On the Merits: The SCS Legal Blog

IRS v. WorldCom



Internal Revenue Service v. WorldCom, Inc. (In re WorldCom, Inc.), Second Circuit Court of Appeals Case No. 12-803


In reversing and remanding District Court’s affirmance of Bankruptcy Court’s granting of Debtors’ objection to IRS’s proof of claim and Debtors’ motion for refund of previously paid taxes, Second Circuit held that Debtors must pay federal excise taxes on their purchase of a telecommunications service connecting customers using dial-up modems to the Internet.

Procedural context:

Post-confirmation, Debtors objected to IRS’s proof of claim asserting approximately $16.3 million in excise taxes and moved for refund of approximately $38.3 million of excise taxes already paid. Bankruptcy Court ruled in favor of Debtors. District Court reversed and remanded for further factual findings. On remand, Bankruptcy Court again ruled in favor of Debtors and District Court affirmed. This appeal followed.


In the late 1990′s, WorldCom purchased COBRA, a “central-office-based remote access” service, from local telephone companies that permitted people the ability to use their modems to connect to WorldCom’s network (and the Internet) over their regular telephone line. In objecting to the IRS claim and seeking a refund of the excise taxes previously paid, WorldCom took the position that its purchase of COBRA was not subject to the Internal Revenue Code’s (“IRC”) three percent excise tax on the purchase of a “local telephone service.” 26 U.S.C. sec. 4251.

Section 4252(a) of the IRC defines a “local telephone service” as any service that provides “(1) access to a local telephone system, and the privilege of telephonic quality communication with substantially all persons having telephone or radio telephone stations constituting a part of such local telephone system and (2) any facility or service provided in connection with a service described in paragraph 1.”

On remand from the District Court after the Bankruptcy Court ruled in favor of the Debtors, the Bankruptcy Court concluded that WorldCom had only purchased the ability to plug into the high-speed Internet data stream provided by the local telephone companies which could not support “telephonic quality communication” or, in the Bankruptcy Court’s view, regular phone calls. Likewise, on the second appeal, the District Court concluded that COBRA (i) was an “intermediate” step in the Internet-connection process and not a local telephone service and (ii) did not provide the ability to communicate with “substantially all persons” who are part of such telephone system in that COBRA was a self-contained service within the telephone company’s facility that did not permit people to access the telephonic quality communications that the COBRA-specific high-capacity telephone lines could theoretically support.

The Second Circuit solely reviewed the District Court’s conclusions of law, as the parties did not dispute the District Court’s adoption of the Bankruptcy Court’s findings of fact. It viewed the issue of whether COBRA was a local telephone service as a question of statutory interpretation.

In support of its holding, the Court carefully parsed through the three core elements of the federal tax code’s definition of “local telephone service.” Due to the newer technology at issue, the Court found ambiguity in the plain text of the statute and drew upon, and distinguished where applicable, case law, statutory canons of interpretation, IRS revenue rulings, legislative history and the Oxford English and Webster’s New Collegiate dictionaries. First, the Court found access in the context of the purchase of a local telephone service to be limited to direct connectivity to a specific local telephone system, which was satisfied by WorldCom’s separate contracts with each local telephone company. Second, the Court concluded that “telephonic quality communication” referred to the technological capacity of the channel to transmit voice signals, whether or not the channel is used for voice communication, and that such communication included a data communication transmitted by a modem. As such, this element covered any service that makes use of the traditional telephonic network for communication, regardless of the form of the communication or whether the service also used non-telephone technology, as COBRA did, to accomplish that communication. Third, the Court determined that the statute’s requirement of communication with “substantially all persons” in a local telephone system is part of the “privilege” definitional element that focuses on the capacity of the purchaser to communicate with ‘substantially all persons,” not whether the purchaser actually does so. WorldCom satisfied this element as, in a self-imposed limitation, it chose to resell the COBRA data stream to internet service providers like AOL, rather than act as an internet service provider.

In its decision, the Second Circuit remarked that “[I]t is somewhat odd to fit Internet technology into a statutory definition that has not been updated since the Mad Men era.”

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Serving as Executor or Trustee: No Good Deed Goes Unpunished


Individuals are often asked to serve as executor and/or trustee in the wills and trusts of relatives and friends.  Sometimes they are asked in advance, that is, when the documents are being prepared, and sometimes they are unaware of their appointment until the documents become effective.  In many, if not most, instances, the appointed individual has little or no idea what responsibilities and personal and financial risks he or she is accepting by agreeing to serve.  The following points out some of those risks.

The duties and responsibilities of executors and trustees (“fiduciaries”) are set forth in New York in the Estates, Powers & Trusts Law and the Surrogate’s Court Procedure Act.  In addition, there is a large body of case law going back hundreds of years dealing with such duties and responsibilities.  A fiduciary holds title to the assets and property of the estate or trust, as the case may be, and is required to preserve, invest and distribute the assets and property in accordance with the provisions of the will or trust and as required by law.  The fiduciary is required to file the appropriate income and estate tax returns and is responsible for the payment of the taxes due to the extent of the assets and property of the estate or trust.  Failure to properly discharge those duties may result in personal financial liability to the fiduciary.

Fiduciaries in New York are entitled to compensation (called commissions) in amounts fixed by the EPTL.  If a fiduciary fails to properly discharge his or her duties, he is subject to being surcharged by the appropriate Surrogate’s Court.  A surcharge, in effect, is a reduction in commissions, but fiduciaries may be surcharged for improper conduct beyond their entitlement to commissions.  Wills and trusts that name family members or close friends as fiduciaries often contain provisions requiring the fiduciary to waive his or her right to commissions or otherwise to limit them to fixed amounts.  In many cases, relatives and friends will agree to serve without commissions, even if the will or trust does not eliminate or reduce what would otherwise be allowed.

No fiduciary should agree to serve without a full understanding of, not only his or her legal obligations, but the provisions of the will or trust under which he or she will serve.  The will or trust should be viewed as a letter of instructions from the decedent or settlor of the trust to the fiduciary as to what to do, how to do it and who is to benefit from the trust or estate.

In addition to financial and legal decisions, fiduciaries often have to make personal decisions.  For example, if a trust provides that distributions may be made to a beneficiary based upon certain standards (or no standards at all) it is the fiduciary’s responsibility to determine the appropriate distributions.  It is not at all uncommon for a fiduciary to be placed in a most uncomfortable position with the beneficiary because the fiduciary has reason to believe that the requested distribution may be inappropriate or even self-destructive, such as making a distribution to a known substance abuser or a person whose creditors will immediately attempt to attach the distribution.  It is difficult to be in a position of telling a 75 year old widow that she cannot take her 25 year old boyfriend on a six-month around-the-world cruise or to tell a 22 year old that she doesn’t need a new Rolls Royce convertible.

Fiduciaries are entitled to select lawyers of their choice to advise them.  They are not required to use the lawyer who represented the decedent or settlor or who drafted the documents in question.  Where there are multiple fiduciaries, each is entitled to have his own lawyer.  Obviously, a person who is considering acceptance of the appointment as a fiduciary or who has already committed to serve should take great care in selecting a lawyer familiar with trusts and estates.

Fiduciaries are surcharged both for sins of omission and sins of commission.  Doing nothing may be just as bad as doing something improperly or incorrectly.

If you are asked to serve as a fiduciary, be aware of the above, read the documents under which you will serve and get competent advice as to your duties and responsibilities.

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Are You Your Brother’s Keeper?


The answer is “yes,” at least when it comes to a lawyer’s duty to supervise his brother, who acted as bookkeeper for the law firm.

Recently, the Appellate Division, Second Department, unanimously supported a decision suspending an attorney from the practice of law for two years, for, among other things, failing to properly supervise his bookkeeper brother who was convicted of embezzling more than $4 million in client funds.

In his defense, the lawyer pointed to his cooperation in connection with the criminal prosecution of his bookkeeper/brother, his legal efforts to reclaim the misappropriated funds, his testimony concerning the negative impact of his brother’s conduct on his personal and professional life and 37 letters of good character submitted on his behalf.

Nevertheless, in sustaining a Special Referee’s report, the Court found that the attorney “failed to maintain appropriate vigilance over his firm’s bank accounts, resulting in actual and substantial harm to clients.”  Repeatedly, the Court stated that the lawyer, at the very least, should have known what was going on.

Has the Court established a new legal duty to supervise your siblings, lest you be charged vicariously with their ill-doings?  The good news is that the answer is “no.”  A reading of the decision leads to the conclusion that the result would have been the same whether or not the bookkeeper was also a brother.  A lawyer’s ethical duty to safeguard clients’ funds is sacrosanct, and the legal system is ready to make an example of those who fail to adequately discharge that duty.

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Investment in Real Property by Non-U.S. Citizens


With the ever-growing global market, and with the development of more condominiums than cooperatives in New York City, more and more foreign investors are finding opportunities to purchase real property in New York City. Treasury Decision 9082 (effective November 4, 2003) requires all transferees and foreign transferors of U.S. real property interests to provide their Taxpayer Identification Numbers (TINs), names and addresses on tax documents executed in connection with real property transfers. It is therefore important to remind clients that prior to closing, if not at the time that a contract of sale is executed, all foreign parties to a real estate transaction must obtain a TIN to be provided at closing.

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IRS Amnesty on Independent Contractors: Too Good to be True?


One long-continuing battle between the IRS and taxpayers has been over the classification of workers as employees or independent contractors.  Now comes an IRS program offering a tantalizing offer for businesses to right previous mis-classifications at a bargain price.  Should taxpayers jump at the offer?  The answer is a definite maybe.

The stakes in the battle over contractor/employee classifications can be pretty high.  If a business properly treats someone as an independent contractor, then the business does not withhold taxes.  On the other hand, if that characterization was incorrect and the person performing services was more properly described as an employee, then taxes should have been withheld and paid over to federal and local taxing authorities.  The failure to withhold and pay over taxes can subject businesses to substantial penalties.  Making matters worse, the individuals running the business who are responsible for withholding and paying over these amounts may be subject to crushing personal liabilities.

In general, the determination of contractor/employee classification rests on facts relating to the level of control asserted by the business over the worker.  A discussion of the factors and arguments involved in this kind of battle is beyond the scope of this blog entry.

In Announcement 2011-64, issued September 21, 2011, the IRS commenced its Voluntary Classification Settlement Program (the “VCSP”), providing partial relief from Federal employment taxes for eligible taxpayers that agree to prospectively treat workers as employees.

What’s the proposed deal in this amnesty?  A taxpayer who participates in the VCSP will agree to prospectively treat the class of workers as employees for future tax periods. In exchange, the taxpayer will pay only 10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year; will not be liable for any interest and penalties on the liability; and will not be subject to an employment tax audit with respect to the worker classification of the workers for prior years.

For a business faced with a real worker classification problem with potentially massive tax underpayments and penalties, this offer can sound like a no-brainer.  Unfortunately, it is absolutely necessary to apply one’s grey matter before coming to a conclusion that, all things considered, participating in the VCSP is the right choice to make.

Federal income tax withholding is not the only issue raised by the classification of service providers as employees or independent contractors.  Think of the following items that affect W-2 deductions:  social security taxes, Federal unemployment taxes, state unemployment taxes, and workers’ compensation insurance.

Furthermore, there are a host of other considerations that have nothing to do with the amount deducted from a worker’s paycheck:  labor laws, workers compensation obligations, statutes regarding discrimination, ratings for unemployment experience, reimbursement of business expenses, availability of medical, pension and other employee benefits, indemnification of a worker for liabilities incurred while performing services, the scope of liabilities and responsibilities to third parties, and so on.

For instance, suppose a worker who is reclassified as an employee under the VCSP had not been covered by the employer’s medical benefit plan during the period he was previously classified as an independent contractor.  Imagine further that, during that period of time, he was uninsured and diagnosed with a tragic health condition requiring the payment of massive amounts of money for treatment to ensure his survival.  After the business voluntarily participates in the VCSP, the worker takes the position that he should have been covered under the employer’s medical plan and makes a claim for $500,000.

Or suppose another worker, while driving under the influence in the midst of performing a task for the business during a period he was classified as an independent contractor, killed a pedestrian.  The business now voluntarily classifies the worker as an employee under the VCSP.  The heirs of the decedent now slam the business with a wrongful death suit by reason of the actions of its employee, a position that would have been so much harder to support if the business had not admitted that the drunkard is an employee.

You get the picture.  Jumping into the VCSP is not a no-brainer decision.  Is the IRS amnesty program attractive?  Sure.  But failing to survey the lay of the land is approximately as smart as diving head first into a dark lake without knowing whether your head will smash into something lurking beneath the surface.

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Court Upholds Disinheritance


A recent decision by the New York County Surrogate’s Court on a novel question of law, in which we represented the prevailing parties, illustrates the importance of how arguments are presented to courts in litigated matters. The case involved interpretation of a provision in a will in which the facts were not in dispute.

A granddaughter of a decedent, who was born a year after the decedent executed his will, sought a ruling from the Court that she be included with the decedent’s other named grandchildren, among whom were her siblings, in a gift of a remainder interest in a trust. The granddaughter argued that she should not be excluded from sharing in the gift solely because she was not living when the will was executed and that, if she had been living at the time the will was executed, she would have been included. She argued further that it was not her grandfather’s intention that she be excluded.

At SCS’s urging, the Court made short shrift of the granddaughter’s primary argument that a statute, which would have required her inclusion had she and the other grandchildren been children of the decedent rather than grandchildren, be extended to apply to her. The Court said that the statute was clear on its face that it applied only to children and that the granddaughter offered no authority that it had ever been extended to grandchildren.

The Court noted, on the issue of intention, that the decedent died 15 years after the will was executed and 14 years after the granddaughter’s birth, giving him more than ample time to include her if that was his intention. The Court also observed that, as the granddaughter’s father (one of the decedent’s sons) was also expressly disinherited in the will, there was no general intention to benefit all family members.

Finally, the Court adopted SCS’s argument that another provision of the will, which left a different trust remainder to his grandchildren living at the time of his daughter’s death (if she survived him) and which included the granddaughter, showed that the decedent understood the difference between a gift to named grandchildren and a gift to grandchildren as a class of persons.

While we believe that the Court reached the correct result, a reading of the decision indicates that, had the granddaughter attempted to distinguish the circumstances of the two different trust remainders as her primary argument, and they were distinguishable despite our arguments to the contrary, instead of relying on a reading of a statute which was clearly contrary to law, the Court might have been more sympathetic to the granddaughter’s inclusion.

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