PSCs--beware of unreasonable compensation.

• Author: Lerman, Jerry L.
• Position: Personal service corporations

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 dividends--avoiding 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 corporation's 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 board's discretion; no bonuses were paid to the non-shareholder-surgeons.

2. The non-shareholder-surgeon employment agreements contained non-compete 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 company's 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 shareholder's services, less his or her allocable expenses. The court...