Tax Court Recharacterizes Portion of Bonus Paid to Physician as Nondeductible Dividend

In Midwest Eye Center, S.C.,[1] the Tax Court held that $1 million of a $2 million bonus paid to the physician sole shareholder of a personal service corporation was a non-deductible dividend distribution. Under the facts of the case, the taxpayer, a C corporation, conducted an ophthalmology surgery and care center during the tax years at issue.  The taxpayer operated four locations and employed around 50 employees during the 2007 tax year.  Of the 50 employees, 5 were physicians who could perform surgery, 3 were optometrists, 3 were nurses, 2 were surgical technicians, 10 were non-surgical technicians, and 15 were non-administrative employees.  The remaining employees served administrative functions.  The taxpayer had at least one manager at each of its four locations, a full-time billing specialist, a number of front office staff and a bookkeeper.

Dr. Ahmad was the taxpayer’s president, medical director, and 100% shareholder.  Dr. Ahmad also served as the taxpayer’s chief executive officer, chief operation officer and chief financial officer.  These positions required him to perform various managerial tasks, as well as being an active surgeon in the practice.  In 2007, the taxpayer paid a salary of $785,000 to Dr. Ahmad, and paid a $2 million bonus via four separate checks totaling $500,000 each, payable on November 8, November 21, December 5 and December 20, 2007.

In 2007, Dr. Ahmad’s workload increased because one of the taxpayer’s busier surgeons quit unexpectedly in June, and the taxpayer’s only other retinal specialist began to reduce her workload because she planned to begin her own practice.

The taxpayer reported a tax loss for 2007 and taxable income of $0 for 2008.  The taxpayer hired a professional return preparer to aid in the preparation of its returns.  The IRS argued that $1 million of the claimed bonus compensation deduction for 2007 was a disguised dividend rather than a bonus compensation.  The IRS also determined that the taxpayer was liable for an accuracy related penalty under Section 6662.

Section 162(a)(1) allows taxpayers to deduct ordinary necessary expenses, including a “reasonable allowance for salaries or other compensation for personal services actually rendered.”  Consequently, compensation is deductible only if:  (1) it is reasonable in amount; and (2) it is paid or incurred for services actually rendered.[2]

The court began by discussing the so-called “independent investor test.”  Under this test, if the corporation’s return on equity remains at a level that would satisfy an independent investor, there is a strong indication that the compensation being paid is reasonable and that profits are not being syphoned out of the corporation as disguised salary.[3]  Interestingly, both the IRS and the taxpayer stipulated that the independent investor test was not applicable to the taxpayer’s case.  Apparently, the taxpayer argued that it was impossible to generate a meaningful comparison of the taxpayer’s business because there were no businesses sufficiently similarly situated.  Because of this lack of comparability, the taxpayer contended that the independent investor test could not be applied.  It is somewhat perplexing that the court did not apply the independent investor test in this case based on the recent application of the independent investor test to disallow amounts paid to the shareholders of an accounting firm in the Mulcahy case.  Additionally, the taxpayer’s contention that there were no businesses similarly situated does not seem plausible and would not seem to be an impediment to applying the independent investor test.[4]

The court then turned its attention to the reasonableness of the compensation paid by the corporation to Dr. Ahmad and provided that the taxpayer had the burden to show that the bonuses paid to Dr. Ahmad were otherwise reasonable.  The taxpayer produced no evidence of comparable salaries because it argued that there were no “like enterprises” under “like circumstances” from which to draw comparisons.  Rather, the taxpayer argued that Dr. Ahmad’s large bonus was reasonable due to his increased workload during 2007, and the various roles that Dr. Ahmad performed, such as CEO, CFO, and COO, and the corresponding managerial duties of those positions.  The court noted, however, that the taxpayer did not provide any methodology to show how Dr. Ahmad’s bonus was determined in relation to those responsibilities.

Additionally, the court observed that the taxpayer did not explain how the amount of the bonus was determined and why it was divided into four payments and provided no evidence to demonstrate that the full $2 million bonus was reasonable.  Consequently, the court determined because the taxpayer failed to show that the bonus constituted reasonable compensation, they did not need to reach the issue of whether it was paid or incurred for services actually rendered and recharacterized $1 million of the $2 million bonus as a nondeductible dividend distribution.

The court went on to impose the accuracy-related penalty under Section 6662(a) on the taxpayer.  Section 6662(a) imposes a 20% penalty on any underpayment attributable to, among other things, negligence or disregard of rules or regulations, or any substantial understatement of income tax.  Under Section 6662(d)(2)(B), the amount of the understatement is reduced to the extent it is attributable to a tax treatment for which the taxpayer had substantial authority.  Substantial authority for a tax treatment exists if the weight of the authorities supporting the treatment is substantial in relation to the weight of the authorities supporting contrary treatment.[5]  After determining that there was a substantial understatement of income as defined in Section 6662(b)(1)(A), the court determined that the taxpayer would be liable for the accuracy-related penalty unless it could show it had reasonable cause and acted in good faith regarding the underpayment.  Under Reg. 1.6664-4(b)(1), a taxpayer may establish reasonable cause and good faith by showing reliance on professional advice.  A taxpayer relies reasonably on professional advice if he or she proves the following by a preponderance of the evidence:

1. The advisor was a competent professional who had sufficient expertise to justify reliance.
2. The taxpayer provided necessary and accurate information to the advisor.
3. The taxpayer actually relied in good faith on the taxpayer’s judgment.[6]

Because the taxpayer failed to provide any evidence about the identity of its tax return preparer, the information it provided to its tax return preparer, or whether it even relied on the preparer’s judgment, the court determined that the taxpayer could not establish reasonable cause and good faith by showing reliance on professional advice, and as such, imposed the accuracy-related penalty under Section 6662(a) to the extent of the understatement.

Observation

Although the Midwest Eye Center case may not provide reliable precedent for the IRS to assert unreasonable compensation arguments against personal service corporations formed as C corporations because the taxpayer in the Midwest Eye Center case failed to produce any evidence of reasonableness, professional corporations and other service corporations should be aware that they are susceptible to unreasonable compensation arguments in light of the application of the independent investor test by the Tax Court and the Seventh Circuit Court of Appeals in the Mulcahy case, as well as the use of the compensatory intent test to recharacterize compensation paid to the shareholder-employees of a professional service corporation as nondeductible dividends in Pediatric Surgical Associates, P.C.[7] and Richland Medical Association[8].

[1] TCM 2015-53.

[2] Reg. 1.162-7(a).

[3] See Exacto Spring Corp., 196 F.3d 833 (CA-7, 1999), Mulcahy, Pauritsch, Salvadore & Company, 680 F.3d 867 (CA-7, 2012), aff’g TCM 2011-74, and Menard, Inc., 560 F.3d 620 (CA-7, 2009), rev’g TCM 2004-207.

[4] Ironically, the taxpayer in this case may have actually received a better result (i.e., had less of the bonus paid to Dr. Ahmad recharacterized as a non-deductible dividend) if it had used the independent investor test.  Recent cases have used 10-20% as a reasonable rate of return on equity to the independent investor, and then “backed into” the amount of reasonable compensation as equal to the balance of the earnings of the corporation  See generally, Multi-Pak, TCM 2010-139, Thousand Oaks, TCM 2013-10, and Aries Communication, TCM 2013-97.

[5] Reg. 1.6662-4(d)(3)(i).

[6] See Neonatology Associates, P.A., 115 TC 43 (2000), aff’d 299 F.3d 221 (CA-3, 2002).

[7] TCM 2001-81.

[8] TCM 1990-660.