Avoiding shareholder-employee compensation pitfalls

While the vast majority of law firms are organized as partnerships or LLPs, there are still some law firms organized as C corporations or personal service corporations (PSCs). PSCs face a unique challenge when it comes to compensating their shareholder-employees. As total income for the year is not easily predicted, PSCs tend to pay out more modest salaries to shareholder-employees throughout the year. Also, as clients generally want to get a deduction for their legal services by December 31, revenues in the last two months of the year can be significantly higher than in earlier months. Because of these factors, many firms pay bonuses to shareholder-employees at year-end. Many firms also pay bonuses to associates and other employees at the same time. Any income that is retained by the firm at year-end is taxed at a flat 35 percent federal tax rate.

Now a recent US Tax Court case puts into question this practice of reducing a PSC’s profits in the form of shareholder-employee compensation and bonuses. In this instance, the court ruled in favor of the IRS and against Brinks Gilson & Lione PC, a PSC law firm in Chicago (Brinks), that a significant portion of their annual shareholder-employee compensation should instead be treated as nondeductible dividends. For additional information about the Brinks Gilson & Lione PC court decision, please see Baker Tilly's whitepaper, Discerning compensation from dividends for shareholder-employees.

Compensation versus dividends

Compensation paid to shareholders for services is a deductible expense to the PSC, whereas dividend payments to shareholders are not deductible by the PSC. Therefore, payments to shareholders in the form of compensation rather than dividends are preferred by PSCs because those payments lower the overall tax bill. As there are no hard-and-fast rules for estimating “reasonable” compensation, the challenge lies in determining what constitutes a reasonable compensation for services performed and what should be classified as dividends.  

Brinks Gilson & Lione PC case

In examining the case, Brinks was found to have a multitude of policies and practices regarding shareholder-employee compensation that left them vulnerable to IRS challenge.

Here are the critical items to note:

• Shareholder-employees were paid year-end bonuses in exact proportion to budgeted compensation and overall ownership percentages. This left little room to argue that the compensation was based on services and the performance of individual shareholders.
• Associates and non-attorney staff were paid bonuses during the year, but not at year-end. If bonuses for all employees were paid at the same time, it would help support the argument that bonuses were not paid strictly to manage income, but were based on individual performance.
• Stock ownership for shareholder-employees mirrored compensation. Many professional firms annually adjust ownership to coincide with compensation. We recommend that ownership and compensation arrangements remain as independent as possible with separate criteria for each.
• Brinks reduced their book income to exactly zero for years 2007 and 2008. Again, this was an indicator to the court that Brinks’ main objective was to manage income at year-end.
• Brinks conceded the underlying compensation versus dividend issue without obtaining penalty relief. Had Brinks initially not conceded to the service, it is still debatable whether they would have been successful. However, it is important to understand that negotiating for waiver of penalties should always be a part of any agreement entered into with the IRS.

The IRS is cracking down on PSCs attempting to disguise payments to shareholder-employees as compensation rather than dividends. It is important to note that some of Brinks’ practices might mirror other PSCs and are not uncommon in the industry. As such, administrators and directors of PSCs need to adhere to a few key best practices regarding shareholder-employee compensation:

1. Be proactive in documenting shareholder compensation arrangements within the corporate minutes and within internal policy documents.
2. Tie compensation paid to shareholder-employees to the performance and services each individual provides rather than to ownership.
3. Apply the shareholder compensation program consistently from year to year and try to plan for steady, consistent growth rather than substantial spikes up or down.
4. When planning for year-end bonuses, try to let some profits be retained by the PSC. Bringing net income as close to zero as possible could be a potential red flag, plus retaining some funds can help the PSC to manage short-term working capital needs.
5. Try to time bonuses to non-shareholder attorneys and staff near year-end when possible.
6. When shareholders invest large amounts of capital, consider establishing a dividend payment policy to shareholders.  

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.