The employee-owner of a corporate business will sometimes ask his or her tax adviser, “How much can I pay myself out of my corporation?”

The astute tax adviser may respond, “First of all, you are not paying yourself. The corporation is a separate entity from you, its shareholder. That being said, the corporation can pay you as much as it can reasonably afford in light of its business needs and other relevant facts and circumstances, and subject to state corporate law requirements, depending on the nature of the payment. For example, . . .”

The client will then typically interrupt, “C’mon wise guy. You know what I mean.”

The offended tax adviser will then say, “From a tax perspective, the corporation can pay you – and deduct against its income – a reasonable amount of compensation for the personal services you have actually rendered to the corporation. Anything in excess of that amount will be treated as a dividend distribution, to the extent of the corporation’s earnings and profits. Of course, . . .”

“I know, I know,” says the client, “and a dividend is not deductible by the corporation in calculating its own taxes. Give me some credit here.”

“OK. Except in the case of a start-up, or any other situation in which the corporation cannot ‘afford’ to pay its shareholder-employees, the corporate employer will – in fact, should – pay an amount of compensation that is reasonable for the services rendered – an exchange of value-for-value, or cash for services. In the case of an S corporation –”

Another interruption.

“Does the amount depend on the nature of the business?” asks the client.

“In general, yes. In a capital-intensive business, it may be more difficult to justify a certain level of compensation than in a business that involves only personal services.

“But,” continues the adviser, let me tell you about a recent decision involving a professional corporation . . .”

And as the adviser began, the client sunk deeper into the chair, recognizing the didactic look on the adviser’s face (the one that would broach no further interruptions), wishing that she had never raised the subject, willing for her phone to ring with some emergency, to extract her from her predicament.

Oblivious to his client’s plight, the tax adviser went on, encouraged by the thought that this client really cared about what he had to share.

Once Upon A Time, . . .

“Taxpayer was a law firm organized as a corporation. During the years at issue, it employed about 150 attorneys, of whom about 65 were shareholders. It also employed a non-attorney staff of about 270.

“Taxpayer’s shareholders held their shares in the corporation in connection with their employment by the corporation as attorneys. Each shareholder-attorney acquired her shares at a price equal to their book value and was required to sell her shares back to Taxpayer at a price determined under the same formula upon terminating her employment.

“Taxpayer’s shareholder attorneys were entitled to dividends as and when declared by the board. For at least 10 years before and including the years in issue, however, Taxpayer had not paid a dividend. Upon a liquidation of Taxpayer, its shareholder-attorneys would share in the proceeds.

“For the years in issue, the board met to set compensation and ownership-percentages in late November or early December of the year preceding the compensation year. Before those meetings, the board settled on a budget for the compensation year. On the basis of that budget, the board determined the amount available for all shareholder-attorney compensation for that year. With that amount in mind, it set each shareholder-attorney’s expected compensation using a number of criteria, then determined the adjustments in their ownership-percentages necessary to reflect changes in proportionate compensation. Adjustments in actual share ownership were made by share redemptions and reissuances.

“The board intended the sum of the shareholder-attorneys’ year-end bonuses to exhaust Taxpayer’s book income. Shareholder-attorneys shared in the bonus pool in proportion to their ownership-percentages. Specifically, Taxpayer calculated the year-end bonus pool to equal its book income for the year after subtracting all expenses other than the bonuses. Thus, Taxpayer’s book income was zero for each year: its income statements showed revenues exactly equal to expenses.”

The client carefully placed the second toothpick at the corner of her right eye. “Great,” she exhaled, “that should do it. Sure hope he’s near-sighted.”

At that point, the adviser glanced over at the client, who seemed to be listening intently, her eyes wide open. Pleased with himself, he continued.

Compensation, Or Something Else?

“Taxpayer treated as employee compensation the amounts it paid to its shareholder-attorneys, including the year-end bonuses.  In each of its tax returns for the years at issue, Taxpayer included the year-end bonuses it paid to its shareholder-attorneys in the amount it claimed as a deduction for officer compensation.

“Taxpayer’s returns reflected a relatively small amount of taxable income. Because Taxpayer’s book income was zero for each year, the taxable income Taxpayer reported was attributable entirely to items that were treated differently for book and tax purposes.”

The IRS Disagrees

“Now comes the good part,” said the adviser, his voice rising slightly.

The client hadn’t moved, yet her eyes were fixed on him, like some Byzantine icon.

“When the IRS examined Taxpayer’s returns, it disallowed the deductions for the year-end bonuses paid to Taxpayer’s shareholder-attorneys. After negotiations, the parties entered into a closing agreement that disallowed portions of Taxpayer’s officer compensation deductions for the years in issue, which portions it re-characterized as non-deductible dividends.”

The client bent forward slightly, then rocked back, as though nodding in agreement.

Encouraged by this sign of assent, the adviser continued.

“The sole issue remaining for the court was whether Taxpayer was liable for accuracy-related penalties on the underpayments of tax relating to its deduction of those portions of the year-end bonuses that it agreed were nondeductible dividends.

“The court began by stating the general rule that the Code allows a deduction for ordinary and necessary business expenses. However, in order for amounts paid as salary to be deductible, they must be paid for services actually rendered, and they must be reasonable. Ostensible salary payments to shareholder-employees that are actually dividends are thus nondeductible.

The Parties’ Arguments

“In support of its deduction of year-end bonuses paid to its shareholder-attorneys that eliminated its book income for the years in issue, Taxpayer cited a number of authorities that purportedly established that capital was not a material income-producing factor in a professional services business.

“The IRS claimed that amounts paid to shareholder-employees of a corporation did not qualify as deductible compensation to the extent that the payments were funded by earnings attributable to the services of non-shareholder-employees or to the use of the corporation’s intangible assets or other capital. The IRS said that amounts paid to shareholder-employees that are attributable to those sources must be nondeductible dividends.

“Taxpayer responded that any ‘profit’ made from the services of non-shareholder-attorneys could justifiably be paid to its shareholder-attorneys in consideration of their business generation and other non-billable services.”

The adviser turned toward the window. “I hope he jumps,” was the first thought that occurred to the client. No such luck – he only opened it a crack.

“It’s a bit stuffy in here,” he said, as if to himself, clearly not expecting a response.

“You have no idea,” she whispered under her breath.

“What’s that?”

“I said I have no idea where this is going.”

Stay tuned for Part II, tomorrow, to find out!