TAX COURT RULES ATTORNEYS WERE EMPLOYEES OF LAW FIRM

March/April 2011

By Scott E. Vincent, Partner

A recent Tax Court decision has important employment tax implications for law firms that do not treat attorneys working with the firm as employees.  In Donald G. Cave A Professional Law Corp. v. Commissioner, T.C. Memo 2011-48, the Tax Court found that attorneys working with an S corporation law firm were employees of the firm for employment tax purposes, and that the firm was liable for employment taxes and penalties with respect to amounts paid to the attorneys for the periods in question.  This decision was contrary to the independent contractor treatment that the law firm sought to sustain with the IRS and in Tax Court, and also required employment taxes with respect to the S corporation’s sole shareholder.

Statutory and Common Law Background

Code Sections 3111 and 3301 impose FICA (social security) and FUTA (unemployment) taxes on employers for wages paid to their employees. Code Section 3121(d)(2) provides that for FICA tax purposes the term “employee” includes any individual who has the status of an employee under common law. Code Sections 3121(d)(1), 3121(d)(3) and 3121(d)(4) describe other individuals who are considered employees for FICA tax purposes regardless of their status under common law. These individuals are commonly referred to as “statutory” employees.

An officer of a corporation who performs substantial services for the corporation and receives remuneration for such services is a statutory employee for employment tax purposes (Code Sections 3121(d)(1), 3306(i), and 3401(c)).

Whether a worker is an independent contractor or employee under the common law rules generally is determined by whether the enterprise he works for has the right to control and direct him in completing the job in question.  The Court of Appeals for the Fifth Circuit, to which the case in question is appealable, considers the following factors in deciding whether a worker is a common law employee:

1. The degree of control the principal has over the worker;
2. the worker's opportunity for profit or loss; 
3. the worker's investment in facilities;
4. the permanence of the relationship; and
5. the skill required in the operation.

However, Section 530 of the Revenue Act of 1978 (as amended) provides retroactive and prospective relief from employment tax liability for employers who misclassified workers as independent contractors using the common-law facts and circumstances standards. Section 530 applies only if:

1. the taxpayer does not treat an individual as an employee for any period, and does not treat any other individual holding a substantially similar position as an employee for purposes of employment tax for any period — the substantive consistency requirement;
2. for post-1978 periods, “all federal returns (including information returns) required to be filed by the taxpayer” with respect to the individual for such period “are filed on a basis consistent with the taxpayer's treatment” of the individual as a nonemployee — the reporting consistency requirement; and
3. the taxpayer had a “reasonable basis” for not treating the worker as an employee (judicial precedent or IRS rulings, a past IRS audit, or a long-standing practice of a significant segment of the relevant industry) — the reasonable basis requirement.

Factual Background

Donald G. Cave A Professional Law Corp. (the “Firm”) was incorporated as a Louisiana professional law corporation. Its business consisted primarily of representing individuals injured in accidents, and fees generated from the provision of legal services were its only source of income in 2003 and 2004.  All attorney's fees and reimbursements of case expenses were paid directly to the Firm, which then paid a portion of the gross fee (generally one-half or one-third) to the attorney who handled the case.

The Firm was an S corporation for Federal income tax purposes in 2003 and 2004. Donald Cave was the Firm's president and sole shareholder.

For 2003 and 2004, Firm did not treat Donald Cave, three associate attorneys and a law clerk as employees for employment tax purposes. The Firm issued Forms 1099-MISC to the associate attorneys and the law clerk for those years. The Firm did not issue a Form W-2 or a Form 1099-MISC to Donald Cave for 2003 and 2004.

Donald Cave believed it was appropriate for the Firm to treat the associate attorneys and law clerk as independent contractors because he did not have sufficient control over their work. The record did not disclose, however, the basis on which he determined it was appropriate for the Firm to treat them and himself as independent contractors. The Firm's certified public accountant agreed with Donald Cave that the attorneys and law clerk should be classified as independent contractors for employment tax purposes but did not investigate the facts or do any research to verify Mr. Cave's position.

Upon examination, the IRS determined that Donald Cave, the associate attorneys and the law clerk were the Firm's employees for 2003 and 2004 and that the Firm was not entitled to Section 530 relief. The IRS concluded that Donald Cave was a statutory employee, and that the associate attorneys and law clerk were common-law employees.  As a result, the IRS determined that the Firm was liable for employment taxes and penalties. The Tax Court agreed with all aspects of the IRS determination.

Tax Court Decision

The Tax Court noted that during the years in question Donald Cave was the Firm's president, made virtually all corporate decisions with respect to the Firm, received a percentage of the legal fees recovered in cases he handled, and received draws from the Firm of $48,000 and $360,000. These facts established that Donald Cave was the Firm's statutory employee under Code Section 3121(d)(1).

After reviewing all of the relevant facts and circumstances, the Tax Court concluded that the associate attorneys were the Firm's common-law employees. Three of the five specific factors — degree of control, investment in facilities, and permanence of the relationship – indicated an employer-employee relationship.  The Tax Court found that the remaining factors were neutral. Importantly, the Tax Court also noted that the work performed by the associate attorneys was an integral part of the Firm's business, which further supported the conclusion that the workers were employees.

The Court also concluded that the law clerk was a common-law employee after finding that three of the five specific factors — degree of control, investment in facilities, and profit or loss — were indicative of an employer-employee relationship. In particular, Firm's control over the law clerk's work and compensation arrangements strongly suggested that he was the Firm's employee during the periods in question.

The Tax Court also agreed with the IRS and determined that no Section 530 relief was available with respect to the workers for the following reasons:

• Although Section 530 relief is not by its terms limited to situations involving worker classification under common law, the Tax Court has previously held that it is not available with respect to statutory employees.  Donald Cave was the Firm's statutory employee for the periods in question, so Section 530 relief was not available with respect to him.
• The Firm did not establish that it had any reasonable basis for treating the associate attorneys as independent contractors, so Section 530 relief was not available for these workers.
• Section 530 relief was not available for the Firm’s law clerk because the Firm had previously treated law clerks as employees.

Conclusion

The Cave case provides a key warning to law firms treating attorneys as independent contractors without carefully documenting the relationship and establishing the basis for the treatment.  It is also an important reminder that S corporation shareholders of a law firm are also employees of the firm, and some reasonable portion of their distributions from the firm should be treated as compensation for employment tax purposes.  

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.