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Cleveland Indians Strike Out: Back Pay Awards Hike Employer's FICA-FUTA Tax Liability, High Court HoldsFriday, April 20, 2001 Deloitte & Touche OnLine The U.S. Supreme Court held on April 17 that back wages paid as damages in 1994 for the years 1986-87 are attributable to the year in which the awards were paid, not to the years in which the wages should have been paid. (United States v. Cleveland Indians Baseball Co., No. 00-203 (U.S. Apr. 17, 2001).) The practical result in this case is that the awards, paid in 1994, generated additional FICA and FUTA tax liability. If the awards had been attributable to the years 1986-87, on the other hand, there would have been no additional liability because the company and the affected baseball players had paid the maximum amount of employment taxes for those years. Background – Both the district court and the Sixth Circuit, relying on Sixth Circuit precedent, had held that the awards were allocable to the prior years in which the wages should have been paid. That Sixth Circuit precedent was based on Social Security Bd. v. Nierotko, 327 U.S. 358 (1946). In the last few years, however, two other U.S. courts of appeals have held that back wages are taxed for FICA purposes in the year in which the wages are paid and received. The government argued that the FICA and FUTA tax provisions (which referred to "wages paid during the calendar years") clearly required that employment taxes be computed based on the rates in effect when the wages are paid. The company argued that the "wages paid" language has no clear meaning in light of Nierotko, under which the same language accommodates an allocation-back rule. But, whereas Nierotko involved Social Security benefits eligibility, the company argued that the same "wages paid" language must be read the same way for tax purposes.
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Supreme Court's Opinion – The High Court agreed with the company only to the extent of rejecting the government's plain-language argument. Under Nierotko, wrote Justice Ruth Bader Ginsburg, there is "no conflict" between an allocation-back rule and the "wages paid" language, at least as far as benefits eligibility is concerned. However, the Court rejected the company's position that the "wages paid" language must be read the same way for tax purposes. Justice Ginsburg explained that in the benefits context, the employee would be harmed by failing to credit wages to the period of service; "no similar concern underlies the tax provisions," where fiscal administrability is served by allocating back wages to the year in which they are paid. The Court acknowledged that the government's rule would lead to arbitrary results, sometimes working to the disadvantage of the employee and other times to the disadvantage of the fisc. But the Court pointed out that such results "must be considered in light of Congress' evident interest in reducing complexity and minimizing administrative confusion." Facing such competing interests, the Supreme Court deferred to the long-standing Treasury regulations that set forth the government's position. |
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Appeals Courts Rule on S Corp
Shareholder Issues
In other recent court developments, two U.S. courts of appeals have ruled on issues affecting shareholders in S corporations. Shareholder Can't Offset Passive Expenses Against Related Nonpassive Income – The Fourth Circuit, reversing the Tax Court, has held that the shareholder of an S corporation could not offset real estate management expenses against the management fee income he received for his participation in the corporation's management activity. (Hillman v. Commissioner, No. 00-1915 (4th Cir. Apr. 17, 2001).) David Hillman materially participated in the management activity of SMC, which provided management services to dozens of passthrough entities in which Hillman also owned interests. The latter passthrough entities paid SMC for its services, and Hillman deducted his share of those expenses. He sought to offset those expenses against the compensation paid to him by SMC for his services. Hillman accepted that the plain language of section 469(a) precludes the offset, but he argued that section 469(l)(2), combined with legislative history, makes clear that Congress intended an exception from subsection (a) for self-charged items. The Fourth Circuit did not agree, finding nothing in the statutory language supporting Hillman's position and no reason to ignore the statute's plain language. The court also was not convinced that the legislative history expressed the intent Hillman attributed to it. Shareholder's "Loan Participation" Was Really Guaranty – In another S corporation case, the Seventh Circuit has held that the sole shareholder of an S corporation was not entitled to adjust his stock basis by the amount of his participation interest in a bank loan made to his corporation, because the participation interest was in substance a loan guaranty. (Grojean v. Commissioner, No. 00-2252 (7th Cir. Apr. 13, 2001).) Thomas Grojean's corporation obtained several bank loans, and the bank had wanted a personal guarantee from Grojean. He refused, but agreed to purchase a participation interest in one of the bank's loans. Grojean treated his participation interest as indebtedness of his corporation to himself, using that "indebtedness" to increase his stock basis so he could deduct his share of the corporation's losses. The Seventh Circuit agreed with the Tax Court that, in substance, the loan participation was a guarantee. From the bank's perspective, the court said, it was irrelevant whether Grojean guaranteed that portion of the loan or purchased a participation interest, because the bank had procured the funds. The court concluded that reclassifying the transaction was appropriate to preclude abuse, where a taxpayer essentially guarantees indebtedness and obtains a "tax advantage intended for a loan or other indebtedness."
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