C Corporation law firm sees huge tax bill

The United States Tax Court[1] held a Chicago law firm liable for negligence penalties for mischaracterizing payments to shareholder attorneys as compensation for services rather than dividends.

Many personal service firms, such as law firms and accounting firms, operate as C corporations for tax purposes. But C corporation earnings are subject to a double tax. First is a corporate income tax imposed on the corporation’s net earnings. Second, after the earnings are distributed to shareholders as dividends, each shareholder must pay taxes separately on their share of the dividends. The Chicago law firm attempted to avoid the double tax by distributing its income as salary to shareholder-employees.

The law firm employed approximately 150 attorneys, about 65 of whom were shareholders. The firm also employed non-attorney staff of about 270. Shareholder attorneys were entitled to receive a dividend if declared by the board of directors, but no dividend had ever been declared. As a matter of course, in November or December of the prior year, the board of directors established a budget including expected compensation for shareholder-employees.

Over the year, each shareholder-employee received only a percentage of his expected compensation with the expectation of receiving an additional amount as a yearend bonus. The board calculated the shareholders’ cumulative yearend bonus to exhaust book income. Shareholder-employees shared in the bonus pool in proportion to their shareholder percentage.

Yearend bonuses were treated as compensation and reported on Form W-2 with the proper employment tax withheld. The Form W-2s were provided to the firm’s outside accounting firm and the corporate tax return was prepared by taking a compensation deduction for the yearend bonuses.

The Tax Court ruled that taking a compensation deduction for the yearend bonus was not reasonable. First, the Court reasoned that amounts paid to shareholder-employees that are attributable to the services of nonshareholder employees must be nondeductible dividends. The Court stated that “… when a thriving firm that has nontrivial capital reports no corporate income, it is apparent that the firm is understating its tax liability.” Second, the tax characterization was not reasonable because of the independent investor test. The Court stated that “… if the bulk of the corporation’s earnings are being paid out in the form of compensation, so that the corporate profits, after payments of the compensation, do not represent a reasonable return on the shareholder’s equity in the corporation, then an independent shareholder would probably not approve of the compensation arrangement.” The Court also ruled that the law firm could not reasonably rely on the advice of its accounting firm because the accounting firm never gave advice regarding the tax deductibility of the yearend bonuses.

Here, the Court failed to recognize the distinction between personal service firms and other businesses. The independent investor test essentially views the facts from the perspective of a hypothetical independent investor having no management role to determine the reasonableness of the compensation paid to the shareholder-employees. However, personal service firms do not have outside investors and their shareholders are generally active participants. Therefore the independent investor test was a poor indicator to determine reasonable compensation for the law firm.

Nevertheless, personal service firms operating as C corporations should consider themselves on notice that distributing corporate earnings to employees as salary to reduce corporate tax liability may be successfully challenged by the IRS. These firms could consider reorganizing as an S corporation or partnership which are entities generally not subject to federal income tax.

The lesson here is that engaging knowledgeable tax counsel is indispensable—whether making choice of entity decisions or challenging IRS positions.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client Alert authored by: David B. Shiner, Principal