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If you are operating a personal service corporation, electing S corporation status or making modifications to bonus or equity structures may be appropriate due to an IRS challenge.

Tax strategies

Personal Service Corporations: How to Address IRS Scrutiny

  • 6/21/2016

In most states, people who offer professional personal services — architects, engineers, legal and physician practices — run their practice as personal service corporations (PSCs). A PSC offers a host of benefits, including tax efficient fringe benefits, more options for retirement savings, and flexibility in how profits are distributed and taxed.

The eight fields that are considered personal services corporations

Any activity of the taxpayer that involves the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting (as defined in Reg § 1.448-1T ) are treated as the performance of personal services.

But the IRS is scrutinizing this entity structure, asserting that certain approaches to compensation can skirt tax law. At issue is the way in which year-end bonuses are paid. 

The most recent case involved a Chicago law firm, Brinks Gilson & Lione. This firm had a history of reducing taxable income to zero and providing the shareholders of the company with no rate of return on their investment through stock appreciation or dividends. The IRS asserted that an “independent investor” would demand a rate of return on his or her investment and would not allow for all the profits to be paid to the shareholders as employee compensation. 

In light of this and other court cases discussed below, it is important that you evaluate your tax classification and year-end bonus and equity structures to minimize the risk of an IRS challenge. 

Prior court cases 

Back in 2001, the Pediatric Surgical court case showed us there was a potential problem when the shareholder-employees paid themselves compensation which represented the profit generated by nonshareholder-employees. 

In Mulcahy, Pauritsch, Salvador & Co. in 2011, the court used an independent investor test as the basis for its ruling: Consulting fees paid to the owner’s related entities would be more properly characterized as dividends. The judge ruled that “…when a thriving firm that has nontrivial capital and reports no corporate income, it is apparent that the firm is understating its tax liability.” 

In all of these cases, the IRS prevailed in the courts, resulting in substantial tax and penalties to the corporations involved. 

S corporation as an alternative solution 

Personal service corporations with eligible shareholders may elect to be taxed as S corporations. An S corporation structure gives a business the more desirable “single layer” of taxation, and thus does not result in the significant tax consequences that would otherwise occur if the IRS re-characterizes certain payments made to shareholder-employees. If a PSC elects to become an S corporation, the remaining issues around year-end bonuses/compensation and equity structures are greatly reduced. 

Generally speaking, an S corporation does not pay taxes at the entity level. It passes out the profits to shareholders via a Schedule K-1. Shareholders then pay tax on those profits at the individual level. Typically, when the shareholders receive a distribution of cash representing the current or historic S corporation profits from this entity, it is considered a tax-free return of capital. 

In pursuing S corporation classification, you need to spend time determining if the corporation has built-in gains (BIG) assets. BIG assets are taxed at the corporate level (BIG tax) even after a C corporation becomes an S corporation. As an example of a BIG asset, think of accounts receivable of a cash-basis entity. The receivables were earned while the company was a C corporation, and were never taxed. When they are collected after the company becomes an S corporation, they are subject to the corporate-level BIG tax. To implement a strategy to help reduce your exposure to the BIG tax, there are two primary strategies for you to consider: 

  • Accrue compensation in an amount greater than receivables, and pay out within two and a half months of year-end 
  • Avoid showing any profit for first five years of S corporation existence 

Bonus structures 

In the court cases above, the IRS is targeting compensation payments that are shared equally or based on an individual’s stock ownership, and attempting to reclassify them as dividends. The thinking is that these payments do not represent income actually generated by the shareholder-employees; therefore the income is properly characterized as income generated by the corporation as a whole and would be a dividend distribution instead of compensation. 

In an attempt to mitigate the risk of having a bonus/compensation structure that the IRS would target, the following are optimal: 

  • Merit-based payments — Those who drive greater volume and value deserve greater compensation
  • Nonshareholder participation — Bonus structures that include nonshareholders are an indication that there is no “disguised dividend” in the bonus payment 
  • Shareholder payment — Compensation structures that do not provide a significant increase in pay when an employee becomes a shareholder 
  • Payment consistency— Compensation structures that do not fluctuate significantly up or down during good and bad years 

Equity structures 

It is important that profitable companies provide a reasonable rate of return to their shareholders as investors. The return should, at a minimum, be based on the tangible capital of the company. In the Brinks Gilson & Lione case, the court acknowledged that the return on investment should also include the intangible value of the company. 

A return on investment may come in the following manner: 

  • Annual dividend 
  • Increase in stock value through retained income of the corporation 
  • A combination of both 

Unfortunately there is no guidance as to what constitutes a reasonable rate of return for an independent investor. 

Many personal service corporations have buy-in and buy-out structures that have a predetermined price for shareholders buying in and out. For example, the buy-in might be $25,000 and the buy-out is also $25,000. Although this approach is not prohibited, it is not possible to argue that the corporation is providing the shareholders a reasonable rate of return through stock appreciation. In this sort of arrangement, an annual dividend should be considered. 

If you are paying a dividend, you will need to consider the tax ramifications of this payment. In order to pay out $100,000 in dividends, the corporation must retain cash equal to the dividend plus whatever cash is needed to pay taxes on the income, as a dividend is not a deductible expense. It is likely that a corporation looking to pay a dividend of $100,000 would need to retain in excess of $150,000 of profits to cover the dividend payment and related taxes. 

How we can help 

In light of recent actions by the IRS, personal service corporations should take a close look at whether they exhibit any of the warning characteristics mentioned here. The outcome of having the IRS reclassify compensation as nondeductible dividend payments comes at a high price. Companies will want to determine whether their actions and structure put them in a comfortable position — or expose them to heightened IRS scrutiny. Our tax practitioners can help determine if payment, bonus, and tax structures are at risk for IRS scrutiny and help you develop a tax plan to address it.