Movement Toward Tax Increases
You may have read last week that Democrats on the Senate Budget Committee announced they had reached a deal on a budget resolution that will enable them to bypass Senate Republicans on the way to enacting most of the “social infrastructure” programs called for under the President’s American Families Plan.[i] Significantly, after the announcement, Senator Manchin, who is not a member of the Committee, indicated he would not stand in the way of the budget resolution, thereby practically assuring its passage and the start of the reconciliation budget process.
Although details have not yet been released, and much remains to be negotiated (even within the Democratic Party), it appears from statements by Senators Schumer and Sanders[ii] that tax increases will contribute mightily toward the cost of implementing and operating these programs. You may recall that among the revenue-generating measures called for by the President is the expanded application of employment taxes.[iii]
Truth be told, the President’s employment tax proposals have their genesis in more than just the need for revenue to fund his Administration’s ambitious social programs. In part, they may be justified as a response to the often creative, sometimes convoluted, and almost always misguided attempts by many taxpayers to avoid the payment of employment taxes.
A recent decision of the U.S. Tax Court considered the efforts of one closely held corporate taxpayer and its shareholders.[iv]
Taxpayer was a corporation that operated several childcare centers during the years in question.
At all relevant times, the Spouses were Taxpayer’s only corporate officers. Spouse A served as Taxpayer’s vice president, secretary, and treasurer. Spouse B served as Taxpayer’s president.
In addition, the Spouses were Taxpayer’s only shareholders, with Spouse B owning 51 percent and Spouse A owning 49 percent of Taxpayer’s issued and outstanding shares of common stock.
The Spouses incorporated a related business entity, Management Corp., and elected to treat it as an S corporation for tax purposes.[v] Taxpayer conveyed to Management Corp. by quitclaim deed certain of Taxpayer’s real estate locations.
The Spouses asserted that the purpose of Management Corp. was to provide property and management services to Taxpayer, which was Management Corp.’s only client.
Taxpayer paid management fees to Management Corp., but there was no written agreement between the two entities as to the specific purpose of the fees. Management Corp. paid modest salaries to the Spouses for services rendered to Management Corp. These salaries were, arguably, for the management of Taxpayer.
Taxpayer asserted that whatever services the Spouses performed for Taxpayer’s business were provided under an oral agreement between Taxpayer and Management Corp.
Spouse B served not only as Taxpayer’s president but also as the director of curriculum and education for Taxpayer’s childcare business. Spouse B served as Taxpayer’s top manager, personally overseeing, and supervising 90 employees, including hiring, and firing and managing care directors at six locations, with all of Taxpayer’s employees ultimately reporting to Spouse B.
Spouse A served not only as Taxpayer’s vice president but also as its secretary and treasurer. During the years at issue, Spouse A also served as the director of accounting and finance for Taxpayer. Spouse A had authority over all of Taxpayer’s bank accounts and had daily responsibility for depositing payments for childcare into Taxpayer’s bank accounts and personally writing all the payroll checks to Taxpayer’s 90 employees, in addition to other responsibilities.
During the tax periods at issue, the Spouses controlled all of Taxpayer’s childcare and education policies and coordinated all physical location and program maintenance decisions. Both actively participated in Taxpayer’s daily operation, frequently working 50 to 60 hours per week at all levels, including those duties described above, as well as paperwork and front office duties, classroom teaching and supervision of teachers, purchasing and delivering food for Taxpayer’s childcare programs, and even maintenance and custodial duties, if needed.
No Compensation Paid?
Taxpayer did not report paying a salary or wages to either Spouse A or Spouse B on its Forms 1120, U.S. Corporation Income Tax Return, for the tax years in question.
In fact, Taxpayer asserted it was not Taxpayer’s responsibility to provide reasonable compensation to its corporate officers (the Spouses) for services provided to Taxpayer.
However, Taxpayer maintained vehicles titled in the Spouses’ names including loan payments and maintenance; Taxpayer claimed depreciation for those autos on its corporate tax returns. In addition, Taxpayer maintained vehicles it did not own, for the benefit of the Spouses’ children and other family members. Taxpayer provided multiple credit cards in the names of each Spouse and for their children. Taxpayer paid personal expenditures for the Spouses’ benefit that were not Taxpayer’s business expenses.
Taxpayer was aware of its obligation to withhold taxes and issue information returns with respect to its service providers; it paid salaries to its other employees and filed timely Forms 941, Employer’s Quarterly Federal Tax Return, for all calendar quarters, and filed timely Forms 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, for all tax years at issue.
However, consistent with its assertion that the Spouses provided services to Taxpayer pursuant to an oral management agreement with Management Corp., Taxpayer did not issue to either Spouse, or file with the IRS, Forms W-2, Wage and Tax Statement, nor did it issue to them, or file with the IRS, Forms 1099-MISC, Miscellaneous Income.[vi]
On its tax returns, Taxpayer claimed deductions for significant management fees paid to Management Corp.
In addition, Taxpayer did not include either Spouse A or Spouse B on the Forms 941 or 940, nor make on their behalf any deposit of employment taxes into any Federal depository for any calendar quarter or annual return for tax years.
The IRS Disagrees
After examining Taxpayer’s returns, the IRS determined that Taxpayer should have classified its corporate officers – the Spouses – as employees for all taxable periods audited.
The IRS also determined that Taxpayer was liable for employment taxes, penalties for failing to deposit tax,[vii] and accuracy-related penalties for negligence.[viii]
The Taxpayer petitioned the Tax Court for a redetermination of the tax deficiencies asserted by the IRS.
The issues for decision before the Court were whether:
(1) the Spouses should have been classified as taxpayer’s employees, such that Taxpayer was liable for employment tax (FICA, comprised of the social security and Medicare taxes) and unemployment tax (FUTA) relating to wages paid to the Spouses for the years in question;
(2) Taxpayer was liable for FICA and FUTA taxes on the basis of the IRS’s determination that the Spouses had wage income from Taxpayer;
(3) Taxpayer was liable for a failure to deposit penalty with respect to the FICA and FUTA tax liabilities; and
(4) Taxpayer was liable for accuracy-related penalties[ix] with respect to these liabilities.
The Court explained that, for purposes of the IRS’s determination, the term “employee” is defined for FICA and FUTA purposes to include “any officer of a corporation”.[x]
Likewise, for purposes of income tax withholding,[xi] the term “employee” also includes “an officer of a corporation”.[xii]
FICA and FUTA impose “employment taxes” that employers must pay, and are also obligated to withhold from their employees, in addition to income tax withholding. Employers are required to make periodic deposits of amounts withheld from employees’ wages and amounts corresponding to the employer’s share of FICA and FUTA tax.[xiii]
According to the Court, an officer of a corporation who performs more than minor services and receives remuneration for such services is a “statutory” employee for employment tax purposes.[xiv]
An officer can escape statutory employee status only if the officer performs no services (or only minor services) for that corporation and neither receives nor is entitled to receive any remuneration, directly or indirectly, for services performed.[xv]
Taxpayer stipulated that the Spouses were corporate officers during all the periods in question. As indicated above, both provided substantial services far beyond minor services, and both directly and indirectly received remuneration for their services in the form of cars for themselves, cars for their children and relatives, credit cards, and access to all cash distributions.
Still, Taxpayer asserted that it operated under an oral management contract with, and paid management fees to, Management Corp. to provide services and that the Spouses, as employees of Management Corp., provided services to Taxpayer and its day care centers.
The Court pointed out that whether a corporate officer is performing services in their capacity as an officer is a question of fact.[xvi] The conclusion that a corporate officer is a statutory employee may not apply to the extent they perform services in some other capacity.
Taxpayer paid Management Corp. money classified as management fees on its general ledger for the years at issue. From these management fees, Management Corp. paid Form W-2 wages to the Spouses, supposedly for the services they were to render to Taxpayer under an oral management agreement. Taxpayer submitted no evidence of a management agreement with Management Corp. Likewise, Taxpayer submitted no evidence as to a service agreement directing the Spouses to perform substantial services on behalf of Management Corp. to benefit Taxpayer, or even a service or employment agreement between the Spouses and Management Corp. Therefore, there was no evidence that either Spouse performed services in a capacity other than as a corporate officer.
The Court found that the Spouses were both statutory employees of Taxpayer for employment tax purposes for all the taxable periods in question.[xvii]
As a secondary position, Taxpayer contended that, even if the Court determined its corporate officers were statutory employees, the determination of additional wages paid to the Spouses – i.e., the additional amount with respect to which employment taxes would be imposed – should be no more than the difference between what was paid to them as Form W-2 employees of Management Corp. and the IRS’s reasonable wage determinations. In other words, Taxpayer argued that the wages paid to the Spouses by Management Corp. should be credited against any amount of compensation the IRS determined should have been paid by Taxpayer.
The Court rejected this suggestion, describing it as “misguided” in that wages paid by Management Corp. did not offset reasonable compensation requirements for the services provided by Taxpayer’s corporate officers in their capacities as such to Taxpayer.[xviii] The services provided to each service recipient had to be separately compensated, and the amount of such compensation had to be determined separately.
Finally, Taxpayer contended that the IRS’s notice of determination was flawed in that the amount of compensation it determined reflected requirements of higher educational qualifications than either Spouse had achieved. The Court responded that, whatever higher educational qualifications might have been required were “far eclipsed by” the Spouses’ practical experience, professional qualifications, success in running day care centers, and ownership prerogatives.
Reasonableness of compensation, the Court continued, is a question determined by all the facts and circumstances of the case. Factors affecting the reasonableness of compensation include the employee’s role in the company, comparisons of the employee’s salary to those paid by similar companies for similar services, and the character and condition of the company. The Court did not find persuasive Taxpayer’s evidence that the services provided by the Spouses were worth something less than the IRS’s determination.
Accordingly, the Court held that Taxpayer was liable for the employment taxes and penalties asserted by the IRS for all periods in issue.
Under current law, the FICA tax applies at a rate of 12.4 percent for social security tax on employment earnings capped at $142,800 in 2021, and at a rate of 2.9 percent for Medicare tax on all employment earnings (not subject to a cap). An additional 0.9 percent Medicare tax is imposed on wages of high-income taxpayers, above a threshold of $200,000 for single filers and $250,000 for joint filers.
As indicated earlier, the tax law requires that owner-employees of S corporations pay themselves “reasonable compensation” for services rendered to the corporation, on which they pay FICA tax like any other employee.
Nonwage distributions to shareholders of S corporations who materially participate in the corporation’s business are not subject to FICA tax – these are deemed to represent a return on a shareholder’s investment rather than compensation for an employee’s services.[xix]
However, an individual shareholder’s share of the income derived from a trade or business conducted by an S corporation in which the shareholder does not materially participate – in other words, the return on the non-employee-shareholder’s investment – is subject to the 3.8 percent surtax on net investment income.[xx]
The Administration’s proposal would impose the 3.8 percent net investment income surtax on the distributive share of every S corporation shareholder, without regard to whether the shareholder materially participates in[xxi] the corporation’s trade or business or not.[xxii] Thus, it seeks to treat the return realized on an employee-shareholder’s investment the same as the return realized on the investment of a non-employee-shareholder.
Query what the effect this proposal, if enacted, would have on the plans of persons like Taxpayer and the Spouses, described above.
Substance and Form
The best advice for such taxpayers: always be mindful that transactions between related parties, including shareholders and their controlled corporations, should be taxed in a manner that is consistent with their economic substance. The latter is generally determined by examining the relevant facts and circumstances, and especially the conduct of the parties.
Once the nature of a transaction has been identified, the parties must clearly reflect their income attributable to the transaction. This requires that the parties treat with one another on an arm’s-length basis, as though they were dealing with unrelated persons.
In the case of a corporation that retains the services of one of its shareholders, that means the corporation should pay the employee-shareholder an amount of compensation that is reasonable for the services rendered. Of course, there are various means and forms by which and in which such compensation may be paid. It is imperative that the corporate employer maintain adequate records to support its intent and to sustain the tax treatment reported on its return.
[i] https://www.whitehouse.gov/briefing-room/statements-releases/2021/04/28/fact-sheet-the-american-families-plan/ .
[ii] Chair of the Senate Budget Committee. “Fair share” is the common refrain.
[iii] https://www.rivkinradler.com/publications/partners-s-corp-shareholders-and-bidens-2022-revenue-proposal-no-more-business-as-usual/#_ednref12 .
[iv] Blossom Day Care Centers, Inc. v. Commissioner, T.C. Memo 2021-86 (July 13, 2021).
[v] IRC Sec. 1361 and Sec. 1362.
[vi] As independent contractors.
[vii] IRC Sec. 6656.
[viii] IRC Sec. 6662.
[ix] In general, the 20% accuracy-related penalty applies if the taxpayer underpays the tax required to be shown on their return. Underpayment may occur if the taxpayer does not report all their income or is they claim deductions or credits for which they do not qualify. Two common accuracy-related penalties applied to individuals are for (i) negligence or disregard of the rules or regulations, and (ii) substantial understatement of income tax.
[x] IRC Sec. 3121(d)(1) and (2) and Sec. 3306(i).
[xiii] IRC Sec. 6302, Sec. 6157; Reg. Sec. 31.6302-1, 31.6302(c)-3.
[xiv] Reg. Sec. 31.3121(d)-1(b), Sec. 31.3306(i)-1(c), Sec. 31.3401(c)-1(f).
[xv] Reg. Sec. 31.3121(d)-1(b), Sec. 31.3306(i)-1(e), 31.3401(c)-1(f).
[xvi] Rev. Rul. 82-83.
[xvii] Having made that determination, the Court stated, it was not required to consider whether the Spouses would also be classified as “employees” under the common law test.
[xviii] Whatever wages paid for whatever purposes by Management Corp. to the Spouses as employees of that corporation would be better addressed in relation to the IRS’s notice of deficiency for the Spouses’ individual income tax, in consideration that Management Corp. was a wholly owned S corporation.
[xix] Nor are they subject to Self-Employment Contributions Act (SECA) tax.
[xx] IRC Sec. 1411. The tax is applied to individual taxpayers with modified adjusted gross income of $200,000 for single returns and $250,000 for joint returns.
[xxi] Is employed by?
[xxii] To the extent this income exceeds certain threshold amounts.