Here’s How IRS Taxes Severance Pay

You may get severance pay when you quit your job, are laid off, or fired. You also might get severance later if you sue and settle. Whether or not your pay is labeled “severance,” and regardless of when it is paid, the IRS generally views severance like any other pay. It’s taxed as wages, so is subject to withholding and employment taxes. If your employer hands you a severance check as you walk out the door, you may well expect it to have all the payroll deductions you’re used to seeing on your regular paycheck.

But payroll deductions may be a big surprise if you’ve sued, and several years later are settling. You might be expecting a big check without tax withholding. Many people are surprised that a former employer can withhold taxes when you no longer work for them. How can a payment be “wages” subject to withholding, you might ask, if you haven’t been an employee for years? If you sue for wrongful termination and settle many years later, isn’t there a time limit?

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As it turns out, timing doesn’t matter. Whether you get a gross check for the full amount or one with payroll tax deductions depends on several variables. They include how careful your employer is about its tax obligations, and how it agrees to resolve your case. Most employment disputes are settled, and it is common to split a settlement between severance (treated as wages) and non-wage income. The employer might agree that some of the settlement is pay for discrimination, emotional distress, or other non-wage income. The severance pay is subject to withholding and employment taxes. The rest would be paid on a gross check with no withholding and reported on a Form 1099. This is one of the many things to know about taxes on legal settlements.

There are two parts to the tax puzzle, income tax withholding and employment taxes. Income tax withholding is simply the employer deducting tax money according to withholding tables, and sending it to the IRS under your Social Security number. Then, in January of the following year, the company will issue you an IRS Form W-2 showing your total income and the taxes withheld. While you might regard the income tax withholding part of the equation as mere timing, the employment tax gets expensive. The employer and employee each pay half the employment tax.

For some years, there was a controversy in the courts over whether all severance pay should be subject to employment taxes. Arguably, severance pay isn’t for services that have been rendered, but for services that will never be rendered. Even so, the IRS position is that any severance pay is subject to employment taxes, and in 2014, the Supreme Court agreed, reversing a key taxpayer win in the Sixth Circuit Court of Appeals. What’s more, the Court voted 8-0 in favor of the IRS.

The Court ruled that severance is subject to tax under the Federal Insurance Contributions Act tax. FICA consists of Social Security tax and Medicare tax. Employers pay Social Security tax of 6.2% and employees also pay 6.2%, or 12.4% total. Add to that the 1.45% employers pay for Medicare and another 1.45% for the employee. With over 15% of pay at stake up to the wage base of $127,200, and 2.9% thereafter, employers and employees both care. Severance pay is sometimes defined as gap pay to cover a period after the employee finishes rendering services. Severance can be paid by company policy, required by state or federal law, or by agreement.

It could be paid willingly or only after a lawsuit. It’s best and safest to assume that any pay labeled as “severance” will face employment taxes. The same is true for pay that looks like it might be severance, regardless of how it is labeled.

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When IRS Can Collect Taxes From You Owed By Someone Else

It seems bad enough that you have to pay your own taxes, let alone someone else’s. But it can happen. The IRS sometimes comes after one taxpayer to collect the tax liability of someone else. How is this possible, you might wonder? The answer is “transferee liability,” a concept embodied in Section 6901 of the tax code. Actually, the concept has deep roots in legal history. In fact, it is a creditor protection device going back hundreds of years. Essentially, the IRS can pursue a “transferee”—someone who received assets or money for less than full and fair value from the taxpayer. You might think of it as kind of a stolen property rule.

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Example: Uncle Johnny owes the IRS a pile of money. He gives you his Mercedes. You may enjoy driving it and may have no idea Johnny owes the IRS. Even so, the IRS may be able to repossess it. The IRS claim on the Mercedes trumps yours, even if you didn’t know about the taxes. The result is the same if you paid Johnny $5,000 for it but the car is really worth $20,000.

As with everything else in the tax code, applying these rules isn’t simple, and procedure and timing are both important. First a bit of nomenclature. The person owing taxes is the “transferor,” and the person being pursued the “transferee.” There are two bases of transferee liability: at law and in equity. You are liable as a transferee at law when you are responsible for the transferor’s tax liability by contract. The IRS must prove the tax liability was within the terms of the contract. In some cases, this arises by statute, such as in corporate mergers.

The great majority of transferee liability cases involve claims in equity. You are liable as a transferee in equity when you receive the transferor’s assets for less than full, fair and adequate consideration and leave the transferor insolvent and unable to pay the tax liability.  An example is the Mercedes your Uncle Johnny gave you. You got it for free, or for a bargain price, so you are on the hook. Your liability is limited to the value of the assets you received. To collect, the IRS must prove five elements:

  1. The transferor became insolvent when the transfer occurred, or because of a series of asset transfers.
  2. The transfer was for less than adequate consideration.
  3. The transfer was made after the tax liability accrued. The tax liability need not have been assessed at the time of the transfer, as long as the tax debt had accrued.
  4. The transferor was liable for the tax.
  5. The IRS made reasonable attempts to collect from the transferor, or it would be futile. An example of the latter would be a dissolved corporation.

In Commissioner v. Stern, 347 U.S. 39 (1958), the U.S. Supreme Court said that the IRS must first satisfy a two-pronged test: (1) the person must be a “transferee” within the meaning of Code Section 6901(h); and (2) the transferee must be substantively liable for the transfer under applicable state law. The principal source of substantive liability to satisfy the second prong of the Stern test is state fraudulent conveyance law. These days, this generally means the Uniform Fraudulent Transfer Act (“UFTA”). Under the UFTA, creditors can invalidate a property transfer by their debtor if: (1) the debtor did not receive reasonably equivalent value in exchange for the transfer; and (2) the debtor was insolvent at the time of the transfer or was left in a perilous financial condition.

Many transferee liability cases are not slam-dunk cases for the IRS. In fact, the IRS has lost a number of transferee liability cases in court. However, fighting with the IRS takes time and is expensive.

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IRS Could Tax Loans Of Bitcoin, Other Cryptocurrencies

Is a loan income for tax purposes? Of course not, since you have to pay it back. In fact, if you are a borrower, other than tax deductions for interest, you might not even think about taxes. Lenders too generally only face taxes on the interest they receive on the loan. Sure, there can be big tax issues when loans are forgiven. If your loan is forgiven, that is income in the amount of the debt discharged. Mostly, though, loans can be neutral from a tax viewpoint. How about loans in bitcoin or other digital currency? You might think the tax rules should be the same, but that’s not so clear. With loans in dollars, money is fungible. But the IRS says digital currency is property, not currency. Most property is not fungible for tax purposes.

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When you receive a loan in cash, the lender usually knows that you will invest or spend the money. Everyone understands that you will pay the lender back with other money. But the same is not necessarily true with a loan of property. If you rent or borrow a lawn mower, can you return a different mower? Probably not. If you lend your car to another person, you probably want your same car back. If the borrower returns a different car, that transaction could be viewed as the sale of the original vehicle for tax purposes, followed by the purchase of another car.

The IRS likes finding more opportunities to collect taxes. That can mean gain or loss, even if the deal ends up netting you a different car with the same value. Except for certain special tax provisions such as Section 1031 exchanges (allowing tax-free swaps of property under certain conditions), just about everything you trade is taxed. In general, if you want to avoid taxes, a loan of property should require the return of the same property. With loans of cryptocurrency, the parties probably intend the cryptocurrency lent to be treated as fungible currency, rather than like property. Whatever the IRS says, people generally view it as money.

A borrower may receive bitcoins and sell them, repaying the lender with other bitcoins. The bitcoins may be intended as fungible currency, a continuation of the bitcoins that were lent (with the same tax basis and the same acquisition date). But will the IRS agree?  Consider the fluctuating value of cryptocurrency, and these tax issues could be big. In light of the IRS’s conclusion that cryptocurrency is property, there is a risk that the IRS may treat the loan as a sale of the original bitcoins for tax purposes. Even if the IRS agrees that loan treatment is appropriate, it is not clear how interest payments will be treated.

In the current climate of uncertainty, careful documentation might help. Emphasize that the transaction is intended to be a loan, not a sale or disposition. Consider stating that both parties will report the loan in this manner for tax and accounting purposes.  If the transaction has profit sharing or equity provisions, that could complicate the argument for loan treatment. The loan documentation could emphasize that repayment should be made in digital currency that is identical in value and denomination to the digital currency lent.

Perhaps the document could even require that repayment be made with the exact same cryptocurrency lent. In practice, this may not be possible. Still, a requirement that the loan repayments be made from the same wallet to which it was lent (and ideally one that is segregated from other funds) might help to strengthen the argument that the very same property has been repaid. The best strategy to avoid IRS problems is not clear. For example, the parties may want to emphasize in the loan documentation that the cryptocurrency is a fungible asset.

Perhaps they want to state that the cryptocurrency received in repayment will be considered identical to the cryptocurrency lent (that will use the same acquisition date and tax basis). Loan documentation could distinguish between transfers made in repayment of the loan principal, and transfers that are payments of interest. Care might also be taken to address possible forks in the cryptocurrency. A loan transaction that began with bitcoin might become even more problematic when the lent funds are now represented by both bitcoin and bitcoin cash. Parties should anticipate what to do, and how to emphasize that repayment is still being made from the same source and property.

Taking steps of this sort may not prevent the IRS from successfully challenging a loan. Even so, it may help put you in a better position in case the loan is examined. The IRS is using tracking software, and is issuing summonses to cryptocurrency exchanges for user personal information and transaction histories. The IRS revealed that nationally, only 802 people reported bitcoin on their tax returns for 2015.  Particularly with meteoric rises in value and high demand, perhaps some people are not reporting? The IRS sure thinks so.

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Bitcoin, Virtual Currency Deals Under $600 Could Become Tax Exempt

The IRS is hunting digital currency users, since very few people seem to be reporting their transactions. The IRS is using John Doe summonses to obtain data on bitcoin and other digital currency users. The IRS is even hunting bitcoin user identities with software. IRS scrutiny is causing many people to worry that they may owe taxes, penalties and interest. Even worse, in extreme cases, the IRS could pursue tax scofflaws criminally. However, help could be on the way. A bipartisan bill, “The CryptoCurrency Tax Fairness Act,” was introduced in the House by Rep. Jared Polis (D-Co) and Rep. David Schweikert (R-Az).

It calls for a tax exemption for transactions under $600. If it passes, it might be a little bit like foreign bank accounts that in the aggregate have less than $10,000 at all times during the year. Despite the IRS’s obsession with offshore bank accounts, those little accounts are exempt from FBAR reporting (but you still have to report any earnings from the small account on your taxes).

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However, the CryptoCurrency Tax Fairness Act would go further. Remember, the IRS announced in Notice 2014-21 that bitcoin and other digital currency is property for tax purposes, not currency. That means gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in your hands. And every time you buy something is a trade. A payment made using virtual currency is subject to Form 1099 reporting too. Wages paid to employees using virtual currency are taxable, must be reported on a Form W-2, and are subject to federal income tax withholding and payroll taxes.

If you pay someone in property, how do you withhold taxes? You pay the employee some cash and some bitcoin and withhold plenty on the cash. Or you sell some of the bitcoin to get dollars to pay the IRS. Virtual currency payments to independent contractors are taxable, and payers must issue Form 1099. You can’t enter “1,000 bitcoin” on the 1099. You must value it in dollars as of the time of payment. Valuation swings can be brutal. So under the bill, any transaction under $600 would be completely exempt. It would mean not having to worry about keeping track of gains on small transactions. Plus, the bill calls for the Treasury Department to provide guidelines for reporting on profits and losses tied to digital currencies.

As the IRS and Coinbase fence over user records, it is worth remembering that the IRS used a John Doe Summons to get names of Swiss bank account holders from UBS. After that, offshore banking changed forever, with all other Swiss (and other) banks eventually coming clean. The IRS ended up collecting over $10 billion. The IRS pursued Coinbase in the same way. Small fries may be OK, though. The IRS agreed to limit its request for customer records from Coinbase to accounts with transactions over $20,000. Beyond that, the IRS will clearly do more data mining for digital currency users.

After all, reports underscore the IRS claims that only 802 people declared a capital gain or loss related to bitcoin in 2015. With millions of transactions, 802 taxpayers reporting in 2015 seems, well, small. This suggests that the bulk—the vast bulk—of bitcoin transaction are not reported. But in 2017, there may be more awareness, and more fear. The estimated value of the cryptocurrecy economy is something on the order of $162 billion. With millions of transactions and the meteoric rise of bitcoin from under $100 to over $4,000 in just a few years, the IRS is gearing up.

The Daily Beast revealed the Chainalysis software contract to identify owners of digital wallets is now part of IRS enforcement. Taxpayers who have hidden income could face taxes, and potentially big penalties. But the record keeping and gain and loss determinations can be dizzying. If this bill passes, many transactions would be in the clear. That would be welcome news for the digital currency community.

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Hiding Assets To Thwart IRS Tax Collection Can Be Criminal

Criminal tax charges are not common, and not every charge ends in a conviction. Still, any tax charge is serious, and charges for obstructing the IRS certainly are. For example, a federal grand jury in the District of Hawaii has indicted a businessman and his accountant with tax crimes, including allegedly concealing income and assets to obstruct IRS collections. The indictment charges Wagdy A. Guirguis and Michael H. Higa, his CPA, with conspiring to defraud the IRS. The indictment further charges Guirguis with filing false corporate tax returns, failing to file a corporate tax return, evading individual income tax liabilities, corruptly endeavoring to obstruct the IRS, and tampering with a grand jury witness. Higa was also charged with aiding and assisting in the filing of false corporate and individual tax returns.

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According to the indictment, Guirguis owned and operated GMP Associates Inc. and several other businesses (GMP) that provided engineering services. Higa, a certified public accountant, allegedly served as the controller of the GMP entities. He prepared individual tax returns for Guirguis, as well as corporate tax returns for some of the GMP entities. The indictment charges that, beginning in 2005, Guirguis and Higa conspired to defraud the IRS by impeding its ability to assess Guirguis’s and GMP’s income tax liabilities, and obstructing its ability to collect GMP’s unpaid employment taxes.

According to the indictment, the IRS assessed approximately $812,000 in GMP’s unpaid employment taxes against Guirguis personally. The indictment alleges that the IRS attempted to collect the unpaid employment taxes—filing notices of federal tax liens, levying bank accounts and serving notices of levy to third parties who owed money to Guirguis. To thwart the IRS’s collection activity, Guirguis and Higa allegedly transferred funds from GMP to a nominee entity that Guirguis secretly controlled through Higa.

The indictment further alleges that Guirguis fraudulently transferred ownership of a luxury condominium to his wife, and used the nominee entity to divert approximately $1.5 million for his and his wife’s personal benefit. After an IRS revenue officer questioned the condominium transfer, Guirguis and Higa allegedly instructed a bookkeeper to alter the books and records of the nominee entity to conceal that he had diverted funds for his personal benefit. The indictment further charges that Guirguis did not report more than $3 million of GMP’s gross receipts and filed false individual tax returns that did not report approximately $465,000 of the income he diverted through the nominee entity.

He is also charged with attempting to tamper with a witness during the course of the grand jury’s investigation, and corruptly endeavoring to obstruct and impede the IRS, by among other things, making false statements to an IRS revenue officer and special agents. If convicted, Guirguis and Higa each face a statutory maximum sentence of five years in prison for engaging in the conspiracy. Guirguis also faces a statutory maximum prison sentence of five years for each of the tax evasion counts, three years for each of the false returns counts, three years for the corrupt endeavor count, one year for the failure‑to‑file count, and 20 years for the witness tampering count. Higa also faces a statutory maximum prison sentence of three years for each of the aiding and assisting counts. In addition, Guirguis and Higa each face a period of supervised release, restitution, and monetary penalties.

It is worth stressing that these charges have not been proven. Individuals charged in indictments are presumed innocent until proven guilty beyond a reasonable doubt. Still, the indictment reads like a how-to for bad missteps.

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California’s 13.3% Tax On Capital Gains Inspires Move Then Sell Tactics

Living in California has many perks, but the state’s 13.3% rate is the highest marginal tax rate in the nation. When you add up to 39.6% federal taxes, it can hurt, especially for those who cannot deduct their state taxes against their federal. California’s taxes were always high, but Proposition 55 extended the 13.3% tax rate ‘temporarily.’ How temporarily? Only until 2030! Personal income tax hikes on incomes over $250,000 started in 2012. It impacts Californians with a single income of $263,000 , or a joint income of $526,000. When people talk of moving away, in many cases, the absence of a capital gain rate that can be the straw that breaks the proverbial camel’s back.

At the federal level, the capital gain rate is 20% for higher income taxpayers. Add the 3.8% net investment tax under Obamacare, and you have 23.8%. California does not tax long term capital gain at any lower rate, so Californian’s pay up to 13.3% too. By paying 23.8% plus 13.3%, Californians are paying more on capital gain than virtually anyone else in the world. As talk turns to possible reductions in federal taxes, disproportionately high California taxes are an increasingly large share of the tax burden. Some Californians weigh the benefits and burdens of tax-free Nevada just across the border. Other no-tax states including Texas, Washington, and Florida may also beckon.

 

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Yet California’s tough Franchise Tax Board (FTB) polices the line between residents and non-residents, and does so rigorously. As with other high tax states, California is likely to probe how and when you stopped being a resident. For that reason, even if you think your facts are not controversial, be careful. A California resident is anyone in the state for other than a temporary or transitory purpose. It also includes anyone domiciled in California who is outside the state for a temporary or transitory purpose. The burden is on you to show that you are not a Californian.

If you’re in California for more than 9 months, you are presumed to be a resident. Check out FTB Publication 1031. Yet if your job requires you to be outside the state, it usually takes 18 months to be presumed no longer a resident. Your domicile is your true, fixed permanent home, the place where you intend to return even when you’re gone. Many innocent facts might not look so innocent to California’s tax agency. For example, do you maintain a California base in a state of constant readiness for your return?

It should be no surprise that former Californians often become residents of no-tax states like Texas. The IRS reports that between 2013 and 2014, over 250,000 California residents moved away. More than 10% went to Texas alone. Some Californians flee the state before selling real estate or a business. Warning: California real estate is taxed here even if you are a non-resident. But settling a lawsuit, or selling stock and other assets after a move can make sense. Some people get the travel itch right before cashing in shares, a public offering, or settling litigation. Some carefully orchestrated deals and moves can work just fine.

However, some people have unrealistic expectations about establishing residency in a new state. They may have a hard time distancing themselves from California, and may not plan on California tax authorities chasing them. When fighting California tax bills, procedure counts. You can have only one domicile, and objective facts can bear on your intent. Start with where you own a home. Where your spouse and children reside counts, as does the location where your children attend school. Your days inside and outside the state are important, as is the purpose of your travels. Where you have bank accounts and belong to social, religious, professional and other organizations is also relevant.

Voter registration, vehicle registration and driver’s licenses count. Where you are employed is key. You may be a California resident even if you travel extensively and are rarely in the state. Where you own or operate businesses is relevant, as is the relative income and time you devote to them. Taxpayers with unrealistic expectations can end up with big bills for taxes, interest and penalties. And the state can have a long memory. California’s main statute of limitations is four years after you file your return. But if you don’t file, that clock never starts ticking. California, like the IRS, gets unlimited time to audit if you never file an income tax return. You might claim that you are no longer a resident and claim that you have no California filing obligation. But the FTB may disagree and can audit you forever unless you file a return. That can make filing a non-resident tax return—just reporting your California-source income as a non-resident—a smart move.

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Estate Tax Repeal Is Not Just For Morons

The estate tax remains terribly controversial. It didn’t exactly help that volatile reputation when White House adviser Gary Cohn allegedly said that ‘only morons pay the estate tax.’ He was evidently trying to say that the well-healed plan around it, even if they have big estates. That is often true, but it hardly means that you are chump or worse if you pay it. In fact, MarketWatch touts IRS data showing that for 2015, 4,918 households paid a total of $17.1 billion on their estates valued at $88.2 billion. Those people surely did not especially want to pay. Meanwhile, 6,999 households who did not pay any estate tax had combined gross estates of $79.2 billion. But that hardly means you are a moron if you pay. Besides, estate taxes generate an emotional fervor that most taxes do not.

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Right now, the federal estate tax remains at 40%. Hillary Clinton wanted to raise the estate tax to an astounding 65%. Last year Democrats proposed to increase it to 45%, and to cut the exemption materially to $3.5 million per person. Trump vowed to repeal it. The estate tax can make people’s blood boil, even if it is not widely paid. Current law exempts estates worth $5.49 million or less, up from $5.45 million in 2016. Beyond that, you pay 40%. President Trump wants to repeal the estate tax entirely. Mr. Trump stands to benefit, as would his heirs. But it would benefit many others too. Steadfast proponents of the estate tax argue that it helps to stop wealthy people from getting even wealthier. But given that income taxes must be paid on earnings that eventually make up the estate’s value, opponents claim that the tax is a true double tax.

Strangely, another argument for the estate tax is that you can plan around it. Well, there’s that moron point again. Yet planning can be  difficult, is expensive, and requires years of planning. Wealthy or not, the estate tax catches many people off guard after they have worked and paid income tax their whole lives. It can force sales of family companies, and sales of family farms and ranches. Ironically, it was only recently–in 2013–that Americans finally got some certainty with a $5 million per person exemption. Indexed for inflation, it now stands at $5.49 million, $10.98 million for a married couple.

Still, small and family businesses and farms can be particularly hard hit. Already, it is hard for many family-owned businesses to stay afloat after the death of a key figure. Not all of the reasons are managerial. Many are financial, and taxes can force a sale. Stephen Moore of the Heritage Foundation calculated that by eliminating basis step up (a President Obama had proposed), we would end up with the world’s highest estate tax rate. President Obama argued that allowing a basis step up on for income tax purposes on death was a huge loophole. He proposed no basis step up, hoping to raise approximately $200 billion over the next decade. When combined with state estate taxes, this proposal would yield the highest estate tax rate in the world.

Dick Patten, chairman of the Family Business Defense Council calculated an effective death tax rate of 57%. If you add in state inheritance taxes, the combined tax rate could go as high as 68%. That sounds reminiscent of the 65% estate tax rate Hillary Clinton proposed as a candidate.

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