A 2017 Tax Court decision, Fleischer v. Commissioner, may call into question a tax planning strategy commonly used by commissioned brokers and salespersons in many industries. This Alert looks at the impact of the decision on insurance brokers and agents.
Fleischer was an insurance agent and a registered representative of broker-dealer LPL. Fleischer received commissions from sales of fixed life insurance policies from the issuing insurance carriers, and received commissions from sales of variable life insurance policies from LPL. On the advice of his lawyer and accountant, Fleischer formed an S corporation, Fleischer Wealth Plan (FWP) of which he was the sole shareholder, and entered into a written employment contract with FWP. When Fleischer received commissions he paid them to FWP, which returned these amounts to him in two forms: A relatively small salary and the rest as a distribution of profit. FWP paid FICA (Social Security and Medicare) self-employment taxes on the salary, but the distributions of profit to Fleischer from FWP were not subject to self-employment taxes.
This S corporation strategy is familiar in the landscape of tax planning for all sorts of professionals and saved Fleischer a significant amount of self-employment tax. The IRS surprised many by challenging the strategy under the "assignment of income doctrine." The assignment of income doctrine is simple to state: The person who earns compensation from services must be taxed on the income. The IRS will resist attempts by an income earner to direct that the compensation be paid – and taxed – to someone else. If an assignment of income challenge is successful, the true earner of the income must pay tax on it, even if the cash ends up in someone else's hands.
Applying this doctrine is tricky when the same person is both the sole shareholder and an employee of a corporation. A series of cases involving athletes and artists in the 1980s eventually resulted in the Tax Court articulating the so-called "Johnson test." Under this test, a corporation must prove two elements to establish that the corporation (rather than the employee/shareholder) is the true earner of income. First, the corporation must show that it has the legal right to control the shareholder/employee's performance of services; this typically requires an employment contract. Second, there must be objective evidence that the person benefitting from the performance of services recognizes the corporation's right of control over the employee in the performance of services; this typically requires a services contract between the corporation and the person benefitting from the services (in this context, the insurance companies and the broker-dealer).
The Tax Court concluded that Fleischer, not FWP, was the true earner of the commissions from sales of insurance policies. Although a valid employment contract existed between Fleisher and FWP, the second part of the Johnson test was not met because Fleischer had not proved that the insurance companies or broker-dealer that paid commissions to Fleischer recognized FWP's requisite control over him. All of the contracts were between Fleischer personally and the broker-dealer and insurance carriers, and not FWP. Mr. Fleischer could not provide any other evidence of that the broker-dealer or carriers intended to pay FWP rather than Fleischer personally, for services. Relying heavily on the fact (admitted by Mr. Fleischer) that the broker-dealer and insurance carriers were actually prohibited by federal securities rules and/or state insurance laws from paying FWP directly for services, the Tax Court concluded that the FWP could not have been the true earner of the income. As a result, Mr. Fleischer was required to include all the commissions in his gross income, which forestalled use of the S corporation strategy discussed above.
So, what does Fleischer v. Commissioner mean for insurance producers who direct that all, or a portion of their commissions be paid to the firm that employs them? If the individual insurance producer, and not the firm employing the producer, must be paid compensation directly by the carrier or broker-dealer, the individual producer will be deemed the earner of the income, and will be required to include the full amount of commissions in gross income, regardless of whether the producer has agreed to remit all or a portion of the commissions to the firm that employers him or her.
- Because FINRA rules require that commissions on sales of variable insurance products be paid to a registered person, a registered representative must claim as income the full amount of commission compensation received from the broker-dealer with whom the producer is registered.
- If an insurance producer is licensed under state insurance laws, but the employing firm is not insurance licensed, state insurance laws may require that carriers pay commissions received on the sales of fixed insurance products to the licensed individual, and not to the employing firm.
The bottom line is that the strategy of shifting compensation to an S corporation to minimize self-employment tax liability may not be viable for independent insurance producers, who may not be able to avoid paying FICA taxes on the gross commissions paid on insurance sales. Insurance producers who currently are employing this strategy should consult with their legal and tax advisors, in light of the Fleischer decision.
 TC Memo 2016-238.