Compensation Deductions in a Professional Service C-corporation

As mentioned in our last newsletter, the IRS continues to keep a watchful eye over S-corporations, requiring minimum levels of “reasonable compensation” to owners who may be otherwise seeking to downplay compensation for tax avoidance purposes. S-corporation shareholders aren’t the only ones who need to be cautious regarding the method and amount of compensation allocated to shareholders. Professional service corporations also are being scrutinized for mischaracterization of dividends to shareholders as deductible compensation.

Personal services include any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law and the performing arts. According to IRS Publication 542, a corporation is deemed to be a personal service corporation if it meets the following requirements:

1. Its principal activity during the “testing period” is performing personal services. Generally, the testing period for any tax year is the prior tax year. If the corporation has just been formed, the testing period begins on the first day of its tax year and ends on the earlier of:
   • The last day of its tax year, or
   • The last day of the calendar year in which its tax year begins.

2. Its employee-owners substantially perform the services noted in number one above. This requirement is met if more than 20% of the corporation’s compensation cost for its activities of performing personal services during the testing period is for personal services performed by employee-owners.
3. Its employee-owners own more than 10% of the fair market value of its outstanding stock on the last day of the testing period.

These professional corporations were a favorable entity choice up and until the mid-1980s when the tax law was changed to tax professional services corporations at a flat rate of 35% whereas in the past corporations had the benefit of a graduated tax scale. Prior to the flat rate of 35%, with creative compensation structuring employee-owners of professional corporations could diminish some of their tax liability. Professional corporations today do not enjoy the tax planning benefits enjoyed by the PCs when in their heyday.

The IRS contends that many personal services corporations attempt to limit taxable income through additional compensation paid out to shareholder owners, so as to reduce corporate taxable income. Since dividend payments are accounted for as a return on investment in the business rather than an expense, it is not deductible which means such payments are effectively subject to corporate tax prior to being distributed. Additionally, the shareholder receiving the dividend is taxable on such dividend income on his or her personal return, resulting in what amounts to double taxation.

In lieu of dividends, professional corporations may lean towards paying out business income to shareholders in the form of salaries, bonuses, and fringe benefits, all of which are deductible business expenses. The IRS has been very aggressive in challenging the issue of unreasonable compensation and will not hesitate to claim that inflated compensation, especially in the form of year-end bonuses, is merely disguised, non-deductible dividends.

A recent decision by the Tax Court demonstrates this aggressive challenge of year-end bonus distributions for a professional corporation law firm. In Brinks Gilson & Lione PC, TC Memo 2016-20, the Tax Court found that the law firm that had a history of no dividend payments to shareholders while paying out significant year-end bonuses, amounted to a mischaracterization of its taxable income and upheld an understatement of tax penalty under Section 6662, despite the defense that an established accounting firm prepared the firm’s tax returns. The IRS again holds firm on its position to ensure that compensation is reasonable, whether in a C corporation such as a professional corporation, or in an S corporation.

For greater analysis on this Tax Court decision, see Scott E. Vincent, Tax Court Sustains Penalties on Law Firm Compensation Deductions, Vol. 72 No. 2, Journal of the MO. Bar, p. 100, (2016).

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*This post was originally published on May 25, 2016