Concerned about 'excessive' compensation?
Everything you read today indicates an overwhelming opinion consensus that veterinarians are paid abysmally as compared to other professions and even occupations.
Be aware - our friends in Washington may have different ideas. In recent months, the IRS has targeted practices during audit, with the specific allegation that too much money is being paid to veterinarians who are also shareholders in their personal service corporations (PSC).
A recent tax court case further highlights the impending danger for any veterinary practice that operates in a Subchapter C corporation format. The U.S. Tax Court decision in Pediatric Surgical Associates, P.C. vs. The Commissioner, found in favor of the IRS. The court upheld the IRS' denial of deduction for certain compensation paid to shareholder-employees. A key point in this case was that the deduction was denied, not because the compensation was unreasonable, but because it was deemed not to be "in fact payment purely for services."
A little history
First, you will need some background to understand why this is becoming a more important issue for veterinary practices operating in the corporate format.
Issues of excess compensation have been raised many times in the past. The reason the IRS questions it in a Subchapter C corporation is that the corporation itself is subject to taxation on any taxable income at the end of the tax year. Now that veterinary corporations are deemed to be personal service corporations, in accord with Revenue Ruling 91-60, they are taxed at a higher tax rate than other corporations at a flat 35 percent on every dollar of profit.
The IRS contends that many closely held businesses operating in a Subchapter C format try to limit taxable income through additional compensation paid out to shareholder owners. Since wages and associated payroll taxes are fully deductible to the corporation, taxed profits can be substantially reduced or even extinguished by timed bonuses at year-end.
The government's stance has been that not all of amounts paid out in wages and salaries represent fair payment for time expended in the business by the shareholders in question. If the IRS can show that a portion of amounts paid out as wages and salaries was in fact a disguised form of dividend, it will force the practice to reclassify them, thus eliminating the deduction, resulting in taxable income, penalties, interest and other costs of defense.
When Subchapter C corporations make dividend payments, which reflect a return on investment in a business, those dividends are subject to "double taxation." The dividend is not deductible by the corporation, but since it has been paid out of current profits, it results in taxable income.
At the same time, the dividend when received by the shareholder is taxable at ordinary income tax rates. Assuming that a personal service corporation shareholder would be subject to the maximum federal tax rates, a combined income tax effect on the dividend could be 35 percent plus 40 percent plus any state effect. In essence, a dividend made from your PSC could result in taxes on that dividend as much as 75 percent or more of the dividend paid.
In recent years, our firm has become increasingly aware of the attention that has been given by the IRS to this specific area. Agents are specially trained to understand, spot and target reasonable shareholder compensation in closely held corporations. In Subchapter C corporations, the major issue the IRS investigates is whether shareholder-employees are reasonably compensated for the personal services they provide in the businesses to which they have ownership rights.
The IRS is interested in determining for higher paid individuals whether salaries are in excess of those ordinarily paid for similar services. In such situations, the excess payments might correspond or bear a close relationship to the shareholdings of the officers involved. The IRS will then allege that salaries are not paid wholly for services rendered; that a portion represents a distribution of earnings on stock, return for equity ownership.
The court case says
The Internal Revenue Code Section 162 provides that for compensation to be deductible, it must be both reasonable and purely for services actually rendered. Most prior challenges by the IRS have been based on the fact that the amount of compensation paid is unreasonable. This has been our experience in clients recently undergoing audit.
This case is different. It focused on whether compensation was "purely for services rendered." In this pediatric surgical practice, the service argued that the net profits of the professional practice that are attributable to non-shareholder efforts cannot be paid to shareholders as compensation because such amounts are not purely for services rendered by the shareholders. Any net profits that were not produced by the shareholder pediatricians personally were deemed to not be attributable to their services and were disallowed as compensation to them.
This result should be of great concern to veterinarians. In veterinary practices, a substantial portion of income comes from ancillary services, the efforts of associate veterinarians, product sales and all of the other activities that the practice provides.
In essence, all of the other efforts provided by shareholders in managing the business and that are, in fact, for services, albeit not veterinary care related services, would be excluded from the computation. In other words, this case implies that professionals providing other services other than those for which they are professionally evidenced and personally provide, should not be compensated!
It seems ludicrous that exhaustive work efforts expended by any person owning a veterinary practice would not be taken into consideration when determining whether compensation was reasonable or not.
What should you do?
First of all, discuss the issues with your CPA. Ascertain your choices in terms of how your corporation is structured. One possible solution is electing small business corporation status under Subchapter S if your corporation would be eligible.
The Subchapter S election is not without difficulties and expense. A whole variety of issues relate to timing and accounting for the elected change. The ultimate result is that corporate profits pass through to the individual shareholders rather than being taxed at the corporate level as occurs in a personal service corporation under Subchapter C.
For some practices, Subchapter S election may not be an option. In these situations, you need to plan a strategy for defending compensatory arrangements.
In the Pediatric Surgical Associates case, shareholder compensation ranged from only $172,896 to $452,969 in the two years that were audited by the service. These amounts are quite comparable to what Subchapter C veterinary corporations experience.
Establish solid documentation as to the reasons for compensation and the type of duties and tasks provided to the corporation, spanning from clinical services to maintenance work on Sunday afternoons.
Maintain records of hours spent working in the practice. Here is a good reason for veterinary practice owners to punch a time clock like everyone else. Document the time you spend. If you can show that your time in the practice, in all areas of activities, is much greater than the normal working class population at 40 hours per week, then you have provided additional evidence as to the reasonableness factor.
Compensation policies should be written and applied consistently from year to year. The use of a formula to determine compensation has been given significant weight in several past cases.
Use objective third parties to determine compensation, such as a CPA or compensation consultant. To be effective, advice should be well documented.
Document compensation decisions in the corporate minutes. The corporate minutes should not only reflect the compensation and bonuses for each employee shareholder, but also the rationale that supports the reason the compensation was paid. Keep corporate minutes each and every year. This is a commonly procrastinated area in veterinary practices that function as corporations.
When possible, plan for steady growth of compensation. It is more difficult to defend explosive growth in one year as compared to another. Even so, records that show that a shareholder employee was clearly under-compensated in early years can provide a defense for catch-up later when the practice is sustaining better economic benefit.
Avoid using compensation and bonuses as a means to negate corporate earnings. Bonuses given at year-end clearly provide evidence that such bonuses were given to eliminate corporate earnings each year.
Pay dividends. As painful as it is to make them, a long history of prior dividend payment can make compensation payments much easier to defend.
Avoid making compensation payments that are proportionate to shareholder ownership and evidence-disguised dividends. Likewise, equalization schedules that provide bonuses to shareholder employees based on various benefits paid by the practice indicate compensation arrangements that do not necessarily represent the value of services provided to the practice.
Pay shareholder employees in relationship to their contributions to the practice's success. Truly productive shareholders, those who spend massive time in rainmaking, management, financial stewardship, training and other aspects of practice administration should be compensated in accord with those efforts. Write contracts or amend employee agreements to show, in writing, the employment obligations that already exist.
The corporate form of business still provides many benefits to the veterinary practitioner. Many practices are now formatted as Subchapter S corporations. Even in a Sub S entity, the same rules as stated above should be followed. Be aware that in Subchapter S corporations, the IRS is looking for the opposite occurrence of that in a Subchapter C: that the shareholders are under-compensated for the services that they provide.
Regardless of your veterinary practice's entity format, you should be aware how these issues will impact now and in the future. Talk with your CPA to obtain a checkup. Bring business documentation up to date, including agreements, documentation of board of director meeting minutes, and all other aspects of prudently running your veterinary practice as a successful business. Even if you are never challenged on these issues, the fact of planning and thinking what you are doing will make big differences in the success of your practice in the years to come.