Tax Court Holds Income was Improperly Attributed to S Corporation

In a recent case, the Tax Court addressed the issue of whether income should be reported by a Taxpayer providing services or an S corporation established by the Taxpayer. Taxpayers often seek to report income generated from services provided through an S corporation on such S corporation’s tax return, but as the case below demonstrates, certain elements must be present in order for income to be properly attributable to the corporation rather than the Taxpayer in his or her individual capacity.

In Fleischer,^[1] the Tax Court upheld an IRS notice of deficiency against an individual, finding that the Taxpayer incorrectly treated the income as earned by an S corporation he had established when he should have reported the income individually because the S corporation did not control the services he provided.  The only issue for decision in the case was whether the Taxpayer individually or his S corporation must report the income earned for the years in issue.

The Taxpayer was a financial consultant, developing investment portfolios for clients.  He had a number of securities licenses and entered into a representative agreement with Linsco/Private Ledger Financial Services (LPL) on February 2, 2006.  The Agreement expressly states that the Taxpayer’s relationship with LPL is that of an independent contractor, and the Taxpayer signed the Agreement in his individual capacity. Subsequently, on February 7, 2006, after consulting both his business attorney and his CPA, the Taxpayer incorporated Fleischer Wealth Plan (FWP) and caused it to elect S status.

The Taxpayer was paid an annual salary by the S corporation to perform duties in the capacity of a financial advisor under an Employment Agreement.  The court noted that the Employment Agreement did not include a provision requiring the Taxpayer to remit any commissions or fees from LPL or any other third party to FWP.  On March 13, 2008, the Taxpayer entered into a broker contract with Mass Mutual Financial Group (Mass Mutual).  Again this contract was between the Taxpayer individually and Mass Mutual, there was no mention of FWP in the contract, and the Taxpayer signed the contract in his individual capacity.

For the years in issue, 2009 through 2011, the S corporation reported on its return the amount of gross receipts or sales indicated on the Forms 1099 that LPL and Mass Mutual issued to Taxpayer.  No amounts were reported on the Taxpayer’s tax returns as self-employment income.  The IRS issued a Notice of Deficiency and determined that under Sections 482 and 61, the gross receipts or sales FWP reported on its Forms 1120S should have been reported by Taxpayer as self-employment income on Schedule C attached to his Forms 1040 for the years in issue.

The Tax Court began by stating the long-held principle of income taxation that income must be taxed to the person who earns it.  The court went on to provide that in determining whether income is that of the corporation or of its service-provider employee, the question has evolved to one of “who controls the earning of the income?”  For a corporation, not its service-provider employee, to be the controller of the income, two elements must be found: (1) the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense;^[2] 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.^[3]  The court stated that because both requirements must be met, and because the court found that there was no contract or other indicium that FWP exhibited control over Taxpayer, the court would only discuss the second element.

The court began by noting that both the agreement with LPL and the agreement with Mass Mutual were entered into individually by the Taxpayer, and that no mention of FWP was made in either of those Agreements (in fact, the LPL contract pre-dated the formation of FWP).  Thus, the court found no indicium that LPL or Mass Mutual were aware that FWP controlled Taxpayer.

The Taxpayer argued that it was impossible for LPL and Mass Mutual to contract directly with FWP because it was not a registered entity under the securities laws and regulations as he was individually.  The Court found the fact that FWP was not registered, thus precluding it from engaging in the sale of securities, did not allow the Taxpayer to assign the income he earned in his personal capacity to FWP.

The Tax Court also rejected the Taxpayer’s argument that it should hold it in his favor because of Sargent vs. Comm’r^[4] and Rev. Rul. 70-101^[5].  The court found the Taxpayer’s reliance on Sargent misplaced, because unlike the taxpayers in Sargent, Taxpayer’s corporation had no contractual relationship with LPL or Mass Mutual.  The Taxpayer also cited Rev. Rul. 70-101, which simply states that the IRS will generally treat professional service organizations formed under state professional association and corporation statutes as corporations for tax purposes.  The Taxpayer argued that since FWP was a validly incorporated entity, it must be recognized as a separate, taxable entity.  The court concluded that the validity of FWP was not an issue in the case, and moreover, the validity of the corporate entity did not preclude reallocation under the assignment of income doctrine.  Consequently, the court concluded that the Taxpayer individually, not FWP, should have reported the income earned under the Representative Agreement with LPL and the Broker Contract with Mass Mutual for the years in issue, and sustained the IRS’s notice of deficiency.

Observation

The situation presented in the Fleischer case is not uncommon, and frequently the IRS will argue that any income should be reported individually but that the expenses were expenses of the S corporation which are not deductible because the Taxpayer had no basis in the S corporation.  However, in the Fleischer case, the IRS allowed the disallowed deductions for certain expenses on the Form 1120S to be taken by the Taxpayer on Schedule C.

About the Author(s):
Stephen R. Looney is the chair of the Tax department at Dean Mead in Orlando. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional services practices. He is a member of the Board of Trustees of the Southern Federal Tax Institute, as well as former Chair of the S Corporations Committee of the American Bar Association’s Tax Section. He is Board Certified in Tax Law by the Florida Bar, as well as being a Certified Public Accountant (CPA). He may be reached at slooney@deanmead.com.

[1] TCM 2016-238.

[2]Vnuk v. Comm’r, 621 F2d 1318 (CA-8 1980).

[3] Pacalla v. Comm’r, 78 T.C. 604 (1982); and Keller v. Comm’r, 77 T.C. 1014 (1981), aff’d 723 F.2d 58 (CA-10 1983).

[4] Sargent v. Comm’r, 929 F.2d 1252 (CA-8 1991).

[5] 1970-1 C.B. 278.