Tax law is sometimes written in shades of grey. Internal Revenue Code (IRC) Subchapters K and S, governing partnerships and S corporations, respectively, are notorious for their complexity and compliance challenges. Tax industry professionals are bitterly divided on who earns the income in a single-shareholder, service-based, S corporation (a personal service corporation, or “PSC”): the individual or the corporation? Licensed real estate professionals in many states are in the crosshairs of this tax controversy.
Part I – Common Business Practices in the Real Estate Industry
Licensees who are associated with a real estate brokerage receive commissions and other compensation personally. Each year, they receive a Form 1099-NEC under their Social Security Number. The reason behind this is because licensed brokerage firms are only allowed to compensate their associated licensees or other licensed brokerage firms. This is specifically dictated in Hawaii by HAR §16-99-3(k), which states: "The brokerage firm shall not compensate a licensee of another brokerage firm in connection with a real estate transaction without paying directly or causing the payment to be made directly to the other brokerage firm." Other states have their own, sometimes similar, regulations. This practice introduces a problem with individual licensees who want to operate their business under a state-level business entity, such as a corporation or LLC.
Brokerage firms will typically refuse to pay commissions to entities owned by their agents and will instead issue Form 1099s only to the person who is actively licensed and signs their Independent Contractor Agreement (ICA). One reason for this is because brokerage firm’s lawyers advise their clients not to contract with their agents’ entities because the entity, itself, is not licensed under state law, and furthermore, they do not want an unlicensed person employed or associated with the unlicensed entity from practicing real estate under the entity. For example, an unlicensed transaction coordinator who is employed by the entity could easily overstep their position and inadvertently start practicing real estate illegally without a license.
I will not discuss the legality of an unlicensed S corporation including real estate commissions in their gross income because it is irrelevant to the application of tax law and does not automatically presuppose unlicensed activity by the entity itself, as we will see later (Hint: it is not acting or purporting to be a real estate brokerage or performing brokerage activities). Even, if you assume unlicensed activity, then realize that tax law, state administrative law, and criminal law are completely separate. If I prepared Danny Ocean’s tax return, I would still need to report his income and pay taxes from the money he stole from MGM casinos. Possibly using Schedule 1 (Form 1040), Line 1z. To be more beneficial, I would actually put it on Schedule C (Form 1040) since I would consider premeditated armed robbery of a major resort casino to be a “trade or business.” Then Danny would get deductions for ordinary and necessary business expenses. Oh, and the QBI deduction too! The analogy is fun but limited because we are talking about one-person businesses, not teams with specialized equipment. The real question here is whether Danny Ocean or Ocean’s Eleven, Inc. earned the income?
States like California, Texas, Florida, and Ohio have gotten around this issue and allow business entities owned by the agents to get paid directly or, through regulations, allow the agent’s entity to contract with the brokerage firm. However, states may require licensees to obtain a license for their business entity prior to allowing them to receive the commission. Rigid states like New York and Hawaii restrict S corporations from being paid a real estate commission unless they are licensed as real estate brokerage firms (which must have a Principal Broker), which restricts licensees associated with a brokerage firm from practicing real estate under anything other than their individually licensed capacity. This practice may create an incentive in those markets for brokerage firms’ highest producing agents to leave and set up their own brokerage firms. This does not imply that licensees’ business entities cannot be taxed on income received by the licensee, for reasons which will be discussed later. Note that licensees with a business entity should never use their entity name in any advertisements or communications; nor should they hold the entity out to be a real estate brokerage firm if the entity does not hold a valid license (HAR §16-99-11). Just know there is a difference between state administrative regulations and tax regulations. The two do not always line up perfectly.
The way around these regulatory challenges is simple. The licensee’s Form 1099-NEC income is reported on their Schedule C (Form 1040). This prevents the tax return from triggering the IRS’s Automated Underreporter (AUR) function. Under the line “Other Expenses,” the entire amount of reported income is deducted by entering “Reported Under EIN XX-XXXXXXX.” This pushes the income onto the S corporation’s tax return. The same amount of income on Form 1099-NEC is then reported as Gross Receipts on the S corporation’s Form 1120-S. Ordinary and necessary business expenses are then deducted, including the licensee’s required reasonable compensation. Whatever ordinary business income is left over gets passed through the S corporation via the licensee’s Schedule K-1 (Form 1120-S), which is not subject to Self-Employment Tax (SECA). That is the entire tax strategy – it is not illegal, nor is it an over-aggressive or abusive tax shelter – but it is a very common practice. However, it simply exists in a gray area of tax law. Experts in the tax industry support it as nominee income. Those who hold unsupportive professional opinions consider it a gratuitous assignment of income. Some even go so far as to call it illegal tax evasion. We believe those types of flagrant exaggerations are without merit as they relate to the income-splitting tax strategy outlined above. Nevertheless, we will now present the arguments of both sides.
Part II – Background
It is not illegal and is very common for licensed individuals in the regulated industries (real estate, financial services, insurance, etc.) to use the S corporation to arrange their business affairs. There has been no case of a person losing their license or going to prison due to use of this tax strategy. Neither Congress, the courts, nor the various administrations have issued bright line guidance on this strategy. The IRS, for what it’s worth, has often been accused of treating PSCs unfavorably. That accusation is justified by the number of court cases surrounding this legal question. Courts have been inconsistent in their application of various contradictory legal tests on the common law doctrine of assignment of income. For the most part, taxpayers have been largely unsuccessful in court when the IRS attacks their PSCs. Mostly due to the fact that taxpayers shoulder the burden of proof in contesting IRS deficiencies, and also due to the courts’ use of inconsistent, subjective, and arguably flawed, methods of determining “who” earned the income.
Tax practitioners are prohibited from “playing the audit lottery” when giving advice on federal tax matters. That means they cannot use, as a factor, the probability that a tax position will not be scrutinized under audit (10 CFR §10.37(a)(2)(vi)). Therefore, I will limit my analysis to a discussion of substantial authority, common law tax doctrines, and opinions of other specialized tax experts. Here are the two ways it is thought that a real estate licensee can use an S corporation without triggering the assignment of income doctrine. This does not imply that it will not trigger opposition from the IRS.
Theory #1 – Licensee, as independent contractor of a brokerage firm, earns commissions as gross income and then fully deducts it when its turned over to their PSC, as per their employment contract.
Theory #2 – PSC earns the income from the work of its employee.
Both theories are correct because they are two sides to the same coin that originated from Lucas v. Earl, 281 U.S. 111 (1930). Theory #1 cleanly avoids trouble with unlicensed activity and is called “nominee income,” which is simply income received that belongs to someone else. An example is dividend income from stocks of publicly traded companies.
When you buy shares of stock on Robinhood, notice how you never receive the share certificates. That is because those shares are held in “street name.” Your Microsoft shares, for instance, are registered in the name of Cede & Co., the nominee (or legal placeholder) of Depository Trust Company (DTC), the clearinghouse who owns them in beneficial trust for you. You are still the ultimate economic owner, just like the PSC. When Microsoft pays a dividend, the money goes to Cede & Co., then to DTC where it allocates the funds to Robinhood based on the number of Microsoft shares held in their client accounts as of the record date. Finally, Robinhood credits your individual brokerage account based on the number of shares of Microsoft you own as of the record date. Your Form 1099-DIV comes from Robinhood, not from DTC, Cede & Co., or the ultimate payor: Microsoft. Those funds are said to be nominated to you, the true owner, and I can assure you that dividend income is not taxable to Cede & Co., DTC, or Robinhood. It’s taxable to you.
Part III – Historical Legal Developments
Beginning in the 1960s, professionals such as attorneys, accountants, doctors, and dentists started using the corporate or partnership form for tax benefits. During the tax years 1965-1981, the highest marginal tax rate for an individual was 70%. When the Reagan Administration took office, the highest marginal rate for individuals was lowered to 50%. The Tax Reform Act of 1986 dropped it to 38.5%, which is slightly higher than current rates for the highest earners of today. Whereas the highest corporate tax rate fluctuated between 46-52.8% during the same period 1965-1981. The Tax Reform Act of 1986 dropped it to 34% when it was completely phased-in in 1988. Furthermore, business entities provided much more favorable retirement plans compared to sole proprietors – particularly high-income earners – until the Employee Retirement Income Security Act (ERISA) of 1974 was passed into law. This was one of the incentives for sole proprietors to incorporate themselves during the 1960s to mid-1970s. There were cases where attorneys who were members of a law firm (a partnership) would earn fees for services that the law firm did not provide. Yet, the partners would turn over the fees to the partnership, and it was the partnership, not the partner, who was taxed on this income (Rev. Rul. 64-90).
Much later, there existed state laws that prevented entities from acting as executors of decedents' estates. Yet, in Rev. Rul. 80-338, the IRS allowed the accountants acting as executors to turn over commissions to their accounting firm, whereby the accounting firm was taxed on the income. Why? The IRS noted that (1) the “function was within the range of services undertaken by accountants," and (2) "[i]t is not unusual in an accounting or legal practice that specific responsibilities must be assumed by an individual partner rather than by the partnership." That seems analogous to the idea that real estate licensees are required by state law to individually practice real estate, while still allowing an unlicensed entity to be taxed on the individual licensee’s nominee income. Out of the two decades, the IRS and the courts tried to fashion some form of legal test to determine to whom income gets taxed. At first, it was the Similarity Test, then they came up with the “agency triangle” theory that attempts to formalize the relationships between principals, agents, and intermediaries. For historical background, let’s briefly introduce those two formulations.
SIMILARITY TEST – Rev. Rul. 64-90 states:
Fees received by a partner for similar services performed in his individual capacity will be considered as partnership income if paid to the partnership in accordance with the agreement. Those fees need not be reported separately by the partner on his individual income tax return. However, the partner’s distributive share of the partnership’s taxable income which he must report on his individual return will include a portion of such fees.
That’s simple. If an attorney is personally practicing law, and he/she has an agreement to turn over the compensation from those personal services to the law firm, then the IRS will recognize that the income belongs to the law firm provided that the taxpayer’s services are similar to the entity’s. This test is seen most often in partnerships. A separate test co-evolved with the Similarity Test that looks at whether or not the taxpayer is acting as an agent of a principal when providing services. This is commonly seen with professional athletes who incorporate their trade or business.
AGENCY TEST – Rev. Rul. 58-220 states:
It is the rule of employment, under which physicians are appointed on a full-time salary basis to the staff of a certain hospital, that such physicians shall receive no fees or compensation for their individual benefit from or on behalf of any patients admitted to the hospital. In some instances, the patients insist on making checks for the services rendered payable directly to the physician instead of to the hospital. The hospital, and not the physicians, actually bills all patients treated. In line with the above condition of their employment, the physicians endorse the checks and turn them over to the hospital. The fees so received are used entirely in the operation of the hospital. Held, where, under the above circumstances, checks are received by a physician and are immediately endorsed to the hospital, the physician is not required to include the amounts thereof in his gross income. He is an agent for the hospital, merely acting as a conduit for the fees collected… See also Revenue Ruling 55- 234, C. B. 1955-1, 217, which held, on the facts therein presented, that income realized from business transacted by a corporation through the nominal agency of one of its officers, acting as purported sole proprietor, is taxable to the corporation. However, a physician who receives fees under the above conditions should attach to his Federal income tax return a schedule setting forth the sources of the fees, the amounts received and the disposition made of them.
The last sentence above is analogous to reporting income on a taxpayer’s Schedule C (Form 1040) and letting the IRS know that it is being deducted and reported under the PSC’s EIN. Arising out of the Agency Test was a similar so-called “Johnson Test,” developed by the U.S. Tax Court in the early 1980s. This is also called the “control” test.
JOHNSON TEST – Johnson v. Commissioner, 78 T.C. 882, 891 (1982):
An examination of the case law from Lucas v. Earl hence reveals two necessary elements before the corporation, rather than its service-performer employee, may be considered the controller of the income.
First, the service-performer employee must be just that – an employee of the corporation whom the corporation has the right to direct or control in some meaningful sense.
Second, there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation's controlling position.
In Johnson, the Tax Court recognizes,
The realities of the business world prevent an overly simplistic application of the Lucas v. Earl rule whereby the true earner may be identified by merely pointing to the one actually turning the spade or dribbling the ball. Recognition must be given to corporations as taxable entities which, to a great extent, rely upon the personal services of their employees to produce corporate income. When a corporate employee performs labors which give rise to income, it solves little merely to identify the actual laborer. Thus, a tension has evolved between the basic tenets of Lucas v. Earl and recognition of the nature of the corporate business form. That tension is most acute when a corporation operates a personal service business and has as its sole or principal employee its sole or principal shareholder.
Elements of Johnson Test are found in CFR §31.3121(d)-1(c)(2), Employment Tax Regulations.
Part IV – Criticism of the Johnson Test
Taxpayers are not always in control of the second prong of the Johnson Test. It is an arbitrary factor that may come down to the lack of a strong negotiating position of a PSC with its customer. A customer may choose “to do business” with an individual rather than the PSC as a subtext of disallowing the individual their limited liability protection in the case of a high stakes contract. It may be due to state or local regulatory restrictions. It may be due to the whim of the customer. Corporations are often hired to obtain the services of a specific employee. And some corporations realize the vast bulk of their revenue from the work and talents of a single VIP employee.
The Johnson Test emphasizes form over substance. There are no probative factors for satisfying the first and second prongs that are dispositive. There is no existing evidence of what can lead a court to find that the first prong is successfully met. The IRS has a long-standing preference for the substance over form doctrine, except when the form over substance doctrine supports its interests. The first prong should be easily satisfied by an employment contract and a reasonable salary, and bright-line guidance should be issued to address this contention, considering the volume of assignment of income cases brought before the federal judiciary in the past 60 years.
Mark J. Kohler is a tax attorney and CPA with over 20 years’ experience and specializes in small business tax and legal strategies, estate planning, retirement, and asset protection. He supports the Nominee Income Theory:
If you have an S corporation… sometimes you are going to receive a 1099 under your personal name or Social [Security number]. You can essentially 1099 your own S corp. It’s called nominee income. You’re going to claim the income on your Schedule C, and push it right back out on page 2, over to your S corp. Very common strategy. The IRS recognizes it. As long as you are depositing the money in your S corp. and using it in your S corp.… you’re fine (Kohler & Sorenson, 2024, 7:36).
I spoke to a group of Realtors yesterday, and they said ‘Mark, in my state – this is in Hawaii – this is common, and in a lot of states, brokers, or the division of real estate, telling brokers what to do, will not pay a Realtor or 1099 a Realtor’s LLC or corporation. So, they say ‘Well, I can’t use my LLC or corporation.’ No, no, no, no! You can. We are going to drive that 1099 through your personal tax return and back into your company. The IRS allows for that, but a lot of accountants miss that. And so, you can still use the company, even if someone 1099s you personally. So, when you fill out the W-9 and your broker goes ‘No we’re not going to pay your corporation’s EIN.’ ‘Fine, here’s my Social.’ Not all is lost. In that situation, it’s okay (Kohler & Nentwick, 2023).
According to the Johnson Test, a taxpayer must have a contract with their PSC, and the PSC must have a contract with the third-party client. In real estate, a licensee has a contract (ICA) with the brokerage firm, and the brokerage firm has a contract with the client (the Exclusive Right-to-Sell Listing Contract or the Buyer Representation Contract). The client does not have a contract with the licensee (but the client has constructive knowledge that the brokerage firm is controlling). That is the source of risk for a real estate agent using a PSC in failing the second prong of the Johnson Test.
According to Manning, on the aspects of the second prong of the Johnson Test, “Important tax issues of this type should not turn on the willingness of the other party to recognize the transaction, which is merely an issue of bargaining power.” As a side note, nominees do not need to 1099 their S corporations because corporate entities are exempt from information return reporting requirements, unless they provide legal services (Treas. Regs. §1.6041-3(p)(1)).
The Johnson Test is a broken legal tool, even though it is the IRS’s go-to mechanism to get courts to look past the corporate form and subject the taxpayer to higher tax burdens. Upper-level federal courts have explicitly labeled it as rigid and narrow. In Schuster v. C.I.R, 800 F.2d 672, 677 (7th Cir. 1986), after the IRS attempted to use the Johnson Test to support its position, the U.S. Court of Appeals for the 7th Circuit ruled:
In our view, the two-part test applied by the Johnson court and the ‘agency triangle’ theory too narrowly restrict the inquiry into an alleged agency relationship. While the dealings between the third-party employer and the alleged principal are an important factor to be considered in assessing the agency determination, there are several other important factors. A flexible test, allowing consideration of all of those factors, better serves our analysis in attempting to determine whether income is to be taxed against the person or entity who actually earned it or against someone else.
Rejecting the Johnson Test, the 7th Circuit chose to use a more flexible six-factor test to analyze the agency relationship between the third-party employer (brokerage firm), taxpayer (agent), and the principal (entity). This test was devised by the U.S. Court of Appeals for the Federal Circuit in Fogarty v. United States, 780 F.2d 1005 (Fed. Cir. 1986). It examines:
the degree of control exercised by the principal over the taxpayer;
ownership rights [to the compensation as] between the taxpayer and the principal;
the purposes or mission of the principal;
the type of work performed by the taxpayer vis-a-vis the purposes or mission;
the dealings between the taxpayer and the third-party employer, including the circumstances surrounding inquiries and interviews, and the control or supervision exercised by the employer; and
the dealings between the employer and the principal.
(The words “Order” and “member” were substituted for “principal” and “taxpayer,” respectively, for clarity and relevancy.)
Part V – Foundation of the Assignment of Income Doctrine
The legal foundation for the assignment of income doctrine was the landmark US Supreme Court case, Lucas v. Earl, 281 U.S. 111 (1930). Earl was a married man from the state of Washington who had a contract with his wife stating that half of his income was hers. That is the essence of community property states, of which Washington ascribed. This prevented the top half of Earl’s income from reaching the higher tax brackets. This was before the Married Filing Jointly status existed. The IRS challenged Earl’s tax position upon audit, and the case found its way all the way up to the US Supreme Court. Referring to, presently, Section 61 of the Internal Revenue Code (IRC), which provides the legal definition of gross income, the court ruled:
No doubt that the statute could tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts, however skillfully devised, to prevent the salary, when paid, from vesting even for a second in the man who earned it.
Justice Oliver Wendell Holmes is credited with developing the Fruit of the Tree doctrine, which states that income (“fruit”) should be taxed to the “tree” that produced it. Put another way, if a person earns income, they cannot assign it to another person to avoid taxation. This is often called the first principal of taxation and is designed to protect the integrity of our graduated tax system. Without it, the entire structure underpinning progressive taxation would collapse. I am highly in favor of enforcing gratuitous assignment of income cases. My entire thesis is that the assignment of income doctrine should not be misconstrued to effectively invalidate the separate legal existence of PSCs.
After Congress created S corporations in 1958, the IRS issued Rev. Ruling 59-221 which provides the basis for the tax-advantaged nature of S corporations. It clearly states that the S corporation’s income which is passed through to a shareholder is not treated as net earnings from self-employment for the purpose of the Self-Employment Contributions Act (self-employment tax or “SECA”). Therefore, S corporation pass-through income escapes the current 15.3% SECA tax that is imposed upon earnings of sole proprietors and partners. In the decades following Lucas v. Earl, there have been a succession of court cases that challenged taxpayers’ use of the S corporation strategy to lower their tax liabilities.
Congress created S corporations to allow businesses to avoid the double taxation of C corporations. The avoidance of SECA is not a bug, it is a feature. The reasonable compensation requirement was the mechanism Congress chose to require that S corporation shareholder-employees pay their fair share of SECA. I am completely in favor of adhering to reasonable compensation requirements. Although, some professionals argue that 100% of the PSC’s income should be paid out as reasonable compensation. That argument is without merit, as I will discuss later.
In Jones v. Commissioner, 64 T.C. 1066 (1975), it was adjudged that a court reporter improperly assigned income to his PSC due to the legal fact that a court reporter was legally required to be an individual, and although the petitioner’s PSC was a valid legal entity, by law it could not perform court reporting services. A congruent argument can be made that an entity without an active real estate license cannot perform real estate brokerage services. It is not known if nominated income from real estate sales constitutes a similar conclusion because it has not been legally tested. Although later in Rev. Rul. 80-338, the IRS did not seem to care about the legal ability of the entity to perform the services. Again, inconsistent.
One of the most disastrous case for the taxpayer (and rightfully so) was Arnold v. Commissioner, T.C. Memo. 2007-168. Mrs. Arnold was a Realtor associated with Coldwell Banker. She owned an S corporation and neglected to pay herself any reasonable compensation or respect basic corporate formalities. There was no evidence that she acted as an employee of her PSC at all. Mr. Arnold was a tax preparer. He had a separate PSC where no reasonable salary was paid to him. For some reason, income from clients was paid to him personally. As with his wife, he endorsed his checks to his corporation. No document was entered into evidence that suggested he was even an employee of his PSC. The case of the Arnolds was significant because they flagrantly abused the corporate form of business. Unlike with Mrs. Arnold, there were no licensing regulations that prevented Mr. Arnold’s PSC from receiving payments directly. What’s worse is that the petitioners not only disregarded the rules, but they brought before the US Tax Court a similar case in Arnold v. Commissioner, T.C. Memo. 2005-256. In both cases, it appears from the record that the petitioners were uncooperative. The court publicly admonished them and considered imposing a §6673(a)(1) penalty worth $25,000 due to their delay tactics. Things may have been different if they followed the rules and respected the corporate form of their business. The lesson learned is that it is not sufficient to just have one piece of paper incorporating your entity. You must use it properly.
On the opposite end of the spectrum, in an upsetting case, Isom v. Commissioner, T.C. Memo. 1995-38, Mr. Isom was an independent insurance agent. He used an S corporation for his business. For years, his insurance brokerage recognized Mr. Isom’s corporation and issued checks made payable to the corporation. At some point, the brokerage firm’s lawyers advised them to stop recognizing corporations as insurance agents. Instead, they started making out checks directly to Mr. Isom personally. With no substantive change in process, Mr. Isom would then endorse the checks over to his S corporation. Upon audit, the IRS declared Mr. Isom’s S corporation “a sham.” While not agreeing with the sham corporation argument, the Tax Court nevertheless ruled in favor of the IRS because Mr. Isom’s S corporation failed both prongs of the Johnson Test. Mr. Isom had to pay SECA tax worth $12,109 covering tax years 1988 and 1989. Mr. Isom could have easily entered into an employment contract with his PSC, but it seems that the second prong of the Johnson Test revolved around the whim of Mr. Isom’s client to not recognize the structure Mr. Isom chose for his business. That highlights the biggest flaw with the Johnson Test, because Mr. Isom appeared to respect corporate formalities apart from entering into an employment contract with his S corporation. The inconsistency here is that the IRS purports to prefer the substance over form doctrine in these cases, but they will inexplicably revert back to form over substance when it suits their position.
Fleischer v Commissioner, T.C. Memo. 2016-238 is the notorious Tax Court case that placed the issue of PSCs and the assignment of income doctrine back into the spotlight for regulated service-based businesses. Tax Court Memo cases are technically not precedential, but their opinions carry significant legal value. Fleischer was an independent financial consultant and certified financial planner who held Series 6, 7, 24, 63, and 65 licenses from the Financial Industry Regulatory Authority (FINRA). After consultation with his business attorney and CPA, Fleischer formed an S corporation and executed an employment contract with it. The contract did not contain a provision whereby Fleischer, as employee, would remit any fees or commissions earned from any other third party to the S corporation. Petitioner entered into independent contractor agreements with two financial brokerage firms in his personal capacity. When doing his taxes, Fleischer reported the income from the 1099s under his SSN to his Schedule C (Form 1040), then expensed an equal amount on the line for Other Expenses, indicating that the income was “Reported by [EIN].” The exact same income was then reported on Form 1120-S along with ordinary and necessary business expenses. The S corporation paid Fleischer a salary of approximately $35,000. Some experts believe that may have been too low based on the corporation earning approximately $148,000 in ordinary business income. The IRS audited him for tax years 2009, 2010, and 2011, and reallocated the corporate income back to Fleischer’s Schedule C (Form 1040) and assessed him a deficiency of $41,563 in SECA taxes. The taxpayer, like others, generally starts out at a legal disadvantage and has to dig themselves out of an existing hole in order to prevail over the IRS. That is because the Commissioner’s (IRS) deficiency determination is presumed correct. Whereas the petitioner (taxpayer) has the burden of proving the Commissioner wrong in court. Without even mentioning the first prong of the Johnson Test, the U.S. Tax Court ruled against Fleischer because he did not meet the second prong of the Johnson Test. Fleischer told the court that his S corporation could not enter into a contract with the brokerage houses because it was not a registered entity under federal securities regulations (15 USC §780(a)(1)). This is analogous to state real estate licensing regulations, especially in Hawaii. The Tax Court did not care, it wrote,
Petitioner testified that it would be overly burdensome and ‘would cost millions and millions of dollars’ for [his S corporation] to register under the Act, but he offered no other evidence to corroborate his testimony. The fact that [the S corporation] was not registered, thus preventing it from engaging in the sale of securities, does not allow petitioner to assign the income he earned in his personal capacity to [his S corporation].
This case, even though it is a Tax Court Memo case, and is not precedential, seems to imply that the only way a licensed professional could operate as an S corporation is by licensing the entity itself so it may enter into contracts directly with clients. This is why tax professionals on the assignment of income side of the aisle argue that a Realtor would need to open a licensed real estate brokerage firm in order to use the S corporation structure.
Assignment of income cases are almost always found in favor of the Commissioner.
Respecting corporate formalities, which are widely ignored by PSCs, gives the taxpayer the best position to place evidence before the court that the controlling of income is by the corporation, even though there are no safe harbor regulations. The Service’s statutory tools for resolving assignment of income cases are provided by IRC §482, which is the preferred method and the common law application of IRC §61. IRC §269A is used for PSCs whose only reason for existence is the avoidance or evasion of federal income tax. Ultimately, corporate income can be “reassigned” back to the shareholder the IRS believes earned the income. This is done by adjustments to the taxpayer’s Schedule C (Form 1040).
Part VI – Counterarguments to the Assignment of Income Viewpoint
Debates on assignment of income vs. nominee income have been occurring in tax professional forums going back to 2005. This is prevalent for accountants who serve clients in the insurance, financial services, and real estate industry… all heavily regulated industries.
First, a real estate agent is a statutory nonemployee under IRC §3508. Therefore, they cannot be treated as an employee of their associated real estate brokerage for tax purposes, regardless of the control the brokerages exert over the agent (I can personally state that there is very little control outside of writing contracts). When courts wrangle over the issue of employee vs. independent contractor, they typically look primarily at the level of control the employer has over the worker. The IRS has attempted to get courts to rule that taxpayers are not employees of their S corporation because the third-party exercises a minimum level of control over the taxpayer. When that happens, the taxpayer automatically fails the first prong of the Johnson Test and the tax deficiency is sustained by the court.
The shareholder is still paying taxes on the corporate income because S corporations are pass-through entities. For each $1 of profit purported to be “assigned” to a corporation, $1 flows through to the “assignor's” individual income tax return. It ends up being taxed to the individual either way. By definition, a single-shareholder PSC cannot make a gratuitous assignment of income to their PSC. What is happening is that the shareholder is exercising an assignment of value. The shareholder turns over income to their PSC. The PSC’s stock value increases by an equal amount. In return, the shareholder-employee is paid a reasonable salary by the PSC. The PSC is “indirectly taxed” on the income it receives via the pass-through mechanism and the shareholder-employee is taxed on the reasonable compensation received. There is no net loss to the government. The only revenue the IRS is missing is SECA tax on the pass-through income, not the reasonable compensation.
The economic philosophy behind the IRS’s stance hinges upon the question of whether or not a shareholder can take “dividends,” which represent a return on investment to the shareholder. The money and time contributed to the PSC is not 100% salary earnings. This is the reason why the “reasonable compensation” structure exists. The Service, as well as some practitioners, hold the opinion that "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation (Instructions to Form 1120-S)." I think it is absurd to require 100% of income to be paid in wages in order to be considered reasonable. I also believe that was not Congress’s intention when they created the S corporation, otherwise, every service-based business owner would just be a sole proprietor.
The Fogelsong cases were four separate assignment of income cases that went back and forth between the Tax Court and the appellate circuit. In Fogelsong v. Commissioner, 691 F.2d 848 (7th Cir. 1982) the key issue was whether income earned by Mr. Fogelsong could be assigned to a corporation he controlled for tax purposes. Mr. Fogelsong had arranged for his third-party client to pay income for teaching and consulting services directly to his corporation, which retained a portion of the payments and distributed the rest to him as dividends. The IRS argued that these payments were still taxable to Mr. Fogelsong personally under the assignment of income doctrine. The Tax Court ruled largely in favor of the IRS, concluding that the income was attributable to Mr. Fogelsong because it stemmed from his personal services, and he could not assign it to another entity to avoid taxation. However, Mr. Fogelsong challenged additional adjustments made by the IRS, arguing that not all payments attributed to him should be treated as taxable income. On appeal, the U.S. Court of Appeals for the 7th Circuit partially agreed with Mr. Fogelsong. While the appellate court upheld the general principle that earned income cannot be reassigned for tax avoidance purposes, it also found that certain payments were improperly characterized by the IRS and should not be taxed to Mr. Fogelsong personally. As a result, the final disposition was a mixed outcome, with both sides prevailing on certain points. This partial resolution highlighted the complexity of applying the assignment of income doctrine in cases involving closely held corporations and underscored the importance of examining the substance and structure of financial arrangements. While the petitioner did not achieve a full victory, his arguments resulted in adjustments to the IRS's determination, reflecting a legal stalemate on some aspects of the case.
In Keller v Commissioner, 77 T.C. 1014 (1981), the taxpayer was a partner of a medical clinic. He assigned his partnership interest to a PSC so he could take advantage of a better tax-free retirement plan. The IRS tried to §482 all of his income back to him individually. However, the US Tax Court ruled that he satisfied the “arms-length rule” of IRC §482 because his compensation was essentially equal to what he would have received from his partnership interest.
The University of Miami Law Review article “The Service Corporation” says “it is not completely clear why the courts, and particularly the Tax Court, thought that the assignment of income doctrine applied to Mr. [Charles] Johnson but not to Mr. Fogelsong or Dr. Keller.” However, in Fogelsong, unlike in Johnson, the other contracting party respected the separate legal existence of the taxpayer’s PSC.
Rev. Rul. 76-363 holds that creation of a corporation to enjoy the benefits of Subchapter S status is not improper tax avoidance. Court explicitly ruled the same in Achiro v Commissioner, 77 T.C. 881 (1981). Therefore, IRC §269A is not applicable. Basically, saying that the IRS cannot punish a taxpayer for using the tax benefits that Congress intended to provide. DUHHH! Congress amended IRC §269 to include retirement benefits as a reason in preventing the IRS from punishing taxpayers before the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982 reduced the disparity between pension benefits for corporations and self-employed taxpayers. There are still exceptions within the law, however, that prevent taxpayer abuse of tax-advantaged pension benefits.
Corporate Intangibles Theory
There are two elements of a business’s profit:
personal service element – which is represented by salary, wages, or “reasonable compensation,” and
entrepreneurial element – return on the risk of capital involved, including on intangible assets such as goodwill.
“The general policy of recognizing PSC’s as separate entities for income tax purposes requires that they be allowed to accumulate entrepreneurial profit (Manning, page 684).” With that in mind, on remand, Fogelsong, although aggressive with his tax planning, failed his burden to prove how much of his profit was personal service and entrepreneurial profit. The IRS’s allocation of 2% to entrepreneurial profit was ridiculous. The IRS, in Rev. Rul. 70-45, declared that it would cautiously recognize a partial transfer of goodwill upon admittance of a partner to a professional practice. That means that the Service will acknowledge the existence of an entrepreneurial element of profit, such as goodwill, in a business, and that a partner can earn a return on investment from such intangibles. This ruling revoked Rev. Rul. 64-235, which said, as a matter of law, a partner cannot make a partial transfer of goodwill when admitting a partner, but only when selling their entire practice. Again, inconsistent.
We will take a look at a final case with Sargent v. Commissioner, 93 T.C. 572 (1989), rev'd, 929 F.2d 1252 (8th Cir. 1991), to show the lengths to which the IRS will go in opposition to the PSC. Sargent was a case of two professional hockey players for the Minnesota North Stars in the late 1980s. The IRS led a special litigation program against players who incorporated PSCs to obtain tax and retirement plan benefits. Gary Sargent incorporated Chiefy-Cat, whereby he was self-appointed as the sole member of the Board of Directors and was imbued with the corporate title of president. Sargent entered into an employment contract with Chiefy-Cat, which stipulated the terms of his employment and his compensation terms. Chiefy-Cat then entered into a contract with the Minnesota North Stars, which provided that Chiefy-Cat would loan out the services of Sargent to the hockey team for compensation. The contract was signed by both parties. The IRS then tried to say that Sargent was actually an employee of the hockey team, not Chiefy-Cat, despite the evidence of the contract to the contrary. The IRS issued Sargent a deficiency of $79,384 by reallocating income from Chiefy-Cat to Sargent. When Sargent took the IRS to the U.S. Tax Court, the IRS dug its heels into Treas. Regs. §31.3121(d)-1(c)(2) – the Johnson Test – of course. The U.S. Tax Court ignored the contract between Chiefy-Cat and Minnesota North Stars, bought the IRS’s nonsense argument, and ordered Sargent to pay the $79,384 in taxes.
Sargent appealed the Tax Court’s decision to the U.S. Court of Appeals for the 8th Circuit. The appellate court immediately recognized the contract between Chiefy-Cat and Sargent to be adequate to establish the Sargent was, in fact, an employee of Chiefy-Cat. That allowed Sargent to pass the first prong of the Johnson Test. In Johnson, the San Francisco Warriors refused to contract with Charles Johnson’s PSC, but in Sargent, the Minnesota North Stars freely contracted with Chiefy-Cat, allowing Sargent to pass the second prong of the Johnson Test. The U.S. Tax Court’s ruling was reversed. Sargent won one of the few assignment of income cases in history. The IRS threw a fit and issued a blistering Action on Decision (CC-1991-022), arguing that the only one in control was Sargent and promised to fight this legal battle in all appellate circuits except the 8th:
The Eighth Circuit concluded that under the above standard, the taxpayers were employees of the PSC's, discarding the "team control" analysis. The court then focused upon what it stated to be the "sanctity" of contractual relations between the taxpayers and their respective PSC's. We disagree with both the manner in which the Eighth Circuit employed the regulation provision as well as its conclusion that the PSC's controlled the taxpayers. Further, it is our view that the Eighth Circuit improperly employed a form over substance analysis to the set of facts at issue herein by relying on the mere existence of the taxpayers' contracts with their respective PSC's, rather than the control imposed directly upon the taxpayers by the team's coaching staff and management.
The IRS has always preferred that substance control over form, except when it prefers that form controls over substance, which leads us to the present day.
Part VII – Risks to Using the PSC
The IRS will likely attack the use of a PSC, if audited. If used improperly, they will likely prevail in court. They will generally follow a certain pattern in their scrutiny of PSCs.
First – they will try to declare the PSC a “sham corporation,” which is a corporation with no legal business purpose. If a PSC is declared a sham, all of the PSC’s income will be taxed to the shareholder personally. Declaring a corporation a sham is a difficult legal feat due to the landmark U.S. Supreme Court case Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943), which held that:
The doctrine of corporate entity fills a useful purpose in business life. Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator's personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity.
The best defense against the sham corporation attack is to adhere to standard corporate formalities. Draft and execute a valid operating agreement or bylaws, at a minimum. Follow your bylaws or operating agreement. Keep records in writing. Hold meetings of the board of directors, even if it is just one director. Take and retain minutes of the proceedings. Enter into contracts, send correspondence, advertise in the corporate name, not your personal name.
Second, if the IRS cannot get the courts to declare the PSC a sham corporation, it will then move on to apply the “alter ego” test, which examines whether the PSC is legally distinguishable from the shareholder, or whether it’s merely an agent or alter ego of the shareholder. Under New Colonial Ice Co. v. Helvering 292 U.S. 435 (1934), the U.S. Supreme Court ruled that a corporation and it’s shareholder(s) are legally separate entities and should be respected as such unless exceptional circumstances warrant otherwise. Again, attention to corporate formalities is a good defense. Keep business and personal funds separate, using separate banking accounts. Don’t pay for personal expenses with business funds. Treat the corporation as someone else’s business, not your personal ATM.
Third, failing the second tactic, the IRS will get the court to apply the “actual earner” or “control” test (AKA, the Johnson Test) under the assignment of income doctrine. This is the point where most PSC taxpayers will lose in court. Because, if the court applies the Johnson Test, the taxpayer will be at the whim of the third-party’s decision to recognize the PSC.
Fifth, if a taxpayer manages to get through the Johnson Test, which is a rare occurrence, the IRS will apply the “constructive receipt” test to see if income should be reallocated using IRC §482, which, by the way, there is at least one court that ruled that §482 cannot be used against PSCs because there is no two-separate trades or businesses (Fogelsong IV).
Part VIII - Conclusion
In conclusion, real estate licensees who are considering using the S corporation strategy for their business should be aware of the relative risks associated with that tax strategy. This article provided both sides of the arguments in favor of and against the use of the strategy. I have left out many assignment of income court cases for the sake of sanity. The official position of Blackjack Tax Services, LLC is to educate the taxpayer on the debate, use, and risks of the strategy and let the taxpayer decide what course of action to take. It should also be said that courts should be hesitant to disregard contracts, lest they deny taxpayers the right to “structure their affairs.”
Judge Learned Hand eloquently articulated the distinction between tax evasion and legitimate tax avoidance, observing in Helvering v. Gregory, 69 F.2d 809 (2d Cir. 1934), that “anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury.” This principle underscores the heart of the debate surrounding the treatment of Professional Service Corporations (PSCs) and Subchapter S taxpayers. Congress's framework for reasonable compensation requirements reflects a deliberate policy choice to allow taxpayers the flexibility to minimize their tax liabilities legally while ensuring fairness through compliance.
Misapplying the assignment of income doctrine to undermine the separate legal existence of PSCs and increase revenues not only contravenes this intent but also erodes the integrity of the tax code by ignoring its careful balance. In aligning with Judge Hand’s pragmatic view, this thesis champions a tax system that respects legal structures while maintaining safeguards against abuse, fostering trust in its administration, and fairness. As Judge Hand made clear in his famous dissent in Commissioner v. Newman, 159 F.2d 848 (2d Cir. 1947):
"Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant."
Sources
Jensen, Ronald H. “Schneer v. Commissioner: Continuing Confusion Over the Assignment of Income Doctrine and Personal Service Income” 1 Florida Tax Review 16 (2023).
Kanis, Bret M. “Utility of Personal Service Corporations for Athletes” 22 Pepperdine Law Review 2 (1995).
Kohler, Mark J., & Nentwick, Katie. “Your LLC May Be Useless: Mark’s First Day in Court” Main Street Business Podcast #419 (2023, March 3).
Kohler, Mark J, & Sorenson, Mat. “Received a 1099…What next?” Main Street Business Podcast #474 (2024, January 30).
Manning, Elliott. “The Service Corporation—Who Is Taxable on Its Income: Reconciling Assignment of Income Principles, Section 482, and Section 351” 37 University of Miami Law Review 3, Article 12 (1983).
Stewart, Robert D. “I Am the Master(s) of My Fate: Owen v. Commissioner and the Assignment of Income Doctrine in the Context of Personal Service Corporations” 67 The Tax Lawyer 2 (2014).
Valdez, Aguinaldo. “One-Man Personal Service Corporations: Singing a New Fogelsong” 58 Notre Dame Law Review 8 (1983).
Vausher, George A. “Incorporation of Pro Athletes:” Skating on Thin Ice?” 14 Loyola of Los Angeles Entertainment Law Review 3, Article 5 (1994).