In the recent Tax Court case of Fleischer (T.C. Memo 2016-238), the taxpayer attempted to utilize an S corporation to reduce his exposure to the self-employment tax. The taxpayer was a certified financial planner who entered into contracts to sell products offered by two different insurance companies. Both of the contracts were between Mr. Fleischer and the insurance company, and neither made any mention of his corporation, Fleischer Wealth Plan. FWP was an S corporation, and Mr. Fleischer reported the income he had received from the insurance companies as having been received by FWP. He paid himself a small salary out of FWP and treated the balance of its net income as simply being passed through to him as the S corporation’s shareholder. A shareholder’s share of the taxable income of an S corporation that is passed through to him on Form K-1 is not subject to self-employment tax, whereas any salary he pays to himself from the S corporation is subject to all the employment taxes.

Taxpayers have long uses S corporations to try to avoid self-employment taxes on what is essentially personal service income. The taxpayer arranges for the income from his services to be received by the corporation and pays himself a small salary, on which all the employment taxes are paid. Most of the net proceeds from the taxpayer’s services are simply allowed to flow out on his K-1 as net income. This net income is not subject to employment taxes. The IRS long ago caught on to this scheme and prevailed in many court cases, resulting in the taxpayer having to pay employment taxes on most or all of the net earnings of the S corporation. The IRS has been successful in convincing courts that the small salary received is not reflective of the value of the taxpayer’s services.

Mr. Fleischer, however, did not even get that far. The Tax Court determined that the amounts paid by the two insurance companies should have been reported directly by Mr. Fleischer on his own income tax return, rather than on the income tax return of FWP. The court pointed out that FWP was not a party to the contract with either of the insurance companies. In order for FWP to be the proper party to report this income, it needed to be a party to the contracts with the insurance companies and it also needed to be able to control the provision of Mr. Fleischer’s services to the insurance companies. Under the court’s holding, all the payments received by Mr. Fleischer from the insurance companies were considered net income from self-employment upon which he was required to pay self-employment tax.