This post was originally published on Forbes Apr 3, 2015
If you viewed the Tax Court decision in the case of Midwest Eye Center as a wake-up call for people who have highly profitable professional practices inside C corporations, I think you would be mistaken. The wake-up call was in 1986. This decision is hitting them over the head with a two by four, particularly coming on top of the Vanney Associates, Inc decision late last summer.
About Midwest Eye Center
Midwest Eye Center is a substantial operation. According to its website, there are eleven physicians and four locations. Only one shareholder though. That would be Dr. Afzal Ahmad. During 2007 one of the physicians in the practice left suddenly and another was phasing out in the hope of starting a new practice, requiring Dr. Ahmad to pick up some of the slack. So for that year Dr.Ahmad's company paid him a larger than normal bonus which brought his total compensation to $2.78 million. Yowzers!
High School Guidance Counselors Take Note
$2.78 million - An impressive number like that makes me reflect on a thought experiment I did some time ago. I was thinking about some bright lads and lasses of eighteen who were willing to work very hard who then get together at their 15th high school reunion. They all went into either medicine or public accounting and they are comparing notes on how they are doing. Remember the starting condition is that they be equally bright and have worked equally hard for the last fifteen years. The psychiatrists, pediatricians and internists in the crowd will be doing not so bad if they are making the same money as, maybe a bit more than their classmates who are Big 4 managers. The latter are positioned though to shoot way ahead if they become partners and when you throw in that they have been making pretty good money for the last ten years while their medical classmates have been racking up more debt, you've really got to wonder. The eye surgeons in the group apparently have even more upside than the CPAs, though.
Of course someone like Dr. Ahmad needs to be something of an entrepreneur besides being a physician to build an operation like Midwest Eye Center. If this article is accurate your average eye surgeon, perhaps like the worker bees in Dr. Ahmed's practice, is scraping by on half a million or so. Not too many CPAs will ever get there and it would be quite a feat to do it even as the top earner in a practice with ten other CPAs.
Back To The Tax Problems
Dr. Ahmad's bonus was large enough relative to the pre-bonus profit to create a net operating loss of $50,434. The IRS determined that the bonus did not constitute reasonable compensation and disallowed $1,000,000. That resulted in a deficiency of $313,o62 for 2007 and $7,608 for 2008. As is routine they threw in the accuracy penalty, which adds over $60,000 to the 2007 tab.
Since Dr, Ahmad had entirely wiped out the corporate profit, his salary would not stand up to the "reasonable investor standard". That then led to a reasonableness inquiry that did not go well.
Petitioner produced no evidence of comparable salaries. Instead, petitioner argues that there are no “like enterprises” under “like circumstances” from which to draw comparisons. Petitioner argues that Dr. Ahmad's large bonus was reasonable for several other reasons. Petitioner points to Dr. Ahmad's increased workload during 2007 and the various roles that Dr. Ahmad performed, such as CEO, CFO, and COO, and the corresponding managerial duties of those positions. However, petitioner did not provide any methodology to show how Dr. Ahmad's bonus was determined in relation to these responsibilities.
Petitioner did not explain how the amount of the bonus was determined and why it was divided into four payments. Dr. Goyal left in June, and Dr. Ahmad increased his surgeries and therefore billings as a result. Petitioner did not explain how the increased billings translated to bonus payments. Petitioner did not provide evidence to show that the full $2 million bonus was reasonable. Accordingly, petitioner did not meet its burden.
Because petitioner failed to show that the bonus constituted reasonable compensation, we do not reach the issue of whether it was paid or incurred for services actually rendered.
Of course the real reason for the bonus is so that Dr. Ahmed is not taxed twice on the same earnings. He could have had that if MEC had made an S election. Had he done that he would have done even better tax-wise had he not taken any bonus, since he would have avoided 2.9% medicare tax by taking the earnings as a dividend. In his coverage of this case Joe Kristan noted that this case is something of a double edged sword that can be used against the IRS by S corporation professional practices
As in any two-front war, a victory on one front might cause problems on the other. A Tax Court victory yesterday for the IRS over an eye doctor who took “too much” compensation may give ammunition to S corporation professional practices that take corporate earnings out via their K-1s and distributions — free of Medicare taxes — rather than as salary and bonus.
Pretty much every case I have noted where S corporations have been hit for salaries being two low, the salaries have been absurdly low or non-existent. So Doctor Ahmad would probably have been let alone if he had taken no bonus and a $ 2 million dividend thereby saving around $60,000 in payroll tax, if he had run as an S Corporation. Instead as a C corporation he is hit with over $300,000 in corporate income tax. He should get a little of that back as an individual since dividends are taxed at a more favorable rate, but it is till pretty costly.
If he ever decides to sell his practice, the contrast will be even more striking.
An Odd Feature Of The Case
In fighting the penalty it was argued that MEC had hired a professional to prepare its return, which should get it out of the accuracy penalty. The answer to that was:
Petitioner failed to provide any evidence about the identity of its tax return preparer, the information it provided to its tax return preparer, or whether it relied on the preparer's judgment. Moreover, the tax return preparer did not testify at trial. Petitioner has not shown that it had reasonable cause or acted in good faith.
I'm scratching my head trying to figure how a top-notch medical practice like MEC does not at least have a medium notch CPA firm that, having failed to convince Doctor Ahmed to make an S election would not have somebody ready to go fall on his sword to try to help him save sixty grand in accuracy penalty.
The Bottom Line
Anybody with a professional practice netting anywhere above the very low six figures needs to have an extremely good reason to consider continuing as a C corporation in light of this and similar decisions. Also this is probably another sign that using S corporations to avoid some, but not all, payroll tax is a very solid strategy.