In a recent Tax Court case, the Court determined that corporate officers were indeed employees of the corporation entitled to reasonable compensation, and as such, the corporation is liable for employment taxes on reasonable compensation imputed to the corporate officers.[1] Mr. and Mrs. Hacker, who owned 51% and 49% of Blossom Day Care Centers (“Blossom”) served as the corporation’s only corporate officers and did not pay themselves any direct compensation from Blossom for the years at issues, 2005 through 2008. The Tax Court found that they were employees, reasonable compensation for the services provided should be imputed to them, and that as employees, the reasonable compensation was subject to employment taxes. Accordingly, Blossom was liable for the employer side of employment taxes on that reasonable compensation.
Facts
As noted above, Mr. and Mrs. Hacker owned 51% and 49% of Blossom respectively. Mrs. Hacker served both as Blossom’s president and as the director of curriculum and education. Blossom had approximately ninety employees across six locations. She was responsible for the management of oversight of all employees, including hiring and firing, and managing Blossom’s six-day care directors. Mr. Hacker served as Blossom’s vice president, treasurer, secretary, director, and director of accountability and finance. Mr. Hacker had authority over all bank accounts, and his daily responsibilities included, but were not limited to, depositing parents’ payments for childcare into Blossom’s bank accounts and personally writing all the payroll checks to Blossom’s 90 employees.
Both Mr. and Mrs. Hacker were members of the Oklahoma Child Care Association, and Mr. Hacker was a member of its board from 2004 through 2008. This State worked with the Oklahoma Department of Human Services (“ODHS”) regarding comments on regulations, training, and education on childcare issues. All of Blossom’s locations were licensed by ODHS, and the Hackers were responsible for ensuring the programs and employees met ODHS standards.
Ultimately, the Court concluded in its discussion of the facts that the Hackers controlled all of Blossom’s childcare policies and education and coordinated all physical location and program maintenance decisions. Both actively participated in Blossom’s daily operation, frequently working 50 to 60 hours per week, including paperwork and front office duties, classroom teaching and supervision of teachers, purchasing and delivering food for childcare programs, and even maintenance and custodial duties, if needed. Further, Blossom provided maintenance for vehicles titled in the Hackers’ names including loan payments for a 2000 Lexus and a 2003 Hummer. Blossom claimed depreciation for those autos on its corporate tax returns for 2005 through 2008. Blossom also maintained vehicles it did not own, for the benefit of the Hackers’ children and a parent and a sibling and provided multiple credit cards in the names of Mr. Hacker and Mrs. Hacker which were used by their children.
Blossom paid salaries and wages to its other employees and filed timely Forms 941, Employer’s Quarterly Federal Tax Return, for all calendar quarters from 2005 through 2008. Blossom also filed timely Forms 940, Employer’s Annual Federal Unemployment (“FUTA”) Tax Return, for tax years 2005 through 2008. Blossom did not include either Mr. Hacker or Mrs. Hacker on the Forms 941 or 940, nor make on their behalf any deposit of employment taxes into any Federal depository for any calendar quarter or annual return for tax years 2005 through 2008.
In addition to Blossom, the Hackers also were the sole shareholders of Hacker Corp., an S corporation that owned all of the real estate on which Blossom’s day care centers were located. The Hackers contended that Hacker Corp. was set up to provide property and management services to Blossom. It’s unclear from the opinion whether rent was paid from Blossom to Hacker Corp., though that was not at issue. Blossom paid and deducted the following management fees to Hacker Corp.: $342,650 in 2005, $378,484 in 2006, $0 in 2007, and $204,514 in 2008. There was no contract between the two organizations. The Hackers maintained there was an oral agreement though no evidence was available to prove this other than oral testimony and the payments received. No evidence was provided to prove how the payments were calculated or what the scope of the duties owed under the contract were. The Hackers received a combined salary from Hacker Corp. from 2005 through 2008 of $73,848, $40,000, $53,847, and $58,462, respectively. The Hackers contended that all of the services they performed for Blossom were done on behalf of Hacker Corp. under the oral management agreement between the two corporations. However, as the Court noted, there was no evidence of this agreement.
After audit, the IRS determined that combined reasonable compensation should be imputed to the Hackers from Blossom in 2005, 2006, 2007, and 2008 of $209,200, $220,210, $231,800, and $244,000, respectively, and that Blossom was liable for employment taxes on these amounts. After concessions from the parties, the Court was asked to decide whether: 1) the Hackers should be legally classified as employees of Blossom such that Blossom is liable for employment tax (“FICA”) and unemployment tax (“FUTA”) relating to wages paid to the Hackers for all tax periods in 2005, 2006, 2007, and 2008; (2) Blossom is liable for FICA and FUTA taxes on the basis of the IRS’ determination that the Hackers had additional wage income from petitioner in 2005, 2006, 2007, and 2008 of $209,200, $220,210, $231,800, and $244,000, respectively; (3) Blossom is liable for a failure to deposit penalty under §6656 with respect to the FICA and FUTA tax liabilities respondent determined for the taxable periods from 2005 through 2008; and (4) Blossom is liable for accuracy-related penalties under §6662(a) with respect to the FICA and FUTA tax liabilities determined by respondent for the taxable periods from 2005 through 2008.
Analysis
Status as Employees
In general, any corporate officer is deemed to be an employee for purposes of FICA and FUTA.[2] FICA and FUTA impose an employment tax on employers which must be paid.[3] These employment taxes must be paid in periodic deposits.[4]
With regard to a corporate officer being deemed an employee for purposes of FICA and FUTA, any officer who performs more than minor services is deemed a statutory employee.[5] Generally, a corporate officer can only escape this employee classification if he or she performs no services and receives nor is entitled to receive any compensation, whether directly or indirectly.[6] However, the conclusion that a corporate officer is an employee may not be applicable if services provided to the corporation were done so in another capacity.[7]
In the present case, the Hackers contended that all of their services for Blossom were performed as employees of Hacker Corp. under the oral management agreement that was allegedly in place. As such, they were not employees of Blossom. However, the Court disagreed, stating there was no evidence of the oral management agreement, and noting that the Hackers received both direct and indirect compensation in the form of the cars for themselves and their family members. Presumably the Hackers themselves provided testimony on the oral management agreement but the Court must not have given the self-serving testimony much weight. Further, the responsibilities and services provided by the Hackers were numerous, and any one of them could have been considered substantial. While management fees were paid to Hacker Corp. from Blossom, and Hacker Corp. paid salaries to the Hackers, the facts that there was no evidence of any oral or written management or service agreement, and that the Hackers individually ran Blossom’s day care centers and handled almost every function related to them, led the Court to conclude they were statutory employees for purposes of FICA and FUTA.
Reasonable Compensation
The next issue to be discussed was the reasonable compensation imputed by the IRS, and whether Blossom should be liable for FICA and FUTA on such amounts.
Blossom contended that, at a maximum, the reasonable compensation amount should be no more than the difference between what was paid to the Hackers as employees of Hacker Corp. and the reasonable wage determinations of IRS. However, the Court noted that there was no such authority or basis to justify offsetting reasonable compensation requirements for the services provided by Blossom’s corporate officers to Blossom. The determination of proper reasonable compensation is a facts and circumstances analysis.[8] Among the factors affecting this determination are the employee’s role in the company, comparisons of the employee’s salary to those paid by similar companies for similar services, and the character and condition of the company.[9] The Court did not buy into Blossom’s arguments and evidence that services provided to Blossom were worth less that what the IRS determined, noting the issue was only passively addressed at trial and not developed in briefs. Based on the burden of proof resting on the taxpayer, Blossom failed to carry its burden of showing the amounts the IRS determined as reasonable compensation were unreasonable.
Penalties
In addition to losing on the classification of the Hackers as employees, and the determination of reasonable compensation, Blossom was also hit with penalties, both for failure to deposit tax under §6656 and accuracy related penalties under §6662(a). Blossom’s contest to the penalties appears to be based solely on lack of supervisor approval as required under §6751(b)(1). However, as the Court noted, that burden of proof for supervisory approval is shifted to the IRS only when the taxpayer is an individual, as §7491(c) does not apply to non-individual taxpayers. Nevertheless, the IRS produced a Civil Penalty Approval Form signed by the proper supervisor which satisfied the supervisory approval requirement of §6751(b)(1). In perhaps a tactical error, Blossom did not appear to contest the penalties on any other grounds, though it is not clear from the facts whether there may have been any other basis to do so.
Conclusion
The Court sided with the IRS on all issues, and this seems to be the logical conclusion based on the facts and the law. The facts were certainly not on Blossom’s side, with the Hackers performing almost all services and management of the day care centers, and clearly both were very active in the business and in the industry. Further, they used Blossom to pay for their personal cars as well as those of other family members.
This case is a good example of documenting intracompany agreements and respecting the terms of the same. Had Blossom been able to produce a properly prepared management agreement that set out the terms of the deal between Blossom and Hacker Corp., including services to be provided and compensation for such services, as well as evidence of proper and consistent implementation of the terms of said agreement, the case may well have turned out differently. In that case, Blossom would likely have been able to prove that at least some of services the Hackers provided were done so as employees of Hacker Corp. and pursuant to the management agreement rather than in their roles as corporate officers of Blossom.
This case also serves as a good reminder of the requirement that a corporation pay reasonable compensation to its employees. This often comes up in the case of an S corporation and a shareholder employee[10] where the shareholder/employee may be attempting to circumvent employment taxes by not paying himself or herself reasonable compensation, but the same concept is applicable to a C corporation such as Blossom. As evidenced here, not paying reasonable compensation and accounting for the related employment taxes can be rather costly, with Blossom being hit with back taxes, an additional 10% penalty under §6656, an additional 20% penalty under §6662, and interest on both the tax and penalties. While not the subject of this opinion, the Hackers themselves will also owe back taxes, both income and employment, interest, and may well find themselves liable for penalties as well. Working with advisors to properly structure a business and its related compensation models should not be overlooked, as seen here, failing to do so can wind up coming back to bite you.
[1] Blossom Day Care Centers, Inc. v. Comm’r, TC Memo 2021-86 (See also Blossom Day Care Centers, Inc. v. Comm’r, TC Memo 2021-86).
[2] §3121(d)(1), (2); §3306(i); §3402.
[3] §3402.
[4] §6320; Treas. Reg. §31.6302-1.
[5] Joseph M. Grey Pub. Accountant, P.C. v. Commissioner, 119 T.C. 121 (2002), aff’d 93 AFTR 2d 2004-1626 (3rd Cir. 2004).
[6] Veterinary Surgery Consultants, P.C. v. Commissioner, 117 T.C. 141 (2001).
[7] Nu-Look Design, Inc. v. Commissioner, 85 T.C.M. 927 (2003).
[8] Joly v. Commissioner, T.C. Memo 1998-361.
[9] Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983).
[10] See Gray Edmondson’s article on this issue: https://esapllc.com/reasonable-comp-ward2021/
