Unreasonable compensation for employee-stockholders of a professional corporation: it is not an unreasonable proposition.

• Author: Dietrich, Mark O.

The IRS has various weapons at its disposal in combating the perceived abuses of personal service corporations (PSCs), including Sec. 269A, enacted with much fanfare in the Technical and Fiscal Responsibility Act of 1982, but little used; the required year of Sec. 441(i), added by the Tax Reform Act of 1986 (TRA), as modified by Sec. 444; and the repeal under Sec. 11(b)(2) of the graduated corporate rates for PSCs by the Revenue Act of 1987. Lost, perhaps, in the flurry of statutory activity is the possible claim of unreasonable compensation in the event of an examination by the IRS. Personal service corporations are under increased scrutiny as a result of the Jerome Mirza and Associates, Ltd. (1) case and the IRS's small defined benefit plan audit program. (2) (Several test cases are to be heard in the Tax Court in early 1992.) This article will examine the factors involved in reasonable compensation cases in general and how they might apply to a professional corporation, and offer pointers in preparing for an examination or Appeals Protest.

Overview

There is a notable lack of case history involving claims of unreasonable compensation against personal service corporations, and for good reason. The success of the corporation is generally directly related to the efforts of the individual professional, and compensation generally reflects that success. The right of professionals to practice in corporate form is well established by virtue of the long line of cases following the Kintner (3) decision. At the time of the Kintner decision, much more favorable retirement plan options were available to incorporated businesses than to unincorporated ones, and this drove professionals to seek corporate status. Despite changes in many state corporate statutes permitting professionals to practice in corporate form, the IRS steadfastly maintained that it would not recognize such entities as corporations for federal tax purposes, treating them as partnerships instead. The IRS even went so far as to issue anti-Kintner regulations after the decision. These regulations were likewise overturned by the courts.

Nowadays, physicians, attorneys, accountants and other professionals primarily use the corporate form in an attempt to limit general (as opposed to professional) liability and obtain certain fringe benefits, notably health insurance, not fully deductible in a partnership or S corporation setting.

The Service and the courts regard the existence of a corporation as evidence of a corporate profit motive, in addition to the individual salary motivations of the stockholder/employees. It is important to remember this position in any tax planning surrounding the reasonable compensation issue. A common profit motive is one of the four factors considered in determining whether an entity is a partnership or corporation. The taxpayer thus has the burden of establishing the premise that all the net earnings available before stockholder compensation should be considered as salary and not as a dividend.

Characteristics of a PSC

Capital is usually not a material income-producing factor in a small professional practice. The services provided by nonprofessional employees are often in the nature of administration and support and do not generate revenue. The main source of revenue in a small firm comes from the efforts of the principals. There is a direct "one-to-one" relationship between the number of patients/clients the professional has and the amount of fee income earned by the taxpayer. Likewise, there should be an unequivocal requirement that the compensation earned by the professional reflect that one-to-one relationship. The more clients receiving services, therefore, the more income the professional is entitled to earn. In Eduardo Catalano, Inc., Pension Trust, which involved a oneman professional corporation engaged in architecture, the Tax Court stated: "As the sole employee of ECI [Catalano] is the fount of that company's income. In light of the fact that ECI had adequate resources from which it could pay Mr. Catalano . . . , it is difficult to support a finding that such payments were unreasonable in amount." (4)

Larger practices, notably of lawyers and accountants, and increasingly of physicians, do not fit this small firm picture. Capital may, in fact become a material income-producing factor. large investments in computers and other business equipment, along with furnishings, are common to all the professions. Group practices of physicians may acquire substantial amounts of laboratory, radiographic and other equipment on which the fee income may, in part, be based. "Buyins" based on the tangible asset cost, as well as goodwill, may lend credibility to an argument by the Service that "distributions" labeled as compensation are in fact a distribution on invested capital, i.e., a dividend.

All of these professions afford the opportunity for "leveraging" of associates and staff people through billing rates or similar arrangements. The "profits" on these revenue centers are paid to the employee-owners as compensation, along with their direct earnings from client or patient service activities. Compensation plans, which allocate income in whole or in part, using a partner's client base, capital account balance and other factors not based on individual productivity, (5) may also lend credibility to the argument that certain distributions should be regarded as dividends. The prior services argument (discussed below) may be of value in attributing compensation to the client base portion of a stockholder's total earnings.

What Is Compensation?

Compensation includes more than just W-2 earnings. Pension and profit-sharing contributions are part of compensation in making a determination of reasonableness. Fringe benefits such as various group insurances, medical reimbursement plans and unfunded deferred compensation plans also need to be included. Taxpayers who used defined benefit plans with what are now seen as aggressive funding factors in light of recent legislative and audit attacks may be at risk for unreasonable compensation. The IRS's small defined benefit plan audit program, aimed at raising approximately $600 million in revenue as a result of its success in the Mirza case, may also be the source of unreasonable compensation cases.

In Mirza, a self-employed attorney established a defined benefit plan covering himself and one employee. The actuary computed a liability in excess of $500,000, all of which was paid and deducted in a single year. A substantial net operating loss carryback resulted and refunds were paid by the IRS. The court upheld the IRS's denial of the deduction on a variety of legal theories, including failure to amortize prior service cost and the use of a 5% assumed rate of return when 30-year Treasury bonds were yielding 14%. (Note that 30-year Treasury bonds have recently been yielding in the range of 7.5%.) The use of such plans, primarily by both incorporated and unincorporate small business owners, will result in the audit of many PSCs. (The lack of a retirement plan...