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Mulcahy, Pauritsch, Salvador & Co., Ltd v. Commissioner of Internal Revenue

May 17, 2012


Appeal from the United States Tax Court. No. 4901-08--Richard T. Morrison, Judge.

The opinion of the court was delivered by: Posner, Circuit Judge.


Before BAUER, POSNER, and HAMILTON, Circuit Judges.

A corporation can deduct from its taxable income a "reasonable allowance for salaries or other compensation for personal services actually rendered." 26 U.S.C. § 162(a)(1); see Treas. Reg. §§ 1.162-7, 1.162-9. But it cannot deduct dividends. They are not an expense, but a distribution to shareholders of corporate income after the corporation has paid corporate income tax. Thus a corporation that can get away with pretending that a dividend paid to a shareholder is a business expense will have a lower corporate income tax liability. The income tax liability of the recipient of the "salary" will be greater, because dividends are taxed at a substantially lower maximum rate (with irrelevant exceptions) than ordinary income--15 percent versus 35 percent. 26 U.S.C. §§ 1(h)(1), (11), (i)(2). But the offset will not be complete. Corporate revenue paid as salary is deductible from corporate income and so is taxed only once, as income to the recipient, while revenue paid as a dividend is taxed at both the corporate and the personal level. Assume that corporate income is taxed at 34 percent, dividends at 15 percent, and personal income at 35 percent. If paid as a dividend, $100 of corpo- rate income becomes $56.10 in the owner-employee's hands because the corporation pays a 34 percent tax on its income and then the owner-employee pays 15 percent on the $66 dividend, and $100 x .66 x .85 = $56.10. But if recharacterized as salary, the $100 in corpo- rate income becomes $65.00 in the owner-employee's hands. The corporation would deduct the salary expense from its income, thus paying no tax on it; the owneremployee would pay a 35 percent tax; and $100 - (.35 x $100) is $65, which beats $56.10.

Because owner-employees thus have an incentive to recharacterize dividends as salary to the extent that they can get away with the recharacterization, the courts have from time to time to decide whether income denominated as salary is really a dividend and thus has been improperly deducted from the corporation's income. See, e.g., Menard, Inc. v. Commissioner, 560 F.3d 620, 621-22 (7th Cir. 2009); Exacto Spring Corp. v. Commissioner, 196 F.3d 833, 834 (7th Cir. 1999); Haffner's Service Stations, Inc. v. Commissioner, 326 F.3d 1, 3 (1st Cir. 2003); Eberl's Claim Service, Inc. v. Commissioner, 249 F.3d 994, 996 (10th Cir. 2001); LabelGraphics, Inc. v. Commissioner, 221 F.3d 1091, 1095 (9th Cir. 2000). Invariably the taxpayer in such cases is a closely held corporation in which all (or at least most) of the shareholders draw salaries as em- ployees, because shareholders who did not draw salaries would not be compensated for the dividend reduction that enabled the shareholder-employees to increase their after-tax income. Treas. Reg. § 1.162-7(b)(1); Exacto Spring Corp. v. Commissioner, supra, 196 F.3d at 838;

Eberl's Claim Service, Inc. v. Commissioner, supra, 249 F.3d at 998. And so it is here, but this case is unusual because the employer is a professional services company.

The typical firm organized in the corporate form com- bines labor and capital inputs to produce goods or services that it sells, and the sales generate revenues that if they exceed the costs of the firm's inputs create prof- its. Some of the labor inputs into the firm may be contrib- uted by an owner-employee, who is compensated for them in salary though he may also receive a share of the firm's profits in the form of dividends as compensation for his capital inputs. Whether the deduction that the corporation takes for the owner-employee's salary really is a dividend can usually be answered by comparing the corporation's reported income with that of similar corporations, the comparison being stated in terms of percentage return on equity, the standard measure of corporate profitability. See, e.g., Menard, Inc. v. Commis- sioner, supra, 560 F.3d at 623-24. The higher that return, the stronger the evidence that the owner-employee de- serves significant credit for his corporation's increased profitability and thus earns his high salary. Indeed there is a presumption that salary paid an owner- employee is reasonable--hence not a disguised dividend, and hence deductible from corporate income--if the firm generates a higher percentage return on equity than its peers. Exacto Spring Corp. v. Commissioner, supra, 196 F.3d at 839; see also Menard, Inc. v. Commissioner, supra, 560 F.3d at 623.

This is the "independent investor" test. Its premise is that an investor who is not an employee will not begrudge the owner-employee his high salary if the equity return is satisfactory; the investor will con- sider the salary reasonable compensation for the owner- employee's contribution to the company's success. 7

Mertens Law of Federal Income Taxation § 25E:1 (2012). But the presumption is rebuttable, since as we noted in the Menard case it might be that the "company's success was the result of extraneous factors, such as an unexpected discovery of oil under the company's land." 560 F.3d at 623; see also Exacto Spring Corp. v. Commissioner, supra, 196 F.3d at 839. When this is a possibility, other factors besides the percentage of return on equity have to be considered, in particular comparable salaries. The closer the owner-employee's salary is to salaries of comparable employees of other companies who are not also owners of their company (or to salaries of non-owner employees of his own firm who make contributions comparable to his to the firm's success), the likelier it is that his salary was compensation for personal services and not a con- cealed dividend. 7 Mertens Law of Federal Income Taxation, supra, §§ 25E:18, 19; 1 Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates & Gifts ¶ 22.2.2, p. 22-23 (3d ed. 1999).

But what if, as in a typical small professional services firm, the firm's only significant input is the services rendered by its owner-employees? Maybe it has no other employees except a secretary, and only trivial physical assets--a rented office and some office furniture and equipment. Such a firm isn't meaningfully distinct from its employee-owners; their income from their ren- dition of personal services is almost identical to the firm's income. The firm is a pane of glass between their billings, which are the firm's revenues, and their salaries, which are the firm's costs. To distinguish a return on capital from a return on labor is pointless if the amount of capital is negligible.

It is thus no surprise that most professional-services firms (including firms much larger than in our exam- ple) are organized as limited liability companies (LLCs), limited liability partnerships (LLPs), limited partnerships (LPs), small business corporations (S-corps), or other pass-through entities. In those entities as in a general partnership (which differs from the pass- throughs we listed mainly in not limiting partners' per- sonal liability for the entity's debts, and for that reason has largely given way to those other pass-throughs), the company's receipt of income is not a taxable event; instead the income is deemed to pass directly to the owners and is taxed as personal income to them.

The taxpayer in this case is not the very small firm of our example; it is not a "pane of glass." It has physical capital to support some 40 employees in multiple branches, and it has intangible capital in the form of client lists and brand equity--and capital in a solvent firm generates earnings. The taxpayer decided to do business as a conventional corporation (a "C corporation" as it is called) rather than as a pass-through, and this required it to pay corporate income tax if it had income. It contends that it had virtually no income, and so owed virtually no corporate income tax, because its revenues (though substantial--$5 million to $7 million a year) were offset by deductions for business expenses, primarily compensation paid directly or indirectly to its owner- employees, who are three of the firm's accountants--the "founding shareholders," as they are called. Their names form the name of the firm and they owned more than 80 percent of the firm's stock in 2001 (slightly less in the following two years) and received salaries from the firm that year that totaled $323,076. The firm reported taxable income of only $11,279 that year and in the fol- lowing year it reported a loss of $53,271, and as a result of carrying forward part of that loss it reported zero taxable income the third year.

The Internal Revenue Service did not question the salary deductions, but it disallowed more than $850,000 in "consulting fees" that the firm paid in each of the three years to three entities owned by the founding share- holders--PEM & Associates, Financial Alternatives, Inc., and MPS, Ltd.--which in turn passed the money on to the founding shareholders. Seconded by the Tax Court, the Internal Revenue Service reclassified the fees as dividends, resulting in a deficiency in corporate income tax of more than $300,000 for 2001 and similar deficiencies for the following two years.

The Tax Court added to the deficiencies the 20 percent statutory penalty for "substantial understatement of income tax," 26 U.S.C. §§ 6662(a), (b)(2), defined as an understatement either greater than $10,000 or greater than 10 percent of the tax due. Treas. Reg. § 1.6662-4(b). The firm's understatement exceeded $280,000 in each year. Reasonable good-faith efforts to determine tax liability--efforts that usually consist in obtaining tax advice from a reputable professional tax adviser--will protect a taxpayer from the imposition of the penalty, 26 U.S.C. § 6664(c)(1); Treas. Reg. §§ 1.6664-4(a), (c)(1); United States v. Boyle, 469 U.S. 241, 250-51 (1985); Richardson v. Commissioner, 125 F.3d 551, 558 (7th Cir. 1997), provided the adviser has no conflict of interest. American Boat Co., LLC v. United States, 583 F.3d 471, 481-82 (7th Cir. 2009). But there was a huge conflict in this case: taking tax advice from ...

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