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Issue 6 - May 2003

Finance & taxes by Mark Battersby
Excessive compensation:
Dealing with too much of a good thing

Should you take a big salary and bonus – or pay yourself large dividends from your incorporated practice? The answer partially depends on the Internal Revenue Service – and quite a bit on how much you are willing to pay in taxes.

A chiropractor who takes a reasonable salary and bonus from his or her practice obviously pays taxes on that salary and bonus. Salaries are a tax-deductible business expense for the practice.

But if the practice pays you – the principal – a dividend, then your total tax bill increases substantially as the result of a unique “double tax” on dividends.

The reason? Dividends are not deductible for the practice. In fact, dividends are taxable profits in an incorporated practice. If you pay yourself dividends, you pay two taxes – one on the corporate level and one on the personal income level.

Reasonable and deductible
Before you defer all dividends into a bonus for yourself – which would be considered salary – you should know that the IRS currently only allows a deduction for “reasonable” salaries. If the bonus you pay yourself falls outside of its guidelines, the tax deduction for your practice will be disallowed.

According to the IRS, the test for “reasonable compensation” is whether the salary compares to an amount that would reasonably be paid for services by like enterprises in like circumstances. Additional factors often considered by the IRS include the personal ability of the recipient, responsibility of the position occupied and the economic conditions in the locality where the recipient works.

Court decisions dealing with the question of excessive salaries arise almost exclusively with closely-held companies. Not too surprisingly, each case is decided upon its particular facts. The U.S. Court of Appeals for the Seventh Circuit has, however, come up with a so-called “independent-investor” test that is gaining acceptance in many quarters. This test presumes that compensation is reasonable if the business’s investors earn their expected rate of return.

Under that test, if a profitable business can pay its owner/shareholder a salary or bonuses and still have earned sufficient profits to provide an investor – real or hypothetical – with a reasonable return on his or her investment then, in the eyes of that court, the compensation should be considered “reasonable.” A similar test might apply to chiropractors and their practices.

Repayment loophole
What happens if the IRS determines that your compensation is excessive and does not meet the “reasonable” test? When that happens, recipient (usually the practice’s principal or major shareholder) sees his or her salary recharacterized as “dividend” income with little or no impact on his or her annual tax bill. After all, income is income.

But your practice is then hit with a substantial change in its tax bill – because the dividends are profits that are subject to tax.

Determining ‘reasonable’ compensation

The U.S. Court of Appeals for the Ninth Circuit recently ruled that a corporation could only deduct $406,000 as “reasonable” compensation instead of the $878,000 claimed by the company. Despite its small size, LabelGraphics increased its gross receipts significantly each of its first eight years and then declined slightly over the next two years, due to market conditions. During the last two years, when profits revenues decreased slightly, the company developed a proprietary process for producing “clean” room labels. Lon D. Martin, the president and founder, was instrumental in that development and was the “heart” of the company, setting corporate policy, monitoring quality control and compliance and external relationships. Martin’s compensation consisted of a salary and a bonus. The bonus, in 1990, was substantially higher than normal, $772,913. LabelGraphics took deductions for the bonus as reasonable compensation for services rendered. The IRS disallowed $633,313 of Martin’s total compensation. The corporation filed a petition with the U.S. Tax Court.

The Tax Court ruled that the corporation was entitled to deduct only $406,000 of the $878,000 that it had paid in total compensation (most of which was bonus) to Martin. The court noted that $722,900 was nearly three times the amount of Martin’s largest prior bonus. LabelGraphics acknowledged that the bonus was “unusually high,” but failed to establish that it had been intended to remedy gross underpayment in prior years. Even more damaging, the court noted that because of the bonus paid to Martin, LabelGraphics suffered a loss and had a negative 6.19 percent return on equity for 1990. The court believed an independent investor would not be satisfied with that negative return on equity, especially when the bonus equaled about 45 percent of the investor’s equity in the company.

Circuit Judge M. Margaret McKeown, agreed with the Tax Court. She said that given Martin’s role in the company; comparison of his salary with other companies’ salaries for similar services; the character and condition of the company; and the potential conflicts of interest, the Tax Court had not erred in its determination of the correct amount of compensation that could be considered “reasonable.”

Accumulated earnings tax
An “obvious” way to avoid the problems of excessive compensation or double-taxes dividends would be to just leave the money in your practice.

Unfortunately, our lawmakers and the IRS have already thought of that strategy and have come up with an “accumulated earnings tax.”

This is an extra tax, in the form of a penalty, imposed on any incorporated chiropractic practice or business that accumulates profits or earnings instead of distributing them. Although the rate of tax on improper accumulations is 39.6 percent of “accumulated taxable income,” it can be reduced with a special credit.

The accumulated earnings credit allowed under our tax rules is an amount equal to the part of the earnings and profits retained for the “reasonable needs” of the practice. A minimum amount of $250,000 ($150,000 for personal service corporations) may be accumulated from past and present earnings combined but in order to justify an accumulation of income in excess of that amount, there must be a reasonable business need for it and a definite plan for its use.

Being reasonable
Under today’s tax laws, avoiding the label of “excessive compensation” has become almost a game between many taxpayers and the ever-vigilant Internal Revenue Service. Thanks in large part to the record low numbers of tax returns currently being subjected to audits, the taxpayers are winning. Unfortunately, in those cases where they do lose, the added taxes, penalties and interest can be quite painful.

Obviously, every chiropractor in an incorporated practice would like to receive the earnings and profits from that practice with the lowest possible tax cost. When profit distributions are labeled as dividends, a double tax must be paid. If too much profit is left in the practice, especially amounts in excess of the accumulated earnings “credit,” there is the risk of the penalty tax for “accumulated earnings.” Taking those profits out of the practice in the form of compensation and bonuses is the least expensive, legal answer. Naturally, every chiropractor will keep in mind the tax law’s trap for too much compensation.

Mark E. Battersby is a tax and financial advisor, freelance writer, lecturer and author with offices in suburban Philadelphia. He can be contacted at 610-789-2480.

   
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