When professional C corporations go bad

April 1st, 2011 by Joe Kristan

You can operate a professional corporation as a C corporation and get tax-free fringe benefits unavailable to partnerships or S corporations. Sure, C corporations are subject to a flat 35% tax on every dollar of taxable income left at year end, but you just suck out all the earnings as salary at the end of the year. Right?
For an Orland Park, Illinois CPA firm, that failed spectacularly yesterday in Tax Court, and those fringe benefit tax savings are turning out to be quite expensive.
Like many professional C corporations, the firm sucked out all the cash as (purportedly) deductible expenses at year-end to take its taxes down to zero. The Illinois firm did this by paying “consulting fees” to entities controlled by the firm’s owners. Tax Court Judge Morrison explains:

The firm made a number of payments to the related entities that it designated as “consulting fees”. It now claims that these payments were compensation for the services of the founders. It paid PEM, as “consulting fees”, $136,570 in 2001, $147,837 in 2002, and $81,467 in 2003. It paid Financial Alternatives, as “consulting fees”, $755,000 in 2001, $468,306 in 2002, and $610,524 in 2003. And it paid MPS Ltd., as “consulting fees”, zero in 2001, $250,000 in 2002, and $301,537 in 2003.

The IRS took exception:

In a notice dated December 5, 2007, the IRS determined the following deficiencies in tax: $317,729 for 2001, $284,505 for 2002, and $377,247 for 2003. The deficiencies primarily resulted from disallowance of the deductions for “consulting fees”. The IRS also determined that the firm was not entitled to the $34,421 interest expense deduction in 2003. And, as a result of its disallowance of the “consulting fee” deductions for 2001 and 2003, the IRS determined that for 2003 the firm was entitled to neither the credit for prior-year minimum tax nor the deduction for the net operating loss carry forward.
The IRS also determined that the firm was liable for accuracy-related penalties under section 6662 in the following amounts: $63,546 in 2001, $56,901 in 2002, and $73,238 in 2003.

That’s real money. Naturally the firm defended the deductibility of the payments, saying that they were intended to be compensation to firm owners for services, and the compensation amounts were reasonable.
The judge found otherwise. He said even if the payments were intended to be compensation, they were too high. He also said found that they weren’t really intended as compensation:

We find that the firm intended for the payments to the related entities to distribute profits, not to compensate for services. As discussed above, [one of the owners] chose the amount to pay each year so that the payments distributed all (or nearly all) accumulated profit for the year. He did this for tax planning purposes. Each founder’s percentage of the payments to the related entities was tied to hours worked, but the firm’s intent in making the payments was to eliminate all taxable income. The firm did not intend to compensate for services.

This sounds a lot like business as usual for many professional C corporations. This case should put many C corporation law, medical and accounting firms on notice that they need to do more than just suck out their cash at the end of the year; they need to document that they are making reasonable salary payments. That could be a tough circle to square.
Not only were the expenses non-deductible to the corporation, the distributions were presumably taxable as dividends to the owners also. That’s why the IRS likes to win excess compensation cases — the owners still get taxed, but the corporation gets no deduction.
On the other hand, this case could be useful to S corporations. The IRS has an incentive to try to jack up the salaries of S corporation owner, which is the opposite of their goal for C corporation owners. S corporation earnings left in the company pass through without self-employment tax on a K-1; IRS likes to reclass such earnings as salary and subject them to employment taxes. This case makes a good argument that you don’t have to treat all of the earnings of a professional practice as salary.
Cite: Mulcahy, Pauritsch, Salvador & Co. Ltd., T.C. Memo 2011-74


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