Compensation Deductions in a Professional Service C-corporation
As mentioned in our last newsletter, the IRS continues to keep a watchful eye over S-corporations, requiring minimum levels of “reasonable compensation” to owners who may be otherwise seeking to downplay compensation for tax avoidance purposes. S-corporation shareholders aren’t the only ones who need to be cautious regarding the method and amount of compensation allocated to shareholders. Professional service corporations also are being scrutinized for mischaracterization of dividends to shareholders as deductible compensation.
Personal services include any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law and the performing arts. According to IRS Publication 542, a corporation is deemed to be a personal service corporation if it meets the following requirements:
Its principal activity during the “testing period” is performing personal services. Generally, the testing period for any tax year is the prior tax year. If the corporation has just been formed, the testing period begins on the first day of its tax year and ends on the earlier of:
The last day of its tax year, or
The last day of the calendar year in which its tax year begins.
Its employee-owners substantially perform the services noted in number one above. This requirement is met if more than 20% of the corporation’s compensation cost for its activities of performing personal services during the testing period is for personal services performed by employee-owners.
Its employee-owners own more than 10% of the fair market value of its outstanding stock on the last day of the testing period.
These professional corporations were a favorable entity choice up and until the mid-1980s when the tax law was changed to tax professional services corporations at a flat rate of 35% whereas in the past corporations had the benefit of a graduated tax scale. Prior to the flat rate of 35%, with creative compensation structuring employee-owners of professional corporations could diminish some of their tax liability. Professional corporations today do not enjoy the tax planning benefits enjoyed by the PCs when in their heyday.
The IRS contends that many personal services corporations attempt to limit taxable income through additional compensation paid out to shareholder owners, so as to reduce corporate taxable income. Since dividend payments are accounted for as a return on investment in the business rather than an expense, it is not deductible which means such payments are effectively subject to corporate tax prior to being distributed. Additionally, the shareholder receiving the dividend is taxable on such dividend income on his or her personal return, resulting in what amounts to double taxation.
In lieu of dividends, professional corporations may lean towards paying out business income to shareholders in the form of salaries, bonuses, and fringe benefits, all of which are deductible business expenses. The IRS has been very aggressive in challenging the issue of unreasonable compensation and will not hesitate to claim that inflated compensation, especially in the form of year-end bonuses, is merely disguised, non-deductible dividends.
A recent decision by the Tax Court demonstrates this aggressive challenge of year-end bonus distributions for a professional corporation law firm. In Brinks Gilson & Lione PC, TC Memo 2016-20, the Tax Court found that the law firm that had a history of no dividend payments to shareholders while paying out significant year-end bonuses, amounted to a mischaracterization of its taxable income and upheld an understatement of tax penalty under Section 6662, despite the defense that an established accounting firm prepared the firm’s tax returns. The IRS again holds firm on its position to ensure that compensation is reasonable, whether in a C corporation such as a professional corporation, or in an S corporation.
For greater analysis on this Tax Court decision, see Scott E. Vincent, Tax Court Sustains Penalties on Law Firm Compensation Deductions, Vol. 72 No. 2, Journal of the MO. Bar, p. 100, (2016).
The Unexpected Passing of Prince and the Importance of Estate Planning
One of the Hood Law Group’s areas of specialty is the focus on a well thought out and structured estate plan to account for the inevitable event of one’s passing. Unfortunately, end of life planning tends to be an area many people tend to “put off” for one reason or another, whether it be prioritization of more pressing matters, reliance on a simple will or an internet package plan without the benefit of legal counsel, or allocation of funds elsewhere. As our firm also handles many probate matters when someone passes, we see time and time again the ramifications of either poorly-planned estate plans or lack of a plan altogether, resulting in significant and unnecessary expenses and family turmoil for the surviving members of the family.
It’s been over a month since the passing of the musician Prince, who failed to execute a will or any estate plan to determine what would happen to his fortune after his death, who would manage his affairs and other issues to account for after one’s death. This has been interesting news the past few weeks as we are seeing potential heirs coming out of the woodwork claiming entitlement to a share of the estimated $300 million estate.
When a person dies and a will has been properly executed during their lifetime, it will spell out who will serve as the executer and who will receive the decedent’s assets, in what allotments, etc. The matter is addressed through the probate court and although there is a clear process to follow, time and expense can occur that can be otherwise minimized through the use of a Revocable Living Trust created during the person’s lifetime (which also has the benefit of keeping the decedent’s distributions to beneficiaries private). In addition, wills may be contested for lengthy and expensive probate court disputes. However, a will does serve to avoid the disaster of intestacy.
So, what happens when a person dies without a will, such as the situation with Prince? The probate court will appoint a person to serve as administrator. In most states, any person of interest can apply to be an administrator. This includes your creditors such as a mortgage company or credit card company. Typically the next of kin will be appointed, but courts may have discretion for appointing any party of interest.
The result of passing without a will is sure to be a mess, especially with a considerable fortune. If there is one thing to learn, it’s that everyone should have a plan in place, preferably for most a Living Trust, but a simple will has the advantage of avoiding many unintended consequences. It reduces the chance that controversy and family infighting will occur, as well as many unintended consequences of probate in intestacy. In the absence of a will or other planning, the disposition of assets are controlled by state statute that may not be in accordance with the wishes of the decedent.
Now we are seeing people claiming to be descendants of Prince, including a local Kansas City man who claims to have been fathered by Prince from a chance encounter with his mother in the late 1970s when he was on one of his first tours. If proven true, Prince likely had no connection to this person and may not have wanted any portion of his estate to go to this man.
Don’t let the dollars involved with Prince’s estate dissuade you from the need to have proper planning. You can’t choose your beneficiaries without a will. You don’t get to choose who will manage your affairs. You don’t have the advantages of careful planning to reduce or eliminate inheritance and/or estate taxes or income taxes. The state statutes will control everything. You will have no control over disposition or other matters.
Do your intended beneficiaries a favor, and yourself, and ensure you have a proper estate plan in place. Whether a basic will or a carefully drafted Living Trust, make life easier for your extended family and/or intended beneficiaries, as well as giving you peace of mind and more control upon your passing.
I am from out of state and needed a local attorney to handle a complex family estate matter. Matt Hood provided exceptional service. He is knowledgeable, professional, and efficient - I highly recommend his firm.
- Mark Muntean. 7/7/2019
The Hood Law Group (Matt, Ed, and Paul) represented us in a legal case dealing with a border line dispute with our neighbors. They are very knowledgeable, experienced, professional, careful and helped us win the case. We are very pleased with their excellent service and highly recommend the Hood Law Group.
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Matt is professional, easy to communicate and gets things done in a timely manner. Highly recommended!
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The Hood Law Group prepared my will and durable power of attorney for my assets (property) and healthcare directive. I was glad to have this firm do my estate planning, as they are knowledgeable and have many years experience in this area.
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