If you are part of an accounting firm that filed its federal income taxes incorrectly, don't expect any kind words from Seventh Circuit Court of Appeals judge Richard Posner.
In an opinion issued on May 17, 2012, Posner ruled against an accounting firm in a tax dispute case that should serve as an example to all similar corporations.
The dispute originally arose over whether "consulting fees" paid to the firm's founding shareholders were to be classified employee income or dividends.
The firm claimed that the fees were employee income, while the Internal Revenue Service (IRS) reclassified the fees as dividends. So what's the problem?
Corporate revenue paid as employee salary is deductible from corporate income and is thus taxed only as income to the recipient, while revenue paid as a dividend is taxed at both the corporate and the personal level.
Because of this, Posner explains, the effective tax rate is higher for dividends than salaries, at least in the hands of an owner-employee of a closely-held corporation.
This obviously creates an incentive for such owner-employees to characterize any and all income they receive from the business as wages (so that the corporation can claim that deduction) rather than dividends.
Because of this incentive, the IRS is vigilant of dividends incorrectly categorized as employee income.
The corporation in this case – the aforementioned accounting firm – got in trouble with the IRS for just that kind of mistake.
There are a variety of tests to determine whether the employee salaries claimed are actually dividends, but the "independent investor" test is the most prominently used.
That test, in a nutshell, determines whether the salary of an owner-employee is reasonable by comparing the salary against the corporation's equity return (the rate of return on the ownership interest of common stock holders).
Posner found that the accounting firm "flunked" the independent-investor test.
If the "consulting fees" are treated as salary, that would reduce 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.
When taken with the fact that each of the three owner-employees received, on average, an income approaching $400,000 each of the three years at issue, and that the firm's annual gross revenue was $5 to $7 million, one can see how the test was flunked.
In addition to this somewhat drab numbers test, the opinion contained some colorful criticisms of the accounting firm.
Aside from the "flunk" comment, Posner noted his astonishment at the failure of "an accounting firm's lawyers...to understand the difference between compensation for services and compensation for capital."
Posner was referring to the firm's reply brief claiming that, because the owner-employees made capital contributions to the business, they deserved more in services rendered compensation.
He also closed the opinion with the observation, "that an accounting firm should so screw up its taxes is the most remarkable feature of the case."
And, to put a little salt in the wound, Posner had some accounting advice for the firm.
Namely, Posner noted that had the firm reorganized itself from a C corporation, which imposes tax liability on the corporate entity, to an S corporation or a partnership (the "obvious alternative"), which imposes tax liability only on the owners, there wouldn't have been any tax liability to worry about to begin with.
I mentioned earlier that the opinion should serve as an example to other accounting firms. Here's why:
If you are going to appeal an adverse tax ruling twice, make sure that you got your accounting right.
If you insist on appeal in the face of flawed accounting, just make sure you aren't going in front of Judge Posner, who will be sure to issue a lesson in humility for the entire world to see.
Jeremy Byellin is a practicing attorney in the state of Minnesota, and a writer for the Westlaw Insider blog. His articles for the blog cover a wide range of legal topics, with a specific focus on major legal developments and cyberlaw.