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Few things say “Washington” like Embassy Row. And the myriad outposts of foreign governments in our nation’s capital and in major cities throughout this country would not open their doors every day without their staffs — many of them Americans who perform critical services for embassies and consulates without special recognition. Those personnel, however, have recently attracted attention from an unwelcome source: the Internal Revenue Service. A tax provision that was originally designed as an accommodation to foreign diplomatic offices here has become a trap for the innocent — including many who wanted to comply fully with their tax obligations and sought professional advice to do so — although, according to the IRS, some individuals may have taken advantage of those provisions to cut corners. PAYCHECK WITHHOLDING The issue begins with rules under the Internal Revenue Code about withholding federal income tax and taxes for Social Security and Medicare from paychecks. For all wages paid to employees on account of employment, the tax code requires employers to withhold a portion of those employees’ paychecks as contributions for Social Security and Medicare under the Federal Insurance Contributions Act. (Employers also must pay part of the total FICA contribution themselves, the so-called employer tax.) Similarly, an employer must withhold income taxes from those wages. The tax code contains many exceptions to the definitions of “employment” and “wages,” mostly to serve policy objectives. Two exceptions are relevant here. First, regarding FICA contributions, “employment” excludes “service performed in the employ of a foreign government.” Second, for purposes of income-tax withholding, “wages” excludes “remuneration . . . for services by a citizen or resident of the United States for a foreign government.” These provisions exempt embassies and consulates from the employer tax under FICA and relieve them from the obligation to withhold FICA contributions and income tax from the compensation they pay to their staff. Now, however, some personnel in those organizations who have taken additional positions based on those withholding exemptions are under IRS attack. In particular, relying on guidance (including some that appeared on the IRS Web site at one time) that analogizes them to independent contractors, many embassy and consular staff members established tax-favored retirement plans (such as simplified employee pension plans using individual retirement accounts, known as SEP-IRAs) that are now in jeopardy. In the course of an extensive 2006 investigation the IRS identified several widespread practices among embassy and consular personnel that the agency believes are inconsistent with those individuals’ tax obligations. In particular, the IRS believes that some of these individuals have not filed tax returns or have underreported income or claimed unallowable deductions in addition to establishing retirement plans that they may not technically have been entitled to. In November 2006 the IRS announced a settlement initiative for U.S. citizens and lawful permanent residents working (now or formerly) for foreign embassies and consulates in the United States who may not have complied with these provisions. The initiative covers the most likely “open” tax years (from 2004 onward) for individuals not already under criminal investigation. In summary, acceptance of the initiative requires an eligible individual to: • file or amend her returns to report her correct liability;

• pay all taxes and interest due and waive claims for refunds or interest abatements; • agree to recapture taxes (with interest) associated with any disallowed contributions to any self-employment retirement plan she funded for post-2003 years; • pay a penalty for the year with the highest tax deficiency; • provide an income verification statement from her employer; • document all deductions and credits claimed on those tax returns with respect to compensation from her employer; and • agree to file on a correct and consistent basis for all later years.

The IRS announcement contains additional procedural requirements relating to payment of the amounts due and the possibility of additional requests for information. As originally issued, the announcement required individuals wishing to accept the settlement initiative to do so by Feb. 20, 2007. The IRS subsequently extended that deadline to June 30, 2007. Absent a further extension, covered taxpayers who do not accept the settlement initiative face the likelihood of a rigorous tax audit. Depending on the facts, that audit could result in (among other things) one or more of the following consequences: • the assessment of tax deficiencies, interest, and penalties for all open tax years (not just the most recent ones) regarding any unpaid taxes, disallowed deductions, and invalid contributions to retirement plans;

• the preparation of so-called statutory returns for years in which no returns were filed (these are prepared by the IRS on the basis of the information it has and are usually unfavorable to taxpayers); • the assessment of penalties and excise taxes for amounts wrongfully contributed to or earned in invalid retirement plans; and • in cases of willful or intentional conduct, civil or criminal prosecution.

In an unusual action for the agency, the IRS conducted a series of on-site meetings at embassies and consulates to explain its view of the state of the law, answer questions, and encourage personnel to seriously consider accepting the settlement initiative. The IRS reportedly warned its audiences that it would vigorously pursue diplomatic personnel who it believed violated their tax obligations and who did not come forward as provided by the announcement. CLOSE CALLS On the one hand, it seems uncontroversial that exemptions granted to foreign governments and their instrumentalities do not translate into a free pass to their personnel to shortcut or ignore their tax liabilities. Affected individuals who thought otherwise may be happy to seize upon the settlement initiative as a way to come in from the cold with comparatively benign consequences. On the other hand, many affected personnel did the best they could to follow the law and made reasonable assumptions about what their status permitted them to do (such as establish SEP-IRAs), often with professional tax advice. In spite of that, the statutory case for the IRS position seems strong: SEP-IRAs are permissible only for individuals who have “self-employment income,” and the tax code expressly excludes compensation for services to a foreign government from that term. The IRS announcement, however, makes no reference whatsoever to that exclusion and does not base the disallowance of SEP-IRAs on it. Instead, the IRS resorts to a “common-law employee” analysis that has no foundation in the code. The reason for adopting this unusual rationale may be found in a cryptic reference to self-employment (SECA) tax (essentially, FICA for the self-employed) in the IRS announcement. The agency appears to be leaving itself the option of asserting liability for unpaid SECA tax, even though SECA taxpayers are statutorily permitted to form SEP-IRAs. Any such effort by the IRS to have its cake and eat it too may be vulnerable to challenge. In sum, the impact of the announcement will vary with the situation and past conduct of affected individuals. Although prompt acceptance of the settlement initiative may be a sensible choice for any individuals who defaulted substantially on their tax obligations (nonfilers, nonpayers, and taxpayers who claimed inappropriate deductions), others who acted in good faith and with professional advice will find the decision a closer call. What seems clear, however, is that the IRS is serious about this issue. And it has identified a number of individuals — by name, or at least by function within specific embassies and consulates — who it believes may be appropriate targets for audit and enforcement action if they do not accept the initiative by June 30. Thus, keeping one’s head down and hoping to be missed in any subsequent examinations would probably be an unwise strategy.
Richard E. Andersen is a partner in the New York office of Arnold & Porter. The author acknowledges the valuable contribution of Barbara Yuen. The views expressed are his own and do not constitute tax advice.

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