May 26

Professional Corporation that does not elect subchapter S – be careful of using yearend bonuses to zero out taxable income

Some professional entities are C corporations.  The case of Brinks Gilson & Lione, a professional corporation v. Commissioner, TC Memo 2016-20, points out the danger in operating a professional entity as a C corporation.  In Brinks, the professional corporation had a substantial number of attorneys that were not shareholders.  The professional corporation had a substantial amount of capital.  An expert admitted that the good will of a law firm is a valuable asset.

The professional corporation tried to zero out its taxable income by yearend bonuses.  On audit, the IRS disallowed a substantial amount of the yearend bonuses and recharacterized the yearend bonuses as non-deductible dividends.  The taxpayer conceded the issue and the main focus of the Court’s attention was on the penalties.

The Tax Court applied an independent investor test, “If the bulk of the corporation’s earnings are being paid out in the form of compensation, so that the corporate profits, after payment of the compensation, do not represent a reasonable return on the shareholder’s equity in the corporation, then an independent shareholder would probably not approve of the compensation arrangement”.  The Court noted that the professional corporation had substantial capital.  The Court held that the professional corporation’s practice of paying out yearend bonuses to its shareholders that eliminated its income failed the independent investor test.

The taxpayer argued that it should not be liable for a penalty for it reasonably relied on its accountant to prepare the tax return.  However, to avoid penalties, one can only reasonably rely on professional “advice”.  The taxpayer did not put forth any evidence of the accountant giving advice as to the deductibility of yearend bonuses to shareholders.

The lesson to be learned is that it may be hazardous to use a C corporation to conduct a professional practice, especially where there are non-shareholder professional employees and their services add to the profit.  From a tax point of view, a safer alternative is to use an entity classified as a partnership such as an LLP or in the alternative, use an S corporation.

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