Winter 2011 Edition

IRS MAY RECHARACTERIZE DIVIDEND PAYMENTS TO S CORP
SHAREHOLDER-EMPLOYEE AS WAGES

By F. Stephen Glass

A federal district court recently concluded that an S corporation shareholder-employee's $24,000 salary in 2002 and 2003 was unreasonably low, and allowed IRS to reclassify as salary over $67,000 in dividend payments to the officer during each of those years. The corporation will also owe employment taxes on the reclassified dividend payments.

This is a long standing compliance issue with IRS, which feels that many service professionals try to minimize Medicare and Social Security taxes by routing what would otherwise be self-employment income through an S corporation and then paying themselves a nominal salary. Since the amount of compensation that an S corporation pays its employee-shareholder is within the employee-shareholder's discretion, he may have an incentive to claim less than a reasonable salary and take from the S corporation other payments (e.g., dividends) that aren't subject to employment taxes.

In 2010, the House but not the Senate passed legislation that included a crackdown on service professionals who try to minimize Medicare and Social Security taxes by routing their self-employment income through an S corporation and then paying themselves a nominal salary.

Facts.

David E. Watson had a bachelor's degree in business administration and a specialization in accounting. He owned a professional corporation called DEWPC that, since its inception, had elected to be taxed as an S corporation. Watson was its sole shareholder, employee, director, and officer, and was the only person to whom DEWPC distributed money during the years at issue. His $24,000 annual salary was documented in the corporate minutes. In selecting his salary, he did not look at what comparable businesses paid for similar services. For both years at issue, Watson received dividend distributions from DEWPC that totaled over $175,000 annually.

The IRS assessed $48,519 in taxes, penalties, and interest against DEWPC for the eight calendar quarters of 2002 and 2003. It determined that portions of the dividend distributions from DEWPC to Watson should have been characterized as wages paid to Watson and thus subject to employment taxes.

Law.

Employers are liable for FICA (Social Security) taxes on wages paid to their employees. The IRS frequently warns S corporations not to attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages. Factors that courts have considered in determining reasonable compensation include:

• training and experience;
• duties and responsibilities;
• time and effort devoted to the business;
• dividend history;
• payments to non-shareholder employees;
• timing and manner of paying bonuses to key people;
• what comparable businesses pay for similar services;
• compensation agreements; and
• use of a formula to determine compensation.

Court's Ruling.

The court said that the proper tax treatment of funds disbursed by an S corporation to its employees or shareholders turns on an analysis of whether the payments were remuneration for services performed (wages). The court concluded that DEWPC structured Watson's salary and dividend payments in an effort to avoid federal employment taxes, with full knowledge that the dividends paid to Watson were actually "remuneration for services performed." The court believed that a reasonable person in Watson's role as DEWPC's sole shareholder, officer, and employee would be expected to earn far more than a $24,000 salary for his services. The court pointed out that Watson was an exceedingly qualified accountant, with both bachelor's and advanced degrees, working as one of the primary earners in a reputable firm that had over $2 million in gross revenues in 2002 and nearly $3 million in 2003.

FRANCHISE DISCLOSURE DOCUMENT - ITEM BY ITEM ANALYSIS
(Part four of a series)

By M. Blen Gee, Jr.

ITEM 12 - Territory.

One of the most important questions that you want to ask is will you have a protected territory. Increasingly, many franchisors do not provide territorial protection for their franchisees. Other franchisors will give some protection to a franchisee in an area that is too small. Encroachment on a franchisee's territory is a major area of abuse in franchising, and Item 12 of the FDD should be examined carefully.

Remember, as a franchisee your goal is to maximize profits. However, since the franchisor is typically paid a percentage of gross sales, far too many franchisors are less concerned about their franchisee's profitability than making certain that gross sales, and therefore royalties, are as high as possible. In many franchise systems this leads to saturation and then oversaturation of the franchisee's market by placing too many outlets in the same territory. For this reason, for most franchise systems, adequate territorial protection from encroachment is essential, and a prospective franchisee should seriously question a franchise system that does not grant the franchise a reasonable territorial restriction .

Some franchisors may tie the territorial protection to performance standards, such as minimum gross sales or achieving target scores under a system developed by the franchisor. You should be certain that any such performance standards are easily achievable. Otherwise, you may find that your sales are less than expected and, rather than assist you in improving sales, the franchisor points at your poor performance as a ground for placing another franchisee in your territory, making it impossible to ever achieve the required performance standards or maintain profitability.

If the franchisor refuses to provide you with a protected territory, one helpful, though inadequate remedy, would be to negotiate a "right of first refusal." This would allow you to protect your territory from possible encroachment by agreeing to open a second franchise in the proposed location of a potential new franchisee in your territory. The obvious problem with a right of first refusal is that opening a new store will over-saturate your market; you will be substantially increasing your financial risk by incurring the cost of opening a new store in a market that you know will be over-saturated. On the other hand, by having two stores reasonably close to each other, you may be able to take advantage of economies of scale that would allow you to operate both stores more cheaply and profitably.

If you are granted an exclusive territory, it is essential that the territory be large enough to provide you with an adequate number of customers. The franchisor will have some incentive to provide you with a reasonable territory so that you will be successful. However, remember that the franchisor's principal interest will be to maximize gross sales. By providing you with an unreasonably small territory, it can be certain it saturates the market by surrounding your small territory with other franchisees.

Depending on the nature of the franchise opportunity, mail order and internet sales by the franchisor can be a major encroachment issue. In some industries, the franchisee may find that he spends a great deal of time, energy and expense introducing a prospective customer to a product, and then the customer returns to his home and buys the product on-line.

A typical but worrisome clause allows the franchisor to sell into your market or authorize others to sell into your market under different trademarks. It is unclear how often franchisors actually license competing franchisees under other brands. However, the practice of reserving the right to do so is very common.

ITEM 13 Trademarks.

The grant to you to use one or more trademarks is an essential element of franchising . Typically, the franchisor has adequately protected its existing trademarks and infringement of the trademarks by third-parties is not a problem. However, occasionally infringement occurs where the franchise is a start-up franchise or lesser known. You should promptly report any infringement to franchisor in writing and follow-up to make sure that the franchisor takes any necessary legal action to prevent the infringement. It is probably a breach of the franchise agreement not to notify the franchisor of any known infringement. Frequently, the franchise agreement will state that the franchisor has no duty to you to take actions against persons infringing on the trademarks. However, in practice, most franchisors will vigorously protect their trademarks.

It is common for franchisors to change trademarks, trade names, logos, color schemes, etc. For you as a franchisee this means new signs, new stationary, new ads, etc. all at your cost. In most cases, these expenses are unavoidable. It is important for the franchise system to stay modern and competitive. However, a poorly run franchise system may force the franchisee to make excessively frequent or expensive changes.

In addition to your franchise agreement, the franchisor's trademarks are protected by Federal and state law. In the event that you terminate your franchise, you must promptly cease using all of the franchisor's trade names and trademarks. This is true even if you have validly terminated your franchise agreement because of breaches by the franchisor.

ITEM 14 Patents. Copyrights and Proprietary Information.

Typically, all advertising produced by the franchisor is protected by copyright law, and you cannot use it without the franchisor's consent. Probably the most important document that you will receive from the franchisor is the operations manual. This manual is protected by the copyright laws. Further, the typical franchise agreement provides that you may not make copies without consent and that the operations manual is only loaned to you; it remains property of the franchisor. Upon termination of your franchise agreement, the operations manual should be returned to the franchisor. As with trade names and trademarks, once you terminate your franchise agreement, you cannot use any materials provided to you by the franchisor, and these should be returned to the franchisor or destroyed. If the documents are destroyed, you should send a letter to the franchisor indicating that all copyrighted materials have been destroyed. Although not required to be listed in section 14, frequently the franchise agreement will recite that any patents, creative materials such as advertising copy, artwork or other proprietary information that you develop become the property of the franchisor.

>> Read part five of our Franchise Disclosure Document series

Capital Gains and Losses

By F. Stephen Glass

The IRS reminds taxpayers that almost everything owned and used for personal and investment purposes is a "capital asset." Some pertinent facts about capital gains and losses include:

• if capital losses exceed capital gains, the excess can be deducted up to an annual limit of $3,000, or $1 ,500 if married filing separately;
• if total net capital loss is more than the annual limit, the unused portion can be carried over to the next year;
• capital gains rates are generally lower than the tax rates that apply to other income; and
• capital losses cannot be deducted on property held for personal use,

 

Employment Law Special

By F. Stephen Glass

Staub v. Proctor Hospital Upholds Employer's "Cat's Paw" Liability For Discrimination

The United States Supreme Court recently issued its holding in Staub v. Proctor Hospital. This decision adhered to a "cat's paw" theory of employer liability for discrimination, finding that employers would be subject to liability for discrimination "where lower-level supervisor with discriminatory motives influence, but do not make, adverse employment decisions made by higher-level managers." This decision is expected to make it more difficult for employers to resolve discrimination cases early through motions for summary judgment.

HR director could pursue claims that she was retaliated against because she advocated for minority workers

A female HR director, who was suspended and eventually discharged after allegedly persuading management not to fire certain minority employees, sufficiently pled her retaliation claims and withstood her employer's motion to dismiss (Adams v Northstar Location Services, LLC, WONY). The court held that in order to find that the HR director engaged in protected activity, she must have alleged that she stepped outside her role of representing the company and either filed, or threatened to file, an action adverse to the employer, actively assisted other employees in asserting Title VII rights, or otherwise engaged in "activities that reasonably could be perceived as directed towards the assertion of rights." She claimed that she reported a gender-based pay and bonus discrepancy, and that she persuaded management that it would be "inappropriate" to fire certain minority employees. While raising the pay discrepancy was arguably within the scope of her HR duties, her advocacy for certain minority employees was an "assertion of rights" and thus constituted protected activity, the court held.

Employee who presented evidence of her supervisor's age-based comments and replacement by a 16-year-old could pursue age bias claims.

A 54-year-old secretary-receptionist, who was terminated after more than 19 years on the job, could proceed with her AOEA claim, (Hird-Moorhouse v Belgian Mission, SDNY). She made out her prima facie case of age bias, as she was 54 years old when she was terminated and replaced by a 16-year-old. Moreover, her 19 years of employment demonstrated that she had the basic skills necessary for the position of secretary-receptionist and was therefore qualified. She also presented sufficient evidence of circumstances that could give rise to an inference of discrimination based on her supervisor's alleged age-based comments, made two days before her discharge, that he needed a "younger image" and that she was "too old for her job." As its legitimate, non-discriminatory reason for its decision, the employer asserted that the secretary/receptionist was terminated as part of a service reorganization to reduce personnel costs. However, "reorganization may not be used as a pretext to remove or demote a particular employee, particularly where that employee is a member of a protected class ," noted the court.

Sales rep suffering from mental health issues and hypertension was not disabled within meaning of ADA

A sales rep formerly employed by a commercial sign maker was not disabled under the ADA, because she failed to show that her mental health issues and hypertension substantially limited her in the major life activities of work or travel, the First Circuit Court of Appeals ruled in affirming a district court's grant of summary judgment to the employer (Faiola v APCO Graphics, 1stCir, December 10, 2010). She failed to show that she was significantly restricted in either a class, or a broad range, of jobs, as the ADA requires when a plaintiff alleges that their impairment substantially limits their ability to work. The court found that an inability to attend, or fly to, a conference, did not evince a restriction relating to a class or range or even one particular job. Furthermore, the court found that the alleged impairment was further undercut by the rep's own testimony that her conditions did not impact her ability to perform all essential aspects of her job. Thus, the court found that the rep was not substantially limited in the major life activity of work.

Jury's pregnancy discrimination verdict in favor of employee overturned; no evidence that employer terminated employee for anything other than poor performance

A district court overturned a $75,000 verdict in favor of the employee on pregnancy discrimination claims, finding that the employee failed to produce substantial, competent evidence of discrimination and that the jury's verdict was therefore only supported by employee's suspicions of discrimination (Brown v Yellow Trans. Inc, DKan, December 1, 2010). After working for only a month, the employee, who had not disclosed her pregnancy until after receiving an offer of employment, was terminated for poor performance and filed suit under Title VII and the Pregnancy Discrimination Act. After the jury returned a verdict in favor of the employee, the employer renewed its motion for judgment as a matter of law or for a new trial. In ruling on the employer's post trial motion, the court determined that, notwithstanding the jury's verdict, the employee did not provide sufficient competent evidence that either there was a reasonable probability that the employer engaged in illegal discrimination on account of her pregnancy or that the employer's stated reasons for her termination were pretextual and unworthy of belief. The employee's evidence failed to provide more than her uncorroborated suspicions of discrimination, said the court, granting the employer's motion for judgment as a matter of law.

Free room and board no substitute for overtime pay.

A federal court recently ruled that employees who worked at least 65 hours per week were entitled to overtime pay, even though the total of their base salary plus free housing and meals may have exceeded what they would have received if they had been paid the minimum wage plus overtime. Mendoza v. Uptown Buffet. Inc.

Employer's changing and inconsistent explanations about discharged sales manager's alleged performance issues were enough to allow age bias claims to proceed [The "Spring Chickens" case]

An over-40-year-old national sales manager, who was terminated due to alleged performance-related issues, presented sufficient evidence to proceed with his ADEA and state law age bias claims, a federal district court in Texas ruled (Woolsey v Klingspor Abrasives, Inc., NDTex,). Although an alleged remark by the president referring to the sales manager and another older employee as not being "spring chickens" was not direct evidence, the court held it could support an inference of age bias. Further, the sales manager presented Sufficient. evidence of pretext based on the employer's changing and inconsistent reasons for the termination, reasoned the court. Moreover, the reasons for the employee's termination and the identity of the decision maker set forth during discovery in the underlying litigation were also conflicting. Because the employer failed to provide a legitimate explanation for such inconsistencies, the court held that the unexplained variations could allow a jury to infer that the employer's proffered reasons for the employee's discharge were pretext.

Employer may not set-off severance payout against potential overtime due under FLSA

An employer may not set off the value of benefits that it paid out under a severance agreement against a claim for overtime wages under the FLSA, the Fifth Circuit ruled, reiterating its bright-line rule that set-offs and counterclaims are not permissible in FLSA suits (Martin v PepsiAmericas. Inc, ).

Employee's retaliation claims proceed after being disconnected from employer's e-mail, network systems.

An employee's Title VII and FLSA retaliation claims survived employer's summary judgment motion, as a federal court found that employer's actions, which included deactivating the employee's keyfob, disabling her network and e-mail access and ultimately terminating employment after she reported gender discrimination. The court noted that these were adverse employment actions. (EEOC v. Southeast Telecom, Inc.) The fact that the complaint of discrimination was made, the disconnections occurred and the employee was terminated all within one week gave rise to an inference of a causal between her complaint and the employer's adverse actions, including but not limited to the termination of her employment.

About our authors:

M. Blen Gee, Jr. is an honors graduate of the University of North Carolina School of Law. His areas of concentration include business and corporate law, including sales of businesses; business litigation, including arbitration and mediation; franchise law; automobile dealer law; and insurance company insolvency. Mr. Gee has earned the highest peer-review rating for professional excellence and ethical standards by the national publication Martindale Hubbell.

 

F. Stephen Glass the author of numerous publications on business and business entities as well as estate planning. He is a frequent presenter for the National Business Institute. His practice is concentrated in the areas of business and corporate law, business succession planning and estate planning. He serves on the Cary board of Capital Bank. Mr. Glass has earned the highest peer-review rating for professional excellence and ethical standards by the national publication Martindale Hubbell. He serves on the American Bar Association Business Law Committee on Corporate Governance.

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