Reasonable Compensation for Personal Service Corporations

iStock_000005794823LargeIn Midwest Eye Center, S.C. v. Commissioner, T.C. Memo. 2015-53, the Tax Court held that $1 million of a $2 million bonus paid to the physician sole shareholder of a personal service C corporation was a non-deductible dividend distribution.

Factual Background. The taxpayer, Midwest Eye Center, Inc. (“Midwest”), was a C corporation that conducted an ophthalmology surgery and care center.  Midwest employed around 50 employees, including physicians, nurses, technicians and administrative staff.  Midwest had at least one manager at each of its four locations, a full-time billing specialist, a number of front office staff and a bookkeeper.

Dr. Ahmad was the president, medical director, and 100% shareholder of Midwest.  Dr. Ahmad also served as Midwest’s CEO, COO and CFO, which roles required him to perform various managerial tasks, as well as being an active surgeon in the practice.

In 2007, Dr. Ahmad’s workload significantly increased because one of Midwest’s busier surgeons quit unexpectedly, and the only other retinal specialist was reducing her workload in anticipation of starting her own practice.  Consequently, in addition to his regular salary of $785,000, Midwest paid Dr. Ahmad a larger-than-usual year-end bonus of $2 million by four separate checks of $500,000 each.  Dr. Ahmad’s bonus was large enough relative to the pre-bonus profit to create a net operating loss of $50,434 for 2007.

I.R.C. § 162(a)(1) allows taxpayers to deduct ordinary necessary expenses, including a “reasonable allowance for salaries or other compensation for personal services actually rendered.”  Consequently, compensation is deductible only if:  (1) it is reasonable in amount; and (2) it is paid or incurred for services actually rendered.  In Midwest, the IRS determined that the bonus did not constitute reasonable compensation and disallowed $1,000,000.

tax iconTax Court Analysis. On the issue of the reasonableness of the compensation paid by Midwest to Dr. Ahmad, the Tax Court held that Midwest had the burden of proof.  The Tax Court found Midwest failed to carry its burden for several reasons:

  • Midwest produced no evidence of comparable salaries, arguing that there were no “like enterprises” under “like circumstances” from which to draw comparisons;
  • Instead, Midwest argued that Dr. Ahmad’s large bonus was reasonable due to his increased workload during 2007, and the many positions and attendant managerial duties those positions entailed. However, Midwest did not provide any methodology to show how Dr. Ahmad’s bonus was determined in relation to those responsibilities;
  • Midwest did not explain how the amount of the bonus was determined or why it was divided into four payments; and
  • Midwest provided no evidence to demonstrate that the full $2 million bonus was reasonable.

Finding that Midwest had failed to show that the bonus constituted reasonable compensation, the Tax Court did not reach the issue of whether it was paid or incurred for services actually rendered and affirmed the Service’s recharacterization of $1 million of the $2 million bonus as a nondeductible dividend distribution.

Good News for Personal Service S Corps? For S corporation taxpayers, litigation over “reasonable compensation” invariably falls in the opposite direction, i.e. the sole shareholder draws little to zero salary, and instead takes the company’s entire annual net profits as a distribution.  Unlike salary, distributions to a materially participating S corporation shareholder are not subject to self-employment tax or the 2.9% Medicare tax.  Thus, the shareholders would save over 15% by employing this structure.

Correspondingly, the IRS has targeted these arrangements in a host of cases, e.g. JD & Associates, Ltd. v. U.S., Watson v. U.S.and McAlary Ltd., Inc. v. Commissioner.  The decision in Midwest can be taken as further support for the principle that it is not “reasonable” that all of a corporation’s income be paid out as compensation to its sole shareholder.  Considering Dr. Ahmad’s substantial base salary, if Midwest had made an S election and then distributed the $2 million as a dividend, it is likely that the IRS may not have even challenged it based on current caselaw.  This would have saved around $60,000 in payroll tax.  Instead, as a C corporation, Midwest was liable for over $300,000 in corporate income tax.

Yet another reason for personal service corporations to make an S election.