The Tax Court decision may require some practices that employ both shareholder and non-shareholder physicians to consider a portion of these bonus payments as non-deductible dividends to the physician shareholders. The Court decision involved the profits earned by a corporation resulting from duties performed by non-shareholder physicians. The Court found that these profits should not be allocated to shareholder physicians in the form of bonuses and classified as deductible officer’s compensation on the corporation’s corporate return. Instead, the Court found that they were in fact a distribution of earnings and profits or nondeductible dividends.

Caution should be exercised, however, before determining that the IRS has launched another attack on physicians and the medical profession. On reading the decision, one of the reasons the Court reached its conclusions was the fact that the corporation in question kept poor records. This permitted the IRS to convince the Court that its analysis was correct over that of the corporation. However, even with this win, the IRS had to concede a large amount of the tax originally assessed in its notice of deficiency.

The decision, Pediatric Surgical Associates P.C. v. Commissioner, involved a physician practice that was audited by the IRS for the calendar years 1994 and 1995. For the years under audit, the corporation employed four shareholder surgeons (one retired in the second audit year) and two non-shareholder surgeons. Initially, the IRS issued a notice of deficiency for $598,710 of the $1,300,231 paid shareholders for calendar year 1994. The notice of deficiency for 1995 disallowed $805,469 of the $1,528,125 paid shareholders. The IRS also assessed a 20 percent accuracy-related penalty in both years. The IRS later amended its disallowance to $140,766 and $19,450, respectively and the Court further reduced the assessment to $61,234 and $9,037, respectively. The average shareholder salary in each of these years was $325,058 and $382,031, respectively. The non-shareholder physicians were employed using two-year employment contracts with fixed salaries of $12,000 or $12,500 per month, without bonuses.

The IRS’s position in this matter was that the taxpayer was entitled to only deduct as wages the actual collections of the shareholder-employees, less their share of the corporation’s expenses. These expenses included those considered directly allocated to compensation, such as payroll taxes or individual fringe benefits and those considered overhead items.

The corporation disagreed that the compensation deduction was based solely on shareholder collections. It attempted to rely heavily on the fact that all of the payments to the shareholders were treated as wages and reported on W-2s. The corporation stated the payments made to the shareholders surgeons were clearly compensation for services rendered and not disguised dividends. The corporation issued W-2 forms to its shareholder surgeons and that income was duly reported on the surgeon’s personal income tax returns. The corporation also claimed that the payments were reasonable because the shareholder’s received less than their gross collections.

The Court’s decision revolved around its interpretation of Internal Revenue Code (IRC) Section 162 regarding trade or business expenses. Section 162(a)(1) establishes a two-prong test for the deductibility of payments as salaries or other compensation for personal services actually rendered. To be deductible as compensation for services, the payments must be (1) "reasonable," and (2) "in fact payments purely for services." The Court dispensed with an analysis of the reasonable prong and stated the primary issue was whether the payments were "purely for services." To prevail, wrote the Court, the corporation had to show that the remaining amounts were paid to the shareholder surgeons purely for their services. The difficulty with proving this, the Court stated, was that the shareholder surgeons were not the only service providers employed by the corporation. There were also the non-shareholder surgeons, whose contributions to corporate profit cannot be assumed to be zero.

The Court’s analysis continued with a review of IRC Reg. 1.162-7(b)(1) that states, "Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible." The regulations further provide that an ostensible salary may, if paid by a corporation, be a distribution of a dividend on stock, or may be in part a payment for property. The issue of whether such a payment is a dividend or a payment for property is a factual issue, to be decided by the Court based on the particular facts and circumstances of the case.

The Court ultimately accepted in its analysis of the facts and circumstances of the case the IRS’ position, with modifications, that the deducible compensation paid to the shareholders was limited to their individual receipts less their allocable share of corporate expenses. Thus, the amount of collections of the non-shareholder surgeons, less an allocation for expenses, was determined to be a non-deductible dividend.

The Court also refused to dismiss the accuracy-related penalty assessed against the corporation because it found a lack of good faith on the part of the corporation. The Court found the penalty was justified based on the shareholder surgeons "utter indifference" to the possibility that part of their bonuses were derived from the non-shareholder surgeons.

To date, this is an isolated decision, although it is one that has the potential to impact any medical practice that employs both shareholder and non-shareholder physicians. Care must be used in analyzing the impact of the decision on a specific practice. Although the Court came down on the side of the IRS, the practice involved here created some of its own problems by failing to keep adequate records supporting the allocation of expenses, especially for 1994. With better record-keeping, the corporation may have been able to show that it lost money on the non-shareholder physicians. It is certainly telling that the original deficiencies assessed by the IRS were extraordinarily reduced, both by the IRS initially and later by the Court.

This decision should serve as a wake-up call for physician practices to analyze their compensation policies. This decision raises the specter that the IRS may now begin reviewing distributions by physician corporations more closely. This additional scrutiny may involve determining whether reassigning income from the physician back to the corporation, and thereby disallowing the compensation deduction and taxing the distribution as a dividend, can raise additional revenue. As a result of this decision, physician practices having both shareholder and non-shareholder employees may want to seek tax counsel regarding this matter.