People you competitively face in business may say they want to see you succeed, but they all put their interests first and are generally more than willing for your business’ demise. A startup needs to consider everything on this list before making any moves on any point so that all of the points can be used to wisen the genius making a start. The harassment that a startup seeks to avoid is all future harassment, and not just “how can I be harassed now”. Each error in setting up and operating a business is an opening for you to be harried, harassed and hurt in moving forward. The point of considering everything is to prevent harassment from occurring at ALL points in development and not just “perpetually later on.”
II. Collect Data Before Start
Keep a Low Profile Until Official Start
Product samples provided with return provision and written opinion input (Don't start selling before you are certain what the configuration of the business entity will be)
Look at similar industries, similar products, similar distribution (This (a) tests your expected level of success, (b) tests how you will be viewed by government, & (c) gives an idea of competition and how to set pricing for entry into the product/services field.
Use massive, free IRS database to gather cost & profitability ratios (uspto.gov has a massive amount of free data; why not use it?)
Investigate systems to facilitate maintenance of your own business data (cost of "keeping records" needs to be minimized, consistent with other goals, like privacy)
Consider Starting Only After Unambiguous Data Configuration is Identified (Use data to prove to yourself that entry into the business field is justified, in the same manner you would urge an investor.)
Discover all the hidden costs (This may involve conversations with others in the business, especially at trade shows, in addition to other intense research.)
Discover small, medium and large sized operations (Some operations have to be large size to make money, while others can be small and cellular, and both large and small can morph and change places over time)
Discover the cost and needs of a complete data system for recording transactions (some businesses rushed to high volume operation when demand was high and forgot to keep records-- such as loan servicers that lost records -- don't let it happen in business)
III. Consider All Possibilities (Any business can have thousands of permutations, including continua from monolithic versus distributed, domestic versus international, own versus rent; and more.)
Performing tasks internally versus using outside firms (The so-called gig economy may have shifted to the use of outside services for non-critical functions and a need for a more security, confidentiality and control for internal tasks and management.)
Focussing on one product or service or diversifying into more than one. (This dichotomy often follows the inflation index and the ability to get higher returns when external investment returns falter, but the dichotomy also can cause waste when inflation cools.)
Consider lower profit products and services where customers demand availability (Its not unusual that a business can be second best at providing accessories, but such integration might be necessary where loss of core business could result from customers that require integration.)
IV. Business entity & portability (The infrastructure, such as electricity; the politics, such as adoption of punishing anti-manufacturing laws in a given jurisdiction; dictate that a business should always be prepared to change location if it enhances profitability and survivability.)
One or More Out of State Master/Main Corporation (A mixture of out-of-state corporations can facilitate survival by reducing the cost of smaller, fine tuning type organizational changes.)
Provides one possible greater layer of sale isolation when leaving a state. (State being left will not be able to capture as much taxable gain as it would in a dissolution and sale )
Reorganization easy: simply stop business in one jurisdiction & starting in another (Instead of an internal revenue code reorganization, its simpler for a given entity in state Z to stop business in state A and start business in state B)
Eliminates having to resort to federal reorganization (IRS) statutes (Complex reorganizations can be more costly when reorganizing a single main entity that relocates)
Can facilitate further easy splitting into different states and overseas (Every entity should be poised to consider expansion anywhere, and sale of separate lines of business; multiple different entities may in some circumstances facilitate a quick action, as well as a more accurate valuation).
Facilitates a multiplicity of Out of State Master/Main Corporations (For purposes of tax credits and cash grants, this factor alone could keep the entity perpetually in the game for state and city assistance.)
Facilitates separate state operating corporations. (Having one or more master corporations for each business increases flexibility, and may enable some locations to fall below regulatory thresholds.)
V. Contracts with Others (business setup and operations) (This is a critical aspect of business, every contract could produce a lawsuit that drains time and money.)
Includes more than written contracts. (Contracts can arise through business custom and oral agreements that are supported by their continued use.)
Avoid dangerous& harmful agreements & relationships with others. (There will be times when an important deal is only possible by agreeing to terms that could destroy the business entity and/or wreck the owner's personal finances, and it may be important to simply walk away.)
Make clear that it is the ENTITY that is agreeing and not any of the owners or partners (Recitations in the contract should include language and examples demonstrating and limiting the involvement and liability of parties, as well as waivers and indemnification that operate in the favor of your business entity.)
All agreements should be between one or more business entities and others (leases, etc.) (Binary contracts help to avoid confusion on the identity of a party, as well as to avoid the possibility that a 'third party' will claim to be a beneficiary under a contract of which they did not agree and are not a party.)
Being safe from the start may avoid a need for later wasteful emergency damage control. (It is a little like setting up strength points to withstand an outward assault)
Any non-option agreement that is fixed & executed, binds the parties at a risk of lawsuit. (Every binding agreement has the potential to come back and bite; and one of the most difficult skills to acquire is to imagine all the negative outcomes before finalizing an agreement.)
Potential for Bankruptcy control of the entity requires “what if” analysis for all contracts (Any provision that is overtly triggered by bankruptcy will be disallowed, and thus planning to keep control in the event of either party's bankruptcy has to be not overtly connected with a bankruptcy filing act, but associated with other events, conditions and thresholds.)
Supplier and Distributor disruption, regardless of source, requires preparation in advance (This includes everything from UCC rights, to second and third sourcing, performance bonds and insurance, to name a few.)
AB5/Dynamex, makes independent contractors potential extortion claimants, documentation required. (The law is so new and draconian that any non-employee status carries a significant negative liability.)
New California Rules attempt to create liability for out of jurisdiction contractors (This is an attempt to claw-back payments to California paid to non-corporate individuals that perform services for California businesses; and will likely become a disruptive burden on interstate commerce as it begins to be implemented.)
VI. Begin the positioning of the business for potential sale from the very first moment (This will hopefully keep the business entity from becoming complaicent and reinforce a value maximizing view for decisions.)
More sales value potential will reduce loan risk & permit available capital (Valuation rules apply some changes to a sole proprietor model; a value-based model is more readily accepted by lenders as a measure against lending risk.)
Understand the valuation rule computation and measure value monthly (Having constantly fresh valuation data and computations will reduce the need for 'emergency' data gathering and enhance the veracity of multiple value measurements made and verified in real time.)
Detailed Record keeping is absolutely necessary for high confidence valuation (The potential purchaser might have a differing approach in valuing the business, such as translocation, and can quickly determine value with adjustments to highly reliable detailed data maintained by a target business.)
Detailed Record keeping enables a more intimate understanding and control of all operations and their taxation (Detailed Records are more readily accepted as evidence if they were prepared often and on a regular basis.)
VII. Entity Liability (Because if some financial disaster can occur, it will occur.)
Insurance coverage can be made to be complete and beyond complete (Enough insurance should be obtained that the main concern is over-insuring or multi-coverage)
The combination of Insurance and Entity arrangement can be efficient. (Even more efficient can be agreements with others to indemnify the entity and to waive liability caused by the entity or its actions.)
If the business name will be unique, make sure it follows the trademark rules (It should be selected to avoid liability and easily establish a not reasonably contestable challenge)
If the business name will be generic, keep to the generic & descriptive (Do not over-use or "mantracize" the terms as you would a trademark.)
Customer Data Liability requires computational strategic arrangement. (Insurance costs and availability will usually require a plan to keep customer data confidential.)
Workers Compensation Insurance (WCI) is a major liability limiter (With the ever-present push toward "Employee status" preference, the lack of WCI could result in a double surprize penalty if an independent contractor was found to be an employee.)
Business using occasional and part-time workers can benefit from pay-as-you go WCI (Employees require not just tax witholding, but all of the attributes of being an employee, even if it is only one hour per year.)
Valuation and Debt can accommodate each other to an extent - optimize. (Business owners need to make decisions on how much of the entity's value is left in versus how much banks are relied upon for periodic swings in working capital.)
Isolate Post-tax entity level earnings into special function entities (This will help to earmark the purpose of funds and memorialize their intended use for expansion under IRS rules, for example)
Trademarks applied for as a sole proprietor makes you PERSONALLY liable! (Its best to have the entity apply for trademarks directly and avoid any individual's ownership of it, even for a day.)
Trademark additions and morphing can be done quietly over a long time. (The trademark portfolio built in future may best serve & match the entity's goods in future, only cultivation over time will optimize value.)
Bankruptcy is always a possibility in any business scenario: (The entity should prepare for its own bankruptcy and the bankruptcy of others with which it deals)
Licensor / Licensee (Licensor bankruptcy has the possibility of loss of license to licensee, Licensee bankruptcy may inhibit replacement of te licensee.)
Secured creditor (Secured creditor dissolution may disrupt equipment continuity, entity bankruptcy may result in repossession of machinery or an onerous buyout choice.)
Entity Bankruptcy versus Personal Bankruptcy (segregate & DO NOT guarantee) (The entity's bankruptcy should ideally not impact the entrepreneur but in some instances it can.)
Lawsuits for liabilities not covered; or not completely insured (Coverage gaps should be investigated and evaluated constantly, with insurance adjustments to eliminate gaps.)
Product / Service Liability for entity products & services (If the product or service has more than an absolute zero probability of harm, this insurance is necessary)
Government Induced Liability (regulatory, fines, taxes, policy)(Business interruption insurance should be assured to operate if government causes a disruption)
VIII. Entity Liability from Outsiders (One example of this is computer hacking.)
If the business name will be unique, make sure it follows the trademark rules (Trademark insurance is needed if the trademark has any probability for potential liability)
If the business name will be generic, keep to a random generic & descriptive usage (A review of term usage would be helpful if a large player decides that a generic terms is "theirs.")
Evaluating production & product ownership versus licensing versus enforcement (This is a major liability relief issue, it releives liability for sales tax and derivative sales tax liability AND provides an ability to get indemnity and waivers from contracting parties.)
IX. Entity Liability from Insiders (Individuals with access could access & sell customer lists and private data.)
Put controls in place to avoid theft and embezzlement from entity and customers (Fraud controls can help dissuade wrongdoing.)
Teach the mathematics of employment harassment (Most work problems stem from not being obsessed with work success and goals, and unfortunately displacement focus can lead to many types of trouble, including harassment.)
Teach export and import tariff controls and establish direct lines of liability (Its important to reinforce our duty to uphold export regulations and to insure that import items are properly classified and the tarriff is paid in the correct amount.)
Protect entity trade secrets and customer information from any unauthorized discovery (Further, the protections need to be embodied in a policy and memorialize the technical steps taken.
X. Avoid Personal Liability - Especially Personal Liability Seepage (One of the most difficult work tasks is to be vigilant in keeping the entity & work isolated from personal liability entanglement.)
Several mechanisms exist that can “jump” entity liability into personal liability (Only a few are mentioned here.)
Sales Tax in California under R&TC 6829 - but easily defeated if planned for (Planning may include not collecting tax reimbursement, as well as filing personal returns to start the statute of limitations as to personal liability)
Payroll Trust Fund Tax (Deafeat with PEO, Bond, or Insurance) (Payroll is one area which is easy for the government to attach liability to individuals directly if the taxes are not accurate and paid; Insurance can be important.)
Fraudulent Transfer (taking money from an entity under liability-Ralite case)(This case defined circumstances under which shareholders were not liable for franchise tax.)
Personal Liability $0 sales tax filings while entity under way + years later H.C.McCoon) (This case defined circumstances under which responsible persons could be held not liable for sales taxes.)
Withdrawing money from entity while anyone is owed (See Raylight case procedure)(In addition see "Fraudulent Transfers" and/or "voidable transfers.")
Being in a product's chain of title can give PERSONAL liability! (Simply holding title to product (purchased or sold) can create liability.)
If starting as a sole proprietor, eliminating PERSONAL liability may be impossible. (Yet another reason to start with a business entity if you are going to have an entity.)
Entity Selection driven by asset isolation & risk diversification. (Think about where the entity should end up, and how you are going to get it there)
Plan against personal bankruptcy liability. (Personal bankruptcy is the last place the entrepreneur wants to be, and thus several plans should be made for how to handle dire economic circumstances.)
XI. Entity Optimization
Continually explore techniques used by competitors (New techniques are adopted because they are usually efficient; don't continue operating at a lower profitability than everyone else.)
Continually explore techniques & products employed by overseas companies (This form of exploration enables a view of not just what, but why; and the socio-economic & tax regime that enabled or forced such new techniques & products.)
Continually track new legislation that could impact profitability (Forecasting new legislation could affect your producs & services mix, a change in business locations, changes in personnel, and much more.)
Continually evaluate operational advantage obtainable by moving to & operating in other states (Tax rates, worker's compensation insurance, minimum wage, and state forced time off, benefits, and employment liability are only a few factors that could make a big difference to both entity value and profitability.)
Continually evaluate valuation levels that could be obtained by changing jurisdiction (Its not just current operations that should be considered, but a growth model based upon the direction to move the entity's configuration.)
Consider Continually applying for cash & tax credit awards from cities, counties & states. (Even if you are not in a position to change location, knowing the most up-to-date amound of assistance you could get from other jurisdictions can help you negotiate local assistance available to help you while you remain at a present location.)
Continually consider entity value & income optimization for changing operational infrastructure (With the consideration the questions "what is likely to happen" and "how can we configure to be in a position to take advantage of the likely scenarios in future.)
Infrastructure = shipping, order turnaround, JIT, automation, personnel, contractors and more (Its difficult to investigate and consider everything, but money and sacrifice of survival capability may be squandered.)
Contract with the use of options that can be exercised in the entity’s favor (Some of the worst outcomes are those that no one thinks will happen; right now the Mall of America 3 story anchor building is being held by Sears with a $10 lease, because no party thought that retail would be suffering as it is now.)
Collect entity rights in a separate protected entity to provide flexibility for entity sale to maximize value (Currently some properties, patents and copyrights, have been re-classified as non-assets until 2025; keeping them in one or more non-operating entities increases the probability of lower tax rates under the right circumstances and depending upon the form of sale.)
Consider & compare operations in California, Oregon, Nevada, Arizona, Texas & Florida. (These are benchmark jurisdictions to consider from a state income tax, state sales tax, and commercial tax comparisons.)
XII. Legal (The rules of engagement with suppliers, distributors and customers should always be under review; learn and become familiar with the federal codes that relate to your business.)
Use and understand the UCC-9 system of filing to keep up with your own debts. (Secured transactions give creditors priority; review security interest documents and update as conditions change.)
Use and understand the UCC-9 system of filing to keep up with debts of suppliers, distributors and customers. (You need to know your position, especially if parties with whom you deal become insolvent.)
Learn to use PACER to investigate other entities. Cost is zero for quarterly charges that total to less than $15 (Use pacer to investigate parties and potential parties.)
Use the internet and free public library data bases to look-up entities and individuals dealt with. (Dunn & Bradstreet is just one data base of many that you can use to help characterize entities with whom you deal.)
If leasing a premises make certain that it is zoned & licensed for your activities (Having a lease for premises that can't be used, is often a fatal disaster.)
Worldwide, continually understand/consider tariffs, transportation and license/franchise possibilities
Continually consider importing and exporting goods and services.
Export tariffs can be a huge liability and nightmare, unless you know the answer ship local (Until international tariffs and procedures are known arrange to ship locally or arrange for C.O.D. shipper involvement.)
XIII. Employment Headaches (Hiring and firing is problematic, and rules tend to inhibit "getting to know" employees before hire.)
Avoid, to the extent possible, staffing until and unless it is demand driven (And even if demand driven, arrange for employee leasing and occasional / few hours per month part-time relationship until "you get to know" capabilities and work ethic of potential organization members.)
For minimum problems pay a minimum wage with no O/T & supplement with profit bonus (This is just one strategy to try and gauge the match between potential organization members and the organization's compatibility & needs.)
Consider employee leasing especially if full time operations have not been achieved (Also consider a contract for occasional & part time help to help limit the organization's exposure to adverse action.)
Consider using a PEO that can guarantee payroll to IRS in all conditions. (The key to a PEO relationship is that the PEO agrees to pay the payroll withholding and tax whether or not the PEO is paid in advance -- this is an IRS rule.)
Consider part-time / occasional worker’s compensation provider for non-independent contractors (The Quickbooks organization appears to have launched this product recently -- https://quickbooks.intuit.com/payroll/workers-compensation/ .)
XIV. AB5/Dynamex Employee Problem (California = CA ) (This is a two prong problem, with the first prong requiring a close look into the organizational structure of the independent contractor and evaluating their eligibility under the rules -- an onerous requirement of being located in California.)
CA takes the position that nearly everyone is an employee; a burden on interstate commerce. (Another reason for a startup to look at having its needs met as a California entity versus an entity of another jurisdiction where contractor help could be available without a draconian penalty.)
CA Employees have higher liability than other employees in other jurisdictions, so a separate entity can help (Segregation of operations and risk can help in differentiating valuation.)
CA has announced that they will tax out-of-state independent contractors working for CA entities (This is the second prong of interstate burden, causing out of state goods and services producers to either have an entity or change the configuration of an entity for California customers to avoid having California reach out and try to characterize income earned by contractors in other states as California source income subject to California tax.)
CA has recently taken a position that foreign service providers could be CA employees (This may mean that a copyrighter or web developer may have to obtain a corporate form in the developer's home state to avoid California Taxation or a California punishment visited on their California customers.)
Foreign service provider rules seem to target individuals not affiliated with out of state corporations (Its unknown at this time whether other forms, such as partnerships, LLPs etc. would qualify to shield earned income.)
Federal attitude is that if someone is employee under state rules, they probably won't argue. (Therefore, don't expect any help in controlling aggressive state taxing authorities.)
State Determinations under AB5/Dynamex can drive Federal Audits. (The general federal-state scheme is that states characterize the nature of an asset and the federal government controls the procedures under which it is taxed;If California "employee" designations are generally accepted by IRS, then California will drive payroll audits for IRS within the state. The employers within California will get a multiple punishment (a) the risk and uncertainty of paying an independent contractor, (b) the risk and uncertainty of hiring out of state services that might be re-characterized the same as hiring an in-state contractor, (c) a double penalty (state and federal) whenever an independent contractor is found to be mis-categorized, and (d) the push of small business into a higher threshold whenever service providers, even from out of state, are forcibly characterized as employees.
State Determinations under AB5/Dynamex will remain uncertain until case law begins to emerge (Making California a riskier place to do business will hurt all of small business in California, and force unwarranted incorporation of sole proprietor business at a significant cost for minimum franchise tax, worker's comp, disability and corporate tax return requirements.)
Develop complete factual checklists testing independent contractors & consider indemnity provision (Small business will have no choice than to pay for and take greater time for probing investigations into independent contractor business to create the due diligence necessary to exculpate such small business from a charge that it has improperly hired an independent contractor.)
Use of temporary staffing / Employee rental company may be preferred for occasional use. (This can be especially helpful when the times between the need for an occasional employee are long.)
XV. Ownership v. non-ownership of product and services. (Ownership puts the owner in the chain of title and increases the probability of liability for sales tax liability and record keeping.)
Arrange a system to protect customer data (This is most important where the entity business has some outlet directly to customers)
Carefully plan a complete system to track & sum sales by jurisdiction (After Wayfair case, any seller could trigger in-state status for sales tax collection for direct sales that exceed either a transaction numerosity threshold or a dollar amount threshold.)
Explore Export assistance for goods or services (This is especially critical for a start in which the entity staff may be less familiar with exporting into a new jurisdiction (domestic or foreign).)
Take steps to require contract exclusivity with strict penalties (Control requires strengthening contracts to several parties, and close tracking and control.)
Obtain non-compete agreements and conditions from manufacturers (Use of IP to control manufacturers is critical.)
Obtain non-compete agreements and conditions from service providers (Even where IP is weakest, non-compete, and possibly trade secret based agreements need to be tightened.)
XVI. Insurance (base commercial liability)
Insurance specialty (many areas, & each depends on type of business):
Professional Liability (Even where the business is a professional or hires professionals, this insurance is important.)
Theft Insurance (May involve asset or payroll or machinery theft.)
Dishonesty Bond (Involves theft or embezzlement, inside and outside.)
Fraud & theft (Normally may involve outsiders.)
Directors & Officers Insurance (D&O) (This policy covers losses from actions brought against company officers for alleged wrongful acts.)
Product Liability Insurance (This policy covers defects in products entered into the chain of distribution.)
Employment Practices Liability Insurance (ELPI) (This type of policy provides liability for mistreatment, harassment and breach of duty to employees.)
Errors & Omissions Insurance (E&O) (This policy covers lack of due diligence and possibly self-dealing voting.)
Insurance for Data Breach (Arrange a system to protect customer data) (This policy covers hacking and data breach, and typically conforms closely around and covers liability between policy and beyond.)
Trademark Insurance is expensive and more necessary when name is in crowded field (When a selected name is above generic, but cosmetically similar to a famous name, this type of insurance is useful, especially at the first instance of the trademark's adoption.)
For each special category set up decisions on insurance versus contractual warranties (This principle is an efficiency principle to lessen coverage on liabilities waived by others.)
XVII. Taxes (Tax organizations have more power to act quickly against a business entity)
Select a tax year & do your & entity’s own taxes for many reasons (Tax preparation combined with constant weekly familiarity with the books can yield the best return and the most in-depth knowledge of business operations.)
Paid Preparer => NO Privilege (even if an Attorney) (A paid preparer, even if that preparer is an attorney waives all privileges of the business entity against the preparer.)
Paid Preparer => can testify against the taxpayer (To begin with, there is no 5th amendment privilege for corporations, and then to compound this shortcoming by having a paid preparer means that a hired outsider can testify against the corporate entity as well.)
Most Entities have no 5th Amendment Privilege, so smaller group knowledge is better (The president should know and the treasurer, but everyone else should be on a need-to-know basis)
Preparer Penalties => Make Paid Preparers Skittish & they avoid position advantages (A company president that knows operations, future plans and fiscal health is in the best position to prepare the taxes and the confidential records supporting the tax return.)
Filing Electronically Restricts Helpful Explanations and should be avoided if possible (You can mail all sorts of justification to potentially foreclose the possibility of a later time-wasting audit.)
Can't Conspire to Defraud IRS (18 U.S.C. 371) If preparing the taxes alone (One person within the organization should have total responsibility for the taxes, preferably the president.)
More Involvement by owner => Better Knowledge => Less Tax Paid Legally (Efficiency of tax and time is king.)
Self knowledge and preparation especially important if business depends on tax credits (Tax credit blend is highly specialized and the president of the company should be extremely familiar when its a core business consideration.)
Evaluating production & product ownership for entity and personal sales tax liability avoidance (Sales Tax is dependent upon location, documentation, and can cause liability to bleed through to the company officers and owners.)
Personal Liability for Sales Tax (esp. where its a trust fund) varies by jurisdiction (Location, insurance, allocation of responsibility, and having the documentation to fight any unfair attempts of government to impose liability.)
Consider using multiple entities in different jurisdictions; to reduce allocation audits (Group treatment is not always the rule if segregation can trump allocation.)
Consider using multiple entities as preparation for sale of a separate line of business (Separation can help naturally justify and identify the boundaries of business separation and the need for efficient duplication of prior overlapping tasks.)
Use non-operating entities for holding IP assets so as to have no tax history inhibiting sale (One of the main valuation reduction reasons is the potential for tax liability; non-operating status of the holding entity can reduce this effect.)
Use the Portfolio Interest exception to lower borrowing interest from overseas lenders. (Negotiation will be in order, but the form of borrowing as a straight loan is important to be documented.)
Keep in mind that IRS or State will shut down your business in a split second if payroll is not paid (IRS is relatively forgiving for income tax, but payroll compliance is important because it can carry (1) personal liability, (2) lack of bankruptcy dischargeability, (3) fraud characterization, and (4) a greater chance of criminal liability -- with easier math proof.)
IRS is more likely than the state to facilitate a payment plan/compromise for ordinary taxes (Normally the more onerous state plan is first and the second is federal.)
Some overseas payments require withholding; never agree to payment before checking withholding (This is a double problem for scammers is that they not only take money from innocent victims, but cause the victims to violate withholding, and violation of withholding can be another personal liability.)
Some overseas relationships may result in your having an FBAR reporting obligation; check it first (Be mindful of all overseas activities and operations because a heightened disclosure requirement exists.)
Some assets, foreign corporation ownership or control trigger significant reporting; check it first (Ownership and activity limits should be roadmapped so that gaps in reporting don't occur inadvertently)
Some rental activities can trigger state sales & use tax; check it first (Before business decisions are made, the cost of all activites need to be formulated as part of the decision.)
Some states inventory depends upon assets in-state on certain tax days; be aware of states & days (Its not a problem if you arrange operations to minimize tax.)
Consistency between Federal Income, State Income, and Sales Tax is critical (In general, any mismatch will raise an audit flag.)
Analyze & warn regarding adjunct nonprofit entities for improper relationships. (Nonprofits cannot have too close of a relationship with any for-profit entity.)
In March of 2019 there was a terse announcement by the IRS entitled "Recipient of sexual harassment settlement may deduct attorney fees" (as reported in a tax daily newsletter communication). My initial impression was that the IRS had magically decided to allow the same types of deductions for which plaintiffs in certain enumerated employment & whistle blower claims are eligible, and which can be categorized as "above the line deductions"(IRC sec. 62(20)&(21)). Sadly, this was not the case. The announcements were not complete and probably had the character limitation malady from which Twitter suffers.
Of course, the "whole" of the announcement was expanded and corrected by follow-up language that narrowed the breadth of the announcement. The whole of the announcement stated "the recipient of a settlement of a sexual harassment claim is not precluded, by Code Sec. 162(q)'s disallowance of deductions related to sexual harassment claim payments, from deducting attorney fees related to the payment." I again mistook this to mean that attorney's fees and costs could be deducted from harassment awards.
The IRS finally put out an FAQ on its site that stated: "Question: Does section 162(q) preclude me from deducting my attorney's fees related to the settlement of my sexual harassment claim if the settlement is subject to a nondisclosure agreement? The somewhat evasive answer: "No, recipients of settlements or payments related to sexual harassment or sexual abuse, whose settlement or payment is subject to a nondisclosure agreement, are not precluded by section 162(q) from deducting attorney's fees related to the settlement or payment, IF OTHERWISE DEDUCTIBLE [capitalized emphasis].
This qualifying language "if otherwise deductible"means that for victims, sexual harassment claims are like other personal injury recoveries, generally NOT deductible and therefore are 100% includable in the plaintiff's income unless the damages are due to "personal physical injuries or physical sickness." IRC Sec. 102(a)(2) states:
"(a) In general, except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include: (2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;"
Further any settlement agreement must "spell out" and allocate to the "personal physical injuries or physical sickness" claims separately if the claimant has any hope of having that portion of the settlement be recognized as non-taxable. In the non-published case of Mumy v. CIR (T.C. Summary Opinion 2005-129 of 2005) a $12,000 settlement for harassment and a physical arm pinch "referenced the harassment, personal injury, and emotional distress allegations in a preliminary "whereas" clause...and then specifically stated that "Settlement is made only to buy peace and to compromise disputed claims, and to avoid the expense and inconvenience of trial." All of the $12,000 was found to be income of plaintiff.
If the parties had agreed and made two claims, one claim for $6,000 for the pinch and one claim for $6,000 for the emotional damage, the income would likely have been only $6,000 and the attorney fee of $500 would have been split in accord with the recovery absent some evidence of the amount of attorney time spent on each claim. Only a precise, reasonable amount of detail in the settlement agreement can mitigate the lack of deductibility of costs and attorney fees for "emotional distress."
An example of tax non-deductible of court costs and attorney fees might include a $100,000 settlement with $10,000 of court costs, and $40,000 of attorney fees. All $100,000 is added to the income of the plaintiff, who may pay as much as $15,416 in federal taxes (assuming no other income and excluding state tax). After paying the attorney fee, court costs and taxes, the plaintiff benefits by $100,000 - $10,000 - $40,000 - $15,416 = $34,584. (If the settlement is large enough to push the plaintiff into a higher tax bracket, the final benefit percentage drops further.)
The same example for complete exclusion from income (such as for physical injury) might include a $100,000 settlement with $10,000 of court costs, and $40,000 of attorney fees. All $100,000 is excluded from income, and the plaintiff benefits by $100,000 - $10,000 - $40,000 = $50,000 after paying the attorney fees, & court costs.
Against this tax deductibility system, is the Tax Cuts & Jobs Act. Congress added 26 U.S.C. Sec. 162(q): Payments related to sexual harassment and sexual abuse No deduction shall be allowed under this chapter for: (1) any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement, or (2) attorney's fees related to such a settlement or payment.
The above was the provision that caused so many to mistakenly postulate that no tax deductibility would be allowed to victims who agree to keep their settlements confidential. The IRS FAQ emphasized that "otherwise deductible" referred to the prior state of tax deductibility as it was before section 162(q), but they could have simply interpreted 26 U.S.C. Sec. 162(q) to relate only to payor defendants (though that would have been too clear and easy an announcement) .
The purpose of IRC Sec. 162(q) is to deny a payor defendant a tax deduction when the settlement is made with confidential provisions. The idea might be such that an extra penalty is in order for a company electing confidentiality since confidentiality makes it more likely for a coverup or for the conditions that created the violation to continue. In addition, the extra cost due to inability to tax deduct a payor's damage payment might cause parties to opt for a non-confidential settlement benefitting the public.
Of course, the differential cost between confidential and non-confidential settlement will depend upon the marginal tax rate of the payor. Currently (2019) the top marginal rates are 21% for C corporations, 35% for professional corporations, and 37% for individuals. Using a $100,000 settlement amount, the ability to tax deduct the settlement is worth $21,000 to a C corporation, $35,000 to a professional corporation and $37,000 to an individual sole proprietor employer. It is financially painful enough to pay $100,000.00 as a settlement, but the loss of deductibility amounts to an additional fifth to one third as a penalty because the settlement is confidential.
This appears to be what congress had in mind when they passed Sec. 162(q). However, the use of insurance can severely mitigate this "economic punishment" arising from blocked tax deductibility. Commercial insurance policies typically work from a coverage limit and a policy deductible. The policy deductible is an amount that the insured is responsible for paying, while the insurance policy limits above the deductible is the responsibility of the insurance company.
The policy premiums are typically deducted as ordinary and necessary business expense after purchase and before an insurable event occurs. The policy deductible is typically subtracted from any claim paid. This means that only the deductible is paid by the insured. As such the deductibility or limit of deductibility is controlled by and paid by the insured. The insurance company's payout is related to reserves, and taxation of insurance performance is beyond the scope of this article.
An ELPI (Employment Practices Liability Insurance) policy is the type of commercial liability insurance that insures against employment harassment claims. Continuing the example above, if an insurance policy for $100,000 with a $1000 deductible will cause and enable the insured to deduct $1000 if the claim is non-confidential, and no deduction if the claim is confidential.
At the tax rates above, the inability to tax deduct the $1000.00 policy deductible costs employer payors an additional costs of $210.00 to a C corporation, $350.00 to a professional corporation and $370.00 to an individual sole proprietor. This can be considered to be either (a) a much reduced penalty for keeping the settlement confidential, or (b) a signal for the plaintiff to ask for more compensation to try and capture the "theoretical restored artificial tax deductibility" that comes from having insurance.
Of course, if the case goes to jury, the jury will probably not be allowed to consider insurance. The presence of insurance is likely to benefit the plaintiff even more where the plaintiff presses for some part of the "theoretical restored artificial deductibility" that comes from having insurance. In the example, the additional available benefit of not needing tax deductibility amounts in play (due to the presence of insurance) are $20,790 to a C corporation, $34,650 to a professional corporation and $36,630 to an individual sole proprietor.
Therefore, when an ELPI policy is present, the payor is likely to be insensitive to tax deductibility and thus may always want confidentiality unless the policy deductible amount is very large. When an ELPI policy is present and confidentiality is sought, a savings of roughly 20.8%; 34.65% and 36.6% of the claim results by having bought the insurance policy. These amounts of money were sought by congress as a tax deductibility punishment for non-insured payors, and under proper circumstances may represent percentage additional recoveries for plaintiffs as a starting bid for agreeing to confidentiality.+++++++++++++++++++++++++++++++++
Handy Tips From:
Tip #1: A tax account with IRS should be treated with the same concern and care as one would treat a credit card or billing account. There are rights for credit card accounts, billing accounts and tax accounts and they are each different.
Tip #2: A taxpayers opportunity to demand and make use of taxpayer rights are maximum at the earliest possible moment of discovery, and diminish for every time increment and deadline which passes, whether because of not knowing the problem or ignoring the problem.
Tip #3: The procedural burden and risk on the
taxpayer to suffer the punitive financial pain from misunderstandings
regarding the tax debt account should encourage high involvement in
investigation and tracking of the taxpayer’s tax accounts, but many
taxpayers “put their heads in the sand” because facing something they
believe they cannot control is simply too painful. Ignoring the problem is a
gateway to disaster.
Tip #4: Lien, levy, garnishment should be NO REASON
for taking blind, quick action with a mind simply to stop such lien, levy,
or garnishment. First, taking action will extend the IRS collection statutes
(all years), and the bankruptcy tax discharge statutes(all years). Where
there is a distant milestone with significant savings to the taxpayer, an
immediate action is likely to push such a valuable milestone, such as a CSED
expiration date farther into the future. It could be that if the taxpayer
avoided doing such a tolling act, that the taxpayer may have a balanced
chance to achieve enough passage of time to reduce the tax owed.
Tip #5: Any criminal trouble a taxpayer has had in
the past should make them doubly anxious to insure additional corroborating
documentation and proof of legitimacy for all tax transactions, especially
since the taxpayer with prior convictions will receive longer sentences than
a taxpayer having had no such prior convictions. (Put another way, the
Justice Department can prosecute a case with a lesser tax loss and still
achieve a felony incarceration for a defendant.)
Tip #6: If the reader of this blog was sitting on a
jury and judging another taxpayer’s good faith efforts, what types of
actions would you want to see them attempt or do in order to show good
faith? For example, a tax debtor should consider making a payment to IRS
from time to time, and especially diverting a portion of an unusual windfall
to show intent to repay. Should a prosecution occur, it might be difficult
for a judge to block the evidence of payments from the jury.
Tip #7: One of the most valuable tools a taxpayer
has in dealing with the IRS is an independent tax practitioner that will
deal with IRS in a non-emotional way, keep IRS on topic to both limit the
scope of the audit where possible, as well as to document any attempts to
“hunt” for other taxpayer problems in order to leverage the outcome of the
audit to the IRS’ favor.
Tip #8: Consider choosing an attorney for IRS
representation and be completely forthright about which aspects of the IRS
interaction may likely turn criminal. An attorney that can represent a
taxpayer criminally, and who is forearmed with knowledge of the problem has
a much greater chance of either minimizing the probability of trouble, or at
least minimizing the degree of damage.
Tip #9: Depending upon all conditions, it can be a
real advantage for a taxpayer to operate their own repayment plan in accord
with month-to-month and week-to-week ability to pay. Such a “taxpayer
directed” payment plan will provide flexibility, the ability to allocate tax
and years, and proof of intent to pay.
Tip #10: Review all financial aspects and debt
relief possibilities for tax debt, including bankruptcy enabling statutes
and tolling, Bankruptcy outcomes, the collection statute and tolling, the
effect of taking an action, and the effect of monitoring and planning to
take action after specific milestones are significantly passed in the
Tip #11: A taxpayer should self-prepare and file
their own tax returns in accordance with their own involvement in their
financial lives, and also remember to keep all financial information,
discussions, and bookkeeping off the Internet and isolated from any possible
breach in confidentiality by anyone.
Other Sections within the Tax Debt Approach
Instructive Warning Cases
Bankruptcy & Offer-In-Compromise – The Hot Dog Stand Paradigm
A Tax Debt Only Comparison of Offer-In-Compromise and Chapter 7 Bankruptcy in California Graduating From a Homelessness Base Case
How Far Can You Delay Paying Federal Tax Authorities Before Criminal Tax Evasion Charges are Filed?
Taxpayer First Act Credit Card Trap
There are Usually 6 Tax Choices At Any Given Point In Time
Other Articles Outside the Tax Debt Approach
Debt Control Extensive Outline (8/14/2019)
Pre-Startup Efficiency – Introduction (Parts 1&2) (2016)
9th Circuit Rejects “One Day Late Rule” for Late Filed Return Tax Dischargeability (2016)
Give My Start-Ups a Break! (2015)
The recent case of Hugger v. Warfield (In re Hugger), 2019 WL 1594017 (9th Cir. BAP Apr. 5, 2019)(not officially published for citation)(http://cdn.ca9.uscourts.gov/datastore/bap/2019/04/08/Hugger%20-%20Memorandum%2018-1003.pdf), U.S. Bankruptcy Appellate Panel of the Ninth Circuit (the “BAP”) in an Appeal from the United States Bankruptcy Court for the District of Arizona, illustrates mathematically one of the harshest outcomes to occur when seeking tax debt relief. A debtor sought to discharge $40,000 in tax debt through a chapter 7 bankruptcy. The amount of non-tax debt totaled $569.
As is not untypical, the
taxpayer in this case filed late tax returns
for 2001, 2002, 2005, 2006, 2009, 2010, and 2012, all in September 2015. Under the bankruptcy discharge of taxes rules, the tax year due date must be at least three years old at the time of at the time of filing the return and as to this, all years qualified except for 2012. The second requirement is that at the time of filing the bankruptcy case, the tax filing date must have been at least two years old.
The September 2015 tax return filing date indicates that September 2017 would have normally been the earliest date that bankruptcy should have been filed. A decent temporal safety factor might have even been added, depending upon potential tolling activity after all taxpayer records were searched and analyzed. Even with no indicated tolling it would have probably have been better to file the bankruptcy October 2017 or later.
Debtors can face significant pressure and financial pain before taking action. However, a bankruptcy filing has significant negative effects and is not easy to undo, and in some cases is impossible to undo. Any bankruptcy filing that is dominated by a desire for tax debt relief should be investigated thoroughly to avoid the type of result that In re Hugger exemplifies.
The In re Hugger debtor filed a chapter 7 bankruptcy case on January 9, 2017, at least 9 months too early (even without tolling). On May 9, 2017, the U.S. Bankruptcy Court for the District of Arizona entered the Debtor’s discharge, and the bankruptcy case was closed a few days later. By September 2017 it was realized that the bankruptcy was filed too early and the debtor began action to re-open the case, undo the discharge, and ask that the bankruptcy case to be dismissed so that taxpayer could have a later “do over,” so to speak.
Requesting and receiving a chapter 7 case withdrawal of discharge followed by a dismissal is not as easily done as in a chapter 13 case. The main standard to be met is that the actions must be shown to benefit, and not harm the creditors. In this case the creditor was the United States. The premature bankruptcy filing benefited the United States, and to allow an unwind would be prejudicial to the creditor interests. Both the bankruptcy court and the BAP denied withdrawal of the discharge and dismissal of the case. The bankruptcy filing and discharge (which did not discharge the tax debt) stands.
Some factors to consider from this case are:
(1) The bankruptcy filing date was so premature that it may be likely that the statute of limitation rules were not understood.
(2) Even if the taxpayer was facing a garnishment, putting up with 9 or more months of garnishment would have been preferable to tossing away the right to discharge the balance.
(3) As in (2) above, any motivation to take quick, thoughtless action should be avoided. Tax debt based bankruptcy filings should be well thought out, carefully prepared, and absolutely complete.
(4) Another reason for a well thought out filing is to make as certain as possible that bankruptcy judges will have no reason to rule against the debtor. Where the IRS insolvency unit indicates that they will oppose a tax debt discharge, the court requires an adversary proceeding by the debtor. Getting IRS insolvency unit assent might encourage debtor’s counsel to forego an adversary proceeding (which still might be risky for the debtor).
(5) It is typical for IRS to simply determine nondischargeability of part or all of the tax debt, and then sit by while a debtor omits having an adversary, then once discharge and case closing occurs, simply re-start collection activities. This is somewhat of a trap as it forces a debtor to either accept the failure, or try and fix it, by re-opening the case for the purpose of filing an adversary proceeding that perhaps should have been filed to begin with.
(6) Where tax debt is greater than fifty percent of all debt (as it was in this case) the means test is not necessary. This might facilitate haste in filing rather than increase the quality of information in the schedules.
Aside from the limitation periods and tolling, the case of Ilko v. California State Board of Equalization (In re Ilko) 651 F.3d 1049 (9th Cir. 2011) (http://cdn.ca9.uscourts.gov/datastore/opinions/2011/06/27/09-60049.pdf) is instructive of dischargeability of derivative taxation before assessment. In Ilko, bankruptcy was filed based upon a contingent debt under California’s Rev. & Tax Code 6829. Debtor believed that a bankruptcy filing based upon a contingent (possible future) secondary debt would result in discharge.
The thought may have been to simply “list” potential creditors for contingent debts in the hope of getting an advance discharge. This case emphasizes that by contrast tax debt cannot be discharged in bankruptcy before it is assessed. What it means is that assuming a tax debt that meets the 3-year, 2-year, and 240 day rule in bankruptcy, that future assessments for that year are not dischargeable.
Thus, a taxpayer making it past the 3 year assessment statute, knowing that some fraudulent amounts have been omitted from the return, may have the added amounts assessed, and they will be nondischargeable unless a further bankruptcy filing occurs more than 240 days after the assessment. So, a bankruptcy filing at year 3.5 followed by later assessed debts based upon fraud will not discharge for at least 240 days after the assessment. So, the timing for filing bankruptcy within any limitations period should always consider the possibility of unassessed (or not yet assessed) tax debt liability potential.
For any later assessment, the prohibition on bankruptcy re-filing will provide an additional obstacle as there are time limits for filing a further bankruptcy that depending upon which chapters were chosen for the first and subsequent bankruptcies. Failure of discharge of tax is more often followed by an offer in compromise if there is a genuine inability to pay, rather than a second bankruptcy. Of course, most secondary assessments are based upon some sort of finding of “responsible person” liability so at least there may be some ability to avoid an assessment on that basis before considering bankruptcy, offers in compromise, etc.
Have you ever walked down the street and made eye contact with a hot dog stand vendor? Did you notice that the vendor grabs his tongs and pulls out a square of hot dog wrap paper in preparation for you to complete an order even before you have had a chance to say one word? It can be awkward to ask the time, or to ask directions, once the vendor is armed with their “weapons of the trade.”
The next quick action is asking you what type bun and what type link you want. You might have been approaching the vendor to ask for marital advice. It doesn’t matter. The vendor scoops up his tools of the trade and positions to complete a hot dog assembly without having to look. Its such a smooth move, as if it were the billionth time this month.
Of course, if the vendor was asked to provide a “t-bone steak lunch,” all hell would break loose. “What do you think this is, a fancy restaurant?” The vendor expects that when the cart says “hot dogs,” that it can be read easily and that if you approach and make eye-contact, that you are “going to order a hot dog.” The irritation at a request to provide a “t-bone steak lunch,” will be greater than if you had asked the time of day or even to provide marital advice. The point is that asking about a service that is not along the same lines as “the usual” will provoke hostility and rejection. You would be lucky to get a “get out of here,” and “don’t come back”.
This “expected service” situation exists in the tax debt world. On one side there are large numbers of tax practitioners that can predominantly directly provide IRS based help, such as offer-in-compromise services. On the other side there are bankruptcy practitioners that can potentially provide tax debt relief through a bankruptcy filing. Two factors account for the rift between these two services.
First, the professionals that can provide the tax related services include enrolled agents, CPA’s, and Attorneys. CPA’s are the most numerous and have the closest connection with taxpayers by virtue of tax and accounting services. Next are the enrolled agents that provide tax preparation but not accounting services. Last and fewest in number are the attorneys that are specialized in tax and provide tax related services. As an example, the number of tax specialists attorneys in California is less than 310 at the time of this writing, although there are an unknown number of attorneys that predominantly practice tax law. The number of enrolled agents nationally is cited as 53,000 and if the distribution follows the population, California is 12% and thus 6330 enrolled agents in California.
NASBA (nasba.org) indicates that there are 654,375 actively licensed CPAs in California. So, even if tax practice attorneys were to number twenty times the 310 tax specialists, it can be easily seen that the non-attorney practitioners would be 99% of the tax practitioners available in California, excluding multiple license overlaps. This means that the overwhelming majority of the population of tax practitioners are generally unable or unwilling to apply their tax expertise to bankruptcy. Practice before IRS will involve all of the IRS actions and remedies, but bankruptcy is likely to be an unexplored mechanism for the vast majority of tax practitioners.
Bankruptcy, on the other hand, has practitioners that from a consumer (taxpayer) standpoint operate mostly with non-tax debt. Most bankruptcy lawyers know the main basic bankruptcy debt-related limitations rules relating to the 3 year from tax filing due date, 2 years from filing late return date, and 240 day from assessment date. Some may not know in-depth about the complexities of tolling, a mechanism that stops the normal day-to-day progress toward getting past a limitations date. Inaccurate and inconsistent IRS record keeping creates further difficulty in determining which of the lesser ranked events have been recorded as tolling and which are not.
Many bankruptcy practitioners, even those that understand tax debt may refrain from not ordering the taxpayer’s full records to match against transcripts to analyze tax dischargeability in detail.. In some cases this may be driven by urgency or the necessity for quick action. Often, the procrastinating public seeks help and perhaps even bankruptcy practitioners versed in the basic tax mechanism will not take the time to order a freedom-of-information act full IRS file in addition to a full set of tax account transcripts. The bankruptcy practice approach might be simply skewed toward immediate quick filing in response to some myopic impression of a focused threat.
A monolithic threat is what we humans have become most accustomed to. If we see a first hint of danger, we focus on that danger typically ignoring other dangers that may be more deadly. Many citizen taxpayers perceive a threat and only then approach either a tax practitioner or bankruptcy practitioner for the first time. The citizen taxpayer wants the matter to be resolved instantly. The problem is that the best solution for the taxpayer may be unknown in circumstances where the taxpayer demands immediate resolution.
To take one partial example from one of hundreds of possible configurations, what if a taxpayer hires a bankruptcy practitioner that computes the tax discharge eligibility based upon the 3-year/2-year/240-day computation? What if the client states that there are no tolling events, but in fact there were tolling events? What if the taxpayer transcripts have entries associated with tolling events, but they are incorrect? If there is an SFR (Substitute for Return), will it be investigated? Will the bankruptcy practitioner use the Freedom of Information Act and order the taxpayer’s whole file to verify the transcript, or simply ask the taxpayer to waive any possibility of nondischargeability of tax debt for all years?
To take that same partial example again, from one of hundreds of possible configurations, what if a taxpayer hires a tax practitioner that computes reasonable collection potential without analyzing the transcripts and testing for tolling? What if a tolling event was not reported on the transcripts? What if a tolling event was reported and was improperly entered from someone else’s records, or left open ended? Will the tax practitioner use the Freedom of Information Act and order the taxpayer’s whole file, or simply ask the taxpayer to waive any possibility of taking action before a tax year collection statute expires?
In both cases, I question whether the average
taxpayer been presented with a more complete picture going forward, in order
to see when milestone opportunities occur (such as the expiration of a
collection statute). A taxpayer can blindly wait for a stressor, and then
run to one side (bankruptcy) or the other (IRS remedies) and act, often
without knowing the other side, the bankruptcy statutes, nor the tax
More importantly, the taxpayer may not have a view going forward into the future if a decision is made to take no immediate action at this time.
A taxpayer facing the need to take action now, might not know if a 2 week wait could result in substantial tax savings, and whether an eight week wait could produce even more savings. The taxpayer also needs to know that taking action will generally result in a tolling with respect to all the statutes of limitation as to other potential actions. An overly simplistic example is that a bankruptcy filing tolls the collection statute for later offer-in-compromise filings and later bankruptcy filings, just as an offer-in-compromise filing will also toll the collection statute for later offer-in-compromise filings and later bankruptcy eligibility filings.
Therefore, for any variety of reasons, a taxpayer might choose (in some cases wisely) to wait years before taking some form of action, if that taxpayer knew the approximate series of dates associated with a corresponding series of tax relief milestones going forward. Where a tax or bankruptcy practitioner is knowledgeable about statutes of limitation, its not unusual for the client to be informed about the next milestone, but usually not all the milestones extending into the future. Most practitioners don’t see themselves as having a duty to enable a “continue to monitor” outcome (which may be in the client’s best interest).
A knowledge of the nature of things going forward, what the future will look like without taking action and with triggering tolling, can be advantageous particularly where the client can’t know what exigency pressure they will face in future. The problem is that there is an extended list of actions that can toll the statute. Putting the taxpayer in control of continually monitoring future milestones while realizing that the driving impetus to take action should be a decision made perhaps at that future point in time.
Even further complicating the picture is that some tolling actions have a higher probability of being accurately recorded (or even recorded at all) than others. Actions may be recorded (accurately or inaccurately) in the IRS computer system and obtainable as transcripts, as well as a more complete total taxpayer record, possibly retrievable using the freedom of information act (FOIA). In instances where a taxpayer is taking an action that can only be justified based upon the ability to favorably compromise the tax debt it is extremely important to know as much about ALL the IRS records as is possible.
If a taxpayer is a step behind in knowledge, their efforts can create more problems for themselves than if they took no action at all. The IRS makes errors. IRS doesn’t always mean to make an error, but its something for which taxpayer should not have to suffer.
Errors in the record have to be discovered and advantageously addressed, always sooner rather than later. IRS is said to have a 40% error rate in computing the collection statute termination dates (dates where taxpayers no longer owe tax for a given tax years). If a taxpayer is past the termination of collection date, a taxpayer doesn’t owe any tax and should not be made to pay. IRS also uses substitute for returns (SFR’s) notices and “non-filer notices” to encourage taxpayers to file returns. This technique essentially depends upon the taxpayers to do tax error correction. 10-20% of SFR’s and other encouragements to file are sent in error with reliance on the taxpayer to fix the problem.
The error in SFR generation can stem from: (a) the issue of 1099 to a contractor that wrote your social security number by mistake, (b) making an inquiry to IRS and having the inquiry trigger a tolling period unexpectedly or without your knowledge (such as asking the taxpayer advocate’s office for help, as an example). For every correction response, other mailings may have been sent to a wrong address, or SFRs may be based upon errors in 1099s, social security numbers and many other bases for inaccuracy.
Even worse for bankruptcy filers, an SFR is treated as a first return filing, setting a threshold below which no amount for less than the SFR income amount can be discharged in bankruptcy. (See Chief Counsel Memo 2010-016(SFR)) (http://www.irs.gov/pub/irs-ccdm/cc_2010_016.pdf) For example, in a typical case of a taxpayer that normally receives $100,000 of revenue and a “cost of goods sold” of $80,000 would report (after reduction by the $12,000 standard deduction) a salary of $8,000 and pay a tax of about $1000. However, if IRS learns of receipt of $100,000 of revenue after receiving no return, an SFR having $88,000 of income ( $100,000 of revenue – $12,000 standard deduction revenue ) will be prepared and a tax of about $21,000 will be assessed against the taxpayer.
Even if the taxpayer submits a proper return to reduce the actual tax to $1000, any amount of tax under the threshold of $21,000 established on the initial SFR cannot be discharged. So, checking the SFR to the extent possible to determine if it was generated properly, could eliminate an impediment to discharge for the year it was wrongfully generated. It should be understood that not every non-filed return will result in an SFR, and that a proper SFR should have some verification that the basis upon which it was generated has significant legitimacy.
Given the above less-than-perfect state of affairs in discovering the correct state of the record regarding tax debt, it is important to consult with a practitioner that is interested in presenting a full and complete picture of the taxpayer’s future milestones, including (a) expiration of the 10 year collection statute of limitations for all years owing, (b) the limitation periods beyond which the tax debt is dischargeable in bankruptcy and (c) the tolling events for each tax year relating to (a) and (b), and much much more. The “professional” that is motivated to only serve up their standard fare regardless of the state of the client’s records and circumstances increase an unknown potential for harm.
PDF Version of:
A Tax Debt Only Comparison of
Offer-In-Compromise & Chapter
7 Bankruptcy in California Starting From a
Homelessness Base Case
The result would be different for each state in accord with available state bankruptcy exemptions. This paper does give an outline of one approach to organizing an analysis in other states.
How Far Can You Delay Paying Federal Tax Authorities
Before Criminal Evasion Charges are Filed?
A series of related cases
illustrate the very bad results that can come from fighting the IRS in a
non-direct way. We have heard informal rules of thumb regarding tax evasion. One
rule of thumb might be that if you actually evade payment of tax for huge sum of
money that you are more likely to be prosecuted for tax evasion. Another rule of
thumb might be that if you are a well-known celebrity that evades payment of tax
for a modest sum of money that you are also more likely to be prosecuted for tax
evasion. Both ends of the well-known celebrity and high wealth parallel but
oppositely oriented continua yield a less pronounced middle span largely due to
the amount of approvals and signatures that must be obtained before launching a
tax evasion case.
The potential criminal charges for tax evasion do not
exist in a vacuum. Civil punishments can magnify the potential for criminal
liability. The fundamental time period during which a taxpayer owes the
government is either 10 years once tax has been assessed, or its an infinite
number of years of no tax return is filed and no assessment has been made. Given
a relatively slow pace of development for a non-celebrity, small dollar tax
evasion prosecution, it doesn't pay to arrange to be under the IRS microscope
for an extended period of time. It helps even less to become more noticeable
during such an extended period of time.
The typical taxpayer files a
return on time triggering an assessment (debt owed to the government) that
"exists" for 10-years. At the 10 year mark, if nothing has occurred to increase
the 10 year "statute of limitations" period (known as "tolling"), the IRS is no
longer owed the tax debt associated with the tax event. Also, from the time of
assessment, the IRS has a 3-year period to challenge the return with an audit.
If some understatement problem is found (from an audit or any other source), of
a sufficient magnitude to be characterized a presumptive fraud, the 3-year
potential audit period turns into a 6-year audit period (from assessment).
Stating this another way,
the normal flow of the process is that a taxpayer gets (1) a chance to file a
correct return on time, (2a) the government gets 3 years to challenge the return
via audit if the taxpayer made a less than presumptively fraudulent attempt to
file a correct return, or (2b) the government gets 6 years to challenge the
return via audit if the taxpayer made a more than presumptively fraudulent
attempt to file a correct return. (3) the government gets a full 10 year period
(absent tolling) from the day after assessment to the tax collection statutory
expiration date to collect the tax.
The 10 year collection is
unfortunately extended, whenever the taxpayer takes an action which requires the
government suspend its collection. Some of these actions include bankruptcy,
offer-in-compromise, filing a tax court petition. There are many more actions
that cause tolling of the collection statute of limitation to move forward into
the future. The result is that the 10 year collection period might become a 15
year collection period, or even more.
In addition, when a taxpayer
has been particularly problematic for the government, the IRS can file a civil
suit and obtain a judgement for collection of the tax which extends the period
for collection by an additional 20 years. The judgement is renewable before the
end of the additional 20 years and for an additional 20 years. So, even if there
was no tolling, the use of the civil suit to obtain judgement means a 50 year
collection period during which the taxpayer still owes the money.
There is a general
impression that the progression of tax evasion involves cheating, then filing,
and then getting caught due to the cheating mechanism. People forget that you
can evade taxes by simply not paying. An evader can take action to emit chaff in
hopes of escaping IRS attention. This may be foolishly done thinking that the
IRS will grow weary and forget about the debt. Mostly blind, reason-deficient,
struggles simply create a fervor to collect. There are procedures and rules that
govern the negotiation, should be followed for a quick resolution.
Fighting IRS collection in a
desperate way that ignores the policies that enable settlement, appears very
like an evasive action to delay and prevent payment. Couple a perceived
unwillingness to cooperate with temporal expansion (due to tolling) of the
collection statutes of limitation, and the taxpayers spend a much longer period
of time during which they owe and don't cooperate with the IRS. Even though the
transaction of the tax year is long over, and the audit activities are probably
long over, the collection period is extended, leaving the taxpayers under the
collection microscope for an extended period.
IRS then has a much longer
course of action with which to suspect and establish an evasion based upon
non-payment and lack of cooperation. So even in cases in which the transaction
and audit did not produce an evasion pattern, a long, drawn-out delay in
cooperation can possibly supply the evasive elements needed to build a criminal
Any administrative inhibition due to the extended
time required for criminal investigation and administrative approval will vanish
when the taxpayer provides extension of time via statutory tolling.
Further, when the ire of the IRS has noticed activities of the taxpayer causing
a value judgement that the taxpayer is problematic in delaying and
misrepresenting efforts to bring the matter to a proper conclusion, it is much
more likely that a judgement for collection of tax which extends the period for
collection by an additional 20 years will be done. If owing tax debt to the
government is painful, then extending that pain for an additional 20 years is
tantamount to self-torture for what could be an additional one-third of a
Imagine the following theoretical facts, and how they
might appear to the IRS:
(1) Yr 0: Taxpayer avoids paying year capital gains
on the sale of a business by using a tax shelter.
(2) Yr 3-10: IRS collection
(3) Yr 10: Taxpayer files for bankruptcy in an
attempt to discharge the tax owed, but the bankruptcy court denies discharge and
finds that taxpayers willfully attempted to evade or defeat the collection of
tax under 11 U.S.C. § 523(a)(1)(C). (which recently has been set by legal
decision to carry the same standard of proof applicable to tax evasion).
(4) Yr 12: After tolling
delay from the bankruptcy, IRS resumes collection activity.
(5) Yr 15: Taxpayer utilizes
administrative due process procedures, including collection due process and
offer-in-compromise and are unsuccessful.
(6) Yr 16: IRS refers The
Justice Department to file suit to reduce the assessments to judgement and thus
extend the period for collection for another 20 years (possibly to Yr 36, and
possibly to Yr 56 if extended before Yr 36).
(7) Yr 18: Taxpayer files a
complaint in federal district court against a number of federal workers,
including a revenue officer, collection supervisor, an advisor, a settlement
officer appeals officer, offer in compromise manager, tax examiner, offer
specialist, group manager and the acting director for area collection, and other
yet unknown tax and justice personnel in a "Bivens" action for "a conspiratorial
plot to deny him his constitutional rights, purportedly on account of his
alleged disability, at all relevant stages of the aforementioned tax collection
(8) Yr 19: The Bivens action was dismissed based upon
the fact that because the Internal Revenue Code gives taxpayers meaningful
protections against government transgressions in tax assessment and collection .
. . Bivens relief is unavailable for plaintiffs' suit.
Establishment of evasion
using the courses of action from the past can possibly be added to acts
occurring in future to perhaps show a continuous course of dealing, an intent,
establishment of a plan for tax evasion. Would YOU wish a quick resolution to
this tax debt? What actions would YOU take begin such resolution?
(1) Would you start a stream
of payment to IRS on a regular basis?
(2) Would you compute your
reasonable collection amount and liquidate everything else and attempt a further
offer-in-compromise without delay?
(3) Would you begin your own
payment plan subject to a formula that was based upon the IRS cost of living
(4) If your income was steady, would you set up and
be willing to risk failure to try a long-term repayment plan?
(5) Given that a tax crime
conviction would set up the tax debt owing as an even more onerous restitution
payment, what acts and statements could you telegraph to IRS to show that steps
are being taken to begin liquidation to an IRS living standards connected
(6) After liquidation to an IRS living standards
connected subsistence level and achievement of a $0 further collection
potential, would you consider asking to being placed on currently not
collectible (CNC) status?
(7) Would you consider
living overseas in order to possibly enable yourself to repay the tax debt more
rapidly and efficiently through foreign earned income exclusion?
(8) What other actions would
you consider to stave off criminal prosecution while paying off your tax debt?
Announcing a new posting for no-cost CLE on August 14, 2019 :
California Continuing Education, Inc., Presents
Taking Charge of your Relationship with the IRS
Taxpayer First Act Credit Card Trap
President Donald Trump signed the Taxpayer First Act on July 1, 2019. The Taxpayer First Act has a number of provisions, some of which will help IRS with its internal processes, and some of which are external and aspirational. As to one of the provisions, the IRS is about to embark on a relationship with credit card companies to allow taxpayers the ability to pay their taxes directly by credit card. As you may or may not be aware, one major possibility for a taxpayer to favorably resolve solve their IRS debt, when conditions permit is via bankruptcy. A resolution requires use of the 3-year, 2-year & 240 day limitation provisions with tolling.
Bankruptcy Code §523(a)(14) states that if a nondischargeable tax debt to the United States ( such as a nondischargeable tax or a customs duty) then any credit card debt incurred to pay such nondischargeable tax debt is excepted from discharge. As a practical matter this has been the rule for some time, but the possibility of paying federal tax debt directly with credit cards is expected to have a "short circuiting" effect, exposing what was has otherwise been an obscuring relationship between the credit card borrowing and its traceable application directly to a tax debt.
Currently, the use of credit cards to obtain money for use in paying taxes is difficult to trace because it probably involves a borrowing mechanism that uses currency as an intermediate, such as with an ATM machine. Only a few services allow transfer directly from credit card into a bank account, but the fees range from 10%-15%. Over the next few months, the IRS may be able to negotiate credit card transaction fees to 1-2% (not including interest). If and when this occurs, the use of direct credit card payment to the IRS will the greatly preferred in instances where credit cards are used as a source of tax payment funding.
This also will probably mean that tax transcripts can be expected to carry some indication to reflect the fact that a tax payment was accomplished with a credit card. Whether this indication shows up in taxpayer transcripts or is available internally at IRS, the tracing to verify the type of payment should be expected to be easy. Because the charging taxpayer is going to have to pay a publicly known credit card processing fee the records of the transactions may be even more identifiable in the bank credit card records, especially if the user fee is independently posted. In short, the fact of the direct use of a credit card to pay tax debt should be instantly and unambiguously available to both the IRS insolvency unit and to the credit card account creditor.
The combination of direct credit card use and an expected low initial transaction fee should make this option very popular, but once the option is used, it will work to the detriment of tax debtors and shift the possible remedy chosen as between bankruptcy, offer-in-compromise, and other alternatives. Worse still, if tax debt practitioners fail to ask about credit card tax payment, or discover and understand it on the account transcript, and take it into account for an analysis of the debtor's options, unpleasant surprises will result. Also needed is a warning advisement to avoid the direct use of credit cards to pay tax debt as soon as possible, starting before this mechanism is fully implemented.
July 10, 2019
Tax Debt Approach (Blog)
There are Usually 6 Tax Choices At Any Given Point In Time
July 07, 2019 Taxpayer First Act Pt 2
To be fair, there are already a number of mechanisms to help taxpayers re-enter the middle road of tax compliance. The main theme that has operated for 10 years is "talk to me," and a need for taxpayers to get into contact with IRS. The contact a taxpayer should have is to access & watch their IRS account in a way not terribly different from the way they access a credit card account, bank account, or other creditor's account.
One "meaty" provision of the Taxpayer First Act is the "single point of contact"
mechanism for ID theft. Not only will it help IRS internal mechanisms
synchronize to help combat ID theft, it will enable IRS to get and analyze a
more complete and consistent data set to help better discover the causes of such
identity theft. IRS can then formulate prevention protocols and begin to
publicize warnings and how the particular form of identity theft can be avoided.
July 06, 2019 Taxpayer First Act Pt 1
On July 1, 2019, President Trump signed the Taxpayer
First Act. I'm expecting that enforcement of the changes may not mean much. The
main fix might be a reduction in the Tax Court Load. What has happened up to now
is that the taxpayer habit of not opening their mail has served a federal policy
requiring an issue to be raised at a first possible (due process / appeals)
hearing opportunity, or waived if the first possible hearing opportunity was
missed. Since tax court petitions are usually sent back to appeals, many
taxpayers file a skeletal tax court petition to try and generate a hearing
opportunity before appeals. If the first hearing opportunity was waived, that
waiver mechanism is still employed by appeals during the tax court remand. The
result has been a bloated number of tax court filings that were submitted not to
get to tax court, but to get to appeals.
Any mechanism that
allows a taxpayer some appeals hearings without causing them file in tax court
simply in order to get to appeals is a good thing, but the Taxpayer First law
does not upset the current "first hearing opportunity" mechanism. The Taxpayer
states that "For purposes of this section, subsections (c), (d) (other than
paragraph (3)(B) thereof), (e), and (g) of section 6330 (which contains
the "first hearing opportunity" rules) shall apply." This means
that the mechanism for challenging the underlying tax CONTINUES to depend upon such a
hearing's being the first opportunity to raise the issue. The tide of petitions
to tax court will probably not be affected. Taxpayers may not feel any increased incentive to open their IRS mail.
May 15, 2019 Las Vegas 19-527
Tax Evasion: Conspiracy to Defraud the Government
How: Cause IRS to issue fraudulent income tax refunds
False Claims: More than $6 million
Fraudulent Refunds: More than $2 million
Prison: 18 Months + 3yrs Supervised Release + $362,328.00 Restitution
Co-Conspirator(1) Prison: 102 Months
Co-Conspirator(2) Prison: 12 Months
Extreme measures were taken to avoid detection; which results in sentencing enhancement under the Sentencing Guidelines
Use of e-mail & telephone involves risk of message interception by third
parties (such as the government), and contacting me by a method you choose
carries this risk. Your mode of communication is my notice that you waive
the risk of interception by that mode and by such contact you consent to
return contact in the same manner. If you have ANYTHING that is sensitive to
convey to me, it should be given in a face-to-face meeting. No
attorney-client relationship exists in the absence of (1) a signed fee contract and (2) remission of an agreed-upon retainer. Absent such, I am not engaged by you as an attorney, nor is any other member of my law firm.
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Tax Debt Approach (Blog)
If you kow of any new cases or changes in policy that impacts any of the blog entries please comment by email with attachments