Professional Service Firms

Tips for Owners of Professional Service Firms

Have You Documented the Services You Provide?
law-booksOwners of professional service firms do not usually keep logs of their daily activities except to the extent that they need those records for client billing purposes.  However, Internal Revenue Code section 6001 and Regulation section 1.6001-1(a) specifically require that these firms:

"shall keep such permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return of such tax or information."

Owners of professional service firms should realize that client billing records may not be enough to substantiate the total value of the services they provide in exchange for their compensation.  These professionals often provide valuable services that are not reflected in client billing records, such as business development, training, administrative tasks, and guaranteeing firm debts.

If the compensation amounts that were paid to a shareholder-employee become an issue during an IRS examination, accurate records of the shareholder's broad range of duties will be essential.  A recent Tax Court case illustrates just how high the bar is set.  This case involved an ophthalmology surgery and care center which had four locations in Illinois and employed around 50 people.  Among those employees were five physicians who could perform surgery, three optometrists, three nurses, two surgical technicians, ten non-surgical technicians, and fifteen other non-administrative employees.  This medical practice was a C corporation owned by one surgeon.

The Tax Court also acknowledged that the shareholder's patient load increased because another doctor began to reduce her workload in anticipation of leaving.  Despite the increased workload, the IRS had claimed that the shareholder had been paid unreasonable compensation in 2007.  His total compensation for that year was $2,780,000, which included four bonuses of $500,000 each late in the year.

In its published opinion, the Tax Court said:
"Taxpayers are required to substantiate each claimed deduction by maintaining records sufficient to establish the amount of the deduction and to enable the Commissioner to determine the correct tax liability."

The court also wrote:
"Generally, the Commissioner's determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving that those determinations are erroneous."

After acknowledging that the shareholder's workload had increased, the court stated:
"However, petitioner did not provide any methodology to show how Dr. Ahmad's bonus was determined in relation to these responsibilities.

Petitioner did not explain how the amount of the bonus was determined and why it was divided into four payments.  Dr. Goyal left in June, and Dr. Ahmad increased his surgeries and therefore billings as a result.  Petitioner did not explain how the increased billings translated to bonus payments."

Therefore, the Tax Court agreed with the IRS and re-characterized the $2,000,000 of year-end bonuses as dividends.

In this published opinion, there was no mention of any compensation expert witnesses being involved.  Midwest Eye Center, S.C., T.C. Memo 2015-53

Tip: Electronic calendars and emails can be helpful in documenting a professional’s work hours and activities. However, they must be kept long-term, since an IRS auditor may not ask for them until a couple years after the year has ended and a tax return has been filed. Although helpful, these types of records are not enough to justify large bonuses without some analysis.

Are You Following Your Compensation Agreements?
Professional service firms are often set up as S corporations which may help reduce the payroll tax burden.  However, professionals need to be careful when determining how much their S corporations pay them in compensation, and how much net income is distributed to them without payroll taxes and withholding.

Sean McAlary was a licensed real estate agent in California who incorporated his practice under the name Sean McAlary Ltd, Inc.  The corporation elected to be taxed as an S corporation.  Mr. McAlary was the President and sole shareholder.  He also was the only person working for the firm that held a real estate broker's license.  He managed all aspects of the company's operations including recruiting and supervising sales agents and conducting real estate sales.  He helped the company grow by increasing the number of sales agents and associate brokers on the company's staff during 2006.  Mr. McAlary supervised eight sales agents but most of the company's gross receipts were attributable to sales commissions generated by Mr. McAlary.

During the year at issue, the company transferred $240,000 to the personal account of Mr. McAlary.  However, the company treated this amount as distributions and did not issue a Form W-2 or report any amount as shareholder compensation.

The IRS issued a notice of determination of worker classification, with the intent of reclassifying some of the distributions as compensation subject to payroll taxes.

In a summary opinion (which is not to be treated as precedent for any other case), the Tax Court stated that for federal employment tax purposes, an employee is defined as "any officer of a corporation" (Code section 3121(d) (1)).  The court also acknowledged that the IRS "may re-characterize a distribution as compensation in order to reflect the true nature of the payment."

The company had a compensation agreement with Mr. McAlary which set his annual base pay at $24,000.  However, the Tax Court stated, "we are not persuaded that the remuneration agreement represents a sound measure of the value of the services that Mr. McAlary provided to the petitioner during 2006."  The court disregarded the remuneration agreement and looked at a number of factors including Mr. McAlary's qualifications, work hours and duties.

The IRS brought in an expert witness (Igor Ostrovsky, an employee of their engineering and valuation program).  He performed an analysis which included the use of comparability data from various sources.  The court used an hourly rate based on that analysis to reclassify $83,200 of distributions as compensation subject to payroll taxes.

In addition, the Tax Court upheld penalties, despite the corporation's efforts to claim that it had reasonable cause because it had relied upon a tax preparer, Mr. Botta.  The court would not waive the penalties since, "there is no evidence that petitioner investigated Mr. Botta's background or qualifications or that petitioner otherwise confirmed that Mr. Botta was a competent professional who had sufficient expertise to justify reliance on his advice."

Sean McAlary Ltd, Inc. v. Commissioner, T.C. Summary 2013-62

Tip: If you have a written compensation agreement, it’s better to comply with it than to ignore it, but be sure the terms are fair and reasonable.  As the business grows and changes, the agreement may need to be updated.

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"Do your job and demand your compensation - but in that order."
~ Cary Grant

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Have You Carefully Considered what Generated the Revenue?
Large amounts of shareholder compensation may be considered to be reasonable if that compensation is paid to a solo professional based on the fees generated by his or her own work, i.e., a solo practitioner with no leverage (ability to make income) from other employees or equipment.

For example, one law firm paid its sole shareholder high compensation after receiving a large contingent fee.  The compensation was held to be reasonable despite the fact that some of the compensation deduction was used to create an NOL to recoup previously paid corporate income tax.

Richard Ashare, PC was a C corporation that provided legal services through its sole shareholder-employee, Richard Ashare, and his secretary.  For a number of years, the practice consisted almost entirely of one case that was finally settled in 1989, and the law firm received over $12,000,000 in legal fees.

No dividends were ever paid and approximately $10,000,000 was paid as compensation to Mr. Ashare between 1989 and 1992.  In 1993, the corporation paid Mr. Ashare compensation of $1,750,000 that resulted in a net operating loss that year.  (The 1993 loss created an NOL carryback to a preceding year.  That carryback produced a tax refund of almost $600,000 for that prior year.)

The IRS contended that the main reason the corporation paid Mr. Ashare the $1.75 million in 1993 was to capture that tax refund, and not to compensate him for his services.  However, the Tax Court sided with the law firm, and gave the Board of Directors wide latitude, finding that it had established Mr. Ashare's compensation in 1993, believing that his services were worth $1.75 million in 1993, notwithstanding that this compensation far exceeded the firm's revenues in that particular year.

Applying the Business Judgment Rule, the court refused to "second guess the board's wisdom."

The board was composed of Mr. Ashare, his spouse and his tax adviser, and their meeting had occurred on the telephone to fix his compensation in accordance with an "unwritten compensation policy" under which Mr. Ashare himself "sets the specific amount of compensation."

In holding his compensation to be reasonable, the Tax Court stated:
"We have no doubt that the $1,750,000 paid to Mr. Ashare meets the first test for deductibility, i.e., it is reasonable in amount as to the compensation that a personal service corporation such as Petitioner can pay its key employee in a year for his service.  Mr. Ashare's qualifications for his position with Petitioner justify high compensation, as does the fact that he is vital and indispensable in Petitioner's operation and success.  Petitioner's business also is complex and highly specialized, and it demands a person of Mr. Ashare's expertise."

Richard Ashare, P.C. v. Commissioner T.C. Memo. 1999-282

Tip: Carefully analyze what generated the revenue.  Was it the shareholder-employee?  Was it other employees?  Tangible assets such as equipment or intangible assets such as trade secrets?  Was it professional goodwill or enterprise goodwill?

Compensation Issues in Shareholder Disputes
Although (un)reasonable compensation issues often come up in IRS audits of professional service firms, similar issues are also raised in shareholder disputes.

Firms with multiple owners should ensure that they have workable agreements with respect to how their compensation amounts will be determined.  They should also address the timing of payments for bonuses, guaranty fees and non-compete agreements.  Rules of thumb may not work.  

Compensation issues can also come up when a shareholder goes through marital dissolution.  The estranged spouse of a shareholder may question compensation amounts since that can affect the firm’s valuation and the shareholder’s ability to pay alimony.

By having workable agreements in place, the owners may be able to reduce the chance of lengthy, disruptive and expensive litigation.

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A consultant is someone who…
Congratulates business owners on successful value creation,
Reads professional journals every evening,
Thinks that whoever retires with the most frequent flyer miles wins, and
Uses footnotes in all correspondence.

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Disclaimer

Information on this website is provided for discussion purposes only and should not be construed as advice for any specific situation.  Please seek wise counsel before making decisions.  Atlantic Executive Consulting, LLC is a consulting firm and does not provide legal advice or investment advice.