On July 13, 2021, the Tax Court issued a Memorandum Opinion in the case of Blossom Day Care Centers Inc. v. Commissioner (T.C. Memo. 2021-86). The issues presented in Blossom Day Care Centers Inc. v. Commissioner were whether: (1) the day care’s corporate officers should be legally classified as employees of petitioner such that petitioner is liable for employment tax (FICA) and unemployment tax (FUTA); (2) petitioner was liable for FICA and FUTA taxes; (3) petitioner was liable for a failure to deposit penalty under IRC § 6656; and (4) petitioner was liable for accuracy-related penalties under IRC § 6662(a).

Hackers in Oklahoma

The petitioner, Blossom Day Care Centers, Inc. was an Oklahoma corporation, originally incorporated in 1986, with its principal place of business in Tulsa and its principal line of business watching over little snot-goblins whilst their parents wiled away their days in the drudgery of Tulsa matters.  At all times, the Hackers—Barry and Celeste—were the petitioner’s only corporate officers. There were no other corporate officers. In addition, the Hackers were the petitioner’s sole shareholders, Mrs. Hacker owning 51% and Mr. Hacker owning 49% of petitioner’s stock.

In October 2002, the Hackers, as sole shareholders, incorporated Hacker Corp., electing to be taxed as a S corporation pursuant to IRC § 1362. Though the petitioner was not a shareholder in Hacker Corp, in May 2005, the petitioner conveyed to Hacker Corp. by quitclaim deed certain real estate locations of the day cares (six to be exact). The Hackers asserted that the purpose of Hacker Corp. was to provide property and services management to the petitioner, the only “client” of the S corporation. On its returns, the petitioner claimed deductions of management fees paid to Hacker Corp.

The “Management Fees” in Blossom Day Care Centers Inc. v. Commissioner

There was not, technically, a “written” agreement regarding the management fees that Hacker Corp. paid to the Hackers.  The Tax Court notes that such fees were paid “arguably for management of the petitioner.” The petitioner, however, rather vehemently argued that whatever services the Hackers performed for the day cares were actually provided under an “oral management agreement” between the petitioner and Hacker Corp. for the benefit of the day cares, and it was certainly not the petitioner’s responsibility to provide reasonable compensation to its corporate officers, the Hackers, for services provided to the petitioner.  It can be assumed, I think, the petitioner took great personal offense to this insinuation and perhaps became quite cross at the accusation, though the opinion is silent as to this matter.

The Involvement of the Hackers in the Day Cares

At all times relevant, the Hackers controlled all of the petitioner’s childcare policies and education, and they coordinated all physical location and program maintenance decisions. Both actively participated in petitioner’s daily operation, frequently working 50 to 60 hours per week.  It seems that they were the directors, administrative staff, teachers, custodians, and general jacks of all trade.

The Hackers’ Compensation

The petitioner did not report paying a salary or wages to either of the Hackers on its Forms 1120, except for one year when it reported compensation to its officers of $100,000.

That might have been enough to turn the tide against the Hackers, but they weren’t done just yet.  The petitioner maintained vehicles titled in the Hackers’ names including loan payments and maintenance for a 2000 Lexus and a 2003 Hummer. The petitioner claimed depreciation for those autos on its corporate tax returns for 2005 through 2008. In addition, the petitioner maintained vehicles it did not own, for the benefit of the Hackers’ children, a parent, and a sibling. The petitioner provided multiple credit cards in the names of both Mr. Hacker and Mrs. Hacker and their children. The petitioner paid personal expenditures for their benefit that were not petitioner’s business expenses. In sum, the daycares were the Hackers’ personal piggy bank, which sat about as well with the Tax Court as spoiled milk.

The Petitioner’s Forms 941 and 940

In fairness to the petitioner, it did pay salaries and wages to its other employees, it did file timely Forms 941 and Forms 940 reporting such wages. This is where the fairness ends. The petitioner, however, did not issue the Hackers or file with the IRS a single Form W-2 or Form 1099-MISC. In addition, the petitioner did not include either Mr. Hacker or Mrs. Hacker on the Forms 941 or 940, nor did it make on their behalf any deposit of employment taxes into any Federal depository for any calendar quarter or annual return for the periods at issue (2005-2008).

Burden of Proof

Taxpayers bear the burden of proving the IRS’s notice of determination of worker classification is in error. See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); Ewens & Miller, Inc. v. Commissioner, 117 T.C. 263, [*10] 268 (2001). The petitioner bears the burden of proving that its officers, the Hackers, were not its employees as determined in the notice of determination for the tax periods in issue. The petitioner, a corporation, also bears the burden of proving that it is not liable for the penalties under IRC § 6656 (for failure to deposit tax), as well as accuracy-related penalties under IRC § 6662(a) (for negligence). See NT, Inc. v. Commissioner, 126 T.C. 191, 194-195 (2006).

So, what is an “Employee” for “Tax” Purposes?

Unfortunately for the petitioner, the term “employee” is defined (rather on the nose, one observes in this case) for FICA and FUTA purposes to include “any officer of a corporation.” See IRC § 3121(d)(1), (2); IRC § 3306(i). For purposes of income tax withholding under IRC § 3402, the term “employee” also includes “an officer of a corporation.” See IRC § 3401(c). FICA and FUTA impose employment taxes that employers “must pay” and are “obligated to withhold” in addition to income tax withholding under IRC § 3402. Employers are further “required” to make periodic deposits of amounts withheld from employees’ wages and amounts corresponding to the employer’s share of FICA and FUTA tax. IRC § 6302; IRC § 6157; Treas. Reg. § 31.6302-1; Treas. Reg. § 31.6302(c)-3.

Corporate Officers as “Statutory” Employees

The trouble with the term “statutory” employees is that there’s not a whole bunch of wiggle room within the statute. An officer of a corporation who performs more than minor services and receives remuneration for such services is a “statutory” employee for employment tax purposes. See Joseph M. Grey Pub. Accountant, P.C. v. Commissioner, 119 T.C. 121, 126 (2002), aff’d, 93 F. App’x 473 (3d Cir. 2004); Central Motorplex, Inc. v. Commissioner, T.C. Memo. 2014-207; Glass Blocks Unlimited v. Commissioner, T.C. Memo. 2013-180; Nu-Look Design, Inc. v. Commissioner, T.C. Memo. 2003-52 (2003), aff’d, 356 F.3d 290 (3d Cir. 2004); Treas. Reg. § 31.3121(d)-1(b); Treas. Reg. § 31.3306(i)-1(c); and Treas. Reg. § 31.3401(c)-1(f).

An officer can escape statutory employee status only if he performs no services (or only minor services) for that corporation and neither receives nor is entitled to receive any remuneration, directly or indirectly, for services performed. See Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. 141, 144-145 (2001), aff’d sub nom. Yeagle Drywall Co. v. Commissioner, 54 F. App’x 100 (3d Cir. 2002); Treas. Reg. § 31.3121(d)-1(b); Treas. Reg. § 31.3306(i)-1(e); Treas. Reg. § 31.3401(c)-1(f).

There is even less wiggle room when, as here, the petitioner stipulated that the Hackers were corporate officers during all of the calendar quarters at issue and that both provided substantial services and that both directly and indirectly receive remuneration for said services. Nevertheless, whether a corporate officer is performing services in his capacity as an officer is a question of fact. Joseph M. Grey, 119 T.C. at 129-130; Rev. Rul. 82-83. The conclusion that a corporate officer is a statutory employee may not apply to the extent that he or she performs services in some other capacity. Nu-Look Design, T.C. Memo. 2003-52 at *10.

A Dearth of Evidence

What is clear (corroborated by actual evidence) is that the petitioner did pay Hacker Corp. money classified as “management fees” on its general ledger. From these management fees, Hacker Corp. paid Form W-2 wages to the Hackers, “supposedly for the services the Hackers were to render to the petitioner under an oral management contract.” Unfortunately for the petitioner, it submitted no evidence of a management agreement, either written or oral, with Hacker Corp., which was likely a direct result of the fact that there was, actually, no such evidence in existence. Similarly, the petitioner submitted no evidence as to a service agreement directing the Hackers to perform substantial services on behalf of Hacker Corp. to benefit the petitioner, or even a service or employment agreement between the Hackers and Hacker Corp.

Although the Tax Court doesn’t go quite so far as to call bullshit on the management “arrangement,” the utter lack of evidence in existence translated to an utter lack of evidence on the record that Mr. Hacker or Mrs. Hacker performed services in a capacity other than as a corporate officer of the petitioner.

Reasonableness of Compensation

But wait, there’s more…

The petitioner argued, alternatively, even if the Tax Court determined that its corporate officers are statutory employees, the determination of additional wages paid to the Hackers should be no more than the difference between what was paid to the Hackers as Form W-2 employees of Hacker Corp. and the reasonable wage determinations of the IRS. Judge Paris is not exactly persuaded by this argument.  She observes that the petitioner’s arguments are “misguided,” insofar as wages paid by Hacker Corp. do not offset reasonable compensation requirements for the services provided by petitioner’s corporate officers to petitioner. “Whatever wages paid for whatever purposes” by Hacker Corp. to the Hackers as employees of the S corporation “will be better addressed in relation to respondent’s notice of deficiency for the Hackers’ individual income tax, in consideration that Hacker Corp. is a wholly owned S corporation.”

“But them Hackers, they’re simple folks,” the petitioner continued beseechingly. After all, Mr. Hacker was a college dropout, and Mrs. Hacker only has her associate’s degree.  Have mercy on us, says the petitioner.  “Nay,” sayeth Judge Paris.

Reasonableness of compensation is a question determined by all the facts and circumstances of the case. See, e.g., Glass Blocks Unlimited, T.C. Memo. 2013-180, at *13; Joly v. Commissioner, T.C. Memo. 1998-361, *4, aff’d without published opinion, 211 F.3d 1269 (6th Cir. 2000). Factors affecting the reasonableness of compensation include the employee’s role in the company, comparisons of the employee’s salary to those paid by similar companies for similar services, and the character and condition of the company. Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-1246 (9th Cir. 1983), rev’g T.C. Memo. 1980-282; see also Pepsi-Cola Bottling Co. of Salina, Inc. v. Commissioner, 528 F.2d 176, 179 (10th Cir. 1975), aff’g 61 T.C. 564 (1974).

The Tax Court did not “find persuasive” the petitioner’s “evidence” (really just a blubbering plea) that the services provided by the Hackers were worth something less than respondent’s determination. The petitioner’s briefs failed to provide evidence or cogent argument as to why the IRS’s determination was unreasonable.  Accordingly, the petitioner failed to carry its burden to show that the amounts the IRS determined are unreasonable compensation.

Penalties, Burdens, and Non-Individuals

In a final volley of barbless arrows, the petitioner argued that the IRS failed to meet its burden of production with respect to the penalties because it did not introduce evidence that the initial determination of the penalties was approved in writing by the immediate supervisor of the individual making the determination, as required by IRC § 6751(b)(1).  Gotcha, thought the Hackers.

Unfortunately, as illustrated in the Plentywood Drug and Estate of Jackson cases, IRC § 7491(c), which shifts the burden of production to the IRS in any court proceeding with respect to liability for any penalty, addition to tax, or additional amount, applies only to individuals. See Povolny Grp., Inc. v. Commissioner, T.C. Memo. 2018-37, at *27. The IRS, therefore, had no burden of production in this case. That burden remained, utterly unfulfilled, with the petitioner. Nevertheless, a nonindividual taxpayer may raise the lack of supervisory approval as an affirmative defense to penalties. See, e.g., Palmolive Bldg. Inv’rs, LLC v. Commissioner, 152 T.C. 75, 83 (2019); Endeavor Partners Fund v. Commissioner, T.C. Memo. 2018-96, slip op. at *63-*64, aff’d, 943 F.3d 464 (D.C. Cir. 2019). Nevertheless, nevertheless, the petitioner failed to raise the question of supervisory approval in its brief, arguing for IRC § 6751(b)(1) relief for the first time on brief.

Oh, and for the record (and it was actually placed in the record) the revenue agent’s supervisor had, in fact, approved the penalty…on a signed Civil Penalty Approval form…in a timely manner…

So, yeah, there’s that, too.

(T.C. Memo. 2021-86) Blossom Day Care Centers, Inc. v. Commissioner

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