Don’t make the same mistake with your legal entity.

A recent ruling by a Federal Tax Court could have serious implications for financial advisors – take steps now to avoid a similar finding against your practice.

The scenario

Ryan Fleischer was a financial advisor who had entered, as an individual advisor, into a representative agreement with Linsco/Private Ledger Financial Services, (LPL), and MassMutual Financial Group as an independent contractor.  Shortly after his agreements with LPL and MassMutual, Fleischer formed an S corporation known as “FWP.”  Fleischer was the sole shareholder of this entity and it appears he was the sole employee as well.   Fleischer had an employment contract with FWP, which listed his duties as those customarily engaged in by financial advisors.

From 2009 through 2011, Fleischer paid himself a very low annual salary within FWP (approximately $35,000 in 2010 and 2011).  In tax years 2010 and 2011, Fleischer reported “K-1” passive income via the S Corp of $147,640 and $115,330 respectively. Fleischer paid little or no self-employment taxes for those tax years in proportion to the total compensation received through his individual agreements with the broker dealers.

The IRS audited Fleischer and FWP, and found several deficiencies.  Fleischer appealed, arguing that it was the legal entity that received the income and he, as an employee of the entity, was entitled to be paid a reasonable salary for work that was performed as well as distributions on the remaining profit. The Court disagreed.

The Court’s perspective

The Tax Court performed an analysis weighing two competing legal principles.  The first was “fruit and tree” or assignment of income, that holds that the true owner of income is the one who actually earns it.  The competing principal is the long-standing notion that a properly formed legal entity is a unique and separate “person under the law.”

The Court analyzed the facts of the case with one general question in mind: “Who controls the earning of the income?”  The Court held that two basic elements must be present, based upon prior rulings in similar cases.  The first element must demonstrate that the person providing the services be employed by and under the control of the corporation.  The second element is that there must exist some evidence (preferably contractual) demonstrating the corporation’s controlling position over the employee and the income.

The Court seemed to hold that any scenario lacking these two elements amounts to a bare assignment of income, thus preventing the advisor from characterizing his compensation within the entity as a combination of employee wages and K-1 distributions.  The Court did not accept Fleischer’s argument that the SEC/FINRA laws concerning payment of compensation (notably transaction-based compensation) prohibited the “check” being paid directly to the legal entity from the broker dealer. Instead it ruled that the advisor has the ability to register and license his legal entity as a broker dealer.

What this means to the industry

The basic structure Ryan Fleischer employed is extremely common in the industry.  This case’s application directly to financial advisors, however, is the first time these “assignment of income” principles were applied by the Tax Court.  Whether this could result in increased enforcement is unknown at this point, but this case does provide legal precedent that an auditor and/or future tax courts may follow.  What is known is that the failure on the part of an advisor to properly analyze, structure and protect their practice through proper agreements, bookkeeping and compensation arrangements could result in substantial adverse tax consequences.

What the ruling means to you

You can and should employ best practices to protect your practice from an attack of this nature. You need to consider many factors to determine if a legal entity is right for you. EmployShare has consulted with advisors on this very issue for many years and is able to work with your legal counsel and tax professional to analyze whether your existing structure adheres to the principles of this case – or what steps you may need to take to shore up your foundation against such an attack.

Questions?  Contact us at EmployShare.  We’re here to help.

Jeffery A. Bovalino, J.D.

Business Development Consultant & Team Player – Whatever It Takes

EmployShare, Inc.
Phone: 724-843-3094
Mobile: 330-974-8670
Fax: 412-774-1548