Federal Tax Bulletin - Issue 132 - January 13, 2017

Steep Penalties Put a Premium on Timely, Accurate 1099 Reporting

With sharply increased information reporting penalties in their second year (as high as $260 per late Form 1099), timely issuance of Form 1099s has become a critical imperative for many businesses. The urgency for timely reporting is compounded by the continued presence of questions on Forms 1065, 1120, 1120S, and 1040, asking whether the taxpayer made any payments in 2016 that would require the taxpayer to file Form(s) 1099. Starting this year, taxpayers also face earlier deadlines for reporting W-2 and 1099 information to the Social Security Administration and the IRS.

Practice Aid: See ¶320,690 for a client letter that explains the requirement to file Form 1099 and the significance of the Form 1099 question on the various 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 2016 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.

Observation: Last year's increase in information return penalties represents the second time in just a few years that Congress has enacted sharp increases. For Form 1099s filed after August 1 or not filed at all, taxpayers face a 500% increase in the per-item penalty compared with the pre-2010 amount.

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.

The Protecting Americans from Tax Hikes Act of 2015 (Pub. L. 114-113) established a safe harbor from penalties 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.

New Information Return Due Dates in 2017

Beginning with 2017, the due dates for providing Forms W-2 to the Social Security Administration (SSA) have changed. Rather than providing Forms W-2 to the SSA by February 28, the deadline is now January 31. In other words, the forms must be filed with the SSA on the same date they are due to be filed with employees.

The new January 31 deadline also applies to certain Forms 1099 that were previously due to be filed with the IRS on February 28. Beginning in 2017, any Form 1099-MISC on which an amount is reported in the Box 7 (i.e., Nonemployee Compensation) is due to the IRS by January 31, rather than February 28. If no amount is reported in Box 7 of Form 1099-MISC, then the deadline remains February 28 for paper filings or March 31 for electronic filings.

One automatic 30-day extension of time to file a Form 1099 beyond the due date for filing is allowed if the filer or the person transmitting the information return for the filer (i.e., the transmitter) files an application with the IRS on Form 8809, Request for Extension of Time to file Information Returns, on or before the due date for filing the form.

1099 Question Remains on Major Tax Forms

The 2016 Forms 1065, 1120, 1120S, and 1040, Schedules C, E, and F, all contain questions asking if the taxpayer made any payments in 2016 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.

When the questions first showed up a few years ago, practitioners immediately expressed concern that their clients may not be aware of the full ramifications of incorrectly reporting Form 1099 income and the impact on their own liability for checking these boxes. If a client reports that all Form 1099s were filed when they were not, he or she is committing perjury (because the returns are signed under penalties of perjury). If the client reports that not all Form 1099s were filed, then that's a red flag for an audit.

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, and the taxpayer will be responsible for issuing a Form 1099-MISC to that independent contractor. 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?

With the penalties once again sharply increasing for 2016 information returns and payee statements filed, these questions are more relevant than ever.

Form 1099-MISC

Generally, any person, including a corporation, partnership, individual, estate, and trust, which 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. A payer is engaged in a trade or business if it operates for gain or profit. Thus, personal payments are not reportable. 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 specific 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.

Backup-Withholding Requirement

A backup withholding requirement applies to reportable payments where the payee does not furnish a taxpayer identification number (TIN). The backup withholding rate is equal to 28 percent of the amount paid. The requirement does not apply to payments made to tax-exempt, governmental, or international organizations.

In determining whether a payee has failed to provide a TIN, a payer is required to process the TIN within 30 days after receiving it from the payee or in certain cases, from a broker. Thus, the payer may take up to 30 days to treat the TIN as having been received.

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 Constitutes a Trade or Business That Requires Reporting on Form 1099?

The characterization of an activity as a "trade or business" took on a new importance in 2013 with the implementation of the net investment income tax. Effective for tax years beginning after December 31, 2012, 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 the net investment income tax.

As previously mentioned, taxpayers not in a trade or business are not required to file Form 1099s. Whether a taxpayer is considered to be in a trade or business has become a hot topic because of the net investment income tax. As a result, taxpayers may be claiming that their activity is not subject to the net investment income tax because it rises to the level of a trade or business without considering the impact that will have on their Form 1099 filing requirements and the associated penalties if such forms are not filed.

Conclusion

Practitioners should ensure that their business clients are on top of the new filing deadlines 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 revising their engagement letter to 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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Financial Advisor Can't Use S Corporation to Shield Himself from Self-Employment Taxes

The Tax Court held that a financial advisor who purchased and sold securities should have reported income earned under agreements with financial institutions on his individual return as Schedule C self-employment income rather than running the income through his S corporation and treating it as K-1 income on which self-employment taxes were not due. The court rejected his argument that the S corporation itself could not contract with the financial institutions because a provision in the 1934 Securities and Exchange Act that would impose a prohibitively expensive licensing requirement on the corporation. Fleischer v. Comm'r, T.C. Memo. 2016-238.

Background

Ryan Fleischer, a financial consultant, obtained his Series 6, 7, 24, 63, and 65 licenses so that he could purchase and sell securities under the Securities Exchange Act of 1934 (Act), the Financial Industry Regulatory Authority (FINRA), and the North American Securities Administration Association (NASAA) rules. Fleischer started his career with an investment firm that sold proprietary products and performed financial planning. He left that firm to work for a bank, where he again sold proprietary products to the bank's clients. Eventually, Fleischer struck out on his own because he wanted to have his own clients and accounts.

On February 2, 2006, Fleischer entered into a representative agreement with Linsco/Private Ledger Financial Services (LPL) in his personal capacity. The agreement expressly states that Fleischer's relationship with LPL is that of an independent contractor. After consulting both his business attorney and his CPA, Fleischer incorporated Fleischer Wealth Plan (FWP) and caused it to elect S corporation status. Fleischer was the sole shareholder and the president, secretary, and treasurer of FWP. On February 28, 2006, Fleischer entered into an employment agreement with FWP. The agreement expressly states that Fleischer's term of employment with FWP began on February 28, 2006.

Fleischer was paid an annual salary to "perform duties in the capacity of Financial Advisor." Those duties consisted of: (1) acting in the clients' best interests in managing client investment portfolios; (2) expanding FWP's client base and the "overall presence" of FWP; (3) drafting and reviewing financial documents; and (4) representing FWP "diligently and responsibly at all times."

The agreement gives FWP the right to reasonably modify Fleischer's duties at its discretion. The agreement includes other common provisions found in employment agreements, such as provisions for the reimbursement of expenses and how to terminate the agreement, an arbitration clause, and a noncompete clause. The agreement does not include a provision requiring Fleischer to remit any commissions or fees from LPL or any other third party to FWP.

In 2008, Fleischer entered into a broker contract with MassMutual Financial Group (MassMutual). The contract was signed by Fleischer and is between Fleischer and MassMutual, with no mention of FWP. The contract explicitly states that there is no employer-employee relationship between Fleischer and MassMutual. There were no addendums or amendments to either the LPL agreement or the MassMutual contract requiring those entities to begin paying FWP instead of Fleischer or to recognize FWP in any capacity.

Fleischer's 2009, 2010, and 2011 Tax Returns

For 2009, 2010, and 2011, Fleischer reported taxable wage income each year from FWP of approximately $35,000 on his Form 1040. For 2009, 2010, and 2011, he also attached a Schedule E to his Form 1040 reporting nonpassive income of approximately $12,000, $148,000, and $115,000, respectively from FWP. No amount was reported for self-employment tax, but Fleischer did claim a self-employed health insurance deduction for each year on his Form 1040. There were no Forms 1099 from LPL or MassMutual and no Schedule C attached to Fleischer's 2009, 2010, or 2011 Form 1040.

For 2009, 2010, and 2011, FWP reported ordinary business income of approximately $12,000, $148,000, and $115,000, respectively on its Form 1120S. This ordinary business income was then reported on FWP's 2009, 2010, and 2011 Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc., that were issued to Fleischer. Fleischer then reported those amounts on the Schedules E he attached to his tax returns.

The amount of gross receipts or sales used to calculate the FWP's ordinary business income came from the Forms 1099 that LPL and MassMutual issued to Fleischer for 2009, 2010, and 2011.

The IRS assessed a deficiency on the basis that, under Code Sec. 482 and Code Sec. 61, the gross receipts or sales that FWP reported on its Forms 1120S should have been reported by Fleischer as self-employment income on Schedule C of his Form 1040 and self-employment tax should have been paid.

Fleischer's Position

Before the Tax Court, Fleischer did not dispute that LPL and MassMutual never contracted directly with FWP. He argued that it was impossible for those entities to do so because FWP was not a registered entity under the securities laws and regulations and, under the law, FWP could not enter into representative agreements and broker contracts. Fleischer relied on Section 78o, Registration and Regulation of Brokers and Dealers, of the 1934 SEC Act, which provides that:

"it is unlawful for any broker or dealer which is either a person other than a natural person or a natural person not associated with a broker or dealer which is a person other than a natural person (other than such a broker or dealer whose business is exclusively intrastate and who does not make use of any facility of a national securities exchange) to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security or commercial paper, bankers' acceptances, or commercial bills) unless such broker or dealer is registered in accordance with subsection (b) of this section. [15 U.S.C. sec. 78o(a)(1).]"

Fleischer testified that it would be overly burdensome and "would cost millions and millions of dollars" for FWP to register under the 1934 SEC Act.

Tax Court's Analysis

The Tax Court began its analysis by stating that the first principle of income taxation is that income must be taxed to the person who earned it. The court noted that, while this principle is easily applied between two individuals by simply asking who performed the services or created the goods, the question of who earned the income is not so easily answered when a corporation is involved. Citing Johnson v. Comm'r, 78 T.C. 882 (1982), the court observed that, in the case of a corporation and its service-provider employee, the relevant question has evolved to one of "who controls the earning of the income." For a corporation, not its service-provider employee, to be the controller of the income, the court said that two elements must be found:

(1) the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense; and

(2) there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation's controlling position.

The Tax Court focused on the second element and looked at whether FWP entered into a contract or other indicium with LPL or MassMutual that exhibited its control over Fleischer. The court noted there was no mention of FWP in either of the contracts that Fleischer signed in his individual capacity and both contracts provided that there was no employer-employee relationship. Moreover, there was no evidence of any amendments or addendums to those contracts after they were signed. Thus, the court concluded that there was no indicium for LPL or MassMutual to believe that FWP had any meaningful control over Fleischer.

The court then looked at Fleischer's argument that it was impossible for LPL and MassMutual to contract with FWP because of a provision in the 1934 SEC Act. The fact that FWP was not registered, thus preventing it from engaging in the sale of securities, did not mean that Fleischer could assign the income he earned in his personal capacity to FWP, the court said. The court cited its decision in Jones v. Comm'r, 64 T.C. 1066 (1975), in which it held that a court reporter improperly assigned income to his personal service corporation because a court reporter was legally required to be an individual, and although the corporation was a valid entity, by law it could not perform such services.

In conclusion, the court held that Fleischer, individually, not FWP, should have reported the income earned under the representative agreement with LPL and the broker contract with MassMutual for the years in issue.

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IRS Provides Guidance on De Minimis Safe Harbor from Information Reporting Penalties

The IRS has issued guidance for complying with Section 202 of the Protecting Americans from Tax Hikes Act of 2015, which provides that an error on an information return or payee statement need not be corrected to avoid a penalty if the error relates to an incorrect dollar amount and differs from the correct amount by no more than $100 (or $25 in the case of tax withheld). Notice 2017-9.

Background

Code Sec. 6721 and Code Sec. 6722 authorize civil penalties for (1) the failure to file correct information returns, and (2) the failure to furnish correct payee statements, respectively. The amount of each penalty varies based on (1) when the return/statement is filed or furnished; (2) whether the failure to file or furnish is corrected on or before 30 days after the required filing date, or after the 30th day but on or before August 1; and (3) whether the failure to file or furnish is due to intentional disregard of the rules.

As part of the Trade Preferences Extension Act of 2015, Congress increased the Code Sec. 6721 and Code Sec. 6722 penalty amounts, effective January 1, 2016. Generally, the penalties under Code Sec. 6721 and Code Sec. 6722 range from $50 to $260 for each occurrence of a failure to furnish correct information returns or a failure to furnish correct payee statements. Both penalties are annually adjusted for inflation.

Penalty for Failure to File Correct Information Return

Under Code Sec. 6721(a)(2), the penalty for failing to file a correct information return applies to failures to (1) file an information return with the IRS by the due date (failure to file timely), and/or (2) include correct information on the return (failure to include correct information). The second type of failure encompasses situations where a business does not include all required information on the return, or includes incorrect information. Depending on the facts, the failure to include information in the correct format can be a failure to file timely or a failure to include correct information.

A failure to file timely includes a failure to file in the required manner, for example, on magnetic media or in other electronic form as provided by Code Sec. 6011(e). However, under Reg. Sec. 301.6721-1(a)(2), no penalty is imposed for failing to comply with Code Sec. 6011(e)(2) - which mandates special electronic filing requirements for return preparers filing 11 or more Form 1040 series returns, Form 1041 returns, or a combination of these returns - except to the extent that such a failure occurs on more than 250 information returns or in the case of a partnership with more than 100 partners, more than 100 information returns (collectively, the threshold requirements).

The threshold requirements apply separately to (1) each type of information return, and (2) original and corrected returns. For example, if a business files 300 Forms 1099-DIV and later files 70 corrected Forms 1099-DIV, the corrected returns can be filed on paper (because they fall below the 250-threshold requirement) or electronically.

The penalty for the second type of failure, the failure to include correct information on a return, does not apply to:

(1) 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. This exception cannot apply to the greater of 10 returns or 0.5 percent of the total number of information returns required to be filed for the year.

(2) Inconsequential errors or omissions, which are failures that do not prevent or hinder the IRS from processing the return, correlating the information with the taxpayer's return, or otherwise putting the return to its intended use. However, errors or omissions relating to the following are never inconsequential: (1) a taxpayer identification number, (2) the taxpayer's surname, or (3) dollar amounts.

Example: Assume that a Form 1099-MISC misspells the taxpayer's first name as "Willaim." If the error does not prevent the IRS from processing the form or correlating the Form 1099-MISC information with William's tax return, a penalty will not be imposed. But if the Form 1099-MISC misspells William's last name as "Simth" instead of "Smith," a penalty will be imposed because an incorrect surname is never an inconsequential error.

Penalty for Failure to Furnish Correct Payee Statements

Under Code Sec. 6722(b), the penalty for failing to furnish correct payee statements applies to failures to (1) furnish a payee statement by the due date (failure to furnish timely), and/or (2) include correct information on the payee statement (failure to include correct information). The second type of failure encompasses situations where a business does not include all information required to be shown on the statement, or includes incorrect information on the statement.

Reg. Sec. 301.6722-1(d)(2) provides that the term "payee statement" includes the following statements:

• Form 1099-MISC, Miscellaneous Income; Form 1099-INT, Interest Income; Form 1099-DIV, Dividends and Distributions; Form 1099-C, Cancellation of Debt; Form 1099-OID, Original Issue Discount;
• Form W-2, Wage and Tax Statement;
• Schedules K-1 required in conjunction with Forms 1041, 1065, and 1120S;
• Form 1098, Mortgage Interest Statement;
• Form 8300, Report of Cash Payments Over $10,000 Received in Trade or Business;
• Form 8282, Donee Information Return;
• Information returns reporting minimum essential coverage; and
• Information returns relating to offers of health insurance coverage by applicable large employers.

The penalty for the failure to include the correct information on a payee statement does not apply to inconsequential errors or omissions. An inconsequential error or omission is a failure that cannot reasonably be expected to prevent or hinder the taxpayer from timely receiving correct information and reporting it on his/her/its tax return, or from otherwise putting the statement to its intended use.

However, errors or omissions relating to the following are never inconsequential: (1) dollar amounts; (2) significant items in the taxpayer's address; (3) the appropriate form for the information provided; and (4) the manner of furnishing a statement required under Code Secs. 6042 (Form 1099-DIV), 6044 (Form 1099-PATR), 6049 (Form 1099-INT), or 6050N (royalties reported on Form 1099-MISC).

Example: Assume that a Form 1099-MISC misspells the word "boulevard" in the taxpayer's address. The error cannot reasonably be expected to prevent the taxpayer from timely receiving correct information and reporting it on his/her/its tax return or otherwise putting the statement to its intended use. Therefore, a penalty will not be imposed. But if the form lists the taxpayer's address as "4821 Grant Boulevard" when the correct address is "8421 Grant Boulevard," a penalty will be imposed.

Safe Harbor for De Minimis Errors on Information Returns

Section 202 of the Protecting Americans from Tax Hikes Act (Pub. L. 114-113), also known as the PATH Act, amended Code Secs. 6721 and 6722 to establish a safe harbor from the application of these penalties when the information return or payee statement is correctly filed but includes a de minimis error in the amount required to be reported. The safe harbor applies to information returns required to be filed and payee statements required to be furnished after December 31, 2016. In general, an incorrect amount need not be corrected if the error for any single amount does not exceed $100, or $25 for errors in reporting a withholding or backup withholding amount.

Therefore, under the safe harbor, businesses need not correct an error on an information return or payee statement, and are not subject to penalties for failing to file a correct information return or payee statement, if the error relates to an incorrect dollar amount and is not more than $100, or $25 if the error relates to the amount of tax withheld.

According to Notice 2017-9, which is discussed more fully below, the de minimis safe harbor only applies to inadvertent errors on information returns or furnished payee statements. This means that:

(1) The safe harbor does not apply to a business that intentionally misreports a dollar amount, since doing so falls under the intentional disregard rules of Code Secs. 6721(e) and 6722(e).

(2) The safe harbor only applies to information returns that have been filed and payee statements that have been furnished.

Election Not to Have the Safe Harbor Apply

The PATH Act also added (1) Code Sec. 6722(c)(3)(B), which provides that the safe harbor does not apply to any payee statement if the payee makes an election for the safe harbor not to apply; and (2) Code Sec. 6721(c)(3)(B), which states that the safe harbor does not apply to an incorrect dollar amount for which an election has been made under Code Sec. 6722(c)(3)(B). If an election is made, penalties for incorrect information on the return or statement continue to apply (i.e., the business may be subject to penalties for an incorrect dollar amount on an information return or payee statement even if the incorrect amount is a de minimis error).

Observation: While payors are not required to correct payee statements with de minimis errors in the absence of an election by the payee, the IRS is encouraging employers to correct any errors on Form W-2 to ensure that employees receive proper credit for their earnings and ensure that employers have paid and reported the proper amount of taxes.

The IRS recently issued Notice 2017-9 to provide guidance on the de minimis error safe harbor and the election by a payee to not have the safe harbor apply. Specifically, the notice (1) addresses the time and manner for making and revoking the Code Sec. 6722(c)(3)(B) election; (2) clarifies that the de minimis safe harbor does not apply to intentional errors or businesses that fail to file an information return or furnish a payee statement; (3) requires businesses to retain certain records; (4) solicits comments on the rules in the notice, including potential abuse of the de minimis safe harbor; and (5) confirms that to the extent future regulations incorporate the rules in the notice, the regulations will be effective for returns required to be filed, and payee statements required to be furnished, after December 31, 2016.

According to Notice 2017-9, if a payee makes the election under Code Sec. 6722(c)(3)(B), but the business furnishes a corrected payee statement to the payee and files a corrected information return with the IRS within 30 days of the date of the election, the error will be treated as due to reasonable cause and not willful neglect. Therefore, the Code Sec. 6721 and 6722 penalties will not apply to the error. When other rules or regulations provide additional time to file a corrected information return or furnish a corrected payee statement, Notice 2017-9 confirms that those rules or regulations apply instead of the 30-day rule.

Businesses cannot impose prerequisites, conditions, or time limitations on the payee's ability to request a corrected payee statement. However, they can prescribe reasonable rules for making the election, including whether the election can/must be made in writing, online (electronic), or by telephoneassuming the business provides written notification of the rules before the payee makes the election. Nevertheless, an online (electronic) option cannot be the exclusive way to make the election. If the business has not prescribed rules for making the election, the election can be made in writing to the address appearing on a payee statement furnished by the business to the payee, or as directed by the business after the payee makes "an appropriate inquiry."

The election must (1) clearly state that the payee is making the election; (2) provide the payee's name, address, and taxpayer identification number; (3) identify the type of payee statement(s) and account number(s), if applicable, to which the election applies; and (4) confirm that the election only applies to payee statements required to be furnished in a specified calendar year, if the payee wants the election to only apply to that year.

If the payee does not identify the type of payee statement and account number or the calendar year to which the election relates, the business must treat the election as applying to all types of payee statements required to be furnished to the payee in the calendar year in which the election is made and any succeeding calendar years.

Reasonable Cause Exception to Penalties

Regardless of whether the PATH Act de minimis safe harbor applies, Code Sec. 6724 provides that no penalty is imposed under Code Sec. 6721 or 6722 if the failure is due to reasonable cause. While "reasonable cause" is not defined in the Code, Reg. Sec. 301.6724-1(a)(2) clarifies that the business must establish one of the following:

(1) There were significant mitigating factors for the failure to file. Two examples are the business was not previously required to file the particular return or furnish the particular statement, or the business has an established history of complying with the particular information reporting requirement at issue.

(2) The failure was due to events beyond the business's control. Examples of this include the unavailability of pertinent business records, reliance on erroneous written information from the IRS, or contracting with an agent to file timely and correct returns and/or furnish timely and correct payee statements.

Internal Revenue Manual (IRM) 20.1.7.8.1 provides additional guidance on meeting the reasonable cause exception.

In addition to satisfying one of these prongs, Reg. Sec. 301.6724-1(a) provides that the business must have acted in a responsible manner before and after the failure occurred. According to IRM 20.1.7.8.2, businesses act in a responsible manner when they (1) exercise reasonable care in determining their filing obligations and handling the account numbers and balances; and (2) take significant steps to avoid the failure, such as requesting an extension of time to file, attempting to remove the cause of a failure once it has occurred, and correcting the failure once the cause has been removed.

For a discussion of information reporting penalties, see Parker Tax ¶262,130.

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Company Not Entitled to Deduction under Code Sec. 83 for Stock Transferred to Officer

The Fourth Circuit affirmed a Tax Court decision disallowing a company's deduction under Code Sec. 83 for stock issued to an officer. After noting that forfeiture provisions triggered by termination for cause or by engaging in competition do not constitute a "substantial risk of forfeiture," the Fourth Circuit concluded that the remaining ground for forfeiturethe taxpayer's voluntary resignationwas unlikely to happen. QinetiQ US Holdings Inc. v. Comm'r, 2017 PTC 6 (4th Cir. 2017).

Background

In March 2002, Thomas Hume formed Thomas G. Hume, Inc. A few months later, Hume created new classes of voting and nonvoting stock and changed the name of the corporation to DTRI to facilitate Julian Chin joining the business. On December 12, 2002, Hume executed a "Consent in Lieu of the Organizational Meeting" which offered the issuance and sale of 4,500 shares of voting stock to himself, 4,455 shares of voting stock to Chin, and 45 shares of nonvoting stock to Chin. Included in the consent was authorization for the company to enter into a shareholder and employment agreements with Hume and Chin. Attached to the consent were signed acknowledgements by Hume and Chin of their intent to subscribe to the stated number of shares.

The shareholder agreement calculated the value of the shares and gave the company the option of repurchasing Hume's or Chin's shares at the calculated value in the event of their death, disability, or termination of employment. In the case of voluntary resignation, the company had the option to purchase the stock at 5 percent of the calculated value for every year of the departing employee's employment up to a maximum of 100 percent. However, the maximum was reduced to 25 percent if the departing employee voluntarily resigned and engaged in competition with the company, or was terminated for cause.

From 2002 through 2007, the company did not report the stock issued to Hume and Chin in 2002 as compensation, and did not withhold federal payroll taxes on the value of the issued stock. On the other hand, Hume and Chin did report as compensation shares later granted to them. In 2008, DTRI merged into another corporation, QinetiQ. Before the merger closed, Hume and Chin executed agreements waiving DTRI's rights with respect to stock transfer restrictions or partially vested stock. QinetiQ withheld payroll taxes on the value of the stock received by Hume and Chin in 2002, and claimed deductions under Code Sec. 83(h) for the value of the shares issued to them in December 2002.

In its notice of deficiency, the IRS determined that QinetiQ had not established that it was entitled to a deduction under Code Sec. 83, and increased QinetiQ's taxable income for the year by more than $117 million. The Tax Court held that QinetiQ was not entitled to the deduction because the stock was not property "transferred in connection with the performance of services," and was not "subject to a substantial risk of forfeiture" when Chin acquired the shares.

Analysis

QinetiQ argued that the value of the stock issued to Chin in 2002 qualified as a trade or business expense in 2008, because the stock was issued in connection with Chin's employment and was subject to a substantial risk of forfeiture until Chin sold the shares in 2008 as part of the merger. The IRS responded that Chin subscribed to the stock as an investment and not in connection with his employment, and the stock was not issued subject to a substantial risk of forfeiture.

The Fourth Circuit noted that Code Sec. 83(a) generally treats property transferred in connection with the performance of services as income of the person performing the services (the service provider), in which case the employer is entitled to a deduction for the value of the property as a trade or business expense. This rule is modified when the property is subject to a substantial risk of forfeiture. In that case, the property is not treated as income of the service provider until the first tax year in which the property is no longer subject to a substantial risk of forfeiture.

Therefore, to claim a 2008 deduction for the value of the stock transferred to Chin in 2002, QinetiQ had to show that the stock was transferred in connection with the performance of services, and was subject to a substantial risk of forfeiture from the time it was transferred until the merger closed in 2008. The failure to establish either of these two required elements would nix QinetiQ's desired deduction.

Under Reg. Sec. 1.83-3(c), property is not subject to a substantial risk of forfeiture if the facts demonstrate that the forfeiture condition is unlikely to be enforced, or the employer is required to pay the employee the value of the property upon its return. Conditions imposed at the time of transfer that require the return of property if the employee is discharged for cause or for committing a crime, or accepts a job with a competing firm, are not sufficient to constitute a substantial risk of forfeiture.

The Fourth Circuit concluded that the only circumstance in which Chin would be required to forfeit his stock at a below-market price would be if Chin voluntarily resigned before 20 years of employment, voluntarily resigned and entered into competition with the company, or was terminated for cause. Because the regulation provides that forfeiture provisions triggered by termination for cause or by engaging in competition do not constitute a substantial risk of forfeiture, the only remaining ground for forfeiture would be Chin's voluntary resignation.

The Tax Court made a factual determination that Hume would have been unlikely to enforce the shareholder restrictions on the stock in the event of Chin's voluntary departure. Based on Chin's significant ownership position, important roles as chief operating officer and executive vice president, and strong relationship with Hume, the Fourth Circuit concluded that this factual determination was supported by the record and was not clearly erroneous. It therefore held that the Tax Court did not err in concluding that QinetiQ failed to establish its entitlement to the claimed deduction.

For a discussion of substantially vested and substantially nonvested property, see Parker Tax ¶124,515.

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Accumulated Earnings Tax Applies Despite Corporation's Lack of Liquidity

According to the Office of Chief Counsel, a corporation was subject to the Code Sec. 531 accumulated earnings tax despite a lack of liquidity to make distributions. As the Chief Counsel's Office noted, the tax is based on accumulated taxable income, and at least with respect to a mere holding company for which reasonable business needs are not relevant, is not concerned with the corporation's liquid assets. CCA 201653017.

Background

An individual incorporated a corporation and was the sole owner at all relevant times. Since its inception and during the years at issue, the corporation conducted no business activity other than holding and maintaining various partnership interests contributed to it by its sole shareholder. According to a representative for the corporation, the sole shareholder contributed his partnership interests to the corporation to avoid potential taxation by various tax jurisdictions, such as the state where one of the partnerships is located and the country where the sole shareholder lives. The corporation had no employees and paid no wages or expenses, other than a minimal amount for taxes and accounting and other fees. Each of the partnership agreements contained a provision allowing the partnership to make distributions sufficient to pay the partner's federal and state tax liability, but the remainder of a partner's distributive share of the partnership income was retained in the partnership. Accordingly, the corporation reported its share of distributive partnership income but only received distributions sufficient to pay its tax liability. The corporation, which reported retained earnings each year, neither declared dividends nor made any other distributions to the shareholder during the years at issue. The IRS Office of Chief Counsel was consulted as to whether the corporation could avoid the accumulated earnings tax because it lacked liquidity from which to make distributions to its sole shareholder.

The corporation did not provide justification for the accumulation of earnings, and the board of director minutes for the years at issue did not contain or provide plans for using the accumulated earnings. Instead, the corporation contended that it was not liable for the tax because it did not have control over distributions from the partnerships. Specifically, it argued that since its taxable income was derived solely from the partnerships, and since it could not control what distributions it received, it did not have liquid capital from which to distribute earnings to its shareholder and, thus, should not be subject to the tax.

Analysis

Code Sec. 531 imposes a tax, equal to 20 percent of a corporation's accumulated taxable income, on every corporation (other than personal holding companies and other companies described in Code Sec. 532(b)) formed or used for the purpose of avoiding the income tax with respect to its shareholders or the shareholders of any other corporation, by permitting earnings and profits to accumulate instead of being divided or distributed. Under Code Sec. 533, a corporation that is a "mere holding company or investment company" is presumed to accumulate earnings to avoid income tax on shareholders. Any corporation other than a mere holding company or investment company is treated as accumulating earnings to avoid income tax only if it accumulates earnings beyond the reasonable needs of the business.

Reg. Sec. 1.533-1(c) defines a "holding company" as a corporation having practically no activities except holding property and collecting the income therefrom or investing therein. Here, the corporation had no activity other than holding and maintaining the various partnership interests transferred to it by its shareholder. Furthermore, none of the partnerships appeared to perform any activity other than investment activity. Accordingly, the Chief Counsel's Office found that the corporation was a mere holding or investment company, which is prima facie evidence that it was formed to avoid tax.

The corporation suggested that accumulated surplus must be represented by cash available for distribution. However, the Chief Counsel's Office noted that the accumulated earnings tax is based on accumulated taxable income and, at least with respect to a mere holding company for which reasonable needs are not relevant, is not concerned with the corporation's liquid assets.

Moreover, the Chief Counsel's Office said, the corporation could have declared consent dividends (which are treated as a distribution of money) to avoid the accumulated earnings tax, irrespective of the lack of liquidity. The Chief Counsel's Office cited TAM 9124001 for the proposition that consent dividends under Code Sec. 565 provide a mechanism to avoid the accumulated earnings tax when there is limited or no ability of a corporation to make distributions. Because consent dividends were not declared in TAM 9124001, the distributive share of a corporation's partnership income was taken into account in determining whether the accumulated earnings tax should be imposed.

In CCA 201653017, the Office of Chief Counsel stated that Congress intended to treat companies declaring consent dividends as if they had made distributions even though they lack the ability to actually do so. Because the corporation was a mere holding or investment company that accumulated earnings and profits, and because consent dividends could have been used to avoid (or at least reduce) the tax but were not used, the Chief Counsel's Office concluded that the corporation remained subject to the accumulated earnings tax in spite of its lack of liquidity and lack of control over the partnerships in which it invested.

For a discussion of the accumulated earnings tax, see Parker Tax ¶42,510.

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While Sympathetic, Tax Court Finds No Financial Hardship Exception to IRA Early Withdrawal Penalty

The Tax Court held that distributions from a taxpayer's IRA in 2011 to support herself and her children, after she was laid off from her long-time job and was unable to find another one, were subject to the Code Sec. 72(t) early withdrawal penalty tax. While "sympathetic to her financial straits," the court found that that none of the statutory exceptions were available to the taxpayer, and thus the distributions were subject to the Code Sec. 72(t) penalty tax. Elaine v. Comm'r, T.C. Memo. 2017-3.

Background

In June 2009, Candace Elaine was laid off from her job of 23 years as a call center manager with a mutual fund company. At that time and during the year in issue, she was a single mother, raising two daughters on her own without support from anyone else. On account of the economic downturn, she was unable to find another job, and remained unemployed for several years.

To provide for her own subsistence and that of her daughters, Elaine made a series of withdrawals from her individual retirement account (IRA). During 2011, at which time she was not yet age 59she received four distributions totaling $119,000 from that account. For each distribution, the bank issued Elaine a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. According to the IRS's wage and income transcript for Elaine's 2011 tax year, each Form 1099-R reported that the entire distribution was taxable and was an early distribution with "no known exception." Each Form 1099-R also reflected federal income tax withheld.

Elaine prepared and filed timely her Form 1040 for 2011. She reported taxable IRA distributions of $119,675, among other items of income (including unemployment compensation) and loss. After itemized deductions totaling $45,148 and exemptions totaling $11,100 (for herself and her daughters), Elaine reported taxable income of $33,184 and total tax of $4,119. She did not report the additional tax on early distributions from her IRAs, and did not attach Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, to the return. After reporting her federal income tax withheld, Elaine claimed an overpayment of $4,849, which was refunded to her in May 2012.

On June 3, 2013, the IRS proposed changes to Elaine's 2011 return attributable to her not reporting any additional tax on her IRA distributions. Elaine timely responded to the IRS and explained that, because the IRA was her only means of income to pay bills and support herself and her daughters, she thought that the distributions from her IRA would fall under a financial hardship exception. In subsequent correspondence to the IRS, Elaine continued to plead financial hardship.

The IRS subsequently issued a notice of deficiency which assessed a Code Sec. 72(t) 10 percent penalty tax on the 2011 distributions from Elaine's IRA, as well as a substantial understatement of tax penalty. Elaine timely petitioned the Tax Court. She stated that she believed that the amounts withheld from her IRA distributions included a "10% federal and a 10% state penalty," and asked that she not be held liable for the tax and the penalty on the ground that, during 2011, she was experiencing financial hardship.

Analysis

Taxpayers can withdraw assets from their traditional IRA at any time. However, distributions before age 59are considered early distributions. Generally, an individual who takes an early distribution from a traditional IRA must pay a 10 percent additional penalty tax. Under Code Sec. 72(t)(1), the 10 percent penalty tax applies only to the part of the distribution that the individual must include in gross income, and is in addition to any regular income tax on the amount.

However, an individual who receives a distribution before age 59may not be subject to the penalty tax under several circumstances, such as if:

• The individual has unreimbursed medical expenses that are more than 10% of his/her AGI.
• The distribution is not more than the cost of medical insurance due to a period of unemployment.
• The individual is totally and permanently disabled.
• The individual is the beneficiary of a deceased IRA owner.
• The individual is receiving distributions in the form of an annuity.
• The distribution is used for qualified higher education expenses.
• The distribution is used to buy, build, or rebuild a first home.
• The distribution is due to an IRS levy on the plan.

Before the Tax Court, Elaine testified that the distributions were essentially her only means of income to pay bills and to support herself and her daughters. She indicated that she used a portion of the distributions to pay monthly medical insurance premiums and her student loan debt. While the court noted that the relevant statutory exceptions to the 10 percent penalty tax include distributions to an unemployed individual for health insurance premiums, as well as distributions for qualified higher education expenses, it found Elaine's testimony regarding the insurance premiums and student loan debt to be too general, and noted that she was unable to produce any documentation substantiating her testimony.

After concluding that Elaine took withdrawals from her IRA because of financial hardship, the Tax Court repeated what it has held on many other occasionsthat there is no exception under Code Sec. 72(t) for financial hardship (e.g., see Dollander v. Comm'r, T.C. Memo. 2009-187; Milner v. Comm'r, T.C. Memo. 2004-111; and Gallagher v. Comm'r , T.C. Memo. 2001-34). While "sympathetic to taxpayer's financial straits," the Tax Court stated that it could not disregard the express and unambiguous wording of the statute. Since none of the enumerated statutory exceptions applied to Elaine, all distributions from her IRA in 2011 were subject to the Code Sec. 72(t) additional penalty tax.

However, the Tax Court also held that Elaine was not liable for the substantial understatement of tax penalty under Code Sec. 6662. This was based on the (1) common misunderstanding among taxpayers that financial hardship is an exception to the Code Sec. 72(t) penalty tax; and (2) the fact that, "for whatever reason," the IRS closed an examination of Elaine's 2010 tax return for the same Code Sec. 72(t) issue without change. Because of that, Elaine "proceeded under that misunderstanding not only with respect to 2011 but apparently with respect to 2012 as well."

For a discussion of early distributions from traditional IRAs, see Parker Tax ¶134,555.

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IRS Announces that 2016 Filing Season Begins on January 23, 2017

The IRS notified taxpayers and practitioners that the 2017 individual income tax filing season (for 2016 Forms 1040) will open on January 23, 2017. Because Emancipation Day, a holiday in Washington, D.C., will be observed on Monday, April 17, the normal filing deadline will be pushed back to Tuesday, April 18, 2017.

The 2017 individual income tax filing season (for 2016 Forms 1040) will open on Monday, January 23, 2017 (News Release IR-2017-1). The IRS expects more than 153 million tax returns to be filed in 2017. More than four out of five returns are expected to be filed electronically, with a similar proportion of refunds issued through direct deposit.

While 2016 tax returns will not be processed before January 23, 2017, taxpayers who are e-filing can still submit returns to their software provider before that date, in which case the provider will hold the returns and transmit them to the IRS when the IRS's processing systems open. The IRS also reminds taxpayers that they don't have to wait until January 23 to contact their tax professional.

Observation: As a practical matter, most taxpayers will have to wait until they receive one or more Forms W-2 and/or 1099 before they can prepare and file their return. While the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) revised the deadline for filing Form W-2 and certain types of Forms 1099 with the IRS, the revised deadline also affects the Form W-2 copy filed with the Social Security Administration. The deadline for providing electronic or paper Forms W-2 to employees, and for providing Forms 1099 to payees (including recipients of nonemployee compensation), remains January 31; specifically, Tuesday, January 31, 2017, for 2016 forms.

Filing Deadline Pushed back for Emancipation Day

According to Reg. Sec. 301.7503-1, when the deadline for filing tax returns or paying tax falls on a Saturday, Sunday, or legal holiday, the deadline is delayed until the next business day. For this purpose, the term "legal holiday" means legal holidays in the District of Columbia.

Paper tax returns are treated as timely filed if the envelope is properly addressed, postmarked, and deposited in the mail by the due date. Electronically filed tax returns are not considered filed until the IRS acknowledges acceptance of the electronic portion of the tax return for processing. The IRS accepts individual income tax returns electronically only if the taxpayer signs the return using a Personal Identification Number (PIN). If the provider transmits the electronic portion of a return on or shortly before the due date, and the IRS rejects it but the provider and the taxpayer comply with the requirements for timely resubmission of a correct return, the IRS considers the return timely filed.

April 15 falls on a Saturday in 2017, and while Emancipation Day in the District of Columbia is Sunday, April 16, 2017, it will be observed on Monday, April 17, 2017. This in means that taxpayers will have until Tuesday, April 18, 2017, to file their 2016 tax returns and pay any tax due.

Delayed Receipt of Some Tax Refunds

In 2016, the IRS issued 111 million individual tax refunds, and the IRS expects more than 70 percent of taxpayers to receive a refund in 2017. However, a new law requires the IRS to hold refunds claiming the Earned Income Tax Credit (EITC) or the Additional Child Tax Credit (ACTC) until February 15. This additional period is due to several factors, including banking and financial systems needing time to process deposits, as well as the IRS confirming the identities and wages and withholdings of those claiming the credit.

While the IRS will begin releasing EITC and ACTC refunds on February 15, it cautions taxpayers that these refunds likely will not start arriving in bank accounts or on debit cards until the week of February 27. The IRS wants taxpayers to know it will take additional time for their refunds to be processed and for financial institutions to accept and deposit the refunds to their bank account. Furthermore, many financial institutions do not process payments on weekends or holidays, which can affect when refunds reach taxpayers. For example, the President's Day holiday weekend may affect the receipt of the taxpayer's refund.

Where's My Refund? irs.gov and the IRS2Go phone app will be updated with projected deposit dates for early EITC and ACTC refund filers a few days after February 15. Taxpayers will not see a refund date on Where's My Refund? through their software packages until then. The IRS, return preparers, and software providers will not have additional information on refund dates, so Where's My Refund? remains the best way to check on the status of a refund.

Form 1065 Filing Deadline One Month Earlier in 2017

The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 made an important change to the due date for partnership tax returns, effective for tax years beginning after 2015. Now, partnerships are required to file their returns by the 15th day of the third month following the close of a tax year. For calendar year partnerships, the due date for the 2016 Form 1065 will be March 15, 2017, instead of April 15. The Act did not change the filing deadlines for S corporation returns, which means that partnership and S corporation returns share the same due date.

The March 15 deadline for calendar year partnerships and multi-member LLCs taxed as partnerships should make it a little easier for individuals who are partners or LLC members to file their tax return by (or soon after) the April 18, 2017, filing deadline.