The Tax Court held that the income earned by a financial adviser was his income, not the income of his wholly owned S corporation, and he was subject to self-employment tax on the income.
Background
Ryan Fleischer is a registered financial consultant, Certified Financial Planner, and licensed seller of variable health and life insurance policies who develops investment portfolios for clients. He initially provided services as an employee of an investment firm and then as an employee of a bank. Wanting to have his own clients and accounts, for whom he could provide varying investment opportunities, he decided to start his own business.
On Feb. 2, 2006, to provide services on his own, Fleischer signed an agreement with LPL, a brokerage company. The agreement expressly states that Fleischer is an independent contractor with respect to LPL, and he signed the agreement in his personal capacity.
On Feb. 7, 2006, Fleisher incorporated Fleischer Wealth Plan (FWP) and elected S corporation status for the company. Fleischer is the sole shareholder of FWP and holds the positions of president, secretary, and treasurer. On Feb. 28, he entered into an employment agreement with FWP under which the company pays him a salary to "perform duties in the capacity of Financial Advisor."
In addition, on March 13, 2008, Fleischer entered into a broker contract with MassMutual Financial Group (MassMutual). The contract is between Fleischer and MassMutual, with no mention of FWP in the contract, and Fleischer signed the contract in his personal capacity. The contract explicitly states that there is no employer-employee relationship between Fleischer and MassMutual.
Through the end of the tax years in question, Fleischer and the companies had not modified the terms of the contracts.
On each of his income tax returns for 2009 to 2011, Fleischer reported wage income paid to him by FWP and the ordinary income of FWP (as calculated on FWP's Form 1120S, U.S. Income Tax Return for an S Corporation, and reported to Fleischer on a Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc., from the company) as nonpassive income on Schedule E, Supplemental Income and Loss. Fleischer did not report any self-employment tax on the returns.
The IRS issued Fleischer a notice of deficiency for the years 2009 to 2011. It determined that for the entire period, FWP's income was actually self-employment income to him that he should have reported each year on a Schedule C, Profit or Loss From Business, instead of as a passthrough from FWP on Schedule E, and that Fleischer should have reported and paid self-employment tax on the income. Fleischer filed a petition with the Tax Court challenging the IRS's determination.
The Tax Court's Decision
The Tax Court held that Fleischer should have treated the income attributed to FWP as his own income on Schedules C for the years in question and should have reported and paid self-employment tax on the income. The court came to this conclusion because Fleischer, not FWP, controlled the earning of the income.
The Tax Court stated that, based on precedent going back to the Supreme Court's decision in Lucas v. Earl, 281 U.S. 111 (1930), "the first principle of income taxation is that income must be taxed to him who earned it." In a case involving an individual and a corporation, the question that the court must ask is, "Who controls the earning of the income?" For a corporation to be in control of the income, two elements must be present: (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" (Johnson, 78 T.C. 882, 891 (1982)).
The Tax Court only discussed its analysis of the second element. It first looked at whether FWP had contracts with LPL and MassMutual or whether LPL and MassMutual were aware that FWP controlled Fleischer. Regarding LPL, the court pointed out that not only was FWP not mentioned in the agreement between Fleischer and LPL, but also that FWP was not formed until after the agreement was signed. Furthermore, Fleischer did not enter into his employment agreement with FWP until approximately three weeks after FWP was formed. Thus, there was no indication that LPL was aware that FWP controlled Fleischer.
With respect to MassMutual, although the contract was signed after the formation of FWP, the Tax Court noted the contract did not mention FWP, and there was no other evidence that MassMutual was aware that FWP had any control over Fleischer. Furthermore, the court found that FWP could have signed the contract because it covered only the sale of fixed insurance contracts, and the reason Fleischer signed it in his individual capacity was that it left open the possibility of his selling variable insurance contracts, which FWP could not sell.
Fleischer argued that the only reason that he, rather than FWP, signed the contracts with LPL and MassMutual was that it was not possible for those companies to sign with FWP because it was not a registered entity under securities laws and regulations. While the court agreed that the law cited by Fleischer, 15 U.S.C. Section 78o(a)(1), prohibited FWP from selling securities without being registered to do so, the court found that the law in no way prohibited FWP from registering. Therefore, the court concluded, the fact that FWP had not registered to sell securities did not allow Fleischer to assign income he earned personally to FWP.
Fleischer also argued that the under Sargent, 929 F.2d 1252 (8th Cir. 1991), which is binding precedent in the Eighth Circuit, where his appeal would lie, the Tax Court should rule in his favor. In that case, two hockey players formed personal service corporations, which signed contracts with the teams they played for, and, in turn, the corporations paid the players' salaries and contributed to pension plans for them. The Eighth Circuit held that the corporations earned the income from the contracts. The Tax Court, however, determined that Sargent did not apply to Fleischer because FWP did not have a contractual relationship with LPL or MassMutual.
In addition, Fleischer claimed that Rev. Rul. 70-101, which states that the IRS will generally treat professional service organizations formed under state professional association or corporation statutes as corporations for tax purposes, applied in his case, and, accordingly, FWP must be recognized as a separate, taxable entity. The Tax Court, however, found that the revenue ruling did not apply, observing that the validity of FWP was not at issue, and, moreover, the validity of the corporate entity did not preclude reallocation under the assignment-of-income doctrine, citing the Eighth Circuit case of Wilson, 530 F.2d 772 (8th Cir. 1976).
Because the evidence showed that FWP had not entered into a contract with LPL or MassMutual, and there was nothing to indicate that either corporation believed that FWP had meaningful control over Fleischer, the Tax Court determined that Fleischer did not meet the second element of the control test. Because both elements of the test must be met for a corporation to be considered to control a service provider and to earn the income generated by the service provider, the court found no reason to decide whether the first element of the control test was met. Because the control test was not met, the court held that the income reported on FWP's returns belonged to Fleischer and was subject to self-employment tax.
Reflections
Having set up FWP as an S corporation—presumably to avoid self-employment tax—Fleischer did not follow through and use the S corporation to create the situation he claimed existed. He testified that he did not set up FWP to sell securities because registering FWP to sell securities would have been enormously expensive (although he provided no evidence for this claim). This should serve as a valuable reminder to clients that simply creating a type of entity that can provide the desired tax results is generally not the only step necessary to actually achieve those results.
Fleischer, T.C. Memo. 2016-238
