The IRS takes a stern view on what is known as assignment of income. There are long-standing legal doctrines that prevent assigning one's income to a third party or another entity, such as an S corporation. Substitution is not allowed even if the taxpayer has an ownership interest in the S corp. If taxpayers were permitted to assign income to others, it would result in a drastic reduction in tax revenue for the IRS and make the concept of tax deductions nearly irrelevant.
S Corporation Status
Depending on the type of taxable entity, business income may be taxed and reported differently. Some corporations are taxed directly; however, an S corporation is an entity that has made a special election with the IRS to be taxed only at the shareholder level. This is fairly commonplace among small businesses.
Pass Through Taxation
Since the income earned by an S corporation is passed through to its shareholders, the S corporation files a tax return using IRS Form 1120S, for informational purposes only. IRS Schedule E is filed with the tax return of each shareholder; these forms allocate the company's profits and losses to shareholders so taxes can be paid at the individual level on their respective personal income tax returns.
In general, IRS Form 1099-MISC reports income made by a person in his role as an independent contractor, sole proprietor or freelancer. The customer or client who pays the independent contractor generates the 1099; payment is reported under the social security number or Employer Identification Number of the individual. Thus, the individual's 1099 income cannot be assigned to the S corporation.
Read More: What Is the Difference Between a W-9 Form and 1099 Form?
For practical purposes, to direct 1099 income to an S corporation, the hired individual must instruct the customer or client to pay the corporation instead of the individual at the outset of the work. This may be achieved by completing IRS Form W-9 using the corporate EIN and identifying the S corporation as the formal payee. However, this form does not have retroactive effect, so once a 1099 has been issued, the official payee is responsible for reporting the income to the IRS.
Jeff Clements has been a certified public accountant and business consultant since 2002. He has also worked in private practice as an attorney. Clements founded a multi-strategy hedge fund and has served as its research director and portfolio manager since its inception. He holds a Juris Doctor, as well as a master's degree in accounting.