Fall 2007 • Issue 26, page 5

Are Receivers Their Brother's Keepers? Must A Receiver Recharacterize An Entity's Tax Assumptions/Practices?

By Rosen, Charles*

CHUCK DOES TAXES

(Editor’s Note: This concludes a Q & A piece by Chuck Rosen on difficult tax issues facing receivers.)

Q: A receiver is appointed over an operating company that is treating all of its employees as independent contractors. The Receiver is a tax whiz and believes that most of these individuals are properly classified as employees, and not as independent contractors. Can the Receiver continue the practices of prior management in order to preserve and protect the business, or is the Receiver required to treat the “independent contractors” to employee status for tax purposes?

A: If a receiver continues the (potential) mischaracterization of employees as independent contractors he or she does so at his or her own peril, as an action outside the scope and authority of his or her office and of the limited immunity a receiver may have as an officer of the court. The IRS takes the position that foreknowledge of a violation of law does not countenance a continuance of that action. It may constitute a fraud and could constitute a crime under both the Federal Crimes and Criminal Procedure codes and under state law.

If the receiver is quite sure that the vague rules in this area make a reclassification mandatory, the receiver should immediately cease the prior improper booking of employees as independent contractors, secure appropriate and signed W-4 withholding forms from the employees and commence to withhold.

The more important question is does the receiver have an obligation to file proper payroll tax returns with the IRS and EDD for all employees for current and for prior taxable quarterly periods and/or to amend previously filed returns to include all of those persons who should have been included as employees for such prior periods?

The receiver is under such a duty. Normally, the IRS will only require amended returns for the immediately preceding 12 quarters, i.e. three years. But if fraud is identified the Service may elect - and often does - to extend an audit back for a full six years. If fraud is identified, the Service may seek a federal indictment for tax crimes. The only manner in which a receiver may avoid the burden of filing amended returns is to prove to the taxing authorities (if asked) that each independent contractor filed his/her income tax returns, declared the self-employed income, and paid the obligated income tax, Social Security tax and the Medicare tax. This, of course, is an almost insurmountable process.

An existing inappropriate characterization provides a receiver with no defense for failure to file and pay correct future payroll tax returns. To fail to do so could expose a receiver to personal civil and criminal liability.

There are also associated questions. Assuming that back tax is owing, who must pay this additional tax? When? Is prior management exposed to potential criminal tax prosecution? Is prior management subject to personal assessment for unpaid payroll taxes? Perhaps we’ll treat these questions in a future column.

Q: A receiver is appointed over an operating company and discovers that the entity in receivership has been paying employees one-half via payroll (with proper withholdings and proper tax returns) and one-half in cash, with no reporting or withholding. What are the Receiver's responsibilities with regard to the cash payments made and unreported prior to the appointment of the Receiver?

A: The same as above. Need you even ask? However, should the receiver (wrongly) elect not to file the appropriate amended/corrected payroll tax returns, at a minimum, a Form 1099 should be given to each employee for the total amount of wages paid in case. It might also be appropriate to attach a brief letter to the 1099's indicating that it is the responsibility of the employee to declare the income on their own income tax returns and to pay the taxes.

*Charles F. Rosen is an attorney with the firm Law Offices of A. Lavar Taylor and is an expert in receivership and bankruptcy tax law. Mr. Rosen served as bankruptcy advisor for the Special Procedures Branch of the Internal Revenue Service for more than twenty years.