Allocating Compensation and Dividends to a Shareholder in a Corporation
By Daniel Gniadek, Supervisor, Tax & Business
Recent Tax Court rulings have highlighted some ways in which the IRS reviews compensation versus dividends to shareholder-employees in a corporation. The following will highlight some key areas that the IRS focuses on when determining reasonableness in the allocation of compensation versus dividends in a corporation.
In Brinks Gilson & Lione P.C. v. Commissioner, decided earlier this year, the Court ruled to uphold underpayment penalties to a law firm organized as a Personal Service Corporation (“PSC”). The underpayment penalties originated from a substantial understatement of tax in which the taxpayer paid out all net income to shareholder-employees, in the form of salary and bonuses of $8,986,608 in 2007 and $13,736,331 in 2008, thereby eliminating taxable income.
The issue of payments as compensation versus dividends paid out in a PSC has become a focus area for the IRS since compensation is deductible to the corporation and dividends are not. While the impact of deductible or non-deductible expenses is more significant for PSCs than for other types of entities because PSCs are subject to a flat tax of 35 percent, this issue applies to all corporations.
In the Brinks case, the IRS deemed the bonuses to be excessive and reclassified them as dividends. The difference in tax between treating the income before bonuses as non-deductible dividends versus treating them as a deductible expense as a bonus was $3,145,312 for tax year 2007 and $4,807,715 for tax year 2008. While there is no set rule on what compensation should be, the allocation between compensation and dividends must be reasonable related to the services that are performed.
In reviewing the case, the Tax Court concluded that the law firm would fail the “independent investor” test. The independent investor test states that if 100 percent of net income was paid out to employees as compensation in a company that has significant capital (in this case, the law firm had invested capital of $8 million at the end of 2007 and $9.3 million at the end of 2008), then there would be no return left for the shareholders, which would be unacceptable to outside investors. The law firm argued that the independent investor test does not apply since the shareholders received stock in connection with employment and must sell it back upon termination. Therefore, the shares do not represent real equity interests. The IRS rejected this claim because the shareholder-attorneys would bear the economic risk of loss if there were a decline in the value of the company.
The Tax Court also held that payments to shareholders do not qualify as deductible compensation if the earnings come from non-shareholder employees or the corporation’s intangible assets or other capital. In this case, the shareholder-employees were paid bonuses based upon their share of stock ownership in the firm at year-end.
When a PSC evaluates yearly compensation and bonuses, the company should be aware of the above-mentioned treatment of compensation and dividends that was disallowed by the IRS and should review Brinks Gilson & Lione P.C. v. Commissioner for additional insights.