The United States Tax Court has held that a law firm organized as a professional corporation is liable for accuracy-related penalties for treating year-end bonuses to the shareholder attorneys as compensation (deductible) rather than dividends (non-deductible). It has been 15 years since the Tax Court reached a similar holding for a medical practice organized as a professional corporation. Is it time for professional corporations to rethink making an S corporation election?

Brinks Gilson & Lione is an intellectual property law firm organized as a professional corporation. It has a calendar year taxable year, and uses the cash receipts and disbursements method of accounting. During 2007 and 2008, the taxable years that are the subject of the Tax Court case, it employed about 150 attorneys, of whom about 65 were shareholders, and also employed a non-attorney staff of about 270.

The law firm followed the practice of many professional corporations. The shareholder attorneys would receive salaries based on a number of factors. The shareholder attorneys also would receive year-end bonuses. The law firm’s board of directors would calculate the amount of the year-end bonuses to reduce the law firm’s book income to zero. The entire firm’s book income would be distributed as salary with no distributions to the shareholder attorneys as dividends. Although the shareholder attorneys were entitled to dividends as and when declared by the board, for at least 10 years before and including 2007 and 2008, the law firm had not paid a dividend.

When the Internal Revenue Service (IRS) examined the law firm’s tax returns for 2007 and 2008, it disallowed the deduction for the year-end bonuses. The law firm and IRS eventually agreed that certain amounts of the year-end bonuses would be disallowed and recharacterized as non-deductible dividends. The law firm and the IRS could not agree, however, on whether the law firm was liable for accuracy-related penalties for treating the year-end bonuses as deductible compensation. After examining the rules for applying the accuracy-related penalties, the Tax Court held that the law firm was liable for the accuracy-related penalties. Brinks Gilson & Lione P.C. v Commissioner, T.C. Memo 2016-20.

As part of its analysis, the Tax Court cited its 2001 Memorandum decision in Pediatric Surgical Associates, P.C. v. Commissioner (T.C. Memo 2001-81). Pediatric Surgical Associates was a medical practice that provided pediatric surgical services. For the tax years involved (1994 and 1995), the practice employed approximately 20 individuals, including six pediatric surgeons, four of whom were shareholders and two of whom were not shareholders. The issue was whether some of the compensation paid to the shareholder surgeons should be recharacterized as dividends. The Tax Court held that a portion of the shareholder surgeons’ compensation should be recharacterized as a dividend.

There was much discussion after the Pediatric Surgical Associates decisions about whether a professional corporation should make an S corporation election to eliminate the risk of having a portion of the shareholder professionals’ compensation, including year-end bonuses, recharacterized by the IRS as dividends. Some viewedPediatric Surgical Associates as an aberration and of little precedential value. Others viewed it as very important, creating a new, harsh test for professional corporations that are C corporations and have non-shareholder professionals. In the wake ofPediatric Surgical Associates, some professional corporations made S corporation elections, while others chose to continue past practices.

The Brinks Gilson & Lione decision is important for two significant reasons. First, it shows that Pediatric Surgical Associates was not an aberration. Second, in holding that the accuracy-related penalties applied, the Tax Court found that the law firm (1) did not have reasonable cause for claiming a deduction for the year-end bonuses, (2) did not act in good faith, and (3) did not have substantial authority for claiming the deduction.

Given the Brinks Gilson & Lione decision, medical practices, dental practices, law firms, accounting firms, and other professional corporations with non-shareholder professionals should carefully consider whether it is time to make an S corporation election. In addition to avoiding the risk of compensation payments being recharacterized as dividends, an S corporation election may offer other tax benefits to a professional corporation.