Taxpayer losses in two recent Tax Court cases serve as reminders that physician and other incorporated medical practice groups should take care in the “zero out” approach to the payment of compensation to the group’s owners and that success in this area may depend on whether the practice is organized as a “C” corporation or has elected to be taxed as an “S” corporation and if the practice group is owned by one or more professionals.

Regardless of whether the practice group is organized under local law as a professional corporation (PC) or a professional association (PA), is taxed as a “C” corporation or as an “S” corporation for federal tax purposes, the entity typically compensates its physicians or other licensed professional shareholders by payment of base compensation that constitutes an advance estimate of a pre-determined percentage of budgeted annual operating profits.

Once actual year-end operating results are determined (or reasonably estimated), prior to its taxable year–end, the PC or PA pays a bonus to members of the practice group based on its distributable cash using the formula adopted by the practice group members to pay annual compensation to and among its professionals. These bonuses “take into account” the amounts previously paid to each professional as base compensation during the year.

Through the payment of year-end bonuses, the taxable income of the PC or PA is reduced to zero or a nominal amount. Because the bonuses are deducted by the PC or PA as a compensation expense, if the group is organized as a “C” corporation, the PC or PA typically pays little or no federal income tax. By contrast, if the group is organized as an “S” corporation, the group may treat the payments to its professionals who are shareholders as dividends and not as wages to avoid the payment of self-employment income taxes on the amounts distributed to the practice group’s owners.

In a case decided in January, 2021, Aspro, Inc., TC Memo 2021-8, the Tax Court found that payments made during each of three tax years by the taxpayer, a “C” corporation, to its three shareholders were non-deductible dividends and not deductible as compensation for personal services provided to the corporation.

The court noted that the corporation had never previously paid any dividends to its shareholders, the payments were made in roughly the same proportions as share ownership of the taxpayer and that two recipients of the payments were corporations that were shareholders of the taxpayer and were “paid” for services performed by the individuals who owned these two shareholder-corporations.

Finally, the court noted that the personal services that the taxpayer alleged were performed throughout the entire year but the payments were made annually and the payments eliminated almost 90 percent of the taxpayer’s taxable income in two of the three years and just under 80 percent of the taxable income in the third year.

In reaching its decision, the Court relied on a tax regulation that limits deductible compensation for services only to amounts paid “as the purchase price for services” and that payments made that “correspond or bear a close relationship to the stockholdings of the officers or employees” are subject to re-characterization as dividends. Since the payments were not deductible, the taxpayer was found to be liable for corporate income taxes based on its net income determined without the denied compensation deductions.

In the March, 2021 decision, Lateesa Ward, TC Memo 2021-32, the Tax Court found that payments made to an attorney who was the sole shareholder of a law firm organized as an S corporation were subject to employment taxes and could not be treated as distributions of the firm’s net income (i.e., as dividends). As a result, these payments were subject to self-employment tax both on the employer side and on the employee side.

In this case, the IRS asserted that the payments made by the corporation to its owner should be taxed as compensation subject to self-employment taxes and not as dividends. In upholding the IRS’s recharacterization of the payments, the Tax Court pointed out that the payments in question had been reported on the law firm’s corporate income tax returns Form 1120-S as officer compensation and wages, but that the corporate taxpayer had not included these payments in its Form 941 employment tax returns that properly reported employment taxes paid to a non-shareholder attorney employed by the firm and the shareholder of the law firm had incorrectly reported the compensation as dividends of the firm’s earnings and profits (not taxable since the attorney had cost basis in her stock) and not as wages subject to employment taxes. Notably, as to the attorney’s treatment of the payments she received from her law firm on her personal income tax returns, the Tax Court found that the attorney should have reported all payments she received from the law firm as compensation for services.

Even though the Ward case is instructive on a stand-alone basis only to illustrate that physician and other practice groups should engage competent accountants or tax preparers, several lessons can be learned from the Aspro and Ward cases taken together.

Lesson 1: For a practice group organized as a C corporation that wants to claim compensation deductions for payments made to its owners, the entity should make periodic payments during the year based on services rendered and not “bonus out” large chunks of otherwise taxable income at year-end.

In the Aspro case, the taxpayer “C” corporation did not make any payments for services until year-end. The Tax Court cited several cases in support of its conclusion that payments made in a lump sum at the end of a year rather than throughout the year should be viewed as disguised distributions of profits.

(1. In Ward, both the law firm and its individual shareholder were taxpayers whose returns were audited by the Internal Revenue Service.)