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Sixth Circuit Court Rules Law Firm is not Exempt from Taxes


February 26, 2016
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Sixth Circuit Court rules Law Firm is not Exempt from Taxes

Law Firm is not Exempt from Taxes

Recently, in the case of a Michigan law office, the Sixth Circuit Court upheld a decision to penalize the law firm for not filing a Form 5330, Return of Excise Taxes Related to Employee Benefit Plans. According to a Bloomberg BNA report, the court ruled that the firm was penalized for reasonably acknowledging that it had not paid its taxes.

The background of the initial case

The law office established an employee stock ownership plan in 1998, a Law 360 report explained. This ESOP is a retirement plan that owns securities of the employer that sponsors the program. Then, after the principal established the ESOP, he transferred his ownership to the plan. At the time, ESOPs at S corps like the firm in question were exempt from taxes on income attributable to stocks held in the ESOP until it was distributed. As the principal and his firm were exempt from taxes, there were no returns filed.

However, in 2001, Congress amended the provisions, giving taxpayers a six-month grace period to make back payments and ensure compliance. This provision was amended to combat tax abuses by S corporations that established ESOP programs that were designed to benefit a few key personnel rather than large groups of employees. Congress imposed a 50 percent excise tax on S corp. ESOP programs that did not have employee ownership. Ultimately though, the law firm did not comply within the grace period.

Further complicating the case was the fact that the IRS waited until 2011 to collect the excise tax – which was over $200,000 – that resulted from the firm’s decision not to come into compliance. In the initial case, the court found that Section 4979A, which enforces the excise tax, governed the statute of limitations, and that the time had expired for the IRS to impose the tax.

The court’s initial ruling

The court initially found the IRS was required to adhere to a three-year statute of limitations imposed under Section 4979A. However, when the court reconsidered the case, it ruled that the IRS should have applied a different tax code section.

Therefore, the court found that the statute of limitations never expired because the law firm never properly filed the necessary tax form for the ESOP, which meant that the statute of limitations never started.

The significance of the Sixth Circuit Court’s decision

The lesson for taxpayers, particularly S corps, is that in order to benefit from the three-year statute of limitations, it is crucial that they file the necessary tax form – even if they did not need to when they established the ESOP. Taking this one step further, the guidance for taxpayers in general is that they should file tax returns, even if they believe in good faith that they are tax exempt. It is best that the IRS is provided with the information so that they can calculate any potential taxes.