March 2003

Worker Classification and S Corporations

By Mark A. Segal

Taxpayers and the IRS have long battled over whether a worker is an employee or an independent contractor. Typically, the IRS asserts that the worker is an employee, whereas the employer asserts that the worker is an independent contractor.

The tax stakes involved in these disputes concern the following:

Common-Law Employee Test

Classification of a worker as an independent contractor or employee is generally determined pursuant to a common-law employee test. All relevant facts and circumstances must be examined in light of the 20 factors provided in Revenue Ruling 87-41, 1987-1, CB 296. Exceptions to strict application of this test exist in certain IRC sections and the safe harbor provisions of Section 530 of the 1978 Revenue Act.

Recent cases have addressed certain unique aspects of the tax treatment of items related to worker status. In Cleveland Indians (87 AFTR2d Par. 2001-798), back pay awarded to baseball players in a settlement agreement was found subject to FICA and FUTA taxes under the rules applicable to the year the award was paid, rather than the rules applicable to the year the amount should have been paid. In North Dakota State University (87 AFTR2d 2001-1036), nonacquiescence by the IRS, amounts paid to tenured faculty for early retirement were held not subject to FICA because they were received for a property right (tenure rights) and not as compensation. In contrast, amounts paid to tenured administrators for early retirement were held subject to FICA.

Other fact patterns of note in this area concern employee leasing. In this regard, Microsoft had a group of workers originally classified by it as temporary, freelance independent contractors reclassified as common-law employees, despite the following facts:

Subsequently, the workers were still found to be employees of Microsoft despite the use of a temporary agency as an intermediary between the worker and Microsoft (for background, see the cases of Vizcaino v. Microsoft).

S Corporation Issues

S corporations have long held appeal as a means to mitigate FICA and FUTA obligations. Use of an S corporation for this purpose is premised on the following:

The computation of basis for the purposes of determining the impact of S corporation distributions follows the steps in the Exhibit.

The impact of a distribution on shareholder basis and the determination of whether the distribution will cause gain recognition occurs after the positive adjustments shown in the Exhibit, and prior to the downward adjustments. Distributions constitute a return of capital and act to recover the shareholder’s S corporation stock basis. Should the return of capital exceed basis, the excess constitutes a gain, generally classified as a capital gain. Whether the gain is considered long-term or short-term depends upon the duration of the shareholder’s holding period as of the date of the distribution producing the gain.

The stock basis determined after taking into account the above adjustments serves as a ceiling on the taxpayer’s ability to use pass-through deductions and credits. Note that the ability to use pass-through deductions and credits may also be restricted due to the application of the at-risk rules (IRC section 465) and the passive activity loss limitation rules (IRC section 469). Deductions and credits unused due to inadequate basis are carried forward.

Example: J is the sole shareholder in an S corporation called S-Co. At the beginning of the tax year, J’s basis in S-Co’s stock is $50,000. During the year, S-Co has the following items:

Based upon this data, J’s basis is first increased by the net non separately computed income of $50,000 ($70,000 – $20,000), and then the separately disclosed income item ($3,000 tax-exempt interest). These adjustments bring the basis of J’s S-Co stock to $103,000. The next step is to examine the impact of the distribution received. Because the distribution does not exceed J’s basis, none of the distribution is taxable. Instead, the distribution merely reduces his stock basis to $53,000. The $5,000 short-term capital loss is a separately disclosed item that passes through to J. It will be reflected on J’s Schedule D, and it reduces J’s basis to $48,000 ($53,000 – $5,000).

Example: Assume the same facts as above except that the distribution is $110,000. In this case, J’s basis would also be increased to $103,000, but because the distribution exceeds this amount, J will recognize a gain of $7,000. J’s basis after taking into account the distribution would be zero, and the pass-through short-term capital loss could not be used on J’s current-year tax return.

Example: If the distribution of $50,000 is considered salary, it would be subject to FICA and FUTA obligations, and S-Co would have certain withholding and matching obligations. Failure to meet such obligations would result in penalties, interest, and a tax deficiency. S-Co and J would incur equal amounts of additional taxes (FICA and FUTA) totaling $7,650 (.153 x $50,000).

Veterinary Surgical Consultants

The IRS has long sought to have purported distributions from an S corporation to a shareholder/service provider classified as employee compensation. This attack has met with some success, particularly where the shareholder controls the corporation and is the sole source of the S corporation’s income. This scenario is reflected in two recent cases.

In Veterinary Surgical Consultants [117 T.C. No. 14 (October 15, 2001)], the Tax Court held that amounts received by a person who was the sole shareholder, officer, and source of income of an S corporation constituted salary subject to federal employment taxes. The shareholder had spent some 33 hours a week performing services for the S corporation, was the sole signature authority on the corporation bank account, and had withdrawn funds at his discretion. The corporation issued neither a W-2 nor a 1099 to the shareholder/service provider.

Tax Court Judge Jacobs noted the following regarding FICA and FUTA obligations:

The court then rejected arguments that an exception to employee classification applied to the facts under the safe harbor provisions of Section 530 of the 1978 Tax Act. According to the safe harbor, employee status need not apply where:

The court found that the S corporation lacked a reasonable basis for not treating the sole shareholder/service provider as an employee. According to the court, a reasonable basis for not treating a person as an employee must be based upon reasonable reliance on judicial precedent, published rulings, technical advice, a letter ruling to the taxpayer, or a longstanding practice of the taxpayer’s industry.

The fact that the purported worker had already met the ceiling on FICA obligations due to withholding from another position was found irrelevant to the duties of the S corporation to withhold and match. The S corporation itself was not impacted by the taxpayer’s having met such a ceiling. The court indicated that the worker could later recoup excess withholding through acquisition of a refund or credit.

The court found IRC section 1366 not controlling, because its provision concerning S corporations applied only to the pass-through of net income and not to amounts subject to FICA or FUTA obligations under the Federal Employment Tax Provisions.

Yeagle Drywall

Yeagle Drywall Co. [TC Memo 2001-284 (October 15, 2001)], a companion case to Veterinary Surgical Consultants, had a similar conclusion. The case concerned amounts distributed to John Yeagle, the 99% owner of Yeagle Drywall Co. Yeagle performed substantial services for the corporation. His tasks included the placement of orders, solicitation of business, entry into contracts, collection of revenue, hiring and firing of independent contractors, and possession of authority over the bank accounts of the business. Yeagle withdrew funds and paid his own expenses from the S corporation accounts. At no time did the corporation treat Yeagle as an employee for tax purposes; instead, it treated amounts taken out of the business by Yeagle as distributions of net income. As in Veterinary Surgical Consultants, the court found that Yeagle was an employee of the S corporation, and all of the distributions made to Yeagle were deemed remuneration and wages.

As in Veterinary Surgical, Yeagle argued that employee status was not applicable because of the provisions of section 530 of the Revenue Act of 1978 (P. L. 95-600, 92 Stat. 2885). According to the court, however, the S corporation had no reasonable basis for not treating Yeagle as an employee.

Mark A. Segal, LLM, CPA, is a professor of accounting at the University of South Alabama, Mobile.

Edwin B. Morris, CPA
Rosenberg Neuwirth & Kuchner

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