T.C. Memo. 2016-20

UNITED STATES TAX COURT

BRINKS GILSON & LIONE A PROFESSIONAL CORPORATION,

FORMERLY BRINKS HOFER GILSON & LIONE A PROFESSIONAL

CORPORATION, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 14414-13. Filed February 10, 2016.

Held: P, an incorporated law firm, liable for accuracy-related

penalties for mischaracterizing, as compensation for services,

dividends paid to shareholder attorneys. P lacked substantial

authority for its treatment of payments as compensation and has failed

to show reasonable cause for the resulting underpayments of income

tax and that P acted in good faith.

Brian T. Gale and Jay Howard Zimbler, for petitioner.

James M. Cascino, Tracy M. Hogan, and Elizabeth Y. Williams, for

respondent.
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[*2] MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, Judge: Respondent determined deficiencies of $245,760 and

$122,353 in petitioner's 2007 and 2008 Federal income tax, respectively, and

accuracy-related penalties of $221,930 and $203,155 for those years, respectively. 

The parties entered into a stipulation of settled issues, and the only issue

remaining for decision is whether petitioner is liable for accuracy-related penalties

on underpayments of tax relating to amounts it deducted as officer compensation

that it now agrees were nondeductible dividends. Unless otherwise indicated, all

section references are to the Internal Revenue Code in effect for the years in issue,

and all Rule references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

General Background on Petitioner

Petitioner is an intellectual property law firm organized as a corporation. 

When it filed the petition, it maintained its principal offices in Chicago, Illinois. It

computes its taxable income on the basis of a calendar year, using the cash method

of accounting. For the years in issue, it prepared its financial statements on that

basis and using that method. During those years, it employed about 150 attorneys,

of whom about 65 were shareholders. It also employed a nonattorney staff of
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[*3] about 270. Its business and affairs are managed by a board of directors

(board).

Ownership of Petitioner's Stock

Petitioner's shareholders hold their shares in the corporation in connection

with their employment by the corporation as attorneys. Each shareholder attorney

acquired his or her (without distinction, his) shares at a price equal to their book

value and is required to sell his shares back to petitioner at a price determined

under the same formula upon terminating his employment. Subject to minor

exceptions related to the firm's "name partners", each shareholder attorney's

proportionate ownership of petitioner's shares (share-ownership percentage)

equals his proportionate share of compensation paid by petitioner to its

shareholder attorneys. For the years in issue, as for previous years, the board set

the yearly compensation to be paid to shareholder attorneys and then determined

the adjustments in the shareholder attorneys' share-ownership percentages

necessary to reflect changes in proportionate compensation. Adjustments in actual

share ownership were made by share redemptions and reissuances.

Petitioner's shareholder attorneys are entitled to dividends as and when

declared by the board. For at least 10 years before and including the years in
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[*4] issue, however, petitioner had not paid a dividend. Upon a liquidation of

petitioner, its shareholder attorneys would share in the proceeds.

Compensation Mechanics

For the years in issue, the board met to set compensation and shareownership percentages in late November or early December of the year preceding

the compensation year. Before those meetings, the board settled on a budget for

the compensation year. On the basis of that budget, the board determined the

amount available for all shareholder attorney compensation for that year. With

that amount in mind, it set each shareholder attorney's expected compensation

using a number of criteria including hours billed, collections, business generated,

and other contributions to the welfare of the corporation. Before finalizing its

compensation decisions, the board shared its estimates of total shareholder

attorney compensation and each shareholder attorney's expected portion with all of

the shareholder attorneys. Because the board's estimate of the amount available

for compensation-year payments to shareholder attorneys was only an estimate,

each shareholder attorney received during the course of the compensation year

only a percentage of his expected compensation (draw), with the expectation of

receiving an additional amount (yearend bonus) at the end of the year. The board

intended the sum of the shareholder attorneys' yearend bonuses (bonus pool) to
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[*5] exhaust book income. With limited exceptions for certain older, less active

shareholder attorneys, shareholder attorneys shared in the bonus pool in

proportion to their draws (and, likewise, in proportion to their share-ownership

percentages). Specifically, for each of the years in issue petitioner calculated the

yearend bonus pool--$8,986,608 in 2007 and $13,736,331 in 2008--to equal its

book income for the year after subtracting all expenses other than the bonuses. 

Thus, petitioner's book income was zero for each year: Its income statements

showed revenue exactly equal to expenses.

Petitioner treated as employee compensation the amounts it paid to its

shareholder attorneys, including the yearend bonuses. In particular, petitioner

withheld applicable income and employment taxes, paid the employer's share of

employment taxes, and filed appropriate reporting forms, such as Form W-2,

Wage and Tax Statement, and Form 941, Employer's Quarterly Federal Tax

Return. An independent payroll processing firm prepared petitioner's Forms W-2

for 2007 and 2008 using records and information that petitioner provided. 

Petitioner then provided the Forms W-2 to McGladrey & Pullen (McGladrey),

petitioner's accounting firm. Gary Ropski, petitioner's president during the years

in issue, testified at trial that petitioner's board did not consider at all the Federal

income tax impact of paying the yearend bonuses. Mr. Ropski acknowledged,
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[*6] however, that petitioner's chief financial officer, Lee Rendino, and its

accountants were responsible for considering the tax impact of petitioner's

activities.

Petitioner's Invested Capital

Petitioner had invested capital, measured by the book value of its

shareholders' equity, of about $8 million at the end of 2007 and about $9.3 million

at the end of 2008. Petitioner's balance sheets for the years in issue do not show 1

goodwill or other intangible assets. At trial, petitioner's expert witness, legal

industry consultant Bradford Hildebrandt, questioned whether the goodwill of a

law firm's business is an asset of the firm or, instead, of its individual partners. He

opined that clients base hiring decisions on the reputations of individual lawyers

rather than those of the firms at which they practice. Nonetheless, upon

questioning by the Court, Mr. Hildebrandt admitted that a firm's reputation and

customer lists could be valuable entity-level assets, even though determining their

precise worth might be difficult.

Because petitioner reported zero book income for 2008, the increase in 1

shareholders' equity between 2007 and 2008 was attributable not to retained

earnings but instead to capital contributions and the net of proceeds of share

issuances and amounts paid in redemption.
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[*7] Petitioner's Tax Returns for the Years in Issue

McGladrey prepared petitioner's U.S. corporate income tax returns for the

years in issue. At that time, McGladrey was the fifth largest public accounting

firm in the United States and held itself out as a leading provider of accounting,

tax, and consulting services to middle-market businesses. Petitioner electronically

filed its returns for 2007 and 2008 in September 2008 and 2009, respectively. In

each return, petitioner included the yearend bonuses it paid to its shareholder

attorneys in the amount it claimed as a deduction for officer compensation. Before

filing its return for each year, petitioner did not specifically ask McGladrey

whether the full amount of the yearend bonuses it paid to shareholder attorneys

was deductible as compensation for services, and McGladrey did not comment on

the deductibility of the bonuses.

Petitioner's 2007 return reported total income of $91,742,819, taxable

income of $539,902, and tax liability of $188,966. Its 2008 return reported total

income of $107,019,812, taxable income of $561,075, and tax liability of

$196,376. Because petitioner's book income was zero for each year, the taxable

income petitioner reported was attributable entirely to items that were treated

differently for book and tax purposes.
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[*8] Respondent's Examinations of Petitioner's Returns

Petitioner's return for 2006, before the years in issue in the present case, had

been examined by Internal Revenue Agent Ray Berg. During the course of that

examination, petitioner provided board minutes and financial statements to Mr.

Berg. Upon the completion of the examination, petitioner received a letter

advising it that no changes had been made to its reported tax liability as a result of

the examination.

When respondent later examined petitioner's returns for 2007 and 2008, he

disallowed various deductions, including the yearend bonuses petitioner paid to its

shareholder attorneys. After negotiations, the parties entered into a closing

agreement that provides, among other things, that portions of petitioner's officer

compensation deductions for the years in issue--$1,627,000 in 2007 and

$1,859,000 in 2008--"should be disallowed and re-characterized as non-deductible

dividends". As a result of concessions that petitioner made in settlement, its

agreed tax liability is $1,298,618 for 2007 and $1,212,152 for 2008, resulting in

underpayments of $1,109,652 and $1,015,776 for 2007 and 2008, respectively.

2

The deficiencies determined by respondent were based on reduced 2

underpayment amounts because, in accordance with the closing agreement,

respondent employed "rough justice adjustments" that take into account the

refunds of income and employment taxes that would otherwise have been due to

(continued...)
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[*9] OPINION

I. Background

Because the parties' closing agreement provides that a portion of petitioner's

officer compensation deductions for the years in issue "should be disallowed and

re-characterized as non-deductible dividends", the deductibility of petitioner's

yearend bonuses is not in issue. The sole issue remaining for our decision is 3

whether petitioner is liable for accuracy-related penalties under section 6662 on

the underpayments of tax relating to its deduction of those portions of the yearend

bonuses that it has now agreed were nondeductible dividends.

Section 6662(a) and (b)(1) provides for an accuracy-related penalty of 20%

of the portion of an underpayment of tax attributable to negligence or disregard of

rules and regulations (without distinction, negligence). Section 6662(a) and (b)(2)

provides for the same penalty on the portion of an underpayment of tax 

(...continued) 2

petitioner and its shareholders as a result of the recharacterization of compensation

as dividends.

Sec. 162(a) allows a deduction for ordinary and necessary business 3

expenses, including reasonable allowances for salaries. To be deductible,

however, amounts paid as salary must be for services "actually rendered." Sec.

162(a)(1); see also sec. 1.162-7(a), Income Tax Regs. (stating that to be

deductible, compensation payments must be reasonable and they must be "in fact

payments purely for services"). Ostensible salary payments to shareholder

employees that are actually dividends are thus nondeductible.
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[*10] attributable to "[a]ny substantial understatement of income tax". Section

6662(d)(2)(A) defines the term "understatement" as the excess of the tax required

to be shown on the return over the amount shown on the return as filed. In the

case of a corporation, an understatement is "substantial" if, as relevant here, it

exceeds the lesser of (1) 10% of the tax required to be shown on the return for the

tax year or (2) $10 million. Sec. 6662(d)(1)(B). An understatement is reduced,

however, by the portion attributable to the treatment of an item for which the

taxpayer had "substantial authority". Sec. 6662(d)(2)(B)(i). Section 6664(c)(1)

provides an exception to the imposition of the section 6662(a) accuracy-related

penalty if it is shown that there was reasonable cause for the underpayment and the

taxpayer acted in good faith.

Petitioner does not dispute that the deficiency to which it has agreed for

each of the years in issue exceeds 10% of the agreed income tax it was required to

show on its return for the year. Petitioner argues, however, that it had substantial 4

authority for deducting in full the yearend bonuses it paid to its shareholder

attorneys. In addition, petitioner argues that, because it relied on the services of a

reputable accounting firm to prepare its returns for the years in issue, it had 

Because the tax required to be shown on petitioner's return for each of the

4

years in issue was less than $10 million, the 10% threshold of sec.

6662(d)(1)(B)(i) applies.
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[*11] reasonable cause to deduct those amounts and acted in good faith in doing

so. If petitioner is correct that it had substantial authority for its position, the

disallowance of a portion of its claimed officer compensation deduction for each

year would not increase its "understatement" within the meaning of section

6662(d)(2)(A). In that case, the substantial understatement penalty would not

apply to the portion of the underpayment for each year attributable to the

disallowance of part of those deductions, regardless of whether petitioner had

reasonable cause and acted in good faith. Moreover, a determination that

petitioner had substantial authority for its position would prevent imposition of the

negligence penalty as well. Taking a position that has a "reasonable basis" is not

negligent, sec. 1.6662-3(b)(1), Income Tax Regs., and substantial authority is a

more stringent standard than reasonable basis, sec. 1.6662-4(d)(2), Income Tax

Regs. Therefore, we begin by considering whether petitioner had substantial

authority for its deduction of the yearend bonuses.

II. Substantial Authority

The determination of substantial authority requires a weighing of the

authorities that support the taxpayer's treatment of an item against the contrary

authorities. Id. subpara. (3)(i). A taxpayer can have substantial authority for a

position that is unlikely to prevail, as long as the weight of the authorities in 
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[*12] support of the taxpayer's position is substantial in relation to the weight of

any contrary authorities. See id. subpara. (2) (substantial authority standard is less

stringent than the more likely than not standard). The regulations describe the

required weighing as follows:

The weight accorded an authority depends on its relevance and

persuasiveness, and the type of document providing the authority. 

For example, a case or revenue ruling having some facts in common

with the tax treatment at issue is not particularly relevant if the

authority is materially distinguishable on its facts, or is otherwise

inapplicable to the tax treatment at issue.

Id. subpara. (3)(ii). The determination of whether a taxpayer's position has

substantial authority is made as of the last day of the taxable year to which the

return relates and at the time that return is filed. See id. subdiv. (iv)(C). If the

position has substantial authority on either date, the taxpayer's understatement is

reduced. Id.

A. The Parties' Arguments

Petitioner relies on Law Offices--Richard Ashare, P.C. v. Commissioner,

T.C. Memo. 1999-282, 1999 WL 639866, as the principal authority in support of

its deduction of yearend bonuses paid to its shareholder attorneys that eliminated

its book income for the years in issue. In Ashare, this Court allowed a corporate

law firm to deduct an amount it paid to its sole shareholder as compensation that
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[*13] exceeded the firm's revenues for the year. Petitioner also claims that section

83 and its accompanying regulations, dealing with transfers of property in

connection with services, support the proposition that all amounts it pays to its

shareholder attorneys should be treated as compensation for services. Further,

petitioner cites authorities in other areas of current or prior law that purport to

establish that capital is not a material income-producing factor in a professional

services business. See Hubbard-Ragsdale Co. v. Dean, 15 F.2d 410 (S.D. Ohio

1926), aff'd per curiam, 15 F.2d 1013 (6th Cir. 1926); sec. 1.704-1(e)(1)(iv), 5

Income Tax Regs.; sec. 1.911-3(b)(3), Income Tax Regs.; sec. 1.1348-3(a)(3)(ii), 6 7

Hubbard-Ragsdale Co. v. Dean, 15 F.2d 410 (S.D. Ohio 1926), aff'd per

5

curiam, 15 F.2d 1013 (6th Cir. 1926), holds that a corporation engaged in buying

and selling livestock on commission was not a "personal service corporation"

entitled to be taxed as a partnership under provisions of the Revenue Act of 1918,

ch. 18, 40 Stat. 1057. The District Court found that, because capital was a

material income-producing factor in the corporation's business, the taxpayer did

not meet the statutory definition of personal service corporation. The court

distinguished the taxpayer's business from service businesses, such as law firms

and medical practices, for which "the use of capital is merely incidental." Id. at

411.

Sec. 1.704-1(e)(1)(iv), Income Tax Regs., provides: "In general, capital is 6

not a material income-producing factor where the income of the business consists

principally of fees, commissions, or other compensation for personal services

performed by members or employees of the partnership."

Sec. 911(a)(1) excludes from gross income all or a portion of a qualifying

7

individual's "foreign earned income". Sec. 1.911-3(b)(3), Income Tax Regs.,

(continued...)
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[*14] Income Tax Regs.; sec. 1.1361-2(e)(2), Income Tax Regs. (before removal 8

by T.D. 8104, 1986-2 C.B. 153). Finally, petitioner argues that, under substance- 9

over-form principles, the stock held by its shareholder attorneys should be treated

as debt, so that the portion of the yearend bonuses determined to be nondeductible

as compensation should nonetheless have been deductible as interest.

(...continued) 7

treats as "earned income" "all fees received by an individual engaged in a

professional occupation (such as doctor or lawyer) in the performance of

professional activities." The treatment of the fees as earned income applies "even

though the individual employs assistants to perform part or all of the services,

provided the patients or clients are those of the individual and look to the

individual as the person responsible for the services rendered." Id.

Sec. 1.1348-3(a)(3)(i), Income Tax Regs., limited to 30% the portion of an

8

individual's income from an unincorporated business that could be treated as

earned income, for purposes of sec. 1348, which (before its repeal in 1981) limited

the rate of tax applicable to earned income. The 30% limit on the amount of

business income that could be treated as earned income applied if "both personal

services and capital are material income-producing factors". Id. Sec. 1.1348-

3(a)(3)(ii), Income Tax Regs., provides that "the practice of his profession by a

doctor, dentist, lawyer, architect, or accountant will not, as such, be treated as a

trade or business in which capital is a material income-producing factor".

Sec. 1361 of the Internal Revenue Code of 1954 (before adoption of the 9

modern subchapter S rules) allowed unincorporated businesses that met specified

conditions to elect to be taxed as domestic corporations. Sec. 1.1361-2(e)(2),

Income Tax Regs., provided that "an enterprise engaged in rendering professional

services such as law, accounting, medicine, or engineering, ordinarily is not an

enterprise in which capital is a material income-producing factor." Therefore,

these enterprises were generally not eligible to elect to be treated as domestic

corporations. See sec. 1361(b)(4) (before repeal in 1966).
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[*15] Petitioner spends most of its effort, however, trying to distinguish the

authorities relied on by respondent. Respondent claims that amounts paid to

shareholder employees of a corporation do not qualify as deductible compensation

to the extent that the payments are funded by earnings attributable to the services

of nonshareholder employees or to the use of the corporation's intangible assets or

other capital. Instead, says respondent, amounts paid to shareholder employees

that are attributable to those sources must be nondeductible dividends. In support

of its position, respondent relies primarily on this Court's opinion in Pediatric

Surgical Assocs., P.C. v. Commissioner, T.C. Memo. 2001-81, and that of the U.S.

Court of Appeals for the Seventh Circuit in Mulcahy, Pauritsch, Salvador & Co. v.

Commissioner, 680 F.3d 867 (7th Cir. 2012), aff'g T.C. Memo. 2011-74. In

Pediatric Surgical, we determined that compensation payments to shareholder

employees attributable to the services of nonshareholders were nondeductible

dividends. In Mulcahy, the Court of Appeals for the Seventh Circuit denied a

corporation's deduction of consulting fees paid to entities owned by the taxpayer's

founding shareholders. The taxpayer sought to justify the deduction of the

consulting fees on the grounds that they were, in effect, additional compensation

to its shareholders. The Court of Appeals upheld this Court's disallowance of the

deduction, reasoning that "[t]reating * * * [the consulting fees] as salary reduced
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[*16] the firm's income, and thus the return to the equity investors, to zero or

below in two of the three tax years at issue, even though * * * the firm was doing

fine." Mulcahy, Pauritsch, Salvador & Co. v. Commissioner, 680 F.3d at 872. 

"[W]hen a thriving firm that has nontrivial capital reports no corporate income,"

the court observed, "it is apparent that the firm is understating its tax liability." Id.

at 874. Presumably, respondent emphasizes Mulcahy because, absent a stipulation

to the contrary, appeal of the present case would lie with the Court of Appeals for

the Seventh Circuit. See sec. 7482(b)(1)(B) (venue of appeal of Tax Court

decision involving a corporation is the U.S. Court of Appeals for the circuit in

which the taxpayer's principal place of business or principal office is located).

Petitioner argues that its case is distinguishable from Pediatric Surgical

because any "profit" it makes from the services of nonshareholder attorneys can

justifiably be paid to its shareholder attorneys in consideration for business

generation and other nonbillable services. Petitioner attempts to distinguish

Mulcahy on the basis of the allegedly unique nature of its shareholder attorneys'

interests. In particular, petitioner argues that, because its shareholder attorneys

receive their stock in connection with their employment and must sell it back to

petitioner at a price equal to its cash book value, the shares they hold do not 

represent "real" equity interests that entitle them to a return on their invested 
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[*17] capital. In addition, petitioner observes that, because Mulcahy was decided

after it filed its returns for the years in issue, the case cannot be taken into account

in assessing the relative weight of authorities for and against its position. See sec.

1.6662-4(d)(3)(iv)(C), Income Tax Regs.

B. The Centrality of the "Independent Investor Test"

The principle applied in Mulcahy is well established in the law and

grounded in basic economics: The owners of an enterprise with significant capital

are entitled to a return on their investments. Thus, a corporation's consistent

payment of salaries to shareholder employees in amounts that leave insufficient

funds available to provide an adequate return to the shareholders on their invested

capital indicates that a portion of the amounts paid as salaries is actually

distributions of earnings. Well before the years in issue, an increasing number of

Federal Courts of Appeals, including the Court of Appeals for the Seventh Circuit,

were moving away from a multifactor analysis in assessing the deductibility of

amounts paid as compensation to shareholder employees and focusing on the

effect of the payments on the returns available to the shareholders on their capital. 

See Exacto Spring Corp. v. Commissioner, 196 F.3d 833, 838 (7th Cir. 1999),

rev'g Heitz v. Commissioner, T.C. Memo. 1998-220; Rapco, Inc. v. 

Commissioner, 85 F.3d 950, 954-955 (2d Cir. 1996), aff'g T.C. Memo. 1995-128;
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[*18] Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245 (9th Cir. 1983), rev'g

and remanding T.C. Memo. 1980-282; see also Escrow Connection, Inc. v.

Commissioner, T.C. Memo. 1997-17, 1997 WL 5791. Therefore, the fact that

Mulcahy itself is not "authority" for present purposes is of little consequence.

The Court of Appeals for the Seventh Circuit and the other courts that have

assessed compensation paid to shareholder employees by its effect on the returns

available to shareholders' capital refer to the governing inquiry as the

"independent investor test". Exacto Spring Corp. v. Commissioner, 196 F.3d at

838; Dexsil Corp. v. Commissioner, 147 F.3d 96, 100-101 (2d Cir. 1998), vacating

and remanding T.C. Memo. 1995-135. The test recognizes that shareholder

employees may be economically indifferent to whether payments they receive

from their corporation are labeled as compensation or dividends. From a tax

standpoint, however, only compensation is deductible to the corporation;

dividends are not. Therefore, the shareholder employees and their corporations

generally have a bias toward labeling payments as compensation rather than

dividends, without the arm's-length check that would be in place if nonemployees

owned significant interests in the corporation. Owensby & Kritikos, Inc. v.

Commissioner, 819 F.2d 1315, 1322-1323 (5th Cir. 1987), aff'g T.C. Memo. 1985-

267; Elliotts, Inc. v. Commissioner, 716 F.2d at 1243. Thus, the courts consider
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[*19] whether ostensible salary payments to shareholder employees meet the

standards for deductibility by taking the perspective of a hypothetical

"independent investor" who is not also an employee.

C. Application of the Independent Investor Test

Ostensible compensation payments made to shareholder employees by a

corporation with significant capital that zero out the corporation's income and

leave no return on the shareholders' investments fail the independent investor test. 

As the Court of Appeals for the Ninth Circuit observed in Elliotts, Inc. v.

Commissioner, 716 F.2d at 1247: "If the bulk of the corporation's earnings are

being paid out in the form of compensation, so that the corporate profits, after

payment of the compensation, do not represent a reasonable return on the

shareholder's equity in the corporation, then an independent shareholder would

probably not approve of the compensation arrangement." See also Dexsil Corp. v.

Commissioner, 147 F.3d at 101; Escrow Connection, Inc. v. Commissioner, 1997

WL 5791, at *10 (return on equity of 0% would not satisfy an independent

investor); Nor-Cal Adjusters v. Commissioner, T.C. Memo. 1971-200, 1971 Tax

Ct. Memo LEXIS 132, at *21 (inactive shareholder would not have forgone a

return on invested capital while nearly all of the corporation's income was paid out

as salaries and bonuses), aff'd, 503 F.2d 359 (9th Cir. 1974).
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[*20] The record establishes that petitioner had substantial capital even without

regard to any intangible assets. At trial, petitioner's expert witness, Mr.

Hildebrandt, admitted that a firm's reputation and customer lists could be valuable

entity-level assets. For present purposes, however, we need not identify and

attempt to value intangible assets that belong to petitioner rather than its

shareholder attorneys. Regardless of the possibility that petitioner might own

valuable intangible assets, it had invested capital, measured by the book value of

its shareholders' equity, of about $8 million at the end of 2007 and about $9.3

million at the end of 2008.

10

Invested capital of this magnitude cannot be disregarded in determining

whether ostensible compensation paid to shareholder employees is really a

distribution of earnings. We do not believe that petitioner's shareholder attorneys,

were they not also employees, would have forgone any return on invested capital

that at least approached, if it did not exceed $10 million. Thus, petitioner's

practice of paying out yearend bonuses to its shareholder attorneys that eliminated

its book income fails the independent investor test.

Because petitioner used the cash method in keeping its books, its 10

shareholders' equity did not include any excess of receivables over payables.
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[*21] D. Petitioner's Claimed Exemption From the Independent Investor Test

The specific circumstances of the present case do not prevent the

application of the independent investor test. Petitioner observes that its

shareholder attorneys hold their stock in the corporation in connection with their

employment, they acquire their stock at a price equal to its cash book value, and

they must sell their stock back to petitioner at a price determined under the same

formula upon terminating their employment. Petitioner suggests that, as a result of

this arrangement, its shareholder attorneys lack the normal rights of equity owners.

Contrary to petitioner's argument, the use of book value as a proxy for

market value for the issuance and redemption of shares in a closely held

corporation to avoid the practical difficulties of more precise valuation hardly

means that the shareholder attorneys do not really own the corporation and are not

entitled to a return on their invested capital. Any shareholders who are not also

employees would generally demand such a return.

The provisions of section 83 and its accompanying regulations, rather than

supporting petitioner's argument, actually undermine it. Petitioner purports to rely

on rules that determine when property is considered to have been "transferred" by

an employer to an employee. Under those rules, a transfer may not have occurred

if, upon termination of his or her employment, the employee is required to return
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[*22] the property to the employer for a price that "does not approach the fair

market value of the property at the time of surrender." Sec. 1.83-3(a)(3), (5),

Income Tax Regs. Petitioner suggests that the obligation that its shareholder

attorneys sell back their stock upon termination of their employment in exchange

for the book value of the stock means that the stock was never "transferred". 

Consequently, according to petitioner, all amounts it pays to its shareholders--even

any amounts actually designated as dividends--must be treated as compensation

for services. See id. sec. 1.83-1(a)(1).

But petitioner is mistaken in its claim that the book value of one of its

shares does not approach its fair market value. Section 1.83-5(a), Income Tax

Regs., provides: "If stock in a corporation is subject to a nonlapse restriction

which requires the transferee to sell such stock only at a formula price based on

book value * * *, the price so determined will ordinarily be regarded as

determinative of the fair market value of such property for purposes of section 83."

Thus, the examples cited by petitioner, section 1.83-3(a)(7), Examples (3) and (4),

Income Tax Regs., are readily distinguishable. They involve requirements to

resell stock upon termination of employment for amounts that are demonstrably

below the stock's fair market value. Section 1.83-5(c), Example (1), Income Tax

Regs., is more on point. In that example, an employee's obligation to resell stock
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[*23] to his employer at its then-existing book value did not prevent recognition of

the transfer of the stock to the employee.

More generally, petitioner's argument that its shareholder attorneys have no

real equity interests in the corporation that would justify a return on invested

capital proves too much. If petitioner's shareholder attorneys are not its owners,

who are? If the shareholder attorneys do not bear the risk of loss from declines in

the value of its assets, who does? The use of book value as a proxy for fair market

value deprives the shareholder attorneys of the right to share in unrealized

appreciation upon selling their stock--although they are correspondingly not

required to pay for unrealized appreciation upon buying the stock. But acceptance

of these concessions to avoid difficult valuation issues does not compel the

shareholder attorneys to forgo, in addition, any current return on their investments

based on the corporation's profitable use of its assets in conducting its business. 

Petitioner's arrangement effectively provides its shareholder attorneys with a

return on their capital through amounts designated as compensation. Were this not

the case, we do not believe the shareholder attorneys would be willing to forgo

any return on their investments.
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[*24] E. Other Authorities Cited by Petitioner

The other authorities petitioner cites do not refute the general principle that

the owners of an enterprise with significant capital are economically entitled to a

return on their investments. Contrary to petitioner's claim, Law Offices--Richard

Ashare, P.C. v. Commissioner, 1999 WL 639866, does not demonstrate that an

incorporated law firm with significant capital can pay out compensation that

eliminates book income. Although we allowed the taxpayer in Ashare to deduct

compensation that exceeded the firm's revenues for the year in issue (1993), the

taxpayer in that case did not consistently pay compensation that had the intended

effect of eliminating book income. The firm had reported substantial income for

1990, three years before the year in issue. Thus, as we observed: "[T]he board

knew how to limit Mr. Ashare's compensation to the value of his uncompensated

services as of the end of each year." Id. at *9. The failure of the firm "to inflate

Mr. Ashare's compensation", despite having "the opportunity, the means, and a

strong tax incentive" to do so, indicated that "the board was set on establishing

Mr. Ashare's compensation at its fair value." Id. The firm's deficit in retained

earnings and its failure to pay dividends suggested that, on a cumulative basis, if

not year by year, the firm did pay out all of its earnings as compensation. But, in
- 25 -

[*25] contrast to petitioner in the present case, the firm in Ashare had minimal

capital: Its shareholder had invested only $1,000 in the corporation.11

The authorities that purport to establish that capital is not a material incomeproducing factor in a professional services business deserve little or no weight. 

None of those authorities address the deductibility of compensation paid to

shareholder employees. Several involve statutory provisions that have long 12

As petitioner observes, the taxpayer in Law Offices--Richard Ashare, P.C.

11

v. Commissioner, T.C. Memo. 1999-282, 1999 WL 639866, in connection with an

audit of its returns for 1990, 1991, 1992, agreed to treat as constructive dividends

a portion of the compensation it paid to its shareholder in each of those years. 

Petitioner reasons that the taxpayer's concession demonstrates the existence of

"tangible or intangible capital." Instead, the taxpayer's retained earnings from the

end of 1990 to the beginning of 1993 resulted from its board's decision to retain a

portion of the profit it earned in 1990 "for 'the reasonably anticipated needs of the

business for the forthcoming years.'" Id., 1999 WL 639866, at *5. The taxpayer's

profit in 1990 reflected the settlement of its principal case. After the settlement,

however, a "tremendous amount of work" remained to be done administering the

settlement fund. Id. at *3. The board's action proved to be farsighted: By the end

of 1993, the taxpayer had incurred expenses sufficient to eliminate its retained

earnings and produce a deficit of $89,855. Id. at *2. Thus, the taxpayer's retained

earnings were apparently attributable not to capital invested by its shareholder but

to its receipt of legal fees from the settlement of its principal case before the

performance of all of the work for which those fees served as compensation. If the

taxpayer had distributed to its shareholder the earnings it retained at the end of

1990, it would have been left with insufficient resources to pay all of its expenses

before winding up.

Petitioner may be correct that, as a result of sec. 1.911-3(b)(3), Income

12

Tax Regs., the exclusion of foreign professional fees under sec. 911(a)(1) applies

to amounts attributable to invested capital. But the possibility that, in some

(continued...)
- 26 -

[*26] since been repealed. Most simply make observations about what is 13

generally the case in regard to professional service businesses. Thus, none of the

14

(...continued) 12

contexts, the law forgoes an effort to determine that portion of an attorney's

professional services income attributable to capital does not justify treating as

deductible compensation payments made by a corporate law firm to shareholder

attorneys that eliminate its book income and leave no return to the shareholders on

material amounts of invested capital. Cf. Exacto Spring Corp. v. Commissioner,

196 F.3d 833, 835 (7th Cir. 1999) ("[T]he primary purpose of section 162(a)(1)

* * * is to prevent dividends * * * which are not deductible from corporate

income, from being disguised as salary, which is."), rev'g Heitz v. Commissioner,

T.C. Memo. 1998-220.

Hubbard-Ragsdale Co., 15 F.2d 410, addressed provisions of the Revenue 13

Act of 1918. Analogous provisions were included in the Revenue Act of 1921,

but not subsequent acts. Sec. 1361 of the Internal Revenue Code of 1954 was

repealed in 1966. Act of Apr. 14, 1966, Pub. L. No. 89-389, sec. 4(b)(1), 80 Stat.

at 116. The limit on the rate of tax applicable to earned income provided by sec.

1348 was repealed by the Economic Recovery Tax Act of 1981, Pub. L. No. 97-

34, sec. 101(c)(1), 95 Stat. at 183.

The observation, in dictum, of the U.S. District Court for the Southern 14

District of Ohio in Hubbard-Ragsdale, 15 F.2d at 411, that the use of capital by

law firms and similar service businesses is "merely incidental" does not establish

that a law firm that in fact has significant capital need not provide its owners with

a return on that capital.

Sec. 1.704-1(e)(1)(iv), Income Tax Regs., and sec. 1.1361-2(e)(2), Income

Tax Regs. (before removal by T.D. 8104, 1986-2 C.B. 153), simply provide

generalizations about the materiality of capital in a personal services business as

an income-producing factor. As a result of sec. 1.704-1(e)(1)(iv), Income Tax

Regs., the safe harbor of sec. 704(e)(1) will generally not apply to require the

recognition as a partner of any person who owns a capital interest in a partnership

whose income consists primarily of compensation for personal services performed

(continued...)
- 27 -

[*27] authorities support the proposition that a corporation with substantial capital

can pay deductible compensation to its shareholder employees in amounts that

leave no return to the shareholders on their investments in the corporation.

F. Petitioner's Claim That Its Stock Is Really Debt

We can readily dismiss petitioner's claim that the portion of the yearend

bonuses determined to be nondeductible as compensation should nonetheless have

been deductible as interest. We have already rejected petitioner's argument that its

stock is not real equity. Despite a departing shareholder's obligation to sell his

stock back to petitioner at cash book value, shares of petitioner's stock lack the

hallmark characteristics of debt. Cf. Gilbert v. Commissioner, 248 F.2d 399, 402

(2d Cir. 1957) ("The classic debt is an unqualified obligation to pay a sum certain

at a reasonably close fixed maturity date along with a fixed percentage in interest

(...continued) 14

by its members or employees. But the application of sec. 704(e)(1) to a law firm

partnership would seldom matter, given that the primary purpose of that section is

to validate interests in family partnerships acquired by gift. S. Rept. No. 82-781

(1951), 1951-2 C.B. 458, 485-487; H.R. Rept. No. 82-586 (1951), 1951-2 C.B.

357, 380-381.

The classification of a law practice as a business in which capital is not a

material income-producing factor by sec. 1.1348-3(a)(3)(ii), Income Tax Regs.,

did not mean that all of an attorney's income from his practice was treated as

earned income and that any return on invested capital was ignored. It simply

rendered inapplicable the 30% limitation imposed by sec. 1.1348-3(a)(3)(i),

Income Tax Regs., on the amount that could be treated as earned income.
- 28 -

[*28] payable regardless of the debtor's income or lack thereof."), remanding T.C.

Memo. 1956-137.15

G. Weighing the Authorities

Having engaged in the weighing process required by section 1.6662-

4(d)(3)(ii), Income Tax Regs., we conclude that the authorities that support

petitioner's deduction of the full amount of the yearend bonuses it paid to

shareholder attorneys are not substantial when weighed against the contrary

authorities. The independent investor test weighs strongly against the claimed

deductions. Petitioner's efforts to characterize its situation as unique do not

persuade us. If the hypothetical independent investor had provided the capital

demonstrated by the cash book value of petitioner's shares--even leaving aside the

possibility of valuable firm-owned intangible assets--the investor would have

demanded a return on that capital and would not have tolerated petitioner's

consistent practice of paying compensation that zeroed out its income. By

contrast, the authorities cited by petitioner are either "materially distinguishable on

Wilshire & W. Sandwiches, Inc. v. Commissioner, 175 F.2d 718 (9th Cir.

15

1949), rev'g T.C. Memo. 1948-123, cited by petitioner, is readily distinguishable. 

In that case, the U.S. Court of Appeals for the Ninth Circuit, in upholding interest

deductions claimed on advances made by the shareholders of a corporation in

proportion to their stock ownership, found "all the elements of a debtor and

creditor relationship". Id. at 720.
- 29 -

[*29] * * * [their] facts, or * * * [are] otherwise inapplicable to the tax treatment

at issue." Cf. id. Therefore, those authorities are not "particularly relevant". Id.

We do not doubt the critical value of the services provided by employees of

a professional services firm. Indeed, the employees' services may be far more

important, as a factor of production, than the capital contributed by the firm's

owners. Recognition of those basic economic realities might justify the payment

of compensation that constitutes the vast majority of the firm's profits, after

payment of other expenses--as long as the remaining net income still provides an

adequate return on invested capital. But petitioner did not have substantial

authority for the deduction of amounts paid as compensation that completely

eliminated its income and left its shareholder attorneys with no return on their

invested capital.

Because petitioner did not have substantial authority for its treatment of the

yearend bonuses it paid during the years in issue, the agreed disallowance of a

portion of the deductions petitioner claimed for those payments increased a

"substantial understatement", within the meaning of section 6662(d)(1)(B), for

each year. Therefore, we need not determine whether the underpayments resulting

from that disallowance are attributable to negligence. Cf. sec. 6662(b)(1). The

accuracy-related penalties asserted by respondent will apply unless petitioner had
- 30 -

[*30] reasonable cause for its treatment of the yearend bonuses and acted in good

faith in pursuing that treatment.

III. Reasonable Cause and Good Faith

Petitioner argues that, even if it lacked substantial authority for deducting in

full the yearend bonuses it paid to its shareholder attorneys during the years in

issue, respondent erred in imposing the accuracy-related penalty of section

6662(a) because petitioner had reasonable cause and acted in good faith in

claiming the deductions. See sec. 6664(c)(1). In that regard, petitioner alleges

that its reliance on McGladrey to prepare its returns for the years in issue

constituted reasonable cause and demonstrated good faith.

Petitioner's argument that it reasonably relied on McGladrey fails for two

reasons. First, the record provides no evidence that McGladrey advised petitioner

regarding the deductibility of the yearend bonuses. Second, in characterizing as

compensation for services amounts that have been determined to be dividends,

petitioner failed to provide McGladrey with accurate information.

A taxpayer's reliance on the professional advice of an attorney or an

accountant may constitute reasonable cause and good faith. As a general rule,

"[t]he determination of whether a taxpayer acted with reasonable cause and in

good faith is made on a case-by-case basis, taking into account all pertinent facts
- 31 -

[*31] and circumstances." Sec. 1.6664-4(b)(1), Income Tax Regs. In making that

determination, the "most important factor" is usually "the extent of the taxpayer's

effort to assess the taxpayer's proper tax liability." Id. Reliance on the advice of a

professional tax adviser may constitute reasonable cause and good faith "if, under

all the circumstances, such reliance was reasonable and the taxpayer acted in good

faith." Id.

Petitioner argues that McGladrey's failure to apprise it of any issue

concerning the deductibility of the yearend bonuses constituted "advice" on which

it reasonably relied. The regulations define advice as "any communication * * *

setting forth the analysis or conclusion of a person, other than the taxpayer,

provided to (or for the benefit of) the taxpayer and on which the taxpayer relies

* * * with respect to the imposition of the section 6662 accuracy-related penalty." 

Id. para. (c)(2). The parties have stipulated that, before filing its return for each of

the years in issue, petitioner did not specifically ask McGladrey whether the full

amount of the yearend bonuses it paid to shareholder attorneys was deductible as

compensation for services and McGladrey did not comment on the deductibility of

the bonuses. In effect, petitioner argues that silence can be a "communication". In

that regard, petitioner observes that the regulations do not require advice to take

"any particular form." See id.
- 32 -

[*32] While the regulations allow flexibility regarding the form of advice, they

provide detailed requirements for the content of advice that can constitute

reasonable cause and good faith. For example, reliable advice must be "based

upon all pertinent facts and circumstances", it must take into account the

taxpayer's purposes for its actions, and it cannot be based on unreasonable

assumptions. Id. subpara. (1)(i) and (ii).

In prescribing detailed rules regarding the content of professional advice on

which a taxpayer can rely, the regulations necessarily contemplate advice that, in

some form, involves an explicit communication. Silence cannot qualify as advice

because there is no way to know whether an adviser, in failing to raise an issue,

considered all of the relevant facts and circumstances, including the taxpayer's

subjective motivation. Indeed, an adviser's failure to raise an issue does not prove

that the adviser even considered the issue, much less engaged in any analysis, or

reached a conclusion. As we observed in Neonatology Assocs., P.A. v.

Commissioner, 115 T.C. 43, 100 (2000), aff'd, 299 F.3d 221 (3d Cir. 2002): "The

mere fact that a certified public accountant has prepared a tax return does not

mean that he or she has opined on any or all of the items reported therein." Thus,

we conclude that McGladrey's failure to raise concerns about the deductibility of
- 33 -

[*33] the yearend bonuses did not constitute "advice" within the meaning of

section 1.6664-4(c), Income Tax Regs.

Although preparation of a taxpayer's return by a certified public accountant

does not provide carte blanche protection against substantial understatement or

negligence penalties, our cases recognize that, in some circumstances, a taxpayer's

reliance on a competent and experienced accountant in the preparation of the

taxpayer's return may constitute reasonable cause and good faith. To show good

faith reliance, however, "the taxpayer must establish that the return preparer was

supplied with all necessary information and the incorrect return was a result of the

preparer's mistakes." Weis v. Commissioner, 94 T.C. 473, 487 (1990); see also

Westbrook v. Commissioner, 68 F.3d 868, 881 (5th Cir. 1995), aff'g T.C. Memo.

1993-634; Enoch v. Commissioner, 57 T.C. 781, 802 (1972) ("The ultimate

responsibility for a correct return lies with the taxpayer, who must at least furnish

the necessary information to his agent who prepared the return.").

Petitioner could not have relied in good faith on McGladrey's preparation of

its returns for the years in issue because it provided McGladrey with inaccurate

information. The error that led to the claiming of the disallowed deduction was, in

the first instance, petitioner's.
- 34 -

[*34] Petitioner consistently followed a system of computing yearend bonuses

that disregarded the value of its shareholder attorneys' interests in the capital of the

firm and inappropriately treated as compensation amounts that eliminated the

firm's book income. The record provides no evidence that petitioner based that

practice on the advice of McGladrey or any other qualified tax professional. 

Although petitioner offered no evidence as to why it adopted its practice of paying

yearend bonuses, it is difficult to imagine reasons that are not tax related. Because

the proportionate ownership interests of petitioners' shareholder attorneys are

(with minor exceptions) identical to their proportionate shares of compensation,

the characterization of a distribution as either a dividend or additional

compensation has no apparent economic consequence. Petitioner's shareholder

attorneys would receive the same amounts either way. Petitioner argues that the

board awarded yearend bonuses that exactly zeroed out book income "because the

Board believed this approach was an appropriate manner in which to compensate

its shareholders for their services." But it would be a striking coincidence if, year

after year, the actual value of the services provided by petitioner's shareholder

attorneys exactly equaled the amounts necessary to eliminate petitioner's book

income. The only apparent consequence of characterizing as additional

compensation amounts that would otherwise be available for distribution as 
- 35 -

[*35] dividends is to reduce petitioner's corporate income tax liability. Therefore,

while it may be true, as petitioner claims, that the board did not consider the

Federal income tax consequences of its method of determining yearend bonuses,

we doubt that taxes were ignored in the initial design of that method.

Because petitioner initiated for its own reasons--whatever those reasons

might have been--the practice of paying yearend bonuses that eliminated its book

income, any culpability of McGladrey was secondary, in failing to recognize

petitioner's erroneous characterization of part of the yearend bonuses. As a

general matter, in the fulfillment of professional responsibilities, an accountant

preparing or signing a return is entitled to rely on information furnished by the

taxpayer and has only a limited obligation to make inquiries in the case of

manifest errors. See 31 C.F.R. sec. 10.34(d) (2008) (duties of return preparers

under rules governing practice before Internal Revenue Service, effective for

returns filed after September 26, 2007); id. sec. 10.34(c) (same, before amendment

by T.D. 9359, 2007-2 C.B. 931); American Institute of Certified Public

Accountants, Statement on Standards for Tax Services No. 3, Certain Procedural

Aspects of Preparing Returns (2000); see also Whitehouse Hotel Ltd. P'ship v.

Commissioner, 139 T.C. 304, 359-360 (2012) (taking into account relevant

professional standards in evaluating a taxpayer's ability to rely on return preparer),
- 36 -

[*36] aff'd in part, vacated in part and remanded, 755 F.3d 236 (5th Cir. 2014). 

McGladrey's failure to bring to petitioner's attention the possible

mischaracterization of the yearend bonuses does not absolve petitioner of

responsibility because the mischaracterization was petitioner's doing in the first

place. Indeed, petitioner provided to McGladrey Forms W-2 that characterized the

amounts paid to shareholder attorneys as employee compensation. Therefore,

petitioner's reliance on McGladrey in preparing its returns for the years in issue

does not constitute reasonable cause and good faith and does not relieve petitioner

of liability for the accuracy-related penalty.

Petitioner argues that the "no-change" letter it received at the conclusion of

the audit of its 2006 return helps to show that its treatment of the yearend bonuses

was not "too good to be true", and that, consequently, its reliance on McGladrey

was reasonable. Petitioner concedes, however, that the no-change letter is not "of

itself * * * sufficient to establish reasonable cause and good faith." The record

presents no evidence that Mr. Berg, the agent who examined petitioner's 2006

return, specifically considered the deductibility of any yearend bonus paid in that

year. Moreover, the evidence introduced does not clearly establish that Mr. Berg

was provided with sufficient information to bring the issue to his attention. 

Petitioner failed to introduce the board minutes provided to Mr. Berg that
- 37 -

[*37] petitioner's chief financial officer, Mr. Rendino, alleged would have

described petitioner's practice of awarding yearend bonuses designed to zero out

book income. Similarly, petitioner failed to introduce the financial statements

provided to Mr. Berg. Even assuming that petitioner's income statement for 2006,

like those for 2007 and 2008, showed revenue exactly equal to expenses, it would

not necessarily have identified the yearend bonuses as the factor that produced that

coincidence. Moreover, regardless of the 2006 no-change letter, we have already

concluded that petitioner's reliance on McGladrey did not constitute reasonable

cause or good faith because McGladrey did not provide petitioner with advice

regarding the deductibility of the yearend bonuses, while the information that

petitioner provided to McGladrey was inaccurate in characterizing as

compensation for services amounts that have been determined to be dividends.

IV. Conclusion

For the reasons explained above, petitioner failed to show that it had

reasonable cause for deducting in full the yearend bonuses it paid to its

shareholder attorneys in the years in issue or that it acted in good faith in claiming

those deductions. Therefore, section 6664(c)(1) provides petitioner with no

defense to the imposition of accuracy-related penalties. Because we have

determined that petitioner did not have substantial authority for the deductions in
- 38 -

[*38] issue and because, consequently, the parties' agreed treatment of part of the

bonus in each year as a nondeductible dividend increased a "substantial

understatement", within the meaning of section 6662(d)(1)(A), the accuracyrelated penalty applies to the portion of petitioner's underpayment for each year

attributable to the recharacterization of part of the bonuses.

Decision will be entered under

Rule 155.