Taxpayers often establish Subchapter S corporations to avoid Social Security and Medicare taxes on a portion of their earnings. This is a very common arrangement. The Fleischer v. Commissioner, T.C. Memo. 2016-238, court case provides an example of how the Subchapter S corporation must be structured to avoid these taxes.
Facts & Procedural History
In Fleisher, the taxpayer was a financial planner. He entered into an agreement with a broker and an insurance company to sell their products to his clients. He signed the agreements in his individual capacity.
The taxpayer had also formed a legal entity. He chose to have the entity be taxed as a Subchapter S corporation. The taxpayer entered into an employment agreement with the legal entity.
The taxpayer reported his earnings on the S corporation tax return (the Form 1120S) and he reported the flow through wages and distribution on his personal tax return (the Form 1040). The taxpayer did not report any self-employment tax on his personal tax return.
The IRS audited the taxpayer and concluded that his income and expenses should have been reported on his personal tax return, and not on the legal entity’s tax return. If the IRS’s position was correct, this would subject a large portion of the business income to self-employment tax.
Subchapter S Corporations & Income and Self-Employment Taxes
Subchapter S corporations are not subject to income tax. Rather, they file an information return and report their income, expense, etc. which flow through to, and are reported on, the shareholder’s personal tax returns. The shareholder also reports any wages that are paid to him by the corporation.
The shareholder can classify a portion of the S corporation’s income as wages and a portion as a distribution. The wage portion is subject to self-employment tax, which includes both Social Security and Medicare taxes. The distribution portion is not.
Compare this to a sole proprietorship or single-member limited liability company. These businesses are disregarded for federal income tax purposes. The items of income, expense, etc. are reported on the taxpayer’s individual tax returns. The business income is subject to self-employment tax, which, again, includes both Social Security and Medicare taxes.
Whether the Income and Expense Belong to the Subchapter S Corporation
The question for the court was whether the taxpayer’s income and expenses should be reported by the legal entity, resulting in less self-employment tax, or reported by the taxpayer on his personal tax return.
The court noted that there are two factors to consider in answering this question:
- 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.
The court determined that neither element was satisfied in this case. It based this decision on the fact that the taxpayer signed the brokerage and insurance contracts in his personal capacity. He did not sign the contracts on behalf of the business. This meant that the brokerage and insurance companies were paying the taxpayer, not his legal entity. They also reported the income to the IRS in the taxpayer’s name, not in the business’ name. To the court, this meant that the business did not control the taxpayer. Accordingly, the court determined that the income and expenses should have been reported on the taxpayer’s personal tax return.
The takeaway is that business owners need to ensure that their contracts are entered into in the name of the business, the income is paid to the business and not the individual owner, and the income is reported to the IRS as having been paid to the business and not the individual owner.