Tax Court Did Not Have Jurisdiction Over S Corporation's Employment Tax Liability

(Parker Tax Publishing August 2018)

The Eighth Circuit affirmed the dismissal of an S corporation's Tax Court petition challenging an IRS determination that the compensation paid to the sole owner and officer of the S corporation was unreasonable. The Eighth Circuit found that there was no actual controversy under Code Sec. 7436 as to the determination of the S corporation shareholder's employment status for Federal Insurance Contribution Act (FICA) tax purposes and thus Code Sec. 7436 did not come into play. Azarian v. Comm'r, 2018 PTC 229 (8th Cir. 2018).

Martin Azarian is an attorney and the sole owner and officer of Martin S. Azarian, P.A., an S corporation. During 2012 through 2014, Azarian performed services for the S corporation, which paid him about $32,500 to $40,000 in wages subject to Federal Insurance Contributions Act (FICA) tax. Azarian also received some larger amounts which were reported as dividends.

The IRS audited the S corporation. After taking into account the nature and condition of the company, Azarian's role in operations, and similar firms' compensation of employees, the IRS concluded that reasonable compensation for Azarian's services was $125,000 per year and that some of the dividends paid to Azarian were, in substance, wages. Having determined that the S corporation owed over $38,000 in FICA tax and $7,000 in penalties, the IRS sent the S corporation a Summary of Employment Tax Examination and an Employment Tax Examination Changes Report for each year.

The S corporation petitioned the Tax Court, arguing that Azarian's wages were reasonable compensation (or, at least, that reasonable compensation was less than $125,000). The IRS moved to dismiss for lack of jurisdiction and the Tax Court agreed. The S corporation appealed to the Eighth Circuit.

Under Code Sec. 7436(a)(1), the Tax Court has jurisdiction over a petition if there is an actual controversy involving a determination that an individual performing services is an employee for FICA tax purposes. Thus, the issue was whether there was an actual controversy involving a determination that Azarian was an employee for FICA tax purposes.

The S corporation argued that the IRS's determination that some payments to Azarian were wages, not dividends, was a determination as to those payments that Azarian was an employee. The S corporation cited Charlotte's Office Boutique, Inc. v. Comm'r, 121 T.C. 89 (2003), aff'd 425 F.3d 1203 (9th Cir. 2005), a case in which an employer paid wages and royalties, and the Tax Court held it had jurisdiction to decide whether some of the royalties were wages. The S corporation also relied on SECC Corp. v. Comm'r, 142 T.C. 225 (2014). In that case, the Tax Court held it had jurisdiction where the IRS sent a letter to an employer stating that some nonwage payments were wages; the Tax Court found that the letter was a determination as to employee status. The S corporation further argued that ruling for the IRS would lead to an absurd result and punish partial compliance. According to the S corporation, if it had reported no wages, there would be Tax Court jurisdiction; but because it reported some wages, there was no jurisdiction. Thus, the S corporation argued, if it had reported just one dollar of yearly wages, there would be no jurisdiction, and it was absurd that such a small amount could determine jurisdiction.

The Eighth Circuit affirmed the Tax Court's dismissal. The Eighth Circuit found that even if there was an actual controversy, it did not involve a determination that Azarian was an employee for FICA tax purposes as required under Code Sec. 7436(a)(1). The court determined that by reporting wages to Azarian each year, the S corporation claimed Azarian was an employee, so the IRS did not make a determination on that issue. Instead, the IRS relied on the S corporation's classification.

The IRS's determination that some payments were wages did not turn solely on Azarian's status as an employee, according to the court. The court explained that the term "wages" refers to all remuneration for employment, which generally includes any service performed by an employee. The court found that the IRS examined only the amount of remuneration for Azarian's services, and the only determination it made was that some of the payments reported as dividends were really remuneration for his services. The court concluded that such a determination did not give the Tax Court jurisdiction.

The court also rejected the S corporation's reliance on Charlotte's Office and SECC Corp. The court noted that in Charlotte's Office, the Tax Court relied on the fact that the IRS's notice to the taxpayer listed determinations that the owner and other workers were to be classified as employees for FICA tax purposes, and the Ninth Circuit agreed that jurisdiction was properly invoked. The Eighth Circuit distinguished the case before it by noting that the IRS never made a determination about the classification of any worker. Likewise, the Eighth Circuit found that SECC Corp. dealt with worker classification disputes, while no determination in this case concerned worker classification.

Finally, the Eighth Circuit found that ruling for the IRS would not lead to an absurd result as the S corporation contended. The court explained that Code Sec. 7436(a)(1) grants jurisdiction based on the type of controversy, not the relative level of compliance. In the court's view, if the S corporation had never claimed Azarian as an employee, the IRS would have determined he was, and a controversy involving Azarian's status would exist. The court also found no merit to the argument that just one dollar of wages should preclude jurisdiction. By reporting wages in any amount, the S corporation claimed Azarian as an employee, the court explained.

For a discussion of the Tax Court's review of IRS determinations of employment status, see Parker Tax ¶210,115.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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