Law Firm Had No Substantial Authority Nor Reasonable Cause for Deducting Unreasonable Level of Compensation

The only issue remaining to be decided by the Tax Court in the case of Brinks, Gilson & Lione a Professional Corporation v. Commissioner, TC Memo 2016-20 was whether the corporation could escape the accuracy related penalty under IRC §6662 for a substantial understatement of tax.

In this case the corporation had conceded the issue of whether a portion of what it had paid in salaries to shareholders should be treated as dividends.  The resulting tax assessments for each of the years in question exceeded 10% of the tax required to be shown on the return[1], in which case the penalty will automatically apply unless the taxpayer can show it qualifies for one of the exceptions.

A taxpayer is not subject to this penalty if it can be shown:

  • The position that lead to the assessment had substantial authority [as defined in Reg. §1.6662-4(d)] or
  • The taxpayer had reasonable cause for the factors leading to the understatement and acted in good faith [IRC §6664(c)(1)]

The corporation (a law firm) had paid annual bonuses to each of its shareholders in each of the years in question that were (with minor adjustments) based on that shareholder’s ownership interest in the corporation and which managed to zero out taxable income in the years in question. 

The law firm in question was not a small operation.  As the Tax Court noted:

Petitioner is an intellectual property law firm organized as a corporation. When it filed the petition, it maintained its principal offices in Chicago, Illinois. It computes its taxable income on the basis of a calendar year, using the cash method of accounting. For the years in issue, it prepared its financial statements on that basis and using that method. During those years, it employed about 150 attorneys, of whom about 65 were shareholders. It also employed a nonattorney staff of about 270. Its business and affairs are managed by a board of directors (board).

As well, the operation had substantial equity on its balance sheet, sitting at $8 million for 2007 and $9.3 million for 2008.  As the Court noted, these balance sheets did not reflect the value of any intangible assets of the corporation, and the firm’s own expert admitted that “a firm's reputation and customer lists could be valuable entity-level assets, even though determining their precise worth might be difficult.”

As the Court noted, it is possible to have “substantial authority” even if a position fails to prevail:

The determination of substantial authority requires a weighing of the authorities that support the taxpayer's treatment of an item against the contrary authorities. Id. subpara. (3)(i). A taxpayer can have substantial authority for a position that is unlikely to prevail, as long as the weight of the authorities in support of the taxpayer's position is substantial in relation to the weight of any contrary authorities. See id. subpara. (2) (substantial authority standard is less stringent than the more likely than not standard).

The question was whether, in the area of reasonable compensation being paid to the shareholders of the firm, the position taken on the tax return met that standard.

The IRS cited a number of cases that hold that merely because the entity in question is a service firm it doesn’t mean that it’s reasonable to pay all amounts as compensation to the shareholders if there are substantial numbers of non-shareholder employees and/or there is substantial invested capital.

In support of its position, respondent relies primarily on this Court’s opinion in Pediatric Surgical Assocs., P.C. v. Commissioner, T.C. Memo. 2001-81, and that of the U.S. Court of Appeals for the Seventh Circuit in Mulcahy, Pauritsch, Salvador & Co. v. Commissioner, 680 F.3d 867 (7th Cir. 2012), aff’g T.C. Memo. 2011-74. In Pediatric Surgical, we determined that compensation payments to shareholder employees attributable to the services of nonshareholders were nondeductible dividends. In Mulcahy, the Court of Appeals for the Seventh Circuit denied a corporation’s deduction of consulting fees paid to entities owned by the taxpayer’s founding shareholders. The taxpayer sought to justify the deduction of the consulting fees on the grounds that they were, in effect, additional compensation to its shareholders. The Court of Appeals upheld this Court’s disallowance of the deduction, reasoning that “[t]reating * * * [the consulting fees] as salary reduced the firm’s income, and thus the return to the equity investors, to zero or below in two of the three tax years at issue, even though * * * the firm was doing fine.” Mulcahy, Pauritsch, Salvador & Co. v. Commissioner, 680 F.3d at 872. “[W]hen a thriving firm that has nontrivial capital reports no corporate income,” the court observed, “it is apparent that the firm is understating its tax liability.” Id. at 874.

The Court notes that the key test being used in reasonable compensation cases has moved towards a “reasonable investor” test and that this test was applied in Mulcahy.  Under this test the inquiry is whether a theoretically independent investor would receive a reasonable return on his/her investment in the entity and, as well, would approve the payment of compensation in the amount in question.  An investor would presumably object to the corporation paying out as compensation amounts that should more reasonably be available to the investor as a return on his/her invested capital.

Since the corporation in this case did not pay out dividends and had zeroed out income by paying out all earnings as Tcompensation, the Court found that, in fact, a reasonable investor would not have approved this level of compensation.  As the Court noted:

Regardless of the possibility that petitioner might own valuable intangible assets, it had invested capital, measured by the book value of its shareholders’ equity, of about $8 million at the end of 2007 and about $9.3 million at the end of 2008. Invested capital of this magnitude cannot be disregarded in determining whether ostensible compensation paid to shareholder employees is really a distribution of earnings. We do not believe that petitioner’s shareholder attorneys, were they not also employees, would have forgone any return on invested capital that at least approached, if it did not exceed $10 million. Thus, petitioner’s practice of paying out year-end bonuses to its shareholder attorneys that eliminated its book income fails the independent investor test.

The Court rejected the corporation’s argument that, because the shareholders held their stock only as long as they remained employees of the firm and had to sell their stock back at book value, they lacked the normal rights of equity owners and thus the independent investor test should not apply.

The Court disagreed, holding:

…[P]etitioner's argument that its shareholder attorneys have no real equity interests in the corporation that would justify a return on invested capital proves too much. If petitioner's shareholder attorneys are not its owners, who are? If the shareholder attorneys do not bear the risk of loss from declines in the value of its assets, who does? The use of book value as a proxy for fair market value deprives the shareholder attorneys of the right to share in unrealized appreciation upon selling their stock -- although they are correspondingly not required to pay for unrealized appreciation upon buying the stock. But acceptance of these concessions to avoid difficult valuation issues does not compel the shareholder attorneys to forgo, in addition, any current return on their investments based on the corporation's profitable use of its assets in conducting its business. Petitioner's arrangement effectively provides its shareholder attorneys with a return on their capital through amounts designated as compensation. Were this not the case, we do not believe the shareholder attorneys would be willing to forgo any return on their investments.

Ultimately the Court rejected all of the authorities cited by the corporation in support of its position, finding none of them justified the position taken.  The Court noted:

We do not doubt the critical value of the services provided by employees of a professional services firm. Indeed, the employees' services may be far more important, as a factor of production, than the capital contributed by the firm's owners. Recognition of those basic economic realities might justify the payment of compensation that constitutes the vast majority of the firm’s profits, after payment of other expenses—as long as the remaining net income still provides an adequate return on invested capital. But petitioner did not have substantial authority for the deduction of amounts paid as compensation that completely eliminated its income and left its shareholder attorneys with no return on their invested capital.

The Court thus concluded the firm did not have substantial authority for the position it took that all payments to the shareholders represented deductible compensation rather than dividends representing a return on capital.

The corporation argued that, if that was the case, it should still escape the penalty because it had reasonable cause for having claimed the deduction and acted in good faith.  The corporation noted that it had a well-known major accounting firm prepare its corporate tax return each year and that the CPA firm had not objected to the position on the returns.

The Court found that, as it has often before, merely paying a professional to prepare a taxpayer’s return does not automatically provide there is reasonable cause and good faith on the part of the taxpayer for an understatement.

Reasonable cause and good faith based on reliance on the advice of a tax professional generally has required a showing of the following:

  • The taxpayer consulted an adviser that the taxpayer reasonable believed was competent to deal with the issue at hand
  • The taxpayer provided the adviser with complete and accurate information with regard to the matter in question and
  • The taxpayer asked for advice from the adviser on the matter in question and followed that advice.

In this case the Court found issues with the latter two requirements.  First, the actual error was that of the taxpayer.  They provided the firm with books and records, as well as Forms W-2, that showed the payments were compensation.  They did not bring the accounting firm in to the decision making process regarding year bonuses, but rather presented them to the firm as an accomplished fact.

Second the corporation did not show it ever asked for or received advice from the firm on the question of reasonable compensation.  As the Court noted:

Silence cannot qualify as advice because there is no way to know whether an adviser, in failing to raise an issue, considered all of the relevant facts and circumstances, including the taxpayer’s subjective motivation. Indeed, an adviser’s failure to raise an issue does not prove that the adviser even considered the issue, much less engaged in any analysis, or reached a conclusion.

The Court notes that an adviser preparing a return generally can accept the representations of the taxpayer and has only limited requirements “to make inquiries in the case of manifest errors.” 

Thus, the Court concludes, the corporation did not have either substantial authority for the position nor reasonable cause for having taken the position on the return.  Therefore it found that corporation was liable for substantial understatement liability related penalty of IRC §6662.

[1] Actually, the specific trigger for a corporation varies depends on the exact facts of the case.  The 10% test is the general test for a C corporation, but this particular penalty will not apply if the assessment is less than $10,000, and will be triggered regardless of the 10% test if the assessment is more than $10,000,000.  In this case it was the “pure” 10% test that applied.