An LPL Financial advisor was hit with a surprising blow late last year when a United States tax court sided with the Internal Revenue Service, which argued he could not funnel his income through the entity under which he operated—an S corporation. He would have to pay self-employment taxes on the corporation's profits, which flowed through to him as the sole shareholder.
The case brings a new level of confusion into the independent broker/dealer space, which has long advised reps to set up their business using the corporate structure. After all, many reps are often small businesses with employees. Is it just bad tax law? Or, have reps been sold a bill of goods?
“This is very common practice with tens of thousands of investment advisors that structure this in this manner, and that's why it's so detrimental,” said Ryan Fleischer, the Omaha, Neb. based registered rep involved in the case. “It’s really an unequal playing field. This whole thing to me is totally government overreach.”
Fleischer registered with his b/d, LPL, in 2006, then, five days later, incorporated Fleischer Wealth Plan (FWP) and elected S corp status, as his business attorney. CPA advised him and he was the sole shareholder of the firm. In accordance with the rules for S corps, he paid himself an annual salary.
Under the S corp structure, profits and losses can pass through to the shareholders’ tax returns. The business itself is not taxed; the shareholders are taxed on their share of the profits, but those profits are not taxed for Medicare and Social Security purposes. If the shareholder is also the employee, they must pay themselves a “reasonable compensation” from the revenue before profits are distributed, and payroll tax obligations must be met. In 2010, according to court documents, Fleischer paid himself a salary of $34,856, and reported business income from the S corp of $147,642, with no payment of self-employment tax.
His LPL contract, as well as one he signed with MassMutual to sell annuities, were with himself as an individual, with no mention of his S corp, according to court documents. By law, b/d's cannot pay an entity, unless that entity formally registers as its own licensed broker/dealer.
The court claimed that Fleischer failed the “Johnson test,” which is a test to determine who controls the earning of the income. There are two requirements: “the individual providing the services must be an employee of the corporation whom the corporation can direct and control 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.”
Since Fleischer’s S corp didn’t have a contract with LPL, the court determined he failed the test.
“The IRS's argument is, ‘Your corporation is null and void. You as an individual are the one who holds that license, and you're the one that bears the fruit, so you're the one that makes the income, not the corporation, per se,’” Fleischer said.
The judge ordered that Fleischer owed nearly $42,000 in federal income taxes for the three years he was audited. He has until March 29 to appeal the decision.
“You're talking about tens of thousands of revenue because the tax is out the window every year for an average advisor out there,” Fleischer said. “I have a lot of friends in this industry too; that’s going to be extremely impactful for them. They’re going to have to go through this mess, this nightmare of winding down their corporation and having to change everything.”
That said, the decision was a tax court memo, so it has no precedential value, said Howard Kaplan, Fleischer’s attorney.
A Cautionary Tale
This case presents a cautionary tale for other independent reps who set up their businesses using an S corp. It is a widespread belief—perpetrated by IBDs—that you can serve as individual rep or agent of a firm and have that income characterized as corporate income, said Brian Hamburger, president and CEO of MarketCounsel.
“I’ve seen for far too long—well over a decade—b/d's and insurance companies urging people to set up an S corp or a limited liability company,” Hamburger said. “The risk of something like this finding its way to enforcement and a dispute with the IRS is pretty small, so I could understand why a CPA would say, ‘Here’s how we’re going to do it,’ because so many other people do it this way. It doesn’t necessarily make it right. This is not crowd-based regulation.”
Fleischer said he reached out to an LPL representative for help early on and told him "let's put this fire out before it gets bigger." He says the LPL representative told him "The IRS doesn't have a leg to stand on" and that the structure for reps was "commonplace." "Why exactly they're picking on you, I don't know," he says he was told.
An LPL spokesman declined to comment.
Fleischer paid all the deficiencies, and the IRS never considered any penalties against him.
“I don’t think people in your industry are doing anything below board here,” said Christian Kenefick, principal of accounting firm, Kenefick & Co. “I think most people thought they weren’t breaking any rules and that this was legitimate. I kind of think it is.”
“There’s nothing inherently bad about having the S corp or having the LLC,” Hamburger said. “What becomes a problem is when they try to use these entities as a way to recharacterize the income and pay less tax.”
The case also points to a confusing tax code, one that, perhaps, hasn’t evolved along with the securities industry.
Kenefick believes the Johnson test, in particular, is bad tax law. Upper level courts have rejected the test as overly rigid, and case law looks at all the facts and circumstances.
“I think this [S corp] arrangement could pass muster. I think the fact the judge used the Johnson test here, that just doomed Fleischer to failure. I don’t think it’s a good test.”
Advisors in similar situations shouldn’t necessarily be worried, he said.
“I just think that had this thing been better presented to the judge, you might have gotten a different result,” Kenefick said.
Kaplan, Fleischer’s lawyer, attributes the surprising decision to the court not fully understanding the industry.
“It seems to me that the court may have been a little confused with respect to the way the securities industry works and the unique way it works with respect to the relationship between a b/d and financial representatives, such as Ryan Fleischer,” said Kaplan.
“They say, ‘Well we notice that Mr. Fleischer entered into this agreement with LPL, who was the b/d before the corporation was formed.’ Well, so what? Does that truly make any difference? Can it really be that simple that, ‘OK, I can get around this by forming the corporation first and by mentioning Fleischer Wealth Plan in the contract?’ That’s true form over substance," Kaplan said.
At the same time, independent reps are operating under different sets of laws and that can cause confusion.
“We have to operate under financial law, whether it be FINRA or the SEC or whatever the case may be,” Fleischer said. “But you also have to operate under IRS law as well. IRS law trumps everything.”
Despite the confusion, lawyers, CPAs and consultants agree that registered reps should think twice about structuring their business as an S corp, given Fleischer’s outcome.
“I don’t know why these registered reps are telling each other to do something that obviously does not work or is guaranteeing an audit,” said Chris Cooper, owner of Chris & Cooper & Co., a San Diego-based licensed professional fiduciary and former registered rep. “You are inviting the IRS to your office. This is just the beginning of a very big landslide.”