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Unreasonable compensation in PSCs.

Many practitioners routinely advise clients that a personal service corporation (PSC) may pay very high salaries to the key shareholder-employees who provide the corporation's services without worrying about having them reclassified as dividends--still taxable to the employee, but not deductible by the corporation. Generally, excessive compensation issues arise in "product," as opposed to "service," enterprises, in which something--usually some form of capital--other than the individuals' efforts is responsible for generating the corporation's net income.

Some recent cases indicate that this advice may need to be reconsidered. Sec. 162(a)(1) permits deduction of a reasonable compensation for services actually rendered. Regs. Secs. 1.162-7 and 1. 162-9 echo these words and add three concepts: (1) the payments must be purely for services; (2) both cash and in-kind payments count; and (3) donations cannot be deducted.

The often-cited Elliotts case, 716 F2d 1241 (9th Cir. 1983), concerned a farm equipment dealer (definitely not a classic personal service business). The court stressed five factors in its decision: (1) the shareholder-employee's role in the company; (2) what similar companies paid similar employees; (3) the size and complexity of the company's business and its economic climate; (4) the shareholder-key employee conflict of interest and the need for fairness to the shareholder; and (5) the internal consistency of the key employee's compensation--consistent not only with the compensation of other employees, but also with the employer's compensation formulas, operative incentive system, employment contracts and, presumably, corporate minutes. Subsequent cases seem to use combinations of these factors--variously weighted for various facts and circumstances--to reach their decisions.

The most important thing to remember in examining recent service corporation cases is that the results are very dependent on the facts and circumstances of each case. The next most important factor is that the first court that considers the facts and circumstances of a case is the one that has prime jurisdiction. Later appeals must show clear error on the original court's part to have its decision changed. of late, the Tax Court seems to be the jurisdiction in which the IRS is having the most success. All of these factors may make early construction of the taxpayer's factual case and successful satisfaction of the IRS's concerns the most crucial elements of success.

Four recent cases are particularly enlightening. All concern classic personal service entities, under both the general concept of Secs. 269A(b)(1) and 441(i) and the more specific one of Secs. 11(b)(2) and 448(d)(2), although only two concerned tax years in which the restrictive tax rules for PSCs came into play. They concern various degrees of service leverage, ranging from sole husband-wife shareholder-employee teams up to groups of 70-plus nonshareholder-employees. All concern situations I involving closely held stock.

The first of these cases is Owensby & Kritikos, 819 F2d 1315 (5th Cir. 1987). Here, there were payments to key individuals--consulting engineers, most (incidentally) related by blood or marriage--by a group of commonly controlled C and S corporations employing over 80 people. The years involved were 1978 and 1979, during which there was a 70% tax on dividend income (versus the 50% limited tax rate applicable to earned income). In all of the entities, the court determined that capital was not a material income-producing factor. The key shareholder-employees all made over $500,000 in 1978 and 1979, and the majority of them made over $800,000 each year. There was a close correspondence between shareholdings and compensation patterns.

The Fifth Circuit did a complete Elliotts analysis in reaching its verdict. It found the key employees crucial to corporate success, and noted that they wore the maximum possible number of employee "hats." It noted that the companies were led through complex and difficult environments by the key individuals. it further noted that the net income not paid out as salaries should have satisfied any independent shareholder-although given the low capital base displayed, this may not have been crucial--and noted that many independent shareholders invest willingly in entities that do not pay dividends, preferring instead growth stocks. Where the court focused its attention were the second and fifth Elliotts criteria.

Crucial to the court's decision for the IRS was the selection of what constituted similar companies for compensation comparisons, and what the unrelated nonshareholder-employees were paid. it found that the taxpayer's expert had focused on the wrong group of publicly held entity salary comparables, and that the employees outside the family group were all being paid less than 20% of the amounts going to the "in" group, implying that one 50% comparison might have saved the day.

The three more recent cases concern a mix of health care professionals and engineers. Richlands, TC Memo 1990-61/20, concerned a group of physicians, three shareholder-associates and 10 or more nonshareholder service providers. The concept of associates arose in the course of an unsuccessful argument that the corporation was really a partnership in disguise. In 1982, the key shareholder-associates all earned over $500,000; one earned over $900,000. The key people had oral employment contracts; the nonshareholders had written contracts specifying everything from straight salaries to 100% of collections for their patient services. The compensation to the shareholder-associates was close in pattern (but not exactly parallel) to their stock ownership.

In reaching its conclusion, the Tax Court gave relatively short shrift to the second and third Elliotts factors, and concentrated on the others. It noted a poor factual demonstration by the associates of their contributions to corporate success beyond that of mere patient services, and a poor delineation of outside comparables in the taxpayer's expert submissions. The most crucial factors seemed to be (1) the relatively underpaid status of the nonshareholder service providers in 1982-the highest-paid one did not make much more than 25% of the compensation of the lowest-paid shareholder-associate; and (2) the fact that the key people all made over twice the net collections from their patient services.

The Tax Court also noted that, once the Service has made its determination of compensatory fairness, the taxpayer has the entire burden of proof that the IRS has erred, and granted penalties in this case.

The two 1994 cases involve a group of health service providers and a group of consulting engineers.

In Curtis, TC Memo 1994-15, there were two shareholder-employees and otherwise a totally leased work force. The physician-husband owned two-thirds of the corporate stock, the nurse-wife, the other one-third. Neither had a written employment contract. Each made over $400,000 in 1988 and 1989, with many significant perquisites as well. Compensation did not parallel stockholdings.

Being prevented from looking at the fifth Elliotts criterion in depth (presumably because of the lack of other employees), the Tax Court proceeded to ignore any problems with the physician-husband's compensation, and concentrated on the nurse-wife. It gave her the first factor handsdown. it found both sides' experts inconclusive on the second factor. On the third factor, it sided mildly with Ms. Curtis, but almost dismissed the factor. It focused on the fourth factor, where it found that a hypothetical outside shareholder would have had a lot of problems with Ms. Curtis's compensation and benefits package. Her case was not aided by the fact that the total compensation paid to Dr. and Ms. Curtis had exceeded the corporation's income before the compensation was paid, throwing it into a net operating loss.

The court noted that written support for shareholder-employee compensation can be only a minor factor in sustaining its deductibility. It also awarded penalties.

In the most recent case, CTI, TC Memo 1994-82, again there was a group of consulting engineers. The year was 1988. The work force varied from 11 to 150 people, but hovered primarily around 11. The sole shareholder-husband was a professional engineer, his wife, an experienced lingerie designer with some bookkeeping and administrative skills who ran the office. He was paid over $500,000; she was paid over $150,000. The IRS tried to disallow everything in excess of their documentable authorized salaries (under $50,000 in each case). Its experts were more lenient on the husband than the wife, but went higher in each case.

The Tax Court cited Elliotts in the opening paragraph of its opinion. It examined the first and third factors in depth, but did not necessarily reach its conclusions based on them. it chose between the two experts, giving the second factor largely to the husband but not to the wife. It virtually ignored the fourth and fifth factors, presumably because they had been ignored in the factual submissions by the parties. The court concluded that the husband should be compensated on reasonably comparable gross revenues generated from services like his rendered by others, and that the wife should be compensated as a very highly paid bookkeeper.

The court analyzed and concluded that on a purely numerical basis, penalties should not apply.

It is difficult to read CTI as standing for anything, other than that the factual showing is critical to taxpayer success. This is not necessarily a case in which the taxpayer was being greedy; rather, it is one in which the facts and circumstances were more poorly arrayed than arranged.

It is interesting that in none of the cases was an argument for automatic deductibility of compensation made because of Sec. 11 (b) (2), the prohibition of graduated tax rates for PSCs, presumably to encourage the stripping of these corporations with shareholder payments. This provision was first introduced in 1987, for years beginning thereafter. At least one of the years in Curtis began after 1987. It may be that Ms. Curtis's counsel failed to consider this argument. It may also be that, without regulations on point, neither the Code nor the committee reports give guaranteed compensation deductibility as even related to the Code provision.

Service businesses can apparently have excess compensation problems. in a planning environment, document the entitlement, file the outside corroboration in event of future need, and be mindful. When a taxpayer plans to pay hefty salaries to spouses, be sure that both spouses are specifically credited for what they plan to do for the company. Revisit the issue of an S election; the additional costs may be well spent in certain circumstances.

In a tax-controversy setting, take the issue seriously. Justify the compensation under all five Elliotts factors. Work with the Service to satisfy all relevant concerns. If litigation is necessary, hire well-qualified experts, and encourage them to do their best work. Consider a venue other than Tax Court (again, the cost may be well spent). Bear in mind that constitutional arguments seldom work in tax cases, but possibly consider issues of latent sex discrimination when a female spouse's compensation is under attack (particularly in community property states). Also, consider that the new rules for PSCs acknowledge that if a taxpayer meets the definition, Congress has implied that profits must be paid out in the form of compensation to prevent unwanted sheltering of service income.

There may be some hope in the fact that the bulk of the cases involve big numbers, and keeping things reasonable may provide some relief.

From Hal McKinney, Jr., CPA, Hood and Strong, San Francisco, Cal.
COPYRIGHT 1994 American Institute of CPA's
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Title Annotation:personal service corporations
Author:McKinney, Hal, Jr.
Publication:The Tax Adviser
Date:Aug 1, 1994
Previous Article:Modifications of legal relationships can have Chapter 14 implications.
Next Article:Election to close S year under sec. 1368 regulations.

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