Mid-Atlantic Health Law TOPICS

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Disguised Dividends

Many physician groups routinely pay all of their profits to their owners at the end of each year as bonuses. However, this practice may no longer be prudent for professional associations that are C corporations (that is, a corporation that pays tax on its taxable income, unlike an S corporation that rarely pays a corporate level tax).
A. Pediatric Surgical Associates Last year, in Pediatric Surgical Associates, P.C. v. Commissioner, the U.S. Tax Court held that Pediatric Surgical Associates, P.C. (PSA) erroneously deducted a portion of bonuses paid to shareholder-employee surgeons as compensation, since such portion constituted disguised dividends. The court also held that PSA was subject to an accuracy-related penalty for negligence in the amount of 20% of the portion of the underpayment of income tax.
PSA was a C corporation, and was in the business of providing pediatric surgical services. It employed shareholder surgeons and nonshareholder surgeons to perform such services. The shareholder surgeons received salaries plus bonuses. The nonshareholder surgeons received fixed salaries. Almost all of PSA's pre-compensation net income was paid out as salary and bonuses, leaving relatively small amounts of taxable income. The bonuses were paid out in equal amounts to the shareholder surgeons.
The position of the Internal Revenue Service (IRS), upheld by the Tax Court, was that a portion of what PSA treated as compensation to the shareholder surgeons was profit attributable to services performed by the nonshareholder surgeons, and should be characterized as a non-deductible, disguised dividend, instead of deductible compensation.
The Tax Court determined the collections attributable to the nonshareholder surgeons and allocated to such collections a portion of PSA's expenses, with a resulting net profit attributable to the nonshareholder surgeons. Such net profit was treated as a non-deductible dividend to the shareholder surgeons rather than deductible compensation, with a resulting increase in PSA's taxable income and tax liability. It is probable that the Tax Court overstated the net profit attributable to the nonshareholder surgeons, since the allocation of expenses to them did not take into account any of the salary and bonuses paid to the shareholder surgeons. Seemingly, some of the services performed by the shareholder surgeons consisted of management of PSA, services that benefited the nonshareholder surgeons.
B. Penalty In imposing the accuracy-related penalty for negligence, the Tax Court noted the testimony of one of PSA's shareholder surgeons that the nonshareholder surgeons "made money" for PSA. The Tax Court stated that "[i]t is the shareholder surgeon's utter indifference to the possibility that a portion of the annual prebonus profits might have been derived from collections generated by nonshareholder surgeons that justifies respondent's imposition of an accuracy-related penalty in this case."
C. Death Knell to C Corporations The PSA case has created quite a stir among tax advisors, notwithstanding that it does not deal with any novel issues or break any new ground. What is noteworthy about the case is that the IRS chose to attack the characterization of payments that were labeled compensation and paid by a personal service corporation where capital was an insignificant income producing factor.
The issue of compensation versus dividends as related to personal service entities has received scant attention from the IRS for many years. Tax advisors fear that this case is a harbinger for personal service corporations that are C corporations with nonshareholder employees that are professionals.
The case makes a compelling argument for all personal service C corporations with nonshareholder employees that are professionals to consider converting to an S corporation. In general, there is no corporate level tax imposed upon an S corporation, and, therefore, there is no issue about an S corporation getting a tax deduction for payments labeled compensation. If PSA had been an S corporation, the case would have resulted in tax benefits to the shareholders, because dividends are not subject to the FICA (Social Security and Medicare) tax.
D. Built-in Gain When a C corporation converts to an S corporation, it may have on the date of conversion "built-in gain," that is, the excess of the fair market value of its assets over the tax basis of its assets. Generally, if those assets are sold within 10 years from the time the corporation became an S corporation, the built-in gain will be taxed at the corporate level.
In most cases, the only built-in gain that a personal service corporation will have will be its accounts receivable. More specifically, the collection by an S corporation of accounts receivable generated by a cash method C corporation prior to conversion to S corporation status will result in built-in gain.
To avoid corporate level tax on the built-in gain, the personal service corporation could, prior to converting to S corporation status, sell its accounts receivable to a finance company or to its shareholders, and pay the amount received as a bonus to its shareholders, recognizing the income at the corporate level but claiming an offsetting deduction.
Alternatively, a personal service corporation that is about to convert to an S corporation could accelerate the collection of its receivables to the greatest extent possible. The corporation could then declare bonuses payable to its shareholder employees, in an amount equal to the remaining receivables, and then pay those bonuses within the first 2 1/2 months of the corporation's first tax year as an S corporation. While collection of the receivables would result in built-in gain, the payment of the accrued bonuses would result in an offsetting built-in loss to the extent the bonuses could be justified as reasonable compensation.
Some commentators have taken the position, with some justification, that the payment of accrued bonuses within the corporation's first tax year as an S corporation, but after the first 2 1/2 months of such year, would reduce the built-in gain recognized from collection of the receivables. Such position may be overly aggressive, because it dispenses with the 2 1/2 months rule set forth in the Treasury regulations.
E. Conclusion The PSA case means that it is no longer business as usual for professional corporations that are C corporations, if those corporations employ non-owner physicians. Such corporations should seriously consider converting to S status, even if that means selling off receivables or declaring bonuses to be paid in the first 2 1/2 months of the first S corporation year. By not doing so, the owners of such medical groups are at risk of incurring a corporate level tax and a shareholder level tax on any bonuses paid to owners that are attributable to the services of non-owner physicians, plus a 20% penalty on the unpaid corporate tax.


March 22, 2002




Rosen, Barry F.


Health Care