IRS Loses SE Tax Challenge

Ever since Congress issued its infamous order to Treasury to halt the issuance of self-employment (SE) tax regulations (Prop. Regs. Sec. 1.1402(a)-2(d)), practitioners have been left without guidance on the SE tax in the limited liability company (LLC) context. Because LLCs continue to be the entity of choice, the absence of authority continues to complicate an advisers task of guiding a client and having assurance in sustaining an IRS challenge. Into this void enters Grigoraci, TC Memo 2002-202, in which the Service loses a dispute to disregard a wholly owned S corporation.

Facts

Grigoraci presents a brief analysis of an S corporation interposed between a taxpayer and his interest in an accounting partnership. During 1995, Victor Grigoraci agreed to become the third partner of GTWP, a general partnership organized under West Virginia law. The two original partners each held their interest in GTWP through a wholly owned S corporation. The taxpayers attorney cautioned him against becoming a member of the partnership as an individual, because he would be the only partner with unlimited liability. As a result, the taxpayer formed an S corporation (GSC), in which he was the sole shareholder, which then joined GTWP as a partner.

For 1996, the tax year at issue, the GTWP income reported to GSC was $106,799, which GSC reported on its 1996 Federal return, along with other income of $21,862. GSCs return also noted some undisputed deductions (including a $32,000 salary paid to the taxpayer), reporting net income of $92,470.

The taxpayers joint return reflected the GTWP income and the GSC salary, but not SE tax, which the IRS disputed. The IRS assessed tax on $124,470 ($32,000 1 $92,470), and a Sec. 6662(a) negligence accuracy-related penalty for failure to treat the taxpayer as a GTWP partner.

Analysis

The IRS asserted that GSC was a sham corporation established for tax-avoidance reasons, not recognizable for tax purposes.

The Tax Court determined that it held jurisdiction only over the $32,000 salary the taxpayer reported from GSC, which the IRS contended was income derived from providing personal services directly to the end user. It rejected the IRSs position that GSC was a sham corporation. Specifically, the court found no evidence to support the Services assertion that GSC was formed primarily to avoid SE tax. Rather, the taxpayer formed the corporation to limit his potential personal liability on entering the GTWP partnership. With GTWP organized as a general partnership, and the other partners in GTWP being corporations, the taxpayer asserted that he chose the corporate form because he did not want to be the only partner personally liable for GTWPs liabilities. According to the court, [u]se of the corporate form to limit the personal liability of a taxpayer has long been recognized as a valid business purpose for incorporating.

Tax purpose. Although this case appears to be rather innocuous as it relates to LLC issues surrounding Prop. Regs. Sec. 1.1402(a)-2(d), the vacuum of authority created after the 1997 Congressional mandate makes any insight into this arena worthy of analysis.

Two primary reasons motivate taxpayers to interpose an S corporation between themselves and LLC ownership. First, the existing rules clearly note that none of the income reported on an S Schedule K-1 is subject to SE tax, which is not the case with an LLC. Second, if an individual is not a direct LLC owner, he or she can remain a W-2 employee of the LLC. With these tax motivations, the use of an S corporation as a shield is not uncommon.

Business purpose. Even though the IRS lost its attempt to disregard the S corporation in Grigoraci, has the Tax Courts opinion actually strengthened its position on LLCs? Having identified the tax-motivated reasons for interposing an S corporation, what is the business purpose? In Grigoraci, it was liability protection. The operating entity was a general partnership; the S corporation clearly provided a layer of protection that did not already exist. For an LLC, that shield is inherent by statute; thus, an interposed S corporation arguably provides no additional protection.

The Tax Courts opinion seems to indicate that there was no additional business purpose for the wholly owned S corporation. This implies that the IRS would have prevailed absent the issue of liability protection as a business purpose. This certainly appears to be a logical conclusion, especially for single-owner S corporations.

Conclusion

What can be gleaned from Grigoraci? First, without a compelling business purpose, interposing a wholly owned corporation between a taxpayer and an LLC to address SE tax issues seems risky. The IRS could use Grigoraci (and several cases cited therein) to support its disregard of an entity that appears to lack one. However, the structure can bestow not only liability protection, but also additional flexibility on SE taxes, with Grigoraci serving as support.

SE taxes and W-2 eligibility issues arise most often when an LLC provides ownership to employees other than the founder or other main owners. Perhaps use of an upper-tier LLC, through which employees own an interest in an operating entity, might be a useful strategy in dealing with SE tax and W-2 status.

For example, if four or five key members owned a managing LLC that owned a 20% interest in an operating LLC, members tax needs would be met and a valid business purpose provided. Under this arrangement, the managing LLC could allow the key employees to separately address buy-sell agreements, ownership vesting, profit sharing, etc. If the employees were to receive reasonable wages as compensation for the services rendered to the operating LLC (and if FICA taxes were paid), the Service would most likely assess SE taxes for their allocable share of the operating LLCs profits.

Grigoraci, in its own way, helps at least to narrow the list of possible strategies.

From Joseph Schlueter, Minneapolis, MN