In March of 1992 I wrote an article for The Tax Advisor entitled Unreasonable Compensation for Employee-Stockholders of a Professional Corporation: It Is Not an Unreasonable Proposition. That now unfortunate title was meant to suggest that the IRS might easily argue such in a professional corporation with employee-professionals or ancillary profit centers, not that the argument should be successful. Since that time there has been mercifully little activity in the Tax Court involving reasonable compensation of professional corporation stockholders, and those stockholders have had some major Tax Court successes.

In the Spring 1999 issue of CPA Expert, I contributed Goodwill Requires Enforceable Covenant Not To Compete, wherein the taxpayer-accountants of a professional corporation avoided gain on the liquidation of their entity (Norwalk vs. Commissioner (TCM 1998-279)). Key to that case was a finding that there was no noncompete between the stockholders and the corporation, which would have had the effect (apparently) of transferring their personnel goodwill to the corporation (seemingly one issue in the instant case).

In February of 2000, I wrote an article for the Health Niche Adviser on a Tax Court case involving physician-oncologists entitled Chemotherapy Drugs Are Not Merchandise, based upon a reviewed decision written by Judge Laro (Osteopathic Medical Oncology and Hematology, PC v. Commissioner (113 TC No. 26, 11/22/99)). I noted in that piece that Judge Halpern had written a strongly worded dissent and warned "Taxpayers not read too much into that determination" and that it would be interpreted narrowly. A careful reading of that decision discloses his view that "service businesses" should not be treated differently than retailers, for example, "The majority’s view that a medical practice such as petitioner’s is inherently a service business is dependent on a number of factors (some of which are conclusory): "the uniqueness of the industry in which petitioner operates", the fact that petitioner’s business is a "quintessential service business", the "inseparable connection" of the chemotherapy drugs to the performance of services, and, finally "[s]ervice income, by definition, does not include income from the sale of goods". From those factors, the majority composes the following rule of law: Doctors (medical and osteopathic) are not in trade. The majority believes that doctors are not in trade because they are members of a learned profession, whose stock in trade is knowledge, not goods or merchandise." … "Finally, the majority’s reliance on Hospital Corp. of Am. v. Commissioner, 107 T.C. 116 (1996), to support its proposition that petitioner’s income is attributable solely to services and not to some combination of services and merchandise is puzzling."

He concludes his dissent by warning, "Taxpayers similarly situated to petitioner should be prepared to demonstrate that the cash method clearly reflects their income or that the hybrid method does not." Notwithstanding the difference in the two issues (unreasonable compensation and the cash method), it is clear that in this Judge’s view, a return on capital is inherent in all types of businesses. Perhaps professional corporation stockholders should take heed.

Observation: Reasonable compensation is certainly a matter subject to valuation. As will be seen from the Court’s review of the case, the return on corporate assets, likewise a valuation matter, was relevant to the case as well. (See, e.g., Exacto Spring Corp., 196 F3d 833 (7th Cir. 1999), rev’g TC Memo 1998-220 and the "independent investor" test). Notwithstanding the relevance of valuation matters, these were not mentioned anywhere in the opinion.

Pediatric Surgical Associates is a Texas corporation. At the time of the audit, it employed four stockholders as surgeons (one who retired in the second audit year), in addition to two employee-surgeons. The initial deficiency notice disallowed $598,710 (46%) of the $1,300,231 paid stockholders resulting in a balance due of $206,455 plus 20% §6662 penalty for calendar 1994. For 1995, $805,469 (53%) of the $1,528,125 paid stockholders was disallowed resulting in a balance $287,606 due plus 20% §6662 penalty. The IRS later amended its disallowance to $140,766 and $19,450, respectively. The Court ultimately disallowed $61,234 and $9,037, respectively. The average stockholder salary in each of these years was $325,058 and $382,031, respectively, certainly not anything extraordinary for a pediatric surgeons with the subject’s level of productivity (see, e.g., the Medical Group Management Association Physician Compensation and Productivity Survey). The physicians were each paid a monthly salary of $16,500 per month, plus periodic bonuses. Notable in the Court’s view was the fact that two of the four stockholders had countywide noncompete clauses in their employment contracts containing a penalty of $5,000 per month for 96 months. (Apparently, the two senior physicians who founded the practice did not have such provisions.)

The nonshareholder physicians had two-year employment contracts with fixed salaries of $12,000 or $12,500 per month, without bonuses. They had similar noncompete provisions with terms of 36 to 96 months and monthly penalties of $6,000 to $8,000.

The Court reviewed individual surgeon productivity for each year, finding "no reliable records of collections" for 1994. The 1995 data appeared as follows (Dr. Ellis was apparently part-time and then retired). Note that the two employee physicians generated very little of the collections:

The Court also noted in its opinion that (predictably) "The petitioner has never declared a dividend."

The IRS argued in its brief that " … the petitioner is entitled to deduct as wages the actual collections of the shareholder-employees, less their share of the petitioner’s expenses." These expenses were apparently directly allocated where applicable, such as payroll taxes or individual fringe benefits and then overhead items were equally allocated.

Counsel for the physicians (at least based upon the written opinion, as one can never be certain without a transcript) attempted to rely heavily on the fact that all of the payments to the stockholders were treated as wages and reported on W-2s. (Author’s Comment: Curiously, I have seen this emphasized in several prior cases by attorneys.) Judge Halpern referred to the following quote from the physicians’ counsel as "Petitioner’s principal argument"(!): "In the instant case, the payments made to the shareholders surgeons were clearly compensation for services rendered and not disguised dividends. Petitioner issued W-2 forms to its shareholder surgeons and that income was duly reported on the surgeon’s personal income tax returns. More over, the salary payments were properly deducted as such on Petitioner’s tax returns." The Court noted that elsewhere in the regulations under §1.162 it is stated that "Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible." Another argument used by petitioner was that the amounts were "reasonable" because they received less than their gross collections. It is difficult to believe that a judge (or anyone else for that matter) would have found this argument persuasive, and Judge Halpern did not.

Curiously enough, Judge Halpern wrote: "We do not believe, however, that whether the return amounts were reasonable in amount is actually in question. The question framed by the parties’ briefs is whether the remaining amounts [i.e., the disallowed amounts in question] were paid to the shareholder surgeons purely for their services." (Emphasis added) This is an interesting and subtle distinction.

Having read this case numerous times, I have come to the conclusion that only two possibilities exist for its outcome: a seriously deficient presentation by counsel for the taxpayers, or an inexplicable decision by the Judge. Cases must, of course, be decided upon the record and Judge Halpern indicates at several points in his opinion that the record lacks certain information he would have liked to have and in at least one instance, he granted a 30 day extension and requested the parties stipulate to an expense allocation scheme, but they failed to do so.

The IRS position from the original Revenue Agent’s Report was preposterous on its face, and one wonders what the Appeals Conference that must have preceded the trial was like. As noted in the Background above, by the time of trial, IRS had conceded nearly $1,250,000 of its original $1,400,000 proposed disallowance.

The Court ultimately accepted, with modification, the IRS’ position that the deducible compensation paid to the shareholders was limited to their individual receipts less their allocable share of corporate expenses. Do we now have an obiter dictum version of an acceptable compensation plan?

In computing the disallowance, another problem for the Judge was the lack of data for 1994. The IRS position at trial was that the dividend received by the shareholders was equal to the profit on the nonshareholders. To determine this profit, it was, of course, necessary to know both receipts and expenditures allocable to those nonshareholders. In the absence of data on those collections, the IRS maintained that the nonshareholder’s collections should be equal to net billings ($245,597), which appears to be defined as the amount expected to be collected from insurers. This is a patently ridiculous position, as anyone familiar with medical billing would know, and particularly so in light of the fact that the nonshareholder physician (Dr. Snyder) had only worked for the taxpayer for one-half of the year. The taxpayer’s accountant submitted an Exhibit that claimed the receipts to have been $146,837, but the Court stated this was not "supported by the evidence." Ultimately, the Court used $171,918 in its calculations. Given that this taxable year generated almost all of the adverse result for the taxpayer, better data might have carried the day.

As to expenses, "Both parties’ allocations of expenses to Dr. Snyder’s collections for 1994 and Dr. Vaughan’s collections for 1995 consist of the salary paid to each plus one-tenth (one-fifth for the one-half of the audit year which each as employed) of other expenses considered equally apportionable to the five surgeons during each year." There was a dispute as to whether certain of the expenses were at all allocable to Drs. Snyder and Vaughan. "We accept respondent’s [IRS’] proposed allocation of expenses as reasonable with the following additional allocations: There should be a pro-rata (one-tenth) allocation of rent, repair and maintenance expenses, depreciation of office equipment (other than shareholder automobiles), telephone expenses, and equipment lease expenses to the nonshareholder surgeons’ collections." This indicates that the IRS had not allocated any of these expenses against the nonshareholders, another ludicrous premise in a case that seems filled with them.

1995 expenses are as follows, as best as could be determined from the opinion:

The final result appears as follows:

It was not possible from the information in the case to replicate the computation of "Expenses" because the amount and detail of "other expenses" was not disclosed. However, my analysis of 1995 indicates that the IRS must have excluded all of the pension contribution and most of the "other expenses" from the computation, including insurance (e.g., health and malpractice), which the opinion notes totaled $113,889. In fact, it appears that more than $187,000 of "other expenses" was excluded from the IRS computation, and for the most part from the Court’s. I was unable to generate a rationale scenario in which there was a profit in 1995 on the nonshareholder. In fact, there appeared to be a loss in every conceivable circumstance. Based upon the Court’s computation of receipts of $129,806 and a salary to Dr. Vaughan of $76,061 plus the fringe benefits required such as FICA, unemployment tax, workmen’s compensation, health and malpractice insurance to name a few, a profit seems unimaginable.

Judge Halpern called attention to the corporate balance sheet, and discussed likely "nonbalance-sheet" assets including " … both the shareholder and nonshareholder employment contracts, petitioner’s arrangement with the hospital to provide on-call services in the hospital’s emergency room, and the goodwill that petitioner undoubtedly built up during its almost 20 years in business in the Fort Worth area." He goes on to say "Together, the balance-sheet and nonbalance-sheet assets account for the in-excess-of $2 million in gross receipts that petitioner reported for each of the audit years." This seems to indicate that the Judge based his decision at least in part on a "return on assets" approach. This is also significant if one compares it to the underlying rationale of Judge Ruwe in deciding the Norwalk case. There, the lack of noncompetes between the CPA shareholder-employees and their corporation was decisive in preventing their personal goodwill from being treated as a corporate asset.

Here, it seems as though the noncompetes of the two junior physician shareholders and the employee-physicians were corporate assets. Unfortunately, this ignores the almost certain fact that the senior shareholders, who did not have noncompetes, possessed the bulk of the personal goodwill and had not assigned it to the corporation. In the real world of medical practice, it is the personal reputation and skill of a surgeon that generates referrals, not the existence of a corporation or an employment contract. Query whether the presence of a noncompete with a "profitable" employee necessitates the payment of a dividend?

The Court mentions an "arrangement" with the hospital for emergency room services. If this agreement was in writing, it may have contained significant information as to the import of the particular individuals covering the emergency room and highlighted the personal goodwill argument. A wiser analysis pre-trial by petitioner’s counsel might have addressed these issues in the brief.

Although the Judge decided that the issue for resolution was "whether the remaining amounts [i.e., the disallowed amounts in question] were paid to the shareholder surgeons purely for their services" this was based upon the positions enunciated in both parties’ briefs. Perhaps the taxpayer would have won what appears to be an easily winnable case had the brief focused on statistical evidence of reasonable compensation. Surely, if one is to retain surgeons of exceptional caliber, one will need to compensate them at salaries comparable to similar individuals. No evidence was apparent in the opinion that a comparable pay analysis was submitted, generally the most important test for reasonable compensation. Further, there is no mention of what administrative responsibilities the shareholder surgeons must have has, although the Judge noted specifically that the nonshareholders did not have any such responsibilities.

One wonders whether the result would have been different if the taxpayer’s had prevailed in their argument that the IRS changes from its original Notice of Deficiency constituted a new matter, resulting in a shift of the burden of proof to the IRS under the IRS Restructuring and Reform Act of 1998. Judge Halpern ruled against the taxpayer’s motion in this regard. Under that provision, taxpayers meeting the following criteria with respect to a factual matter shift the burden of proof to the IRS:

1. Production of credible evidence
2. Cooperation with IRS
3. Meet net worth limit ($7 million for entities)
4. Adhere to administrative procedures and
5. Taxpayer has burden of proving compliance with above.

Conclusion

Bad presentations make for bad decisions. Given the dearth of cases on this topic and the implications for professional practices in general, this case is likely to be given far more weight than the written opinion indicates it deserves. If it is to be considered precedent, then CPA, law, architectural, consulting and a host of other firms need to immediately reevaluate their compensation schemes. S corporations (in particular) and LLCs taxed as partnership look extremely attractive in such an environment. Finally, the most worrisome aspect of the decision is Judge Halpern’s making his decision on this issue: "The question framed by the parties’ briefs is whether the remaining amounts [i.e., the disallowed amounts in question] were paid to the shareholder surgeons purely for their services." This would appear to expose any compensation arrangement not supported by a quantitative methodology to challenge.

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