Payments to related entities are dividends, fail independent-investor test.

• Author: Lindbloom, John W.

The Seventh Circuit in Mulcahy, Pauritsch, Salvador & Co., 680 F.3d 867 (7th Cir. 2012), upheld a Tax Court memorandum decision (T.C. Memo. 2011-74) holding that a C corporation's payments to entities owned by its shareholders for consulting services were disguised dividends.

The cash-basis professional services taxpayer operated as a calendar-year C corporation and was owned by three major shareholders during 2001-2003. The shareholders owned various related entities that did not perform any services for the taxpayer in the years at issue. The shareholders themselves performed various services for the taxpayer, including accounting, consulting, and management services. The taxpayer's other employees (approximately 40) performed accounting and consulting services for the taxpayer. The shareholders were paid various amounts throughout each year that were designated as compensation. In addition, the taxpayer made a number of payments to the related entities that were designated as "consulting fees."

The taxpayer paid its available cash at the end of each year to two of the related entities, reducing its taxable income to zero (or near zero). A compensation committee then allocated the related entity payments among the shareholders according to the hours each shareholder worked for the year. The related entities, in turn, paid the shareholders amounts that approximated the committee's allocation. The payments to each shareholder by the related entities were thus proportionate to his hours worked in relation to the other shareholders and not to his ownership.

The taxpayer claimed deductions for consulting fees for amounts it paid to the related entities, which in turn paid the three major shareholders totals of $911,570 for 2001; $866,143 for 2002; and $993,528 for 2003.

The IRS determined tax deficiencies of $317,729 for 2001; $284,505 for 2002; and $377,247 for 2003, primarily from its disallowance of the consulting fee deductions. The Tax Court, applying the independent-investor test, upheld the IRS's determination.

On appeal, the Seventh Circuit affirmed the Tax Court's decision. In explaining the independent-investor test, the court noted that owner-employees have an incentive to recharacterize dividends as salary, and courts from time to time must decide whether income denominated as salary is really a dividend and thus has been improperly deducted from the corporation's income. In most cases, the taxpayer is a closely held corporation in...