Federal Court: Salaries Were Actually Dividends to Shareholders, Not Deductible

By Joe Forward, Legal Writer, State Bar of Wisconsin

May 17, 2012 – Federal appeals court Judge Richard Posner recently scolded a Chicago accounting firm for what he called a “cockeyed method of distributing profits to its owners.” Now, the firm must pay a large corporate tax and corresponding penalty.

That was the decision of a three-judge panel for the U.S. Court of Appeals for the Seventh Circuit in Mulcahy, Pauritsch, Salvador & Company v. Commissioner of Internal Revenue, No. 11-2105 (May 17, 2012), which upheld a decision of the U.S. Tax Court.

Mulcahy, Pauritsch, Salvador & Company, a Chicago accounting firm founded by three accountants who together owned more than 80 percent of the firm, organized itself as a C-corporation in 1979 when fewer “pass-through” options existed. But it never reorganized.

In tax years 2001-03, the firm paid more than $850,000 in “consulting fees” to three entities owned by the firm’s three founding shareholders.

The “consulting entities” then paid the shareholders (who also took annual salaries from the firm totaling $323,076) for consulting services rendered to the firm’s clients.

The firm used this “salary” method, it argued, to conceal the actual income of the founding shareholders from other employee-shareholders who thought they were overpaid. The firm classified the fees as “salary expenses,” which helped reduce its taxable income.

In fact, the accounting firm – with revenues of $5-7 million a year, reported $11,279 of taxable income 2001, a loss of $53,271 in 2002, and zero taxable income in 2003.

However, the Internal Revenue Service reclassified the consulting fees as dividends, meaning the corporate revenue used to pay the “dividends” could not be deducted as salary expenses.

The reclassification meant the firm substantially understated its corporate tax liability by about $300,000 each year from 2001 to 2003. Substantial understatements greater than $10,000 are subject to a 20 percent statutory penalty under the tax code and treasury regulations.

In his opinion, Judge Posner found it “puzzling” that the accounting firm did not reorganize itself as a pass-through entity to avoid this tax problem. “That an accounting firm should screw up its taxes is the most remarkable feature of the case,” he concluded.