Legal Bulletins

It is a basic principle of federal tax law that while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not. A professional services firm that chooses to organize as a C corporation may be forced to appreciate this principle if the Internal Revenue Service (the “Service”) questions the reasonableness of the compensation paid to its shareholder-employees.

The United States Tax Court, in Brinks Gilson & Lione v. Commissioner (TC Memo 2016-20), a decision issued on February 10, 2016, provides professional service corporations with another reminder about the distinction between reasonable compensation, which is deductible to the corporation, and dividends to shareholders, which are not. The taxpayer in Brinks is a law firm organized and taxed as a C corporation. Upon examination, the Service disallowed compensation deductions for certain amounts paid to shareholders and reclassified such amounts as non-deductible dividends. Although the taxpayer agreed to the reclassification as part of a closing agreement to the examination, it disputed the penalties imposed by the Service with respect to the additional tax resulting from the reclassification by arguing that it had substantial authority for deducting the amounts as compensation. The determination of substantial authority requires a weighing of the authorities that support a taxpayer’s position against the contrary authorities. In order to determine if the taxpayer had substantial authority, the Tax Court undertook an analysis of distinguishing between reasonable compensation and dividends.

Instead of considering various factors to assess reasonableness of compensation (such as the employee’s role in the company, a comparison with similar companies, and the character and condition of the company), the Tax Court focused on the effect of payments made to shareholder-employees on the returns available to shareholders’ capital, referred to as the “independent investor test.” The independent investor test recognizes that shareholder- employees and their corporations generally have a bias toward labeling payments as compensation rather than dividends, as compensation is deductible. An independent investor who is not also an employee, however, would expect a reasonable return on his invested capital and, therefore, would not approve of a compensation arrangement that would allow a bulk of the corporation’s earnings to be paid out as compensation without any payment of dividends. Thus, purported compensation payments made to shareholder-employees by a corporation with significant capital that zero out the corporation’s income and leave no return on the shareholders’ capital will fail the independent investor test, meaning that the Service may recharacterize such payments as dividends.

In Brinks, the Service argued that payments made to shareholder-employees do not qualify as deductible compensation to the extent such payments are funded by earnings attributable to the use of the corporation’s intangible assets or other capital. The taxpayer countered the Service’s argument by asserting that capital is not a material income-producing factor in a professional services business. The Tax Court, however, found that the taxpayer had substantial capital, even without regard to any intangible assets (such as the firm’s reputation and client lists), because the book value of its shareholders’ equity approximated $8 million. Noting such substantial capital, the Tax Court did not believe that the shareholders, if they were not also employees, would have forgone any return on $8 million of invested capital so as to allow compensation payments that zeroed out the corporation’s book income, thus failing the independent investor test.

Because the payments at issue failed the independent investor test, the Tax Court found that the taxpayer did not have substantial authority to support a deduction of the payments at issue and, therefore, upheld the penalties for mischaracterizing the payments made to the shareholder-employees. It should be noted that an appeal of the Tax Court’s decision in Brinks would go to the Court of Appeals for the Seventh Circuit, which favors the use of the independent investor test over a multifactor analysis in determining reasonable compensation. This may explain why the Tax Court accorded so much weight to the independent investor test in the process of weighing authorities to determine if the taxpayer had substantial authority.

Brinks is a reminder for C corporation professional practices that deduct amounts paid as compensation to its shareholder-employees which completely eliminate, or come close to eliminating, its net income. If the shareholders have left net earnings in the corporation in prior years and, therefore, have significant investment in the corporation, the Service may attempt to recharacterize such payments as dividends.

For more information, please contact Douglas T. Coats at 410-576-4002.