117 T.C. No. 14
UNITED STATES TAX COURT
VETERINARY SURGICAL CONSULTANTS, P.C., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 2500-99. Filed October 15, 2001.
P, an S corporation, distributed all of its net income to A, its sole shareholder and president. A performs substantial services for P. On his Forms 1040, A reported P’s net income as nonpassive income from an S corporation.
R issued to P a Notice of Determination Concerning Worker Classification Under Sec. 7436, determining that A was an employee of P for purposes of Federal employment tax.
Held: A is an employee of P for purposes of Federal employment tax pursuant to sec. 31.3121(d)-(1)(b), Employment Tax Regs., because A is an officer who performs substantial services for P and receives remuneration for those services. - 2 -
Held, further, P is not entitled to relief pursuant to sec. 530 of the Rev. Act of 1978, Pub. L. 95-600, 92 Stat. 2763, 2885, because P did not have a reasonable basis for not treating A as an employee.
Joseph H. O’Donnell, Jr., for petitioner.
Kathleen K. Raup, for respondent.
OPINION
JACOBS, Judge: This case is before the Court on a petition
for redetermination of a Notice of Determination Concerning Worker
Classification Under Section 7436 (Notice of Determination). It
was submitted to the Court fully stipulated under Rule 122. The
sole issue to be decided is whether Kenneth K. Sadanaga, D.V.M.
(Dr. Sadanaga), is an employee of petitioner for the period at
issue (each of the four quarters of 1994, 1995, and 1996) for
purposes of Federal employment taxes.1
Rule references are to the Tax Court Rules of Practice and
Procedure, and except as otherwise noted, section references are to
the Internal Revenue Code in effect for the years at issue.
1 For convenience, we use the term “Federal employment tax” to refer to taxes under secs. 3101-3125 (enacted as Federal Insurance Contributions Act (FICA), ch. 9, 53 Stat. 175 (1939)) and secs. 3301-3311 (enacted as Federal Unemployment Tax Act (FUTA), ch. 9, 53 Stat. 183 (1939)). - 3 -
Background
The stipulation of facts and the attached exhibits are
incorporated herein. The stipulated facts are hereby found.
Petitioner is an S corporation that was incorporated in
Pennsylvania on May 22, 1991. At the time the petition was filed,
petitioner’s principal place of business was in Malvern,
Pennsylvania. Petitioner’s only business is providing consulting
and surgical services to veterinarians. Dr. Sadanaga is
petitioner’s sole shareholder and serves as its president,
petitioner’s only officer.
Since petitioner’s incorporation, all of its income has been
generated from the consulting and surgical services provided by Dr.
Sadanaga to Veterinary Orthopedic Services, Ltd. (Orthopedic).
During the period at issue, Dr. Sadanaga spent at least 33 hours
per week providing consulting and surgical services on behalf of
petitioner. He performed surgeries at the Veterinary Referral
Center in Frazer, Pennsylvania, and consulted with veterinarians in
their offices or his home.
Dr. Sadanaga is the only person with signature authority on
petitioner’s bank account. Dr. Sadanaga handled all of
petitioner’s correspondence and performed all administrative tasks
on behalf of petitioner. Petitioner did not make regular payments
to Dr. Sadanaga; rather, Dr. Sadanaga withdrew money from
petitioner’s bank account at his discretion. - 4 -
Petitioner received a Form 1099-MISC, Miscellaneous Income,
from Orthopedic reporting “non-employee compensation” during each
of the quarters at issue. The Forms 1099-MISC reported that
Orthopedic paid petitioner $125,152.63 in 1994, $225,469.24 in
1995, and $212,863 in 1996. Petitioner reported the amount
reflected on the Forms 1099-MISC as its total gross receipts on its
Form 1120S, U.S. Income Tax Return for an S Corporation, for 1994,
1995, and 1996.
On Forms 1120S, petitioner reported net income from its trade
or business for 1994, 1995, and 1996 in the respective amounts of
$83,995.50, $173,030.39, and $161,483.35. Petitioner paid these
amounts to Dr. Sadanaga, and reported these amounts as Dr.
Sadanaga’s share of its income on Schedules K-1, Shareholders’
Shares of Income, Credits, Deductions, etc., of the Forms 1120S.
Petitioner reported on Schedules M-2, Analysis of Accumulated
Adjustments Account, Other Adjustments Account, and Shareholders’
Undistributed Taxable Income Previously Taxed, of the Forms 1120S,
that the amounts it paid to Dr. Sadanaga were distributions other
than dividend distributions paid from accumulated earnings and
profits.
Petitioner did not issue a Form 1099-MISC or a Form W-2, Wage
and Tax Statement, to Dr. Sadanaga for 1994, 1995, or 1996. Nor
did petitioner file a Form 941, Employer’s Quarterly Federal Tax
Return, or a Form 940, Employer’s Annual Federal Unemployment Tax - 5 -
Return, for any quarter during the period at issue. On Schedules
E, Supplemental Income and Loss, of Dr. Sadanaga’s 1994, 1995, and
1996 Forms 1040, U.S. Individual Income Tax Returns, Dr. Sadanaga
reported his share of petitioner’s income (as indicated on the
Schedules K-1) as nonpassive income from an S corporation.
Dr. Sadanaga was a full-time employee of Bristol-Myers Squibb
Co. (Bristol-Myers). He reported wages from Bristol Myers of
$91,212.18 in 1994, $95,891.15 in 1995, and $102,031.14 in 1996.
In 1994, 1995, and 1996, Bristol-Myers withheld Social Security
taxes from Dr. Sadanaga.
Respondent began an audit of petitioner’s return for 1995 in
May 1997. On October 22, 1997, Revenue Agent James Tepper, and
petitioner’s accountant, Joseph Grey, met to discuss the audit.
Revenue Agent Orville Surla joined Revenue Agent Tepper and Mr.
Grey to discuss whether Dr. Sadanaga was an employee of petitioner
in 1995. Mr. Grey asserted that Dr. Sadanaga was not an employee
of petitioner and that the distribution to him from petitioner
represented his share of petitioner’s net income. Mr. Grey
objected to any assessment of Federal employment taxes against
petitioner. Because Mr. Grey and Revenue Agent Tepper could not
reach any agreement with respect to the Federal employment tax
issue, the issue was referred to Revenue Agent Surla.
On March 16, 1998, respondent sent petitioner a 30-day letter,
proposing adjustments to petitioner’s Federal employment taxes for - 6 -
each of the four quarters of 1994, 1995, and 1996. On April 3,
1998, petitioner submitted to respondent a letter protesting the
proposed adjustments.
On October 5, 1998, respondent sent petitioner a letter
advising that there would be no change resulting from the audit of
petitioner’s Form 1120S for 1995. On November 17, 1998, respondent
issued to petitioner a Notice of Determination, in which respondent
determined that (1) Dr. Sadanaga was an employee of petitioner for
purposes of Federal employment taxes, and (2) petitioner was not
entitled to “safe harbor” relief from these taxes as provided by
section 530 of the Revenue Act of 1978, Pub. L. 95-600, 92 Stat.
2885 (Section 530). Attached to the Notice of Determination was a
schedule detailing the amount of the proposed Federal employment
taxes. Thereafter, petitioner filed with the Court a timely
petition seeking our review of respondent’s Notice of
Determination.
Discussion
Petitioner contends that Dr. Sadanaga was not its employee
and that it properly distributed its net income to Dr. Sadanaga, as
its sole shareholder, pursuant to section 1366. On the other hand,
respondent contends that Dr. Sadanaga was an employee of petitioner
because he was an officer of petitioner and performed substantial
services on petitioner’s behalf. - 7 -
Sections 3111 and 3301 impose FICA (Social Security) and FUTA
(unemployment) taxes on employers for wages paid to their
employees. For Federal employment tax purposes, section 3121(d)
defines an employee in part as any officer of a corporation.
However, there is an exception to employee status for an officer
who does not perform any services (or performs only minor services)
and who neither receives nor is entitled to receive remuneration.
Sec. 31.3121(d)-(1)(b), Employment Tax Regs. For Federal
employment tax purposes, the term “wages” is defined as “all
remuneration for employment”.2 Secs. 3121(a), 3306(b). The form
of payment is immaterial, the only relevant factor being whether
the payments were actually received as compensation for employment.
Secs. 31.3121(a)-1(b), 31.3306(b)-1(b), Employment Tax Regs.
Consequently, an officer who performs substantial services for a
corporation and who receives remuneration in any form for those
services is considered an employee, whose wages are subject to
Federal employment taxes.
With respect to the case at hand, Dr. Sadanaga is an officer
of petitioner, and therefore he is an employee of petitioner under
the general rule of section 3121(d)(1). Additionally, Dr. Sadanaga
performed substantial services for petitioner, working
approximately 33 hours a week for petitioner. Indeed, he was the
2 There are some exceptions to this definition that are not relevant to this case. - 8 -
only individual working for petitioner. Tellingly, all of
petitioner’s income was generated from the consulting and surgical
services provided by Dr. Sadanaga.
Petitioner contends that the amounts paid to Dr. Sadanaga were
distributions of its corporate net income, rather than wages.
Petitioner posits that as an S corporation it passed its net income
to Dr. Sadanaga, as its sole shareholder, pursuant to section 1366.
Petitioner’s argument is flawed. Section 1366 permits use of S
corporation passthrough items only in calculating tax liability
under chapter 1, not tax liability under chapters 21 and 23--in
which the Federal employment tax provisions for FICA and FUTA are
located. Sec. 1366(a)(1); see also Ding v. Commissioner, 200 F.3d
587, 590 (9th Cir. 1999), affg. T.C. Memo. 1997-435; Catalano v.
Commissioner, T.C. Memo. 1998-447.
Dr. Sadanaga performed substantial services on behalf of
petitioner. The characterization of the payment to Dr. Sadanaga as
a distribution of petitioner’s net income is but a subterfuge for
reality; the payment constituted remuneration for services
performed by Dr. Sadanaga on behalf of petitioner. An employer
cannot avoid Federal employment taxes by characterizing
compensation paid to its sole director and shareholder as
distributions of the corporation’s net income, rather than wages.
Regardless of how an employer chooses to characterize payments made
to its employees, the true analysis is whether the payments - 9 -
represent remuneration for services rendered. Spicer Accounting,
Inc. v. United States, 918 F.2d 90 (9th Cir. 1990); Joseph Radtke,
S.C. v. United States, 895 F.2d 1196 (7th Cir. 1990).
Dr. Sadanaga’s reporting the distributions as nonpassive
income from an S corporation has no bearing on the Federal
employment tax treatment of those wages. He was petitioner’s sole
source of income. And as petitioner’s sole full-time worker he
must be treated as an employee. Spicer Accounting, Inc. v. United
States, supra at 94-95. Accordingly, we hold that Dr. Sadanaga is
an employee of petitioner for the period at issue and, as such, the
payments to him from petitioner constitute wages subject to Federal
employment taxes.
Despite our determination that Dr. Sadanaga is an employee of
petitioner, and that the payments to him from petitioner are wages
subject to Federal employment taxes, Section 530 allows petitioner
relief from employment tax liability if two conditions are
satisfied. Section 530(a)(1) provides in relevant part:
(1) In general.-–If
(A) for purposes of employment taxes, the taxpayer did not treat an individual as an employee for any period * * *, and
(B) in the case of periods after December 31, 1978, all Federal tax returns (including information returns) required to be filed by the taxpayer with respect to such individual for such period are filed on a basis consistent with the taxpayer’s treatment of such individual as not being an employee, - 10 -
then, for purposes of applying such taxes for such period with respect to the taxpayer, the individual shall be deemed not to be an employee unless the taxpayer had no reasonable basis for not treating such individual as an employee.
Here, the first of the two conditions is satisfied.
Petitioner did not treat Dr. Sadanaga as an employee during the
period in issue. Since its incorporation, petitioner filed its tax
returns reflecting all withdrawals by Dr. Sadanaga as distributions
of petitioner’s income, not wages.
However, the second condition of Section 530(a)(1) is not
satisfied because petitioner had no reasonable basis for not
treating Dr. Sadanaga as an employee. For purposes of Section
530(a)(1), a taxpayer is treated as having a reasonable basis for
not treating an individual as an employee if the taxpayer’s
treatment of the individual was in reasonable reliance on judicial
precedent, published rulings, technical advice with respect to the
taxpayer, a letter ruling to the taxpayer, or longstanding
recognized practice of a significant segment of the industry in
which the individual was engaged. Section 530(a)(2).
Section 3 of Rev. Proc. 85-18, 1985-1 C.B. 518, provides
several alternative standards that constitute safe havens in
determining whether a taxpayer has a reasonable basis for not
treating an individual as an employee. That revenue procedure
provides that reasonable reliance on any one of the following safe
havens is sufficient: - 11 -
(A) judicial precedent or published rulings, whether or not relating to the particular industry or business in which the taxpayer is engaged, or technical advice, a letter ruling, or a determination letter pertaining to the taxpayer; or
(B) a past Internal Revenue Service audit (not necessarily for employment tax purposes) of the taxpayer, if the audit entailed no assessment attributable to the taxpayer’s employment tax treatment of individuals holding positions substantially similar to the position held by the individual whose status is at issue * * *; or
(c) long-standing recognized practice of a significant segment of the industry in which the individual was engaged * * *.
A taxpayer who fails to meet any of the safe havens is still
entitled to relief if the taxpayer can demonstrate, in some other
manner, a reasonable basis for not treating the individual as an
employee. Id.
Here, petitioner asserts that its position is supported by the
following excerpt from Durando v. United States, 70 F.3d 548, 552
(9th Cir. 1995):
[It is] improper to treat income earned by a corporation through its trade or business as though it were earned directly by its shareholders, even when, as here, the shareholders’ services help to produce that income. An S corporation’s income passes through to its shareholders not because they helped to create that income, but because they are shareholders.
The excerpt relied upon by petitioner does not support
petitioner’s position. Respondent is not attempting to treat
petitioner’s income as though the income were earned directly by - 12 -
Dr. Sadanaga. Rather, the issue in this case is whether the
distributions paid to Dr. Sadanaga are wages paid to Dr. Sadanaga
as an employee of petitioner.
Petitioner asserts that Durando v. United States, supra, holds
that an S corporation shareholder is not an employee for purposes
of deducting contributions to a Keogh plan.3 Petitioner misstates
the holding of Durando v. United States. Contrary to petitioner’s
assertion, the taxpayers in the Durando case did not claim to be
employees of an S corporation. Rather, such taxpayers were self-
employed individuals, who in that capacity earned income reportable
on Schedule C, Profit (or Loss) From Business or Profession, and
were shareholders in several S corporations. They claimed Keogh
retirement plan deductions by adding their shares of income from
the several S corporations to the amounts reported on their
Schedules C and taking a deduction of 15 percent of the total. The
Commissioner disallowed the deductions attributable to the income
from the S corporations. The taxpayers’ Keogh plans were not
qualified plans established by the S corporations for their
employees. Citing section 1372, the court specifically noted that
“S corporations can establish retirement plans for their employees,
including those who are also shareholders” and that shareholders
3 Keogh plans are retirement plans for self-employed individuals. A self-employed individual can deduct contributions to a qualified retirement plan up to a limit of 15 percent of his or her earned income. Sec. 404(a)(3)(A), (8)(D). - 13 -
“who provide services to an S corporation can be treated like
employees and covered by that corporation’s retirement plan.”
Durando v. United States, supra at 551. In sum, the Durando case
does not provide a reasonable basis for not treating Dr. Sadanaga
as an employee.
Petitioner also relies on Rev. Rul. 59-221, 1959-1 C.B. 225.
Rev. Rul. 59-221, supra, holds that where a small business
corporation elects under section 1372 not to be subject to Federal
income tax, the amount of its income required to be included in
each shareholder’s gross income does not constitute “net earnings
from self-employment” to such shareholders for purposes of the
Self-Employment Contributions Act. That ruling, like the Durando
case, deals solely with whether amounts a shareholder receives are
derived from a trade or business carried on by the shareholder. In
the case at hand, the issue is whether an officer is an employee of
a corporation. Rev. Rul. 59-221, supra, makes no mention of either
corporate officers or their Federal employment tax status.
Therefore, the ruling does not provide a reasonable basis for
treating Dr. Sadanaga other than as an employee.
Petitioner attempts to distinguish the facts in this case from
cases holding that officers who performed substantial services for
an S corporation are employees for purposes of Federal employment
taxes. In Spicer Accounting, Inc. v. United States, 918 F.2d 90
(9th Cir. 1990), and Radtke v. United States, 895 F.2d 1196 (7th - 14 -
Cir. 1990), the corporations characterized payments to their
officer/shareholders as dividends rather than wages. In those
cases, the courts found that the payments were in reality
remuneration for employment and therefore subject to Federal
employment taxes. Spicer Accounting, Inc. v. United States, supra
at 93; Radtke v. United States, supra at 1197. Petitioner
attempts to distinguish its case from the Spicer and Radtke cases
because petitioner reported the payment to Dr. Sadanaga as a
distribution of its net income, which Dr. Sadanaga reported as
nonpassive income from an S corporation. But as stated previously,
we find that the distributions were remuneration for services
provided by Dr. Sadanaga. Thus, the “dividends” in the Spicer and
Radtke cases are indistinguishable from the distributions in this
case.
Petitioner also misstates the findings and conclusions of this
Court in Joly v. Commissioner, T.C. Memo. 1998-361, affd. without
published opinion 211 F.3d 1269 (6th Cir. 2000). Petitioner
asserts that the corporation in the Joly case was compelled to
treat income distributed to its shareholders as wages for the
reason that the corporation and shareholders could not prove that
any stock was issued to the shareholders. To the contrary, the
Court found that part of the distributions to the two shareholders
was compensation for services and, thus, constituted wages subject
to Federal employment taxes. The balance of the distribution was - 15 -
taxable under section 1368 as gain from the sale or exchange of
property to the extent the distributions exceeded the shareholders’
bases in their stock. The Court found that the shareholders had
not established that their bases in their corporate stock at the
beginning of the first taxable year before the Court was other than
zero. But there was no question as to the shareholders’ ownership
of the stock of the corporation.
Petitioner next cites for support the following excerpt from
Rev. Rul. 71-86, 1971-1 C.B. 285: “The president and sole
shareholder, except for qualifying shares, of a closely held
corporation is an employee of the corporation for [Federal]
employment tax purposes, notwithstanding that he sets his own
salary and prescribes his own duties.” (Emphasis supplied by
petitioner.) Petitioner contends: (1) Rev. Rul. 71-86, supra,
exempts the sole shareholder of an S corporation from Federal
employment taxes with regard to any income distributed to the
“qualifying shares” shareholder, and (2) Dr. Sadanaga is such a
shareholder because he holds all of the stock in the corporation.
Petitioner again misreads the revenue ruling. The individual at
issue in that revenue ruling owned all the stock of the
corporation, except for qualifying shares. The revenue ruling did
not define “qualifying shares”. (We note, however, that the term
generally refers to shares issued to an individual in order to
qualify the individual as an incorporator or director where an - 16 -
incorporator or director is required to own stock in the
corporation. See, e.g., Roche’s Beach, Inc. v. Commissioner, 35
B.T.A. 1087 (1937); 2 Fletcher Cyclopedia of the Law of Private
Corporations, secs. 297-306 (perm. ed., rev. vol. 1998).) Here,
Dr. Sadanaga owns all the shares of petitioner’s stock, and there
is no evidence that any shares were issued solely to qualify Dr.
Sadanaga as a director or an incorporator. Rev. Rul. 71-86, supra,
supports respondent’s position; it does not provide an exception
for petitioner.
Finally, petitioner argues that section 1372 prohibits a 2-
percent shareholder of an S corporation from being treated as an
employee of the S corporation. Section 1372, however, applies only
to the provisions of subtitle A, income taxes, not subtitle C--in
which Federal employment tax provisions are located.
In Rev. Rul. 73-361, 1973-2 C.B. 331, an officer/stockholder
of a small business corporation performing substantial services as
an officer of the corporation was held to be an employee of the
corporation for purposes of Federal employment taxes. Rev. Rul.
73-361, supra, states:
Neither the election by the corporation as to the manner in which it will be taxed for Federal income tax purposes nor the consent thereto by the stockholder- officers has any effect in determining whether they are employees or whether payments made to them are “wages” for Federal employment tax purposes.
In Rev. Rul. 74-44, 1974-1 C.B. 287, two sole shareholders of
an electing small business corporation arranged to receive - 17 -
dividends instead of reasonable compensation for services they
performed. That revenue ruling held that the “dividends”
constituted wages subject to Federal employment taxes.
In this case, respondent’s position is supported by the plain
language of the statute, the applicable Treasury regulations,
published revenue rulings, and cases interpreting the applicable
statutes. Petitioner’s position is inconsistent with the weight of
authority.
Petitioner argues that Dr. Sadanaga paid the maximum FICA tax
required by law in each year at issue and that respondent is
attempting to assess additional tax on Dr. Sadanaga in the form of
withholding taxes. This argument is simply a “red herring”. For
Federal employment tax purposes, the taxable wage base applies
separately to each employer. Thus, if an employee receives wages
from more than one employer, the annual wage limitation does not
apply to the aggregate compensation received. The employee however
may be eligible for a credit or refund of the excess employee
portion of the FICA tax that applies with respect to wages in
excess of the applicable wage base. Secs. 31.3121(a)(1)-1(a)(3),
31.3306(b)(1)-1(a)(3), Employment Tax Regs.
We have considered all of petitioner’s arguments, and, to the
extent not specifically addressed, we find them unpersuasive or
irrelevant. - 18 -
______________
After the petition was filed in this case, Congress amended
section 7436(a) to provide this Court with jurisdiction to
determine the correct amounts of Federal employment taxes that
relate to the Secretary’s determination concerning worker
classification. See Community Renewal Tax Relief Act of 2000
(CRTRA), Pub. L. 106-554, sec. 314(f), 114 Stat. 2763A-643. That
amendment was made retroactive to the effective date of section
7436(a). CRTRA sec. 314(g), 114 Stat. 2763A-643.
The parties filed a Stipulation of Settled Issues setting
forth the proper amount of Federal employment taxes owed by
petitioner in the event we find that Dr. Sadanaga is petitioner’s
employee for purposes of Federal employment taxes (which we do).
The amount so stipulated will be reflected in our decision
document.
To reflect the foregoing,
Decision will be entered
for respondent and in accordance
with the parties’ stipulations
as to amounts.