This post originally appeared on the Forbes PT site on January 4, 2017
Late December’s Fleischer v Commissioner involves facts that are common among many small business service-providing taxpayers wishing to minimize self-employment liability by setting up S Corporations and funneling service income to those corporations. Unfortunately for Fleischer, the Tax Court found that he faced a sizable self-employment tax liability as it reallocated income that was reported on the S Corporation’s 1120-S to his Form 1040.
The case is in the category of who is the appropriate taxpayer, an issue that sometimes gets murky when taxpayers are dealing with closely or solely-held separate entities. I will summarize and simplify the facts somewhat and hone in on why the taxpayer lost despite the plans of both a CPA and lawyer advising on his tax structure.
The Facts of Fleischer: Setting up an S Corp to Avoid Self-Employment Tax
Fleischer is a licensed financial consultant. Based on the advice of his CPA and lawyer, he set up an S Corporation. Fleischer was the president, secretary, treasurer and sole shareholder of the corporation. Fleischer entered into an employment agreement with the S Corporation, and pursuant to that agreement the S Corp paid him a salary in his capacity as financial advisor. In his individual capacity, Fleischer also entered into contracts with financial service companies Mass Mutual and LPL. Those contracts generated significant commissions, which Mass Mutual and LPL reported to the IRS and to Fleischer individually on various Form 1099’s over the years.
The key to the employment tax savings when all works well in this structure is that the S Corp pays a salary less than the gross receipts it receives. The shareholder/employee has employment tax liability to the extent only of the wages that the S Corp pays to the shareholder/employee. Fleischer paid employment tax on his wages from the S Corp. And while Fleischer’s status as sole shareholder meant that all of the S Corp’s income would flow through to him, the nature of the income matters. Individuals who earn service income directly have to pay Social Security and Medicare taxes, which are often referred to collectively as the self-employment tax. [Note that the tax rate for Social Security taxes is 12.4% and the rate for Medicare taxes is 2.9%; for 2017 Social Security taxes are levied only on the first $127,200 while the Medicare rate applies to all service income]. If the S corporation, rather than the individual, earns that income, then the S corporation does not have a separate employment tax liability and the shareholder does not have self-employment tax liability on his share of the S corporation’s income.
Fleischer’s S Corp paid him a salary of about $35,000. The net service income the S Corp earned varied over the years, going as high in one year as about $150,000. When, as was the case here, the S Corp’s wages paid are less than its net service income, the shareholder/employee can potentially avoid self-employment income tax if that income were earned directly by the shareholder/employee or employment tax if the S Corporation does not pay a salary commensurate with the corporation’s net business income.
Underlying this form, however, is the IRS’s ability to allocate the income to the party who truly earns the income. In addition, the compensation the S Corporation pays to its shareholder/employee must be reasonable; if too low IRS can argue that some of the distributive share should be characterized as compensation (Peter Reilly discusses one such situation in S Corporation SE Avoidance Still a Solid Strategy). The taxpayer’s reporting of the income and the mere creation of a separate entity do not give the taxpayer unlimited discretion to treat the income in the way most favorable to the taxpayer.
As an important aside, the consequences of an LLC earning service income differ from that of an S Corporation. When an LLC earns service income, the distributive share of partnership income allocated to members of an LLC is generally subject to self-employment tax. This is a key difference between S Corporations and LLCs in this context. For an excellent discussion of the issue, see our Forbes colleague Tony Nitti’s post from a few years ago, IRS: Partners’ Share of LLC Income is Subject to Self-Employment Tax.
Back to Fleischer. While he varied somewhat in the way that he reported the income in the years in question, Fleisher testified that he intended to “zero out” his possible self-employment income by reporting expenses on Schedule C to offset his reported income from MassMutual and LPL. In the years in question he paid employment taxes on his wages from the S Corp but would report the income from MassMutual and LPL on his 1040 as non-passive income that was not subject to self-employment tax.
In this case, recall that Fleischer was paid by Mass Mutual and LPL in his individual capacity pursuant to contracts that Fleischer and not the S corporation entered into. Fleischer testified that he individually entered into the contracts because it would have been costly and perhaps impermissible for his S corporation to become licensed and registered under federal securities laws.
On audit, IRS disregarded the S Corporation and treated Fleischer as individually earning the commission income, generating a sizable self-employment tax liability. Fleischer naturally disagreed and filed a petition with the Tax Court.
The Tax Court Agrees with the IRS
The lack of contracts between Fleischer’s S Corp and Mass Mutual and LPL proved to be Fleischer’s undoing. In describing the appropriate law, the Tax Court opinion notes a first principle of income tax, namely that “income must be taxed to him who earned it.” The opinion goes on to state that “for almost as long as this first principle of income taxation has been in place, the principle that a corporation is a separate taxable entity has been, too.”
The opinion goes on to discuss the key to reconciling these principles:
Because it is impractical to apply a simplistic “who earned the income” test when the Court’s choices are a corporation and its service-provider employee, the question has evolved to one of “who controls the earning of the income.”
To determine if the corporation and not the shareholder controls the earning the opinion notes that the case law looks to two requirements:
(1) the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense, and
(2) there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation’s controlling position.
While here Fleischer satisfied the first requirement he flunked the second due to the lack of a contractual relationship between the S Corp and the brokerage companies. In other words, there was no recognition from Mass Mutual or LPL that the S Corp had control over Fleischer even though the agreement that Fleischer and the S Corp signed had the bells and whistles that would satisfy the first requirement. Fleischer was an employee of the S corporation and it had the contractual power to control him, but there was not enough to show that Mass Mutual and LPL recognized the control that the S Corporation had the contractual power to exercise over Fleischer.
What about Fleischer’s argument concerning the practical difficulties associated with registering the S Corp under federal securities laws? According to the Tax Court, it did not matter:
Petitioner testified that it would be overly burdensome and “would cost millions and millions of dollars” for [the S Corp] to register under the Act, but he offered no other evidence to corroborate his testimony. The fact that [the S corp] was not registered, thus preventing it from engaging in the sale of securities, does not allow petitioner to assign the income he earned in his personal capacity to [his S Corp]. See Jones v. Commissioner, 64 T.C. 1066 (1975) (holding that a court reporter improperly assigned income to his personal service corporation because a court reporter was legally required to be an individual, and although the corporation was a valid entity, by law it could not perform such services).
Fleischer apparently followed his tax advisors’ advice in setting up his personal service S Corporation under state law. That is a necessary but not sufficient condition to have those entities be treated as the rightful earner of service income. As the Fleischer opinion shows, the party paying the service income must expressly recognize that the separate corporate entity has legal and actual authority over the individual. By failing to dot the i’s and then cross the t’s, the IRS, as here, can allocate income to the individual and leave the shareholder/employee with self-employment tax in the same manner as if there were no S corporation in the first instance. The opinion is a red flag for small business taxpayers who may not follow the exact letter of tax advice or for advisors who may not carefully detail all the steps needed to get the appropriate tax result.