A recent Tax Court case (Brinks Gilson & Lione PC, TC Memo 2016-20) points out the need for caution in the “zero out” technique by professional practices that operate as professional corporations or professional associations under local law that are taxed as “C” corporations and that compute taxable income on the cash basis. Under this technique, a practice group will typically “bonus out” all remaining undistributed profits prior to the end of the corporation’s tax year and thereby eliminate or dramatically reduce any taxable income on which the corporation will pay state and federal taxes for that year.

The taxpayer in the Brinks case, a law firm that employed roughly 150 attorneys of whom 65 were shareholders, used this practice to eliminate any corporate level taxes by deducting as a compensation expense the year-end bonuses paid to its attorneys based on practice revenues and amounts paid as compensation to certain members of law firm management for service they performed as officers of the corporation. In resolution of an audit prior to the Tax Court case, the law firm and the Internal Revenue Service had agreed that a portion of the year-end bonuses equal to officers’ compensation would be recharacterized as dividends and thus not deductible.

In upholding the imposition of an accuracy-related penalty on the law firm, the Tax Court concluded that the taxpayer did not have substantial authority to claim a deduction for all year-end bonuses and compensation paid to its officers for services as such. In reaching its conclusion, the court cited several factors that supported its findings:

  • Each attorney-shareholder’s annual compensation matched the number of shares owned by the attorney-shareholder in the corporation since the number of shares issued to each attorney was annually adjusted as compensation was adjusted.
  • Although the attorney-shareholders were legally entitled to dividends, no dividends had been paid either during the ten years prior to the years subject to the audit or during the audit period.
  • The taxpayer’s reliance on its accounting firm to prepare its tax returns did not give it grounds to rebut the imposition of the penalty.
  • The taxpayer should have paid dividends to give a reasonable return on the significant amount of capital that each of the attorney-shareholders had invested in the law firm.

Care should be taken in advising incorporated practice groups based on the mistakes made by the law firm in the Brinks case. For example, once issued, shares of stock should only be adjusted as group members are admitted as shareholders or existing group members die, retire or become disabled. The shares of stock owned by each shareholder should not be directly proportionate to annual compensation entitlement from the practice group. In addition, a reasonable dividend should be paid with a portion of practice group earnings in an amount that provides a market driven return on capital.