© Morgan, Lewis & Bockius LLP Chicago Chapter Tax Executives Institute February 25, 2014 Current...

Morgan, Lewis & Bockius LLP Chicago Chapter Tax Executives Institute February 25, 2014 Current Developments in Compensation and Benefits Mary (Handy) Hevener [email protected] (202) 739-5982 Andy R. Anderson [email protected] (312) 324-1177 Morgan, Lewis & Bockius LLP 1

Morgan, Lewis & Bockius LLP Final Affordable Care Act Shared Responsibility Rules Andy R. Anderson [email protected] (312) 324-1177 Morgan, Lewis & Bockius LLP 2

Morgan, Lewis & Bockius LLP 3 Final Shared Responsibility Rules Released 2.10.2014 Prior day (2.9.2014) was a key date in numerous transition rules Finalizes proposed rules from late 2012 Key concepts: Very similar in scope and content to proposed rules Retains and expands proposed transition rules Retains and expands full-time employee determinations Retains and clarifies affordability safe harbors

Morgan, Lewis & Bockius LLP Final Shared Responsibility Rules Confirms 2015 Shared Responsibility effective date for large (100 or more FTE/FTeq) employers Expands proposed 95/5% offer rule to 70/30% for 2015, but can still lead to inadequate coverage penalty The 70% expansion creates new planning opportunities Delays Shared Responsibility effective date until 2016 for mid-size employers (50 to 99 FTE/FTeq) Numerous requirements and a necessary certification in order to qualify Places new emphasis on when an employer is small enough to escape Shared Responsibility rules for 2015 4

Morgan, Lewis & Bockius LLP Final Shared Responsibility Rules Lots (and lots, and lots) of small detail changes that are grounded in comments to the proposed rules and special interest lobbying Final Regulations are generally clean for 2016 and beyond Special rules, transition relief, etc. are found in the preamble to the final rules, the preamble to the proposed rules, and releases that predate the proposed rules Must, as a result, check multiple sources, particularly for 2015 specifics 5

Morgan, Lewis & Bockius LLP Final Shared Responsibility Rules Preamble nice overview of law, prior guidance, and proposed rules See also new Q&As on IRS website: http://www.irs.gov/uac/Newsroom/Questions-and-Answers- on-Employer-Shared-Responsibility-Provisions-Under-the- Affordable-Care-Acthttp://www.irs.gov/uac/Newsroom/Questions-and-Answers- on-Employer-Shared-Responsibility-Provisions-Under-the- Affordable-Care-Act Imbedded expectation for more subregulatory guidance in a number of areas Such as additional FAQs, Q&As, etc. Next up: Reporting Rules 6

Morgan, Lewis & Bockius LLP 7 Prior/Future Material ACA considerations for employers http://www.morganlewis.com/index.cfm/publicationID/8CD8F0A9 -4F6B-4170-A73A-3451008094D6/fuseaction/publication.detailhttp://www.morganlewis.com/index.cfm/publicationID/8CD8F0A9 -4F6B-4170-A73A-3451008094D6/fuseaction/publication.detail ACA considerations for group health plans http://www.morganlewis.com/index.cfm/publicationID/F5C8601D -373C-4E4A-9850-671BB3B82499/fuseaction/publication.detailhttp://www.morganlewis.com/index.cfm/publicationID/F5C8601D -373C-4E4A-9850-671BB3B82499/fuseaction/publication.detail ACA considerations for individuals http://www.morganlewis.com/index.cfm/publicationID/04845943- 61B7-49DE-BB0E-BAF9D3403D4E/fuseaction/publication.detailhttp://www.morganlewis.com/index.cfm/publicationID/04845943- 61B7-49DE-BB0E-BAF9D3403D4E/fuseaction/publication.detail Companion LawFlash to Final Rules is in the pipeline

Morgan, Lewis & Bockius LLP Who Is Subject to the Shared Responsibility Rules in 2015? Only employers with 100 or more FT/FTeq employees On average, at least 100 FT/FTeq employees on business days during the previous calendar year (initially 2014) Six-consecutive-month transition rule for 2014 Determine if large by adding together: FT employees 30 hours per week (or 130 hours per month) FT employee equivalents Total hours worked by all PT employees divided by 120 From all controlled group employers Reserved for government and church employers 8

Morgan, Lewis & Bockius LLP Who Is Subject to the Shared Responsibility Rules in 2015? Special rules for: Seasonal employees (reasonable good faith definition) New employers (look at reasonable expectation for current year) Counts all employeeseven those eligible for Medicare, Medicaid, or other employer coverage Exempts most overseas employees Predecessor employers (still reserved for future guidance) Most employers will know, well in advance of 2015, whether they are subject to the employer mandate 9

Morgan, Lewis & Bockius LLP Who Is Subject to the Shared Responsibility Rules in 2016? Expanded to include employers with 50-99 FT employees Applied the same as 2015 rules for larger employers Measured on the basis of 2014 workforce Must maintain size and hours of workforce for period from 2.9.2014 to 12.31.2015 Must maintain previously offered coverage (if any) from 2.9. 2014 Must certify compliance as part of section 6056 reporting Which apparently will apply to such employers for 2015 Does not generally carryover other 2015 transition rules 10

Morgan, Lewis & Bockius LLP Non-Calendar Year Plans There are revised and new (but still limited) delayed effective date rules for non-calendar year plans existing (and not modified) after 12.27.2012 Delayed until start of non-calendar year for any employee eligible to participate 2.9.2014 Delayed until start of non-calendar year for all employees (whether previously eligible or not) if: Offered plan to at least 1/3 of all employees at most recent OE before 2.9.2014; or Covered at least 1/4 of all employees on a day in 12-month period ending 2.9.2014 11

Morgan, Lewis & Bockius LLP Non-Calendar Year Plans Delayed until start of non-calendar year for FT employees (whether previously eligible or not) if: Offered plan to at least 1/2 of ACA FT employees at most recent OE before 2.9.2014; or Covered at least 1/3 of ACA FT employees on a day in 12- month period ending 2.9.2014 Useful for employers with a significant percentage of employees who will not become ACA FT employees Also applies to 2016 delay for smaller employers Regardless, must do Section 6056 reporting for all of 2015 12

Morgan, Lewis & Bockius LLP 13 Shared Responsibility Basics No Coverage PenaltyInadequate Coverage Penalty If employer does not offer Minimum Essential Coverage to 95% of its FT employees If employer offers coverage to its FT employees, but the coverage is not Affordable and/or does not provide Minimum Value AND One FT employee enrolls in an Exchange and receives a subsidy Employer must pay penalty of: $2,000 (indexed) for all FT employees (less 30) (including those receiving coverage) Employer must pay penalty of: $3,000 (indexed) for each FT employee receiving a subsidy (capped at the maximum No Coverage Penalty)

Morgan, Lewis & Bockius LLP 14 No Coverage Penalty Offer At least 95% of all FT employees (and their children in 2016) or at least 70% for 2015 FT employee = 30+ hours per week (130+ hours per month) Treasury refused to increase above 30 hours Children now excludes foster children and stepchildren Must offer coverage through end of month in which child attains age 26 Excludes children who are not citizens or residents of the U.S. But includes children resident in Canada or Mexico Qualifying coverage... Minimum Essential Coverage (basically any ER-sponsored plan)

Morgan, Lewis & Bockius LLP 15 No Coverage Penalty Or pay No Coverage penalty $2,000 times all FT employees (minus 30; 80 for 2015 only) Note: employers who have less than 30 FT employees (or 80 for 2015) will pay no penalty Only applies if one FT employee enrolls in Exchange and receives a subsidy (tax credit or cost-sharing reduction, called a Section 1411 Certification) No subsidy available if: Eligible for Medicaid (100-133% of federal poverty level) Household income is more than 400% of federal poverty level

Morgan, Lewis & Bockius LLP 16 No Coverage Penalty Calculated on ALL FT employees of each controlled group member separately 30/80 employee reduction apportioned across controlled group members Offer includes offer of coverage from: Multiemployer/single-employer Taft-Harley plans Additional interim guidance for near future PEOs (if client pays more for the offered coverage) MEWAs

Morgan, Lewis & Bockius LLP 17 No Coverage Penalty Includes Evergreen offers Offer by one controlled group member satisfies obligation for all members Useful for large single plan across the entire controlled group No specific rules for demonstrating an offer was made Limited no offer opportunity for coverage providing minimum value that is free or meets Federal poverty level affordability safe harbor

Morgan, Lewis & Bockius LLP 18 Inadequate Coverage Penalty Offer To all FT employees (and their children in 2016)or fail to offer to up to 5% (up to 30% in 2015) of FT employees FT employee = 30+ hours per week (130+ hours per month) Children now excludes foster children and stepchildren Must offer coverage through end of month in which child attains age 26 Excludes children who are not citizens or residents of the U.S. But includes children resident in Canada or Mexico

Morgan, Lewis & Bockius LLP 19 Inadequate Coverage Penalty Offer Qualifying coverage Is Minimum Essential Coverage and Provides Minimum Value That is Affordable Not more than 9.5% of household income for employee-only coverage Safe harbors (discussed later)

Morgan, Lewis & Bockius LLP 20 Inadequate Coverage Penalty Or pay Inadequate Coverage penalty $3,000 per FT employee who receives subsidy (Section 1411 Certification) for Exchange coverage (capped at maximum No Coverage penalty) No subsidy available if: Eligible for Medicaid (100-133% of federal poverty level) Household income is more than 400% of federal poverty level Applied separately to each controlled group member Limits scope of penalty to only part of controlled group

Morgan, Lewis & Bockius LLP Who Is a Full-Time Employee? Average 30 hours of service/week For non-hourly employees, 8 hours/day or 40 hours/week equivalencies 130 hours/month can be used Different from large employer determination No need to combine PT employees into full-time equivalents Determined on a controlled group basis Very challenging for transfers within a controlled group 21

Morgan, Lewis & Bockius LLP Who Is a Full-Time Employee? Determination of FT status Under statute, this is determined monthly on an ongoing basis Final rules contain new details and procedures for determining status on a monthly basis Plugs some of the prior holes applicable to monthly determinations Very complicated new final rules for when individuals move between different methods of determining status over their careers Special phased retirement (and similar situations) rule Employees whose status is clearly full time when hired must be offered coverage within 3 months of hire 22

Morgan, Lewis & Bockius LLP Who Is a Full-Time Employee? Voluntary safe harbor method for new variable hour, seasonal, and part-time employees Permits employers to calculate employee hours during an initial measurement period (3-12 months after employment) and lock in the resulting status for the following stability period (6-12 months) Employer can define periods, subject to consistency, based on categories of employees (i.e., salaried/hourly, union/non- union, different entities, different states) Short (less than 2 months) administration period to start coverage if use full initial measurement period Will be complicated to track and implement Note new part-time requirements!! 23

Morgan, Lewis & Bockius LLP Who Is a Full-Time Employee? Voluntary safe harbor method for ongoing employees Permits employers to calculate employee hours during a consistent ongoing measurement period (3-12 months) and lock in the resulting status for the following stability period (6- 12 months) Employer can define periods, subject to consistency, based on categories of employees (i.e., salaried/hourly, union/non- union, different entities, different states) Expected to be tied to open enrollment process and timing 90-day administration period to start coverage Must transition new variable hour, seasonal, and part-time employees to this ongoing measurement process 24

Morgan, Lewis & Bockius LLP Who Is a Full-Time Employee? Special rules for: Seasonal employees (6 month rule) Volunteers Schools Adjunct faculty (new 2-1/2 hour equivalency) Rehired employees (now 13 consecutive weeksstill 26 for educational organizations) International employees and transfers Temporary staffing firms Section 3508 employees Cruise ships 25

Morgan, Lewis & Bockius LLP Who Is a Full-Time Employee? U.S. territories Student work-study On call hours Layover hours Religious orders Home healthcare workers 26

Morgan, Lewis & Bockius LLP When Is Coverage Affordable? Necessary to avoid Inadequate Coverage penalty Premium for cheapest employee-only coverage must be less than 9.5% of household income No cap on spouse/children premiums May be up to COBRA cost of coverage Three optional safe harbors remain and are clarified: W-2: Premium cannot exceed 9.5% of the employees W-2 wages from the employer for that year New special rules for partial years 27

Morgan, Lewis & Bockius LLP When Is Coverage Affordable? Rate of Pay Premium cannot exceed 9.5% of an amount equal to 130 hours multiplied by the lower of the hourly rate of pay on the first day of coverage or the lowest hourly rate of pay during each month (if reduced) Alternate is monthly salary on the first day of the coverage periodwhich cannot be reduced Federal Poverty Line Premium cannot exceed 9.5% of an amount equal to the Federal poverty line for the year divided by 12 Can use the most recently published guidelines in effect 6 months prior to the beginning of the plan year 28

Morgan, Lewis & Bockius LLP Lingering Concerns Nondiscrimination rules Particularly worrisome if employer has different health coverage across its controlled group ERISA section 510 claims ACA Whistleblower claims Cadillac Tax Some coverage may be too rich for 2018 Is 2015/2016 the time to cut back? 29

Morgan, Lewis & Bockius LLP New Developments in Payroll Tax Controversies: Traveling Employees Crossing U.S. and State Borders, and Developments in Independent Contractor Audits Mary (Handy) Hevener [email protected] (202) 739-5982 Morgan, Lewis & Bockius LLP 30

Morgan, Lewis & Bockius LLP Overview A.Federal Data Collection Program Audits B.Payroll Audits of Expatriate and Impatriate Employees C.Wage Recharacterization Audits D.State Payroll Tax Audits of Traveling Employees E.Developments in Independent Contractor Audits 31

Morgan, Lewis & Bockius LLP DATA COLLECTION AND FRINGE BENEFITS AUDITS 32

Morgan, Lewis & Bockius LLP Data Collection and Fringe Benefit Audits, Overview Since 2009, the IRS has audited over 2,000 employers (under a program that the IRS initially hoped would cover examinations of 6,000 taxpayers during 2009-2011). Most of these audits were of small companies, with an intention to extrapolate the audit results, to measure businesss compliance with worker classification, fringe benefit, and payroll tax laws. The IRSs first extrapolation report was deemed, in May, 2011, by the Treasury Inspector General for Tax Administration to be too small of a sample to provide meaningful compliance estimates, so the IRS was required to restart big company audits in 2012 (most in Silicon Valley). 33

Morgan, Lewis & Bockius LLP Initial IDRs in these audits cover hundreds of issues, and can take over a year to complete. There are typically five basic areas identified for attention during these audits. (Call Mary Hevener for samples of initial IDRs.) 34 Data Collection and Fringe Benefit Audits

Morgan, Lewis & Bockius LLP To comply with the New IDR response deadlines, and to avoid the prompt delinquency notices and summons enforcement procedures outlined in LB&I Directive 04-113-009), taxpayers need to be ready to explain to the Exam team how long the information will take to be collected and why it will take that long. This includes determining: Do you have the information the IRS seeks? Where is the information and what format is it in? Who will be responsible for obtaining and organizing the information and how long will it take that person to do so? Who needs to review the information before it is delivered to the IRS and how long will that take? Are there any privilege or confidentiality concerns? That may require additional review. 35 New IRS IDR Procedures with Mandatory Enforcement Provisions

Morgan, Lewis & Bockius LLP New IRS IDR Procedures with Mandatory Enforcement Provisions Need to ensure that everyone involved in the examination within your organization is aware of the IDRs deadline, because once you agree to the deadline there is virtually no way to extend it and the new enforcement provisions are mandatory. If you miss the initial deadline in the IDR, the IRS will issue a Delinquency Notice within 10 days of the missed deadline and may allow up to 15 days to provide a response. 36

Morgan, Lewis & Bockius LLP Data Collection and Fringe Benefit Audits 1.Fringe benefits; Likely to include use of company cars, planes and home computers, spousal travel, corporate apartments, prizes and awards, tax return preparation, meals (including on-premises cafeterias), life insurance, and various de minimis items (including gift cards) 2.Reimbursed expenses; Code 62(c) compliance 3.Executive compensation; Including deferred compensation and stock-based awards, such as qualified and nonqualified stock options, restricted stock, various phantom stock programs, and for larger companies, Code 162(m) and 280G issues. 37

Morgan, Lewis & Bockius LLP Data Collection and Fringe Benefit Audits 4.Payroll tax compliance (including expatriates, and NRAs traveling to the U.S.); and Focused on W-4/W-9 collections (including investigations of employees who have claimed exempt status or too many exemptions), information return compliance (including inquiries about individuals who have received both Forms W-2 and 1099- MISC), B-1, J, and H-1B visa issues, and payroll tax deposit timing (with focus on options/RSUs). 5.Worker/independent contractor classification Focused on, ultimately, collecting solid revenue estimates for an expected Administration proposal to repeal 530 of the 1978 Revenue Act (as sponsored by then Senator Obama). 38

Morgan, Lewis & Bockius LLP Data Collection and Fringe Benefit Audits Possible State Referrals Not only are these IRS audits painful processes, but, given increased coordination between the IRS and state tax agencies, it is possible that audit findings will be coordinated with state tax authorities. Many states have longer statutes of limitations some extending two or three years after the employer pays taxes to the IRS at the conclusion of the IRS audit, which leads to painful delays, and problems with data-retention. If the employer does not confess to the state its payment of taxes to the IRS, the state SOL may never run (e.g., in California). 39

Morgan, Lewis & Bockius LLP Procedural Delays in Getting to IRS Appeals So many IRS Appeals Officers have retired over the past 3 years that there is a huge backlog in IRS processing of protests, particularly those on payroll tax issues. Many of the Protests filed with respect to the data collection audits of larger employers, which started in late 2011, have not yet been considered even at a first meeting at Appeals. Although the IRS insists that taxpayers have only 30 days (or even less) to file a Protest, the delay before the first Appeals Meeting is 12 to 15 months. 40

Morgan, Lewis & Bockius LLP 2010 Increase in Information Reporting Penalties The Code includes not only penalties on individual taxpayers for underreporting income and underpaying (or late-paying) taxes, but also imposes penalties on employers for making the same types of errors. These penalties were dramatically increased in late 2010, effective for information returns filed in January 2011 for 2010 (although there is a typo in the I.R.M., indicating that for small employers, the increased penalties may be delayed until the 2011 year). Also, employers liability for underwithholding on executives increased in 2013 when the withholding rate on supplemental wages over $1,000,000 jumped from 35% to 39.6%. 41

Morgan, Lewis & Bockius LLP 2010 Increase in Information Reporting Penalties The post-2010 penalties imposed under each of Code 6721 and 6722 are: $100 per W-2, up to maximum of $1,500,000 for all such failures in the aggregate for the year; $30 per W-2, with $250,000 annual cap if corrected within 30 days of January 31; $60 per W-2 with $500,000 annual cap if corrected on or before Aug. 1; In cases of intentional disregard, greater of 10% of underreported amount or $250 per W-2 (with no annual cap). Note that lower annual caps apply to small employers with gross receipts under $5,000,000. 42

Morgan, Lewis & Bockius LLP 2010 Increase in Information Reporting Penalties For errors on any single W-2 (or 1099), this change has effectively doubled penalties from $100 to $200 per return since penalties are imposed on errors in both the employee and employer copies of the forms. For errors by large employers (which affect 15,000 or more employees), the penalties have increased six-fold, from $500,000 to $3 million. Lower caps apply to small employers with gross receipts under $5M. For intentional disregard errors, the penalty is 20% of the underreported income. 43

Morgan, Lewis & Bockius LLP 2010 Increase in Information Reporting Penalties Have these changes increased the accuracy of information returns? Perhaps information returns are more accurate, but certainly these higher penalties (and higher withholding rates on executive compensation) have increased the worry factor for return filers. Will these changes increase the frequency of audits? Maybe, and they certainly will increase costs for those audited. They have also lead to more computer-notice assessments. 44

Morgan, Lewis & Bockius LLP 45 FEDERAL PAYROLL AUDITS OF CROSS-BORDER EMPLOYEES: COMMON AUDIT ISSUES

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Employees 1.Tax Return Preparation 2.Expatriate Withholding 3.Impatriate Withholding 46

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Tax Return Preparation IRS Arguments The tax return preparation benefits only the employee. The Code 132(d) exclusion does not apply to 212 deductions (e.g., return preparation). See Reg. 1.132- 5(a)(1)(iii); Code 212; Rev. Rul. 73-13; P.L.R. 8547003; P.L.R. 199929043; and F.S.A. 200137039 (all addressing employer-paid tax return preparation). The exclusion for non-discriminatory qualified retirement planning services under 132(m) is not applicable. The employers cost measures the benefit value. 47

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Tax Return Preparation Employer Response The assessed tax preparation costs should be excludable under Code 132 as a working condition fringe benefit because incurred primarily for the employers benefit. See, e.g., Rev. Rul. 92-69 (applying this principle to job- search expenses to terminated employees). Even the ruling cited by the IRS imply that under certain conditions the working condition exclusion could apply. There is ample pre- and post-TRA 84 guidance indicating that property and/or services provided to employees for an employers benefit should be excluded from wages. See also Rev. Rul. 63-144 (question 31); Doak v. Commr, 234 F.2d 704 (1956); and Teeling v. Commr, 42 T.C. 671 (1964), acq. 1965-2 C.B. 6 (all allowing deductions for personal meal and entertainment expenses, where it is clearly shown that the taxpayer was incurring costs exceeding those that would have been incurred for their personal expenses). 48

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Tax Return Preparation Employer Response Cost cannot be used to measure value, per Reg. 1.61- 21(b)(2). The amount payable by an employee for the U.S. return preparation is the effective value. The IRS should accept values of $350 to $500 as income imputed to employees for this benefit. (Notably, $500 is more than double the value of tax return preparation services, as estimated by the National Society of Accountants and the IRS.) 49

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Tax Return Preparation Employer Response Because expatriates are only responsible for the hypothetical stay at home tax, the value received by these employees for domestic and foreign tax return preparation services is far less than the employers cost. Much of the return preparation cost is aimed at minimizing the tax equalization payments due expatriates. Expatriates do not benefit from foreign tax return preparation services because they are guaranteed tax equalization payments and gross-ups. Any tax attributes (including FTCs) that generate tax reduction in an expatriates return for prior or future periods, including pre- and post-assignment periods, solely benefit the employer. 50

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Tax Return Preparation Employer Response The facts for most employers are clearly distinguishable from those described in Rev. Rul. 73-13 and P.L.R. 8547003. Under the facts of Rev. Rul. 73-13, the services were rendered primarily for the benefit of the employees. For most employers, the foreign tax preparation expenses were incurred primarily for the employers benefit (as discussed above). P.L.R. 8547003 differs from most employers situations, since few, if any, expatriate employees are ever given a choice between the tax preparation services and cash. 51

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Expatriate Withholding IRS Arguments Withholding should have been collected on wages while the employees were traveling. The Code 911 exclusion was inadequate to protect the wages from withholding. The exempt status Forms W-4 were completed incorrectly (per inclusions of requested exemptions), or had expired (on Feb. 15 of every year). The only way for an employer to abate its liability for underwithheld income taxes is to collect originally signed Forms 4669 from each affected employee. 52

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Expatriate Withholding Employer Response Wages paid to U.S. citizens performing services in a foreign country for an employer are exempt from withholding if at the time of payment it is reasonable to believe the employees wages will be excluded from gross income under Code 911. See Treas. Reg. 31.3401(a)(8)(A)-1(a)(1)(i). In many instances, the IRS agents computations of the Code 911 exclusion significantly understate the available exclusion. 53

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Expatriate Withholding Employer Response Qualified individuals could exclude up to $91,500 in 2010. $92,900 in 2011. $95,100 in 2012, $97,600 in 2013, and $99,200 in 2014. See Code 911(b)(2)(D)(i); Rev. Procs. 2009-50, 2010-40, 2011-52, 2012-42, and 2013-35. The Code 911 exclusion amount is computed on a daily basis based on the number of days that fall within the employees qualifying period during the taxable year. See Code 911(b)(2)(A). Pursuant to Reg. 1.911-3(d)(2)(i), to determine the maximum exclusion amount, the annual exclusion amount is multiplied by the following fraction: The number of qualifying days in the taxable year The number of days in the taxable year IRS agents often misapply (or ignore) this exemption. 54

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Expatriate Withholding Employer Response In addition to the Code 911 exclusion, Code 3401(a)(8)(A)(ii) (and the underlying regulations) provide a wage withholding exemption for remuneration paid for services by a U.S. citizen employee in a foreign country if the employer is required by the law of a foreign country to withhold income tax upon such remuneration. The tax need not be imposed under general income tax laws of the foreign country, so as the foreign tax would otherwise qualify for credit (if elected) under Code 901. See P.L.R. 8129013. Some IRS agents insist on detailed explanations (and translations) or foreign laws, plus proof that withholding in fact occurred, before applying this exclusion. 55

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Expatriate Withholding Employer Response Some employees file Forms W-4 claiming exempt status and the IRS scrutinizes these forms, and the updates to the forms (required every February) very carefully. Here again, many of the criticisms are contradicted by the I.R.M. and the W-4 form instructions, which indicate that the form is NOT invalidated completely if both exempt status and a high number of exemptions are claimed, and also permit reliance on prior-filed Forms W- 4 with high numbers of exemptions. 56

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Expatriate Withholding Employer Response Many examining agents, in calculating proposed taxes, apply the highest possible effective marginal rates, instead of applying the 25% supplemental rate (which admittedly jumped to 39.6% in 2013 for supplemental wages over $1M). This violates instructions in the I.R.M. Moreover, agents sometimes use the 25% supplemental rate in computing adjustments, when in fact the regular wage rate would have been less. Thus, in any audit, agents tend to use the higher of the regular marginal rate or the supplemental rate, when they should use the lower of the two rates. 57

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Expatriate Withholding Employer Response An employers Code 3403 liability for non-withheld taxes can be abated, pursuant to Code 3402(d), if the tax against which such tax may be credited is paid. According to Treas. Reg. 31.3402(d)-1, the employer will not be relieved of his liability for payment of the tax required to be withheld unless he can show that the tax has been paid. One potential method of proof is the Form 4669 but other methods should be available, as discussed below. 58

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Expatriate Withholding Employer Response The I.R.M. does not limit Form 4669 as the exclusive method by which an employer can show that the tax has been paid. It simply provides one manner in which an employer can make a prima facie showing that an employee paid the underlying tax. Alternative forms of satisfying the Code 3402(d) abatement rules have been recognized in numerous court cases. 59

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers : Expatriate Withholding Employer Response Alternative forms of proof include: Providing records relating to affected employees for whom the employers accountant prepared U.S. federal income tax returns, pursuant to the employers expatriate employee benefits program; Providing information return filing records; Providing a list of the names and SSNs of the affected employees, along with a statement that the employer has maintained records of: (1) each affected employees Form W-2 (and, if applicable, Form W-2c); (2) payment to the accounting firm for tax return preparation and filling fees; and (3) a tax equalization computation; or Producing records evidencing the costs of preparing each employees tax return and related tax equalization computations. 60

Morgan, Lewis & Bockius LLP Best Practices to Avoid Expatriate Withholding Issues? What forms should be completed by employee? What are the Dos and Donts of completing Forms W-4 and other election forms? What questions should be resolved in written assignment letters? What steps should be taken to track equity compensation vesting? 61

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Impatriate Withholding Issues For impatriates, different rules apply. Code 861 provides only a limited exclusion (for under $3,000 of income, and for work of under 90 days) for services performed in the U.S. The IRS counts even a minute of a calendar day as a full day, even though the regulations indicate that the calendar day test is a general rule (implying that exceptions exist). In a pending Tax Court case, American Airlines v. Commr, the IRS examining agents proposed to count stays of under 24 hours by flight attendants as two, and possibly three days ignoring Tax Court precedent that would ignore de minimis short-term stays. Note: This American Airlines case presents interesting procedural issues re: the ability to litigate payroll tax cases in the U.S. Tax Court where there is a dispute about the application of Section 530, even if the IRS has not issued a Notice of Determination of Worker Classification. 62

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Impatriate Withholding Issues Income tax treaties (in place with nearly 60 countries) also provide a general exemption from U.S. income taxes for amounts received by nonresident aliens who travel to the U.S. for study, research, or business or technical training (which is precisely why many B-1 visa-holders travel to the U.S.). However, these treaty exemptions do not apply to persons actually working in the U.S. (e.g., employees traveling on L-1, TN, or H-1B visas). Note: Some IRS agents examine even employees on B-1 visas, attempting to prove that the visas were obtained in error, and that the employees are ineligible for treaty protections. 63

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Impatriate Withholding Issues For these NRA workers, whose income and period of stay likely exceeds the Code 861 exclusion limits, many employers arrange to pay their U.S. taxes (even though the foreign entity pays their wages), typically depositing the taxes on a quarterly basis, and then following through with tax return preparation. However, in some audits, the IRS has alleged that the U.S. employers payments of taxes are late-deposited, thus triggering FTD penalties under Code 6656 (even though the U.S. employer never in fact paid the wages). This issue is pending in several appeals. 64

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Impatriate Withholding Issues FICA/FUTA taxes also apply (since the exception discussed below) for work performed for non-American employers applied only to work performed outside the U.S. Unfortunately for many of these NRA workers, they may never qualify for social security or unemployment benefits, but the IRS ignores the basic unfairness of imposing these social taxes, where no benefits will be received. On the other, some workers (e.g., the flight attendants in the American Airlines case) may qualify for lifetime post- retirement benefits, after paying minimal FICA, but there again the IRS attorneys have indicated that receipt or nonreceipt of social security or unemployment benefits is irrelevant to us. 65

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Impatriate Withholding Issues FICA taxes are imposed on all remuneration for employment . Code 3121(b) defines employment to include: Any service performed within the United States (irrespective of the citizenship or residence of the worker or the service recipient); and Any service, of whatever nature, performed outside the United States by a citizen or resident of the United States as an employee for an American employer. Code 3121(h) defines American employer to include a corporation organized under the laws of the United States or of any State. Where NRA employees work outside the U.S. for CFCs corporations organized under the laws of foreign countries FICA taxes are not applicable if the CFCs are not American employers. 66

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Impatriate Withholding Issues This exception for non-American employers does not apply to any work performed in the U.S. However, some wages earned in the U.S. qualify for the totalization tax treaty exemption from FICA (applicable where (and only if) certificates of coverage are obtained). For employees whose wages are not exempt under 861 or a treaty, many employers do withhold FITW (and FICA, if applicable),for foreign employees working in the U.S. who are paid by the U.S. affiliate during their stay. Unfortunately, the IRS is challenging both the payment and the nonpayment of payroll taxes for these impatriate employees. 67

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Impatriate Withholding Issues For employers who have withheld and deposited FICA (as well as other payroll taxes), as noted above, the IRS has alleged that the FICA-taxes are late-deposited, and has proposed FTD penalties. This penalty is hard to justify, since the U.S. employer in many instances did not pay the wages in the first instance, and no FTD penalties can be applied to an employer that has not withheld (and, as a practical matter, has not even paid the wages). This issue is also still pending in several IRS appeals. 68

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Impatriate Withholding Issues For employees whose wages likely exempt under 861 or a treaty, where no payroll taxes are paid, the IRS has announced in several audits that it intends to audit the foreign affiliate, even though: the U.S. has no jurisdiction over the foreign employer; the U.S. affiliate cannot be held liable for underwithheld taxes, except for certain government contractors affected by Code 3121(z); and It is very hard to obtain the information, given strict procedures for seeking and obtaining foreign records, and limitations on information exchanges (on top of IRS budget limitations on traveling to the foreign countries). 69

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Impatriate Withholding Issues It is possible, in opening audits of these foreign affiliates of U.S. employers, that the IRS is only trying to collect unpaid employment taxes (for workers with compensation not exempt under Code 861 or a treaty). It is also possible that the IRS is trying to determine visa violations, which it could report to US immigration authorities. Finally, it is possible that the IRS is trying to prove that the foreign affiliates have created a permanent establishment in the U.S. The IRSs motives are not as yet very clear, since most of these foreign affiliate audits are in early stages. 70

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Impatriate Withholding Issues Additional problems arise when NRA employees (or green card holders) move back overseas and exercise option or receive other equity compensation (e.g., RSUs), since at least FICA withholding, and possibly also income tax withholding, applies to that compensation attributable to U.S. services, irrespective of the fact that the employees are working for non- American employers at the point the compensation is ultimately received. 71

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Impatriate Withholding Issues In sourcing income from options and other equity compensation, the U.S. generally applies the grant-to-vest method. See Treas. Reg. 1.861-4(b)-(d). However, this is not the exclusive method, as source-of- income allocation must turn on the specific facts and circumstances of the particular case. An alternative to the grant-to-vest method allocates income based upon the taxpayers residence during the period of significant appreciation in the underlying stock. Many agents also make mistakes in their computations, counting income from equity grants after leaving the U.S. 72

Morgan, Lewis & Bockius LLP Common Audit Issues for Cross-Border Workers: Impatriate Withholding Issues Since the IRS has never issued adequate guidance supporting the application of U.S. payroll taxes to non- citizens employees who have moved back overseas, the principles outlined in the Confusion Doctrine bar the IRS from imposing FICA taxes on employers. See Central Illinois Public Service Co. v. U.S., 435 U.S. 21 (1978) (waiving liability for payroll taxes, where the IRS has never issued guidance or outlined clear rules governing the computation and collecting of payroll taxes). 73

Morgan, Lewis & Bockius LLP Best Practices to Avoid Impatriate Withholding Issues? What forms should be completed by employee (e.g., Forms W-2, collection of Certificates of Coverage (if applicable) under foreign social security system, and Forms 4669?? What questions should be resolved in written assignment letters? Are secondment agreements advisable? Note: in OECD commentary issued in 2012, the OECD has made clearer that the adoption of secondment agreements which allow multinationals to put personnel in countries without separating them from their formal employers (typically with with cost-plus charges to the local affiliate) can minimize the PE risk. What are the does and donts of entering into secondment agreements? 74

Morgan, Lewis & Bockius LLP 75 WAGE RECHARACTERIZATION AUDITS

Morgan, Lewis & Bockius LLP Wage Recharacterization Audits: Choices between Cash and Code 132(d) Benefits Background: Many financial institutions over recent years have cooperated with requests from their senior financial advisors and certain executives to allow the employees to establish reimbursement accounts, funded in part by the employees agreement to forgo certain amounts typically percentages of future compensation. Typically these reimbursement plans are established before the employee has any right to any specific amount of future compensation. Other industries employing high percentages of traveling workers have similar trade-offs between travel expenses and taxable wages. The IRS is now challenging these wage recharacterization plans in dozens of audits particularly in the travel nursing industry. 76

Morgan, Lewis & Bockius LLP Wage Recharacterization Audits: Choices between Cash and Code 132(d) Benefits Code 132(a) provides that gross income shall not include any fringe benefit that qualifies as a working condition fringe, defined as any property or services provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowable as a deduction under Code 162. Cash payments to an employee can also qualify as a working condition fringe benefit, per Treas. Reg. 1.132- 5(a)(1)(v). 77

Morgan, Lewis & Bockius LLP Despite this general exclusion for working condition fringes, there are limitations on structuring choices between fringe benefits and cash, on establishing expense arrangements that are funded out of future employee earnings, and on paying travel expenses which appear to be substituted for taxable wages. However, the IRSs prohibition of employee choices between cash or Code 132 benefits (including working condition fringe benefits) is very confusingly drafted. 78 Wage Recharacterization Audits: Choices between Cash and Code 132(d) Benefits

Morgan, Lewis & Bockius LLP Wage Recharacterization Audits: Choices between Cash and Code 132(d) Benefits Specifically, Treas. Reg. 1.132-5(a)(1)(i) provides as follows: A service or property offered by an employer in connection with a flexible spending account is not excludable from gross income as a working condition fringe. For purposes of the preceding sentence, a flexible spending account is an agreement (whether or not written) entered into between an employer and employee that makes available to the employee over a time period a certain level of unspecified non-cash benefits with a predetermined cash value. No IRS guidance explains or illustrates this rule. Even the 2012 ruling (discussed below) does not cite it. 79

Morgan, Lewis & Bockius LLP Wage Recharacterization Audits: Choices between Cash and Code 132(d) Benefits In addition, the proposed regulations under Code 125 (re-proposed in August 2007) specifically provide that Code 125 is the exclusive means by which an employer can offer employees an election between taxable and nontaxable benefits without the election itself resulting in inclusion in gross income by the employees. See Prop. Reg. 1.125-1(b). If a plan does not meet the requirements of the proposed regulations, the employee will be taxed on the value of the taxable benefit regardless of what benefit is elected and when the election is made. Id. 80

Morgan, Lewis & Bockius LLP Wage Recharacterization Audits: Choices between Cash and Code 132(d) Benefits The proposed regulations prohibit offering fringe benefits in Code 132, including working condition fringe benefits, through a Code 125 cafeteria plan. See Prop. Reg. 1.125- 1(q). The scheduled effective date for these proposed regulations was plan years beginning on or after January 1, 2009. See Prop. Reg. 1.125-1(s). The IRS has never finalized these proposed regulations. Until proposed regulations are formally adopted, they carry no more weight than a position advanced on brief by the IRS. See F. W. Woolworth Co. v. Commr, 54 T.C. 1233, 1265-66 (1970). 81

Morgan, Lewis & Bockius LLP Wage Recharacterization Audits: Choices between Cash and Code 132(d) Benefits The IRS has changed its position numerous times over the last 20 years as to when and whether expense accounts might be effectively arranged for by agreement to reduce future bonuses. See P.L.R. 9325023 (elective commission reduction to place specified amounts in a reimbursement account not an accountable plan); In both P.L.R. 9822044 and in an unpublished 1998 field service advice, F.S.A. 002985, issued to the IRS district director in connection with an audit of a travel-licensed clinician staffing company, the IRS concluded that a mandatory nonelective reduction of pay and establishment of a reimbursement arrangement satisfied the accountable plan and Code 132(d) rules. 82

Morgan, Lewis & Bockius LLP Wage Recharacterization Audits: Choices between Cash and Code 132(d) Benefits In P.L.R. 199916011, the IRS ruled that an elective salary reduction arrangement to set up an expense reimbursement plan satisfied the accountable plan rules, but then nine months later, in P.L.R. 200035012, the IRS announced that it was reconsidering that conclusion. The reconsideration did not extend to nonelective arrangements. No P.L.R. has ever been issued on agreements to reduce compensation before it is earned, and to receive specified noncash fringe benefits and expense reimbursements. 83

Morgan, Lewis & Bockius LLP Wage Recharacterization Audits: Choices between Cash and Code 132(d) Benefits Taxpayers have won two cases in which the facts showed that local employees (who did not receive per diems and travel expenses) were paid higher wages than traveling employees, who were reimbursed for expenses. Trucks, Inc. v. U.S., 234 F.3d 1340 (11 th Cir. 2000), reversing and remanding 987 F. Supp 1474 (N.D. Ga. 1997). Worldwide Labor Support of Mississippi, Inc. v. U.S. 312 F.3d 712 (5 th Cir. 2002), vacating and remanding 2001-1 U.S.T.C. 50,463. 84

Morgan, Lewis & Bockius LLP Wage Recharacterization Audits: Choices between Cash and Code 132(d) Benefits At a 2007 meeting of the Fringe Benefit Tax Section of the American Bar Association, IRS attorneys present conceded that there were practical difficulties with enforcing an absolute prohibition on wage recharacterization; they also admitted that if an arrangement was properly structured, it would be unlikely to be challenged by the IRS on audit. In 2008, some Treasury Department attorneys admitted that the proposed cafeteria plan regulations are overbroad and should be revised so as not to attempt to block all choices made by employees among different types of benefits. 85

Morgan, Lewis & Bockius LLP Wage Recharacterization Audits: Choices between Cash and Code 132(d) Benefits In a significant recent reversal of its prior reluctance to challenge wage recharacterization, on September 10, 2012, the IRS issued Rev. Rul. 2012-25, providing various examples of prohibited wage recharacterization most in the context of per diem travel expense reimbursement plans. Three examples in Rev. Rul. 2012-25 (for cable installers, travel nurses, and construction workers) conclude that plans provide all taxable benefits, where employees taxable wages have been reduced to accommodate tax-free allowances for travel and job- related expenses. 86

Morgan, Lewis & Bockius LLP Wage Recharacterization Audits: Choices between Cash and Code 132(d) Benefits One example in Rev. Rul. 2012-25 allows prospective wage reductions for all employees in a housecleaner workforce, coupled with a reimbursement plan for workers documented expenses. Rev. Rul. 2012-25 does not address the prospective establishment of different amounts of salary reduction (and different sizes of reimbursement accounts) for different employees, nor does to address how frequently a reimbursement arrangement might be modified. It is unclear whether the IRS will use this 2012 revenue ruling to challenge choices by financial industry employees between wages and working condition fringes. 87

Morgan, Lewis & Bockius LLP Wage Recharacterization Dos and Donts Advisable Protections for Establishment of Any Salary-Choice Reimbursement Plans: Require determination of expense reimbursement budget well before the employees right to the compensation has ripened, and while the amount to be received is still speculative. The compensation reduction should be some percentage of as yet unaccrued, undetermined future compensation, so that the account is not funded with a pre-determined amount in violation of Treas. Reg. 1.132-5(a)(1)(i). The accounts should cover pre-specified types of reimbursable business expensesagain to avoid any violation of Treas. Reg. 1.132-5(a)(1)(i) (which prohibits the establishment of accounts to pay fixed amounts of unspecified noncash benefits). 88

Morgan, Lewis & Bockius LLP Wage Recharacterization Dos and Donts The give up of compensation should occur at specific times preferably before the year in which the future compensation will be earned. The assigning employee must forfeit all rights to the assigned compensationabsolutely no reversion of unspent amounts. The employer should have discretion to make the final determination of the reimbursement amounts. Consider obtaining opinion of outside counsel confirming the arrangements compliance with tax rules. 89

Morgan, Lewis & Bockius LLP Wage Recharacterization Dos and Donts Arguments Supporting Legitimacy of Such Assignments: No violation of the regulations under Code 132(d) or 62(c). They comply with the Lucas v. Earl prohibition (also discussed below) on assignments of ripened rights to income. No constructive receipt of any compensation under Treas. Reg. 1.451-1 and -2; Rev. Rul. 60-31, because the assigning employee never had any immediate or current right to any specific amount. See Trucks, Inc. and Worldwide Labor Support (cited above. 90

Morgan, Lewis & Bockius LLP Wage Recharacterization Dos and Donts Steps Not to Take in Designing an Expense Reimbursement Plan. Dont pay tax-free reimbursements for any expenses that are already covered under a per diem arrangement or to persons receiving tax free lodging in kind. Dont offer cash options. Dont allow pay per diem allowances, regardless of whether or not the worker travels away from home on the employers business. Dont pay expenses on non-travel days. Dont pay amounts exceeding Federal per diem rates. Dont pay per diems on an hourly basis (or otherwise on the same basis as other wages). 91

Morgan, Lewis & Bockius LLP STATE AND LOCAL TAX DEVELOPMENTS FOR MOBILE WORKFORCE EMPLOYERS 92

Morgan, Lewis & Bockius LLP Topics Covered I.Current State Rules II.Mobile Workforce State Income Tax Simplification Act III.Voluntary Compliance Programs IV.NY MTA Payroll Tax Refund Claims V.Federal Protections 93

Morgan, Lewis & Bockius LLP I.Current State Rules: State Taxation of Workers in Multiple States & Employer Withholding Obligations Companies with peripatetic workforcesemployees and contractors working in, and moving among, many different states, either in a single year or over the course of the vesting period for bonuses, stock options, restricted stock, or other equity compensationhave special problems due to myriad state laws governing the taxation of residents and non-residents. 94

Morgan, Lewis & Bockius LLP State Taxation of Workers in Multiple States: Impediments/Opposition Form W-2 includes spaces in Boxes 15-20 at the bottom of the Form for reporting income to two different states (separated by a broken line). The IRS instructions to Form W-2 say, If you need to report information for more than two states or localities, prepare a second Form W-2. Payroll systems may not accommodate (or capture) multiple work locations. But employees almost invariably complain if employers report wages in more than one state. 95

Morgan, Lewis & Bockius LLP State Taxation of Workers in Multiple States: Employer Withholding The employer nexus to trigger withholding, for most states is: Employer office in state, or some other nexus to trigger state income tax; and Payments of any wages subject to income tax in the state (or subject to contribution under the states unemployment compensation laws). 96

Morgan, Lewis & Bockius LLP State Taxation of Workers in Multiple States: Employer Withholding Some states provide thresholds before withholding is triggered, based on days worked, dollars earned, or some combination of the two. (See map on following slide.) Examples: NY reasonable expectation that employee will work 14 days or less in NY GA 23 days a quarter, or GA-allocated wages exceeding 5% of total compensation CT 14 working days a year ND 20 working days a year 97

Morgan, Lewis & Bockius LLP Overview of Thresholds 98 WA ID AZ NM LA AL ME HI CT MA AK AR CO MD CA KS FL GA IA IL MI MN MO MT NC SC VA WV WY OK NY PA OR ND NV NH OH RI VT NJ TX UT SD NE MS TN KY IN WI DE Nonresident employees subject to tax withholding on first day of travel Nonresident employees subject to tax withholding after reaching threshold No general personal income tax (or, in the case of Washington, DC, no tax on nonresidents)

Morgan, Lewis & Bockius LLP State Taxation of Workers in Multiple States: Risks of Employer Audits As with any payroll audits, it is simpler for state/local tax officials to audit employers, holding them liable for nonwithheld income taxes where allocated wages exceed the states personal exemption, because that is more efficient than finding and auditing individual employees. If employers have neither reported nor withheld on the income, it is extremely unlikely that any non-resident of a state would have voluntarily paid income taxes (thereby enabling the employers to abate their liability for nonwithheld income taxes). 99

Morgan, Lewis & Bockius LLP State Taxation of Workers in Multiple States: Risks of Employer Audits However, it is nearly impossible for employers to keep track of day-counting income allocation rules (or with 183+ days residency tests). Some states have poorly explained rules on income allocations. Historically, many states were not aggressive in auditing non-residents or conducting payroll audits. Some states (e.g., NY) have been operating amnesty programs or Voluntary Disclosure Agreements to encourage employers to voluntarily confess their withholding/reporting errors. 100

Morgan, Lewis & Bockius LLP State Taxation of Workers in Multiple States: Some NY Horror Stories Part-Day Counting: Any portion of a day in NY can trigger allocation of income to NY. See Matter of Holt, DTA No. 821018 (2007) (petitioner [a Florida resident] finds it incredible that an individual's presence in New York for a portion of a day constitutes a day for New York tax purposes). No Minimum Number of Days: Many states have some minimum number of days of work in a particular state before state income-allocation rules apply. NY does not. 101

Morgan, Lewis & Bockius LLP State Taxation of Workers in Multiple States: Some NY Horror Stories Meeting Burden of Proof to Show Non-Resident Status: In In the Matter of Julian H. and Josephine Robertson, NY DTA 822004 (2009 and 2010), NY auditors had maintained that a couple had been in NY for 183 days and that the taxpayers records showing time outside NY were inadequate for 4 days, and thus the taxpayers, as NY residents for more than 183 days, would owe additional NY City taxes totaling $26,702,341 for 2000. After an extensive trial, in a 100+ page opinion, the judge believed the taxpayers testimony; after an exception was filed, the case was argued again, another opinion was issued, and the taxpayers won again. But see Puccio, NY DTA 822476 (2011). 102

Morgan, Lewis & Bockius LLP State Taxation of Workers in Multiple States: Some NY Horror Stories Convenience of Employer Rule: NY counts even services performed by any NY non-resident at the taxpayer's out-of-state home that could have been undertaken at the employer's office in NY, unless the services were performed out of state for the employers necessity, not the employee's convenience. (20 NYCRR section 132.18(a). See, e.g., Matter of Phillips v. New York State Department of Taxation and Finance, 267 AD2d 927, 700 NYS2d 566, lv denied, 94 NY2d 763, 708 NYS2d 52, Matter of Page v. State Tax Commission, 46 AD2d 341, 362 NYS2d 599; Matter of Simms v. Procaccino, 47 AD2d 149, 365 NYS2d 73), Matter of Zelinsky v. Tax Appeals Tribunal of State of New York, 1 NY3d 85, 769 NYS2d 464, cert denied 541 US 1009, 158 L Ed 2d 619), In the Matter of the Petition of Manohar and Asha Kakar, DTA No. 820440 (Feb. 16, 2006), and Matter of Huckaby v. New York State Division of Tax Appeals, 4 NY3d 427, 796 NYS2d 312, cert denied 546 US 976, 126 S Ct 546, 163 L Ed 2d 459). 103

Morgan, Lewis & Bockius LLP State Taxation of Workers in Multiple States: Some NY Horror Stories See Edward A. Zelinsky, New Yorks Convenience of the Employer Rule Is Unconstitutional, State Tax Notes Doc. 2008-9044 (New Yorks convenience of the employer doctrine has not fared well in the court of professional opinion.). These harsh results are one of the drivers behind efforts to enact federal blockers on states abilities to tax non- residents. (See discussion below.) 104

Morgan, Lewis & Bockius LLP State Taxation of Employers Due to Telecommuting Employees Telebright New Jersey Appellate Division found company subject to income tax based solely on presence of one telecommuting computer programmer. Company did not care where employee worked. Employee was originally based outside NJ, but asked to continue employment after moving there. No solicitation/marketing activities in NJ. Employees daily presence in NJ for the purpose of carrying out her responsibilities as an employee was sufficient to satisfy the substantial nexus requirement of the Commerce Clause. See Warwick McKinley, Inc., Cal. SBE 489090. 105

Morgan, Lewis & Bockius LLP State Taxation of Workers in Multiple States: Stock Option/SAR Allocation Methods The state rules governing the taxation of stock options (or SARs) and the income allocation withholding rules for option income received by non- residents vary greatly depending on the state (and some states have never adopted any option-sourcing rules): Grant-to-Vest Method: Taxes option exercise income based on the percentage of time in the state between the date of grant and the date the options vest; Grant-to-Exercise Method: Taxes option exercise income based on the percentage of time between the date of grant and the date the options are exercised; Year-of-Exercise Method: Option spread from exercise is taxable only if services were performed during the year of exercise and not over a multiyear period; Degree of Appreciation Method: Allocates the income based on the amount of appreciation of the underlying option that occurred while the taxpayer was a resident of the state. The variance between the states, and from year to year within certain states, clearly suggests there is no set rule, and the most appropriate method is to allocate the income based on a reasonable facts and circumstances analysis. 106

Morgan, Lewis & Bockius LLP II. Mobile Workforce State Income Tax Simplification Act (aka Marketplace Fairness Act) This bill would address the taxation of non-resident employees (excluding professional athletes, professional entertainers, and some public figures) and would set a threshold of days below which a state could not subject the non-resident to state income tax. H.R. 1864 passed the U.S. House of Representatives on May 15, 2012. H.R. 1129, containing language identical to H.R. 1864, was reintroduced to the House and referred to the House Committee on the Judiciary on March 13, 2013. Its lead sponsors are Reps. Howard Coble (R-NC) and Hank Johnson (D-GA), plus 28 more House cosponsors. S. 1645, the corresponding Senate bill, was introduced in November 2013, by an impressive list of bipartisan original cosponsors, including Senators Sherrod Brown (D-OH) and John Thune (R-SD) (both on Senate Finance). For information about the 254-member coalition of supporters, contact Maureen Riehl at [email protected]. [email protected] 107

Morgan, Lewis & Bockius LLP Mobile Workforce State Income Tax Simplification Act Establishes a 30-day threshold that non-residents would have to work in a state before becoming subject to out- of-state taxes Strong state opposition The initial bills had proposed a 60-day threshold, but because of state clamor a compromise was reached between employers and states, and in the most recent version of the bill a 30-day threshold was proposed. 108

Morgan, Lewis & Bockius LLP Mobile Workforce State Income Tax Simplification Act A day is attributed to the state where an employee performs more of his employment duties compared to another state, UNLESS, the employee performs employment duties in a resident state and ONLY one non-resident state during one day. In this case the employee will be considered to have performed more of the duties in the non-resident state. Incentive to visit two states in a travel day Recordkeeping issues Unclear whether it simplifies anything 109

Morgan, Lewis & Bockius LLP Mobile Workforce State Income Tax Simplification Act In testimony before the House Committee on the Judiciary on May 25, 2011, the President of the Federation of Tax Administrators (FTA) opposed H.R. 1864, arguing that: The 30-day rule should count work for any part of a day A dollar threshold should be added so that highly paid employees might be subjected to withholding for less than 30 days of work Stock options and multiyear compensation should be exempted The House Committee on the Judiciary approved H.R. 1864 on November 17, 2011 after rejecting changes proposed by Rep. Nadler (NY), but recognizing that changes may be required to respond to the FTAs concerns. 110

Morgan, Lewis & Bockius LLP MTC Model Statute The Multistate Tax Commission (MTC) has proposed a mobile workforce withholding and individual income tax model statute that would decrease the threshold to 20 days. The MTCs model statute provides that MOST non-residents income from work performed in states of non-residence would be exempt from withholding if the non-residents: have no income derived from the non-resident states; worked fewer than 20 days in such states (days in transit would be exempt from the day count); and reside in states that have reciprocal exemptions or do not impose personal income taxes. 111

Morgan, Lewis & Bockius LLP MTC Model Statute Certain workers would be excluded from the withholding protections provided by the MTCs model statute: professional athletes; persons of prominence who perform services on a per- event basis; professional entertainers; construction laborers; and key employees. 112

Morgan, Lewis & Bockius LLP MTC Model Statute Under the MTCs model statute, qualifying employees would not have a filing requirement in the state of nonresidence; and employers would not have a withholding requirement regarding qualifying employees. However, the model act does not explicitly address nexus issues for employers with no nexus to the state. Also, states with income thresholds instead of day-counting thresholds (e.g., Montana) have criticized the MTC's model statute and its days of working presence test for creating problems for states that have an income threshold for taxability. They also note that high-earner non-residents working less than 20 days would be exempt from filing returns, while lower-paid non-residents working more than 20 days in a state would have to file. 113

Morgan, Lewis & Bockius LLP Telecommuter Tax Fairness Act First introduced in 2004, and most recently introduced in November 2011 (S. 1811, 112th Cong.) Would bar states from adopting a convenience of the employer rule, and require that an employee be physically present in the state as a precondition to imposition of tax on that worker. 114

Morgan, Lewis & Bockius LLP III. Voluntary Compliance Opportunities As noted previously, many states have voluntary disclosure agreements and/or temporary amnesty programs. Processes and requirements are not consistent. Limitation of look-back period and penalty relief New York has a streamlined program. California has both a voluntary compliance program and a filing compliance agreement program. Other states 115

Morgan, Lewis & Bockius LLP Voluntary Compliance Opportunities Given the heightened focus on audits and unreasonableness of the one-day rule in certain states, we are seeing many clients take advantage of these programs Typically anonymous Formal agreement Correction programs have worked for executive groups and have eliminated the need to file individual returns. 116

Morgan, Lewis & Bockius LLP IV. NY MTA Payroll Tax Refund Claims Employers in New York City and several surrounding counties have paid a 0.34% payroll tax since 2009 on the wages and certain other compensation paid to employees employed within this Metropolitan Commuter Transportation District. Although several prior challenges to the legality of this MTA Payroll Tax had failed, on August 22, 2012, the 10 TH District of the NY State Supreme Court struck down this mobility tax, on grounds that it had been enacted without first obtaining the constitutionally required prior approval of local legislative bodies (a home rule message), or, alternatively, approval under a message of necessity by 2/3 of each NY legislative house. 117

Morgan, Lewis & Bockius LLP NY MTA Payroll Tax Refund Claims Although this ruling in Mangano, et al. v. Silver, et al., N.Y. S. Ct., No. 14444/10, is being appealed, any employers that have been paying this payroll tax may file protective refund claims. On October 17, 2012, the New York State Department of Taxation and Finance published guidance regarding the procedures for taxpayers to file these refund claims. See http://www.tax.ny.gov/bus/mctmt/mctmt_legal proceedings.htmhttp://www.tax.ny.gov/bus/mctmt/mctmt_legal proceedings.htm and the claim form, at https://www8.tax.ny.gov/MCPC/mcpcStarthttps://www8.tax.ny.gov/MCPC/mcpcStart Some employers estimate that their refunds could exceed $1 million. 118

Morgan, Lewis & Bockius LLP V.Federal Protections: Federal Blocker of State Taxation of Certain Retirement Income of Former State Residents Since 1996, 4. U.S.C. 114 has prohibited states from imposing an income tax on qualified retirement plan income and certain other types of non-qualified deferred compensation benefits paid to any individual who had earned the income while working in one state (either as a resident, domiciliary, or part-time worker) but had retired and moved out of the source state before the income was paid. 119

Morgan, Lewis & Bockius LLP Federal Blocker of State Taxation of Certain Retirement Income of Former State Residents These rules were lobbied into the interstate commerce section of the Federal Code in 1996 by RESIST (Retirees Eliminating State Income Source Taxation), the American Payroll Association, and other affected mobile workforce employees. The rules were later extended to certain retired partners (as described in Code 7701(a)(2)) who have retired under their partnership agreements. 120

Morgan, Lewis & Bockius LLP Federal Blocker of State Taxation of Certain Retirement Income of Former State Residents There will never be federal regulations because no federal agency would undertake such a project. There are some states that have issued regulatory guidance, and some that have issued private rulings on the rules application. 121

Morgan, Lewis & Bockius LLP Federal Blocker of State Taxation of Certain Retirement Income of Former State Residents The definition of retirement income that cannot be taxed when earned by non-residents generally includes the following items: Qualified retirement plans; Excess benefit plans or wrap-around plans; and Certain other forms of nonqualified deferred compensation described in Code 3121(v)(2) paid out in equal periodic installments over at least a 10-year period or for a recipients life or life expectancy. 122

Morgan, Lewis & Bockius LLP Federal Blocker of State Taxation of Certain Retirement Income of Former State Residents The excepted payments from Qualified Retirement Plans include: 401(k) plans; 408(k) simplified employee pensions; 403(a) annuity plans; 403(b) annuity contracts; 7701(a)(37) individual retirement accounts; 457(a) eligible deferred compensation plans; 414(d) governmental plans; Military retired or retainer pay plans; and 501(c)(18) employee contribution trusts. 123

Morgan, Lewis & Bockius LLP Federal Blocker of State Taxation of Certain Retirement Income of Former State Residents Excess benefit plans or wrap-around plans are defined as: Plans solely for the purpose of providing retirement benefits for employees in excess of the limitations imposed by one or more of Sections 401(a)(17), 401(k), 401(m), 402(g), 403(b), 408(k), or 415 of such Code or any other limitation on contributions or benefits in such Code on plans to which any of such sections apply. The description of these plans in the legislative history references a statute before it was amended in conference, which confuses interpretation of this provision. 124

Morgan, Lewis & Bockius LLP Federal Blocker of State Taxation of Certain Retirement Income of Former State Residents The final exception encompasses other forms of nonqualified deferred compensation described in Code 3121(v)(2) paid out in equal periodic installments over at least a 10-year period or for the recipients life or life expectancy. Directors and independent contractors are not eligible for this exception because SECA taxes have no corollary to 3121(v)(2). We are waiting to see if a petition is filed, or a settlement offer is proposed. Retired partners have special statutory protections added to the Federal statute in 1996. 125

Morgan, Lewis & Bockius LLP Federal Blocker of State Taxation of Certain Retirement Income of Former State Residents Presumably the determination of whether distributions meet the substantially equal periodic payment rule would be determined by Reg. 1.402(c)2, Q&Q 5(a) (providing that the determination is made at the annuity starting date, and is not affected by subsequent contingencies and modifications, such as death of a participant) and Q&A 5(d) (specifying that distributions over ten years can be paid under a declining balance of years method, which pays 1/10 in year 1, 1/9 of the remainder in year 2, etc.). 126

Morgan, Lewis & Bockius LLP Federal Blocker of State Taxation of Certain Retirement Income of Former State Residents The Code 3121(v)(2) regulations expressly exempt stock options, stock appreciation rights, restricted stock, severance, sick leave, compensatory time, and vacation pay. Stock options, SARs, and restricted stock could not be paid out over 10 years or as an annuity in any event. Code 409A has significantly limited application of this exception by barring most changes in deferred compensation distribution schedules. 127

Morgan, Lewis & Bockius LLP Federal Blocker of State Taxation of Certain Retirement Income of Former State Residents Since Code 3121(v)(2) applies only to common law employees, it is not clear whether this provision applies to corporate directors or other non-employees (excepting certain retired partners who are covered by a later statutory expansion of this federal source tax legislation). 128

Morgan, Lewis & Bockius LLP Additional Specialized Federal Blockers of State Taxation of Transient Non-Resident Workers Congress has enacted several industry-specific laws that fully or partially block states from mandating withholding on wages of certain non-resident employees of certain types of employers: Railroads 49 USC 11502 (4-R Act); Airlines 49 USC 40116 (Anti-Head Tax Act); Motor Carriers 49 USC 14503; Fishing vessels, or vessels engaged in foreign, coastwise, intercoastal, interstate, or noncontiguous trade 49 USC 11108. 129

Morgan, Lewis & Bockius LLP IRS and Independent Contractors: Basic Questions Audit Who are Independent Contractors (ICs)? What are the Applicable IRS Tests? Who are the Stakeholders? Why does Employee/IC Status Matter? What are the Financial Stakes? The Tax Relief Provisions Best Practices and Methods to Reduce Exposure IRS Information Sharing with the DOL and the states (including particularly California) 130

Morgan, Lewis & Bockius LLP IRS and Independent Contractors: Audit Triggers and Audit Developments Increased requests for post-termination Form 1099 reporting (including in settlements); automatic review of all information reporting where the same worker received a Form W-2 and a Form 1099. requests for withholding on director fees (and pending legislation on this issue); and backup withholding audits (involving both alleged underwithholding, and penalties for non-filing of Information returns). 131

Morgan, Lewis & Bockius LLP IRS and Independent Contractors: Audit Triggers and Audit Developments California worker classification audits; Developments in ability to take worker classification cases to Tax Court (which historically had not had jurisdiction over payroll taxes). 132

Morgan, Lewis & Bockius LLP Employee or Independent Contractor? Common Law Employee Independent Contractor Leased Employees Joint Employment/Co-Employment Dual-Status Workers Corporate Officers and Other Statutory Employees Statutory Nonemployees Section 218 Agreement Employees 133

Morgan, Lewis & Bockius LLP Employee Misclassification: Government Stakeholders Federal and State Agencies Affected by Employee Misclassification AgencyAreas potentially affected by employee misclassification IRSFederal income and employment (payroll) taxes DOLMinimum wage, overtime, and child labor provisions Job protection and unpaid leave Safety and health protections Immigration/Form I-9 issues IRS, DOL and PBGCPension, health, and other employee benefit plans Department of Health and Human ServicesMedicare benefit payments EEOCProhibitions of employment discrimination based on factors such as race, gender, disability, or age NLRBThe right to organize and bargain collectively SSARetirement and disability coverage and payments State AgenciesUnemployment insurance benefit payments State income and employment taxes Workers compensation benefit payments 134

Morgan, Lewis & Bockius LLP Employee or Independent Contractor: The Common Law Test 135 20-Factor Test instructionsorder or sequences set integrationreports paymentsexpenses traininginvestment services rendered personallytools and materials hiring assistantsprofit or loss continuing relationshipworks for more than one person or firm set hours of workoffers services to general public full-time workright to discharge work done on premisesright to quit

Morgan, Lewis & Bockius LLP Independent Contractor Tests: IRS Three-Factor Test For audit purposes, IRS auditors use a modified version of the 20-Factor Test that focuses on three factors: Behavioral Control Factors Financial Control Factors Relationship of the Parties Factors IRS Three-Factor Test considers the work that is being performed and the business context in which it is being performed 136

Morgan, Lewis & Bockius LLP Why Does It Matter? Benefits and Business Expenses Differences Among Benefits Responsibilities Type of BenefitsEmployeesIndependent Contractors Retirement plansEmployers sponsor benefit plans Employers and employees contribute Contractors sponsor plans Contractors bear the full financial cost of the plans HealthcareEmployers sponsor on a tax- free basis Employers and employees contribute Contractors obtain coverage Contractors bear the full financial cost, but receive a tax deduction Reimbursed expenses/ accountable plans Employers can reimburse expenses Nontaxable to the extent they are paid under an accountable plan Service recipient can reimburse, although expenses are generally unreimbursed Reimbursed expenses are nontaxable if they are under an accountable plan Unreimbursed expensesMany employers dont fully reimburse expenses Unreimbursed expenses are subject to a 2% floor and AMT Businesses dont generally reimburse expenses Not subject to a 2% floor or AMT 137

Morgan, Lewis & Bockius LLP Why Does It Matter? Payroll Taxes Differences Among General Tax Responsibilities EmployeesIndependent Contractors Type of Tax Businesses' general responsibilities Workers' general responsibilities Businesses' general responsibilities Workers' general responsibilities Federal income Tax Withholding (FITW) Withhold tax from employees' pay Pay full amounts owed, generally through withholding Generally, nonePay full amounts owed, generally through estimated tax payments Social Security and Medicare Taxes (FICA) Withhold one-half of taxes from employees' pay and pay other half Pay half of total amounts owed, generally through withholding NonePay full amounts owed, generally through estimated tax payments Federal Unemployment Taxes (FUTA) Pay full amountNone State Unemployment Taxes (SUTA/SUI) Pay full amount, except in certain states None, except pay partial amount in certain states None 138

Morgan, Lewis & Bockius LLP Why Does It Matter? Payroll Taxes and the Tax Gap 139 $5 billion associated with FICA/FUTA $51 billion-$56 billion associated with SECA Other estimates place the annual Employment Tax Gap at $15 billion (IRS, in introduction of NRP program), $54 billion (Treasury study issued 9/26/06), or up to $78 billion. (Billions)

Morgan, Lewis & Bockius LLP Why Does It Matter? Payroll Taxes Full-rate Federal statutory liability equal to at least 40% of compensation payments to independent contractors 25% FITW exposure 15.3% Employer and Employee FICA (Social Security and Medicare)* Social Security Taxable Wage Base ($110,100 for 2012) Interest-free adjustments and rarely impose penalties Full-rate state liability varies by state, by UI experience rates and taxable wage bases. In California, the following rates apply: Unemployment Insurance (UI)rate varies and is imposed on first $7,000 of wages Personal Income Tax Withholding (PIT)6.0% on all wages, but is generally eliminated if the company has issued Forms 1099 to the ICs Supplemental Disability Insurance (SDI)1.0% on approximately first $95,000 of wages Impose interest and penalties * The rate varies due to the 2011 and 2012 payroll tax holiday that reduced employee Social Security taxes from 6.2% to 4.2% 140

Morgan, Lewis & Bockius LLP IRS Payroll Tax Audits: Example of Tax Exposure and Tax Relief The annual full rate tax exposure for 60 misclassified independent contractors averaging $50,000 is approximately $1,500,000. $1,167,000 for federal taxes (FITW, FICA and FUTA) $332,000 for California EDD tax liabilities (PIT, SUI, SDI, interest and penalties), but reduced to $125,000 if Forms 1099 issued to ICs Relief provisions can reduce the four year full-rate exposure of approximately $5 million as follows: One-Year Total Four-Year Relief Provision Exposure Exposure No Relief 1,167,000 4,668,000 Statutory relief 320,400 1,281,600 100% CSP Offer 320,400 320,400 25% CSP Offer 80,100 80,100 VCSP Offer 32,000 32,000 Section 530 Off-Code Relief 0 0 141

Morgan, Lewis & Bockius LLP Federal Payroll Tax Relief Significant Statutory and Administrative Payroll Tax Relief Exists: 1.Section 530 Relief 2.Section 3509 Relief 3.Classification Settlement Program Relief 4.Voluntary Classification Settlement Program Relief (best settlement rates, but shifting standards) 142

Morgan, Lewis & Bockius LLP Federal Payroll Tax Relief: Section 530 Relief Reduces the employers federal employment tax exposure to zero for all past and future years Employer-only relief and only for employment taxes Can continue treatment of the workers as independent contractors for payroll tax purposes IRS bears burden of proof Three Tests Reporting Consistency Substantive Consistency Reasonable Basis (prior audit, industry practice, judicial precedent or any other reasonable basis) 143

Morgan, Lewis & Bockius LLP Federal Payroll Tax Relief: Section 3509 Relief Provides an opportunity for reduced employment tax assessments if service recipient issued Forms 1099. Section 3509 does not provide any relief regarding the employers portion of FICA taxes nor the FUTA tax. The effective Section 3509 rate is 10.68% for both FICA and FITW for the compensation paid to reclassified worker. (Note however, that due to the 2% payroll tax holiday applicable to employee-share FICA taxes in 2011 and 2012, the Section 3509 rate for these two years was 10.28%. Also, the comparative rate is slightly higher for 2013, due to the Additional Medicare Tax applicable to employees with FICA-taxable wages in excess of $200,000.) 144

Morgan, Lewis & Bockius LLP Federal Payroll Tax Relief: IRS CSP Relief The Classification Settlement Program (CSP) is available if the business previously issued Forms 1099 and agrees to prospectively reclassify the ICs as employees Only applies if the business is under an actual ongoing IRS audit The business will is assessed employment tax liability as either 25% or 100% of the Section 3509 liability for the most recent year under audit (i.e., generally ranges from 0.5% to 3% of the remuneration paid to the ICs) 145

Morgan, Lewis & Bockius LLP Federal Payroll Tax Relief: IRS VCSP Relief The Voluntary Classification Se

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