You are an employee when …
By Mark E. Battersby

It may only be a matter of several hundred dollars each year, but over the course of a career, it can add up. We are talking about the employment taxes that must be paid on “wages” paid to the owner or principal in a chiropractic practice.

Recently, the U.S. Tax Court agreed with the IRS’s determination that an S-corporation officer who performs “substantial services” for the corporation and who receives remuneration from them, is an employee whose wages are subject to federal employment taxes.

This ruling was made, despite the fact that an S-corporation is supposed to be a pass-through entity whose income and deductions are carried to the shareholder’s personal return where any resulting profit is taxed at the chiropractor’s personal tax rate.

Our tax rules impose FICA (Social Security) and FUTA (unemployment) taxes on employers for wages paid to their employees. Under those rules, an employee is defined, in part, as any officer of a corporation. There is, of course, an exception to that label of “employee” for any officer who does not perform services (or performs only minimal services), and who neither receives nor is entitled to receive remuneration.

For federal employment tax purposes, the term “wages” is defined as “all remuneration for employment.” The form of payment is immaterial, the only relevant factor being whether the payments were actually received as compensation for employment.

Consequently, an officer who performs substantial services for a corporation and who receives remuneration in any form for those services is considered an employee whose wages are subject to federal unemployment taxes.

Unfortunately, the rules only permit use of S-corporation pass-through items in calculating tax liability for income tax purposes — not tax liability under the federal employment tax provisions of FICA and FUTA.

An employer cannot avoid federal employment taxes by characterizing compensation paid to its sole director and shareholder as distributions of the corporation’s net income rather than as wages.

Regardless of how an employer chooses to characterize payments made to its employees, the true analysis, according to the courts, has been whether the payments represent remuneration for services rendered.

Section 530 of the tax law allows relief from employment tax liability — if two conditions are satisfied. Specifically, if:

A. For purposes of employment taxes, the taxpayer did not treat an individual as an employee for any period; and

B. In the case of periods after December 31, 1978, all federal tax returns (including information returns) required to be filed by the taxpayer with respect to such period are filed on a basis consistent with the taxpayer’s treatment of such individuals as not being an employee.”

If these conditions are not met, then you have to pay the tax.

Mark E. Battersby is a tax and financial advisor, freelance writer, lecturer, and author with offices in suburban Philadelphia. He can be contacted at 610-789-2480.

Disclaimer: The author is not engaged in rendering tax, legal or accounting advice. Please consult your professional advisor about issues related to your practice.