John F. Johnson v. Shirley S. Chater , 127 F.3d 756 ( 1997 )

United States Court of Appeals
FOR THE EIGHTH CIRCUIT
____________
No. 96-3610
____________
John F. Johnson, Sr.; *
Joann Johnson; Ella Johnson, *
*
Appellants. *
* Appeal from the United
States
v. * District Court for the
* Eastern District of
Missouri
Shirley S. Chater, Social *
Security Administration, *
*
Appellee. *
____________
Submitted: April 16, 1997
Filed: October 16,
1997
____________
Before McMILLIAN, Circuit Judge, HENLEY, Senior Circuit
Judge, and
BEAM, Circuit Judge.
____________
McMILLIAN, Circuit Judge.
John F. Johnson, Sr., his wife, Joann Johnson, and
their daughter, Ella Johnson (collectively claimants),
appeal from a final order entered in the District Court1
for the
1
The Honorable Lawrence O. Davis, United States Magistrate Judge for the
Eastern District of Missouri. The case was tried to a magistrate judge pursuant to
the consent of the parties under 28 U.S.C. § 636(c).
2
Eastern District of Missouri granting summary judgment in
favor of the Commissioner of Social Security. Johnson v.
Chater, No. 1:95CV00075 LOD (E.D. Mo. July 29, 1996)
(order and memorandum). For reversal, claimants argue
(1) the Commissioner did not have the authority to
reallocate undistributed corporate profits as wages to
John Johnson, Sr., in 1991 for the purpose of computing
excess earnings under 42 U.S.C. § 403 and (2) the
Commissioner erred in “piercing the veil” of their family
salary arrangements to reallocate some of the salary paid
in 1990 from Joann Johnson to John Johnson, Sr., and to
attribute self-employment profits to John Johnson, Sr.
For the reasons discussed below, we affirm in part and
reverse in part the order of the district court and
remand the case to the district court for further
proceedings.
The following statement of facts is taken in large
part from the order and memorandum of the magistrate
judge. John Johnson, Sr., filed an application for
retirement insurance benefits and began receiving
benefits in May 1989. His wife, Joann Johnson, filed an
application for spouse’s benefits, and their daughter,
Ella Johnson, filed for child’s benefits on the record of
her father. In March 1993 the Social Security
Administration (SSA) notified John Johnson, Sr., that he
had received benefits greater than those to which he was
entitled because of excess earnings. The excess earnings
were wages and self-employment income attributable to him
in 1990 and 1991 from two family farming corporations,
Cowhill Farms, Inc., and J & J Hog Farms. John Johnson,
Sr., was president of Cowhill Farms until January 1989,
when he reduced his activities. In May 1989 he
3
officially retired from Cowhill Farms, and Joann Johnson
became president upon her husband’s retirement. John
Johnson, Sr., also retired from J & J Hog Farms in
January 1989. Their son, John Johnson, Jr., took on more
of the management responsibility for the two family
farming corporations.
4
For 1990 John Johnson, Sr., reported wages of $6,000
and Joann Johnson reported wages of $9,482 from Cowhill
Farms. The SSA reallocated their wages and determined
that John Johnson, Sr., had received $9,482 in wages and
Joann Johnson had received $6,000 in wages from Cowhill
Farms. The SSA also determined that John Johnson, Sr.,
was self-employed with respect to J & J Hog Farms and had
received profits of $6,217 in 1990. For 1991 John
Johnson, Sr., reported wages of $7,000 and Joann Johnson
reported wages of $8,400 from Cowhill Farms. The SSA
agreed that $8,400 was a reasonable salary for Joann
Johnson, but decided that John Johnson, Sr.’s work was
worth twice that of his wife, and thus determined that
his salary was $16,800. The SSA noted that in 1991
Cowhill Farms had “ample” profits available to pay these
wages and to invest in corporate assets. Record at 228
(Special Determination dated Feb. 27, 1993) (noting 1991
corporate profits were $11,102 and expenses were down
$13,484 over 1990)). These amounts exceeded the exempt
earnings amount for 1990 and 1991. The redeterminations
were based on income and corporate tax returns, W-2
forms, self-employment questionnaires, interviews, and
other information.
In June 1994 a hearing was held before an
administrative law judge (ALJ). The ALJ found that the
SSA had properly reallocated wages between John Johnson,
Sr., and Joann Johnson for 1990 and 1991 and that John
Johnson, Sr., had been overpaid retirement benefits in
1990 and 1991 in the amount of $5,488. (The ALJ also
found that Ella Johnson had been overpaid benefits.) The
ALJ found that John Johnson, Sr., had provided more than
“minimal” services to the two corporations, including 25%
5
of the labor, such as spraying and combining, for Cowhill
Farms. The ALJ also found there had been considerable
commingling of activities among family members, Joann
Johnson’s duties had not substantially increased in 1990
and 1991 to justify the significant increase in her
salary after 1989, and John Johnson, Sr., had continued
to exercise significant decision-making responsibility
and had provided invaluable services to Cowhill Farms.
6
The ALJ’s decision was affirmed by the Appeals
Council. Claimants sought judicial review in federal
district court. 42 U.S.C. § 405(g). The parties filed
motions for summary judgment. The district court denied
claimants’ motion for summary judgment and granted
summary judgment in favor of the Commissioner. This
appeal followed. 28 U.S.C. § 1291; Fed. R. App. P.
4(a)(1).
We will uphold the final decision of the Commissioner
if it is supported by substantial evidence in the record
as a whole. 42 U.S.C. § 405(g). “Substantial evidence
is that which a reasonable mind might accept as adequate
to support the [Commissioner]’s conclusion.” House v.
Shalala, 34 F.3d 691, 694 (8th Cir. 1994).
Qualified applicants are entitled to retirement
benefits. 42 U.S.C. § 402(a). However, an applicant who
is eligible for social security benefits may not work or
engage in self-employment which results in income in
excess of a certain amount per year. Id. § 402(f).
“Wages are defined to mean all employment remuneration,
irrespective of the name by which the compensation is
designated or the way in which it is paid.” Martin v.
Sullivan, 894 F.2d 1520, 1531 (11th Cir. 1990) (citing
applicable Social Security regulations).
An applicant for benefits must submit the
evidence necessary to establish that all
entitlement requirements are met, and failure to
submit such evidence shall be the basis for the
SSA to determine that the conditions for receipt
of Social Security benefits have not been met.
The claimant, therefore, has the burden of
rebutting the presumption of excess earnings
under the Act.
7
Id. at 1531-32 (citations omitted).
“[T]he [Commissioner] has the right to examine the
substance over the form of business transactions and
relationships for purposes of the Social Security Act.”
Heer v. Secretary of Health & Human Services, 670 F.2d
653, 655 (6th Cir. 1982) (per curiam). “Determination of
an individual’s earnings for Social Security purposes
must
8
be related to the reality of his [or her] connection with
the labor market and cannot be based on paper allocation
of income.” Martin v. Sullivan, 894 F.2d at 1524, citing
Reconsideration Redetermination at 2. In particular, the
Commissioner can “pierce the veil” of fictitious family
salary arrangements “where a claimant’s alleged
retirement and consequent shifting of salary to a family
member is for the purpose of receiving Social Security
[retirement] benefits.” Id. at 1532. The Commissioner
should consider the following factors before “piercing
the veil” of “fictitious family salary arrangements”:
“(1) whether the claimant continues to contribute
substantial and valuable services to the corporation; (2)
whether the family member receiving the income increases
his or her duties commensurate with the increase in
salary; and (3) whether the family member’s income is
used to support the claimant.” Heer v. Secretary of
Health & Human Services, 670 F.2d at 655; cf. Diamond v.
Harris, 512 F. Supp. 216, 219 (W.D.N.Y. 1981) (holding
Secretary cannot allocate half of wife’s salary to
claimant husband absent evidence that her salary was
excessive or that she had not earned it or her salary
increased in direct relation to decrease in his salary
and cannot reclassify distributed Subchapter S dividends
as salary absent evidence that dividends were paid as a
result of his services).
UNDISTRIBUTED CORPORATE PROFITS
Claimants first argue the Commissioner does not have
the authority to reallocate undistributed corporate
profits as wages to John Johnson, Sr., for the purpose of
computing excess earnings under 42 U.S.C. § 403, citing
9
Ludeking v. Finch, 421 F.2d 499 (8th Cir. 1970).
Claimants also argue that, even assuming the Commissioner
does have the authority to reallocate undistributed
corporate profits, it was an abuse of discretion to do so
because the undistributed corporate profits had been
retained by the corporation for future capital
improvements.
These arguments have not been preserved for appellate
review. In the statement of facts in the memorandum in
support of their motion for summary judgment in the
10
district court, claimants referred to the SSA’s
determination that Cowhill Farms had “ample profits” to
pay John Johnson, Sr., a salary of $16,800 in 1991, mem.
at 6, funds which John Johnson, Sr., had never received,
id., and which Cowhill Farms had retained for
“grading/leveling” corporate lands. Id. at 7. Claimants
challenged, among other things, the determination that
John Johnson, Sr.’s services were worth twice as much
those of Joann Johnson and the failure to specify what
those invaluable services were. Id. at 9 (¶ 5).
Claimants did not challenge the reallocation of
undistributed corporate profits in the district court
review proceeding. However, we cannot affirm the
decision of the Commissioner unless it is supported by
substantial evidence. We have found nothing in this
record which supports the Commissioner’s decision to
“reallocate” funds that have never in fact been
distributed in any form by Cowhill Farms or received by
claimants. For that reason, we reverse that part of the
Commissioner’s decision attributing to John Johnson, Sr.,
$16,800 in wages from Cowhill Farms in 1991, an increase
of $9,800 over the $7,000 that he reported.
“The [Commissioner] has, without question, the
authority and the duty to pierce any fictitious
arrangements among family members, and others, to shift
salary payments from one to the other when the
arrangement is not in accord with reality.” Gardner v.
Hall, 366 F.2d 132, 135 (10th Cir. 1966) (citing cases
shifting salary payments from one family member to
another). This is what the Commissioner did with respect
to the wages reported by the claimants for 1990. The
Commissioner examined the wages reported by the claimants
11
in light of their respective corporate offices,
experience, responsibilities, and hours worked, and
reallocated their wages, reducing those reported by Joann
Johnson by $3,482 and increasing those reported by John
Johnson, Sr., by $3,482 (as well as $6,217 in
self-employment income). For 1991, however, the
Commissioner did not reallocate salary payments between
John Johnson, Sr., and Joann Johnson, but instead
reallocated undistributed profits from Cowhill Farms to
John Johnson, Sr.
12
Reallocation often arises in cases involving
Subchapter S corporations because, for income tax
purposes, the net profits of Subchapter S corporations
are taxable to the shareholder as dividends. The
corporation is treated as a partnership. For social
security purposes, dividends are excluded from
“self-employment income,” 42 U.S.C. § 411(a)(2), but are
not specifically excluded from “wages.” Id. § 409. For
this reason, benefits claimants would often argue that
all earnings of a Subchapter S corporation, whether or
not denominated as dividends for income tax purposes, are
not wages for social security purposes and that the SSA
has no authority to classify or recharacterize Subchapter
S dividends as wages. The courts rejected these
arguments and distinguished between distributed and
undistributed corporate dividends. For example, in
Ludeking v. Finch, the claimant received no salary from
the Subchapter S corporation but did receive $8,400 in
the form of corporate dividends. The Secretary found
that the claimant was much more than a mere shareholder,
that he had not retired and was the principal officer of
the corporation, and that his services were worth a
minimum of $400 per month, or $4,800 per year. The
Secretary determined that $4,800 of the $8,400 received
as Subchapter S dividends was in reality remuneration for
services rendered and should be denominated as wages for
social security purposes. This court upheld the
Secretary’s authority to reclassify or denominate as
wages such portion of distributed Subchapter S corporate
dividends as found to reasonably constitute wages or
salary for the purpose of determining whether a claimant
had excess earnings. 421 F.2d at 502-04, citing Gant v.
Celebrezze, No. C-124-G-62 (N.D.N.C. Mar. 6, 1964)
13
(claimant was president of newly incorporated Subchapter
S corporation actively engaged in its operation and who
received distributed corporate dividends but no salary
and was considered to be employee of corporation
receiving wages for social security purposes); accord
Owens v. Sullivan, 790 F. Supp. 195, 197-98 (E.D. Ark.
1991) (holding claimants who received Subchapter S
distributed dividend income, part of which was in
exchange for services rendered, were recipients of wages
for social security purposes).
14
The distinction between distributed and undistributed
corporate profits is important. Although the distinction
often arises in cases involving Subchapter S
corporations, we think the distinction is not limited to
Subchapter S corporations and instead reflects the
broader distinction between actual and merely theoretical
or constructive payments of corporate profits in any
form, whether as salary, dividends or otherwise. For
example, in Somers v. Gardner, 254 F. Supp. 35 (E.D. Va.
1966), the claimant was the president of a Subchapter S
corporation, owned all of the outstanding stock, and
exercised complete control over the corporation. He
performed services for the Subchapter S corporation but
did not in fact receive any income from the corporation
in any form. The Secretary argued that the claimant had
received constructive dividends for income tax purposes
and that, for social security purposes, such constructive
dividends could be reclassified as salary for services
rendered. The district court rejected the Secretary’s
argument and held that the Secretary could not reclassify
the undistributed net income of a Subchapter S
corporation as wages but could reclassify distributed
dividends as wages. Id. at 36-38. The district court
carefully noted that
where dividends are in fact received by the sole
stockholder who had performed services for his
corporation, there may be authority for
permitting the Secretary to reclassify the de
facto dividends as salary to reflect appropriate
compensation for such services. Additionally,
there is substantial authority for the general
principle that the Secretary can allocate funds
in fact paid out by a corporation in order to
properly reflect the value of services rendered
15
by employees and to prevent fraudulent
arrangements which are tantamount to “shifting
wages.” However, no case has been cited nor
found by this Court which authorizes the
Secretary to “reallocate” moneys which have
never in fact been distributed in any form by
the corporation involved.
Id. at 36-37 (citations omitted).
16
Similarly, in Gardner v. Hall, the Secretary
contended that undistributed income and earnings had been
“channeled” to the claimant. The claimant, his wife and
their sons operated a ranch first as a partnership and
then as a Subchapter S corporation. The claimant was in
active charge of the ranch, and his wife was actively
involved in the bookkeeping and related activities. Each
family member was a shareholder and corporate officer.
Each corporate officer, except the claimant, received a
salary. The claimant received no salary or other
remuneration directly from the corporation for his
services. His wife deposited her salary into a joint
checking account and some of the household expenses were
paid from that account. The Secretary argued that part
of the salary paid to the wife should be reallocated to
the claimant. The court of appeals disagreed, holding
that this was not a reallocation case because there was
no evidence or finding that the wife’s salary was
excessive or not earned by her or that there was any
shifting in the corporation of salary payments from the
claimant to the wife. 366 F.2d at 135. In addition, and
more important to our analysis, the court of appeals held
that the Secretary had no authority to allocate a portion
of the corporation’s undistributed profit and income to
the claimant as remuneration for his services. Id.;
accord Herbst v. Finch, 473 F.2d 771, 774-76 (2d Cir.
1972) (holding it was improper to make excess earnings
deduction where corporation did not actually or
symbolically set aside funds to pay salary to claimant
and neither he nor corporation contemplated payment);
Taubenfeld v. Bowen, 685 F. Supp. 237, 240 (S.D. Fla.
1988) (holding Secretary cannot allocate retained
corporate earnings as additional wages to claimant); Letz
17
v. Weinberger, 401 F. Supp. 598, 602 (D. Colo. 1975)
(holding Secretary could not allocate to claimant
corporate profits of Subchapter S corporation that had
not been distributed and were not available for personal
use of claimant, emphasizing that remuneration must be
paid by the employer and received by the employee, either
actually or constructively, before Secretary can
reallocate or shift salary payments).
The present case is analogous to Notini v. Heckler,
624 F. Supp. 552 (D. Mass. 1986), in which the
Secretary’s theory was essentially that the claimant had
been underpaid. In that case the claimant had been the
chief executive officer and plurality
18
shareholder of a successful corporation. In 1979 he
worked part-time, about 12 hours per week, mostly, in his
words, “puttering around,” and later retired; he attended
directors meetings several times a year but did not make
significant managerial decisions or control daily
management. The corporation paid him wages of $4,410 in
1979, $4,960 in 1980 and $5,500 in 1981, and a bonus of
$100,000 in 1982. The Secretary determined that the
claimant’s services to the corporation were worth more
than the wages paid and that his benefits for 1979-1981
would instead be based on estimated earnings of $37,925
(which represented 25% of his 1978 income of $151,700).
There was no evidence of any additional or “hidden”
payments from the corporation to the claimant. The
district court upheld the Secretary’s characterization of
the $100,000 bonus as compensation for 1981, id. at 554,
but held that the Secretary could not allocate
undistributed corporate profits to the claimant on the
grounds that he had been “underpaid.” Id. The district
court noted that no corporate distributions had been
made, in any form, during the period in question and,
thus, there was no plan to “hide” salary in dividends.
Id. Nor was there any evidence that the capitalized
earnings of the corporation had been unusually high
during the relevant period or that the value of the
claimant’s stock had been inordinately affected by his
failure to draw a full salary. Id.
Here, the Commissioner did not seek to shift 1991
salary payments from Joann Johnson to John Johnson, Sr.
Under the Commissioner’s calculations, Joann Johnson’s
1991 salary of $8,400 remains unchanged. The
Commissioner did not argue that Joann Johnson’s salary
was unreasonable or excessive or had not been earned by
19
her. Rather, the Commissioner determined that John
Johnson, Sr., was underpaid, that is, that his services
were worth $16,800, or $9,800 more than he was paid in
1991. Even though Cowhill Farms apparently had the
corporate funds available to make such a payment, there
is no evidence in this record that such funds (in excess
of the reported $7,000) were actually paid or distributed
to John Johnson, Sr. We hold the Commissioner cannot,
for social security purposes, allocate a portion of
undistributed corporate profits to John Johnson, Sr., as
remuneration for his services for social security
purposes.
20
Whether or not the corporation is a Subchapter S
corporation is irrelevant, and in fact the record
indicates that Cowhill Farms is not a Subchapter S
corporation (it filed Tax Form 1120 and not Tax Form
1120-S). The Commissioner does not argue that Cowhill
Farms is not a bona fide corporation.
For this reason, we reverse that part of the district
court order affirming the Commissioner’s reallocation of
$9,800 as wages to John Johnson, Sr., for 1991 and remand
the case to the district court for further proceedings.
REALLOCATION OF FAMILY SALARIES
Claimants next argue the Commissioner erred in
“piercing the veil” of their family salary arrangements
to reallocate some of the salary paid in 1990 from Joann
Johnson to John Johnson, Sr., and to attribute
self-employment profits from J & J Hog Farms to John
Johnson, Sr. Claimants argue that the circumstances did
not justify “piercing the veil” of their family salary
arrangements because John Johnson, Sr., did not
contribute substantial and valuable services to Cowhill
Farms or J & J Hog Farms in 1990 and that Joann Johnson
had increased her corporate duties commensurate with her
increased salary in 1990. Claimants specifically argue
that the ALJ failed to identify the “invaluable services”
provided by John Johnson, Sr., and improperly discounted
Joann Johnson’s farming skills and contributions to
Cowhill Farms. We disagree.
21
We hold that the Commissioner did not err in piercing
the veil of the family salary arrangements. Substantial
evidence in the record as a whole supports the findings
that John Johnson, Sr., provided substantial and valuable
services to Cowhill Farms and J & J Hog Farms in 1990 and
that Joann Johnson had not increased her corporate duties
commensurate with her increased salary in 1990. The
burden of proof was on the claimants. The record showed
that the operations of the two corporations were the same
as they were in 1989 when it was determined in another
social security
22
proceeding that John Johnson, Sr., had provided valuable
services to Cowhill Farms; there were no written
agreements or corporate minutes showing the manner in
which the two corporations were operated; there was
considerable evidence of commingling of activities among
the Johnsons and their son; and there was evidence that
John Johnson, Sr., had provided at least 25% of the field
work and other “invaluable” services to the corporations,
including significant decision-making responsibilities
and invaluable experience. With respect to Joann
Johnson, no specific evidence showed what corporate
decisions she had made since taking over as president of
Cowhill Farms in 1989 or how her corporate activities had
substantially increased in 1989 to correspond to the
significant increase in her salary since 1988.
We hold that substantial evidence supports the
determination of the Commissioner that there was a
fictitious family salary arrangement in this case and
that the Commissioner did not err in making adjustments
to John Johnson, Sr.’s wages and income for 1990 for the
purpose of computing excess earnings under 42 U.S.C. §
403.
Accordingly, the order of the district court is
affirmed in part and reversed in part and the case is
remanded to the district court for further proceedings.
A true copy.
Attest:
23
CLERK, U.S. COURT OF APPEALS, EIGHTH
CIRCUIT.
24