By RALPH Z. LEVY JR.
A prior article in this publication (IRS Attack on Zeroed Out Taxable Income in Recent Tax Court Cases) discussed the lessons that physician and other incorporated medical practice groups could learn from taxpayer losses in two then recent Tax Court cases in use of the “zero out” technique in the payment of compensation to the group’s owners. Under this approach, the practice group typically compensates its physician-owners or other licensed professional shareholders by payment of a portion of the anticipated pre-tax operating profits as compensation (salary) in regular increments during the tax year and then it will distribute the bulk of its profits in bonuses that are paid at year-end. For practice groups organized as ‘C’ corporations, the salary and year-end bonuses are deducted as compensation. As a result, the practice entity will pay little or no federal income taxes. The potential tax risk to this compensation method is that, depending on the facts and circumstances of each situation, the Internal Revenue Service (IRS) could disallow the compensation deduction for the “salary” and bonuses paid and treat these payments as non-deductible dividends made by the practice entity to its shareholders.
Two recent cases provide additional insight into how the zero out approach to compensation can be properly structured to support the deductibility of payments made by ‘C’ corporations to their owners as compensation for services provided. In one case, the Tax Court issued a lengthy opinion in support of its denial in part of the deduction of compensation paid to the owner of a construction business organized as a ‘C’ corporation. In another case, the Eighth Circuit Court of Appeals affirmed a Tax Court case discussed in the prior article that upheld the IRS’s characterization of payments made by an asphalt paving company to, or for, its owners as non-deductible dividends rather than deductible compensation.
On April 26, 2022, the Eighth Circuit Court of Appeals affirmed a 2021 Tax Court case (discussed in detail here). Even though the taxpayer generated income throughout the year, it made no payments for services to, or for the benefit of, its three shareholders (an individual and two corporations each of which was wholly owned by one individual) until the end of the year. The year-end payments (characterized by the taxpayer as “management fees”) were made roughly based on share ownership rather than based on the value of services provided by each individual who directly or indirectly owned the taxpayer. Moreover, the taxpayer made payments to the two corporate shareholders rather than to the individuals who performed services on behalf of the corporate shareholders. The taxpayer had never paid any dividends and, by making the payments, the taxpayer eliminated a substantial portion of its taxable income (just under 90% in two of the three tax years covered in the case and just under 80% in the third year). The Tax Court upheld the IRS’s characterization of the payments made in all three years as non-deductible dividends and not deductible compensation.
The Court addressed the substantive issue posed – whether the payments made could be deducted as management fees – and thoroughly analyzed the reasons for the Tax Court’s decision to support the IRS’s denial of the deductions claimed by the taxpayer. The Court of Appeals noted that all compensation arrangements within closely held corporations should be closely scrutinized, that the payments made by the taxpayer were made in a lump sum at the end of the year (a true “zero out” approach) and that the corporation did not pay and had never paid any dividends to its owners.
In Clary Hood, Inc. (TC Memo. 2022-15), which was decided on March 2, 2022, the Tax Court redetermined the deductible amount of the substantial “one-time” bonuses that the closely held construction company paid its CEO/founder during two tax years. The Tax Court found that a significant portion, but not all of the bonuses paid to the sole shareholder in each tax year, could be deducted as reasonable compensation for services provided to the corporation.
The Tax Court also noted that the taxpayer had bonused out to the founder during the two tax years in question a relatively small portion of the business’s pre-tax operating profits (approximately 40% in one year and 25% in another tax year).
These two cases can provide valuable lessons to owners of physician and other incorporated medical practice groups as they develop methods for compensating employed physicians and other licensed professionals:
• As the construction company did in Clary Hood, do not wait until the end of the year to pay bonuses to practice group owners, but make periodic payments of base compensation during the year (salary) using an objective formula that takes into account the value of the services provided by each licensed professional;
• Do not pay compensation to the licensed professionals who are shareholders of the practice group in the same percentages as their relative share ownership;
• Engage competent accountants, tax preparers or compensation consultants to provide advice and counsel in structuring any compensation method and the Board of Directors of the practice entity should review and consider written guidance and reports from these advisors prior to approval of any compensation method (or year-end bonuses based on that method);
• For practice groups with corporate shareholders (typically an ‘S’ corporation owned by a licensed professional), pay the individuals who perform the services the compensation earned and do not make these payments to their wholly owned corporations;
• Do not zero out all corporate pre-tax profits each year as compensation but declare and pay annual dividends of a portion of these profits and pay federal income taxes on the remaining pre-tax profits of the incorporated practice group; and
• Enter into written employment agreements with each physician or other licensed professional who is a shareholder of the practice entity that contain an objective formula for determining at least the contingent portion of compensation.