Ouch! In affirming a Tax Court decision that an accounting firm set up as a C corporation could not deduct consulting fees paid to entities controlled by the firm’s owners, the Seventh Circuit Court of Appeals statement of its decision cut to the quick: “That an accounting firm should so screw up its taxes is the most remarkable feature of the case.”

The firm, Mulcahy, Pauritsch, Salvador & Co. Ltd., set up as a C corporation in 1979 (when there were fewer options for entities that wished to be protected from liability) and paid “consulting fees” to the three founding members of the firm through three entities they owned. The firm, based in Orland Park, Ill., reported virtually no income because its revenues, although in the range of $5 million to $7 million a year, were offset by deductions for business expenses, primarily compensation paid directly or indirectly to its owner-employees, who are three of the firm’s accountants. The IRS reclassified the fees as dividends, resulting in a deficiency in corporate income tax of more than $300,000 in 2001 and the following two years.

“The Tax Court was correct to reject the firm’s argument that the consulting fees were salary expenses,” the appeals court stated in an opinion written earlier this month by Judge Richard Posner. “Treating them as salary reduced 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, judging by the salaries received by the founding shareholders, the firm was doing fine. And so the firm flunks the independent-investor test.”

The court was “puzzled” as to why the firm continued as a C corporation and sought to avoid double taxation by overstating deductions for business expenses, when reorganizing as a pass-through entity would have achieved the same result without inviting a legal challenge.  However, the court noted the Supreme Court’s statement that “while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not.”

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