DISREGARDED ENTITIES ARE NOT ALWAYS DISREGARDED

Under the check the box rules, entities owned by one person can often be disregarded for federal tax purposes. Such entities are referred to as "disregarded entities."

As time has progressed since the passage of the check the box rules, the IRS has created more and more exceptions to the disregarded treatment. For example, disregarded entity status is ignored or modified in regard to employment and withholding taxes of a disregarded entity.

The IRS has now issued final treasury regulations that provide that an entity whose disregarded status is ignored for employment tax purposes will be treated as a corporation. Treas. Regs. §301.7701-2(c)(2)((iv)(B).

It would be helpful to put in one place the several exceptions that now exist to disregarded entity status. The following is a summary of the principal exceptions, but is not intended to be exhaustive. If any readers think I have missed anything major, please feel free to comment to this posting and let us know what the item is.

     A. Status is modified if the single owner of the entity is a bank. Treas. Regs. §301.7701-2(c)(2)(iii).

     B. Status is modified for certain tax liabilities. Treas. Regs. §301.7701-2(c)(2)(iii). These include:  (1) federal tax liabilities of the entity with respect to any taxable period for which the entity was not disregarded; (2) federal tax liabilities of any other entity for which the entity is liable; and (3) refunds or credits of federal tax.

   C. Disregarded status ignored or modified for taxes imposed under Subtitle C—Employment Taxes and Collection of Income Tax (Chapters 21, 22, 23, 23A, 24, and 25 of the Internal Revenue Code) and taxes imposed under Subtitle A, including Chapter 2—Tax on Self-Employment Income. Treas. Regs. §301.7701-2(c)(2)(iv)(A).

     D. Status is modified for certain excise taxes, as described in Treas.Regs. §301.7701-2(c)(2)(v). Although liability for excise taxes isn't dependent on an entity's classification, an entity's classification is relevant for certain tax administration purposes, such as determining the proper location for filing a notice of federal tax lien and the place for hand-carrying a return under Code §6091 .

     E. Conduit financing proposed regulations will treat a disregarded entity as separate from its single member. Code §7701(l).

     F. Special rules will apply in hybrid situations. Hybrid situations are circumstances where an entity is not disregarded in one jurisdiction but is disregarded in another.

          (1) Hybrid payments made between a CFC and its hybrid branch, or between two hybrid branches of a CFC, would be recharacterized as subpart F income in the same amounts, if the conditions of the regulations are met. Those conditions are as follows: (1) the hybrid branch payment reduces the foreign tax liability of the payer; (2) the payment would have been FPHC income if paid between two CFCs; and (3) a disparity exists between the effective rate of tax on the payment in the hands of the payee and the hypothetical rate of tax that would have applied if the payment had been taxed to the payer. If no tax rate disparity exists, no recharacterization would occur. Proposed Regulations under TD 8827, 1999-30 IRB 120.

          (2) In certain cases, payments made by domestic reverse hybrid entities to related foreign interest holders are recharacterized as a dividend. Such payments are recharacterized as dividends to the extent of the interest holder's proportionate share of payments by the domestic entity to the domestic reverse hybrid entity that are treated as dividends by either jurisdiction. The recharacterization as a dividend means that the payments cannot be deducted by the domestic reverse hybrid entity. This prevents the use of a domestic reverse hybrid entity to make deductible payments to the foreign interest holder that are taxed at lower withholding tax rates. Treas.Reg. §1.894-1(d)(2)(ii)(B).

          (3) Special rules relating to allocation of foreign tax credits. Prop.Regs. §1.901-2(f)(3).

NO SURPRISE HERE

There has been quite a bit of buzz about a recent bankruptcy case involving an Alaska asset protection trust. However, the case merely confirms a weakness in the use of domestic asset protection trusts that was obvious even before this case.

Domestic asset protection trusts (DAPTs) promise the holy grail of creditor protection – a trust where the settlor/grantor can transfer assets to, be a discretionary beneficiary of, but still have the assets of the trust be protected from the settlor’s/grantor’s creditors. Alaska, Delaware, and Nevada are three popular jurisdictions for these trusts.

There are open questions about the effectiveness of the trusts for creditor protection purpose, including enforceability across state lines under the U.S. Constitution. A major issue is the 10 year voidability provision of 11 U.S.C. §548(e) that entered the U.S. Bankruptcy Code in 2005. That provision provides that a trustee in bankruptcy can reach the assets a debtor transferred to a trust:

that was made on or within 10 years before the date of the filing of the petition, if –

(A) such transfer was made to a self- settled trust or similar device;
(B) such transfer was by the debtor;
(C) the debtor is a beneficiary of such trust or similar device; and
(D) the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.

A transfer to a DAPT will typically meet the requirements of (A)-(C) above. The big question is whether a transfer to a DAPT demonstrates the requisite “actual intent to hinder, delay or defraud” under (D). Since DAPTs were created to address creditor issues, and are marketed as providing that benefit, a reasonable person would suspect that the use of one demonstrates the actual intent to hinder, delay or defraud, even if the settlor was not rendered insolvent by reason of the transfer. Note, however, that Alaska law expressly provides that a settlor’s expressed intent to protect trust assets from a beneficiary’s potential creditors is not evidence of an intent to defraud.

In Battley v. Mortensen, a bankruptcy court in Alaska found that a transfer to a DAPT could run afoul of 11 U.S.C. §548(e), even though the debtor was solvent at the time of creation of the trust. The court noted:

when property is transferred to a self-settled trust with the intention of protecting it from creditors, and the trust’s express purpose is to protect that asset from creditors, both the trust and the transfer manifest the same intent. In this case, I found that the trust’s express purpose could provide evidence of fraudulent intent.

The court did not give any effect to the provision of Alaska law that indicated the trust language could not be used as evidence of an intent to defraud. There were other factors that the court found that evidenced intent to defraud, so it is uncertain how the court would have ruled absent those other factors.

Nonetheless, the case confirms the exposure that the use of a DAPT leaves the door open to the reach of a trustee in bankruptcy within 10 years of the funding of the trust. Since a debtor can be placed in bankruptcy by his creditors on an involuntary basis, one cannot simply avoid this exposure by not filing for bankruptcy protection.

DAPTs are still useful for those that do not expect to have significant creditor issues within the next 10 years, but are in a high risk field and thus still desire its protections over an extended period beyond 10 years. Further, DAPTs can provide tax benefits via moving assets out of the taxable estate of a grantor while still allowing a discretionary beneficiary interest to the grantor. Nonetheless, in these circumstances, the constitutional issues regarding DAPTs still remain.

Battley v. Mortensen, Memorandum Decision & Memorandum on Defendant’s Motion for Reconsideration (Case No. A09-00565-DMD, United States Bankruptcy Court, D. Alaska)

DETAILED PROTECTIVE REFUND CLAIM GUIDANCE RELEASED

The IRS has released detailed guidance to taxpayers on how to file and administer protective refund claims for amounts that are not currently deductible under Code Section 2053 when the Form 706 is filed (such as contested or uncertain claims and expenses that have not yet been paid). As part of its guidance, the IRS announced that it will create a Schedule PC to be attached to the Form 706 to assist taxpayers in filing these protective claims at the time of filing of the Form 706.

FACTS

Final regulations under Code Section 2053 were published on October 20, 2009 to provide guidance in determining the deductible amount of a claim against a decedent's estate, particularly in regard to contested or uncertain claims and expenses. The final regulations provide, with certain exceptions, that the amount deductible for a Code Section 2053 claim or expense is limited to the amount actually paid in settlement or satisfaction of that claim or expense. For amounts not paid or otherwise deductible by the time the Form 706 is filed, the Regulations allow a protective refund claim to be filed. This allows for a refund to be sought later if amounts are paid or become deductible after the expiration of the estate tax statute of limitations. Rev.Proc. 2011-48 provides details on how to file and administer protective refund claim.

TIMING. The protective refund claim must be filed before the expiration of the Code Section 6511(a) statute of limitations. This is 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid.

CONTENT OF PROTECTIVE CLAIM. The protective claim must be a written declaration that is executed under penalties of perjury, listing each ground upon which a refund is claimed and facts sufficient to apprise the Commissioner of the exact basis of the claim. Required information includes:

a. An explanation of the reasons and contingencies delaying the actual payment to be made in satisfaction of the claim or expense.

b. Information on whether other protective claims for refund are being filed or were previously filed and the approximate date on which each was filed.

c. If the claim is being contested, specified information about the contested matter and the potential liability of the estate.

EVIDENCE OF AUTHORITY. The protective claim must be accompanied by documentary evidence, including certified copies of the letters testamentary, letters of administration, or other similar evidence, to establish the legal authority of a fiduciary or other person to file and pursue a protective claim for refund on behalf of the estate of a decedent. However, if the protective claim is filed by same person that submitted the Form 706, the only thing needed is a statement affirming that the fiduciary or other person filing the protective claim for refund also filed the Form 706 and that such fiduciary or other person is still acting in a representative capacity.

WHICH FORM TO USE. For decedents dying after October 19, 2009, and before January 1, 2012, the claim is filed using Form 843. For decedents dying on or after January 1, 2012, the claim can be filed on a Form 843, or on a Schedule PC filed with Form 706. This Schedule does not yet exist, but should simplify the process for making a protective claim if made at the time of the Form 706 filing.

SEPARATE CLAIM REQUIREMENT. A separate claim filing is required for each claim or expense for which a deduction may be sought. Multiple Schedules PC should be used, if making the claims with the Form 706 filing.

Related and ancillary expenses relating to resolving, defending, or satisfying the identified claim or expense as well as certain expenses relating to pursuing the claim for refund for the identified claim or expense are not considered separate claims for this purpose, but are included in the separate claim to which they relate.

REJECTION PROCEDURES. If a protective claim filing is rejected by the IRS, a corrected (and signed) protective claim for refund can be refiled before the expiration of the period of limitation or within 45 days after the date of the Service's notice of the defect, whichever occurs later. Thus, a defective election filed shortly before the expiration of the statute of limitations should have an opportunity to cure even though the statute runs out before receiving the Service’s rejection.

FOLLOW-UP REQUIREMENTS. The IRS will generally accept or reject filed protective claims, and notify the taxpayer. The taxpayer should contact the IRS if no IRS acknowledgment of the protective claim filing is received within 180 days of filing a Schedule PC or 60 days of filing a Form 843. If such taxpayer contact is not made within 30 days of the applicable deadline, an estate will lose the ability to correct a defective claim if the statute of limitations has expired (even if the estate has proof of mailing the protective claim to the IRS).

NOTIFICATION OF RESOLUTION OF CONTINGENCIES. To obtain a refund, the taxpayer must notify the IRS when the claim is ready for consideration (that is, once deductibility is permitted by reason of payment or otherwise meets the regulatory requirements for deduction). The notification generally should describe the relevant facts that support, and provide evidence to substantiate, a deduction under Section 2053 and should claim a refund of the overpayment of tax based on the deduction under Section 2053 and the resulting recomputation of the estate tax liability.

This notification must be submitted within a "reasonable period" after the item becomes deductible. There is a 90 day safe harbor that will meet the “reasonable period” requirement. If filed later, a reasonable cause explanation must be submitted. Special rules apply for multiple or recurring payments.

The Revenue Procedure provides specific information on what must be included in the notification, and whether the notification must be made on a Supplemental Form 706 or a Form 843.

MISC. The existence of a protective claim will not affect Form 706 audits. The new rules are applicable with respect to protective claims for refund filed on behalf of estates of decedents dying on or after October 20, 2009.

COMMENT

The drafters of the Revenue Procedure should be commended for providing detailed and precise rules to address most of the basic protective claim filing issues.

The ability to make a protective claim on a Schedule PC on the Form 706 is especially welcomed. This will make it easier for taxpayers to comply with the requirements. Also, it will help taxpayers avoid inadvertently missing the statute of limitations deadline for submitting the protective claim. Presently, many estates will defer filing a protective refund claim, instead adopting a wait-and-see attitude to see if claim and expense issues resolve themselves before the statute of limitations expires and hopefully avoiding the bother of a Form 843 filing. By easing the process for filing the protective claim, more taxpayers should take advantage of the procedure at the time the estate tax return is filed and thus avoid missing the deadline later. Indeed, the existence of the Schedule PC will likely educate some preparers that might not be knowledgeable of the protective claim procedure of its availability.

Note that some claims are deductible, even if not paid when the Form 706 is filed. These include executor and attorney fees (Treas. Regs. §20.2053-1(d)(4)), claims against the estate relating to property or claims included in the gross estate (Treas. Regs. §20.2053-4(b)), and claims not totaling more than $500,000 (Treas. Regs. §20.2053-4(c)). Taxpayers may still want to file a protective claim for additional amounts not reported on the Form 706 or that do not meet the foregoing statutory requirements. There is a trap, here, since the Revenue Procedure requires that such protective claims, in addition to meeting the regular protective claim requirements, the taxpayer must also disclose the amount of the deduction already claimed on the Form 706 for the subject claim or expense and must reference the regulatory provision under which the deduction was claimed. See §4.05(4) of the Revenue Procedure.

For more information regarding when uncertain or contested claims and expenses can be deducted under the Code Section 2053 regulations, I refer readers to my article on the subject in the March 2010 Journal of Taxation.

Rev. Proc. 2011-48

[This article will also be published on Leimberg Information Services, Inc.]

APPLICABLE FEDERAL RATES–NOVEMBER 2011

HERMAN CAIN’S 9-9-9 TAX PLAN IS REALLY JUST A FANCY 25.38% NATIONAL SALES TAX

According to the Tax Policy Center, presidential candidate Herman Cain’s 9-9-9 tax plan is essentially three sales taxes.

Obviously, the 9% national sales tax component is just that – a retail sales tax.

The business tax component is effectively a subtraction method value-added tax, or a business transfer tax. It is a 9% tax on all sales minus purchases from other businesses. It is the same as a retail sales tax, but it is collected in pieces on the value added at each stage of production. In the aggregate, all retail sales are then taxed under this component.

The 9% individual flat tax is also a subtraction method value-added tax, except that businesses may deduct wages and workers are taxed on their wages. A charitable contribution deduction may be allowed.

The plan has the merits of a certain level of simplicity, the removal of various tax regimes (such as estate and gift taxes) and the spreading of the tax burden. It has the detriments of a lack of progressivity (if you consider that a detriment based on your political beliefs, although persons below the poverty line are exempted from the taxes), being a disincentive to consumer purchasing, and the introduction of a tax regime (the VAT) that many blame for the anemic economies of Europe.

Whatever its pros and cons, this is the first I have seen it characterized as being effectively a combined 25.38% national sales tax (which would be in additional to state and local sales taxes).

TAX POLICY CENTER ANALYSIS

SHAM PARTNERSHIP STRIPS PARTNER OF DESIRED LOSSES

A recent case before the 5th Circuit Court of Appeals provides an instructive illustration of a sham partnership.

A condensed version of the facts are as follows (with some liberties taken to keep this simple):

1. LLC formed, with Chinese government-owned financial institution (Cinda) and  a 1% third party. Cinda contributes $1.1 billion portfolio of nonperforming loans. A U.S. investor (Beal) contributes $180 million of GNMA securities to the LLC and buys 90% of Cinda’s interest from Cinda for $19.4 million. Lots of strings are tied to the LLC’s ability and economic benefits from the GNMA securities, all running to the benefit of Beal.

2. The loans are carried on the LLC books at a tax-loss, since Cinda invested much more into them than current value. Normally, when these losses are realized by the LLC, they would be allocated back to Cinda under Section 704(c). However, by buying most of Cinda’s interest, Beal now gets the benefit of most of the losses when they arise. Since he obtained a large basis in the LLC via his investment of the GNMA securities, he has a large basis against which to use the losses.

3. The LLC operates, and losses are generated and allocated to Beal. Cinda, who is responsible for servicing the loans, does a terrible job, and in fact threatens to bring the matter to the IRS if the LLC and Beal don’t stop bothering it about its failure to properly service the loans. The LLC and Beal back down, and indeed do another deal with Cinda.

The IRS sought to challenge the losses taken by Beal. The court affirmed the lower court that the acquisition of the loans had economic substance. Unfortunately for the taxpayer, the court also affirmed a finding that the LLC was a sham partnership. Beal was instead treated as having bought the loans directly and receiving a tax basis equal to what he paid – and thus lost the ability to deduct Cinda’s losses (as successor partner to Cinda) on the loan portfolio.

Under the Supreme Court’s decision in Culbertson, whether a partnership will be respected for tax purposes depends on whether “the parties in good faith and acting with a business purpose” genuinely “intended to join together for the purpose of carrying on the business and sharing in the profits and losses.” This determination is made in light of all the relevant facts and circumstances. The appellate court focused on three particular aspects of this test.

LACK OF AN INTENT TO JOIN TOGETHER. At first, it does appear that the partners intended to operate a joint venture to make a profit on collecting the nonperforming loans. However, when the partners failed to force Cinda to fulfill its functions as loan servicer (after Cinda threatened to disclose the transaction to the IRS), the court determined that the tax benefit was the real purpose of the transaction, not the potential profits from loan collections. It also did not help that Cinda obtained regulatory approval for the transaction by indicating that its retained 10% LLC interest was only “symbolic” and characterizing its transaction as a “package sale of bad debts.”

LACK OF INTENT TO SHARE PROFITS AND LOSSES. Again it first, such an intent appears – Beal did after all contribute $180 million of GNMA securities to the LLC which were at risk of loss. However, by retaining the rights to income, and controlling the use and disposition of funds and the securities themselves, the court found that Beal personally received all of the potential benefits from those securities and retained all of the risks. Even though Cinda could benefit from appreciation in those securities, Beal’s ability to control any sales of the securities substantially diminished any chance of Cinda benefitting in this manner. Thus, there was a lack of intent to share profits and losses.

LACK OF A BUSINESS PURPOSE. This question focused on whether there was a non-tax need to form the LLC to profit from the nonperforming loans investment – or whether it was all about tax benefits. The taxpayer raised six reasons why an LLC was needed, but the court did not buy into any of them.

Thus, the court found that Beal directly purchased the loans from Cinda. The LLC was ignored, and the loss benefits predicated on the partnership form, disappeared.

The court did not impose any penalties on the taxpayer based on tax opinions obtained from a law firm and an accounting firm that the taxpayer relied on.

SOUTHGATE MASTER FUND, L.L.C. v. U.S., 108 AFTR 2d 2011-XXXX, (CA5), 09/30/2011

MORTGAGE INTEREST DEDUCTION ALLOWED, EVEN WITHOUT A RESIDENCE

Section 163(h) of the Code allows a deduction for qualified residence interest. This is interest paid or accrued on acquisition indebtedness with respect to any qualified residence of the taxpayer (or home equity indebtedness), subject to maximum debt limits.

A "qualified residence" is the principal residence of the taxpayer, and one other residence used by the taxpayer as a residence.

In a recent Tax Court case, a taxpayer purchased land, upon which he was going to build a residence. He took out a mortgage loan to buy the property. He then started the design and approval process to build the residence. Two years after, everything was set for construction to begin. However, because of the decline in the real estate market, the taxpayer could not obtain financing for additional funds needed for construction. The house was never built and the taxpayer eventually sold the land (for a large loss).

The taxpayer deducted the interest he paid on the mortgage loan for two years as qualified residence interest. The IRS disallowed the deductions, claiming that there was never a "qualified residence."

The Tax Court sided with the taxpayer and allowed the deduction, even though the residence was never built. The key provision allowing deductibility was Treas.Regs. Section 1.163-10T(p)(5) which allows a taxpayer to treat a residence that is UNDER CONSTRUCTION as a residence for up to 24 months after construction has begun. The Court did not care that the residence was never completed. In effect, it would be illogical for the deduction to be ultimately determined on whether a residence is built, since the deduction that is allowed for the 2 year construction period would have to be taken on a return oftentimes before it is known whether construction will be completed. This would violate the principle that each tax year stands on its own.

The court was also generous with the term "construction." It held that construction began even before the taxpayer acquired the land, since the taxpayer required the seller to demolish an old house on the lot and clear the land before closing. Further, taxpayer's permitting process was also considered to be construction.

Rose v. Commissioner, T.C. Summary Opinion, 2011-117

SETTLEMENT ALLOCATION PRINCIPLES, IN ACTION

When amounts are paid in settlement of litigation, different tax consequences can apply based on what the payments are for. For example, punitive damages will typically generate ordinary income for the recipient, while payments for damage to goodwill can generate capital gain. Such differing tax consequences bring about taxpayer efforts to characterize payments in the manner most favorable to them.

Two principles are important in determining whether the IRS will respect an agreed-upon characterization of settlement proceeds.

The first is the origin of the claim doctrine, under which the tax treatment of the proceeds of a settlement or judgment will depend on the nature of the claims made and the actual basis of the recovery. The tax consequences of a settlement depend on the nature of the claim that was the basis for the settlement, rather than the validity of the claim.

The second is that the IRS will be more likely to respect a settlement allocation of the parties if they have adverse interests as to that characterization. If one party is indifferent to the allocation, or both parties obtain tax advantages from the same characterization, the risk of IRS challenge is heightened. 

A recent Tax Court case demonstrates the real world application of these principles. The case involved the settlement of a lawsuit for false advertising, unfair competition, and trademark dilution, with damages relating to loss of goodwill and reputation, lost profits, and punitive damages.

ORIGIN OF THE CLAIM. The Tax Court determined that the character of the settlement proceeds paid was to be allocated among the various claims made, in accordance with the origin of the claim doctrine. The parties characterized only a relatively small portion of the settlement to lost profits (an item which would produce ordinary income and not capital gain to the recipient) and no portion to punitive damages (another ordinary income item).  Under the origin of the claim doctrine, the settlement proceeds should have been allocated among all the claims made.

ALLOCATION AMONG CLAIMS – NO ADVERSE INTERESTS. The court determined that the parties’ allocation was suspect since the payor was generally indifferent to the characterization (and the payee would benefit from allocations away from ordinary income items). Thus, the parties did not have an adverse interest to each other and their allocation was subject to much higher scrutiny. As to the punitive damages question, the taxpayer pointed out that the payor was against paying punitive damages and was not indifferent, since it would put the payor in a bad light and implied wrongdoing. Thus, the implied argument was the allocation away from punitive damages was not collusive and done solely to avoid ordinary income for the recipient, but was a bargained for element by the payor and was perhaps sought but compromised away by the recipient. This was an interesting argument, but the Tax Court did not buy into it since the payor was agreeable to the amount to be paid for punitive damages but just didn’t like the label applied.

An important aspect of this case is that just because the settlement arises from a bona fide dispute involving unrelated and truly adverse parties, the parties cannot count on IRS acceptance of a damages allocation unless the parties have adverse interests over the allocation itself. The type of adversity that most impresses courts in these circumstances is where a given type of payment produces a tax negative for one party while producing a better tax result for the other – that was not the situation here.

ALLOCATION AMONG CLAIMS – THE SEARCH FOR OBJECTIVE EVIDENCE. The origin of the claim doctrine does not provide any direct guidance on how to allocate settlement proceeds among various claims when there is more than one. In this situation, one can expect taxpayers, the IRS, and courts, to search for objective guidelines to use in the allocation. Such objective guidelines may not always exist – however, in the instant case they did. The lawsuit at issue was actually the second lawsuit arising from similar facts and claims. Since the original lawsuit was tried and a judgment was made by a jury that allocated the damages, the Tax Court used the percentage allocations from that case and applied them to the settlement.

ALLOCATION AMONG CLAIMS – OTHER HELPFUL ASPECTS. Taxpayers seeking to uphold an allocation that does not involve truly adverse issues should look long and hard for some methodology or expert opinion to help backstop their allocation. Such contemporaneous methodology and analysis will put the taxpayer in a better defensive position than the parties simply agreeing on an allocation with no methodology or analysis to justify it.

Healthpoint, Ltd, et al, TC Memo 2011-241

IRS TEMPTS EMPLOYERS WHO HAVE BEEN MISCLASSIFYING EMPLOYEES

Employers have a strong withholding and employment tax incentives to classify their workers as independent contractors instead of employees. Such a course avoids income tax withholdings and FICA, FUTA, and Medicare taxes and withholdings, shifting responsibility of such items to the worker.

As such, employers may have aggressively or inappropriately classified employees as independent contractors. An IRS settlement program known as the “Voluntary Classification Settlement Program,” or VCSP, provides a semi-painless way for employers to correct their classifications and come into the fold of compliant taxpayers. A recent set of FAQs provides details on the new program. Below is a summary of the key provisions.

WHO CAN USE THE PROGRAM?

Businesses, tax-exempt organizations, and government entities.

BASIC ELIGIBILITY REQUIREMENTS

To be able to apply, the employer must:

     (1) have consistently treated the subject workers as nonemployees,

     (2) have filed all required Forms 1099 for the workers for the previous three years, and

     (3) not be under audit by IRS, or currently under audit concerning the classification of the workers by the Department of Labor or a state government agency.

EFFECT OF PROGRAM

The employer will have to pay a relatively small sum to enter the program, but will then receive absolution for its mischaracterizations for past years. More particularly, the employer  will:

     (1) owe 10% of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, applying the special reduced rates of Code Section 3509, and without interest or penalties being imposed on that liability,

     (2) be safe from an employment tax audit for the worker classification of the subject workers for prior years, and

      (3) have to agree to extend the period of limitations on assessment of employment taxes for three years for the first, second and third calendar years beginning after the date on which the taxpayer has agreed under the VCSP closing agreement to begin treating the workers as employees.

Of course, the employer will begin classifying the subject workers as employees and paying appropriate employment and withholding taxes.

Given the relatively small amount that is due, the program provides an excellent opportunity for taxpayers to put themselves into compliance. In an example provided in the FAQ, an employer who paid $1,500,000 to workers in the subject tax year owed only $16,020 for the required 10% payment.

Application for the program is made on Form 8952, Application for Voluntary Classification Settlement Program. More information on the VCSP is available in Announcement 2011-64.

Voluntary Classification Settlement Program (VCSP) Frequently Asked Questions