This is a very long blog because it is an important, complicated and current topic!
I am privileged to count among my clients some of the elite wealth advisers in the Dallas-Fort Worth area. I team with them and a number of other prominent wealth advisers and financial planners to serve my high and ultra-high net worth clients. Some of these professionals operate as independent registered investment advisers (“RIAs”). They do not work as employees for a broker/dealer; they contract to be independent representatives of the broker/dealer. Many of these independent RIAs may be affected drastically by a Tax Court Memorandum decision, Ryan M. Fleischer v. Comm., handed down in late December of 2016.
Understanding some important concepts underlying the Fleischer case
Three important background concepts undergird this looming challenge caused by Fleischer.
First, many independent RIAs, as well as many other service professionals, operate their businesses inside of S corporations. Some sources have said that this structure is used by tens of thousands of RIAs. S corporations don’t pay Federal income taxes on their earnings; their shareholders do, whether or not the income is distributed. An employee (including, let’s say, an employee who owns 100% of an S corporation) pays FICA taxes. The S corporation/employer also pays FICA taxes on those wages. S corporation income, not in the form of employee compensation, recognized by an S corporation shareholder is not burdened by these payroll taxes. Also, if the shareholder materially participates in the business, the shareholder does not pay the 3.8% net investment income tax on his/her share of the S corporation income. The shareholder does not pay the 0.9% additional Medicare tax on his/her share of S corporation income. So, if someone is a 100% shareholder of an S corporation, why take a salary at all? (Hold that thought.)
Second, bad facts make bad law. While underpaid, overworked, and often abused, a lot of IRS employees are smart people. When the IRS does not like what it considers to be a “tax dodge,” its operatives will often lie in wait for a case with a good fact pattern (a bad fact pattern for the taxpayer). When they find the sucker, they pounce. They’ll win the case in court – usually pretty easily – and establish precedent that will be used to attack positions that are similar, but less dicey.
Third, pigs get fat and hogs get slaughtered.
Where Mr. Fleischer made a wrong turn and ran into the IRS
Mr. Fleischer is a financial adviser in Nebraska. He is appropriately licensed to offer financial advice, to buy and sell securities, and to sell variable health and life insurance policies. After working for some big companies, he struck out on his own. On February 2, 2006, he personally entered into a representative agreement with Linsco/Private Ledger Financial Services (“LPL”), a securities broker/dealer. On February 7, 2006, he incorporated Fleischer Wealth Plan (“FWP”). Mr. Fleischer entered into an employment agreement with FWP on February 28, 2006. On March 13, 2008, he personally entered into a broker contract with MassMutual Financial Group (“MassMutual”).
As I understand the pertinent rules affecting broker/dealers and their representatives, broker/dealers cannot pay an entity, unless that entity formally registers as its own licensed broker/dealer – a rather expensive and cumbersome process that requires additional ongoing expense and efforts.
So, the typical work and money flow is as follows. The independent RIA works for an S corporation of which he/she may own all or part of the outstanding stock. The independent RIA engages in a transaction with a client as an independent representative of the broker/dealer. The broker/dealer collects the money from the client, including any fees associated therewith. The broker/dealer gives the independent RIA his/her share of the fees. The independent RIA remits those fees in their entirety to his/her employer, the S corporation, according to his/her contract with the S corporation. With those fees, the S corporation then compensates the RIA employee, pays the expenses, and, hopefully, generates a profit for its shareholders. Actually, the relationships among the parties can be more complicated and vary. In the instant case, however, this is the work and money flow.
In two of three years at issue in the case, Mr. Fleischer reported on Schedule C in his personal tax return the income on 1099s issued to him by LPL and MassMutual and then deducted the entire amount of that income on Schedule C. He indicated that he was collecting the money for FWP. Then FWP reported all of the income.
For the years under consideration in the case, Mr. Fleischer paid himself a salary of about $35,000. By the dint of his personal efforts, Mr. Fleischer did pretty well. In one of the years, he had S corporation income of about $150,000 (after subtracting his $35,000 salary). Is that a hog I hear in the pen?
What the IRS argued and what the Tax Court decided
The IRS could have argued simply, authoritatively, and probably successfully, that Mr. Fleischer should have paid himself a much higher and more reasonable salary than he did: the success of FWP was derived from the sweat of his employee brow. The IRS could have gotten more payroll and other taxes referred to above.
But the IRS went further. In a nutshell, the IRS said that because Mr. Fleischer personally executed the contracts with LPL and MassMutual and because the two companies did not have contracts with FWP, the income was his and he owed self-employment taxes on all of the fees (in lieu of his and the corporation’s FICA taxes on an appropriate amount of wages). The additional Medicare tax would follow. It appears that the IRS allowed the expenses in the S corporation in computing Mr. Fleischer’s income tax – whew!
The Tax Court agreed with the IRS. It relied on the “Johnson test” (named after the 1982 Tax Court case that established the “test”) to determine that Mr. Fleischer, not FWP, controlled the earning of the income and, thus, was taxed on the income. The Court pointed to several facts that it considered incriminatory. It noted that the LPL contract was executed with Mr. Fleischer personally, that the contract was executed before FWP was incorporated, and that the contract did not mention FWP. The MassMutual contract was executed after FWP was incorporated, but the contract was between MassMutual and Mr. Fleischer personally and the contract did not mention FWP.
So, based on this case, it appears that many, if not most, existing contracts between independent RIAs and broker/dealers may be open to attack by the IRS for employment taxes. Some arrangements could result in strange results. I am aware of situations where one independent RIA has the contract with the broker/dealer, on behalf of an S corporation of which he/she is a part owner. There are many producers that work for the S corporation and whose fees are reported on the single 1099 going to the contracting RIA. Will the one RIA be taxed on every RIA’s income?
What can independent RIAs do?
What is one to do? Well, we’re still working on answers to that question. There are several avenues of action that we are examining. On a go-forward basis, could the answer be as simple as being sure that the previously-incorporated employer/S corporation is mentioned in the contract between the RIA and the broker/dealer? Alternatively, must the S corporation become a broker/dealer so that it can contract with the broker/dealer to receive the fees directly? Must each RIA employee enter into a contract with the broker/dealer?
The RIA’s position should be enhanced and distinguishable from Fleischer if the RIA executes an agreement with his S corporation that says all of his income from each personal contract is assigned to the S corporation.
Definitely, the S corporation must pay reasonable and appropriate compensation to the RIA.
The Fleischer decision has some technical weaknesses. While the memorandum decision is precedential, a memorandum decision is supposed to involve only cases where the law is well-established. I think that is not the case here. But the damage is done.
The Fleischer decision glosses over the fact that it is well established that nominees and agents don’t pay tax on income that they receive for someone else; that someone else pays the tax.
The case could be appealed and overturned. The “Johnson test” is very rigid and not well-regarded in all jurisdictions.
If the case is not overturned, an RIA caught in the future in the crosshairs of the IRS might consider paying the disputed tax and seek a refund of those taxes in a jurisdiction other than the Tax Court. The Tax Court would probably consider this Fleischer case precedential with respect to a wide array of fact patterns. Other courts may not.
We will be working with other tax advisers and our clients on these and other possible solutions.
As I said, bad facts make bad law. This is a perfect example.