Thursday, February 27, 2003

A Blacker Shade of Grey

Yesterday, the Tax Court issued a six-pack of memorandum opinions on the question of avoidance of the requirement to pay F.I.C.A. and F.U.T.A. by declaring the income to be S corporation dividends rather than wages. The cases, Nu-Look Design, Inc., Water-Pure Systems, Inc., Specialty Transport & Delivery Services, Inc., Superior Proside, Inc., Mike J. Graham Trucking, Inc., and Veterinary Surgical Consultants, P.C. (yes, the same guy as before, just different tax years) all share several factors.

First, and perhaps foremost, the same accountant concocted the scheme to avoid tax practiced by all of the taxpayers in this case. The accountant, Joseph M. Grey, himself utilized the scheme, but to no avail. (The opinion in his case was a formal published opinion.)

Second, they were all chozzers. (The term "chozzer," sometimes spelled "chazzer," is a technical tax term derived from the Yiddish word for pig. As explained by Leo Rosten in his book, The Joys of Yiddish, it is rarely used to describe someone dirty, but rather is used for the ungrateful, the cheap, the selfish, greedy, stingy, or flagrantly unfair.) The taxpayers attempted to describe virtually all of their income as being S corporation dividends. Thus, they could not raise the argument that the amount of W-2 income that they did admit to was reasonable.

Third, the taxpayers were represented by the same counsel. I checked and found that this attorney also represented the taxpayer in Yeagle Drywall Company, Inc. Presumably, Mr. Grey was the Yeagle Company's tax preparer as well.

Fourth, the taxpayers all lost.

Now I'll bet that some of you are feeling rather smug after reading this. You're saying to yourself: I'm not a chozzer. My clients will carve out a reasonable salary for themselves and thus they won't meet the same fate as Grey’s clients.

Not so fast. In a e-mail bulletin to North Carolina tax practitioners, the I.R.S. said as follows: "An S Corporation must pay reasonable compensation (subject to employment taxes) to shareholder-employee(s) in return for the services that the employee provides to the corporation, before a non-wage distributions may be made to that shareholder-employee. This issue has been identified as an area of non-compliance and will receive greater scrutiny in the foreseeable future." (Emphasis added.)

While the bulletin goes on to make it clear that the Service will only attack S corporation distributions if the W-2 compensation is not reasonable, don't most business owners really feel that any compensation less than whatever the OASI limit is unreasonably low? In addition to exposing clients to an increased risk of audit, by reclassifying income as S corporation dividends, the amount that the employee (sorry, I mean shareholder) can put away in a qualified plan is limited.

Maybe I'm a traitor to my profession, but I think that the Service has the better part of this argument.

Thursday, February 20, 2003

All In The Family

The United States Court of Appeals for the Sixth Circuit issued an opinion Wednesday that suggests a strategy for the possibility of minimization of estate tax.

Under the facts of the case, Estate of Costanza v. Commissioner, (that’s Duilio, not George), a father sold his business to his son in exchange for a self-canceling installment note. The note required that the son make regular installment payments, but provided that any balance due at the time of the father's death would be automatically canceled. The father died five months after the consummation of the transaction and the execution of the note. The Service attempted to include the value of the note in the father's estate for federal estate tax purposes, arguing that the transaction that gave rise to the promissory note was not a bona fide transaction. Alternatively, the Service argued that the transaction was a "bargain sale" which gave rise to a taxable gift on the difference between the value of the note taken back and the actual (presumably, higher) value of the business purchased by the son.

The court rejected the Service's argument, pointing out that, at the time the note was executed, the father had a fairly substantial life expectancy. (He died from unanticipated complications that arose during open heart surgery.) And, most importantly, there was a clear expectancy that the note would be paid in the ordinary course, an expectancy that was not met only because of the father's premature death. As evidence, the court noted that the payments with respect to the first quarter of the note had, in fact, been made.

The court remanded for further proceedings the bargain sale issue.

The opinion opens the possibility of taking the value of a family business out of a taxable estate. Of course, there are income tax issues since the father's death caused the son to recognize cancellation of indebtedness income. However, the income tax issues are frequently more manageable since the marginal tax rates are often low. Moreover, the tax on the income that has to be recognized can be partially offset by depreciation or amortization of the asset that is acquired.

Tuesday, February 18, 2003

The Beer Ain't Cold

A recent opinion by the 8th Circuit makes it clear that taxpayers cannot necessarily control the tax treatment of a transaction even if both sides to the transaction concur. In Langdon v. Commissioner, the appeals court rejected the allocation of a substantial portion of the purchase price paid for a business to a covenant not to compete by the owner.

The business was operated in corporate form. There would have apparently been a benefit to the seller to have a substantial portion of the purchase price allocated to the covenant, since such an allocation would not have been subject to double tax, once at the corporate level and then again when distributed to the sole shareholder. About 50% of the sale price was allocated in the contract of sale to the covenant not to compete. None of the purchase price was allocated to corporate intangibles, such as good will or going concern value.

The appeals court affirmed the Tax Court’s re-valuation of the allocation, reducing the amount allocated to the covenant by about 70%. The court noted that the buyer and the seller both had an interest in allocating a large portion of the purchase price to the restrictive covenant. More significantly, the court, using a nine factor test, determined that the covenant lacked economic reality. The nine factors used by the court were: (i) The seller’s (i.e., the covenantor’s) ability to compete; (ii) the seller’s intent to compete; (iii) the seller’s economic resources; (iv) the potential damage to the buyer posed by the seller’s competition; (v) the seller’s business expertise in the industry; (vi) the seller’s contacts and relationships with customers, suppliers, and others in the business; (vii) the buyer’s interest in eliminating competition; (viii) the duration and geographic scope of the covenant, (ix) and the seller’s intention to remain in the same geographic area. The court noted that the corporation that was sold was the premier beer distributor in the area and it was unlikely that the buyer could have been harmed to the tune of $1M (the amount allocated to the covenant) if the former owner of the company had determined to become a competitor. Moreover, the former owner also had a fairly lucrative consulting contract with the buyer.

Wednesday, February 12, 2003

Power to Tax, Power to Destroy?

Today's edition of The Sun reported that Comptroller (formerly Governor, formerly Mayor) Schaefer has asked the Maryland General Assembly to broaden the powers given to his office to initiate and conduct criminal investigations.

The bill, HB 86, was favorably reported out of committee in the House of Delegates. I am not going to comment on the specific merits of the proposal at this point in order to allow myself some time for reflection. However, it has been clear for a good while that the enforcement mechanisms at the Comptroller's office are woefully underfunded. The principal question in my mind is whether additional funds would yield greater returns if they were spent on audit and civil collection efforts.

The status of HB 86 and a link to the text of the bill can be found by clicking here.

Tuesday, February 11, 2003

Technical Difficulties

Yesterday, I discovered that for several days subscribers had not been receiving notices of postings. I believe that the last three postings were not sent to subscribers. The postings dealt with the following topics: What constitutes a tax return for the purposes of bankruptcy, a lengthy discussion of the IRS's position on limited liability in the context of LLCs, and a discussion of the inability of partners in limited partnerships and, by extention, members of an LLC, to elect out of Subchapter K. Of course, all of the postings are available at the weblog site.

Sorry for any inconvenience.

Sunday, February 09, 2003

Better Late Than Never

In a posting on January 24, I discussed the Izzo case. There, a taxpayer had his income computed by the IRS, but subsequently filed returns were accepted by the Service as amended returns. These amended returns showed substantially lower amounts of tax due for the years in question. More importantly, however, the taxpayer was allowed to discharge his entire tax liability for the years in question in a bankruptcy proceeding.

The Bankruptcy Court for the Southern District of Florida recently issued an opinion that serves to underline the importance of filing a return, even where the conclusion as to the computation of the tax due is the same as reached by the IRS in their computation.

In this case, In Re Klein, the taxpayer initially failed to file returns. As was the case in Izzo, the IRS computed the tax due for the years in question. Subsequently, the IRS initiated an broad amnesty program. At about that time, Klein apparently "got religion" and filed returns for the years in question, as well as for subsequent years. In all years after that, he remained in compliance with his filing obligations. The opinion quotes from Klein's deposition as follows: "I remember them saying, if you hadn't filed your taxes, come clean, come clean. This is when I started living, [19]95. I cleaned up my life. I got married, I quit all of my bad habits. Filed my tax returns . . . I said, great, I can file the returns and get on with my life."

Accepting Klein's testimony in conjunction with the uncontested facts surrounding his subsequent tax compliance, the Court concluded that the returns for the years in question represented a good faith effort on Klein's part to fulfill his tax obligations. Therefore, it concluded that the taxes due with respect to the years in question could be discharged in bankruptcy.

I note that there is a difference of opinion among the various courts that have considered this issue as to whether the returns filed in these sorts of cases constitute returns for the purposes of the bankruptcy discharge provisions. The opinion in Klein discusses those cases at some length and is worthy of review.

The opinion is apparently not available on the web except through proprietary websites. Anyone who wants a copy of the opinion can send me an e-mail and I will forward a copy.

Thursday, February 06, 2003

Limited Liability and Its Discontents, Part 2

LLCs do have a certain Chesire cat aspect to them. For instance, single member LLCs may be disregarded for all income tax purposes, but, for state law purposes, they nevertheless have identities separate and apart from their owners. And, there has always been a tension in the partnership tax area between treating a tax partnership as an entity versus treating it as an aggregation of individual members. Undoubtedly, the limited liability shell present in all LLCs affects this tension.

In PLR 200235023, the IRS began to address these issues. Specifically, the ruling addresses the following questions: (i) Who is liable for the tax resulting from the operation of a multi-member LLC?; (ii) Who is liable for the tax resulting from the operation of a single member LLC?; (iii) If the Service makes an assessment against an LLC that is a disregarded entity, is that a valid assessment against the single member owner?, (iv) If the Service files a Notice of Federal Tax Lien ("NFTL") naming the disregarded LLC as the taxpayer, is that a valid NFTL against the single member owner?; and (v) Are there state law theories that the Service could use to collect the single member owner's liability from the disregarded LLC?

The first question was answered quite easily. If a multi-member LLC has elected to be classified as a corporation for income tax purposes, the LLC will be liable for the tax, except to the extent that IRC Section 6672 is applicable. Significantly, however, even if an LLC is classified as a partnership, members are not liable for federal taxes except to the extent that the members are either liable for the LLC's obligations under state law or IRC Section 6672 is applicable. Thus, in a multi-member business, a multi-member LLC has liability advantages, even for income tax liabilities, over a plain vanilla general partnership.

In a single member LLC, as is the case with a multi-member LLC, a single member LLC that has elected to be classified as a corporation is liable for the tax and the sole member is only liable to the extent that IRC Section 6672 is applicable. Not surprisingly, the Service takes the position that in a single member LLC that is a disregarded entity, the assessment is against the single member. Thus, the single member's assets may be attached, but the assets of the LLC may not be.

Surprisingly, however, the Service stated that it will honor the division between the LLC, as an entity, and its sole member, when it comes to collecting the tax obligation of the member. Thus, the Service will not, automatically, move to use the assets of the LLC to satisfy the obligations of the sole member. However, collection action can be taken against the single member's ownership interest in the LLC. This may result in a foreclosure action which ultimately exposes the LLC's assets to the IRS's claims.

However, note that it is the member who is the taxpayer of a single member LLC that is a disregarded entity. Thus, all income, loss, etc., as well as obligations for withholding taxes, flows directly to the owner. The Service is not limited to relying, for instance, on Section 6672 if there has been a failure to pay over withholding.

With respect to notice of federal tax liens, a notice inadvertently naming as the taxpayer an LLC that is a disregarded entity for the obligations of the member may sometimes be valid. To determine whether the notice of lien is valid, the so-called "substantial compliance" test is used. As stated in the ruling, "The guiding legal principle is that the name on the NFTL must be sufficient to put a third party on notice of a lien outstanding against the taxpayer. . .Such a determination will depend on the facts and circumstances in each particular case. . . .[T]he substantial compliance test is met when the third party examining the public record is alerted to the possibility of the federal tax lien."

In cases where the notice of lien has been filed incorrectly and there is no substantial compliance (e.g., the lien is filed in the name of Eagle, LLC, a single member LLC owned by John Jones), the Service can withdraw the notice of lien and refile under the name of John Jones.

Finally, PLR 200235023 discusses various state law theories that the Service could use to collect the single member's liability from his or her disregarded LLC. It is in this area that the ruling becomes troubling.

For instance, in its discussion of the "piercing the corporate veil" or "alter ego" doctrine, the Service described the doctrine as follows: "The alter ego theory has been asserted in the corporate context when facts show that there is such a unity of interest and ownership between the subject taxpayer and corporation that the individuality or separateness of the taxpayer and the corporation has ceased. Generally there are facts that show that adhering to the fiction of a separate existence of the corporation would, under the particular circumstances, sanction a fraud or promote an injustice."

In a sense, this is a correct, black-letter statement of the law. However, the formula that leads to this conclusion is not necessarily composed of the same factors in every state. The Service listed some of these factors as "occurrences of fraud; inadequate capitalization of the corporate entity; failure to adhere to corporate formalities (such as commingling of funds); and abuse of the corporate entity so as to amount to complete dominance by the shareholder or shareholders."

Well, some of these probably don't apply in Maryland (complete dominance by one shareholder and lack of corporate formalities, for instance). Maryland, correctly I think, applies an economic analysis: Did the principals of the corporate debtor act to divert assets that should have gone to pay the creditor. At its core, this concept is very close to the concept of a fraudulent conveyance.

The Service seems to go further, however. In one particularly chilling remark, the ruling stated that "the fact that the LLC is disregarded under the 'check-the-box' regulations for purposes of computing the taxpayer's tax liability may make the courts amenable to applying the alter ego/piercing the corporate veil concepts to the LLC. Arguably, where due to the 'check-the-box' regulations the individual taxpayer is responsible for reporting and paying all income earned by the LLC, and the individual arranges his business affairs so that the LLC, rather than the individual taxpayer, has the assets to pay the tax liability, this could be significant factor supporting piercing the LLC veil."

In other words, a single member LLC is more at risk for veil piercing than a multi-member LLC. This idea runs counter to the basic predicate of an LLC--that the assets of the LLC and its business are the assets and business of an entity that has an identity that is separate from the owner. It should not matter that the LLC has one member or one hundred members.

Finally, the ruling also states that liability may also be founded on a theory that the LLC is a mere nominee, that transferee liability is applicable, or that the LLC may be liable as a transferee under IRC Section 6901. With respect to transferee liability, the ruling notes that "many of the factors which tend to support piercing the LLC veil--such as pervasive control by the individual taxpayer over the LLC--also tend to support transferee liability."

While PLR 200235023 ostensibly gives guidance only to the employees of the IRS, bad news travels fast. To the extent that the Service misstates the law (as in the veil piercing context with respect to Maryland law) or undermines the efficacy of the limited liability shield in single member situations, the theories espoused in PLR 200235023 might be adopted by non-governmental creditors with devastating effect. Going one step further, to the extent that the law is not settled, PLR 200235023 is even more troublesome, since the Service may take litigating positions that are more extreme than those a private creditor might take. And, going even one further step, courts might be less reluctant to rule in the creditor's favor in breaking down limited liability shields when the creditor is the government.

When You're In, You're In

There has been some question whether members of a multi-member LLC that has not elected to be classified as a corporation for income tax purposes can also "elect out" of Subchapter K pursuant to the provisions of IRC Section 761(a). In PLR 200305026, the Service rejected an attempt by a limited partnership to elect out of Subchapter K. The result indicates that the Service would likely reject a similar effort by an LLC.

The ruling notes that Treas. Reg. Section 1.761-2(a)(2) requires that the participants in the joint purchase, retention, sale, or exchange of investment property meet three conditions to elect out of Sub K. Namely, (i) they must own the property as co-owners, (ii) they must reserve the right separately to take or dispose of their shares of any property acquired or retained, and (iii) subject to certain exceptions, they cannot not actively conduct business or irrevocably authorize any some person or persons acting in a representative capacity to purchase, sell, or exchange the investment property.

The Service rejected the attempt to elect out of Sub K because the partners in the limited partnership did not own the limited partnership's property as co-owners. Members of an LLC have the same relationship to the LLC's property as do the limited partners to the property held by their limited partnership. That is, the property belongs to the LLC, not the members as co-owners. Hence, it is likely that the Service will rule that the members of an LLC are similarly barred from electing out of Subchapter K.

Wednesday, February 05, 2003

Limited Liability and Its Discontents, Part 1

Last week, I gave a brief presentation at the Advanced Limited Liability Entity Institute which I entitled "Limited Liability and Its Discontents." The presentation discussed PLR 200235023 which sets forth the Internal Revenue Service's position with respect to the limited liability shield of LLCs in a variety of factual settings.

I will discuss PLR 200235023 in a subsequent posting later this week. However, the IRS is not the only potential attacker of the ramparts of limited liability. I suspect that this is a topic that I will come back to with some regularity. Happily, I can begin the series with a case in which liability limitations were respected.

On January 22, a unanimous Supreme Court upheld the dismissal of a claim for a violation of the Fair Housing Act against the principal of a corporation engaged in the real estate business. There was no question but that a violation of the Act had occurred--an interracial married couple had been hindered in their attempt to purchase a home for racially discriminatory reasons. In addition to bringing an action against the agent, who was directly responsible for the acts complained of, and the corporation for which he worked, the plaintiffs brought a claim against Meyer. Meyer was the president and sole shareholder of the corporate defendant. Furthermore, he was the licensed "officer/broker" of that corporation under a California law that requires corporations, in order to engage in acts for which a real estate license is required, to designate one of its officers to act as the licensed broker. However, there was no allegation that Meyer participated in, authorized, directed, or in any way countenanced the wrongful actions of the agent.

The district court had dismissed the claims against Meyer, construing them as claims to impose vicarious liability, which it concluded was not imposed on corporate officers by the Fair Housing Act. The Ninth Circuit reversed, holding that Meyer could be held liable because he had the authority to control the acts of the corporation's sales agent and, even if he neither participated in nor authorized the discrimination in question, that control or authority to control was sufficient to impose liability upon him.

The Supreme Court reversed the appeals court and upheld the dismissal. The Court construed the question before it as whether "owners and officers of corporations . . .are automatically and absolutely liable for an employee's or agent's violation of the [Fair Housing] Act . . .even if they did not direct or authorize, and were otherwise not involved in, the unlawful discriminatory acts."

The logic of the opinion is as follows: Statutes are written against the background of the common law and common law principles ought to be applied in interpreting a statute’s meaning unless it is clear that the legislature intended a specifically contrary result. Traditionally, wrongful acts of agents acting in the course of their agency will cause liability to be imposed upon their principals. However, when an agent is employed by a corporation, the agent's principal is the corporation, not the corporation's owner or the agent's supervisor. Thus, "the 'right to control' is insufficient by itself, under traditional agency principles, to establish a principal/agent or employer/employee relationship."

In a sense, it's heartwarming to see a court apply traditional principles. (Although it would have been nicer if that same court was consistent in its application of traditional principles. I seem to recall a case in November of 2000 in which they shot tradition to hell.) But the Court was equally clear that these traditional principles could be overridden by legislative action. Thus, limited liability remains at risk of future attacks by its discontents.

Tuesday, February 04, 2003

Some of My Best Friends Are Accountants

I can't quite figure out whether on this FICA/SECA issue accountants are stubborn and hardheaded or simply dogged, but there is now another instance of an accountant failing in an attempt to avoid the characterization of compensation as, well, compensation.

In CCM 200305007, an accountant was the managing "partner" of an accounting firm doing business as a professional corporation. He had a written employment agreement with the professional corporation. That agreement contained an "exclusive effort" clause, but no covenant not to compete.

Together with other individuals (presumably the other principals in the professional corporation) the taxpayer formed a limited partnership with a virtual identical name as the professional corporation (i.e., ABC, LP and ABC, P.A., respectively). They purported to assign to ABC, LP, the rights to use their respective client lists in consideration for certain royalty payments. ABC, LP was given the exclusive right to perform accounting services for these clients. There was also a one-year covenant not to compete.

ABC, P.A. paid to the taxpayer and other shareholder/officers W-2 wages. ABC, P.A., paid to non-shareholder officers a slightly lower amount of W-2 wages and additional compensation in the form of purported "royalties" that it reported on Form 1099-MISC. Finally, ABC, P.A. paid what it categorized as royalty payments to ABC, LP. Of course, ABC, LP paid to each of its partners, including the taxpayer at issue, payments categorized as royalties. And, of course, the taxpayer contended that the royalty payments were not subject to FICA or SECA.

The Service did not have a difficult time rejecting the taxpayer's argument and said as follows:

"The parties characterization of payments does not control the taxability of the payments. In Phillies v. United States, 153 F. Supp. 2d 612 (E.D. Pa. 2001) the court stated, 'both FICA and FUTA define 'wages' as 'all remuneration for employment' unless excluded. 26 U.S.C. Sections 3121(a), 3306(b). 'Employment' as used in this definition means 'any service of whatever nature performed by an employee for the person employing him...' 26 U.S.C. Sections 3121(b), 3306(c).'

"Based on the expansive definition of wages, the definition of royalty payments, and the lack of economic substance of the parties' royalty arrangement, we conclude that amounts received by Taxpayer and other accountants performing services for ABC PC which were treated as royalty payments were, in fact, wages subject to FICA, FUTA, and income tax withholding."