TIGTA recently released a report discusses their audit of the IRS’s estate and gift tax examination procedures.  TIGTA made eight recommendations of changes to the estate and gift tax examination process.  The bulk of TIGTA’s recommendations address the informal processes, lack of consistency, and unknown effectiveness of the estate and gift tax examination procedures.

One of the more significant findings of the report is that while the examination division proposed over $577 million of estate and gift tax deficiencies for FY 2016, only $98 million of those deficiencies were sustained after cases were considered by IRS Appeals.  The Examination division attributed this statistic to the fact that the Examination division proposes alternative deficiencies in order to prevent being whipsawed.  However, the Examination division could not separately identify the amount of deficiencies that were attributable to these alternative positions.  TIGTA highlighted that the Government could be subject to suits for attorneys’ fees pursuant to Section 7430 if the positions set forth in the notices of deficiency were not substantially justified.  TIGTA recommended that Examination division develop written guidance “on the circumstances in which it is advisable to propose and issue notices of deficiency in estate and gift tax examinations that contain alternative positions.”

Other highlights from the report include:

  • there is one gatekeeper who decides whether or not to route a case for examination and how to prioritize cases;
  • there is no quality review process;
  • unlike the process for selecting income tax returns for examination, the process of selecting estate and gift tax examinations for examination is based minimal written guidance and involves almost no objective procedures, but instead relies on human involvement and judgment; and
  • procedures for documenting case selection, examination documentation and managerial review either did not exist or if they did exist were not followed as closely as they should be.

TIGTA’s report can be accessed here.

The President has declared a major disaster in the State of Texas. The declaration permits the IRS to postpone certain deadlines for taxpayers who reside or have a business in the disaster area.

Individuals who reside or have a business in the following counties may qualify for tax relief: Aransas, Austin, Batrop, Bee, Brazoria, Calhoun, Chambers, Colorado, DeWitt, Fayette, Fort Bend, Galveston, Goliad, Gonzales, Hardin, Harris, Jackson, Jasper, Jefferson, Karnes, Kleberg, Lavaca, Lee, Liberty, Matagorda, Montgomery, Newton, Nueces, Orange, Polk, Refugio, Sabine, San Jacinto, San Patricio, Tyler, Victoria, Walker, Waller and Wharton.

Taxpayers not in the covered disaster area, but whose records necessary to meet a deadline are in the disaster area are also entitled to relief. In addition, all relief workers affiliated with a recognized government or philanthropic organization assisting in the relief activities in the disaster area and any individual visiting the covered disaster area who was killed or injured as a result of the disaster are entitled to relief.

The IRS gives the affected taxpayers until January 30, 2018 to file most tax returns (including individual, corporate, and estate and trust income tax returns; partnership returns, S corporation returns, and trust returns; estate, gift, and generation-skipping transfer tax returns; and employment and certain excise tax returns), that have either an original or extended due date occurring on or after August 23, 2017, and before January 31, 2018. This includes taxpayers who had a valid extension to file their 2016 return that was due to run out on October 16, 2017. It also includes the quarterly estimated income tax payments originally due on September 15, 2017 and January 16, 2018, and the quarterly payroll and excise tax returns normally due on October 31, 2017. In addition, penalties on payroll and excise tax deposits due on or after August 23, 2017, and before September 7, 2017, will be abated as long as the deposits were made by September 7, 2017.

If an affected taxpayer receives a late filing or late payment penalty notice from the IRS that has an original or extended filing, payment or deposit due date that falls within the postponement period, the taxpayer should call the telephone number on the notice to have the IRS abate the penalty.

Casualty Losses

Affected taxpayers in a federally declared disaster area have the option of claiming disaster-related casualty losses on their federal income tax return for either the year in which the event occurred, or the prior year. Individuals may deduct personal property losses that are not covered by insurance or other reimbursements.

August brought three wins for taxpayers who donated conservation easements that were challenged by the IRS.  In all of the cases, terms of the conservation easement deed document carried the day. 

  • In BC Ranch II, L.P. v. Comm’r, No. 16-60068, 2017 BL 282040 (5th Cir. Aug. 11, 2017), the Fifth Circuit overturned a Tax Court decision finding that an easement deed allowing for small boundary adjustments violated the perpetuity requirement of Section 170(h)(2)(C).  The perpetuity requirement provides that, in order to qualify for a charitable contribution deduction for a conservation easement donation, a taxpayer must restrict, in perpetuity, the use which may be made of the real property.  The Fifth Circuit held that the Tax Court’s reliance in Belk  v. Comm’r, 140 T.C 1 (2013), aff’d 774 F.3d 2210 (4th Cir. 2014), to hold that the conservation easement restrictions violated the perpetuity requirement was misplaced because Belk involved a provision where the easement land could be substituted in its entirety for a new parcel of land.  The Fifth Circuit looked at similar cases where small adjustments to the easement were permitted to promote the underlying conservation purpose.  Because that was the case here, the court found that the perpetuity requirement was met.  Addressing the IRS alternative theory that the partners entered into disguised sales for partnership property, the court also determined that the portions of capital contributions made by partners, other than those attributable to the parcels that were distributed to them, were not disguised sales of partnership assets.  
  • Next, in 310 Retail, LLC, v. Comm’r, T.C. Memo 2017-164, and Big River Development, L.P. v. Comm’r, T.C. Memo 2017-166, the Tax Court held that the conservation easement deeds at issue met the contemporary written acknowledgement requirement set forth in Section 170(f)(8)(B).  The contemporary written acknowledgement provision requires that, in order to claim a charitable contribution deduction, the donor is required to obtain from the charity a written statement that describes the donation, states whether the charity provides goods and services in exchange for the donation, and, if goods and services were provided, the fair market value of those goods and service.  This documentation must be obtained before the earlier of the due date of the return or the date the return in filed.  In both cases, the donor did not obtain from the charity separate documentation that is traditionally sent to donees with this specific language.  However, because the conservation easement deeds contained language discussing the consideration given and stating that the deed was the complete agreement of the parties (known as a merger clause), the deed itself acknowledged that the charity did not provide goods and services to the donor and therefore satisfied the contemporaneous written acknowledgement requirements. 
  • In all three cases, while the taxpayers now presumably have established the right to claim the charitable contribution deduction, the next step of determining the value of the conservation easement will be a separate battle.

The Tax Court has issued its long-awaited decision addressing captive insurance arrangements. In Avrahami v. Commissioner, 149 T.C. No. 7 (2017), the Tax Court held that payments made from a number of businesses owned by the Avrahamis to a microcaptive insurance company that was wholly-owned by Mrs. Avrahami were not for “insurance,” and thus were not deductible as insurance premiums paid. Here is what you need to know.

Captive Insurance Generally

Amounts paid for insurance are deductible as ordinary and necessary business expenses. Insurance companies are generally taxed on the insurance premiums they receive. However, small insurance companies that satisfy certain requirements are eligible to make a section 831(b) election, in which case they are only taxed on their taxable investment income (which does not include premiums received). For 2009 and 2010, an insurance company other than a life insurance company that had written premiums that did not exceed $1.2 million could elect to be taxed under section 831(b) as long as they met all other requirements.

A pure captive insurance company is one that only insures the risks of companies related to it by ownership. A captive insurance company that is eligible to make a section 831(b) election (referred to as a “microcaptive”) does not pay tax on the premiums it receives. Thus, if a business owner creates a microcaptive that insures only the risks of the business owner’s business, the business is able to deduct up to $1.2 million for insurance premiums paid to the related microcaptive while the microcaptive does not pay tax on the premiums received. However, the premiums are only deductible if the payments are for “insurance,” which begs the question: what is “insurance”? This is the question Avrahami addressed in the context of payments made to microcaptives.

Case Background

The Avrahamis owned jewelry stores and commercial real estate companies (the “Avrahami Entities”). In November 2007, they created an insurance company (the “Captive”) to insure the risks of the Avrahami entities. The Captive was wholly-owned by Mrs. Avrahami. In 2009 and 2010 – the years at issue in this case – the Avrahami entities paid the Captive premiums for direct insurance policies of approximately $730,000 and $810,000, respectively, for policies covering seven types of risk including: administrative actions, business risk indemnity, business income protection, employee fidelity, litigation expense, loss of key employee, and tax indemnity. In addition to its direct policies, the Captive participated in a risk distribution program with other small captive insurance companies through Pan American. Through Pan American’s risk distribution program, the Avrahami Entities paid approximately $360,000 to Pan American for terrorism coverage only. Pan American then reinsured all of the risk it had assumed and would make sure that the Captive received reinsurance premiums equal to the amount paid by the Avrahami Entities to Pan American ($360,000), and in exchange the Captive would reinsure a small percentage of Pan American’s total losses. In total, the Avrahamis deducted approximately $1.1 million and $1.3 million in 2009 and 2010, respectively, for insurance premiums paid from the Avrahami Entities to the Captive or Pan American for both direct policies and for the terrorism coverage obtained through the risk distribution program. Only the Avrahami Entities were covered by the direct policies while over 100 insureds were included in the risk distribution program.

The IRS argued that neither the Captive nor Pan American sold “insurance”, meaning the premiums paid by the Avrahami Entities were not deductible as ordinary and necessary business expenses. The Tax Court agreed.

The Court’s Analysis

To be considered insurance, the arrangement must: (1) involve risk-shifting; (2) involve risk-distribution; (3) involve insurance risk; and (4) meet commonly accepted notions of insurance. The Tax Court analyzed only two of these elements: risk distribution and commonly accepted notions of insurance.

Risk distribution occurs when the insurer pools a large enough collection of unrelated risks. The Tax Court looked to the number of companies the Captive insured and the “number of independent risk exposures” (i.e., how many policies does the Captive issue and what do those policies cover). Ultimately, the Court determined that insuring 3 companies in 2009 and 4 in 2010, issuing 7 direct policies that covered 3 jewelry stores, 3 commercial real estate companies, 2 key employees, and 35 other employees did not cover a sufficient number of risk exposures to achieve risk distribution through the affiliated entities. The Court distinguished the facts present in this case from other cases where they have determined that insurers adequately distributed risk.

The Avrahamis argued that they adequately distributed risk because, in addition to the Captive insuring the Avrahami Entities, the Captive participated in the Pan American risk distribution program and reinsured third-party risk. The Court determined that Pan American was not a bona fide insurance company in the first place, meaning the policies it issued were not “insurance” and the Captive could not have distributed risk by reinsuring policies that were not insurance to begin with. The Court looked to a number of factors to determine whether Pan American was a bona fide insurance company, ultimately concluding that it was not for the following reasons:

  • There was a circular flow of funds. Avrahami Entities paid Pan American, Pan American turned around and reinsured all of the risk it had assumed, making sure that the Captive received reinsurance premiums equal to those paid by the Avrahami Entities. Thus, money was effectively transferred from an entity owned by the Avrahamis (one of the Avrahami Entities) to an entity wholly-owned by Mrs. Avrahami (the Captive).
  • The premiums charged for terrorism coverage were “grossly excessive”. The only policy Pan American issued was for terrorism coverage, and the policy was worded in a way that it was highly unlikely that the triggering event would ever occur.
  • Pan American charged high premiums for an event that was unlikely to ever occur (and had never occurred in the past), and if the event did occur Pan American may have not been able to pay the claims.
  • Because the risk distribution program was not recognized by the Court, when the Court reviewed the direct policies it determined that on a stand-alone basis they also did not adequately distribute risk because the direct policies only covered the Avrahami Entities and the combination of risks and entities covered by the direct policies did not distribute risk among an adequate number of independent insurance risks.

For these reasons, the Court concluded that the Captive did not adequately distribute risk.

The Tax Court then analyzed whether the Captive met commonly accepted notions of insurance, which required the Court to work through a number of factors. The Court determined that the Captive was not selling insurance in the commonly accepted sense. The Court explained:

  • The Captive did not operate like an insurance company. No claims were filed until the IRS began its audit. The Captive only invested in illiquid, long-term loans to related parties and failed to get regulatory approval before transferring funds to them.
  • The Captive returned substantial portions of its surpluses to the insureds and owners of the insured through various loans and distributions.
  • The Captive policies were questionable because they were unclear and contradictory.
  • The Captive charged unreasonable premiums even though an actuary priced the policies. The Court did not find the actuary’s pricing methodology at all persuasive, noting that the actuary consistently chose inputs that would generate higher premiums. The Court noted that before creating the Captive, the Avrahami Entities paid $150,000 for commercial insurance policies. After creating the Captive, the Avrahami Entities paid $1.1 million and $1.3 million in 2009 and 2010, and paid $90,000 for a commercial insurance policy.

As a result, the Court concluded that payments made from the Avrahami Entities to the Captive and Pan American were not for insurance, and thus were not deductible as ordinary and necessary business expenses.

It is worth noting that the Captive was incorporated under the laws of the Caribbean nation of Saint Christopher and Nevis (St. Kitts). The Captive made a section 953(d) election to be treated as a domestic corporation for federal income tax purposes, and also made an election to be taxed as a small insurance company under section 831(b). However, since the Captive’s policies were not for “insurance”, both elections were invalid, and it was thus treated as a foreign corporation for federal income tax purposes. The parties stipulated that the taxable premiums earned by the Captive were not subject to U.S. Federal income tax.

Impact on Continuing IRS Scrutiny of Captive Insurance Arrangements

For several years, the IRS has devoted significant resources to examinations of captive insurance arrangements and numerous cases are the subject of Tax Court petitions.  There are several cases pending in the Tax Court post-trial.  The IRS increased its scrutiny of microcaptives when it issued Notice 2016-66, requiring self-reporting by taxpayers engaging in captive insurance arrangements where there has been a low incidence of claims or where significant loans have been made to related parties. In light of the Avrahami decision, the IRS is likely to continue devoting resources to scrutinizing and challenging captive insurance arrangements it believes are abusive.

2000px-Seal_of_the_United_States_Department_of_Justice_svgFollowing a relentless flurry of press releases announcing criminal charges against tax evaders in the run up to today’s tax filing deadline (see here, here, and here), the Justice Department wasted no time in turning its attention to its next target:  employers and individuals who violate the federal employment tax laws. In a press release entitled “Justice Department Continues To Sue, Prosecute Delinquent Employers,” the Justice Department emphasizes that it is continuing its employment tax “enforcement push” by bringing civil and criminal enforcement actions against employers and individuals who violate employment tax laws:

Many Americans associate April with “Tax Day” and the annual deadline for filing individual income tax returns. But the end of April is also the first deadline for employers to file quarterly employment tax returns. Those who do not comply with filing requirements or who fail to pay the taxes withheld from their employees’ wages face civil lawsuits or criminal prosecutions as part of the Department of Justice’s ongoing focus to enforce employment tax laws using all tools available.

By way of background, employers in the United States are required to collect, account for, and pay over to the Internal Revenue Service tax withheld from employee wages, including federal income tax and social security and Medicare taxes. Employers also have an independent responsibility to pay their matching share of social security and Medicare taxes.

“Employers who willfully fail to comply with their employment tax obligations are cheating the U.S. Treasury at the expense of taxpayers, such as law-abiding employers and employees, who pay their taxes on time and in full,” said Acting Assistant Attorney General David A. Hubbert of the Justice Department’s Tax Division. “The Department is committed to holding employers that willfully fail to pay their employment taxes accountable with, as appropriate, criminal prosecution, bringing these offenders into compliance through civil injunctions, and working with the IRS to collect what is owed.”

“Employment taxes are a critical part of the tax system, generating more than $1 trillion a year in payments to the government, and the IRS works closely with employers and the payroll community to help ensure compliance in this area,” said IRS Commissioner John Koskinen. “We want to help employers avoid problems in the employment tax area. When problems do arise, we use civil enforcement tools and, when appropriate, work closely with the Justice Department in the pursuit of criminal cases. The collection of employment taxes is a priority area for the IRS and helps ensure fairness for employers and taxpayers. Employers who fail to pay or withhold these taxes enjoy an unfair economic advantage over those who comply with the tax laws.”

The Justice Department’s press release serves as a reminder that an individual’s willful failure to comply with employment-tax obligations is not simply a civil matter. Employers whose business model is based on a continued failure to pay employment tax, who use withheld employment taxes as a slush fund to pay personal expenses or other creditors, who pay employees in cash to avoid employment tax obligations, or who file false employment tax returns can subject themselves to prosecution, imprisonment, monetary fines, and restitution.

Aggressive criminal and civil enforcement of the federal employment tax laws has been a top priority of both the Justice Department and the IRS for the past several years. Amounts withheld from employee wages represent nearly 70% of all revenue collected by the IRS. According to a recent report from the Treasury Inspector General for Tax Administration (TIGTA), as of December 2015, 1.4 million employers owed approximately $45.6 billion in unpaid employment taxes, interest, and penalties. The Justice Department’s Tax Division reports that as of June 30, 2016, more than $59.4 billion of taxes reported on quarterly federal employment tax returns remained unpaid. Employment tax violations represent more than $91 billion of the “Tax Gap,” which measures the difference between the total amount of tax owed to the U.S. Treasury and the amount actually paid. During fiscal year 2016, employment tax investigations were one of the few categories of tax crimes for which IRS-Criminal Investigation initiated more investigations than in the prior fiscal year.

Employment tax schemes can take a variety of forms. Some of the more common schemes include employee leasing, paying employees in cash, filing false employment tax returns, failing to file employment tax returns, and “pyramiding.” Pyramiding refers to the practice of withholding taxes from employee wages, but failing to remit such taxes to the IRS. After the employment tax liability accrues, the business owner starts a new business and begins to accrue employment tax liabilities anew.

Today’s press release highlights recent examples of employment tax enforcement in both the criminal and civil arenas, starting with the following examples of employers who engaged in “pyramiding” taxes by opening successive businesses:

In January, Napoleon Robinson of Lauderhill, Florida, was sentenced to serve 18 months in prison for evading more than $500,000 in employment taxes. Robinson owned and operated a series of ship welding and repair businesses in Virginia and New York. Robinson was not paying over employment taxes and would close down one company and open a new one in the name of a nominee owner, while continuing to run the company, making its financial and personnel decisions and controlling the businesses’ bank accounts. He was also ordered to pay restitution to the IRS.

In January, two West Virginia business owners, Michael and Jeanette Taylor, were sentenced to serve 21 and 27 months in prison for failing to pay over more than $1.4 million in employment taxes. The Taylors owned a construction business that transported steel and sold gravel and concrete. They changed the name of their business several times, though the operations of the business remained the same. Both were responsible for collecting, accounting for and paying over the employment taxes withheld from their employees’ wages. Instead of paying over the taxes that they collected, the Taylors used the funds to purchase property and finance their horse farm. They were also ordered to pay restitution to the IRS.

The following cases demonstrate examples of employers who used withheld employment taxes to pay personal expenses, or to pay other creditors:

In January, Paul Harvey Boone of Hillsborough, North Carolina, was sentenced to serve 15 months in prison for failing to pay over employment taxes. Boone owned and operated Boone Audio Inc. From 2008 through 2011, Boone used company funds for personal expenses while failing to pay over the employment taxes withheld from his employees’ wages. He was also ordered to pay restitution to the IRS.

In December 2016, Sreedar Potarazu, a Maryland surgeon and entrepreneur, pleaded guilty to failing to account for and pay over $7.5 million in employment taxes and to shareholder fraud. Potarazu founded VitalSpring Technologies Inc., a corporation that provided data analysis and services related to health care expenditures. Potarazu was responsible for collecting, truthfully accounting for and paying over VitalSpring’s employment taxes. Instead of paying over the employment tax, Potarazu spent millions on personal expenses including transferring funds to himself and others, travel, car service and the publication of a book.

In January, Steven Lynch, a tax attorney and owner of the Iceoplex in Pittsburgh, Pennsylvania, was sentenced to serve 48 months in prison, fined $75,000 and ordered to pay restitution to the IRS of more than $793,000, after being convicted of failing to collect, account for and pay over employment taxes. Lynch co-owned and operated the Iceoplex, a recreational sports facility which included a fitness center, ice rink, soccer court, restaurant and bar. He controlled the finances for these businesses and was responsible for collecting, accounting for and paying over tax withheld from employee wages and timely filing employment tax returns. Lynch failed to pay over more than $790,000 in employment taxes withheld.

In June 2016, Muzaffar Hussain of Pleasanton, California, pleaded guilty to failing to account for and pay over employment taxes for Crossroads Home Health Care Inc. Hussain was the CFO and was responsible for filing the company’s employment tax returns and paying over the employment taxes. Hussain transferred funds in an amount equal or close to the amount of employment taxes from the business bank account into other accounts and used the money to fund other business and personal expenses.

In the following case, the Justice Department prosecuted an employer who paid employees in cash to avoid paying employment taxes:

In September 2016, Phillip Hui of Sicklerville, New Jersey, was sentenced to serve 15 months in prison for conspiring to evade payroll taxes on cash wages paid to illegal immigrants employed at his dry cleaning business. Hui hired foreign nationals from Mexico and Guatemala who did not have legal status in the United States and paid them in cash. Their wages were not reported on the quarterly employment tax returns filed with the IRS. He was also ordered to pay restitution to the IRS.

Employers who file false employment tax returns are also subject to prosecution, as the following cases demonstrate:

In March, Richard Tatum, a Houston, Texas, business owner of an industrial staffing company, pleaded guilty to failing to pay more than $18 million in employment taxes. Tatum filed false employment tax returns that did not report the majority of his employees and did not pay over the taxes he withheld from his employees. Instead, he used the money for luxury travel and to make payments on his ranch.

In January, Janis Ann Edwards, an Oklahoma City, Oklahoma, business owner, pleaded guilty to evading more than $3.5 million in employment taxes. Edwards was the sole owner of Corporate Resource Management Inc. and a number of related companies that operated as professional employer organizations. Edwards directed her employees to alter quarterly employment tax returns to reflect less payroll tax liability than was actually owed.

The Justice Department’s Tax Division is also aggressively pursuing civil enforcement action against those who fail to meet their employment tax obligations. Since 2003, the Division has permanently enjoined more than one hundred employers and obtained tens of millions of dollars in money judgments. Civil injunctions are court orders requiring the employer and principal officers to timely deposit and pay employment taxes to the U.S. Treasury. These court orders also impose various other requirements and prohibitions, including the obligation to provide notice of each deposit to the IRS, as well as restrictions on opening and operating new businesses and transferring or dissipating assets.

In recent years, the Tax Division increased the number of civil actions brought against employers who violate employment tax laws. In 2016, the Tax Division obtained employment tax injunctions against 38 employers—more than double the number of injunctions obtained in 2015. The injunctions obtained in the past year include court orders against employers throughout the United States, such as a St. Louis concrete business, a Florida restaurant, an Iowa lawn care business and a Michigan custom kitchen company.

Since January 1, 2017, the Tax Division filed 17 suits, collectively seeking more than $10 million in unpaid employment taxes, against tax-delinquent medical-care providers who, despite IRS notices and efforts to collect, have been non-compliant for three or more quarters, despite persistent attempts by the IRS to remind them of their obligations and to collect the unpaid taxes.

These 17 suits collectively seek more than $10 million in unpaid employment taxes and are part of an ongoing effort by the Justice Department and the IRS focusing on employment tax compliance. Among these cases is a suit filed in federal court in Minnesota to enjoin Dawda Sowe and Nurse Staffing Solutions Health Care from failing to pay employment taxes and to obtain a $2 million judgment against the business for employment taxes the business allegedly failed to pay over an eight-year period. Also, this month the Tax Division filed suit in federal court in Texas to obtain a court order requiring Jeanna Smith to timely file employment and unemployment tax returns for her business and pay those taxes in full, amongst other requirements. In this suit, the government also seeks a judgment for unpaid employment taxes and alleges that Smith incorporated several home-health care businesses, such as Paris Senior Care Group Inc., which accumulated more than $1.3 million in unpaid employment taxes.

Finally, those who violate an injunction can be charged with civil and criminal contempt and face being shut down, paying compensation for the damage the contempt caused and incarceration of the principal corporate officers. For example, a federal court in Washington held Dr. James Hood and his wife, Karen Hood, in contempt of court for a consistent pattern of failing to meet their tax obligations. The court later ordered the two to close their dental care businesses, cease operating as employers, and barred them from opening any new businesses where the Hoods would serve as employers by June 8, 2017.

Any individual who is responsible for ensuring that employment taxes are collected, truthfully accounted for, and paid over to the IRS, and willfully fails to do so or willfully attempts to evade or defeat paying employment taxes may be subject to a civil penalty equal to the amount of the unpaid withholdings. This civil penalty, referred to as the Trust Fund Recovery Penalty (TFRP), may be imposed even if the individual uses the employment tax to pay other creditors or keep the business afloat. Individuals subject to these penalties include, but are not limited to, corporate officers, treasurers, managers, and, in some circumstances, bookkeepers. In fiscal year 2015, the IRS assessed the TFRP against approximately 27,000 responsible individuals.

Since January 2013, the Tax Division has obtained tens of millions of dollars in money judgments against individuals subject to these penalties. For example, in July 2016, a Florida jury found the CEO and owner of a professional employer organization personally liable for more than $4.2 million due to his failure to pay his company’s employment taxes. In addition, in December 2016, the U.S. Court of Federal Claims found that the CFO of an Internet-marketing platform was responsible for his company’s failure to pay its employment taxes and entered a judgment of more than $500,000 against him. And in April, a federal court found the co-manager of an architectural woodwork installation company personally liable for $1.9 million due to his failure to pay his company’s employment taxes.

In contrast to the Justice Department’s press release touting its successes in the employment tax field, a TIGTA report issued less than 30 days ago painted a considerably less rosy picture of the government’s efforts to ensure employment tax compliance. In a report entitled “A More Focused Strategy Is Needed to Effectively Address Employment Tax Crimes,” TIGTA concluded that the IRS needs a better strategy to enhance the effectiveness of the agency’s efforts to address, and punish, egregious employment tax violators:

Employment tax noncompliance is a serious crime. Employment taxes finance Federal Government operations plus Social Security and Medicare. When employers willfully fail to account for and deposit employment taxes, which they are holding in trust on behalf of the Federal Government, they are in effect stealing from the Government. As of December 2015, 1.4 million employers owed approximately $45.6 billion in unpaid employment taxes, interest, and penalties. The TFRP is a civil enforcement tool the Collection function can use to discourage employers from continuing egregious employment tax noncompliance and provides an additional source of collection for unpaid employment taxes. In FY 2015, the IRS assessed the TFRP against approximately 27,000 responsible persons – 38 percent fewer than just five years before as a result of diminished revenue officer resources. In contrast, the number of employers with egregious employment tax noncompliance (20 or more quarters of delinquent employment taxes) is steadily growing—more than tripling in a 17-year period. For some tax debtors, assessing the TFRP does not stop the abuse. Although the willful failure to remit employment taxes is a felony, there are fewer than 100 criminal convictions per year. In addition, since the number of actual convictions is so miniscule, in our opinion, there is likely little deterrent effect.

TIGTA recommended that the IRS should use data analytics to better target egregious employment tax noncompliance, including identification of high-dollar cases and individuals with multiple companies that are noncompliant. In addition, TIGTA recommended that the IRS Collection Division expand the criteria used to refer potentially criminal employment tax cases to IRS-CI to include any egregious cases (not only those where a firm indication of fraud is present).

Notwithstanding TIGTA’s recent criticism, it is readily apparent that employment tax enforcement is a top priority for both the Justice Department and the IRS.  With the massive amounts of unpaid employment taxes that remain outstanding, we can undoubtedly expect to see vigorous enforcement in this area, both criminal and civil, in the coming months and years.

Recently, a Colorado business protested the IRS’ disallowance of their business expenses.  The IRS alleges that the taxpayer was a Colorado medical marijuana dispensary to which Section 280E applies, as a result the IRS asserted that the taxpayers owed additional tax.  The taxpayers paid the tax and sued for a refund in Federal Court.  In a motion for summary judgment, the taxpayer asserted that the IRS did not have the authority to investigate whether the taxpayer violated the Controlled Substances Act (“CSA”), that Section 280E violates the Sixteenth Amendment, that the taxpayer properly deducted its expenses, and that the IRS did not produce evidence that Section 280E applies to the taxpayer.  The taxpayer also asserted that the application of Section 280E violated their Fifth Amendment rights and that Section 280E violates the Eighth Amendment prohibition against excessive fines and penalties.

The District Court ruled that:

  • the IRS application of Section 280E to a business it determined was selling marijuana was within its authority to apply the Internal Revenue Code;
  • the IRS’ application of Section 280E was a “purely tax-based determination” that did not violate the taxpayer’s Fifth Amendment rights;
  • the taxpayer did not allege that the IRS disallowed costs other than cost of goods sold and therefore the court could not determine that the Sixteenth Amendment was not violated;
  • the taxpayer did not allege enough facts for the court to determine whether Section 280E is an excessive fine and penalty in violation of the Eighth Amendment; and
  • the taxpayer did not allege any facts to show that the IRS lacked evidence to show that the taxpayer was violating the CSA.

The taxpayer has filed a motion for reconsideration and an amended complaint to add allegations necessary to support its claims, so the case may move forward based on those new allegations.   However, the taxpayer’s attempt to stop the IRS from enforcing Section 280E was not successful under the facts of this case.

The case is Alpenglow Botanicals, LLC v. U.S., Colorado Dist. Ct. Case No. 16-cv-00258-RM-CBS.  Opinion and Order Continue Reading Colorado District Court: IRS Enforcement of Section 280E Is Not A Criminal Investigation

Previously, we discussed Congress’s enactment of the FAST Act requiring the IRS to use private debt collection agencies to recover inactive tax receivables. In September, the IRS announced that it had contracted with four collection agencies to begin private collection, and last week, the IRS posted to its website a sample of the letter it will send to some taxpayers to notify them that their overdue account has been assigned to a private collection agency (Notice CP40). A copy of the letter can be found here.

The letter contains the name, address and phone number of the private collection agency and notes the following:

  • The private collection agency will explain payment options.
  • The private collection will provide the taxpayer with a payment plan if the taxpayer can’t pay the full amount.
  • Taxpayers should go to www.irs.gov/payments for information about how to pay an account that was transferred to a private collection agency.
  • The private collection agency is required to maintain the security and privacy of the taxpayer’s tax information. To do this, it will ask the taxpayer to provide their name and address of record before assisting the taxpayer in resolving his account. Also, it will perform two-party verification by asking the taxpayer for the first five numbers of their taxpayer authentication number at the top of the CP40. The private collection agency will then provide the subsequent five numbers.

The letter also suggests that the taxpayer refer to Publication 4518, What You Can Expect When the IRS Assigns Your Account to a Private Collection Agency. Publication 4518 can be found here and provides answers to questions taxpayers may have when their account has been assigned to a private collection agency including:

  • What will the private collection agency do?

The private collection agency assigned to your account is working on behalf of the IRS. They will send you a letter confirming assignment of your unpaid tax liability and then contact you to resolve your account. They will explain the various payment options and help you choose one that is best for you.

  • How can I be sure it is the private collection agency calling me?

The private collection agency will send you a letter confirming assignment of your tax account. The letter will include the same unique taxpayer authentication number that is on the letter sent to you from the IRS.

  • Who do I make my payments to?

Make all payments to the IRS. The private collection agency can provide information on ways to pay.

Helpful Tips

The private collection agencies must abide by the consumer protection provisions of the Fair Debt Collection Practices Act (the “FDCPA”) and have agreed to be courteous and respectful of taxpayer rights. Under the FDCPA, if a taxpayer sends the private collection agency a letter stating that it does not want to work with the private collection agency and requests that the case be handled by the IRS, the private collection agency must honor the request.

In addition, it is important for taxpayers to be on the lookout for scams, especially around this time of year. Taxpayers should only make payments to the IRS, not the private collection agency. There are electronic payment options for taxpayers on IRS.gov and payments by check should be payable to the U.S. Treasury and sent directly to the IRS, not the private collection agency.

I was recently interviewed by the Wall Street Journal about the IRS LB&I audit campaigns discussed here.  An interesting part of the conversation included a discussion of why the IRS would tell taxpayers what issues they are targeting.  The bottom line is to increase compliance.  The IRS has identified issues it believes a significant number of taxpayers are non-compliant and is focused on those for one reason: to generate revenue and collections.  There are a few things to keep in mind as you evaluate how to respond to the IRS audit campaigns:

  • The use of “soft letters” indicates the IRS is encouraging taxpayers to self-correct.  It is always better to self-correct than to deal with an issue in audit.  Especially when that issue is something the IRS has highlighted publicly as an issue they are targeting.
  • Failure to self-correct may give the IRS a stronger position for asserting penalties.
  • The 13 IRS audit campaigns identified is not a finite list.  It is an initial list which we expect will evolve over time.

Due to budget constraints, it makes sense that the IRS is targeting significant issues and encouraging self-correction which allows the IRS to increase revenues without significant manpower.

You can read the Wall Street Journal article here.

In a strongly worded opinion that is very favorable for taxpayers who engage in sophisticated tax planning, the Sixth Circuit overturned a Tax Court opinion denying the benefits of a domestic international sales corporation (“DISC”) under the theory that the transaction violated the substance over form doctrine.  In short, a DISC was used to channel large amounts to a Roth IRA, permitting accumulation of substantial funds which will be available tax free to the owners of the Roth IRA after they reach a certain age.  The details are not as fun as the opinion, which, assuming it stands, will surely be cited many times over.  The Court’s words are strong:

  • “If the government can undo transactions that the terms of the Code expressly authorize, it’s fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is.”
  • Because the taxpayer “used the DISC and Roth IRAs for their congressionally sanctioned purpose – tax avoidance – the Commissioner has no basis for recharacterizing the transaction and no basis for recharacterizing the law’s application to them.”
  • “It’s one thing to permit the Commissioner to recharacterize the economic substance of a transaction-to honor the fiscal realities of what taxpayers have done over the form in which they have done it.  But it’s quite another to permit the Commissioner to recharacterize the meaning of statutes-to ignore their form, their words, in favor of his perception of their substance.”
  • “The line between disregarding a too-clever-by-half accounting trick and nullifying a Code-supported tax-minimizing transaction can be elusive.”
  • “Decisions from our sister courts also straddle the line between holding that the transactions were a sham and suggesting that the Commissioner has a broad power to recharacterize transactions that minimize taxes, though none of them holds that a tax-avoidance motive alone may nullify an otherwise Code-compliant and substantive set of transactions.”
  • “The substance-over-form doctrine does not authorize the Commissioner to undo a transaction just because taxpayers undertook it to reduce their tax bills.”

The case is Summa Holdings, Inc. v. Comm’r.