Newsletter Reminds Us That Those Who Do Not Learn From Tax History Are Bound To Repeat Its Mistakes

A recent newsletter stated that a common business structure for independent broker-dealers suffered a setback in Tax Court when the IRS prevailed. The individual, a broker-dealer held several series licenses to annuities and other financial products. The individual, not his corporation, signed contracts with LPL and Mass Mutual. The corporation elected S status and in 2010 paid the individual salary of $35,000 and dividend income of $147,000. The desired tax savings would result from the dividends escaping self-employment tax. The $147,000 dividend initially escaped self-employment tax but not the attention of the IRS which issued an assessment for $42,000 covering 2010 and two other years. The Tax Court held in Fleischer v. CIR (T.C. Memo 2016-28) that the individual controlled the right to receive this income in exchange for his efforts and it was compensation subject to self-employment tax. It appears Fleischer was the only employee. The Court held that the taxpayer failed the Johnson Test which determines who controls the activity resulting in the income. This test has two prongs and the taxpayer failed both. First, the individual providing the service must be a true employee of the corporation and the corporation must be able to direct and control the employee. Second, the recipient or user of the services must have a contract or arrangement with the corporation.

Johnson v. United States

Johnson v. United States, 698 F.2d 372 (9th Cir. 1982). In Johnson, a professional basketball player assigned his salary to a corporation in exchange for the right to receive monthly payments for life from the corporation. The player then claimed only the monthly payments as income. We concluded that the entire salary amount was taxable. Over the following years, many athletes tried various modifications of this strategy without success. Essentially, these strategies sought to avoid payroll tax or to have income taxed at the then much lower corporate rates. Typically, the later strategy was coupled with a defined benefit plan requiring substantial contributions that were tax deductions to the corporation. Lest we think that broker-dealers and athletes are the only taxpayers using this structure, there have been repeated attempts by lawyers and accountants to press this approach. A court in another case remarked on two attorneys who were the sole shareholders of an S corporation and performed all of the legal work. They reported no compensation and received only dividends. The court stated that: To reach the conclusion that the payments were dividends would require the court to accept that [the shareholders] were providing legal services on behalf of the corporation without regard to receiving payment for legal services.

Fleischer article

The article on Fleischer commented that operating as an S corporation is a common business structure for broker-dealers. It is also useful for other taxpayers but any analysis of utility must be tempered by the reality of the circumstances. A corporation acts through its employees and it is hard to provide services without personal effort being expended. Decades ago, rock bands would contract with a corporation in a favorable treaty country and then go on tour. The loan-out corporation would contract, at a price that would absorb substantial profits, with a domestic corporation that conducts the tour. The loan-out company would then pay the band in the low-tax jurisdiction thereby escaping all or virtually all tax. Every treaty was amended to prevent this.

Do you have any questions? Would you like to discuss the matter further? If so, please contact me, James McDonough, at 201-806-3364.