Cash Intensive Businesses & the IRS; a marriage made in Hell

Cash intensive businesses

Cash Intensive Business and the IRSOperating a cash intensive business is often accompanied by poor record keeping as well as the lack of any meaningful internal controls. These two factors make it difficult, if not impossible, to determine the taxpayer’s operations, financial condition, and most important, whether the taxpayer’s tax returns are true and accurate. Where tangible evidence concerning the taxpayer’s business is absent, an IRS agent will have to rely on the oral testimony of the taxpayer as it relates the financial information contained in the taxpayers returns in order to determining whether the taxpayer’s testimony is credible.

A taxpayer, who is not represented by an attorney, is at a clear disadvantage when the IRS comes calling. A nervous response or responses to confusing questions may result in the examiner forming a negative opinion of the taxpayer and a decision to expand the scope of the examination or make a criminal referral.  A taxpayer operating a cash intensive business should never submit to an IRS interview without the presence of an experienced tax attorney.

IRS examination of a cash intensive business entails:

  • Conducting an initial interview of the taxpayer to determine how cash is handled from the time the income is received to the time the income is deposited into a bank account or spent. This is a painstaking process where the IRS agent tries to understand the taxpayer’s business cycle and the identity of the individuals involved in handling the cash. The taxpayer has to explain in detail the mechanics of cash handling. This involves each step in the process including collection of gross receipts from every source and the manner in which cash sales are recorded.
  • Preparing a cash flow chart reflecting the time cash is received to the time it is placed in the hands of a third party. The flow chart will also contain the names of each individual who has contact with the cash at each point. Following its preparation, the agent will ask the taxpayer if the flow chart is correct. The above process will likewise be applied to cash disbursements. An agent will want to know who is authorized to pay cash and where the cash comes from. Where expenses are paid in currency, the agent will inquire as to how the expenses are recorded, whether a receipt was retained, whether the transaction was entered into books and an explanation as to how the disbursement is included in determining net income or a net loss.
  • Determining whether the taxpayer has an accounting system in place, and if so, who is responsible for maintaining the records. This a critical part in the examination. The examiner will ask about cash-on-hand that the taxpayer has access to, including funds available from friends or relatives. The agent is required to explain to the taxpayer that cash-on-hand includes pocket money plus cash in a safe or other location, and cash held in trust by others. The taxpayer’s responses to the agent’s questions will be taken down in detail and often times are accompanied by actual quotes from the taxpayer.
  • Developing data related to the taxpayer’s business and related businesses and determining whether any related party transactions exist. The IRs agent will ask about any recurring losses that are reflected on the taxpayer business or personal returns and attempt to determine what caused the losses and whether any remedial action has been taken by the taxpayer.
  • Careful scrutiny as to whether the taxpayer is commingling funds from his business accounts with his/ her personal bank accounts or his/ her immediate family member’s bank accounts. In this regard, the agent will inquire about the existence of any bank or personal loans, accounts payable and other borrowed funds as well as personal loans made to or from family members.

Take Away

With all the scrutiny and complexity embedded in cash intensive businesses by the IRS, operating a cash intensive business presents significant risks in terms of the tax and potential criminal consequences. If you operate a cash intensive business and have been notified of an IRS examination, it is important that you immediately seek the advice of an experienced and knowledgeable tax attorney prior to ever speaking with anyone. In some cases, IRS agents will show up at the taxpayer’s place of business or home, in an attempt to catch the taxpayer off guard. Should this happen to you, you should always refrain from answering any questions and ask to have an attorney present.

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Quiet Disclosure Guilty Plea

Florida man pleads guilty to tax evasion and hiding funds around the world

FBAR Quiet disclosuresIn April 2020, a Florida man pleaded guilty to tax evasion and the willful failure to file FBAR’s. What makes this case particularly interesting is that the taxpayer made use of a “quiet disclosure” rather than entering into the Offshore Voluntary Disclosure Program (OVDP). This is a classic case of greed on steroids.

Experienced tax attorneys will usually discourage their clients from making quiet disclosures. However, some practitioners may be tempted to recommend using a quiet disclosure to help close the deal with the client. An uninformed or greedy client will invariably opt for the least costly strategy. Unfortunately, these same practitioners routinely fail to provide the client with an explanation of the downside risks associated with making a quiet disclosure.

The following discussion is limited to the defendant’s foreign financial accounts, his failure to file FBAR’s and his unsuccessful attempt at making a quiet disclosure. If you interested in the tax evasion portion of the case you can click on the link hereand you will be linked to the Department of Justice, Tax Division, website.

Case background

–The taxpayer owned and operated a U.S. business that bought U.S.-made agricultural machinery and parts and sold them throughout the world.  The taxpayer failed to not only file business, personal and employment income tax returns but also failed to pay corporate, employment or individual income taxes. Although the taxpayer never received a salary, he certainly was living large. In addition to the business paying all of his personal expenses, the defendant was also able to siphon off significant amounts of cash, which he used for a variety of reasons. In total, the taxpayer failed to report more than $7.7 million in income, resulting in a total tax loss to the Government of over $2.7 million.

-From 2007 to 2011, the taxpayer transferred 5.8 million from the company’s bank accounts to foreign financial accounts. The taxpayer maintained these foreign financial accounts in Croatia, Germany, Serbia, and Switzerland from 2008 to 2015. Despite knowing that he had an obligation to report these accounts on FinCEN Form 114 (FBAR), the defendant kept these accounts secret in order to avoid IRS detection.

–In 2010, an account the taxpayer held at Credit Suisse in Zurich, Switzerland reached a year-end high value of $6,177,586. The taxpayer used the Credit Suisse account to fund the purchase of a $1,350,000 yacht and a $1,650,000 waterfront home in Florida.

–In 2015, Credit Suisse closed the taxpayer’s account in Switzerland and advised him to enter the IRS’s Offshore Voluntary Disclosure Program (OVDP). To provide some context, the OVDP was terminated in September of 2018 and replaced that same year with the Voluntary Disclosure Practice rules.

–The taxpayer failed to heed the Bank’s advice and elected not participate in the OVDP. The last iteration of the OVDP provided taxpayer’s with undeclared offshore accounts the opportunity to come clean in exchange for the prospect of avoiding criminal prosecution. Under the OVDP, participating taxpayers were required to:

  • File 8 years of delinquent or amended tax returns
  • File FBARS for 8 years.
  • Submit his or her returns and copies of the electronically filed FBAR, together with a penalty worksheet to the OVDP unit of the IRS.
  • Pay any outstanding income tax, together with a 20% accuracy penalty and interest.
  • Pay a one-time miscellaneous offshore penaltyequal to 27.5% of the highest aggregate account balance(s) in any one disclosure year.

In exchange for making these disclosures and paying all taxes, penalties and interest as well as the miscellaneous offshore penalty, the taxpayer and IRS would enter into a “Closing Agreement” (Form 906). A Closing Agreement effectively bars any additional claims by the IRS or the taxpayer for any of the years included in the disclosure period.

The taxpayer’s quiet disclosure consisted of filing several delinquent tax returns with the hope that the filings would fly under the radar, and the taxpayer would avoid paying income taxes, penalties and interest as well as the miscellaneous offshore penalty. Ironically, the taxpayer did not file any FBAR as part of his quiet disclosure.

Findings of the case

As it turns out, the tax returns filed by the defendant were materially false in several respects. First, the income tax returns disclosed only the taxpayer’s Credit Suisse account but failed to disclose his other foreign financial accounts. Second, the income tax returns submitted by the taxpayer failed to include the income the defendant earned from his company as well as the foreign source income earned from the taxpayer’s undisclosed foreign financial accounts.

Making a quiet disclosure, even in cases where the taxpayer files all FBAR’s in addition to his or her amended or delinquent income tax returns, is strong evidence of the taxpayer’s intent to prevent or hinder the IRS from detecting the existence of the taxpayer’s foreign financial accounts. It also demonstrates the taxpayer’s intent to avoid the assessment and payment of FBAR penalties.

Takeaway from the defendant’s guilty plea

If you make a quiet disclosure and are caught, there are significant financial consequences, even if you are fortunate enough to avoid criminal prosecution. The use of a quiet disclosure will invariably result in the assessment of the Willful FBAR Penalties which are substantial. Any hope of merely paying the Non-Willful FBAR penalty is out the window. In addition, if you are discovered, you will have to pay the outstanding tax, as well as the related penalties and interest on any unreported income. Among the IRS penalties, you could be subject to the 75% Civil Fraud Penalty.

Where criminal risk is minimal or non-existent, it may be possible to utilize the foreign or domestic streamlined procedures, thereby eliminating or limiting the FBAR penalty to a onetime 5% penalty.

While some taxpayers have been successful in avoiding detection by the IRS by using a quiet disclosure, you do not want to be the last person without a chair when the music stops. If you have undisclosed foreign financial accounts and foreign income, don’t let greed cloud your judgment. Nor should you make a decision based upon any potential savings in legal costs. Take the time to meet with an experienced and knowledgeable tax attorney to see what your options are. If any practitioner mentions the use of a quiet disclosure as a potential disclosure strategy, run like hell!

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Bank Fraud and Criminal Tax Charges Against Michael Avenatti

Michael Avenatti’s Indictment

Michael Avenatti Case on Criminal TaxThe temptation to use unfilled or altered tax returns as well as doctored financial statements for purposes of securing a bank loan, while not common, does occur. This practice typically occurs where an individual is faced with financial difficulties and sees no other way out. The consequences of submitting false documents including unfiled and false returns are strong evidence of the willful failure to file income tax returns as well as income tax evasion.

Recently convicted in New York for trying to shake down Nike, “Creepy Porn Lawyer” Michael Avenatti(“Avenatti”)must now travel to California to face multiple charges. Among the charges in the 36 count indictment, .

The discussion that follows is limited to the practice of using false tax and financial documents for purposes of securing bank loans and the criminal tax consequences associated therewith.

According to Counts 31 and 32 of the indictment, between 2014 and 2016, Avenatti obtained three loans from Peoples Bank on behalf of companies that Avenatti either owned or controlled. The loans  included an $850k loan to GB LLC (the “January 2014 loan”), a $2,750m loan to  Avenatti’s law firm, Eagan Avenatti, LLP (“EA”) (the “March 2014 loan”) and a loan to EA in the amount of $500k (the December 14, 2014 loan”).

The Indictment

The indictment alleges that in order to secure the March 2014 loan, Avenatti provided People’s Bank with false and fraudulent individual and partnership income tax returns as well as false and fraudulent financial statements, including a 2011 unfiled individual income tax return reflecting adjusted gross income of $4.5m and a tax due of $1.5m. Avenatti also provided the bank with a personal financial statement which failed to disclosethat Avenatti still owed the IRS $850k in unpaid personal income taxes for 2009 and 2010.

In addition to his personal return and financial statement, Avenatti provided the bank with a copy of the EA’s unfiled partnership return(Form 1065) for 2012 reflecting gross income of $11.5m and ordinary business income of $5.8. In October of 2014 Avenatti filed the 2012 partnership return for EA with the IRS. The partnership return filed with the IRS materially differed from the partnership return submitted to the bank. The filed return reflected $6.2m in gross receipts compared with the $11.5m on the return submitted to the bank. Furthermore, the partnership return filed with the IRS reflected only $2.1m compared with the $5.7m in operating income.

In support of the December 2014 loan, Avenatti submitted a balance sheet for EA reflecting a cash balance of $712k as of September 2014, even though the true balance was only $27k. Avenatti also submitted a personal financial statement as of November 1, 2014 which failed to disclose the unpaid 2009 and 2010 tax liability to the IRS. In furtherance of the  December 2014 loan application, Avenatti also provided the bank with copies of his unfiled U.S. individual income tax returns for 2012 and 2013, respectively reflecting $5.4 and $4m in income and estimated tax payments of $1.6m and $1.2m. Furthermore, the 2013 individual return reflected $103k in federal withholding.

According to the indictment, Avenatti last filed individual income tax returns for the 2010 tax year but failed to file individual income tax returns for the tax years subsequent thereto. In addition, Avenatti failed to file partnership and corporate returns.

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Taxing Foreign Corporations in the Digital Age

Effectively Connected Income and it’s Tax Consequences

Taxing Foreign CorporationsForeign entities that deliver digital goods and services using the internet as a point of distribution may be subject to U.S. income tax. The nature and character of the goods and services will dictate how the income is taxed. In the interest of clarity, the following discussion is limited to effectively connected income.

The explosion of foreign companies using the internet to deliver digital products and services has afforded foreign businesses the opportunity to compete in global markets without the necessity of a traditional bricks and mortar operation. In this regard, the critical question is always this: Does the United States have a right to impose an income tax? It is important to note that jurisdiction to tax a foreign entity requires determining whether a sufficient connection or nexus with the United States exists to justify imposing an income tax. Foreign corporations are subject to U.S. income tax on income that is considered effectively connected income (“ECI”) and associated with conducting a trade or business within the United States 26 U.S.C. § 864(b), 26 U.S.C. § 871(b) and26 U.S.C. § 882(a).

Business Presence in United States Tax Consideration

ECI is based upon the permanent establishment of a presence in the United States. In some cases, the question of permanent establishment is easy. For instance, a foreign company that leases office space and employs its administrative staff in Phoenix will be deemed to have permanently established a U.S. presence. Other cases are less clear, for example, a case where goods and services are digitally delivered to consumers in the United States, while the company’s operation, employees, website and servers are located in one or more countries. Generally, the existence of a website alone is insufficient to establish a permanent establishment within the United States due to the absence of any tangible physical component. In contrast, the location of the server, where the website is hosted is a piece of equipment with a physical location. Thus, the presence of a server in the United States may be sufficient for purposes of permanently establishing a U.S. presence. This is particularly true where a foreign company owns and operates its servers or has physical access to them. For U.S. tax purposes, the delivery of goods and services through a server that is located in the United States but neither owned, leased nor at the disposal of a nonresident does not currently create a permanent establishment in the United States.

Foreign companies will often deliver their products and services via the Cloud using the Software as a Service(“SaaS”) model or by using a CD, portable USB device or by the customer downloading a copy of the software from the company’s website. The SaaS model involves using a third party to host a foreign company’s website and software and to store and process its hardware infrastructure. These solutions are generally delivered to consumers over the internet for a fee. The manner in which these products and services are delivered will affect how the income is characterized for U.S. tax purposes.

Character of Income in US Business Tax Consideration

The amount of a foreign company’s ECI depends, in part, on the source and character of the income.The starting point for evaluating these inbound transactions can be found in the Treasury Software Regulations(the “Regs.”). Under the Regs, the character of payments received in transactions involving computer programs is based on the nature of the rights conveyed. The determination is made without regard to the transaction form adopted by the parties or the terms they apply (26 C.F.R. § 1.861-18(g) (1)). Moreover, the means of the transaction (that is, whether by purchase of physical disc or electronic download) is irrelevant (26 C.F.R. § 1.861-18(g) (2)).

Under the Regs, computer software transactions are classified into four categories:

  • The sale of a copyright right: the right to make copies of the property, the right to prepare derivative property, the right to make public performances, or the right to publicly display the property (26 C.F.R. 1.861-18(c) (1) (i) and 26 C.F.R. § 1.861-18(c) (2) (i)-(iv)).
  • The license of a copyright right: considered a sale or exchange for income tax purposes if under the facts and circumstances, the transferee receives substantially all of the right to the underlying copyright. Where less than substantially all of the rights to the underlying copyright are transferred, the transfer will be treated as a license (26 C.F.R. §1.861-18(f) (1)).
  • The sale of a copyrighted article: transferee receives a copy of a software program but acquires no rights (or a deminimis grant of rights) that accompany a copyright right (26 C.F.R. § 1.861-18(c) (1) (ii)). To qualify for sale treatment, the transferee of the copyrighted article must receive all the “benefits and burdens” of ownership
  • The lease of a copyrighted article: Where all of the benefits and burdens of ownership have not been transferred, the transaction will be treated as a lease generating rental income (26 C.F.R. § 1.861-18(f) (2)).

The Regs, however, do not applyto transactions involving digitized content or services that do not involve the transfer of a computer program. Transactions involving hosted software, such as SaaS, do not include a transfer of a computer program, and, as such, are not subject to the Regs (26 C.F.R. §1.861-18(b) (1)). The question then is: whether hosted software transaction is a property or services transaction? That distinction can be found in 26 U.S.C. §7701(e),which provides that a contract that “purports to be a service contract” can be recast as a lease based upon the existence of the following factors:

  • The customer is not in physical possession of the software.
  • The customer does not control the software application.
  • The customer does not have a significant economic or possessory interest in the software.
  • The provider uses the software to provide services to multiple third parties.

The Section 7701 (e) factors should be carefully examined when considering SaaS services or similar digital transactions. Payments made in exchange for SaaS services are generally characterized as service income because such transactions do not satisfy a number of the Section 7701(e)factors.

In Tidewater Inc. v. U.S.,(565 F.3d 299 (5th Cir. 2009), the U.S. Court of Appeals for the 5th Circuit applied the 26 U.S.C. § 7701(e) factors in holding that income earned by a time charter that supplied a vessel complete with a crew to its customers constituted leasing income.In Xerox Corp. v. U.S., (656 F.2d 659 (Ct. Cl. 1981), the U.S. Court of Claims applying a set of factors predating Section 7701(e) determined that a supply of copying machines was treated as a service.

Source of income in US Business Tax Determination

In addition to the “character” of the income”, the “source” of the income will also drive certain U.S. federal income tax consequences (e.g., application of withholding tax to foreign persons, application of the foreign tax credit limitation formula).

Income earned from the performance of “services” is sourced according to the place of performance. If the services are performed in the United States, the income is U.S. sourced income, and subject to U.S. federal income tax; if the services are performed outside the United States, the income is considered foreign-sourced income and exempt from U.S. tax.

Determining where a digital service is performed, and, thus, the source of the income derived in connection with such service, can be difficult in certain cases. For instance, in Piedras Negras Broad Co. v. Comm’r,the United States Board of Tax Appeals held that the source of a Mexican broadcaster’s income was Mexico since the broadcast originated in Mexico and the facilities and personnel were located in Mexico, not the United States, where its customers were located ((43 BTA 297 (1941) (nonacq. 1941-1 CB 18), aff’d, 127 F.2d 260 (5th Cir. 1942)). Similarly, in  Korfund v. Comm’r,(1 T.C. 1180 (1943), the Tax Court interpretingPiedras Negrasheld that the source of such income was not within the United States, by holding that the source of income is the situs of the income-producing service and that the source of the income was the act of transmission.

In conclusion, tax jurisdiction as well as the character and source of incomeplay a critical role in determining the U.S. federal income tax consequences as well as how the income will be taxed. Accordingly, foreign companies planning to do business within the U.S. would be well advised to consult with an experienced and knowledgeable tax attorney prior to conducting business.

 

 

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Good News for Rental Property Owners; Qualified Business Deduction

Business Income Deduction for Taxpayer

Qualified Business Income Deduction 2On September 24, 2019, the IRS issued Revenue Procedure 2019-38  now permitting  certain taxpayers who hold an interest  or interests in rental real estate to be treated as a trade or business for purposes of the Qualified Business Income Deduction (“QBID”) under 26 U.S.C. § 199A.

Under the new Revenue Procedure, an interest in real estate will be treated as a single trade or business for purposes of the QBID if it meets all of safe harbor requirements. Where all the requirements are not met, a taxpayer or other entity may, nevertheless, qualify as a trade or business for purposes of section 199A deduction, provided he or she otherwise meets the definition of a trade or business under Treas. Reg. § 1.199A-1(b)(14 ).

This safe harbor provision is limited to the QBID. In all other respects, where licensing of tangible or intangible property (rental activity) does not qualify as trade or business, Section 162, will apply.

Under the safe harbor provision, the IRS defines a Rental Real Estate Enterprise (the “Enterprise”) as an interest in real property held to generate rental or lease income. The Enterprise may consist of an interest in one or multiple properties. The Revenue Procedure further requires that a taxpayer or Relevant Pass through Entity (“RPE”) own the rental property directly or through a single member LLC or other entity that is disregarded for federal income tax purposes.

Real estate used by a taxpayer or RPE as a residence as well as real estate which is subject to a triple net lease is specifically excluded from the safe harbor provision.

Criteria for Consideration under Safe Harbor Provision 

To qualify for the safe harbor provision under the Revenue Procedure the taxpayer or RPE must meet the following criteria:

  1. Books and records. A taxpayer or RPE must maintain separate books and records reflecting income and expenses for each rental property;
  2. Services required. In the case of an Enterprise that has been in existence less than four years, 250 or more hours of rental services must be performed each year. In all other cases, the Enterprise must perform 250 or more hours of rental services in at least three of the past five years;
  3. Contemporaneous records. The taxpayer or RPE must maintain contemporaneous records, in the form of time reports, logs, or similar documents, detailing the hours, dates and description of all services performed, and  identifying who performed the services; and
  4. Statement attached to the tax return. Finally, in order to comply with the safe harbor provision, the taxpayer or RPE must attach a statement to the return filed for the tax year(s) the safe harbor is relied upon.

The new safe harbor rule should serve to encourage future investment in rental properties, since the QBID has the overall effect of increasing the internal rate of return to investors.

 

 

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Tax Relief for Expats who Renounce U.S. Citizenship

Relief Procedures for former U.S. Citizens

Tax relief for renouncing citizenship 1The new procedures attempt to address problems faced by some U.S. citizens, whose only connection with the United States is that they were born in America. Many of these individuals have been living overseas since an early age, and in some cases, are also citizens of the foreign country in which they reside.

The new procedures are aimed at providing relief to these former citizens who have had to deal with the problems associated with FATCA and other U.S. tax and reporting obligations. In case of FATCA, many foreign financial institutions have elected to close the accounts of U.S. expats rather than deal with the onerous compliance requirements and the 30% withholding obligations.

Consequently, expats have found banking overseas difficult if not impossible. In response to the problem, some have decided to renounce their U.S. Citizenship after determining that the benefits of U.S. Citizenship were outweighed by the problems FATCA and other U.S. tax and financial reporting requirements have created. Prior to the announcement, however, these expats were still expected to pay income tax on money they previously earned. The new Procedures address this concern.

Eligibility criteria and requirements under the Relief Procedures

Under the new procedures, eligible Individuals include those who relinquished their U.S. citizenship any time after March 18, 2010, the year FATCA was enacted and who also meet the following criteria:

  1. The Taxpayer has failed to file U.S. tax returns;
  2. The Taxpayer owes a limited amount of back taxes to the U.S. government ($25,000 in the past six years);
  3. The Taxpayer has net assets of less than $2 million; and
  4. Any prior U.S. compliance failure with the IRS was not due to willful conduct.

It is important to note that the procedures are only available to individuals. This means that estates, trusts, corporations, partnerships and other entities can’t use the procedures.

Those who are eligible are required to file outstanding U.S. tax returns, including all required schedules and information returns for the five years preceding and their year of expatriation. If the total tax for the six years period is less than $25,000, the taxpayer is relieved from paying U.S. taxes. Individuals who qualify for the procedures won’t be assessed penalties and interest.

Despite the relief the new procedures provide for U.S. citizens, the IRS cautions citizens regarding the permanent nature and consequences associated with relinquishing U.S. citizenship:

 “Relinquishing U.S. citizenship and the tax consequences that follow are serious matters that involve irrevocable decisions,” said the IRS. “Taxpayers who relinquish citizenship without complying with their U.S. tax obligations are subject to the significant tax consequences of the U.S. expatriation tax regime. Taxpayers interested in these procedures should read all the materials carefully, including the FAQs, and consider consulting legal counsel before making any decisions.”

The decision to relinquish one’s U.S. citizenship requires a careful evaluation of both quantitative and qualitative factors including income tax consequences, quality of life and mobility. In addition, any such decision needs to be evaluated in the context of political risk. Therefore, it is advisable that those who are contemplating renouncing their U.S. citizenship should consult with an experienced tax attorney who is familiar with the process, as well as the risks.

 

 

 

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Employment Tax Consequences with Workers Misclassification

Employee versus Independent Contractor

Employment taxes, IRS and workers classification

Deciding whether to classify an individual as an employee or independent contractor is a decision which requires a careful evaluation of many factors and the assistance of a tax attorney. A misclassification can result in significant tax consequences to a business, and in certain instances, personal liability for the business principals.

The question of a worker’s status can come under scrutiny in a number of circumstances. First, the status of an individual is most often questioned during an employment tax examination by the IRS. The issue may also arise during a general IRS tax examination of a business or where a former worker is successful in filing a claim for unemployment.

Although less common, the issue may  come to light where a former worker files a complaint against the business  under the Fair Labor Standard Act (FLSA) and includes allegations that the business willfully and fraudulently misrepresented the worker’s amount of wages under 26 U.S.C. § 7434(a) (See Greenwald et al v. Regency Management Services, LLC. et al, No. 1:2018cv00227 – Document 21 (D. Md. 2019).

Business owners will often default to treating an individual as an independent contractor based upon cost savings and administrative convenience. In some cases, the decision is borne out of ignorance. In others, it is the by-product of a deliberative process. There are also occasions where a business owner relies upon the advice of his attorney or accountant to treat his workers as independent contractors.

The mere classification of a person as an independent contractor does not determine the individual’s status for employment tax purposes.  Every employment tax examination will focus on two questions: First, is the business classification of its workers correct? Second, if the business misclassified its workers, was there a reasonable basis for the business doing so?

Currently, an individual’s status for federal employment tax purposes will depend upon the level of control the business exerts over the worker and the relationship between the parties.

Factors the IRS Uses to Determine Status of a Worker

In 1987 Revenue Ruling, the IRS identified 20 factors that it generally looks at to determine the status of a worker. The factors mirror the common law approach to determining whether a worker is an employee or independent contractor.  However, the recent shift by the IRS favors using a three part test. In this regard, the IRS considers the following:

  1. Behavioral Control. Whether the business has a right to direct and control the work performed by the worker, even in cases where the control is never exercised by the business. In this context, IRS examiners will look at the type  and degree of instruction given to the worker by the business, the evaluation systems used by the business to measure the details of how the work is done, and the amount and frequency of training on how the work is to be performed that is provided to the worker.
  2. Financial Control. Whether the business has the right to direct the financial and business aspects of the individual’s job. In this regard, IRS examiners will look at how significant is the enterprise’s investment in the equipment used by the worker to perform his or her work. They will also look for the existence of unreimbursed expenses, the absence of which tends to demonstrate that the worker is an employee.  Examiners will also look to see whether the worker is free to pursue other work within the same industry or whether the worker is at liberty to compete with the business on whose behalf he or she is performing work for.  Finally, Examiners will look at the payment arrangements made with a worker including whether a guaranteed wage exists, whether performance bonuses and commissions are being paid and the frequency of payments.
  3. Relationship of the Parties. The type of relationship will be based upon how the worker and the business perceive their interaction with one another. In determining the relationship of the parties, the IRS will look to the existence of any written document which describes the relationship between the parties and their intentions. However, the mere existence of an agreement is not dispositive on the issue of the worker’s status.  Examiners will also look to see whether any employee type benefits are being offered and paid on behalf of the worker and whether the relationship between the parties is subject to termination at a fixed point in time. Finally, Examiners will look at the nature of the services performed and determine whether those services are seen as key to the operation of the business and whether the services involve a proprietary process or interest owned by either the business or the worker.

Where the Internal Revenue Service determines that a business misclassified its workers, the next inquiry is whether there was a reasonable basis for the employer’s misclassification of its workers as independent contractors. In this regard, the business bears the burden of establishing reasonable basis for its misclassification.

Eligibility for Business Relief from Employment Tax Following Worker Misclassification

Whether a business had a reasonable basis for misclassifying its workers, is evaluated in the context of the Employment Tax Relief Requirements (the “Relief”) provided for under Section 530 of the Revenue Act of 1978. Eligibility for the Relief is predicated upon a business meeting all of the following criteria:

  1. Reporting Consistency. Reporting consistency is established by evidence that you have filed all the necessary federal tax and information returns that are consistent with your treatment of the worker. Thus, if you treated a worker as an independent contractor and paid the individual $600.00 or more, you should be able to establish that you filed Form 1099 Misc. If you failed to issue a Form 1099 Misc., you do not qualify for the relief. In addition, you should have also treated the worker as an independent contractor on the relevant tax return, where you deducted the payments. For instance, if you issued a 1099, but included the payments to the worker as “Salaries and Wages” on line 13 of your corporate income tax return (Form 1120), your treatment of the worker would not be considered consistent.
  2. Substantive Consistency. In order to establish substantive consistency you must be able to establish that you treated other similarly situated workers in a like manner. For instance, you have five workers, one is your nephew and the other 4 are unrelated. All five of them work on the loading dock in shipping and receiving.  You elect to treat your nephew as an employee so he can participate in your company health insurance plan. You treat the others as independent contractors. Under this scenario it would extremely difficult, if not impossible, to establish substantive consistency.
  3. Reasonable Basis. In addition to reporting and substantive consistency, you must be able to establish a reasonable basis for not treating your workers as employees. Examples of a reasonable basis would include reliance on a court case involving federal employment taxes, or a Revenue Ruling issued in your industry on the specific question of worker status.  You could also establish a reasonable basis for your misclassification if you were previously audited where you treated similar workers as independent contractors and the IRS did not reclassify those workers as employees. In addition, establishing the existence of an industry standard of treating workers as independent contractors could constitute a reasonable basis. Finally, you may be able to establish a reasonable basis for misclassifying your workers if you relied upon an attorney or accountant after disclosing all of the relevant facts.

If the all three of the conditions are met, the business may be provided with the Relief from federal employment taxes. While the Relief afforded by the IRS is available, few businesses will actually qualify, given the high bar for eligibility. Consequently, most businesses that are currently subject to an employment tax examination or at risk of being examined may not be able to provide a reasonable basis for misclassification of their workers as independent contractors.

If the IRS determines that a business misclassified its workers as independent contractors, and that the business is unable to establish that there was a reasonable basis for the misclassification, the business will be subject to the assessment of employment taxes. Moreover, to the extent the business lacks the financial means to satisfy the employment taxes, those who are deemed to be “responsible persons” could face imposition of the Trust Fund Recovery Penalty under 26 U.S.C. § 6672.

Way Forward in Determining Worker’s Status

If a business is unsure of how to treat a worker, it can use Federal Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding). A worker may also utilize this form.

In addition and depending upon the circumstances, other programs such as the Classification Settlement Program and the Voluntary Classification Settlement Program (VCSP), may be of interest to businesses that are eligible for Relief or the prospective relief provided for under the VSCP.

If you currently own and operate a business, irrespective of its size, or you anticipate launching a new business, understanding the role your workers play in your business is critical to your success and continuity. Labeling your workers as independent contractors without careful assessment could spell trouble. Unfortunately, the issue of employment taxes is seldom seriously considered, and oftentimes overlooked by established businesses as well as startups. The situation has been exacerbated by the erroneous information found during a google search, the advent of services like Legal Zoom, and what I refer to as the: “Do It Yourself Syndrome.”

The IRS has clearly indicated that employment taxes are a high priority for the Agency and that they will closely be scrutinizing businesses. For those who have failed to take meaningful action to substantiate and properly document their practice of treating their workers as independent contractors, rough seas lie ahead.

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IRS Detection of Tax Fraud Proliferates

Data Analytics is the Key

IRS Data AnalyticsDuring the last decade, the Internal Revenue Service has been limited in its ability to ferret out tax cheats, due, in large part, to a 17% cut in its budget in 2010 as well as a 14% reduction in its labor force. Despite dwindling monetary and human resources, the Agency has been able to keep up with its investigations thanks to advance in information technology.

While budget cuts have certainly hampered traditional methodologies for selecting returns for examination (for example identification of mathematical errors, or mismatches in information provided by taxpayers and third parties), the IRS has a new weapon in data analytics.

The IRS has been using its data analytics platform to uncover potential tax cases, as well as detect undeclared offshore assets. The platform consists of developing models using algorithms to assist in areas of tax noncompliance.

In 2018 the IRS Criminal Investigation Annual Report (the “Report”) cited the formation of the Nationally Coordinated Investigations UNIT and its early success in lead generation based upon these technological developments. The success of data analytics in the detection of criminal tax fraud is further evidenced by the 400% increase in the detection of tax fraud. According to the Report, the IRS Criminal Investigation Division experienced an increase from $2.5 billion to $10 billion in tax fraud.

The impact that the new technologies have had and will continue to have on IRS investigative initiatives and collaborative enforcement efforts by the United States and its partners can’t be ignored. In 2018 the Internal Revenue Service established a new international financial crime group in the Washington DC field office and also memorialized the creation of the Joint Chiefs of Global Tax Enforcement (“J5”). Other areas the Criminal Investigation unit is focused on are: employment tax and refund fraud, and identity theft.

As the IRS continues to develop its technology platform, taxpayers should expect increased scrutiny. Of particular importance is the IRS current emphasis on international tax compliance and enforcement.

 How IRS is using technology in curbing tax evasion

In response to the rapid proliferation of global financial crimes, the IRS Criminal Investigation unit has stepped up its game. Some of the things the IRS has been able to do is to have its Criminal Investigation Special Agents track the proceeds of financial crimes by using cutting edge technology. Also, together with sophisticated investigative work, the IRS case selection process has significantly been enhanced.

The IRS use of data in its investigation of tax cheats is also evident in the Government’s data mining of public information from sources such as Facebook, LinkedIn, Twitter and Google and its use of other automated computer programs to track taxpayer activity.

Finally, the impact of recent cyber breaches, such as the Panama and Paradise Papers cannot be over emphasized. In the event of a leak or security breach, the Government has the absolute right and the ability to collect taxpayer and other relationship data which can later be used to identify non-compliant taxpayers. In these instances, there is no expectation of privacy.

The role of data analytics as an investigative tool cannot be overstated. Despite a shortage of Special Agents in the Criminal Investigation Division, the IRS achieved a 91.7% conviction rate for the fiscal year 2018. Working smarter and more efficiently, not typically associated with government agencies, is definitely paying off.

However, the IRS data analytics platform does have its critics, who maintain that the new practices violates federal law and may also constitute discrimination. In addition, concerns have been raised that the IRS data collection practices may be used for nefarious purposes such as political targeting, data breaches and the misuse of information. While the above concerns may be legitimate, it is unlikely, that the IRS will capitulate at any time soon.

Consequently, taxpayers need to make sure they accurately report all items of income and expenses, particularly those taxpayers who self-report (self-employed and small business owners). In addition, taxpayers should be cautious with their use of social media or other platforms, since that information is free for the taking. That selfie of you and your new Porsche on Facebook is probably not a good idea.

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