Thursday, October 31, 2019
An interesting question was posed to me at a recent tax seminar. The question was whether director fees are subject to self-employment tax. That question comes up because sometimes farmers, ranchers and others receive income for serving as a director of a farming or ranching business, an agricultural cooperative, an ag lender or other organization.
Whether a director fee is subject to self-employment tax turns on whether the fee constitutes employee wages. Making that determination turns on the facts and circumstances of the particular situation.
Director fees and self-employment tax – it’s the topic of today’s post.
Self-Employment Tax Basics
A self-employed individual is one who has net earnings from self-employment as defined by I.R.C. §1402(a). “Net earnings from self-employment” means gross income derived from a trade or business that the taxpayer conducts (less associated deductions). Id. But, a “trade or business” for self-employment tax purposes does not include “the performance of services by an individual as an employee.” I.R.C. §1402(c)(2).
A corporate director, under the right set of facts, is not a corporate employee. Treas. Reg. §31.3121(d)-1(b) specifies that, “Generally, an officer of a corporation is an employee of the corporation. However, an officer of a corporation who as such 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. A director of a corporation in his capacity as such is not an employee of the corporation.”
On the self-employment tax issue, the IRS ruled in 1972, that director fees are self-employment income subject to self-employment tax. Rev. Rul. 72-86, 1972-1 CB 273. That is certainly the case if a “director” performs no services for the corporation. But, what if some services are provided? When does a “director” cross the line and grade over into “employee” status with payments received constituting wages? If the fees constitute “wages” they aren’t subject to self-employment tax and there could be other implications.
The Blodgett case
In Blodgett v. Comr., T.C. Memo. 2012-298, the petitioner served on a local bank board. The board operated independently and represented members of the community that owned the bank. The board supervised bank management but did not participate in daily bank operations. The bank provided liability coverage, life and disability insurance and retirement benefits, but not health insurance to the board members. The petitioner was also vested in the bank’s retirement plan for board members. He put in less than five hours a week on board member business and did not hold himself out as a contractor and did not claim any tax deductions for business expenses because the bank paid all expenses. The bank issued him a Form 1099-MISC, Miscellaneous Income, reporting "nonemployee compensation" of $26,750 for his services. He reported the amount on line 21 of his return as “other income” not subject to self-employment tax. The IRS disagreed, asserting that the income was attributable to work the petitioner performed as an independent contractor and that self-employment tax was owed.
The Tax Court agreed with the IRS and analyzed the facts based on a seven-factor test. Those factors, set forth in Weber v. Comr., 103 T.C. 378 (1994), are: (1) extent of control maintained by the bank; (2) responsibility for providing work facilities; (3) the opportunity for the trustee to receive a profit or loss; (4) the ability of the bank to fire the trustee; (5) the trustee duties as part of the bank’s regular business activities; (6) the permanency of the bank-trustee relationship; and (7) the intent of the bank-trustee relationship.
Here's how the factors shook out in Blodgett:
Factors favoring employee status:
- The bank provided the trustees with meeting rooms, office supplies, and other items necessary to fulfill their duties.
- The trustees were paid for attending board meetings and did not have additional opportunities for profit or loss.
- The petitioner had been reelected to his position for more than 10 consecutive three-year terms, but bank management was appointed for one-year terms.
Factors favoring nonemployee status:
- The board of trustees operated independently from the bank’s management and were not subject to any meaningful control by the bank.
- Only corporate members could terminate the trustees, and then only on a limited basis including by a vote of the members.
- The trustees’ duties were primarily related to oversight with no involvement in daily bank operations.
- Evidence showed that the bank had no intent to create and employer-employee relationship with the trustees and issued Forms 1099-Misc. instead of Forms W-2 to all of the trustees.
The court didn’t simply stack up the factors and see whether a majority of them favored employee or nonemployee status. Instead, the court placed the most weight on how much control the bank exercised over the trustees and determined that the trustees were not employees and that self-employment tax was owed.
The Burbach Case
In Burbach v. Comr., T.C. Memo. 2019-17, the petitioner was an engineer whose LLC business involved working with towns to determine the need for a public pool. If it was determined that a pool had merit, the petitioner would plan and market the pool and organize fundraising for the construction of the pool. Ultimately, he changed his business form from an LLC to two corporations – one to hold the operating assets of the business and another corporation to hold real estate. With help from his tax advisor, the petitioner established a self-employed pension plan. He funded the plan by taking “director fees” out of the operating entity which he then deposited into his personal checking account with subsequent transfers to his pension account. He reported the director fees on Schedule C and claimed an offsetting deduction for the contributions to his self-employed retirement plan.
The facts got tangled with respect to late-filed corporate returns and ultimately it was determined that the pension plan needed to be an employer-sponsored plan run through the operating entity because it had employees and also because all the compensation on which plan contributions were based was W-2 compensation that the corporation paid to the petitioner as an employee. The plan was corrected retroactively with the operating entity as the plan sponsor including all eligible employees in the plan and including the amounts the petitioner received as director fees for plan purposes.
The parties settled on the plan qualification issues, but the IRS claimed that the director fees the petitioner received were wages as remuneration for employee services. As wages, the IRS argued, the petitioner couldn’t claim I.R.C. §404 pension plan deductions because he had no self-employment income.
The Tax Court agreed with the IRS for the following reasons:
- The petitioner was the operating entity’s sole shareholder and was involved hands-on in the company’s daily affairs.
- While the petitioner was the operating entity’s only director, there was no evidence that he provided any director services. Instead, the services provided involved daily decisions concerning engineering, project management and marketing.
- The petitioner had represented to the IRS when he and the operating entity applied for a compliance statement for the pension plan that he was providing services that were essentially employee services.
Consequently, the petitioner had no earnings from self-employment and I.R.C. §404(a)(8) barred him from claiming any deductions for contributions he had made to his Keogh-type pension plan for the tax years at issue. Instead, he was an “employee” within the meaning of I.R.C. §401(c)(1) and the operating entity was his “employer” under I.R.C. §401(c)(4) by virtue of I.R.C. §404(a)(8).
Note that the outcome in Burbach was different that the typical outcome with respect to directors’ fees. While it’s a facts and circumstances determination, most often those facts indicate that directors’ fees are self-employment income. Had that been the case in Burbach, the petitioner, as a corporate director, could have established a Keogh plan based on those fees. See, e.g., I.R.C. §3121(d)(1); Treas. Reg. §31.3121(d)-1(b). However, the petitioner provided more than minor services and was classified as an employee whose director fees were classified as wages.
It’s not uncommon in rural areas for farmers, ranchers and others to serve on various corporate boards for which compensation is received. It’s important to properly report the director fee income on the return. That will turn on the classification of the relationship of the taxpayer to the entity involved. Facts and circumstances of each situation are critical. If the taxpayer is deemed to be an independent contractor with self-employment income, perhaps there are associated costs that can be deducted to help offset the income and self-employment tax. Likewise, it may be possible to establish a pension plan. But the facts must support the classification desired.