CARPENTER WIGGINS JORDAN THOMAS & SCARBOROUGH PC

The IRS has announced a significant increase in enforcement actions for syndicated conservation easement transactions. This is a "priority compliance area" for the agency.

Throughout the IRS, coordinated examinations are being conducted in the Small Business and Self-Employed (SB/SE) Division, Large Business and International (LB&I) Division, and Tax Exempt and Government Entities (TE/GE) Division. The IRS Criminal Investigation (CI) Division has also been initiating investigations. The audits and investigations cover billions of dollars of potentially inflated deductions, as well as hundreds of partnerships and thousands of investors.

"We will not stop in our pursuit of everyone involved in the creation, marketing, promotion and wrongful acquisition of artificial, highly inflated deductions based on these aggressive transactions. Every available enforcement option will be considered, including civil penalties and, where appropriate, criminal investigations that could lead to a criminal prosecution," said IRS Commissioner Charles "Chuck" Rettig. "Our innovation labs are continually developing new, more extensive enforcement tools that employ advanced techniques. If you engaged in any questionable syndicated conservation easement transaction, you should immediately consult an independent, competent tax advisor to consider your best available options. It is always worthwhile to take advantage of various methods of getting back into compliance by correcting your tax returns before you hear from the IRS. Our continued use of ever-changing technologies would suggest that waiting is not a viable option for most taxpayers," he added.

Syndicated Conservation Easements

The IRS issued Notice 2017-10, I.R.B. 2017-4, 544, in 2016, which designated certain syndicated conservation easements as listed transactions. In these types of transactions, investors in pass-through entities receive promotional material which offer the possibility of a charitable contribution deduction worth at least two-and-a-half times their investment. The deduction taken in many transactions has been significantly higher than 250 percent of the investment.

Syndicated conservation easements were included on the IRS’s 2019 "Dirty Dozen" list of tax scams to avoid.

Not only do these transactions grossly overstate the value of the easement that was purportedly donated to charity, they often also fail to comply with the basic requirements for claiming a charitable deduction for a donated easement.

Taxpayers may avoid the imposition of penalties for improper contribution deductions if they fully remove the improper contribution and related tax benefits from their returns by timely filing a qualified amended return or timely administrative adjustment request.

Enforcement Actions

The IRS has prevailed in many cases involving the charitable deduction basic requirements, and has established a body of law that it believes supports disallowance of the deduction in a significant number of pending conservation easement cases. The IRS will soon be moving the Tax Court to invalidate the claimed deductions in all cases where the transactions fail to comply with the basic requirements, leaving only the final penalty amount to be determined.

In addition to auditing participants in syndicated conservation easement transactions, the IRS is pursuing investigations of promoters, appraisers, tax return preparers and others, and is evaluating numerous referrals of practitioners to the IRS Office of Professional Responsibility. The IRS will develop and assert all appropriate penalties, including:

penalties for participants (40 percent accuracy-related penalty);
penalties for appraisers (penalty for substantial and gross valuation misstatements attributable to incorrect appraisals);
penalties for promoters, material advisors, and accommodating entities (penalty for promoting abusive tax shelters, and penalty for aiding and abetting understatement of tax liability); and
penalties for return preparers (penalty for understatement of taxpayer’s liability by a tax return preparer).

Rettig, Desmond Highlight Heightened Focus

Rettig and IRS Chief Counsel Michael J. Desmond have each highlighted the IRS’s heightened, agency-wide focus on syndicated conservations easements.

While speaking at the American Institute of CPAs (AICPA) 2019 National Tax Conference in Washington, D.C., Rettig and Desmond both separately underscored the IRS’s increased enforcement efforts toward abuses of certain tax-advantaged land transactions under Code Sec. 170(h).

"We appreciate the value of conservation easements," Rettig said. "We do not appreciate the activities that have gone on with respect to the syndicated conservation easements—there are some artificial appraisals there… some fatal flaws."

Reiterating the IRS’s tough stance on the matter, Rettig said that the IRS is not going to "stand down." The information in IR-2019-182 issued on November 12 was "fair warning," Rettig said.

Likewise, Desmond stressed that the challenges surrounding syndicated conservation easements are an "institutional concern" for the IRS, "one that we will be responding to," he emphasized.

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Treasury and the IRS are expected to release proposed rules in "early 2020" that would clarify certain limitations on the carried interest tax break, according to David Kautter, Treasury’s assistant secretary for tax policy. Kautter briefly addressed the proposed regulations’ timeline while speaking at the American Institute of CPAs (AICPA) 2019 National Tax Conference in Washington, D.C.

Carried Interest Limitation

The forthcoming regulations are expected to restrict S corporations from taking advantage of a carried interest exemption provision under the Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97). The TCJA requires certain money managers to hold investments for at least three years before becoming eligible for the lower, 20 percent capital gains rate. However, it exempted corporations from this holding period, which Treasury and many lawmakers on Capitol Hill say resulted in an unintended "loophole."

The proposed regulations are expected to clarify the law’s intent that S corporations are subject to the three-year holding period for carried interest, according to Treasury’s last press release on the matter issued in March 2018 (see "Treasury, IRS Issue Guidance On Carried Interest," at https://home.treasury.gov/news/press-releases/sm0302).

Legal Questions May Arise

Most notably, however, the TCJA does not expressly contain this limitation on S-corporations, which has left some on Capitol Hill questioning Treasury and the IRS’s authority to implement such a restriction via regulations. The IRS on November 15 directed Wolters Kluwer to Treasury for confirmation on this anticipated rule and projected timeline. As of press time, Treasury had not responded to Wolters Kluwer’s request for comment.

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Hopes for a year-end tax extenders package appear to be dwindling on Capitol Hill.

Tax Extenders Need a Legislative Vehicle

Over 30 expired or soon-to-be expired tax breaks known as tax extenders were originally considered a top contender for hitching a ride on a larger, must-pass government funding bill. Considering the lack of time left on the legislative calendar this year, a stand-alone tax bill has been considered an unlikely initiative. Thus, a must-pass appropriations bill was seen by several lawmakers as the likely legislative vehicle for tax extenders and other tax items such as technical corrections to Republicans’ 2017 tax reform law.

However, a spokesperson for Senate Finance Committee (SFC) Chair Chuck Grassley, R-Iowa, confirmed to Wolters Kluwer on October 28 that Grassley believes there is "no hope" for action this year on a tax extenders package if lawmakers do not move quickly with respect to its legislative driver. Many within the practitioner community following these developments have said that the chances of providing taxpayers with certain tax breaks retroactively significantly decrease if Congress moves into next year leaving them expired.

Another Stopgap Spending Bill Appears Likely

Currently, the federal government is operating on a stopgap spending bill temporarily extending fiscal year (FY) 2019 funding levels through November 21. Previously, several lawmakers, in particular Grassley, had hoped that a tax extenders package would be attached to a larger, more comprehensive appropriations bill next month. However, Senate Appropriations Committee Chair Richard Shelby, R-Ala., told reporters that another short-term stopgap spending bill is the more likely option to keep the government open after November 21. "Unless a miracle happens around here with the House and Senate, we will have to put forth another [continuing resolution] CR," Shelby told reporters.

Notably, another short-term government funding bill is considered unlikely to have any policy riders. Generally, stop gap spending bills are usually considered "clean," for the most part. Also playing a role in tax extenders’ fate is whether President Trump would sign a more comprehensive appropriations bill. At this time, his support for a larger FY 2020 funding bill, apart from tax policy reasons, remains unclear.

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Senate Finance Committee (SFC) Chair Chuck Grassley, R-Iowa, and other top Senate tax writers are calling for Senate action on the bipartisan Setting Every Community Up for Retirement Enhancement Secure bill (HR 1994) (SECURE Act). The House-approved, bipartisan retirement savings bill has remained stalled in the Senate since May.

SECURE Act’s Route to Senate Floor Remains Unclear

Grassley’s communications director Michael Zona told Wolters Kluwer on October 21 that it remains "unclear at this point" whether the SECURE Act will move through committee, reach the Senate floor by unanimous consent, or be attached to a larger, year-end tax package. "Grassley supports the House-passed SECURE Act. There are several holds on the bill, and he is working to get them lifted," Zona said.

The SECURE Act cleared the House on May 23 by a 417-to-3 vote. The bipartisan measure, which proposes sweeping changes to retirement savings tax policy, was originally expected to quickly clear the Senate after its approval in the House. However, Sen. Ted Cruz, R-Tex., blocked the bill from reaching the Senate floor. Cruz blocked the bill in protest of House Democrats’ 11th hour-removal of a provision from the original bill that would have expanded tax-advantaged Section 529 education savings plans to include homeschooling and certain elementary and secondary expenses. Cruz and Sen. Patty Murray, D-Wash., are reportedly still holding up the measure from reaching the Senate floor.

Catch-All Tax Package

However, the SECURE Act, among other bipartisan tax-related items including tax extenders, could be attached to a catch-all tax package that is expected on Capitol Hill to hitch a ride on a year-end government funding bill. A "must-pass" appropriations bill, like the one currently being negotiated to keep the government open after funding expires on November 21, could serve as the tax package’s legislative vehicle, thus fast tracking its approval.

"As the economy continues to change, the way we approach retirement savings must change as well. Otherwise, too many Americans will be left behind," Grassley said on October 21, noting that the SECURE Act is under "active consideration."

Similar to Grassley’s push, Sen. Tim Scott, R-S.C., led a letter sent to Senate Majority Leader Mitch McConnell, R-Ky., urging immediate Senate consideration of the SECURE Act. "This bipartisan legislation would expand access to retirement plans for millions of Americans, allow older workers and retirees to contribute more to their retirement accounts, increase 401(k) coverage to part-time employees, prevent as many as 4 million people in private-sector pension plans from losing future benefits, protect 1,400 religiously affiliated organizations whose access to their defined contribution retirement plans is in jeopardy, and do the right thing for Gold Star families," according to Scott.

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The Senate blocked a Democratic resolution on October 23 to overturn Treasury rules preventing certain workarounds to the $10,000 state and local tax (SALT) federal deduction cap.

SALT Cap Workaround

Senate Democrats’ resolution, S.J. Res. 50, forced a vote on Wednesday to nullify Treasury regulations that block taxpayers from circumventing the SALT cap through certain states’ programs that convert state and local taxes into fully deductible charitable contributions. The resolution failed by a largely party-line vote of 43-to-52.

Sen. Michael Bennet, D-Colo., voted against the Democratic measure while Sen. Rand Paul, R-Ky., supported it. While the resolution would not repeal the SALT cap itself, House Democrats are reportedly crafting legislation to do so. Democrats and some Republicans, particularly from high-tax states, have criticized the SALT cap since its enactment in 2017 under the Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97).

Debate on SALT Cap, Treasury Rules

"Without any clear authority to do so, the Treasury Department reversed a long-standing IRS position that had allowed taxpayers a full deduction for charitable contributions to state tax credit programs," Senate Finance Committee (SFC) ranking member Ron Wyden, D-Ore., said on the Senate floor before the vote. "My view is the Treasury Department should not be putting its thumb on the scale on behalf of Republican interests, and it shouldn’t be using phony regulatory justifications to fix Republicans’ extraordinarily poorly drafted law."

However, several Republicans cited to a recent report from the nonpartisan Joint Committee on Taxation (JCT), which estimated that repealing the SALT cap beginning in 2019 would result in over $40 billion of the associated tax cut going to taxpayers with incomes of at least $1 million ( JCX-35-19).

"It’s bad enough that my Democratic colleagues want to unwind tax reform, but it’s downright comical that their top priority is helping wealthy people in blue states find loopholes to pay even less," Senate Majority Leader Mitch McConnell, R-Ky., said from the Senate floor on October 23. "Repealing the SALT cap would give millionaires an average tax cut of $60,000. Meanwhile, the average tax cut for taxpayers earning between $50,000 and $100,000 would be less than ten dollars."

Vaping Tax

In other news, the House Ways and Means Committee approved a bipartisan vaping tax bill, ( HR 4742), on October 23 by a 24-to-15 vote. The bill would establish a $27.81 tax per gram of nicotine used in vaping devices.

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Treasury and the IRS on October 31 announced the release of a new, draft form implementing certain reporting requirements under the Tax Cuts and Jobs Act Opportunity Zone program.

The proposed Form 8996 for Qualified Opportunity Funds (QOFs) comes after numerous calls on Capitol Hill for more transparency within the Opportunity Zone program. "The form is designed to collect information on the amount of investment by opportunity funds in business property by census tract," according to a Treasury press release.

Opportunity Zones’ Architect Applauds Treasury’s Steps Toward Reporting Requirements

Ken Farnaso, press secretary for Sen. Tim Scott, R-S.C., chief architect of the TCJA’s bipartisan Opportunity Zone program, told Wolters Kluwer on October 31 that reporting requirements, "an important piece of the puzzle," were, in fact, originally in the bill. "Unfortunately, during the tax reform process, Senate Democrats blocked these requirements from being included in the Tax Cuts and Jobs Act. Since then, Senator Scott has continued working to restore those reporting requirements," Farnaso said.

Additionally, Farnaso told Wolters Kluwer that Scott applauds Treasury’s steps to ensure a clearer picture of the impact the Opportunity Zones initiative can have on the country. "Senator Scott will also continue to push for his current bill restoring robust reporting requirements to create a holistic picture of how the initiative is functioning," Farnaso said. "Overall, today is a good day for Opportunity Zones. We look forward to the more than $44 billion in currently anticipated investment being deployed in distressed communities across the nation, and that number growing even larger in the future."

Opportunity Zones Tax Incentive

The Opportunity Zone Program enacted under TCJA ( P.L. 115-97) is considered on Capitol Hill as one of the most generous and ambitious tax incentives for investors in distressed communities. Under Code Sec. 1400Z-2, investors may defer taxation of capital gains that are invested in a QOF.

Generally, the following investor tax benefits were created under the Opportunity Zone program:

a temporary tax deferral for capital gains realized on the sale of appreciated assets and reinvested within 180 days in a QOF;
the elimination of up to 10 or 15 percent of the tax on the capital gain that is invested in the QOF and held between five and seven years; and
the permanent exclusion of tax when exiting a qualified opportunity fund investment held for at least 10 years.

Draft IRS Form 8996

Specifically, the new, draft Form 8996 for the 2019 tax year requires QOFs to report the following information:

the Employer Identification Number (EIN) of each business in which the QOF has an ownership interest;
the census tract location of the tangible property of the business;
the value of the QOF’s investment; and
the value and census tract location of qualified business property directly owned or leased.

"This is an important step towards a thorough evaluation of the Opportunity Zone tax incentive," Treasury Secretary Steven Mnuchin said. "We want to understand where Opportunity Zone investments are going and strengthening the economy so that investors and communities can learn from the successes of this bipartisan, pro-growth policy."

Generally, the collection of this information will play a role in allowing lawmakers and the public to evaluate the effects of the tax incentive and to understand why some locations may be more successful than others at attracting investment, according to Treasury.

Opportunity Zones Criticism

The Opportunity Zone program has not come to fruition without its share of criticism, however. Although lawmakers have called for reporting requirements related to QOFs since the TCJA’s enactment, the program has recently come under increased scrutiny and criticism. Senate Finance Committee (SFC) ranking member Ron Wyden, D-Ore., has said that the lack of reporting requirements are "inexcusable."

"Requiring taxpayers to prove they’re actually following the rules of the Opportunity Zone program is a positive first step, but it’s one that should have been taken two years ago…," Wyden said in an October 31 statement. "The Opportunity Zone program has been operating without any effort to ensure compliance and that’s inexcusable."

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A California-based medical marijuana dispensary corporation’s motion for summary judgment challenging the constitutionality of Code Sec. 280E was denied. The Tax Court also addressed whether Code Sec. 280E applies to marijuana businesses legally operating under state (California) law, and whether the prohibition on deductions is limited to ordinary and necessary business expenses.

Section 280E

Congress enacted Code Sec. 280E after the court had allowed certain deductions for expenses incurred in connection with an illegal drug trade. Generally, Code Sec. 280E disallows any deductions attributable to a taxpayer’s illegal drug related trade or business. Taxpayers may reduce their income by the cost of goods sold (COGS), and Code Sec. 280E does not generally disallow deductions attributable to a taxpayer’s non-drug-related business.

Constitutionality

The Eighth Amendment of the Constitution prohibits excessive fines or penalties. The dispensary in this case claimed that Code Sec. 280E is a punitive provision that violates the Eighth Amendment. However, because Congress generally has the power to levy taxes under the Sixteenth Amendment, the Tax Court found that the law’s denial of certain deductions cannot be construed as a penalty.

Legality Under State Law

The dispensary also argued that its actions could not be considered "trafficking" for purposes of Code Sec. 280E because its activities were not illegal under California law. The court noted that because marijuana is still considered a Schedule I controlled substance and is banned under federal law, the application of Code Sec. 280E does not depend on the legality of marijuana sales under California law.

Additional Deductions

Finally, the dispensary argued that Code Sec. 280E only applies to deductions under Code Sec. 162, and that other deductions such as those under Code Secs. 164 and 167 should be permitted. However, the text of Code Sec. 280E broadly states that "no deduction or credit shall be allowed." It does not limit the deductions to those claimed under Code Sec. 162.

Dissenting Opinions

The Tax Court decision included several concurring and dissenting opinions, which primarily addressed the issue as to whether Code Sec. 280E is in fact a penalty provision that would violate the Eighth Amendment.

The dissenting opinions found that Code Sec. 280E is punitive in nature. One dissenter noted that rather than specify a narrow range of disallowed expenses, Code Sec. 280E attacks the entire marijuana industry with a broad denial of otherwise allowable deductions. The opinion stated that Congress passed Code Sec. 280E order to deter the sale of controlled substances and to penalize the drug trade. That intent was found to be "clearly in the nature of a penalty." Both dissents concluded with two additional questions, which the dissenters felt need to be addressed:

Is the punitive nature of Code Sec. 280E excessive to the point where it violates the Eighth Amendment?, and
Does the Eighth Amendment apply to corporation taxpayers?

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The IRS has proposed regulations that define an eligible terminated S corporation (ETSC), and provide rules relating to distributions of money by an ETSC after the post-termination transition period (PTTP). The proposed regulations also extend the treatment of distributions of money during the PTTP to all shareholders of the corporation, and update and clarify the allocation of current earnings and profits to distributions of money and other property.

Code Sec. 1371(f), as added by the Tax Cuts and Jobs Act ( P.L. 115-97) extends the period during which C corporation shareholders can benefit from the corporation’s accumulated adjustment account (AAA) generated during its former status as an S corporation. Specifically, the provision allows the C corporation to source qualified distributions of money to which Code Sec. 301 would otherwise apply to in whole or part to AAA. The provision only applies if the corporation is an ETSC as defined in Code Sec. 481(d).

Under the proposed regulations, the revocation of S corporation status may be made during the two-year period beginning on December 22, 2017, even if the effective date for the revocation occurs after the conclusion of the two-year period.

Shareholder Identity Requirement

A former S corporation is not an ETSC unless the owners of its stock are the same owners (and in identical proportions) on December 22, 2017, and on the date of the S corporation revocation. The proposed regulations identify various categories of stock transfers that are not considered an ownership change for purposes of this rule.

ETSC Proration

A distributing ETSC’s AAA is allocated to qualified distributions and the distributions are chargeable to the ETSC’s accumulated earnings and profits (AE&P) based on the ETSC proration. The ETSC proration is implemented in a manner that facilitates the prompt distribution of AAA and full transition to C corporation status. Specifically, the proposed regulations:

specify the time at which amounts of AAA and AE&P are determined for purposes of the ETSC proration;
provide AAA and AE&P ratios used to the implement the proration; and
describe in detail the method of characterizing qualified distributions.

The proposed regulations adopt a "snapshot" approach under which amounts of AAA and AE&P are determined on a specified date. As a result, the same ETSC proration is applied to all qualified distributions. Under the proposed regulations, the determination date is the date when the S corporation revocation election is effective. A "dynamic" approach that recalculated the amounts before each qualified distribution was rejected as administratively cumbersome.

The proposed regulations provide two ratios for determining the part of a qualified distribution that is sourced from AAA and from AE&P. The AAA ratio is the ratio of historical AAA to the sum of historical AAA and historical AE&P. The AE&P ratio is the ratio of historical AE&P and the sum of historical AAA and historical AE&P. The qualified distribution is multiplied by these ratios to determine the amount sourced from AAA and AE&P.

The proposed regulations provide a priority rule under which ETSC proration first applies to qualified distributions during the tax year. The rules of Code Sec. 301 and allocation rules of Code Sec. 316 then apply to any nonqualified distributions that are not fully accounted for by the ETSC proration because the corporation’s AAA or AE&P are exhausted.

Effective Date

The proposed regulations will be effective in tax years beginning after the date they are published as final regulations. A taxpayer may apply the regulations in their entirely to tax years that begin on or before the date of publication as final regulations.

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Taxpayers recovering from the current economic downturn will get at least some relief in 2013 by way of the mandatory upward inflation-adjustments called for under the tax code, according to CCH, a Wolters Kluwer business. CCH has released estimated income ranges for each 2013 tax bracket as well as a growing number of other inflation-sensitive tax figures, such as the personal exemption and the standard deduction.

Projections this year, however, are clouded by the uncertainty of expiring provisions in the tax code. If Congress allows the so-called Bush-era tax cuts to expire at the end of 2012, many taxpayers could lose more ground than they will otherwise gain. These tax cuts, first enacted within Economic Growth Tax Recovery and Reconciliation Act of 2001 (EGTRRA) with a ten-year life, were last extended by the 2010 Tax Relief Act, but only for two years through 2012.

When there is inflation, indexing of brackets lowers tax bills by including more of taxpayers' incomes in lower brackets – in the existing 15-percent rather than the existing 25-percent bracket, for example. The formula used in indexing showed an average amount of inflation this year of about 2.5 percent – the highest in several years. Most 2013 figures therefore have moved higher.

Tax Rates

The current 10, 15, 25, 33 and 35-percent rates are now officially scheduled to sunset to the pre-EGTRRA rate structure of 15, 28, 31, 36 and 39.6-percent. While no one in Washington is calling for a full sunset of all the current tax rates, congressional gridlock might produce a cliffhanger on what will happen until after the November elections, and perhaps not even before January when the new, 113th Congress convenes. In the meantime, there are three possible alternative scenarios being debated by lawmakers:

Extend the current tax bracket structure in its entirety;
As proposed by President Obama, keep the current rate structure except revive the 36 and 39.6-percent rates, starting at a higher-income bracket level of $200,000 for single filers, $250,000 for joint filers, $225,000 for head-of-households and $125,000 for married taxpayers filing separately, also indexed for inflation since initially proposed in 2009 but keyed to adjusted gross income (AGI) rather than taxable income (indexed 2013 projections for those AGI levels, based on the Administration's FY 2013 Budget, are $213,200 / $266,500 / $239,850 / and $133,250, respectively); or
As proposed by certain Senate Democrats, raise the top tax rate only for individuals making more than $1 million.

Tax Brackets

Here is a sample of how inflation will raise rate brackets in 2013, assuming a full extension of tax rates:

Joint returns. For married taxpayers filing jointly and surviving spouses, the maximum taxable income subject to the 10-percent bracket will rise from $17,400 in 2012, to $17,850 in 2013; the top of the 15-percent tax bracket will increase from $70,700 to $72,500. The bracket amounts for the remaining tax rates will show similarly proportionate increases: $146,400 as the maximum for the 25-percent bracket (up $3,700 from 2012); $223,050 for the 28-percent bracket (up $5,600 from 2012); and $398,350 for the 33-percent bracket (up $10,000 from 2012). Amounts above the $398,350 level will be taxed at the 35-percent rate.

Single filers. For single taxpayers, the maximum taxable income for the 10-percent bracket will increase to $8,925 for 2012 (up from $8,700 in 2012). The remainder of the rate brackets show inflation increases of: $900 for the top of the 15-percent bracket (to $36,250); $2,200 for the 25-percent bracket (to $87,850); $4,600 for the 28-percent bracket (to $183,250); and $10,000 for the top of the 33-percent bracket (to $398,350).

Standard Deductions

The 2013 standard deduction will increase for all taxpayers. The standard deduction amounts for 2013 is projected to be $6,100 for single taxpayers; $8,950 for heads of households; $12,200 for married taxpayers filing jointly and surviving spouses; and $6,100 for married taxpayers filing separately. The standard deduction for dependents rises $50 to $1,000 (or earned income plus $350). The additional standard deduction for those have reached 65 or are blind will rise to $1,200 for married taxpayers; $1,500 for unmarried individuals.

Personal Exemptions

The amount of personal and dependency exemptions for 2013 will increase to $3,900 from the 2012 level of $3,800.

Gift Tax Exclusion

The gift tax annual exclusion, which rose from a base of $10,000 to $11,000 in 2002; $12,000 in 2006, and $13,000 in 2009, once again will rise in 2013 to $14,000. Pursuant to the IRC, the exemption can rise only when the inflation adjustment produces an increase of $1,000 or more.

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In light of the IRS’s new Voluntary Worker Classification Settlement Program (VCSP), which it announced this fall, the distinction between independent contractors and employees has become a “hot issue” for many businesses. The IRS has devoted considerable effort to rectifying worker misclassification in the past, and continues the trend with this new program. It is available to employers that have misclassified employees as independent contractors and wish to voluntarily rectify the situation before the IRS or Department of Labor initiates an examination.

In light of the IRS’s new Voluntary Worker Classification Settlement Program (VCSP), which it announced this fall, the distinction between independent contractors and employees has become a “hot issue” for many businesses. The IRS has devoted considerable effort to rectifying worker misclassification in the past, and continues the trend with this new program. It is available to employers that have misclassified employees as independent contractors and wish to voluntarily rectify the situation before the IRS or Department of Labor initiates an examination.

The distinction between independent contractors and employees is significant for employers, especially when they file their federal tax returns. While employers owe only the payment to independent contractors, employers owe employees a series of federal payroll taxes, including Social Security, Medicare, Unemployment, and federal tax withholding. Thus, it is often tempting for employers to avoid these taxes by classifying their workers as independent contractors rather than employees.

If, however, the IRS discovers this misclassification, the consequences might include not only the requirement that the employer pay all owed payroll taxes, but also hefty penalties. It is important that employers be aware of the risk they take by classifying a worker who should or could be an employee as an independent contractor.

“All the facts and circumstances”

The IRS considers all the facts and circumstances of the parties in determining whether a worker is an employee or an independent contractor. These are numerous and sometimes confusing, but in short summary, the IRS traditionally considers 20 factors, which can be categorized according to three aspects: (1) behavioral control; (2) financial control; (3) and the relationship of the parties.

Examples of behavioral and financial factors that tend to indicate a worker is an employee include:

The worker is required to comply with instructions about when, where, and how to work;
The worker is trained by an experienced employee, indicating the employer wants services performed in a particular manner;
The worker’s hours are set by the employer;
The worker must submit regular oral or written reports to the employer;
The worker is paid by the hour, week, or month;
The worker receives payment or reimbursement from the employer for his or her business and traveling expenses; and
The worker has the right to end the employment relationship at any time without incurring liability.

In other words, any existing facts or circumstances that point to an employer’s having more behavioral and/or financial control over the worker tip the balance towards classifying that worker as an employee rather than a contractor. The IRS’s factors do not always apply, however; and if one or several factors indicate independent contractor status, but more indicate the worker is an employee, the IRS may still determine the worker is an employee.

Finally, in examining the relationship of the parties, benefits, permanency of the employment term, and issuance of a Form W-2 rather than a Form 1099 are some indicators that the relationship is that of an employer–employee.

Conclusion

Worker classification is fact-sensitive, and the IRS may see a worker you may label an independent contractor in a very different light. One key point to remember is that the IRS generally frowns on independent contractors and actively looks for factors that indicate employee status.

Please do not hesitate to call our offices if you would like a reassessment of how you are currently classifying workers in your business, as well as an evaluation of whether IRS’s new Voluntary Classification Program may be worth investigating.

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