Movement towards tax increases
You may read last week that Democrats on the Senate Budgets Committee announced that they had reached a budget resolution agreement that would allow them to bypass Senate Republicans on the way to passing most of the "social infrastructure" programs that were called for under the American President's President's Family Plan. (i) Significantly, after the announcement, Senator Manchin, who is not a member of the committee, indicated that he would not stand in the way of the budget dissolution, thereby practically ensuring their adoption and the start of the budgetary process for reconciliation.
Although details have not yet been released and much remains to be negotiated (including within the Democratic Party), statements made by Senators Schumer and Sanders (ii) indicate that tax increases add powerfully to the costs of implementing and operating these programs become. You may recall that one of the revenue-generating measures called for by the President is the expanded application of wage tax. (Iii)
To be honest, the president's proposals on payroll taxes have more to do with the need for revenue to fund his government's ambitious welfare programs. In part, they can be justified in response to the often creative, sometimes confused, and almost always misguided attempts by many taxpayers to avoid paying wage taxes.
A recent U.S. tax court ruling took into account the efforts of a closely-knit corporate taxpayer and its shareholders. (Iv)
The taxpayer was a corporation that operated several day care centers during the years in question.
At all relevant times, the spouses were the taxpayer's only officers. Spouse A served as the taxpayer's vice president, secretary, and treasurer. Spouse B was the taxpayer's president.
In addition, the spouses were the taxpayer's sole shareholders, with Spouse B owning 51 percent and Spouse A owning 49 percent of the taxpayer's common shares issued and outstanding.
The spouses formed an affiliated business unit, Management Corp., and chose to treat it as an S company for tax purposes. (v) Taxpayer who is sent to Management Corp. was transferred by receipt deed of certain property locations of the taxpayer.
The spouses claimed that the purpose of Management Corp. consisted of providing real estate and administrative services to the taxpayer, Management Corp.'s sole client.
The taxpayer paid management fees to Management Corp., but there was no written agreement between the two companies on the specific purpose of the fees. Management Corp. paid modest salaries to the spouses for services that Management Corp. were provided. These salaries were arguably for the taxpayer's management.
The taxpayer alleged that all of the services the spouses provided to the taxpayer's business were made under an oral agreement between Taxpayer and Management Corp.
Spouse B was not only President of Taxpayer, but also director of the curriculum and education for Taxpayer's childcare business. Spouse B acted as the top Taxpayer manager, personally overseeing and overseeing 90 employees, including the hiring, firing and running of nursing directors in six locations, with all Taxpayer employees ultimately reporting to Spouse B.
Spouse A served not only as the taxpayer's vice president, but also as the taxpayer's secretary and treasurer. During the disputed years, Spouse A also worked as Director of Accounting and Finance for Taxpayer. Spouse A had authority over all of the taxpayer's bank accounts and, in addition to other duties, was daily responsible for depositing childcare payments into the taxpayer's bank accounts and personally writing all paychecks to the taxpayer's 90 employees.
During the tax periods in question, the spouses oversaw the taxpayer's overall childcare and education policies and coordinated all decisions about location and program maintenance. Both took an active part in the day-to-day running of Taxpayer, often working 50 to 60 hours a week on all levels, including the duties described above, as well as paperwork and front office duties, classroom instruction and supervision of teachers, grocery shopping and delivery for Taxpayerpay's childcare programs and, if necessary, even maintenance and supervision obligations.
No compensation paid?
The taxpayer has not reported any salary or wages paid to Spouse A or Spouse B on their Form 1120, US Corporation Income Tax Return, for the tax years in question.
Indeed, the taxpayer claimed that it was not the taxpayer's responsibility to pay his officers (the spouses) adequate compensation for the services provided to the taxpayer.
However, the taxpayer maintained vehicles in the names of the spouses, including loan payments and maintenance; The taxpayer claimed a write-off for these cars on his corporate income tax return. In addition, the taxpayer maintained vehicles that did not belong to him for the benefit of the children of the spouses and other family members. The taxpayer provided several credit cards in each spouse's name and for their children. The taxpayer paid personal expenses in favor of the spouses that were not the taxpayer's business expenses.
The taxpayer was aware of his obligation to withhold taxes and to submit information declarations to his service providers; It paid salaries to its other employees and submitted timely forms 941, the employer's quarterly federal tax return for all calendar quarters, and timely forms 940, the employer's annual federal unemployment tax return (FUTA), for all tax years in question.
Consistent with his allegation that the spouses will pay the taxpayer under an oral administrative arrangement with Management Corp. However, the taxpayer has not issued, issued to, issued to, or submitted to the IRS, Forms 1099-MISC, Miscellaneous Income, to the spouse, W-2 Forms, Payroll and Tax Returns. (Vi)
In his tax returns, the taxpayer requested deductions for substantial management fees paid to Management Corp.
In addition, the taxpayer has not included spouse A or spouse B in Forms 941 or 940, nor has he filed wage tax for a calendar quarter or an annual return for tax years with a federal depositary on his behalf.
The IRS disagrees
After examining the taxpayer's tax returns, the IRS determined that the taxpayer should have classified their corporate representatives – the spouses – as employees for all tax periods examined.
The IRS also found that the taxpayer is liable for wage taxes, penalties for not paying taxes (vii), and accuracy-related penalties for negligence. (Viii)
The taxpayer requested the tax court to re-assess the tax deficiencies alleged by the IRS.
The questions to be decided before the court were whether:
(1) The spouses should have been classified as employees of the taxpayer, so that the taxpayer for the years in the wages paid to the spouse of the wage tax (FICA, consisting of the social insurance and Medicare tax) and the unemployment tax (FUTA) guilty was question;
(2) The taxpayer was liable for FICA and FUTA taxes based on the IRS finding that the spouses had wage income from the taxpayer;
(3) The taxpayer is liable for failure to post a penalty in relation to the FICA and FUTA tax liabilities; and
(4) The taxpayer was liable for accuracy-related penalties (ix) in relation to these liabilities.
The court stated that for the purposes of determining the IRS for FICA and FUTA purposes, the term “employee” is defined to include “any officer of a company”. (X)
For income tax withholding purposes (xi), the term “employee” also includes “an officer of a corporation”. (Xii)
FICA and FUTA levy "labor taxes" that employers must pay and are required to withhold income tax from their employees in addition to withholding income tax. Employers are required to make regular payments of amounts withheld from employees' wages, as well as amounts equal to the employer's share of FICA and FUTA tax. (Xiii)
In the court's view, a corporate officer who performs more than minor services and receives remuneration for those services is a "statutory" employee for wage tax purposes. (Xiv)
An executive employee can only evade the statutory employee status if he does not provide any (or only minor) services for this company and neither directly nor indirectly receives or is entitled to remuneration for the services provided. (Xv)
The taxpayer stipulated that the spouses were officers in all periods in question. As noted above, both of them provided significant services that went well beyond minor services and received both direct and indirect compensation 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 claimed that under an oral management contract with Management Corp. acted and management fees to Management Corp. paid to provide services and that the spouses as employees of Management Corp. Provided services for Taxpayer and its daycare centers.
The court noted that whether an officer provides services in his capacity as an officer is a matter of fact. (Xvi) The conclusion that an officer is a statutory employee may not apply when providing services in an other property.
The taxpayer paid Management Corp. funds for the disputed years which were classified as management fees in its ledger. From these management fees, Management Corp. Form W-2 wages for the spouses, allegedly for the services they had to provide to the taxpayer under an oral administrative agreement. The taxpayer has not provided evidence of a management contract with Management Corp. Likewise, the taxpayer has not provided evidence of a service contract instructing the spouses to perform essential services on behalf of the management company for the benefit of the taxpayer, or even a service or employment contract between the spouses and Management Corp. As a result, there was no evidence that either spouse provided any service other than an officer.
The court found that the spouses were both statutory employees of the taxpayer for wage tax purposes for all tax periods in question. (Xvii)
As a secondary position, Taxpayer alleged that even if the court found that the company's officers were statutory employees, the determination of the additional wages paid to the spouses – that is, the additional amount on which wage tax would be collected – should be no more than the difference between what you received as employees of the Management Corp. Form W-2. has been paid and the IRS's reasonable wage regulations. In other words, the taxpayer argued that the payments made to the spouses by Management Corp. wages paid should count towards any compensation determined by the IRS that should have been paid by the taxpayer.
The court rejected this proposal, describing it as "misguided" because the management corp. wages paid do not compensate for adequate compensation requirements for the services rendered by the taxpayer's executives in their capacity as such for the taxpayer. (xviii) The recipient of the service is to be compensated separately and the amount of this remuneration is to be determined separately.
Finally, Taxpayer alleged that the IRS assessment notice was flawed in that the amount of compensation it set reflected requirements for higher education qualifications than each spouse achieved. The Court countered that any higher education qualifications required were “overshadowed” by practical experience, professional qualifications, success in day-care centers and property rights of the spouses.
The adequacy of the compensation, the court continued, is a question that is determined by all the facts and circumstances of the case. Factors affecting the adequacy of compensation include the employee's role in the company, comparisons of the employee's salary with those paid for similar services by similar companies, and the character and condition of the company. The court found no convincing evidence from the taxpayer that the services provided by the spouses were worth anything less than the IRS finding.
Accordingly, the court ruled that the taxpayer would be liable for wage taxes and penalties claimed by the IRS for any period in question.
Under applicable law, FICA tax applies at a rate of 12.4 percent for Social Security tax on employment income, which is capped at $ 142,800 in 2021, and a rate of 2.9 percent for Medicare tax on all Income from employment (no upper limit). An additional 0.9 percent Medicare tax is levied on high-income taxpayers' wages that are above a threshold of $ 200,000 for single filers and $ 250,000 for joint filers.
As previously mentioned, tax law requires that S company owner employees pay themselves “reasonable compensation” for the services provided to the company on which they pay FICA tax like any other employee.
Secondary wage distributions to shareholders of S companies who have a significant stake in the company's business are not subject to FICA tax – they are regarded as a return on a shareholder's investment and not as remuneration for the services of an employee. (Xix)
However, the share of an individual shareholder in the income from a trade or business of an S-corporation in which the shareholder does not have a significant interest – i.e. the return on the investment of the non-employed shareholder – is subject to the 3.8 percent surcharge on net asset income. xx)
The government proposal would add a 3.8 percent surcharge to the distributing portion of each S-member shareholder, regardless of whether or not the shareholder has a material interest in the trading or business of the company (xxi) or not (xxii ) treat the return obtained from the investment of an employee-shareholder in the same way as the return obtained from the investment of a non-employee-shareholder.
Ask what effect this proposal, when it comes into force, would have on the plans of individuals such as taxpayers and spouses as detailed above.
Substance and form
The best advice to such taxpayers: Always remember that transactions between related parties, including shareholders and their controlled corporations, should be taxed in a manner that is commensurate with their economic substance. The latter is usually determined by examining the relevant facts and circumstances, in particular the behavior of the parties.
Once the nature of a transaction has been determined, the parties must clearly reflect their revenue attributable to the transaction. This assumes that the parties treat each other on market terms as if they were dealing with independent persons.
In the case of a corporation using the services of one of its shareholders, this means that the corporation should pay the employee-shareholder adequate compensation for the services provided. Of course, there are various means and forms by which and in which such compensation can be paid. It is imperative that the company's employer keep adequate records to demonstrate its intent and to maintain the tax treatment set out in its return.
(ii) Chairman of the Senate Budget Committee. “Fair Share” is the common refrain.
(iv) Blossom Day Care Centers, Inc. v Commissioner, T.C. Memo 2021-86 (July 13, 2021).
(v) IRC section. 1361 and sec. 1362.
(vi) As an independent contractor.
(vii) IRC Section. 6656.
(viii) IRC sec. 6662.
(ix) In general, the accuracy-related penalty of 20% applies if the taxpayer pays too little of the tax to be reported in their tax return. An underpayment can occur if the taxpayer fails to report all of their income or to claim deductions or credits for which they are not entitled. Two common accuracy-related penalties imposed on individuals are (i) negligence or disregard of rules or regulations and (ii) significant understatement of income tax.
(x) IRC sec. 3121 (d) (1) and (2) and Sec. 3306 (i).
(xii) 3401 (c).
(xiii) IRC sec. 6302, sec. 6157; Registration number. Sec. 31.6302-1, 31.6302 (c) -3.
(xiv) Reg.No. Sec. 31.3121 (d) -1 (b), par.31.3306 (i) -1 (c), par.31.3401 (c) -1 (f).
(xv) Reg. no. 31.3121 (d) -1 (b), par.31.3306 (i) -1 (e), 31.3401 (c) -1 (f).
(xvi) Rev. Rul. 82-83.
(xvii) According to this finding, it was not necessary to examine whether the spouses were to be classified as "employees" even after the common law test.
(xviii) Whatever wages for whatever purposes Management Corp. Paid to the spouses as employees of that corporation should be better treated in relation to the IRS notice of deficiency for the individual income tax of the spouses since the Management Corp is owned by the S corporation.
(xix) You are also not subject to tax under the Self-Employment Contributions Act (SECA).
(xx) IRC sec. 1411. The tax is levied on individual taxpayers with a modified adjusted gross income of $ 200,000 for individual returns and $ 250,000 for joint returns.
(xxi) Is employed by?
(xxii) To the extent that this income exceeds certain thresholds.