Many legal practices operate their businesses as C-corporations, which automatically makes them a personal service corporation (PSC). While the PSC designation offers several benefits, it carries with it a high price tag in the rate of tax charged – a flat 35% on every dollar of net income. To reduce or eliminate tax owed, many PSCs have tried to “strip out” or “zero out” net income at year end via bonuses to shareholder employees. But the IRS has taken issue with this practice, and has targeted companies that try to avoid taxes in this way. So it’s important to be aware of recent cases and potential options to minimize risk.
“Stripping out” net income
The IRS has challenged companies that stripped out their net income – including Pediatric Surgical in 2001, Mulcahy, Pauritsch, Salvador & Co. in 2011 and Midwest Eye Center in 2015. The most recent case, Brinks Gilson & Lione (“Brinks”) in early 2016, has created a buzz within the PSC industry.
Brinks is a Chicago-based law firm that reduced its net income to zero via year-end bonuses and left no capital in the company for the payment of dividends. Therefore, shareholders received no rate of return on their investment. The IRS asserted that an “independent investor” would demand a rate of return on his or her investment and would not allow for all of the profits to be paid out via compensation.
Independent investor test
The crux of the “independent investor test” is that the owners of a company with significant capital are entitled to a return on their investments. Consistent payments of salaries to shareholder employees in amounts that leave insufficient funds available to provide an adequate return to the shareholders indicates that a portion of the amounts paid as salaries is actually distribution of earnings. In theory, if a hypothetical investor (non-employee/shareholder) would be satisfied with the rate of return, 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.
Starting with the Mulcahy case (and later applied in Brinks), courts began using the independent investor test in these types of PSC cases and moved away from a multi-factor analysis in assessing deductibility of amounts paid as compensation to shareholder employees. The courts focused on the effect of the payments on the returns available to the shareholders. However, they still have the ability to attack compensation paid to the shareholders of a professional services firm based on the compensatory intent prong of IRC Sec. 162, as used in the Pediatric Surgery case.
Notes on the Brinks case
In the Brinks case the Tax Court did not rule on the re-characterization of part of the compensation as dividends, as Brinks had already conceded on that issue. The court ruled on the assessment of the IRC Sec. 6662 accuracy-related penalty, and ultimately Brinks was unsuccessful, and was liable for over $425,000 in penalties in addition to the tax assessment. The important takeaway is that the risk lies not only with the re-characterization but also with penalties if substantial authority cannot be proven.
The second interesting point in Brinks is that they had significant invested capital, as well as potential for intangible equity. In addition, their buy-sell agreement provided for no appreciation in buy in rate versus sell rate.
S corporation as an innovative solution
So how can you avoid these potential risks and penalties? If you are a C corporation in the legal area it may be worth considering S-election. In addition to many tax-related benefits, such as no double taxation and the potential reduction of Medicare taxes, the issues around year-end bonuses/compensation and equity structures are greatly reduced.
In the evaluation process for S-election, you will want to review your built-in gains asset exposure as well as your strategy for paying reasonable compensation for shareholder employees.
Review your risk
Having the IRS reclassify compensation as dividends can be costly, both in tax and penalty assessment. Legal entities and other PSCs should evaluate their tax classification, year-end bonus structures and equity arrangements to determine if they are at risk for an IRS challenge. Our tax experts can help with that process, as well as develop recommendations regarding this issue and other tax matters. Contact your CSH advisor or request a consultation.