Rock Terrace School - DLA Piper Opinion

8/13/2019 Rock Terrace School - DLA Piper Opinion

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[ o L J P R

ATTACHM

MEMOR N UM

TO: Dr. Joshua Starr, Secretary/Treasurer to the Board of Education of Montgomery County

FROM: DLA Piper LLP (US)

DATE: December 9, 2013

RE: Tax Treatment of Certain Program Payments

You asked for our advice onwhether certain payments made to students at Rock Terrace Schoolby Montgomery County Public Schools ( MCPS )should be considered taxable income and/or wagessubject to Federal and State income and employment tax withholding and reporting.

Statement of Facts

We have been advised that the relevant facts are as follows.

One of the schools in the MCPSsystem, RockTerrace School in Rockville, Maryland, is a

separate public day school serving students from age 11through 21 who have a wide range of significantphysical and cognitive disabilities such as autism spectrum disorders, speech and language disorders,emotional impairment, and other health impairments. The school prepares students for independentliving, integrated employment, and participation in the community using functional learning experiences,vocational skills training, transition to independent living preparation, and a modified MCPS program ofstudies.

RockTerrace School is composed of three academic levels: the Middle School (Grades 6, 7 and8; ages 11-14); the High School (Grades 9, 10, 11 and 12; ages 15-17); and the three-year Upper SchoolTransition Program (referred to, at Rock Terrace, as grades 13, 14 and 15; typically ages 18-21). Withineach level, classes may contain students from various grades. Each student has an IndividualizedEducation Program ( IEP ). Students typically require close supervision by faculty members to protect thestudents and provide special guidance and training.

The Upper School Transition Program concentrates on teaching functional life skills with acurriculum designed to teach independent living skills, including skills related to potential employmentfollowing completion of the Transition Program. Rock Terrace offers two varieties ofwork experienceprograms: school-based programs and off-campus programs.

Over the past several years, the curriculum of these various work experience programs hasincluded a component designed to teach selected students the real-life skill of receiving and handlingmoney and to simulate the connection between work and compensation. A part of this program includedstudents receiving and handling certain limited amounts of funds provided by the school or the school



system. While the manner in which this program was implemented has changed over the years, the

program was always intended to be solely for educational purposes and the funds used in and payments

to students under the program were never intended to be, or structured as, compensation for servicesrendered by students. Any indication to the contrary would have been due only to the educational nature

of the program and the attempt to create a real-life experience for students taking into account their

cognitive disabilities and the purpose of the program.

School-based Work Experience Programs

There are three school-based work experience programs: Culinary, Office Skills and Practices,and Home Survival Skills. These programs provide prevocational training in basic culinary skills, officework, and woodworking/home living skills and include various types ofwork training experiencewithin theschool itself. Studentswork in the food service cafe and catering program (culinary), therecycling/shredding program (office skills), and woodshop program. For example,with assistance ofschool staff, they sell coffee and snacks to students and staff in the morning, help prepare schoollunches, and learn how to wash dishes as part of the culinary skills class. They learn to unpack boxes,stack paper and supplies, and use the shredder as part of the office skills class. They learn how tochange a light bulb, use a hammer, and other rudimentary household chores.

In order to teach about money, the school periodically paid selected students small amountsbased on the number of these prevocational classes taken and their level of performance/participation. Inthe earlier years of this program, the school wrote separate checks made payable to each student inthe program. To teach the student about banking, a faculty memberwould help the student open anaccount at the Montgomery County Teachers' Credit Union ( MCTCU ),which had a physical branch atthe Rock Terrace School until 2010, and make deposits of these checks into that account. Due tocomplaints by MCTCU, in later years the school wrote a single check representingthe amounts forseveral students, and that faculty memberwould then assist students in depositing amounts into separateMCTCU accounts. While all banking records are not yet available for these MCTCU accounts andtransactions, it appears that prior to 2008, these accountswere established as joint accounts naming thestudent and a faculty member as the accountholders. As a result of some incidentthat raised a concernabout liability of the faculty member named asjoint owner on the accounts, beginning in 2008, itwas nolonger the practice for faculty members to be listed as joint owners of these accounts and some facultymember nameswere taken off of existing accounts.

Sometime in 2009 or 2010, MCTCU indicated that itwould not continue the in-school bankingprogram. Thereafter, the amounts students were deemed to earn in the school-based work experienceprogramswere credited to a sub-account in the school's Independent Activity Fund ( IAF ). The IAF is anaudited account established by the school to promote the general welfare, education, and morale ofstudents aswell as to finance the recognized extracurricular activities of the student body. The school'sprincipal is the fiduciary agent of the IAF charged with determining the manner inwhich funds are raisedand expended for activities such as field trips, admission events and fundraisers.

It is unclear whether these amounts paid to the students pursuant to the program actuallybelongedto the students. It is our understanding that some of the faculty members who administered theprogram understood that the funds at all times belonged to the school and the funds were given tostudents to teach them about money. Presumably this would be no different from giving students

textbooks and other educational materials to use in the education process. This understanding of theprogram funds would be consistentwith the fact that at various times the school madewithdrawals fromthe accountswith MCTCU and from the IAF sub-account to pay for educational and school activities andstudent programs that may or may not have directly benefited or been used for activities that involved thestudent to whose accounts the funds were allocated. We also understand that other faculty membersunderstood that the funds paid to students belonged to the students, even though the amounts were not

Priorto 2008, studentswere given up to 2.00 per class period. From2008 until 2012, the amounts

were based on grades: an A = 1.00; B = 0.80; and a C = 0.70 per class. Beginning in 2012, thissystem was simplified to be 1.00 per class if the student earned a grade of 85% or better.



intended to be compensation for any services performed by the students. Prior to 2010, there were

instances where students were given any unexpended funds in their accounts upon graduation. That

practice was discontinued in 2010, however, when the amounts were credited to a sub-account in theschool's IAF.

Off-campus Work Experience Programs

There were two types of off-campuswork experiences. The first was unique to a limited numberof Rock Terrace studentswho attended class for the first and last periods of the day and, in the interim,went off-site to work for business partners such as CVS, Kohl's and Giant,where they could learn reallifework skills. The school provided all training and all on-site supervision. For example, for a hotelpartner, the student might learn to do laundry; for a supermarket partner,the student might learn how tostock shelves, unload trucks, and unpack boxes; for a retail business partner, the student might learn tofold clothes; for an office partner, the student might learn to copy and collate. Itdepended on the type ofbusiness partners available at a given time and the interests, capability, and skill level of the individualstudents. The students' activitieswere solely for training purposes, did not take the place of services thatwould otherwise be performed by regular employees, and the students' quality of work was not expectedto meet the same standards as employees. The students' services were not subject to termination by thebusiness partners, and the school maintained the sole right to control the students and the performanceof services in the context of the educational purpose of the program. There were no payments from thebusiness partners to the students in connectionwith this training, and this program did not involvepayments from the school similar to those made to students in the school-based programs to teach themabout money.2

There is a second off-campuswork experience program that is operated by the school system'sTransition Services Unit. This program is for select studentswho have successfully completed the inschool vocational programs, the off-campuswork experiences, and, consistent with the students' IEPs,skills, and abilities, are deemed to have the potential for independent, outside employment in the privatesector. These students prepare for a mockjob interview, learn to fill out job applications, and generallygo through a mock realworld job application and hiring process before they are placed in positions withbusiness partners or MCPS. The work activities are on a daily basis, and the nature of the trainingdepends on the operations of the business partner. The students' activities in this program are solely fortraining purposes, do not take the place of services that would otherwise be performed by regular

employees of the business partner or MCPS, and the students' quality of work is not expected to meet thesame standards as employees. The school system is solely responsible for supervision of thesestudents. The degree of supervision and support from school staff declines as the students become moreproficient and are able to perform their assigned tasks independently. The goal is to enable students tobe hired by that business partner or another private employer when they graduate.4

Students in this program are not employed or paid for their labor by the business partner orMCPS. However, as part of this training program, to teach the student about money and the relationship

2SYMSwas a business partner for this program and it made donations directly to the school based

generally on a formula based on the number of students and the number of hours those students worked per day/week. Information from staff estimated that SYMS donated approximately 500- 600per month and a total of 10,000 over the period inwhich itwas a business partner. These donation

amounts were not intended to be compensation paid to students and the donations were not in fact paidto the students who participated in this off-campuswork program. SYMS did not issue Forms W-2 for thestudents who participated in this program at SYMS. Although Rock Terrace had as many as ten (10) students participate in the past, more recently

approximately three (3) students per year participate in the Transition Services Program where studentsare paid through the MCPS payroll system. This work experience program operates in a number ofMCPS high schools, not just Rock Terrace.4 It is possible for a student to be hired by the employer before the student's education terminates at theend of the school year inwhich the student becomes 21 years of age. Students who are hired and paidby the private employer before their education ends continue to attend school, but on a part-time basis.



between work and pay, MCPS issues a paycheck to these students through the MCPS payroll system.

Students in this program receive 3.65 for each day worked for a business partner or MCPS; it was

intended that the students could keep these amounts. Solely for internal MCPS systems purposes, inorder to issue these checks, these students were listed in the payroll system as temporary, part-time

workers even though they did not in fact qualify as such under MCPS regular classifications. MCPS did

not withhold or pay any income or employment taxes on these amounts paid to the students in this

program. The funds used to make the payments to the students were drawn from a line item in the

school system's budget for special education. Where possible, these checks generated by the MCPSpayroll system were direct deposited into the students' individual accounts at the MCTCU or elsewhere.

Because these payments were made using the MCPS payroll system, that system automatically

generated Forms W-2, even though there was no intent that these students be treated as employees who

earned wages from MCPS. MCPS failed to separate the Forms W-2 generated with respect to amounts

paid in connection with this educational program from the Forms W-2 generated with respect to amounts

paid to employees, and those system-generated W-2s were inadvertently sent to the IRS along with the

W-2s for employees. MCPS did not intend that any such amounts would be treated as W-2 income withrespect to any student receiving these Transitional Service Unit payments.

To the extent that these payments made to students in the Transition Services Unit program were

deposited into joint MCTCU accounts established prior to 2008, it is possible that amounts were

commingled with amounts attributable to the school-based programs and withdrawn to pay program

expenses. That appears to be unlikely, however, because students in the Transition Services Unitprogram would not have participated in most of the school-based activities that were funded with amounts

attributable to those accounts.

Summary of Conclusions

Based on these facts and for the reasons stated below, we believe that there is a reasonable

basis to conclude that the amounts that MCPS paid to Rock Terrace School students as part of their work

experience training should not be considered gross income and/or wages subject to Federal or Stateincome or employment tax withholding, payment or reporting.

Analysis

Status as School Funds

Under Section 451 (a) of the Internal Revenue Code of 1986, as amended (the Code ), an

amount is treated as gross income for a taxable year in which it is actually or constructively received.

While in most circumstances, the receipt of an amount clearly results in that amount being taxable to the

recipient, under certain circumstances the result is not so clear. For example, in some circumstances,

where an individual receives funds that may belong to or may be subject to claims of others, he may not

be taxable on the amount. In Ill. Power Co. v. Comm., 58 AFTR 2d 86-5122 (792 F.2d 683) (1986), the

court stated that gross income does not include amounts for which an individual may be a mere custodian

with no claim of right to the funds. Likewise, an individual may not be taxable on amounts credited to his

account where the facts indicate that the individual does not know about it or derive any benefit from the

funds. For example, in Roberts v. U.S., 66 AFTR 2d 90-5109 (734 F. Supp. 314) (1990), taxpayers were

not required to pay tax on funds erroneously credited by their brokerage firm to their personal options

trading account where they were not aware the funds were credited and did not treat the funds asbelonging to them. The fact that the taxpayers could have used the money while it was in the account

was irrelevant. Because the taxpayers derived no benefit, profit, or gain from the funds, the court foundthat the funds were not taxable income to the individuals. Id.

Based on this authority, there appears to be a reasonable basis to conclude that the students

should not have been taxable on the payments made for instructional purposes only pursuant to the

school-based work experience programs. While we understand that the facts related to these payments

are not clear and there are inconsistent views about the ownership of the funds, there are several facts

which do support the conclusion that the funds did not belong to the students. First, the purpose of the

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payments indicates that amounts were not earned for services rendered but were a tool for teaching

these students basic concepts related to the receipt and handling of money. In this respect, the

payments to the students may be similar to providing them with textbooks or other educational tools thatare the property of the school. Second, the fact that the amounts were deposited into joint bank accounts

prior to 2008 indicates that the school intended to, and did, maintain control over and ownership of these

amounts. The fact that the amounts were later maintained in a sub-account in the IAF, which is an

account maintained and owned by the school, also is consistent with the understanding that the amounts

belonged to the school and not the student. Third, the school from time to time withdrew and used money

from these accounts for programmatic purposes that benefited students other than the student named on

the account, which indicates that the funds were not intended to belong solely to the student listed on the

account. These facts indicate that the funds used for the payments belonged to the school, not to thestudents who received them. Ill. Power Co. v. Comm., supra. Moreover, even if ownership of the funds

may be contested and subject to differing interpretations, to the extent that the student receiving the

payments under the program did not actually derive a benefit from the funds because they were used forthe benefit of other students, the student should not be taxable on those amounts. Roberts v. U.S.,

supra.

General Welfare Exemption

Section 61 of the Code provides that, unless an exemption applies, gross income means all

income from whatever source derived. Through rulings, however, the IRS has established a general

welfare exemption from treatment of amounts as gross income. Under the general welfare exemption,

disbursements by a governmental unit that are made to individuals in the interest of the general welfare,

where services are not rendered, are excludable from the recipient's gross income.

In Revenue Ruling 75-246, 1975-1 CB 24, the IRS addressed whether allowances paid to

participants in a work training program should be considered gross income or exempt general welfare

payments. The IRS stated that the determination of whether payments under the work training programsare includable in the participant's gross income rests on whether the activity for which the payments are

received is basically the performance of services or is only participation in a training program that

promotes the general welfare. If the activity engaged in is basically the performance of services, the

payments are compensation for services rendered, and are includible in the gross income of the recipient.

Conversely, if the activity amounts only to participation in a training program, the payments are in the

nature of relief payments made for the promotion of the general welfare and are excludable from thegross income of the recipient. The IRS ruled that where private and public agencies provided training

designed to upgrade occupational skills, and the trainee performed no services for the agencies,

payments received by the trainee from the agencies as an allowance were in the nature of reliefpayments made for the promotion of the general welfare and were not includible in the recipient's income.

Id.

The Rock Terrace School programs should be treated as work training programs for this purpose.

Based on the facts as we understand them, the payments that participants receive appear to be based on

the educational purpose of the program and not for the performance of any valuable services. The

payments to students in the school-based programs are nominal amounts based on attendance or

academic performance, and payment to students in the Transition Services Unit training program is no

more than 3.65 per day. In all cases, the amounts bear no relation to the minimum wage or the

performance of services. The payments are intended only to help students learn how to handle money.Based on these facts, it should be reasonable to conclude that any payments deemed to have been

received by students as part of the Rock Terrace School school-based or off-campus training program

should be exempt from gross income based on the general welfare exemption described in Revenue

Ruling 75-246 because the payments are associated only with participation in the program and not the

performance of services.

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Gift Exemption

Section 102 of the Code excludes gifts from income. Neither the Code nor the regulationsthereunder define the term gift for this purpose. Moreover, the courts have not provided anycomprehensive definition. Rather, they have tended to apply a broad definition that looks at all of thefactors and relies on practical human experience , recognizing that reasonable men could reach

differing conclusions in many cases. Commissionerv. Duberstein 363 U.S. 278, 287-8, 291-2 (1960).

To the extent that the funds paid to students belonged to the school, we understand that prior to2010, in some cases, the funds used in the school-based instructional programswere given to studentsupongraduation. If and to the extent that the funds paidto students belongedto students at any priorpoint in time as a result of these educational programs, the school does not appear to have been underany obligation to pay those amounts. Rather, the facts indicate that these amounts were paid solely foreducational purposes and not as compensation for services rendered or other considerationwhichresulted in any economic benefitto the school. We are not aware of any binding obligation of the schoolto make these payments or to allow the students to keep them.

Given the non-technical nature of the term gift under the Code, we believe that a court couldreasonably conclude that, under these circumstances and considering the disabled nature of the studentsinvolved, allowing them to keep small amounts that were paid to them solely to teach them about moneywould constitute a gift for Federal income tax purposes.

Classificationas Wages for Reporting and Tax Withholding Purposes

For the reasons set forth above,we do not believe that the amounts received bystudents as partof the Rock Terrace School school-based or off-campus training program should be treated as taxableincome. However, even if they were so treated, those amounts should not be treated as wages paid byMCPSsubject to income and employment tax withholding and reporting. In a number of rulings, the IRShas recognized that an employer-employee relationship does not exist where the primary purpose of thearrangement is for training and an employer-employee relationship is not intended. See e.q. Rev. Rul.65-165, 1965-1 CB 446 (administrative exclusion from employee status for certain disabled individualsperforming services in a sheltered workshop) and Private Letter Ruling (PLR) 8040025 ( [t]he fact that the[shelteredworkshop] requires the trainee to provideservices in an employment-type atmosphere does

not create a legal relationship of employer and employee because it is done only to give the trainee atruer sense of the work experience. ). Although many of the rulings involve unique facts, based on thefacts set out above,we believe that the primary purpose of the MCPS program is training and that noemployer-employee relationship is intended.

Maryland State Taxes

Pursuant to Md. Code Ann. Tax-Gen. section 10-203, an individual's Maryland state grossincomesubject to tax starts with gross income for Federal tax purposes, and pursuant to Md. CodeAnn.Tax-Gen. section 10-905(e-1), Maryland generally follows the Federal tax definition ofwages subject towithholding. Therefore, although there is no specific authority on point regarding the treatment of theseprograms under Maryland tax laws, it is reasonable to conclude that the tax treatment under Maryland lawshould bethe same as under the Code as described above.

The analysis in this memorandum is based on our understanding of the statement of factsprovided to us and set forth herein. We have not performed an independent investigation of the facts orreviewed any documents related to the facts stated above. Any change to the facts or misstatement ofthe facts could change the conclusions and therefore, in that case, this analysis would not apply. Inaddition, the facts are general in nature, may have changed from year to year, and may be different for

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each student. Therefore, the analysis herein may not be relied upon by MCPS, the Board of Education,

or any student as tax advice with respect to the treatment of any amounts paid to that student. This

memorandum is based on regulations, rulings, and decisions generally available as of the date hereof.Because the facts are unique, and we did not find any guidance directly addressing the specific facts

described herein, the conclusions in this memorandum cannot be said to be entirely free from doubt. The

IRS, state, or any court, if called upon to address these issues, could reach a different conclusion.

This memorandum, which is addressed solely to you as the Secretary/Treasurer to the Board of

Education of Montgomery County, may not be used, circulated, quoted or otherwise relied upon by any

other person or entity or for any other purpose.

Circular 3 Notice: In compliance with U.S. Treasury Regulations, please be advised that anytax advice given herein (or in any attachment) was not intended orwritten to be used, and cannot beused, for the purpose of (i) avoiding tax penalties or (ii) promoting, marketing or recommending to anotherperson any transaction or matter addressed herein.

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