Sidney Kess
Sidney Kess ()

While Congress enacts tax laws and the IRS interprets them, the courts provide additional guidance and clarification on tax rules. Three important recent cases illustrate this point.

FICA Taxes on SUB Pay

Companies downsizing often give severance payments to laid off workers. When the payments are made to workers who are terminated due to a reduction in the work force, job elimination, reorganization, or other similar situation, the payments are called supplemental unemployment benefits (SUB) pay. Employers have been questioning for some time whether these payments should be treated as wages for purposes of FICA taxes.

Until now, the question of whether SUB-pay was subject to FICA was unsettled. One appellate court said no (United States v. Quality Stores, 693 F.3d 605 (6th Cir. 2012)) (2013-1 USTC ¶50,150). In that case, Quality Stores filed for Chapter 11 bankruptcy and laid off about 3,100 workers to whom they gave SUB-pay. The payments were reported as wages on their Form W-2s, but later the company filed a refund claim on behalf of about 1,800 of these workers, which the appellate court approved. But the IRS did not pay the refund because other courts had concluded that some types of severance pay are wages (CSX Corp., 518 F.3d 1328 (Fed. Cir. 2008); University of Pittsburgh, 507 F.3d 165 (3d Cir. 2007); North Dakota State Univ., 255 F.3d 599 (8th Cir. 2001)). The U.S. Supreme Court agreed to decide the matter.

Now the U.S. Supreme Court has settled the question of whether SUB-pay should be treated as wages (Quality Stores, 572 US __ (2014)). In a unanimous decision (with Justice Elena Kagan recused), the court concluded that the definition of wages for FICA purposes under Code Sec. 3101 was broad enough to encompass SUB-pay. It disagreed with the Sixth Circuit’s view that the language in the withholding rules under Code Sec. 3402(o) resulted in the opposite treatment of SUB-pay. The result: Employers must pay FICA on severance payments, including SUB-pay.

The decision ends the hopes for refunds by thousands of employers that filed protective refund claims after the favorable appellate court decision. These claims were estimated to exceed $1 billion.

Trusts, Material Participants

Material participation is an important consideration for purposes of two different tax rules. First, under the passive activity loss (PAL) rules (Code Sec. 469), losses from a business activity in which the taxpayer is passive are subject to limitations. However, if the taxpayer can establish material participation in the activity, then losses are not limited by the PAL rules. In the case of real estate, if the taxpayer can establish that he/she is a real estate professional, then losses, even from rental realty, are exempt from the PAL limitations. Real estate professional status is established by meeting two tests (Code Sec. 469(c)(9)):

1. More than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

2. The taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

Second, if a taxpayer materially participates in a business activity, income from the activity is not treated as investment income for purposes of the additional Medicare tax on net investment income (NII) (Code Sec. 1411). This is because the definition of investment income for the NII tax is based on the PAL rules.

The issue of material participation for estates and trusts is currently under study by the Treasury Department and the IRS and likely will be addressed in regulations under Code Sec. 469 for the passive activity loss rules (Preamble to T.D. 9644; Reg. Sec. 1.469-8 is reserved for this purpose). In the absence of regulations, trusts and estates have only conflicting guidance to review in determining whether material participation should be based solely on the activities of fiduciaries or can take activities of beneficiaries and employees into account.

Recently, the Tax Court held that services performed by trustees with respect to real estate properties, as well as those working for the trust’s wholly owned corporation and members of the executive committee to which the trustees formally delegated their power, are treated as personal services by the trust for determining material participation under the real estate professional rule of Code Sec. 469(c)(7) (Frank Aragona Trust, 142 TC No. 9 (2014)). The Tax Court rejected the IRS argument that a trust cannot perform personal services. The court took a broad view of trusts qualifying under the material participation exception for real estate professionals, saying that if Congress had wanted to exclude trusts from this possibility it could have done so.

Previously, the IRS had taken the position that the participation of a beneficiary or anyone else is not taken into account for purposes of determining whether the income from a business is passive (investment) income. For example, one trust named a “special trustee” who happened to be the president of the S corporation owned by the trust. The IRS said that the participation of this special trustee is not taken into account because his activities as president were not in the role as fiduciary (TAM 201317010; see also TAMs 200733023 and 201029014). It appears that the fiduciary does not have to meet the same tests under the passive activity loss rules as does an individual (e.g., the 750-hour test under Code Sec. 469). Instead, the fiduciary must be involved directly in the operations of the business on a “regular, continuous, and substantial” basis.

However, a district court took a pro-taxpayer position in a case where a trust owned a ranch and the trustee hired a ranch manager and employees. The court concluded that there was material participation for purposes of the passive activity loss rules because the trustee had ultimate decision-making over the financial matters for the ranch (Mattie K. Carter Trust, 256 F.Supp.2d 536 (N.D. Tex. 2003)). The court said, “[c]ommon sense dictates that the participation of Carter Trust in the ranch operations should be scrutinized by reference to the trust itself, which necessarily entails an assessment of the activities of those who labor on the ranch, or otherwise in furtherance of the ranch business, on behalf of Carter Trust.”

Whether regulations under Code Sec. 469 that are expected to be written will reflect the Tax Court’s position remains to be seen.

IRA Rollovers

Transferring funds from one IRA to another can be done as often as the taxpayer wants if the transfer is direct from one trustee or custodian to another. However, if the taxpayer takes a distribution from an IRA and wants to avoid tax on it, the funds must be rolled over to another IRA or a qualified retirement plan within 60 days. A rollover in this manner can be done only once a year. This is not a calendar year but a 12-month period starting with the date of the first rollover. The question recently put to the Tax Court is whether the once-a-year rule should be applied per IRA account or per-taxpayer. The court concluded that it means one rollover per year (“per-taxpayer”) (Bobrow, TC Memo 2014-21).

In the case a tax law attorney maintained two IRA accounts at Fidelity Investments: a traditional IRA and a rollover IRA. His wife also had a traditional IRA at the same firm. In April 2008, he took a distribution from his traditional IRA and, within 60 days, re-deposited the funds back in the IRA. In June of the same year he took a distribution from his rollover IRA and, again, re-deposited the funds within 60 days. In July, his wife took a distribution from her traditional IRA and the funds were partially re-deposited in September. However, her action was not within the 60 days; she was one day late.

The IRS said that the distribution from the husband’s traditional IRA was taxable because it was made within 12 months of the rollover of his rollover account. He argued that the law permits one rollover per IRA account within this period. He acknowledged that the law bars multiple distributions from the same IRA account within a 12-month period, but that he didn’t try to make two rollovers from the same account.

The court agreed with the IRS that only one rollover per year is allowed, but disagreed which rollover was tax-free and which was taxable. Based on the plain language of the statute, the law limits a taxpayer to one rollover (or partial rollover) per year, regardless of how many IRA accounts he or she maintains. Since the first distribution and completed rollover was from the traditional IRA, the distribution from the rollover IRA was taxable. In other words, the first rollover is the permissible one; any additional rollover within the same 12-month period is taxable.

The taxpayer in this case did not point out to the court that the IRS’s own publication (Publication 590, page 25) specifically allows one rollover per account per year. The publication even has an example of IRA-1 and IRA-2.

The wife’s distribution was fully taxable. Only part of the funds was re-deposited, but even this action was one day beyond the 60-day rollover period. Because she was under age 591/2, the distribution was also subject to a 10 percent early distribution penalty (Code Sec. 72(t)).

In addition to the tax on both one of the husband’s rollovers and the wife’s rollover, the couple was subject to a substantial underpayment penalty of 20 percent. The husband argued that the penalty should be waived because of the fact that he a tax attorney. The court, which noted that the briefs repeatedly mentioned his professional status, did not, by itself, establish that the couple used reasonable cause and acted in good faith, which would have mitigated the penalty.

IRS update. In light of the Tax Court’s decision, the IRS is adopting the “aggregate rule” for IRA rollovers and will only allow one rollover per year per taxpayer. However, because trustees and custodians in financial institutions need time to revise their rollover procedures, the IRS announced it will not apply the one-rollover-per-year rule to any rollover that involves a distribution made before Jan. 1, 2015 (Announcement 2014-15). And any anticipated change in regulations will not be effective before Jan. 1, 2015.

Conclusion

Court decisions usually provide useful clarification on tax issues. The results, however, are not always favorable to taxpayers.

Sidney Kess, CPA-attorney, is of counsel at Kostelanetz & Fink, consulting editor to CCH, author and lecturer.