Bonus Payments to Employee-Shareholders of Personal Service Corporation Treated as Dividends

A personal service corporation (“PSC”), as the name implies, is a corporation whose main activity is the performance of personal services.  The term should not be confused with professional corporations, which are corporations formed for the purpose of conducting business in a licensed profession.  Although all PSCs are professional corporations, not all professional corporations are PSCs.  The distinction is important, as PSCs are subject to specific tax rules.

There are various criteria to determine whether the “personal service corporation” definition has been met.  Two of the criteria are whether the corporation performs services in the fields of health, law, engineering or accounting (among others), and whether such services are substantially performed by employee-shareholders.

If an entity qualifies as a personal service corporation, it will pay a flat 35% tax rate on all of its income for Federal income tax purposes.  Moreover, as is the case with all corporations, any dividend payments to its shareholders are not deductible by the corporation, although they are included in shareholder income.  To avoid this situation, personal service corporations oftentimes pay a bonus to their shareholders at year-end to reduce taxable income. 

Such was the central issue in the 2016 case of Brinks Gilson & Lione (a Professional Corporation) v. Commissioner.  Upon audit by the IRS, the law firm of Brinks Gilson & Lione (“the Firm”) was challenged on the treatment of a portion of the shareholder bonuses as compensation rather than as non-deductible dividends.  After negotiations, the parties agreed to re-characterize a portion of the bonuses as dividend payments, resulting in a substantial understatement of the Firm’s income tax liability for the years in issue.  Accordingly, the IRS assessed the 20% accuracy-related penalty.  The Firm petitioned the Tax Court for a redetermination of the penalty, asserting (among other things) that it had substantial authority for its position.  The Court applied the “independent investor” test and determined that an independent investor who was not an employee of the corporation would expect to receive a return on the capital he invested in the Firm.  The Court also analyzed various cases cited by both the Firm and the Commissioner using such test and concluded that the Firm did not have substantial authority, as the cases cited supporting its position were not “substantial when weighed against the contrary authority.”

This decision will require personal service corporations to reassess their tax planning strategies.  Shareholders will need to consider the reasonableness of the payments they receive from the PSC.  It is, therefore, imperative that the implications of the Brinks decision be discussed with a tax advisor.

If you are an owner of a PSC and wish to discuss bonus planning or how this decision may affect your business, contact your Marcum tax professional.