ostensibly cooperated with the IRS during the audit by submitting amended returns prepared by a professional those returns, the court observed, continued his trend of underreporting Schedule C gross receipts. The court concluded that Mr. Ballard's actions with respect to his 2008 and 2009 tax years were clearly undertaken with an intent to conceal income and prevent the collection of tax and thus the IRS satisfied its burden of proof with respect to Mr. Ballard's fraudulent intent for 2008 and 2009.

However, the court held that Ms. Ballard bore no liability for the fraud penalties for 2008 and 2009. According to the court, there was insufficient evidence in the record to justify holding that Ms. Ballard acted fraudulently or intended to evade tax for 2008 or 2009. Citing its decision in Stone v. Comm'r, 56 T.C. 213 (1971), the court noted that the actions of Mr. Ballard may not be imputed to Ms. Ballard. The paucity of evidence relating to Ms. Ballard, the court said, contrasted with the overwhelming evidence showing that Mr. Ballard acted with fraudulent intent throughout 2008 and 2009. For 2008, Ms. Ballard individually filed a return whose accuracy the IRS had not questioned.

Similarly, the court said, no facts indicated that Ms. Ballard knew about or aided in the preparation of Mr. Ballard's fraudulent 2009 head of household return, of which she was not a signatory. The court also noted that the IRS did not allege, and the facts did not indicate, that Ms. Ballard made a habit of underreporting her income or underpaying her tax liabilities. The court said that the facts suggested she was not involved in her husband's business activities legitimate or illicit. Similarly, the court said, the bank deposits analysis examined only the accounts of Mr. Ballard and gave rise to no inference that Ms. Ballard knew of, had an interest in, or was authorized to draw upon those accounts.

With respect to the fraud penalty assessment for 2010, the Tax Court held that neither Mr. Ballard nor Ms. Ballard were liable for the penalty. According to the court, there was no clear and convincing evidence of an underpayment for 2010. Neither, the court said, was there any evidence that either Mr. Ballard or Ms. Ballard acted with the requisite fraudulent intent in 2010. The court noted that, for 2010, unlike 2008 and 2009: (1) the IRS did not allege that Mr. Ballard maintained bank accounts for subterfuge or the intermingling of business and personal assets; (2) the couple did not file a flagrantly false return; and (3) the IRS did not determine that the couple underreported gross income or overstated deductions. The facts with respect to 2010, the court said, established a run-of-the-mill deficiency arising from a failure to substantiate expenses underlying claimed deductions, not the existence of fraud.

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Nursing Home Manager Liable for Penalties for Failing to Pay Over Payroll Taxes

A nursing home manager was liable under Code Sec. 6672 for the employee withholding taxes he willfully failed to pay over to the IRS. His claims that he used all available funds to rescue nursing home patients from horrific conditions and to avoid having to lay off hundreds of employees did not meet the reasonable cause exception. U.S. v. Hodges, 2017 PTC 167 (10th Cir. 2017).

Facts

In 2000, the Oklahoma Department of Health appointed Rex Hodges as the temporary manager of four nursing homes. Under Oklahoma law, the Oklahoma Department of Health has the power to place a qualified person in a nursing home facility as a temporary manager if conditions at the facility pose an immediate threat to residents' health and safety. As the manager, Hodges was responsible for depositing the employees' payroll tax withholdings with the IRS and filing payroll tax returns. Hodges paid the nursing homes' operating expenses and net payroll. He also paid himself a salary of $22,000 per month. Although the payroll processor sent him biweekly reports detailing the amounts withheld from employees' paychecks and instructions for making the deposits with the IRS, Hodges failed to pay the employees' withheld payroll taxes to the IRS. He was removed as temporary manager of the four nursing homes in early 2001. Later in 2001, Hodges decided to invest in his own nursing home. He and a former coworker formed Sand Springs Care Center LLC (Sand Springs). Hodges was named manager and his role was similar to his role as the temporary manager of the four nursing homes and included the same powers and responsibilities. Hodges paid Sand Springs' operating expenses and net payroll, and paid himself a salary, but once again failed to remit payroll taxes that had been withheld from employees' salaries.

The IRS determined that Hodges was a responsible person under Code Sec. 6672 who willfully failed to pay over taxes withheld from employees' paychecks. In 2004, the IRS began assessing penalties against Hodges for the unpaid payroll taxes which accrued both during his time as temporary manager of the four nursing homes and as manager of Sand Springs. In February 2004, federal tax liens attached to property Hodges owned as a joint tenant with his wife. In April 2004, Hodges transferred his interest in the property to his wife. The IRS continued assessing penalties and liens continued to attach to the property after the transfer. Hodges' wife received a notice of lien in 2015. She was identified as her husband's nominee or recipient of a fraudulent transfer.

Before a district court, the IRS moved for summary judgment on its assessments and to enforce the liens on the property. Hodges argued that he relied on others to pay the payroll taxes. Thus, he claimed he had reasonable cause for failing to pay over the taxes and should not be liable for the penalties. Hodges' wife argued that her due process rights had been violated because she was denied a Collection Due Process (CDP) hearing. She also denied she had received her husband's interest in the property through fraudulent transfer or as his nominee.

District Court's Decision

The district court sided with the IRS, finding no evidence to support Hodges' reasonable cause argument. A judgment was entered against Hodges for approximately $1.9 million. The district court also granted partial summary judgment with respect to pre-transfer liens of approximately $329,000. Finally, the district court rejected the motion by Hodges' wife to dismiss. It concluded that she did not dispute the validity of the pre-transfer liens, and that those were the only ones the government sought to enforce with summary judgment.

The district court found it premature to consider whether Hodges' wife took the property as Hodges' nominee or whether she was unfairly denied a hearing because those issues applied only to the post-transfer liens. The district court entered an order of sale, then approved a settlement between the parties under which the property would be sold to Hodges' wife and the IRS would discharge all liens on the property arising from assessments against Hodges.

Appeal to the Tenth Circuit

Hodges appealed to the Tenth Circuit, arguing that (1) the IRS wrongfully assessed penalties under Code Sec. 6672 on him because he did not act willfully in failing to pay over the taxes, and (2) the district court erred in ordering foreclosure on the property and in denying Hodges' wife's motion to dismiss because her right to a CDP hearing had been denied.

Under Code Sec. 6672, a person who is responsible for collecting and paying over employee withholding tax is liable for the amount of any tax the person willfully fails to collect and pay over. However, if the person has reasonable cause for failing to pay withholding taxes, then the failure is not willful, and the person is not liable. The reasonable cause exception, articulated in Finley v. U.S. 123 F.3d 1342 (10th Cir. 1997), applies if (1) the taxpayer made reasonable efforts to protect the funds held in trust for the government, and (2) those efforts were frustrated by circumstances outside of the taxpayer's control.

Hodges made three arguments as to why the reasonable cause exception applied. First, he said, there was an urgent necessity to rescue the nursing home residents from the horrific conditions that existed when he became temporary manager of the four nursing homes and he "naively" put all available funds toward rehabilitation of the facilities and care of the residents. He claimed that he would have had to close the nursing homes and that hundreds of employees would have been let go if he had paid over the taxes. Second, he claimed that the owner of three of the four facilities, Gary Kading, promised that he would pay for all rehabilitation expenses, which Hodges understood to include payroll taxes. Finally, Hodges argued that he relied on an Oklahoma statute that was cited in the order appointing him as temporary manager and which says that if funds are insufficient to meet the expenses of performing the powers and duties conferred on the temporary manager, the temporary manager may borrow the funds or contract for indebtedness as necessary. The Tenth Circuit rejected all three arguments.

Reasonable Cause Exception Did Not Apply

First, the Tenth Circuit found that Hodges did not make reasonable efforts to protect the withheld taxes and that the financial condition of the nursing homes did not constitute circumstances outside of his control. Hodges did not, in the court's view, show any evidence that he tried to protect the withheld taxes. Rather, he admitted he voluntarily and intentionally chose to pay operating expenses, including employees' net wages, his own salary, and other creditors, before paying over the taxes. The financial concerns Hodges described were not circumstances outside of Hodges' control. The court noted that virtually every Code Sec. 6672 violation arises because a business is in financial straits. The financial condition of the nursing homes was therefore not sufficient to qualify Hodges for the reasonable cause exception.

The court also rejected Hodges' argument that he had relied on a promise by Kading to pay for all rehabilitation expenses. First, the court noted that a similar argument had been rejected in a prior Tenth Circuit decision, Denbo vs. U.S., 988 F.2d 1029 (10th Cir. 1993). Hodges, the court said, was guilty of willfully failing to remit the withheld taxes because he knew the nursing homes were not paying over the taxes, and he bore responsibility for making these payments. The court said that he could not now claim that he relied on Kading's promise to pay rehabilitation expenses as justification for not remitting the payroll taxes to the IRS. Hodges knew the taxes were not being paid over and nothing in Kading's promise to pay rehabilitation expenses suggested otherwise. The court also noted that even if Hodges had relied on Kading's promise, Kading was not involved with the fourth nursing home or with the Sand Springs home, so Hodges could not claim that his failure to pay over taxes with respect to those facilities had anything to do with Kading's promise. The court concluded that Hodges made no effort to pay the taxes, showed no outside circumstances interfering with his efforts to do so, and that Kading's alleged promise fell far short of evidence that Hodges had attempted to protect the funds but was frustrated in his efforts.

Finally, the court rejected Hodges' argument that he had reasonable cause because of the Oklahoma statute that he cited. The court found that the statute said nothing about taxes and did not attempt to preempt Code Sec. 6672. The statute did not, in the court's view, immunize a responsible person from Code Sec. 6672 liability when that person had the withholding taxes available to pay the IRS but failed to do.

Liens Were Valid

The court also rejected arguments made by Hodges and his wife regarding the validity of the liens on their property. Hodges argued that when he transferred his interest to his wife, she took the property without notice of the pre-transfer liens, and that she therefore took his interest free of that liability. The court disagreed and found that under Code Sec. 6322, the liens survived the transfer.

The court also was not persuaded by arguments that Hodges' wife was denied due process by not receiving a CDP hearing and that she did not receive the property by fraudulent transfer or as her husband's nominee. After the district court granted summary judgment on the pre-transfer liens, the liens were discharged and the IRS waived any claims that Hodges's wife took the property as nominee or as fraudulent transferee, so those issues were moot, as were the issues relating to the CDP hearing.

For a discussion of the penalty for failing remit payroll taxes, see Parker Tax ¶210,108.

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IRS Records of Workers' Income Tax Payments Were Discoverable by Employer

The Tax Court held that an employer could seek third-party taxpayer information in an effort to absolve itself of withholding tax liabilities. The fact that the burden of proof was on the employer to show its workers paid income tax did not make their confidential return information nondiscoverable. Mescalero Apache Tribe vs. Comm'r, 148 T.C. No. 11 (2017).

During the 2009-2011 tax years, the Mescalero Apache Tribe either employed or contracted with several hundred workers. The Tribe timely issued Forms W-2 to its employees and Forms 1099 to its independent contractors. The IRS audited the Tribe and reclassified hundreds of independent contractors as employees.

Under Code Sec. 3402(a), an employer must deduct and withhold income and employment taxes on the wages it pays to employees. The employer is liable for the taxes it fails to withhold if it misclassifies workers as independent contractors. However, Code Sec. 3402(d) provides that the employer is not liable for the taxes if the employees paid the tax on their income. To take advantage of Code Sec. 3402(d) and show that the workers paid their income tax, the Tribe asked each worker to complete a Form 4669, Statement of Payments Received. The Tribe was unable to find 70 of the workers who had either moved or lived in remote areas. With respect to those workers, the Tribe sought IRS records of those workers to determine whether the workers had reported their Form 1099 income and paid their tax liabilities. The IRS refused the request, arguing that it was barred under Code Sec. 6103 from disclosing these confidential records. Under the general rule in Code Sec. 6103, returns and information on returns must be kept confidential. However, an exception is provided in Code Sec. 6103(h)(4)(C), which permits disclosure in judicial or administrative proceedings pertaining to tax administration if the return information directly relates to a transactional relationship between a person who is a party to the proceeding and the taxpayer which directly affects the resolution of an issue in the proceeding.

The case went before the Tax Court, which had to decide (1) whether the records of tax payments were return information, (2) to whom the disclosure permitted in Code Sec. 6103(h)(4)(C) could be made, (3) whether the relationship between the Tribe and its workers was a transactional relationship, (4) whether the requested return information directly related to the relationship, and (5) whether the information directly affected the resolution of an issue in the case.

The Tax Court sided with the Tribe and held that the requested records were disclosable under Code Sec. 6103(h)(4)(C). First, the Tax Court noted that, under Code Sec. 6103(b)(2)(A), return information is defined to include tax payments. There was therefore no doubt that the records requested by the Tribe qualified as return information.

Next, the Tax Court considered to whom return information may be disclosed. Noting a split among the circuits, the court followed the Tenth Circuit's decision in First Western Government Securities v. U.S., 796 F.2d 356 (10th Cir. 1986) which held that third party tax return information may be disclosed in judicial and administrative tax proceedings to persons other than government officials as long as the other requirements of Code Sec. 6103(h) are met.

The Tax Court then considered whether the relationship between the Tribe and its workers qualified as a transactional relationship under Code Sec. 6103(h)(4)(C). It found that the ordinary meaning of "transact" was simply to carry on business. Based on the wide variety of business relationships that other courts had held met the definition of a transactional relationship, the Tax Court found that the relationship between an employer and its workers was one that pertains to the carrying on of business and thus was a transactional relationship.

In analyzing whether the requested information directly related to the transactional relationship, the Tax Court found that whether the Tribe's workers paid their tax liabilities was relevant to whether they considered themselves independent contractors or employees, and thus directly related to their relationship with the Tribe.

Finally, the Tax Court considered whether the return information directly affected the resolution of an issue in the instant case. The Tax Court reasoned that workers' views of themselves as either employees or independent contractors is generally a factor in worker classification cases. Further, determining whether the Tribe's workers paid their income tax liabilities as independent contractors would, in the Tax Court's view, tend to prove or disprove the Tribe's case, which would directly relate to the resolution of one of the issues. Finally, the Tax Court noted the overarching issue that if the Tribe's workers did pay their tax liabilities, the Tribe's Code Sec. 3402(d) defense would be proven and that issue would therefore be entirely resolved.

For a discussion of the consequences of treating employees as nonemployees, see Parker Tax ¶210,115.