The Tax Court recently dealt a blow to professional service C-corporations (“PSCs”) seeking to avoid corporate federal income taxes by making employee-shareholder compensation payments to reduce (in this case, zero-out) taxable income. The case, Brinks Gilson & Lione A Professional Corporation v. Commissioner, (2016) TC Memo 2016-20, ostensibly addressed only the application of accuracy-related penalties. However, the opinion sheds light on the Court's view of the common practice used by PSCs of “zeroing-out” or reducing income by making compensation payments to employee-shareholders.
Brinks Gilson & Lione (the “Law Firm”) was an incorporated, intellectual property law firm that employed about 150 attorneys, of whom about 65 were shareholders. Each shareholder acquired his shares at “book value,” and was required to sell his shares back at book value upon termination of his employment. During the years at issue in the case, the cumulative book value of the Law Firm's shares was approximately $10 Million. For the years at issue, each shareholder's proportionate ownership of shares equaled his proportionate share of Law Firm compensation for the year. At the end of the year, the Law Firm's board set the yearly compensation to be paid to each employee-shareholder and then determined the dividend to be paid to the employee-shareholders. The board had not paid a dividend in the 10-year period including and preceding the years at issue. The accounting firm used by the Law Firm consistently reported the employee-shareholder compensation as salary, based on W-2 information provided by the Law Firm.
Upon audit by the IRS, the Law Firm and the IRS stipulated that a certain portion of the “compensation” payments to the employee-shareholders should be re-characterized as non-deductible dividends. The adjustment created a “substantial understatement of income tax” for the years in issue. Accordingly, the IRS asserted the 20% accuracy-related penalty. The Law Firm petitioned the Tax Court for a redetermination of the penalty, claiming that it had (1) “substantial authority” for its reporting position or (2) that it had reasonable cause and acted in good faith in deducting the disallowed compensation payments. If the Law Firm had prevailed on either issue, penalties would not have been applicable.
The Court first determined that the taxpayer did not have “substantial authority” for its reporting position. In making this determination, the Court applied the “independent investor” test, reasoning that the Seventh Circuit (like most circuit courts of appeals) had adopted that test. The Court determined that an independent investor, who was not an employee of the Law Firm, would expect to receive some return on the capital he invested in the Law Firm. The Court analyzed a litany of cases cited by both the Commissioner and the Law Firm utilizing this test, and ultimately determined that the cases cited by the Law Firm were not “substantial when weighed against the contrary authority.”
Next, the Court rejected the taxpayer's argument that it acted with reasonable cause and good faith by relying on its CPAs in reporting the payments as compensation as opposed to dividends. The Court determined that the CPA firm merely reported the W-2 information that was provided to it and did not provide advice as to whether the payments were properly characterized as compensation or dividends. The Court seemed to find it important that the taxpayer did not obtain independent advice when setting up its compensation plan and characterizing its payments.
The Brinks decision is important on many fronts. First, the Court had no problem in finding impermissible the very common practice among PSCs (including law firms, physician practices and other personal service corporations) of zeroing out or reducing year-end income through shareholder-employee compensation payments. Practitioners in this area should be concerned, and planning strategies in this area should be reevaluated. Of equal concern is the Court's disregard for the ambiguity most practitioners believed was inherent in this area of the law, finding that there was not “substantial authority” for the taxpayer's position.