Compensation: Lessons Learned from Two Court Cases
Two recent court cases send a very clear message about what the Internal Revenue Service (“IRS”) thinks about trying to change compensation arrangements after they’ve already been agreed upon.
That message is: While you have many choices for how to structure your compensation, the choice must be made when you enter into an arrangement to provide services. It can sometimes be changed later, but not with respect to amounts that have already been earned.
In other words, if you try to change your compensation arrangement after the fact to avoid or delay taxes, the IRS is very likely to challenge your treatment.
Court Case #1: Ryan M. Fleischer v. Commissioner of Internal Revenue
In Fleischer v. Commissioner (T.C. Memo 2016-238), the taxpayer was a financial consultant who was licensed to buy and sell securities and certain insurance policies. On February 2, 2006, he signed an independent contractor agreement with a broker dealer. This agreement allowed him to earn commissions for selling various investment products.
On February 7, just a few days later, he established an S corporation. He was the corporation’s sole shareholder, officer and employee. He signed an employment agreement with his S corporation on February 28 that stated he would be paid an annual salary to “perform duties in the capacity of Financial Advisor” (T.C. Memo 2016-238, Section II. Petitioner’s Agreements and Contract, p. 4). The agreement with the broker dealer was never amended to refer to the S corporation, and the taxpayer’s employment agreement with the corporation did not refer to the agreement with the broker dealer.
Two years later, he personally entered into an independent contractor agreement with an insurance company under which he could earn commissions for selling insurance products. The agreement did not contain any reference to his S corporation, and his employment agreement was not amended to refer to the agreement with the insurance company.
In short, the taxpayer personally signed contracts under which he would receive compensation. Then, he reported the income from those contracts on his corporate tax returns. The corporation paid him an annual salary that was much lower than the corporation’s earnings. He did not pay any self-employment tax on the corporation’s net earnings.
The IRS and the Tax Court both decided that because the contracts were entered into by the individual rather than the S corporation, the income from the contracts had to be treated as self-employment income.
The takeaways from this case are:
- Make sure your paperwork for your compensation supports your desired tax treatment. If the taxpayer in this case had entered into the contracts in his corporation’s name, he would have documentation to support his tax returns.
- If you earn income, you cannot assign that income to someone else and avoid tax on the amounts. In other words, if you render services and ask the recipient to pay your wife, your children, or even a charity, you must still report that as income you have earned.
“Although it wasn’t addressed by this case, the taxpayer’s efforts to avoid self-employment tax highlight another common planning technique that the IRS frequently audits,” adds Deborah Walker, CPA, National Director of Compensation and Benefits at Cherry Bekaert. “Individuals who perform services through a wholly-owned corporation sometimes pay themselves a relatively small salary. They then distribute remaining corporate earnings, which are not subject to FICA, Medicare or self-employment tax. For this to be successful, an owner must be able to show that the salary is reasonable for the services provided.”
Walker continues, “Contemporaneous documentation of how the reasonable salary was determined can be especially helpful. To the extent that it can be shown that salary is reasonable, FICA, Medicare and self-employment tax can be avoided on corporate distributions.”
Court Case #2: QinetiQ U.S. Holdings, Inc. v. Commissioner of Internal Revenue
QinetiQ v. Commissioner (T.C. Memo 2015-123) is a little more complicated, but the takeaways are similar.
In this case, two men owned the majority of the stock in a corporation and were both actively involved in the corporation’s business. They had each paid par value for the shares when they were issued. Corporate documents did not contain any indication that the shares were unvested or had been issued as compensation for services. In contrast, shares had been issued to other individuals, and those stock certificates and employment agreements clearly indicated that the shares were issued as compensation and were subject to a vesting schedule.
The corporation had an S election in place for the first five years of its existence, and its activity was allocated to and reported by its shareholders. However, when the entity was sold after it revoked the S election, both the company and the two principal owners claimed that certain stock was issued for services and was subject to a substantial risk of forfeiture until the time of sale. (For more information on substantial risks of forfeiture, see our recent tax alert about the effect of substantial risks of forfeiture on deferred compensation.) As a result, the company claimed a compensation deduction for the fair value of the stock at the time of sale, and the shareholders each treated the amount that they received as wages.
The compensation deduction was disallowed by the IRS and two courts because the evidence, which included both documentation and prior treatment on tax returns, indicated that the stock was vested in the year it was issued. In making this determination, the court found that had the stock been subject to some forfeiture provisions, the company had not shown that it was likely to enforce them.
The takeaway here is that compensation arrangements need to be agreed upon ahead of time and should be clearly documented. Comparing the potential tax treatment of different arrangements should be part of the process, as you decide what your compensation arrangement will be. In this particular case, if the stock was considered compensation in a year subsequent to issuance, the company would have been allowed a deduction for the fair value of the stock (and the individuals would have recognized income) in that year. Further, the annual allocation of S corporation income would not have considered those shares.
Had the company and the individuals wanted this result, they should have imposed a vesting schedule on the shares, making them subject to a substantial risk of forfeiture. The company could also have used annual bonuses to allocate operational profits prior to vesting. Alternatively, they could have used a different arrangement, such as a phantom stock plan. Either of these options would have made a big difference in tax treatment and in the taxes owed by each party.
Examine your situation carefully and compare the potential tax outcomes when you’re setting compensation arrangements.
Your Next Action Steps
Do you have questions about these court cases? Perhaps you want help walking through your own compensation arrangements for current and future employees?
Compensation arrangements can be complex – and expensive, if you structure them wrong. What’s going to be best for you, other stakeholders, and associates? Get the answers you need from Deborah Walker, CPA, National Director of Compensation and Benefits. She’s available for consultation – wherever you are in the process of setting up, managing, or selling your business.
Or, reach out to your local Cherry Bekaert advisor for answers and guidance for your unique situation. If you get even one new idea from the conversation, it will be worth your time.