The Supreme Court has recently decided two tax cases.
Getting the Supreme Court to take a tax case is often difficult, so getting two decisions within a month of each other is a fairly rare event. Justice Harry Blackmun is quoted as saying that a Supreme Court justice knows he is in trouble with the chief justice when he starts getting assigned the tax cases. They are not very popular with the court.
Supreme Court cases are especially helpful because they often finally resolve issues that have been sources of confusion and conflicting decisions in the lower courts for years. Legislative action can still change a Supreme Court decision that is based on statutory, rather than constitutional, interpretation, but having the Supreme Court finally resolve a dispute often puts the matter to rest.
The Supreme Court’s recent tax decisions came down in the partnership and ERISA areas, both reversing appellate court decisions. Both involved employers, one providing favorable pension asset protection for the small business owner/employee and the other underscoring the vulnerability of partners for their partnership’s employment tax liability. Both suggest revised tax strategies. (And for those readers seeking to test the validity of Justice Blackmun’s quote, the two majority opinions were written by Justice Ruth Bader Ginsburg and Justice Clarence Thomas.)
Reversing a decision of the Sixth Circuit, the Supreme Court ruled in Yates, on March 2, 2004, that a small business owner may be treated as both an employer and an employee for ERISA purposes. As an employee, small business owners are entitled to full participation in qualified plans and are further entitled to employee rights afforded by ERISA, including creditor protection.
The Yates facts involved a doctor who was the sole shareholder of a medical professional corporation. The corporation maintained a profit sharing plan and a money purchase plan, which was later merged into the profit sharing plan. Dr. Yates originally borrowed $20,000 from the money purchase plan and made no payments on the loan for several years until it was repaid in a $50,000 lump sum three weeks before the professional corporation was forced into bankruptcy by its creditors.
The bankruptcy court, district court and Sixth Circuit treated Dr. Yates as an employer and said, as such, that he could not also claim the rights of an employee — ruling that the bankruptcy trustee could get access to the funds.
The Supreme Court did not agree.
In the Supreme Court’s opinion, it was important that there were employees covered by the qualified plan other than the sole owner of the professional corporation and his spouse. The same employee rights would not appear to be recognized where the owner of the professional corporation is the only participant in the plan.
The court also stated that conferring this protection on small business owners would serve the societal goal of promoting the establishment of qualified retirement plans.
Left undecided by the court, because it had not been addressed by the lower courts, was whether the manner in which Dr. Yates handled the loan repayments in this particular case, i.e. failing to make timely regular payments and making a lump sum payment within the bankruptcy preferential transfer period, was inconsistent with the anti-inurement provisions of ERISA prohibiting an employer from benefiting from the qualified plan’s assets. The case was remanded for consideration of this issue.
This is an important victory for small business owners, and is unlikely to be overcome legislatively, at least by the current Congress, although Dr. Yates might still suffer a loss on remand on his particular facts.
With the growing emphasis on asset protection strategies, small business owners can now look with some confidence at qualified retirement plans as an important link in those strategies.
In United States v. Galletti, the Supreme Court sided with the government, rather than the taxpayer, in holding on March 23, 2004, that timely assessment of employment taxes against a partnership is sufficient to allow a collection action against the general partners without the necessity of having also timely assessed the partners.
The Internal Revenue Service assessed unpaid employment taxes against the partnership within the required three-year period. Once timely assessment is made, the IRS has ten years from the assessment to initiate collection action. The IRS filed a claim four years after the assessment in the bankruptcy cases of the general partners.
The bankruptcy court, district court and Ninth Circuit all barred the IRS from collecting against the partners on the basis that timely assessment only against the partnership did not create a 10-year collection period against the partners individually.
Again, the Supreme Court disagreed.
The Supreme Court held that the IRS is only required to assess the tax against the taxpayer who was the employer. The partnership was the employer, and the partnership was properly assessed. This created the 10-year collection window. Who was liable for the debts of the partnership was a matter of state law and did not affect who the IRS was required to assess.
The court stated that it is the tax that is assessed, not the taxpayer; and, once the tax has been properly assessed, nothing in the code requires the IRS to take further steps to assess the tax against other taxpayers who may under state law be secondarily liable for the tax.
Left open by the court was a possible defense that a state statute of limitations barred the collection action against the partners. The court rejected this argument on the basis that it was not properly raised in the lower courts. This argument might, however, give partners some hope in future litigation over liability for employment taxes.
Unpaid employment taxes have long been a significant exposure for general partners of a partnership. The Galletti case further reduces the arguments available to general partners to escape ultimate liability for those unpaid taxes.
Although the taxpayers came out of the two recent Supreme Court decisions in Yates and Galletti with only a 50-50 record, they had only gone into the Supreme Court with a 50-50 record. With the Supreme Court reversing in both cases consistent positions of the bankruptcy court, district court and appellate court, both cases must be viewed as something of a surprise.
Probably the more significant case of the two is Yates, clearly establishing for the first time creditor protections for the assets of small business owners held in qualified retirement plans.
The Galletti case adds yet another reason why general partners should try to avoid accumulating unpaid employment taxes in their partnerships, or at least recognize that the protections afforded corporate ownership cannot always be duplicated in the partnership form.
George G. Jones, JD, LL.M, is managing editor, Tax & Accounting, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, Tax & Accounting, at CCH Inc.
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