ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – MUST A SINGLE MEMBER LLC TREAT WORKERS AS EMPLOYEES? – PART 3
By Robert S. Schriebman
This is Part 3 of a 3-Part series.
An LLC (Limited Liability Company) is treated as a corporate entity for IRS and EDD purposes. LLCs must treat common law employees as W2 wage earners with the exception of a single-member LLC. A single-member LLC files a 1040 individual tax return and is not required to pay employment and withholding taxes on its sole officer-member. It must, however, pay payroll taxes on all other employees. A multiple-member LLC must treat officer-members as W2 wage earners because corporate officers are by law statutory employees. What happens when a single-member-officer-employee disregards the law and treats all workers as independent contractors? The short answer is – big problems. The Cardiovascular Center, LLC v. Commissioner (U.S. Tax Court, TC Memo. 2023-64, May 18, 2023) case is the latest Tax Court decision clearly illustrating what not to do.
Cardiovascular Center, LLC Case – The Facts
Dr. K practices medicine as a single member LLC. His practice is in Arizona. Between 2010-2015 the LLC employed 5 workers all doing medical-related work. Apparently, Dr. K did not wish to get his hands dirty keeping those pesky books and records and paying employment and withholding taxes. He paid all of his workers with cashier’s checks. He took out no withholdings and he never filed a quarterly or annual payroll tax return. Each worker worked an average of 70 hours every two weeks. If they put in more time, they would be paid overtime. Each worker had to submit an “employee timesheet,” which had to be approved by the office manager who was Dr. K’s live-in partner, Ms. Smith. Dr. K did not give her a paycheck per se, but paid her personal expenses including mortgages, and interest on several real properties she owned.
Between 2010-2015, Dr. K never gave any worker either a W2 or a 1099. He treated all workers as independent contractors. All workers were subject to Dr. K’s supervision and reported to him. The workers were expected to follow office procedures that were set by Dr. K. None of the workers was able to realize a profit or loss because of their services. There were no formal employment contracts. The workers determined their own schedules where they were permitted to arrive and leave at any time. The workers were directed by Ms. Smith, the office manager, and Dr. K’s girlfriend. At her direction, the workers performed both “front office” and “back office” duties. Some of these duties were administrative and some were involved in patient care, such as scheduling appointments, checking blood pressure, pulse and weight, making entries into patient’s charts, and taking patients to patient rooms.
No quarterly 941 returns or annual FUTA 940 returns were ever filed with the IRS.
The IRS audited Dr. K and issued 6-years worth of quarterly and annual payroll tax assessments together with penalties and interest to the tune of over $325,000.
Dr. K Argued Safe Harbor
Dr. K argued that he should have been entitled to a safe harbor relief that would make him exempt from having to pay taxes. The safe harbor provisions are not stated in any specific statute in the Internal Revenue Code. In other words, there is no section 530 in the Internal Revenue Code dealing with employment tax safe harbor provision (§ 530 of the Code deals with Coverdell Education savings accounts). The law was part of the Revenue Act of 1978. Section 530 and when applicable affords a taxpayer relief from federal employment taxes even if the relationship between the principal and the worker would otherwise require the payment of those taxes. RA 1978 § 530(a)(1), 92 Stat. at 2885; Charlotte’s Office Boutique, 121 T.C. at 106.
In order for RA 1978 § 530 relief to apply, a taxpayer:
- Must not have treated the worker as an employee for any period for purposes of federal employment taxes (historic treatment requirement);
- Must have consistently filed all federal tax returns (including information returns) required to be filed by the taxpayer with respect to the individual for periods after 1978 on a basis consistent with the taxpayer’s treatment of that individual as not being an employee (reporting consistency requirement);
- Must have had a reasonable basis for not treating the worker as an employee, e.g., the taxpayer’s treatment if the worker was “reasonable reliance” on one of the items specified in § 530(a)(2) (reasonable basis requirement); and
- Must not have treated as an employee any individual holding a position “substantially similar” to that of the worker in question (substantive consistency requirement).
The Tax Court next examined whether Dr. K had a reasonable basis for treating the staff members and Ms. Smith as independent contractors.
To qualify for safe harbor relief, a person in Dr. K’s position must have a reasonable basis. Reasonable basis is established by three tests as follows:
- Judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer;
- A past Internal Revenue Service audit of the taxpayer in which there was no assessment attributable to the treatment (for employment tax purposes) of the individuals holding positions substantially similar to the position held by this individual; or
- Long-standing recognized practice of a significant segment of the industry in which such individual was engaged.
In the case of Dr. K and the LLC reasonable cause factors A., B. and C. do not apply.&
The applicable rule is factor number 2 (RA 1978 § 530) where Dr. K must prove that he consistently filed all federal tax returns, including information returns. Dr. K paid his staff with cashier’s checks. He never filed quarterly or annual payroll tax returns. This was OK with the Tax Court. The problem – Dr. K failed to file information returns which included 1099s and the summary 1096 forms. This failure made him ineligible for § 530 relief.
The case of Dr. K and his LLC clearly illustrates the risks involved in playing fast and loose with the payroll tax laws. The IRS has been granted huge sums of money from Congress and a great emphasis will be placed upon payroll tax compliance including conducting many more audits of taxpayers who vies the system by doing what Dr. K did such as paying workers with cashiers checks, not giving them either a W2 or a 1099 and not filing quarterly and annual payroll tax returns such as 941s and 940s and failing to issue information returns. Frankly, Dr. K got what he deserved – a big tax bill with penalties and daily accruing interest.
Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 50 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD, and he is not employed by the EDD or any other agency of the State of California.
Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
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