Davis v. United States, 1994 U.S. Dist. LEXIS 10725 (D. Colo. 1994)

Carol Davis and Henry Adams owned Mile High Calcium, Inc., an S corporation later operated as a partnership after its charter was revoked. Adams, nominally president, performed almost no work; Davis, secretary, worked about 12 hours/month doing clerical and business tasks worth $8/hour. Payments to them were treated as loan repayments or profit distributions. The IRS, in a separate FICA/FUTA audit, reclassified all such payments as wages to both, assessing $39,220.66 in taxes, penalties, and interest. 

The court concluded that IRS acted arbitrarily and without evidentiary support in imputing wages to both.  Adams was not an employee under Treas. Reg. § 31.3121(d)-1(b) because he performed only minor services without remuneration. Davis was an employee, but her FICA/FUTA liability was limited to the reasonable value of her services ($647.32).

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Parties & Claims

• Plaintiff: Carol L. Davis d/b/a Mile High Calcium, Inc. (“Mile High”)
• Defendant: United States (IRS)
• Davis sought:
  • A tax refund of $2,336.04 in FICA/FUTA taxes (1987–1989)
  • A declaratory judgment that IRS assessments were improper
• U.S. counterclaimed against Davis and her husband Henry Adams for $39,220.66 in additional employment taxes.

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Facts

• Mile High incorporated in 1981 as an S corporation, owned by Davis and Adams.
• Corporate charter revoked Jan. 1, 1989; thereafter operated as a partnership.
• Adams: Nominal president, performed almost no work for Mile High (worked elsewhere; lived partly in Texas).
• Davis: Secretary, performed ~12 hours/month clerical and business duties; value of services estimated by accountant at $8/hour.
• Payments from Mile High to Davis/Adams were treated as loan repayments or profit distributions, not wages.
• In 1991 IRS accepted Mile High’s income tax returns, but separately assessed FICA/FUTA taxes by reclassifying all such payments as wages to both Davis and Adams.

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IRS Position

• Treated Adams as an employee and taxed all checks in his name as salary.
• Treated Davis as earning substantial wages, ignoring her actual work hours and value of services.
• Assessed total of $39,220.66 in taxes, interest, and penalties.

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Court’s Findings

• Adams performed only minor services and received no compensation → qualifies for exception to “corporate officer = employee” rule under Treas. Reg. § 31.3121(d)-1(b).
• Davis was an employee, but government’s imputed salary had no evidentiary basis.
• Uncontroverted evidence showed Davis’s services worth $8/hour × ~12 hrs/month → total FICA/FUTA liability = $647.32.
• IRS acted arbitrarily and capriciously; its position not substantially justified.

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Outcome / Order

1. Refund: Davis entitled to $1,688.72 (original claim minus $647.32 liability), plus statutory interest.
2. Declaratory Judgment: IRS assessments improper.
3. Dismissal: U.S. claims against Davis and Adams dismissed with prejudice.
4. IRS to revoke assessments and remove liens.
5. Attorney’s Fees: Davis awarded reasonable costs, expenses, and professional fees under 26 U.S.C. § 7430 (amount to be determined).

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Key Takeaway:
The court rejected the IRS’s blanket reclassification of shareholder distributions/loan repayments as wages when evidence showed one shareholder performed only minimal services (thus not an “employee”) and the other’s services were worth far less than the IRS claimed. The decision underscores that IRS FICA/FUTA assessments must be supported by evidence of actual services and reasonable value, especially in closely held entities.