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Deductible Physician Bonuses: The Tax Court Throws a Compensation Curveball
By Christine Izaj, CPA, MBA, Senior Tax Manager, Alpern, Rosenthal & Company
Due to a recent court case, shareholder surgeons may be in for a
surprise when it comes to the deductibility of bonus compensation.
Documentation has become more essential and may be a surgeon's best
ally to avoiding additional tax burdens.
In a recent decision of the United States Tax Court, payments made to
shareholder surgeons that were attributable to services performed by
non-shareholder surgeons were held to be nondeductible dividend
distributions rather than deductible compensation. The case presents
the classic trap for the unwary, and should be taken seriously, since
it also provides subtle guidance as to the means by which to avoid
such a result. This decision is also significant, in that it
represents a victory for the Internal Revenue Service (IRS) in an
arena (i.e., physician practices) in which the IRS has not been
particularly successful as of late.
In Pediatric Surgical Associates, P.C. v. Commissioner, 81
T.C.M. (CCH) 1474 (2001), the taxpayer was a professional corporation
that provided medical services. The corporation employed shareholder
and non-shareholder surgeons to perform pediatric surgical services.
The shareholder surgeons received a fixed monthly salary plus a
monthly bonus, each of which were deducted by the corporation as
officer compensation. By contrast, the non-shareholder surgeons
merely received a fixed salary.
Each shareholder surgeon was a party to an employment contract with
the corporation. Each agreement described the employee/employer
relationship and addressed the services to be provided by the
shareholder surgeons, including medical and administrative services.
Each agreement also defined the compensation package to include base
compensation and discretionary bonuses.
In addition, each non-shareholder surgeon was a party to an employment
agreement with the corporation. Each defined the compensation package
to include base compensation only, to the exclusion of bonuses. The
non-shareholder surgeons had no significant administrative
duties.
As a part of its monthly financial activities (typically mid-month),
the shareholder surgeons computed the monthly bonuses by first
determining the cash necessary to meet future cash-flow needs of the
corporation. The surgeons next compared that amount to the actual
cash on hand. The excess would then be earmarked for the payment of
bonuses, pursuant to the employment agreements. Such bonus payments
were included as deductible compensation for purposes of the corporate
income tax return.
The IRS selected the 1994 and 1995 corporate income tax returns for
examination, and disallowed the deductions related to the bonuses.
The IRS took the position that the bonuses were payments to the
surgeons that were not entirely related to services that they
rendered. As such, the IRS concluded that a portion of the payments
were necessarily distributions of earnings and profits (i.e.,
nondeductible dividends). Specifically, the IRS determined the
portion of the current profit that was attributable to services
rendered by the non-shareholder surgeons by first reviewing the
corporation's collection data for the years in question, followed by a
review of the expense data of the corporation for the same years. The
IRS then determined the net profit attributable to the non-shareholder
surgeons (and thus the nondeductible amount of the bonuses) by
determining the amount of the collections attributable to the
non-shareholder surgeons and then subtracting their salaries and other
allocated expenses.
Section 162(a) of the Internal Revenue Code permits a deduction for
compensation that meets two conditions. First, the compensation must
be reasonable. Second, it must represent payment for personal
services actually rendered. The IRS took the position that the
bonuses received by the surgeons were partially the result of services
rendered by others (i.e., the non-shareholder surgeons). Thus, the
IRS disallowed this portion of the bonus deduction. Interestingly,
the IRS did not address the issue of reasonable compensation.
The taxpayer disagreed with the position of the IRS, and the matter
ultimately went to trial in the United States Tax Court.
At trial, the corporation cited Bianchi v. Commissioner, 77-1
U.S.T.C. (CCH) ¶9270 (2d Cir. 1977), aff'g, 66 T.C. 324
(1976), as support or the proposition that the bonus payments were
fully deductible. In Bianchi, a dentist converted his sole
proprietorship to a corporation. In attempting to determine the
amount of reasonable compensation for services rendered, the dentist
determined that the strongest indication of reasonable compensation
was his net earnings as a sole proprietor (i.e., his net profits).
The Tax Court agreed, and the Second Circuit affirmed, that
self-employment net profits could be used as a benchmark.
In Pediatric, the IRS argued that Bianchi was
distinguishable. Specifically, the IRS pointed out that, in
Bianchi, the dentist was the sole service provider. Thus, the
value of the services provided was clear. In Pediatric, the
IRS argued that the shareholders were not the only service providers.
In fact, the shareholder surgeons and non-shareholder surgeons
rendered services, and thus contributed to the profits of the
corporation. The value of the services rendered was not as
evident.
The Tax Court held for the IRS. In the absence of any meaningful data
that the shareholder surgeons had earned the full amount of the
bonuses that they had received during the years in question, the Court
agreed with the IRS' calculations. Furthermore, the Court agreed with
the IRS' imposition of the negligence component of the
accuracy-related penalty. Since the shareholder surgeons were aware
that a portion of the profits was attributable to non-shareholder
services, the corporation's treatment of such bonuses as fully
deductible compensation was not considered to be negligent.
Physicians (and other professional service providers) should take
serious heed from the ruling. Yet, the news is not as grim as one
might expect. At best, the Pediatric case is nothing more than
a lesson in basic planning. As an initial matter, the physicians must
be prepared to engage corporate counsel to monitor compliance with
legal responsibilities under state law. This process includes the
required maintenance of corporate shareholder and director minutes,
whether required by state law or in addition to the requirements of
state law. Though seemingly insignificant in nature, such maintenance
can operate to prevent the result that occurred in
Pediatric. Such attention to detail can also avoid or reduce
costly liability issues under state corporate law.
As a practical matter, the minutes and corporate records should
provide sufficient detail to memorialize the intent of the
shareholders and the related basis for computations (and payments) of
compensation and, in particular, bonuses. All bonuses should be
accompanied by appropriate written declarations of the directors
and/or the shareholders. The grounds for such declarations should be
clear. All bonuses should be accompanied by an expression of intent
that they are made in response to the services (including
administrative services) provided by the shareholder physicians. Such
services should be documented. It is clear that the courts generally
do not rely on specific dollar-amount thresholds or guidelines.
Rather, determinations are made on a case-by-case basis. Facts and
circumstances, as well as the intent of the parties, are controlling.
A compensation package should withstand a challenge by the IRS if it
conforms with the mandate of Section 162, and follows the suggestions
set forth above.
Christine Izaj, CPA, MBA, is a Senior Tax Manager with Alpern,
Rosenthal & Company, one of the largest certified public accounting
and business consulting firms in Western Pennsylvania. She is a
member of the firm's Medical Services Group and has extensive
experience in tax and physician compensation issues.
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