Eastern Investment Corp. And Lowen Corporation v. United States
Docket: 94-3029
Court: Court of Appeals for the Tenth Circuit; March 1, 1995; Federal Appellate Court
Eastern Investment Corporation and its subsidiary, Lowen Corporation, appealed a district court ruling that found them liable for federal employment taxes, penalties, and interest. The case, heard by the Tenth Circuit Court, originated from the IRS's determination that Lowen's sales representatives were employees rather than independent contractors during the period from January 1, 1984, to December 1, 1986.
Lowen Company Inc., incorporated in Kansas in 1961, specialized in designing and manufacturing decals and real estate signs. In the early 1980s, the company faced sales tax audits from several states, prompting a corporate restructuring in July 1984. This restructuring involved transferring sales functions to a new entity, Lowen Sales Corporation, and reclassifying sales representatives as independent contractors to mitigate state sales tax exposure. Despite the changes, the operational relationship with the sales representatives remained largely unchanged.
In 1987, following an IRS audit, it was determined that the sales representatives were indeed employees, leading to the assessment of federal employment taxes and penalties. Lowen contested this decision, leading to the current lawsuit by paying the disputed taxes for one employee and filing for refunds, while the government counterclaimed for the remaining assessments. The Tenth Circuit affirmed the district court’s judgment, agreeing with its findings.
Following a bench trial, the district court determined that out of 113 sales representatives, 15 were classified as employees, while the remaining 98 were independent contractors. The court upheld the IRS's assessment of penalties and interest for the taxes owed by these 15 employees. Subsequently, both parties filed motions to amend the judgment; the court denied Lowen's motion but granted the government’s request to classify three additional decal salespersons as employees.
On appeal, Lowen argued that the district court improperly focused on fixed fee compensation to classify 18 sales representatives as employees, neglecting a holistic view of the circumstances. Although Lowen acknowledged the trial court's factual findings, it contended that the legal conclusions drawn were incorrect. The appellate court reviews legal conclusions de novo.
The definition of "employee" is derived from statutes governing tax withholding, with guidelines found in corresponding employment tax regulations. Courts have identified various factors to assess employer-employee relationships, emphasizing that no single factor is determinative; rather, the totality of the circumstances matters.
In its analysis, the district court applied a 20-factor test based on IRS guidelines, which included all relevant factors previously established in case law, such as method of payment.
The district court determined that 18 of Lowen's sales representatives were employees based on their method of payment and other factors. Under the 1984 agreement, these individuals received commissions plus a fixed fee, effectively maintaining their prior salary and expenses. The court found uncontroverted evidence that Lowen intended to keep their compensation consistent. It emphasized that the distinction between salespersons paid solely on commission versus those receiving a fixed amount was crucial.
The court noted that the method of payment significantly influenced other determinants in their employee-independent contractor analysis, particularly the financial risk aspect. Since the representatives did not bear financial risk from their services, this favored an employee classification. Additionally, the regular payment structure implied greater control by Lowen over the representatives.
Other distinctions were highlighted, such as the fact that most of the 18 individuals participated in Lowen's group health plan, with premium costs deducted from their fixed fees. The court also recognized differences between decal and sign sales representatives, noting that decal representatives were more dependent on Lowen, received more training, had better communication with staff, and were encouraged to attend annual meetings. The long-term relationships between the 18 individuals and Lowen further supported the conclusion of an employer-employee relationship. Overall, the court relied on a comprehensive analysis of 20 factors, emphasizing the totality of evidence rather than any single factor.
Lowen's classification of its sales representatives as either employees or independent contractors is irrelevant under the law; however, the district court found that all 18 sales representatives were treated as employees by Lowen in 1984. Lowen asserted that the agreements made that year did not alter the employment status of these individuals, indicating that they remained employees in Lowen's view after July 1984. The district court's conclusion that these representatives were employees was upheld, as it was determined that the court adequately considered all relevant circumstances.
Regarding penalties imposed for failing to file a timely tax return and for not depositing withheld taxes, Lowen must prove that its failures were not due to willful neglect and were for reasonable cause. Lowen argues that the district court incorrectly determined it did not establish reasonable cause, noting that this assessment involves factual determinations but that the legal standard is a matter of law. Lowen does not contest the factual findings but claims misapplication of the law.
To support its reasonable cause claim, Lowen argued reliance on attorney advice for restructuring the corporation and categorizing sales representatives as independent contractors. Although reliance on professional advice can sometimes be a valid defense, in this case, it was not sufficient. Lowen presented three attorney letters, two of which pertained to state tax liability and assumed the independent contractor status based on Lowen's representations, without addressing the accuracy of that classification. The third letter merely summarized the previous two and included a draft of an independent contractor agreement for review.
Lowen sought to label its sales representatives as "independent contractors" but did not obtain professional legal advice regarding the appropriateness of this classification. There is no evidence that attorneys examined the nature of the relationship between Lowen and its sales representatives or advised that they were indeed independent contractors. Consequently, Lowen lacked reasonable cause for its actions. The court also notes that it need not address whether Lowen's late tax filings constituted "willful neglect."
Additionally, there is a dispute regarding when interest begins to accumulate on Lowen's additional tax liability under 26 U.S.C. Sec. 6205(a)(1). The government argues that interest starts from the date of assessment, while Lowen claims it should only begin after a final judicial determination of tax liability. This matter is reviewed de novo, based on undisputed facts from an IRS audit initiated in 1987 and subsequent assessments made in 1990. Lowen signed an agreement consenting to immediate assessment and collection of owed taxes and penalties.
Under Internal Revenue Code Sec. 6205(a)(1), specific underpayments may be adjusted without interest until the due date of the return for the period in which the error is recognized. The related regulations state that an error is ascertained when an employer has sufficient knowledge to correct it. Lowen contends it lacked such knowledge until the court's determination, arguing that an error is not ascertained while under contest. The court disagrees with this assertion.
Lowen's misclassification of its sales representatives as independent contractors constituted an error, as determined by the district court. The court found that Lowen was aware of this misclassification after exhausting its appeal rights, following notification from the Appeals Office that the representatives were employees. This conclusion aligns with the relevant statutes and regulations, as well as Revenue Ruling 75-464, which, while not legally binding, warrants consideration. The error was deemed "ascertained" in January 1990, making Lowen liable for interest under 26 C.F.R. Sec. 31.6205-1. The district court's decision has been affirmed. Testimony from Lowen's former president indicated that the payment method significantly influenced the company's financial risk, highlighting the cost of maintaining employees. The Chief Operating Officer acknowledged that despite the legal changes, they continued treating the sales force as independent contractors without proper recognition of their employee status, leading to unaddressed financial obligations such as social security and medical expenses.
Lowen argues that its good faith belief that 18 individuals were independent contractors, independent of any reliance on legal counsel, constitutes reasonable cause. However, this argument is undermined by evidence indicating that Lowen had previously classified those individuals as employees before a 1984 reorganization. Testimony from Glenna Cooley, the former national sales manager, revealed that there was no substantial change in the treatment of these sales representatives after the reorganization; the only alteration was in their compensation structure, shifting from salary plus expenses to a fixed fee equivalent to prior earnings. The district court noted that Lowen's intent in changing the compensation structure was simply to maintain the same financial position for the individuals. Consequently, Lowen's assertion of a good faith belief in their independent contractor status following the new agreements in July 1984 lacks validity. Additionally, Section 6205, which addresses certain tax obligations, does not pertain to Federal Unemployment Tax Act taxes.
