                      117 T.C. No. 14



                UNITED STATES TAX COURT



 VETERINARY SURGICAL CONSULTANTS, P.C., Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 2500-99.                     Filed October 15, 2001.



     P, an S corporation, distributed all of its net
income to A, its sole shareholder and president.       A
performs substantial services for P. On his Forms 1040,
A reported P’s net income as nonpassive income from an S
corporation.

     R issued to P a Notice of Determination Concerning
Worker Classification Under Sec. 7436, determining that
A was an employee of P for purposes of Federal employment
tax.

     Held: A is an employee of P for purposes of Federal
employment tax pursuant to sec. 31.3121(d)-(1)(b),
Employment Tax Regs., because A is an officer who
performs substantial services for P and receives
remuneration for those services.
                              - 2 -

          Held, further, P is not entitled to relief pursuant
     to sec. 530 of the Rev. Act of 1978, Pub. L. 95-600, 92
     Stat. 2763, 2885, because P did not have a reasonable
     basis for not treating A as an employee.



     Joseph H. O’Donnell, Jr., for petitioner.

     Kathleen K. Raup, for respondent.


                             OPINION


     JACOBS, Judge:   This case is before the Court on a petition

for redetermination of a Notice of Determination Concerning Worker

Classification Under Section 7436 (Notice of Determination).     It

was submitted to the Court fully stipulated under Rule 122.     The

sole issue to be decided is whether Kenneth K. Sadanaga, D.V.M.

(Dr. Sadanaga), is an employee of petitioner for the period at

issue (each of the four quarters of 1994, 1995, and 1996) for

purposes of Federal employment taxes.1

     Rule references are to the Tax Court Rules of Practice and

Procedure, and except as otherwise noted, section references are to

the Internal Revenue Code in effect for the years at issue.




     1
          For convenience, we use the term “Federal employment
tax” to refer to taxes under secs. 3101-3125 (enacted as Federal
Insurance Contributions Act (FICA), ch. 9, 53 Stat. 175 (1939))
and secs. 3301-3311 (enacted as Federal Unemployment Tax Act
(FUTA), ch. 9, 53 Stat. 183 (1939)).
                                     - 3 -

                                   Background

      The   stipulation    of   facts      and   the   attached     exhibits      are

incorporated herein.          The stipulated facts are hereby found.

       Petitioner is an S corporation that was incorporated in

Pennsylvania on May 22, 1991.         At the time the petition was filed,

petitioner’s      principal     place      of    business    was     in    Malvern,

Pennsylvania.     Petitioner’s only business is providing consulting

and    surgical    services     to      veterinarians.       Dr.     Sadanaga      is

petitioner’s      sole   shareholder       and   serves     as    its     president,

petitioner’s only officer.

      Since petitioner’s incorporation, all of its income has been

generated from the consulting and surgical services provided by Dr.

Sadanaga to Veterinary Orthopedic Services, Ltd. (Orthopedic).

During the period at issue, Dr. Sadanaga spent at least 33 hours

per week providing consulting and surgical services on behalf of

petitioner. He performed surgeries at the Veterinary Referral

Center in Frazer, Pennsylvania, and consulted with veterinarians in

their offices or his home.

      Dr. Sadanaga is the only person with signature authority on

petitioner’s      bank   account.          Dr.    Sadanaga       handled    all    of

petitioner’s correspondence and performed all administrative tasks

on behalf of petitioner.        Petitioner did not make regular payments

to    Dr.   Sadanaga;    rather,     Dr.    Sadanaga    withdrew        money     from

petitioner’s bank account at his discretion.
                                    - 4 -

        Petitioner received a Form 1099-MISC, Miscellaneous Income,

from Orthopedic reporting “non-employee compensation” during each

of the quarters at issue.           The Forms 1099-MISC reported that

Orthopedic paid petitioner $125,152.63 in 1994, $225,469.24 in

1995,    and    $212,863   in   1996.   Petitioner    reported   the   amount

reflected on the Forms 1099-MISC as its total gross receipts on its

Form 1120S, U.S. Income Tax Return for an S Corporation, for 1994,

1995, and 1996.

        On Forms 1120S, petitioner reported net income from its trade

or business for 1994, 1995, and 1996 in the respective amounts of

$83,995.50, $173,030.39, and $161,483.35.             Petitioner paid these

amounts    to   Dr.   Sadanaga,   and   reported     these   amounts   as   Dr.

Sadanaga’s share of its income on Schedules K-1, Shareholders’

Shares of Income, Credits, Deductions, etc., of the Forms 1120S.

Petitioner reported on Schedules M-2, Analysis of Accumulated

Adjustments Account, Other Adjustments Account, and Shareholders’

Undistributed Taxable Income Previously Taxed, of the Forms 1120S,

that the amounts it paid to Dr. Sadanaga were distributions other

than dividend distributions paid from accumulated earnings and

profits.

        Petitioner did not issue a Form 1099-MISC or a Form W-2, Wage

and Tax Statement, to Dr. Sadanaga for 1994, 1995, or 1996.                 Nor

did petitioner file a Form 941, Employer’s Quarterly Federal Tax

Return, or a Form 940, Employer’s Annual Federal Unemployment Tax
                                    - 5 -

Return, for any quarter during the period at issue.          On Schedules

E, Supplemental Income and Loss, of Dr. Sadanaga’s 1994, 1995, and

1996 Forms 1040, U.S. Individual Income Tax Returns, Dr. Sadanaga

reported his share of petitioner’s income (as indicated on the

Schedules K-1) as nonpassive income from an S corporation.

     Dr. Sadanaga was a full-time employee of Bristol-Myers Squibb

Co. (Bristol-Myers).         He reported wages from Bristol Myers of

$91,212.18 in 1994, $95,891.15 in 1995, and $102,031.14 in 1996.

In 1994, 1995, and 1996, Bristol-Myers withheld Social Security

taxes from Dr. Sadanaga.

     Respondent began an audit of petitioner’s return for 1995 in

May 1997.     On October 22, 1997, Revenue Agent James Tepper, and

petitioner’s accountant, Joseph Grey, met to discuss the audit.

Revenue Agent Orville Surla joined Revenue Agent Tepper and Mr.

Grey to discuss whether Dr. Sadanaga was an employee of petitioner

in 1995.    Mr. Grey asserted that Dr. Sadanaga was not an employee

of petitioner and that the distribution to him from petitioner

represented    his   share   of   petitioner’s   net   income.   Mr.   Grey

objected to any assessment of Federal employment taxes against

petitioner.    Because Mr. Grey and Revenue Agent Tepper could not

reach any agreement      with respect to the Federal employment tax

issue, the issue was referred to Revenue Agent Surla.

     On March 16, 1998, respondent sent petitioner a 30-day letter,

proposing adjustments to petitioner’s Federal employment taxes for
                               - 6 -

each of the four quarters of 1994, 1995, and 1996.       On April 3,

1998, petitioner submitted to respondent a letter protesting the

proposed adjustments.

     On October 5, 1998, respondent sent petitioner a letter

advising that there would be no change resulting from the audit of

petitioner’s Form 1120S for 1995. On November 17, 1998, respondent

issued to petitioner a Notice of Determination, in which respondent

determined that (1) Dr. Sadanaga was an employee of petitioner for

purposes of Federal employment taxes, and (2) petitioner was not

entitled to “safe harbor” relief from these taxes as provided by

section 530 of the Revenue Act of 1978, Pub. L. 95-600, 92 Stat.

2885 (Section 530).   Attached to the Notice of Determination was a

schedule detailing the amount of the proposed Federal employment

taxes.     Thereafter, petitioner filed with the Court a timely

petition    seeking   our   review   of   respondent’s   Notice   of

Determination.

                             Discussion

     Petitioner contends that Dr. Sadanaga was not its employee

and that it properly distributed its net income to Dr. Sadanaga, as

its sole shareholder, pursuant to section 1366. On the other hand,

respondent contends that Dr. Sadanaga was an employee of petitioner

because he was an officer of petitioner and performed substantial

services on petitioner’s behalf.
                                       - 7 -

        Sections 3111 and 3301 impose FICA (Social Security) and FUTA

(unemployment)       taxes     on   employers    for   wages   paid    to    their

employees.        For Federal employment tax purposes, section 3121(d)

defines an employee in part as any officer of a corporation.

However, there is an exception to employee status for an officer

who does not perform any services (or performs only minor services)

and who neither receives nor is entitled to receive remuneration.

Sec.        31.3121(d)-(1)(b),      Employment   Tax   Regs.     For    Federal

employment tax purposes, the term “wages” is defined as “all

remuneration for employment”.2           Secs. 3121(a), 3306(b).       The form

of payment is immaterial, the only relevant factor being whether

the payments were actually received as compensation for employment.

Secs.       31.3121(a)-1(b),     31.3306(b)-1(b),      Employment     Tax    Regs.

Consequently, an officer who performs substantial services for a

corporation and who receives remuneration in any form for those

services is considered an employee, whose wages are subject to

Federal employment taxes.

        With respect to the case at hand, Dr. Sadanaga is an officer

of petitioner, and therefore he is an employee of petitioner under

the general rule of section 3121(d)(1). Additionally, Dr. Sadanaga

performed         substantial       services     for   petitioner,          working

approximately 33 hours a week for petitioner.             Indeed, he was the


        2
          There are some exceptions to this definition that are
not relevant to this case.
                                        - 8 -

only   individual     working     for    petitioner.        Tellingly,     all   of

petitioner’s income was generated from the consulting and surgical

services provided by Dr. Sadanaga.

       Petitioner contends that the amounts paid to Dr. Sadanaga were

distributions of its corporate net income, rather than wages.

Petitioner posits that as an S corporation it passed its net income

to Dr. Sadanaga, as its sole shareholder, pursuant to section 1366.

Petitioner’s argument is flawed.                Section 1366 permits use of S

corporation passthrough items only in calculating tax liability

under chapter 1, not tax liability under chapters 21 and 23--in

which the Federal employment tax provisions for FICA and FUTA are

located.    Sec. 1366(a)(1); see also Ding v. Commissioner, 200 F.3d

587, 590 (9th Cir. 1999), affg. T.C. Memo. 1997-435;                  Catalano v.

Commissioner, T.C. Memo. 1998-447.

       Dr. Sadanaga performed substantial services on behalf of

petitioner. The characterization of the payment to Dr. Sadanaga as

a distribution of petitioner’s net income is but a subterfuge for

reality;    the     payment     constituted       remuneration     for    services

performed by Dr. Sadanaga on behalf of petitioner.                   An employer

cannot     avoid     Federal      employment       taxes    by     characterizing

compensation       paid   to    its    sole   director     and   shareholder     as

distributions of the corporation’s net income, rather than wages.

Regardless of how an employer chooses to characterize payments made

to   its   employees,     the   true    analysis    is   whether    the   payments
                                     - 9 -

represent remuneration for services rendered.             Spicer Accounting,

Inc. v. United States, 918 F.2d 90 (9th Cir. 1990); Joseph Radtke,

S.C. v. United States, 895 F.2d 1196 (7th Cir. 1990).

     Dr.   Sadanaga’s      reporting    the    distributions    as   nonpassive

income   from    an   S   corporation    has   no   bearing    on   the   Federal

employment tax treatment of those wages.            He was petitioner’s sole

source of income.         And as petitioner’s sole full-time worker he

must be treated as an employee.         Spicer Accounting, Inc. v. United

States, supra at 94-95.       Accordingly, we hold that Dr. Sadanaga is

an employee of petitioner for the period at issue and, as such, the

payments to him from petitioner constitute wages subject to Federal

employment taxes.

     Despite our determination that Dr. Sadanaga is an employee of

petitioner, and that the payments to him from petitioner are wages

subject to Federal employment taxes, Section 530 allows petitioner

relief   from    employment    tax     liability    if   two   conditions    are

satisfied.      Section 530(a)(1) provides in relevant part:

     (1) In general.-–If

                (A) for purposes of employment taxes, the
           taxpayer did not treat an individual as an
           employee for any period * * *, and

                (B) in the case of periods after December
           31, 1978, all Federal tax returns (including
           information returns) required to be filed by
           the taxpayer with respect to such individual
           for such period are filed on a basis
           consistent with the taxpayer’s treatment of
           such individual as not being an employee,
                                      - 10 -


     then, for purposes of applying such taxes for such period
     with respect to the taxpayer, the individual shall be
     deemed not to be an employee unless the taxpayer had no
     reasonable basis for not treating such individual as an
     employee.

     Here,       the    first   of   the    two    conditions      is    satisfied.

Petitioner did not treat Dr. Sadanaga as an employee during the

period in issue. Since its incorporation, petitioner filed its tax

returns reflecting all withdrawals by Dr. Sadanaga as distributions

of petitioner’s income, not wages.

     However, the second condition of Section 530(a)(1) is not

satisfied because petitioner had no reasonable basis for not

treating Dr. Sadanaga as an employee.                For purposes of Section

530(a)(1), a taxpayer is treated as having a reasonable basis for

not treating       an   individual    as    an    employee   if    the    taxpayer’s

treatment of the individual was in reasonable reliance on judicial

precedent, published rulings, technical advice with respect to the

taxpayer,    a    letter    ruling    to    the    taxpayer,      or    longstanding

recognized practice of a significant segment of the industry in

which the individual was engaged.            Section 530(a)(2).

     Section 3 of Rev. Proc. 85-18, 1985-1 C.B. 518, provides

several   alternative       standards      that   constitute      safe    havens   in

determining whether a taxpayer has a reasonable basis for not

treating an individual as an employee.                 That revenue procedure

provides that reasonable reliance on any one of the following safe

havens is sufficient:
                                  - 11 -

          (A) judicial precedent or published rulings,
     whether or not relating to the particular industry or
     business in which the taxpayer is engaged, or technical
     advice, a letter ruling, or a determination letter
     pertaining to the taxpayer; or

          (B) a past Internal Revenue Service audit (not
     necessarily for employment tax purposes) of the taxpayer,
     if the audit entailed no assessment attributable to the
     taxpayer’s employment tax treatment of individuals
     holding positions substantially similar to the position
     held by the individual whose status is at issue * * *; or

          (c) long-standing    recognized practice of a
     significant segment of the industry in which the
     individual was engaged * * *.

     A taxpayer who fails to meet any of the safe havens is still

entitled to relief if the taxpayer can demonstrate, in some other

manner, a reasonable basis for not treating the individual as an

employee.    Id.

     Here, petitioner asserts that its position is supported by the

following excerpt from Durando v. United States, 70 F.3d 548, 552

(9th Cir. 1995):

     [It is] improper to treat income earned by a corporation
     through its trade or business as though it were earned
     directly by its shareholders, even when, as here, the
     shareholders’ services help to produce that income. An
     S corporation’s income passes through to its shareholders
     not because they helped to create that income, but
     because they are shareholders.

     The    excerpt   relied   upon   by   petitioner   does   not   support

petitioner’s position.         Respondent is not attempting to treat

petitioner’s income as though the income were earned directly by
                                     - 12 -

Dr. Sadanaga.        Rather, the issue in this case is              whether the

distributions paid to Dr. Sadanaga are wages paid to Dr. Sadanaga

as an employee of petitioner.

     Petitioner asserts that Durando v. United States, supra, holds

that an S corporation shareholder is not an employee for purposes

of deducting contributions to a Keogh plan.3               Petitioner misstates

the holding of Durando v. United States.             Contrary to petitioner’s

assertion, the taxpayers in the Durando case did not claim to be

employees of an S corporation.            Rather, such taxpayers were self-

employed individuals, who in that capacity earned income reportable

on Schedule C, Profit (or Loss) From Business or Profession, and

were shareholders in several S corporations.                They claimed Keogh

retirement plan deductions by adding their shares of income from

the several     S    corporations    to    the   amounts    reported    on   their

Schedules C and taking a deduction of 15 percent of the total.                 The

Commissioner disallowed the deductions attributable to the income

from the S corporations.            The taxpayers’ Keogh plans were not

qualified    plans    established     by   the   S   corporations      for   their

employees.    Citing section 1372, the court specifically noted that

“S corporations can establish retirement plans for their employees,

including those who are also shareholders” and that shareholders



     3
          Keogh plans are retirement plans for self-employed
individuals. A self-employed individual can deduct contributions
to a qualified retirement plan up to a limit of 15 percent of his
or her earned income. Sec. 404(a)(3)(A), (8)(D).
                                   - 13 -

“who provide services to an S corporation can be treated like

employees and covered by that corporation’s retirement plan.”

Durando v. United States, supra at 551.          In sum, the Durando case

does not provide a reasonable basis for not treating Dr. Sadanaga

as an employee.

       Petitioner also relies on Rev. Rul. 59-221, 1959-1 C.B. 225.

Rev.   Rul.   59-221,    supra,   holds   that   where   a   small   business

corporation elects under section 1372 not to be subject to Federal

income tax, the amount of its income required to be included in

each shareholder’s gross income does not constitute “net earnings

from self-employment” to such shareholders for purposes of the

Self-Employment Contributions Act.          That ruling, like the Durando

case, deals solely with whether amounts a shareholder receives are

derived from a trade or business carried on by the shareholder.            In

the case at hand, the issue is whether an officer is an employee of

a corporation. Rev. Rul. 59-221, supra, makes no mention of either

corporate     officers   or   their   Federal    employment    tax    status.

Therefore, the ruling does not provide a reasonable basis for

treating Dr. Sadanaga other than as an employee.

       Petitioner attempts to distinguish the facts in this case from

cases holding that officers who performed substantial services for

an S corporation are employees for purposes of Federal employment

taxes.    In Spicer Accounting, Inc. v. United States, 918 F.2d 90

(9th Cir. 1990), and Radtke v. United States, 895 F.2d 1196 (7th
                                    - 14 -

Cir.    1990),   the   corporations      characterized      payments     to   their

officer/shareholders as dividends rather than wages.                     In those

cases,    the    courts   found   that     the   payments    were   in    reality

remuneration     for   employment    and    therefore    subject    to    Federal

employment taxes.      Spicer Accounting, Inc. v. United States, supra

at 93;     Radtke v. United States, supra at 1197.                     Petitioner

attempts to distinguish its case from the Spicer and Radtke cases

because petitioner reported the payment to Dr. Sadanaga as a

distribution of its net income, which Dr. Sadanaga reported as

nonpassive income from an S corporation. But as stated previously,

we find that the distributions were remuneration for services

provided by Dr. Sadanaga.         Thus, the “dividends” in the Spicer and

Radtke cases are indistinguishable from the distributions in this

case.

       Petitioner also misstates the findings and conclusions of this

Court in Joly v. Commissioner, T.C. Memo. 1998-361, affd. without

published opinion 211 F.3d 1269 (6th Cir. 2000).                       Petitioner

asserts that the corporation in the Joly case was compelled to

treat income distributed to its shareholders as wages for the

reason that the corporation and shareholders could not prove that

any stock was issued to the shareholders.               To the contrary, the

Court found that part of the distributions to the two shareholders

was compensation for services and, thus, constituted wages subject

to Federal employment taxes.         The balance of the distribution was
                                       - 15 -

taxable under section 1368 as gain from the sale or exchange of

property to the extent the distributions exceeded the shareholders’

bases in their stock.         The Court found that the shareholders had

not established that their bases in their corporate stock at the

beginning of the first taxable year before the Court was other than

zero.    But there was no question as to the shareholders’ ownership

of the stock of the corporation.

        Petitioner next cites for support the following excerpt from

Rev.    Rul.   71-86,      1971-1    C.B.    285:     “The    president    and    sole

shareholder, except for qualifying shares, of a closely held

corporation     is    an   employee    of    the    corporation      for   [Federal]

employment tax purposes, notwithstanding that he sets his own

salary and prescribes his own duties.” (Emphasis supplied by

petitioner.)      Petitioner contends:             (1) Rev. Rul. 71-86, supra,

exempts the sole shareholder of an S corporation from Federal

employment taxes with regard to any income distributed to the

“qualifying shares” shareholder, and (2) Dr. Sadanaga is such a

shareholder because he holds all of the stock in the corporation.

Petitioner again misreads the revenue ruling.                    The individual at

issue    in    that   revenue       ruling    owned    all     the   stock   of    the

corporation, except for qualifying shares.                   The revenue ruling did

not define “qualifying shares”.              (We note, however, that the term

generally refers to shares issued to an individual in order to

qualify the individual as an incorporator or director where an
                                   - 16 -

incorporator    or   director   is   required   to    own   stock    in   the

corporation.    See, e.g.,   Roche’s Beach, Inc. v. Commissioner, 35

B.T.A. 1087 (1937); 2 Fletcher Cyclopedia of the Law of Private

Corporations, secs. 297-306 (perm. ed., rev. vol. 1998).)             Here,

Dr. Sadanaga owns all the shares of petitioner’s stock, and there

is no evidence that any shares were issued solely to qualify Dr.

Sadanaga as a director or an incorporator. Rev. Rul. 71-86, supra,

supports respondent’s position; it does not provide an exception

for petitioner.

     Finally, petitioner argues that section 1372 prohibits a 2-

percent shareholder of an S corporation from being treated as an

employee of the S corporation. Section 1372, however, applies only

to the provisions of subtitle A, income taxes, not subtitle C--in

which Federal employment tax provisions are located.

     In Rev. Rul. 73-361, 1973-2 C.B. 331, an officer/stockholder

of a small business corporation performing substantial services as

an officer of the corporation was held to be an employee of the

corporation for purposes of Federal employment taxes.            Rev. Rul.

73-361, supra, states:

          Neither the election by the corporation as to the
     manner in which it will be taxed for Federal income tax
     purposes nor the consent thereto by the stockholder-
     officers has any effect in determining whether they are
     employees or whether payments made to them are “wages”
     for Federal employment tax purposes.

     In Rev. Rul. 74-44, 1974-1 C.B. 287, two sole shareholders of

an   electing   small   business     corporation     arranged   to   receive
                               - 17 -

dividends instead of reasonable compensation for services they

performed.    That   revenue   ruling   held   that   the   “dividends”

constituted wages subject to Federal employment taxes.

     In this case, respondent’s position is supported by the plain

language of the statute, the applicable Treasury regulations,

published revenue rulings, and cases interpreting the applicable

statutes. Petitioner’s position is inconsistent with the weight of

authority.

     Petitioner argues that Dr. Sadanaga paid the maximum FICA tax

required by law in each year at issue and that respondent is

attempting to assess additional tax on Dr. Sadanaga in the form of

withholding taxes.   This argument is simply a “red herring”.       For

Federal employment tax purposes, the taxable wage base applies

separately to each employer.    Thus, if an employee receives wages

from more than one employer, the annual wage limitation does not

apply to the aggregate compensation received. The employee however

may be eligible for a credit or refund of the excess employee

portion of the FICA tax that applies with respect to wages in

excess of the applicable wage base.     Secs. 31.3121(a)(1)-1(a)(3),

31.3306(b)(1)-1(a)(3), Employment Tax Regs.

     We have considered all of petitioner’s arguments, and, to the

extent not specifically addressed, we find them unpersuasive or

irrelevant.
                                         - 18 -

                                   ______________

      After the petition was filed in this case, Congress amended

section    7436(a)       to   provide    this     Court   with   jurisdiction        to

determine the correct amounts of Federal employment taxes that

relate     to    the     Secretary’s      determination        concerning       worker

classification.          See Community Renewal Tax Relief Act of 2000

(CRTRA), Pub. L. 106-554, sec. 314(f), 114 Stat. 2763A-643.                       That

amendment was made retroactive to the effective date of section

7436(a).    CRTRA sec. 314(g), 114 Stat. 2763A-643.

      The parties filed a Stipulation of Settled Issues setting

forth the       proper    amount    of   Federal    employment        taxes   owed   by

petitioner in the event we find that Dr. Sadanaga is petitioner’s

employee for purposes of Federal employment taxes (which we do).

The   amount     so    stipulated    will    be    reflected     in    our    decision

document.

      To reflect the foregoing,



                                                     Decision will be entered

                                                for respondent and in accordance

                                                with the parties’ stipulations

                                                as to amounts.
