Putting Out Fires (S Corp Edition)

In a way, we’ve all been spoiled these last few years. Gridlock in Washington has meant little change in the tax code. Sure, we had a little action at the end of 2013, when the “fiscal cliff” threatened to upend us all in a sea of government red ink. And we’ve had new Obamacare taxes and reporting responsibilities, the 1094s and net investment income taxes that have added to our workload (and our clients’ tax bills). But most tax changes have been pretty marginal and often short-lived. (Anybody remember the “Making Work Pay” credit? We don’t either.)

The lack of action in Washington has been both a blessing and a curse. It’s a blessing because it’s given us more certainty for planning – obviously, it’s easier to plan when we know what the rules are going to be. And it’s a curse because we have less chance to create and demonstrate value by helping clients navigate upcoming changes.

(We’ll see what sort of opportunities we get on that front if the new administration and Congress get their acts together to pass any sort of tax reform. For better or worse, the chance of that happening is dimming by the day. Conventional wisdom says if it doesn’t happen in 2017, it certainly won’t pass in a heated election year. My early prediction, for what it’s worth, is that we see no Obamacare repeal and no significant tax reform.)

Having said all that, every so often the IRS or a court will issue something that changes a pretty important rule. In December, the Tax Court issued the Fleischer decision that does just that. I’ve been asked about it on every TaxCoach member call since then, and I wanted to share my thoughts here as a reference for future questions.

Here’s the scenario. Everyone knows how to use an S corporation to minimize employment taxes. It’s a long-established strategy, and popular, too! Last year, the IRS received over 4 million S corp returns, and audited less than one-half of one percent of them.

The problem, for some taxpayers, comes when the income is reported to the individual owner rather than the corporation itself. This is frequently the case in sales, where a real estate broker or securities broker-dealer pays commissions to an individual agent, and sends them a 1099 reporting the income under their individual social security number. How does the client get the income to the corporation?

In the past, we’ve recommended “nomineeing” the income. Report it on the individual’s Schedule C, then take a corresponding deduction for the entire amount and explain it as being reported on the corporation report. Some practitioners deduct the entire amount as “Commissions and fees” on Line 10 of Schedule C. Others would create an entry in “Other Deductions” that would look something like this: “Reported on Taxpayer S Corp, Inc., 31-1xx7177,” or words to that effect. Again, this has been standard operating procedure for TaxCoach members across the country.

Well, that was fun and games until December 29. (Merry Christmas, everyone!) That was when the Tax Court issued their opinion in Fleischer v. Commissioner, TC Memo 2016-238. That decision concerned a financial advisor who used this strategy to pass income from a broker-dealer and an insurance company through himself to his S corp. The court shot him down on the grounds that Fleischer himself, rather than the corporation, controlled the earning of the income. The broker-dealer and insurance company both contracted with the advisor individually, rather than the corporation – meaning the advisor should be taxed and responsible for employment tax on all the income.

So, where do we go from here? If you’re like many TaxCoach members, you have clients in a similar situation. Their S corporation planning, that you may have done for them, is in jeopardy, and it’s up to you to demonstrate your value by saving it.

Fortunately, there’s an answer we feel comfortable recommending. I originally heard it from a longtime TaxCoach member, and I’ve seen it repeated in other places. The answer is to establish a bona fide contractual arrangement between the client who earns the income individually and the corporation. That way, the corporation controls the earning of the income through the contract, rather than just receiving income passed through the Schedule C.

Let’s say your client is a real estate agent, and state law prohibits paying the commissions directly to the corporation. You’ve previously used the “nominee” method to pass earnings through to the corporation. Now, you’ll set up a contract between the agent and the corporation to provide services to the Schedule C business. These might include marketing, management, sales, or whatever other functions you recommend. Your client will deduct the cost of those services from their Schedule C, the same as they would for any other contractor. They’ll pay tax, including self-employment tax, on whatever income is left on that Schedule C. But they’ll still be able to pass the bulk of the earnings through to the S corporation.

This is going to take some work. Your client will have to dot their I’s and cross their T’s. They can’t do it all through journal entries – they’ll have to show that funds were actually deposited into the proprietorship bank account, then transferred into the corporation account. Of course, they’ll appreciate your help walking them through the mechanics. (This is why maintenance packages are so important!)

TaxCoach has resources to help you explain this new strategy to your existing S corp clients as well as prospects. The S corp minipresentation should be especially valuable – we’ve just updated it with a new slide explaining this issue, as well as all-new script language for the rest of the slides. You’ll find it in the Seminar Presentations section of TaxCoach. There’s also a template independent contractor agreement they can use to start thinking how to “paper” the arrangement to survive IRS scrutiny. You’ll find this in the “Document Templates” section.

We realize that this week’s Briefs isn’t the usual fun marketing-oriented topic we normally cover. But technical planning like this, even when it involves putting out fires, is how you really prove your value. (And anyway, this one still presents a marketing opportunity – just ask your realtor clients, for example, “What’s your tax pro telling you to do about the recent Tax Court ruling on S corporations?”)

We’ll be keeping a close eye on the Fleischer decision and everyone’s reaction. So keep your eyes open with us and let’s see how well we can take care of our clients!