Late December’s Fleisher v Commissioner involves facts that are common among many small business service-providing taxpayers wishing to minimize self-employment liability by setting up S Corporations and funneling service income to those corporations. Unfortunately for Fleisher, the Tax Court found that he faced a sizable self-employment tax liability as it reallocated income that was reported on the S Corporation’s 1120-S to his Form 1040.

The case is in the category of who is the appropriate taxpayer, an issue that sometimes gets murky when taxpayers are dealing with closely or solely-held separate entities. I will summarize and simplify the facts somewhat and hone in on why the taxpayer lost despite the plans of both a CPA and lawyer advising on his tax structure.

The Facts of Fleisher: Setting up an S Corp to Avoid Self-Employment Tax

Fleisher is a licensed financial consultant. Based on the advice of his CPA and lawyer, he set up an S Corporation. Fleisher was the president, secretary, treasurer and sole shareholder of the corporation. Fleisher entered into an employment agreement with the S Corporation, and pursuant to that agreement the S Corp paid him a salary in his capacity as financial advisor. In his individual capacity, Fleisher also entered into contracts with financial service companies Mass Mutual and LPL. Those contracts generated significant commissions, which Mass Mutual and LPL reported to the IRS and to Fleisher individually on various Form 1099’s over the years.

The key to the employment tax savings when all works well in this structure is that the S Corp pays a salary less than the gross receipts it receives. The shareholder/employee has employment tax liability to the extent only of the wages that the S Corp pays to the shareholder/employee. Fleisher paid employment tax on his wages from the S Corp. And while Fleisher’s status as sole shareholder meant that all of the S Corp’s income would flow through to him, the nature of the income matters. Individuals who earn service income directly have to pay Social Security and Medicare taxes, which are often referred to collectively as the self-employment tax. [Note that the tax rate for Social Security taxes is 12.4% and the rate for Medicare taxes is 2.9%; for 2017 Social Security taxes are levied only on the first $127,200 while the Medicare rate applies to all service income]. If the S corporation, rather than the individual, earns that income, then the S corporation does not have a separate employment tax liability and the shareholder does not have self-employment tax liability on his share of the S corporation’s income.

Fleisher’s S Corp paid him a salary of about $35,000. The net income the S Corp earned varied over the years, going as high in one year as about $150,000. When, as was the case here, the S Corp’s wages paid are less than its net service income, the shareholder/employee can potentially avoid the self-employment income tax if that income were earned directly by the shareholder/employee or the employment tax if the S Corporation does not pay a salary commensurate with the corporation’s net income.

Underlying this form, however, is the IRS’s ability to allocate the income to the party who truly earns the income. In addition, the compensation the S Corporation pays to its shareholder/employee must be reasonable; if too low IRS can argue that some of the distributive share should be characterized as compensation (Peter Reilly discusses one such situation in S Corporation SE Avoidance Still a Solid Strategy). The taxpayer’s reporting of the income and the mere creation of a separate entity do not give the taxpayer unlimited discretion to treat the income in the way most favorable to the taxpayer.

As an important aside, the consequences of an LLC earning service income differ from that of an S Corporation. When an LLC earns service income, the distributive share of partnership income allocated to members of an LLC is generally subject to self-employment tax. This is a key difference between S Corporations and LLCs in this context. For an excellent discussion of the issue, see our Forbes colleague Toni Nitti’s post from a few years ago, IRS: Partners’ Share of LLC Income is Subject to Self-Employment Tax.