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Tax Tactics is a bi-monthly column devoted to technical tax topics and strategies. Written by a recognized expert, this is a must-read for tax planners. 

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S Corporation Speed Bump

S corporations are typically the best tax entity for businesses generating ordinary income. However, Tax Court’s 2016 Fleischer decision complicates life for some business owners selling real estate, insurance, and securities.

S corps let you and your clients split your income from your business into two parts. You get a salary, reported on Form W2 just like from any other employer. And you get the net income, just like with a proprietorship or a partnership. (The corporation reports that income on Form K1, which goes on Schedule E of your 1040.)

You pay employment tax on your salary, just as if you were working for any other employer. But you avoid employment tax entirely on the amount that passes through to you as “net income” on Form K1. That tax starts at 15.3% up to the Social Security wage base, which is $142,800 for 2021. The tax continues at 2.9% on any amount above that, plus an Additional Medicare Tax on earned income above $200,000, or $250,000 for joint filers.

Minimizing employment tax through an S corporation can save tens of thousands per year when business income is high enough. It’s a core planning strategy for most business owners. And given the Biden administration’s proposal to impose the full 12.4% OASDI tax on employment income above $400,000, it may become even more important.

Ordinarily, when you establish an S corp, your customers will do business with the corporation. Income will go directly into the corporate bank account, expenses will come out, and there won’t be any question of operating under the corporate umbrella. However, some business owners who start out as sole proprietors will receive income under their individual name, and even get 1099s under their individual social security number. In that case, they would use a process called “nomineeing” to get the income into the S corp:

• First, they reported all of the income paid to them personally on their Schedule C, as required.

• Next, they took a single deduction for “other expenses” for that same entire amount.

• Finally, they reported that amount as “Gross Income” on their S corp return.

That seemed to work just fine until the Tax Court issued a decision in Fleischer v. Commissioner (TC Memo 2016-238).

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S Corporations and the Fleischer Decision

That seemed to work just fine until the Tax Court issued a decision in Fleischer v. Commissioner (TC Memo 2016-238).

Fleischer was a financial advisor, selling insurance and securities. He earned commissions in his own name, because that’s how securities and insurance licensing laws work: the broker-dealer and insurance companies paid commissions to the licensed agent. At the end of the year, those vendors reported those commissions on Form 1099, payable to him under his own name and his personal social security number.
Fleischer wanted to take advantage of the S corp. So he used the nomineeing technique to move the commissions from himself to his corporation. That was standard operating procedure for commissioned salespeople, especially financial advisors and real estate agents. Fleischer had no reason to believe he was skirting the rules or doing anything wrong. But the IRS saw differently, and the two wound up in Tax Court.

The Tax Court struck down the “nominee” arrangement. They ruled that Fleischer’s corporation was not registered to sell securities, it had no contractual relationship with the vendors, and there was no reason for the vendors to believe it had any meaningful control over him. Therefore, Fleischer had to report the commission income (and pay both income and self-employment tax on that income) personally.

TMN members are constantly running into this scenario with licensed sales pro clients. There’s no shame in discovering for the first time that Fleischer has thrown a roadblock in their way.

So . . . how do we structure commission income to avoid the problems that doomed Fleischer? It’s easiest if you can just switch the contract from you to your corporation. In some states, for example, real estate brokers can pay commissions directly to a licensed agent’s corporation. Mission accomplished.

Where that isn’t possible, though, nomineeing it isn’t good enough.

If you can’t renegotiate your contract with your vendors to direct commissions directly to your corporation, we suggest you establish a contract for services between yourself and your corporation. You’ll continue to report your gross commission income on Schedule C just as before. But now you’ll transfer funds by contract, rather than by nominee. Then, you’ll provide the same reasonably-compensated services to your corporation as you would have provided before the Fleischer decision.

Now, how much of your income can you or should you transfer from your proprietorship to your corporation? We don’t know. Unfortunately, we don’t have any case law, IRS rules, or “best practices” to guide us, at least not yet. It’s certainly plausible that if all you’re doing for the proprietorship is holding the licenses you need to earn your commissions, and the corporation is providing all the rest of the work to maintain and grow that income, you could transfer nearly all of that income. But what does “nearly all” mean? How do you determine a commercially reasonable amount? We don’t know for sure.

So if you take this approach, use your head. Be reasonable. (Remember, “reasonable” is the tax attorney’s favorite word. More lawyers have billed more hours arguing the meaning of the word “reasonable” than any other word in the tax code.) Dot your I’s and cross your t’s. Observe contractual formalities.

TMN’s Tax Operating System® includes a color flowchart, forms and checklists (including a template independent contractor agreement to shift income from an individual proprietor to their S corporation). We recommend you use the RC Reports system to determine an appropriate amount of compensation once the income is routed properly.

Edward Lyon

Edward Lyon

Edward A. Lyon is CEO of the Tax Master Network, where he's coached tax professionals to add planning and financial services to their business since 2005. Go here to join the network. Go here to upgrade your membership or discuss opportunities in financial services.
Edward Lyon

Edward Lyon

Edward A. Lyon is CEO of the Tax Master Network, where he's coached tax professionals to add planning and financial services to their business since 2005. Go here to join the network. Go here to upgrade your membership or discuss opportunities in financial services.

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