Why personal service corporations should care about the amount paid to shareholders.

• Author: Koppel, Michael

A personal service corporation is a C corporation that performs services in the professions listed in Sec. 448(d)(2) (A) and substantially all of the stock of which (by value) is held directly or indirectly by employees of the corporation and certain other persons as described in Sec. 448(d)(2)(B). The professions listed in Sec. 448(d)(2)(A) include the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. A personal service corporation is not entitled to any graduated tax rates on its taxable income, and thus all of its income is taxed at the highest corporate tax rate of 35%.

It would seem at first glance that it is beneficial to leave profits in the corporation. However, doing so exposes the profits to double taxation--tax at the personal service corporation level, currently 35%, plus tax as a dividend, which can be 23.8% or higher, counting phaseouts for high-income individuals. This can result in an effective tax rate far over 50%. To avoid this situation, most personal service corporations distribute substantially all their income as wages to the employee/shareholders.

Now comes the Tax Court case of Brinks, Gilson & Lione, P.C., T.C. Memo. 2016-20. At first glance, this appears to be just another case dealing with accuracy-related penalties. However, what is important is the reason the IRS assessed the penalties. During the course of the audit of the corporations 2007 and 2008 tax returns, the IRS and the taxpayer agreed that the amount of compensation paid to the employee/shareholders of the law firm was overstated. There were other agreed-upon changes, but they were minor. Because of the recharacterization's magnitude, the IRS imposed accuracy-related penalties for a substantial understatement of income tax. The accuracy-related penalty is the only issue the court considered.

For purposes of the substantial-understatement penalty, an understatement is reduced by the portion attributable to the treatment of an item for which the taxpayer had "substantial authority" under Sec. 6662(d)(2)(B)(i). Sec. 6664(c)(1) provides an exception to the imposition of the Sec. 6662(a) accuracy-related penalty if it is shown that there was reasonable cause for the underpayment and the taxpayer acted in good faith.

The taxpayer claimed that it had substantial authority for deducting the bonuses it paid to its employee/ shareholders in full, and therefore its understatement was reduced under...