S-Corporations and federal employment taxes: safe harbors and sunken ships.

Pullis, Robert M. ; Zhao, Fang "Jenny" ; Pullis, Joe M. 等

INTRODUCTION

The following questions (and their supporting legal precedence) are frequently raised with respect to taxation applicable to S-Corporations and their shareholders:

* Is the sole shareholder of an S-Corporation subject to federal self-employment tax if the person characterizes the income as an S-Corp distribution (that generally is not subject to employment taxation)?

* Does an S-Corporation have to have at least one "employee" for employment tax purposes?

* How do tax practitioners explain to their clients (who own an S-Corp) the application of two seemingly contradictory rules, with one rule being that employers must pay and withhold employment taxes and a different rule being that distributions from S-Corporations to its shareholders are not subject to federal employment taxation?

* What are some common but improper methods that tax practitioners need to be aware of that some clients may desire to implement in an effort to avoid paying federal employment taxes?

* Are there any safe harbor provisions available to help innocent taxpayers who mistakenly misclassify their employment status with regard to S-Corporations and federal employment taxes?

* What is the distinction in treatment between an employee who pays FICA taxes, a shareholder of an S-Corp who receives a distribution and who is not an employee of the company, and a shareholder who is both a shareholder and an employee of the S-Corporation?

* What are some potential problems with using S-Corporations from a federal estate tax perspective?

This article addresses the preceding questions and provides legal precedence that supports and explains the answers to such questions.

BACKGROUND AND PRECEDENCE

The Third Circuit Court of Appeals has decided a pivotal case concerning whether someone who is an officer and sole shareholder of an S-Corporation was an "employee," thereby subjecting the corporation to the requirement to pay federal employment taxes. The court's decision was one upholding an earlier decision by the Tax Court in the government's favor. In Nu-LookDesign, Inc. v. Commissioner of Internal Revenue, 356 F.3d 290 (CA-3, 2004), the taxpayer (Nu-Look), which was an S-Corporation, petitioned for review of the IRS's determination that Ronald A. Stark, its officer and sole shareholder, was an employee of the company and that the company owed employment taxes. The Tax Court held in favor of the IRS, and Nu-Look appealed to the Third Circuit, which upheld the decision in favor of the IRS, holding that Mr. Stark was in fact an employee and that the S-Corporation owed employment taxes on distributions made to the S-Corporation's sole shareholder.

Nu-Look had operated as an S-Corporation since 1987, providing residential home-improvement services including carpentry, siding installation, and general home-improvement construction services to the general public. Mr. Stark was the sole shareholder and president. He also managed the company, solicited new business, performed necessary bookkeeping, handled company finances, and hired and supervised workers. Mr. Stark did not take any salary for his services to the company, but rather he had the company make shareholder distributions to him when he needed the money. The company reported income on its Form 1120S (for years 1996, 1997, and 1998), and Mr. Stark reported the same amounts of income as non-passive income on Form 1040, Schedule E, for the same time period.

Nu-Look asserted that Mr. Stark was not an employee under FICA (Federal Insurance Contributions Act) and FUTA (Federal Unemployment Tax Act) laws, either as a statutory employee or as a common-law employee. Nu-Look contended further that even if it was mistaken as to Mr. Stark's employee classification, it should be entitled to relief under the safe harbor provisions of I.R.C. [section] 530 in that Nu-Look had a reasonable (even if mistaken) basis for not treating Mr. Stark as an employee. Nu-Look also made an argument that for procedural reasons it was denied due process by the IRS (which both courts rejected; see Nu-Look 356 F.3d at 295).

The court first addressed the fact that it had proper jurisdiction over the controversy. Next, it addressed the issue of whether Mr. Stark was a statutory employee. The court stated that the Federal Insurance Contributions Act (FICA) considers corporate officers to be automatically classified as employees. The court acknowledged an exception to this automatic classification for an officer who performs only minor services and who is neither directly nor indirectly compensated, citing Treas. Reg. [section] 31.3121(d)-1(b). The court agreed with the previous holding of the Tax Court that, factually, Mr. Stark's services were much more than "minor," and therefore he was not entitled to fall under the exception provided by the Treasury Regulations. The court affirmed that Mr. Stark was an officer of the corporation in his capacity as president (a fact that was not disputed by Nu-Look or Mr. Stark). Nu-Look argued that Mr. Stark was not both an employee as an officer and an employee under common-law principles; therefore, Mr. Stark should not be considered an employee. NuLook's argument failed on two levels. First, the statute does not require that one must be both a common-law employee and an officer in order to be classified as an employee. Quite the opposite--a plain reading of the statute states, inter alia, that one is an employee if one is an officer or would be considered an employee under a common-law analysis. The court went on to hold that in this case, Mr. Stark would be considered an employee because he was an officer of the corporation, that he performed substantial (more than "minor") services to the corporation, and that his services were enough to be considered an employee under common-law principles as well. In an effort to defeat the common-law classification, Mr. Stark argued that as the sole shareholder of the company, he was in control and therefore Nu-Look was not in control over him. The court rejected this line of reasoning and reiterated that even if the Tax Court did not address this argument, it did not need to do so because as president of the company (and not entitled to the "minor services" exception), Mr. Stark was determined by the lower court to be an employee for federal employment tax purposes.

Lastly, Nu-Look appealed for relief under the safe harbor provisions of IRC [section] 530, stating that it had a reasonable basis to believe Mr. Stark was not an employee, citing Texas Carbonate v. Phinney [IRS] 307 F.2d 289, 291-93 (CA-5, 1962) as supporting precedent. (Nu-Look tried to argue judicial precedent via Texas Carbonate, which was held to actually support the government, not Nu-Look.) The court was most kind in calling Nu-Look's reliance on Texas Carbonate merely "puzzling." Any reading of Texas Carbonate could only support the government's position and would only add long-standing judicial precedence to the IRS's position. Under either the analysis of Texas Carbonate or Treas. Regs. [section] 31.3121(d)-1(b) and [section] 31.3306(i)-1(e), Mr. Stark would be classified as an employee. The court stated the three safe harbors listed in I.R.C. [section] 530 as being a taxpayer's reliance upon (1) judicial precedent, (2) past IRS audit, or (3) long-standing industry practices. The court then found that Nu-Look was not entitled to relief under any of the three provisions. Interestingly, the court stated that it agreed with and found "instructive" a Ninth Circuit case that held that a person must be classified as an employee if the person who is an S-Corporation's sole shareholder is the "central worker for the taxpayer" or if the person is a "corporation's sole full-time worker . . ." [citing Spicer Accounting 918 F.2d at 94-95].

Nu-Look lost on all counts, and Mr. Stark was determined by the Third Circuit to be an employee for federal employment tax purposes, with Nu-Look and Mr. Stark owing their share of such taxes.

THE INTERVIEW

The following situation may seem familiar to many tax professionals. You are in your office when Karl Klient walks in and asks you to help him do his taxes. He tells you about how he has recently been able to quit his construction job and start his own home-building business, which is growing and doing well. He tells you that he incorporated using an S-Corporation because he wanted the protection from potential creditors, and he didn't want to pay double taxes at both the corporate level and the individual level.

You look at Karl and say, "I understand. It sounds like you're off to a good start. Let's look at your financial information." You finish looking at his documented information and then ask him where the receipts for the employment taxes are. Karl responds, "What do you mean, 'employment taxes'?" You explain that while the corporation's income is not subject to its own income tax, it is liable for its half of the employment taxes based on how much it pays its employees. Karl's countenance changes as his face turns red, and he begins to get frustrated. "Look! I told you that I work for myself now and don't answer to any boss! It's my corporation--I do the work and make the money. Nobody signs my paycheck! Besides, everyone knows that an S-Corp doesn't have to withhold employment taxes from the distributions it pays to its shareholders. I called the IRS and even looked it up on the internet just to be sure. S-Corp money 'flows through' to its shareholders. What tax school did you graduate from?"

You are now contemplating how to explain to Karl that he is partly correct in that the following two statements are true:

* S-Corporation income "flows through" to its shareholders and is not subject to income taxation at the corporate level.

* Distributions made by S-Corporations to shareholders are not subject to employment tax withholding.

You are also trying hard to think of a way to explain how not all of the money that is earned by an S-Corporation can be paid directly to its shareholders as a shareholder distribution, but that some of the money earned by the company needs to be paid to its employee(s) who provided the services necessary for the corporation to earn its revenue. In short, the following statement is also true:

* S-Corporations are not exempt from the federal employment tax-withholding requirement for its employees.

* You are now wishing that you could summon the interpersonal skills of a Dr. Phil or that your office had a back door handy for a rapid exit. You look at Karl, and the conversation goes something like this:

YOU: "Karl, you are absolutely right about the tax rules you just quoted. The only hitch is that there are a couple of other tax rules that we have to apply because the IRS applies them and the federal courts will too. While you are indeed your own boss, as the boss or 'employer,' you are also your own 'employee' when you are working building houses." At this point, you notice that Karl's 19-inch neck is not as red as it was earlier, but he is still not sure of your expertise in the area. "Karl, it's like this," you continue to explain, "when you worked for AJAX Construction Company, they withheld money from your paycheck. You probably saw it noted on your pay stub as 'FICA' or something similar, right?"

KARL: "Yeah, that's right."

YOU: "So, the owner of AJAX could be lying around his swimming pool all day if he wanted to because he hired a management team to run the company and other employees to perform the construction work, right?"

KARL: "Sure, I suppose. As a matter of fact, I rarely ever saw the owner. We called him 'Mr. Bermuda' because he always seemed to be playing golf there."

YOU: "Assuming AJAX was an S-Corp, when AJAX made some money, it had to pay its suppliers and employees, and it also had to pay the employment taxes. AJAX paid half of the employment taxes itself and withheld the other half from your paycheck. Those were the social security and Medicare taxes--or FICA--as noted on your pay stub. You may not have realized it, but they also paid federal unemployment taxes (FUTA); however, none of these taxes were withheld from your check, as your employer was required to pay them and not withhold these taxes from the employees' paychecks. Once all of the expenses of operating the business (and taxes) were paid, the company then would make a distribution of money to its shareholder(s), and no withholding was taken from this shareholder payment. Mr. Bermuda, as you called him, as a shareholder would get his share of corporate profits, and then he would report the income on his individual income tax return. Karl, your S-Corporation is just as real to the IRS as AJAX is. It is just a smaller-size S-Corporation."

KARL: "So how much money do I earn as an 'employee,' and how much do I make as a shareholder, like Mr. Bermuda? Oh, and my wife helps me by working ten hours a week answering the phone and doing office stuff. My son, Sam, is a surgeon, and he helped me get started in the business by contributing $100,000 so I could get a truck and some tools and take out an ad in the telephone book. My daughter, Donna, has actually followed in her old man's footsteps, as she has had her own window-installation contracting business for the last five years. When I build a new home for a customer, it's great to be able to hire my daughter to do all of the window-installation work. We are all shareholders in the S-Corp. Business is going great, the money is coming in, and I already have enough headaches dealing with sub-contractors--except Donna--and I don't want any more headaches, especially one with the IRS! So how do we get the S-Corp's taxes done properly, taking all the tax rules into consideration--and making sure that I, er, I mean, the corporation and I both do not pay too much in taxes?"

Thus, the interview continues with Karl, and you are no longer wanting or needing that handy back door in your office.

TAXATION BACKGROUND

It is important to understand and distinguish between the various applicable taxation schemes of which more than one can apply to any one person and/or entity. Specifically, tax professionals must be concerned with federal income tax as applied to employees, self-employed persons, shareholders of corporations, and the business entities themselves and must also be aware of the federal employment tax schemes and the requirements when employers are required to withhold such taxes from employee wages.

DISTRIBUTIONS TO SHAREHOLDERS OF S-CORPORATIONS

While S-Corporations and partnerships are similar in that they are both pass-through entities with regard to federal income tax, they are not treated the same for federal employment tax purposes. Partnership distributions are subject to self-employment income taxes [see Treas. Reg. [section] 1.1402(a)1(a)(2)], while distributions to shareholders of S-Corporations are not subject to self-employment tax, as dividends paid to a shareholder are not considered "net earnings from self-employment" and, therefore, are not subject to section 1401 self-employment tax [see Rev. Rul. 59-221, 1959-1 CB 225 and Ding v. Comr., T.C. memo 1997-435, aff'd, 200 F.3d 587 (CA-9, 1999)]. The IRS in its Publication 533 specifically states that while the income received via an S-Corp is includible in a taxpayer's gross income, it is not characterized as self-employment income [see also I.R.C. [section] 1366(a)-(b)].

So, if a person working for an S-Corp receives wages, the employee does not need to report and pay self-employment taxes. It stands to reason that if a person is not a self-employed person (e.g., an independent contractor), then the worker is an employee of the S-Corp, and, as such, the corporation must pay its share of employment taxes and withhold from the employee the worker's half of the employment taxes. This line of reasoning is precisely that taken by the IRS and the federal courts. The next section of this article considers employment taxes and their impact on employers, especially S-Corporations.

FEDERAL EMPLOYMENT TAXES

Employment taxes include the following (for more details, see Pub. 15 Circular E, Employer's Tax Guide):

Social Security and Medicare Taxes. The Federal Insurance Contributions Act (FICA) provides for a federal system of old-age, survivors, disability, and hospital insurance. The old-age, survivors, and disability insurance part is financed by the social security tax. The hospital insurance part is financed by the Medicare tax, with each of these taxes being reported separately. The total rate of tax for 2008 is 12.4% for social security and 2.9% for the Medicare tax, with the employer paying one-half of the amounts and one-half of the amounts being withheld by the employer from the employee's paycheck (i.e., the employer pays 6.2% of the social security tax and the employee pays 6.2% via withholding, plus 1.45% each for the Medicare tax). For 2008, the first $102,000 of wages is subject to social security taxes. Wages paid in excess of this amount ($102,000 in 2008) are not subject to social security taxes. All of the employee's wages are subject without limit to the Medicare tax (for more information, see IRS Publication 15 Circular E, Employer's Tax Guide).

Federal Income Tax. An employer must withhold income taxes from wages paid to employees. A Form W-4 should be used and signed by each employee to determine the employee's amount of tax withholding (see also the IRS website at www.irs.gov/individuals for assistance in calculating withholding).

Federal Unemployment (FUTA) Tax. The Federal Unemployment Tax Act (FUTA), together with state unemployment systems, provides for unemployment compensation benefit payments to workers who have lost their jobs. Employers usually pay unemployment taxes to both federal and state governments (see Pub. 926 for a list of state unemployment agencies). Only the employer pays FUTA tax. No FUTA tax is to be withheld from the employee's wages. If one spouse employs another spouse in a trade or business (not including domestic services), then the employee-spouse is normally not subject to FUTA tax (i.e., the employer-spouse will not owe FUTA tax on his/her employee-spouse's wages). However, the other employment taxes do apply. If one spouse employs his/her spouse but the employment is not considered a trade or business (e.g., domestic service), then such domestic service in a private home is not subject to social security, Medicare, and FUTA taxes. However, the wages of a child or a spouse are subject to income tax withholding as well as social security, Medicare, and FUTA taxes if such a_child or a spouse works for a corporation (or a partnership or an estate), even if the corporation is controlled by the child's parent or the individual's spouse. S-Corporations are just that--corporations. Federal unemployment tax should be reported on Form 990 (or Form 990-EZ, if applicable). FUTA taxes (as well as other employment taxes) are now generally paid via the Electronic Federal Tax Payment System (EFTPS). For more information on EFTPS, go to www.eftps.gov. Any new business that has federal tax obligations and that requests an employer identification number (EIN) will automatically be enrolled in EFTPS. Employers can opt to use EFTPS even if they are not required to use the system; otherwise, the employer may continue using the old coupon system and send payments and coupons to a federally authorized bank.

The employer (e.g., an S-Corporation) will report income and taxes withheld to the IRS and the worker via one of the following forms:

Form W-2 Wage and Tax Statement is used to report wages, tips, and other compensation paid to employees and to report any taxes withheld as well as any advance earned income payments.

Form 1099-MISC is used to report certain payments a business makes including payments of $600 or more for services performed for the business by non-employees, such as independent contractors, attorneys, accountants, or directors. Also, this form is used to report rent payments of $600 or more (other than rents paid to real estate agents) and royalty payments of $10 or more. The form is used to report winnings of $600 or more that are not for services (e.g., if a taxpayer wins a trip to Hawaii from a local radio station, the taxpayer will receive a Form 1099-MISC indicating the value of the prize--and this value amount will be treated as income to the taxpayer).

Form 8300 is used if a person receives a cash (or like) payment of over $10,000 (for more information, see IRS Pub. 1544 Reporting Cash Payments of Over $10,000).

Thus, while an S-Corp making a payment of a distributive share of corporate income to its shareholders is not considered a payor for purposes of employee backup withholding under section 3406, the corporation is still an employer and generally required to pay (and withhold when required) federal employment taxes. If the S-Corp has one or one thousand employees, it must pay/withhold federal employment taxes. There have been several cases citing Nu-Look, and all have held in accordance with the Nu-Look decision. The following cases discussing Nu-Look are listed in order of depth of discussion (from most to least): Specialty Transport & Delivery Services, Inc. v. C.I.R., 93 AFTR 2d 2004-1364 (CA-3, 2004); Veterinary Surgical Consultants, P.C. v. C.I.R., 93 AFTR 2d 2004-1273 (CA-3, 2004); Grey v. C.I.R., 93 AFTR 2d 2004-1626 (CA-3, 2004); Superior Proside, Inc. v. C.I.R., 93 AFTR 2d 2004-647 (CA-3, 2004); Greco v. United States, 380 F.Supp. 2d 598, 614 (M.D. Pa., 2005); Peno Trucking, Inc. v. C.I.R., 93 T.C.M. 1027 (U.S. Tax Ct., Mar. 21, 2007). There has been one IRS Chief Counsel Advice memorandum issued on the subject as well, which also (not surprisingly) supports the holding in Nu-Look (see IRS CCA 200542034 (Oct. 21, 2005)). It is safe to state that if the corporation is engaged in any business at all, it will have at least one employee. The corporation is expected to pay applicable federal employment taxes based upon compensation that is reasonable, considering the nature of the services being performed by its employee--which leads to a discussion of the games some people play.

GAMES PEOPLE PLAY

Game #1: Characterizing all of the income as a shareholder distribution or declaring "I'm just an independent contractor" if the shareholder argument fails.

This game sounds like the following scenario: "I do not like the rules about the requirement for the payment of federal employment taxes. I want to be the sole shareholder (or merely one of 100 or fewer shareholders) of an S-Corp and characterize all of the money flowing through the S-Corp to me as being paid to me as a shareholder (and I might forget to report the money as self-employment income too)." Of course, not every taxpayer is so indifferent to the law. Although many taxpayers do rely upon the rule of S-Corp distributions not being subject to employment taxes and income tax withholding as the only and absolute rule concerning such distributions, those employees who do characterize all of their receipts received via an S-Corp as a shareholder distribution are running a great risk of ending up like the taxpayer in Nu-Look Design, Inc., 356 F.3d 290 (CA-3, 2004), which was an appeal from the Tax Court where the government prevailed. Recall that in that case an individual, Mr. Stark, operated a home-improvement company. He was the sole shareholder and president of his S-Corp named Nu-Look Design, Incorporated. Mr. Stark actively managed the company, solicited new business, performed necessary bookkeeping, and hired and supervised workers. He did not take any salary or wages from the company, but he had the company distribute money to him as his needs arose. Mr. Stark reported all such distributions as non-passive income on Schedule E of his Form 1040 tax returns for a three-year period. The court held that he was in fact an "employee" of the S-Corporation and that the S-Corporation was liable for federal employment taxes that were not paid.

Both the FICA and the FUTA impose taxes upon employers based upon the wages the employers pay to individuals in their employ. "Wages" include all remuneration for employment [26 U.S.C. [section][section] 3121(a), 3306(b)]. "Employment" is any service of whatever nature, performed by an employee for the person employing him [see 26 U.S.C. [section][section] 3121(b), 3306(c)]. While Treas. Reg. [section] 31.3121(d)-1(b) provides that there is an exception to the general rule that an officer of a corporation is an "employee" for employment tax purposes, the exception applies only to an officer who "does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration[.]" Note that one can become an "employee" of a corporation for FICA and FUTA purposes by being:

(1) any officer of a corporation, or

(2) any individual who, under the usual common-law rules applicable in determining the employer-employee relationship, has the status of an employee [see 26 U.S.C. [section][section] 3121(b), 3306(c)].

The court stated that under the facts presented in the Nu-Look Design, Inc. case, Mr. Stark was an "employee" for FICA/FUTA purposes, as he was both an officer of the corporation (and not entitled to the "minimal services rendered" exception) AND would qualify as an "employee" using the common-law standard as articulated in prior case law. Anytime a corporation has a sole shareholder who provides labor for a corporation, the sole shareholder is treated as an employee for FICA/FUTA purposes [see Joseph Radtke, S.C. v. United States, 712 F.Supp. 143, 145 (E.D. Wis. 1989), affirmed, 895 F.2d 1196 (CA-7, 1990)].

In a similar and more recent case, an S-Corp was held liable for failure to pay employment taxes when a husband-wife team each owned a 50% share of the S-Corp and the husband provided accounting services as a CPA and worked in furtherance of the corporation's business interests. The CPA argued that he was a mere shareholder of the S-Corp and his income was properly reported as corporate distributions and, in the alternative, if the court declined to rule in favor of his first argument, that he was an independent contractor and not an employee of the S-Corp. The court agreed with the government that the CPA was an employee of the S-Corp and not an independent contractor [see Spicer Accounting, Inc., 918 F.2d 90 (CA-9, 1990)].

Game #2: Receiving inadequate compensation but also receiving greatly increased dividends.

The shareholder cannot take inadequate compensation from the corporation to avoid paying employment taxes [see Rev. Rul. 74-44, 1974-1 CB 331]. If a client wants to take $100 as salary and $100,000 as a dividend, he needs to be reminded that unless he is prepared to explain to a federal judge that only $100 is approximately what others are typically paid who perform similar services that he has performed, he had best not try that approach.

SAFE HARBOR RELIEF FOR THE INNOCENTLY MISTAKEN

When a taxpayer is mistaken regarding worker classification (e.g., the taxpayer classifies a worker as an independent contractor instead of correctly classifying the worker as an employee), I.R.C. [section] 530 provides a safe harbor. If the taxpayer (e.g., an S-Corp) can show a reasonable basis for not classifying a worker properly, it may avoid liability for its failure to file employment tax returns pursuant to I.R.C. [section] 6651 and for its failure to deposit payroll taxes under I.R.C. [section] 6656. A reasonable basis for the incorrect classification may be established if the taxpayer can show that it was done in reliance on judicial precedent, published rulings, past IRS audit, and/or long-standing practice of a significant segment of the taxpayer's industry. While such "reasonable basis" is to be "construed liberally in favor of taxpayers" [see General Investment Corp. v. United States, 823 F.2d 337, 340 (CA-9, 1987)], one should be careful not to be inordinately aggressive, as courts, including the U.S. Supreme Court, are also quick to look at the realities and substance of the underlying economic transactions and not the mere form of the transactions [see Frank Lyon Co. v. United States, 435 U.S. 561, 573 (S.Ct 1978)].

APPLICATION OF THE LAW TO S-CORP OPERATIONS IN KARL KLIENT'S SITUATION

So, we are back in the office with our friend, Karl Klient, and need to advise him about how his S-Corp should handle its employment tax and shareholder distribution issues. His situation is most easily viewed by looking at the flow of money as occurring in two stages. First, the corporation receives capital and must pay its employees and independent contractors (if any). Second, the corporation will distribute net profits (net of business expenses, wages paid to employees, taxes paid, etc.) to its shareholders in accordance with the number of shares held by its shareholders.

In looking at Karl's company, Karl's Kastles, Inc., an S-Corp, and how it should be advised concerning federal employment taxes, let's make some basic assumptions, the first of which is that the corporation has issued 100 shares to its shareholders as follows: 55 shares to Karl (Karl is president of the company); 30 shares to his wife, Wanda; 10 shares to his son, Sam; and 5 shares to his daughter, Donna. [Note: For purposes of counting the number of shareholders to qualify for S Corporation status--a husband, wife, and all other family members are counted as one (1) shareholder with respect to the 100 shares.] A presumed reasonable compensation amount paid to Karl for his expert construction skills and for his service as president of the company (acquiring new customers, managing the daily operations of the company, etc.) would be $120,000 annually. A presumed reasonable compensation that would be paid to an employee performing clerical work in an office would be $10 per hour; thus, wife Wanda should be paid $10 per hour for the ten hours per week she works answering the phone ($5,200 annually). Daughter Donna is paid $35,000 for installing windows (materials and labor). Son Sam is paid nothing as an employee, as he is busy performing surgery (but he will receive a distribution later because he is a shareholder).

After considering the previously cited cases, it is doubtful that anyone could assert a reasonable argument that Karl is not an employee of the corporation, as he is an officer of the corporation and is providing substantial services for the company. Accordingly, the first $102,000 of Karl's wages in 2008 are subject to social security taxes. The company pays 6.2% and withholds 6.2% from Karl's salary check. Wages paid in excess of $102,000 (in 2008) are not subject to social security taxes. All of the employee's wages are subject without limit to the Medicare tax. Therefore, 1.45% of $120,000 is paid by the company, and 1.45% of $120,000 is withheld from Karl's paycheck for the Medicare tax. The company issues a Form W-2 to Karl and to the government reflecting his wages and withholdings, for use by Karl in preparing his individual income tax return (or joint return with Wanda).

Wanda's status is somewhat more interesting. If she is listed as an officer of the corporation, then she would generally be held to be an employee, but remember the exception for officers who perform minimal services. On the other hand, under a common-law analysis, she could be held to be an employee--but there are not sufficient facts presented to make that determination thus far (i.e., how much control does the company, via its president, Karl, exercise over her performance of services; does the company supply her with the tools needed for her to perform her tasks, etc.). Assuming the company determined that Wanda is not an employee and the government successfully challenged this determination, the safe harbor provisions may protect the company in this instance, as there is judicial precedent that could be used to argue that the company had a reasonable basis to not consider Wanda an employee but to consider her as a mere shareholder performing minimal services. In Davis, d/b/a Mile High Calcium, Inc. v. United States, 74 AFTR 2d 94-5618 (D. Colo. 1994), the court supported the taxpayer's characterization of S-Corp distributions as dividends payable to an officer who performed minimal services when the shareholder was the wife in a husband-wife team who held all of the shares of the corporation and when the wife merely performed twelve hours per month of clerical work. Wanda may or may not be listed as an officer, but note that Wanda works 10 hours per week rather than 12 hours per month (as in Davis). The less contestable alternative is to pay employment taxes on Wanda's $5,200. Of course, if Karl is willing to gamble on paying a tax attorney to litigate the issue in an effort to save a few hundred dollars, it would be Karl's decision. [Aside: The CPA readers are shaking their heads "no," while some tax attorney readers are smiling and thinking about telling Karl to "Go for it, as we can argue ...."] If the corporation decided to consider Wanda a clerical employee, it would pay/withhold employment taxes and issue her a Form W-2 reflecting such tax withholdings. If the corporation did not classify Wanda as an employee in an ambiguous situation and did so in reliance upon professional advice, then the courts should find a "reasonable cause" for the employment classification determination and allow the taxpayer to benefit from the safe harbor provisions under the Supreme Court holding in United States v. Boyle, 469 U.S. 241 (S.Ct. 1985), reversing 710 F.2d 1251 (CA-7, 1983).

For Karl's daughter, Donna, the facts as presented earlier would strongly indicate that she is truly an independent contractor. She is given an order to install windows and will be paid a flat amount for the work to be performed, with little or no control over how she will perform the task. Therefore, the corporation will not pay or withhold any employment taxes from Donna's payments totaling $35,000. The corporation will issue a Form 1099-MISC to Donna reporting to Donna and the government the amount paid to Donna.

For Karl's son, Sam, no wages of any kind are payable, as he has provided no services to the company in the capacity of an employee or of an independent contractor.

After paying all of the above wages to its employees and to its one independent contractor, and after paying all other business expenses, the corporation will next make distributions to its shareholders. The net profits are paid to the corporate shareholders as follows:

 Karl receives 55% of the net profits (55 shares held with 100
 shares issued);
 Wanda receives 30% of the net profits;
 Sam receives 10% of the net profits; and
 Donna receives 5% of the net profits.

There should be no withholding of federal employment taxes from these payments, as they represent proper payments to the S-Corp's shareholders.

Note that in our hypothetical, the S-Corp is profitable. In instances where the S-Corp incurs a loss, there is a temptation for owner-operators of an S-Corp to use the corporate losses to reduce the owner's self-employment income for self-employment tax purposes. A taxpayer cannot offset S-Corp losses against self-employment income in calculating the self-employment tax when the taxpayer is an officer who performs significant services to the corporation (see IRS Letter Ruling 9530005, April 26, 1995). Remember, the taxpayer needs to account for the income from the S-Corp that is earned as an employee and the income that is received as a mere shareholder separately.

EXPLORATION OF ONE COMMONLY OVERLOOKED ESTATE-PLANNING "LAND MINE" WHEN DEALING WITH S-CORPS

Many closely held businesses are formed as S-Corporations in order to provide the operators of the businesses with the benefits of protecting their personal assets from creditor attack as well as pass-through taxation treatment, much akin to partnerships, for the corporations' shareholders. In order to qualify for S-Corp status, a corporation must meet the criteria as specified in I.R.C. [section] 1361(b)(1), and not be an "ineligible corporation" under I.R.C. [section] 1361(b)(2). The corporation must be a domestic corporation that is incorporated in the United States. The corporation must not have more than 100 shareholders. For purposes of counting the number of shareholders, a husband and wife (and their estates) are counted as one (1) shareholder pursuant to I.R.C. [section] 1361(c)(1). Recent changes to the law (2004 American Jobs Creation Act amending IRC [section] 1361) permit family members to be counted as one shareholder together with their parents (i.e., a grand total of one (1) shareholder reflecting the parents and children). The term "members of a family" means the common ancestor, any lineal descendant of the common ancestor (up to six generations), and any spouse or former spouse of either common ancestor or any such lineal descendant. Individuals (other than a married couple) who hold shares of stock as tenants in common or as joint tenants are considered separate shareholders in determining the number of shareholders [see Treas. Reg. [section] 1.1361-1(e)(2)]. All of the shareholders must be individuals and be either U.S. citizens or resident aliens. As with most rules, there are exceptions. Some exceptions to the "individual person shareholder" rule allow the following types of entities to own S-Corp shares (and therefore not disqualify the corporation's "S" status triggering "C" corporation status together with the tax bill for corporate income taxes that are associated with C-Corporations):

1. a deceased shareholder's estate--[i.e., if a deceased shareholder has 200 heirs, only the one estate is counted as "the shareholder" and not the 200 heirs],

2. a bankrupt shareholder's estate,

3. a Qualified Subchapter S Trust (QSST)--[only the current income beneficiary is treated as a shareholder (not current beneficiaries and potential beneficiaries as with the ESBT)],

4. an Electing Small Business Trust (ESBT)--[but if there are 200 beneficiaries of the trust, all 200 are counted as shareholders and may disqualify the corporation's "S" status],

5. voting trusts--[a trust established to exercise the voting rights of S-Corp stock transferred to it will be allowed to hold the S-Corp stock, and each beneficiary of the trust is counted as a shareholder (and each beneficiary must be otherwise qualified to hold S-Corp shares); other requirements apply but are beyond the scope of this article], and

6. specified tax-exempt organizations.

The preceding six entities are considered "individuals" eligible to hold S-Corp stock.

Additionally, an S-Corp may not issue more than one class of stock; however, for purposes of this rule, shareholder voting rights are disregarded. Therefore, an S-Corp may issue both voting and non-voting stock [see Treas. Reg. [section] 1.1361-1(l)(1)]. But beware of clients who want to provide for certain shareholders to have special rights as to profits or liquidation rights, as these shares will be viewed by the IRS as "preferred stock" and therefore be a second class of stock, thereby disqualifying the corporation from having S-Corporation taxation treatment.

In addition to "individuals" and the entities considered as "individuals" that may hold S-Corp shares, certain trusts are allowed to be S-Corp shareholders. These are as follows:

1. Grantor trusts under I.R.C. [section][section] 671-678 [see also Treas. Reg. [section] 1.1361-1(h)(1)(i)].

2. Testamentary trusts. A trust created by a decedent's Last Will & Testament may hold S-Corp stock for up to two years beginning on the date of the decedent's death. The decedent's estate (not the trust or heirs) is considered to be the shareholder.

The "land mine" that may await many business persons is one whereby the business person (or any family member or other person who receives shares in an S-Corp) does some estate planning by buying one of those "legal in all 50 states" Last Will & Testament kits or a Living Trust kit. The $20 kit may (and frequently does) provide that, upon death, the decedent's property is to be placed into certain trusts or that the shares of S-Corp stock are to be currently held in trust (a revocable trust that will become irrevocable upon the death of the settlor). Subject to the two-year rule stated above, if these trusts do not contain the provisions required by I.R.C. [section] 1361(d)(3), the trust is not a "qualified" trust; therefore, the S-Corp will be deemed to have a non-qualified shareholder, and therefore the corporation may lose its "S" status. Treas. Reg. [section] 1.1361-1(j)(6)(ii) provides the procedure for making the irrevocable QSST election to treat a trust as a QSST.

CONCLUSION

The tax practitioner should be especially careful when advising and/or performing tax preparation services if S-Corporations are involved, as one must be aware of the necessity for the S-Corp to pay federal employment taxes and provide withholding of employment taxes from its employees' paychecks. Care should be taken in the classification of workers to ensure that workers are not erroneously classified as non-employees when there is no "rational basis" to classify a worker as a non-employee (e.g., classifying the worker as an independent contractor, or as a mere shareholder, or as an officer entitled to the "minimal services rendered" exception to officers being automatically classified as employees, etc.). S-Corps that have a sole shareholder should designate that sole shareholder as an employee and pay federal employment taxes (based on precedent by the Tax Court and several federal courts of appeal).

Also, courts, including the U.S. Supreme Court, are quick to look at the realities and substance of the underlying economic transactions and not the mere form of the transactions. While there is a very narrow safe harbor that may protect a few taxpayers who are able to meet its criteria, the best safe harbor is for the taxpayer to accurately and honestly determine which persons providing labor for the corporation's benefit are indeed corporate employees and for the corporation to then make the required employment tax payments based upon the employees' reasonable compensation for the services rendered.

Finally, once an S-Corporation is operational, careful attention must be paid to business succession planning and estate planning in order to avoid taking any actions that may cause the IRS to determine that the corporation is no longer qualified to retain its S-Corporation status and therefore be deemed to be a C-Corporation, subjecting the corporation to income taxation at the corporate level.

REFERENCES

Cases

Davis, d/b/a Mile High Calcium, Inc. v. United States, 74 AFTR 2d 94-5618 (D. Colo. 1994)

Ding v. Comr., T.C. memo 1997-435, affd, 200 F.3d 587 (CA-9, 1999)

Frank Lyon Co. v. United States, 435 U.S. 561, 573 (S.Ct. 1978)

General Investment Corp. v. United States, 823 F.2d 337, 340 (CA-9, 1987)

Greco v. United States, 380 F.Supp. 2d 598, 614 (M.D. Pa., 2005)

Grey v. C.I.R., 93 AFTR 2d 2004-1626 (CA-3, 2004)

Joseph Radtke, S.C. v. United States, 712 F.Supp. 143, 145 (E.D. Wis. 1989), affirmed, 895 F.2d 1196 (CA-7, 1990)

Nu-Look Design, Inc. v. Comr. (356 F.3d 290, CA-3, 2004)

Peno Trucking, Inc. v. C.I.R., 93 T.C.M. 1027 (U.S. Tax Ct., Mar. 21, 2007)

Specialty Transport & Delivery Services, Inc. v. C.I.R., 93 AFTR 2d 2004-1364 (CA-3, 2004)

Spicer Accounting, Inc. v. United States, 918 F.2d 90 (CA-9, 1990)

Superior Proside, Inc. v. C.I.R., 93 AFTR 2d 2004-647 (CA-3, 2004)

Texas Carbonate v. Phinney [IRS] (307 F.2d 289, 291-93; CA-5, 1962)

United States v. Boyle, 469 U.S. 241 (S.Ct. 1985)

Veterinary Surgical Consultants, P.C. v. C.I.R., 93 AFTR 2d 2004-1273 (CA-3, 2004)

Federal Legislation

2004 American Jobs Creation Act, P.L. 108-357, [section] 232

Federal Insurance Contributions Act (FICA)

Federal Unemployment Tax Act (FUTA)

IRS Letter Ruling

IRS Letter Ruling 9530005, April 26, 1995

United States Code

26 U.S.C. [section][section] 3121(a), 3306(b)

26 U.S.C. [section][section] 3121(b), 3306(c)

United States Internal Revenue Code

I.R.C. [section] 530

I.R.C. [section][section] 671-678

I.R.C. [section] 1361(b)(1)

I.R.C. [section] 1361(b)(2)

I.R.C. [section] 1361(c)(1)

I.R.C. [section] 1361(d)(3)

I.R.C. [section] 1366(a)-(b)

I.R.C. [section] 6651

I.R.C. [section] 6656

United States Internal Revenue Service Chief Counsel Advice

IRS Chief Counsel Advice: IRS CCA 200542034 (Oct. 21, 2005)

United States Internal Revenue Service Publications

IRS Pub. 15 Circular E, Employer's Tax Guide (2008)

IRS Pub. 926 State Unemployment Agencies (2008)

IRS Pub. 1544 Reporting Cash Payments of Over $10,000 (2008)

United States Internal Revenue Service Revenue Rulings

Rev. Rul. 59-221, 1959-1 CB 225

Rev. Rul. 74-44, 1974-1 CB 331

United States Treasury Regulations

Treas. Reg. [section] 1.1361-1(e)(2)

Treas. Reg. [section] 1.1361-1(h)(1)(i)

Treas. Reg. [section] 1.1361-1(j)(6)(ii)

Treas. Reg. [section] 1.1361-1(l)(1)

Treas. Reg. [section] 1.1402(a)-1(a)(2)

Treas. Reg. [section] 31.3121(d)-1(b)

Treas. Reg. [section] 31.3306(i)-1(e)

Websites

www.eftps.gov

Electronic Federal Tax Payment System (EFTPS)

www.irs.gov.individuals

Robert M. Pullis, Pullis Law Firm

Fang (Jenny) Zhao, Siena College

Joe M. Pullis, Louisiana Tech University

Darshan L. Wadhwa, University of Houston, Downtown