Regular corporations, which are taxed as separate legal entities and more commonly known as “C corporations” (since they are taxed under Subchapter C of the Internal Revenue Code), were once a popular entity structure for small and medium-sized privately-held enterprises. Though no longer widely-used as a tax vehicle, in some instances, a C corporation tax structure can make sense. One of these instances is “personal service corporations.”
Essentially, a personal service corporation, as its name implies, is one in which the primary operating activity is the provision of personal services. To meet the Internal Revenue Service definition of a personal service corporation, those services must be of a professional nature, in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
Moreover, the tax law requires that a certain percentage of ownership be held by the professionals rendering the services. As such, a personal service corporation is a type of C corporation in which more than 10% of the fair market value of the corporation’s stock is owned by the employees providing the personal services to their clients.
The Internal Revenue Code further separates personal service corporations from qualified personal service corporations by imposing two tests:
- Substantially all (more than 95%) of the activities of the corporation are to provide services of the employee-owners in the qualified fields, and
- By fair market value, 95% of the stock must be held directly or non-directly, by the employee- owners
The reason for the distinction of “qualified” personal service corporation is principally to limit certain tax-beneficial provisions generally afforded C corporations that Congress deemed abusive in the context of providing personal services. The primary limitations imposed on qualified personal service corporations are the inability to use the graduated income tax rates generally afforded C corporations and a shorter net operating loss carry back period.
By definition, a qualified personal service corporation is subjected to a flat tax rate at 35%. However, this 35% rate is rarely invoked because the owners generally arrange that all of the income be paid out as salary, bonuses, and fringe benefits. These income payments are deductible by the entity, but the advantages of income splitting between the corporation and the employee-owners, which would otherwise be possible with a C corporation, are removed.
The strategy of zeroing out qualified personal service corporation income via the payment of “compensation” to the employee owners is consistent with general tax planning for professionals for many years. However, one limitation on this planning is that the amounts paid out as tax deductible compensation to the employee-owners must be ordinary and necessary, as well as reasonable, to be allowed the tax deduction at the corporation level. If the amounts paid out are found by the Internal Revenue Service to be unreasonable, the unreasonable amounts are recharacterized as dividends.
Dividend treatment results in taxation at the employee-owner level as ordinary income. This is generally the same treatment as the compensation treatment (excepting payroll taxes). However, the big tax hit falls to the corporation, which may not deduct dividends from its taxable income as it could with the compensation; thus, the corporation is subjected to double tax. When the excess payment is characterized as a dividend, the lack of a deduction increases the taxable income, which is subject to tax at a rate of 35%.
Historically, the Internal Revenue Service has not focused sharply on this issue for qualified personal service corporations. However, the risk of overpaying employee-owner compensation is very real as illustrated by a number of Tax Court cases, as noted below.
Pediatric Surgical Associates P.C. (T.C Memo. 2001-81)
In this leading court case addressing this issue historically, a personal service corporation issued monthly bonuses to its employee-owners to distribute all of the company’s available cash, after the calculation of monthly expenses. The bonuses are then considered a deduction for officers’ compensation in computing the corporation’s taxable income. Upon examination, the Internal Revenue Service challenged the validity of the deductions and argued that the bonuses should be treated as dividends paid to the individual shareholders, with no corresponding deduction of compensation in computing the corporate taxable income. Upon challenge by the taxpayer, the Tax Court confirmed the position of the Internal Revenue Service.
Brinks Gilson & Lione P.C. (T.C. Memo. 2016-20)
A recent penalty case has now brought this issue to the forefront again. In this case, the Internal Revenue Service found the corporation (a major law firm headquartered in Chicago) liable for a 20 percent accuracy-related penalty for mischaracterizing their distribution of earnings to the shareholder-attorneys as a form of deductible compensation.
The facts of the case are as follows: During 2007 and 2008, the two years at issue, the firm, employed approximately 150 attorneys, about 65 of whom were shareholders/owners of the firm. In addition, the firm employed about 270 non-attorney employees. The firm’s shareholders owned their shares in connection with their employment in the corporation. They received the shares at a price equal to the shares’ book value and upon ending employment were required to sell their shares back to the firm at book value. Each shareholder attorney received compensation from an aggregate budgeted amount in the same percentage as his or her ownership share, with a year-end bonus as an adjustment that, in the aggregate, was intended to reduce book income for the year to zero.
In the course of an examination, the Internal Revenue Service disallowed various deductions, including the year-end bonuses. As is often the case, the law firm negotiated with the Internal Revenue Service to produce an agreement whereby portions of the compensation deduction for shareholder attorney compensation should be disallowed and recharacterized as nondeductible dividends.
In addition to the tax assessment resulting from the recharacterization of the payments to the employee/shareholders, the Internal Revenue Service imposed (and the Court later upheld), a 20% accuracy-related penalty on the personal service corporation for the amount of substantially-understated income tax due to the reclassification of dividend payments as compensation. The law firm took this issue to the Tax Court.
No accuracy-related penalties will be imposed, however, if a taxpayer can prove that there was reasonable cause for the position taken and the he or she acted in good faith with respect to the amount paid as compensation, under the Internal Revenue Code.
Unfortunately, in the case of Brinks Gilson & Lione PC, the firm was unable to support an argument for reasonable cause. As such, the accuracy-related penalties assessed by the Internal Revenue Service were affirmed by the Tax Court and applied to the portion of understatement for each tax year examined.
The Internal Revenue Service has made it clear that the attack on personal service corporations for the understatement of taxable income by reclassifying dividend payments as compensation is alive and well. In addition, the recently-released Job Aid for Internal Revenue Service personnel addressing reasonable compensation ensures that focus in this area will continue.
Options and strategies are available to avoid this risk and should be evaluated with your tax adviser. Should you prefer to discuss these options or have questions regarding this issue, please contact Bob Grossman or Melissa Bizyak at 412-338-9300.
