Compensation to Law Firm Shareholder-Employees Disallowed by Tax Court

In Brinks,[1] the Tax Court once again applied the independent investor test to recharacterize compensation paid by a professional corporation, a law firm, to its shareholder-employees as nondeductible dividend distributions, and held the corporation liable for accuracy-related penalties for mischaracterizing the dividends as deductible compensation. This case should serve as a warning for many mid-size to larger professional service corporations operating as C corporations that they are not immune from unreasonable compensation attacks by the IRS.

Facts of Case

The taxpayer was an intellectual property law firm organized as a C corporation which used the cash basis of accounting. During the years in issue, the taxpayer employed about 150 attorneys, of whom about 65 were shareholders, and also employed a non-attorney staff of about 270.

Each shareholder-attorney of the taxpayer acquired his or her shares at a price equal to their book value and is required by agreement to sell his or her shares back to the taxpayer at a price determined under the same formula upon terminating his or her employment. Subject to minor exceptions related to the firm’s “name partners,” each shareholder-attorney’s proportionate ownership of taxpayer’s shares (“share-ownership percentage) equals his or her proportionate share of compensation paid by the taxpayer to its shareholder-attorneys. For the years in issue, the board of directors of the taxpayer set the yearly compensation to be paid to shareholder-attorneys and then determined the adjustments in the shareholder-attorneys’ share-ownership percentages necessary to reflect changes in proportionate compensation. These adjustments in share ownership were effected by share redemptions and reissuances.

For at least 10 years prior to and including the years in issue, the taxpayer did not pay any dividends to its shareholders. In late November or early December of the year preceding the compensation year, the taxpayer’s board meets to set the amount available for all shareholder-attorney compensation for that year, set compensation and share-ownership percentages. Because the board’s estimate of the amount available for compensation-year payments to shareholder-attorneys is only an estimate, each shareholder-attorney receives during the course of the compensation year only a percentage of his or her expected compensation (draw), with the expectation of receiving an additional amount (year-end bonus) at the end of the year. The board intended the sum of the shareholder-attorneys’ year-end bonuses to reduce the taxpayer’s book income to zero. With limited exceptions for certain older, less active attorneys, shareholder-attorneys shared in the bonus pool in proportion to their draws (and, likewise, in proportion to their share-ownership percentages). For each of the years in issue, 2007 and 2008, the taxpayer calculated the year-end bonus pool for 2007 to be $8,986,608 and for 2008 to be $13,736,331, which equaled its book income for the year after subtracting all expenses other than the bonuses.

The taxpayer treated as employee compensation the total amounts paid to its shareholder-attorneys, including the year-end bonuses. The taxpayer used an independent payroll processing firm to prepare Forms W-2 for 2007 and 2008 to its shareholder-employees, which Forms W-2 were then forwarded to its accountant, McGladrey and Pullen (McGladrey).

The taxpayer had invested capital, measured by the book value of its shareholders’ equity, of approximately $8 million at the end of 2007 and approximately $9.3 million at the end of 2008. Although the taxpayer’s expert witness opined at trial that clients base hiring decisions on the reputations of individual lawyers rather than those of the firms at which they practice, the expert did admit that a firm’s reputation and customer list could be very valuable entity-level assets.

The taxpayer’s return had previously been audited for 2006, and resulted in a “no change” letter. However, when the IRS audited the taxpayer for 2007 and 2008, the year-end bonuses that the taxpayer paid to its shareholder-attorneys were disallowed as nondeductible dividend distributions. After negotiations, the parties entered into a closing agreement providing that portions of the taxpayer’s compensation deductions to its shareholder-employees for the years in issue, $1,627,000 in 2007 and $1,859,00 in 2008, should be disallowed and recharacterized as nondeductible dividends. Consequently, the only issue remaining for decision was whether the taxpayer was liable for accuracy-related penalties on underpayments of tax relating to amounts deducted as compensation that it conceded were nondeductible dividends.

Accuracy-Related Penalties

Sections 6662(a) and (b)(1) provide for accuracy-related penalty of 20% of the portion of an underpayment of tax attributable to negligence or disregard of rules and regulations. Sections 6662(a) and (b)(2) provide for the same penalty on the portion of an underpayment of tax attributable to “any substantial understatement of income tax.” Section 6662(d)(2)(A) defines the term “understatement” as the excess of the tax required to be shown on the return over the amount shown on the return as filed. In the case of a corporation, an understatement is substantial if it exceeds the lesser of (1) 10% of the tax required to be shown on the return for the tax year, or (2) $10 million. An understatement is reduced, however, by the portion attributable to the treatment of an item for which the taxpayer has “substantial authority.”[2] Additionally, Section 6664(c)(1) provides an exception to the imposition of the Section 6662(a) accuracy-related penalty if it is shown there was “reasonable cause” for the underpayment and the taxpayer acted in good faith.

Although the taxpayer did not dispute that the deficiency to which it has agreed for the years in issue exceeds 10% of the agreed income tax it was required to show on its returns for such years, the taxpayer argued that it has substantial authority for deducting in full the year-end bonuses paid to its shareholder-attorneys. In addition, the taxpayer argued that because it relied on the services of a reputable accounting firm to prepare its returns for the years in issue, it had reasonable cause to deduct those amounts and acted in good faith in doing so.

Substantial Authority

The Tax Court’s analysis of whether the taxpayer had substantial authority for its position provides valuable insight as to the Tax Court’s current position on the ability to recharacterize wages paid to shareholder-employees of professional corporations as nondeductible dividend distributions. Specifically, the IRS claimed that the amounts paid to the shareholder-employees of the corporation did not qualify as deductible compensation to the extent the payments were funded by earnings attributable to the services of non-shareholder employees or to the use of the corporation’s intangible assets or other capital. Rather, amounts paid to shareholder-employees that are attributable to such sources must be characterized as nondeductible dividends. In support of its position, the IRS relied primarily on its opinion in Pediatric Surgical Associates,[3] and the recent decision by the Seventh Circuit Court of Appeals in Mulcahy[4] (affirming the Tax Court’s decision). In the Pediactric Surgical Associates case, the court recharacterized compensation paid to the shareholder-employees of a medical practice which was attributable to the profits of the non-shareholder-employees as nondeductible dividends based on failing the compensatory intent prong of Section 162(a)(1). In the Mulcahy case, the Seventh Circuit Court of Appeals, affirming the Tax Court, applied the independent investor test to recharacterize consulting fees paid to the founding shareholders of an accounting firm as nondeductible dividend distributions.

Independent Investor Test

Much of the Tax Court’s decision addressed the application of the “independent investor test” in determining the deductibility of compensation paid by a C corporation to its shareholder-employees. As discussed above, Mulcahy was the first case in which the court applied the independent investor test to a professional services corporation. The Tax Court stated that well before the years in issue, an increasing number of Federal Courts of Appeal, including the Court of Appeals for the Seventh Circuit, were moving away from a multi-factor analysis in assessing the deductibility of amounts paid as compensation to shareholder-employees and focusing on the effect of the payments on the returns available to the shareholders on their capital.[5] Under the independent investor test, the courts consider whether payments made as salary to shareholder-employees meet the standards for deductibility by taking the perspective of a hypothetical “independent investor” who is not an employee. In essence, the test provides that if the corporation’s return on equity remains at a level that would satisfy an independent investor, there is a strong indication that management is providing compensable services and that profits are not being syphoned out of the corporation as disguised salary. Consequently, ostensible compensation payments made to shareholder-employees by a corporation with significant capital that zeroes out the corporation’s income and leaves no return on the shareholders’ investment fails the independent investor test.

The Tax Court found that the taxpayer had substantial capital even without regard to any intangible assets based on the shareholders’ equity of $8 million at the end of 2007 and $9.3 million at the end of 2008. The Tax Court found that investor capital of this magnitude cannot be disregarded in determining whether ostensible compensation paid to shareholder-employees is really a distribution of earnings. Consequently, the Tax Court concluded that the taxpayer’s practice of paying out year-end bonuses to its shareholder-employees that eliminated its book income failed the independent investor test.

Reasonable Cause and Good Faith

The Tax Court then addressed the taxpayer’s argument that it had reasonable cause for its position and acted in good faith. Specifically, the taxpayer alleged that its reliance on McGladrey to prepare its returns for the years in issue constituted reasonable cause and demonstrated good faith. The Tax Court found that the taxpayer’s argument failed for two reasons.

First, the record provides no evidence that McGladrey advised petitioner regarding deductibility of the year-end bonuses. Second, in characterizing the compensation for services amounts that have been determined to be dividends, the taxpayer failed to provide McGladrey with accurate information.[6]

The Tax Court concluded that the taxpayer consistently followed a system of computing year-end bonuses that disregarded the value of its shareholder-attorneys’ interest in the capital of the firm and inappropriately treated its compensation amounts that eliminated the firm’s book income. Specifically, the Tax Court stated that “Although petitioner offered no evidence as to why it adopted its practice of paying year-end bonuses, it is difficult to imagine reasons that are not tax related.”

Observation

As demonstrated by the Brinks case and the Mulcahy case, it is very difficult, if not impossible, for most professional corporations to meet the independent investor test where the professional corporation distributes all or substantially all of its income in the form of compensation to its shareholder-employees (in which case the return for the independent investor would be 0%). The Brinks and Mulcahy cases represent yet another tool in the IRS’s arsenal for attacking compensation paid to the shareholder-employees of a professional services corporation. In addition, the IRS has the ability to attack compensation paid to the shareholders of a professional services corporation based on the compensatory intent prong of Reg. 1.162-7(a), as demonstrated by Richlands Medical Association,[7] and Pediatric Surgical Associates.[8] The Brinks case should send a strong message to mid-size to large personal service corporations operating as C corporations that the courts can and will recharacterize wages as nondeductible dividends where the professional corporation’s normal practice is to zero out all income by payment of compensation to its shareholder-employees.

About the Author:
Stephen R. Looney is the chair of the Tax department at Dean Mead in Orlando. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional services practices. He is a member of the Board of Trustees of the Southern Federal Tax Institute, as well as former Chair of the S Corporations Committee of the American Bar Association’s Tax Section. He is Board Certified in Tax Law by the Florida Bar, as well as being a Certified Public Accountant (CPA). He may be reached at slooney@www.deanmead.com.

[1] Brinks Gilson & Lione, P.C. v. Comm’r, TCM 2016-20

[2] Section 6662(d)(2)(B)(i).

[3] Pediatric Surgical Assocs. v. Comm’r, TCM 2001-81.

[4] Mulcahy, Pauritsch, Salvador & Co. v. Comm’r, 680 F.3d 867 (CA-7 2012), aff’g TCM 2011-74.

[5] See Exacto Spring Corp. v. Comm’r, 196 F.3d 833 (CA-7 1199), rev,’g Heitz v. Comm’r, TCM 1998-220); Rapco, Inc. v. Comm’r, 85 F.3d 950 (CA-2 1996), aff’g TCM 1995 – 128; and Elliotts, Inc. v. Comm’r, 716 F.2d 1241 (CA-9 1983), rev’g and remanding TCM 180-282.

[6] The court also rejected the taxpayer’s argument that the “no-change” letter it received at the conclusion of the audit of its 2006 return was sufficient to establish reasonable cause and good faith.

[7] Richlands Medical Association v. Comm’r, TCM 1990-66, aff’d without published opinion, 953 F.2d 639 (CA-4 1992).

[8] TCM 2001-81.

A longer version of this article is accessible HERE.