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.   Alistair M. Nevius at the Journal of Accountancy, in the article Accounting firm payments to owners flunk independent investor test,  reports:  

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 company’s owners (Mulcahy, Pauritsch, Salvador & Co., No. 11-2105 (7th Cir. 5/17/12), aff’g T.C. Memo. 2011-74).

The firm was founded in 1979 by three accountants. During the tax years at issue—2001, 2002, and 2003—the three founders served as the firm’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 firm’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 founders’ services. A corporation can deduct a “reasonable allowance for salaries or other compensation” (Sec. 162(a)(1)), but cannot deduct dividends.

The IRS disallowed the firm’s deductions for the “consulting fees,” reclassifying them as dividends, and also imposed Sec. 6662 accuracy-related penalties on the firm. The Tax Court upheld the IRS’s determinations.

On appeal, the Seventh Circuit, in an opinion authored by Judge Richard Posner, applied the “independent investor test” to the facts of the case. The Seventh Circuit characterized the premise of this test as “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 consider the salary reasonable compensation for the owner-employee’s contribution to the company’s success” (slip op. at 4). However, in this case the payments reduced the firm’s income—and thus its equity return to investors—to zero. Thus, the court held, “the firm flunks the independent-investor test” (slip op. at 8).

Read the whole piece here. 

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