Don’t miss Part I, here!
“I appreciate your eagerness,” said the adviser. “You can just imagine how I feel every morning when I read through the latest tax news. It takes a Herculean effort to contain myself.”
“OMG,” he’s crazy, “what was my dad thinking when he retained this guy?!”
“I see the look in your eyes. Rest assured, your patience is about to be rewarded.
The “Independent Investor Test”
“I’m sure you are familiar with the basic economic principle that the owners of an enterprise with significant capital are entitled to a return on their investment. Thus, a corporation’s consistent payment of salaries to its shareholder-employees in amounts that leave insufficient funds available to provide an adequate return to the shareholders on their invested capital indicates that a portion of the amounts paid as salaries is actually a distribution of earnings.
“The ‘independent investor test,’ the Court noted, recognizes that shareholder-employees may be economically indifferent to whether payments they receive from their corporation are labeled as compensation or as dividends.
“From a tax standpoint, however, only compensation is deductible to the corporation; dividends are not. Therefore, the shareholder-employees and their corporations generally have a bias toward labeling payments as compensation rather than dividends, without the arm’s-length check that would be in place if nonemployees owned significant interests in the corporation.
“Thus, the courts consider whether ostensible salary payments to shareholder-employees meet the standards for deductibility by taking the perspective of a hypothetical ‘independent investor’ who is not also an employee.
“Ostensible compensation payments made to shareholder-employees by a corporation with significant capital that ‘zero out’ the corporation’s income, and leave no return on the shareholders’ investments, fail the independent investor test. An independent (non-employee) shareholder would probably not approve of a compensation arrangement pursuant to which the bulk of the corporation’s earnings are being paid out in the form of compensation, so that the corporate profits, after payment of the compensation, do not represent a reasonable return on the shareholder’s equity in the corporation.
“The record established that Taxpayer had substantial capital even without regard to any intangible assets, although Taxpayer’s expert witness admitted, at trial, that a firm’s reputation and customer list could be valuable entity-level assets.
“Invested capital of the magnitude described in the decision, the Court said, could not be disregarded in determining whether ostensible compensation paid to shareholder-employees was really a distribution of earnings. The Court did not believe that Taxpayer’s shareholder-attorneys, were they not also employees, would have forgone any return on this invested capital. Thus, Taxpayer’s practice of paying out year-end bonuses to its shareholder-attorneys that eliminated its book income failed the independent investor test.
Exemption From the Independent Investor Test?
“Taxpayer observed that its shareholder-attorneys held their stock in the corporation in connection with their employment, they acquired their stock at a price equal to its cash book value, and they had to sell their stock back to Taxpayer at a price determined under the same formula upon terminating their employment. Taxpayer suggested that, as a result of this arrangement, its shareholder-attorneys lacked the normal rights of equity owners.
“Contrary to Taxpayer’s argument, the Court noted, the use of book value as a proxy for market value for the issuance and redemption of shares in a closely-held corporation to avoid the practical difficulties of more precise valuation hardly meant that the shareholder-attorneys did not really own the corporation and were not entitled to a return on their invested capital. Any shareholders who were not also employees would generally demand such a return.
“More generally, Taxpayer’s argument that its shareholder-attorneys had no real equity interests in the corporation that would have justified a return on invested capital proved too much. If Taxpayer’s shareholder-attorneys were not its owners, who was? If the shareholder-attorneys did not bear the risk of loss from declines in the value of its assets, who did? The use of book value as a proxy for fair market value deprived the shareholder-attorneys of the right to share in unrealized appreciation upon selling their stock—although they were correspondingly not required to pay for unrealized appreciation upon buying the stock.
“But acceptance of these concessions to avoid difficult valuation issues did not compel the shareholder-attorneys to forgo, in addition, any current return on their investments based on the corporation’s profitable use of its assets in conducting its business.
“Taxpayer’s arrangement effectively provided its shareholder-attorneys with a return on their capital through amounts designated as compensation. The Court believed that, were this not the case, the shareholder-attorneys would not have been willing to forgo any return on their investment.
“The Court concluded that the independent investor test weighed strongly against the claimed deductions. The independent investor who had provided the capital demonstrated by the cash book value of petitioner’s shares—even leaving aside the possibility of valuable firm-owned intangible assets—would have demanded a return on that capital and would not have tolerated Taxpayer’s consistent practice of paying compensation that zeroed out its income.
“The classification of a law practice as a business in which capital is not a material income-producing factor, the Court said, did not mean that all of an attorney’s income from his or her practice was treated as earned income and that any return on invested capital was ignored.
“The Court did not doubt the critical value of the services provided by employees of a professional services firm. Indeed, the employees’ services may be far more important, as a factor of production, than the capital contributed by the firm’s owners. Recognition of these basic economic realities might justify the payment of compensation that constitutes the vast majority of the firm’s profits, after payment of other expenses—as long as the remaining net income still provides an adequate return on invested capital.
“But Taxpayer, the Court said, did not have substantial authority for the deduction of amounts paid as compensation that completely eliminated its income and left its shareholder-attorneys with no return on their invested capital.
“Because Taxpayer did not have substantial authority for its treatment of the year-end bonuses it paid during the years in issue, the disallowance of a portion of the deductions Taxpayer claimed for those payments represented a ‘substantial understatement’ for each year.”
The tax adviser turned back from the window and looked at the client. The client’s head was resting against the back of the chair. Was that drool trickling from the side of her mouth?
He cleared his throat. Nothing. He cleared it again, this time more forcefully. Her head was now upright. He looked meaningfully into her eyes. “They were lifeless eyes,” he thought, “like a doll’s eyes.” He realized he was channeling Captain Quinn from “Jaws.”
“You’ve always told me that clients, like me,” she said, base hiring decisions on the reputation of the individual lawyer rather than upon that of the firm at which the lawyer practices. If I heard you correctly just now, “ and she doubted anything she might have heard by that point, “the goodwill of a law firm may be an asset of the firm, rather than of its individual partners, is that right?”
“In the right circumstances, that’s correct. That’s one of many reasons why most firms operate as a pass-through entity, like a partnership, for tax purposes.” He went to the shelf behind his desk, and as he began to remove a volume on “choice of entity” issues, the door slammed. He turned, but the client was gone.
Who can blame her for wanting to avoid another long-winded lecture, but she should have stuck around a while longer. The message of the decision described above is not limited to the personal service business, though it is chock-full of guidance for such a business.
Taxpayers have long sought structures by which they could reduce the double tax hit that attends both the ordinary operation of a C corporation and the sale of its assets.
Many of you have come across the concept of “personal goodwill,” probably in the context of a sale by a corporation. Some shareholders have argued that they own personal goodwill, as a business asset that is separate from the goodwill of their corporation. They have then attempted to sell this “personal” asset to a buyer, hoping to realize capital gain in the process, and – more to the point of this post – also hoping to avoid corporate level tax on a sale of corporate goodwill.
Of course, the burden is on the taxpayer to substantiate the existence of this personal goodwill and its value, not only in the context of the sale of the corporate business, but also in the sale of his or her services to the corporate business. The best chance of supporting its existence is in the circumstances of a business where personal relationships are paramount, or where the shareholder has a reputation in the relevant industry or possesses a unique set of skills.
The right circumstances may support a significant compensation package for a particular shareholder-employee, either on an annual basis or in the context of an asset sale by his or her corporation. In each case, a separate, corporate-level tax would not be imposed in respect of the portion of the payments made to the shareholder-employee.
However, before a taxpayer, hell-bent on avoiding corporate-level tax, causes his or her corporation to pay compensation in an amount that wipes out any corporate-level tax, he or she needs to be certain that the existence and value of the personal goodwill – the reasonableness of the compensation for the service rendered – can be substantiated. The taxpayer needs to plan well in advance.