An accounting firm operated as a C corporation. The firm paid substantial fees to three related entities created by the founding shareholders of the firm. The fees were so high as to reduce the net income of the firm to a de minimis amount in one year, and a loss in the next.
It is common for C corporations to pay compensation to shareholders to avoid double taxation. C corporation income is taxed twice – first at the corporate level, and then the shareholders are taxed on after-tax dividends. If compensation is paid to a shareholder, there is only one level of tax – the shareholder pays tax on the compensation and the corporation gets a deduction for the payment. Because of this advantage, the IRS and the courts will limit compensation payments to “reasonable compensation,” and characterize payments to shareholders in excess of reasonable compensation as dividends (which generate no deduction for the corporation).
While one cannot tell from the case, the above C corporation may have attempted to disguise unreasonable (and thus nondeductible) payments to shareholders as deductible consulting payments to the entities of the founding shareholders – although there is a suggestion that this arrangement was instead entered into to hide the payments to founders from the employees of the firm. Whatever its rationale, the IRS challenged the payments on the basis that the consulting firms actually performed no services. That fact alone disqualified the payments as being deductible compensation services. The founders also indicated that the payments were also in payment of services performed by the founders for the accounting firm, but this did not hold up factually. Further, even if that was the case, the payments were still so high as to flunk the independent-investor test for what qualifies as reasonable compensation. Thus, the trial court found, and the appeals court affirmed, that over $800,000 in payments over the years were disguised dividends and not deductible by the firm. This resulted in substantial income taxes and penalties being imposed on the firm.
The appellate court was puzzled why the accounting firm continued to operate as a C corporation over the years, instead of as an LLC, partnership, or other pass-through entity that would not suffer from these double taxation exposures. But that was not the most remarkable feature of the situation – the court noted:
That an accounting firm should so screw up its taxes is the most remarkable feature of the case.
Mulcahy, Pauritsch, Salvador & Co., Ltd. v. Comm., 109 AFTR 2d 2012-XXXX (05/17/2012 CA7)