FTB Retroactively Denies "Qualified Small Business Stock" Personal Income Tax Benefits

FTB Retroactively Denies "Qualified Small Business Stock" Personal Income Tax Benefits

1/9/2013

By David Herbst, Matthew Portnoff, Manatt, Phelps & Phillips, LLP

On December 21, 2012, the Franchise Tax Board ("FTB") released Notice 2012-03 (the "FTB Notice"), which notice outlines the procedures the FTB will apply in response to the Court of Appeal's recent decision in Cutler v. Franchise Tax Board, 208 Cal. App. 4th 1247 (2012).  In Cutler, the court held as unconstitutional under the Commerce Clause California's personal income tax exclusion or deferral of gain from certain "qualified small business stock" ("QSBS") dispositions as applied to California-based businesses only.

In what appears to be a very aggressive posture by the FTB, the FTB Notice provides that the FTB will deny any exclusion or deferral claimed on the sale of QSBS by taxpayers for California personal income tax purposes for tax years beginning on or after January 1, 2008.  For tax years before January 1, 2008, the FTB will allow taxpayers to file a claim for refund of tax attributable to an exclusion or deferral of gain on the sale of QSBS, even for businesses that are not California-based; however, few taxpayers are likely to benefit from this because the applicable statute of limitations for filing such claim for refund is close to expiring or has expired.  The FTB Notice also indicates that taxpayers who claimed any exclusion or deferral after January 1, 2008, should expect to receive notices of deficiency if an exclusion or deferral was claimed.

Background

In Cutler, the taxpayer challenged the constitutionality of California's QSBS statutory provisions for qualified small businesses.  The taxpayer sold stock acquired in a start-up company and used some of the proceeds to purchase stock in several other small businesses.  The taxpayer deferred a portion of the gain from the sale on his 1998 California tax return under Revenue and Taxation Code ("RTC") Sections 18038.5 and 18152.5, which together, provide for elective gain-recognition deferral for individuals on the sale or exchange of QSBS held for more than six months, to the extent the amount realized was used to purchase QSBS within a 60-day period beginning on the date of the sale to the extent QSBS sold and purchased was issued by "domestic corporations" (i.e., corporations that use 80% of their assets in the conduct of business in California and maintain 80% of their payrolls in California).

The FTB disallowed the deferral on the grounds that the stock sold by the taxpayer did not meet the definition of QSBS as provided in RTC Section 18152.5(c), and further, did not meet the statutory requirements of RTC Section 18038.5.  The taxpayer filed suit in Los Angeles Superior Court, asserting that:  (1) the transaction met California's statutory requirements,

(2) the payroll and property requirement set forth in RTC Section 18152.5(c) was unconstitutional under the Commerce Clause because it unfairly discriminates against investors in companies that conduct a certain portion of their business outside California, and (3) the Due Process Clause of the Fourteenth Amendment required a full refund.  The trial court granted the FTB's motion for summary judgment finding that the payroll and property requirement under RTC Section 18038.5 was not unconstitutional.

On appeal, the FTB argued that the property and payroll requirement does not violate the Commerce Clause because it does not tax out-of-state goods or services.  The California Court of Appeal rejected the FTB's contention and reversed the trial court's determination declaring that RTC Section 18038.5 favors domestic corporations in violation of the Commerce Clause.  However, citing the FTB's claim that the taxpayer did not meet the other requirements of the QSBS statute separate from the property and payroll requirement, the court declined to decide whether the taxpayer should be afforded the refund requested or whether some other appropriate remedy, if any, should apply.

The Court of Appeal remanded the case to the trial court to determine an appropriate remedy but noted that such remedy should fall within one of three categories in accordance with McKesson Corp. v. Florida Alcohol & Tobacco Div., 496 U.S. 18 (1990):  (1) refund to taxpayer the difference between the tax it paid and the tax it would have been assessed were the taxpayer extended the same tax treatment for the sale of a domestic corporation's QSBS; (2) assess and collect back taxes from taxpayers that benefited from the QSBS statutes; or (3) a combination of a partial refund to taxpayer and a partial retroactive assessment on taxpayers who benefited from the QSBS statutes to reflect a scheme that does not discriminate against interstate commerce, each subject to applicable statutes of limitation.

Implementation of FTB Notice 2012-03.  The FTB Notice is remarkable insofar as the taxpayer in Cutler won on the argument that the limitations under the QSBS statutes favoring domestic corporations were unconstitutional.  Nonetheless, the FTB is now penalizing a broad class of taxpayers, and has effectively preempted the trial court's decision on remand by adopting a variation of the third approach cited above, i.e., refund for years in which most taxpayers are foreclosed by the statute of limitations and retroactive assessment for those taxpayers who benefited from either exclusion or deferral in a year in which the statute of limitations is still open.  In taking such approach, the FTB has relied upon another Court of Appeal decision, River Garden Retirement Home v. Franchise Tax Board, 186 Cal. App. 4th 922 (2010), which sanctioned corrective retroactive assessment.

For tax years beginning before January 1, 2008, the FTB Notice provides that the FTB will allow the benefit of the QSBS statutes to apply to sales of stock for all corporations, including foreign corporations (i.e., for the very few individuals who disputed this issue before the limitations period expired, while all other taxpayers who thought their QSBS sales did not qualify are time-barred from filing an amended return or a claim for refund).  For all other tax years, 2008 to present, the FTB has declared as unconstitutional the QSBS statutes in their entirety (which, incidentally, was not the pronouncement of the Court of Appeal in Cutler) for California personal income tax purposes.  As such, the FTB will seek to assess additional income taxes on all stock sale transactions for which taxpayers claimed exclusion or deferral under the QSBS statutes rather than issue refunds to taxpayers selling non-California stock.  Those taxpayers who benefitted from the exclusion or deferral will be notified by the FTB, and additional taxes (plus interest) will be assessed.

The FTB Notice recommends that all affected taxpayers self-assess by filing amended returns, paying applicable taxes due or taking other steps that could allow partial abatement of interest.

Conclusion

The FTB Notice is expected to affect countless taxpayers who have benefited from the QSBS statutes since 2008.  Any and all such taxpayers should expect to receive notices of deficiency from the FTB in the coming months.

The appropriate response to an FTB notice of deficiency is dependent upon each taxpayer's particular facts and circumstances.  Some taxpayers may wish to forgo responding until the Cutler trial court releases its opinion on remand.  Other taxpayers, however, may wish to immediately file a protective refund claim to preserve open tax years in the event any undecided issues are favorably resolved by the trial court.  Whereas other taxpayers who claimed exclusion or deferral pursuant to the QSBS statutes on their 2008 returns may benefit by waiting for the FTB to issue a notice of assessment before responding so as to take advantage of interest abatements (applicable only to the portion of interest assessed more than 36 months after the return was filed).  Depending upon when such taxpayers filed their 2008 returns, the statute of limitations could potentially run before the FTB issues a notice of assessment.

In summary, because the FTB Notice may affect taxpayers differently, it is recommended that taxpayers consult with their tax advisors before responding to an FTB notice of deficiency.  Lastly, it should be noted that the FTB Notice has no impact on federal QSBS exclusions and deferrals, which remain in effect.

If you have any questions or would like more information concerning the FTB Notice, please do not hesitate to contact us.

IRS modifies and temporarily expands worker Voluntary Classification Settlement Program

IRS modifies and temporarily expands worker Voluntary Classification Settlement Program

   By Jeffery T. Allen

The IRS announced an important settlement program, the Voluntary Classification Settlement Program or VCSP, on September 21, 2011.  Under VCSP, qualifying employers who misclassified workers as independent contractors were able to come forward and enter into a settlement with the IRS on favorable terms.  Details of the settlement program were provided in IRS Announcement 2011-64 and are discussed in a prior blog concerning the initial announcement.

The IRS has now made important modifications to VCSP in Announcements 2012-45 and 2012-46 which relax the requirements that must be met in order to participate in the program and eliminate a requirement to agree to extend the period of limitations on assessment as a condition of participation in VCSP.

Under VCSP, taxpayers generally must have filed all Forms 1099 to be eligible to participate.  The IRS has temporarily expanded VCSP eligibility to include taxpayers who have not filed all required Forms 1099.  The temporary expansion is only available, however, until June 30, 2013.  A taxpayer who participates in the VCSP Temporary Eligibility Expansion agrees to prospectively treat the class or classes of workers identified in the application as employees for future tax periods.  In exchange, the taxpayer pays 25 percent of the employment tax liability that would have been due on compensation paid to the workers being reclassified for the most recent tax year if those workers were classified as employees for such year (taxpayers who have filed all Forms 1099 pay 10 percent of the employment tax liability instead of 25 percent).  In addition, a graduated penalty is imposed for the failure to file required Form 1099.

The IRS has also relaxed the eligibility requirements for taxpayers under audit.  Prior to modification, taxpayers were ineligible for VCSP if they were under audit for any type of tax.  As modified, taxpayer will only be ineligible for VCSP if they are under an employment tax audit.

Taxpayer Impact

Taxpayers who have not filed all Forms 1099 have a brief window of opportunity to participate in VCSP.  Participation will resolve not only worker misclassification issues, but also the failure to file required Forms 1099, all on favorable terms.  Reclassifying workers is not to be done lightly, however, as state workers compensation, state unemployment, and state employment tax laws may also be implicated when workers are reclassified under VCSP.

Taxpayers who desired to participate in VCSP but who were under an audit other than an employment tax audit may now participate in VCSP.  As the risk of an employment tax audit is ever present, particularly when the IRS is already on the scene, taxpayers should move quickly if they desire to participate in VCSP.

The elimination of the requirement to extend the period of limitations on assessment in order to participate in the program is a favorable modification of VCSP.  This welcome relief will help to bring finality to prior tax periods while still allowing settlement on favorable terms.

McNair Law Firm PA

    Jeffrey T. Allen

    December 18 2012

Mexican Land Trust is Not a Trust U.S. Federal Income Tax Purposes

Mexican Land Trust is Not a Trust U.S. Federal Income Tax Purposes
by Mark Muntean

It is not uncommon for Californians to own vacation property in Mexico.  The Mexican Constitution prohibits non-citizens of Mexico from owning property within 100 kilometers of the border or fifty kilometers of the coast.

  

To acquire property in Mexico and comply with Mexico’s laws, property is placed in a “bank trust” in Mexico, or more often a “Mexican Land Trust” (a “fideicomiso”).  The Internal revenue Service (“IRS” or “Service”) compared a Mexican Land Trust to an Illinois Land Trust, as described in IRS Rev. Rul.  92‑105, and found both trust to be similar.  See PLR 201245003 (discussed below).  The bank trust or Mexican Land Trust provides that all taxes, insurance, and other expenses related to the property are the responsibility of the individual beneficiary (the “California Owner”), and the bank charges an annual fee to hold title in its name.

Recently a U.S. taxpayer asked the IRS to issue a ruling on whether the Mexican Land Trust was a “trust” for U.S. federal income tax purposes as defined in Treasury Regulations Section 301.7701-4(a).  If the Mexican Land Trust is treated as a true trust for U.S. federal income tax purposes, additional tax filings with the Service would be required (for example IRS Form 3520).  See IRC Section 6038.  The penalty for failing to file the IRS Form 3520 upon transfer of assets to the trust are set at the higher of $10,000 or 35 percent of the value of the property transferred.   IRC Section 6677.  Additionally, an argument might be made that the use of the property in Mexico is a taxable distribution from the Mexican Land Trust to the beneficiary (the California Owner).

With respect to the Illinois Land Trust, the IRS had previously held that because the trustee’s sole duty was to hold and transfer title at the direction of the beneficiary, the Illinois Land Trust was an agent for the holding the title to the property, and for federal income tax purposes the property is treated as being held directly by the beneficiary of the trust.  Rev. Rul. 92-105.   Accordingly, the Illinois Land Trust was not a trust for federal income tax purposes. 

For the same reasons the IRS ruled that the Mexican Land Trust only holds the title to the property and transfers that title at the direction of the beneficiary, and as such is also not a trust for federal income tax purposes.  Accordingly, in response to the taxpayer’s requested for a private letter ruling (“PLR”) the Service held that a Mexican Land Trust is not a “trust” for U.S. Federal income tax purposes.  PLR 201245003 (November 9, 2012)

While the Service’s private letter ruling is address only to the particular taxpayer that requested the ruling, and it therefore cannot be cited as authority, PLR 201245003 does provide an indication as to the Service’s position on the matter.  Thus, this ruling can be viewed as good news for a number of taxpayers.

Department of Justice, Civil Tax Division, awarded summary judgment to collect civil penalties against taxpayer for willfully failing to FBAR reports for two years

Fox Rothschild LLP

Jerald David August

November 19 2012

The United States District Court for the District of Utah, Central Division, on November 8, 2012, Judge Nuffer, granted the United States its motion for summary judgment for the taxpayer-defendant’s, Jon McBride, willful failure to report his interest in foreign bank accounts in contravention of 31 U.S.C. Section 5314 for the years 2001 and 2002. (U.S. v. McBride, No. 2:09-cv-00378 (D. Utah 2012). Penalties were assessed of approximately $200,000 plus interest.

Mc Bride had engaged in a scheme to launder U.S. business income through foreign shell companies that he established. He employed a financial management firm to set up accounts in the name of several international business corporations to shelter or non-report, U.S. business income and then repatriated the funds. He did not file FBAR reports for the tax years in which the accounts existed. The government filed a civil suit to collect an FBAR penalty from Jon McBride, alleging that he had failed to properly report interest in several foreign accounts for the 2000 and 2001 tax years. McBride had entered into an elaborate scheme to launder his U.S. business income through foreign shell companies.

A key question before the Court was the standard to be used in whether the government’s request to impose FBAR penalties in the subject proceeding would be granted. Would it be a “by a preponderance of the evidence” standard, or a “clear or convincing standard”? Granted the case was civil in nature. Judge Nuffer cited U.S. v. Williams, No. 1:09-cv-00437 (E.D. Va. 2010) as the only court to consider this issue. That court held that because the FBAR penalty is monetary only, preponderance was the correct standard, pointing to acceptance of that standard by federal appellate courts in other civil tax penalty cases. The Utah federal district court in the Mc Bride case agreed. In applying this standard it held that the government met its burden of proof based on a preponderance of the evidence as to the elements of: (i) ownership of the funds; (ii) willful failure of the defendant-taxpayer to file FBAR reports either by reckless disregard of a known duty or by willful blindness or neglect to read the contents of the income tax return; and (iii) the taxpayer was found to have purposely kept this information about his foreign bank accounts (and tax evasion scheme) from his tax return preparer. See Global-Tech Appliances, Inc. v. SEB S.A., 131 S. Ct. 2060, 2068-69 (2011) ("persons who know enough to blind themselves to direct proof of critical facts in effect have actual knowledge of those facts") (citing United States v. Jewell, 532 F.2d 697, 700 (9th Cir. 1976) (en banc)). The civil penalty for FBAR willful failures to file is up to 50% of the account balance for each year the offense is committed.

After making a substantial number of findings of fact, the Court then addressed the standard of proof and then the taxpayer’s willful failures to file the FBAR reports. f. McBride's Failure to Report His Interest in the Foreign Accounts was willful. See Lefcourt v. United States, 125 F.3d 79, 83 (2d Cir. 1997) (defining "willfulness" in the context of a civil penalty for willfully failing to disclose required information to the IRS as conduct that "requires only that a party act voluntarily in withholding requested information, rather than accidentally or unconsciously."); accord Denbo v. United States, 988 F.2d 1029, 1034-35 (10th Cir. 1993) (defining "willful" conduct as a "voluntary, conscious and intentional decision") (quoting Burden v. United States, 486 F.2d 302, 304 (10th Cir. 1973), cert. denied, 416 U.S. 904 (1974)). Conduct that evidences "reckless disregard of a known or obvious risk" or a "failure to investigate . . . after being notified [of the violation]" also satisfies the civil standard for willfulness in such contexts.

Willfulness may also "be proven through inference from conduct meant to conceal or mislead sources of income or other financial information." United States v. Sturman, 951 F.2d 1466, 1476-77 (6th Cir. 1991). Moreover, willful intent may be proved by circumstantial evidence and reasonable inferences drawn from the facts because direct proof of the taxpayer's intent is rarely available. Spies v. United States, 317 U.S. 492, 499 (1943)).

The Court found that the defendant was fully aware that he was engaged in a plan to avoid income taxes by hiding his interest in assets in overseas shell corporations and also the FBAR filing requirements, which filings would in effect interfere with his scheme.

On this issue of imputing willful failure to file FBAR reports when taxpayer check-the-foreign bank account “no” on their income tax return, the Court surveyed the law in this area and turned to United States v. Williams, supra,  as the “only  case to examine willfulness in the context of a civil FBAR penalty”. In Williams, the Fourth Circuit recently held that a taxpayer was willful in failing to comply with FBAR requirements when he signed a federal tax return that failed to disclose the existence of foreign accounts, "thereby declaring under penalty of perjury that he had 'examined this return and accompanying schedules and statements' and that, to the best of his knowledge the return was 'true, accurate, and complete.'" The Fourth Circuit reversed the district court's findings of fact as "clearly erroneous," on the grounds that the district court failed to consider the taxpayer's signature on his returns sufficient evidence of his knowledge of his failure to comply with the FBAR requirement. "A taxpayer who signs a tax return will not be heard to claim innocence for not having actually read the return, as he or she is charged with constructive knowledge of its contents." At a minimum, "line 7a's directions to '[s]ee instructions for exceptions and filing requirements for Form TD F 90-22.1'" puts a taxpayer "on inquiry notice of the FBAR requirement." Id. As a result, the Fourth Circuit held that Williams's explicit statement that he never consulted Form TD F 90-22.1 or its instructions, never read line 7a, and "never paid any attention to any of the written words on his federal tax return" constituted a "'conscious effort to avoid learning about reporting requirements,'" and his false answers on his federal tax return "evidence conduct that was 'meant to conceal or mislead sources of income or other financial information.'" Id. (quoting Sturman, 951 F.2d at 1476).

A taxpayer's signature on a return is sufficient proof of a taxpayer's knowledge of the instructions contained in the tax return form and in other contexts. "In general, individuals are charged with knowledge of the contents of documents they sign -- that is, they have 'constructive knowledge' of those contents." Consol. Edison Co. of N.Y., Inc. v. United States, 221 F.3d 364, 371 (2d. Cir. 2000). 

While there are cases that have stated that "[a] taxpayer's signature on a return does not in itself prove his knowledge of the contents, but knowledge may be inferred from the signature along with the surrounding facts and circumstances, and the signature is prima facie evidence that the signer knows the contents of the return." See, e.g., United States v. Mohney, 949 F.2d 1397, 1407 (6th Cir 1991); accord Hayman v. Comm'r, 992 F.2d 1256, 1262 (2d Cir. 1993) (holding that where a taxpayer "claims to have signed the returns without reading them, [he or] she nevertheless is charged with constructive knowledge of their contents").

Inferring knowledge of the contents of a return signed by the taxpayer is consistent with the conclusion drawn by the Sixth Circuit in United States v. Sturman, which held that, "It is reasonable to assume that a person who has foreign bank accounts would read the information specified by the government in tax forms," including the reference on Schedule B to the FBAR. 951 F.2d at 1477. Moreover, the line of criminal cases dealing with whether or not a taxpayer's signature on a return demonstrates knowledge of the contents has upheld convictions where the jury was permitted to infer knowledge of the contents of the return from the signature on the return alone. See, e.g., United States v. Olbres, 61 F.3d 967, 971 (1st Cir. 1995) (in prosecution for tax fraud, "jury may permissibly infer that a taxpayer read his return and knew its contents from the bare fact that he signed it"); United States v. Romanow, 509 F.2d 26, 27 (1st Cir. 1975) (jury could believe from the uncontested signature of the defendant on return that he had read the form, despite his claim that he merely signed the return that was prepared by bookkeeper).

Judge Nuffer also cited a recent Northern District Court of Illinois case, Thomas v. UBS, AG, No. 1C4798, 2012 WL 2396866, where the plaintiffs alleged that a bank had a duty to inform its depositors of the FBAR requirement. In response, the Thomas court rejected the plaintiffs’ argument of justifiable or reasonable reliance on any advice given (or not given) by the bank in interpreting the instructions on the tax return.

The District Court in McBride held that the defendant had knowledge of his obligation to file FBAR reports for the foreign accounts, and failed to do so. Such knowledge can easily be imputed. Indeed the tax return speaks to such obligation and filing of Form TD F 90-22.1. Accordingly, McBride is charged with having reviewed his tax return and having understood that the federal income tax return asked if at any time during the tax year, he held any financial interest in any foreign bank or financial account. McBride's willfulness is supported by evidence of his false statements on his tax returns for both the 2000 and the 2001 tax years, and his signature, under penalty of perjury, that those statements were complete and accurate. Moreover,  McBride actually read the marketing and promotional materials provided to him by  the financial advisor who helped him carry out the scheme that under federal law he was required to report his interest in foreign banks and financial accounts. This led to the finding by Judge Nuffer that McBride “had actual knowledge of his duty to file an FBAR for any account in which he had a financial interest prior to filing his 2000 and 2001 tax returns. McBride even testified that "the purpose of Merrill Scott" was to avoid disclosure and reporting the existence of interests "because . . . if you disclose the accounts on the form, then you pay tax on them, so it went against what [he] set up Merrill Scott for in the first place.’ "

If that wasn’t enough, the Court also found McBride’s conduct reckless sufficient to rise to the level of willful.  Continuing on, the Court stated that “’[A]n individual's actions may be deemed willful if the individual recklessly ignores the risk that conduct is illegal by failing to investigate whether the conduct is legal. Taxpayers have long been cautioned that they have a responsibility to "investigate claims when they are likely 'too good to be true.'" Pasternak v. Comm'r, 990 F.2d 893, 903 (6th Cir. 1993) .

The Court did not stop here but went further to block any escape route on appeal for the defendant. The effort of the Court to go over every path that leads to a finding to willfulness and precluding the presence of any path that would excuse

Filing late tax returns: reducing penalties and the risk of prosecution

Morvillo Abramowitz Grand Iason Anello & Bohrer

Jeremy H. Temkin

April 15 is commonly viewed as “Tax Day” in the United States, but approximately 11 million taxpayers take advantage of the automatic extension that allows them to file their returns by October 15. While many taxpayers file for this six month extension because of unavoidable delays in obtaining information from third parties, for some taxpayers the decision to “go on extension” is driven by procrastination.

October 15 has now come and gone and, if history is any guide, some of the taxpayers who deferred filing their tax returns for no apparent reason other than avoidance of an unpleasant task failed to meet the extended deadline. These non-filers may now be subject to criminal prosecution. They will, however, be infinitely better off filing their returns late, than not at all.

While the government can use an untimely return as an admission that the taxpayer had income and owed taxes, the cost of making these admissions often pale in comparison to the alternative. The failure to file a timely income tax return is a misdemeanor, punishable by a year in prison, and prosecutors often use the repeated failure to file returns, combined with the substantial underpayment of taxes, to argue that the taxpayer intended to evade her tax obligations. Filing a late tax return before being contacted by an IRS special agent (i.e., criminal investigator) will substantially reduce the likelihood of a criminal prosecution for either the initial failure to file or more serious felony tax evasion charges.

Of course, for some taxpayers, the decision not to file is a misguided reaction to the lack of resources to satisfy their tax obligations. Unfortunately, this creates a vicious cycle whereby the failure to file returns on a timely basis results in the imposition of failure to file penalties on top of the failure to pay penalties that would be imposed regardless of whether the return was filed without payment. In other words, in addition to reducing the likelihood of a criminal prosecution, filing delinquent returns without the required payment will lower the taxpayer’s ultimate financial burden by stopping the accrual of some (but not all) penalties.

The IRS has increasingly recognized the dilemma facing the taxpayers who have fallen behind on their tax obligations, and has implemented a “Fresh Start” initiative to provide penalty relief to certain unemployed taxpayers, offer installment agreements to more taxpayers, and make the “offer in compromise” program more accessible. This is not to say that the IRS is showing a “warm and fuzzy” side to all delinquent taxpayers, but taxpayers who fall behind on their tax obligations need to be aware of their options for catching up.

Unfortunately, many taxpayers who have failed to file their returns over a number of years have an irrational fear of the consequences of coming forward, and thereby exacerbate the damage caused by their conduct. It is important for these taxpayers to recognize that, while dealing with an IRS revenue officer collecting back taxes, interest and penalties is undoubtedly unpleasant, it is a lesser evil than ignoring the problem and increasing both the financial burden and the risk of prosecution.

Court Rules Depression is a Taxable Damage

In Blackwood v. Commissioner, T.C. Memo. 2012-190, No. 23530-10, the Tax Court sided with the IRS in finding that the symptoms of depression do not qualify as a tax exempt physical injury.

Julie Blackwood (“Blackwood”) worked for Siemens as a trainer assigned to Siemens' client, the Charleston Area Medical Center (“hospital”). Her job duties included training hospital personnel in the use of a Siemens-developed computer program for the collection of patient information at the time of the patient's admission to the hospital.  

Following the admission of her son to the hospital in December 2007, Blackwood observed the hospital nurse taking her son's medical history without using the Siemens data entry program. Following the release of her son from the hospital, Blackwood used her Siemens access to view her son's electronically stored medical records. Upon review Blackwood learned that the hospital nurse had input information regarding questions she failed to ask her son during the admissions process. Blackwood reported her observation of the hospital nurse's use of the Siemens system to her superiors at work and requested guidance as to how to report the hospital nurse's actions. Upon returning to work on January 3, 2008 after vacation Blackwood was informed that her employment had been terminated by Siemens because she had accessed her son's hospital medical records without permission and in violation of the Health Insurance Portability and Accountability Act. 

Before January 3, 2008, Blackwood suffered from depression. As a result of her termination, her depression relapsed, causing her to suffer symptoms such as insomnia, sleeping too much, migraines, nausea, vomiting, weight gain, acne, and pain in her back, shoulder and neck.

On August 21, 2008, Blackwood signed a confidential settlement agreement in which Siemens agreed to pay her $100,000 for alleged damages for illness and medical expenses allegedly exacerbated by, and allegedly otherwise attributable to Blackwood’s alleged wrongful discharge. The settlement agreement stated that Blackwood was responsible for all applicable taxes, if any, as a result of the receipt of the settlement and was issued a Form 1099-MISC reporting the $100,000 Siemens paid to her in 2008. On the advice of counsel, Blackwood did not report or disclose the $100,000 as income on her Federal income tax return for 2008. On July 26, 2010, the IRS issued Blackwood a notice of deficiency for 2008; and Blackwood subsequently filed a petition disputing the deficiency. 

In order for damages to be excludable from gross income under Section 104(a)(2), a taxpayer must demonstrate that the damages were received on account of personal injuries that are physical or a sickness that is physical. The court focused on whether Blackwood’s depression symptoms qualified as a physical injury or physical sickness under Section 104(a)(2).

Blackwood provided medical documentation that she suffered from increased levels of anxiety and depressive symptoms that seemed directly related to the termination from her job, and that she was receiving psychiatric services and medications from a psychiatrist. There was no documentation that Blackwood suffered from any physical injuries or specific physical symptoms of depression. At trial Blackwood testified that she suffered from insomnia, sleeping too much, migraines, nausea, vomiting, weight gain, acne, and pain in her back, shoulder, and neck as a result of her depression.  

The flush language of Section 104(a) provides: "For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness." The legislative history of Section 104(a) states it "is intended that the term emotional distress includes symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress." H.R. Conf. Rept. No. 104-737, at 301 n.56 (1996), 1996-3 C.B. 741, 1041. The legislative history of Section 104 specifically contemplates that emotional distress may manifest itself in physical symptoms by explicitly listing physical symptoms as symptoms that may result from emotional distress. Congress' listing of physical symptoms of emotional distress is evidence of Congress' intent to establish that not every physical symptom will qualify as a physical injury or physical sickness under Section 104(a)(2). Therefore, the fact that a taxpayer suffers physical symptoms from emotional distress does not automatically qualify the taxpayer for an exclusion from gross income under Section 104(a)(2).  

Blackwood relied on the recent case of Domeny v. Commissioner, T.C. Memo. 2010-9, 2010 Tax Ct. Memo LEXIS 9.  In Domeny, the taxpayer suffered from multiple sclerosis. Due to a hostile and stressful work environment, Domeny's MS symptoms began to worsen and her primary care physician determined the taxpayer was too ill, because of her MS symptoms, to return to work. After giving the physician's instructions to her supervisor, Domeny was terminated from her job. After her termination, Domeny’s MS symptoms began spiking. The Tax Court found the worsening of her MS due to be excludable under Section 104(a)(2). 

The court distinguished Blackwood’s case from Domeny, finding Blackwood’s symptoms did not show the level of physical injury or physical sickness in Domeny and that she did  not provide evidence that her physical symptoms of depression were severe enough to rise to the level of a physical injury or physical sickness. Therefore, the court concluded that Blackwood’s depression and corresponding physical symptoms did not qualify as physical injuries or physical sickness under Section 104(a)(2) and that the $100,000 settlement payment from Siemens was taxable. 

Section 6662(a) imposes a 20% accuracy-related penalty on any portion of an underpayment attributable to a substantial understatement of income tax.  Blackwood testified that she was advised by her counsel that the settlement payment was not taxable. Her counsel was both a certified public accountant and lawyer. The court concluded that Blackwood acted with reasonable cause and in good faith as to excluding the settlement payment from gross income and was therefore not liable for the accuracy-related penalty under Section 6662(a). 

Author’s Note:  We see yet another emotional distress case deemed taxable by the IRS and upheld by the Tax Court.  The novel aspects of this one include a misreading of the Domeny case by Blackwood’s counsel (Domeny already had a physical sickness that was worsened by her employer), as well as the fact a lawyer who was also a CPA would counsel their client that an emotional distress injury was tax free.  This has been the law since 1996 and nothing in the Domeny decision would change that.

For help with any employment, D&O, E&O or taxable/punitive case, please contact:

John McCulloch, JD, FLMI, CSSC
Vice President, EPS Settlements Group
1300 W. Belmont Avenue, Suite 306
Chicago, IL 60657
630-864-8420 cell
773-880-1478 office

Email me - jmcculloch@structures.com
Company Profile - http://www.epssg.com/Professionals.aspx?professionalID=212
LinkedIn - http://www.linkedin.com/pub/john-mcculloch/2/b50/46

UBS client from Miami Beach, Florida sentenced to prison

    Akerman Senterfitt  July 30 2012

   

A former UBS, AG ("UBS") client from Miami Beach, Florida was sentenced to four months in federal prison for willfully failing to file a Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts ("FBAR"), for the UBS account the man held with as much as $4,000,0000 in it. This information was released by the U.S. Attorney for the Southern District of Florida on July 25, 2012.

The former UBS client paid a civil penalty of $2,000,000 related to the $4,000,000 high account balance stemming from tax year 2006. Additionally, the former UBS client was sentenced to four months in federal prison, three years of supervised release, 250 hours of community service and a $20,000 criminal fine.

The UBS account related to two offshore corporations owned by the man, one in the Virgin Islands and one in the Republic of Panama. These corporations opened accounts at UBS. The man was not named as the direct owner but instead he was deemed only the "beneficial owner." The accounts with UBS were opened from tax years 2005 through 2007.

It is stated that the man was aware of the obligation on the FBAR to report as he had previously filed FBARs for other offshore corporations. An FBAR is required to be file by both U.S. citizens and residents who have a financial interest in or signatory authority over a non-U.S. financial account with a value of more than $10,000 at any point during the tax year. The $10,000 amount is an aggregation of all non-U.S. financial accounts and not just an analysis on an account by account basis. See our Practice Update.

The information on the former UBS client was turned over after UBS agreed in February, 2009 to pay $780,000,000 under a deferred prosecution agreement to settle the claim that UBS conspired to defraud the U.S. by impeding the Internal Revenue Service ("IRS"). UBS also agreed to turn over information to the U.S. Department of Justice on 300 account holders. See our Practice Update.

A US citizen or resident that held an account with UBS or any other institution that has not filed the necessary FBARs for the last eight tax years, should immediately reach out to legal counsel to discuss any potential issues they may have and their alternatives.