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 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.
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:
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:
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.