Reasonable-wage adjustment is not worker reclassification

Plain-English summary

Chief Counsel advised that an employment tax audit did not involve worker classification when a corporation had consistently treated its sole officer as an employee. In some years the corporation paid reported wages directly, and in others a professional employer organization paid and reported wages under its own employer identification number. The IRS proposed to treat part of the officer's separately reported shareholder distributions as additional wages because the reported compensation was unreasonably low. That dispute concerned the amount of wages, not whether the officer was an employee. Chief Counsel therefore advised assessing the additional employment taxes under section 6201 rather than treating the case as a section 7436 worker-classification determination.

Ruling snapshot

• Question: Does recharacterizing an employee-officer's distributions as additional wages create a worker-classification case when wages were already reported directly or through a professional employer organization?
• Outcome: advice given
• Key authorities: IRC §§ 3121(d)(1), 6201, 7436; Treas. Reg. § 31.3121(d)-1(b)

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201735021
           Release Date: 9/1/2017
           CC:TEGE:EOEG:ET1:LPAzmon                      Third Party Communication: None
           POSTN-116084-17                               Date of Communication: Not Applicable

 UILC:     3121.10-00, 7436.01-03, 6201.00-00, 3121.04-15

  date:    May 18, 2017

     to:   Jeremy H. Fetter
           Area Counsel
           CC:TEGEDC:GCDAL
           4050 Alpha Road, 13th Floor
           MC 2000 NDAL
           Dallas, Texas 75244
           (TEGE Division Counsel)

  from:    Paul Carlino
           Branch Chief, Employment Tax Branch 1 (Exempt Organizations/Employment
           Tax/Government Entities)
           (TEGE Associate Chief Counsel)


subject:   Whether an Employment Tax Audit Concerns Worker Classification

           This Chief Counsel Advice responds to your request for assistance dated May 18, 2017.
           This advice may not be used or cited as precedent.

           QUESTIONS

           1. Whether the employment tax audit of                               (the Taxpayer)
           involves worker classification for the taxable periods and taxable years at issue when
           the Taxpayer used the Services of a professional employer organization (PEO) to pay
           compensation to its sole corporate officer, and the Service has determined that the
           Taxpayer is liable for additional employment taxes1 due to the Service’s
           recharacterization of payments made by the Taxpayer to its corporate officer as wages?

           CONCLUSION

           1
             For purposes of this memo, employment taxes means the Federal Insurance Contributions Act (FICA)
           tax (under I.R.C. §§ 3101-3128), the Federal Unemployment Tax Act (FUTA) tax (under I.R.C. §§ 3301-
           3311), and the collection of income tax at source on wages (under I.R.C. §§ 3401-3406).

POSTN-116084-17                                      2


    1. The employment tax audit does not involve worker classification for the taxable
       periods and years at issue because the Taxpayer treated its corporate officer as
       an employee, either by withholding employment taxes from wages paid to the
       corporate officer or pursuant to the terms of the contractual agreement between
       the Taxpayer and the PEO.

                                                 FACTS

The Taxpayer is currently under an employment tax audit for each of the four taxable
quarters included in the -------------------- taxable years, as well as the taxable years
ending -------------------------------------------------------------

On --------------------, the Taxpayer entered into a contract entitled “CLIENT SERVICE
AGREEMENT” with ----------------------------------------------------------entire workforce, including
its corporate officer (Assigned Employees).2 Under the terms of the contract, the
Taxpayer was required to “supervise all Assigned Employees and set their times, wages,
and other terms and conditions of employment”. The contract further provides that “control
over the day-to-day job duties of Assigned Employees and over the job site at which, or
from which, the Assigned Employees perform their duties is solely and exclusively
assigned and assumed by” the Taxpayer.

The duties of the PEO under the contract include: 1) administering Taxpayer payroll,
designated benefits, and personnel policies and procedures related to the Assigned
Employees; 2) providing human resource administration and payroll administration with
respect to the Assigned Employees; 3) furnishing and keeping workers compensation
insurance covering the Assigned Employees; 4) processing and paying wages from its
own accounts to the Assigned Employees based on the hours and wage information
reported by the Taxpayer; and 5) filing all employment tax returns (i.e., Form 940,
Employer's Annual Federal Unemployment (FUTA) Tax Return, and Form 941,
Employer's Quarterly Federal Tax Return) with the Government and furnishing information
returns to the workers.

The PEO’s duties under the contract, however, were limited to only those wages that were
reported and verified by the Taxpayer to the PEO for each pay period. In the event the
Taxpayer paid wages to the Assigned Employees that were not reported to the PEO, the
contract provides that the Taxpayer will be “solely responsible for damages of any nature
out of the Client’s failure to report payment of unreported wages to any of the Assigned
Employees”.



2
  The third party was part of an industry that, among other things, markets its ability to assist employers
with ministerial tasks associated with the reporting and payment of employment taxes. A professional
employer organization (PEO) is the name commonly used to reference entities in this industry and we will
reference the third party as such for the duration of this memo.

POSTN-116084-17                              3

For the taxable quarters included in the ------ taxable year, as well as the -------taxable
year, the Taxpayer’s corporate officer received wage payments through the PEO.
These wages were reported on a Form W-2, Wage and Tax Statement, issued by the
PEO (under the PEO’s EIN) and included on Forms 940 and 941 filed under the PEO’s
EIN. During this same year, the corporate officer also received distributions directly
from the Taxpayer reported on a Schedule K-1 (Form 1120S), Shareholder’s Share of
Income, Deductions, Credits, etc., under the Taxpayer’s EIN. The distributions were not
reported or verified by the Taxpayer to the PEO as wages so were not included on the
employment tax returns filed under the PEO EIN.

For the taxable quarters included in the ------ taxable year, as well as the ------- taxable
year, the Taxpayer did not contract with the PEO. Instead, the Taxpayer withheld
employment taxes from wages it paid to its common law employees and corporate
officer. The Taxpayer reported these wage payments on Forms 940 and 941, and
issued Forms W-2 to its common law employees and its corporate officer. During the ---
------- taxable year, the corporate officer also received distributions directly from the
Taxpayer reported on a Schedule K-1 (Form 1120S) under the Taxpayer’s EIN.

During the audit, the Service determined that the wages reported for the --------------------
tax years with respect to its corporate officer are unreasonably low. Thus, the Service is
proposing to recharacterize portions of the distributions paid by the Taxpayer directly to
the corporate officer as wages, and is proposing to assess additional employment tax
liabilities on such wages.

LAW AND ANALYSIS

For employment taxes to apply, an employer-employee relationship must exist. An
officer of a corporation who performs more than minor services and receives
remuneration for such services is a considered an employee. I.R.C. § 3121(d)(1);
Treas. Reg. § 31.3121(d)-1(b), 31.3306(i)-1(e) 31.3401(c)-1(f). See Joseph M. Grey
Pub. Accountant, P.C. v. Commissioner, 119 T.C. 121, 126 (2002), aff’d, 93 F. App’x
473 (3d Cir. 2004).

When an employer has provided additional compensation to an employee, but has not
subjected that compensation to withholding because it believes an exception from the
definition of “wages” or of “employment” applies, the Service will assess employment
taxes under Code section 6201 against the portion of the payment that is being
recharacterized as wages.

In contrast, a worker classification issue arises when a service recipient (employer) has
classified an individual performing service as an independent contractor (or some other
non-employee designation) and has not withheld employment taxes from compensation
paid to the individual. Code section 7436(a) provides the Tax Court with jurisdiction to
review certain employment tax determinations made by the Service in a worker

POSTN-116084-17                                     4

classification case and the proper amount of employment tax under such
determinations.3

In the present case, there is no dispute that at all times during the taxable periods and
taxable years at issue, the Taxpayer’s corporate officer performed more than minor
services for the Taxpayer, received compensation for such services, and was an
employee of the Taxpayer pursuant to Code section 3121(d)(1).

For ------, the Taxpayer treated the corporate officer as an employee, evidenced by its
issuance of a Form W-2 to the corporate officer reporting wage compensation, as well
as inclusion of such wage compensation on the Forms 940 and 941 it filed with the
Service. Thus, the audit of the ------- taxable periods and taxable year with respect to
the corporate officer is not properly considered worker reclassification.4 The Service
should assess employment taxes for ------- under section 6201 against the portion of the
payment that is being recharacterized as wages.

The position taken in this memorandum, i.e. that the audit of the ------ taxable periods
and taxable year does not involve worker classification, is consistent with the Tax
Court’s Orders in Martin S. Azarian. P.A. v. Commissioner, Docket No. 28957-15 (Azarian)
and Patricia Arroyo DDS. Corp., Alex Mansilla and Mercedes P. Arroyo v. Commissioner,
Docket No. 5874-15 (Arroyo). These cases were dismissed by the Court for lack of
jurisdiction on the basis that the Service had not made any determinations for purposes
of section 7436 when the corporations treated the officers as employees by issuing
them a Form W-2 reporting wages and did not claim entitlement to Section 530 relief.
The Court stated that section 7436 only confers jurisdiction on the Court to determine
the correct amount of employment tax when the Service makes a worker classification
determination or a determination that a taxpayer was not entitled to Section 530 relief,
not when the Service concludes that a taxpayer underreported reasonable wage
compensation.

For ------, the corporate officer also received a Form W-2 reporting wages for services
rendered to the Taxpayer, and the wages were also reported on Forms 940 and 941,
however, the Forms were filed under the PEO’s EIN and not the Taxpayer’s. The use of
a PEO by the Taxpayer as a conduit for paying wages to its corporate officer, however,

3
  Specifically, the Court has jurisdiction to review determinations that: (1) individuals are employees for
purposes of employment taxes under subtitle C of the Code (i.e., requiring reclassification of a
nonemployee to employee status), or (2) the person for whom services are performed is not entitled to
relief under Section 530 of the Revenue Act of 1978 (Section 530). The Tax Court has held that it has
jurisdiction under section 7436 when four required elements are present: (1) an examination in
connection with the audit of any person; (2) a determination by the Secretary that "one or more individuals
performing services for such person are employees of such person for purposes of subtitle C, or such
person is not entitled to the treatment under subsection (a) of Section 530 of the Revenue Act of 1978
with respect to such individual;"(3) an "actual controversy" involving the determination as part of an
examination; and (4) the filing of an appropriate pleading in the Tax Court. American Airlines, Inc. v.
Commissioner, 144 T.C. 24, 32 (2015). See also, SECC Corp. v. Commissioner, 142 T.C. 225 (2014).
4
  The Taxpayer has not claimed entitlement to Section 530 relief.

POSTN-116084-17                              5

does not affect whether the audit for ------- with respect to the distribution made by the
Taxpayer to its corporate officer is considered a worker classification audit. The
contractual arrangement demonstrates that no underlying issue of employment tax
classification status exists because the Taxpayer specifically contracted with the PEO to
fulfill its obligations as an employer with respect to the treatment of the corporate officer
as its employee. Thus, the dispute is not whether the corporate officer performed more
than minor services for the Taxpayer and received compensation for those services,
i.e., whether the corporate officer was an employee. Rather, the dispute is limited to the
amount of compensation required to be treated as "wages" paid to the corporate officer
– including distributions paid directly by the Taxpayer that did not flow through the PEO

- for employment tax purposes, i.e. whether the additional payments constitute wages,
rather than distributions.

Consistent with the Tax Court’s reasoning in Azarian and Arroyo, the Service has not
made a worker classification determination for the ------ taxable periods and taxable
year with regard to the corporate officer when the Service concludes that the Taxpayer
underreported reasonable wage compensation. Therefore, the Service should also
assess employment taxes for ------- under section 6201 against the portion of the
payment that is being recharacterized as wages.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 317-6798 if you have any further questions.