In Brinks Gilson & Lione, P.C. v. Commissioner, T.C.Memo. 2016-20, the law firm was taxed as a C corporation. The shareholder-attorneys were paid a draw and then, at year-end, the remaining money was divided proportionate to the draw. The year-end bonus was treated as employee compensation, deductible by the corporation. This was done year after year after year. The law firm had a large, well-established accounting firm prepare its returns. Brinks argued that it had substantial authority for deducting the year-end bonuses for shareholder-attorneys as employee compensation and that it acted in good faith because it relied on a reputable accounting firm.
The Tax Court found that zeroing-out the earnings was not based on substantial authority, but rather that the excess earnings were in the nature of dividends. The Tax Court found the consistency of zeroing-out the earnings to be particularly problematic given that it had a relationship to profitability, not to the work performed that year. The Tax Court found that the law firm did not act with reasonable cause and in good faith because the accounting firm had not specifically advised about the deductibility of bonuses.
The Tax Court seems particularly inclined to uphold penalties when they may be applicable to law firms. It seems the Tax Court is saying, “You should know better.”
Regardless of how you structure your practice, make sure you abide by the rules set by the Service. If the practice is a C corporation, do not deduct bonuses which are really just dividends in disguise. Rather, they should be treated as dividends. In Brinks, If the bonuses had been a flat percentage of the base draw, rather than zeroing-out income, I suspect the firm would have fared much better with the Service and the Tax Court.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (800) 846-1555