Posted by: Steven Toscher | May 8, 2021

SAVE THE DATE – 13th Annual NYU Tax Controversy Forum

We are pleased to invite you to the  13th Annual NYU Tax Controversy Forum Webinar to be held June 24 and 25. 

You do not want to miss this program.

Co-Chairs Bryan Skarlatos and Steven Toscher are pleased to announce this year’s NYU Tax Controversy Forum which will feature updates on what the IRS is doing to enhance compliance through communication and enforcement. Panels will highlight the new IRS focus on intra-agency collaboration, new initiatives with respect to penalties and fraud referrals, and IRS’ handling of tax collection challenges. Tune in from your computer, at home or the office, to hear Tax Compliance and Procedure Updates from senior IRS personnel. We are excited that the following officials of the IRS have agreed to speak at this year’s program. 

  • Charles P. Rettig, Commissioner, Internal Revenue Service
  • Nikole Flax, Deputy Commissioner, Large Business and International Division, Internal Revenue Service
  • Darren John Guillot, Commissioner, Small Business/Self-Employed Division, Collection, Internal Revenue Service
  • De Lon Harris, Commissioner, Small Business/Self-Employed Division, Examination, Internal Revenue Service
  • James C. Lee, Chief, Internal Revenue Service Criminal Investigation
  • Douglas O’Donnell, Deputy Commissioner, Services and Enforcement, Internal Revenue Service

SAVE THE DATE FOR THIS YEAR’S FORUM

We are pleased to announce that Dennis Perez, Michel Stein, and Robert Horwitz will be speaking at the upcoming CalCPA webinar, “Federal and State Residency Issues: Remote Workers and Navigating IRS Examination Guidance and State Regulations in the Post-Covid-19 World” on Tuesday, May 25, 2021, 9:00 a.m. – 10:00a.m. (PST).   This webinar will guide tax professionals and advisers on the latest IRS examination guidance and state tax law issues regarding taxpayer residency. The panel will discuss federal and state tax residency rules, residency and allocation matters, U.S. income tax treaties, available tax planning techniques, managing nonresident audits, and overcoming state regulatory challenges. Advising taxpayers on issues relating to residency has become even more cumbersome. The IRS LB&I unit has issued examination guidance focused on taxpayer residency and the application of U.S. income tax treaties. State tax residency rules and an increase in state audits and enforcement require tax professionals to become knowledgeable of new state residency and allocation issues to implement effective tax planning strategies for taxpayers. including:  Recognizing the importance of both citizenship and residence in determining tax liabilities of individuals Purposes of income tax treaties and their applicability Common residency provisions and tiebreakers for dual residents Allocating income between jurisdictions Principal items targeted by state regulatory authorities California tax residency rules and guidelines New York domicile test and primary factors in determining tax residency Dual-residency issues with non-personal income tax states Preparation for nonresident audits Current planning techniques and best practices for tax professionals  

Please join us.

Click Here for more information

Richard and Kimberly Gaetano owned marijuana dispensaries.  After a falling out with their legal advisor/business partner, he apparently ratted them out to IRS Criminal Investigations (“CI”).  In 2017, they sued to bar CI from discussing attorney-client matters with their former legal advisor.  That case was dismissed. Gaetano v United States, 942 F.3d 727 (6th Cir. 2019). 

While that case was pending before the Sixth Circuit, the Gaetanos filed a petition to quash a summons issued by a CI Special Agent to a company, Portal 42, that made point of sale software featuring the capacity for businesses to track customer sales data or delete the data remotely with a “kill switch.”  They asserted the summons was issued in “bad faith.”  The Government moved to dismiss for lack of standing but in reply to the Gaetanos’ opposition it argued that the court lacked subject matter jurisdiction.  The magistrate judge recommended that the case be dismissed for lack of standing and that the summons be enforced.  The district court ordered that the case be dismissed for lack of jurisdiction but did not enforce the summons because it lacked jurisdiction and because Portal 42 had already complied.  The Sixth Circuit Court of Appeals affirmed. Gaetano v U.S. 2021 WL 1326825 (6th Cir. 2021). 

Before we get to a discussion of the Sixth Circuit’s reasoning, a brief overview of third-party summonses.  One of the investigative tools that the Government has for, among other things, “ascertaining the correctness of any return, making a return where none has been made, determining the liability of any person for any internal revenue tax” and “inquiring into any offense connected with the administration or enforcement of the internal revenue laws” is the administrative summons.  Internal Revenue Code (“IRC”) §7602(a), (b).  That section authorizes the IRS to:

(1) Examine any books, papers, records or other data which may be relevant or material to such inquiry;

(2) To summon the person liable for tax or required to perform the act, or any officer or employee of such person, or any person having possession, care, custody of books of accounts containing entries relating to the business of the taxpayer to give testimony  under oath or produce books, papers, records, or other data; and

(3) To take testimony of the person concerned, under oath, as may be relevant or material to such inquiry.

There are special procedures for summonses served on third parties.  IRC §7609(a)(1) provides that when an IRS summons is served on a third party requiring production of records, “any person (other than the person summoned) who is identified in the summons” is entitled to notice of the summons.   A person entitled to notice can intervene in any proceeding to enforce the summons and may file a petition to quash the summons.  §7609(b)(1), (2).

IRC §7609(c)(2) contains several exceptions to the notice and petition to quash provisions of §7609, including a summons by an IRS criminal investigator in connection with the investigation of an offense connected with the administration or enforcement of the revenue laws and served on someone who is not a “third-party recordkeeper” as defined in IRC §7603(b).  IRC §7609(c)(2)(E).

The summons issued to Portal 42 sought records for the period January 1, 2015 to September 1, 2019.  The Gaetanos petition alleged that the summons was issued in bad faith and that the IRS should have notified them about the summons.  The government moved to dismiss for lack of standing and attached a declaration of the special agent who stated that he was conducting a criminal investigation to determine if the Gaetanos understated their tax liability in violation of the IRC and that the summoned records were relevant and necessary to the investigation. 

In their opposition to the motion, the Gaetanos conceded that Portal 42 was not a “third-party recordkeeper” as defined in §7603(b) but argued that the summons was issued in bad faith because the special agent did not state the tax years being investigated and there could be no criminal investigation for 2019 because when the summons was issued the 2019 return was yet due.  In its reply, the Government argued that §7609(c)(2)(E) is an exception to the United States’ waiver of sovereign immunity for petitions to quash, that the special agent was an IRS criminal investigator and Portal 42 was not a third-party recordkeeper.  It also filed a supplemental declaration of the special agent, who testified that he was investigating income and employment tax returns for 2015 through 2018 and quarterly filings for 2019.  

The Sixth Circuit first addressed the issue of subject matter jurisdiction.  The Government cannot be sued unless there is an express statutory waiver of sovereign immunity.  If sovereign immunity is not waived, the courts lack subject matter jurisdiction over the proceeding. 

IRC §7609(h) vests district courts with jurisdiction over actions to quash summonses for which notice is required under IRC §7609(a).  The question confronting the Sixth Circuit was whether the exceptions contained in IRC §7609(c)(2) were limitations on standing or exceptions to the waiver of sovereign immunity.  The Ninth Circuit has held that an exception in §7609(c)(2) meant the plaintiff lacked statutory standing, Viewtech, Inc. v. United States, 653 F.3d 1102 (9th Cir. 2011), while other courts have held that a §7609(c)(2) exception deprives the court of subject matter jurisdiction, since there has been no waiver of sovereign immunity.  Haber v. United States, 823 F.3d 746 (2nd Cir. 2016). 

Note: In Viewtech, Inc., the Government moved to dismiss solely on the ground that the petitioner lacked standing while in Haber, the Government moved to dismiss solely on the ground that sovereign immunity had not been waived and, therefore, the court lacked subject matter jurisdiction.

Why is this question important?  The Sixth Circuit explained: first, statutory standing is not jurisdictional, so it would not implicate the court’s power to adjudicate the case.  While one person may lack standing to bring an action, there may be someone else who can bring a valid action.  If it is jurisdictional, then a valid action could not be brought.

Second, sovereign immunity cannot be waived by an attorney or agent of the Government, can be raised at any stage of the proceedings and can even be the basis for a collateral attack on a judgment.  Thus, if the exception was a limitation on standing, rather than on jurisdiction, and the Government did not raise it early in the proceeding, it could be deemed waived and the court would have the power to address the question of whether the summons was issued in bad faith.

Because the language of §7609(c)(2) was similar to the language in other statutes where the Supreme Court held that an exception was a limitation on the waiver of the United States’ sovereign immunity, the Sixth Circuit held the exceptions in 7609(c)(2) were jurisdictional.

The Sixth Circuit then turned to who had the burden of proving that the exception applied.  Since the Gaetanos’ petition did not, on its face, show that an exception applied, the burden was on the Government to prove that an exception applied.  The summons was issued by IRS CI and the special agent’s declaration established that he was a criminal investigator with CI and that he was investigating offenses connected to the administration and enforcement of the internal revenue laws.  Thus, the exception in IRC §7609(c)(2)(E) applied. 

Next up was the Gaetanos’ assertion that the summons could not have been issued “in connection with a criminal investigation” because the “periods” listed on the summons were January 1, 2015 to September 1, 2019 and there is no period ending September 1, 2019.  There is nothing in the statute that requires the summons to identify the tax periods under investigation, the special agent’s declaration stated what periods he was investigating, and as the Supreme Court pointed out in United States v. Powell, 379 U.S. 48 (1964), the elements needed to enforce a summons are normally established by affidavit.  More importantly, the Gaetanos’ argument went to the merits of the case.  Given the lack of subject matter jurisdiction, whether the summons was issued in bad faith was something that a court could not decide.  

The discussion of whether the exceptions contained in 7609(c)(2) are limits on standing or subject matter jurisdiction may seem esoteric.  It is nonetheless an important issue in tax procedure since it goes to the question of the court’s power to rule on the merits of a case.  Traditionally, the federal courts had interpreted rules relating to waivers of the United States’ sovereign immunity, including deadlines, as being jurisdictional.  Recent Supreme Court jurisprudence requires that for a statutory condition to be jurisdictional, it must be clearly stated in the statute.  Irwin v. Dep’t of Veteran’s Affairs, 498 U.S. 89 (1990); United States v. Kwai Fun Wong, 575 U.S. 402 (2015).  Presently pending before the Supreme Court are several certiorari petitions raising the issue of whether the 90-day period for filing a petition with the United States Tax Court is jurisdictional.  See Organic Cannabis Foundation v. Commissioner, Supreme Court Docket No. 20-1014.  If it is not jurisdictional, it would mean the time period for filing a Tax Court petition would be subject to equitable tolling.

NOTE:  Even though there is a split in the Circuits on whether the exceptions contained in IRC §7609(c)(2) are limitations to standing or to the waiver of sovereign immunity, Gaetano is unlikely to be the type of case in which the Supreme Court would grant certiorari, since a decision by the Supreme Court that IRC §7609(c)(2) limits standing would not change the result: either way, the Gaetanos’ petition to quash would be dismissed.

Robert S. Horwitz is a Principal at Hochman Salkin Toscher & Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He represents clients throughout the United States and elsewhere involving federal and state administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C.

Why is it that tax compliance involving this emerging asset continues to be problematic?  Aside from any individualized taxpayer’s confusion or potential motivations, one additional answer may be the direct result of the lack of third-party reporting requirements.  While digital currency exchanges, under Title 31 and the Bank Secrecy Act, are generally regulated as money transmitters and required to maintain certain records,[1]  for many cryptocurrency exchanges, the reporting requirements under Title 26 are somewhat limited.  For example, there is no requirement for the issuance of a Form 1099-B to their users and 1099-K is only required if the user exceeds $20,000 in transactions and the aggregate number of such transactions exceed 200 in one year.[2]  Unfortunately, as experience has shown, third-party reporting is often one of the great human regulators when it comes to tax compliance.  In other words, this lack of third-party reporting obligations often means “out of sight, out of mind” for taxpayers.  This in turn can lead to what the IRS considers to be a rampant amount of intentional “forgetfulness” on the part of taxpayers, who may otherwise have independent obligations to report cryptocurrency transactions on their tax returns.    

The IRS has not been shy in recent years in expressing its position that obtaining information about a U.S. taxpayer’s cryptocurrency transactions is necessary to tax administration.  Obtaining such information, however, can be a bit like looking for a needle in a haystack.  That said, in instances where the IRS can establish that a group of unidentified taxpayers are engaged in conduct that may violate U.S. tax laws, Congress has provided an investigation tool for the IRS to use to make its search a bit easier.  That tool is known as a John Doe summons.

A John Doe summons, unlike an individualized summons used in an investigation of a single taxpayer and which the IRS can issue without judicial approval,[3] permits the Government to obtain information about a larger group of unidentified taxpayers where the Government can demonstrate a reasonable belief that the “unidentified” taxpayers are engaged in conduct that may violate U.S. tax laws.  In the context of obtaining information related to unidentified taxpayers’ use of cryptocurrency transactions, the Government’s first attempt to use a John Doe summons was in 2017 and was directed at Coinbase, the largest cryptocurrency exchange in the world.  That case was heard by the United States District Court for the Northern District of California, which initially determined the scope of the Government’s request for information to be overbroad.[4]  While the Court narrowed the reach of the summons, ultimately, Coinbase, was required to respond and turned over 14,355 users’ information to the IRS.

Since the decision in Coinbase, the law involving the issuance of John Doe summons has been narrowed by the Taxpayer First Act of 2019 (“TFA”).  The three prong test must still be met by the Government for a Federal Court to grant the right for the IRS to issue a John Doe summons, namely the following:[5]

  1. The John Doe summons relates to the investigation of a particular person or ascertainable group or class of persons;
  2. There is a reasonable basis for believing that such person or group or class of persons may fail or may have failed to comply with any provision of any internal revenue law, and
  3. The information sought to be obtained from the examination of the records or testimony (and identity of the person(s) with respect to whose liability the summons is issued) is not readily available from other sources.

However, now the Government must also meet the narrowly tailored requirement in the flush language of the statute added as part of the (TFA).[6]  That language requires that the information sought to be obtained in the summons should be narrowly tailored to information that pertains to the failure or potential failure of the group or class of persons that have failed to comply with one or more provisions of the internal revenue laws which have been identified.  So, in light of the TFA and the decision in Coinbase, both of which involve a narrowing of the reach of the IRS under a John Doe summons, what can taxpayers expect in future IRS’s requests for authorizations to issue John Doe summonses?  The answer may already be before us, based upon the filing of two recent John Doe summons cases discussed herein.

The Circle John Doe Summons Case

On March 30, 2021, the Government filed a petition for approval to issue a John Doe summons to Circle Internet Financial, Inc. and its affiliate Poloniex LLC cryptocurrency exchange (“Circle”).[7]  Poloniex is the 18th-largest cryptocurrency exchange by trading volume and is known for supporting a variety of digital currencies.[8]  The case was filed in the United States District Court for the District of Massachusetts.   The Government cited to the TFA and Coinbase case and spelled out why it believes that virtual currency transactions are not being properly reported and the role that the lack of third-party reporting plays in this deficiency.   In the words of the Government, this “information gap” increases tax noncompliance and makes the “likelihood of underreporting significant.”[9]  The Government also noted that the limitations imposed in Coinbase were not in the summons for Circle because the terminology of Circle’s exchanges differ.[10]  The Government also argued that the summons meet not only all three of the numbered criteria in § 7609(f), but also the new “narrowly tailored” requirement.[11]  On April 1, 2021, the Court issued an order allowing the Government to serve the requested John Doe summons against Circle.[12]   

The Kraken and Coinbase John Doe Summons Cases

The same day, March 30, 2021, that it filed the Circle case, the Government filed another John Doe summons case, seeking authorization to summons records from the cryptocurrency exchange Payward Ventures Inc. d/b/a Kraken (“Kraken”).[13] Kraken is one of the largest digital currency exchanges with over 4 million clients and over $140 billion in trading activity since 2011.[14]  It has been reported that, as of the end of 2017, Kraken was registering up to 50,000 new users a day.[15]     

The John Doe summons case against Kraken was filed in the United States District Court for the Northern District of California, the same Court which heard the Coinbase matter.  Perhaps, as might have been expected, the filing of the Kraken case was met with judicial resistance from the Court.  Citing to the  limitations set forth in  the Coinbase case, the Court in Kraken issued an order requiring that the Government show cause why the petition to grant the John Doe summons should not be denied.[16] Specifically, the Court, relying on the analysis in the Coinbase decision, questioned whether the broad category of information sought in the John Doe summons was irrelevant and premature, such that the IRS should first review the basic user information and transaction histories (e.g., derived from a more limited summons to Kraken) should happen before determining whether further summonses – to either the cryptocurrency exchange or to individual users – are necessary or appropriate under the law.[17]

The Government, in response to the Court’s order, agreed, as it had done in Coinbase, to  narrow the scope of the information requested in the Kraken John Doe summons.[18]  Thus, the  revised summons request for Kraken excluded, from the original summons request, “all correspondence between Kraken and the User or any third party with access to the account pertaining to the account, including but not limited to e-mails, chat support logs, telephone logs or recordings, letters, or other memoranda of communication.”[19] 

Conclusion

The adverse impact on tax administration by the lack of third-party reporting by cryptocurrency exchanges that may result in taxpayer non-disclosure and non-compliance is clearly something the IRS recognizes as a problem.  It is also information that the IRS, by the filing of simultaneous, coast-to-coast John Doe summons requests, has very publicly signaled it has every intention of affirmatively going after “one haystack at a time”.

Sandra R. Brown is a Principal at Hochman Salkin Toscher Perez P.C., and former Acting United States Attorney, First Assistant United States Attorney, and the Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal). Ms. Brown specializes in representing individuals and organizations who are involved in criminal tax investigations, including related grand jury matters, court litigation and appeals, as well as representing and advising taxpayers involved in complex and sophisticated civil tax controversies, including representing and advising taxpayers in sensitive-issue audits and administrative appeals, as well as civil litigation in federal, state and tax court. 

Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C.


[1] See FinCEN Guidance No. FIN-2013-G001: Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies (Mar. 18, 2013), available at https://www.fincen.gov/sites/default/files/shared/FIN-2013-G001.pdf [https://perma.cc/E9C8-YH3C]; FinCEN Guidance No. FIN-2019-G001: Application of FinCEN’s Regulations to Certain Business Models Involving Convertible Virtual Currencies (May 9, 2019), available at https://www.fincen.gov/sites/default/files/2019-05/FinCEN%20Guidance%20CVC%20FINAL%20508.pdf [https://perma.cc/6BVK-AJVP]. 

[2] IRC §6050W(e).

[3] 26 U.S.C. §7602(a).

[4] United States v. Coinbase, Inc., No. 17-cv-01431-JSC, 2017 WL 5890052, at *6-7 (N.D. Cal. Nov. 28, 2017).

[5] 26 U.S.C. §7609(f).

[6] Pub. L. No. 116-25, §1204(a), 133 Stat. 988 (2019).

[7] In the Matter of the Tax Liabilities of John Does, No. 21mc91201 RGS, Docket No. 3, (D.Mass. March 30, 2021).

[8] Evelyn Cheng, Circle Acquisition of Poloniex is Just The Beginning of Likely Consolidation in Crypto, CNBC, (Feb. 26, 2018), available at https://www.cnbc.com/2018/02/26/circle-acquisition-of-poloniex-is-just-the-beginning-of-likely-consolidation-in-crypto.html.

[9] In the Matter of the Tax Liabilities of John Does, No. 21mc91201 RGS, Docket No. 3, page 8, (D.Mass. April 1, 2021).

[10] Id. at 9.

[11] Id. at 15.

[12] In the Matter of the Tax Liabilities of John Does, No. 21mc91201 RGS, Docket No. 5, (D.Mass. April 1, 2021).

[13] In re Tax Liability of John Does, Case No. 21-cv-02201-JCS, Docket No. 2, (N.D. Cal. March 30, 2021).

[14] Lara AbdulMalak, Kraken Crypto Exchange Opening up Shop in UAE, Unlock, available at https://www.unlock-bc.com/news/2019-05-14/kraken-crypto-exchange-opening-up-shop-in-uae.

[15] Frank Chaparro, Bitcoin exchange Coinbase reportedly made more than $1.25 billion in revenues last year, Business Insider, (Jan 23, 2018), available at https://www.businessinsider.com.au/coinbase-reportedly-made-more-than-1-billion-in-revenues-last-year-2018-1.

[16] In re Tax Liability of John Does, Case No. 21-cv-02201-JCS, Docket No. 6, (N.D. Cal. March 31, 2021).

[17] Id. at 3.

[18] In re Tax Liability of John Does, Case No. 21-cv-02201-JCS, Docket No. 8, page 8, (N.D. Cal. March 31, 2021).

[19] Id. at 15.

We are pleased to announce that Steven Toscher, Michel Stein, and Robert Horwitz will be speaking at the upcoming Spidell webinar, “Federal and State Residency Issues: Remote Workers and Navigating IRS Examination Guidance and State Regulations in the Post-Covid-19 World” on Wednesday, May 5, 2021, 10:00 a.m. – 12:00 p.m. (PST).

This webinar will cover practical considerations for partners and advisers to partnerships now operating under the new partnership audit regime. Our panel of experts will review the latest guidance, explain partnership audit adjustments, and make recommendations for steps to take in light of the implementation of this new regime, including:

  • Recognizing the importance of both citizenship and residence in determining tax liabilities of individuals
  • Purposes of income tax treaties and their applicability
  • Common residency provisions and tiebreakers for dual residents
  • Allocating income between jurisdictions
  • Principal items targeted by state regulatory authorities
  • California tax residency rules and guidelines
  • New York domicile test and primary factors in determining tax residency
  • Dual-residency issues with non-personal income tax states
  • Preparation for nonresident audits
  • Current planning techniques and best practices for tax professionals

Click Here for more information.

We are pleased to announce that Steven Toscher will be moderating and Evan Davis will be speaking at the upcoming ABA webinar, “A New Regime of Transparency: Anti-Money Laundering and Corporate Transparency Acts of 2020 and Expansion of Cryptocurrency Reporting” on Tuesday, April 27, 2021, 1:00 p.m. (EST), 10:00 a.m. (PST).
Joining the panel will be Andrew Winerman, Acting Deputy Associate Director of FinCEN’s Strategic Operations Division and Deborah Connor Chief, Money Laundering and Asset Recovery Section, U.S Department of Justice, and leading defense counsel Ian Comisky, Stephanie Brooker and Bryan Skarlatos


Join us for a two hour program covering the substantial legislative changes made by the Anti-Money Laundering and Corporate Transparency Acts of 2020 and the recent expansion of cryptocurrency reporting announced by FinCEN.  This is the first major overhaul of the Bank Secrecy Act (“BSA”) in fifty years. The program will cover the expanded powers and duties of FinCEN highlighting AML priorities and regulations, streamlining Currency Transaction Reporting (“CTR”); Suspicious Activity Reporting (“SAR”); the creation of a FinCEN Exchange; and inter-agency coordination and information sharing. The program will also cover the new federal beneficial ownership reporting regime creating a FinCEN beneficial ownership registry and new whistleblower provisions provided for money laundering violations permitting a reward of up to 30 % of what has been collected as monetary sanctions.

Click Here for more information.

A recently released IRS legal memorandum appears to be intended to clarify inventory tax accounting principles for state-legal marijuana businesses despite not mentioning the restriction they face, according to practitioners.

Jonathan Kalinski of Hochman Salkin Toscher Perez PC told Tax Notes in part that “Most taxpayers aren’t asking to capitalize costs to inventory and would rather immediately deduct them, with the exception of businesses subject to section 280E.”

Click Here to read full article.

We are pleased to announce that Dennis Perez and Steven Toscher will be speaking at the upcoming Jewish Community Foundation of Los Angeles webinar, “The (Tax) Truths and Consequences of Leaving California” on Wednesday, April 28, 2021, 12:00 p.m. – 1:30 p.m. (PST). This webinar will guide tax professionals and advisers on the latest California tax law issues regarding taxpayer residency. Covid-19 has caused many of us to re-assess where we live and work and the ever increasing tax cost of being a California resident including the possibility of a new wealth tax has all of us thinking that a move out of California to a lower tax state can make sense. California tax residency rules are complex, often misinterpreted by taxpayers and an increase in state audits and enforcement require tax professionals to become knowledgeable of state residency rules to implement effective tax planning strategies for taxpayers. When you leave California the last thing you want is the tax collector to follow you.

Click Here to Register.

In September 2019, California enacted Assembly Bill 5, which codified the three part “ABC test” of Dynamex Operations West Inc. v. Superior Court, 4 Cal.4th 903 (2018), to determine whether workers are employees and not independent contractors.  Under the ABC test a worker is presumed to be a common law employee unless the hiring entity can establish three factors:

  1. The individual is free from the control and direction of the hiring entity in connection with the performance of work;
  2. The individual performs work that is outside the usual course of the hiring entity’s business; and
  3. The individual is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.

The California Court of Appeal in Vendor Surveillance Corporation v. Patrick W. Henning Jr., 2021 WL 1034833 (2021), declared that, except with respect to wage orders, the “ABC” test does not apply for years before 2020. Instead, the eleven-factor test of S.G. Borello & Sons, Inc. v. Department of Industrial Relations, 48 Cal.3d 341 (1989), applies to determine whether workers were employees or independent contractors.  These factors are also set out in an EDD regulation, California Code of Regulations, Title 22, § 4304-1.

The most important of the Borello factors is the right to control the manner and means of accomplishing the result desired.  Other factors are:

  • Whether the one performing services is engaged in a distinct occupation or business;
  • The kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of the principal or by a specialist without supervision;
  • The skill required in the particular occupation;
  • Whether the principal or the workman supplies the instrumentalities, tools, and the place of work;
  • The length of time for which the services are to be performed;
  • The method of payment, whether by the time or by the job;
  • Whether the work is a part of the regular business of the principal; and
  • Whether the parties believe they are creating the relationship of employer-employee

In Vendor Surveillance Corporation, the California Employment Development Department (EDD) audited Vendor Surveillance Corporation (“VSC”) for tax years 2011 through 2013.  VSC maintained a database of project specialists who are qualified to perform source inspections of manufacturing operations to ensure no defective parts escape detection and are installed in an aircraft.  VSC classified its project specialists as independent contractors and engaged them under an “Independent Contractor Agreement.”  Since it treated them as independent contractors, VSC did not pay unemployment insurance tax on the earnings of the project specialists.

In the audit, the EDD determined that VSC misclassified project specialists and that VSC’s project specialists were common law employees under Unemployment Insurance Code section 621 and regulation 4304-1 (Borello factors). The EDD assessed VSC $1,046,578.35 for unemployment insurance, state disability insurance, and personal income tax, plus approximately $48,000 in interest. After VSC’s administrative challenges, EDD reduced the assessment to $278,692.45.  VSC paid the tax and sued for a refund.

In the refund suit in the superior court, the EDD argued that Dynamex’s ABC test applied retroactively to the unemployment insurance assessments for tax years 2011 through 2013. VSC maintained that Borello applied. The superior court applied both tests and held that the project specialists were independent contractors.  VSC appealed.

The two issues before the California Court of Appeal were (1) for purposes of assessing unemployment insurance tax, what is the appropriate test for determining whether a worker was an employee or independent contractor for work performed during that period; and (2) did the trial court correctly apply the appropriate test in reaching its decision. VSC argued that as a matter of law, Borello applies in determining liability for unemployment insurance tax for work performed during the audit years and that its due process rights would be violated by applying Dynamex retroactively.  The Court of Appeals agreed with that Borello applies, making it unnecessary to consider the second. The Court of Appeals held that the superior court’s determination under the Borello factors was supported by substantial evidence.  Thus, it affirmed the superior court’s ruling that the project specialists were employees and that VSC was not entitled to a refund.  Despite the loss to the taxpayer, this decision will help guide taxpayers and the EDD during audit of tax periods ending before January 1, 2020, and makes it clear that the more stringent ABC test will not apply in determining worker classifications.

Robert S. Horwitz is a Principal at Hochman Salkin Toscher & Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He represents clients throughout the United States and elsewhere involving federal and state administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C.

The views: Steve Toscher (Managing Principal, Hochman Salkin Toscher Perez) and Stuart Gibson (Chief Editor, Global News and US, IBFD) discuss the main tax issues you should be aware of regarding virtual currency. They summarize the IRS’s public guidance on virtual currency, efforts within the United States to advise taxpayers of their reporting obligations, as well as global efforts to monitor compliance.

The news: This week’s episode kicks off with news on:

  • Biden’s big tax proposals
  • Carbon taxes gain traction
  • “Danish cases” make their mark

Click Here to access the podcast.

Older Posts »

Categories