This Insights was contributed by Richard Pasquantonio, CPA/CFF, CFE, CDFA (NC License Number 33577), an associate at Adam Shay CPA, PLLC.
 
This article is intended to communicate a very narrow issue that the US Tax Court recently decided in December 2016, Fleischer v. Commissioner, 112 T.C.M. (CCH) 723, T.C. Memo. 2016-238.  It affects independent contractors with a Limited Liability Company (LLC) that elect S corporation status with the IRS.
 
Independent contractors often create LLCs to offer them liability protection. These single member LLCs are labeled “disregarded” by the IRS. Disregarded Entities do not file their own income tax returns and are instead treated as sole proprietorships, with the income and expenses reported in Schedule C of the owner's Form 1040.
 
It is not uncommon for independent contractors who execute this strategy to forgo certain formalities. For instance, independent contractors often provide their personal information instead of their business information to customers when completing the W-9, Request for Taxpayer Identification Number. The result is that the independent contractor may receive some Forms 1099-Misc reporting income to his or her business’s name and EIN number and some Forms 1099-Misc reporting income individually with his or her social security number. Although careless, as long as the entity remains disregarded there are no negative tax consequences.
 
However, once a single member LLC has about $40,000 in net income, it begins to make sense to consider the tax benefits of making a federal tax election to request that the IRS treat the LLC as an S corporation for income tax purposes. 
 
An S election can offer significant tax-planning opportunities. One inherent benefit is that a portion of the owner’s earnings is shielded from self-employment taxes (Social Security and Medicare). Once approved, the previously disregarded entity is now recognized by the IRS and required to file its own income tax return. The Independent Contractor becomes an employee of the S corporation. 
 
This is when your past can come back and haunt you.
 
Prior to Fleischer, when a single member LLC made an S election and the taxpayer received a mix of business and individual Forms 1099-Misc, a common practice was to report the income on the Schedule C of the taxpayer’s Form 1040 and report an amount equal to the income as a deduction, with a reference to the S corporation’s name and EIN number. This would result in zero income from self-employment and therefore zero self-employment taxes.  
 
As indicated, the income would also be reported on the S corporation's return as income. All ordinary, necessary and reasonable expenses would be deducted (including a reasonable salary for the taxpayer) and the resulting net income would pass through to the owner's Form 1040 free of self-employment tax. These were essentially the facts in Fleisher, but the Tax Court held a different opinion.
 
In support of its decision, the Tax Court cited Johnson v. Commissioner.  The Johnson case established two tests, both of which must be met:
 
“For a corporation, not its service-provider employee, to be the controller of income, two elements must be found: (1) the individual providing the services must be an employee of the corporation whom the corporation can direct 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 court found that Fleisher failed the second test.  Fleisher's S corporation did not have an agreement with the entity using the service (the customer), nor did it notify the customer of the employment relationship. The court was silent regarding the first test.
 
Although Fleisher involved a highly regulated industry (Fleisher was a broker dealer), I think we can learn from this opinion and apply those lessons to similarly situated businesses. The court’s decision in citing Johnson has left open an avenue for taxpayers to work with their CPA and legal counsel to design compliant and enforceable agreements with their customers and their S corporation employers to preserve the tax savings strategies that they have implemented. 
 
The Fleisher decision makes it clear that the lack of formality in these arrangements will no longer be tolerated by the IRS and by not addressing the issue proactively, you are inviting unwanted scrutiny and assessment of additional tax, interest and penalty.
 
Richard Pasquantonio, CPA/CFF, CFE, CDFA (NC License Number 33577), is an associate at Adam Shay CPA, PLLC. He focuses on forensic accounting, fraud prevention and detection, and tax controversy resolution. He is also an AICPA CFF Champion. The purpose of the CFF Champion program is to inform the professional community about the vital role of forensic accounting professionals, the knowledge required to become a CFF, and the benefits of the CFF credential. For more information, visit http://www.wilmingtontaxesandaccounting.com/ or email him at [email protected]. Pasquantonio can also be reached by phone at (910) 256-3456.