Posted by: Robert Horwitz | June 25, 2021

Treating an Employee as an Independent Contractor Can Lead to a Fraud Penalty by ROBERT HORWITZ

Ron Bell was an engineer who earned an MBA and went into finance.  After a number of years working for various financial firms, he set up his own company, Bell Capital Management, Inc. (“BCM”), in Atlanta, Georgia, to provide investment services and financial planning for clients.  He was quite successful.  From BCM’s founding throughout its history he was its sole shareholder and president.  Prior to 1996, he received a salary from BCM that was reported by the company as wages.  In 1996, Bell had BCM enter into contracts with offshore employee leasing companies (“OEL”).  For 1996 through 2001, the OELs “leased” Bell’s services to BCM, which paid the OELs what had formerly been paid as wages to Bell.  Bell remained president and sole shareholder of BCM and performed the same services that he previously performed as an employee.  However, in light of the offshore employee leasing contracts, BCM treated Bell as an independent contractor and thus, did not include the amounts paid to the OEL on its employment (Form 941) and unemployment (Form 940) tax returns.

Internal Revenue Code §7436 authorizes the IRS to issue a Notice of Determination of Worker Classification (“NDWC”) if it determines that a person treated by an employer as an independent contractor was an employee.  The employer can challenge the NDWC by petitioning the Tax Court.

The IRS issued a NDWC to BCM determining that Bell was an employee, not an independent contractor of BCM and that BCM owed FICA, FUTA and income tax withholding for the monies paid the OELs for 1996 through 2001, plus failure to deposit and fraud penalties.  BCM petitioned the Tax Court.  On June 14, 2021, the Tax Court issued its opinion in Bell Capital Management, Inc. v. Commissioner, Tax Court Memo. 2021-74, granting the IRS’s motion for summary judgment.

By way of background, Bell is not new to the Tax Court.  Foxworthy, Inc., v. Commissioner, T.C. Memo. 2009-203, aff’d, 494 F. App’x 964 (11th Cir. 2012), dealt in part with the OEL transaction and held, among other things, that OEL transactions lacked economic substance, that the payments by BCM to the OELs was income to Bell that he constructively received when paid and that Bell was liable for the fraud penalty because the OEL and other transactions were for purposes of fraudulently underpaying tax. 

According to the Tax Court, in the current litigation, the summary judgment motion posed five issues: 1) did the decision in Foxworthy collaterally estopp BCM from claiming it was not liable for paying the employment taxes; 2) should Bell be legally classified as an employee of BCM; 3) was BCM liable for the employment tax as determined by the IRS; 4) was BCM liable for the fraud penalty; and 5) had the statute of limitations on assessment expired.

Under the doctrine of collateral estoppel, once an issue of fact or law is “actually and necessarily determined by a court of competent jurisdiction, that determination is conclusive in subsequent suits based on a different cause of action involving a party to the prior litigation.”  Collateral estoppel applies to both the parties in the first case and to those in privity with them.  Because Bell was the sole shareholder and president of BCM during the periods in issue, he and BCM were in privity for collateral estoppel purposes.  Whether the OEL transactions lacked economic substance and whether they were entered into so as to fraudulently underreport and underpay tax were actually litigated and necessary to the decision in Foxworthy.  The Tax Court held that BCM was therefore collaterally estopped to deny that the OEL transactions lacked economic substance and that they were entered into to fraudulently underreport and underpay tax.  Because the issues of Bell’s employment status, BCM’s withholding requirements and its intent were not essential to the decision in Foxworthy, BCM was not estopped from contesting them.  Little good that did it.

Under Internal Revenue Code §3121(d)(1), a corporate officer is considered an employee for employment tax purposes, unless the officer does not perform services (other than minor services) and neither receives nor is entitled to receive remuneration.  Bell was president of BCM during all times relevant and performed services that were not minor for which he received remuneration.  Thus, he was an employee of BCM under §3121(d)(1). 

There were two more issues to go: fraud penalty and statute of limitations.  The statute of limitations for assessing employment taxes is three years from the date the return is filed.  If the return was fraudulent, additional tax can be assessed at any time.  For purposes of the statute of limitations, the IRS had to prove that an underpayment of tax existed and that the taxpayer intended to evade tax.  When the taxpayer is a corporation, fraud turns on the intent of the corporate officers.  The Court held that BCM intentionally omitted payments for Bell’s benefit made to the OEL to evade tax.  First, prior to 1996 it reported payments to Bell as wages.  Second, Bell, in his capacity as a BCM officer, entered into the OEL transactions to evade tax.  The Court rejected BCM’s argument that the IRS failed to prove fraud because Bell was not the sole officer or sole decision maker since it offered no evidence that the actions of its other officers with respect to the OEL agreements were separate from Bell’s scheme to defraud the IRS.

The resolution of the statute of limitation issue also resolved the fraud penalty issue.  The Court rejected BCM’s claim that the fraud penalty violated the Eighth Amendment, since it is remedial and not punitive.  It also rejected the argument that the amount of tax was overstated because BCM was entitled to “an unquantified credit” for employment tax allegedly paid by the OELs.  The issue before the Court was whether BCM was the employer liable to pay employment tax on Bell’s wages, which it was.  The Court noted that it was “not subjecting Mr. Bell’s wages to a second employment tax,” implying that BCM would get a credit for any employment tax and income tax paid with respect to Mr. Bell’s wages.  This is consistent with IRS practice, since while several people can be liable for unpaid employment taxes, the IRS will only collect the entire amount of tax once.

Treating someone as an independent contractor whom the employer knows should be treated as an employee can result in fraud penalties (and possibly criminal charges).  While the employment tax on Bell’s wages won’t be paid twice, in attempting to game the system, Bell wound up owing two fraud penalties, one against himself (in Foxworthy) and one against BCM (in Bell), for the same payments. 

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.


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