New 7th Circuit decision confronts professional service firm owners’ compensation

The recent Mulcahy, Pauritsch, Salvador & Co., LTD. v. Commissioner (T.C. Memo. 2011-74) Tax Court case, speedily upheld by the 7th Circuit Court of Appeals (No. 11-2105 (7th Cir. 5/17/12)), highlights the increasing exposure to challenges in owners’ compensation deductions that a professional firm operating as a C corporation faces. Because this case involves an accounting firm with the same issues inherent in medical practices, it has broad implications in the determination of both deductible compensation as well as fair market compensation in the tax-exempt sector. Analysts untrained in taxation often do not understand that the standards of IRC §162’s “ordinary and necessary” test apply just as fully to tax-exempt entities as they do to taxable companies, with the added burden of meeting the inurement prohibition of §501(c) (3).

The firm in this case made a critical error by shifting what were intended to be compensation deductions into “consulting” payments to shell entities. The firm reported that it had “virtually no income” and owed “virtually no corporate income tax” because its revenues were offset by deductions for business expenses—mostly the “consulting fees” paid directly or indirectly to its owner-employees. The IRS disallowed the firm’s deductions for “consulting fees,” reclassifying them as dividends. Ultimately, the Tax Court and the 7th Circuit Court of Appeals upheld the IRS’s determination finding that the firm could not deduct payments to related entities. The court said that the payments were, in fact, dividends or return on equity, not compensation for services rendered by the firm’s owners. Both courts went on to find that the compensation was unreasonable under several other theories, including the independent investor standard of Exacto Springs, another well-known 7th Circuit case.

Here is the Tax Court’s discussion of what “return on equity” actually means.

The firm claimed, in effect, that because such companies are typically valued on the basis of a multiple of gross revenue (which is, in fact, true), the owners received their equity return for each year that firm revenues grew. This is a sound argument from a valuation standpoint because, according to Morningstar/Ibbotson data, for example, it is well established that “return” consists of both income (cash or dividend) return and capital appreciation. However, no valuation that would have offered evidence on the capital appreciation was submitted in the case. Nonetheless, this highlights why the income approach in addition to a “market approach” is useful in addition to such “market methods” as the rule of thumb the firm cited in the case.

The firm contends that the rate of return on equity is equal to its gross revenue for one year minus its gross revenue for the prior year, divided by the gross revenue for the prior year.  This definition is based on the theory that the value of the firm’s equity is equal to the firm’s gross revenue for one year….

We agree with the IRS that the rate of return on the firm’s equity should be calculated by reference to annual net income, not the year-to-year change in gross revenue. It is inappropriate to look at gross revenue (or to changes in gross revenue) to determine if equity investors are receiving good returns on their investment. A corporation’s shareholders do not seek to maximize gross revenue.  They seek to maximize profit….

Using annual net income comports with the approach taken by the Seventh Circuit in Exacto Spring Corp. v. Commissioner.... Both the Tax Court and the 7th Circuit dismissed the firm's expert's testimony in disparaging terms. Here is the critical takeaway from the expert’s opinions: “Even though the $300,000 in payments [to the owners] were nominally labeled by the company as ‘salary,’ the payments could in reality be a return on the owner’s investment in the company….”

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