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Continued IRS Attack On ‘Zero Out’ Of Profits – Tax Authorities & More Breaking News Headlines Today

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A prior article in this publication (IRS Attack on Zeroed Out
Taxable Income in Recent Tax Court Cases) discussed the lessons
that physician and other incorporated medical practice groups could
learn from taxpayer losses in two then recent Tax Court cases in
use of the “zero out” technique in the payment of
compensation to the group’s owners. Under this approach, the
practice group typically compensates its physician-owners or other
licensed professional shareholders by payment of a portion of the
anticipated pre-tax operating profits as compensation (salary) in
regular increments during the tax year and then it will distribute
the bulk of its profits in bonuses that are paid at year-end. For
practice groups organized as ‘C’ corporations, the
salary and year-end bonuses are deducted as compensation. As a
result, the practice entity will pay little or no federal income
taxes. The potential tax risk to this compensation method is that,
depending on the facts and circumstances of each situation, the
Internal Revenue Service (IRS) could disallow the compensation
deduction for the “salary” and bonuses paid and treat
these payments as nondeductible dividends made by the practice
entity to its shareholders.

Two recent cases provide additional insight into how the zero
out approach to compensation can be properly structured to support
the deductibility of payments made by ‘C’ corporations
to their owners as compensation for services provided. In one case,
the Tax Court issued a lengthy opinion in support of its denial in
part of the deduction of compensation paid to the owner of a
construction business organized as a ‘C’ corporation.
In another case, the Eighth Circuit Court of Appeals affirmed a Tax
Court case discussed in the prior article that upheld the
IRS’s characterization of payments made by an asphalt paving
company to, or for, its owners as non-deductible dividends rather
than deductible compensation.

On April 26, 2022, the Eighth Circuit Court of Appeals affirmed
a 2021 Tax Court case (discussed in detail here). Even though the
taxpayer generated income throughout the year, it made no payments
for services to, or for the benefit of, its three shareholders (an
individual and two corporations each of which was wholly owned by
one individual) until the end of the year. The year-end payments
(characterized by the taxpayer as “management fees”)
were made roughly based on share ownership rather than based on the
value of services provided by each individual who directly or
indirectly owned the taxpayer. Moreover, the taxpayer made payments
to the two corporate shareholders rather than to the individuals
who performed services on behalf of the corporate shareholders. The
taxpayer had never paid any dividends and, by making the payments,
the taxpayer eliminated a substantial portion of its taxable income
(just under 90% in two of the three tax years covered in the case
and just under 80% in the third year). The Tax Court upheld the
IRS’s characterization of the payments made in all three
years as non-deductible dividends and not deductible
compensation.

The Court addressed the substantive issue posed – whether
the payments made could be deducted as management fees – and
thoroughly analyzed the reasons for the Tax Court’s decision
to support the IRS’s denial of the deductions claimed by the
taxpayer. The Court of Appeals noted that all compensation
arrangements within closely held corporations should be closely
scrutinized, that the payments made by the taxpayer were made in a
lump sum at the end of the year (a true “zero out”
approach) and that the corporation did not pay and had never paid
any dividends to its owners.

In Clary Hood, Inc. (TC Memo. 2022- 15), which was decided on
March 2, 2022, the Tax Court redetermined the deductible amount of
the substantial “one-time” bonuses that the closely
held construction company paid its CEO/founder during two tax
years. The Tax Court found that a significant portion, but not all
of the bonuses paid to the sole shareholder in each tax year, could
be deducted as reasonable compensation for services provided to the
corporation.

The Tax Court also noted that the taxpayer had bonused out to
the founder during the two tax years in question a relatively small
portion of the business’s pre-tax operating profits
(approximately 40% in one year and 25% in another tax year).

These two cases can provide valuable lessons to owners of
physician and other incorporated medical practice groups as they
develop methods for compensating employed physicians and other
licensed professionals:

  • As the construction company did in Clary Hood, do not wait
    until the end of the year to pay bonuses to practice group owners,
    but make periodic payments of base compensation during the year
    (salary) using an objective formula that takes into account the
    value of the services provided by each licensed professional;
  • Do not pay compensation to the licensed professionals who are
    shareholders of the practice group in the same percentages as their
    relative share ownership;
  • Engage competent accountants, tax preparers or compensation
    consultants to provide advice and counsel in structuring any
    compensation method and the Board of Directors of the practice
    entity should review and consider written guidance and reports from
    these advisors prior to approval of any compensation method (or
    year-end bonuses based on that method);
  • For practice groups with corporate shareholders (typically an
    ‘S’ corporation owned by a licensed professional), pay
    the individuals who perform the services the compensation earned
    and do not make these payments to their wholly owned
    corporations;
  • Do not zero out all corporate pre-tax profits each year as
    compensation but declare and pay annual dividends of a portion of
    these profits and pay federal income taxes on the remaining pre-tax
    profits of the incorporated practice group; and
  • Enter into written employment agreements with each physician or
    other licensed professional who is a shareholder of the practice
    entity that contain an objective formula for determining at least
    the contingent portion of compensation.

Originally Published by Healthcare Michigan, May
2022

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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