August 8, 2012
In a recent decision by the District of Columbia’s Office of Administrative Hearings, a food distributor defeated an attempt by the District of Columbia’s Office of Tax and Revenue to impose corporate franchise tax and ball park fees for tax years 2000 to 2009. The distributor argued that it did not conduct business in the District within the meaning of the District’s tax laws and therefore the District lacked authority to tax it. This case serves as a reminder that before a state (or the District) can impose its income tax on a business, the state’s (or the District’s) applicable tax law must first authorize it. This is the third major taxpayer win in the last two years before the new Office of Administrative Hearings.
Click here to read the full article on nixonpeabody.com.
For more information regarding state and federal business income tax, please contact your regular Nixon Peabody attorney or:
January 11, 2012
A recently-disclosed exchange of correspondence between the top management of IRS and the head of the Taxpayer Advocate Service (TAS) has raised the hopes of many taxpayers that there may be some relief for the high cost of participating in the offshore account voluntary compliance initiatives. Are you eligible for lower FBAR penalties?
Click here to read the full article on nixonpeabody.com.
For further information, contact your Nixon Peabody attorney or:
By Kenneth H. Silverberg
The anxiously-awaited decision of the NJ Supreme Court in Whirlpool Properties, Inc. was issued yesterday. Taxpayers won half a loaf, but they clearly got the smaller half. Still, most multistate corporations that paid New Jersey income tax between 2002 and 2008 are now entitled to a partial refund.
The Whirlpool decision points out that the throwout rule increased New Jersey’s share of a corporation’s income in two situations:
- when sales are made to a state that has no income tax; and
- when sales are made to a state in which the corporation has too little business activity to have tax nexus (“nowhere sales”).
The analysis of constitutionality is very different in these two situations. The court concluded that another state’s decision to have no corporate income tax does not entitle New Jersey or any other state to tax a greater share of worldwide income. That, the justices believe, interferes with the sovereignty of another state, is unrelated to the extent of the corporation’s New Jersey activity, and therefore violates the Commerce Clause.
However, in the second category, nowhere sales throwouts, the justices stated that New Jersey obviously contributed more to making the sale in question than did the no-nexus destination state. Therefore increasing the New Jersey sales factor may not lead to a fair outcome in every case, but the “systematic distortion would not render the result facially unconstitutional.”
The justices suggested that Whirlpool’s litigation strategy may have been its undoing. They note that some other taxpayer who elects to challenge the throwout by stating it was unconstitutional as applied to them might have gotten a different result. However, Whirlpool and its counsel elected to challenge the throwout as unconstitutional on its face. Such a challenge is easier to litigate, because the argument can be made with hypothetical facts rather than the real facts of the case. However, the burden of proof facing the taxpayer is more strict – to succeed in a “facial” challenge, the taxpayer must prove that there is no possible set of circumstances in which the tax passes muster. Here, Whirlpool failed to do that.
So what about your refund claim? If you made a lot of sales to Nevada customers between 2002 and 2008, you’ll get a nice refund. But if most of your refund claim is based on nowhere sales, the Whirlpool decision doesn’t do much good for you. Unless you’re willing to litigate it yourself and claim the throwout was unconstitutional as applied to your particular facts.
The full text of the decision can be downloaded at http://www.nixonpeabody.com/linked_media/publications/whirlpool.pdf.
By Forrest Milder
Over the years, several theories have been applied by the courts in considering whether a transaction was undertaken for tax avoidance reasons so that the transaction should not be “respected” as a matter of federal income tax law. Courts differed in how they considered this issue and which tests they applied. Some in government thought there should be a uniform standard for the application of these tests, often referred to as the “economic substance doctrine”, and in March, 2010, Congress passed, and the President signed into law, the “Health Care and Education Affordability Reconciliation Act of 2010 .Part of the 2010 Act included the “codification” of the economic substance doctrine in Section 7701(o) of the Internal Revenue Code. The new law is effective for transactions entered into after March 30, 2010.
On September 13, 2010,the IRS published a notice on the new economic substance doctrine that is found in Section 7701(o). In my humble opinion, it is remarkable in its failure to actually say anything "new". It largely recites the statute, and then says that the IRS will rely on existing authorities to interpret the applicable tests.
As a quick refresher of the rules and commentary on the notice --
(1) 7701(o) has a two part test -- (A) the transaction must change, in a meaningful way (apart from tax effects) the taxpayer's economic position, and (B) the taxpayer must have a substantial purpose (apart from Federal income tax effects) for entering into the transaction. The IRS makes clear that this is a "conjunctive test", by which they mean to remind taxpayers that BOTH tests must be passed.
(2) The notice mentions the provision of section 7701(o) stating that these rules apply only if "economic substance is relevant to a transaction", although it provides no additional guidance on that issue.
(3) If the taxpayer wants to rely on "profit" as a motivation, the computation must be based on the present value of the pre-tax profit.
(4) A 40% penalty will apply, rather than a 20% penalty, if the taxpayer does not disclose the transaction on his/her/its return. The notice states which forms should be used.
(5) Under regulations to be issued, foreign taxes will be considered in determining pre-tax profit.
(6) As I noted above, the notice includes words like"the IRS will continue to rely on relevant case law" throughout.
(7) The notice does not mention tax credits, or other congressionally-favored tax incentives . Some will remember that footnote 344 of the Technical Explanation that accompanied the Act included a sort of "savings provision", suggesting that these rules did not apply to transactions which featured those Congressionally favored tax provisions. So, we seem to still be awaiting guidance on that front.
By Gary J. Oberstein and Gauri A. Patil
Misclassification of workers as independent contractors has apparently become so prevalent that the United States Department of Labor believes up to 30% of employers misclassify their workers. Citing the denial of basic rights to workers and accrual of less revenue to the Treasury, the federal government is increasingly cracking down on employers who incorrectly classify workers as independent contractors. The IRS recently launched a widespread audit of thousands of employers across the nation. In addition, Congress is considering a new bill which will strengthen protection for employee rights. Accordingly, it is very important for employers to take extra care when designating workers as independent contractors.
Correctly classifying workers as independent contractors has proven troublesome for many employers. Under federal law, the standards for independent contractor classification generally center on the level of control the employer exercises over the worker, but are often constructed in a manner that is too vague and difficult for employers to interpret with confidence. In addition, the laws in several states provide for a presumption that workers are employees, and place the burden of proving workers are independent contractors squarely on the employers. Then there is the law in Massachusetts, which not only presumes workers are employees but also requires employers to satisfy an exceptionally difficult three-prong test or face severe penalties for incorrect classification. (See discussion below on Massachusetts law.) It comes as no surprise that many employers mistakenly, but in good faith, classify workers as independent contractors.
IRS Enforcement Program
In February 2010, the IRS began conducting audits of randomly selected employers throughout the country. Over the next three years, the IRS plans to review the tax returns of 6,000 employers across various industries primarily to analyze five employment tax issues: worker classification, officer compensation, reimbursed expenses, fringe benefits, and non-filers. These National Research Program (NRP) audits will likely focus only on these five issues and be very detailed in nature. While the IRS will focus its audits on employment tax returns for 2007 and 2008, it may expand its investigation into other employment tax years or other tax categories. The IRS intends to have 200 to 300 of its most experienced agents conduct both face-to-face interviews and line-by-line reviews of selected companies’ income tax and employment tax returns, along with W-2s, 1099s and other forms issued to workers. It is safe to assume that returns will be closely scrutinized.
In addition, the Obama administration intends to re-write a long-standing IRS rule that permits employers to classify their employees indefinitely as independent contractors based on a once held reasonable belief that the workers were employees. If the rule is changed, employers will need to demonstrate on an ongoing basis why they have classified a particular worker as an independent contractor.
Increased action by other employment agencies
Employers should also be aware of other current governmental trends in favor of employees in line with the Obama administration’s pro-worker agenda. In February 2010, the President proposed an allocation of $25 million to the Department of Labor (DOL) strictly for the purpose of combating employee misclassification. Under this “Misclassification Initiative,” the DOL will add 100 enforcement personnel to their current staff and incentivize states with competitive grants to address the issue of misclassification. Other departments also may receive substantial boosts in their funds under the proposed budget to address employee issues, such as paid leave programs and increasing employment of individuals with disabilities.
In December 2009, Senator John Kerry (D-Mass.) introduced a bill to prevent employers from further taking advantage of a loophole found in the Internal Revenue Code. Section 530 of the Revenue Act of 1978 currently provides employers with a “safe harbor” for classifying workers as independent contractors for employment tax purposes regardless of their status under a common law test. The bill, known as the Taxpayer Responsibility, Accountability and Consistency Act of 2009, intends to revise Section 530 by requiring employers to possess a reasonable basis for designating certain workers as independent contractors. The bill also seeks to ensure workers are provided with workplace protections, including workers’ compensation, Medicare, Social Security, minimum wage, overtime, and unemployment compensation.
What to expect from the IRS
The IRS plans to audit employers of differing size and legal form, so there is not much that employers can do to avoid an audit. However, in anticipation of an audit, employers should review their current payroll practices, making sure to address and remedy any weakness or discrepancy in records with regard to the five employment tax issues stated above. Employers should also review their employment tax returns for the preceding three years.
Employers selected to be audited by the IRS should make sure they are following good IRS examination management practices. At a minimum, employers should:
- Appoint a clear “chain of command” to respond to audit notices, as well as other IRS communications;
- Involve expert outside advisors from the outset of the process; and
- In an attempt to maintain control over the audit, request additional time to respond appropriately to information document requests, or, where appropriate, narrow the scope of the information requested.
As noted above, Massachusetts is one of a number of jurisdictions where the law presumes a worker is an employee and sets forth specific requirements that employers must satisfy before classifying a particular worker as an independent contractor. Incorrect classification, even if done in good faith, may result in stiff mandatory penalties including treble damages and attorneys fees. Specifically, M.G.L. c.149, s.148B provides that all workers are employees until the company can show that all three of the following requirements are satisfied:
- The individual is “free from control and direction in connection with the performance of the service.”
- The service that the individual performs is “outside the usual course of business.” Unfortunately, neither the law defines “usual course of business” nor have Massachusetts courts set forth a clear definition.
- The individual “is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service performed.”
Although an employer may attempt to rebut this presumption by satisfying these three prongs, it will be an uphill battle, as the requirements are demanding, and Massachusetts courts and agencies usually find in favor of the employee. Therefore, it is especially critical for Massachusetts employers to be careful in their classification of workers and have reasonable documentation to defend itself in any enforcement action.
What to take away
In light of increased enforcement on the federal and state levels, all employers, regardless of their size, are at risk of an audit by the IRS or a charge by a state agency with regard to worker misclassification. Penalties can be severe, as evidenced by a recently proposed $300 million assessment against FedEx Corp. for misclassifying 12,000 of its drivers as independent contractors. Therefore, it is in the best interest of all employers to review their current practices of classifying workers to ensure the classifications are defensible.
For further information, please contact:
By Amanda Pugh
IRS Commissioner Douglas Shulman announced the recent formation of a new unit of the Internal Revenue Service, dubbed the Global High Wealth Industry Group, which will focus on the nation’s wealthiest individuals and their entities. “We will take a unified look at the entire web of business entities controlled by a high-wealth individual, which will enable us to better assess the risk such arrangements pose to tax compliance and the integrity of our tax system,” Shulman said in his speech to the American Institute of Certified Public Accountants.
Some criteria that are likely to raise a red flag for an audit are:
1. Assets or Income of $10 Million or Greater - Shulman pointed out that “at least initially, [the IRS] will be looking at individuals with tens of millions of dollars of assets or income.” The group of taxpayers with $10 million or more in income is relatively small - just .05% of all tax returns received in 2007. Large bonuses or retirement packages can cause additional taxpayers to fall into this group. Taking into account taxpayers with significant assets (as opposed to income) will greatly greatly expand the target group.
2. Complex Financial Arrangements - Shulman said “They may include trusts, real estate investments, royalty and licensing agreements, revenue-based or equity-sharing arrangements, private foundations, privately-held companies, and partnerships and other flow-through entities that require looking at the entire, and often huge, spectrum of transactions and entities. A single high-wealth individual may have actual or beneficial ownership of numerous related entities, sometimes alone and sometimes along with other family members or business associates." Therefore, according to a wealth advisor, you will likely be at more risk if you have substantial wealth, dual citizenship and assets in another country, are a legal resident alien (i.e., you do not have U.S. citizenship, but are working or living in the U.S. temporarilty), or have assets outside of the U.S.
3. Offshore Income or tax residency - Other tax considerations include “international sourcing of income and tax residency, and offshore structures and bank accounts,” Shulman said.
4. Movie and rock stars, athletes, expats - Individuals in these and other similar professions will have an increased likelihood of being scrutinized due to having a high amount of income being earned overseas.
Any of these factors will put a taxpayers at a higher risk of an audit by the IRS. Further, under this new approach, there is the likely possibility that once the taxpayer is individually on the IRS' radar, it could also lead the IRS to audit the taxpayer's businesses as well.
For more information, please contact:
By Christian McBurney
Earlier this year the Treasury Inspector General for Tax Administration issued a report recommending that the IRS create an agency-wide employment tax program to address the issue of worker classification and to conduct a compliance study to measure the impact of worker misclassification on the tax gap. Starting this month, November 2009, the IRS will begin conducting random audits as part of this program. The IRS recently announced that 6,000 companies will be audited and that they have hired and trained approximately 200 new agents to work on employment tax issues. This is expected to be the most comprehensive IRS examination of employment tax compliance since 1984, with the main focus on whether businesses are properly classifying their workers as employees or independent contractors. Companies that have not considered this issue recently should spend time analyzing their circumstances.
In addition to this effort at Treasury, it is still possible that legislative action in this area could occur later this year, although not until Congress has completed action on health care reform. In July, Rep. Jim McDermott (D-WA) introduced H.R. 3408 to clarify the rules classifying workers as independent contractors versus employees to ensure proper tax filing. It would replace Section 530 with a new safe-harbor provision that fewer taxpayers could satisfy and whose protections would be retroactive in nature. There has been no further activity on H.R. 3408 since it was referred to the House Ways and Means Committee. We will continue monitoring this area.
By Scott Novick
On August 13, 2009, the U.S. Court of Appeals for the First Circuit issued its highly anticipated en banc decision in United States v. Textron (2009 U.S. App. LEXIS 18103 (1st Cir. 2009)), with a 3-2 majority holding that the work product privilege does not attach to Textron’s tax accrual work papers because they had not been prepared “for use in” possible litigation. While the decision is controversial and may be appealed to the U.S. Supreme Court, there are practical steps that companies should undertake now in light of Textron’s immediate impact on the uneven landscape of privilege.
Synopsis Of Case
The tax accrual work papers requested by IRS examiners included: (i) a spreadsheet summarizing Textron’s uncertain tax positions, including a risk-factor estimating Textron’s chances of prevailing on each issue in litigation and the amount reserved therefore; and (ii) notes and memoranda prepared by Textron’s in-house tax attorneys expressing their opinions as to which items should be noted on the spreadsheet and the risk factor associated with each such item. The U.S. District Court denied the Government’s summons enforcement action under the work product doctrine. A three-judge panel of the First Circuit affirmed that decision. The panel opinion was, however, subsequently vacated, and the case was reheard en banc. On rehearing, a 3-2 majority reversed the District Court’s decision, reasoning that the work papers were prepared to support financial filings and gain auditor approval, rather than for use in possible litigation.
What You Can Do Now to Protect your Company
The lack of work product protection for tax accrual work papers can have detrimental consequences to the bottom line. Although the IRS currently adheres to a policy of restraint by requesting only those tax accrual workpapers that concern “listed transactions” (the IRS determined Textron had invested in SILO transactions), in preparing for an uncertain future, tax departments can and should adopt certain internal procedures to provide as much protection as possible against such requests. To the extent practical, these procedures should include:
- Limiting tax accrual work papers to numerical analysis with minimal supporting narrative.
- Requesting assistance of outside tax counsel in preparing any opinions or supporting narratives about the specific issues identified in the tax accrual work papers.
- Keeping legal opinions separate from the corresponding work papers and under the control of in-house counsel.
- If in-house counsel act in a dual capacity (litigation assessment and financial statement preparation) in your company, ensure that they maintain a separate file cabinet for legal opinions and memoranda, whether prepared internally or by outside tax counsel.
By Susan Reaman
The Federal Court of Claims in Thompson v. U.S., 104 AFTR 2d 2009-XXXX, 07/20/2009 granted the Taxpayer summary judgment in deciding that its LLC member interest was not a limited partner interest for purposes of the passive activity rules under IRS Code § 469 and the regulations therunder. This case follows another recent taxpayer favorable case Tax Court opinion in Paul D. Garnett, et ux. v. Commissioner, 132 T.C. No. 19.
In Thompson the Taxpayer structured his business activity in the form of a limited liability company (“LLC”) under State law that treated LLCs as hybrid entities that are neither partnerships nor corporations. The taxpayer held directly a 99% member interest in LLC and indirectly the remaining 1% through a Subchapter S corporation.
Because LLC did not elect to be treated as a corporation for federal tax purposes, by default the Code treated it as a partnership, see Treas. Reg. § 301.7701-3 (b)(1)(i). The Taxpayer claimed losses of the LLC on its individual income tax return. The IRS denied the losses because it concluded that the taxpayer did not materially participate in the business of the LLC.
Generally, under Treas. Reg. § 1.469-5T(a). an individual may establish his material participation for a given taxable year by demonstrating any of the following:
(1) The individual participate[d] in the activity for more than 500 hours during such year;
(2) The individual's participation in the activity for the taxable year constitute[d] substantially all of the participation in such activity of all individuals ... for such year;
(3) The individual participate[d] in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year [was] not less than the participation in the activity of any other individual ... for such year;
(4) The activity was a significant participation activity ... for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeded 500 hours;
(5) The individual materially participated in the activity ... for any five taxable years ... during the ten taxable years that immediately precede[d] the taxable year;
(6) The activity is a personal service activity ..., and the individual materially participated in the activity for any three taxable years ... preceding the taxable year; or
(7) Based on all of the facts and circumstances ..., the individual participated in the activity on a regular, continuous, and substantial basis during such year.
The Code treats limited partners differently because it presumes that they do not materially participate in their limited partnerships. Section 469(h)(2) provides that except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates. In fact, under the Treasury Regulations implementing § 469, if a taxpayer holds a limited partnership interest, only three of the seven tests described above—(1), (5), and (6)—are available to measure the taxpayer's material participation in the partnership.
Except as provided in paragraph (e)(3)(ii) of this section, Treas. Reg.§ 1.469-5T(e)(3)(i)(B) provides that a partnership interest shall be treated as a limited partnership interest if the liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized.
Treas. Reg. § 1.469-5T(e)(3)(ii) provides that a partnership interest of an individual shall not be treated as a limited partnership interest for the individual's taxable year if the individual is a general partner in the partnership at all times during the partnership's taxable year ending with or within the individual's taxable year (or the portion of the partnership's taxable year during which the individual (directly or indirectly) owns such limited partnership interest).
The government argued that it was proper for the IRS to treat taxpayers’ interest in LLC as a limited partnership interest under Treasury Regulation § 1.469-5T(e)(3)(i)(B) because the taxpayer elected to have LLC taxed as a partnership for income tax purposes and because plaintiff's liability is limited under the laws of the state in which was organized.
However, the court in agreeing with the taxpayer, concluded the IRS’s own regulations literally requires that the ownership interest be in a business entity that is, in fact, a partnership under state law—not merely taxed as such under the Code. In addition, the Court raised the possibility that the taxpayer could also prevail under the general partner exception from treatment as a limited partner given the high degree of control taxpayer exerted over business operations as its sole manager.
The court ultimately concluded that the terms—“material participation” and “passive activity”—indicate that Congress was primarily concerned with the taxpayer's level of involvement in the activity in question and not the extent to which liability is limited.
The IRS raised the same argument in Garnett, in which the petitioners owned interests in both LLCs and limited liability partnerships (“LLPs”).
The Tax Court held that members of LLPs and LLCs, unlike limited partners in State law limited partnerships, are not barred by State law from materially participating in the entities' business. It cannot be presumed that they do not materially participate, but rather, it is necessary to examine the facts and circumstances to ascertain the nature and extent of their participation.
For more information, please contact Susan Reaman at (202) 585-8327 or email@example.com.
In Comm’r of Revenue v. Comcast Corp., SJC-10209 (March 3, 2009), the Massachusetts Supreme Judicial Court extended work product protection to documents prepared by an accounting firm because of existing or expected litigation. Anticipating that a certain stock sale transaction could have significant tax consequences, Comcast’s in-house counsel engaged the help of Arthur Andersen, who prepared a memo discussing the pros and cons of various planning opportunities for structuring the sale, and the attendant litigation risks. When Comcast was later audited by the Department of Revenue, Comcast withheld these documents claiming that they were protected by the work product doctrine. The Department of Revenue, however, argued that these documents were not prepared in order to assist with litigation, and were therefore not protected. Applying a test developed by the U.S. Court of Appeals for the Second Circuit in United States v. Adlman, 134 F.3d 1194 (2d Cir.1998), the MSJC found that documents are considered "prepared in anticipation of litigation" if they are prepared "because of" existing or expected litigation, even if their purpose is not to "assist in" litigation. It, therefore, held that the documents prepared by Arthur Anderson were in fact protected by the work product doctrine, affirming the decision of the trial court.