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A recent tax court decision was handed down to a law firm operating as a professional corporation (P.C.) in which the IRS held the firm liable for accuracy-related penalties for mischaracterizing payments made to shareholders. The firm initially paid amounts to shareholders and characterized them as year-end bonuses, the IRS argued they should have been classified as dividends. These dividends would have been taxable to the shareholders as well as not deductible by the corporation.
March 28, 2016

A recent tax court decision was handed down to a law firm operating as a professional corporation (P.C.) in which the IRS held the firm liable for accuracy-related penalties for mischaracterizing payments made to shareholders. The firm initially paid amounts to shareholders and characterized them as year-end bonuses, the IRS argued they should have been classified as dividends. These dividends would have been taxable to the shareholders as well as not deductible by the corporation.


The most relevant facts in the case are as follows:

  • Generally, each shareholder attorney's proportionate ownership of shares equaled his/her proportionate share of compensation paid. The firm in question filed their returns on a calendar year basis. Shareholders’ compensation was set and ownership was adjusted in November of the preceding year. The firm then revised shareholder attorneys’ ownership percentages to proportionately reflect the changes in compensation.
  • The firm’s compensation plan regularly brought the firm’s taxable income to a minimal amount after paying shareholders year-end bonuses.
  • The IRS applied the Independent Investor Test, which essentially states “the owners of an enterprise with significant capital are entitled to a return on their investments. Thus, a corporation's consistent payment of salaries to shareholder employees in amounts that leave insufficient funds available to provide an adequate return to the shareholders on their invested capital indicates that a portion of the amounts paid as salaries is actually distributions of earnings.”


The application of the Independent Investor Test was a determining factor in whether the compensation paid to the shareholders in the form of salaries and bonuses was reasonable. As a result, many law firms organized as professional corporations may need to revisit their compensation policies in order to ensure they are in compliance with the IRS’s stance. In our opinion, here are a few considerations to keep in mind when revisiting a compensation policy in light of the IRS’s decision in this case:


  • Develop a written compensation plan in advance and make note of all shareholders, directors and officers who approved it. Make sure documentation of the approval is available. An example of doing so would be to include the plan and related approvals in the corporation’s minutes.
  • Shareholder compensation should not be proportionate to ownership in the firm nor should ownership be adjusted in order to match shareholder compensation. Conversely, we suggest that a compensation plan be formula-based and tied directly to shareholder performance, as well as whether partners meet the firm’s objectives. A simple example of this would be to tie the bonus for a practice group leader directly to the goals for a specific practice for which he/she is responsible. Detailed notes are also highly encouraged, the more objective the performance measurements the better.
  • Consider including nonshareholders in the firm’s bonus pool.
  • Consider paying small dividends every few years based on a particular metric, such as the average dividend yield for the companies included in the S&P 500 index.


Based on the recent stance the IRS is taking, many law firms structured as professional corporations may need to revisit their policies when it comes to shareholder compensation. If you have any questions on this matter or about how to apply the considerations mentioned, please contact RubinBrown's Law Firms professionals.

 


Sources:

Journal of Accountancy, Preventing a challenge to (un)reasonable compensation, September 1, 2013

United States Tax Court, T.C. Memo 2016-20, 2/10/16, Docket No. 14414-13

 

Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.

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