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Executive compensation is under attack from many quarters. In the world of publicly traded corporations, shareholder activists have argued that, in many instances, executive compensation is excessive and is diluting shareholder value (the average annual compensation earned by CEOs of corporations included in the S&P 500 is approximately $13.5 million). In response, the SEC has imposed new rules that mandate a more thorough disclosure of executive compensation, and Congress is now debating legislation that would require shareholder approval for a broad range of compensation issues. Although not as widely reported, the IRS has also begun to increase its enforcement of compensation issues relating to closely held businesses. Most recently, the IRS has provided guidance and affirmed existing auditing practices with respect to officer compensation cases for closely held corporations as they relate to employee classification issues which give rise to possible employment tax obligations. On March 22, the IRS published a memorandum from the IRS Small Business/Self-Employment Division Chief, John Tuzynski that highlights an abuse whereby the officers of closely held businesses are either not properly classified as “employees” and the payments they receive for services rendered are not being properly classified as “wages.” Rather, such payments are frequently being characterized as interest, profits, dividends or rent. The intent of such improper treatment is to avoid the payment of applicable federal employment taxes. Subtitle C of the Internal Revenue Code governs the payment of employment taxes. In particular, sections 3111 and 3301 impose taxes on employers under FICA (Social Security) and FUTA (Federal Unemployment Compensation Act) respectively, based on wages paid to employees. The FICA tax is imposed at an aggregate rate of 7.65 percent and consists of a 6.25 percent component for old age, survivors and disability coverage (imposed on a 2007 wage base of $97,500) and a 1.45 percent component for Medicare (imposed on all wages without limit). The FUTA tax is imposed at the rate of 6.2 percent on wages up to $7,000 (and a partial credit is allowed for the employer’s state unemployment insurance tax liability). The term “wages” for FICA and FUTA purposes generally encompasses “all remuneration for employment.” Also for these purposes, the term “employee” is defined to mean any officer of a corporation or any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee. The statutory definition that “any” officer of a corporation constitutes an employee has been limited by both the FICA and FUTA regulations. Under these regulations, an officer of a corporation who “does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is considered not to be an employee of the corporation.” In the recently published IRS memorandum, a number of cases are cited in which officers of closely held S corporations have received payments from their corporations which they have characterized as dividends, which are generally not subject to FICA or FUTA. The most instructive of the cases cited in the Memorandum is Nu-Look Design Inc. v. Commissioner. In this case, Ronald Stark was the sole shareholder, sole director and sole officer of an S corporation that performed home improvement services. Stark claimed no salary or other form of compensation from the corporation and merely reported the net earnings of the corporation, as reflected on a Form K-1, on his personal income tax return (Form 1040). Citing the FICA and FUTA regulations, the tax court held that Stark was properly reclassified by the IRS as an employee, and that any payments Stark received from the corporation were in the nature of “wages” subject to FICA and FUTA taxes. In reaching its decision in Nu-Look Design Inc., the tax court rejected the taxpayer’s argument that code Section 1366, which provides for the pass-through of S corporation income to shareholders, precludes the finding of an employer-employee relationship between Stark and the taxpayer-corporation. Similarly, the court rejected the argument that code Section 1372, which denies certain employee fringe benefit to 2 percent S corporation shareholders, was in any way germane to the issues of FICA and FUTA liability. Similar decisions were reached by other courts in a variety of the cases cited in the memorandum. Both the memorandum and the cases cited therein also address certain important procedural issues relating to the reclassification of employees and the re-characterization of payments as wages. The most significant of these procedural issues involves the application of Section 530 of the Revenue Act of 1978. Section 530 provides employers with relief from FICA and FUTA taxes which would otherwise be due if an individual who was previously not properly treated as an employee were to be re-characterized as an employee upon examination. Section 530 specifically provides that if for purposes of employment taxes, the taxpayer did not treat an individual as an employee for any prior period, the individual will not be deemed to be an employee on a prospective basis if the taxpayer (i.e., the employer) filed all federal tax returns in a manner consistent with the taxpayer’s treatment of such individual as not being an employee and the taxpayer had a “reasonable basis” for not treating the individual as an employee. Section 530 provides three safe harbors that will establish a “reasonable basis” for not treating an individual as an employee. A taxpayer will be deemed to have a reasonable basis for not treating an individual as an employee if such characterization was in reasonable reliance on any of the following: A judicial precedent, published ruling, technical advice or a letter ruling issued to the taxpayer; A past IRS audit of the taxpayer in which there was no assessment for employment taxes attributable to the treatment of individuals holding positions substantially similar to the position held by the individual in question; or Long-standing recognized practice of a significant segment of the industry in which the individual was engaged. In the case of Nu-look Design Inc. and the other cases cited in the memorandum, the courts concluded that none of the safe harbors identified in Section 530 were applicable. Accordingly, no relief from the assessment of employment taxes was available. In fact, in each case, the respective courts cited the large body of rulings, regulations and cases that were contrary to the positions asserted by the taxpayers. The memorandum also addresses the availability of relief under code Section 3509(a). This section provides for reduced tax rates for income tax withholding and the employee portion of FICA that is imposed on an employer when the employer fails to deduct and withhold those taxes because it improperly treated an individual as not being an employee. Under Section 3509(c), relief under Section 3509(a) is not available if the taxpayer intentionally disregarded the employment tax requirements. In light of the extensive authority that there is no basis to treat an officer who renders significant services to a corporation as anything other than an employee, the memorandum suggests that any misclassification of such an officer would be viewed as intentionally disregarding the employment tax requirements imposed under the code and no relief would be available under Section 3509(a). Although the spotlight on officer compensation issues has shined most brightly on public corporations, taxpayers and practitioners should realize that similar issues exist for closely held corporations. Among other issues, the IRS is aggressively seeking to re-characterize any payments by a corporation to its officers who render services as “wages” subject to employment taxes. MARK L. SILOW is the administrative partner and chief operating officer of Fox Rothschild. Silow formerly was chairman ofthe firm’s tax and estates department. Silow’s work involves a broad range of commercial and tax matters including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planning and employee benefits.

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