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.
read more...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.
About Leslie Book
Very refreshing to hear that someone finally got caught on this. Mr. Fleischer is very much not alone in trying to pull this off. It’s ridiculous to think that any financial adviser can attribute earnings away from him or herself. This is a very abusive practice that’s been employed by thousands of financial advisers all over the country for many years.
Too bad for the CPAs and lawyers advising them on this — they can now study the provisions of their own professional liability insurance. Two thumbs up on this one.
Your article has some inaccuracies. First off the question was never a matter of tax avoidance or what my set salary was. The salary was actually was higher than you indicated before company retirement plan contributions. The case was solely the fact on who earned the income. I am not sure how it’s an abusive practice by marketing and operating one’s wealth practice under the corporation doing the business. Yes, captive advisors it is abusive, but those that own their practice and book. Pretty soon the government will say I don’t own my office furniture, my investment model, and my book client’s….all under the corporation’s name. If a client has an investment account at the bank, he is not signing paperwork with the bank, rather with the custodian or BD. Are you saying the bank should not get paid for having investment services?
While guaranteed payments are subject to self-employment, the distributive portion may not be. Since final regulations have not been issued, an allocation can be made for the distributive portion.
Assuming that and LLC is not one of the enumerated ones, an allocation of the distributive portion can be made between capital and service. Only the service portion is subject to self-employment tax.
Thank you for the clarification.
Mr. Coffman: I am the attorney who tried the case. I did not structure the transaction in question. Before suggesting that people review their professional liability policies, I would suggest that you read the case, with a particular eye on the unique legal issues of the securities industry. Hint: It was legally impossible for the S corporation to contract directly with LPL. Hint #2: The IRS never once suggested that penalties of any nature be imposed.
“It’s ridiculous to think that any financial adviser can attribute earnings away from him or herself.”
It’s ridiculous to think that self-created intangibles, like customer accounts, don’t have value just because they’re not on the Balance Sheet. And by all accounts, these assets were either contributed to the corporation and/or created by the corporation. Fleischer essentially exchanged his LPL contract, and other intangibles, for corporate stock. A fair trade of equivalent value. As shareholder, he’s entitled to a return on his investment, as Mr. Cohen points out, albeit in the partnership context. In other words, just because 100% of the earnings are generated by one guy doesn’t mean that 100% of the profits needs to show up on the guy’s W2. This assumes the corporation is viewed as the earner of said profits to begin with. Unfortunately, the Johnson Test is so one sided and flawed – only looking at LPL and who it believed it was transacting with – there was no real possibility for the corporation to be recognized as the earner. But don’t get me wrong. Even if the IRS recognized the corporation as the earner, they could have possibly attacked the contribution of the contract as not being property under 351.
My understanding is that these arrangements are fairly commonplace, not because of some subversive attitude, but because the financial regulations want an individual’s name on the contract owing to broker/dealer issues (but someone who knows more than me about it can feel free to chime in). The form of that transaction shouldn’t overtake the substance of it and the substance of it can only be gleaned by examining ALL facts and circumstances, which is something the Johnson Test doesn’t do. Fleischer may also have argued that if he was, in fact, the earner of the gross income, he should get an offsetting deduction for his personal payments to the corporation.
This case is not what many people may think it is about. The issue was not whether the salary paid to the financial planner was adequate, considering all the facts and circumstances. That is the issue in many S Corp cases, but not here. The issue here is whether the income from the brokerage house and the insurance company should have been reported on the corporation tax return.
No, IRS said and the court agreed, because it was not paid to the corporation, it was paid to the individual. Significantly (everything a Tax Court judge writes is significant) the opinion points out, “The agreement [between the corporation and its owner] does not include a provision requiring petitioner to remit any commissions or fees from LPL or any other third party to FWP.”
The advice to others, then, may just be to make sure you agree with yourself in writing that this will happen. It’s also a good idea to make sure your contract with your broker is not dated before your contract with yourself. The Court leaves some other hints about the way it should have been done. And incidentally, there is no indication that the lawyer or CPA gave advice involving taxes, or that any such advice was followed.
“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.”
Unless, of course, the LLC elects to be taxed as an S Corporation.
“This case is not what many people may think it is about. ”
It’s an assignment of income case. Seminal case being the SC case of Lucas vs. Earl, which stands for the simple proposition that he who earns it, pays tax on it. The Fruit and the Tree. If we evaluate the case from that simple standpoint, we see that the corporation earned it by virtue of the employment relationship with Fleischer and based on an evaluation of all other facts and circumstances. We are not talking about the assignment of an already-earned cash basis receivable. All the fruit in this case grew from the same corporate tree. Of course, like many other areas of the tax law, this one has drifted far, far away from its original principle. And to that point, I question if the Johnson Test should have even been applied. Seems to me that when a higher authority exists, we go that route first, even though it might not be the easiest. We shouldn’t jump to some test created by a lower court, even though that would, of course, give the easy answer since the test is so lopsided. Some higher courts have disavowed the Johnson Test altogether.
“The advice to others, then, may just be to make sure you agree with yourself in writing that this will happen.”
That made me laugh. If that really is a requirement, that leaves zero room for common sense to prevail (see Mr. Kaplan’s comments about the unique issues of the securities industry). Of course, if there was such a written agreement, the IRS would likely chalk it up as “self-serving.” Nonetheless, if we look at the facts of this case – all of them – not just the one-sided ones pertaining to the Johnson Test – the end result (i.e. the substance) totally comports with your suggestion. The money made it into the corp. The corp paid Fleischer as an EE, in accordance with the corporation/Fleischer employment contract. The corporation paid routine operating costs. Etc, etc. A corporation wouldn’t pay any bills, or agree to any obligation, unless there was some understanding that it would have some source of gross income.
“Significantly (everything a Tax Court judge writes is significant) the opinion points out”
It’s not significant if the Johnson Test is applied.
I would also point out that the economic substance test is now codified in Sec 7701(o). I see no reason why a taxpayer can’t rely on it, or at least argue for its application.
The Court’s opinion imposes a conflict between the broker dealer, the contracts entered into, and the limited liability that an S- Corp. is to provide under that state’s guidelines. It appears the Court is stating that any insurance or securities professional cannot use the limited protection offered because the S-Corp can be disregarded when they choose to because the income cannot be assigned for paying expenses the S- Corp has entered into, at least in this case.
My concern is whether a contractual agreement entered into years ago will be allowed to be modified by that companies legal department without incurring more legal fees for the broker dealer. I’m under the impression the Tax Court was out to set a precedence that any broker dealer that challenges the IRS’s opinion of structuring their income under the advice of legal counsel for asset protection reasons and tax planning will lose.
I would like to hear what a congressman would opine?
There is one item not mentioned that I can see is where were the monies received deposited? Realtors are in the same situation. The individual is the licensee. If the Realtor wants to be an LLC (s-corp or otherwise), the Realtor gets paid directly as the broker does or cannot pay the non-licensee. If the Realtor deposits the money in the business account, can it be considered constructive receipt on the part of the corporation. Of course there is the issue of reasonable compensation, but that is another issue all by itself.
I am sure that even many professionals (lawyers, Enrolled Agents) have been given checks written to their individual name versus their active legal entity, but the professional deposits these monies in their entity’s account. Are saying that these monies are then considered income automatically subject to SE Tax. I would think not…..
The revenues were directly deposited by the sources(BD and insurance company) into the corporations bank account.
I am kind of disappointed here to see how little support there is for the Tax Court’s routine implementation of the assignment of income doctrine in this case. If we accept the argument made by some commenters that a person can simply assign income paid to him or her to an entity controlled by the person, why couldn’t the person also just assign it to a spouse or relative in a lower bracket? That’s what Lucas v. Earl is about.
The Tax Code is willing to accept that, since corporations only can deliver personal services through employees, compensation to corporations for work done by employees is corporate income. But, if there is no sense by the payor of the fee that he or she is aware of the corporation or that state law does not permit a corporation to render these kinds of services, I have a hard time seeing that it is right for an individual payee to just deposit a check made out to him or her into a corporate account and call it corporate income.
Query: If someone comes from my cable company to install a box for a fee, and I write a check to the installer, rather than the company, wouldn’t the company insist that the check be rewritten to make the company the payee because that is the taxpayer who is deemed to have performed the work (the only taxpayer with whom I have a contractual relationship)?
I am not bothered by the fact that in certain high-paid professions only an individual can render services (or that a corporation can render the services only after going through expensive registration requirements). If a person in that profession doesn’t like that set-up, pick a different profession or call your legislator to get the state law changed that prevents a corporation from earning the income (or get the hurdles lowered to this result).
“If we accept the argument made by some commenters that a person can simply assign income paid to him or her to an entity controlled by the person, why couldn’t the person also just assign it to a spouse or relative in a lower bracket?”
Because the spouse or relative didn’t do the work. That’s what Lucas vs. Earl is all about. And no one ever said “simply assign.” Fleischer went to great lengths to ensure that the work he did was as an employee for the corporation.
“Query: If someone comes from my cable company to install a box for a fee, and I write a check to the installer, rather than the company, wouldn’t the company insist that the check be rewritten to make the company the payee because that is the taxpayer who is deemed to have performed the work (the only taxpayer with whom I have a contractual relationship)?”
Maybe, maybe not. Depends on the company. Maybe the company could care less, so long as it gets the money, whether it comes from you or the installer. In Fleischer’s case, the corporation did get the money, pursuant to its agreement with Fleischer. And the fact that the corporation did get the money is evidence of the arrangement.
Again, the Johnson Test is lop-sided, only looking at who LPL believed it was contracting with. Lucas vs. Earl says we look to who actually earned the money. And even if it is found that the corporation didn’t earn the earn the money directly, then the corporation earned it indirectly, meaning Fleischer would have a Schedule C deduction.
Query: What if Fleischer sold all of his stock to an unrelated party…and the arrangement continued on, with Fleischer personally collecting and then forwarding the money to the corporation, which is now owned by someone else? Are we to believe that the corporation still has no gross income, from the date of the stock sale forward?
“If a person in that profession doesn’t like that set-up, pick a different profession or call your legislator to get the state law changed that prevents a corporation from earning the income (or get the hurdles lowered to this result).”
That is all irrelevant as per Lucas vs. Earl, where the test is, “Who earned the income?”
It is a violation of securities law for a Broker/Dealer to pay compensation to a non-member firm. Unless Mr. Fleischer registered his S-Corp and was approved by the regulators and SRO’s as a Broker/Dealer, it is illegal for LPL to pay the S-Corp directly.
LPL (and other B/D’s) pays the Advisor by direct depositing the 1099 income to a brokerage account in the name of the Advisor (a firm member) under the Advisor’s SSN. The funds are then electronically transferred from the personal brokerage account to the corporate entity.
Thereby paying the individual and not the corporation. The 1099 is then sent to the individual who received the funds.