COURT RULES: ANY PAYMENTS IN EXCHANGE FOR SERVICES ARE TAXABLE

A small business owner recently failed to persuade the Tax Court that royalty payments made by the corporation to her were not wages and should not be subject to federal payroll taxes. The court reminded her that she is free to call the payments whatever she liked but if they are made in exchange for services, they are taxable.

Royalty Payments

The taxpayer and her husband owned equal shares in a closely-held small business. The business sold office and other supplies to the federal government.

The husband had a full-time job and was only minimally involved in the business. The wife, however, was the business' sole employee. She took orders from customers, filled the orders, received payments from customers and paid creditors. She also served as the corporation's president and director.

In 1996, the business entered into three contracts with the wife. The first was an employment agreement. The business agreed to pay the wife $400 per month in return for her services. The wife also received $600 per month under a rental agreement. Under the third and final agreement, she received a monthly royalty payment.

The monthly royalty payment was the greater of $200 or five percent of gross receipts. The royalty was purportedly paid in exchange for the wife's transfer of her exclusive knowledge, existing contracts, and her status as a woman business owner.

Over four years, the wife received more than $175,000 in royalties from the business. The company did not withhold FICA and FUTA taxes on the royalties because it contended the payments were not wages. The IRS disagreed. It determined that the royalties were really wages and, therefore, they were taxable.

Tax Court's Analysis

The Tax Court began its analysis by looking at the definition of "wages." Federal tax law takes a very expansive view of the term wages. All remuneration for employment is treated as wages.

When a corporate officer performs substantial services for the company and receives remuneration, he or she is treated as an employee. His or her compensation, in any form, is taxable.

In this case, the court found that the wife was an officer of the business. She was its president. The court also found that the wife performed substantial services for the business. Because she was the only person engaged in the business daily, her services were essential to the success of the business.

She was responsible for taking orders from customers, filling the orders, and shipping merchandise. She negotiated with vendors for the best price for merchandise. She also kept the company's books and paid its creditors. Therefore, her remuneration, even though it was called "royalty payments" was wages and subject to FICA and FUTA.