Ethics of Taxation & Employee Determination & Bankruptcy

NRP

U.S. tax authorities started to audit 6,000
randomly selected companies to focus on
employment tax issues ranging from
executive compensation to fringe benefits,
Internal Revenue Service officials said.

The audits began in February 2010 and
stretch across all types and sizes of
companies. The exams will be deeper
than typical audits, and also look at the
use of independent contractors and other
worker classification issues. A report
should be issued soon.

Robert E. McKenzie Arnstein & Lehr 3
LLP

ALERT!!

9-21-11 IRS announced Voluntary Worker Classification
Program

Employers can apply for the program by filing Form
8952, Application for Voluntary Classification Settlement
Program, at least 60 days before they begin treating the
workers as employees.

A taxpayer who participates in the VCSP will agree to
prospectively treat the class of workers as employees for
future tax periods.

In exchange, the taxpayer will pay 10 percent of the
employment tax liability that may have been due on
compensation paid to the workers for the most recent tax
year, determined under the reduced rates of section
3509

Robert E. McKenzie Arnstein & Lehr 4
LLP

VIZCAINO ET AL v. MICROSOFT
CORPORATION, ET AL

When hired, each freelancer signed an agreement,
"as an Independent Contractor,...to be responsible
for all federal and state taxes, withholding, social
security, insurance, and other benefits."

In 1990 the IRS determined that the freelancers
were actually common law employees.

Microsoft Corp. must pay benefits under two
employee benefit plans to a group of workers that
the company had misclassified as independent
contractors.

Robert E. McKenzie Arnstein & Lehr 5
LLP

Financial Impact of IRS

Reclassification

Very high, in excess of 40% of payments to independent
contractors.

The IRS assumes a rate for withholding of up to 28% of
payments to reclassified workers. It also imposes liability for
both employee and employer FICA and Medicare for a total
of 15.3% of payments. The employer also becomes liable for
FUTA.

IRC Section 3509 provides for assumed rates for FICA and
withholding which would result in deficiencies between about
11% and 14% of a company's reclassified payroll.

Employee benefits

Robert E. McKenzie Arnstein & Lehr 6
LLP

COMMON LAW TEST

TWENTY COMMON LAW FACTORS

Compliance with instructions
Training
Integration with business
Personal rendition of service
Hiring, supervising and payment of assistants
The existence of a continuing relationship

Robert E. McKenzie Arnstein & Lehr 7
LLP

COMMON LAW TEST 8

TWENTY COMMON LAW FACTORS

Set hours of work
Exclusive full-time work
Work on employer's premises
Sequence of work done
Reports recruited
Payment by hour, week, or month
Expense account

Robert E. McKenzie Arnstein & Lehr
LLP

COMMON LAW TEST 9

TWENTY COMMON LAW FACTORS

Tools and materials supplied
Facilities-furnished
Risk of loss
Number of "employers"
Availability to general public
Power to fire
Termination damages

Robert E. McKenzie Arnstein & Lehr
LLP

Worker Agreement

Common law test controls even if there is
an agreement with the worker that she is
an independent contractor
Substance of relationship determines
status not agreement

Robert E. McKenzie Arnstein & Lehr 10
LLP

State Tests

Even if a worker is an employee pursuant
state law for unemployment or worker’s
comp that does not in fact he is an
employee for federal purposes.

Robert E. McKenzie Arnstein & Lehr 11
LLP

SECTION 530 OF THE REVENUE
ACT OF 1978

SAFE HARBORS

Judicial precedents, published IRS rulings, technical
advice memorandum, or private letter ruling or
determination letter ruling directed to the taxpayer

A long-standing, recognized practice of a significant
segment of the industry in which the taxpayer is
engaged

The statute allows the taxpayer to demonstrate

"reasonable basis" for its treatment of workers in

some other manner. 12
Robert E. McKenzie Arnstein & Lehr
LLP

Section 530 Additional
Requirements

Even if you satisfy one of the requirements
of Sec 530 must meet 2 more:

– TP must not have previously treated the
individuals as employee

– TP must have filed all required information
returns

Burden of proof is on the IRS once TP
establishes a prima facie case

Robert E. McKenzie Arnstein & Lehr 13
LLP

Section 530 Additional
Requirements

Consistency requirement

– IRS aggressively tries to find inconsistency
– Example trucking company case

Treated as employee similarly situated
individuals

– W/H taxes or
– Filed employment tax returns showing as

employees

Robert E. McKenzie Arnstein & Lehr 14
LLP

Reasonable Basis for Industry
Practice

25% or more of an industry segment
IRS plays games with geographic
definition

Robert E. McKenzie Arnstein & Lehr 15
LLP

Other Issues

Industries many times will not assist
competitors caught in the IRS gun sights
The Job Protection Act provided that you
may raise Sec. 530 first and that is not an
admission that workers are employees

Robert E. McKenzie Arnstein & Lehr 16
LLP

Sec. 1706

May not raise Sec. 530 with respect to
“technical service specialists” whose
services are by broker

Robert E. McKenzie Arnstein & Lehr 17
LLP

IRC Sec. 3508

Relief for certain industries

– RE agents
– Direct sellers (Avon, Amway)

Robert E. McKenzie Arnstein & Lehr 18
LLP

Sec. 3509

No intentional disregard & gave 1099’s:

– 1.5% of total for W/H

All of employer share of FICA & Medicare (7.65%)

– 20% of 7.65% of employees share of FICA &
Medicare (1.53%)

– Total10.68%

No intentional disregard & no 1099’s:

– 3% of total for W/H
– All of employer share of FICA & Medicare (7.65%)
– 40% of 7.65% of employees share of FICA &

Medicare (3.06%%)
– Total13.71%

Robert E. McKenzie Arnstein & Lehr 19
LLP

FUTA

Computed on the federal FUTA wage
base

Robert E. McKenzie Arnstein & Lehr 20
LLP

Interest Free Adjustments

Sec. 6205
Error is ascertained and there is no
intentional disregard.
Does not apply to FUTA

Robert E. McKenzie Arnstein & Lehr 21
LLP

Special Abatement

Secs. 3402(d)(D) & 6521

If higher rates of full FICA and 28% rates apply
may receive abatement of employee share of
FICA & Medicare to the extent you prove
employee paid taxes

Forms 4669 & 4670

Does not apply if TP given Sec. 3509 rates

Employer may seek refund in statute has run for
employee refund

Now more liberal for employees to seek refund

Robert E. McKenzie Arnstein & Lehr 22
LLP

CSP

Graduated settlement offers

If does not satisfy substantive consistency
test or Reasonable basis 1 year for Sec
3509 liability

Colorable argument of substantive
consistency test or Reasonable basis 1
quarter for Sec 3509 liability

If meet Sec. 530 tests- no liability

Robert E. McKenzie Arnstein & Lehr 23
LLP

Tax Court

Tax Court has jurisdiction to determine
Sec 530 liability
No need to pay to litigate
TC may determine amount of liability since
2000

Robert E. McKenzie Arnstein & Lehr 24
LLP

TFRP

If intentional disregard officers may be
held liable
If Sec Sec 3509 no officer liability

Robert E. McKenzie Arnstein & Lehr 25
LLP

Form 8919

Worker can file w/ 1040 to avoid paying
SE
Must meet criteria under common law test
May file form SS-8

Robert E. McKenzie Arnstein & Lehr 26
LLP

SFR’s

CCA 200822026
RO may prepare SFR
Must give Notice of Determination of
Worker Classification (NDWC)

Robert E. McKenzie Arnstein & Lehr 27
LLP

SS-8

Does not necessarily result in exam
Even if there is an adverse determination

Robert E. McKenzie Arnstein & Lehr 28
LLP

HAVE A PROFITABLE
YEAR!!!!!

Thank You!!!!!!

Robert E. McKenzie Arnstein & Lehr 29
LLP

Bankruptcy Questions
Answered!

Robert McKenzie, EA, Esq.

Types of Bankruptcies

 This is not an
easy subject, but
our goal is to
distill it to key
issues you need
to know as a
return preparer.

 Hopefully at the
end of the session
you will know
what questions to
ask to know when
you’re in trouble…

Chapter 7

 All of the debtor's nonexempt
property is liquidated and the
proceeds distributed to creditors.

 A Trustee is appointed to do the
liquidation; the trustee works on a
percentage of assets liquidated.

 After about six months, most
debts are discharged.

Text Page 1

Chapter 13

 Eligible individuals pay part or all of
their debts over a three to five year
period.

 Debtor keeps their assets
 Debtor repays a portion of their

dischargeable debt, and all of their
nondischargeable debt.
 Simplest reorganization
 Under about $340,000 Unsecured Debt

Chapter 12

 Eligible farmers pay part or all of
their debts over a three to five year
period.

Text Page 1

Chapter 11

 The debtor proposes a
reorganization plan and seeks
approval of creditors.

 Debtor keeps their assets
 Debtor repays a portion of

dischargeable debt.
 Expensive: Large legal fees,

monthly fees and very
complicated.

Plain Language Practice Tip!

 How to remember what the categories
mean…

 Once a debtor files a petition with the
USBC, the law prohibits creditors
(including the IRS) from taking certain
collection actions and protects certain
assets from liquidation.

 This prohibition on collection is known
 as the “automatic stay.”

Before the Process Begins

 Why is it that we
get clients in a
panic, saying they
need to file prior
year returns ASAP
just because they
are contemplating
bankruptcy?

Text Page 2

Creation of the Bankruptcy Estate

 I’m having trouble
with this
concept…but if I
try to relate it to
my experience with
regular trusts and
estates, I think I
can better grasp it.

Bankruptcy proceedings begin
with the filing of a petition…

 …that filing creates the bankruptcy
estate. Typically an individual debtor
files either a Chapter 7 or Chapter 11
Petition.

 In no-asset 7’s, the debtor
continues to file income tax returns
as though there were no bankruptcy
and there were no separate taxable
bankruptcy estate.

Text Page 2

When a separate taxable bankruptcy estate is
created, the estate inherits and takes into account

the following income attributes of the debtor:

1. Net operating loss carryovers
2. Charitable contribution carryover
3. Recovery of tax benefit items
4. Carryovers of any credit
5. Capital loss carryovers
6. The debtor's basis, holding period,

and character of any asset
7. The debtor's accounting method.
8. Other tax attributes of the debtor.

Text Page 3

Caution!

 You may need to
talk to the client’s
bankruptcy lawyer
to confirm the
status they are
in…

 but watch out
before you use
any tax attribute
while the t/p is in
this process.

Background and general legal
principals

 The commencement of a bankruptcy
case creates an estate, which
generally includes all legal or
equitable interests of the debtor in
property as of the commencement of
the case.

 Property excluded from the estate is
never included in the estate

Text Page 3

We need some plain language

 Come on
Bob…what’s really
going on here?

Here’s what’s going on:

 The bankruptcy estate property will be used to
pay the debtor's creditors.

 The bankruptcy estate is treated as a separate
taxable entity from the debtor.

 The trustee or debtor-in-possession is
responsible for preparing and filing the
estate's tax returns and paying its taxes.

 The debtor remains responsible for filing his or
her own returns and paying taxes on income
that does not belong to the estate.

 When the bankruptcy estate is terminated or
dissolved, any resulting transfer of the estate's
assets back to the debtor is also not treated as
a disposition. The transfer does not result in
gain or loss, recapture of deductions or
credits, or acceleration of income or
deductions to the estate.

 The abandonment of property by the estate to
the debtor is a nontaxable disposition of
property. If the debtor received abandoned
property from the estate, the debtor has the
same basis in the property that the estate
had.

Trustee or Debtor in Possession

 When a trustee is appointed, the debtor
generally must turn over to the trustee
control over the assets of the
bankruptcy estate.

 In most Chapter 11 cases, a trustee is
not appointed and the debtor (referred
to as the debtor in possession) remains
in control of the property of the
bankruptcy estate.

 The debtor in possession must perform
all the functions and duties of a trustee.

Attribution of Income

 If there is a separate taxable entity, the
trustee or DIP will need to obtain an EIN.

 IRC Section 1398(e)(1) provides that the
gross income of the estate includes the gross
income of the debtor to which the estate is
entitled under the Bankruptcy Code.

 IRC Section 1398(e)(2) provides that the
gross income of the debtor does not include
any item to the extent the item is included in
the gross income of the bankruptcy estate.

Text Page 5

Supreme Court Case

 May14, 2012
 The Supreme Court agreed with the appeals court

and ruled in favor of the IRS. In the ruling,
written by Justice Sonia Sotomayor, the high
court noted that the federal income tax liability
resulting from the Halls’ post-petition farm sale is
not “incurred by the estate” under the
Bankruptcy Code and “thus is neither collectible
nor dischargeable in the Chapter 12 plan.”
 In a 5-4 decision Monday, the high court found
that Lynwood and Brenda Hall owed capital gains
taxes of $26,000 on the $960,000 sale of their
320-acre farm in Willcox, Ariz., which they were
forced to sell during Chapter 12 bankruptcy
proceedings

Ask what type of bankruptcy your client has
entered so you know the filing requirements.

 The bankruptcy estate is not
treated as a separate entity for tax
purposes when an individual files a
petition under Chapter 12 or 13.

 The individual should continue to
file the same federal income tax
returns that were filed prior to the
bankruptcy petition…but don’t use
the attributes!

Individuals in Chapter 7 or 11

 The bankruptcy estate is treated as a
new taxable entity, separate from the
individual taxpayer. The estate in a
Chapter 7 case is represented by a
trustee.

 In Chapter 11, the debtor often remains
in control of the assets (DIP) and acts
as the bankruptcy trustee.

 The debtor files a Form 1040; the
bankruptcy trustee files a Form 1041
for the estate. If the debtor remain as
the DIP, the debtor must file both Form
1040 & 1041 for the bankruptcy estate

Taxation of Bankruptcy Estate

 The estate is entitled to one personal
exemption and to the standard
deduction for a married person filing
separately (if the estate does not
itemize deduction). Income tax rates
are those for "Married Persons Filing
Separately.”

 The bankruptcy estate can adopt either
a calendar year or a fiscal year since it
is taxed as a separate new entity.

Caution!

 Responsibility for
filing Form 1041 lies
with the fiduciary of
the estate. That
person may be your
client, because it is
either the trustee (if
one is appointed), or
the debtor in
possession (your
client, if one is not).

Gross Income of the Estate

 The gross income of the estate includes
all gross income of the debtor that is
received or accrued after
commencement of the bankruptcy
proceedings and to which the estate is
entitled .

 Amounts paid or incurred by the
bankruptcy estate will be allowed as a
credit, deduction, administrative
expense.

Net Operating Losses

 Carry backs and carry forwards
originating from the estate are only
available to the estate, not the debtor.

 However, a net operating loss incurred
by the estate can be carried back to the
debtor's pre- bankruptcy tax years, as
well as to previous tax years of the
estate.

Exhibits

 Notice 2006-83 Statement for Ch.11
cases in allocation of
individual/estate income

 Example: Tax return for the
bankruptcy estate

Requests for Prompt Determination
of Liability

 Because the debtor is responsible for
any unpaid tax liability of the
bankruptcy estate, the debtor should
urge the trustee to make the request.

 Tax returns filed by the trustee are
open for inspection by the debtor.

 The trustee of the estate is responsible
for paying the income tax liability of the
estate. However, the debtor can be
liable for the tax if the assets of the
estate are not sufficient to pay the tax.

Abandonment of Property

 The trustee can  Yikes!
abandon any property
of the estate that is Couldn’t this toss the
burdensome or troubled, underwater
inconsequential. asset back to the
debtor to face any
 Abandonment of the tax consequences
property does not personally?
include abandonment
of proceeds after a  The miracle of
taxable sale or washing…recourse to

exchange. non-recourse.

Text Page 10

Taxation of the Individual Debtors

 When no separate taxable bankruptcy is
created, the debtor must file tax returns as
though there was no bankruptcy proceeding.

 When a separate bankruptcy estate is created
under the individual Chapter 7 or Chapter 11
proceeding, the debtor can elect to close his or
her tax year on the day before the bankruptcy
proceeding commences.

 The debtor must have property other than
exempt property to make the election.

When to Elect Short Years

 An individual debtor who
has taxable income for
the short tax year ending
the day before the
bankruptcy petition is
filed, should make the
election.

 The debtor should not
make the election if he or
she has a loss for the first
short year tax year
because the loss would
be carried over to the
bankruptcy estate.

Conclusion of Bankruptcy

 At the end of the bankruptcy  Just how
proceedings the debtor long can a
inherits the tax attributes of bankruptcy
the bankruptcy estate that proceeding
were not reduced by debt last?
discharge.
Text Page 12
 The debtor may not carry
back a NOL occurring on a tax
year ending after
commencement of the
bankruptcy to any pre-
bankruptcy tax year.

Income from Discharge of
Indebtedness

 Although no income is realized from a
debt discharged in bankruptcy, the
excluded amount must be reflected in
one of two ways.

 The debtor, or estate in a Chapter 7 or
11 case can either:

• Reduce tax attributes by that amount, or
• Elect to reduce basis in depreciable property

by the excluded amount.

Income from Discharge of
Indebtedness

 Any part of the excluded amount that
does not go to reduce basis is then
applied to reduce other tax attributes.

 The bankruptcy exclusion for
discharged debt is closely related to
exclusions for debts discharged when:

• The taxpayer is insolvent , or
• A solvent farmer's discharge of "qualified,

farm indebtedness."
• A solvent taxpayer's discharge of debt on

qualified depreciable real property.

Discharge of an Insolvent Debtor

 An insolvent debtor can exclude from
gross income discharged debt up to the
amount of his insolvency.

• Insolvency equals the excess of liabilities
over the fair market value of assets
immediately before the debt discharge.

 An insolvent debtor who is solvent
following the debt discharge realizes
income to the extent post-discharge
assets exceed post-discharged
liabilities.

• Excluded amounts can either reduce tax
attributes or reduce depreciable assets in
the same manner as in bankruptcy.

Caution!

 Beware of property transferred to
satisfy creditors. The insolvency
exception only applies to debt
cancellation income and only to
the extent of the debtor's
insolvency.

 In a bankruptcy case, a property
transfer to creditors that results
in forgiveness or discharge will
not create income.

No Debt Discharge Income on
Some Real Estate Debt

 The excluded COD income reduces the
taxpayer's basis in depreciable real property.

 Applies to the forgiveness of debt on trade or
business realty.

• The excluded COD income is limited to the amount
by which the debt exceeds the property's FMV, and
can not be more than the taxpayer's total basis in
depreciable realty.

 The debt must have been incurred by the
taxpayer in connection with real property used
in a trade or business, and must be secured
by that property.

Coordination of Exclusions

 Bankruptcy rules take precedence over
insolvency rules

 Insolvency take precedence over qualified
farm debt and qualified real property business
exclusion

 Insolvency, qualified farm debt, and qualified
real property do not apply to a discharge that
occurs in bankruptcy

 Insolvency exclusion is applied first before
applying the qualified debt exclusion.

 The principal residence exclusion takes
precedence over insolvency.

Reduction of Debtor’s Tax
Attributes

 Unless the debtor chooses to use all or a part of
the amount of canceled debt to first reduce the
basis of depreciable property, use the amount of
canceled debt to reduce the tax attributes in the
order listed below:
• Net operating loss
• General business credit carryovers
• Minimum tax credit
• Capital losses
• Basis
• Passive activity loss and credit carryovers
• Foreign tax credit

Practice Tip – Attributes or Basis?

 If taxable income is anticipated in the near future, it is
usually best to reduce depreciable property and
preserve operating loss and credit carryovers so as to
offset taxable income and taxes while increasing cash
flow.

 If NOL carryovers and net credit carryovers are going to
expire on you, it is usually best to reduce these tax
attributes instead of losing them.

 If depreciable property that might be reduced will be
held for a long period of time, it is usually best to
reduce depreciable property and defer any tax
consequences.

 State and local taxes should be tested under each
alternative

Caution!

 – Tax Attribute
Reduction Example

 – Discussion Example
 – Tax Tools:

Computing Insolvency
 – Insolvency

Worksheet
 – Form 982



IRS Procedures for Nondischargeable
and Dischargeable Tax Debts Post-
Bankruptcy

 Generally, once a bankruptcy petition is filed,
all collection against the debtor stops until the
automatic stay is lifted, i.e., the bankruptcy
case is closed, dismissed, or a discharge is
granted or denied.

 When the proceeding is complete, the IRS
separates out collection activity

 into two functions – one for dischargeable
debts and one for nondischargeable debts.

Post-Bankruptcy

 Nondischarged debts are returned to
the normal collection stream.

 Discharged tax debts go through a
separate process that includes
screening of both real and personal
property for the possibility of collecting
from assets exempted, excluded, or
abandoned from the bankruptcy
proceeding, if certain dollar thresholds
are met

Bad News

 The 10th Circuit, (In re Mallo, 2014 WL 7360130
(10thCir. 2014)), & the 1st Circuit in Fahey v. Mass.
Dep’t of Revenue, No. 14-1328 (1st Cir.
2015) followed the Fifth Circuit (In re McCoy, (CA 5
2012) 666 F.3d 924) & and several other tax
bankruptcy court cases which held that late-filed tax
returns cannot be discharged in
bankruptcy. Unfortunately, this draconian result
known as the One-Day-Late Rule could preclude the
taxpayer’s goal of eliminating back taxes
in bankruptcy and obtaining a fresh start.

Good News

 IRS does not choose to follow McCoy
and its progeny

 Chief Counsel Notice 2010-16, 2010
WL 3617597 and Chief Counsel
Advisory 201044008 (Nov. 5, 2010),
2010 WL 4384171.

Tax Liabilities & Bankruptcy

See Exhibits & Checklists:
 Classifying Your Tax Debt
 –Dischargeability at a

Glance –

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