For the last few years the IRS has warned taxpayers that it would look closely at year-end bonuses that resulted in “zeroing out” taxable income of a corporation by deducting the bonuses as salary rather than a payment of dividend to stockholders. This position landed squarely at the doorstep of a law firm in a case decided on February 10, 2016 in the United States Tax Court.
In Brinks, Gilson & Lione a Professional Corporation v. Commissioner, TC Memo 2016–20, the United States Tax Court upheld an IRS determination that Brinks had mischaracterized dividends that it paid to its attorney-stockholders as compensation. As a result, the Court also imposed penalties against Brinks finding that its actions were not supported by “substantial authority” and it lacked “reasonable cause” for underpayment of the tax which resulted from the mischaracterization. It also found that Brinks lacked “good faith” in its actions thereby subjecting it to penalties.
Brinks is by no means a small operation. At the time the case arose it employed approximately 150 attorneys, roughly half of whom were shareholders, and a staff of about twice the number of attorneys. Its business and affairs are managed by a board of directors (the “Board”). Brinks operated on a calendar year using the cash basis method of accounting.
The Board set attorney compensation. Bonuses were determined at the end of the year and were intended to “zero out” the corporation’s taxable income. The shareholders were entitled to dividends but none had been paid for the two years in question (2007 and 2008) and had not been paid from then retrospectively for a total of ten previous years. Brinks’ total income for the two years amounted to roughly $100 Million a year and its income tax returns were prepared by outside accountants.
Important in the sole Tax Court Judge’s opinion was the invested capital of Brinks, measured by the book value of its shareholders’ equity, of about $8 million at the end of 2007 and $9 million at the end of 2008. The Judge opined that it was not reasonable to expect an “independent investor” to forego a return on its investment in which significant capital was involved by way of “consistently” leaving insufficient income in the corporation so that dividends could not be paid to the shareholder-investors. The Court also found that a significant portion of Brinks’ revenue was attributable to non-shareholders, thus negating Brinks’ argument of a substantial basis in determining the compensation due its shareholders as opposed to dividend payments. In so doing, the Court cited Pediatric Surgical Associates and Mulcahy, Pauritsch, Salvador & Co, the former a Tax Court case and the latter a case which came before the U.S. Seventh Circuit Court of Appeals, the Circuit to which an appeal of the instant case would lie.
In dismissing Brinks’ arguments that it relied on its outside accountants in determining compensation, the Court found that there was no evidence that the accounting firm advised the law firm on the deductibility of the bonuses and in characterizing the amounts as compensation for services (e.g., on Form W-2s); that Brinks provided the accounting firm with accurate information; and that the accountants’ silence as to the deductibility of the bonuses as compensation constituted a communication on which Brinks relied. As a result, accuracy related penalties were imposed on Brinks.
If Brinks appeals its case to the U.S. Seventh Circuit Court of Appeals, the appeal would face a number of hurdles, on the face of the facts of the case. First, there is the lack of return on capital to Brinks’ shareholders which would not be tolerated by an “independent investor”. Second is the contribution of non-stockholders to the total income of the Firm. Finally, there is a lack of evidence that Brinks relied on the advice of its accountants in making its determination as to the amount of compensation due its shareholders as opposed to dividends payable to them.
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