Corporation, Securities & Business Law Forum
December 2002 VOL. 48, NO. 2
Statements or expressions of opinion or comments appearing herein are those of the editors or contributors, and not necessarily those of the association or section.
Contents
By Robyn Halsey, Husch & Eppenberger, LLC
On April 2, 2002, the United States Tax Court handed down its decision in Pediatric Surgical Assoc., P.C. v. Commissioner, Docket No. 12743-28, T.C. Memo 2001-81 (2001), indicating a harsher income tax review and audit process for professionals. The implications of this case are that incorporated groups of professionals need to pay close attention to their recordkeeping procedures and compensation of their employees, or face costly consequences.
Pediatric Surgical Associates, P.C. was a personal service corporation incorporated as a professional corporation (PC) under the laws of Texas. During the years of 1994 and 1995, it employed four shareholder surgeons and two nonshareholder surgeons, all of whom performed pediatric surgical services on behalf of the corporation.
The shareholder surgeons received a fixed monthly salary of $16,500 plus monthly cash bonuses, which were determined by the amount of funds available. For instance, in the middle of each month the corporation would determine the amount remaining in its bank account and the amount of cash necessary to meet anticipated cash-flow needs for the immediate and near future. The difference, if any, was paid in equal amounts to the shareholder surgeons pursuant to their employment agreements. The nonshareholder surgeons, on the other hand, received only a fixed monthly salary of $12,000 to $12,500. Their employment agreements specifically stated that no bonuses were available.
The employment agreements further provided that the shareholder surgeons were employed to engage "exclusively, and actively in the practice of medicine on behalf of the Association." All fees, compensation, and other things of value, charged by the Association and received or realized as a result of the rendition of services by the shareholder surgeons were paid and delivered directly to the Association. All of the income received by the corporation on account of the employment of the shareholder surgeons was received on account of the provision of medical services by those shareholder surgeons. Unlike the shareholder surgeons, the nonshareholder surgeons had no significant duties with respect to the administration of the corporation.
On its income tax returns for the years 1994 and 1995, the corporation deducted compensation paid to all of its surgeons as "Compensation officers." Included in this amount were the monthly cash bonuses received by the shareholder surgeons. The corporation used the cash receipts and disbursements method of accounting. The corporation had never declared a dividend in any year, including the years 1994 or 1995.
After conducting an audit, the Commissioner of the IRS disallowed a portion of the deduction for "Compensation officers" on the ground that a portion of the amount paid to the shareholder surgeons was a dividend rather than officers' compensation. The corporation claimed that the expenses were properly deducted under section 162 of the Internal Revenue Code, which allows a deduction for trade or business expenses, including "a reasonable allowance for salaries or other compensation for personal services actually rendered." The case proceeded to the United States Tax Court.
The court noted that to be deductible as compensation for services under section 162(a)(1), the payments must be (1) Reasonable; and (2) In fact payments purely for services. It was the second prong that concerned both the Commissioner and the Tax Court. To prevail, the corporation needed to show that not only were the bonuses paid to the shareholder surgeons purely for services, but purely for their services.
The corporation argued (and cited several Tax Court decisions in support thereof) that "the best evidence of value of services provided in a professional personal service corporation is the profit made by the corporation." One such case was Bianchi v. Commissioner, 66 T.C. 324 (1976), aff'd per curiam, 553 F.2d 93 (2nd Cir. 1977), where the Tax Court held the prior self-employment earnings of a corporate employee could be used to determine whether compensation currently paid to such employee by the corporation was reasonable. In Bianchi, a dentist incorporated his individual proprietorship into an S corporation and transferred his equipment, accounts receivable and goodwill to the S corporation. In that case, the Tax Court determined that "the clearest evidence of worth of the petitioner's services is [his] earnings from his dentistry practice as an individual proprietor." The petitioner's "earnings" were the profit he earned as an individual proprietor.
The court refused to apply Bianchi to the Pediatric Surgical case, explaining it was unable to find the value of the services provided by the shareholder surgeons to the corporation equal to the profit made by the corporation (determined without any deduction for the compensation of the shareholder surgeons). One reason why the court could not do so was that the shareholder surgeons were not the only service providers employed by the corporation. There were also the nonshareholder surgeons, whose contribution to petitioner's profit, the court assumed, could not be zero.
The court also refused to apply Richlands Med. Assoc. v. Commissioner, T.C. Memo 1990-660, aff'd without published opinion, 953 F.2d 639 (4th Cir. 1992), another case relied upon by the corporation. In Richlands, the Tax Court determined that the taxpayer-corporation's associates (taxpayer was a corporation providing physicians' services and owned a hospital that provided medical services ancillary to the physicians' services) were entitled to receive, as compensation for their services to patients, 100 percent of the collections recorded by the corporation as attributable to such services. The court, distinguishing Richlands, noted in that case the Commissioner had allowed such amounts as a deduction for compensation, unlike in the Pediatric Surgical case. Moreover, the court reminded the corporation that in Richlands, it held a portion of what the taxpayer treated as compensation to its associates, particularly the "ancillary hospital service charges" that were not shown to be allocable to the associates, was a nondeductible distribution of profits. Therefore, the court concluded Richlands did "not establish a rule of law that, in all circumstances, an employer may deduct as compensation paid to an employee amounts collected for services performed by such employee."
The court described the issue in Pediatric Surgical as the factual question of whether the corporation intended to pay compensation for services to the shareholder surgeons. In this case, "careful scrutiny" was required since the shareholder surgeons owned the corporation. In other words, the board was not necessarily concerned that shareholder surgeon compensation not be overstated.
The Commissioner was willing to allow the corporation to deduct, as compensation for services, the collections attributable to the shareholder surgeons less their allocable share of the corporation's expenses. However, the Commissioner also believed that the corporation had understated its profit on the nonshareholder surgeons by both understating the collections with respect to such nonshareholder surgeons and overstating its overhead allocable to such nonshareholder surgeons. Thus, in determining whether a "disguised distribution of profit" was given to the shareholder surgeons, the court looked to the profit attributable to the nonshareholder surgeons.
To determine the profit attributable to the nonshareholder surgeons, the court used the collections attributable to such surgeons minus the expenses attributable to such surgeons. The collections were derived from corporate financial statements and the opinions of experts. If the records were not clear, the court assumed the collections to be 70 percent of net billings. The court allocated various expenses to the nonshareholder surgeons, including a pro-rata share of rent expenses, repair and maintenance, office equipment depreciation, telephone expenses, and equipment lease expenses. After making the necessary calculations, the court determined the profit attributable to the nonshareholder surgeons was improperly claimed as a deduction for compensation to the shareholder surgeons. In other words, the deductions claimed for the salaries paid to the shareholder surgeons for each year exceeded reasonable allowances for services actually rendered by them. The court characterized the disallowed amounts as dividends, subject to both corporate and personal income taxation.
Not only did the court disallow the deduction, it further assessed a negligence penalty against the corporation. Defining negligence as "lack of due care of failure to do what a reasonable and prudent person would do under like circumstances," the court explained that a penalty would not be imposed if it could be shown that the corporation acted in good faith and that there was reasonable cause for the underpayment of tax.
When asked during the trial why the corporation had never paid a dividend, one of the incorporating/shareholder surgeons replied: "Well, we are not a very big organization and all of our income comes from just the work we did. And we just treated everything as salary." The corporation argued this was a good faith belief that the monthly bonus payments of all available earnings reasonably represented payments for services rendered by the shareholder surgeons.
The court disagreed, saying whatever good faith belief the shareholder surgeons might have had was belied by later testimony that the nonshareholder surgeons also "made money" for the corporation. Since the shareholder surgeons were at least aware that a portion of the corporation's profits were attributable to services performed by the nonshareholder surgeons, the monthly distribution of essentially all the corporation's profits to the shareholder surgeons as "compensation" was not done in good faith, the court concluded. The court could not believe that the shareholder surgeons could reasonably conclude that all pre-distribution profits were solely attributable to services performed by them and, therefore, available for bonus payments to them. The court determined that the shareholder surgeons acted with "utter indifference" to the possibility that a portion of the annual prebonus profits might have been derived from collections generated by nonshareholder surgeons. Thus, the court disallowed the deduction and imposed a 20 percent penalty upon the corporation.
The implications of this case have been discussed in two recent articles. First, Larry Jones, a Dallas attorney practicing in federal income tax controversy matters, explains the lesson from this case as professionals who basically earn what they collect must be careful in determining that their compensation is appropriate. Mr. Jones emphasizes good recordkeeping as well as appropriate employment agreements and corporate minutes because he cautions that after this case, individuals should expect the IRS to be more aggressive in auditing professionals. Larry Jones, "Paying the Professionals Tax Court Says Paid Too Much," 65 Tex. B.J. 61 (2002).
The American Law Institute recently described Pediatric Surgical as a "frightening result." Alson Martin & Morton Harris, "Recent Trends in Unreasonable Compensation: An Old Nemeses Rears Its Ugly Head," SG078 ALI-ABA 129, 183 (2002). Martin & Harris describe the legal theory embraced by the Tax Court (the net profits of a professional practice attributable to non-shareholder efforts cannot be paid to shareholders as compensation because such amounts are not solely for services rendered by the shareholders) as allowing the IRS to find significant dividends in every professional corporation that derives profit from any sources other than the shareholder practitioners. The problem is that a door has been opened, of finding non-deductible compensation, with unknown or undeclared limits.
For instance, as Martin & Harris point out, the IRS arguably would be justified in treating net profit derived from nonshareholder professionals, paraprofessionals, staff services, or ancillary services as dividends. Although it is doubtful that Pediatric Surgical will ever be stretched so far, arguments and actions for limiting its effect should be developed now. Martin & Harris give several suggestions for avoiding the costly consequences of Pediatric Surgical.
First, a stronger argument should be made that the "business" of a professional practice involves much more than simply providing professional services. Most shareholders in a professional corporation are extensively involved in such activities as business development, practice management, continuing education and training efforts, and compliance efforts. There is no reason why these work-related activities are not compensable. If employees do perform these or similar services, such services should clearly be outlined in their employment agreements. Having these "extra" services in writing will justify additional compensation for such services.
Other actions that professional practices should consider to protect themselves from the consequences of Pediatric Surgical include discontinuing operation as C corporations and converting to a "pass-through" entity such as an S corporation or a limited liability company where taxation may be avoided. This is obviously an extreme remedy and less cumbersome measures should be considered first. One such option is to pay a meaningful dividend. Although this might not completely avoid a review or attack by the IRS, it most certainly would have helped in Pediatric Surgical Associates' situation.
Another option is to contractually require shareholder employees to perform services other than direct patient or client services. Again, such services should be outlined in writing. Likewise, the corporation should document the time and effort made by shareholder employees in performing services for the corporation that do not involve billable patient or client services. Documentation of services performed by nonshareholders should also be extensive, particularly with respect to the monies received or profit claimed by a corporation. Thorough recordkeeping is the best way to account for the time spent by any employee performing any services for the corporation. Good recordkeeping will support the respective compensation paid to employees and perhaps avoid questioning by the IRS.
By Linscott R. Hanson, Chair, Illinois Secretary of State Corporation Acts Advisory Committee
1. Legislating morality
A. Your Report. We often say, or think "You can't legislate morality." You said it in your report, § I.B., p. 10, "No set of legal rules or guidelines can guarantee that such active care will be achieved in practice." In your footnote you cite The Business Roundtables' May, 2002 Principles of Corporate Governance to the same effect.
Congress has now enacted, and President Bush has signed into law the Sarbanes-Oxley Act of 2002, so there is no point discussing whether or not to adopt a legislative "fix." It has been done. We can go on to look at what additional fixes ought or ought not be adopted, and I take it that is the direction in which your report directs us.
All of us who serve on committees know how they work. We recognize and chuckle at the statement that "A camel is a horse designed by a committee." So I understand how you can start out recognizing that it is impossible to legislate morality, and then proceed for 50 pages to discuss how to go about doing it.
B. Professor Ribstein's critique. One of our committee members, Larry E. Ribstein, a professor of law at the University of Illinois Urbana-Champaign, has written a scholarly critique of the new legislation, "Market -vs- Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002" which you may care to examine in detail. You may read it in full at <http://luna.law.uiuc.edu/~ribstein/enron.doc>. Professor Ribstein has summarized his critique by saying:
"The crashes of Enron and WorldCom and frauds or irregularities at many other companies have reinvigorated the debate over regulating corporate governance. Numerous pundits called for corporate regulation to restore confidence in the securities markets. These recommendations appear to be supported by the fact that neither the contracting devices that were supposed to control managers, nor efficient securities markets, worked to prevent or spot the problems. Congress responded with the Sarbanes-Oxley Act of 2002. But this article shows that, given the limited effectiveness of new regulation, its potential costs, and the power of markets to self-correct, new regulation of fraud in general, and Sarbanes-Oxley in particular, is unlikely to do a better job than markets."
C. Other critical comments. In the Sunday, September 15th, 2002, edition of The New York Times, there was an article entitled "Reining In the Imperial C.E.O." The article addresses the effects of the Sarbanes-Oxley Act, and mentions "The recent corporate responsibility bill signed by President Bush does not specifically address severance packages...." Still looking for a legislative fix. The same edition of the paper also contained an article "From Investor Fury, a Legal Bandwagon" which portrays our profession in a less than favorable light, as birds of prey circling over the remains of these fallen corporate giants. The August 29 issue of The New York Times suggests that "split-dollar" insurance may be an unintended victim of the new law. See "Insurance Plans of Top Executives May Violate Law." On the other hand, loan transactions commenced prior to the effective date of the new law continue. See Appendix B to these comments.
D. Costs and complications of the Legislature approach. One by-product of the "new" legislative fix as well as the other economic conditions arising out of the September 11th attacks have been and will continue to be increased insurance costs for Director and Officer liability insurance. This will result in a reduction in such coverage provided by some companies, and thereby reduce the number of eligible candidates for board positions. Additionally, the possibility of adverse press coverage itself may have a chilling effect on candidates for board positions.
E. Public opinion. Particularly at this time, public opinion may be a more effective tool in securing corporate responsibility. See Appendix C regarding surrender by former GE CEO, Jack Welch, of high profile post retirement benefits, apparently motivated in large measure by public criticism.
2. Internal corporate governance
Of the two action recommendations contained in your report, the first deals with several aspects of corporate governance.
A. Public/Non-public companies. You have (correctly, I feel) made a distinction between the publicly traded corporation and the thousands of more closely held corporations, and chosen to apply your suggested actions only to the public corporations. Illinois has made a similar distinction in the treatment of its domestic corporations. See the Illinois Business Corporation Act, §12.55:
"In an action by a shareholder of a corporation that has shares listed on a national securities exchange or regularly traded in a market maintained by one or more members of a national or affiliated securities association...."
and §12.56:
"In an action by a shareholder in a corporation that has no shares listed on a national securities exchange or regularly traded in a market maintained by one or more members of a national or affiliated securities association....."
For ease of reference, a copy of our act is available on the Internet, through the offices of Secretary White, at: <http://www.ilga.gov/ilcs/ch805/ch805actstoc.htm>.
B. Independent directors. The six specific actions you have recommended in the area of corporate governance all hinge in one way or another on the concept of independent directors. You are recommending creation of Board Committees either entirely populated with independent directors, or with a majority of such directors, and that they function in an environment isolated from inside director/officers. Governance, Audit and Compensation committees are discussed in your report in detail.
i. Illinois experience. Our Business Corporation Act §8.60, has dealt with the concept of Independent Directors, calling them "Interested Directors" and "Disinterested Directors."
"For purposes of this Section, a director is "indirectly" a party to a transaction if the other party to the transaction is an entity in which the director has a material financial interest or of which the director is an officer, director or general partner.
The presence or absence of a majority of Disinterested Directors voting to approve a transaction shifts the burden of proof in determining fairness under our law. Very careful drafting is urged in this area. Too stringent a requirement of Independent Directors can cause corporate paralysis, as Illinois has learned.
ii. State corporation law. Your report indicates you are "not at this time addressing possible changes in state corporation law. You make reference to the activity of the ABA Business Law Section, and its Model Business Corporation Act. It seems to me that your suggestions lack any method of practical application without adoption by the states, or by the agencies and exchanges that regulate trading of securities.