Nontax rules often require that those performing certain services (such as selling investment products) be licensed to do so.  Quite often that license is held in the name of an individual.  In the case of Fleischer v. Commissioner, TC Memo 2016-238 a person in just such a position wanted to form an S corporation in which to conduct his investment advisory business in order to reduce his exposure to self-employment taxes.

When he did so he did not attempt to have the corporation he formed become licensed to perform the services in question.  He already had entered into an agreement with Linsco/Private Ledger Financial Services (LPL) as a representative prior to forming the corporation.  He did not have his contract with LPL revised to recognize his S corporation, Fleischer Wealth Plan (FWP), although he began treating the income he received from LPL as corporate income.

He later entered into an agreement with MassMutual Financial Group (MassMutual).  Although the corporation was in existence at this time, he still signed the contract in his personal capacity and the contract made no mention of FWP.

In neither case did Mr. Fleischer produce any evidence that either LPL or MassMutual were aware of FWP.

Mr. Fleischer took a salary from the S corporation for each of the years in question, but larger sums flowed out on his K-1s as income from the S corporation.  While FICA was paid on the wages he took from the S corporation, he reported no self-employment income nor did he pay any self-employment tax for the years in question.

The IRS argued that the arrangement represented an impermissible assignment of income by Mr. Fleischer to the S corporation and that, in fact, all the income and expenses should have been reported on Mr. Fleischer’s Schedule C, with the net earnings subject to self-employment tax.

The Tax Court noted that determining the owner of income between a corporation and an employee that owns 100% of its stock is not a simple “who earned the income test” and points out:

Because it is impractical to apply a simplistic “who earned the income” test when the Court’s choices are a corporation and its service-provider employee, the question has evolved to one of “who controls the earning of the income.” Johnson v. Commissioner, 78 T.C. 882, 891 (1982) (citing Vercio v. Commissioner, 73 T.C. 1246, 1254-1255 (1980)), aff’d without published opinion, 734 F.2d 20 (9th Cir. 1984). 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, id. (citing Vnuk v. Commissioner, 621 F.2d 1318, 1320-1321 (8th Cir. 1980), aff’g T.C. Memo. 1979-164); 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”, id. (citing Pacella v. Commissioner, 78 T.C. 604 (1982), and Keller v. Commissioner, 77 T.C. 1014 (1981), aff’d, 723 F.2d 58 (10th Cir. 1983)). These elements can be found in the employment tax regulations. Sec. 31.3121(d)-1(c)(2), Employment Tax Regs.; see Sargent v. Commissioner, 929 F.2d 1252, 1256 (8th Cir. 1991) (“Accordingly, within Regulation § 31.3121(d)-1(c)(2), two necessary elements must be met before the corporation * * * may be considered the true controller of the service-provider.”), rev’g 93 T.C. 572 (1989).

In this case the second prong of the test would prove to be the taxpayer’s undoing—he needed to show that there was a recognition by those using the services (LPL and MassMutual) of the FWP’s controlling position in this matter.

With regard to LPL the Court noted:

On February 2, 2006, petitioner individually entered into a representative agreement with LPL. There is no mention of FWP in the representative agreement. Moreover, FWP was not incorporated until February 7, 2006, meaning it did not exist as a separate entity when petitioner entered into the representative agreement with LPL. Additionally, petitioner did not enter into an agreement that purportedly created an employer-employee relationship with FWP until approximately three weeks later. Therefore, there was no indicium that LPL was aware that FWP controlled petitioner.

With regard to MassMutual the Court noted similarly:

There is also no mention of FWP in the broker contract petitioner signed with MassMutual. Petitioner did enter into the broker contract after FWP 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 MassMutual and petitioner. There is no mention of FWP in the contract and no evidence in the record that MassMutual was aware of whether FWP had any degree of meaningful control over petitioner.

In this case the taxpayer argued he could have had the corporation enter into an agreement with MassMutual but did it personally to retain the ability to expand into selling other products.  As the opinion continues:

Additionally, petitioner testified that FWP could have signed the broker contract with MassMutual because fixed insurance products were the only products that would be sold. He chose to sign the broker contract in his individual capacity because of the possibility of selling variable insurance products in the future. Although the contract with MassMutual allowed petitioner to sell variable insurance products, he neither testified, nor offered any other evidence, that that possibility had come to fruition.

While the taxpayer argued that he structured matters this way because the corporation could not have been registered, the Court noted that he failed to show that was true and, in fact, the taxpayer conceded that while it would have been possible it just wasn’t practical.

As the opinion continues:

Petitioner testified that it would be overly burdensome and “would cost millions and millions of dollars” for FWP to register under the Act, but he offered no other evidence to corroborate his testimony. The fact that FWP was not registered, thus preventing it from engaging in the sale of securities, does not allow petitioner to assign the income he earned in his personal capacity to FWP. See Jones v. Commissioner, 64 T.C. 1066 (1975) (holding that a court reporter improperly assigned income to his personal service corporation because a court reporter was legally required to be an individual, and although the corporation was a valid entity, by law it could not perform such services).

Or, to put it more simply, if the taxpayer wanted this result he would have needed to qualify FWP to sell securities—and if it was barred from doing so (either because he did not go through the process to qualify it or it simply was barred from qualifying) then he would not be allowed to simply assign his income to the corporation.

This case is, unfortunately, not that unusual—and often taxpayers enter into the arrangement at the behest of their tax advisers looking to use S status to reduce exposure to self-employment taxes.  Telling a client (or potential client) that this structure simply doesn’t work (and it clearly does not) is not likely going to make the client happy.  But our job is to advise the client on the reality of the law, no matter how unfair the client may believe that law is.