When battling the IRS, knowledge is power.  Nowhere is this more true than in worker-classification cases, where the IRS often seems hell-bent on treating all workers as employees, regardless of the facts.  One bright spot for taxpayers under IRS scrutiny is an obscure provision, commonly known as Section 530, that grants taxpayers a brand of “civil immunity” if they meet three criteria.  One requirement is that taxpayers file Forms 1099 (Miscellaneous Income) for all workers considered to be independent contractors.

For over three decades, the IRS has taken the position that Section 530 relief is not available unless taxpayers file their Forms 1099 in a “timely” manner.  One problem with the IRS’s stance is that it has been questioned and contradicted by at least two courts, including the Fifth Circuit Court of Appeals in a recent case called Bruecher Foundation Services, Inc. v. United States.  The bigger problem is that too many taxpayers, unaware of the relevant rules and caselaw, allow themselves to lose worker-classification cases, unnecessarily prolong audits, and/or miss opportunities to seek fee reimbursement from the IRS.  This article, published in the May 2013 issue of TAXES – The Tax Magazine, aims to alleviate these problems by highlighting and analyzing the taxpayer-favorable authorities regarding Section 530 relief and the Form 1099 filing requirement.

Taxpayers with undisclosed foreign accounts wish it were not true, but the reality is that the U.S. government, after a long period of inactivity and ineffectiveness, has taken significant steps over the past few years to identify and punish failures to file Forms TD F 90-22.1 (Report of Foreign Bank and Financial Accounts), or foreign bank account reports (“FBARs”) as they are commonly known.  These steps include enacting legislation obligating foreign institutions to automatically provide the IRS with information about U.S. account holders, paying handsome rewards to whistleblowers, introducing a new information return forcing taxpayers to report their foreign financial assets (including foreign accounts) to the IRS each year, imposing multi-million dollar fines and disclosure duties on foreign banks that collaborate with taxpayers to evade U.S. taxes, extracting valuable data about international tax transgressions from taxpayers participating in the Offshore Voluntary Disclosure Program (“OVDP”), and criminally prosecuting FBAR offenders.  Another step has become apparent in the past few months, i.e., litigation to collect civil penalties for “willful” FBAR violations.  To date, two cases have been decided, both in favor of the U.S. government.  The attached article, “McBride Willfull FBAR Penalty Case Article,” examines the most recent case.  The article was published in the most recent version of the Journal of Taxation (April 2013).

Choice of entity is one of the first and most important tax-planning decisions that any entrepreneur must make. Conventional wisdom holds that most entrepreneurs should organize their businesses as “pass-through” entities – primarily limited liability companies, partnerships, subchapter S corporations, or sole proprietorships. Pass-through entities are not themselves taxable. Rather, all of their income is “passed through” and taxable to their owners. By contrast, operating a business in the other main form – a corporation – subjects the business’s income to the dreaded “double tax” because the corporation itself is subject to tax, and then the shareholder is subject to tax when he receives dividends from the corporation or sells its stock at a gain.

Historically, the expense associated with the double tax has varied, depending on the prevailing tax rates, but it almost always exceeded the tax expense on pass-through income. At this unique time, however, entrepreneurs following the conventional wisdom may be missing a valuable tax-planning opportunity:  two features of the American Taxpayer Relief Act of 2012 make corporations much more attractive compared to pass-through entities.

First, corporations now pay less tax than many individuals do on income allocated from pass-through entities. The Act increased the highest tax rate on ordinary income taxable to individuals from 35% to 39.6%. However, corporations remain subject to a maximum 35% income tax rate.

Second, entrepreneurs may be able to eliminate the double tax on corporate income. The Act extended a narrow income tax exclusion on the sale of “qualified small business” (QSB) stock issued by a corporation. If an entrepreneur’s stock qualifies for the exclusion, then the entrepreneur’s gain is not subject to income tax. The exclusion is subject to a number of conditions, but it’s broadly available. To qualify for the exclusion, the following conditions must be satisfied:

• The stock must be issued before 2014 – which means the entrepreneur must incorporate his or her business this year;
• The entrepreneur must hold the stock for five years;
• The corporation itself must operate an active business; and
• The corporation must have less than $50 million in assets.

Stock of corporations engaged in business in a narrow set of industries do not qualify. For instance, businesses that primarily trade on the reputation of an employee (e.g., law firms and doctors) do not qualify, nor do banks, insurers, farms, mines, hotels, or restaurants. Just about all other businesses qualify.

Taken together, these two changes weigh heavily in favor of organizing a business as a corporation. And, while nobody can predict future tax changes, momentum has been building for several years to lower the corporate tax rate – perhaps all the way down to 25%. If that happens, businesses that incorporated in 2013 will retain a permanent tax advantage over those that missed the opportunity.

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Dustin Covello is a tax attorney in the Philadelphia office of Chamberlain Hrdlicka. He assists domestic and foreign companies of all sizes in their tax planning and tax controversies.

On March 25, the Supreme Court accepted certiorari in U.S. v. Gary Woods.  (Supreme Court order) The issue presented to the Court arose from a split in the Circuits over whether a taxpayer can avoid the valuation misstatement penalties of section 6662(e) and (h) by conceding that there was no economic substance to its return position (and thus that the valuation misstatement was not the basis for its tax deficiency).  Compare, e.g., Todd v. Commissioner, 862 F.2d 540 (5^th Cir. 1988) (no penalty imposed under predecessor of section 6662), with e.g., Gustashaw v. Commissioner, 110 A.F.T.R.2d 2012-6169 (11^th Cir. 2012) (9/28/12) (criticizing Todd).

In accepting the case, the Supreme Court also directed the parties to address an additional matter – whether the trial court even had jurisdiction under section 6226 (dealing with TEFRA partnership-level proceedings) to consider the valuation misstatement penalty.

Taxpayers who have disputed and lost cases involving the same issue would be wise to preserve their appeal rights, if still available, so that they can potentially benefit from a favorable decision by the Supreme Court.

In a blog posting earlier this year, we talked about the Sixth Circuit’s decision in United States v. Quality Stores (Civil No. 10-1563, 6th Cir. 2012) affirming a lower court’s decision that supplemental unemployment compensation benefit (SUB) payments are not taxable as wages and are consequently exempt from FICA taxes. The Sixth Circuit’s decision in Quality Stores directly conflicts with the Federal Circuit’s prior decision in CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008), which held that such payments were subject to FICA.  For many employers who have filed protective refund claims, the favorable resolution of this conflict could result in meaningful refunds.

Those speculating on whether Quality Stores will be appealed to the Supreme Court, and whether the Supreme Court will grant certiorari, will have to wait a little longer to find out.  The original deadline for filing a petition for certiorari has been extended from April 4th to May 3, 2013.

Although the deadline for the government’s petition has been extended, the April 15, 2013 deadline to file protective refund claims for 2009 (the oldest eligible year) has not.  For employers that haven’t already done so, particularly those located within the Sixth Circuit (Kentucky, Michigan, Ohio and Tennessee), there is still a small amount of time left.

A final word of caution about deadlines:  If a protective FICA tax refund claim is denied, employers have two years from the date of denial to file a tax refund suit or obtain an extension of the two-year period by filing a Form 907.   Given the uncertainty over the final outcome of this issue, it is unclear whether the IRS will summarily deny protective refund claims or wait until the dust settles.  Nonetheless, employers whose refund claims are denied are well advised to keep track of the two-year deadline.  If the Supreme Court accepts certiorari, it may take that long before the final word on the subject is written.

Life isn’t fair.  Neither is the IRS’s most recent settlement initiative designed to entice taxpayers to proactively resolve their international tax non-compliance, such as failing to report foreign income, foreign accounts, foreign entities, etc.  In both instances, some people win and some people lose, often with little or no regard to what is equitable.  Among those basking in the benefits of favored status lately are certain Canadians, residing either in the United States or the homeland, who have neglected their tax-related obligations with Uncle Sam.  Indeed, thanks to recent modifications to the offshore voluntary disclosure program (“OVDP”) and the introduction of a special “streamline procedure” for select expatriates, many Canadians are able to resolve their tax transgressions on terms vastly superior to those applicable to the masses.  This is particularly true for persons with specific types of Canadian retirement plans.  The article, “IRS Introduces Two Unique Remedies for U.S. Persons with Unreported Canadian Retirement Plans and Accounts,” which was published in the most recent edition of the International Tax Journal, analyzes the unique options available to Canadians.

For companies that have implemented employee layoffs in the past several years and made severance payments to terminated employees, the prospect of eligibility for federal tax refunds for any FICA taxes withheld from such payments took another step forward with the Sixth Circuit’s January 4th denial of the government’s petition for rehearing en banc in United States v. Quality Stores (Civil No. 10-1563, 6th Cir. 2012).

The rehearing petition was filed after a government loss in September of last year in which the appellate court affirmed a lower court’s decision that supplemental unemployment compensation benefit (SUB) payments are not taxable as wages and are consequently exempt from FICA taxes. Under section 3402(o)(2) of the Internal Revenue Code, SUB payments are defined as “amounts which are paid to an employee, pursuant to a plan to which the employer is a party, because of an employee’s involuntary separation from employment (whether or not such separation is temporary), resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions.”

The Sixth Circuit’s decision in Quality Stores directly conflicts with the Federal Circuit’s prior decision in CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008), which held that such payments were subject to FICA.  With the denial of the petition for rehearing in Quality Stores, the stage is now set for the government to seek Supreme Court review.  Because the eventual outcome of this conflict has enormous financial implications, a petition for certiorari is reasonably foreseeable.  Such a petition would be due by April 4, 2013.

Although the final word on the issue may not yet be written, for companies located within the Sixth Circuit’s purview (Kentucky, Michigan, Ohio and Tennessee), the taxpayer-friendly Quality Stores decision is currently binding authority which, unless reversed by the Supreme Court, will entitle those who have filed timely refund claims to the refund of FICA taxes paid over on SUB payments. In the rest of the country, Quality Stores is not binding on the IRS.  Nonetheless, the case at least raises the prospect of a taxpayer victory on the issue when the dust finally settles.

Many companies have already filed protective tax refund claims to preserve their rights to receive potentially significant refunds of FICA tax.  For those that haven’t, filing such claims for each open taxable year in which FICA was withheld on SUB payments is an absolute prerequisite to obtain any refunds. There is little cost associated with filing a protective refund claim but the potential benefit could be quite large.  Accordingly, any eligible employers who have not already done so are advised to file their claims as soon as possible for all open years to avoid being barred by the applicable statute of limitations, which typically remains open for the later of three years after the return due date or two years after the date of payment.

A final point about which employers filing refund claims should take note is that under Treas. Reg. § 31.6402(a)-2, a refund claim seeking the refund or credit of an employee’s share of FICA taxes requires the employer to certify either that it has repaid or reimbursed the tax to its employee or that it has secured the employee’s written consent to the filing of the refund claim (except to the extent the taxes were not withheld from the employee).  In Quality Stores, for example, roughly 1,800 of 3,000 former employees consented to the company filing FICA tax refund claims on their behalf.  Consequently, the employer’s refund claim for its own share of FICA taxes exceeded the refund sought for its former employees’ share.

2013 Withholding Tables. Notice 1036 includes the 2013 Percentage Method Tables for Income Tax Withholding. Employers should implement the 2013 withholding tables as soon as possible, but not later than February 15, 2013. Employers can use the 2012 withholding tables until they implement the 2013 withholding tables.

Social Security Tax. For 2013, the employee tax rate for social security increases to 6.2%. The social security wage base limit increases to $113,700. Employers should implement the 6.2% employee social security tax rate as soon as possible, but not later than February 15, 2013. After implementing the new 6.2% rate, employers should make an adjustment in a subsequent pay period to correct any underwithholding of social security tax as soon as possible, but not later than March 31, 2013. The employer tax rate for social security remains unchanged at 6.2%.

Medicare Tax. The Medicare tax rate is 1.45% each for the employee and employer, unchanged from 2012. There is no wage base limit for Medicare tax.

Additional Medicare Tax Withholding. In addition to withholding Medicare tax at 1.45%, employers must withhold a 0.9% Additional Medicare Tax from wages paid to an employee in excess of $200,000 in a calendar year. Employers are required to begin withholding Additional Medicare Tax in the pay period in which it pays wages in excess of $200,000 to an employee and must continue to withhold it each pay period until the end of the calendar year. Additional Medicare Tax is only imposed on the employee. There is no employer share of Additional Medicare Tax. All wages that are subject to Medicare tax are subject to Additional Medicare Tax withholding if paid in excess of the $200,000 withholding threshold.

In Example 1, joint taxpayers earn $400,000 of ordinary income and another $200,000 in net capital gains.  Under the new law, the first $50,000 of net capital gains is taxed at the lower rate, with the remaining $150,000 taxed at the higher rate.  The effective rate of 18.75% reflects the blending of the 15% and 20% rates.

In Example 2, joint taxpayers now earn $200,000 of ordinary income and another $400,000 in net capital gains.  Because a greater portion of the taxpayers’ taxable income has shifted from ordinary income to net capital gain, the effective net capital gain rate is lower than the previous example because a greater portion of the taxpayer’s below-the-threshold income is taxed at the 15% rate, leaving a smaller remainder subject to the 20% tax.

The above examples do not take into account the new 3.8 % medicare surtax on capital gains (and other net investment income) imposed by section 1411 of the Internal Revenue Code. Because the income threshold under that section is lower than the 39.6% tax rate threshold ($200,000 for single filers and $250,000 for joint filers), the surtax would apply to the entire net capital gain amounts in both examples, resulting in an effective rate of 22.55% and 20.68% respectively.

With the looming increase in tax rates on investment income and capital gains in particular, a large number of stock market investors have been selling long-term positions to lock in the 2012 rate, which currently tops out at 15%.  Come January 1,2013, gain on the same sale could be taxed at a rate as high as 23.8%, consisting of a long-term capital gains tax rate of 20% plus a Medicare surtax of 3.8% imposed on joint filers with AGI greater than $250,000 and single filers with AGI greater than $200,000.  (See Internal Revenue Code § 1411).

A question attracting attention as the year draws to a close and the pace of this activity has accelerated has been whether a stock sale undertaken solely to take advantage of the lower 2012 capital gains tax rates might fall within the scope of Code § 7701(o), the relatively new economic substance statute codified as part of the landmark Health Care and Education Reconciliation Act of 2010 (Pub. L. 111-152, 124 Stat. 1029).  Concerns about coming within the scope of this statute are that it might subject the investor to a 20% penalty enacted as part of the new law.  See Code § 6662(b)(6).  The penalty, if applicable, is a “strict liability” one, which means that taxpayers cannot avoid it on grounds of reasonable cause, such as reliance on a tax advisor. (The penalty for a transaction determined to lack economic substance is also increased to a whopping 40% if the transaction is undisclosed.  See Code § 6662(i).  However, as long as a taxpayer reports the transaction on his or her tax return, the 40% penalty should not apply.)

Thankfully, the eleventh hour concerns expressed about this issue should be put to rest for stock investment gain-recognition transactions in 2012.  Even assuming the economic substance statute is conceptually broad enough to ensnare stock sale transactions undertaken to lock in lower capital gains tax rates, the penalty is only applicable to “underpayments.”  Because a long-term capital gain recognized in 2012 does not reduce a taxpayer’s taxable income but rather increases it (unless the gain is offset by otherwise unused capital losses), there is no underpayment against which to apply a penalty.

Now let’s vary the circumstances by introducing a simultaneous buyback of the stock at the time of sale to reestablish the same position.  Does that change anything vis a vis a potential penalty risk?  We still have a gain recognition transaction in 2012, so there is no tax underpayment against which a penalty could apply for this year.  As for the repurchased stock, its cost basis is at the repurchase price, which means that a subsequent sale in a future year will either produce a smaller taxable gain or larger taxable loss than would have occurred had the original share lots with their lower cost basis simply been maintained.  Some have speculated that this could produce a tax underpayment against which the strict liability economic substance penalty might apply in the year of sale.  After all, in defining a transaction that has economic substance, § 7701(o) requires (1) that the transaction change in a “meaningful way” the taxpayer’s economic position apart from federal tax benefits, and (2) that the taxpayer have a non-tax purpose for entering into the transaction.

In theory, a sale and instantaneous repurchase might fail to satisfy both of these tests.  On the other hand, a repurchase transaction that occurs sometime after the sale introduces an element of market risk from stock price fluctuation that should mitigate any penalty risk.  Similarly, a repurchase in a different type of account (e.g., in a tax-deferred account where the original sale was in a taxable account or vice versa) should also put the taxpayer on firmer ground.

So what are the real risks that the IRS might choose some unfortunate taxpayers to assert a strict liability penalty?  It has, after all, been less than forthcoming in providing guidance on what types of plain vanilla transactions, if any, may be viewed as falling within the scope of the new economic substance statute.  Perhaps the best indicator one can draw upon is the title of § 7701(o), “Clarification of Economic Substance Doctrine.”  The codified doctrine has been portrayed as merely a clarification of the economic substance law in effect for transactions entered into before March 30, 2010. Under the pre-codification doctrine, which is derived solely from the common law, there do not appear to be any reported economic substance cases involving a taxpayer’s sale and repurchase transaction that results in accelerated gain recognition. Couple this with the fact that no court has been asked to interpret the breadth of the new economic substance statute since it was passed in 2010, and it is reasonable to believe that the IRS would prefer to choose a different, and presumably more compelling battleground to make its first stand defending the application of Section 7701(o) and the strict liability penalty.

Finally, in the case of a 2012 gain-recognition stock sale and simultaneous repurchase, it cannot be entirely certain that the transaction will even produce a tax savings when all is said and done.  This is because of the difference between the tax rates for long and short term capital gains (which are taxed at ordinary income rates).  Because a new holding period is established for the repurchased stock, it remains possible that the stock, when sold, will produce a short-term capital gain subject to a larger tax burden than might have occurred if if the original long-term position was held into 2013 or beyond.  In the end, the lack of certainty about the ultimate tax effect until the second sale occurs may be taxpayers’ best argument that the sale and repurchase transaction had economic substance after all.