Or, Cutting Up the Pie
The perennial question that arises when the partners/shareholders/manager-members of personal services firms convene the annual compensation bloodbath (sorry, I meant meeting) is, what part of the pie is compensation for services (deductible as a business expense but generating payroll tax obligations) and what part distribution of profits (nondeductible but not salary or wages and therefore not requiring payroll tax withholding).
The answer to that question can involve heavy numbers, as we learn from Mulcahy, Pauritsch, Salvador & Co., Ltd., T.C. Mem. 2011-74, released 3/31/11.
The founders of the firm, Messrs. Mulcahy, Pauritsch and Salvador, established various entities controlled by them, to which the firm paid what they called “consulting fees”, ostensibly for services rendered by the founders. The firm also paid rent to a founder-controlled entity (not an issue in the case), and interest (disallowed as no proof that such payment was ever made).
Judge Morrison’s analysis is the classic Section 162(a)(1) “ordinary and necessary”, including a “reasonable allowance for salaries or other compensation for personal services actually rendered”.
First, one of the founders claimed that some part of the consulting fees was return of capital, but offered no evidence as to what part of the consulting fees was a return of capital, nor any theory to sustain the deductibility of any return of capital.
“The firm did not withhold payroll taxes on the ‘consulting fee’ payments, as it would have been required to do with respect to employee compensation payments to the founders. It did not include the ‘consulting fee’ payments on the founders’ Forms W-2, Wage and Tax Statement, as it would have been required to do with respect to employee-compensation payments to the founders. It did not issue the founders Forms 1099-MISC, Miscellaneous Income, as it would have been required to do with respect to payments of nonemployee compensation to the founders. Finally, it did not report the ‘consulting fee’ payments on its income tax returns as officers’ compensation.” T.C. Mem. 2011-74, at p. 12 (footnote).
A presumption of reasonableness of compensation for services is tied to investors’ expectation. Would arms’-length investors be happy with excess compensation over industry-wide scales of pay? Yes, said the Court, but only if the return on investment was higher than reasonably expected.
How to compute return on investment? There’s the rub. The firm wanted to take year-over-year increase in gross revenue, and based the methodology on the fact that apparently someone once offered to buy the firm for one year’s gross (and by the way, that calculation is not crazy, for I’ve seen it used in similar contexts for personal services firms such as this one, but here it’s irrelevant).
IRS said they had no fixed formula, but the return-on-investment number had to be based upon net income, because gross income was no indicator of bottom-line cash available for distribution. As the Court put it: “A corporation’s shareholders do not seek to maximize gross revenue. They seek to maximize profit.” T.C. Mem. 2011-74, at p. 15. And the founders ran the firm (a C corporation) so that its year-end profit, taking the “consulting fees” into account, was zero or nearly so. No investor would be happy with that result.
The presumption of reasonableness based upon investor satisfaction having been rebutted, founders’ expert brought forth irrelevant data. First he took examples of what other firms paid their “name partners”, but did not distinguish among compensation for services, return of capital and distributions of profit. Next the expert concluded that the payments were reasonable. All very well, says the Court, but that isn’t the question–the question is whether the payments were reasonable as compensation for services. That, the expert never discussed. The firm failed to produce competent evidence to show that the amounts paid to the founders by way of “consulting fees” were in fact paid for services rendered, at a rate reasonable under all the facts and circumstances.
Even though the “consulting fees” were paid to the founders based upon their respective billables, and not in proportion to their shareholdings, that did not save the deduction, as the amounts were paid to “zero-out” the firm’s income at year end. Profits need not be distributed in proportion to shareholdings in order to remain profits and cannot by some formula be transmuted into compensation for services.
So the Court found no intent to compensate but only the intent to “zero-out” whatever cash was left at year end.
The Court sustained the substantial underreporting penalty, as the firm could not show that they relied upon their trial expert’s advice in handing out the year-end cash, because the founders only looked at what cash they had, and didn’t bother with expert’s formulae.
Trust me, I’ve been in partners’ compensation meetings in personal service firms (and the firm here was an accounting and consulting firm). If polled, the universal response would be “we don’t need no stinkin’ expert formula, gimme my money now!”
The founders got their money. Plus heavy tax liabilities plus interest plus penalties.
The takeaway? Get your experts on board before you start parceling out the money. You may not like the result, but it’s “pay me now or pay me later with interest and penalties”; your call.