Thursday, March 31, 2005

Scout Update

On March 28, H.B. 296, the bill to award college scholarships to all Eagle and Gold Star Scouts (my previous discussion here) was reported out of the Appropriations Committee unfavorably. This effectively kills the bill for this year.

Thursday, March 24, 2005

Making an S of Yourself

The Service today issued a new Form 2553, Election by a Small Business Corporation. The revised instructions can be found here.

Tuesday, March 22, 2005

Previews of Coming Attractions

Maryland follows the so-called lex loci delicti rule with respect to choosing the law to apply in tort actions. That is, the courts will apply the law of the jurisdiction where the wrong occurred. However, it is unclear where the "wrong" occurs in cases of fraud or negligent misrepresentation if the alleged wrong and alleged loss occur in different jurisdictions. In the case of Hardwire, LLC v. The Goodyear Tire & Rubber Co., Judge Bennett certified that question and sent it to the Court of Appeals. He also certified the similar question of what jurisdiction's substantive law governs in the case of tortious interference with economic relationships where the wrongful act and the plaintiff's injury occur in two different jurisdictions.

Choice of law issues presented in cases such as Hardwire are taking on new importance due to the rapidly falling telecommunications prices and the growth of the internet. Even as late as fifteen years ago, most business activity could be tied to a specific physical location. For instance, business deals, even if negotiated via fax or letter, were typically concluded at a discrete place. That is no longer the case, since negotiations are often concluded electronically with even the closing of a deal taking place in more than one location.

Wednesday, March 16, 2005

Gut Equity

In a case that is likely to be appealed, Judge Deborah Chasanow of the District Court re-affirmed that hard cases make, if not bad law, then strained law. The case, Valley Forge Life Insurance Co. v. Liebowitz, involved a $2 Million life insurance policy.

Bruce Liebowitz was married to Shelley Liebowitz. His father, Howard Liebowitz, is an independent insurance agent. In the late spring of 2000, Bruce applied for a life insurance policy from Valley Forge with a death benefit of $2 Million. His father was the issuing agent. The policy was formally issued on November 1, 2000. Bruce died of esophageal cancer on September 5, 2002.

The application for the policy directly asked about the insured's foreign travel, both past and prospective. Bruce had traveled extensively in the Mideast and had lived in Spain in the two years prior to the date of the application and continued to travel extensively after the application was submitted. However, on the application he denied any foreign travel in the two years prior to the date of the application and he denied any plans to travel out of the country in the future. After his death, Valley Forge brought this action alleging that Bruce had made a material misrepresentation with respect to the policy application and requested that the policy be declared a nullity.

On cross motions for summary judgment, the Court ruled in favor of Mrs. Liebowitz, holding that (i) Howard was the agent of Valley Forge, (ii) that Howard knew of the falsity of the statements on the applications, (iii) Howard's knowledge could be imputed to Valley Forge, and therefore (iv) Valley Forge was estopped from denying coverage due to Bruce's false statements concerning his foreign travel. The Court also ruled that the statements on the application were representations, not warranties, and that Valley Forge, due to its knowledge of the misstatements (via imputation from Howard) waived its right to rescind the contract. The Court did not address the question of whether the misstatements were material, perhaps because that would have required a weighing of conflicting facts, taking it out of summary judgment territory.

Cases like this give insurers a bad reputation. Even though Bruce essentially lied on his application, it is unlikely that Valley Forge would have refused to issue the policy even had it known about Bruce's extensive foreign travel, although there may have been a slight surcharge added to the premium, a trivial amount in the context of this case. Moreover, Bruce's death can in no way be traced to his foreign travel. Going one step further, had Bruce lived another 55 days or so, the policy would likely have become incontestable. Thus, under the circumstances of the case, it appears that Valley Forge was asking to be relieved of its obligations under the contract due to misrepresentations that caused it no material harm.

On the other hand, Howard and Bruce do not present an altogether savory picture. At the least, Howard failed to honor his fiduciary duties to Valley Forge. However, the claimant here was a young widow who was left to care for the toddler child of the deceased. There were no facts that would indicate that she had been in any way complicit in a scheme to cheat the insurer. Under these circumstances, the gut equities clearly favored her and the judgment followed.

Tuesday, March 15, 2005

There Will Be Some Changes Made, Part I

Recently, the Staff of the Joint Committee on Taxation prepared a report entitled Options to Improve Tax Compliance and Reform Tax Expenditures. The proposals in the report would change a broad variety of tax procedures. Even though these proposals have not yet been set forth in a specific bill, it is almost certain that in due course legislation will be introduced that reflects some of these ideas.

Today, and in forthcoming posts, I will address some of the proposals. The first that I will discuss are the proposal to modify the determination of amounts subject to employment or self-employment tax for partners and S corporation shareholders and a related proposal to treat guaranteed payments to partners as payments to nonpartners.

It will come as no surprise to regular readers of this blog that, as the Committee Report notes:

[T]here are significant differences in the employment tax treatment of individuals who are owners of interests in passthrough entities and who perform services in the business. S corporation shareholder-employees are treated like other employees (i.e., subject to FICA), whereas a broader category of income of some partners (other than limited partners) is subject to self-employment tax. These discontinuities cause taxpayers choice-of-business form decisions to be motivated by a desire to avoid or reduce employment tax, rather than by nontax considerations.


The Committee Staff is more than aware of the growing number of taxpayers playing audit roulette in this area. Thus the report notes that:

S corporation shareholders may pay themselves wages below the wage cap, while treating the rest of their compensation as a distribution by the S corporation in their capacity as shareholders. They may take the position that no part of the S corporation distribution to them as shareholders is subject to FICA tax. While present law provides that the entire amount of an S corporation shareholders reasonable compensation is subject to FICA tax in this situation, enforcement of this rule by the government may be difficult because it involves factual determinations on a case-by-case basis.


The reform suggested by the Committee has three parts.

First, all partners of any type of partnership, general, limited, or LLC, would be subject to self-employment tax on their share of self-employment income. This general rule would be subject to a carve-out for certain specified types of income or loss, such as certain rental income, dividends and interest, certain gains, and other items. However, income from service partnerships, described by the report as being partnerships substantially all of whose activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, would be entirely subject to SECA.

Second, the general rule would be further blunted in the case of a partner who did not materially participate in the business of the partnership. In such a case, only that portion of that partner's income that represented reasonable compensation for the services the partner actually rendered to the partnership would be subject to SECA.

Finally, in the most radical departure from current law, S corporation shareholders would be treated for all employment tax purposes as partners. That is, instead of being subject to FICA, they would be subject to SECA. More importantly, unless they did not materially participate in the business of the corporation, all of their income from the corporation (subject to the source limitations noted above) would be subject to SECA. Thus, S corporation shareholders could no longer engage in audit roulette by taking an aggressive position and hoping that the Service would either not challenge the position or that they could compromise with the Service if it did raise a challenge. The change to the manner in which employment taxes are imposed on S corporation shareholders would be coupled with an end to all income tax withholding for these individuals. In other words, they would not be treated in any way as employees for federal tax purposes.

The staff estimates that over a ten-year period beginning in 2006, this proposal would generate $57.4 Billion. It would be effective for tax years beginning after the date of enactment.

The proposal has several shortcomings, either perceived or real.

First, it rejects any carve-out of income from employment tax based upon some imputed return on invested capital. A proposal of this sort had been suggested by the AICPA. Thus income from a radiology practice, for instance, would be completely subject to SECA, even though a significant portion of the income represents a return on capital invested in the practice's expensive equipment. I haven't read the actual text of the proposal, but it would seem that there will have to be fairly complicated anti-abuse provisions to prevent businesses from forming separate equipment or real estate partnerships and entering into leases with their service partnerships to generate SECA-exempt income.

Second, the proposal does not address the "lowly employee" issue. That is, an employee who has only a small percentage of the equity of the business, but who works there full time. As I understand the proposal, all income paid to these employees would be treated as partnership income and none of the affected employees would be subject to withholding. This works a hardship on lower level employees who actually desire to have their taxes withheld from their wages. Also, the Report seems to have overlooked the possibility that it is likely that suddenly "partners" will be popping out the woodwork in order to allow unscrupulous employers to avoid their withholding tax obligations on compensation paid to their employees. Taken to its logical extreme, § 6672 could be, for all practical purposes, written out of the Code entirely.

In a closely related area, there is a seemingly contradictory proposal to repeal § 707(c). Specifically, it is proposed that all compensation for services or use of capital that is not based on the net income (or an item of net income) of the partnership is treated as arising from a transaction between a partnership and a nonpartner. The proposal with respect to employment tax is not discussed here, however it is noted that the under the § 707(c) proposal the income and deduction timing rule for guaranteed payments is repealed and such payments are subject to the income and deduction timing rules for nonpartner payments. What this means, I suspect, is that whether these payments are subject to SECA will continue to be governed by the rules proposed in the employment tax reform area.

If the employment tax law is changed along the guidelines suggested by these proposals, it can be fairly stated that justice in this area will be swift if not particularly fine.