Trust, But Verify – Employers Should Monitor Payroll Tax Service Providers

In 2014, several payroll tax service providers allegedly embezzled millions of dollars in federal payroll tax payments from their clients. In June, the owner of Checkmaster Payroll Service in Massachusetts was indicted for allegedly stealing client funds that were supposed to have been used to pay clients' federal employment taxes.

The owner allegedly provided clients with "client copy" tax returns indicating that the taxes had been paid to the IRS, when they had not. The owner also allegedly falsely told his clients that payroll tax delinquency notices that they had received from the IRS were the result of administrative errors by the IRS, not his company's failure to remit the payroll taxes.

Similarly, in February, the owner of Fenton-based Paymaster Business Solutions was indicted for his alleged failure to remit taxes to the IRS that had been deducted from client bank accounts. Paymaster allegedly withheld, but failed to turn over to the proper taxing authorities, in excess of $2,700,000. Additionally, the owner, as power of attorney for Paymaster's clients, allegedly covered up inquiries made by the IRS regarding the failed payments.

When clients learned that Paymaster had not forwarded their funds to the taxing authorities, the owner allegedly lied to them and told them that Paymaster had made the payments. In these types of fraud cases, the victim employer can still be held liable to the IRS for the unpaid payroll taxes even though they paid the funds to the service provider. This poses a substantial risk to employers who use outside payroll tax service providers, but one that can be easily mitigated.

Avoiding A Payroll Tax Nightmare

To avoid a costly payroll tax nightmare, employers should trust, but verify that third party payroll tax service providers are indeed making tax payments to the IRS. First, confirm that your payroll tax service provider uses the Electronic Federal Tax Payment System (EFTPS) to make your payroll tax payments. EFTPS is a free service provided by the U.S. Department of Treasury that allows employers or their agents to make online tax payments.

If your provider does not use EFTPS, you should find a new provider. If your provider does use EFTPS, you or your employees can log onto the system and monitor payments yourself. Enrolling with EFTPS is simple, and provides the best way to monitor payroll tax payments. Any missed payments should immediately raise a red flag.

Payroll tax compliance is burdensome enough without having to worry about your payroll tax service provider scamming you. By periodically logging onto the EFTPS system to monitor payments, you should be able to avoid a costly payroll tax nightmare.

California's "Doing Business" Standard Requires Neither Any "Doing" Nor Any "Business" In California

The California Franchise Tax Board (FTB) issued a legal ruling determining that it will attribute the business activities of a multiple-member limited liability company, classified as a partnership for tax purposes (LLC), to its members when determining whether such members are "doing business" in California. As a result, out-of-state business entities that own a membership interest in an LLC doing business in California will be subject to tax themselves.

In reaching this determination, the FTB acknowledged that LLCs share characteristics with both partnerships and corporations but determined that LLCs that do not "check the box" for federal tax purposes are considered partnerships under California tax law. Because "the activities of [a] partnership are attributed to each partner," the FTB concluded that "if an LLC...is 'doing business' in California [then] the members of the LLC are themselves 'doing business' in California."

The FTB declined to extend the exception provided to limited partnerships in Amman & Schmid Finanz AG, et al., 96-SBE-008, April 11, 1996, to LLCs on the ground that, unlike limited partners, LLC members have the statutory right to manage or control the decision-making process of the entity.

The legal ruling includes six examples. The first two examples find that an LLC merely registering to do business or organizing in California is not actively engaging in a transaction for the purpose of financial gain or profit attributable to its members, and therefore will not create a filing requirement for its members. The other examples demonstrate that the FTB will consider a member of an LLC to be doing business in California if the LLC is commercially domiciled in California or has activities or factor presence in California sufficient to constitute "doing business" within the meaning of Cal. Rev. & Tax. Code § 23101.

The ruling has come under criticism from practitioners not only disagreeing with the ruling's substantive conclusions but also its timing, as the FTB is actively litigating related issues in the California courts. California FTB Legal Ruling 2014-01 (July 22, 2014).

Use Of §121 Gain Exclusion Does Not Block Treatment Of Sale As Fully Taxable Disposition For Passive Loss Purposes

If a taxpayer sells a rental property formerly used as the taxpayer's principal residence that has been used as a rental, there is the possibility that §121 may be available to be used to exclude gain from the sale of the rental. But if the rental activity has unused passive losses, does invoking §121's gain exclusion prevent the ability to release the excess losses under IRC §469(g)(1)'s special rule for dispositions?

Generally, IRC §121 allows for exclusion of up to $250,000 of gain ($500,000 for a married couple filing a joint return) from the sale of property that was owned and used by the taxpayers as their principal residence for two of the five years immediately before the sale.

IRC §469(g)(1) provides:

(1) Fully taxable transaction.

(A) In general. If all gain or loss realized on such disposition is recognized, the excess of-

(i) any loss from such activity for such taxable year (determined after the application of subsection (b) ), over

(ii) any net income or gain for such taxable year from all other passive activities (determined after the application of subsection (b)),

shall be treated as a loss which is not from a passive activity.

Chief Counsel Advice 201428008, http://www.irs.gov/pub/irs-wd/201428008.pdf, deals with that situation.

The ruling concludes that the use of §121 does not serve to create a transaction that is not a "fully taxable transaction" under IRC §469(g)(1)(A). The ruling finds that:

Section 121 is not a nonrecognition provision for property exchanges. Nonrecognition Code sections generally provide "no gain or loss shall be recognized." The sale of a principal residence is not an exchange of reciprocal property in which particular differences exist between the property parted with, and the property acquired, but such differences are more formal than substantial. Rather a sale of a principal residence is a transfer of property for money consideration and, as such, gain realized on the sale is recognized in the year of the sale. Section 121 is simply an exclusion provision for gain that is realized and recognized in the year of sale.

The memo notes that §121 simply says the gain shall not be included in gross income if the election is made. It is, as noted above, nevertheless recognized in the view of the memo.

The memo does conclude, though, that the excluded gain is not an item of passive income and thus cannot be used to "free up" losses from other passive activities.

Determination Of Whether Taxpayer Is A Real Estate Professional Not Affected By Election To Combine Rental Activities

In Chief Counsel Advice 201427016 ( http://www.irs.gov/pub/irs-wd/201427016.pdf) the IRS addressed the question of whether there's an impact on whether a taxpayer may qualify as a real estate professional depending on whether or not the taxpayer makes an election to combine rental properties under Reg. §1.469‑9(g).

The issue arises because, as the memo notes:

Under Treas. Reg. §§ 1.469-9(b)(5) and (c)(3), only time spent in real property trades or businesses in which the taxpayer materially participates under Treas. Reg. § 1.469-5T counts towards meeting the requirements of being a qualifying taxpayer.

However, a real estate professional must test each rental separately unless there is an election made under Reg. §1.469‑9(g). As the memo also notes:

In accordance with section 469(c)(7)(A), each interest of the taxpayer in rental real estate is treated as a separate activity for purposes of determining whether the taxpayer materially participates in the rental real estate activity, unless the taxpayer makes an election to treat all interests in rental real estate as a single rental real estate activity under Treas. Reg. § 1.469-9(g).

So, it appears that it would be far more difficult to have the rentals meet material participation unless they are combined.

However, the memo concludes this is not the proper way to look at this. The election under Reg. §1.469‑9(g) is only available if the taxpayer is a real estate professional. As well, the mandatory separate treatment of the rentals under IRC §469(c)(7)(A) only applies once a taxpayer is a real estate professional.

Thus the memo concludes the proper guidance is found under Reg. §1.469‑9(d) which holds:

The determination of a taxpayer's real property trades or businesses for purposes of [meeting the definition of qualifying taxpayer] is based on all of the relevant facts and circumstances. A taxpayer may use any reasonable method of applying the facts and circumstances in determining the real property trades or businesses in which the taxpayer provides personal services. Depending on the facts and circumstances, a real property trade or business consists either of one or more than one trade or business specifically described in section 469(c)(7)(C).

Under that guidance, applied before a taxpayer is deemed to be a real estate professional, the taxpayer can combine the real properties with the underlying trade or business for purpose of meeting the 750 hour test to be a real estate professional.

Effectively, once the taxpayer is determined to be a real estate professional, the grouping is "broken" by §469(c)(7)(A)-but only after the qualification.

Note that the taxpayer may have won only a temporary reprieve-though the taxpayer is now a real estate professional, having failed to elect to combine the rental activities the taxpayer may find it much more difficult to get an actual deduction for losses on the rental. But at least the taxpayer will have the option.

Erroneous Advice Served Obtained From Two CPAs Deemed To Allow Taxpayer To Escape Substantial Understatement Penalty

Reasonable reliance on a tax professional can serve to get taxpayers out of the accuracy related penalty of IRC §6662. In the case of English v. Commissioner, TC Summary Opinion 2014-66, http://www.ustaxcourt.gov/InOpHistoric/EnglishSummary.Gerber.SUM.WPD.pdf, the taxpayers were able to use what turned out be erroneous advice to escape the penalty (albeit, not the tax) on an assessment.

Cheryl English had been receiving disability payments from Hartford Insurance after she became disabled in 2007 and could no longer work. The policy provided that her benefits would be reduced if she qualified for Social Security disability benefits. While she applied for such benefits in 2007, she did not receive any in 2007, 2008 or 2009.

In 2010 she was finally awarded Social Security benefits of $49,610 for her prior years and thus had to repay Hartford Insurance $48,144. Since the Hartford benefits had been excluded from Cheryl's income when paid as disability benefits, she wondered if she might be able to exclude the Social Security benefits that she had to require to pay back to Hartford Insurance.

To answer that question she consulted two CPAs and they generally advised her that the benefits would not be taxable. The return for the couple was prepared by a CPA who did not include the benefits as taxable income, though the Court did not indicate if this was one of the two CPAs from whom they initially sought advice.

The IRS disagreed with that view, seeing the payment as being simply Social Security benefits and the Tax Court concurred. The Court noted:

Section 86 provides that a taxpayer's gross income includes up to 85% of Social Security benefits, including disability benefits, received during the taxable year. However, for purposes of that section, taxpayers may reduce Social Security benefits by repayments of other Social Security benefits previously received. Sec. 86(d)(2)(A). A Social Security benefit is defined as "any amount received by the taxpayer by reason of entitlement to-(A) a monthly benefit under title II of the Social Security Act, or (B) a tier 1 railroad retirement benefit." Benefits received from private insurers, such as Hartford, do not satisfy this definition.

As the understatement of tax exceeded 10% of the amount required to be shown on the return and was also greater than $5,000, the threshold for the substantial understatement accuracy related penalty under IRC §6662(b)(2) and (d)(1) was initially triggered.

However, the penalty is not applicable if the taxpayer can show she acted with reasonable cause and in good faith. [IRC §6664(c)(1)]

In this case, the Court noted that the underlying is "curious" stating:

Congress saw fit to make a certain percentage of Social Security benefits taxable, even if the payments are for a disability. Congress also provided that in circumstances where Social Security benefits had to be repaid, the initial receipt of the benefits would not be taxable. The disparate treatment of private and public disability benefits for tax purposes is curious and somewhat confusing.

Noting that Cheryl looked to two CPAs for advice on the situation and was told the Social Security was not taxable to the extend it was used to repay the tax free disability benefits, the Court had to decide if that was acting in reasonable cause and with good faith. The Court found that it did.

Note that even though the advice was in error, the taxpayer still escaped the penalty due to reliance on the work of a professional. Generally such reliance is deemed to create reasonable cause if the taxpayer can show:

  • The taxpayer sought out the advice of a professional whom they reasonably determined (based on the taxpayer's own knowledge and sophistication) was competent to give such advice;
  • The taxpayer provided the adviser will all information they believed to be relevant, as well as any information the adviser requested and
  • The advisor was not a promoter of the transaction in question (and whose advice therefore cannot be reasonably assumed to be unbiased).

Advisers should be aware that due to the existence of this defense, the director of the Office of Professional Responsibility has commented multiple times that an adviser who prepared the return and then represents the client before the IRS must consider whether an impermissible conflict of interest exists in representing the client if the adviser's own work becomes an issue.