A recent tax case in the 7th circuit, which is Indiana’s circuit, was decided in favor of the IRS. This tax case should cause professional services firms that are set up as C-Corporations to take notice and reconsider their ownership structure.  This case actually references a prior 7th circuit case, as support for the IRS, to disallow compensation to attorney-owners and to re-class such payments as dividends, specifically as it relates to income generated by its non-owner attorneys.

Penalties were assessed as well.

At this point, the case could be appealed by the law firm. A Tax court memo decision is a one judge decision which does not have as much merit for precedential value as a full tax court decision would which involves multiple tax court judges.

See full case memo below. Please contact your Somerset Tax Advisor with questions.

Penalties upheld against firm that eliminated income by deducting shareholder “bonuses”

Brinks Gilson & Lione PC, TC Memo 2016-20TC Memo 2016-20

The Tax Court has upheld IRS’s imposition of accuracy-related penalties against a law firm in respect to underpayments resulting from the firm’s conceded mischaracterization of dividends that it paid to shareholder-attorneys as deductible compensation for services. The Court found that the law firm lacked substantial authority for its treatment of the payments and failed to establish reasonable cause for the underpayments and that it acted in good faith.

Background. Code Sec. 6662 imposes an accuracy-related penalty if any part of an underpayment of tax required to be shown on a return is due to, among other things, negligence or disregard of rules or regs, or a substantial understatement of tax. “Understatement” is defined in Code Sec. 6662(d)(2)(A) 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, as relevant here, 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 had “substantial authority.” (Code Sec. 6662(d)(2)(B)(i)) The determination of substantial authority requires a weighing of the authorities that support the taxpayer’s treatment of an item against the contrary authorities, as of (i) the last day of the tax year to which the return relates, or (ii) when the return is filed. (Reg. § 1.6662-4(d)(2))

Under Code Sec. 6664(c)(1), no penalty is imposed under Code Sec. 6662 with respect to any portion of an underpayment if it is shown that there was reasonable cause for the underpayment and the taxpayer acted in good faith.

Facts. Brinks Gilson & Lione PC, a law firm organized as a corporation (law firm), computes its taxable income on the basis of a calendar year, using the cash method of accounting. For 2007 and 2008, the years in issue, law firm prepared its financial statements on that basis and using that method. During those years, it employed about 150 attorneys, of whom about 65 were shareholders, and a non-attorney staff of about 270. Its business and affairs are managed by a board of directors (board).

Law firm’s shareholder-attorneys hold shares in the corporation in connection with their employment, with proportionate ownership generally reflecting the shareholder’s proportionate share of compensation from the firm. For the years in issue, consistent with past practice, the board set the yearly compensation to be paid to shareholder-attorneys. In general, the way that compensation was calculated and paid meant that the shareholder-attorneys would receive a percentage of their expected compensation over the course of the year, with an additional bonus paid at year-end that was intended to exhaust the firm’s book income (i.e., reduce it to zero). The shareholder-attorneys are also entitled to dividends as declared by the board, but for at least 10 years before and including the years in issue, no dividends had been paid. The firm also had invested capital, measured by the book value of its shareholders’ equity, of about $8 million at the end of 2007 and $9.3 million at the end of 2008.

The law firm treated all amounts paid to the shareholder-attorneys as deductible employee compensation, including the year-end bonuses. On its 2007 return, the firm reported total income of almost $92 million, taxable income of $540,000, and a tax liability of 189,000. The corresponding amounts reported for 2008 were $107 million, $561,000, and $196,000. (The amounts reported as taxable income were attributable to items treated differently for book and tax purposes.) Both returns were prepared by an established accounting firm.

IRS examined both returns and disallowed various deductions, including for the year-end bonuses. After negotiations, the parties entered into a closing agreement that ultimately resulted in underpayments of $1.1 million and $1 million for 2007 and 2008, and IRS imposed accuracy-related penalties of $222,000 and $203,000.

Firm’s arguments. The law firm claimed that: (i) it had substantial authority for deducting in full the year-end bonuses it paid to its shareholder-attorneys; and (ii) 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.

In arguing that it had substantial authority, the firm pointed to Ashare, TC Memo 1999-282TC Memo 1999-282, where the Tax Court allowed a corporate law firm to deduct an amount it paid to its sole shareholder that exceeded the firm’s revenues for the year as compensation. The firm also argued that, under substance-over-form principles, the stock held by the shareholder-attorneys should be treated as debt such that whatever portion of the bonuses is determined to be other than deductible as compensation can nonetheless be deductible as interest.

IRS, on the other hand, asserted that amounts paid to shareholder employees of a corporation do not qualify as deductible compensation to the extent that the payments are funded by earnings attributable to the services of nonshareholder employees or to the use of the corporation’s intangible assets or other capital; rather, these are nondeductible dividends. IRS cited Pediatric Surgical Associates, TC Memo 2001-81TC Memo 2001-81, where the Tax Court held that compensation payments to shareholder employees attributable to the services of nonshareholders were nondeductible dividends, and Mulcahy, Pauritsch, Salvador & Co, (CA 7 2012) 109 AFTR 2d 2012-2140109 AFTR 2d 2012-2140, where Seventh Circuit Court of Appeals — i.e., the Circuit which an appeal of the instant case would lie — found that indirect payments made to founders of an accounting firm were disguised dividends, not compensation. (See Weekly Alert ¶ 16 5/24/2012 for more details).

Penalty upheld. The Tax Court first determined that the law firm lacked substantial authority for its position. It cited Mulcahy as standing for the general proposition that owners of an enterprise with significant capital are entitled to a return on their investment — and that a corporation’s consistent payment of salaries to shareholder-employees in amounts that leave insufficient funds available to provide an adequate return to the shareholders on their invested capital indicates that a portion of the “salaries” is in fact distributions of earnings (i.e., dividends). This practice of zeroing out a corporation’s earnings clearly fails the independent investor test — especially considering the firm’s millions of dollars worth of invested capital — as investors in such a situation would expect a return on their investment. The Court also rejected the firm’s argument that the manner in which the shareholder-attorneys held their stock and the way that it was valued effectively deprived them of the normal rights of equity owners so as to render the independent investor test inapplicable.

The Court then turned to the authorities cited by the firm and found that they failed to refute the general principle that owners of an enterprise with significant capital are economically entitled to a return on their investments. It also specifically rejected the firm’s reliance on Ashare, as that case only upheld deduction of compensation in excess of revenues for a single year and not as a consistent practice of eliminating book income, and easily dismissed the firm’s claim that the stock was really debt as the shares lacked the “hallmark characteristics of debt” (i.e., an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest).

Overall, considering the authorities on both sides, the Court found that those cited by the law firm in support of deducting the year-end bonuses were not substantial.

The Court then found that the law firm didn’t act with reasonable cause and good faith. The law firm’s argument that it relied on the accounting firm that prepared its returns failed where there was no evidence that the accounting firm advised the law firm on the deductibility of the bonuses; and, in characterizing the amounts as compensation for services (e.g., on Form W-2s), the law firm didn’t provide the accounting firm with accurate information. The law firm’s claim that the accounting firm’s silence as to the deductibility of the bonuses constituted a communication thereon was rejected. Finally, the Tax Court also dismissed the law firm’s argument that the fact that its practice of deducting bonuses passed IRS muster in a prior year audit helped show that its reliance on the accounting firm was reasonable.