IRS loses SE tax challenge.

• Author: Ochsenschlager, Thomas P.
• Position: Self-employment tax

Ever since Congress issued its infamous order to Treasury to halt the issuance of self-employment (SE) tax regulations (Prop. Kegs. Sec. 1.1402(a)-2(d)), practitioners have been left without guidance on the SE tax in the limited liability company (LLC) context. Because LLCs continue to be the entity of choice, the absence of authority continues to complicate an adviser's task of guiding a client and having assurance in sustaining an IRS challenge. Into this void enters Grigoraci, TC Memo 2002-202, in which the Service loses a dispute to disregard a wholly owned S corporation.

Facts

Grigoraci presents a brief analysis of an S corporation interposed between a taxpayer and his interest in an accounting partnership. During 1995, Victor Grigoraci agreed to become the third partner of GTWP, a general partnership organized under West Virginia law. The two original partners each held their interest in GTWP through a wholly owned S corporation. The taxpayer's attorney cautioned him against becoming a member of the partnership as an individual, because he would be the only partner with unlimited liability. As a result, the taxpayer formed an S corporation (GSC), in which he was the sole shareholder, which then joined GTWP as a partner.

For 1996, the tax year at issue, the GTWP income reported to GSC was $106,799, which GSC reported on its 1996 Federal return, along with other income of $21,862. GSC's return also noted some undisputed deductions (including a $32,000 salary paid to the taxpayer), reporting net income of $92,470.

The taxpayer's joint return reflected the GTWP income and the GSC salary, but not SE tax, which the IRS disputed. The IRS assessed tax on $124,470 ($32,000 + $92,470), and a Sec. 6662(a) negligence accuracy-related penalty for failure to treat the taxpayer as a GTWP partner.

Analysis

The IRS asserted that GSC was a sham corporation established for tax-avoidance reasons, not recognizable for tax purposes.

The Tax Court determined that it held jurisdiction only over the $32,000 "salary" the taxpayer reported from GSC, which the IRS contended was income derived from providing personal services directly to the end user. It rejected the IRS's position that GSC was a sham corporation. Specifically, the court found no evidence to support the Service's assertion that GSC was formed primarily to avoid SE tax. Rather, the taxpayer formed the corporation to limit his potential personal liability on entering the GTWP partnership. With GTWP...