When one person’s misstep in using a common industry practice gets reported in the press or a blog, a reader may worry if he or she has also strayed. Some have this response to the recent Tax Court case Fleischer v. Commissioner. The many differing opinions and commentaries on that case have advisors asking how this ruling affects their existing entity structures and tax reporting.
Many of the articles on Fleischer either oversimplify the court’s ruling, misinterpret the court’s decision to suggest an advisor with a business entity (either a corporation or a limited liability company) must abandon the entity, or miss the point entirely. The danger in those messages is their failure to understand the details of the Fleischer case, and not emphasizing that in the proper execution of an integrated plan – one that accommodates corporate law, tax law, and FINRA regulations – there would have been a different outcome.
From the Fleischer case, understand this: You won’t have a problem if you do things right. But setting up an entity in a highly regulated industry and operating it correctly is intricate. You cannot do it on LegalZoom or with an attorney or accountant unfamiliar with FINRA regulations. The Fleischer decision does not change the fact that entities are worthwhile for a wide variety of reasons.
The Fleischer Case
In the Fleischer case, the court focused on who controls the earning of the income, citing the two-part test recognized in the 1982 case of Johnson v. Commissioner. In that case, Charles Johnson played for the NBA’s San Francisco (now Golden State) Warriors in the 1970’s. He formed a Panamanian corporation to receive his income from the team. Citing additional precedent, the Johnson court held that the corporation did not meaningfully control Mr. Johnson’s services as a basketball player, nor did the Warriors have notice that its player was contractually affiliated with the entity. For those reasons, passing the player’s salary through the foreign corporation did not shelter Mr. Johnson from employment tax. The Johnson court stated two tests, both of which must be met:
“For a corporation, not its service-provider employee, to be the controller of income, two elements must be found: (1) the individual providing the services must be an employee of the corporation whom the corporation can direct in a meaningful sense; and, (2) 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.”
The holding in Fleischer is more narrow, but draws on Johnson as precedent. The relevant facts in the court’s determination were that Mr. Fleisher did not form his corporate entity until after he personally contracted with LPL and MassMutual, and then did not advise LPL and MassMutual that he was contracted to the corporation. The court held that, as a result, the taxpayer failed the contract test. The court did not need to reach the control test. It follows that had the taxpayer informed LPL and MassMutual that he was an employee of his corporation serving at its direction, both tests could have been met and the pass through could have been recognized.
In a practical sense, how should things be done correctly?
First of all, as a matter of the tax law pertaining to when the entity may realize the income instead of the service-provider, payors should be notified when an advisor forms and becomes an employee of a business entity.
Second, as a matter of FINRA compliance regarding commission-based revenues, advisors need to remember they cannot avoid realizing commission revenues at the service-provider level. Revenue received as fees may be recognized at the entity level, but only if the contract and control tests are met.
Third, advisors can avoid uncertainty and ill consequence by seeking expert advice prior to executing entity, cash flow, and tax structures for their business.
To be comprehensive, note that the Fleischer case did not address strategies for sheltering commission revenue realized at the service-provider level, nor did it clarify the differentiation between cash flow and tax accounting for those advisors who affiliate with a broker dealer that remits commissions to an entity under a joint rep code.
Lessons to Be Learned
This case makes no change to industry regulation or tax law. There are lessons to be learned, however, from the result of the proceedings:
1. Structuring your financial services business as a corporation or LLC involves weaving together:
• the organic law controlling business entities in the forum state;
• the employment law of the forum state;
• the federal tax code;
• both FINRA and SEC regulations; and
• acceptable accounting practices.
2. Doing so correctly results in a successful, enduring enterprise.
3. The total return to owners must strike a fair balance between compensation subject to employment tax and compensation exempt from employment tax – an issue raised by but not decided by the Fleischer court.
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We realize that cases like this often create more questions that can easily be answered in a short narrative. We’re here to help. Please give us a call at 800-934-3303.