Law Firm Hit by IRS After Paying out All Earnings as Deductible Compensation to Shareholders

A Chicago law firm operating as a corporation regularly zeroed out its taxable income by making year-end bonuses to its shareholders and deducting such payments as compensation. The IRS attacked the reasonableness of the compensation, seeking to convert some of the payments to taxable dividends, and thus increasing the corporation’s taxable income and income taxes. The Tax Court agreed.

The Tax Court applied the “Independent Investor Test” to attack the amount of deductible compensation. This test is based on the premise that the owners of an enterprise with significant capital are entitled to a return on their investments - they would not agree to the corporation paying out all of the net revenues of the company to employees on a regular basis since that would leave no net income to pay to the shareholders a return on capital (via dividends). Since the law firm had over $8 million in paid in capital, this was an open door for the IRS and Tax Court to convert some of the payments to nondeductible dividends.

In determining the amount of capital, the Tax Court declined to add to it intangible assets not on the books,such as the firm’s reputation and customer lists - a good thing for the corporation.

So a lesson from the case is to look closely if a corporation is regularly paying out all of its net revenue as compensation to its shareholders.

Of course, if the operating business is not a ‘C’ corporation (i.e., it is an ‘S’ corporation, LLC, or other pass-through entity), then the issue of deductibility of the compensation is minimized since the entity does not pay any income tax.

This case was also interesting since the law firm sought to avoid penalties based on reasonable cause and good faith per its reliance on an accounting firm to prepare its tax returns. This was rejected because the law firm did not specifically advise the law firm on the deductibility of the bonuses, and that the law firm did not provide accurate information to the accountants.

A question discussed was whether the law firm’s silence on the issue of deductiblity (i.e., its failure to discuss it with the law firm) constituted “advice” upon which the taxpayer could reasonably rely to avoid penalties. Silence is not advice, said the Tax Court:

In prescribing detailed rules regarding the content of professional advice on which a taxpayer can rely, the regulations necessarily contemplate advice that, in some form, involves an explicit communication. Silence cannot qualify as advice because there is no way to know whether an adviser, in failing to raise an issue, considered all of the relevant facts and circumstances, including the taxpayer's subjective motivation. Indeed, an adviser's failure to raise an issue does not prove that the adviser even considered the issue, much less engaged in any analysis, or reached a conclusion. As we observed in Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 100 (2000), aff'd, 299 F.3d 221 [90 AFTR 2d 2002-5442] (3d Cir. 2002): “The mere fact that a certified public accountant has prepared a tax return does not mean that he or she has opined on any or all of the items reported therein.” Thus, we conclude that McGladrey's failure to raise concerns about the deductibility of [*33] the yearend bonuses did not constitute “advice” within the meaning of section 1.6664-4(c), Income Tax Regs.

Brinks Gilson & Lione A Professional Corporation, TC Memo 2016-20