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SECC Corporation v. Commissioner: How It Started, How It Ended, and What Might Happen Going Forward

Posted on June 29, 2016

In this three-part post, we welcome back Lavar Taylor, who discusses one of the more interesting procedural cases of the past few years, SECC v Commissioner. As Congress has expanded the types of cases that the Tax Court may consider, the court, the IRS and taxpayers themselves often struggle to apply ambiguous rules to complex real life situations. The SECC case involves the extent of the Tax Court’s jurisdiction to hear employment tax disputes under Section 7436. Lavar, counsel for SECC and a gifted lawyer with a deep knowledge of procedural issues, takes us through the issues he and his client confronted, the arguments that both parties raised, the somewhat surprising Tax Court opinion, and the underlying concerns that led to the IRS settling SECC and eventually issuing a Notice expressing its agreement with the decision. Les

When the Tax Court issued its opinion in SECC Corporation v. Commissioner, 142 T.C. 225 (2014)(“SECC”), no one was more surprised than I was. After all, how often does the Tax Court hold that it has jurisdiction over a case when both parties have filed motions to dismiss the petition for lack of jurisdiction (albeit based on different grounds). The Tax Court’s opinion in SECC radically altered the landscape on the question of when the Tax Court has jurisdiction under section 7436 of the Internal Revenue Code (“Code”) to resolve worker classification disputes which affect the amount employment, withholding, and unemployment taxes for which an employer (or putative employer) may be liable under the Code. (Worker classification disputes can also arise in income tax deficiency proceedings, but SECC was not an income tax deficiency case.)

Not long after the Tax Court issued its opinion in SECC, Les Book and Keith Fogg asked me whether I would do a guest blog post about the SECC opinion. Because the Tax Court’s opinion in SECC did not resolve the litigation, however, I respectfully declined their invitation. I told them that I did not want to say anything about the opinion until the case concluded. I did, however, indicate that, subject to the approval of my client, I would do a blog post once that case (and two similar cases in which no published decisions or orders were ever issued by the Court) was resolved.

That day has finally arrived. The SECC case has now settled (as have the other two cases), and the stipulated decisions in all of these cases are now final. Those of you who are already familiar with the opinion in SECC understand that, now that the SECC case is resolved and the Tax Court’s stipulated decision is final, the Ninth Circuit Court of Appeals will never opine on the question of whether the Tax Court had jurisdiction in SECC. Whether the Courts of Appeal might rule on that jurisdictional issue in a future case is a topic I discuss later.

This post is the first of three posts discussing the SECC opinion. Part 1 discusses how the case arose and the arguments made by the parties leading up to the issuance of the Court’s opinion in 2014. Part 2 discusses the majority, concurring, and dissenting opinions in the case.  Part 3 discusses the case’s aftermath, the resolution of the case, and the practical effect of the case going forward.

How the Case Arose

The SECC case was a tax procedure nerd’s dream – and a client’s nightmare. Few other cases have taxed my knowledge of tax procedure as this case did. Not all of the tax procedure issues in the case were addressed in the Tax Court’s opinion, as you will see.

The case started innocently enough with an employment tax audit of the company’s Forms 941 for the 1st quarter of 2005 through the 4th quarter of 2007. SECC had cable splicers who it paid two different ways during the quarters at issue. First, the company paid “wages” to the splicers for their labor. These “wages” were reported as wages on the company’s Forms 941, and Forms W-2 were timely issued to all of the splicers. Second, the company paid “rent” to the splicers for their specialized equipment and tools. The equipment and tools generally took the form of specially equipped trucks that were rather expensive to buy. The splicers owned the specially equipped trucks, and there were rental agreements signed by the parties under which SECC paid “rent” to the splicers for the use of their truck. The “rent” that was paid by SECC to the splicers was reported on Forms 1099 that were timely issued to the splicers. SECC’s tax compliance record, from SECC’s perspective, was spotless.

Those of you who deal with employment taxes by now have probably started muttering phrases like “What about an accountable plan?” There was no accountable plan during the quarters at issue. What there was, however, was an employee of SECC (a former employee by the time of the IRS employment tax audit) who had, prior to 2005, called the IRS for instructions on how SECC should treat the “rent” payments to the splicers. This employee, after describing the “dual” arrangement with the splicers to the IRS over the phone, was told by the IRS that the dual status of the workers was proper, and that the “rent” payments should be reported on Forms 1099 issued to the splicers, while the “wages” should be reported on Forms W-2 issued to the splicers. SECC dutifully followed the advice given by the IRS employee.

The company had even undergone an income tax audit prior to the start of the employment tax audit, in which the Revenue Agent asked for copies of the company’s employment tax returns. The company emerged from that income tax audit with a “no change” audit report, believing that the company was correctly reporting both the “wages” and the “rent” paid to the splicers.

Then came the employment tax audit. At the conclusion of that audit, the Revenue Agent issued an audit report reclassifying as “wages” all of the “rent” paid to the splicers during all twelve quarters in the audit. Taxes were computed using the maximum rates, with no adjustments under section 3509. No consideration was given to section 530 of the Revenue Act of 1978. There was no discussion of possibly reducing the assessment under section 3402(d). The proposed employment tax assessments were roughly $1.2 million, plus proposed penalties, and statutory interest. Had these proposed liabilities been sustained, they would exceed $2 million today.

Both Parties’ Arguments At Exam and Appeals

At that point, my firm was retained. We filed a timely protest, arguing, inter alia, that a) the splicers should have been treated as independent contractors for all purposes (i.e., that the payments to the splicers that had been treated as “wages” for employment tax purposes were not in fact “wages” for employment tax purposes because the splicers were actually independent contractors), b) alternatively, the splicers were “dual status” workers, i.e., they were independent contractors with respect to the rent payments even if they were employees with respect to the “wage” payments, see Rev. Rul. 82-83, 1982-1 C.B. 151, c) in the event the splicers were employees with respect to the “wage” payments, section 530 provided complete relief from the proposed assessments, d) in the alternative, section 3509(a) rates applied, or e) in the further alternative, that the assessments should be reduced under section 3402(d) because the splicers had paid their own income taxes on the “rent” income.

The argument that the splicers were independent contractors for all purposes was potentially meritorious. The Fifth Circuit had previously held in Thibault v. BellSouth Telecommunications, Inc., 612 F.3d 843 (5th Cir. 2010), a case not directly involving any tax issues, that cable splicers were independent contractors.

The Office of Appeals ultimately sustained the results of the audit report and notified SECC by letter dated April 15, 2011 that the proposed employment tax liabilities would be assessed as proposed by the Examination Division. The history of the case between the date of the submission of the protest to the audit report and the decision by the Office of Appeals to sustain the results of the audit report is itself rather lengthy. I don’t describe that history in detail here, because that history is not legally relevant to the outcome of the case.

Suffice to say, however, I was not in a good mood by the time Appeals sustained the results of the audit report. Despite the fact that a) the case was handled by three different Appeals Officers, b) the case was returned to the Examination Division for factual development, and c) at one point in time I suggested that Appeals request Technical Advice on the question of whether section 530 relief is available in situations where the taxpayer has treated workers as “dual status” workers for employment tax purposes, the case was never factually developed by the IRS. (Examination returned the case to Appeals without requesting any information from us and without doing any additional work.) It appeared to me that no serious effort was made by anyone in the IRS to look at the issues which were raised in the protest.

I was in an even less charitable mood after the IRS sent bills to SECC totaling roughly $1.5 million, without first issuing a Notice of Determination under section 7436. I picked up my Code and read section 7436, which can be read in relevant part (subsections (a) – (d)) here.

My reading of section 7436 was that the IRS was required to send a Notice of Determination to SECC before assessing any additional employment taxes in this situation. After all, there was a dispute as to whether the splicers were independent contractors or employees and, even if they were employees as to the “rent” payments, there was a dispute as to whether section 530 applied. I discovered, however, that the IRS did not share my view on that point.

In Chief Counsel Advice Memo 200009043 (January 4, 2000), the IRS Chief Counsel’s Office discussed the circumstances under which the IRS believed it was required to issue a Notice of Determination under section 7436 before assessing additional employment taxes against a taxpayer. The memo discussed at length the circumstances under which Chief Counsel’s Office believed there was (or was not) an “actual controversy” within the meaning of section 7436(a) which required the IRS issue a Notice of Determination under that section.

It is clear from reading this Chief Counsel Memo that there had been a debate within Chief Counsel’s Office about the definition of the term “actual controversy.” It is likewise clear that, if a person (whether a worker or a corporate officer) had been treated as an “employee” for employment tax purposes, i.e., the person had been treated by the taxpayer on a Form 941 as having been paid “wages,” Chief Counsel’s Office position was that the IRS was not required to issue a Notice of Determination to the taxpayer before assessing additional employment taxes against the taxpayer based on “non-wage” payments that had been made to the person(s) who had been treated as an employee for employment tax purposes.

I thought the reasoning of the Chief Counsel Memo was faulty. The fact that a person had been treated as an “employee” on a taxpayer’s employment tax return did not preclude that person from being treated as an independent contractor with respect to payments to that person which were not treated as “wages” for employment tax purposes. Situations involving “dual status” workers had been addressed by the IRS for a number of years. See Rev. Rul. 82-83, supra. Furthermore, the Chief Counsel Memo failed to address the fact pattern in the SECC case, where, in response to the issuance of the audit report, SECC took the position that the amounts reported as “wages” on the relevant Forms 941 were not wages at all because the workers in question were independent contractors.

Notwithstanding our disagreement on this point, there was another key point on which I agreed with the IRS. The IRS had previously concluded that the IRS must issue a Notice of Determination under section 7436 before the Tax Court can exercise jurisdiction under section 7436. See Notice 2002-5, 2002-1 C.B. 320 and Notice 98-43, 1998-2 C.B. 207. The Tax Court also apparently agreed with this conclusion in Henry Randolph Consulting v. Commissioner, 113 T.C. 250, (1999), see also Charlotte’s Office Boutique, Inc. v. Commissioner, 425 F.3d 1203 (9th Cir. 2005), affirming 121 T.C. 89 (2003). For what it was worth (which turned out to be nothing), I also agreed with this conclusion.

Based on our belief that the IRS should have issued a Notice of Determination under section 7436 to SECC before assessing additional employment taxes and our belief that the Tax Court could not exercise jurisdiction under section 7436 unless the IRS first issued a Notice of Determination under that section, we decided that the appropriate course of action was for SECC to file a petition with the Tax Court and then seek to dismiss the petition based on the failure of the IRS to issue a valid Notice of Determination prior to assessing the additional taxes against SECC. We hoped that the Court would analogize to the line of cases that permits taxpayers to file a petition and then seek to dismiss that petition for lack of jurisdiction where the IRS failed to issue a valid notice of deficiency to the taxpayer because the notice of deficiency was not sent to the taxpayer’s last known address. See O’Brien v. Commissioner, 62 T.C. 543 (1974). While there were other potential judicial remedies available to challenge the procedural validity of the audit assessments, those other potential remedies posed difficulties. I discuss other potential remedies and the difficulties associated with these potential remedies below.

The Issues Before the Tax Court

The petition in SECC was filed in February of 2012. (For those of you wondering whether the petition was filed after what we believed was the expiration of the statute of limitations on assessment for the quarters at issue, the answer is yes, it was. Interestingly, the IRS had earlier concluded that the filing of a Tax Court petition under section 7436 by a taxpayer, where the IRS had previously failed to issue a Notice of Determination under section 7436(b) did NOT suspend the running of the statute of limitations on assessment. Chief Counsel Memoranda 200240042, June 28, 2002.) Both parties filed motions to dismiss for lack of jurisdiction.

The IRS argued that the Tax Court lacked jurisdiction because the IRS had never issued a Notice of Determination under section 7436. They further argued that the IRS had not made any “determination” within the meaning of section 7436 but that, if the notice to SECC that the Office of Appeals was sustaining the audit report was a “determination” within the meaning of section 7436, the petition was untimely because it had been filed more than 90 days after the date of the notice.

The IRS also argued that the Tax Court lacked jurisdiction to rule on the question of whether the IRS was required to issue a Notice of Determination to SECC under section 7436 prior to assessing the additional taxes against SECC. Per the IRS, because it was agreed by the parties that no Notice of Determination had been sent to SECC, the Court simply had no jurisdiction to say anything other than it lacked jurisdiction due to the failure of the IRS to issue a Notice of Determination. That argument was troubling to me.

SECC argued that the Tax Court, in dismissing the petition for lack of jurisdiction, was required to address the question of whether the IRS was legally required to issue a notice of determination under section 7436 prior to making the large audit assessments against SECC. In support of that position, SECC cited to Rosewood Hotel, Inc. v. Commissioner, 275 F.2d 786 (9th Cir. 1960).

In Rosewood, the taxpayer filed a petition that was unquestionably late, but the taxpayer argued that the Notice of Deficiency was invalid because it had not been sent to the taxpayer’s last known address. The Tax Court dismissed the petition for lack of jurisdiction as being untimely, without addressing the question of whether the Notice of Deficiency had been sent to the taxpayer’s last known address. On appeal, the Ninth Circuit vacated the dismissal order and remanded the case with instructions to the Tax Court to decide the question of whether the Notice of Deficiency had been sent to the taxpayer’s last known address. By analogy, SECC argued that the Tax Court was required by Ninth Circuit case law to address the question of whether the IRS was required to issue a Notice of Determination to SECC prior to assessing the deficiency in employment taxes.

SECC also argued that, if the Tax Court were to hold that it did not have jurisdiction to rule on whether the IRS was required to issue a notice to SECC under section 7436 prior to assessing the additional taxes, SECC might lack an effective judicial forum in which to challenge the procedural validity of the audit assessments against SECC. First, the Ninth Circuit has held that taxpayer may not use a quiet title action under 28 U.S.C. section 2410 to challenge an income tax deficiency assessment by claiming that the IRS did not send a valid Notice of Deficiency to the taxpayer. See Elias v. Connett, 908 F.2d 521 (9th Cir. 1990), accord, PCCE v. United States, 159 F.3d 425 (9th Cir, 1998), contra, Robinson v. United States, 920 F.2d 1157 (3rd Cir. 1990). Arguably, the Ninth Circuit would similarly bar SECC from challenging the validity of the employment tax assessments through a quiet title action.

Second, the Ninth Circuit has held that, where the IRS has illegally assessed and collected an income tax deficiency in violation of the restrictions on assessment contained in what is now section 6213 of the Code, a taxpayer may not obtain a refund of the taxes illegally assessed and collected in violation of these restrictions unless the taxpayer can demonstrate that the taxpayer is owed a refund based on the merits of the tax liability. Van Antwerp v. United States, 92 F.2d 871 (9th Cir. 1937), contra, United States v. Yellow Cab Company, 90 F.2d 699 (7th Cir. 1937). Thus, in a refund suit, SECC would not be able to challenge the validity of the employment tax assessments unless the government counterclaimed for a judgment of the unpaid portion of these assessments. I previously handled a refund suit where the government purposely did not file a counterclaim in response to the complaint that we filed, in order to prevent our office from the litigating the procedural validity of an assessment under section 6672 of the Code. I have no doubt whatsoever that the government would have not filed a counterclaim for the unpaid portion of the employment tax audit assessments against SECC had we attacked the validity of those assessments in a refund suit. Thus, in the refund suit, we would not have been able to challenge the procedural validity of the assessments.

Third, the Ninth Circuit has held that, where the IRS has illegally assessed income tax deficiencies in violation of the restrictions on what is now section 6213(a) of the Internal Revenue Code, but the taxpayer has not yet paid the illegally assessed taxes, a taxpayer MAY be entitled to injunctive relief. Ventura Consolidated Oil Fields v. Rogan, 86 F.2d 149 (9th Cir. 1936), cert. denied, 300 U.S. 672 (1937). But the Ninth Circuit has also held that no injunctive relief is available unless the taxpayer can show BOTH irreparable injury AND an inadequate remedy at law. Cool Fuel, Inc. v. Connett, 685 F.2d 309 (9th Cir. 1982). Whether SECC would have been able to sustain that burden was at best unclear. My own experience is that the ability of a taxpayer to carry that kind of burden often depends on the proclivities of the judge assigned to the case.

While SECC acknowledged that it might be able to challenge the validity of the unpaid assessments in the context of a Collection Due Process case, the IRS had not conceded that point in the litigation. Also the filing of a lien notice against the company for such a large amount could have effectively destroyed the company, rendering meaningless the ability to challenge the procedural validity of the assessments in a Collection Due Process case.

While the company conceivably could have challenged the validity of the audit assessments in a Chapter 11 bankruptcy, see Bunyan v. United States, 354 F.3d 1149 (9th Cir. 2004), that course of action was not a realistic possibility.

SECC thus argued that, because the IRS had been required to issue a Notice of Determination under section 7436 prior to assessing the additional taxes and had failed to do so, the Tax Court should dismiss the petition for lack of jurisdiction based on the failure of the IRS to issue a valid Notice of Determination prior to assessing the taxes against SECC.

After the parties completed their briefing on the motions to dismiss, the Tax Court issued an Order directing the parties to brief the following two questions: 1) whether a letter from the Office of Appeals indicating that the case with Appeals was being closed constitutes a “determination” under section 7436, and 2) if the Court has jurisdiction under section 7436, what remedies might be available to petitioner in the Tax Court case. Much of the ink spilled in response to this Order regurgitated what was previously argued by the parties. For differing reasons, both parties argued that the IRS had never issued a proper Notice of Determination.

SECC also included the following comments in its supplemental brief:

The language of sections 7436(a) and (b)(2) is somewhat ambiguous. Under one possible reading, subsection (a) would grant the Court jurisdiction over a petition to determine the correctness of the Respondent’s determination at any time after a formal “determination” is made by the IRS, even though a “notice of determination” is never issued under subsection (b)(2). Under this reading, subsection (b)(2) operates only to establish the outer time limit by which an action must be filed in Tax Court to challenge the IRS’s “determination.” The deadline would only be fixed after respondent mails a “notice of determination” to the putative employer. Thus, if a “determination” is made by the Commissioner, but the Commissioner does not issue a “notice of determination,” the putative employer could theoretically file a Tax Court petition at any time after the “determination” is made. Whether the statute of limitations on assessment would ever run under this interpretation of the statute is an issue that is discussed below.

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There would be significant practical problems if the Court were to hold that taxpayers can file a petition at any time after respondent makes a “determination,” even though respondent has not issued a “notice of determination.” First, there could be significant disputes about what constitutes a “determination” which triggers the right of a taxpayer to file a Tax Court petition. Would a preliminary audit report be a “determination”? An audit report? A decision by the Office of Appeals? Something else? **** If the IRS made a “determination” but never issued a “notice of determination,” the period for filing a Tax Court petition could last indefinitely.

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There would also be a related problem involving the statute of limitations on assessment that would be caused by such an interpretation of section 7436. Under section 7436(d), the principles of various other provisions of the Code, including sections 6213(a) and 6503(a), apply as if the “determination described in subsection (a) were a notice of deficiency.” If a taxpayer could file a Tax Court petition once the IRS has made a “determination,” an issue would arise as to whether it is the making of a “determination” or the issuance of a “notice of determination” that operates to suspend the running of the statute of limitations on assessment.

The parties’ supplemental briefs were filed in August of 2013. At the time SECC filed its supplemental brief, I had a very bad case of heartburn. Why? In one of the related cases involving the same issue that was present in the SECC case, and in which the operative facts were almost identical to the facts in the SECC case, the Tax Court had granted the IRS’s motion to dismiss for lack of jurisdiction in May of 2013 in an unpublished Order. That jurisdictional issue had been briefed in that case in a manner similar to the briefing in the SECC case. That Order adopted the arguments made by the IRS on a wholesale basis, and the petition was dismissed for lack of jurisdiction, without the Court addressing the question of whether the IRS was required to issue a Notice of Determination prior to making the employment tax audit assessments against the petitioner. How and why that Order was issued, I don’t know.

Of course, a motion for reconsideration was promptly filed. The parties settled in to wait for the Court to issue an opinion in the SECC case and to see how the Court would deal with the motion for reconsideration in the related case. Given the Court’s ruling in the unpublished Order in the related case, I was concerned about how the Court would ultimately rule, even though I strongly believed that the IRS had improperly assessed the employment tax audit deficiencies against my clients.

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