Back to Basics
This is not a silly question. In fact, it is often one of the most difficult issues confronted by a tax adviser, and it arises from one of the most basic of tax principles; specifically, that income is taxable to the person who earns it. The difficulty in addressing the issue derives from the many varieties of situations in which it is presented.
For example, taxpayers have often tried to transfer their earned income or built-in gain to others (including family members, partnerships, and charities) so as to avoid or reduce the liability for the tax attributable thereto. In some instances, the Code provides rules that seek to prevent the shifting of one’s tax liability. (See, e.g., the rules regarding a taxpayer’s contribution of appreciated property to a partnership, which effectively prevent a taxpayer from shifting the tax inherent in the “built-in gain” to the other partners – a topic that will be covered in a later post.) In other situations, the courts have had to parse through sometimes convoluted fact patterns to determine who actually earned the income at issue, or whether a taxpayer’s transfer of “property” succeeded in also transferring any income that had accrued with respect to such property, or whether any property has been transferred at all (as opposed to a transfer of earned income), or whether the purported transferor even owned the property being transferred (see our previous discussion on personal vs. corporate goodwill).
It only seems appropriate, as we begin a new tax year (at least for those persons who use the calendar year as their tax year – tax humor), that we discuss this basic principle. Fortunately, the Tax Court recently provided us with a fairly simple scenario to illustrate the application of this principle. The issue for decision was whether Taxpayer or his S corporation had to report the income earned for the years in issue.
There Once Was A Taxpayer . . .
Taxpayer was a financial consultant. He provided advice and services to his employer’s clients. Wanting to have his own clients and accounts on which to
work, Taxpayer struck out on his own.
Shortly thereafter, Taxpayer entered into an agreement with Firm. The agreement stated that Taxpayer’s relationship with Firm was that of an independent contractor. Taxpayer signed the agreement in his personal capacity.
A few weeks later, after consulting with his attorney and his accountant, Taxpayer created Corp., and caused it to elect S corporation status. Taxpayer was the sole shareholder of Corp. He then entered into an employment agreement with Corp. The agreement stated that Taxpayer’s term of employment with Corp. began with the date of its incorporation.
Under this employment agreement, Taxpayer was paid an annual salary to “perform duties in the capacity of financial advisor.” Those duties consisted of: (1) acting in the best interests of Corp.’s clients in managing their investment portfolios; (2) expanding Corp.’s client base and the “overall presence” of Corp.; and (3) representing Corp. “diligently and responsibly at all times.” The agreement did not include a provision requiring Taxpayer to remit any commissions or fees from Firm or any other third party to Corp. Taxpayer signed the agreement twice–once as Corp.’s president and once in his personal capacity. Outside of the employment agreement, Corp. did not enter into any other contracts during the years in issue.
Two years later, Taxpayer entered into a contract with Financial Group. The contract was between Taxpayer and Financial Group – there was no mention of Corp. in the contract. The contract stated that there was no employer-employee relationship between Taxpayer and Financial Group. Taxpayer signed the contract in his personal capacity.
There were no amendments to either the Firm agreement or the Financial Group contract requiring those entities to begin paying Corp. instead of Taxpayer, or to recognize Corp. in any capacity.
The Tax Returns
For the years in issue, both Firm and Financial Group issued Forms 1099 to Taxpayer in his individual capacity for the years in issue. In general, Form 1099-MISC, Miscellaneous Income, is the form used to report nonemployee compensation.
For the same years, Corp. reported ordinary business income on its Form 1120S, U.S. Income Tax Return for an S Corporation. The amount of Corp.’s gross receipts was calculated from the Forms 1099 that Firm and Financial Group issued to Taxpayer for those years.
Generally, an S corporation is not subject to income taxes, though it is required to file an annual information return. The corporation’s income, losses, deductions, and credits are passed through to the shareholders based upon their pro rata stock ownership. These passthrough items are taken into account in determining a shareholder’s income tax liability, but not for purposes of the employment tax. The Schedule K-1s issued to Taxpayer for the years in issue reported Corp.’s ordinary business income.
Taxpayer reported taxable wage income from Corp. on his Form 1040, U.S. Individual Income Tax Return. He also attached a Schedule E to his Form 1040, reporting the S corporation income that passed through to him from Corp. No amount was reported as income from self-employment, notwithstanding the 1099s that were issued to Taxpayer.
The IRS issued Taxpayer a notice of deficiency for the years in issue in which it determined that the gross receipts that Corp. reported on its Forms 1120S should, instead, have been reported by Taxpayer as self-employment income on Schedule C of his Forms 1040 for the years in issue. Taxpayer challenged the IRS’s determination in Tax Court.
Corporation or Shareholder as Taxpayer?
As stated above, it has long been a first principle of income taxation that income must be taxed to the person who earned it. While this principle is easily applied, relatively speaking, between two individuals by simply asking who performed the services or sold the goods, the question of who earned the income is not as easily answered when a corporation is involved. In part, this is because another basic principle of income taxation provides that a corporation is generally treated as a separate taxable entity.
Because it may be difficult to apply a simplistic “who earned the income” test
when the choices are a corporation and its service-provider employee, the
question has evolved to one of “who controls the earning of the income.” In order for a corporation – as opposed to its service-provider employee – to be the controller of the income, two elements must be found: (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 using the services a contract or similar “evidence” recognizing the corporation’s controlling position.
The Court began by examining the second element.
Indicia of Control
When Taxpayer individually entered into the agreement with Firm, there was no mention of Corp. because it was not even incorporated until a few weeks later. It did not exist as a separate entity. Additionally, Taxpayer did not enter into an agreement that purportedly created an employer-employee relationship with Corp. until after Corp. was created. Therefore, there could be no indicium that Firm was aware that Corp. controlled Taxpayer as its employee.
There was also no mention of Corp. in the contract that Taxpayer signed with Financial Group. In contrast to the agreement with Firm, Taxpayer enter into this contract after the creation of Corp., but he still signed the contract in his individual capacity. The contract expressly stated that there was no employer-employee relationship between Financial Group and Taxpayer. There was no mention of Corp. in the contract and no evidence in the record that Financial Group was aware of whether Corp. had any degree of meaningful control over Taxpayer.
Taxpayer did not dispute that Firm and Financial Group never contracted
directly with Corp. In fact, Taxpayer testified that Corp. could have signed the contract with Financial Group, but he chose to sign the contract in his individual capacity because, he claimed, this would afford him the flexibility to sell other products in the future. He also argued that it was impossible for those entities to contract with Corp. because Corp. was not registered to sell securities under the securities laws and regulations. In other words, Taxpayer implied that he had acted on behalf of Corp. in entering into these arrangements in order to circumvent these rules.
The Court responded by pointing out that the securities rules did not prohibit a business entity, such as Corp., from registering. The fact that Corp. was not registered, the Court stated, did not allow Taxpayer to assign the income he earned in his personal capacity to Corp.
The Court continued by noting there was no reason for Firm to believe that Corp. had any meaningful control over Taxpayer as Corp. had not been incorporated, and no purported employer-employee relationship between Corp. and Taxpayer existed, at the time he signed the agreement with Firm. Moreover, there was no evidence of any amendments to the Firm agreement after Corp. was incorporated. Although Corp. had been incorporated before Taxpayer entered into the contract with Financial Group, Corp. was not mentioned in the contract, and Taxpayer offered no evidence that Financial Group had any other indicium that Corp. had any meaningful control over him.
Based on the foregoing, the Court found that Taxpayer had failed to meet the second element of the control test outlined above; i.e., that there must exist between the corporation and the person using the services a contract or similar “evidence” recognizing the corporation’s controlling position. Therefore, Taxpayer individually, not Corp., should have reported the income earned under the agreement with Firm and the contract with Financial Group for the years in issue. Consequently, Taxpayer owed self-employment tax with respect to such income.
Another Basic Principle
It is clear that Taxpayer sought to avoid the self-employment tax on the ordinary business income generated under the agreements above.
Other taxpayers have sought to use S corporations for the same avoidance purpose. Recognizing that a shareholder’s pro rata share of an S corporation’s ordinary business income is not subject to employment tax, shareholder-employees have caused their corporate-employer to pay them a below-market (often unreasonably low) salary for their services provided to or on behalf of the corporation. Although this salary is subject to employment taxes, the remaining corporate profit is not. Unfortunately for them, the IRS has caught on to this gambit and has taken steps to address it.
Which brings us to another basic tax principle, and recurring message of this blog: a taxpayer and his advisers have to examine a proposed structure or arrangement with a critical eye – they cannot ignore that which they do not want to see. Before embarking upon any course of action, they need to objectively consider: How will the IRS and a court view the arrangement? What legal authority supports the taxpayer’s position? Will parts of the arrangement be disregarded as having no bona fide business purpose? Will the taxpayer be able to substantiate the stated business reason for the structure? Will the form of the arrangement be respected, or will the IRS recharacterize it (for example, by ignoring certain steps or constructing “missing” steps)? These and other questions will need to be considered if the taxpayer hopes to convince the IRS as to the identity of the proper taxpayer and the desired tax consequences.