Seventh Circuit Applies ‘Independent Investor’ Test to Help Determine Reasonable Compensation
Payments an accounting firm characterized as consulting fees were really disguised dividends and should have been taxed as corporate income, the Seventh Circuit held on Thursday. The payments reduced the firm’s income to zero, and the court applied the “independent investor” test to recharacterize them as dividends paid to the firm’s owners. Â Alistair M. Nevius at the Journal of Accountancy, in the articleÂ Accounting firm payments to owners flunk independent investor test,Â Â reports: Â
The Seventh Circuit held that an accounting and consulting firm organized as a C corporation could not deduct payments to related entities because they were dividends, not compensation for services rendered by the companyâ€™s owners (Mulcahy, Pauritsch, Salvador & Co., No. 11-2105 (7th Cir. 5/17/12), affâ€™g T.C. Memo. 2011-74).
The firm was founded in 1979 by three accountants. During the tax years at issueâ€”2001, 2002, and 2003â€”the three founders served as the firmâ€™s board of directors and sole officers. During those years, the firm made payments to three related entities, which then passed those payments on to the founders in proportion to their hours worked for the firm.
The payments to the related entities reduced the firmâ€™s taxable income to zero or near zero. The firm initially characterized those payments as consulting fees, but during the trial in Tax Court, claimed they were compensation for the foundersâ€™ services. A corporation can deduct a â€śreasonable allowance for salaries or other compensationâ€ť (Sec. 162(a)(1)), but cannot deduct dividends.
The IRS disallowed the firmâ€™s deductions for the â€śconsulting fees,â€ť reclassifying them as dividends, and also imposed Sec. 6662 accuracy-related penalties on the firm. The Tax Court upheld the IRSâ€™s determinations.
On appeal, the Seventh Circuit, in an opinion authored by Judge Richard Posner, applied the â€śindependent investor testâ€ť to the facts of the case. The Seventh Circuit characterized the premise of this test as â€śan investor who is not an employee will not begrudge the owner-employee his high salary if the equity return is satisfactory; the investor will consider the salary reasonable compensation for the owner-employeeâ€™s contribution to the companyâ€™s successâ€ť (slip op. at 4). However, in this case the payments reduced the firmâ€™s incomeâ€”and thus its equity return to investorsâ€”to zero. Thus, the court held, â€śthe firm flunks the independent-investor testâ€ť (slip op. at 8).
Read the whole piece here.Â