From The Tax Adviser:

Royalties or Wages?

he Tax Court ruled that “royalties” paid to a C corporation’s officer were wages for which the corporation was liable for payroll (for example, Social Security, Medicare and unemployment) taxes (Charlotte’s Office Boutique, Inc., 121 TC no. 6 (2003)). The case teaches CPAs how not to structure a self-employed client’s transfer of intangibles to a corporation.

BACKGROUND
In 1995 Charlotte Odell incorporated Charlotte’s Office Boutique Inc. as a C corporation. Before incorporation Odell (an officer of the corporation and one of two shareholders) operated the business as a sole proprietorship that sold office supplies and equipment to the federal government.

On incorporation Odell purportedly did not transfer ownership interests in her customer lists and contracts. Instead, she entered into a “licensing and sale agreement” that set forth a royalty fee, based on gross receipts, stemming from the transfer of her “know-how,” “existing contracts” and “woman-owned-business status,” and also executed employment and rental agreements with the C corporation. She was to be paid $400 a month under the employment agreement.

The corporation paid Odell rent, wages and royalties, and sporadically filed employment tax returns. In 2001, after an employment tax audit, the IRS issued a notice reclassifying Odell as the corporation’s employee.

In Tax Court the IRS established that Odell, as a corporate officer, was performing significant services for the corporation and receiving remuneration. This is the definition of employee (Veterinary Surgical Consultants, P.C., 117 TC 141 (2001)).

TAX COURT’S RULING
The court held for the IRS; the amounts paid to Odell were wages subject to employment taxes and not royalties. The existing contracts, know-how and customer lists that triggered the royalty payments were the same ones Odell had used in her sole proprietorship to generate income subject to SE tax.

Employment tax relief. The next issue was the availability of section 530 relief under the Revenue Act of 1978. If such relief is granted, the employer is not liable for employment taxes on the amounts reclassified as wages. There are three requirements:

The taxpayer did not treat the individual as an employee for any period.

For all periods beginning after 1978, the taxpayer’s returns consistently treated the individual as a nonemployee.

There was a reasonable basis for not treating the individual as an employee.

The Tax Court held that the corporation failed to meet the last requirement; its cites did not support the proposition that it reasonably believed the payments to Odell were made to her as a nonemployee.

CONCLUSION
Odell’s transfer of lists, contacts and contracts did not change the fact that, before incorporation, those assets generated income on which she paid self-employment taxes. After the incorporation of the business, she deemed these same lists, contacts and contracts intangible assets generating royalties. But documents do not close sales—workers do.

For more information, see the Tax Clinic, edited by Michael Koppel, in the December 2003 issue of The Tax Adviser.

—Lesli Laffie, editor
The Tax Adviser