Failing To Take A Paycheck

I am looking at a case involving numerous issues. The one that caught my attention was imputed wage income from a controlled company in the following amounts:

2004                    $198,740

2005                    $209,200

2006                    $220,210

2007                    $231,800

2008                    $244,000

Imputed wage income means that someone should have received a paycheck but did not.

Perhaps they used the company to pay personal expenses, I think to myself, and the IRS is treating those expenses as additional W-2 income. Then I see that the IRS is also assessing constructive dividends in the following amounts:

2004                    $594,170

2005                    $446,782

2006                    $375,246

2007                    $327,503

2008                    $319,854 

The constructive dividends would be those personal expenses.

What happened here?

Let’s look at the Hacker case.

Barry and Celeste Hacker owned and were the sole shareholders of Blossom Day Care Centers, Inc., an Oklahoma corporation that operated daycare centers throughout Tulsa. Mr. Hacker also worked as an electrician, and the two were also the sole shareholders of another company - Hacker Corp (HC).

The Hackers were Blossom’s only corporate officers. Mrs. Hacker oversaw the workforce and directed the curriculum, for example, and Mr. Hacker was responsible for accounting and finance functions.

Got it. She sounds like the president of the company, and he sounds like the treasurer.

For the years at issue, the Hackers did not take a paycheck from Blossom.

COMMENT: In isolation, this does not have to be fatal.

Rather than pay the Hackers directly, Blossom made payments to HC, which in turn paid wages to the Hackers.

This strikes me as odd. Whereas it is not unusual to select one company out of several (related companies) to be a common paymaster, generally ALL payroll is paid through the paymaster. That is not what happened here. Blossom paid its employees directly, except for Mr. and Mrs. Hacker.

I am trying to put my finger on why I would do this. I see that Blossom is a C corporation (meaning it pays its own tax), whereas HC is an S corporation (meaning its income is included on its shareholders’ tax return). Maybe they were doing FICA arbitrage. Maybe they did not want anyone at Blossom to see how much they made.  Maybe they were misadvised.

Meanwhile, the audit was going south. Here are few issues the IRS identified:

(1)  The Hackers used Blossom credit cards to pay for personal expenses, including jewelry, vacations, and other luxury items. The kids got on board too, although they were not Blossom employees.

(2)  HC paid for vehicles it did not own used by employees it did not have. We saw a Lexus, Hummer, BMW, and Cadillac Escalade.

(3) Blossom hired a CPA in 2007 to prepare tax returns. The Hackers gave him access to the bank statements but failed to provide information about undeposited cash payments received from Blossom parents.

NOTE: Folks, you NEVER want to have “undeposited” business income. This is an indicium of fraud, and you do not want to be in that neighborhood.

(4)  The Hackers also gave the CPA the credit card statements, but they made no effort to identify what was business and what was family and personal. The CPA did what he could, separating the obvious into a “Note Receivable Officer” account. The Hackers – zero surprise at this point in the story - made no effort to repay the “Receivable” to Blossom.  

(5) Blossom paid for a family member’s wedding. Mr. Hacker called it a Blossom-oriented “celebration.”  

(6) In that vein, the various trips to the Bahamas, Europe, Hawaii, Las Vegas, and New Orleans were also business- related, as they allowed the family to “not be distracted” as they pursued the sacred work of Blossom.

There commonly is a certain amount of give and take during an audit. Not every expense may be perfectly documented. A disbursement might be coded to the wrong account. The company may not have charged someone for personal use of a company-owned vehicle. It happens. What you do not want to do, however, is keep piling on. If you do – and I have seen it happen – the IRS will stop believing you.

The IRS stopped believing the Hackers.

Frankly, so did I.

The difference is, the IRS can retaliate.

How?

Easy.

The Hackers were officers of Blossom.

Did you know that all corporate officers are deemed to be employees for payroll tax purposes? The IRS opened a worker classification audit, found them to be statutory employees, and then went looking for compensation.

COMMENT: Well, that big “Note Receivable Officer” is now low hanging fruit, isn’t it?

Whoa, said the Hackers. There is a management agreement. Blossom pays HC and HC pays us.

OK, said the IRS: show us the management agreement.

There was not one, of course.

These are related companies, the Hackers replied. This is not the same as P&G or Alphabet or Tesla. Our arrangements are more informal.

Remember what I said above?

The IRS will stop believing you.

Petitioner has submitted no evidence of a management agreement, either written or oral, with Hacker Corp. Likewise, petitioner has submitted no evidence, written or otherwise, as to a service agreement directing the Hackers to perform substantial services on behalf of Hacker Corp to benefit petitioner, or even a service or employment agreement between the Hackers and Hacker Corp.”

Bam! The IRS imputed wage income to the Hackers.

How bad could it be, you ask. The worst is the difference between what Blossom should have paid and what Hacker Corp actually paid, right?

Here is the Court:

Petitioner’s arguments are misguided in that wages paid by Hacker Corp do not offset reasonable compensation requirements for the services provided by petitioner’s corporate officers to petitioner.”

Can it go farther south?

Respondent also determined that petitioner is liable for employment taxes, penalties under section 6656 for failure to deposit tax, and accuracy-elated penalties under section 6662(a) for negligence.”

How much in penalties are we talking about?

2005                    $17,817

2006                    $18,707

2007                    $19,576

2008                    $20,553

I do not believe this is a case about tax law as much as it is a case about someone pushing the boundary too far. Could the IRS have accepted an informal management agreement and passed on the “statutory employee” thing? Of course, and I suspect that most times out of ten they would. But that is not what we have here. Somebody was walking much too close to the boundary - if not walking on the fence itself - and that somebody got punished.

Our case this time was Blossom Day Care Centers, Inc v Commissioner, T.C. Memo 2021-86.