It would seem at first glance that it is beneficial to leave profits in the corporation. However, doing so exposes the profits to double taxation—tax at the personal service corporation level, currently 35%, plus tax as a dividend, which can be 23.8% or higher, counting phaseouts for high-income individuals. This can result in an effective tax rate far over 50%. To avoid this situation, most personal service corporations distribute substantially all their income as wages to the employee/shareholders.
Now comes the Tax Court case of Brinks, Gilson & Lione, P.C., T.C. Memo. 2016-20. At first glance, this appears to be just another case dealing with accuracy-related penalties. However, what is important is the reason the IRS assessed the penalties. During the course of the audit of the corporation's 2007 and 2008 tax returns, the IRS and the taxpayer agreed that the amount of compensation paid to the employee/shareholders of the law firm was overstated. There were other agreed-upon changes, but they were minor. Because of the recharacterization's magnitude, the IRS imposed accuracy-related penalties for a substantial understatement of income tax. The accuracy-related penalty is the only issue the court considered.
For purposes of the substantial-understatement penalty, an understatement is reduced by the portion attributable to the treatment of an item for which the taxpayer had "substantial authority" under Sec. 6662(d)(2)(B)(i). Sec. 6664(c)(1) provides an exception to the imposition of the Sec. 6662(a) accuracy-related penalty if it is shown that there was reasonable cause for the underpayment and the taxpayer acted in good faith.
The taxpayer claimed that it had substantial authority for deducting the bonuses it paid to its employee/shareholders in full, and therefore its understatement was reduced under Sec. 6662(d)(2)(B)(i) below the threshold for the substantial-understatement penalty, relying primarily on Law Offices—Richard Ashare, P.C., T.C. Memo. 1999-282, for support. The IRS argued 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, citing Pediatric Surgical Associates P.C., T.C. Memo. 2001-81, and Mulcahy, Pauritsch, Salvador & Co., 680 F.3d 867 (7th Cir. 2012). The court agreed with the IRS and held that the taxpayer did not have substantial authority for deducting the bonuses
The taxpayer also argued that the shares of the company's stock really were debt and, thus, the recharacterized amount was deductible interest, not dividends. The court dismissed this argument because it found that the taxpayer could show no evidence that its stock was debt rather than equity.
The taxpayer also argued it had reasonable cause for its understatement because it relied on its tax preparer's advice. The court disallowed this rationale, as there was no evidence that the taxpayer relied on the preparer's advice. Furthermore, the court pointed out that the taxpayer provided the tax preparer with inaccurate information.
Like most Tax Court cases, this case is long and the arguments are provided in great detail. However, in this case the consequences for personal service corporations are clear. The IRS has a clear precedent to attack personal service corporations, other than possibly entities owned by one shareholder, which may be protected (see Law Offices—Richard Ashare, P.C., T.C. Memo. 1999-282).
Many multiowner personal service corporations distribute all or substantially all of their income as compensation to their employee/shareholders. The warning flags are waving high and cannot be ignored. Options are available to avoid this situation (the most obvious is converting to an S corporation), and every personal service corporation needs to review its situation and the options available with its tax advisers. As Brinks shows, personal service corporations risk having compensation reclassified as dividends, which are subject to double taxation, and they could face substantial accuracy-related penalties. It is important to discuss this situation with clients.
Michael Koppel is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or email@example.com.
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