Originally published on Passive Activities and Other Oxymorons on May 19th, 2011.
Mulcahy, Pauritsch, Salvador and Co., LTD. v. Commissioner
TC Memo 2011-74
I've wavered on whether to give this one the full treatment. It is getting a little stale and it was generating a good bit of schadenfreude on my part, which I find unseemly. The more I look at it, though, the more important it seems. It is about an accounting firm and it brings back ancient memories:
The firm is an accounting and consulting firm with its principal place of business in Orland Park, Illinois. The firm was founded in 1979 by Edward W. Mulcahy, Michael F. Pauritsch, and Philip A. Salvador. We refer to the three men collectively as the founders. Throughout the years in issue—2001, 2002, and 2003—the founders served as the firm's board of directors and sole officers. The founders also served as the only members of the firm's compensation committee, which determined what the firm paid its employees, officers, and board members. The firm was a C corporation and a cash-basis taxpayer; it used a calendar year for its taxable year.
The founders (or in my terms - the big guys) owned 78% of the firm (MPS) and the other three partners (little guys) owned 22%. The big guys weren't content to just set their own salaries and decide how the remaining crumbs would be allocated among the little guys. For some reason not entirely clear from the record they paid some of what would have been their comp to various entities:
At issue is the deductibility of payments the firm made to three related entities: Financial Alternatives, Inc. (Financial Alternatives), PEM and Associates (PEM), and MPS Limited (MPS Ltd.).
The sole shareholders of Financial Alternatives were the founders (Mulcahy, Pauritsch, and Salvador). The founders owned Financial Alternatives in equal shares. Financial Alternatives was a C corporation that used a taxable year ending June 30. It filed Forms 1120, U.S. Corporation Income Tax Return, for taxable years ending June 30, 2002, 2003, and 2004.
The year end difference hints that there was some sort of deferral game going on, MPS was a calendar year C corporation. In order to not have corporate tax they would have had to have paid out salaries in December. By instead paying another corp with a June year end which they zero out in June, they defer income for a year. Conceivably they could have classified "Financial Alternatives" as other than a personal service corporation which would allow them to take advantage of graduated corporate rates. That seems a little unlikely. It is interesting to note, however, that the big guys owned 78% of MPS. Had they owned more than 80%, the two corporations, MPS and "Financial Alternatives", would have been part of a controlled group. When you count the little guys five or fewer individual do own 80% of each corporation and taking everybody's lowest percentage in each corporation you get more than 50%. However thanks to Vogel Fertilizer, the little guys, who own 0% of Financial Alternatives don't count toward the 80% test on MPS.
The founders also owned PEM in equal shares. PEM was a general partnership. It filed Forms 1065, U.S. Return of Partnership Income, for taxable years 2001, 2002, and 2003.
Mulcahy and Salvador owned MPS Ltd. in equal shares, but Pauritsch was not an owner. MPS Ltd. was a limited liability company filing as a C corporation. It filed Forms 1120 for taxable years 2002 and 2003.
MPS Ltd would not have been part of a controlled group with either of the other two C corporations, once again thanks to Vogel Fertilizer. I've always thought that having an LLC elect to be treated as a C corporation is like hitting your head against the wall because it feels so good when you stop, but I imagine they were up to something when they made the election.
The case doesn't tell us what the big guys were up to. The deferral is pretty apparent and maybe multiple use of corporate graduated rates. Of course it is not inconceivable that they were doing it all just for the hell of it. Whatever, they were trying to accomplish, though, I think it turned out not to be worth it. The IRS disallowed the deductions for fees paid to the three other entities. It made for some impressive numbers:
The IRS determined the following deficiencies in tax: $317,729 for 2001, $284,505 for 2002, and $377,247 for 2003. The IRS also determined that the firm was liable for accuracy-related penalties under section 6662 in the following amounts: $63,546 for 2001, $56,901 for 2002, and $73,238 for 2003.
The IRS argument was that the entities didn't really do anything for MPS. The defense to that is that MPS was really paying for the work that the big guys did. I find the Court's commentary a little confusing:
Therefore, the IRS argues, the “consulting fee” payments should be tested for deductibility as payments for the related entities' services—as opposed to payments for the founders' services. We need not reach this issue because, even if the payments are tested for deductibility as payments for the founders' services, the firm failed to show that the payments are deductible.
Section 1.162-7(a), Income Tax Regs., provides that “There may be included among the ordinary and necessary expenses paid or incurred in carrying on any trade or business a reasonable allowance for salaries or other compensation for personal (Emphasis added.) The firm services actually rendered.” concedes that no services were rendered by the related entities. Therefore the firm is not entitled to deduct the “consulting fee” payments as payments for services rendered by the related entities. “consulting fee” payments, as it would have been required to do with respect to employee compensation payments to the founders. It did not include the “consulting fee” payments on the founders' Forms W-2, Wage and Tax Statement, as it would have been required to do with respect to employee-compensation payments to the founders. It did not issue the founders Forms 1099-MISC, Miscellaneous Income, as it would have been required to do with respect to payments of nonemployee compensation to the founders. Finally, it did not report the “consulting fee” payments on its income tax returns as officers' compensation.
Evaluating the payments as if they were payments for the founders' services, we find that the firm has failed to show that it is entitled to the deductions.
The IRS argument is very simple. The entities didn't perform any services. Only the IRS can argue "substance over form". The taxpayer got to choose the form and is stuck with it. You can't now say that the payments were really to the big guys, themselves, rather than the entities. It seems like the Court is neither agreeing or disagreeing with that position. Instead it is saying that it doesn't matter because the payments have not been established to be reasonable compensation to the big guys. So much of the discussion is what you would find in a reasonable compensation case.
One of the tests for reasonable comp is whether an "independent investor" would be satisfied with the return they received after the comp. MPS made an argument on that basis:
The parties disagree on how to calculate the rate of return on investment, which is also known as the rate of return on equity. The firm contends that the rate of return on equity is equal to its gross revenue for one year minus its gross revenue for the prior year, divided by the gross revenue for the prior year. This definition is based on the theory that the value of the firm's equity is equal to the firm's gross revenue for one year. The firm claims that annual gross revenue is an appropriate measure of the firm's equity because someone once offered to buy the firm for a purchase price equal to one year's gross revenue. Gross revenues were $5,496,028 for 2001, $5,742,420 for 2002, and $6,338,482 for 2003, and the firm claims that gross revenues for 2000 were $5,405,102. 12 So the firm calculates that from 2000 to 2003 the cumulative rate of return for the shareholders was 17.27 percent.
Yeah right. I'm sure that if they ever did an asset deal they would recognize more than 6,000,000 of corporate gain and then liquidate. The never heard of personal good will or consulting fees and deferred compensation or who knows what else.
Regardless, I think that the Court misunderstood the taxpayers argument:
We agree with the IRS that the rate of return on the firm's equity should be calculated by reference to annual net income, not the year-to-year change in gross revenue. It is inappropriate to look to gross revenue (or to changes in gross revenue) to determine if equity investors are receiving good returns on their investment. A corporation's shareholders do not seek to maximize gross revenue. They seek to maximize profit. See Boyer v. Crown Stock Distribution, Inc., 587 F.3d 787, 793
Gross revenue was being used as a short-cut valuation method. If you had an entity that held assets that were increasing in value without income recognition you might consider that was a good deal. They were maintaining that the value of the accounting firm was going up because the valuation would be based on gross revenue. The Court then indicates that an investor would evaluate return based on taxable income:
Both rates of return were high enough to create a presumption that the compensation received by the respective shareholders for their services was reasonable. But in this case, the firm reported taxable income of $11,249 for 2001, a tax loss of $53,271 for 2002, and taxable income of zero for 2003. This makes the rate of return on equity either near zero, below zero, or zero, in each respective year. Thus the independent investor test does not create a presumption that the amounts were reasonable.
Remember MPS is a cash basis taxpayer. One might argue that accrual basis income would be the correct measure. Frankly, though a professional firm that consistently has accrual income in excess of cash income may be heading for a trouble. I had a managing partner early in my career who I determined, counting himself, his brother and his father, had boiled over 100 years of public accounting experience down to two fundamental principles "Money coming in is good." "Money going out is bad." Whevever someone was packing up to do field work, he would ask him where he (and it was more than likely a he) was going. The managing partner always had the same direction, regardless of the client, "Bring back a check". Whevever one of the whippersnapper partners mentioned the concept of accrual basis income for the firm his response was "You're kidding yourself".
So much for the "independent investor" test, which brings us to the next stage of the analysis:
Without the aid of the presumption of reasonability, the firm has not otherwise shown that the amounts it seeks to deduct as compensation were reasonable. Generally, “reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”
Things did not start off well for MPS:
Marc Rosenberg, opined on the reasonableness of amounts paid to each founder, which included (i) amounts designated as compensation and (ii) amounts designated as “consulting fees”. The first problem with his analysis is that the statistics he gathered from other firms were irrelevant. He appears to have relied on the following statistic he gathered from each firm: (i) the sum of (a) the salaries the other firm ostensibly paid its owners for its owners' services and (b) the other firm's net income, divided by (ii) the other firm's total number of owners. This statistic does not necessarily correspond to what owners of other firms received for their services. For example, suppose that another company paid its sole owner $300,000 per year in “salary” payments that were ostensibly for services. This does not mean that the owner's services to the company were worth $300,000. Even though the $300,000 in payments were nominally labeled by the company as “salary”, the payments could in reality be a return on the owner's investment in the company (or a repayment of the investment).
They then wheeled out their most powerful argument. The actual salaries that the big guys took were not that much more, possibly even less, than what the little guys and even some of the non-shareholders were making. It is a fundamental law of nature that the big guys are supposed to be making a lot more, because, well, they are the big guys. Apparently the judge wasn't aware of that fundamental principle:
The firm—which has the burden of proof—simply has not offered enough evidence to allow us to compare the relative value of the founders' services and the services of the nonshareholder employees.
The final piece of the reasonable compensation argument concerns "intent to compensate". Taxpayer did not do well in that one either:
We find that the firm intended for the payments to the related entities to distribute profits, not to compensate for services. As discussed above, Salvador chose the amount to pay each year so that the payments distributed all (or nearly all) accumulated profit for the year. He did this for tax planning purposes. Each founder's percentage of the payments to the related entities was tied to hours worked, but the firm's intent in making the payments was to eliminate all taxable income. The firm did not intend to compensate for services.
MPS was founded in 1979. It could be a good idea for a professional service firm to be a C corporation then - mainly because of the pension rules. Being a C corporation is like being married. It's easy to get into, but can be expensive to get out. I can't ever recall seeing a C corporation service firm that either accumulated taxable income or paid dividends. I think the owners of MPS find themselves in this world of hurt, because they were too cute with the other entities. If they had just paid themselves "big guy" salaries there is a good chance that they would have had a no change audit. What would be supremely ironic is if the side entities were created for purely cosmetic purposes to avoid reasonable comp exposure. If they weren't using graduated corporate rates, it may be that the purpose of the careful Vogel Fertilizer ownership structuring was to avoid disclosing that there was a controlled group.
Nonetheless, the case would be much less disturbing if the Court had just gone with the IRS theory. The entities did not do anything and that's who you paid instead of yourselves. Instead the court accepted, arguendo, that the payments might be compensation to the "big guys" and did a reasonable compensation analysis, which is very disturbing. The IRS may use this decision as a weapon against personal service C corporations. Whatever you think you are getting out of remaining a C corporation may no longer be worth it in light of this case.
I haven't seen a lot of other commentary on this case. One blogger observed that it would have been better to get expert opinion on splitting the pie before doing it.