California licensed tax attorney Elizabeth Gonsalves presents thoughts on how to address and deal with Default Assessments as they might be assigned to you by the state.
Offer in Compromise (Video)
TIME IS NOT ON YOUR SIDE WHEN TAX IS OWED
WHY YOU SHOULDN’T WAIT TO ADDRESS YOUR TAX BALANCES
By: Elizabeth Gonsalves, Esq.
You have just received notice of a certified mailing waiting for you at the post office. You haven’t had a chance to pick it up yet. Perhaps you should just ignore it? You’ll get to it tomorrow or Saturday… Fast forward a few months and all the money in your accounts has been absorbed by a tax levy. More embarrassing is the morning you come in to work to find a wage garnishment order has been issued to your employer, now you’re trying to avoid the eyes of co-workers in the payroll department. Worse still is learning a professional or driver’s license has been suspended. It does not pay to wait, it costs much more when one procrastinates with the IRS, the FTB, the Board of Equalization and the EDD.
LEVY RELEASES
If you are fortunate enough 1) to contact my office for help, and 2) happen to fall within one of the many criteria I can work with to obtain a release, you are still looking at a bill for the time I spent working to release the levy, which on the high end can take many hours over several days. Money comes back and your reputation can be restored but money is also lost and a lot of anxiety ensues in the interim. If you are not fortunate, a mini financial crisis occurs in your immediate household. It is not pleasant. I do not recommend it to my clients and I do not protect my clients from new problems this way.
AVOIDING COLLECTIONS ACTIVITY
On the other hand, if you had picked up that certified mailing right away and accepted it was there to notify you of the IRS or state’s final notice of intent to levy, a collections hold would have been something I probably would have been able to obtain before a levy issued and a lot of scrambling was suddenly the order of the day. When I am retained before forced collections occurs I can usually buy us time long enough to produce information the agencies require in a strategic manner that keeps an eye on the outcome while tempering the damage now. Sometimes we have to work together quickly to circumvent a complete emergency but at least we’re working on a long term solution to the problem, fees are saved and levy activity is avoided.
A second complication to waiting is that you, as the taxpayer, do not look so good when I contact the agency to argue a release is in order. Instead, it looks as though the levy did its job, which was to bring the unresponsive taxpayer forward. The agency and its staff are thinking, “Now you want to work with us? You want something from me?” It’s an uphill battle just to get back on track and back to normal life activities. Levies are very disruptive to work and cash flow.
I CAN’T AFFORD PROFESSIONAL ASSISTANCE RIGHT NOW
Of my clients that come in and retain me to address their levy or licensure issues (as opposed to hiring me before the levy or suspension issued), most of them provide a very reasonable explanation for their delay, which is that they are having trouble financially and didn’t feel they could afford to hire an attorney to help them. Days turn into weeks, weeks turn into months and boom! Catastrophe! Now, the taxpayer can’t afford to wait because waiting means up to 25% of their earnings or 100% of the funds in a levied bank account will be lost forever.
It’s the wrong way to look at the problem. Waiting means paying more, it does not mean paying less. Waiting also means stressing out the entire time I’m working to get you some relief. Further, you’re distracted from what it is that we really need to do, which is to gather up your financial information and talk about your goals so I can form a strategy for resolution and get it going for you.
There’s another important reason feeling you can’t afford professional assistance is not a good reason to wait, I get far better results more quickly when you are in a financial hardship. When times are tough, resolutions are far more straight forward and there are more options available to you. I can buy time and lock in something low before the agencies figure out you have turned the corner on your tough spell. My fees are lower because less time is needed to resolve your problem. Time is only on your side with regard to the collections statute and then, only if you have a strategy in place. The IRS has ten years to collect, the state has at least twenty years. If I am retained early we can reach an agreement with the agencies that is more favorable to you. At the same time we can now take advantage of allowing time to pass in a way that works for you, paying lower payments without worrying the whole time. Being direct about solving the problem with my help puts you in the best position to comfortably watch your account move closer to the time when other options for relief are available, such as bankruptcy or an expiration of the collection statute.
WORRY WITTLES AWAY AT HEALTH
The last and most important reason not to wait is your health and peace of mind. The worry that comes with an unaddressed tax balance is not worth the toll on your health nor the strain on your relationships. Financial trouble is the primary reason people break up and part ways. It causes health problems and breaks you down from the inside. Financial trouble muddles your perspective and appreciation for the good stuff in life. Every client tells me pretty soon after I’m retained that they’re relieved, they’re comfortable, they can see they’re going to be okay. Hand me the problem and let me help you with it. It’s not fun, but facing it with me will be worth it. You’ll be able to breathe again.
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THE PITFALLS OF OWING PAYROLL TAX
WHAT IS PAYROLL TAX AND HOW DID I END UP OWING IT?
By Elizabeth Gonsalves, Esq.
PAYROLL TAX
“Payroll tax” or “Employer tax” are terms of art used in reference to FICA and FUTA tax. FICA is an acronym for the Federal Insurance Contributions Act. FICA tax is a combination of Social Security tax and Medicare tax, both of which are used to fund a variety of federal insurances and benefits for taxpayers. FICA tax is paid by both the employee and the employer. Employees pay FICA tax from their wages. Employers withhold employee FICA taxes and submit them to the IRS following each payroll along with the employee’s income tax withholding and the employer’s FICA taxes for each employee. FUTA refers to the Federal Unemployment Tax Act. FUTA, with state unemployment systems, provides for payments of unemployment compensation to workers who have lost their jobs. Most employers pay both a Federal and a state unemployment tax. Only the employer pays FUTA tax; it is not deducted from the employee’s wages.
PERCENTAGE APPORTIONED BETWEEN EMPLOYEE AND EMPLOYER
For the 2014 tax year, an employee’s share of the Social Security portion of the FICA tax is 6.2% of gross compensation up to a limit of $117,000 of gross wages (resulting in a maximum Social Security tax of $7,254). The employer is also liable for 6.2% Social Security and 1.45% Medicare taxes making the total Social Security tax 12.4% of wages and the total Medicare tax 2.9%. FUTA tax is typically .6% of taxable wages paid per year. FUTA is paid annually while FICA is paid quarterly.
HOW DID I END UP OWING PAYROLL TAX?
Payroll tax liabilities may be incurred in several ways. The most straight forward way a taxpayer winds up with an outstanding payroll tax liability occurs when an employer fails to submit their federal tax deposits following each pay period for employees or when payment is not issued upon filing a quarterly payroll tax return with the IRS. When federal tax deposits are required and are not submitted following each pay period the IRS assesses a 10% deposit penalty against the tax due which is applied to the balance due in addition to the payroll tax due. This can make it rather easy to fall behind on payroll tax balance dues.
Lesser known situations where a taxpayer may find themselves with a payroll tax assessment occur when a corporate shareholder performs services for the business and issues only distributions to themselves instead of having a portion of their payment issued to themselves as wages. The IRS frowns upon paying corporate shareholders in distributions alone. The reason is because distribution income is not subject to Social Security and Medicare taxes. Social Security and Medicare taxes are paid through wages. A corporate shareholder avoids contributing to Social Security and Medicare taxes and pays only income tax on their distributions if a “reasonable salary” is not paid first. For this reason, the IRS may audit a business or shareholder who shows distribution income to corporate shareholders without showing salaries and wages paid to corporate officers.
Where distributions are paid by a corporation to a corporate officer without also issuing a reasonable salary to the officer, a business risks being assessed payroll tax by the IRS against those distributions paid. The IRS audits the records of the business tracking all income paid to the corporate officer and assesses both the employer and employee portions of Social Security and Medicare tax against the total distribution paid to the corporate shareholder during the year. The assessment is initially made against the business if the business is a corporate entity. Sometime thereafter, typically four to six months following the initial assessment against the business, a personal assessment of the employee portion of the payroll tax will be made against a responsible person associated with the business.
TRUST FUND ASSESSMENTS AGAINST A RESPONSIBLE PERSON
This personal assessment is called a Trust Fund Recovery Penalty and often appears on an IRS notice as a “Civil Penalty.” In this way a business may incur payroll taxes for both the employee’s portion of Social Security and Medicare tax and the employer’s portion of Social Security and Medicare tax. The Trust Fund Penalty portion assessed against a responsible individual for the business is an assessment of the employee’s portion of the tax that should have been withheld from wages for the employees benefit (in trust). The personal assessment is made in addition to the full assessment of both employer and employee FICA tax against the incorporated business. The trust fund portion is a duplicate assessment, not a double assessment. As the business pays down the trust fund portion, the individual personally assessed also experiences a reduction in the trust fund portion owing on their personal account with the IRS. Trust fund penalties are one of the few exceptions to the protections from personal liability afforded to individuals by incorporating one’s business.
The process for assessing payroll tax against a responsible person associated with the business is called a Trust Fund Recovery Penalty Hearing. It is a fairly simple process the IRS engages to complete the personal assessment. A hearing is conducted by scheduling a meeting with persons believed to be responsible for incurring the payroll tax. The IRS is essentially looking to determine who decided not to pay payroll taxes when due. In most cases, Trust Fund Recovery Penalty Hearings are not a forum for contesting a personal assessment unless the persons identified as responsible persons truly did not make payroll tax payment decisions for the business. Persons who were not signatories on bank accounts and did not sign payroll tax returns may contest a personal assessment or argue another individual was responsible for signing pay checks, payroll tax returns and handling financial aspects of the business. If there was more than one officer or shareholder of the corporation that also shared in responsibilities for paying payroll tax, then the Trust Fund Recovery Hearing is a good forum for arguing the personal assessment should be divided by the number of responsible persons for the business. In this way, the amount of the personal assessment may be reduced as to each individual’s personal assessment. Other issues which arise in a Trust Fund Recovery Hearing may be to contest a spouse being personally assessed or a family member who worked for the business but did not make financial decisions for the business. If you are a responsible person for the business and were the person who signed payroll tax returns and pay checks, the best advice is to be cooperative in the hearing and focus instead on negotiations over the payment plan to be agreed upon to allow the business to continue operating.
Professional assistance is advisable if you and your business have a payroll tax liability you cannot pay off in full right away. Negotiations are necessary and begin with preparation of the business’s financial disclosure soon followed by preparation of financial disclosure for the responsible person. Navigating negotiations is an exercise in being tactful and strategic with your figures and records. Feel free to contact me to discuss your matter and your goals for resolution.
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DISCHARGING CALIFORNIA SALES TAX IN BANKRUPTCY – Part Two
How to Operate a Business (or Your Life) with a Sales Tax Liability
Installment Plans for Operational Businesses
While a business operates, any outstanding sales tax owed remains a liability of the business and the business only. Generally speaking, the first, most important ingredient necessary to a smooth resolution is to immediately focus on filing and paying current sales tax returns and payments (what is referred to in the industry as “compliance”). If compliance is established, the urgency and severity of the Board’s response to your liability will be lessened long enough to get financials gathered and a strategy formulated. Some clients want to eliminate the balance as quickly as possible and seek an aggressive repayment strategy. Other clients have business expenses in the pipeline which put pressure on their ability to make large lump sum payments to reduce the balance due or which are already causing cash flow risks to the business which are not desired. As a general rule, there is no penalty for paying more than the amount the Board agrees to; therefore, I recommend pursuing the lowest installment payments for the business while strongly recommending to my clients that they pay as much as they can when gross receipts are up or business expenses have stabilized. Financial data about the business’s income and expenses are gathered, reviewed then analyzed. There must be a way to make the financial package reflect the outcome desired, otherwise the desired outcome must be adjusted.
The Board is a government agency and as such the taxpayer has rights when tax is due. Professional representation is certainly advised to oversee what documents should be produced, how best to produce them (over what look back period, how to provide information that must be disclosed without divulging incriminating information, etc.), and how best to spin the story of what the taxpayer’s allowable expenses are such that allowable expenses are paid first and deducted from the calculation of the taxpayer’s disposable income. Disposable income is a key indicator when evaluating what the business can afford to pay for past liabilities. Negotiations circle around what figure for disposable income is accurate and what figures for expenses are reliable. Each business is different, some businesses are seasonal, others collect substantial gross receipts but carry very high operational costs that absorb most income earned. It is important that your representative take interest in and understand the business that owes the liability to line up a strategy that will bring results that provide the taxpayer with the buffer it needs to handle its past missteps while still providing room for survival and growth.
Responsible Person Assessments
If a business terminates operations, dissolves or is abandoned, the Board will begin the process of assessing the unpaid sales tax against a “responsible person” associated with the business. Pursuant to Part 1, Division 2 of the CA Rev & Tax Code, any responsible person who willfully fails to pay or to cause to be paid any taxes due from a corporation, partnership, limited partnership, limited liability partnership, or limited liability company shall be personally liable for any unpaid taxes and interest and penalties on those taxes not so paid upon the termination dissolution, or abandonment of the business of the corporation, partnership, limited partnership, limited liability partnership, or limited liability company.
To assess an incorporated business’s sales tax liability against an individual as a personal liability, the Board must establish that while the person was a responsible person the corporation, partnership, limited partnership, limited liability partnership, or limited liability company:
1) sold tangible personal property as a part of its business and collected sales tax on the sale and failed to remit such tax when due; or
2) purchased personal property and failed to pay the sales tax to the seller or the Board; or
3) issued a receipt for use tax and failed to report and pay the tax.[1]
Responsible person sales tax assessments are assessments of the business’s outstanding unpaid sales taxes against an individual owner or operator of the business. In common practice, the individual who is at risk of being personally assessed is someone associated with the business or associated with the business’s sales permit who is deemed by the Board of Equalization to have been responsible for foregoing the payment of sales tax when it was due. To successfully establish that a particular individual should be assessed personally, the Board must find that the individual had access to business funds and directed these funds somewhere other than to payment of the tax when the sales tax was due. If the business had no funds at the time sales taxes were due and therefore did not divert funds to another obligation instead of using them to pay the tax, there may be grounds to protest quarterly business sales tax assessments against that individual during such periods. If the individual did not have decision making authority for the business and did not make decisions about what business expenses to pay, there may be grounds to protest assessments against the named individual. An officer or owner cannot be “responsible” for failing to pay tax when there were no funds available to pay any expenses and none were paid. These are among the arguments that may be made if circumstances surrounding how the liability arose are conducive. Careful attention to the timing of receipt of income and the timing for paying out business expenses must be given before protesting an assessment.
Often, the responsible person assessed business sales taxes on their personal account was in fact a responsible person for the business who, due to cash flow issues or late payment from accounts receivables, made an executive decision to pay a business obligation before paying the sales tax. In these cases where assessments against the business or a responsible person for the business are high and bankruptcy is not possible (which is most often the case) the most important strategy to employ is that of cooperation with the Board. This does not mean that an individual should simply turn over their records to a demanding collections agent. This means the business (or the liable individual) must agree to provide disclosure and should do so in a timely fashion, but they must be tactful about their disclosure and take advantage of historical data in conjunction with recent events to argue the lowest payment possible. Of the California state agencies, the Board of Equalization is often the most aggressive about collections. The Board is short fused and impatient about being paid back when sales tax is owed and a liable party has been identified. To that end, installment agreements are feasible and can be accomplished such that an individual can dig themself out of the debt or establish an installment agreement long enough to line up a different exit strategy for addressing the liability. The key to a good financial disclosure is to be cooperative with the agency while maintaining razor focus on the strategy employed to reach your payment goal.
If you are faced with an outstanding sales tax liability, I am available to discuss your matter for purposes of representing you before the Board. A plan can be created together, with my expertise and your intimate knowledge of your business. We will form an informed plan, then we execute, together, and as a team.
[1] Business Taxes Law Guide, Revision 2013, Article 18, Regulation 1702.5
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DISCHARGING CALIFORNIA SALES TAXES IN BANKRUPTCY – Part One
DISCHARGING CALIFORNIA SALES TAXES IN BANKRUPTCY
Part One
By. Elizabeth Gonsalves, ESQ.
A recent 9th Circuit case, Ilko v. California State Board of Equalization, 2011 WL 2520271 (9th Cir., 2011) outlined the requirements for successfully discharging sales tax in bankruptcy. Until recently, California sales taxes were interpreted as “trust fund” taxes that are never eligible for discharge in bankruptcy. A debate has ensued in the courts for decades over whether the legislative history associated with statutes governing priority of certain creditor claims intended sales taxes to be a type of tax liability that could never be discharged or a type of tax liability that can be discharged after rigid and specific time requirements and filing requirements are met.
Many cases have involved arguments by taxpayer’s counsel that sales tax should be interpreted as a tax to be categorized as either a type of “gross receipts” tax (dischargeable under 11 U.S.C. s. 507A) or, in the alternative, as an “excise tax” (dischargeable under 11 U.S.C. s. 507E). Until recently, the 9th Circuit held sales tax was to be treated as a trust fund tax that was not dischargeable in bankruptcy. In re Shank, 792 F2d 829.
In 2011, in Ilko v. California State Board of Equalization, 2011 WL 2520271 (9th Cir, 2011) the 9th Circuit ruled sales tax was dischargeable under both 507A and 507E. In finding sales tax was dischargeable under both 507A and 507E, the court noted sales tax could be interpreted as either a type of gross receipts tax or a type of excise tax.
Ilko only discusses discharging sales tax in circumstances where there has been a personal bankruptcy filing as to the owner of the business who has been assessed “responsible person” sales tax liabilities (as opposed to a corporate bankruptcy filing). It is required that the business has ceased operations because only then does the three year statute begin to run for assessing a responsible person who can then seek relief from personal liability through bankruptcy (the 3 year statute for assessing a responsible person only applies if the owner gave notice to the BOE that the business ceased operations, otherwise it is an 8 year statute for assessing a responsible person).
The Ilko court ruled that the following elements, if met, may serve to successfully discharge “responsible person” sales taxes:
- The business must have terminated because a “responsible person” cannot be assessed personal liability for the unpaid sales tax under Tax Code § 6829 until the corporation terminates or abandons its business or dissolves; and
- The State Board of Equalization must receive timely notification that the business has terminated (this is important to establish a 3 year assessment statute because balances which are not assessed before bankruptcy but which are still assessable after the bankruptcy filing are never discharged, thus an 8 year assessment statute should be avoided); and
- Filing a custom personal tax return for the sales tax liability (because the corporation and the “responsible person” are viewed as separate persons under Tax Code § 6005.18); and
- At least 3 ½ to 4 years must pass before filing a personal bankruptcy case (to provide for timing requirements as set forth for excise tax and gross receipts tax in 11 U.S.C. § 507(a)(8)(A) & (E), §523(a)(1).
It is important to note that there is a strong likelihood that the state will file a lien against the responsible person personally assessed sales taxes. Any perfected lien survives bankruptcy and is enforceable against the real property or personal property of the responsible person after bankruptcy. Therefore, even if the responsible person successfully discharges responsible personal sales tax assessments from collection action against them personally, their attachable property may be subject to the sales tax after bankruptcy.
UNDERSTANDING HOW TO CREATE A PROFIT & LOSS – FEDERAL & STATE TAX PROBLEMS COMMON TO THE SELF-EMPLOYED
LEARNING HOW TO PREPARE A PROFIT & LOSS AND LOVING IT
By. Elizabeth Gonsalves, ESQ.
A profit and loss is simply a spreadsheet setting forth your gross receipts (gross income) against your categorical business expenses for purposes of arriving at your net income, or “taxable income.” “Profit” is the gross income or gross receipts, the total of all raw income you received, while “Losses” are the costs of doing business, the “operating expenses.” I have seen complicated Profit & Losses and simple Profit and Losses, neither is better than the other. What counts is 1) that the gross income claimed is accurate (matches reported income and/or deposits into bank accounts), and 2) that all business expenses claimed are legitimate business expenses that are permitted deductions or expenses that a business can claim to arrive at net business income.
NEW INCOME – COMMINGLED ACCOUNTS
Don’t bother beating yourself up if you have commingled accounts, take the time to avoid commingling going forward. Stated simply, commingling is the act of mixing personal income and/or personal expenses with business income and/or business expenses or any combination thereof. The strongly advised practice is to keep business income and business expenses completely separate from personal income and personal expenses. The primary reason to separate them is not only because the IRS or state will judge you poorly as a business person – the primary reason is simple, keep them separate so you can track them separately and know where you stand with each, respectively. It goes without saying, you can only analyze your business, its earnings, its operating expenses and its return on investments, if you know what your business makes and what its spends. Only then can you determine how to optimize profitability. Further, knowing your taxable business income is imperative to calculating estimated tax before taking income for personal expenses. Commingled accounts require far more work from a tax representative and make it more difficult for the revenue agencies to determine what business expenses are incurred, what personal income is received and how personal income is used to pay necessary personal expenses. It is the government’s job to find income and in doing so, tax owed. It is the taxpayer’s burden to prove their deductions (i.e., legitimated business expenses) against income. Keeping a clear record of your income and the expenses you incur to earn that income are your responsibility as the taxpayer and bring you the benefit of reducing your taxable income. Keep these records organized for yourself. Its empowering.
Personal Income Distinguished
Personal income can be wages (which do not belong in a Profit and Loss) or pension income, or some other source of income that should be included on your personal income tax return in the income section of the tax return (page 1). Distributions from a corporation of which you are a shareholder are not personal business income. They are personal income from a partnership, corporation or entity and are claimed on line 17 of a federal income tax return. Business income is income earned by a sole proprietorship (which is a non-entity) or income received by a disregarded entity such as a single member LLC, or income earned by you – just you by yourself in your name. Line 12 is for reporting income from a personal business such as a sole proprietorship or a single member LLC. Personal business income is income reported on Schedule C (or Profit & Loss which is a part of a personal income tax return) the net income of which flows over to Line 12 on a personal income tax return. If you operate as a DBA or a single member LLC or just as yourself, then the income received is “business income” and is reported on Schedule C. For purposes of reporting income on a personal income tax return and for simplicity’s sake, “business income” when defined in relationship to a personal income tax return does not include income received from an incorporated entity. Business income, for our purposes of speaking about self-employed individuals is the income received from clients, patrons, vendors, employers, etc. in exchange for your goods or services or both when your business is not incorporated. A “doing business as” or “DBA,” or “Fictitious Business” is an example of a business that is not incorporated. As previously stated, a single member LLC is also a disregarded entity for tax purposes. A single member LLC is also reported on a Schedule C in a personal income tax return. No corporate return is required to report “business income.” This type of income is subject to estimated tax requirements and maintenance of records to track both income “profits” and business expenses “losses” for purposes of determining taxable income, which is that income you net after reducing your profits by your losses. If the IRS or state only receives reports of your gross earnings as an independent contractor it assesses tax based on a figure that has not yet been reduced (via a Schedule C) by business expenses. The tax assessed on gross income is almost always more than it would be if assessed against net income (profits left over after paying all business expenses).
New Income v. Re-Deposits of Income Previously Received
If you withdraw income from your business, then put it in a personal account (or keep it in cash in a safe place) and later re-deposit it into your business’s accounts due to cash flow issues, the re-deposited funds are not new income and should not be included in your tally of gross receipts. Gross receipts are only the original income received in exchange for your goods and services.
Business Losses/Expenses
All businesses are not made the same. All business do not pay for the same expenses. The expenses your business can claim relative to the next business are roughly the same but vary depending upon your industry. Generally speaking, what you must spend to earn business income is a business expense – with several exceptions.
Costs of Goods Sold
Some businesses sell goods in addition to services, such as a plumber or a mechanic. The patron hires you to fix a broken alternator. They need to purchase an alternator through you, but they also need you to install it. There are parts and labor charges to the patron and in most cases there are parts and labor costs to the business providing the service. Both the parts and the labor are deductible, meaning the money you receive from the patron to pay for the parts and the service you provide are first reduced by your costs to supply the part and the worker you pay to install it, the amount left over is your net income on that particular transaction – your net profit. Obviously, you need to charge such that there is a net profit, unless you are a charity or are otherwise working in a not-for-profit capacity. This means you need to know how much you can obtain the part for, how much you must pay your worker to install the part, all while remaining competitive relative to other mechanics. It is not enough to know you can reduce your taxable income by these expenses, the goal is to profit despite these expenses. If you fail to claim any expenses (i.e., fail to file a return), then the IRS or state assume you simply made $400, without knowing you obtained an alternator for the patron and spent $150 on the part and paid your employee $45 to install the part in order to earn that $400. In this example you were paid $400, but you spent $195 to earn that $400. This means your taxable income on the transaction is $205, not $400. “Cost of Goods Sold” refers to the costs for goods you must purchase to conduct the business that you do. The cost of goods sold is 100% deductible. As a side note, when selling goods in a wholesale capacity there is no sales tax; however when selling goods in a retail capacity, sales tax may also be implicated as an additional “expense” or obligation that you must collect from a patron and deliver to the state. Your costs and the tax on retail goods sold must be built in to every transaction to insure a net profit is realized. Costs of goods sold are a deductible expense and should be carefully analyzed and tracked by maintaining a year-to-date profit and loss.
Salaries and Wages
Salaries and wages paid to employees are 100% deductible. An issue which arises with salaries and wages occurs more recently in the case of corporate shareholders taking distributions of income from their business without first paying themselves a “reasonable salary.” There is a trend, particularly with the IRS, of assessing payroll tax against corporate shareholders who have paid themselves distributions (draws from the corporation) only. A corporate shareholder should register themselves as an employee of the business and pay themselves a wage. The reason for these payroll tax assessments against shareholders is to discourage shareholders from paying themselves distributions to bypass employer FICA and FUTA taxes against their income. A shareholder may pay themselves a distribution in addition, but the better practice is to pay a regular wage to a corporate shareholder and pay out any other net profits intended for the shareholder at the end of the year as a single wage or bonus pay check which deducts income tax as well as FICA and FUTA taxes. In the case of sole proprietors, DBA’s and single member LLC, an owner need not pay themselves in wages, they may simply take income from their business provided all income tax and self-employment taxes have been paid first. A sole proprietor may write off as business expenses the salaries and wages they report and pay to staff, but they need not pay themselves as a wage earner.
Rent
Business rent is straight forward unless you work from home. This expense is relevant to preparing a Profit and Loss and is tricky in a beneficial way if you work from home.
Business Use of Home
Whether you rent your home, your apartment, or own your own home or condo, the calculation is the same and is extremely important to the bottom line. Any part of your personal home (be it rented or owned) that is exclusively used for a business purpose is deductible as a business expense. It is recommended that you establish a distinct area of your personal home that is to be used for business and business only. Put your printer, your fax, your supplies, your storage for the business materials, etc. in this area. If you have a second bedroom in your apartment, or a garage or spare bedroom in your home, it is best to use such a space as your business space. Honor the boundaries, not just for you but for tax purposes. Calculate the total square footage of your home. Let’s imagine its 1000 square feet. Now, calculate the total square footage of your home that is now exclusively used for a business purpose – the “office.” In this scenario, let’s imagine the office is 400 square feet of your home. Divide 400 by 1000 to arrive at the percentage of square footage of your home that is used for an exclusive business use. We come to 40%. This means 40% of your rent/mortgage is now a business expense. Likewise, 40% of your home utilities such as gas or electricity is a business expense and may be claimed as such on your Schedule C Profit and Loss. If you have a fax line, or special internet service for your business operations you can probably claim 100% of it, as you probably would not pay for this service unless there was a business need to have and use such equipment. Business Use of Home is claimed on form 8829 of your personal income tax return and is a business expense deduction on your Schedule C. Now, don’t start abusing this by including Hulu, Netflix and cable as a business expense unless you are in the entertainment industry. Be reasonable, be smart, be ethical, be strategic and you will be okay in claiming these expenses.
Mileage
Mileage is a red flag for most revenue officers, collections agents and examiners. The best advice is to carry and maintain a mileage log of travel for business. Track the date you traveled in your personal vehicle, the number of miles you traveled and the purpose of the travel. It is also worthwhile to note that you may not claim travel commuting from home to your office. Business travel is travel to a destination you must visit to conduct business beyond your normal commute from home to office and office back to home. Business travel does not include travel from home to your office to conduct business.
For example, if you have an office but must visit sites to earn new clients, the travel from your office to the prospective client are business miles which should be recorded in a business mileage log. If you have a prospective client that is closer to your home than your office, thus you opt to travel from home to the client then back to your office, the miles to the client from home are business miles. Arguably the miles from the client to your office are also business miles; however, the miles from your office back home are not business miles, nor are the miles from home to your office the following day.
PAYING CURRENT TAX AS A KEY TO MINIMIZING PAYMENTS FOR BACK TAX
Perhaps the most important aspect of being self-employed is calculating your estimated taxes and submitting them timely. A key strategy to negotiating an installment agreement or an offer in compromise with either the IRS or the state is making a case for the current tax that must be paid and prioritized before discussing a dollar amount you can afford to apply to your past due balances. If you’re preparing to provide financial disclosure to the IRS or the state, it is probably best to get a professional opinion and strategy for how to proceed, but as a general rule in going through the financial disclosure process to arrive at a monthly payment or offer amount, it’s a good idea to beef up and pay your current estimated taxes, then circle back to calculating how much is really owed for the year once the resolution has been established. This is important for a second reason, any balance owed after the 15th of April the following year will cause any agreement put in place to default. If you’re going to go through the trouble of dealing with the IRS or the state, do everything in your power to make sure you don’t have to do so on a regular basis. Dealing with the IRS and the state is uncomfortable, unpleasant and puts you at risk for enforced collections which everyone knows (or has heard) is no fun.
CALCULATING YOUR ESTIMATED TAXES
Federal & State Personal Income Tax
It is really very difficult to calculate current taxes without the assistance of tax software, for this reason the self-employed are required to submit estimated taxes on a regular basis. As a general rule, and specifically for tax year 2014 (tax rates may change annually), a self-employed individual must first calculate at the end of each quarter (March 31st, June 30th, September 30th, and December 31st) their net income, as discussed above. Once you have arrived at your net income on a year-to-date basis (all income over the year must be analyzed on a cumulative basis given tax brackets are derived from total annual income figures), check the income tax table for the current year for both the IRS and the state. Tracking your net income using these tables will give you a sense of the total federal and state income tax you owe against the net income you have earned. Make sure you submit at least this amount (keeping in mind you may have paid a portion of the balance due in a previous quarter earlier in the year when your net income was lower).
Federal & State Self-Employment Tax
Yep, you have more tax to pay beyond your income tax. You must also pay self-employment tax to the federal government when you earn 1099 income. Self-employment tax is essentially the employee side and employer side of social security and Medicare tax on the federal level. For self-employment income earned in 2013 and 2014, the self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
For both 2010 and 2011, the first $106,800 of your combined wages, tips, and net earnings are subject to any combination of the Social Security part of self-employment tax, Social Security tax, or railroad retirement tax. The amount increased to $110,100 for 2012, $113,700 for 2013, and $117,000 for 2014.
All your combined wages, tips, and net earnings in the current year are subject to any combination of the 2.9% Medicare part of Self-Employment tax, Social Security tax, or railroad retirement tax.
In 2013 an additional Medicare tax rate of 0.9 percent went into effect and applies to wages, compensation, and self-employment income above a threshold amount received in taxable years beginning after Dec. 31, 2012.
If you use a tax year other than the calendar year, you must use the tax rate and maximum earnings limit in effect at the beginning of your tax year. Even if the tax rate or maximum earnings limit changes during your tax year, continue to use the same rate and limit throughout your tax year.
COMMON MISUNDERSTANDINGS ABOUT FILING AN EXTENSION
An extension to file your tax return only extends the deadline for filing a return. An extension does not extend the deadline for paying the tax owed. When considering an extension in any given tax year, particularly if you are self-employed, it is important to first calculate the tax owed for the previous year so the tax owed can be paid to the IRS and state by April 15th of the following year to insure you are not subject to failure to pay penalties. If you file an extension, then file your return by the extension deadline of October 15th of the following year you can safely forego the assessment of failure to file penalties. The point here is that there are several types of costly penalties which accrue at an alarming rate if left unchecked. Tax is always due for a given tax year by mid-April of the year following the tax year in question. If the full amount of tax is not paid to the federal or state agencies by this date, penalties will be assessed and a default of any payment plan or other resolution put in place prior to that date will automatically default.
LIFE GOES ON EVEN WITH A TAX LIABILITY
Tax is not death or grave illness. Its stressful, its scary and it can put a really good sized wrench in your future financial plans but it is not the end of the world and its not permanent. There is a ten year statute of limitations for collecting a federal tax debt. There is a twenty year statute for collecting a California state tax debt. Balances due will expire, there are several ways to get your problem under control by preventing future assessments and, most importantly, by recognizing there is usually a lot that can be done to make the balances owed manageable for you. An important point to note here is that tax is owed to government agencies, not private lenders like banks, automobile financiers or credit card companies. Because the IRS and FTB collect funds owed to a secured creditor, they are powerful and they can mess with your life far more easily than a private creditor can and they can do so without having to jump through as many hoops as a private creditor must jump to reach your assets against your will. For this reason, its important to be responsive and cooperative with the agencies. Of course, you also want to be tactful and strategic in navigating their collections rules. There is a plus side to dealing with a government creditor. Because they are a government agency, cooperation, even cooperation without an ability to make meaningful payments, is acceptable to the agencies. The IRS and the state are very responsive to a taxpayer who is reasonable and cooperative. There is a lot more that can be done for a cooperative taxpayer who has insufficient funds to pay the balances owed than would be available to a borrower unable to pay their mortgage to a bank. Assets can be preserved, life can be lived with reasonable comfort in most circumstances as long as the taxpayer is being reasonable. The first step is taking the initiative to understand how the liability happened, how it can be avoided in the future, and how to deal with it in between the two.
Should you have additional questions or believe you may need the benefit of professional assistance, please do not hesitate to contact me for a consultation regarding representation before federal or state revenue agencies.
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NEGOTIATING REDUCTIONS TO GOVERNMENT TAX ASSESSMENTS
FEDERAL & STATE TAX PROBLEMS COMMON TO THE SELF-EMPLOYED
Perhaps you have been self-employed and have received 1099 Non-Employee Compensation tax reports from your clients and your vendors for years, or perhaps the downturn in the economy has forced you to make your own way by going into business for yourself. Perhaps you are contemplating moonlighting to augment your regular wages. Whether you have an outstanding tax liability due to non-payment of estimated taxes on self-employment income or if you just want to know the ropes in taking on a new venture, there is no time like the present to understand the basics which led to owing taxes, how to go about addressing the problem, or even better still, how to avoid having an outstanding balance owed in the first place.
REDUCTION OF IRS & STATE TAX ASSESSMENTS WHEN NO RETURN HAS BEEN FILED BY THE TAXPAYER
At least fifty percent of my clientele are self-employed persons working in a colorful variety of industries that have not filed tax returns for several years and wonder how it is that the IRS or state revenue agency has assessed tax against them for years during which they worked but never submitted a tax return. There are two basic ways this happens, depending upon whether you received tax assessments from the IRS or the state.
How Does the IRS and State Figure Out Where I Bank or Who My Employer Is?
Most employers must report to the IRS and the California Franchise Tax Board (“FTB”) all compensation they pay to wage earners (W-2) via a paycheck and all compensation paid to individuals working as independent contractors (1099) via a flat fee or commission. The reason these employers must report such payments is they are legitimate business expenses to the employer, reducing the employer’s taxable income. These business expenses also represent taxable income paid to and earned by someone else (i.e., the employee or independent contractor). The IRS uses W-2 and 1099 information reported by an employer to identify income received by other parties, namely, the employees or independent contractors. The income reports submitted by employers to the IRS are processed and tracked by social security number or employer identification number (“EIN”) in the IRS system. Often, the FTB and IRS work cooperatively together and share resources for collecting old tax liabilities. From these reports, the IRS and FTB know when you have earned income and calculate tax owed against this income. These same reports can be retrieved to help you know what income has been reported under your SSN or EIN.
Most taxpayers can confirm the income that has been reported to the IRS by requesting an IRS Wage and Income Transcript. Information about California state income taxes that are credited to your account can be retrieved by calling the FTB. The IRS Wage and Income Transcript is an annual record of all types of income received by each taxpayer from a variety of sources. Not all sources of income are employers, some are banks, stock trading organizations and government agencies such as the Employment Development Department (“EDD” which issues unemployment insurance benefits) or the Social Security Administration. There are several types of 1099 income reports, the most common is the 1099-Miscelanneous (1099 Misc), which is used to report non-employee compensation (independent contractor income). The IRS keeps records of many types of income reported by payors that should be claimed by taxpayers in filing a return. These reports are used by the IRS to assist the IRS in tracking taxable income and deductible business expenses claimed by individuals and corporate entities. A limited example of these are reports from lenders of mortgage interest paid to a mortgage lender by a borrower, student loan interest paid by former students who took out educational loans, tax deferred retirement accounts liquidated in some amount during the year, or proceeds received by a taxpayer for the sale of stocks. The IRS also keeps record of federal income tax withholdings and estimated tax payments. Tax withholdings are payments made by taxpayers to account for their income tax by having them withheld by their employer and submitted to the IRS and state on their behalf by the employer or by instructing an agency to withhold tax when liquidating an asset that is taxable as income. The IRS does not keep record of state income tax withheld or paid; therefore, the IRS Wage and Income Transcript is not a complete record of all tax payments a particular taxpayer may have made during the year to all agencies. To learn information about state tax withholdings, it is best to contact your state revenue agency for this information. Estimated tax payments are payments which should be submitted on a quarterly basis by persons receiving 1099 income to account for federal income tax, federal Medicare tax and federal social security tax. Estimated taxes must also be submitted to the state of California (FTB) to pay state income tax, employer training tax, unemployment insurance and disability insurance. It is important to determine all tax payments made during the year (i.e., state income tax) as these may be deductible expenses on a federal tax return.
Now, we have a sense of how and where information is gathered and used by the agencies to make assessments of tax against you with or without your participation. We also know where you can go to retrieve information about what income was reported to the federal and state government, as well as, any tax against this income you paid during the year for purposes of filing an original return.
IRS Tax Assessments in Lieu of Filing Your Own Return
When the IRS receives a return which they want to select for audit or if the IRS fails to receive an original tax return from a taxpayer it has three years from the date the return was processed or due (usually April 15th of the following year) to assess additional tax against the taxpayer. Should the IRS fail to assess tax within the three year time frame, it loses the opportunity to assess additional tax owed. This is referred to as the Assessment Statute or Assessment Statute Expiration Date (“ASED”). The state of California has four years to assess additional tax once a return is filed and has no restriction for assessing additional tax if no return is filed by a taxpayer. R&T Code §19087.
When the IRS uses reports of income it has received to assess tax against a taxpayer who fails to file a return (before losing the opportunity to) the IRS does not have record of tax deductions that could have been claimed by the taxpayer during the year the income was earned because it has received no information about such deductions from the taxpayer. As a result, in many cases an assessment of tax made by an agency against a taxpayer who has not filed a return will be higher than the tax assessed after submitting a return claiming legitimate credits and deductions. IRS unilateral assessments are called Substitute for Returns or “SFRs.” The state of California calls such assessments Notices of Proposed Assessment or “NPAs.”
If you have worked and received 1099 income in an amount sufficient on its face to implicate an income tax liability (i.e., if you have received income in amounts reaching minimum income thresholds requiring that a return be filed) and you have not filed a return but have an assessment which appears to have been made by the IRS or the state, then it is probably advantageous to file an original return as doing so will likely reduce your tax assessments. It is always advisable to evaluate your SFR balances or Proposed Assessment balances against the balances that would be due if you filed your own return (being sure to add charges for interest and penalties) to confirm it is more beneficial to file.
“SFR” balances are typically assessments of tax in excess of what your actual tax would be, particularly if you are self-employed and incur business expenses (tax deductions) as a part of earning your income. The IRS and state assessments are made based on income alone and contemplate that you are single and have no deductions or credits to claim. These types of assessments are made without knowing what operating expenses you might have incurred, without knowing the basis in stock you sold and without accounting for marriage deductions, deductions for dependents, or deductions for medical insurance to name a few.
State Tax Assessments
Generally speaking, the state is far more rigid and outrageous in its practice of assessing tax and collecting tax. In California, the Franchise Tax Board will assess “an industry standard” amount of income tax against a taxpayer that fails to file a return even if there is no report of income or very low reports of income showing in the FTB system. For example, a person holding a real estate broker license, a license to practice law, or a license to practice medicine who had no reports of income would still be assessed at least $7,000+ in income taxes simply by virtue of the FTB’s having received report that the taxpayer held a professional license in the state. The state can in some cases suspend a professional license when balances owed become very high ($300,000 to $500,000 in range) or when they become very old and near the time for expiring completely. State income tax assessments often occur when a taxpayer holds a professional license and fails to file an original return on their own. Such suspensions can be lifted and tax assessments can be reduced by filing an original return.
Can I Reduce Tax That Was Assessed by the IRS or State When I Did Not File a Return?
Yes. In many cases tax as assessed by the IRS or FTB without your input can be reduced by filing an original return. A taxpayer may lose their ability to collect a refund due to state and federal statutes limiting the time during which a taxpayer may claim a refund, but reductions to tax assessed can almost always be accomplished by filing an original return to reduce SFR or Proposed Assessment balances. When faced with a potential tax balance owed, concerns about a lost refund go out the window and the focus is instead on reducing the tax liability. Reducing or eliminating a tax liability to avoid collections is far more satisfying long term than worrying about the fact that you have missed the opportunity to receive an old refund from years ago.
Preparing to File Original Returns on IRS Substitute For Return Balances or FTB Notice of Proposed Assessment Balances
The first order of business if you are self-employed and have not filed returns is to prepare original returns using your business expense information from the year in question to claim business expenses against the gross income received during that year. Information from bank statements is very helpful and recommended as it is a source document generated at the time the income was earned or expenses incurred, further bank statements are maintained in the regular course of a neutral third party’s business and can be used to verify expenses claimed on a return if you were ever to be audited. Check images and check carbons, receipts and credit card statements are also helpful source documents to use in tallying up previous years’ business expenses. Often vendors you paid have records of invoices they submitted to you, as well as, your payments to them in satisfaction of invoices they have issued. It is worthwhile to reach out to vendors should you have gaps in records you kept internally. Medical insurance premiums and mortgage interest can also be claimed on previous years’ returns. There is a wide plethora of events that may be claimed on a tax return to reduce your income tax liability. Examples include federally recognized natural disasters, stolen property, depreciation on equipment and vehicles, and charitable contributions to a qualified charity.
Both the IRS and the state take a lot longer to process an original return when a government assessment of tax has previously been made, but the good news is, assuming the return matches their reports of income and tax deductible expenses, or is a legitimate deduction that you actually incurred during that year, the return will be accepted and the principle tax will be reduced along with interest and penalties accrued on that portion of the original principle tax assessed that has been reduced by virtue of submitting an original return. This represents the first most important and cost effective way to reduce principle tax assessments in situations where returns were missing and taxes were assessed by a revenue agency.
Compliance
There is another reason to file an original return beyond reducing principle tax. In most cases the agencies will require all returns be filed before they will negotiate a settlement with a taxpayer for all balances owed. The IRS and state will not entertain settlement discussions over past tax liabilities unless or until all taxes owed are known to them. While the IRS and state may have assessed tax against you for previous years, likely they have not assessed the most recent years’ tax returns; therefore, it is common to find you must pull your documents together to file originals because all missing returns must be on file before the negotiations may begin. If there was no requirement to file because you earned too little income, you may avoid filing a return for years having no filing requirement. Further, the IRS and state will not require an original return for a year having an agency assessment (SFR or NPA) but it is usually in the best interest of the taxpayer to file an original in this situation anyway, for the reasons just explained – it will probably reduce your principle tax liability and the interest and penalties accrued on the difference between the principle tax reflected on your original return and that of the principle tax assessed by the revenue agency.
In some cases, it may not be advisable to file an original return if you have very old balances assessed by the IRS as an SFR. This shall be discussed in more detail below.
Collection Statutes
The IRS has ten years to collect tax it has assessed against you before it loses the opportunity to collect it completely. These statutes are commonly referred to as Collection Expiration Statute Dates, or “CSEDs.” This is true whether you filed a return showing a balance owed or the IRS assessed an SFR against you. The Franchise Tax Board is quite different as it has twenty years to collect tax owed pursuant to an original return filed by a taxpayer. This means your tax balances, no matter how high, return to zero once the collection statute expires. There is no statute of limitations for collections on Franchise Tax Board balances owed pursuant to a Notice of Proposed Assessment. Therefore, it is best to file an original return with the state even if doing so does not reduce your balances significantly.
Collections Statutes are important to note for two reasons, 1) in most cases, though the tax will be there a long time, it will not be there forever, and 2) it is important to analyze government assessment dates as this impacts the time the agency has to collect the tax and how long you may be dealing with the debt. In some cases, it is not advisable to file an original return on an IRS SFR balance. This is typically because the collection statute is set to expire very soon. Filing an original return restarts the ten year collection statute. For example, if the IRS assessed an SFR tax liability in the amount of $40,000 against you for tax year 2000 in 2003, then the ten year collection statute started on that assessment date in 2003 which means the tax should expire sometime in 2013. If that is the case, it may not be advisable to file an original return for tax year 2000 to reduce the tax liability to $10,000. If the entire $40,000 balance expires in several months it may be more effective to manage the $40,000 owed through a payment plan long enough to see the balance disappear. If the original 2000 tax return was filed now, there would be another ten years from the date the original is filed for the IRS to collect the $10,000 owed (plus interest and penalties on that balance accrued since April 16, 2001).
Unless the IRS SFR assessment was made on what is now a very old year, or the assessment is lower than what it would be if you filed an original, it is usually advisable to prepare an original return for any year having a government tax assessment of income tax on file.
Understanding the Legal Effect of Federal Tax Liens When Selling, Refinancing, or Purchasing Real Property
By: Elizabeth Gonsalves, Esq.
Taxpayers owing balances to the IRS in excess of $10,000 for past tax years could have a Notice of Federal Tax Lien filed against their social security number or property. The legal effect of a Federal Tax Lien is to give the federal government legal claim to your property as security or payment for a tax liability. A Federal Tax Lien should not be confused with a Federal Levy on Wages or Bank Account. You can learn more about the difference between these two by clicking on our Federal Tax Lien link on our Free Advice page. A Notice of Federal Tax Lien may only be filed after a liability is assessed, a Notice and Demand for Payment is served on you and, you fail to fully pay the debt within 10 days of being notified of the liability.
Once these requirements are met, a Notice of Federal Tax Lien can issue in the amount of your tax liability. The Notice is a way of publicly notifying creditors that the federal government has a claim against all of your property, even property you acquire after the lien is filed. A federal tax lien establishes the federal government’s priority, in relationship to other creditors associated with your account, for use during such proceedings as bankruptcy, and the sale of real or personal property, among others.
Federal Tax Liens can often have an adverse effect on a taxpayer’s credit, as it tends to show a significant creditor (the federal government) has not received funds owed. Federal Tax Liens often create problems for taxpayers either trying to sell a property, refinance a property, or purchase a property. Such transactions implicate possible sale proceeds, loan proceeds, or sums intended for down payments which might be routed to the federal government instead of the delinquent taxpayer.
In each of these transaction situations, the IRS may be willing to cooperate with taxpayers in a way that assists such transactions to process successfully. Of course, the IRS requires a taxpayer’s cooperation in return, as well. You can read more about Notice of Federal Tax Lien here.
Taxpayer Selling a Property Having a Federal Lien on Record
When a taxpayer is attempting to sell real property having a Federal Tax Lien filed against it, the IRS will consider Discharging the Federal Tax Lien to allow the property to be sold free and clear of the cloud on title. A Discharge of Federal Tax Lien releases the effects of the lien against one piece of property. The IRS requires that Form 14135 be prepared and submitted to the Lien Unit with accompanying documentation relevant to the sale. A discharge request will be reviewed for important pieces of information such as, whether the proceeds of sale will provide for some or all satisfaction of the tax liability. In situations where the proceeds are not sufficient to provide for payment of the tax liability, such as a short sale, the IRS may require information about any other property owned by the taxpayer that may be used to secure the government’s interest. To learn more about requesting a Discharge of Federal Tax Lien you may refer to IRS Publication 783 for more information.
Taxpayer Refinancing a Property Having a Federal Lien on Record
In circumstances where a taxpayer is attempting to borrow funds by using collateral having a Federal Tax Lien on record, such as refinancing a property, the federal government may be willing to subordinate the lien in favor of the lender to assist the taxpayer in receiving the loan. A lien subordination involves making the federal lien secondary to another lien, such as that which would attach to property in circumstances where refinancing is approved. Similar to a Discharge request, the IRS would require information about the proceeds of such a loan and whether any sums could be used to pay all or a part of the tax delinquency on file. IRS Form 14134 is used to request a Lien Subordination and requires the inclusion of documents relevant to the transaction for approval. To learn more about Lien Subordination requests, you can read IRS Publication 784.
Taxpayer with a Federal Lien on Credit History Attempting to Purchase a Property
In situations where a taxpayer is attempting to purchase a property, having a Federal Tax Lien on a credit report often upsets the Purchase Money Mortgage loan approval process. Banks typically require a showing that any outstanding federal tax liability has already been accounted for in the form of a formal repayment agreement with the IRS. In other words, banks regularly require a showing that a tax resolution has already been established to account for debt to income ratios in evaluating a buyer for loan financing. While this may make sense from a lender point of view, we find this requirement counterproductive given the IRS Federal Tax Lien rules. Pursuant to Publication 785, and Revenue Ruling 68-57, where Purchase Money Mortgages or Purchase Money Security Interests are sought by a taxpayer having a Federal Tax Lien on file, the Federal Tax Lien is automatically subordinate and a request for Subordination of the Federal Tax lien is not required, nor will subordination be provided if applied for. This is true even in situations where the Federal Tax Lien was filed long before a Purchase Money Mortgage or Purchase Money Security Interest was approved and issued by a lender.
When a delinquent taxpayer attempts to purchase a home, has a Federal Tax Lien recorded against their social security number, and has not yet established a tax resolution with the IRS, a prospective lender that is not familiar with this rule will often require a showing that the liability is in a repayment plan, or has been satisfied in full. The problem here is that the IRS typically requires financial disclosure to approve a payment plan over time to account for back taxes owed. Financial disclosure involves a thorough review of your bank statements, including investment accounts, savings accounts, CD’s, etc. If the IRS is able to see that a taxpayer has sufficient funds to pay some or all of a tax liability owed (i.e., a significant sum of money sitting in a bank account intended to be used as a down payment for the purchase of a home) they will require immediate liquidation and payment on the tax balance, rather than a payment plan over time. Because the taxpayer intends to use that sum for a down payment, forfeiting such funds to the IRS will cause the purchase to fall through.
The fact is, a lender contemplating approval of a Purchase Money Mortgage for a taxpayer should simply approve the loan without requiring a payment plan with the IRS. First off, the Federal Tax Lien is secondary to the Purchase Money Mortgage by operation of law. Second, so long as the mortgage is reasonable, meaning the mortgage and utilities expenses do not exceed the national standard for Housing and Utilities as set forth by the IRS by county of residence, the housing and utilities expenses will be allowed. If the housing and utilities total an amount close to the national standard in your area, the IRS will accept a payment plan based on the taxpayer’s ability to pay, or disposable income, which is calculated after allowing the funds needed for the mortgage as a necessary living expense. You can check out the National Standard for Housing and Utilities in your county by number of people in your household here.
The concept behind Revenue Ruling 68-57 which renders a Federal Tax Lien automatically secondary to a Purchase Money Mortgage is that the taxpayer has acquired property or a right to property only to the extent that the value of the whole property or right exceeds the amount of the Purchase Money Mortgage.
Persons seeking to purchase a home are best advised to either resolve their outstanding tax liability owed to the IRS first, before significant sums are accumulating in a personal account, then take steps to purchase a home, or to provide a copy of Publication 785 to their lender for review by the lender’s underwriter. If you have an outstanding tax liability and plan to try to purchase a home soon, contact The Law Office of Elizabeth Gonsalves for assistance in negotiating the lowest possible payment plan first before you solicit lenders to purchase a home. We can assist you and help the transaction to run smoothly.
California Licensed Attorney
Elizabeth Gonsalves
Liz is regarded as one of the most esteemed and sought after Tax Controversy attorneys in Los Angeles. Her exceptional experience with high dollar clients and complex cases sets her apart as a true professional.