Concerned about 'excessive' compensation?

Everything you read today indicates an overwhelming opinion consensusthat veterinarians are paid abysmally as compared to other professions andeven occupations.

Be aware - our friends in Washington may have different ideas. In recentmonths, the IRS has targeted practices during audit, with the specific allegationthat too much money is being paid to veterinarians who are also shareholdersin their personal service corporations (PSC).

A recent tax court case further highlights the impending danger for anyveterinary practice that operates in a Subchapter C corporation format.The U.S. Tax Court decision in Pediatric Surgical Associates, P.C. vs. TheCommissioner, found in favor of the IRS. The court upheld the IRS' denialof deduction for certain compensation paid to shareholder-employees. A keypoint in this case was that the deduction was denied, not because the compensationwas unreasonable, but because it was deemed not to be "in fact paymentpurely for services."

A little history

First, you will need some background to understand why this is becominga more important issue for veterinary practices operating in the corporateformat.

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 thecorporation itself is subject to taxation on any taxable income at the endof the tax year. Now that veterinary corporations are deemed to be personalservice corporations, in accord with Revenue Ruling 91-60, they are taxedat a higher tax rate than other corporations at a flat 35 percent on everydollar of profit.

The IRS contends that many closely held businesses operating in a SubchapterC format try to limit taxable income through additional compensation paidout to shareholder owners. Since wages and associated payroll taxes arefully deductible to the corporation, taxed profits can be substantiallyreduced or even extinguished by timed bonuses at year-end.

The government's stance has been that not all of amounts paid out inwages and salaries represent fair payment for time expended in the businessby the shareholders in question. If the IRS can show that a portion of amountspaid 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.

Dividend payments

When Subchapter C corporations make dividend payments, which reflecta return on investment in a business, those dividends are subject to "doubletaxation." The dividend is not deductible by the corporation, but sinceit has been paid out of current profits, it results in taxable income.

At the same time, the dividend when received by the shareholder is taxableat ordinary income tax rates. Assuming that a personal service corporationshareholder would be subject to the maximum federal tax rates, a combinedincome tax effect on the dividend could be 35 percent plus 40 percent plusany state effect. In essence, a dividend made from your PSC could resultin taxes on that dividend as much as 75 percent or more of the dividendpaid.

In recent years, our firm has become increasingly aware of the attentionthat has been given by the IRS to this specific area. Agents are speciallytrained to understand, spot and target reasonable shareholder compensationin closely held corporations. In Subchapter C corporations, the major issuethe IRS investigates is whether shareholder-employees are reasonably compensatedfor the personal services they provide in the businesses to which they haveownership rights.

The IRS is interested in determining for higher paid individuals whethersalaries are in excess of those ordinarily paid for similar services. Insuch situations, the excess payments might correspond or bear a close relationshipto the shareholdings of the officers involved. The IRS will then allegethat salaries are not paid wholly for services rendered; that a portionrepresents a distribution of earnings on stock, return for equity ownership.

The court case says

The Internal Revenue Code Section 162 provides that for compensationto be deductible, it must be both reasonable and purely for services actuallyrendered. Most prior challenges by the IRS have been based on the fact thatthe amount of compensation paid is unreasonable. This has been our experiencein clients recently undergoing audit.

This case is different. It focused on whether compensation was "purelyfor services rendered." In this pediatric surgical practice, the serviceargued that the net profits of the professional practice that are attributableto non-shareholder efforts cannot be paid to shareholders as compensationbecause such amounts are not purely for services rendered by the shareholders.Any net profits that were not produced by the shareholder pediatricianspersonally were deemed to not be attributable to their services and weredisallowed as compensation to them.

This result should be of great concern to veterinarians. In veterinarypractices, a substantial portion of income comes from ancillary services,the efforts of associate veterinarians, product sales and all of the otheractivities that the practice provides.

In essence, all of the other efforts provided by shareholders in managingthe business and that are, in fact, for services, albeit not veterinarycare related services, would be excluded from the computation. In otherwords, this case implies that professionals providing other services otherthan those for which they are professionally evidenced and personally provide,should not be compensated!

It seems ludicrous that exhaustive work efforts expended by any personowning a veterinary practice would not be taken into consideration whendetermining whether compensation was reasonable or not.

What should you do?

First of all, discuss the issues with your CPA. Ascertain your choicesin terms of how your corporation is structured. One possible solution iselecting small business corporation status under Subchapter S if your corporationwould be eligible.

The Subchapter S election is not without difficulties and expense. Awhole variety of issues relate to timing and accounting for the electedchange. The ultimate result is that corporate profits pass through to theindividual shareholders rather than being taxed at the corporate level asoccurs in a personal service corporation under Subchapter C.

For some practices, Subchapter S election may not be an option. In thesesituations, you need to plan a strategy for defending compensatory arrangements.

In the Pediatric Surgical Associates case, shareholder compensation rangedfrom only $172,896 to $452,969 in the two years that were audited by theservice. These amounts are quite comparable to what Subchapter C veterinarycorporations experience.

Document compensation

Establish solid documentation as to the reasons for compensation andthe type of duties and tasks provided to the corporation, spanning fromclinical services to maintenance work on Sunday afternoons.

Maintain records of hours spent working in the practice. Here is a goodreason for veterinary practice owners to punch a time clock like everyoneelse. Document the time you spend. If you can show that your time in thepractice, in all areas of activities, is much greater than the normal workingclass population at 40 hours per week, then you have provided additionalevidence as to the reasonableness factor.

Policies

Compensation policies should be written and applied consistently fromyear to year. The use of a formula to determine compensation has been givensignificant weight in several past cases.

Use objective third parties to determine compensation, such as a CPAor compensation consultant. To be effective, advice should be well documented.

Document compensation decisions in the corporate minutes. The corporateminutes should not only reflect the compensation and bonuses for each employeeshareholder, but also the rationale that supports the reason the compensationwas paid. Keep corporate minutes each and every year. This is a commonlyprocrastinated area in veterinary practices that function as corporations.

When possible, plan for steady growth of compensation. It is more difficultto defend explosive growth in one year as compared to another. Even so,records that show that a shareholder employee was clearly under-compensatedin early years can provide a defense for catch-up later when the practiceis 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 weregiven to eliminate corporate earnings each year.

Pay dividends

Pay dividends. As painful as it is to make them, a long history of priordividend payment can make compensation payments much easier to defend.

Avoid making compensation payments that are proportionate to shareholderownership and evidence-disguised dividends. Likewise, equalization schedulesthat provide bonuses to shareholder employees based on various benefitspaid by the practice indicate compensation arrangements that do not necessarilyrepresent the value of services provided to the practice.

Pay shareholder employees in relationship to their contributions to thepractice's success. Truly productive shareholders, those who spend massivetime in rainmaking, management, financial stewardship, training and otheraspects of practice administration should be compensated in accord withthose efforts. Write contracts or amend employee agreements to show, inwriting, the employment obligations that already exist.

The corporate form of business still provides many benefits to the veterinarypractitioner. 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 oppositeoccurrence of that in a Subchapter C: that the shareholders are under-compensatedfor the services that they provide.

Regardless of your veterinary practice's entity format, you should beaware how these issues will impact now and in the future. Talk with yourCPA to obtain a checkup. Bring business documentation up to date, includingagreements, documentation of board of director meeting minutes, and allother aspects of prudently running your veterinary practice as a successfulbusiness. Even if you are never challenged on these issues, the fact ofplanning and thinking what you are doing will make big differences in thesuccess of your practice in the years to come.