A Bad Tax Court Case for Certain Contractors

It is regular practice in this practice & others to incorporate individuals who are paid 1099 income. This allows the contractor recognize part of the income as “earned income subject to FICA and Medicare employment taxes” and part as “unearned income not subject to employment taxes.  This is a simple traditional tax savings technique that is recognized and utilized by probably 50% of tax professionals.

That practice requires the taxpayer make arrangements with the employer to treat the corporation as the contractor instead of the individual owner and pay the corporation directly. But in some industries, such the financial services industry, contracting with the individual is required. There’s no way around it. This practice requires the individual contractor to pay FICA & Medicare tax on 100% of the earnings instead of just the part of the earnings that represent the value of his time.

A 2016 tax court case, Fleischer v. Commissioner required the owner to pay employment taxes on the entire earnings paid to the owner in the owner’s name. Fleischer was the result of a Tax Audit. 

This creates a problem for many contractors that we solved this years ago, before this audit or this court case even occurred. First the problem., then the solution we have developed.

However, in some cases the contractor does not have a proactive tax professional like Ellis that warn them about this up front, they don’t take precautions, they get caught on audit & ordered to pay a large shortfall in income tax plus penalties & interest. That creates a problem. We created the solution.

PROBLEM: The wage base for FICA tax is $132,900. The FICA tax rate is 6.2%. Maximum FICA tax is $8,603. This decision probably cost the taxpayer $4,300 for every year involved in the original audit. Plus penalties & interest.

SOLUTION:The likely solution to this problem is an employment contract.  I have a template of such a contract if you’d like to see it, drop me a message and I’ll shoot you a copy. If you’d prefer to draft your own, here are some considerations. Neither are guaranteed and have never been challenged by the IRS. There are no guarantees.

  1. Require Mr. Fleischer to remit revenues he receives from xxx to Corp.
  2. Make the payor aware in an email that you are employed by your corporation, Individual PC.
  3. Have an employment contract between the individual providing the services and the corporation (Individual, pc.) who the corporation can direct and control in a meaningful sense.
  4. The employment contract should disclose & make corporation’s controlling position clear.
  5. When possible, enter into contracts in the name of your S-Corp, and consider revising those that were entered prior to its formation;
  6. Use a corporation named Individual, pc. Then get a dba to do business in another name. Try using the name Individual, pc. name.
  7. Prepare a written employment agreement between you and your S-Corp;
  8. If you work in an industry, such as the financial services industry, where contracting in the name of an individual is required (whether by rule or as a function of practical considerations), ensure that any contract between you and your S-Corp includes the relevant provisions cited in Fleischer (1&2);
  9. Work with trusted professional advisers who can help you navigate the complex statutes and regulatory rules applicable to your business.

 

If you have a contractor friend, call this problem to his/her attention. He, she & you can find my contact info on my LinkedIn profile page.

Here is an article on the court case itself.

Keep plugging. If we can help you by cutting your income tax, our specialty, get in touch.

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