Law firm is held liable for accuracy-related penalties

The independent-investor test is applied to a corporation that mischaracterized dividends as compensation.
By Beth Howard, CPA, Ph.D.

The Tax Court found that a law firm was liable for accuracy-related penalties related to payments to shareholder attorneys treated as compensation for services that the court determined were in fact dividends. The court determined that the firm did not have substantial authority for treating the payments as compensation, nor did it demonstrate reasonable cause for the related underpayments of income tax or show that it had acted in good faith.

Facts: During 2007 and 2008, the years at issue, the firm Brinks Gilson & Lione PC, with its principal offices in Chicago, employed approximately 150 attorneys, about 65 of whom were shareholders of the firm, in addition to about 270 nonattorney employees. The firm's shareholders owned their shares in connection with their employment in the corporation. They received the shares at a price equal to the shares' book value and upon ending employment were required to sell their shares back to the firm at book value. Each shareholder attorney received compensation from an aggregate budgeted amount in the same percentage as his or her ownership share, with a year-end bonus as an adjustment that, in the aggregate, was intended to reduce book income for the year to zero.

After auditing the firm, the IRS disallowed various deductions, including the year-end bonuses. After negotiation, the parties stipulated that portions of the compensation deduction for shareholder attorney compensation should be disallowed and recharacterized as nondeductible dividends.

Issues: The remaining issue before the Tax Court was whether the firm was liable for a 20% accuracy-related penalty under Sec. 6662 for a substantial understatement of income tax related to the recharacterization of the amounts as dividends. For a corporation, an understatement is considered substantial if it exceeds the lesser of $10 million or 10% of the tax required to be shown on the tax return for the year. The understatement is reduced by any portion attributable to the treatment of items for which the taxpayer had substantial authority. Further, Sec. 6664(c)(1) offers an exception to the accuracy-related penalty if the taxpayer can show that it had reasonable cause for the underpayment and that it acted in good faith.

The firm cited Law Offices—Richard Ashare, P.C., T.C. Memo. 1999-282, in which the Tax Court allowed a corporate law firm to deduct as compensation an amount paid to its sole shareholder that exceeded the firm's revenues for the year. Among several alternative arguments, the firm also argued that the stock held by its shareholder attorneys should actually be treated as debt under the substance-over-form principles, meaning that the year-end bonuses should be treated as deductible interest.

The IRS cited Pediatric Surgical Associates, P.C., T.C. Memo. 2001-81, in which the court held that compensation payments to shareholder employees that could be attributed to the services of nonshareholder employees were nondeductible dividends. And in Mulcahy, Pauritsch, Salvador & Co., 680 F.3d 867 (7th Cir. 2012), the Seventh Circuit disallowed the deduction of consulting fees paid to entities owned by the group's founding shareholders, noting that the treatment of the fees as salary reduced the firm's income to zero or below in two out of three years, while the firm was thriving (see "Tax Matters: Accounting Firm's Payments to Owners Flunk Independent-Investor Test," JofA, Aug. 2012, page 73).

Holding: The Tax Court reasoned that, as in Mulcahy, the instant case should be determined under the "independent investor test," which says that the owners of a business with significant capital are entitled to a return on their investment. While shareholder employees may be indifferent economically to whether their payments are treated as dividends or compensation, the deductibility of compensation biases the corporation toward labeling the payments as compensation, without the same check that would exist if nonemployees owned a significant portion of the company. Thus, courts look at the situation from the perspective of a hypothetical independent investor who is not an employee of the company. In this case, the Tax Court noted that, while the corporation had significant capital, paying out the year-end bonuses zeroed out the firm's income, leaving no return on shareholders' investments and thus failing the independent-investor test.

The firm argued that because its shareholder attorneys held their stock in the corporation in connection with their employment, acquired their stock at a price equal to its cash book value, and were required to sell their stock back to the petitioner at a price determined under the same formula upon terminating their employment, the shareholders lacked the normal equity rights of shareholders. The court disagreed, stating that this did not mean that the shareholder employees did not own the corporation and would not be entitled to a return on their investment. Further, the court, having already determined that the stock was equity, rejected the notion that the year-end bonuses should be treated as deductible interest rather than as dividends. Finally, the court determined that after weighing the authorities, the firm did not have substantial authority for claiming the year-end bonuses as compensation. Thus, the accuracy-related penalties would apply unless the firm could show reasonable cause and good faith.

The firm argued that it relied on what at the time was the fifth-largest public accounting firm in the United States to prepare its tax returns and that this established reasonable cause and showed good faith. It claimed that the accounting firm did not point out any issue with the treatment of the year-end bonuses and that this constituted advice on which it relied. It also pointed to a no-change letter the firm had received from the IRS for the year previous to the two at issue as evidence that its reliance on its accountants was reasonable.

The court did not accept these arguments, noting that the law firm presented no evidence that it asked for, or the accounting firm offered, advice on the deductibility of the year-end bonuses. Moreover, it held, the law firm did not provide the accounting firm with accurate information in showing the year-end bonus amounts as compensation. The court found that the no-change letter was of no consequence because there was no evidence that the IRS examiner for that year had considered the deductibility of the bonuses or that the firm had provided the examiner sufficient information to bring the issue to his attention.

  • Brinks Gilson & Lione, T.C. Memo. 2016-20

—By Beth Howard, CPA, Ph.D., associate professor of accounting at Tennessee Technological University in Cooke-ville, Tenn.

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