Continued IRS Attack on ‘Zero’ Profits – Tax Authorities
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An earlier article in this publication (IRS Attack on Zeroed Out Taxable Income in Recent Tax Court Cases) discussed lessons that physicians and other incorporated medical practice groups could learn from taxpayer losses in two then-recent Court of tax by using the “zero on” technique in the payment of compensation to group owners. Under this approach, the practice group generally compensates its physician-owners or other approved professional shareholders by paying a portion of the profits of operating before taxes scheduled as compensation (salary) in regular installments during the tax year, then it will distribute most of its profits in the form of bonuses paid at the end of the year. in “C” corporations, salary and year-end bonuses are deducted as compensation.As a result, the practice entity will pay little or no tax. federal income tax. The potential tax risk of this method of compensation is that, depending on the facts and circumstances of each situation, the Internal Revenue Service (IRS) may disallow the offsetting deduction for “salary” and bonuses paid and treat such payments as non-deductible dividends paid by the practice entity to its shareholders.
Two recent cases provide additional insight into how the zero offset approach 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 company organized as a “C” corporation. In another case, the Eighth Circuit Court of Appeals upheld a Tax Court case discussed in the previous article that upheld the IRS’ characterization of payments made by an asphalt paving company to or for its owners as non-deductible dividends rather than deductible compensations.
On April 26, 2022, the Eighth Circuit Court of Appeals upheld a 2021 Tax Court case (discussed in detail here). Although the taxpayer generated income throughout the year, it made no payments for services or for the benefit of its three shareholders (one individual and two corporations each of which was wholly owned by an individual) until ‘at the end of the year. Year-end payments (referred to by the taxpayer as “management fees”) were made roughly on the basis of share ownership rather than the value of services provided by each individual who directly or indirectly owned the taxpayer. Further, the taxpayer made payments to the two corporate shareholders rather than to the individuals who provided services on behalf of the corporate shareholders. The taxpayer had never paid dividends and, in making the payments, the taxpayer eliminated a substantial portion of his taxable income (just under 90% in two of the three tax years covered by the case and just under 80% in the third year) . The Tax Court upheld the IRS’ characterization of the payments made over the three years as non-deductible dividends and not deductible compensation.
The Court considered the substantive question posed – whether the payments made could be deducted as a management fee – and thoroughly analyzed the reasons for the Tax Court’s decision to uphold the IRS’s denial of deductions claimed by the taxpayer. The Court of Appeal noted that all compensation arrangements within closely held corporations should be scrutinized, that payments made by the taxpayer were paid out in a lump sum at the end of the year (a true approach “zero”) and that the company was not paying and had never paid dividends to its owners.
In Clary Hood, Inc. (TC Memo. 2022-15), which was released on March 2, 2022, the Tax Court redetermined the deductible amount of large “one-time” bonuses that the private construction company paid to its CEO/founder for two fiscal years. The Tax Court found that a significant portion, but not all, of the bonuses paid to the Sole Shareholder in each taxation year could be deducted as reasonable compensation for services provided to the society.
The Tax Court also noted that the taxpayer had paid the founder in the two tax years in question a relatively small part of the company’s pre-tax operating profits (around 40% one year and 25% another year). tax).
These two cases can provide valuable lessons for physician owners and other incorporated medical practice groups as they develop methods of remunerating employed physicians and other licensed professionals:
- Like the construction company did to Clary Hood, don’t wait until the end of the year to pay practice group owner bonuses, but make periodic base compensation payments throughout 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 licensed professionals who are practice group shareholders in the same percentages as their relative shareholding;
- Engage competent accountants, tax preparers or compensation consultants to provide advice and guidance in structuring any method of compensation and the practice entity’s board of directors should review and consider the written instructions and reports from such advisors prior to the approval of any compensation method (or year-end bonuses based on such method);
- For practice groups with corporate shareholders (usually an “S” corporation owned by a licensed professional), pay the individuals who provide the services the compensation earned and do not make these payments to their wholly owned corporations;
- Do not reduce all pre-tax corporate profits to zero each year as compensation, but declare and pay annual dividends of a portion of those profits and pay federal income taxes on the remaining pre-tax profits of the group of practice incorporated; and
- Enter into written employment contracts 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.
Originally published by Healthcare Michigan, May 2022
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
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