Alter Ego of Law Firm was Liable for Its Unpaid Employment Taxes

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1 Alter Ego of Law Firm was Liable for Its Unpaid Employment Taxes Western Management, Inc. v. U.S., (CA FC 12/12/2012) 110 ATR 2d Over one dissent, the U.S. Court of Appeals for the Federal Circuit has generally upheld a Court of Federal Claims finding that an attorney and his wife couldn't relitigate a Tax Court decision that held his law firm liable for failing to withhold and pay employment taxes for the services he provided. The law firm had instead treated the attorney (and also sole shareholder) as an independent contractor. Further, the Court found that the attorney, as the alter ego of the law firm, was personally liable for the judgment. However, the appellate court did find that, as the law firm's alter ego, the taxpayer may be entitled to at least a partial credit for his self-employment taxes. Robert Kovacevich formed a C corporation, Western Management, Inc. (WMI). Its only source of income was providing legal services, and Kovacevich was its sole shareholder, president, and secretary-treasurer. He performed all services necessary to generate gross receipts on WMI's behalf, including paying creditors, hiring employees, signing checks, determining employee compensation, renewing its malpractice insurance, and signing its Federal tax returns. No other person performed legal services on its behalf. Kovacevich received funds from WMI as his needs arose and wasn't compensated for his services at predetermined intervals. In '94 and the first quarter of '95, respectively, WMI paid Kovacevich $132,000 and $33,250. WMI also issued checks to Kovacevich, his wife, and their creditors. Kovacevich informed WMI's accountant and tax return preparer that the payments were draws. WMI classified the payments as loans on its corporate ledgers and did not file Forms 1099-MISC, Miscellaneous Income, for these payments. WMI also paid Kovacevich's law license renewal fees, 1

2 office expenses, bar dues, and health insurance premiums and deducted most of these expenses on its corporate income tax returns. WMI treated Kovacevich as an independent contractor who was employed by the firm he owned and operated. Accordingly, it did not withhold or pay any federal taxes in connection with the services he provided. The Kovaceviches appear to have paid self-employment taxes, consistent with Robert's professed status as an independent contractor. IRS challenged his employment classification. The Tax Court found that Kovacevich was WMI's employee and that his wages were subject to income tax withholding and FICA and FUTA taxes for the four quarters of '94 and the first quarter of '95. He was clearly a statutory employee under Code Sec (Western Management, Inc., TC Memo ) On appeal, the Ninth Circuit affirmed the Tax Court decision, but remanded for reconsideration of the extent to which Kovacevich had already paid income tax on his wages. (Western Management, Inc. v. Comm., (CA 9 1/27/2006) 97 AFTR 2d ) On remand, the Tax Court found that because Robert had paid his income taxes, IRS could not penalize WMI for failing to withhold, but it refused to abate WMI's liability for the employer's share of employment taxes. The Ninth Circuit affirmed. In September of 2003, April of 2004, and November of 2004, the Kovaceviches wrote a series of checks to IRS, which credited the check amounts to WMI's tax account, offsetting part of the corporation's liabilities for the five quarters at issue in this litigation ('94 and the first quarter of '95). The Kovaceviches sought a refund of amounts that they paid for the tax periods in question. They asserted that the checks were payments for Robert's trust-fund-recovery penalty, and that when that penalty was abated, the amounts should have been refunded. They also sought a refund for the amount of a fourth check drawn on Robert's account in '91, on the theory that IRS had wrongfully assessed WMI for taxes that had already been paid 2

3 by the Kovaceviches individually. The government counterclaimed, seeking to hold both members of the couple individually liable for WMI's remaining employment tax liabilities for '94 and the first quarter of '95. The government sought a judgment for recovery of these amounts from Kovacevich, as the alter ego of WMI, and from Yvonne as a member of the community with Robert under Washington state's community property law. The Court of Federal Claims awarded summary judgment to the government. With regard to the three checks from 2003 and 2004, it read an earlier Tax Court ruling as finding that IRS's decision to credit these checks to WMI was proper, and held that the Kovaceviches were precluded from relitigating this issue. With regard to the March '91 check, the court found that the statute of limitations for claiming a refund had expired. Finally, with regard to the government's counterclaim, the court found that Robert was liable as WMI's alter ego, and Yvonne was liable as an owner of community property. The court further held that the doctrine of res judicata barred the Kovaceviches from relitigating the issue of WMI's liability for employment taxes, penalties, and interest stemming from Mr. Kovacevich's employment. The Court generally upheld the lower court's conclusions. Some of the more notable points follow. As to the disputed 2003 and 2004 checks, the Court of Appeals for the Federal Circuit affirmed the Court of Federal Claims' award of summary judgment to the government, but on different grounds. It held that since the Kovaceviches were now liable for WMI's tax liability, they had received the full benefit of these payments and, as such, were not entitled to any further credit or refund for these payments. The Federal Circuit also affirmed the lower court's finding that the statute of limitations expired on the '91 check, and the holding that Robert was liable for WMI's unpaid taxes as its alter ego. The Kovaceviches did, however, manage to eke out a small victory of sorts, in their claim that they should get a credit against the government's recovery for self-employment taxes they allegedly paid along with their '94 and '95 3

4 income tax returns. They relied on Code Sec. 6251, which mitigates the effects of an expired period of limitations when: (a) an amount is erroneously treated as self-employment income or an amount is erroneously treated as wages; (b) correction of the error requires the assessment of one tax and the refund or credit of another; and (c) correction of one tax is authorized, but the other tax is prevented by any rule of law (other than Code Sec. 7122). If these requirements are satisfied, when the authorized correction is made, the amount of the allowable assessment or refund will be reduced by the refund or assessment that would be required if such was not prevented by law. The Kovaceviches argued that since the judgment in their case stemmed from WMI's failure to pay employment taxes for the same quarters for which they mistakenly paid self-employment taxes, Code Sec allowed them to offset their mistaken payments against the judgment. The Court of Federal Claims concluded that the government appeared to be correct that Code Sec did not entitle the Kovaceviches to claim a credit against WMI's tax liability because at the time that the liability was determined, they could have sued for a self-employment tax refund. The Kovaceviches were not entitled to a credit against WMI's corporate liability, the Court of Federal Claims said, but they were (potentially) entitled to a credit against their individual liability resulting from the alter ego determination. That liability was first determined in 2011, when the Court of Federal Claims entered judgment in the litigation, and will only be finally determined when the decision on appeal becomes final. By that time, the statute of limitations for a refund claim under Code Sec. 6511(d)(7) will have expired. Under these circumstances, the Federal Circuit concluded that Code Sec allowed the Kovaceviches to claim a credit for selfemployment tax paid against their liability for WMI's unpaid taxes to the extent that such a credit has not already been allowed. It remanded the case to the Court of Federal Claims to determine, in the first instance, the amount of such a credit. 4

5 A sole dissenter argued that the Court of Federal Claims lacked subject matter jurisdiction over the case. He concluded that the judgment against the Kovaceviches should have been vacated and the claims and counterclaims should have been dismissed. 5