Two owners of closely held companies were paid by their own corporations but reported the pay as 1099 nonemployee compensation, not wages. Can they still claim the employee wage exemption from gross receipts tax?

Subject

Louis & Carolyn Bortot (D&O 98-52)

Plain-English summary

Louis and Carolyn Bortot ran two small, closely held family corporations in Gallup, New Mexico: Lumic, Inc. (a commercial rental building, 51% owned by the Bortots and 49% by their children) and Nizhoni Self Storage, Inc. (self-storage units, split 50/50 with a cousin). The Bortots did everything to run both companies — collecting rents, maintaining the properties, and managing operations.

In 1993 the corporations paid Mr. Bortot $3,000 and Mrs. Bortot $28,100. On the corporations' federal returns (Form 1120) those amounts were deducted as "commissions" or "management commissions," and the corporations issued the Bortots Form 1099s reporting the pay as "nonemployee compensation." The Bortots, in turn, reported the money on Schedule C-EZ as net profit from a business and paid self-employment tax on it. Their accountant chose this treatment to simplify reporting and avoid income-tax-withholding paperwork — not to avoid tax.

After an IRS information-sharing match, the Department assessed $2,737.22 in gross receipts tax, $273.72 penalty, and $1,300.18 interest for 1993. The Bortots protested, arguing the pay was really employee wages, which are exempt from gross receipts tax under Section 7-9-17. Hearing Officer Gerald B. Richardson denied the protest.

Ordinarily, "employee vs. independent contractor" turns on the common-law right-to-control test, and here control was not in doubt — the Bortots, as officers, managers, and majority shareholders, controlled their own activities. But the Hearing Officer never had to resolve that, because a separate, well-settled rule decided the case: in New Mexico a taxpayer must treat a transaction consistently for federal and state tax purposes. Because the Bortots had reported the pay federally as self-employment income (nonemployee compensation / commissions) rather than wages, they were bound by that election and could not now recharacterize it as exempt wages to escape gross receipts tax. The decision relied on a line of cases — Co-Con, Stohr, and Sutin, Thayer & Browne — all holding that taxpayers cannot report one way federally and another way for state tax. The Bortots' remedy was to file amended federal returns reclassifying the pay as wages; they conceded the pay could have been reported as wages but chose not to amend, so the exemption was denied.

What this means for you

• How you report pay to the IRS controls how New Mexico treats it. If your corporation pays you and reports it as 1099 nonemployee compensation (and you file a Schedule C and pay self-employment tax), you have elected to treat that money as business income — not exempt wages — and New Mexico will hold you to that choice.
• The Section 7-9-17 wage exemption is only for genuine employee wages. Owners of closely held companies can be employees of their own corporations, but only if they actually treat the pay as wages: W-2s, income-tax withholding, and FICA — not 1099s and self-employment tax.
• Consistency is a rule, not a technicality. New Mexico courts require you to treat a transaction "uniformly for all purposes within the tax scheme." You cannot show a business/self-employment characterization to the IRS and a nontaxable employment characterization to the state.
• Simplifying your paperwork can cost you the exemption. The Bortots' accountant used 1099/commission reporting to avoid withholding filings. That convenience — even with no intent to dodge tax — locked in a treatment that made the pay taxable gross receipts.
• If you got the classification wrong, the fix is to amend the federal return. As long as the federal filing stands, the state result follows it. The Bortots declined to file amended returns, so they lost the exemption.
• Changing course going forward doesn't fix past years. The Bortots began reporting the pay as wages starting in 1997, but that did not rescue the 1993 assessment.

Key questions answered

Weren't the Bortots employees of their own corporations?
Possibly — as officers and majority owners they clearly controlled their own work, which is the usual test for employee status. But the Hearing Officer did not decide the case on control. He decided it on the separate rule that a taxpayer is bound by how it reported the transaction federally, and the Bortots had reported the pay as self-employment income, not wages.

What is the "consistency" rule that decided this case?
New Mexico law requires a taxpayer to treat a transaction the same way for federal and state tax purposes. As the Court of Appeals put it, a taxpayer "must treat transactions uniformly for all purposes within the tax scheme" and cannot show one characterization for federal purposes and a different, nontaxable one for state tax. The Bortots chose self-employment/commission treatment federally, so they could not claim exempt-wage treatment for state gross receipts tax.

Why did reporting the pay as commissions on a 1099 matter?
Section 7-9-17 exempts a genuine employee's wages, salaries, or commissions. A 1099 reporting "nonemployee compensation," combined with Schedule C business reporting and self-employment tax, is the hallmark of an independent contractor / business owner, not an employee. That reporting characterized the pay as taxable business receipts.

Could the Bortots have fixed this?
Yes — by filing amended federal returns reclassifying the pay as employee wages. The Hearing Officer noted taxpayers have the option, "if not the obligation," to file amended returns when their reporting does not reflect the true nature of a transaction. The Bortots conceded the pay could have been reported as wages but chose not to amend.

Did it help that there was no intent to avoid tax?
No. The accountant used commission/1099 reporting only to simplify paperwork, and the Bortots paid self-employment tax on the income. Intent was not the issue — the consistency rule applied regardless of motive.

Verbatim citations

The exemption the Bortots invoked (Section 7-9-17), as quoted in the decision:

Exempted from the gross receipts tax are the receipts of employees from wages, salaries, commissions or from any other form of remuneration for personal services.

The consistency requirement, quoting Co-Con, Inc. v. Bureau of Revenue:

Taxpayers must treat transactions uniformly for all purposes within the tax scheme and not attempt to show, first, a lease for federal purposes and second, a non-taxable event for state tax purposes.

The controlling principle, quoting Stohr v. New Mexico Bureau of Revenue:

The controlling factor, however, is that the taxpayer must treat transactions uniformly for all purposes within the tax laws. The taxpayer must not attempt to show one scheme for federal tax purposes and a nontaxable event for purposes of state gross receipts taxes.

The Hearing Officer's application of the rule:

As all of the above cases make clear, when there is a conflict in how a taxpayer has reported a transaction for federal purposes and how they are requesting that it be treated for state purposes, they are bound by the manner in which they reported for federal purposes.... Unless that is done, the Taxpayers are bound by their method of reporting their compensation with the IRS and are not entitled to claim the exemption provided at § 7-9-17 NMSA 1978.

The holding:

Because the Taxpayers reported the compensation they received as nonemployee compensation and as commissions from operating a business, they are not entitled to claim it as wages, salary or commissions from employment for purposes of claiming an exemption from gross receipts tax pursuant to Section 7-9-17 NMSA 1978.

Source

• Listing: New Mexico Decisions & Orders
• Decision post: Louis & Carolyn Bortot
• Decision PDF: D&O 98-52

Original ruling text

BEFORE THE HEARING OFFICER
OF THE TAXATION AND REVENUE DEPARTMENT
OF THE STATE OF NEW MEXICO

IN THE MATTER OF THE PROTEST OF
LOUIS AND CAROLYN BORTOT, NO. 98-52
ID. NO. 02-324191-00 8, PROTEST
TO ASSESSMENT NO. 2092481

DECISION AND ORDER

This matter came on for formal hearing on August 31, 1998 before Gerald B. Richardson,

Hearing Officer. Louis and Carolyn Bortot, hereinafter, “Taxpayers”, were represented by James

Jay Mason, Esq. The Taxation and Revenue Department, hereinafter, “Department”, was

represented by Jana C. Werner, Special Assistant Attorney General. Based upon the evidence

and the arguments presented, IT IS DECIDED AND ORDERED AS FOLLOWS:

FINDINGS OF FACT

1. For the 1993 calendar and tax year, the Taxpayers did not report any wages,

salaries or tips on their federal income tax return. The Taxpayers did report on the Schedule C-

EZ form for reporting net profit from business (sole proprietorship) that Mr. Bortot received

$2,950 in net profit and Mrs. Bortot received $43,925 in net profit.

2. The Department has an information sharing agreement with the Internal Revenue

Service (“IRS”) whereby the IRS provides information to the Department with respect to New

Mexico residents’ federal income tax returns.

3. Based upon the information contained in the Taxpayers’ 1993 Schedule C-EZ

forms, on December 14, 1996, the Department issued Assessment No. 2092481 to the Taxpayers
assessing $2,737.22 in gross receipts tax, $273.72 in penalty and $1,300.18 in interest for the

January through December, 1993 reporting periods.

4. On February 11, 1997, the Taxpayers requested a sixty-day extension of time in

which to file a protest to Assessment No. 2092481.

5. On February 20, 1997 the Department granted a retroactive extension of time to

file a protest and acknowledged the Taxpayers’ letter, postmarked January 14, 1997, as a timely

protest.

6. Lumic, Inc. is a small, closely held family corporation in which the Taxpayers

own 51% of the stock, with the other 49% owned by their children. Lumic, Inc. owns a

commercial building in Gallup, New Mexico, which generates rental income. The Taxpayers did

everything required to run the corporation, including collecting rents and maintaining the

property.

7. Lumic, Inc. filed a federal corporation income tax return, federal form 1120,

which reported no deductions for compensation of officers or for salaries or wages paid to

employees for periods relevant to the 1993 tax year. Lumic, Inc., however, paid Mr. Bortot

$3,000 during the 1993 tax year. It reported that amount on a federal form 1099 as nonemployee

compensation. It also reflected this amount as “commissions” on its statement of other

deductions on its federal form 1120. Because of a difference in the corporate fiscal year and the

calendar year used as the tax year by the Taxpayers, the amounts reported as commissions on the

form 1120 and the amounts reported as nonemployee compensation on form 1099 do not match.

8. Nizhoni Self Storage, Inc. is a small, closely held family corporation in which the

Taxpayers own 50% of the stock, with the other 50% being owned by a cousin. Nizhoni Self

Storage, Inc. owns self-storage units which generate rental income. The Taxpayers’ did

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everything required to manage the corporation, including collecting rents and maintaining the

property.

9. Nizhoni Self Storage, Inc. filed a federal corporation income tax return, federal

form 1120, which reported no deductions for compensation of officers or for salaries and wages

paid employees for periods relevant to the 1993 tax year. Nizhoni Self Storage, Inc., however,

paid Mrs. Bortot $28,100 during the 1993 tax year. It reported that amount on a federal form

1099 as nonemployee compensation. It also reflected that amount as “management

commissions” on its statement of other deductions on its federal form 1120. Because of a

difference in the corporate fiscal year and the calendar year used as the tax year by the Taxpayers,

the amounts reported as management commissions on the form 1120 and the amounts reported as

nonemployee compensation on form 1099 do not match.

10. Mr. Steve Petranovich, the accountant for the Taxpayers, Lumic, Inc. and Nizhoni

Self Storage, Inc., treated the amounts paid the Taxpayers by the two corporations as

commissions rather than wages in order to simplify tax reporting by avoiding the necessity of

filing reports with the Department and the IRS reporting income tax withholding. Because the

Taxpayers reported and paid self-employment tax to the IRS on these amounts, and because these

amounts were included in the Taxpayers’ income as reported to both federal and state tax

authorities, Mr. Petranovich’s method of reporting the amounts paid to the Taxpayers was not

intended to result in any tax avoidance by the Taxpayers or their closely held corporations.

11. Neither Lumic, Inc. or Nizhoni Self Storage, Inc. purchased worker’s

compensation insurance or paid unemployment insurance on behalf of the Taxpayers.

12. The compensation paid to the Taxpayers by Lumic, Inc. and Nizhoni Self Storage,

Inc. was not based upon the keeping of time records of the time the Taxpayers spent managing

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the businesses or upon any set periodic schedule for compensating the Taxpayers. The

Taxpayers paid themselves based upon when they felt that the corporations could afford to pay

them compensation and in amounts they felt the corporations could afford to pay.

13. The Taxpayers performed management services for the corporations based upon

the corporations’ needs and not upon an established schedule.

14. The Taxpayers received no paid vacation and accumulated no sick leave from the

corporations of which they were shareholders.

15. The Taxpayers have conceded that the compensation they received from their

closely held corporations could have been reported more accurately as wages paid to them as

employees of the corporations they manage, but the corporations and the Taxpayers do not wish

to file amended returns to more accurately report this compensation for the tax year at issue.

16. Commencing with the 1997 tax year, the compensation paid to the Taxpayers by

their closely held corporations has been reported as wages paid to employees for both state and

federal purposes.

DISCUSSION

The Taxpayers have protested the assessment of gross receipts tax based upon their claim

that the compensation they received from their closely held corporations was actually wages they

were paid as employees of the corporations. Wages received by employees are exempt from

gross receipts tax pursuant to § 7-9-17 NMSA 1978, which provides:

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Exempted from the gross receipts tax are the receipts of employees
from wages, salaries, commissions or from any other form of
remuneration for personal services.

Because the statute exempts any form of remuneration paid to “employees”, it does not matter

whether the compensation is classified as wages, salary or commissions. The determinative

factor is whether an employer-employee relationship exists between the payor and the recipient

of the compensation.

The Department argues that the Taxpayer is bound by the manner it elected to report the

compensation at issue, and without an amendment to the federal returns filed by both the

Taxpayers and the corporations they manage, that they are not entitled to claim the exemption

provided at § 7-9-17.

Because the corporations which paid the compensation at issue are closely held

corporations managed by the Taxpayers, this case presents a highly unusual situation which has

not heretofore been addressed. What should the interface be between the standards for

determining the existence of an employment relationship and the common law requirements that

taxpayers file consistently for both state and federal purposes?

An employee is not defined in the Gross Receipts and Compensating Tax Act, Chapter 7,

Article 9 NMSA 1978, so we will look to the common law definition of employee. In

determining whether a person is an employee or an independent contractor, the rule in New

Mexico and in general is that the principal consideration is the right to control. Thus, the

relationship of employer and employee usually results where there is control over the manner and

method of performance of the work to be performed. Where there is only control over the

results, however, and not the details of the performance, the worker is usually considered to be an

independent contractor. Buruss v. B.M.C. Logging Co., 38 N.M. 254, 31 P.2d 263 (1934). The

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most recent pronouncement of this rule can be found in Harger v. Structural Services, Inc., 121

N.M. 657, 663, 916 P.2d 1324, 1330 (1996). In that case the New Mexico Supreme Court

adopted the approach set out in the Restatement (Second) of Agency § 220(1) to determine a

worker’s status as an employee or an independent contractor:

The important distinction is between service in which the actor’s
physical activities and his time are surrendered to the control of the
master, as service under an agreement to accomplish results or to
use care and skill in accomplishing results. Those rendering
service but retaining control over the manner of doing it are not
servants.

Among the factors to be considered are: whether the party employed engages in a distinct

occupation or business; whether the work is part of the employer’s regular business; the skill

required in the particular occupation; whether the employer supplies the instrumentalities, tools

or the place of work; the duration of a person’s employment and whether that person works full-

time or regular hours; whether the parties believe they have created the relationship of employer

and employee and the manner and method of payment. The totality of all of the circumstances

must be considered in determining whether the employer has the right to exercise that degree of

control over a worker so as to make the worker an employee.

The Department has adopted a regulation under Section 7-9-17 to provide criteria by

which the status of a worker may be determined. Regulation 3 NMAC 2.12.7. provides as

follows:

In determining whether a person is an employee, the department
will consider the following indicia:

1. is the person paid a wage or salary;
2. is the “employer” required to withhold income tax from the
   person’s wage or salary;
3. is F.I.C.A. tax required to be paid by the “employer”;
4. is the person covered by workmen’s compensation insurance;

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5. is the “employer” required to make unemployment insurance
   contributions on behalf of the person;
6. does the person’s “employer” consider the person to be an
   employee;
7. does the person’s “employer” have a right to exercise control
   over the means of accomplishing a result or only over the
   result (control does not mean “mere suggestion’).
   If all of the indicia mentioned are present, the department will
   presume that the person is an employee. However, a person may
   be an employee even if one or more of the indicia are not present.

In this case, because the alleged “employer” is a closely held corporation managed by the

Taxpayers, it is difficult to dispute that sufficient control over the acts of the “employees” does

not exist, since the Taxpayers, as officers, managers and shareholders of the corporations, control

their own activities. Thus, the question, ultimately, is whether those same individuals are bound

by their own actions as to how they treated their compensation for federal tax reporting purposes.

Although the issue has not arisen in this unique context, the law in New Mexico has been

unequivocal on the issue of whether consistency is required in how taxes are reported for both

state and federal purposes. The first case to address this issue was Co-Con, Inc. v. Bureau of

Revenue, 87 N.M. 118, 529 P.2d 1239 (Ct App., 1974), cert. denied, 87 N.M. 111, 529 P.2d

1232 (1974). Co-Con, Inc. was a wholly owned subsidiary of Universal Constructors, Inc.

During the audit period, pieces of construction equipment common to the operations of both

corporations were utilized by both on their construction projects without regard to which

corporation held legal title to the equipment. Each corporation owning the equipment attributed

a value to the use of its equipment and reflected that value as “gross rentals” for federal income

tax purposes. The Department assessed gross receipts tax on those gross rental amounts reflected

on the federal returns of Co-Con, Inc. and Universal Constructors, Inc. as gross receipts from

leasing property in New Mexico. The corporations argued that they did not have gross receipts

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from equipment rental. The Court of Appeals upheld the assessments, finding that the treatment

by the corporations of the transactions as gross rentals for federal income tax purposes indicated

that the intent of the taxpayers was to treat the arrangement as rentals or leases. The court went

on to state:

Taxpayers must treat transactions uniformly for all purposes within
the tax scheme and not attempt to show, first, a lease for federal
purposes and second, a non-taxable event for state tax purposes.
We find ample evidence in the record to indicate that taxpayers
engaged in leasing, both by intent and within the scope of the
statutory definition.

Id., 87 N.M. at 121-122.

In Stohr v. New Mexico Bureau of Revenue, 90 N.M. 43, 559 P.2d 420(Ct. App. 1976),

cert. denied, 90 N.M. 254, 561 P.2d 1347 (1977), the Court of Appeals upheld an assessment of

gross receipts tax against Mr. Stohr on the compensation he was paid by various individuals for

doing carpentry. Mr. Stohr argued that these amounts were wages exempt from gross receipts

tax under § 72-16A-12.5 NMSA 1953, the predecessor to § 7-9-17 NMSA 1978. The court

noted that Mr. Stohr had filed self employment tax returns for social security purposes with the

IRS for the compensation he received from the customers who did not withhold FICA tax and

had filed a federal Schedule C during the audit years reporting his compensation as being from a

business or profession. In determining Mr. Stohr liable for gross receipts tax, the court examined

the indicia of employment found in the Department’s regulation, which are the same ones

contained in the current regulation, 3 NMAC 2.12.7. However, the court stated:

The controlling factor, however, is that the taxpayer must treat
transactions uniformly for all purposes within the tax laws. The
taxpayer must not attempt to show one scheme for federal tax
purposes and a nontaxable event for purposes of state gross
receipts taxes. (citations omitted, emphasis added).

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Thus, the court found that the manner by which Mr. Stohr reported his compensation for federal

purposes controlled the determination of whether that compensation could be considered wages

exempt from gross receipts taxes.

The most recent case to address the issue of whether consistency is required in filing state

and federal returns is Sutin, Thayer & Browne v. Revenue Division of the Taxation and

Revenue Department, 104 N.M. 633, 725 P.2d 833 (Ct. App. 1985), cert. denied. 102 N.M. 293,

694 P.2d 1358 (1986). That case concerned whether the Sutin firm could claim a wage

deduction for state corporate income tax reporting purposes that exceeded the wage deduction

claimed for federal corporate income tax purposes. Under the Tax Reduction and Simplification

Act of 1977, Pub. L. No. 95-30, a new jobs tax credit was enacted to provide employers with a

tax incentive to create new jobs. Under the act, a corporation could either claim a federal tax

deduction for the wages paid to its employees or elect a jobs credit for wages paid to certain new

employees. New Mexico did not have a similar jobs credit. The Sutin firm had claimed the jobs

credit with the IRS, foregoing a deduction for wages paid to those employees for whom the credit

was claimed. Because New Mexico did not have a similar jobs credit, the Sutin firm claimed a

deduction for those wages on its New Mexico return that it had not claimed on its federal return,

arguing that to deny it the wage deduction would be unfair and result in overstating its taxable

income for state tax purposes. The court denied the Sutin firm’s claim of deduction, stating that,

“[A] taxpayer who makes an election for federal purposes is bound by that election in calculating

the amount of its state taxes.” Id., 104 N.M. at 636.

As all of the above cases make clear, when there is a conflict in how a taxpayer has

reported a transaction for federal purposes and how they are requesting that it be treated for state

purposes, they are bound by the manner in which they reported for federal purposes. It should

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also be noted that if, as Taxpayers argue, their method of reporting does not reflect the true

nature of a transaction or taxable activity, the Taxpayer has the option, if not the obligation1 to

file amended federal returns. Unless that is done, the Taxpayers are bound by their method of

reporting their compensation with the IRS and are not entitled to claim the exemption provided at

§ 7-9-17 NMSA 1978.

CONCLUSIONS OF LAW

1. The Taxpayers filed a timely, written protest to Assessment No. 2092481 pursuant

to § 7-1-24 NMSA 1978 and jurisdiction lies over both the parties and the subject matter of this

protest.

2. Because the Taxpayers reported the compensation they received as nonemployee

compensation and as commissions from operating a business, they are not entitled to claim it as

wages, salary or commissions from employment for purposes of claiming an exemption from

gross receipts tax pursuant to Section 7-9-17 NMSA 1978.

For the foregoing reasons, the Taxpayers’ protest IS HEREBY DENIED.

DONE, this 28th day of September, 1998.

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Tax reporting, even when it does not distort income or result in tax savings, is not a matter of convenience or
selecting a manner which simplifies reporting requirements. Tax returns are supposed to accurately reflect the
transactions being reported.

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