IRS reclassifies royalties as wages.

In a landmark decision, Charlotte's Office Boutique, Inc., 121 TC No. 6 (2003), the Tax Court determined that "royalties" paid to a C corporation officer were actually wages. In addition, the corporation was liable for payroll taxes on the wages, without entitlement to relief under Revenue Act of 1978 (RA '78) Section 530.

Facts

Charlotte's Office Boutique, Inc., a C corporation, was formed on Jan. 3, 1995. Before incorporation, Ms. Odell (an officer of the corporation and one of its two shareholders) operated the business as a sole proprietorship. The business sold office supplies and equipment to the Federal government.

Allegedly, on incorporation, Ms. Odell did not transfer ownership interests in her customer lists and contracts; rather, she entered into a licensing and sale agreement that set forth a royalty fee, based on gross receipts, stemming from the transfer of her "know-how," "existing contracts" and "woman owned-business status." Ms. Odell also executed employment and rental agreements.

The business itself seemed to require very little labor; Ms. Odell worked an average of two hours per day. The employment agreement provided that the corporation would pay Ms. Odell $400 per month to fulfill her responsibilities.

The corporation paid rent, wages and royalties and sporadically filed Form 941, Employer's Quarterly Federal Tax Return, from 1996-1998. In January 2001, as result of an employment tax audit, the IRS issued a Notice of Determination Concerning Worker Classification Under Section 7436.

IRS's Position

The IRS established that Ms. Odell, in her position as a corporate officer, was performing significant services for the corporation and receiving remuneration. This is the definition of an employee; see Veterinary Surgical Consultants, P.C., 117 TC 141 (2001). The court held for the IRS; thus, all of the amounts paid to Ms. Odell were wages subject to employment taxes. Further, despite the court's recognition that royalties may be paid for the use of intangible property rights (see Or. State Univ. Alumni Ass' n, 193 F3d 1098 (9th Cir. 1999)), it determined that the payments to Ms. Odell were not royalties. The "existing contracts" "know how" and customer lists that gave rise to the royalty payments were the same ones Ms. Odell had used when self-employed (SE) and had generated income subject to SE tax.

RA '78 Section 530 Relief

The next issue was whether the taxpayer was eligible for RA '78 Section 530 relief from employment taxes on the wages; there are three requirements:

1. The taxpayer did not treat the individual as an employee for any period.

2. For all periods beginning after 1978, the taxpayer's returns consistently treated the individual as a nonemployee.

3. There was a reasonable basis for not treating the individual as an employee as to the payments.

The Tax Court held that the taxpayer failed to meet the third requirement. The cases and revenue rulings the taxpayer cited did not support the proposition that it reasonably believed the payments to Ms. Odell were made to her in her capacity as a nonemployee.

Penalties

Finally, the taxpayer was found liable for additions to tax. Although it appears that this case is an attack on nonemployee compensation and royalty payments, certain subtleties reveal there was also some misuse of form. Before incorporation, Ms. Odell derived SE income and paid SE taxes on the revenues generated from the lists, contacts and contracts she developed. Following the incorporation of the business, she deemed these same lists, contacts and contracts--so crucial to a successful sales business--intangible assets generating royalty payments. Lists, contacts and contracts are merely paper. Without a competent individual/employee, these intangibles could never close a sale.

FROM DONNA MEDOFF, CPA, GRAY, GRAY & GRAY, LLP, WESTWOOD, MA

Editor:

Michael D. Koppel, CPA

Partner

Gray, Gray & Gray, LLP

Accounting Firms Associated, Inc. (AFAi)

Westwood, MA