Tuesday, December 31, 2002

No Stay

The U.S. Court of Appeals for the 5th Circuit rejected an attempt to stay an I.R.S. assessment under Section 6672 against the sole shareholder of a corporation in a Chapter 11 bankruptcy.

The I.R.S. was attempting to assert the so-called “100%” penalty against the sole shareholder on the basis that he was the person responsible to collect and pay over employee withholding taxes and that he willfully failed to discharge that obligation. The shareholder argued that the proposed $250,000 assessment would interfere with his ability to operate the corporation. He testified that the assessment would be “a dark cloud hanging over me and . . .it's very distracting to realize that being a single parent of two, an 11- and 13-year-old, both girls, it's a lot of responsibility on my shoulders to make sure that I am successful in paying back the I.R.S. and without, you know, being able to get into the housing market.” This argument was accepted by the bankruptcy court and the district court, both of which concluded that an assessment against the shareholder would jeopardize the possibility that the corporate reorganization would be successful.

The appellate court vacated the injunction that stopped the Service from proceeding with the assessment. The court concluded that the proposed assessment was, in essence, a tax against the shareholder, individually. Since the bankruptcy court proceeding concerned the corporation, the shareholder’s dispute with the I.R.S. over the proposed assessment was not even before that court.

It is worthy of some note that the bankruptcy plan that had been approved by the bankruptcy court also provided that payments to the Service under the plan “would be applied to the trust fund portion” of the unpaid employment taxes until that portion of the liability had been paid in full.

The case is entitled In the Matter Of: Prescription Home Health Care, Inc.
Marital COBRA

In Rev. Rul. 2002-88, 2002-52 I.R.B. 995, the Service was presented with a case where one spouse had employer-provided health insurance benefits covering both himself/herself and his/her spouse. In “anticipation of a divorce” the spouse who had the employer-provided coverage terminated the coverage of the other spouse. The Service held that “If an employee eliminates the coverage of the employee's spouse under a group health plan in anticipation of their divorce, a plan that is required to make COBRA continuation coverage available to the spouse must begin to make that coverage available as of the date of the divorce.”

A couple of points are of interest.

First, under the facts set forth in the ruling, there was apparently not a significant hiatus between the date coverage was terminated and the divorce. The outcome may very well have been different if, as part of a protracted marital war, the spouse with coverage had terminated the other spouse’s coverage as part of preliminary skirmishing.

Second, the plan administrator was provided with notice of the divorce within 60 days after the issuance of the divorce decree. This supports the first point, above, but also serves as a warning that someone ought to make certain that, in all cases where one spouse provides coverage for the family, the plan administrator gets notice of the divorce within the 60 period after the issuance of the divorce decree.

Monday, December 30, 2002

No Fault Foot Fault

Smaller corporations often have their formal corporate existence terminate when they fail to make any one of a variety of annual filings. In Maryland, the failure to file tangible personal property tax returns will cause the corporate charter to be forfeit. However, if the failure is rectified and articles of revival filed, the corporation can spring back into life. Under Maryland law, all obligations incurred during the period that the charter was annulled are limited to corporate assets once the articles of revival have been filed. (By the way, this is not the case in other states, notably Virginia. If a Virginia corporation’s charter lapses, obligations incurred during the period in which the corporation remains out of existence are personal obligations of the corporate owners.)

Recently, in PLR 200252033, the Service ruled that the S election of a lapsed corporation remains in effect even though it is not formally revived in the original state of incorporation. Under the facts of that ruling, the corporate charter was forfeit in State X. Rather than “revive” the corporation in that state, the owners merely formed a new corporate entity in State Y. The IRS held that the new corporation was merely a reincorporation of the initial entity and, thus, the S election remained intact.

Sunday, December 29, 2002

A Matter of Intent

A goodly amount of legal commentary crosses my desk--law reviews, law journals, and a variety of law-related newsletters. Much of this material is overly pedantic or otherwise not of great interest to practitioners. A notable exception is the latest issue of Real Property, Probate and Trust Journal, the quarterly academic publication of the ABA’s Section of Real Property, Probate and Trust Law. Literally all of articles are worthy of a read even by a busy practitioner.

In future postings, I will discuss a number of the articles. The article that I want to turn my attention to first, Thomas C. Homburger’s and James R. Schueller’s "Letters of Intent–A Trap for the Unwary,” is of special interest because its focus, letters of intent, are used so frequently and, probably, just as frequently misunderstood, that the article should be obligatory reading for practitioners.

Homburger and Schueller identify three types of letters of intent: (i) those that create an enforceable contract to consummate the intended transaction, (ii) those that create an obligation to negotiate in good faith, and (iii) those that simply set forth a term sheet and that, therefore, do not create enforceable contracts. Their article makes a convincing case that one should decide which of the three categories one intends a letter of intent to fall into.

One aspect of the topic that came as a bit of surprise to me was the possibility that a broker could argue that it had earned its commission once the letter of intent had been executed. Just such an argument was raised in the case of The Fischer Organization, Inc. v. Landry’s Seafood Restaurants, Inc., decided earlier this year by the Court of Special Appeals of Maryland. The broker’s argument in that case was rejected because the Court found that the terms set forth in the letter of intent did not match the terms in the brokerage contract that would have entitled the broker to a commission. However, the fact that the case was brought at all should serve as a signal for caution both in drafting letters of intent and brokerage contracts.

In an opinion delivered last year, Burback Broadcasting Co. of Delaware v. Elkins Radio Corp., the Fourth Circuit discussed the difference between the two types of enforceable letters of intent identified in the Homburger/Schueller article. Quoting Corbin (“Letters of intent have lead to much misunderstanding, litigation, and commercial chaos.”), the Court sustained a judgment in favor of the intended purchaser seeking to enforce the letter of intent, holding that the letter created an enforceable obligation to negotiate a contract in good faith. The intended seller’s attempt to alter various agreed upon terms of the deal was held to constitute a breach of its obligation to negotiate in good faith the various components that the letter of intent left open.

Homburger and Schueller suggest language that can allow a party an out if the negotiations on the open items reach an impasse. There seems to me to be an inference that this suggested language leaves an escape hatch that is somewhat larger than the Court in Burback Broadcasting would allow. Thus, Homburger and Schueller suggest that rejecting a contract after conducting a full due diligence review is probably acceptable. I am not certain that the Burback Broadcasting Court would agree. The opinion in that case seems to indicate that the escape hatch is available only if there are good faith differences as to specific open items that prevent the ultimate consummation of the deal.

Since it is the job of the practitioner not merely to allow a client to win litigation, but to avoid it in the first instance, it is helpful to make it clear what is really intended. Thus, if the letter of intent would allow a prospective purchaser to back out if the due diligence review caused it to rethink the deal, the letter of intent should state that the purchaser need only go forward to closing if it determines, in its sole discretion, to go forward on the terms stated after making its review.

Monday, December 23, 2002

Sweet Vinegar at Least?

Glynn Shaw of San Clemente, California writes and notes that: "However, the payment of a 'reasonable' salary together with the 'correct' pension plan can significantly reduce and defer the tax burden. For 'reasonable' I use government statistics on salaries and wages published on the Internet. It is my view that the government can not easily dispute statistical data [it] maintain[s]."

I think that this is a start, but I am not certain that I fully agree. For instance, assume that Dr. X has a practice that grosses 2.5 times the national average gross for his/her specialty. I would think that, under the circumstances one cannot credibly argue that the national average net for the specialty is all that Dr. X's professional corporation needs to pay him/her to avoid the attack mounted in Veterinary Surgical and Yeagle.

I would note also that there is an older case, Spicer Accounting, Inc. v. Commissioner, 918 F.2d 90 (9th Cir. 1990) where the court focused on the fact that capital was not integral to the success of the business (the operation of an accounting practice) and that "Mr. Spicer's services were integral to the operation of Taxpayer, as he was the only accountant in the accounting concern, the only one who signed customers' returns as preparer, the only one who performed financial planning for the firm, and the only one who audited clients' books." In other words, the question of whether his salary was "reasonable" did not factor into the determination. If there was a direct correlation between his efforts and the profitability of the practice, all of those profits are subject to FICA.

Finally, there is even an earlier case, Joseph Radtke, S.C. v. U.S., 895 F.2d 1196 (7th Cir. 1990) that presented a similar fact pattern and reached an identical conclusion.

Based on decided case law, I believe that one must tie any dividend return to some reasonable return on invested capital, not merely take the position that the amounts paid as wages are, based on general indices, reasonable.

Thursday, December 19, 2002

Still No Wine

Perhaps one of the most frequent disputes that I have with accountants involves FICA taxes. Many accountants believe that their clients can lower the amount of FICA taxes that they pay by incorporating their businesses, making S elections, and then paying themselves low or nominal salaries. The clients then take the remainder of their compensation in the form of dividends that are not subject to FICA.

Early this month, the U.S. Court of Appeals for the Third Circuit, in an appeal of two decisions from the Tax Court, rejected this strategy. While the appellate decision is not binding as precedent, one of the Tax Court opinions is.

The two Tax Court opinions, Veterinary Surgical Consultants, P.C. v. Commissioner and Yeagle Drywall Company, Inc. v. Commissioner, were both decided on October 15, 2001. In both cases, the corporations involved had essentially one shareholder, who was also the principal officer, head supervisor, chief rainmaker, and just about everything else. In the Veterinary Surgical case, the owner took no salary. In Yeagle, the owner took a fairly nominal salary. The taxpayers categorized all income from their businesses other than salary as S corporation dividends.

The Tax Court opinions and that of the Third Circuit make short shrift of the taxpayers’ arguments that officers are not employees. In essence, the courts looked to the economic reality of the businesses–the income of the business was principally generated by the efforts of these sole shareholders. The funds paid to them by their corporations were paid to them for their labor.

Interestingly, these opinions can be contrasted with another Tax Court opinion of last year, Pediatric Surgical Associates, P.C. v. Commissioner. In that case, the physicians working for a professional corporation fell into two categories, non-shareholder physicians and shareholder physicians. In essence, they performed identical duties and the lion’s share of their compensation was tied to their performance–hours worked, fees generated, etc. However, the shareholder physicians received additional compensation based essentially on their ownership. There, the shareholder physicians tried to make the argument that the Service made in Veterinary Surgical and in Yeagle, namely that the additional compensation was for services rendered as officers of the corporation. The Tax Court rejected that argument, finding that the time spent by the shareholder physicians on administrative tasks did not materially differ from that spent by the non-shareholder physicians. In that case, the additional payments made to the shareholder physician could only be related to their ownership of the corporation. Thus, the payments were not deductible as compensation, but were recharacterised as dividends. Because the payments were not deductible, the corporation had profits on which it had to pay taxes. Of course, the payments themselves were also taxable, so there were two levels of taxability on the same funds.

I still expect to spar with accountants over this issue. And, given the low level of IRS audits, clients may feel that there is an acceptable level of risk in playing "audit roulette." However, given the growing importance of FICA and SECA as part of the federal tax base, it seems certain that the Service will be devoting additional resources to focus on this issue.

Wednesday, December 18, 2002

Barely Risible

There are various "tests" used by lawyers to determine whether a proposed form of transaction is in some way troublesome--the "smell" test for instance. I believe that I have created a new test, the "barely risible" test. Yesterday, the Tax Court handed down an opinion in which the argument presented by the taxpayer failed that test.

In the case, Alt v. Commissioner, the taxpayer was the wife of a cardiologist. She lived what was, by most standards, a fairly opulent lifestyle. Aided and abetted by their daughter, the Alts embarked on a course of what some might term energetic tax avoidance, but which others (notably government prosecutors) termed conspiracy to commit tax fraud. (I hasten to point out that only Dr. Alt and the parties' daughter were actually indicted for tax fraud.)

Mrs. Alt argued that she deserved to be relieved of liability for federal taxes for the years in question because she was a "innocent spouse" entitled to relief under Section 6015 of the Internal Revenue Code.

Not cracking a smile, the Tax Court denied relief, noting that Mrs. Alt had shared (wallowed would be a better word) in the fruits of the parties' failure to pay taxes and that she never even bothered to argue that she was unaware of the underpayment. Moreover, she remains married to Dr. Alt and could not show that payment of the tax, penalty, and interest (around $2 million) would leave her destitute.

Tuesday, December 17, 2002

You Can't Turn Water Into Wine

A Tax Court decision handed down yesterday proves that it's not easy to turn the water of ordinary income into the wine of capital gain.

In Parker v. Commissioner, the taxpayer was self-employed and worked under contract as a district manager for a group of insurance companies. The insurance companies canceled his contract and paid him an amount designated “Contract Value”, based on the quantity (length of service) and quality (final 6 months’ earnings) of the services rendered by him to the insurance companies. The taxpayer failed to pay self-employment tax with respect to the Contract Value, claiming that it constituted a capital gain.

The Tax Court held that the contract value is subject to the tax on self-employment income and is not capital gain. The taxpayer was hit with a tax assessment of over $90,000, plus interest and penalties.