Electing S corporation status is a common strategy that saves self-employment taxes by splitting cash payments to the shareholder between tax-free distributions and wages. However, as Ryan Fleischer (Fleischer v. Commissioner, TC Memo 2016-238) discovered, this strategy does not work when the income is earned by the individual instead of the corporation.
Fleischer was a licensed independent broker who worked with Linsco/Private Ledger Financial Services (LPL) as an independent contractor. He was also an independent insurance agent with MassMutual and formed an S corporation shortly after he signed his contracts with LPL. About two years later, he began working with MassMutual.
In both cases, he signed the contracts in his own name, not in the name of his S corporation, Fleischer Wealth Plan (FWP). Fleischer had an employment contract with FWP, but this contract did not require him to remit to FWP the commissions he earned as an individual. He also did not inform either LPL or MassMutual of the existence of FWP.
When he filed his 2009, 2010 and 2011 corporate and individual tax returns, he followed this general procedure:
- FWP’s corporate returns reported the commissions that Fleischer received from LPL and MassMutual as income of the corporation.
- FWP deducted operating expenses, including a salary for Fleischer.
- FWP paid Fleischer a salary of $34,851 for 2010 and $34,996 for 2011. No salary was paid in 2009.
- On his 1040s, Fleischer reported the net income passed through on his Schedule K-1 from FWP and his salary from FWP.
- Commissions from LPL and MassMutual were reported on Schedule C of his 1040, but were backed out as an expense, resulting in zero income on his Schedule C.
Over the three years, Fleischer’s returns reported the following:
- Total commissions of $703,110 (reported on FWP’s Form 1120S).
- Total net income of $274,893 (reported on Schedule E of Fleischer’s 1040).
- Total wages from FWP of $69,852.
- Total Schedule C income of $0.
The U.S. Tax Court took issue with shifting the income from Fleischer to his corporation. As the court stated, “The first principle of income taxation is that income must be taxed to him who earned it.” A corporation can only claim income – and file tax returns reflecting that income – when it controls the earning of the income.
In the tax court’s analysis, two elements must be in place for a corporation to control income. One, the individual providing the service must be an employee of the corporation and must be subject to meaningful control by that corporation. Two, the buyer of the services must recognize the corporation as the actual service provider. This second element formed the crux of the court’s argument.
For broker-dealers and insurance agents, state insurance and securities laws require that commissions be paid to the individual who earns them. FINRA rules require that any entity or individual receiving broker commissions must be registered as a broker-dealer to receive that income. Since registering an S corporation as a broker-dealer is a daunting and costly process, it’s not surprising that Fleischer signed the contracts with LPL and MassMutual under his own name and not as FWP.
By the tax court’s analysis, since FWP had no contractual relationship with LPL or with MassMutual, it could not claim the commission income as its own. It was irrelevant that Fleischer transferred this income on his tax return to his S corporation. This income could only be recognized and taxed on Fleischer’s individual tax return. Accordingly, he was assessed self-employment tax of $41,563 across the three years.
Interestingly, one of the most common IRS attacks on S corporation shareholders – Fleischer’s relatively low compensation from FWP – wasn’t even mentioned by the tax court. The court already had enough ammunition with the absence of contractual relationships. However, advisors should keep in mind the source of a corporation’s revenue because the IRS considers that as one of several factors when evaluating reasonable compensation.
When a corporation is dependent on the efforts of a sole shareholder to earn revenue, the IRS prefers that more of the cash paid to the shareholder be in the form of wages, subject to employment taxes, rather than as tax-free distributions. Unfortunately, this can effectively eliminate the tax advantages of S corporations when there is only one shareholder.
Editor’s note: This article originally ran on the Firm of the Future blog.