Personal Service Corporations & Unreasonable Compensation
A topic that has been a long standing issue with the Internal Revenue Service (“IRS”) is the determination of whether or not the compensation paid to shareholders is reasonable. While all corporate taxpayers need to be cognizant of this matter, it is of particular interest to personal service corporations.
PERSONAL SERVICE CORPORATIONS
According to the IRS Publication 542 a corporation is deemed to be a personal service corporation if it meets the following requirements:
- Its principal activity during the “testing period” is performing personal services. Generally, the testing period for any tax year is the prior tax year. If the corporation has just been formed, the testing period begins on the first day of its tax year and ends on the earlier of:
- The last day of its tax year, or
- The last day of the calendar year in which its tax year begins.
- Its employee-owners substantially perform the services noted in number one above. This requirement is met if more than 20% of the corporation’s compensation cost for its activities of performing personal services during the testing period is for personal services performed by employee-owners.
- Its employee-owners own more than 10% of the fair market value of its outstanding stock on the last day of the testing period.
Personal service corporations, which are sometimes known as professional corporations, include any activity performed in the fields of healthcare. Professional corporations also include incorporated physician practices. Personal service corporations are taxed similar to C corporations, but with a flat Federal corporate income tax rate of 35 percent rather than a graduated rate.
BACKGROUND
It is the contention of the IRS that many closely held businesses operating as a C corporation attempt to limit taxable income through additional compensation paid out to shareholder owners. Since wages paid to employees/shareholders are considered tax-deductible business expenses, personal service corporations are likely to pay out all business income to shareholders in the form of salaries, bonuses, and fringe benefits, thus reducing corporate taxable income to zero at year end.
The issue of unreasonable compensation (non-fair market value) has been investigated and challenged by the IRS over the past decade. The IRS has approached tax deductions taken for unreasonable/excessive compensation aggressively; claiming that inflated compensation, which typically comes in the form of year-end bonuses, is merely disguised dividends.
A copy of, Pediatric Surgical Associates, P.C., v. Commissioner, TC Memo 2201-81 can be accessed at the healthcare services section of our Firm’s website
The IRS believes and has proven that not all of the amounts paid out in salaries and bonuses represent reasonable compensation for services provided or time expended in the business by the employee shareholders. If the IRS can demonstrate that a portion of those amounts paid out as wages is actually a disguised dividend, then the practice can be forced to reclassify the deduction, resulting in taxable income for the professional corporation at a flat Federal corporate income tax rate of 35%.
Dividend payments made by C corporations to their shareholders are accounted for as a return on investment in the business, and not a tax deductible expense; thereby leading to the term “double taxation”. The dividend is not deductible by the corporation, which results in corporate taxable income. At the same time, the dividend is received by the shareholder and is therefore taxable on the individual’s personal income tax return.
U.S. TAX COURT DECISION ON PEDIATRIC SURGICAL ASSOCIATES
The 2001 U.S. Tax Court decision in Pediatric Surgical Associates, P.C. v. Commissioner was a wakeup call for personal service corporations. In addition to showing that there was a reason to be concerned about unreasonable compensation, it also created a legal precedent. IRS Code §162 states that for compensation to be deductible, it must be both reasonable and purely for services rendered.
In the U.S. Tax Court Case, Pediatric Surgical Associates, P.C., v. Commissioner, a Texas professional corporation engaged in practicing pediatric surgery, employed six physicians, four of which were shareholders who were paid base salaries but were also entitled to discretionary bonuses. The IRS audited the shareholder compensation and disallowed a significant amount of the shareholders’ compensation, citing that it was in fact disguised non-deductible dividends. Ultimately the U.S. tax court, it was ruled that the net profits of the professional practice that were attributable to non-shareholder efforts could not be paid to shareholders as compensation because these amounts were not purely for services rendered by the shareholders.
CONCLUSION
The outcome of the Pediatric Surgical Associates, P.C. Tax Court case placed a heavy burden on other personal service corporations due to the need to prove that their “excessive” compensation was indeed related to services rendered by the actual shareholders of the corporation.
This case posed the biggest threat to healthcare professionals because their services are typically accounted for on an individual basis, as opposed to other personal service type industries, which are considered to use a more collaborative approach. Even today, this is a tax issue that all personal service corporations (especially those in the healthcare industry) should keep in mind when reviewing their current compensation policies.
A copy of, Pediatric Surgical Associates, P.C., v. Commissioner, TC Memo 2201-81 can be accessed at the healthcare services section of our Firm’s website.
For more information on the topics discussed or services we can provide, please contact:
Scott Mariani, JD, Partner
Practice Leader
973.898.9494 ? [email protected]
Questions or comments?
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To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
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