Zeroing Out Year End Physician Practice Profits

October 10, 2007

Physicians have routinely paid themselves bonuses and classified these payments as officer’s compensation on their corporate returns without often taking into consideration the deductibility of such payments. This is particularly true at year end when most physicians take out enough compensation to avoid paying corporate level income taxes. In a past ruling, Pediatric Surgical Associates P.C. v. Commissioner; T.C. Memo. 2001-81; No. 12743-98 (2 Apr 2001), the tax court held that profits earned from non-shareholder physicians allocated to shareholder physicians in the form of bonuses and classified as deductible officers compensation on the Clinic’s corporate return were in fact a distribution of earnings and profits or nondeductible dividends.

This case is important because (1) the Pediatric Surgical case was not appealed, (2) physician shareholders of C-Corporations (Not S-Corporations) continue to withdrawal out all corporate profits as shareholder compensation and (3) the resulting exposure is that the IRS could begin a campaign to audit group practice C-Corporations. While the IRS has not indicated that it will in fact develop an audit initiative for these physician corporations, they should still prepare themselves for such an initiative nonetheless. The following paragraphs revisit the Pediatric Surgical case:

The pediatric surgical clinic (“the Clinic”) consisted of shareholder surgeons, who received monthly salaries and cash bonuses, and non-shareholder surgeons, who received only monthly salaries.  The Clinic deducted the amounts paid to the shareholder surgeons as officer compensation.  The IRS disallowed part of those deductions, finding they should have been characterized as dividends instead.  The tax court agreed with the Service’s interpretation.

SUMMARY OF THE FACTS

The years under review by the IRS were 1994 and 1995.  In 1994, the Clinic reported gross receipts of $2,080,008 and taxable income of $29,255 on Form 1120.  For 1995, on gross receipts of $2,405,718, the Clinic reported taxable income of $49,323.  The Clinic computed taxable income under the cash receipts and disbursements method of accounting.

During the audit year 1994 the Clinic consisted of four shareholder surgeons and in 1995 the Clinic employed three shareholder surgeons for the entire year and one shareholder surgeon up until his retirement date of June 30, 1995.  In addition, the Clinic employed a non-shareholder surgeon from January 1, 1994 through July 14, 1994.  The Clinic also hired another non-shareholder surgeon on July 1, 1995 and this physician was employed throughout the remainder of 1995.

In the middle of each month, the Clinic would determine the amount remaining in its bank account and the amount of cash necessary to meet anticipated cash-flow needs for the immediate and near future.  The balance in the account, if any, was paid out, in equal amounts, as bonuses to the shareholder surgeons, pursuant to the shareholder employment agreements.  During the audit years 1994 and 1995 the full-time shareholder surgeons were compensated on average $353,455 and $451,743 respectively.  Additionally, the non-shareholder surgeons were compensated at $72,000 in 1994 and $76,061 in 1995.  Total compensation of shareholder physicians reported on the Clinic’s tax returns as officer compensation for 1994 and 1995 was $1,300,231 and $1,528,125 respectively.

The original notice of deficiency received by the practice from the IRS on June 25, 1998 assessed additional taxes and penalties in 1994 of $247,746 and in 1995 of $345,127.  The principal adjustments giving rise to the deficiencies in each year were the IRS’s disallowance of a portion of officers’ compensation.  The amounts disallowed were $598,710 and $805,469 for 1994 and 1995 respectively.  The IRS auditor limited deductible officers’ salaries based on the theory that the salary paid to the new non-shareholder physicians established reasonable shareholder physicians’ salaries.

Ultimately, the IRS sharply reduced the proposed deficiencies to amounts determined to represent the Clinic’s profits attributable to services rendered by the non-shareholder surgeons.  The IRS conceded the deductibility of all but $140,776 and $19,450 of the disallowed amounts.  The IRS’s position was that a portion of what the Clinic has treated as compensation to the shareholder surgeons was profit attributable to services performed by the non-shareholder surgeons, which should have been treated as nondeductible dividends rather than as deductible compensation.

The Clinic’s principal argument was that payments made to the shareholder surgeons were clearly compensation for services rendered and not dividends.  This was because the payments to the shareholder surgeons were reasonable in amount because they did not exceed the corporation’s profits, calculated by subtracting from corporation’s gross receipts (which were exclusively from providing services) all corporate expenses except officers’ compensation. The practice also made the same argument in different terms: “Petitioner’s shareholder surgeons were paid compensation in an amount less than their gross collections, which proves that they were reasonably compensated.”

The Clinic’s treatment of the reported amounts was consistent with the board’s intending such amounts to constitute payments purely for services.  The Clinic also argued that the shareholder employment agreements tied based compensation and bonuses to the number of months worked during the year, which, the Clinic argued, signifies compensation for services.

LAW AND DISCUSSION

The case revolved around Internal Revenue Code (I.R.C.) section 162 concerning trade or business expenses.  I.R.C. section 162(a)(1) establishes a two-pronged test for the deductibility of payments purportedly paid 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 IRS indicated that it was the second prong that the disallowed amounts were not, in fact, payments purely for services that concerned them.  To prevail according to the court, the practice had to show that the remaining amounts were paid to the shareholder surgeons purely for their services. This is difficult because the shareholder surgeons were not the only service providers employed by the practice. There were also the non-shareholder surgeons, whose contribution to corporate profit cannot be assumed to be zero according to the court.

Section 1.162-7(b)(1), Income Tax Regs., 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. Therefore, the medical practice must prove its intent (i.e., the intent of the members of the board) to pay compensation. Whether such intent has been demonstrated is a factual question to be decided on the basis of the particular facts and circumstances of the case.

As previously mentioned, the practice argued that the shareholder employment agreements pegged base compensation and bonuses to the number of months worked during the year, which, the practice argued, signified compensation for services. According to the court, a payment pegged to time worked may be nothing more than a payment for services. It may, however, include a distribution of profits, if the only recipients of such payments are the owners of the enterprise. Here, all of the recipients of such payments were shareholders of petitioner (shareholder surgeons). Three were full-time employees, who were entitled to equal payments, while the fourth was a part-time employee, entitled to a proportionate payment. That disparity did not eliminate the possibility of a disguised distribution of profit according to the court, but may reflect only an implicit redistribution of ownership upon the decision of a shareholder surgeon partially to retire.

Ultimately, the court re-allocated deductible shareholder compensation as non-deductible dividends equal to the “profit” generated by the non-shareholder physicians. The court took the collections generated by these physicians and deducted expenses, which consisted of the salary paid to the physicians plus one-tenth (one-fifth for the one-half of the audit year during which each physician was employed) of other expenses considered equally apportionable to the five surgeons employed during each year. The court ruled there should be a pro rata (one-tenth) allocation of rent, repair and maintenance expense, depreciation of office equipment (other than shareholder automobiles), telephone expenses, and equipment lease expenses to the non-shareholder surgeons’ collections.

The court therefore found the net profit attributable to the non-shareholder surgeons was as follows:

                                    1994               1995

Collections              $171,918        $129,806

Expenses                 (110,684)       (120,769)

Profit                          61,234              9,037

CONCLUSION

This tax court has the ability to impact any group medical practice that employs both shareholder physicians and non-shareholder physicians. The case could have further far reaching consequences because the IRS could calculate profits from ancillary and other services that have nothing to do with “payments to physicians for the services they render” and then reclassify these internal profits as dividend income as well. Characterizing all payments to physician shareholders as compensation not only could result in additional corporate taxes but penalties as well. Keep in mind the court sustained the IRS’s accuracy-related penalty against the practice.  The court, finding a lack of good faith, held that 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.

Group practices are therefore cautioned and suggested to seek tax counsel regarding this extremely important matter. Physician shareholder employment agreements should be reviewed to make sure physician owners are “compensated” for all of the other non-clinical services and duties they render to and on behalf of their corporation. Converting from a C-Corporation to an S-Corporation is also a possibility.

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