Decisions — On the payroll

Image source: Emile Garcke and J. M. Fells, 1889 (Public domain), via Wikimedia Commons

 

Paychecks may be proof that an employer has a sense of humor. Unfortunately, the IRS generally doesn’t find payroll amusing.

In T.C. Memo. 2016-238 (Fleischer), the taxpayer was a financial consultant. In addition to being licensed to buy and sell securities, he was also a certified financial planner, a registered financial consultant, and a licensed seller of variable health and life insurance policies under the laws of his resident state.

On February 2, 2006, the taxpayer personally signed a representative agreement to act as an independent contractor for a financial services firm. On February 7, 2006, he established an S corporation, and was the sole shareholder, the president, the secretary, and the treasurer of the corporation.

On February 28, 2006, the taxpayer entered into an employment agreement with the S corporation stating that his employment with the corporation began on that day. He signed the agreement as the corporations’ president, and also in his personal capacity, and was paid an annual salary to “perform duties in the capacity of financial advisor” for the corporation.

On March 13, 2008, the taxpayer signed, in his personal capacity, a broker contract with a life insurance company to act as an independent contractor selling fixed insurance products.

The taxpayer filed his corporate and personal tax returns for 2009, 2010, and 2011. He reported the income from the two contracts on the corporate tax return, and the wages paid to him from the corporation on his personal tax return.

The IRS sent the taxpayer a notice of deficiency for each of the three years. The IRS said that because the taxpayer entered into the contracts personally, the gross receipts or sales reported on the corporate returns should have properly been reported as self-employment income on the taxpayer’s personal income tax return.

The taxpayer says he signed the contracts himself because his corporation was not a registered entity under the securities laws and regulations, so the two companies he worked for could not enter contracts with his corporation. While the taxpayer’s corporation was not prohibited from becoming a registered entity under the securities laws, he testified that doing so would be overly burdensome and “would cost millions and millions of dollars.”

The tax court said the first principle of income taxation is that income must be taxed to the one who earned it. However, because applying a simplistic “who earned the income” test when the issue involves a corporation and its service-provider employee is impractical, the court said the test becomes “who controls the earning of the income.”

Two elements determine whether a corporation, not its service-provider employee, is the controller of the income.

First, the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense.

Second, “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 met before the corporation will be considered to control the service-provider employee.

Finding that both elements are met means the taxpayer wins. If no elements, or only one element, is met, the IRS wins.

 

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

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Right answer!

For the IRS.

The fact that the taxpayer’s corporation was not registered, thus preventing it from engaging in the sale of securities, does not allow the taxpayer to assign the income he earned in his personal capacity to the corporation.

On February 2, 2006, the taxpayer individually entered into a representative agreement with a financial services firm. There is no mention of the taxpayer’s corporation in the representative agreement.

Moreover, the taxpayer’s corporation was not incorporated until February 7, 2006, meaning it did not exist as a separate entity when the taxpayer entered into the representative agreement with the financial services firm.

Additionally, the taxpayer did not enter into an agreement that purportedly created an employer-employee relationship with his corporation until approximately three weeks later. Therefore, there was no indicium that the financial services firm was aware that the taxpayer’s corporation controlled him.

There is also no mention of the taxpayer’s corporation in the broker contract the taxpayer signed with the life insurance company. The taxpayer did enter into the broker contract after his corporation was incorporated on February 7, 2006, but he still signed the contract in his individual capacity.

The contract expressly states that there is no employer-employee relationship between the life insurance company and the taxpayer. There is no mention of the taxpayer’s corporation in the contract and no evidence in the record that the life insurance company was aware of whether the taxpayer’s corporation had any degree of meaningful control over him.

For the reasons stated above, the court finds that the taxpayer has failed to meet the second element of the control test.

Because the taxpayer does not meet the second element of the test, there is no need for the court to analyze, and the court makes no decision as to, whether the taxpayer was an employee of his corporation.

Therefore, the taxpayer individually, not his corporation, should have reported the income earned under the two agreements for the years in issue.

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