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Understanding the Voluntary Classification Settlement Program

Has your business recently undergone an examination by the state unemployment office?  Did that examination result in independent contractors being recharacterized as wage earners? If so, you likely are facing a new tax debt for unpaid unemployment contributions with the state agency.  Many businesses are finding themselves in this situation.  However, the problem does not end there. The recharacterization will be shared with the federal government, and the IRS will also assess a new debt for unpaid Social Security, Medicare, and income taxes for these employees.  
If your business has concerns about the status of independent contractors, there is an opportunity to be proactive and avoid the problems of federal reclassification by examination. Additionally, you can dramatically reduce the overall debt owed to the federal government.  The Voluntary Classification Settlement Program (VCSP) was created by the IRS to resolve worker classification issues and provide certainty to taxpayers.
The basic concept of the program is simple:  if a business is willing to voluntarily reclassify independent contractors as employees, then the IRS will allow the business to pay a greatly reduced amount for  any unpaid Social Security, Medicare, and income taxes for previous periods.  The important point is that the business will be required to pay all Social Security, Medicare and income taxes for all future periods after the reclassification has been completed.
When a business applies to the VCSP, the IRS will calculate a fee equal to approximately 1% of the amount paid to reclassified workers in the last calendar year.  No further assessment will take place by the IRS if accepted into the program and the employer begins treating the reclassified workers as W-2 employees.
This program has very specific criteria. However, the program is broadly available to businesses, not for profit entities, and governmental entities. In order to be accepted in the program, the taxpayer must meet the following criteria: 

  1. The taxpayer must want to voluntarily reclassify certain workers as employees for federal income tax withholding, Federal Insurance Contributions Act (FICA), and Federal Unemployment Taxes for future periods;
  2. The employer must be treating the workers as non-employees;
  3. The employer must have satisfied any 1099 requirements for each of the workers for the 3 years preceding the calendar year ending before the date the request for reclassification is submitted. If the worker didn’t work for the employer for the entire three year period, this requirement is met if the Form 1099 has been issued to the worker for the time period he or she did work for the employer;
  4. The employer must have consistly treated the worker as a non-employee. In other words, a business cannot reclassify a worker who is on a 1099 if that worker was provided a W-2 in a prior year;
  5. The employer must have no dispute with the Internal Revenue Service as to whether the workers are non-employees for federal employment tax purposes;
  6. The employer cannot be currently under examination by the IRS;
  7. The employer must not be under examination by the Department of Labor or any state agency for the proper classification of the worker. This is key a point—if the issue was brought to the taxpayer’s attention by a state unemployment agency, the taxpayer will want to apply for this program after the conclusion of the state examination, but before receiving a notice from the IRS that the taxpayer is subject to a federal audit!
  8. The taxpayer must not have been previously examined by the IRS or the Department of Labor for the classification of worker, or if the taxpayer has been examined previously by either entity, then the taxpayer must have complied with the results of the prior examination.

 Finally, there is a provision of the agreement that extends the statute of limitations for assessment of employment taxes for three years for the first, second, and third calendar years beginning after the date the taxpayer elects to begin treating the workers as employees under the program.
 The good news is that there is a high level of certainty upon completing this program. Once the proper form is submitted to the IRS, the IRS will review the request and if accepted, enter into a closing agreement with the taxpayer.
 To put the importance of this program into perspective, if an employer requested reclassification of workers previously reported on Forms 1099 that totaled $200,000 in the prior calendar year, and the IRS accepted the employer into the program, the employer would pay a fee of approximately $2,000 to address the periods of questionable classification. Absent this program, the employer would pay $26,600 in delinquent Medicare and Social Security taxes alone! This amount would also be increased by unpaid employee income taxes, penalties, and interest.
 The Voluntary Classification Settlement Program is part of the IRS Fresh Start program and a wonderful window to avoid burdensome delinquent taxes, penalties, and interest. If you have questions about the VCSP, please feel free to contact our office to learn more.

Failed Installment Agreement Proposal

Collection Due Process Hearing

In Richard H. Levin and Linda D. Levin v. Comm’r, T.C. Memo 2018-172, Filed October 15, 2018, the Tax Court ruled that IRS Appeals had acted appropriately in denying taxpayers’ proposal for an installment agreement and sustaining IRS Collections proposed levy action. Taxpayers created a liability for tax year 2010 of $468,696, prior to assessment of penalties and interest. Taxpayers’ representative proposed a payment agreement to the IRS wherein taxpayers would pay their liability within four months. During that time, taxpayers made a $50,000 payment. The IRS issued a final notice of intent to levy, at which point the taxpayers requested a Collection Due Process hearing with IRS Appeals. There is a lengthy narrative in this case regarding the details of financial information. During this time, the Appeals office indicated that the taxpayers must remain compliant with their current tax liabilities in order to qualify for a payment agreement. Taxpayers also requested a face to face meeting with IRS Appeals. IRS ultimately agreed to the face to face meeting – which caused a lengthy delay of over a year. Rather than take advantage of the time to liquidate assets and pay down the tax debt, taxpayers liquidated one of their four homes and paid off other creditors in an amount in excess of the IRS debt – approximately $575,000. These creditors included State taxing authorities and credit cards. They additionally capitalized taxpayer husband’s new law firm in the amount of $281,000. Persistently during negotiations with the IRS, the taxpayers’ representative argued that the filing of a tax lien would have a detrimental effect on taxpayer husband’s ability to earn income in his law firm. The Court ruled that the taxpayers “have repeatedly chosen not to prioritize payment of their 2010 outstanding Federal income tax liability. Indeed their failure to use net proceeds of $843,293 from the sale of their Los Angeles, California home to pay their 2010 liability was particularly brazen.” The Tax Court confirmed the reasonableness of the Appeals’ Settlement Officer to file a notice of Federal Tax Lien and to reject the taxpayers’ proposed installment agreement.

Failure to File Returns

I.R.C. section 6651

The United States Court of Federal Claims granted summary judgment in favor of the IRS to sustain penalties in the case of Shih-Fu Peng and Roisin Heneghan v. The United States, No 16-1263T, Filed October 24, 2018. The plaintiffs were assessed late filing penalties in relation to their 2012 tax return. They allege that their return was filed late due to four reasons: 1) The father of one of the taxpayers died in July 2012, 2) their child was born in January 2013, 3) The grandmother of one of the taxpayers died in October 2013, and 4) their accountant was at times unresponsive while trying to prepare their 2012 return. Of course the Court applied the standard of I.R.C . 6651(a)(1)-(2) in determining if relief was appropriate – was the failure to file due to reasonable cause and not due to willful neglect? Their argument relating to the accountant failed as they only argued that he was the reason they did not file their extension. Ultimately, their return was filed after the extension due date. As such, even if they were correct, their return was still filed late. As for the other events that delayed the taxpayers’ filing, the Court indicated that it has recognized personal hardship as reasonable cause for failure to timely fund under some circumstances – such as an illness or debilitation that, because of its severity or timing, make it virtually impossible for the taxpayer to comply. The Court also explained that a taxpayer could supply evidence of incapacity caused by mental or emotional circumstances. Unfortunately for these taxpayers, it was not clear that their life events made it “virtually impossible,” for them to comply with the filing deadline. As such, no relief was granted.

Innocent Spouse Relief: Income attribution

Income attribution rule addressed by Tax Court

In Connie L. Minton a.k.a. Connie L. Keeney v. Comm’r, T.C. Memo 2018-15, filed February 5, 2018, the Tax Court was asked to review an IRS Appeals’ decision denying innocent spouse relief based on equitable relief. In this case, taxpayer made application for relief after divorce. The return in question reflected income from a 401(k) withdrawal taxpayer instituted at the request of her former spouse – for the purpose of investing in a business venture that failed. Additionally, the spouse’s income from his business, along with a small amount of interest income was reported on the return. The Appeals officer indicated that the taxpayer’s request for relief failed because the tax was attributed to her income. Thus, it did not meet the threshold condition for relief. The Tax Court reviewed this decision and discussed the exceptions to the attribution rule. Those exceptions include: a) attribution due solely to the operation of community property law, b) nominal ownership, c) misappropriation of funds, d) abuse before the return was filed that affects the requesting spouse’s ability to challenge the treatment of items on the return or question payment of any balance due, and e) fraud committed by the nonrequesting spouse that is the reason for the erroneous item. Ultimately, the Court indicated that the taxpayer did not meet any of the exceptions and failed the threshold conditions as to her 401(k) withdrawal. The Tax Court, however, disagreed with Appeals in that they concluded the liability attributed to the nonrequesting spouse’s business income should not be attributed to the taxpayer because her involvement in the business was nominal only. This is a good discussion of some exceptions to the income attribution rule, not regularly reviewed by the Court.

Innocent Spouse Relief: Relief while married

Taxpayer obtains relief while still married

In Hudson v. Comm’r T.C. Summary Opinion 2017-7, filed February 8, 2017, the Tax Court granted equitable relief from joint and several liability under section 6015(f).  It is a rare case that the IRS grants relief to a taxpayer that requests innocent spouse relief, unless that individual is legally separated or divorced from the jointly liable taxpayer. The taxpayer and her husband remained legally married, but were essentially estranged.  Petitioner remained in the marriage because she “regards the vow of marriage as sacrosanct and does not believe in divorce.” The liability reported on the face of the return was largely from the early withdrawal penalty associated with Petitioner’s husband taking a distribution from his retirement account to finance the purchase of a piece of residential real estate – in his name alone. Though petitioner resided at this residence, the Tax Court did not believe she enjoyed a lavish lifestyle.  Petitioner held a bachelors degree and, while she was out of the workplace caring for their children during the year at issue, she later became employed in her field. At the time of filing the Petition in the Tax Court, she was unemployed and struggled with reasonable living expenses. The Court could not provide “streamlined” relief because the Petitioner remained married.  That triggered a facts and circumstances analysis where economic hardship and lack of significant benefit factored heavily into the Court’s grant of liability relief. 

Increased collection activity against federal employees’ Thrift Savings Plans (TSP)

The National Taxpayer Advocate has reported in its Fiscal Year 2016 Objectives report to Congress that a proposal by the IRS to expand collection efforts against retirement plans of federal employees “infringes on taxpayers’ rights to a fair and just tax system.” Federal employees have the ability to participate in the Thrift Savings Plan (TSP), which is similar to a private sector 401(k) plan in that employee savings are tax deferred and qualify for some level of employer, (in this case the federal government), matching.

Taxpayers, including federal government employees, who owe taxes are subject to IRS levy on their property and rights to property.  This power extends to retirement accounts, including the TSP.  However, given the importance of retirement savings to an individual’s welfare during old age, the IRS has historically regarded a levy on retirement funds as a special case that requires additional scrutiny and a manager’s approval. 

Essentially, before a field Revenue Officer can levy a retirement benefit, the agent would determine what property is available to levy – both retirement and non-retirement, determine if the taxpayer has acted in a flagrant manner, and finally determine if the retirement funds are required for necessary living expenses. There are distinct problems with these factors, but that has been partially mitigated by other requirements prior to issuance of the levy.  The field Revenue Officer must either secure the signature of the Area Director of Field collections, or secure a manager’s approval.

In order to obtain a collection manager’s approval in this instance, the field Revenue Officer is required to draft a detailed memo that sets out a summary of all information provided to the agent by the taxpayer, whether the taxpayer has exhibited any flagrant behavior, and more importantly, other collection alternatives that have been considered and rejected.  In other words, the retirement account falls into a secondary level of collection after the field Revenue Officer reviews other property or income to levy. 

Recent activity at the IRS has created a pilot program to levy TSP accounts.  Most importantly, and of greatest concern, this program will be administered by ACS employees.  ACS is the Automated Collection System unit.  When a taxpayer’s account is in ACS, it is not assigned to a single employee for collection, rather, there are various employees in functions and units that work on similar matters.  These employees do not receive the same level of financial analysis training as a field Revenue Officer. 

In addition to the reduced training received by ACS employees, the pilot program calls for ACS employees to document any information that a retirement is impending and that the taxpayer will be relying on funds from the TSP for necessary living expenses.  This lacks any analysis regarding other property the taxpayer may have that would be available to collect from, or if the taxpayer acted in a flagrant manner, all requirements of a field Revenue Officer. 

Finally, the pilot program requires managerial approval prior to levy on retirement accounts – but that is a requirement of many collection actions by ACS employees – hardly elevating these situation to a special case status.  What is not referenced is the required memo to the manager detailing information provided by the taxpayer and collection alternatives considered and rejected before proposing levy to the retirement account – all requirements of the field Revenue Officer.

In summary, the IRS is targeting one type of retirement account, the TSP, for increased collection activity, over all others. ACS does not have the ability to levy any other retirement accounts at this time.  The National Taxpayer Advocate believes that this pilot program undermines both taxpayer rights and retirement security policy.  As such, the National Taxpayer Advocate is going to continue to push the IRS to abandon the Thrift Savings Plan levy pilot program  If the IRS adopts the program, the National Taxpayer Advocate is prepared to accept all TSP levy cases coming from ACS.  Taxpayers should take advantage of this opportunity to protect their retirement income.  Additionally, where possible, taxpayers should seek assistance from the Appeals division in order to entertain collection alternatives through Appeals’ Collection Due Process hearing procedures.  Feel free to contact Caraker Law Firm, P.C. with any questions you may have. 

Notice of Deficiency

I.R.C. section 6213

The United States Tax Court in Jeffrey D. Gregory v. Comm’r, Docket No. 1090-16L, filed November 20, 2018, held that a “reprint” of a notice of deficiency is evidence of the creation of the notice before assessment, even though the reprint was prepared more than two years after the alleged mailing of the original notice and omitted or misstated information that would have appeared on any notice actually mailed. Further, the Court ruled, that the omission from a notice of deficiency of the last day to timely file a petition for re-determination does not invalidate the notice. This case was before the Tax Court for review of a determination by IRS Appeals Office to sustain the filing of a notice of Federal Tax Lien for unpaid income tax liabilities. The Petitioner conceded all aspects of the case except the validity of the notice of deficiency issued by the IRS. The IRS asserted that they issued the petitioner a notice of deficiency for the relevant tax period but admitted there was no copy of the original notice that could be reproduced. The Court ultimately ruled that it did not see why the reprints couldn’t serve as evidence that the IRS prepared the notice of deficiency, even if they were not deemed duplicates. The Court inferred from the inclusion in the IRS database of the information about the taxpayer on the reprint that it had created the notice of deficiency in accordance with its “customary practice.” As for the lack of a date to file the Petition in Tax Court, the reprint would not reflect that information as the IRS had explained this information is entered by hand when the original is issued.