The Seventh Circuit held that an accounting and consulting firm organized as a C corporation could not deduct payments to related entities because they were dividends, not compensation for services rendered by the company’s owners.
The firm was founded in 1979 by three accountants. During the tax years at issue—2001, 2002, and 2003—the three founders served as the firm’s board of directors and sole officers. During those years, the firm made payments to three related entities, which then passed those payments on to the founders in proportion to their hours worked for the firm.
The payments to the related entities reduced the firm’s taxable income to zero or nearly zero. The firm initially characterized those payments as consulting fees, but during the trial in the Tax Court, it claimed they were compensation for the founders’ services. A corporation can deduct a “reasonable allowance for salaries or other compensation” (Sec. 162(a)(1)) but cannot deduct dividends.
The IRS disallowed the firm’s deductions for the “consulting fees,” reclassifying them as dividends, and imposed Sec. 6662 accuracy-related penalties on the firm. The Tax Court upheld the IRS’s determinations.
On appeal, the Seventh Circuit, in an opinion authored by Judge Richard Posner, applied the “independent-investor test.” The Seventh Circuit characterized the premise of this test as “an investor who is not an employee will not begrudge the owner-employee his high salary if the equity return is satisfactory; the investor will consider the salary reasonable compensation for the owner-employee’s contribution to the company’s success” (slip op. at 4). However, in this case the payments reduced the firm’s income—and thus its equity return to investors—to zero. Thus, the court held, “the firm flunks the independent-investor test” (slip op. at 8).
The Seventh Circuit rejected the firm’s argument that the consulting fees were really disguised salary. The court noted that the firm did not otherwise treat them as labor expenses: It did not withhold payroll taxes, report them on W-2s, or disclose them on the officer compensation schedule of Form 1120, U.S. Corporation Income Tax Return.
The court also rejected the firm’s argument that the payments could not have been dividends because they were distributed in proportion to the number of hours each founder worked rather than their ownership percentages. The court said this was irrelevant: “[I]f the fees were paid out of corporate income … the firm owed corporate income tax on the net income hiding in those fees. A corporation cannot avoid tax by using a cockeyed method of distributing profits to its owners” (slip op. at 9–10).
The court affirmed the Tax Court’s decision that the payments were taxable dividends and not deductible business expenses and that the firm was liable for the accuracy-related penalty.