Academic journal article Journal of Accountancy

Accounting Firm's Payments to Owners Flunk Independent-Investor Test

Academic journal article Journal of Accountancy

Accounting Firm's Payments to Owners Flunk Independent-Investor Test

Article excerpt

The Seventh Circuit held that an accounting and consulting firm organized as a C corporation could not deduct payments to related entities because they were dividends, not compensation for services rendered by the company's owners.

The firm was founded in 1979 by three accountants. During the tax years at issue--2001, 2002, and 2003--the three founders served as the firm's board of directors and sole officers. During those years, the firm made payments to three related entities, which then passed those payments on to the founders in proportion to their hours worked for the firm.

The payments to the related entities reduced the firm's taxable income to zero or nearly zero. The firm initially characterized those payments as consulting fees, but during the trial in the Tax Court, it claimed they were compensation for the founders' services. A corporation can deduct a "reasonable allowance for salaries or other compensation" (Sec. 162(a)(1)) but cannot deduct dividends.

The IRS disallowed the firm's deductions for the "consulting fees," reclassifying them as dividends, and imposed Sec. 6662 accuracy-related penalties on the firm. The Tax Court upheld the IRS's determinations.

On appeal, the Seventh Circuit, in an opinion authored by Judge Richard Posner, applied the "independent-investor test." The Seventh Circuit characterized the premise of this test as "an investor who is not an employee will not begrudge the owner-employee his high salary if the equity return is satisfactory; the investor will consider the salary reasonable compensation for the owner-employee's contribution to the company's success" (slip op. …

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