Seventh Circuit Surprised To See Accounting Firm "Screw Up Its Taxes"

Originally published on forbes.com.

"That an accounting firm should so screw up its taxes is the most remarkable feature of the case. "

Yikes.  I used to write things like that before I got  on a classy venue like Forbes.com and started working for a national firm for my day job.  So I want to be clear.  That's not me.  It is the Seventh Circuit in its wrap-up to Mulcahy, Pauritsch, Salvador & Co., Ltd, an appeal of a tax court decision which I wrote about, almost exactly a year ago, in a post titled Personal Service Corporation and C Corp - Recipe For Disaster.  MPS is a full service accounting firm.  For the years in question (2001 - 2003), it was a C Corp, which is a little unusual nowadays, but not so unusual in 1979, when the firm was founded.  Once you have a business in a C corporation, it is not so easy to get it out, so it is understandable that they continued that way.

The firm's structure was more complicated than merely having a C corporation, though:

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.

Having grown up professionally in a similar environment to MPS, I was able to speculate on what they were up to:

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 IRS disallowed the deductions to the entities and added insult to injury by treating the payments as dividends to the principals.  The taxpayers argued that the payments were really compensation to the principals.  They had a non-tax reason for using the entities:

The firm argues that the consulting fees were not for services rendered to the firm by the related entities, as its tax returns would suggest, but payments for accounting and consulting services provided by the founding shareholders to the firm's clients and thus in effect additional salary. They had been paid indirectly, the firm argues, in order to conceal from the firm's other employees how much of the firm's income was being appropriated by the founding shareholders. Some (maybe all) of those other employees, including employee-shareholders who are not among the founders, apparently thought that the founders were overpaying themselves.

An accounting firm where the little guys think the big guys are taking too much.  Such a thing exists! Who knew ?

Rather than rejecting the recharacterization argument out of hand, the Tax Court turned it into a reasonable compensation case and decided that they had not established that the consulting fees represented reasonable compensation.   The Seventh Circuit was even tougher on them than the Tax Court:

 Remarkably, the firm's lawyers (an accounting firm's lawyers) appear not to understand the difference between compensation for services and compensation for capital, as when their reply brief states that the founding shareholders, because they “left funds in the taxpayer over the years to fund working capital,” “deserved more in compensation to take that fact into account.” True—but the “more” they “deserved” was not compensation “for personal services actually rendered.” Contributing capital is not a personal service. Had the founding shareholders lent capital to the company, as it appears they did, they could charge interest and the interest would be deductible by the corporation. They charged no interest.

In terms of explaining things, there is one argument that neither the Tax Court nor the Seventh Circuit seemed to grasp:

The firm argues that the value of a professional services corporation is its annual gross revenues, and therefore the contribution that its managers (the founding shareholders in this case) make to the firm's value is best estimated by the year-to-year change in those revenues; and over the three-year tax period the firm's revenues grew by 17.27 percent, justifying, it argues, the high compensation paid the founding shareholders; for an independent investor would be satisfied with that capital appreciation as the return on his investment. But that ignores the firms' costs, which might be growing in tandem with its revenues. And even if the firm had no costs, so that its revenues were pure profit, the firm's value would not be its annual revenues.

Gross income is often used as a short cut "rule of thumb" valuation method for the goodwill of a professional practice.  There are a lot of reasons to criticize that method and sometimes it is not 100% of gross, but some lesser or in rare cases higher percentage.  So the argument that MPS was making  was that a hypothetical shareholder would be satisfied by the growth in the firm's valuation.  I could understand the courts rejecting the argument, but I do not think they even grasped it.

I think it was rather harsh of the Seventh Circuit to say that MPS had "screwed up".  I have never seen a professional practice C corporation leave profits to be distributed and taxed as dividends.  I suspect that if the MPS shareholders had just taken big salaries to zero out, they would have gotten a no change audit.  It was their creativity that got them in trouble.  Unfortunately for the rest of the professional service C corporations out there, a bad precedent has been set.  My conclusion from the original Tax Court decision stands:

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.

You can follow me on twitter @peterreillycpa.