Tax Court Holds It Does Not Have Jurisdiction to Consider Reasonable Salary Determination in Exams of S Corps

Last month in Financial Consultant Fails To Avoid Self-Employment Tax With S Corp Structure we discussed the possible ways that service-performing employee/shareholders in S Corps can minimize employment taxes. IRS is aware of the abuses in this area and seems to be looking carefully at S Corps that are profitable and pay what it thinks are low wages to those key employee/shareholders.

In the last few weeks there have been some interesting Tax Court orders considering a jurisdictional issue spinning from IRS audits of S Corps and their shareholders.


First some background.

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.

The scheme minimizes employment tax obligations by essentially paying below market wages to the S Corporation’s shareholder/employee; cash still comes out to the shareholder/employee in the form of other distributions.

As part of an IRS audit, IRS will examine the S Corp’s return and analyze the reasonableness of the salaries. If IRS thinks the wages are not high enough, it will send the S Corp a Form 4668, Employment Tax Examination Changes Report, which can propose what it thinks the reasonable salary is and thus propose employment tax increases (as well as penalties). Interestingly, this is the reverse of old reasonable compensation cases where C Corp shareholder/employees would pay themselves a salary that IRS argued was too high. As Keith notes and based on his experience in litigating a couple of those older reasonable compensation cases (see, e.g., Royal Crown v Comm’r) these are time-consuming to litigate and, as with many valuation cases, often involve expert testimony.

As a substantive matter, the key inquiry should be whether the payments that the shareholder received that were not labeled as compensation were remuneration for services. Not surprisingly, comparables are key, and IRS will look to industry and regional standards.

This brings us back to the procedural issues.

In response to the IRS issuing an Employment Tax Examination Changes Report (Form 4668) some S Corps have filed petitions to Tax Court to attempt to get the Tax Court to consider the reasonableness of the salaries.

Employment taxes are generally not subject to the deficiency procedures. The Tax Court has jurisdiction under Section 7436 to consider proceedings relating to determinations of an individual’s employment status. (Lavar Taylor has discussed this provision extensively in his series of posts considering the SECC v Commissioner case).

Even though the S Corps are not getting a notice of deficiency in a couple of recent cases they have essentially claimed that the IRS’s adjustments to the salaries that the corps paid to its shareholders are determinations for purposes of Section 7436.

The Tax Court has disagreed stating that the IRS adjustments have nothing to do with a determination of employee status but only relate to the amount of salary that should have been paid to someone who the parties already agree is an employee.

To that end, see the discussion in Azarian v Commissioner, involving a S Corp that operated a law firm and had a sole shareholder, where the Tax Court granted the IRS’s motion to dismiss on the grounds that it did not have jurisdiction:

Petitioner consistently treated Mr. Azarian as an employee for the taxable periods at issue. Therefore respondent did not make a determination that Mr. Azarian was an employee of petitioner, but rather concluded that petitioner failed to report reasonable wage compensation paid to Mr. Azarian for 2012-14. Section 7436(a)(1) only confers jurisdiction upon this Court to determine the “correct and the proper amount of employment tax” when respondent makes a worker classification determination, not when respondent concludes that petitioner underreported reasonable wage compensation, as is the case here.

The Tax Court took a similar approach in Arroyo Corp v Commissioner, also an S Corp exam looking at the reasonableness of salaries to shareholder/employees, where it stated that while the IRS made a determination with respect to the amount of the compensation, that was insufficient to generate jurisdiction under Section 7436.


S Corps wishing to challenge the IRS on these issues will likely have to go the refund route, though given the divisible nature of employment taxes those corporations need not fully pay any proposed liability. The Tax Court has closed one door though it is possible that a CDP proceeding could allow a taxpayer to challenge the liability, though that issue spins off other procedural issues, including whether the S Corp had a prior opportunity to challenge the liability. That issue is subject to considerable uncertainty, though last week’s Tenth Circuit opinion in Keller Tank v Commissioner sustained the Tax Court and IRS’s restrictive approach to the definition of prior opportunity (stay tuned as we will blog that case this week).

Tip of the hat to our hard-working blogging colleague Lew Taishoff, whose blog on the Tax Court brought these recent orders to my attention.



Plastic Surgeon’s Share of LLC Income Not Subject to Self-Employment Tax

An earlier version of this post appeared in the Forbes PT site on January 20, 2017.

In Hardy v Commissioner the Tax Court considered the self-employment tax consequences of a plastic surgeon’s share of income earned through his investment in an LLC that owned and operated a surgery center. Whether a professional’s share of a pass through’s income is subject to self-employment (SE) tax is an important issue that affects many taxpayers. In Hardy, the taxpayer successfully argued that his share was more like passive income and was not subject to SE tax. In this post I will briefly discuss the issue and the reason for the Tax Court finding in favor of Dr. Hardy.


Readers may recall our discussion of Fleischer v Commissioner, where the Tax Court treated the taxpayer individually, rather than his solely-held S Corp, as the rightful owner of income in Financial Consultant Fails To Avoid Self-Employment Tax With S Corp Structure, a post that generated some excellent comments.

I discussed in that post the contrasting self-employment tax consequences between using an S Corp and other pass through entities. Limited partners, like shareholders in an S Corp, are generally shielded from self-employment income on partnership profits. That is because Section 1402(a)(13) excludes from the definition of self-employment income the distributive share of limited partners’ income, other than a guaranteed payment for services. Section 1402(a)(13) predates the explosion of other pass through entities like LLCs that allow members, unlike limited partners, to actively participate in the business of the entity while also providing in some ways for liability protection.

There has been uncertainty regarding how that income should be characterized. Naturally, taxpayers have analogized members in these entities to limited partners for self-employment tax purposes; IRS, with some success, especially when the members were active in the business that generated the service income, treats the members’ share of the entity’s income as net business income subject to self-employment tax. The key, at least from the Tax Court’s perspective, is to determine whether the income that the member receives is more related to the capital investment in the entity or the services that the members perform in their capacity as individuals.

When the income seems more connected to the services that the members perform, it is treated as self-employment income. The 2011 Tax Court case Renkenmeyer v Commissioner, involving partners in a law firm is instructive. In that case the Tax Court concluded that because the “revenue was derived from legal services performed by the partners in their capacity as partners, they were not acting as investors in the law firm.”

In Hardy v Commissioner, decided this past week, the Tax Court distinguished Renkenmeyer. Hardy was a plastic surgeon specializing in pediatric reconstructive surgery. In 2006 he purchased for $163,974 a 12.5 per cent interest in a surgery center run through an LLC. The opinion held that he did not have self-employment income on his share of the surgery center’s income. To get to its conclusion the opinion walks through Hardy’s role with the surgery center and the ways that surgeons earn income. Hardy had no meaningful non-surgery related service responsibilities with the surgery center:

Dr. Hardy has never managed MBJ [the LLC/surgery center], and he has no day-to-day responsibilities there. Although he meets with the other members quarterly, he does not have any input into management decisions. He generally is not involved in hiring or firing decisions. His role and participation in MBJ have not changed since he became a member.

While Hardy performed some of his surgeries at the surgery center, he had no obligation to do so. The opinion discusses how patients pay surgeons directly for the surgery procedures. Patients separately pay a fee to the surgical facility for the use of facilities and associated services. What was a key fact was the nature of Hardy’s interest more closely resembled that of a passive investor, with his Hardy’s share of the LLC income related to the fees patients paid for the use of the centers. In essence his cut was not explicitly tied to surgeries that he performed. Those fees were due Hardy independent of any services or surgical procedures he chose to perform at the surgery center that generated the income in question:

Dr. Hardy receives a distribution from MBJ regardless of whether he performs any surgeries at the surgery center, and his distribution is not dependent on how many surgeries he performs at MBJ. MBJ does not have a minimum surgery requirement to receive a distribution.

With that as background, the opinion distinguished Renkenmeyer and held that the income was not subject to SE tax:

Dr. Hardy is an investor in MBJ, which is distinguishable from the limited liability partnership formed by the partners in the law firm in Renkemeyer, Campbell & Weaver, LLP v. Commissioner. MBJ owns and operates a surgical center. MBJ is equipped for doctors to perform surgeries that require local and general anesthesia. MBJ bills patients for the use of the facility. Although Dr. Hardy performs surgeries at MBJ, he is not involved in the operations of MBJ as a business. In contrast to the partners in Renkemeyer, Campbell & Weaver, LLP, who are lawyers practicing law and receiving distributive shares based on those fees from practicing law, Dr. Hardy is receiving a distribution based on the fees that patients pay to use the facility. The patients separately pay Dr. Hardy his fees as a surgeon, and they separately pay the surgical center for use of the facility in the same manner as with a hospital. Accordingly, Dr. Hardy’s distributive shares are not subject to self-employment tax because he received the income in his capacity as an investor. [notes and citations omitted]

Parting Thoughts

Hardy stands as useful precedent for members whose income is pegged to a capital investment rather than services those members perform.

It is interesting to note that the information returns Hardy received in fact treated the income as subject to self-employment tax. This is a good reminder (as Keith’s post Proving a Negative The Use of Section 6201(d) discussed) that preparers and taxpayers have to carefully consider the information returns starting to come in; understanding the nature of income, especially in a pass through environment, requires a bit of digging. In fact, in Hardy the parties raised this issue not in the pleadings but only on motion to conform the pleadings to the evidence under Tax Court Rule 41(b)(1). Hardy was fortunate on this issue that the Tax Court concluded that the IRS was not prejudiced or unfairly surprised, thereby letting him raise the issue that he did not flag in his petition.

Financial Consultant Fails To Avoid Self-Employment Tax With S Corp Structure

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).

Final Thoughts

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.

Combining an LLC with a Corporation

Today’s guest post is by Jim Maule, Professor Emeritus at Villanova Widger School of Law and one of the original tax law bloggers. This post, which originally appeared on Mauled Again, on October 10, 2016, discusses who is liable for employment tax when an LLC fails to remit employment taxes following a merger of a C Corp with a single-member LLC. It sweeps in some interesting procedural issues, including the importance of filing required forms to ensure that an LLC is treated as a corporation if one wants it to be treated as a corporation and the uphill battle facing taxpayers who claim IRS should be estopped from taking a position because it has accepted a filing in past years. Les

A recent Tax Court decision, Costello v. Comr., T.C. Memo 2016-184, provides helpful instructions about what to do and not to do when combining an LLC with a corporation. Though it’s too late for the taxpayer in that case, there are lessons that should prove helpful to others facing the issue in the future.

The case involved collection actions for employment tax liabilities. The resolution required identifying the tax status of the employer. Though the amount of the tax liabilities was undisputed, the issue required identification of the responsible taxpayer.


In 1989, the taxpayer’s father incorporated Heber E. Costello, Inc. (HECI). The taxpayer’s father was thesole shareholder of HECI. HECI filed Form 1120 for each of its taxable years. At some point before 2004, the taxpayer’s father died and the taxpayer became the sole owner of HECI.

On December 31, 2003, the taxpayer formed an LLC. He was the sole member. The LLC never filed Form 8832, Entity Classification Election. On December 31, 2003, HECI and LLC merged – though the better word would be “combined” – and HECI ceased to exist. After the combination, the LLC filed Forms 1120 using HECI’s employer identification number. The taxpayer filed Forms 940 and 941 on behalf of the LLC but did not make sufficient tax deposits or pay the tax due for its employment tax liabilities for the first three quarters of tax years 2007 and 2008 or pay the tax due for its employment tax liabilities for the periods ending December 31, 2006 and 2008. The IRS issued a notice of intent to levy (NOIL) on June 1, 2011, for all of those periods and a notice of Federal tax lien (NFTL) filing on December 13, 2011, for all those periods other than 2006. The taxpayer timely submitted Forms 12153, Request for a Collection Due Process or Equivalent Hearing (CDP hearing), on June 26, 2011, and January 6, 2012, in response to the NOIL and the NFTL filing, respectively. The taxpayer indicated he could not pay the liabilities and wanted either an installment agreement or an offer-in-compromise (OIC). Though it was unclear if an OIC was submitted, it appears that any OIC would have been based on his argument that he was not individually liable for the LLC’s employment tax liabilities, which is the same argument he made before the Court. The taxpayer’s CDP hearing requests indicated he wanted Appeals to consider the abatement of taxes. Though asked to do so, the taxpayer did not submit a Form 433-A or any collection alternatives before the hearing. When an Appeals official met with the taxpayer’s representative, the taxpayer did not submit an OIC or any other collection alternatives to Appeals, nor did he present any argument with respect to the abatement of taxes. Instead, the taxpayer argued that the LLC, and not the taxpayer personally, is liable for the LLC’s employment taxes. The IRS issued the notices of determination upholding the proposed lien and levy actions on November 28 and December 3, 2012, respectively. Petitioner timely filed a petition for review of the determination.

After dealing with procedural issues, the Tax Court turned to the substantive question of whether the LLC or the taxpayer was liable for the employment taxes. The court explained that a single-member LLC is disregarded as a separate entity for federal tax purposes unless it elects to be treated as a corporation. The LLC did not file the election. Therefore, it was a disregarded entity.

The taxpayer, however, advanced three arguments in support of his position that the LLC should be treated as a corporation. The Tax Court rejected all three.

First, the taxpayer argued that the combination of HECI and the LLC was a valid F reorganization, and that the resulting entity was a corporation. The court concluded that regardless of whether the combination qualified as a F reorganization, the failure of the LLC to file Form 8832 electing to be a corporation kept it from being a corporation. Though the court did not directly answer the question, is it possible for a disregarded entity to enter into an F reorganization? Logically, the conclusion would appear to be no, because an F reorganization requires a mere change in identity, form, or place of incorporation, and in this case HECI disappeared, and the LLC did not change its identity or form, nor did it have a place of incorporation to change.

Second, the taxpayer argued that by filing Form 1120 for the first taxable year after the combining of HECI and the LLC was a valid election by the LLC to be treated as a corporation. The Tax Court concluded that the election to be treated as a corporation must be made on Form 8832 and is not made simply by filing a Form 1120.

Third, the taxpayer argued that the doctrine of equitable estoppel prevented the IRS from arguing that the LLC is not a corporation because of its “tacit acquiescence” to the filings of Forms 1120 for the year of the combination and subsequent years. The Tax Court concluded that equitable estoppel did not apply, because it requires proof that the IRS made a false representation or wrongful misleading silence, proof that the error was in a statement of fact and not in an opinion or a statement of law, proof that the taxpayer was ignorant of the true facts, and proof that the taxpayer was adversely affected by the acts or statements of the person against whom estoppel is claimed. The court explained that the IRS made no false statements to the taxpayer, and its failure to reject the LLC’s Forms 1120 was not a wrongful misleading silence. The court also explained that the taxpayer knew that the LLC had never filed a Form 8832 to be treated as a corporation.

For wages paid in the years in question, the activities of a disregarded entity are treated in the same manner as those of a sole proprietorship, branch, or division of the owner. Thus, the sole member of an LLC and the LLC itself are a single taxpayer or person personally liable for purposes of employment tax reporting and wages paid before January 1, 2009 [Ed: Regulations now provide that as of January 1, 2009, limited liability companies that are disregarded for all other purposes are treated as corporations for Federal employment tax purposes]. That left the taxpayer liable for the LLC’s unpaid employment tax liabilities.

The lesson is clear. If the member or members of an LLC want the LLC to be treated as a corporation, file Form 8832. There is no alternative. As complicated as tax law is, the filing of Form 8832 is one of the easier tasks to undertake. Though deciding whether to treat the LLC as a corporation requires somewhat more sophisticated judgments, projections, and planning, once the decision is made, the filing of the form is not difficult.