Debtor Owes Self-employment Tax on Earnings from Post-petition Services

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1 Debtor Owes Self-employment Tax on Earnings from Post-petition Services Sisson, TC Memo The Tax Court has concluded that a Chapter 11 debtor was liable for selfemployment tax on self-employment income that he earned after filing for bankruptcy. The Court found that, while the income tax arising from those earnings was a liability of the bankruptcy estate under Code Sec. 1398(c)(1), there was no similar provision for self-employment taxes. A taxpayer's self-employment income is subject to self-employment tax. ( Code Sec. 1402(a), Code Sec. 1402(b) ) Self-employment income is defined as the net earnings from self-employment derived by an individual ( Code Sec. 1402(b) ), which, in turn, refers to the gross income derived by an individual from any trade or business carried on by the individual, minus deductions. ( Code Sec. 1402(a) ) The term "trade or business" generally excludes the performance of service by an individual as an employee, but includes the performance of service in the U.S. by an individual U.S. citizen in the employ of an international organization. ( Code Sec. 1402(c) ) The filing of a bankruptcy petition under Title 11, Chapter 7 of the U.S. Code creates a new taxable entity, the bankruptcy estate, that is separate from the debtor. ( Code Sec ) In general, the "taxable income" of the estate is computed in the same way as for an individual, and "[t]he tax shall be computed on such taxable income and shall be paid by the trustee." ( Code Sec. 1398(c)(1) ) The gross income of the bankruptcy estate of an individual includes any gross income of the individual debtor (other than any amount received or accrued as income by the debtor before the commencement of the bankruptcy case) which, under the substantive law of bankruptcy (Title 11 of the U.S. Code), is property 1

2 of the bankruptcy estate. ( Code Sec. 1398(e)(1) ) This includes, among other things, the debtor's earnings from services performed by the debtor after the filing of the bankruptcy petition. ( 11 USC 1115(a)(2) ) Items included in the estate's gross income under Code Sec. 1398(e)(1) are not included in the gross income of the debtor. ( Code Sec. 1398(e)(2) ) On June 23, 2006, Charles Sisson filed a voluntary Chapter 11 bankruptcy petition. During 2007, he performed services in the U.S. as an employee of the International Monetary Fund (IMF), receiving wages of $207,422 that included a $8,739 "gross up" to help him pay self-employment tax on his earnings. No taxes were withheld from his earnings. Because Mr. Sisson was in bankruptcy during 2007, his IMF earnings for that year were paid over to and became property of his bankruptcy estate. On their 2007 joint return, Mr. Sisson and his wife did not include any of his IMF earnings in their self-employment income. The only self-employment income or losses they reported were self-employment losses from unrelated consulting and farming activities, resulting in zero reported self-employment liability. They did, however, report the IMF earnings in their gross income (which the Tax Court observed was erroneous as the earnings were properly includible in the gross income of the bankruptcy estate). The Sissons claimed various deductions, most of which were attributable to losses from Mr. Sisson's consulting and farming activities, that reduced their reported taxable income such that their reported income tax liability was only $112. In the notice of deficiency, IRS determined that Mr. Sisson's self-employment income for 2007 was $207,422 (i.e., the amount of his IMF earnings) and that his self-employment-tax liability for the year was $17,512. IRS also disallowed deductions from the consulting and farming activities, but didn't make an adjustment to remove Mr. Sisson's IMF earnings from the Sissons' gross 2

3 income, so the deficiency notice reflected an income tax owed of $32,084, for a total deficiency of $49,484. Following a number of stipulations (including one that Ms. Sisson had no deficiency for 2007 under the innocent spouse rule in Code Sec. 6015(c) ), the issue before the Tax Court was whether Mr. Sisson owed self-employment tax for Mr. Sisson contended that he did not because his bankruptcy estate was liable for the self-employment-tax liability corresponding to his IMF earnings. The Court first observed that Mr. Sisson's IMF earnings shouldn't have been included on the Sissons' return for income tax purposes because the income tax is one on "taxable income" and is thus imposed on the bankruptcy estate under Code Sec. 1398(c)(1). However, the self-employment tax is a tax on selfemployment income, not on "taxable income." Therefore, self-employment tax is not a tax liability that is imposed on the bankruptcy estate under Code Sec. 1398(c)(1), and Mr. Sisson is liable for it. The Court noted in its decision that its conclusion is consistent with Notice , CB 596, but stated that it did not rely on the Notice or give it "the deference that would be due a regulation." Notice provides that, where a debtor "continues to derive gross income from the performance of services as a self-employed individual after the commencement of the bankruptcy case, the debtor must continue to report...the self-employment income earned postpetition...and must pay the resulting self-employment tax." CA 9: Online Poker Accounts Weren't Subject to FBAR, but Payment Processing Account Was U.S. v. Hom, (CA 9 7/26/2016), 118 AFTR 2d

4 The Court of Appeals for the Ninth Circuit, affirming in part and reversing in part a district court decision, has found that one of three accounts a taxpayer maintained to facilitate online poker was with a financial company and had to be reported on a Foreign Bank and Financial Accounts Report (FBAR). However, the two online poker services, which created accounts for him in foreign countries, weren't financial companies subject to FBAR reporting. Under the Bank Secrecy Act, U.S. citizens must file an FBAR with the U.S. Treasury disclosing any financial account in a foreign country with assets in excess of $10,000 in which they have a financial interest or over which they have signatory or other authority. (31 USC 5314) Specifically, 31 USC 5314 provides that the Secretary of the Treasury shall require U.S. persons to keep records and file reports when those persons make a transaction or maintain a relation for any person with a foreign financial agency. Under the regs in effect at the time, accounts required the filing of FBAR forms if they were both (1) bank, securities, or other financial account[s] and (2) in a foreign country. 31 USC 5312(a)(1) defines a financial agency as a person acting for a person as a financial institution. 31 USC 5312(a)(2) in turn defines a financial institution as including a number of specific types of businesses, including a commercial bank, a private banker, and a licensed sender of money or any other person who engages as a business in the transmission of funds. The Bank Secrecy Act explicitly empowers the Secretary of the Treasury to determine the method in which covered persons should disclose their relationships or accounts with a foreign financial agency. (31 USC 5314) For the years at issue, those regs were contained in 31 CFR Thereafter, 31 CFR was amended and renumbered 31 CFR ; the amendments did not fundamentally alter any of the reporting obligations. Failure to file the FBAR is subject to penalty. No penalty is imposed, however, if the violation was due to reasonable cause and the amount of the transaction or the balance in the account at the time of the transaction was properly reported. (31 USC 5321(a)(5)(B)) John Hom gambled online and had accounts worth more than $10,000 during the years in question with two online poker companies, PokerStars and PartyPoker. He used a third company, an online financial organization, FirePay.com, to facilitate the transferring of money to and from his two poker accounts; he also had more than $10,000 in his FirePay account during one of the years in question. 4

5 IRS assessed Hom with 31 USC 5321(a)(5) penalties for his failure to submit FBARs regarding his interest in his FirePay, PokerStars, and PartyPoker accounts. District court decision. The district court found that Hom's accounts with FirePay, PokerStars, and PartyPoker had to be reported on an FBAR. (U.S. v. Hom, (DC CA 6/4/2014) 113 AFTR 2d While it noted that the Ninth Circuit hadn't yet answered what constitutes other financial accounts, the district court looked to the Fourth Circuit decision in Clines, (CA ) 958 F2d 578, which held that under 31 USC 5312(a)(1), a person acting for a person as a financial institution or a person who is acting in a similar way related to money is considered a financial agency. Applying this broad definition, the district court concluded that FirePay, PokerStars, and PartyPoker were all financial institutions because they functioned as commercial banks. By holding funds for third parties and disbursing them at their direction, all three organizations functioned as banks. Hom admitted that he opened up all three accounts in his name, controlled access to the accounts, deposited money into the accounts, withdrew or transferred money from the accounts to other entities at will, and could carry a balance on the accounts. Thus, the district court held that FirePay, PokerStars, and PartyPoker functioned as banks, and Hom's online accounts with them were reportable. As to whether the accounts were located in foreign countries, the district court agreed with IRS located in refers to where the financial institution that created and managed the account is located. It said that it was irrelevant where PokerStars, FirePay, or PartyPoker opened their bank accounts; these accounts belonged to them, not Hom. Rather, his accounts were digital constructs that these financial institutions, all located outside of the U.S., created and maintained on his behalf. The court said that the Treasury had reasonably interpreted the statute in finding that an account's location is determined by the location of its host institution, not where the physical money might be stored after it is sent to a financial institution. Hom appealed. Appellate Court. The Ninth Circuit, agreeing with the district court, concluded that Hom's FirePay account fit within the definition of a financial institution for purposes of FBAR filing requirements because FirePay was a money transmitter under 31 USC 5312(a)(2). However, unlike the district court, the Ninth Circuit found that Hom's PokerStars and PartyPoker accounts did not fall within the definition of a bank, securities, or other financial account. 5

6 The Court reasoned that FirePay acted as an intermediary between Hom's Wells Fargo account and the online poker sites. Hom could carry a balance in his FirePay account, and he could transfer his FirePay funds to either his Wells Fargo account or his online poker accounts. It also appeared that FirePay charged fees to transfer funds. As such, FirePay acted as a licensed sender of money or any other person who engages as a business in the transmission of funds under 31 USC 5312(a)(2)(R), and so qualified as a financial institution. Hom's FirePay account was also in a foreign country because FirePay was located in and regulated by the United Kingdom. The Court referenced IRS's FBAR Reference Guide ( (last visited July 19, 2016)): Typically, a financial account that is maintained with a financial institution located outside of the United States is a foreign financial account. On the other hand, the Court found that PartyPoker and PokerStars primarily facilitated online gambling. Hom could carry a balance on his PokerStars account, and indeed he needed a certain balance in order to sit down to a poker game. But the funds were used to play poker, and there was no evidence that PokerStars served any other financial purpose for Hom. His PartyPoker account functioned in essentially same manner. The Ninth Circuit rejected IRS's argument that these entities were functioning as banks. Because neither the statute nor the regs defined banking, the Court looked to the plain meaning of the term. It determined that there was no evidence that PartyPoker and PokerStars were established for any of the purposes of a bank; it defined bank as an establishment for the custody, loan, exchange, or issue of money, for the extension of credit, and for facilitating the transmission of funds. Rather, accounts at PartyPoker and PokerStars were established for the purpose of facilitating poker playing. 6