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Financial Advisor Can't Use S Corporation to Shield Himself from Self-Employment Taxes

(Parker Tax Publishing January 2017)

The Tax Court held that a financial advisor who purchased and sold securities should have reported income earned under agreements with financial institutions on his individual return as Schedule C self-employment income rather than running the income through his S corporation and treating it as K-1 income on which self-employment taxes were not due. The court rejected his argument that the S corporation itself could not contract with the financial institutions because a provision in the 1934 Securities and Exchange Act that would impose a prohibitively expensive licensing requirement on the corporation. Fleischer v. Comm'r, T.C. Memo. 2016-238.


Ryan Fleischer, a financial consultant, obtained his Series 6, 7, 24, 63, and 65 licenses so that he could purchase and sell securities under the Securities Exchange Act of 1934 (Act), the Financial Industry Regulatory Authority (FINRA), and the North American Securities Administration Association (NASAA) rules. Fleischer started his career with an investment firm that sold proprietary products and performed financial planning. He left that firm to work for a bank, where he again sold proprietary products to the bank's clients. Eventually, Fleischer struck out on his own because he wanted to have his own clients and accounts.

On February 2, 2006, Fleischer entered into a representative agreement with Linsco/Private Ledger Financial Services (LPL) in his personal capacity. The agreement expressly states that Fleischer's relationship with LPL is that of an independent contractor. After consulting both his business attorney and his CPA, Fleischer incorporated Fleischer Wealth Plan (FWP) and caused it to elect S corporation status. Fleischer was the sole shareholder and the president, secretary, and treasurer of FWP. On February 28, 2006, Fleischer entered into an employment agreement with FWP. The agreement expressly states that Fleischer's term of employment with FWP began on February 28, 2006.

Fleischer was paid an annual salary to "perform duties in the capacity of Financial Advisor." Those duties consisted of: (1) acting in the clients' best interests in managing client investment portfolios; (2) expanding FWP's client base and the "overall presence" of FWP; (3) drafting and reviewing financial documents; and (4) representing FWP "diligently and responsibly at all times."

The agreement gives FWP the right to reasonably modify Fleischer's duties at its discretion. The agreement includes other common provisions found in employment agreements, such as provisions for the reimbursement of expenses and how to terminate the agreement, an arbitration clause, and a noncompete clause. The agreement does not include a provision requiring Fleischer to remit any commissions or fees from LPL or any other third party to FWP.

In 2008, Fleischer entered into a broker contract with MassMutual Financial Group (MassMutual). The contract was signed by Fleischer and is between Fleischer and MassMutual, with no mention of FWP. The contract explicitly states that there is no employer-employee relationship between Fleischer and MassMutual. There were no addendums or amendments to either the LPL agreement or the MassMutual contract requiring those entities to begin paying FWP instead of Fleischer or to recognize FWP in any capacity.

Fleischer's 2009, 2010, and 2011 Tax Returns

For 2009, 2010, and 2011, Fleischer reported taxable wage income each year from FWP of approximately $35,000 on his Form 1040. For 2009, 2010, and 2011, he also attached a Schedule E to his Form 1040 reporting nonpassive income of approximately $12,000, $148,000, and $115,000, respectively from FWP. No amount was reported for self-employment tax, but Fleischer did claim a self-employed health insurance deduction for each year on his Form 1040. There were no Forms 1099 from LPL or MassMutual and no Schedule C attached to Fleischer's 2009, 2010, or 2011 Form 1040.

For 2009, 2010, and 2011, FWP reported ordinary business income of approximately $12,000, $148,000, and $115,000, respectively on its Form 1120S. This ordinary business income was then reported on FWP's 2009, 2010, and 2011 Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc., that were issued to Fleischer. Fleischer then reported those amounts on the Schedules E he attached to his tax returns.

The amount of gross receipts or sales used to calculate the FWP's ordinary business income came from the Forms 1099 that LPL and MassMutual issued to Fleischer for 2009, 2010, and 2011.

The IRS assessed a deficiency on the basis that, under Code Sec. 482 and Code Sec. 61, the gross receipts or sales that FWP reported on its Forms 1120S should have been reported by Fleischer as self-employment income on Schedule C of his Form 1040 and self-employment tax should have been paid.

Fleischer's Position

Before the Tax Court, Fleischer did not dispute that LPL and MassMutual never contracted directly with FWP. He argued that it was impossible for those entities to do so because FWP was not a registered entity under the securities laws and regulations and, under the law, FWP could not enter into representative agreements and broker contracts. Fleischer relied on Section 78o, Registration and Regulation of Brokers and Dealers, of the 1934 SEC Act, which provides that:

"it is unlawful for any broker or dealer which is either a person other than a natural person or a natural person not associated with a broker or dealer which is a person other than a natural person (other than such a broker or dealer whose business is exclusively intrastate and who does not make use of any facility of a national securities exchange) to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security or commercial paper, bankers' acceptances, or commercial bills) unless such broker or dealer is registered in accordance with subsection (b) of this section. [15 U.S.C. sec. 78o(a)(1).]"

Fleischer testified that it would be overly burdensome and "would cost millions and millions of dollars" for FWP to register under the 1934 SEC Act.

Tax Court's Analysis

The Tax Court began its analysis by stating that the first principle of income taxation is that income must be taxed to the person who earned it. The court noted that, while this principle is easily applied between two individuals by simply asking who performed the services or created the goods, the question of who earned the income is not so easily answered when a corporation is involved. Citing Johnson v. Comm'r, 78 T.C. 882 (1982), the court observed that, in the case of a corporation and its service-provider employee, the relevant question has evolved to one of "who controls the earning of the income." For a corporation, not its service-provider employee, to be the controller of the income, the court said that two elements must be found:

(1) the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense; and

(2) there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation's controlling position.

The Tax Court focused on the second element and looked at whether FWP entered into a contract or other indicium with LPL or MassMutual that exhibited its control over Fleischer. The court noted there was no mention of FWP in either of the contracts that Fleischer signed in his individual capacity and both contracts provided that there was no employer-employee relationship. Moreover, there was no evidence of any amendments or addendums to those contracts after they were signed. Thus, the court concluded that there was no indicium for LPL or MassMutual to believe that FWP had any meaningful control over Fleischer.

The court then looked at Fleischer's argument that it was impossible for LPL and MassMutual to contract with FWP because of a provision in the 1934 SEC Act. The fact that FWP was not registered, thus preventing it from engaging in the sale of securities, did not mean that Fleischer could assign the income he earned in his personal capacity to FWP, the court said. The court cited its decision in Jones v. Comm'r, 64 T.C. 1066 (1975), in which it held that a court reporter improperly assigned income to his personal service corporation because a court reporter was legally required to be an individual, and although the corporation was a valid entity, by law it could not perform such services.

In conclusion, the court held that Fleischer, individually, not FWP, should have reported the income earned under the representative agreement with LPL and the broker contract with MassMutual for the years in issue.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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