Several times during my career, I have encountered a client who entered into a contract, personally, to perform services for a company. The client later formed an S corporation and, for one reason or another, could not (or did not) modify the original contract to name the S corporation as the service provider. Nevertheless, the income that the client received was deposited into the S corporation's bank account and was considered income to the corporation.
When the Form 1099-MISC, Miscellaneous Income, was issued in my client's name, the client picked up the income on Schedule C, Profit of Loss From Business, and then expensed the same amount as contract labor, showing that it was claimed by the S corporation. However, Fleischer, T.C. Memo. 2016-238, an interesting recent Tax Court case, may debunk this method of claiming income.
Ryan Fleischer is a financial consultant who develops investment portfolios for clients. After graduating from college, he obtained licenses that allowed him to purchase and sell securities under the Securities Exchange Act of 1934, the Financial Industry Regulatory Authority, and the North American Securities Administration Association rules. He is also a Certified Financial Planner, a registered financial consultant, and a seller of variable health and life insurance policies licensed in Nebraska.
He started his career with an investment and financial planning firm and then worked for the National Bank of Omaha. Wanting to have his own clients and accounts—and to provide them with varying investments—he struck out on his own.
On Feb. 2, 2006, he entered into an agreement with Linsco/Private Ledger Financial Services (LPL) as an independent contractor. He signed the contract as an individual.
After consulting both his business attorney and his CPA, he incorporated Fleischer Wealth Plan (FWP) on Feb. 7, 2006, and elected S corporation status. He was the sole shareholder and officer. On Feb. 28, 2006, he entered into an employment agreement with FWP that stated that his term of employment with FWP began on that date.
He was paid an annual salary to "perform duties in the capacity of Financial Advisor."
The agreement gave FWP the right to reasonably modify his duties at its discretion and contained other common provisions found in employment agreements. It did not require him to remit any commissions or fees from LPL or any other third party to FWP. He signed the agreement twice—once as FWP's president and once in his personal capacity.
On March 13, 2008, Fleischer entered into a broker contract with MassMutual Financial Group that did not mention FWP but did state explicitly that there was no employer-employee relationship between him and MassMutual. He signed the contract in his personal capacity.
No addendums or amendments to either the LPL agreement or the MassMutual contract were made requiring those entities to begin paying FWP instead of Fleischer or to recognize FWP in any capacity.
2009 through 2011
For each of the years at issue, Fleischer reported that his income was received from his S corporation, after the corporation deducted expenses, and not from the companies that he had contracted with. He also did not pay self-employment tax on any of his income for those years.
The IRS issued a notice of deficiency to Fleischer, determining deficiencies of $14,189, $13,985, and $13,389 for 2009, 2010, and 2011, respectively. The IRS determined that the gross receipts or sales FWP reported on its Forms 1120S, U.S. Income Tax Return for an S Corporation, should have been reported by Fleischer as self-employment income on Schedules C attached to his Forms 1040. Fleischer timely petitioned the Tax Court challenging the IRS's determination.
The Tax Court noted that it is a basic principal of taxation that income is taxable to the person who earned it. In a case involving a corporation and a service-provider employee, the court has previously held (in Johnson, 78 T.C. 882(1982)) that in determining who earned income, the question is who had control of the income? Thus, the court analyzed who controlled the income, Fleischer or his S corporation?
In Johnson, for a corporation, and not its service-provider employee, to be in control of the income, the Tax Court concluded two elements must be found:
- The individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense; and
- 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.
Both elements must be present before the corporation would be considered to control the service-provider employee. In Fleischer's case, because there was no indication that FWP exhibited any control over Fleischer, the court addressed only the second element of the test.
Fleischer entered into an agreement with LPL in his individual capacity with no mention of FWP. Since FWP was not incorporated until Feb. 7, 2006, it did not exist as a separate entity when Fleischer entered into his agreement with LPL. Additionally, Fleischer did not enter into an agreement that purportedly created an employer-employee relationship with FWP until approximately three weeks later. Therefore, the court found there was no indication that LPL was aware that FWP controlled Fleischer.
The broker contract Fleischer signed with MassMutual also did not mention FWP. Fleischer did enter into the broker contract after FWP was incorporated on Feb. 7, 2006, but he still signed the contract in his individual capacity. The contract expressly states that there is no employer-employee relationship between MassMutual and Fleischer. Consequently, the court found there was no evidence that MassMutual was aware that FWP had any meaningful control over Fleischer.
So why didn't Fleischer go back and sign the contract on behalf of his corporation instead of individually?
He argued that it was impossible for those entities to enter into the contracts because FWP was not registered under the securities laws. He pointed to Section 78o, Registration and Regulation of Brokers and Dealers, of the Securities and Exchange Act as evidence that FWP could not enter into representative agreements and broker contracts without registering.
The court, however, found that nothing in the law precluded Fleischer from registering his corporation as a registered entity with the SEC. Fleischer stated that doing so would cost millions of dollars, but the court disregarded this argument. The court stated that the fact that FWP was not registered, thus preventing it from engaging in the sale of securities, did not allow petitioner to assign the income he earned in his personal capacity to FWP.
Having found that neither LPL nor MassMutual had any reason to believe that FWP controlled Fleischer, the Tax Court determined that the second element of the test in Johnson had not been met. Therefore, it found that Fleischer had ultimate control of the income and not the corporation and held in favor of the IRS.
How does this change the way tax practitioners approach agreements and do tax returns? Very simply. Practitioners who have service provider clients who wish to have income from the services they provide be treated as income of their corporations should have their clients draft or revise their independent contractor agreements so that payments are made to their corporations, not to them as individuals.
Craig W. Smalley is an enrolled agent with a Master of Science in Taxation who is the founder and CEO of CWSEAPA PLLC, which provides accounting and financial services.