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We hope you find our complimentary issue of Parker's Federal Tax Bulletin informative. Parker's Tax Research Library gives you unlimited online access to 147 client letters, 22 volumes of expert analysis, biweekly bulletins via email, Bob Jennings practice aids, time saving election statements and our comprehensive, fully updated primary source library.

Federal Tax Bulletin - Issue 143 - June 26, 2017


Parker's Federal Tax Bulletin
Issue 143     
June 26, 2017     

 

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 1. In This Issue ... 

 

Tax Briefs

Court Doesn't Have Jurisdiction to Determine Income Tax Liability of Partners; Court Allows Additional Time for Determining If Trustee Can Claw Back Payment to IRS; Refund Denied Where Couple Was Not Mislead by Incorrect Year on IRS Assessment ...

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Senate Unveils Draft of Better Care Reconciliation Act of 2017; Retains Much of House Healthcare Bill

On Thursday, June 22, a month and a half after the House passed The American Health Care Act of 2017 (AHCA), the Senate released its version of a healthcare bill entitled Better Care Reconciliation Act of 2017 (BCRA). While the Senate hinted that they would rewrite the House bill, many of the provisions stayed the same or were watered down. Like the House bill, the BCRA repeals all of the Affordable Care Act's ("Obamacare") taxes except for the excise tax on high cost employer-sponsored health coverage, which would be delayed until 2025. H.R. 1628, Senate Draft (6-22-2017).

Read more ...

Tax Court Disallows S Corp's Deduction for Accrued Compensation to ESOP Participants

In a case of first impression, the Tax Court held that an S corporation's employee stock ownership plan (ESOP) was a trust for purposes of the Code Sec. 267 disallowance of loss deductions in transactions between related persons. As beneficiaries of the ESOP trust, employee participants in the plan were related persons, so accrued but unpaid compensation to them could not be deducted by the S corporation until the employees included the amounts in income. Petersen v. Comm'r, 148 T.C. No. 22 (2017).

Read more ...

Sale of Businesses Were Sales of Franchises; Gain Was Capital, Not Ordinary

The Tax Court held that sales of municipal waste collection businesses by three related partnerships qualified as sales of franchises resulting in capital gains treatment. The contracts met the definition of franchises under Code Sec. 1253, and the partnerships neither retained any significant interests in the contracts after the sales nor received any contingent payments, so the transactions were not excluded from capital gains treatment under the statute. Greenteam v. Comm'r, T.C. Memo 2017-122.

Read more ...

Treasury Department Moves Forward on Eliminating Unnecessary Tax Regulations

The Treasury Department issued a notice requesting comments on regulations that should be eliminated, modified, or streamlined. The notice is the result of an executive order signed in January directing federal agencies to eliminate two regulations for each new regulation issued. 82 Fed. Reg. 27217 (6/14/17).

Read more ...

Court Addresses Issue of Whether Filing Form 1040 Tolls Statute on Unfiled Form 945

A bankruptcy court held that, because a business owner's individual income tax returns were not part of the record in the case, it could not resolve the question of whether the owner's Forms 1040 contained enough data to calculate his Form 945, Annual Return of Withheld Federal Income Tax, liability with respect to subcontractors he hired for his business. As a result, the court could not determine whether the individual's failure to file Form 945 meant that the IRS had unlimited time to assess withholding tax liability on the business owner. Quezada v. IRS, 2017 PTC 285 (W.D. Tex. Bankr. 2017).

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House Passes Mobile Workforce State Income Tax Simplification Act of 2017

The House of Representatives has passed the Mobile Workforce State Income Tax Simplification Act of 2017, and a similar bill is expected to pass the Senate. The legislation, which has bipartisan support, is aimed at simplifying the complex tax reporting rules faced by employers and employees as a result of numerous state income tax withholding laws when employees work outside their home states. H.R. 1393 (6/20/17).

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IRS's Computation of Taxpayer's Reasonable Collection Potential Wasn't Reasonable

The Tax Court held that an IRS settlement officer's rejection of a corporation's offer in compromise solely on the basis of his calculation of reasonable collection potential that used the corporation's going-concern valuation, but disregarded completely its tax liability, was not reasonable. According to the court, the going-concern value is intended to give some indication of what a third party might pay to buy a corporation, but no third party would buy a corporation without taking into account the corporation's unpaid tax liability. W. Zintl Construction, Inc. v. Comm'r, T.C. Memo. 2017-119.

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Court Rejects Taxpayer's Reliance on "Outlier" Fifth Circuit Decision

A district court denied a taxpayer's motion to dismiss felony charges that he violated Code Sec. 7206(1) when he made false statements on Form 433-A regarding the transfer of assets for less than full value. The court found that a Fifth Circuit decision the taxpayer was relying on, U.S. v. Levy, 533 F.2d 969 (5th Cir. 1976), was an outlier and that many other courts have since disagreed with the result and the rationale of that decision. U.S. v. Yurek, 2017 PTC 292 (D. Colo. 2017).

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S Corporation Liable for Employment Taxes Not Paid by Professional Employer Organization

The Chief Counsel's Office advised that an S corporation that hired a professional employer organization (PEO) to fulfill the S corporation's employment tax obligations was liable for the employment taxes that the PEO failed to pay. Had the S corporation used a certified PEO instead, it would not have been liable for the unpaid taxes. CCA 201724025.

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 2. Tax Briefs 

 

Bankruptcy

Court Doesn't Have Jurisdiction to Determine Income Tax Liability of Partners: In Capitol BC Restaurants, LLC v. Comm'r, 2017 PTC 282 (Bankr. Mass. 2017), the dispositive issue was whether the bankruptcy court had jurisdiction to determine, in a partnership's bankruptcy case, the income tax liability of its partners, where the partnership was seeking an adjustment of deductions and penalties imposed by the IRS pursuant to Bankruptcy Code Section 505(a) and where the partnership was not liable for any such income taxes because its partners were solely liable. The district court held that it lacked jurisdiction with respect to the provisions of Bankruptcy Code Section 505 because only non-debtor partners of the debtor partnership were liable for the taxes at issue.

Court Allows Additional Time for Determining If Trustee Can Claw Back Payment to IRS: In In re Colliau, 2017 PTC 286 (Bankr. W.D. Tex. 2017), a bankruptcy court denied summary judgment to both the debtor and the bankruptcy trustee where the trustee was seeking to claw back from the IRS estimated taxes paid by the debtor to the IRS the day before filing for bankruptcy. The court concluded that, since neither party addressed the calculation of the actual amount due on the date the payment was made, it was appropriate to allow the parties more time to address the fact of what was actually due on those dates.

Refund Denied Where Couple Was Not Mislead by Incorrect Year on IRS Assessment: In Habenicht v. U.S., 2017 PTC 280 (Fed. Cl. 2017), the Court of Federal Claims held that a couple was not entitled to a refund of the taxes they paid that were erroneously assessed for 1986. In reaching its conclusion, the court found that the incorrect year showing on the IRS assessment amounted to nothing more than a typographical error and that the couple was not misled by the error.

 

Criminal

Criminal Prosecution Not Foreclosed by Prior Bankruptcy: In U.S. v. Yurek, 2017 PTC 291 (D. Colo. 2017), a district court rejected a couple's motions to stop a criminal federal tax prosecution on the basis that the alleged misconduct or wrongdoing underlying the criminal charges against them were already raised and resolved in their bankruptcy case and that, as a result, the subsequent criminal prosecution was foreclosed. The court cited the analysis in U.S. v. Ledee, 772 F.3d 21 (1st Cir. 2014) where the First Circuit noted that a taxpayer offered no support for his contention that the decision of a bankruptcy trustee or bankruptcy court to settle claims of misconduct in a bankruptcy case can estop the government from subsequently filing criminal charges.

 

Deductions

Online Gross Receipts Weren't MPGE: In CCM 201724026, the Office of Chief Counsel advised that none of a company's online gross receipts were derived from providing customers access to computer software that was manufactured, produced, grown, or extracted (MPGE) by the company in whole or in significant part within the United States for the company's customers direct use while connected to the online software. The Chief Counsel's Office also concluded that, in calculating its Code Sec. 199 deduction, the company improperly applied the "item" rule in Reg. Sec. 1.199-3(d)(1).

 

Estates

Chief Counsel's Office Says That IRS Claims Should Be Paid First: In CCA 201723018, the Office of Chief Counsel advised that, with respect to a particular case, it appeared undisputed that the IRS's claim was superior to that of a competing creditor. Moreover, the Chief Counsel's Office argued, the case was one in which the federal insolvency statute, 31 U.S.C. Section 3713, arguably applied and, per that statute, claims of the United States should be paid first when a deceased debtor's estate is not large enough to pay all of the debtor's debts.

 

Income

$18 Million Payment Taxed in Year Received Rather Than Year Ordered Paid: In Herrmann v. U.S., 2017 PTC 293 (Fed. Cl. 2017), the Court of Federal Claims held that an $18 million payment by a partnership to a U.S. citizen living in England was not taxable in the year the payment was ordered to be paid but rather in the following year when the taxpayer received the payment. The court also rejected the IRS's argument that the payment was a partnership distribution because the $18 million was disproportionate to the taxpayer's actual ownership share of the partnership, thus supporting a finding that the distribution was for services performed outside the taxpayer's capacity as a member of the partnership.

 

Innocent Spouse

Taxpayer Entitled to Innocent Spouse Relief: In Mencias, T.C. Memo. 2017-109, the Tax Court held that a taxpayer was entitled to innocent spouse relief based on two factors - the fact that the taxpayer and her former spouse were divorced and the fact that the taxpayer received none of a refund her former spouse improperly claimed on the original return they filed, of which he was the sole beneficiary. According to the court, those factors outweighed the one factor weighing against relief - namely, whether the taxpayer knew or had reason to know her former spouse could not pay the balance of taxes due.

 

IRS Procedure

IRS Not Immune from Tax Prep Business Lawsuit: In Snyder v. U.S., 2017 PTC 288 (9th Cir. 2017), the Ninth Circuit held that, with respect to a tax preparation business's assistance in a sting operation aimed at catching people filing for fraudulent tax refunds, 28 U.S.C. 2680 does not confer absolute immunity on the IRS and does not bar the tax preparation business's claims for negligence, conversion, and failure to restore things wrongfully acquired. The operation involved using millions of the business's dollars as bait under the promise of reimbursement, which did not happen, and the revocation of one of business's electronic tax filing privileges, which forced it into bankruptcy.

 

Partnerships

Tax Court Has Jurisdiction to Review Penalty on Partnership Adjustment: In McNeill v. Comm'r, 148 T.C. No. 23 (6/19/17), the Tax Court held that, under Code Sec. 6330(d)(1), the Tax Court has jurisdiction to review an IRS notice of determination when the underlying tax liability consists solely of a penalty that relates to an adjustment to a partnership item excluded from deficiency procedures by Code Sec. 6230(a)(2)(A)(i). According to the court, when Congress amended Code Sec. 6330 in 2006 - making the Tax Court the exclusive venue for review of CDP cases - its intent was not to preclude from review certain issues not subject to the Tax Court's deficiency jurisdiction.

Loss on Disposal of Partnership Interest Was Capital Loss: In Watts v. Comm'r, T.C. Memo. 2017-114, the Tax Court held that the IRS correctly recharacterized a couple's loss on the disposal of a partnership interest as a capital loss, rather than an ordinary loss. However, because the couple reasonably relied on their accountant to prepare their tax return, they were not liable for an accuracy-related penalty on the portion of the underpayment arising from the erroneous reporting of the sale of the partnership interest.

 

Passive Activities

Taxpayer's Improbable Hours Preclude Real Estate Professional Status: In Ostrom v. Comm'r, T.C. Memo. 2017-118 (6/19/17), the Tax Court held that a taxpayer who worked full time as an information technology specialist and who also owned four single-family residential properties in Las Vegas that she rented out and managed herself, was not a real estate professional and thus could not deduct all of her rental losses. The court said it would not accept the taxpayer's claims as to the hours she devoted to real property trades or businesses, finding that the number of hours that the taxpayer claimed she spent on tasks shown on a log sheet and calendar were improbable.

 

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 3. In-Depth Articles 

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Senate Unveils Draft of Better Care Reconciliation Act of 2017; Retains Much of House Healthcare Bill

On Thursday, June 22, a month and a half after the House passed The American Health Care Act of 2017 (AHCA), the Senate released its version of a healthcare bill entitled Better Care Reconciliation Act of 2017 (BCRA). While the Senate hinted that they would rewrite the House bill, many of the provisions stayed the same or were watered down. Like the House bill, the BCRA repeals all of the Affordable Care Act's ("Obamacare") taxes except for the excise tax on high cost employer-sponsored health coverage, which would be delayed until 2025. H.R. 1628, Senate Draft (6/22/2017).

With respect to one of the most contentious issues facing Congress in the healthcare debate - the Medicaid expansion provided for under Obamacare - the Senate bill phases out the expansion, but at a slower rate than the House bill. However, both bills make substantial cuts to the Medicaid program over time.

Like the House's healthcare bill, the Senate's bill eliminates the employer mandate and the individual mandate. Under the employer mandate, a penalty is imposed on certain large employers that do not offer health insurance coverage, offer health insurance coverage that is unaffordable, or offer health insurance coverage that consists of a plan under which the plan's share of the total allowed cost of benefits is less than 60 percent. Under the individual mandate, a penalty is imposed on individuals who do not maintain minimum essential healthcare coverage. These two mandates are a cornerstone of the Affordable Care Act, along with taxes imposed on wealthier individuals, which have also been eliminated under both the House and Senate bills.

Observation: Unlike the House bill, which replaces the individual mandate with a 30 percent health insurance premium surcharge on individuals who allow their coverage to lapse, the Senate bill does not provide any incentives for individuals to maintain continuous coverage. Several reports have indicated that the Senate will deal with this omission by adding to its bill a provision requiring individuals to wait six months to obtain new health insurance after a coverage lapse.

Tax Provisions

The BCRA makes the following tax changes:

  • Repeals the individual mandate, effective January 1, 2016.
  • Repeals the employer mandate, effective January 1, 2016.
  • Repeals the 3.8 percent net investment income tax (NIIT) in Code Sec. 1411, effective for tax years beginning on or after January 1, 2017.
  • Repeals the 0.9 percent additional Medicare tax, effective for remuneration received on or after January 1, 2023.
  • Reduces the income threshold for determining medical expense deductions under Code Sec. 213 from 10 percent to 7.5 percent, effective January 1, 2017. The House bill had reduced the threshold to 5.8 percent.
  • While the House bill would replace the premium assistance tax credit in Code Sec. 36B with a new, age-based credit, ranging from $2,000 to $4,000, the Senate bill instead provides for assistance similar to Obamacare but based on age, income, and cost of coverage. Taxpayers with gross incomes exceeding 350 percent of the poverty line would be ineligible for the credit under the Senate bill (the cutoff is 400 percent under Obamacare). The Senate bill also makes changes to the definition of aliens who are eligible for the credit.
  • Repeals the limitation on recapture of excess advance payments of the premium assistance tax credit, beginning in 2018. Under current law, liability for certain low-income households was limited to an applicable dollar amount.
  • Repeals the small business tax credit under Code Sec. 45R, which provides a credit to certain employers who provide health care to employees, effective for tax years beginning after 2019. The bill also modifies the credit to prohibit it from being used for health plans that include coverage for abortions (other than any abortion necessary to save the life of the mother or any abortion with respect to a pregnancy that is the result of an act of rape or incest) for tax years beginning on or after January 1, 2018.
  • Delays the implementation of the excise tax on high cost employer-sponsored health coverage (commonly referred to as "the Cadillac tax") until 2025. Under current law, the tax goes into effect in 2020.
  • Repeals the increase in the tax on distributions from health savings accounts (HSAs) and Archer medical savings accounts (MSAs) that are not used for qualified medical expenses. The Bill reduces the tax on HSA distributions from 20 percent to 10 percent and reduces the tax on Archer MSA distribution's from 20 percent to 15 percent, effective for distributions made on or after January 1, 2017.
  • Repeals limitations on contributions to flexible spending accounts, effective January 1, 2017.
  • Repeals the medical device excise tax in Code Sec. 4191, effective for sales after on or after January 1, 2018.
  • Repeals the elimination of the deduction for expenses allocable to a Medicare Part D subsidy, effective for tax years beginning on or after January 1, 2017.
  • Repeals the tax on prescription medications effective January 1, 2018.
  • Repeals the tanning tax, effective for services performed after September 30, 2017.

Non-Tax Provisions

The following is a summary of some of the BCRA's other key provisions:

  • Allows children to stay on their parents' healthcare plans until age 26 (same as Obamacare).
  • Continues use of state healthcare exchanges.
  • Allows states to change what qualifies as essential health benefits and define their own "essential health benefits" standards.
  • Relaxes the current-law requirement that prevents insurers from charging older people premiums that are more than three times larger than the premiums charged to younger people. Unless a state sets a different limit, the legislation would allow insurers to charge older people five times more than younger ones, beginning in 2018.
  • Implements a one-year freeze on Medicaid funding for Planned Parenthood.
  • Phases out Obamacare's expanded funding of Medicaid over three years, beginning in 2021 (one year later than the House bill).

CBO Estimates and Reaction to Senate's Bill

The Congressional Budget Office (CBO) has not yet scored the Senate's healthcare plan. An estimate is expected this week, to be followed by rulings from the Senate Parliamentarian on whether key aspects of the bill can move forward under reconciliation (streamlined procedures allowing legislation to pass the Senate with a simple majority instead of a 60 vote supermajority).

Several senators have come out against the plan, either because it doesn't do go far enough in repealing Obamacare, or because it goes too far. Senators Ted Cruz (R-Tex), Ron Johnson (R-Wisc), Mike Lee (R-Utah), and Rand Paul (R-Ky) released a joint statement in which they said they were not yet ready to support the Senate healthcare plan. They expressed pessimism that the bill as drafted would lower health care costs while also repealing Obamacare. Appearing on ABC News' "This Week with George Stephanopoulos", Paul said of his party's health care plan, "They've promised too much. They say they're going to fix health care and premiums are going to down ... There's no way the Republican bill brings down premiums."

On Friday, Senator Dean Heller (R-Nev) gave a press conference in which he sharply criticized the plan's curtailment of Obamacare's Medicaid expansion, and said that he couldn't support the bill in its present form. Senators Lisa Murkowski (R-Alaska), Susan Collins (R-Maine), Bill Cassidy (R-La), and Ben Sasse (R-Neb) have also declared themselves undecided or leaning against the present version of the bill.

Senate leadership finds itself facing the same daunting challenge that confronted their counterparts in the House earlier this year - having to adjust their healthcare plan in a way that brings both moderate and hard right Republicans into the fold. With unified Democratic opposition, Senate Republicans can afford to lose just two votes from their own caucus.

Senate Majority Leader Mitch McConnell (R-Ky) has stated that he hopes to bring the measure to a vote this week, ahead of Congress's Fourth of July recess. Majority Whip John Cornyn (R-Tex) said on Sunday that he considers that timeframe "optimistic."

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Tax Court Disallows S Corp's Deduction for Accrued Compensation to ESOP Participants

In a case of first impression, the Tax Court held that an S corporation's employee stock ownership plan (ESOP) was a trust for purposes of the Code Sec. 267 disallowance of loss deductions in transactions between related persons. As beneficiaries of the ESOP trust, employee participants in the plan were related persons, so accrued but unpaid compensation to them could not be deducted by the S corporation until the employees included the amounts in income. Petersen v. Comm'r, 148 T.C. No. 22 (2017).

Background

Steven and Pauline Petersen owned Petersen, Inc., (Petersen) a Utah S corporation. In 2001, the company formed an employee stock ownership plan (ESOP) for the benefit of its employees and transferred cash and Petersen stock to the related ESOP trust. During 2009 and the first nine months of 2010, the ESOP owned approximately 20 percent of the company. The ESOP acquired the shares owned by the Petersens and other shareholders in October 2010 and became the company's sole shareholder.

At the end of 2009, Petersen had an accrued but unpaid wage expense of approximately $1 million, which was paid to the employees by January 31, 2010. Approximately 89 percent of this amount was attributable to employees who participated in the ESOP. Petersen also had an accrued but unpaid vacation pay expense of approximately $473,000, which was paid to the employees by December 31, 2010. Approximately 94 percent of this amount was attributable to ESOP participants.

Petersen claimed deductions on its 2009 tax return for the accrued but unpaid payroll expenses. Mr. and Mrs. Petersen claimed passthrough deductions on their individual return equal to their pro rata shares of these accrued but unpaid expenses. The IRS audited Petersen's 2009 return and disallowed the deductions under Code Sec. 267 for accrued but unpaid expenses to the extent attributable to employees who participated in the ESOP. The Petersens' passthrough deductions of approximately $1,200,000 were disallowed and an accuracy-related penalty was imposed.

Related Party Rules under Code Section 267

Under Code Sec. 267(a)(2), a payment to a person who is related under Code Sec. 267(b) is not deductible until it is included in the recipient's income. Code Sec. 267(e) provides that for any amount paid by an S corporation, the S corporation and any person who directly or indirectly owns any stock of the S corporation are deemed to be related persons. Under Code Sec. 267(c)(1), stock owned by a trust is treated as being owned by its beneficiaries. Thus, if the stock held by the ESOP was owned by a trust of which the ESOP participants were beneficiaries, then the employee participants in the ESOP would be treated as owners of the stock, and therefore as related persons, and the deduction for their accrued wages would be deferred until the payments were included in the employees' income. In support of their argument against this result, the Petersens asserted that (1) the ESOP documents showed there was no intent to create a trust, and (2) the ESOP could not be a trust under Code Sec. 267(c)(1) as a matter of law.

Tax Court's Decision

The Tax Court held that the ESOP was a trust under Code Sec. 267(c)(1). The court reviewed the ESOP plan documents and found that they closely resembled an ordinary trust arrangement where a settlor establishes a trust for the benefit of specified beneficiaries, contributes property to the trust and designates a trustee to hold the property for the beneficiaries and act in their best interest. The court also noted that the ESOP could not qualify as an employee benefit plan under ERISA unless the assets were held by a trust.

The Petersens' argument that the ESOP documents showed no intent to create a trust was rejected by the Tax Court. According to the Petersens, the company's right to terminate the plan was inconsistent with the idea that a trust holds assets for its beneficiaries. Tthe Tax Court noted that the plan included a provision requiring, in the event of a plan termination, that the trust be liquidated and the assets distributed to the ESOP participants. It also reasoned that a reversionary interest in the trust assets would disqualify the plan from tax exemption under Code Sec. 401. The Petersons said that the plan agreement took precedence over the trust instrument because the trustee would typically act on instructions from the plan administrator, but the court did not see how that affected the proper characterization of the entity owning the assets, and noted that the trustee was explicitly required to hold and protect the assets for the beneficiaries and discharge his fiduciary duties for their exclusive benefit. The Petersens argued that Utah law was controlling in all matters relating to the plan and that Utah law excludes employee benefit plans from the definition of a trust; the court countered that it was well settled that interpretation of the Code was governed by federal, not state, law.

The Petersens' argument that the ESOP could not be a trust under Code Sec. 267(c)(1) as a matter of law was also rejected. The Petersens said that the ESOP had participants rather than beneficiaries. This argument failed, according to the court, because the trust that held the assets was distinct from the plan that created the ESOP; the employees were both participants in the plan and beneficiaries of the trust. The Petersens' assertion that ESOPs are subject only to the Code provisions on qualified plans, and not those governing the computation of taxable income (which includes Code Sec. 267), was also rejected. The court said that the Code provisions on taxable income apply to many entities and relationships regardless of which subchapter addresses their taxation in particular, and that in any event the IRS was applying Code Sec. 267 not to compute the ESOP's taxable income but to determine the Petersens' allowable deductions. The Petersens contended that a trust under Code Sec. 267(c)(1) should be limited to common law trusts subject to the Code provisions on the taxation of estates, trusts and their beneficiaries. The court found that the ESOP trust met the definition of a trust under Reg. Sec. 301.7701-4(a) and that the Petersens had offered no persuasive reason for defining a trust under Code Sec. 267(c)(1) more restrictively. Finally, the Petersens asserted that the ESOP trust was integrated with the plan and had no separate existence for tax purposes. The court responded that this argument misunderstood the statutory requirements of the ESOP's tax exemption, one of which is that the ESOP trust must be a legally distinct entity created by a distinct trust instrument.

The Tax Court also determined that because the application of Code Sec. 267(a) to employers and ESOP participants was a question of first impression for the Tax Court, the Petersens had made a good faith effort to properly determine their tax liabilities and were therefore not liable for the accuracy-related penalty under Code Sec. 6662.

For a discussion of the treatment of accrued expenses for ESOP participants, see Parker Tax ¶33,560.

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Sale of Businesses Were Sales of Franchises; Gain Was Capital, Not Ordinary

The Tax Court held that sales of municipal waste collection businesses by three related partnerships qualified as sales of franchises resulting in capital gains treatment. The contracts met the definition of franchises under Code Sec. 1253, and the partnerships neither retained any significant interests in the contracts after the sales nor received any contingent payments, so the transactions were not excluded from capital gains treatment under the statute. Greenteam v. Comm'r, T.C. Memo 2017-122.

Background

In 2003, three related California partnerships, Greenwaste of Tehama (Greenwaste), Greenteam of San Jose (Greenteam) and Greenteam Materials Recovery Facility (Greenteam Facility) sold their waste disposal and related businesses to Waste Collections, Inc. The partnerships sold substantially all of their assets, including their contracts, to Waste Collections in all-cash deals with no contingent payments. The partnerships did not keep any interest in the contracts.

The Greenwaste business included five contracts giving it the exclusive right to perform waste disposal and recycling services in Tehama County and in the city of Red Bluff. The fifth contract gave it the exclusive right to use the local landfill. As part of the landfill contract, Greenwaste agreed to pay for any needed improvements, although title to the improvements would revert to Tehama County and Red Bluff when the contract ended. The Greenwaste contracts began in 1998 and ran through June 2007, but could be extended by mutual agreement. The parties agreed that in 2003, the four Greenwaste collection contracts were collectively worth approximately $860,000, and the landfill contract was worth approximately $1 million.

Greenteam had entered into a similar contract for waste disposal and recycling services in San Jose. Greenteam made various improvements to San Jose's waste collection system, including installing radio frequency identification tags to every trash bin and outfitting its garbage trucks with computers to monitor collections. In order to process San Jose's recyclables, Greenteam formed Greenteam Facility to build a processing facility. The Greenteam and Greenteam Facility contracts ran through 1999, but could be extended up to three years. Green won the bid again when San Jose issued another request for proposal in 2000.

The IRS audited the Greenteam partnerships' 2003 returns in 2009 under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and issued notices of final partnership administrative adjustment (FPAA) recharacterizing the gains from the sales of the contracts as ordinary income. The FPAA for Greenwaste recharacterized approximately $6,800,000 as ordinary income, Greenteam's FPAA recharacterized approximately $20,200,000 as ordinary income, and the Greenteam Facility FPAA recharacterized approximately $6,200,000 as ordinary income.

Analysis

The partnerships petitioned the Tax Court and argued that the sales of the contracts fell under Code Sec. 1253, which provides that a taxpayer gets capital gains treatment when it sells a franchise unless it has a continuing interest in the franchise after the sale. The IRS contended that according to California industry standard, a contract to provide services for a limited time was a municipal contract, not a franchise, and that a franchise in California meant only a contract that continues to renew until it is terminated. It also interpreted Code Sec. 1253 to be inapplicable because the partnerships kept no interests in the contracts and did not receive any contingent payments. According to the IRS, since Code Sec. 1253 did not apply, the test for whether the contracts were capital assets had to be decided under Code Sec. 1221, the six part test under Foy v. Comm'r, 84 T.C. 50 (1985), and the substitute for ordinary income doctrine.

The Tax Court held that the contracts met the definition of franchises under Code Sec. 1253(b)(1) and that capital gains treatment applied to the sales. Under Code Sec. 1253, the sale of a franchise is not treated as the sale of a capital asset if the transferor retains any significant power, right or continuing interest. The Tax Court articulated the definition of a franchise under Code Sec. 1253(b)(1) as an agreement in which one party receives the right to provide services within a defined area. The contracts met the definition of a franchise under the statute because they were agreements to provide landfill, waste disposal and recycling services within the areas of Tehama County, Red Bluff, and San Jose, according to the Tax Court.

The Tax Court rejected the IRS's argument that the contracts could not be franchises because the industry standard was to refer to contracts for a limited time as municipal contracts. The relevant definition, in the Tax Court's view, was the one provided in Code Sec. 1253(b)(1). The Tax Court also rejected the IRS's argument that Code Sec. 1253 was inapplicable by its own terms, reasoning that the language of Code Sec. 1253(d) referring to capital accounts implied that the sale of a franchise leads to capital gains unless the transaction is specifically denied such treatment under Code Sec. 1253(a). The Tax Court further determined that previous decisions in the Tax Court and in the Fifth Circuit had reached the same conclusion and, moreover, that the legislative history of Code Sec 1253 confirmed the courts' interpretation.

Having found that the contracts were franchises, the Tax Court next determined that the partnerships did not keep any significant interests in the franchises or receive contingent payments. If any interests had been retained, the income from the sales would be ordinary under Code Sec. 1253(a). But because the partnerships retained no interests and received lump sum payments, the transactions were eligible for capital gains treatment under Code Sec. 1253.

The Tax Court concluded that Code Sec. 1253 applied to the transactions because the partnerships kept no significant interests in the contracts and that the partnerships were thus entitled to capital gains treatment on their profits. It therefore was not necessary for the court to decide whether the franchises were capital assets under Code Sec. 1221, Foy, or the substitute for ordinary income doctrine.

For a discussion of capital gains treatment for sales of franchises, see Parker Tax ¶117,115.

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Treasury Department Moves Forward on Eliminating Unnecessary Tax Regulations

The Treasury Department issued a notice requesting comments on regulations that should be eliminated, modified, or streamlined. The notice is the result of an executive order signed in January directing federal agencies to eliminate two regulations for each new regulation issued. 82 Fed. Reg. 27217 (6/14/17).

On January 30, 2017, President Trump signed Executive Order (EO) 13771, Reducing Regulation and Controlling Regulatory Costs. The EO directs agencies to eliminate two regulations for each new regulation issued and to limit costs for the fiscal year to zero. On February 24, 2017, the President issued EO 13777, Enforcing the Regulatory Reform Agenda, which requires agencies to convene a regulatory reform task force to assist in the implementation of EO 13771.

The task force will evaluate existing regulations and make recommendations to the Treasury Secretary to prioritize their possible repeal, replacement, or modification, consistent with applicable law. EO 13777 requires the task force to attempt to identify regulations that eliminate jobs or inhibit job creation; are outdated, unnecessary, or ineffective; impose costs that exceed benefits; create a serious inconsistency or otherwise interfere with regulatory reform initiatives and policies; are inconsistent with the requirements of the Information Quality Act, or guidance issued pursuant to that provision; or derive from or implement EOs or other Presidential directives that have been subsequently rescinded or substantially modified.

EO 13777 encourages agencies to seek input from small businesses, state and local governments, trade associations, and other stakeholders significantly affected by regulations. Accordingly, on June 14, the Treasury Department issued a notice in the Federal Register inviting members of the public to submit views and recommendations for Treasury Department regulations that can be eliminated, modified, or streamlined. According to the Treasury Department, commenters should identify regulations by title and citation to the Code of Federal Regulations and should explain how the regulations could be modified, if appropriate, or explain why the regulation should be eliminated. To the extent available, commenters are asked to provide available data and an explanation of regulatory costs and compliance burdens.

Caution: The notice advises that, in general, comments received, including attachments and other supporting materials, will be part of the public record and made available to the public. Those submitting comments should not enclose any information in the comment or supporting materials that is considered confidential or inappropriate for public disclosure.

In particular, the Treasury Department invited comments on regulations, forms, and guidance documents issued by the IRS, the Alcohol and Tobacco Tax and Trade Bureau, the Bureau of the Fiscal Service, Departmental Offices (Office of the Secretary), the Financial Crimes Enforcement Network, the Community Development Financial Institutions Fund, the Office of Foreign Assets Control, and Treasury regulations and guidance issued under the Department's Customs Revenue Function.

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Court Addresses Issue of Whether Filing Form 1040 Tolls Statute on Unfiled Form 945

A bankruptcy court held that, because a business owner's individual income tax returns were not part of the record in the case, it could not resolve the question of whether the owner's Forms 1040 contained enough data to calculate his Form 945, Annual Return of Withheld Federal Income Tax, liability with respect to subcontractors he hired for his business. As a result, the court could not determine whether the individual's failure to file Form 945 meant that the IRS had unlimited time to assess withholding tax liability on the business owner. Quezada v. IRS, 2017 PTC 285 (W.D. Tex. Bankr. 2017).

Background

James Quezada is a masonry contractor. His company, Quezada Masonry, was hired on a contract basis to provide materials and labor for masonry projects. Quezada typically supplied the materials and hired subcontractors to perform the labor. From 2005 to 2008, Quezada filed tax returns reporting payments made to subcontractors. He also claimed deductions for these payments on his Forms 1040 for each of the years at issue.

The IRS began examining Quezada's 2005 backup withholding liability for the subcontractors in September 2008. Three years later, it began to examine Quezada's withholding liability for 2006-2008. In December 2013, an IRS appeals officer reported his findings and recommended that approximately $600,000 be assessed, together with almost $300,000 of penalties, because Quezada did not file Forms 945, Annual Return of Withheld Federal Income Tax, to report backup withholding or pay backup withholding taxes in 2005-2008.

The IRS assessed Quezada's liability for these years in February 2014, more than three years after Quezada filed his Forms 1040. In March 2015, the IRS sent Quezada a deficiency notice stating that Quezada owed over $1.2 million, including interest and late payment penalties. Quezada filed for bankruptcy under Chapter 11 in 2016 and the IRS filed a proof of claim. Quezada filed an adversary proceeding to determine the debt's dischargeability and for declaratory relief from the taxes listed in the IRS proof of claim.

Analysis

An employer is not generally required to withhold taxes on payments to independent contractors. However, if a contractor fails to provide the IRS with a taxpayer identification number (TIN), the employer must withhold 28 percent of certain taxable payments and report this backup withholding on Form 945, Annual Return of Withheld Federal Income Tax.

However, even if an employer fails to withhold the taxes, and does not file Form 945, the employer can still avoid liability as long as it can be shown that the independent contractor reported and paid taxes on the payments. The employer complies with this requirement by obtaining a Form 4669, Statement of Payments Received, from each independent contractor. By filing Form 4669, the contractor declares under penalty of perjury that he or she filed a tax return reporting the payments received from the employer. So, if a taxpayer employs independent contractors, he or she has to either:

(1) provide the contractor's TIN;

(2) file Form 945 to report the backup withholding on these payments, and pay the backup withholding; or

(3) obtain a complete Form 4669 from each independent contractor.

The IRS has three years three years from the filing of a return to assess any tax deficiency, including backup withholding. If no return is filed, then under Code Sec. 6501(c)(3), the limitations period does not apply and the IRS can assess taxes at any time.

The IRS argued that Quezada did not comply with his backup withholding obligations because he did not submit the independent contractors' TINs, did not file Forms 945, and did not obtain and submit Forms 4669. Therefore, according to the IRS, no return was ever filed to trigger the three year statute of limitations period, and Quezada's backup withholding liabilities could be assessed at any time. Quezada filed a motion for summary judgment arguing that even if he failed to file Form 945, his Form 1040 filings for the years at issue were sufficient to trigger the statute of limitations period for assessing his backup withholding liability. During the hearing on the Quezadas' motion for summary judgment, the parties agreed that fact issues prevented the bankruptcy court from ruling on all but one issue: did Quezada's failure to file Form 945 mean the IRS had unlimited time to assess withholding tax liability under the statute of limitations tolling provisions of Code Sec. 6501(c)(3).

The bankruptcy court denied Quezada's motion for summary judgment. First, it noted that no courts have ruled on whether a Form 1040 filed by a taxpayer triggers the statute of limitations period with respect to an unfiled Form 945. However, the court found precedent indicating that the limitations period is not triggered where taxpayers failed to file other types of required returns. Underlying the rationale in those decisions, the court said, was the substantial compliance standard articulated in Beard V. Comm'r, 82 T.C. 766 (1984), which provides that a document is sufficient for statute of limitations purposes if it -

(1) contains sufficient data to calculate tax liability;

(2) purports to be a return;

(3) is an honest and reasonable attempt to satisfy the requirements of the law; and

(4) is executed under penalties of perjury.

The court held that Form 945 is a return and that the question before it was whether in the information actually filed by Quezada provided enough data to calculate his Form 945 liability. In denying Quezada's motion for summary judgment, the court found that it could not determine whether Quezada's Forms 1040 provided enough data because Quezada had not attached the returns actually filed to his initial brief.

For a discussion of reporting backup withholding on Form 945, see Parker Tax ¶216,130. For a discussion of the statute of limitations for assessments, see Parker Tax ¶260,130.

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House Passes Mobile Workforce State Income Tax Simplification Act of 2017

The House of Representatives has passed the Mobile Workforce State Income Tax Simplification Act of 2017, and a similar bill is expected to pass the Senate. The legislation, which has bipartisan support, is aimed at simplifying the complex tax reporting rules faced by employers and employees as a result of numerous state income tax withholding laws when employees work outside their home states. H.R. 1393 (6/20/17).

On June 20, the House of Representatives passed the Mobile Workforce State Income Tax Simplification Act of 2017. The bill prohibits the wages or other remuneration earned by an employee who performs employment duties in more than one state from being subject to income tax in any state other than:

(1) the state of the employee's residence; and

(2) the state within which the employee is present and performing employment duties for more than 30 days during the calendar year.

The bill exempts employers from state income tax withholding and information reporting requirements for employees not subject to income tax in the state under this bill. For the purposes of determining penalties relating to an employer's state income tax withholding or reporting requirements, an employer may rely on an employee's annual determination of the time expected to be spent working in a state in the absence of fraud or collusion by such employee.

Under the bill, the term "employee" excludes: professional athletes; professional entertainers; production employees who perform services in connection with certain film, television, or other commercial video productions; and public figures who are persons of prominence who perform services for wages or other remuneration on a per-event basis.

A companion bill, S. 540, has been introduced in the Senate and is expected to easily pass.

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IRS's Computation of Taxpayer's Reasonable Collection Potential Wasn't Reasonable

The Tax Court held that an IRS settlement officer's rejection of a corporation's offer in compromise solely on the basis of his calculation of reasonable collection potential that used the corporation's going-concern valuation, but disregarded completely its tax liability, was not reasonable. According to the court, the going-concern value is intended to give some indication of what a third party might pay to buy a corporation, but no third party would buy a corporation without taking into account the corporation's unpaid tax liability. W. Zintl Construction, Inc. v. Comm'r, T.C. Memo. 2017-119.

W. Zintl Construction, Inc. (Zintl Inc.), a commercial construction subcontractor, is a C corporation. On May 28, 2013, the IRS sent a notice of intent to levy to Zintl Inc. with respect to its 2011 and 2012 employment tax liabilities. In response, Zintl Inc. submitted Form 12153, Request for a Collection Due Process or Equivalent Hearing. Several other notices of intent to levy were sent to Zintl Inc. and the company responded to each by filing Form 12153. On all Forms 12153, Zintl Inc. checked "offer in compromise" as a collection alternative.

On August 27, 2013, Zintl Inc. submitted Form 656, Offer in Compromise, and made an offer in compromise (OIC) of $1 million. In support thereof, Zintl Inc. provided a profit and loss statement and a balance sheet ending June 30, 2013, and a Summary Appraisal Report dated February 12, 2013, indicating a "Forced Liquidation Value" for the company's machinery and equipment of approximately $1.2 million. In an accompanying letter to IRS Settlement Officer (SO) Albright, Zintl Inc. indicated an accounts receivable balance of approximately $3.4 million as of August 9, 2013. After quoting the Internal Revenue Manual (IRM) regarding the proper treatment of accounts receivable, the letter explained that "Zintl is profitable and its receivables are part of the income stream required for the production of income. The company must pay for materials and labor to continue operating. Without the income flow from these receivables, the business could not operate." Zintl Inc. also explained that the liquidation of Zintl's inventory, machinery, and equipment would end its ability to operate and that it had recently sold all of the assets it could spare to satisfy a bank obligation that was secured by the company's inventory and equipment.

SO Albright requested additional documentation, including a valuation of the business as a going concern and a copy of the equipment appraisal listing the fair market value of Zintl Inc.'s physical assets. Zintl Inc. sent the documents requested, including a going-concern appraisal dated April 16, 2014. The going-concern appraisal estimated a going-concern fair market value of $2.1 million using three valuation methods, each of which subtracted accrued payroll tax liability and interest of approximately $4.2 million. The largest single asset reflected in the appraisal was the accounts receivable (in excess of $7 million), and the largest single liability was the payroll tax liability. The appraisal did not include the accumulated penalties on the tax liability (estimated to be $2.1 million). The appraisal assigned no value to goodwill. The appraisal also estimated a liquidation value for the company of negative $3.72 million.

In a letter dated April 24, 2014, SO Albright noted that, according to the appraisal, the value of Zintl Inc. was estimated to be $2.1 million after allowing for the IRS debt of $4.2 million. In other words, he said, the value of the business for purposes of the OIC was estimated to be approximately $6.3 million. Further, he noted that in determining the reasonable collection potential (RCP) in an OIC, the IRS generally reduces the asset values by 20 percent. As a result, in Zintl Inc.'s case, SO Albright found that the RCP was approximately $5 million.

SO Albright gave Zintl Inc. an opportunity to submit an amended OIC in an amount at least equal to the $5 million RCP and stated that he likely would reject the original $1 million offer if an amended offer were not received by May 8, 2014. By letter dated May 1, 2014, Zintl Inc. disagreed with the use of the going concern valuation of Zintl Inc. to calculate an acceptable OIC amount. The following month, SO Albright sent Zintl Inc. a letter stating that he had been unable to find anything to indicate that the going-concern value cannot be used in determining the RCP when the taxpayer is a business (as opposed to when the taxpayer is the shareholder of a business) and advised Zintl Inc. to submit an amended OIC to reflect the RCP he had previously calculated.

In a July 9, 2014 meeting and subsequent calls, Zintl Inc. advised SO Albright that it was unable to secure financing to fund a $5 million OIC but was continuing to work with banks on financing. On August 4, 2014, Zintl Inc.'s attorney notified SO Albright that Zintl Inc. anticipated receiving a loan of $3 million that, if approved, would allow the company to increase its OIC to $3.2 million. Because the deadline for increasing the OIC had lapsed and the loan had not yet been approved, the IRS rejected Zintl Inc.'s $1 million OIC offer because its RCP exceeded that amount and sustained the disputed collection actions. Zintl Inc. petitioned the Tax Court to review whether SO Albright abused his discretion by using the going-concern value as described in the Internal Revenue Manual 5.8.5.17 (Sept. 30, 2013) and, on that basis, rejecting Zintl Inc.'s OIC as substantially below its RCP.

The Tax Court held that SO Albright's calculation of Zintl Inc.'s RCP was not reasonable and remanded the case to the IRS Office of Appeals for the purpose redetermining Zintl Inc.'s RCP. The court noted that, in effect, Zintl Inc. was asking it to decide that use of the going-concern value of a business is never appropriate when the business being valued is the taxpayer. The court said that it could not so conclude, nor did it need to. According to the court, SO Albright's calculation of RCP was faulty for a different reason: In calculating Zintl Inc.'s RCP, SO Albright increased the corporation's going-concern value by the amount of the unpaid tax liability, which the appraisal took into account in its calculation of value, and based his determination of RCP solely on this modified value. This modification to the value at first blush seemed logical to the court. Reducing Zintl Inc.'s going-concern value by its tax liability when determining how much of this tax liability the corporation could pay would seem to double count the tax liability and provide a boon to a business taxpayer whose tax debt is part of the business being valued. After all, the court said, it is this tax liability that will be satisfied with the OIC.

However, the court observed, the problem with this is that the going-concern value is intended to give some indication of the value of Zintl Inc. as a continuing business; i.e., what a third party might pay to buy the corporation as a whole, including all of its assets and liabilities. No third party would buy Zintl Inc., the court noted, without taking into account the unpaid tax liability. And the record showed that Zintl Inc. could not obtain financing for the modified RCP amount either. According to the court, this highlights the logical difficulty of using going concern value - which presumes that a taxpayer can sell itself - to determine RCP.

The court also said that it could not conclude that consideration of the going-concern value and the information in the appraisal was irrelevant or that the settlement officer could not consider this information, including the specific assets and liabilities, such as the tax liability, on remand. The court also stated that it was not holding that Zintl Inc.'s offer was reasonable. It was only holding that SO Albright's rejection of Zintl Inc.'s OIC solely on the basis of his calculation of RCP that used the corporation's going-concern valuation but disregarded completely its tax liability was not reasonable.

For a discussion of the rules relating to OICs, see Parker Tax ¶263,165.

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Court Rejects Taxpayer's Reliance on "Outlier" Fifth Circuit Decision

A district court denied a taxpayer's motion to dismiss felony charges that he violated Code Sec. 7206(1) when he made false statements on Form 433-A regarding the transfer of assets for less than full value. The court found that a Fifth Circuit decision the taxpayer was relying on, U.S. v. Levy, 533 F.2d 969 (5th Cir. 1976), was an outlier and that many other courts have since disagreed with the result and the rationale of that decision. U.S. v. Yurek, 2017 PTC 292 (D. Colo. 2017).

Daryl Yurek was charged with violating Code Sec. 7206(1) after submitting to the IRS two Form 433-As, Collection Information Statement for Wage Earners and Self-Employed Individuals, that the IRS said contained false information. On the Form 433-As, Yurek answered "No" to the question, "In the past 10 years, have any assets been transferred by the individual for less than full value?" According to the IRS, Yurek had, in fact, made such transfers, by transferring stock to his sons and to one of his affiliated companies for less than full value.

Code Sec. 7206(1) provides that if a person willfully makes and subscribes any return, statement, or other document, which contains or is verified by a written declaration that it is made under the penalties of perjury, and which the person does not believe to be true and correct as to every material matter, such person is guilty of a felony and, upon conviction thereof, will be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than three years, or both, together with the costs of prosecution.

Yurek argued that the charges should be dismissed pursuant to U.S. v. Levy, 533 F.2d 969 (5th Cir. 1976). In Levy, a defendant was convicted in a district court under Code Sec. 7206(1) based on having signed an IRS Form 433-AB. On appeal, the Fifth Circuit addressed whether Form 433-AB was a "statement or other document" within the meaning of Code Sec. 7206(1). The court acknowledged that the statute uses the words "statement" and "other document" with no limiting exception, and that "[i]f we had only to look to the unadorned words, 'statement' and/or 'document,' no difficulty, at least as to the meaning of the statute, would be involved." However, the Levy court went on to review the "inconclusive" legislative history and noted that criminal statutes must be strictly construed and reasoned that, because Code Sec. 7206(1) is a perjury statute, the party taking the statement must have the authority to take that particular statement. The court then held that Code Sec. 7206(1) applies only to any statement or document required by the Internal Revenue Code or by any regulation lawfully issued for the enforcement of the Code, and therefore reversed the defendant's conviction because Form 433-AB had not been required by statute or regulation.

In the instant case, the district court noted that other courts, such as the Tenth Circuit in U.S. v. Franks, 723 F.2d 1482 (10th Cir. 1983), and the Second Circuit in U.S. v. Holroyd, 732 F.2d 1122 (2d Cir. 1984), have since disagreed with the result and the rationale of Levy. The court rejected Yurek's argument that the issue is "unsettled" and found that the Levy decision remains a significant outlier. The court concluded that the language of Code Sec. 7206(1) provides no hint that it applies only to those statements or documents which are authorized by statute or regulation, and includes no other exception that would make it inapplicable to Yurek's Form 433-A submissions. To the contrary, the court said, Code Sec. 7206(1) applies to any return, statement, or other document. Interpreting the plain language of the Code and in keeping with Franks and Holroyd, the district court denied Yurek's motion to dismiss the charges that he violated Code Sec. 7206(1).

For a discussion of the penalties for making false and fraudulent statements on returns, see Parker Tax ¶265,125.

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S Corporation Liable for Employment Taxes Not Paid by Professional Employer Organization

The Chief Counsel's Office advised that an S corporation that hired a professional employer organization (PEO) to fulfill the S corporation's employment tax obligations was liable for the employment taxes that the PEO failed to pay. Had the S corporation used a certified PEO instead, it would not have been liable for the unpaid taxes. CCA 201724025.

Background

An S corporation employed workers that it obtained through a professional employer organization (PEO) in various capacities, including accounting, administrative and marketing positions. The S corporation and the PEO entered into an agreement with respect to those workers. Under the terms of the agreement, the S corporation was responsible for the day to day supervision and control of the workers and, before each payroll date, it was obligated to pay to the PEO the wages and salaries and any other charges or payments to be paid to, or with respect to, the individuals the PEO retained to work in the S corporation's locations. It agreed to provide a security deposit or procure a letter of credit naming the PEO as the beneficiary for the amount necessary to cover the wages and salaries. The PEO was responsible for payroll, benefits, personnel policies and procedures, human resources services, workers' compensation insurance, and processing and paying wages from its own accounts to the workers. The PEO was also obligated under the contract to file all employment tax returns including Form 940, Employer's Annual Federal Unemployment Tax (FUTA) Return and Form 941, Employer's Quarterly Federal Tax Return, as well as all information returns (i.e., Forms W-2).

For the years at issue, the S corporation filed Forms 1120S and took employee leasing deductions for its entire workforce. It did not claim any deductions for officer compensation or salaries and wages. The S corporation did not file any Forms 940 or 941 or issue Forms W-2 with respect to any workers for any of the years at issue; nor did it take any steps to verify that the PEO filed and paid the employment taxes due or filed the appropriate returns. As the result of an IRS audit, the S corporation learned that the PEO had failed to remit the applicable employment taxes to the IRS. According to the IRS, the S corporation was liable for the unpaid employment taxes.

Liability for Employment Taxes

The responsibility for paying employment taxes falls on the statutory employer as defined in Code Sec. 3401(d) and Reg. Sec. 31.3401(d)-1(f). For employment tax purposes, the employer is the person for whom an individual performs a service, unless the person does not have control over the payment of wages for such services. The focus under the regulations is on the legal control of the payment of wages.

Under Sec. 530 of the Revenue Act of 1978 (Sec. 530), workers are deemed not to be employees of a taxpayer for employment tax purposes if certain requirements are met. If Sec. 530 applies, then for employment tax purposes for a particular period, the worker in question is not an employee, and the taxpayer therefore has no employment tax liability for that period.

S Corporation's Arguments

The S corporation did not dispute that it was the common law employer of the workers at issue, and acknowledged that it was responsible for paying the underlying tax liabilities on wages it paid to its workers. The S corporation asserted, however, that it paid the wages plus the required employment taxes to the PEO, and that the PEO was obligated to withhold employment taxes from the wages and pay those taxes over to the IRS. The S corporation argued alternatively that it was entitled to relief under Sec. 530 from its employment tax liabilities.

Chief Counsel's Conclusion

The Chief Counsel's Office advised that the S corporation was not relieved of its employment tax obligations, and was not entitled to relief under Sec. 530. First, the Chief Counsel's Office concluded that the PEO was not the statutory employer under Code Sec. 3401(d)(1) because it did not assume legal responsibility for the payment of the wages to the employees. The contract provided that the S corporation would pay the PEO an amount equal to the wages in advance of the next payroll date. To ensure that the PEO would not be responsible for the payment of wages to the employees, the S corporation was required to provide a security deposit or letter of deposit naming the PEO as the beneficiary in the amount as determined by the PEO to cover the wages. In the view of the Chief Counsel's Office, the PEO therefore did not meet the definition of an employer under Code Sec. 3401(d), but was rather merely a conduit for the S corporation in making payroll.

With respect to the Sec. 530 issue, the Office of Chief Counsel advised that the S corporation was not entitled to relief from its employment tax liabilities under Sec. 530. Reviewing the legislative history, the Chief Counsel's Office concluded that Congress's intent was to limit the application of Sec. 530 relief only to controversies regarding whether an individual should be reclassified as an employee instead of an independent contractor. In this case, there was no question that the workers were properly classified as employees. The Chief Counsel's Office reasoned that the entire contractual arrangement between the S corporation and the PEO was in fact predicated on the treatment of the workers as employees. The dispute was limited to whether the S corporation as the common law employer remained ultimately liable for the unpaid employment taxes, and Sec. 530 was therefore inapplicable to the S corporation's situation.

Certified PEO Program

The IRS has established a certified PEO (CPEO) program. If a company hires a CPEO, and that CPEO fails to fulfill its obligations, the company is not held responsible for the CPEO's failure. In order to become a CPEO, certain certification requirements under Reg. Sec. 301.7705-2T must be met. The procedures for applying to become a CPEO are set forth in Rev. Proc. 2016-33, as modified by Notice 2016-49. Further guidance for the requirements to remain certified as a CPEO, as well as the procedures for suspension and revocation of a CPEO certification, is provided in Rev. Proc. 2017-14.

For a discussion of PEOs and CPEOs, see Parker Tax ¶218.110.

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Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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