“Too clever is dumb” quipped the humorous poet Ogden Nash. He wasn’t wrong. A couple of named Hacker found that out the hard way, and by that we mean the expensive way.
It has been about seven or eight years since we last had an S Corp Reasonable Compensation challenge come out of the tax courts. In the author’s humble opinion, that’s because there is very little left for taxpayers to test out in court. Most issues have already come up. Precedents have been established.
That didn’t stop the owners of Blossom Day Care (Barry Hacker and Celeste Hacker – The Hackers) from spending a decade and (likely) tens of thousands of dollars trying to subvert Revenue Ruling 74-44 and a 20-year-old plus precedent that classifies corporate officers as employees.
A little background on the Blossom Day Care case:
- Blossom Day Care was an S Corp formed in 1986; wholly owned by the Hackers.
- In 2002, Mr. and Mrs. Hacker thought it clever to form a second S Corp: Hacker Corp., to provide “property and service management” to Blossom Day Care. Think of this as an employee leasing arrangement. They leased themselves back to Blossom.
- Hacker worked 50-60 hours per week and was responsible for: Blossom Day Care’s bank accounts, daily deposits, and payroll for its 90 employees. In addition, Mr. Hacker performed paperwork, front office duties, and classroom teaching, supervised other teachers, and handled purchasing, food delivery, maintenance, and custodial duties if needed.
- Hacker worked 50-60 hours per week and was the GM/CEO responsible for: Blossom Day Care’s curriculum, overseeing and supervising Blossom Day Care’s 90 employees, including hiring, firing, and managing Blossom Day Care’s six daycare directors. Mrs. Hacker performed paperwork, front office duties, and classroom teaching, supervised other teachers, and handled purchasing, food delivery, maintenance, and custodial duties if needed.
- The years audited by the IRS: 2005 – 2008 [ouch 4 years!]
In the years in question, Blossom Day Care paid no ($0.00) monetary compensation to either Hacker*. Instead, Blossom Day Care and the Hacker Corp engaged in the following financial transactions:
- 2005: Blossom Day Care paid $342,650 in management fees to Hacker Corp. Hacker Corp paid $73,848 to The Hackers.
- 2006: Blossom Day Care paid $378,484 in management fees to Hacker Corp. Hacker Corp paid $40,000 to The Hackers.
- 2007: Blossom Day Care paid $0 to Hacker Corp. Hacker Corp paid $53,847 to The Hackers.
- 2008: Blossom Day Care paid $204,514 in management fees to Hacker Corp. Hacker Corp paid $58,462 to The Hackers.
The Hackers claimed that they were not employees of Blossom Day Care, but instead employees of Hacker Corp, providing services and management to Blossom Day Care under an agreement between the two companies. They argued that the compensation paid to them by Hacker Corp should meet the Reasonable Compensation requirements for the services they provided to Blossom Day Care, or at the very least be applied to the Reasonable Compensation requirements of Blossom Day Care.
They lost. The court found that they were employees of Blossom Day Care, citing Revenue Ruling 74- 44 and precedent-setting cases such as Veterinary Surgical Consultants, P.C. vs. Commissioner 2001 and Joseph M. Grey Public Accountant, P.C. 2002. The primary reason for this finding: No written agreement. Nothing was written down to set forth the purpose of the management fees or anything else.
The Hackers were ordered to pay themselves Reasonable Compensation for the services they provided to Blossom Day Care as follows: [2005=$209,200; 2006=$220,210; 2007=$231,800; 2008=$244,000]
Unfortunately, the court documents provide no information on how these compensation amounts were determined. The Hackers asserted that, at the very least, the amount of compensation they were paid via Hacker Corp [2005=$73,848; 2006=$40,000; 2007=$53,847; 2008=$58,462] should be applied to the compensation amounts above. They lost on this as well. The primary reason: No written agreement.
In the end The Hackers were paid compensation from both companies. Their seemingly clever gambit proved a losing strategy. They thought they could avoid paying Reasonable Compensation by shifting the burden from one corporation to another and then under-paying themselves. By doing that, they ended up paying significantly more in payroll taxes than they would have by simply paying themselves Reasonable Compensation via Blossom Day Care. Never mind the penalties and thousands of dollars in legal fees.
So, what are the take-a-ways from the Blossom Day Care case? There are four of note:
- Generally, it makes no sense from a Reasonable Compensation standpoint to set up a second company to provide employee leasing services to only one other company. However, if multiple S Corps are involved then it very well may make sense. Please see: STRATEGIES FOR REASONABLE COMPENSATION AND MULTIPLES CORPS
- Shifting responsibility from one corporation to another does not alleviate the IRS’s requirement to pay the shareholder-employees Reasonable Compensation for the services provided. Both Mr. and Mrs. Hacker wore multiple hats for Blossom Day Care, performing services ranging from maintenance and janitorial duties to overall direction and management of the company, and everything in between. Considering only the last year of the audit, 2008, splitting the compensation paid to The Hackers by Hacker Corp ($58,462) evenly between Mr. and Mrs. Hacker amounts to $29,231 each, an unreasonably low amount for the services provided. A simple stress test would have uncovered this and possibly saved the Hackers tens of thousands of dollars in taxes, penalties, interest, and attorney’s fees. Please see: HOW TO STRESS TEST A REASONABLE COMPENSATION FIGURE
- Not all reasonable comp challenges go to tax court. A 2017 IRS internal memo, when followed, keeps just this type of case out of tax court. If this memo had been out when the Blossom daycare case began, and the examiner and appeals agent followed the memos direction, the Blossom daycare case would have never been allowed to proceed to Tax Court, but instead, The Hackers would have been required to pay up and sue for a refund in federal court. Please see: IRS LAYS OUT STEPS TO KEEP REASONABLE COMP CHALLENGES OUT OF TAX COURT
- Write it down! Written agreements protect you. A management agreement should spell out that the fees are to cover payroll, payroll taxes, and any fringe benefits. With that in mind, looking at 2005, Blossom Day Care paid Hacker Corp $342,650 for management fees that were to cover payroll, it does not make sense that the Hackers’ Reasonable Compensation would be only $73,848.
What did this misguided strategy cost The Hackers?
- Accuracy related penalties for negligence [IRC 6662(a)]: $70,236.63
- Failure to deposit tax penalties [IRC 6656]: $ $6,417.66
- Employment taxes [941 and 940]: $351,183.20
- Grand Total Payroll Taxes + Penalties: $427,837.49
*The Hackers did receive compensation from Blossom Day Care of $100,000 in 2006, however, it was not cash, it was other things of value. Likely reclassified as compensation during the audit process.