Taxpayer losses in two recent Tax Court cases serve as reminders that physician and other incorporated medical practice groups should take care in the “zero out” approach to the payment of compensation to the group’s owners and that success in this area may depend on whether the practice is organized as a “C” corporation or has elected to be taxed as an “S” corporation and if the practice group is owned by one or more professionals. Regardless of whether the practice group is organized under local law as a professional corporation (PC) or a professional association (PA), is taxed as a “C” corporation or as an “S” corporation for federal tax purposes, the entity typically compensates its physicians or other licensed professional shareholders by payment of base compensation that constitutes an advance estimate of a pre-determined percentage of budgeted annual operating profits.  Once actual year-end operating results are determined (or reasonably estimated), prior to its taxable year–end, the PC or PA pays a bonus to members of the practice group based on its distributable cash using the formula adopted by the practice group members to pay annual compensation to and among its professionals. These bonuses “take into account” the amounts previously paid to each professional as base compensation during the year.  Through the payment of year-end bonuses, the taxable income of the PC or PA is reduced to zero or a nominal amount. Because the bonuses are deducted by the PC or PA as a compensation expense, if the group is organized as a “C” corporation, the PC or PA typically pays little or no federal income tax.  By contrast, if the group is organized as an “S” corporation, the group may treat the payments to its professionals who are shareholders as dividends and not as wages to avoid the payment of self-employment income taxes on the amounts distributed to the practice group’s owners.

In a case decided in January, 2021, Aspro, Inc., TC Memo 2021-8, the Tax Court found that payments made during each of three tax years by the taxpayer, a “C” corporation, to its three shareholders were non-deductible dividends and not deductible as compensation for personal services provided to the corporation.  The court noted that the corporation had never previously paid any dividends to its shareholders, the payments were made in roughly the same proportions as share ownership of the taxpayer and that two recipients of the payments were corporations that were shareholders of the taxpayer and were “paid” for services performed by the individuals who owned these two shareholder-corporations.  Finally, the court noted that the personal services that the taxpayer alleged were performed throughout the entire year but the payments were made annually and the payments eliminated almost 90% of the taxpayer’s taxable income in two of the three years and just under 80% of the taxable income in the third year.

In reaching its decision, the Court relied on a tax regulation that limits deductible compensation for services only to amounts paid “as the purchase price for services” and that payments made that “correspond or bear a close relationship to the stockholdings of the officers or employees” are subject to recharacterization as dividends.  Since the payments were not deductible, the taxpayer was found to be liable for corporate income taxes based on its net income determined without the denied compensation deductions.

In the March, 2021 decision, Lateesa Ward, TC Memo 2021-32, the Tax Court found that payments made to an attorney who was the sole shareholder of a law firm organized as an S corporation were subject to employment taxes and could not be treated as distributions of the firm’s net income (i.e., as dividends).  As a result, these payments were subject to self-employment tax both on the employer side and on the employee side.[1]  In this case, the IRS asserted that the payments made by the corporation to its owner should be taxed as compensation subject to self-employment taxes and not as dividends.  In upholding the IRS’s recharacterization of the payments, the Tax Court pointed out that the payments in question had been reported on the law firm’s corporate income tax returns Form 1120-S as officer compensation and wages, but that the corporate taxpayer had not included these payments in its Form 941 employment tax returns that properly reported employment taxes paid to a non-shareholder attorney employed by the firm and the shareholder of the law firm had incorrectly reported the compensation as dividends of the firm’s earnings and profits (not taxable since the attorney had cost basis in her stock) and not as wages subject to employment taxes.  Notably, as to the attorney’s treatment of the payments she received from her law firm on her personal income tax returns, the Tax Court found that the attorney should have reported all payments she received from the law firm as compensation for services.

Even though the Ward case is instructive on a stand-alone basis only to illustrate that physician and other practice groups should engage competent accountants or tax preparers, several lessons can be learned from the Aspro and Ward cases taken together.

Lesson 1:  For a practice group organized as a C corporation that wants to claim compensation deductions for payments made to its owners, the entity should make periodic payments during the year based on services rendered and not “bonus out” large chunks of otherwise taxable income at year-end.

In the Aspro case, the taxpayer “C” corporation did not make any payments for services until year-end.  The Tax Court cited several cases in support of its conclusion that payments made in a lump sum at the end of a year rather than throughout the year should be viewed as disguised distributions of profits.

Lesson 2:  For a practice group with one or more corporate shareholders (typically a wholly owned “S” corporation) that intends to claim compensation deductions for services provided by the professionals that own the corporations, the entity should make the payments directly to the individuals that own the corporate shareholders of the practice group even though that may defeat the purpose of the use by a member of the practice group of a corporation to own his or her equity ownership of the practice group.  The Tax Court in Aspro concluded that the taxpayer’s payments of compensation to its corporate shareholders rather than to the individuals who actually performed the services “indicate a lack of compensatory purpose”.

Lesson 3:  Don’t get greedy.  For practice groups organized as C corporations, declare a dividend each year that is paid to all its shareholders based on proportionate stock ownership.

In the Aspro case, the Tax Court cited as an additional factor in support of its denial of the compensation deduction the fact that since its formation, the taxpayer had never paid dividends to its shareholders. This fact “indicates a lack of compensatory purpose”.  These payments also represented a significant portion of taxable income of the taxpayer.

Lesson 4:  Enter into employment agreements with practice group members that contain objective compensation formulae.

In the Aspro case, the Tax Court found that the fact that the taxpayer had paid its two corporate shareholders the same amount each year (even though the actual amount paid each year varied) indicates the payments “were determined on the basis of their equal ownership interests, not on a good faith valuation of the services they provided”.  To reduce the potential attack on payments by a practice group organized as a C corporation, the practice group should enter into employment agreements with each professional who provides services to the practice entity that contains objective formula for determining compensation.  By doing so, the entity could object to any re-characterization of contractually required payments for services rendered by its employed professionals since the entity would be in breach of its employment agreements if it fails to pay the amounts as required under the agreements with its employed professionals.

Lesson 5:  For practice group entities that are organized as S corporations that are owned by sole shareholders, payments to the sole shareholder will usually be treated as compensation subject to self-employment taxes.

The Ward case is instructive for the proposition that but for services provided by the sole shareholder and any other employed professionals of practice groups organized as S corporations, the practice entity would not have generated gross income.  As a result, the payments by the S corporation should be treated as compensation for services provided.  As noted by the Tax Court, “any compensation paid to Ward in her role as an officer is considered wages” since the individual taxpayer Ward did not offer any evidence otherwise.

Originally published in Healthcare Michigan, April 2021.

About the Author:

Ralph Levy, Jr. is Of Counsel at Dickinson Wright PLLC in the Nashville office. Ralph has over 30 years of experience in counseling clients in the Healthcare arena. He has served as General Counsel for a national health care services provider and manufacturer of medical equipment where he gained critical operating experience and an appreciation of the need for businesses to manage their legal matters in an efficient but proactive manner. Ralph can be reached at 615-620-1733 or rlevy@dickinsonwright.com and you can visit his bio here.

[1]          In Ward, both the law firm and its individual shareholder were taxpayers whose returns were audited by the Internal Revenue Service.

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