A recent Tax Court decision suggests that professional corporations should carefully reconsider the oft-used practice of paying and deducting year-end bonuses to the corporation’s principals with the effect of “zeroing out” taxable income each year. The court upheld the IRS’ audit adjustments recharacterizing the payment of the year-end “bonuses” from compensation to dividend distributions, stating that payments of income attributable to the firm’s substantial invested capital, corporate goodwill and profits generated by non-owner professionals were non-deductible dividend distributions, and not deductible compensation.

To add insult to injury, the court upheld the imposition of accuracy-related penalties on top of the income tax deficiencies, notwithstanding the law firm’s arguments that it had relied on the advice of its outside CPA firm in deducting the payments when arriving at taxable income. (Brinks Gilson & Leone v. Commissioner)