PSCsBeware of Unreasonable Compensation

The risk that unreasonable compensation poses to a personal service corporation (PSC) depends in part on how the entity chooses to be classified for tax purposes. Specifically, there is a tax advantage for a closely held C corporation to maximize compensation for its shareholder-employees, rather than paying dividendsavoiding double taxation. In contrast, the tax advantage for an S corporation or a limited liability company is to increase distributions and minimize other methods of compensation, thereby avoiding employment taxes at both the corporate and individual levels.

Although there have been several cases in which the IRS has questioned the reasonableness of compensation paid to a corporations shareholder-employees, Pediatric Surgical Associates, P.C., TC Memo 2001-81, may cause some PSCs structured as C corporations to consider electing S status.

Background

Pediatric Surgical, Inc. provided pediatric surgical services. During the years in question, the corporation had 20 employees, including four shareholder-surgeons and two non-shareholder-surgeons. Some differences between the employment arrangements for shareholders and nonshareholders included:

1. Shareholder-surgeons were paid bonuses at the boards discretion; no bonuses were paid to the non-shareholder-surgeons.

2. The non-shareholder-surgeon employment agreements contained noncompete clauses; the shareholder-surgeon agreements did not.

3. The non-shareholder-surgeons had no significant administrative duties.

The employment agreements for both shareholder- and non-shareholder-surgeons provided that they were to engage in the practice of medicine on the companys behalf, in furtherance of its best interests.

 During an audit of the years in question, the IRS contended that a portion of compensation paid to the shareholder-surgeons was not deductible and should have been classified as dividends (resulting in additional corporate tax). It also determined that the dividends should have been equal to the profits attributable to services rendered by the non-shareholder-surgeons. The Tax Court agreed with the IRS and determined how the expenses were to be allocated between shareholder- and non-shareholder-surgeons. It also assessed Sec. 6662 accuracy-related penalties.

Analysis

The Tax Court held that, in this case, reasonable compensation for a shareholder-surgeon is calculated on collections attributable to the shareholders services, less his or her allocable expenses. The court did not address the administrative duties involved in the shareholder-surgeons job, leaving the importance of operating and maintaining a business unrecognized.

Historically, the courts have used several methods to determine whether compensation deducted by a C corporation was unreasonable. One approach looks to the Code and regulations for guidance. For example, according to Sec. 162(a)(1), a deduction is permitted for a reasonable allowance for salaries or other compensation for professional services actually rendered. Regs. Sec. 1.162-7(a) contains a two-pronged test: compensation payments must be (1) reasonable and (2) purely for services. Although the two-pronged test serves as an overall guideline, numerous cases resolve the reasonable compensation issue based on the facts and circumstances.

In addition to the Code and regulations, several cases have articulated methods for analyzing reasonable compensation; see e.g., Mayson Mfg. Co., 178 F2d 115 (6th Cir. 1949), and Elliotts, Inc., 716 F2d 1241 (9th Cir. 1983).

The courts have used several criteria from Mayson to support their rulings, including:

• An employees qualifications;

• Nature, extent and scope of an employees work;

• Size and complexities of a business;

• Ratio of salaries paid to gross income and net income;

• Prevailing general economic conditions;

• Comparison of salaries to stockholder distributions;

• Prevailing compensation rates for comparable positions in comparable concerns;

• Taxpayers salary policy as to all employees; and

• Compensation paid to the employee in previous years.

In Elliotts, the Ninth Circuit reversed the Tax Courts decision that payments to a corporations sole shareholder were dividend payments due to the absence of dividends and the payees role as a sole shareholder. The court held that these reasons alone did not require a finding of unreasonable compensation. It stated that in assessing the reasonableness of compensation paid to a shareholder employee, it is helpful to consider the matter from the perspective of a hypothetical independent investor. In applying this test, the court found the compensation payments to be reasonable and, thus, fully deductible. It looked at:

• Whether an independent investor would be willing to compensate the employee in the same manner;

• The nature and quality of services; and

• The corporations rate of return on equity.

Several subsequent cases have used one or both of these techniques, in combination with the Code and regulations, to evaluate unreasonable compensation; see e.g., Exacto Spring Corp., 196 F3d 833 (7th Cir. 1999), Normandie Metal Fabricators, Inc., TC Memo 2000-102, Wagner Construction, Inc., TC Memo 2001-160 and Metro Leasing and Dev. Corp., TC Memo 2001-119. In Pediatric Surgical, however, the Tax Court appeared to focus solely on the two-pronged test, specifically considering whether the compensation paid was purely for services rendered. In addition, by forcing the burden of proof on the taxpayer and assessing the corporation with an accuracy-related penalty, the court indicated that the decision was not a new matter, but was already documented law.

Conclusion

Taxpayers should not ignore these cases if they want to set up PSCs. Even though they must always be concerned with the reasonableness of compensation, Pediatric Surgical suggests a broader application of the regulation than previously considered.

PSCs currently structured as C corporations, with tax years that could be exposed to a challenge on this issue, should analyze and document the additional valuable services that their shareholder-employees provide, to justify additional compensation, such as:

1. Management of day-to-day business operations;

2. New business development;

3. Community relations;

4. Regulatory issues; and

5. Management of other professionals and staff.

Once they document these activities, C corporations may want to consider making dividend payments of any surplus to shareholders.

Finally, new PSCs should strongly consider electing S status. Existing PSCs should examine the pros and cons of converting from a C to an S corporation, focusing especially on built-in gains to see how this planning opportunity can help avoid the risks associated with unreasonable compensation.

From Kristin M. Fay, CPA, Quincy, MA