Tuesday, June 12, 2012

CPAs Blow Their Own Tax Planning

Here is one of my favorite tax quotes thus far in 2012:

                That an accounting firm should so screw up its taxes is the most remarkable feature of the case.”

You can be sure that language isn’t going to make it to the firm’s brochure.

What happened? It started with compensation. There is a CPA firm in Illinois with three senior partners. These partners were making pretty good jack, enough so that they did not want the other partners to know the actual amounts. Considering that they are – you know, a CPA firm – that could be a tall order. So the three senior partners in turn started three other companies.

EXAMPLE: Let’s say you, me, and the guy in the elevator form three companies to hide our good fortunes from our partners. Let’s say company 1 paints and wallpapers CPA offices, company 2 shreds CPA firm files and company 3 provides door-to-door transportation to CPAs during busy season.  We will have our firm “pay” these companies for services and then we will split it up – behind the scenes, of course. Brilliant! What could go wrong?

The firm and tax case is Mulcahy, Pauritsch, Salvador & Co. They had approximately 40 employees and revenues between $5 and $7 million during the years at issue. The firm was organized as a C corporation. This technically made the partners “shareholders,” and the existence of a C corporation allowed for the possibility of dividends. The three shareholders had the following ownership:
                Edward Mulcahy                              26%
                Michael Pauritsch                            26%
                Philip Salvador                                  26%

For the years at issue they received W-2s as follows:
                                               
                                                              2001                       2002                       2003

                Mulcahy                           106,175                 103,156                 102,662                    
                Pauritsch                            99,074                  96,376                   95,048                         
                Salvador                           117,824                 106,376                 112,086

The firm paid consulting fees to the three companies of:

                2001                                   911,570                
                2002                                   866,143
                2003                                   994,028

The three companies then paid the three shareholders according to the hours each worked during the year.

The IRS comes in and asks the obvious question: what consulting services were provided?

Back to our example:
               
                IRS:  Steve, how many paints and wallpapers did you do?
                Me:  Er, none.              
                IRS:  How many files did you shred?
                You: None.
                IRS:  How many transportation clients did you drive?
                Elevator guy: None.

Truly folks, it does not require graduate school and years of study and practice in taxation to guess the IRS’ reaction. They disallowed the deduction and said that it was a disguised dividend to the three shareholders.

MPS is upset. If it is not consulting, they argue, then it is compensation.

The IRS says: please show us the W-2, the 1099, anything which indicates that this is compensation. MPS argues that it is “like” compensation. Heck, at the end-of-the-day the three companies paid the shareholders based on their hours worked. Doesn’t that sound like compensation? “Sounds like” is a childhood game, says the IRS, and is not recognized as sound tax planning. Surely MPS would know this, being a CPA firm and all.

MPS goes to Tax Court. MPS argues that its intent was to compensate, therefore the tax consequence should follow its intent. It brought in experts to prove that the shareholders were undercompensated, malnourished and in need of more sunshine. The Court listened to the argument, gave it weight and said the following:
               
There is no evidence that the ‘consulting fees’ were compensation for the founding shareholders’ accounting and consulting services. If they had been thatrather than appropriations of corporate incomewhy the need to conceal them?”

There is an important point here. There is a long-standing tax doctrine that you may select any form and structure you wish for a transaction, but once you do you are bound by that form and structure. The CPA firm was a C corporation and was transacting with its shareholders. A C corporation transacts in one of two ways with its shareholders: as compensation or as dividends/distributions. If the compensation was disallowed, you have the possibility of a dividend.

The Court did try to work with MPS. It noted that two tests for compensation are that (1) it must be reasonable and (2) it must be for services performed. This brought in the “independent investor test” of Exacto Spring, which precedent the Tax Court had used in the past. The idea is easy: what return would you need on your investment to pay someone a certain amount of compensation?

EXAMPLE: A hedge fund manager receives 20% of the fund’s capital gains. This is referred to as the “carry.” Why would an investor agree to this? What if the manager was returning 20% to 30% to you annually – even after deducting his/her 20%? Would you agree to this? Uh, yes.

So the Court looks at MPS’ taxable income for the years at issue:

                2001                                    11,249
                2002                                   (53,271)
                2003                                      -0-

The Court observed that the firm had money invested in its offices, technology, furniture, etc. It noted that – according to normal market expectations – that invested capital required a rate of return. It did not think that taxable income of zero was a reasonable rate of return. The Court was aware that the firm was zeroing-out its taxable income by paying consulting fees. This indicated to the Court that the firm was not concerned with a reasonable return on invested capital. MPS could not meet the Exacto standard. Without meeting that standard, the Court could not weave “compensation” out of “consulting fees” whole cloth. This was an unfortunate result because the firm received no deduction for dividends but the shareholders had to pay taxes on them. That is the double taxation trap of a C corporation. It is also a significant reason why many planners – including me – do not often use C corporations.

Let’s go tax nerd for a moment. I believe that MPS would have substantially prevailed had it deducted the payments as compensation (and included on the W-2) and the IRS in turn argued unreasonable compensation. Why? Because I believe the Court might have disallowed some of the compensation but permitted the rest. MPS instead came from the other direction: it had to argue that the payments were compensation rather than something else. This changed the dynamic, and it now became an all-or-nothing argument. MPS lost the argument and got nothing.

MPS appealed the case but with the same result. It is here that the Seventh Circuit Court of Appeals gave us the quote:

                That an accounting firm should so screw up its taxes is the most remarkable feature of the case.”

The taxes were almost $980,000. Remember, the personal service corporation lost its deduction (and paid taxes) and the shareholders received dividends (and paid taxes). The penalties alone exceeded $190,000.
MY TAKE: This tax strategy borders on the unforgivable. There were so many ways to sidestep this result.  One way would have been working with disregarded entities, also known as single-member LLCs. The three shareholders performed services for and received W-2s from the accounting firm. The Court however did not agree that their three companies performed services for the accounting firm. A disregarded entity would have avoided that result by having the member’s activities attributed to the SMLLC.
How could the firm pay entities that provided no services? Was nobody in that tax department paying attention? I presume they were steamrolled by the three senior shareholders.
I was brought up with the technique of draining professional service corporation profit to zero by using year-end bonuses. That technique has frayed over recent years as new doctrines – such as Exacto Spring– have appeared. It is as though these MPS guys were stuck in a time warp.
Another way, and the obvious, would be to have just paid the founding partners more compensation. Yes, that would have given away the amount of actual compensation to the senior partners. Then again, this case has also given away that information.

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