Reasonable Compensation Issues Remain On the IRS Radar

Many professional service corporations ("PSC") such as law firms, accounting firms, and medical practices are organized and taxed as C-corporations.  The earnings of a C-corporation can be subject to double tax (at the corporate level when earned and at the shareholder level when distributed as dividends).  To eliminate the double tax, a PSC may be inclined to pay deductible year-end bonuses to "zero out" income instead of paying nondeductible dividends.  The United States Tax Court ("Tax Court"), however, recently upheld accuracy-related penalties against a PSC for treating year-end bonuses as deductible compensation instead of nondeductible dividends.  

The IRS Determination

The case involved a law firm that employed about 150 attorneys (of whom about 65 were shareholders) and about 270 non-attorney staff.  The law firm regularly paid out year-end bonuses to its shareholders to reduce its income to zero.  Although the firm had significant capital and the shareholders were entitled to dividends when declared by the firm's board, no dividends had been paid for at least ten years prior to the tax years at issue.  

Upon examination of the firm's tax returns, the IRS disallowed various compensation deductions including the year-end bonuses.  After negotiations, the firm conceded that a portion of the compensation it paid to its shareholders should have been dividends.  As a result, the firm's underpayment of tax was substantial and the IRS imposed accuracy-related penalties on the underpayment related to the deduction of the year-end bonuses that should have been nondeductible dividends.  

The Tax Court Ruling

The firm appealed the imposition of the penalties to the Tax Court, taking the position that it had substantial authority for deducting the bonuses, which is a defense against the imposition of accuracy-related penalties.  In addition, the firm argued that it had reasonable cause to deduct the bonuses and acted in good faith because a reputable accounting firm prepared its tax returns for the years in issue.  

Although the Tax Court only addressed the issue of the imposition of accuracy-related penalties, the case is significant because it provides a detailed discussion of the Tax Court's and IRS's view on the common practice of paying bonuses to eliminate or reduce corporate profits.  The IRS took the position that the payments to the shareholders were not deductible as 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 capital.  Instead, those payments would be nondeductible dividends.  

The Tax Court upheld the penalties.  As part of its analysis, the Tax Court applied the "independent investor" standard which essentially provides that owners of an enterprise with significant capital are entitled to a return on their investment.  Thus, the Tax Court ruled that the law firm's practice of consistently paying earnings as year-end bonuses in amounts that left little or no return on shareholder equity failed the independent investor test.  

In addition, the Tax Court ruled that the firm did not specifically ask its accountants whether the full amount of the year-end bonuses were deductible as compensation and, as a result, the accountants did not advise on the deductibility of the bonuses.  Therefore, the firm did not have reasonable cause or act in good faith in deducting the year-end bonuses.

This case serves as a reminder that compensation deductions can raise complicated issues and are often scrutinized by the IRS.  Although a corporation and a PSC can generally deduct reasonable compensation, the "reasonableness" of compensation is not only impacted by the amount paid but also the method used for determining the amount.  Therefore, corporations and PSCs may need to revisit their compensation plans and policies.

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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.

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