Now O.C. Water District May Face Tax Problem : Finance: Proper withholding may not have been made on benefits of two top managers who resigned.

The former top managers of the Santa Margarita Water District avoided thousands of dollars in withholding taxes on the value of their district-provided cars and may also be liable for income taxes on expense reimbursements that were not fully documented, district records and interviews reveal.

Former General Manager Walter W. (Bill) Knitz and his assistant, Michael P. Lord, both of whom left the district under a cloud, instructed the district’s financial officers to report to the Internal Revenue Service that the value of their transportation benefits was less than $700 annually for each of the past five years.

However, the two top financial officers of the district, who challenged the practice, warned Lord that he and Knitz should have had $5,000 to $7,000 added to their incomes each year. They said the district should have withheld income taxes on those sums, which reflect the actual value of the benefits each man derived from the cars provided by the water district.

Moreover, according to IRS regulations, Knitz and Lord may also be liable for taxes on thousands of dollars in expense reimbursements that were not properly documented, since they failed to state the business purpose for expenses such as Knitz’s $245 sightseeing tour of Manhattan in a limousine or why lunch and dinner guests were being entertained.

Under IRS rules, the Santa Margarita Water District can be held liable for the full amount of the taxes that should have been withheld.

Don B. Schone, chairman of the district’s board of directors, has estimated that 25% of the $162,069 that Knitz and Lord claimed in reimbursements on their personal expense accounts during the past decade would not be considered legitimate business expenses.

Without proper documentation, the IRS views such reimbursements as wages subject to taxation.

“For employees who have business expenses, they need to document those expenses,” said Judith A. Golden, IRS public affairs officer in Laguna Niguel. “If they receive funds for their expenses, the funds could be considered taxable income if not properly documented.”

Golden said she could not comment on any specific situation involving Knitz and Lord.

Marshall M. Schulman, Knitz’s attorney, said he assumed that his client relied on “professional advice” when computing his taxes. “What he did or didn’t do relating to taxes, I have no comment,” Schulman said.

Lord’s attorneys, Gary M. Pohlson and Thomas M. Goethals, did not return calls for comment.

Suspended with pay from their jobs since early April, Knitz, 61, and Lord, 49, both recently announced their retirements less than two months after their spending and gift-taking habits were disclosed by The Times. The men acknowledged accepting nearly $60,000 in gifts from bankers, builders and engineering firms, some of whom they recommended for district contracts valued at nearly $20 million.

While they have steadfastly denied any wrongdoing, both Knitz and Lord said that they could not return from their prolonged suspensions to lead the district.

Scott Hart, a district spokesman, said that interim manager Daniel T. Miller is aware of the potential tax problems and that the issue will be addressed in an upcoming management audit that will include all district operations. The concern over unpaid taxes involves only Knitz and Lord, however, and no other district employees, Hart added.

Steve Lewis, auditor-controller for Orange County, said that county employees provided with leased cars, as were Knitz and Lord, pay taxes on the full lease value of the automobile, or they must maintain detailed mileage logs to determine how much of the car’s use is personal. Business-related usage is not considered a taxable benefit. In a few cases, officials receive a monthly car allowance that is fully taxed as income, Lewis said.

At the Santa Margarita Water District, employees are supposed to use their government-provided cars exclusively for business purposes, except for trips to and from home, which are valued at $1.50 per trip when calculating the total annual income reported to the IRS.

Since 1988, however, IRS regulations have provided that “control employees”--those who earn the same or more than Class V federal employees--must pay taxes on the “leased value” of their cars. Both Knitz and Lord were paid more than the threshold sum each year since that provision took effect.

According to memos obtained by The Times, the district’s top financial officers, James W. Clark and Carol Megara, raised questions about the taxes paid on the leased cars in 1991, after Megara attended a tax seminar.

But Lord, according to a memo written at the time by Clark, became greatly agitated when the IRS regulations were brought to his attention. “Once the emotional outburst had largely died down . . . he (Lord) insisted that he had had legal counsel review the matter and that the current method of valuing vehicles was correct,” the memo said. Clark said in his memo he was never provided with a copy of any legal opinion.

District spokesman Hart said a search this past week failed to turn up any such legal opinion regarding the valuation method.

The difference in taxes between the two methods of calculation can be significant.

For example, Lord’s $25,000 leased Chevrolet Suburban had a lease value of $6,850 in 1992. But Lord, basing the figure on the $1.50 value of each trip to and from home, instructed the district to report to the IRS transportation benefits totaling $672. In 1991, he asked the district to report $669 in transportation benefits.

Knitz’s 1990 Mercury Colony Park station wagon is valued at $19,599 and the leased value, according to the IRS, is $5,350. But Knitz reported $672 in transportation benefits in 1992 and $654 in 1991. District officials said they could not readily provide the amounts reported to the IRS in the three previous years, because many of the district’s records were either in archives or had been surrendered to law enforcement agencies looking into possible conflict-of-interest law violations by the two men.

Hart said Knitz and Lord always used the $1.50 method because the other calculation was not discovered until recently.

“Depending on an employee’s salary level and amount of personal use of a car, the difference in methods of calculation can have a substantial impact on the taxes paid,” said Golden of the IRS. “The rules on fringe benefits are complicated and any employer providing a fringe benefit should seek professional assistance because there are so many factors influencing taxes.”