Unreasonable Compensation in a Professional Corporation

Until 2001, the general view was that IRS determinations of “unreasonable compensation” were not a concern for shareholder employees of professional corporations. That equanimity was shattered – at least for those paying attention – by the 2001 Tax Court decision in Pediatric Surgical Associates P.C. v. Commissioner (T.C. Memorandum 2001-81). In that case, the tax court determined that compensation paid to the shareholder physicians in a Texas surgical practice was unreasonably high because it exceeded the value of the services performed by the firm's shareholder physicians.

This seminal tax court opinion turned on the issue of profits generated by the non-shareholder surgeons. Analogous compensation scenarios are common in law firms PCs, so they could face similar IRS determinations, with similarly costly results. Lawyers who are PC shareholders should pay close attention to this case.

As I write this update, just after the Labor Day holiday of 2003, there has been no subsequent appellate history in the Pediatric Surgical Associates case. For the other two controlling cases discussed in this article, Richard Ashare and Bianchi, there have been no subsequent appellate history and no negative subsequent appellate history, respectively.

Professional Corporation Background

Professional corporations (PCs) have been around for over 30 years. The initial popularity of the PC concept was largely due to two important advantages:

• Favorable tax benefits, particularly the then-immense differences between qualified retirement programs for incorporated businesses vs. those available for unincorporated businesses.
• Limited liability – both general liability and liability arising out of the malpractice of other shareholder-employees or professional employees not under your supervision.

In the early 1980s, the primary tax reason largely disappeared when the rules for corporate and self-employed pensions were placed on equal status. Later that decade, the tax planning advantages of being able to choose different tax years also largely disappeared. The liability advantages of the PC remained intact, but in many states newer organizational choices – professional limited liability partnerships (LLPs) and professional limited liability companies (LLCs) – have since offered attractive alternatives to the professional corporation.

Those changes did not immediately halt growth in the number of professional corporations, however. For firms already established as PCs, there has been no compelling reason to change to one of the more flexible new forms of organization. Many existing PCs decided to retain that form for two other reasons:

• Minor but popular tax benefits remain, at least for C corporations.
• Undoing the corporate decision without unintended tax consequences is a bit tricky.

Moreover, set thinking patterns and comfort with established precedent, as well as concern for untested forms of organization, all contributed to creation of additional PCs.

Professional corporations have encountered difficulty when the shareholders have not operated the business consistently with the formalities of a corporation. It is not sufficient to create the minimum legal filings and then go about business as usual. Doing so puts the firm at risk of having the “corporate veil” pierced in two ways: by the IRS with respect to tax benefits and by other potential claimants with regard to liability.

Generally, however, when the PC is legitimately established and operated, the tax and legal benefits accrue. The protocols are not onerous once reasonably diligent routines are established.

Compensation Background

Compensation is deductible for a corporation if it is ordinary and necessary, paid or incurred during the year, for personal services rendered, and reasonable. Professional corporations generally have no trouble with meeting these tests.

However, a typical taxation problem for PCs is a carryover from traditional partnership operations – aligning compensation and ownership. The IRS generally views distribution allocations that mirror relative ownership to be dividends and not compensation. The result is the imposition of a corporate level income tax that is added to the individual income tax, ie, double taxation.

Setting aside the rules applicable to publicly traded corporations, unreasonable compensation issues are more common for shareholder-employees of closely held corporations because there is rarely independence between the making of executive compensation decisions and those receiving the compensation. Different courts have outlined varying standards to evaluate what is reasonable.

Each court has identified what it holds to be the defining elements to establish reasonable compensation. For example, in Mayson Mfg. Co. v. Commissioner (178 F.2d 115, 6th Circuit, 1949) the Sixth Circuit set forth nine factors to determine reasonable compensation. In Elliots, Inc. v. Commissioner (716 F2d 1241, 9th Circuit, 1983), the Ninth Circuit developed a five-factor test for reasonable compensation. These tests are not mutually exclusive, as there is similarity among the factors; and the courts have viewed individual factors differently, giving weight where the facts and circumstances warrant.

Multi-factor tests are not always applied; in some court opinions, a sole factor was determinative. Typically, however, the following five groups of factors are considered in determining reasonable compensation:

• The nature and financial condition of the business. Is this business complex, unique or highly specialized? Is the industry highly competitive? Does the business have growing revenues and profits? Are its financial ratios in good order or improving? Is the business performing better than its competitors?
• The roles of the shareholder-employees. Do these individuals have unique skills or knowledge? Have they innovated? How difficult is it to replace their contributions? Can you clearly demonstrate the contributions they made to the success of the business? Do they take on many roles (CEO, CFO, Marketing, etc)? What level of commitment is required in terms of hours? How do the individual roles and compensation of employees compare with other similar businesses?
• The level of consistency in how compensation is set within the business. Are there documented compensation policies? Are they followed over time? Are the compensation arrangements for other employees – particularly similarly situated non-shareholder employees – comparable?
• Compensation paid for prior years' work. Was there a timely executed agreement covering the deferred compensation? Was it reasonable? Was the compensation paid in the prior years less than it should have been? Can you demonstrate reasonable due diligence in determining the amount of the underpayment?
• The independent investor test. Would an independent financial investor be willing to pay that compensation? Is the return on the equity investment, after paying such compensation, sufficient to attract and retain an independent investor?

Professional corporations primarily do one thing: They provide services that are largely the direct result of the personal services rendered by the professionals.

It has been logical to then conclude that the net earnings of the PC represent reasonable compensation to those professionals. This holds even for large compensation amounts, as seen in Richard Ashare, P.C. v. Commissioner (T.C. Memorandum 1999-282). In that case, “a lawyer was the sole shareholder and professional employee in a law firm that devoted itself to a single class action and won a $12.6 million contingent fee from a 1989 settlement. The fee was paid in 1989-92, and the PC paid out the fee as compensation – including $1.75 million in 1993 – long after the lawyer ceased performing substantial services. Still, the Tax Court acknowledged that all of the compensation was reasonable, because the shareholder's personal services had earned the fee.” Tax Planning for Corporations and Shareholders, Second Edition, Zolman Cavitch, LEXIS Publishing, 2001, p. 13-11.

The concept that the net earnings of a practice represent reasonable compensation is further supported in Bianchi v. Commissioner. The tax court “held that it is proper to examine the prior self employment earnings of a corporate employee to determine whether compensation currently paid to such employee is reasonable. In Bianchi, the corporate employee, a dentist, had incorporated his individual proprietorship, transferring to the corporation (which elected status as an S corporation) the equipment previously used in the proprietorship, accounts receivable and good will …. In determining what would be reasonable compensation for his services provided to the corporation, [the tax court] said: 'It cannot be questioned that the clearest evidence of the worth of the petitioner's services is petitioner's earnings from his dentistry practice as an individual proprietor.' … It is clear that, in referring to 'petitioner's earnings,' [the tax court was] referring to the profit earned by the dentist as an individual proprietor. Indeed, [the tax court] restated [their] point as follows: '[T]he best evidence of the value of his personal services is profit he derived from his own practice.' … Undoubtedly, [the tax court was] using the term 'profit' to refer to the excess of the dentist's receipts from his practice of dentistry over the costs of earning those receipts but without any reduction for the value of the dentist's own services.” (T.C. Memorandum 2001-81, pp. 20 and 21)

Richard Ashare and Bianchi establish a rational framework for reasonable compensation in professional practices. Pediatric Surgical Associates is a logical next step for the IRS and one that, frankly, might have been taken years ago.

The Pediatric Surgical Associates Case

The facts of the Pediatric Surgical Associates case are as follows. Pediatric Surgical Associates (PSA), a PC (specifically a Texas personal service corporation), employs shareholder and non-shareholder surgeons to provide pediatric surgical services. The IRS disallowed portions of the officers' compensation expense and reallocated it to dividends, subject to double taxation.

Furthermore, the IRS applied the accuracy-related penalty to the returns for the years under audit. The accuracy-related penalty is 20% of any portion of a tax underpayment attributable to a) negligence or disregard of rules or regulations, b) substantial understatement of income tax, or c) other misconduct with regard to asset valuation or pension liability overstatement. (See IRS instructions to Form 8275.)

As noted above, this case turned on the issue of profits generated by the non-shareholder surgeons. Drawing the line at its Ashare and Bianchi precedents, the tax court backed the IRS's determination that net profits due to the personal services of non-shareholders could not be expensed as reasonable compensation to shareholders; these profits had to be distributed as dividends or retained in the corporation as accumulated earnings, subject to corporate level tax. When distributed to the shareholders as dividends, an individual income tax is imposed.

Specifically, the tax court held “that the deductions claimed by petitioner for 1994 and 1995 for salaries paid to the shareholder surgeons exceed reasonable allowances for services actually rendered by them … and that such amounts, therefore, are not deductible by petitioner ….” (T.C. Memorandum 2001-81, p. 31)

In making its ruling, the tax court was undeterred by terminological or computational challenges:

• The court narrowly defined “net profits” in this instance as collections by non-shareholders less the portion of expenses allocable to non-shareholders.
• Collection records were inadequate to clearly determine an appropriate allocation, so the tax court itself determined the amount of profits generated by the non-shareholder surgeons. The parties stipulated to one non-shareholder's collections, and the tax court used a percentage of the net billings for the other non-shareholder surgeon.
• Expenses for the non-shareholder contract employees consisted of salary (they were ineligible for bonuses) and an allocation of overhead. The tax court looked to the employment contracts to guide its reasoning as to what expenses were or were not apportionable. Rent and other costs relating to the operation of the practice were included; shareholder automobile expenses were excluded. The tax court then applied the parties' own allocation methodology of apportioning such expenses on an equal basis among the surgeon employees based on the number of months they were employed during the year.

Finally, the tax court also affirmed IRS imposition of the accuracy-related penalty. “It is the shareholder surgeons' utter indifference to the possibility that a portion of the annual pre-bonus profits might have been derived from collections generated by non-shareholder surgeons that justifies respondent's imposition of the accuracy-related penalty in this case.” (T.C. Memorandum 2001-81, p. 34)

Implications for Law Firm PCs

Since many law firm PCs could face this same issue, what are the options available to PC owners? One strategy is to elect S-corporation status. Professional corporations with a single class of stock and 75 or fewer shareholders will generally qualify. However, more-than-2%-shareholders in an S corporation are taxed on fringe benefits as if they are self-employed partners rather than employees. A more complex, but possibly superior, alternative is to consider undertaking the conversion from a PC to an LLP or LLC. No matter the course selected, you should consult with your tax advisors before proceeding.

Until 2001, the general view was that IRS determinations of “unreasonable compensation” were not a concern for shareholder employees of professional corporations. That equanimity was shattered – at least for those paying attention – by the 2001 Tax Court decision in Pediatric Surgical Associates P.C. v. Commissioner (T.C. Memorandum 2001-81). In that case, the tax court determined that compensation paid to the shareholder physicians in a Texas surgical practice was unreasonably high because it exceeded the value of the services performed by the firm's shareholder physicians.

This seminal tax court opinion turned on the issue of profits generated by the non-shareholder surgeons. Analogous compensation scenarios are common in law firms PCs, so they could face similar IRS determinations, with similarly costly results. Lawyers who are PC shareholders should pay close attention to this case.

As I write this update, just after the Labor Day holiday of 2003, there has been no subsequent appellate history in the Pediatric Surgical Associates case. For the other two controlling cases discussed in this article, Richard Ashare and Bianchi, there have been no subsequent appellate history and no negative subsequent appellate history, respectively.

Professional Corporation Background

Professional corporations (PCs) have been around for over 30 years. The initial popularity of the PC concept was largely due to two important advantages:

• Favorable tax benefits, particularly the then-immense differences between qualified retirement programs for incorporated businesses vs. those available for unincorporated businesses.
• Limited liability – both general liability and liability arising out of the malpractice of other shareholder-employees or professional employees not under your supervision.

In the early 1980s, the primary tax reason largely disappeared when the rules for corporate and self-employed pensions were placed on equal status. Later that decade, the tax planning advantages of being able to choose different tax years also largely disappeared. The liability advantages of the PC remained intact, but in many states newer organizational choices – professional limited liability partnerships (LLPs) and professional limited liability companies (LLCs) – have since offered attractive alternatives to the professional corporation.

Those changes did not immediately halt growth in the number of professional corporations, however. For firms already established as PCs, there has been no compelling reason to change to one of the more flexible new forms of organization. Many existing PCs decided to retain that form for two other reasons:

• Minor but popular tax benefits remain, at least for C corporations.
• Undoing the corporate decision without unintended tax consequences is a bit tricky.

Moreover, set thinking patterns and comfort with established precedent, as well as concern for untested forms of organization, all contributed to creation of additional PCs.

Professional corporations have encountered difficulty when the shareholders have not operated the business consistently with the formalities of a corporation. It is not sufficient to create the minimum legal filings and then go about business as usual. Doing so puts the firm at risk of having the “corporate veil” pierced in two ways: by the IRS with respect to tax benefits and by other potential claimants with regard to liability.

Generally, however, when the PC is legitimately established and operated, the tax and legal benefits accrue. The protocols are not onerous once reasonably diligent routines are established.

Compensation Background

Compensation is deductible for a corporation if it is ordinary and necessary, paid or incurred during the year, for personal services rendered, and reasonable. Professional corporations generally have no trouble with meeting these tests.

However, a typical taxation problem for PCs is a carryover from traditional partnership operations – aligning compensation and ownership. The IRS generally views distribution allocations that mirror relative ownership to be dividends and not compensation. The result is the imposition of a corporate level income tax that is added to the individual income tax, ie, double taxation.

Setting aside the rules applicable to publicly traded corporations, unreasonable compensation issues are more common for shareholder-employees of closely held corporations because there is rarely independence between the making of executive compensation decisions and those receiving the compensation. Different courts have outlined varying standards to evaluate what is reasonable.

Each court has identified what it holds to be the defining elements to establish reasonable compensation. For example, in Mayson Mfg. Co. v. Commissioner (178 F.2d 115, 6th Circuit, 1949) the Sixth Circuit set forth nine factors to determine reasonable compensation. In Elliots, Inc. v. Commissioner (716 F2d 1241, 9th Circuit, 1983), the Ninth Circuit developed a five-factor test for reasonable compensation. These tests are not mutually exclusive, as there is similarity among the factors; and the courts have viewed individual factors differently, giving weight where the facts and circumstances warrant.

Multi-factor tests are not always applied; in some court opinions, a sole factor was determinative. Typically, however, the following five groups of factors are considered in determining reasonable compensation:

• The nature and financial condition of the business. Is this business complex, unique or highly specialized? Is the industry highly competitive? Does the business have growing revenues and profits? Are its financial ratios in good order or improving? Is the business performing better than its competitors?
• The roles of the shareholder-employees. Do these individuals have unique skills or knowledge? Have they innovated? How difficult is it to replace their contributions? Can you clearly demonstrate the contributions they made to the success of the business? Do they take on many roles (CEO, CFO, Marketing, etc)? What level of commitment is required in terms of hours? How do the individual roles and compensation of employees compare with other similar businesses?
• The level of consistency in how compensation is set within the business. Are there documented compensation policies? Are they followed over time? Are the compensation arrangements for other employees – particularly similarly situated non-shareholder employees – comparable?
• Compensation paid for prior years' work. Was there a timely executed agreement covering the deferred compensation? Was it reasonable? Was the compensation paid in the prior years less than it should have been? Can you demonstrate reasonable due diligence in determining the amount of the underpayment?
• The independent investor test. Would an independent financial investor be willing to pay that compensation? Is the return on the equity investment, after paying such compensation, sufficient to attract and retain an independent investor?

Professional corporations primarily do one thing: They provide services that are largely the direct result of the personal services rendered by the professionals.

It has been logical to then conclude that the net earnings of the PC represent reasonable compensation to those professionals. This holds even for large compensation amounts, as seen in Richard Ashare, P.C. v. Commissioner (T.C. Memorandum 1999-282). In that case, “a lawyer was the sole shareholder and professional employee in a law firm that devoted itself to a single class action and won a $12.6 million contingent fee from a 1989 settlement. The fee was paid in 1989-92, and the PC paid out the fee as compensation – including $1.75 million in 1993 – long after the lawyer ceased performing substantial services. Still, the Tax Court acknowledged that all of the compensation was reasonable, because the shareholder's personal services had earned the fee.” Tax Planning for Corporations and Shareholders, Second Edition, Zolman Cavitch, LEXIS Publishing, 2001, p. 13-11.

The concept that the net earnings of a practice represent reasonable compensation is further supported in Bianchi v. Commissioner. The tax court “held that it is proper to examine the prior self employment earnings of a corporate employee to determine whether compensation currently paid to such employee is reasonable. In Bianchi, the corporate employee, a dentist, had incorporated his individual proprietorship, transferring to the corporation (which elected status as an S corporation) the equipment previously used in the proprietorship, accounts receivable and good will …. In determining what would be reasonable compensation for his services provided to the corporation, [the tax court] said: 'It cannot be questioned that the clearest evidence of the worth of the petitioner's services is petitioner's earnings from his dentistry practice as an individual proprietor.' … It is clear that, in referring to 'petitioner's earnings,' [the tax court was] referring to the profit earned by the dentist as an individual proprietor. Indeed, [the tax court] restated [their] point as follows: '[T]he best evidence of the value of his personal services is profit he derived from his own practice.' … Undoubtedly, [the tax court was] using the term 'profit' to refer to the excess of the dentist's receipts from his practice of dentistry over the costs of earning those receipts but without any reduction for the value of the dentist's own services.” (T.C. Memorandum 2001-81, pp. 20 and 21)

Richard Ashare and Bianchi establish a rational framework for reasonable compensation in professional practices. Pediatric Surgical Associates is a logical next step for the IRS and one that, frankly, might have been taken years ago.

The Pediatric Surgical Associates Case

The facts of the Pediatric Surgical Associates case are as follows. Pediatric Surgical Associates (PSA), a PC (specifically a Texas personal service corporation), employs shareholder and non-shareholder surgeons to provide pediatric surgical services. The IRS disallowed portions of the officers' compensation expense and reallocated it to dividends, subject to double taxation.

Furthermore, the IRS applied the accuracy-related penalty to the returns for the years under audit. The accuracy-related penalty is 20% of any portion of a tax underpayment attributable to a) negligence or disregard of rules or regulations, b) substantial understatement of income tax, or c) other misconduct with regard to asset valuation or pension liability overstatement. (See IRS instructions to Form 8275.)

As noted above, this case turned on the issue of profits generated by the non-shareholder surgeons. Drawing the line at its Ashare and Bianchi precedents, the tax court backed the IRS's determination that net profits due to the personal services of non-shareholders could not be expensed as reasonable compensation to shareholders; these profits had to be distributed as dividends or retained in the corporation as accumulated earnings, subject to corporate level tax. When distributed to the shareholders as dividends, an individual income tax is imposed.

Specifically, the tax court held “that the deductions claimed by petitioner for 1994 and 1995 for salaries paid to the shareholder surgeons exceed reasonable allowances for services actually rendered by them … and that such amounts, therefore, are not deductible by petitioner ….” (T.C. Memorandum 2001-81, p. 31)

In making its ruling, the tax court was undeterred by terminological or computational challenges:

• The court narrowly defined “net profits” in this instance as collections by non-shareholders less the portion of expenses allocable to non-shareholders.
• Collection records were inadequate to clearly determine an appropriate allocation, so the tax court itself determined the amount of profits generated by the non-shareholder surgeons. The parties stipulated to one non-shareholder's collections, and the tax court used a percentage of the net billings for the other non-shareholder surgeon.
• Expenses for the non-shareholder contract employees consisted of salary (they were ineligible for bonuses) and an allocation of overhead. The tax court looked to the employment contracts to guide its reasoning as to what expenses were or were not apportionable. Rent and other costs relating to the operation of the practice were included; shareholder automobile expenses were excluded. The tax court then applied the parties' own allocation methodology of apportioning such expenses on an equal basis among the surgeon employees based on the number of months they were employed during the year.

Finally, the tax court also affirmed IRS imposition of the accuracy-related penalty. “It is the shareholder surgeons' utter indifference to the possibility that a portion of the annual pre-bonus profits might have been derived from collections generated by non-shareholder surgeons that justifies respondent's imposition of the accuracy-related penalty in this case.” (T.C. Memorandum 2001-81, p. 34)

Implications for Law Firm PCs

Since many law firm PCs could face this same issue, what are the options available to PC owners? One strategy is to elect S-corporation status. Professional corporations with a single class of stock and 75 or fewer shareholders will generally qualify. However, more-than-2%-shareholders in an S corporation are taxed on fringe benefits as if they are self-employed partners rather than employees. A more complex, but possibly superior, alternative is to consider undertaking the conversion from a PC to an LLP or LLC. No matter the course selected, you should consult with your tax advisors before proceeding.