Payments to Related Entities Are Dividends, Fail Independent-Investor Test

Editor: Alan Wong, CPA

Corporations & Shareholders

The Seventh Circuit in Mulcahy, Pauritsch, Salvador & Co., 680 F.3d 867 (7th Cir. 2012), upheld a Tax Court memorandum decision (T.C. Memo. 2011-74) holding that a C corporation’s payments to entities owned by its shareholders for consulting services were disguised dividends.

The cash-basis professional services taxpayer operated as a calendar-year C corporation and was owned by three major shareholders during 2001–2003. The shareholders owned various related entities that did not perform any services for the taxpayer in the years at issue. The shareholders themselves performed various services for the taxpayer, including accounting, consulting, and management services. The taxpayer’s other employees (approximately 40) performed accounting and consulting services for the taxpayer. The shareholders were paid various amounts throughout each year that were designated as compensation. In addition, the taxpayer made a number of payments to the related entities that were designated as “consulting fees.”

The taxpayer paid its available cash at the end of each year to two of the related entities, reducing its taxable income to zero (or near zero). A compensation committee then allocated the related entity payments among the shareholders according to the hours each shareholder worked for the year. The related entities, in turn, paid the shareholders amounts that approximated the committee’s allocation. The payments to each shareholder by the related entities were thus proportionate to his hours worked in relation to the other shareholders and not to his ownership.

The taxpayer claimed deductions for consulting fees for amounts it paid to the related entities, which in turn paid the three major shareholders totals of $911,570 for 2001; $866,143 for 2002; and $993,528 for 2003.

The IRS determined tax deficiencies of $317,729 for 2001; $284,505 for 2002; and $377,247 for 2003, primarily from its disallowance of the consulting fee deductions. The Tax Court, applying the independent-investor test, upheld the IRS’s determination.

On appeal, the Seventh Circuit affirmed the Tax Court’s decision. In explaining the independent-investor test, the court noted that owner-employees have an incentive to recharacterize dividends as salary, and courts from time to time must decide whether income denominated as salary is really a dividend and thus has been improperly deducted from the corporation’s income. In most cases, the taxpayer is a closely held corporation in which most or all of the shareholders draw salaries as employees.

The court further explained that businesses organized in corporate form combine labor and capital to produce goods or services for sale. If the sales generate revenues that exceed the costs of the company’s inputs, a business has profits. Some of the labor inputs into a business may come from an owner-employee, who is compensated in the form of salary. An owner-employee may also receive a share of the profits in the form of dividends as compensation for capital inputs. Whether the deduction claimed for the owner-employee is a dividend can usually be determined by comparing the corporation’s reported income with that of similar corporations, in terms of measuring return on equity. The higher the return, the stronger the evidence that the owner-employee deserves significant credit for his corporation’s increased profitability and thus earns his high salary. The presumption is that salary paid to an owner-employee is reasonable and not a disguised dividend if the business generates a higher percentage return on equity than its peers.

The Seventh Circuit stated:

The closer the owner-employee’s salary is to salaries of comparable employees of other companies who are not also owners of their company (or to salaries of non-owner employees of his own firm who make contributions comparable to his to the firm’s success), the likelier it is that his salary was compensation for personal services and not a concealed dividend.

But what if, as in a typical small professional services firm, the firm’s only significant input is the services rendered by its owner-employees? Maybe it has no other employees except a secretary, and only trivial physical assets—a rented office and some office furniture and equipment. Such a firm isn’t meaningfully distinct from its employee-owners; their income from their rendition of personal services is almost identical to the firm’s income. The firm is a pane of glass between their billings, which are the firm’s revenues, and their salaries, which are the firm’s costs. To distinguish a return on capital from a return on labor is pointless if the amount of capital is negligible. . . .

The taxpayer in this case is not the very small firm of our example; it is not a “pane of glass.” It has physical capital to support some 40 employees in multiple branches, and it has intangible capital in the form of client lists and brand equity—and capital in a solvent firm generates earnings. [Mulcahy, Pauritsch, Salvador & Co., slip op. at 4–5 (citations omitted)]

Given this analogy, the Seventh Circuit held the Tax Court was correct to reject the taxpayer’s argument that the consulting fees were salary expenses. The salaries reduced the taxpayer’s income and the potential return to equity investors to zero or below in two of the three tax years at issue. Because no investor would find this level of return on equity acceptable, the court found that the corporation had failed the independent-investor test and that the IRS had properly recharacterized the consulting fees as dividends.

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York City.

For additional information about these items, contact Mr. Wong at 212-697-6900, ext. 986 or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.