C Corporation Law Firm Sees Huge Tax Bill
The United States Tax Court held a Chicago law firm liable for negligence penalties for mischaracterizing payments to shareholder attorneys as compensation for services rather than dividends.
Many personal service firms, such as law firms and accounting firms, operate as C corporations for tax purposes. But C corporation earnings are subject to a double tax. First is a corporate income tax imposed on the corporation’s net earnings. Second, after the earnings are distributed to shareholders as dividends, each shareholder must pay taxes separately on their share of the dividends. The Chicago law firm attempted to avoid the double tax by distributing its income as salary to shareholder-employees.
The law firm employed approximately 150 attorneys, about 65 of whom were shareholders. The firm also employed non-attorney staff of about 270. Shareholder attorneys were entitled to receive a dividend if declared by the board of directors, but no dividend had ever been declared. As a matter of course, in November or December of the prior year, the board of directors established a budget including expected compensation for shareholder-employees.
Over the year, each shareholder-employee received only a percentage of his expected compensation with the expectation of receiving an additional amount as a yearend bonus. The board calculated the shareholders’ cumulative yearend bonus to exhaust book income. Shareholder-employees shared in the bonus pool in proportion to their shareholder percentage.
Yearend bonuses were treated as compensation and reported on Form W-2 with the proper employment tax withheld. The Form W-2s were provided to the firm’s outside accounting firm and the corporate tax return was prepared by taking a compensation deduction for the yearend bonuses.
To learn how the court ruled, click here.