When Compensation Paid as Salary to Shareholder Employees of Personal Service Corporations is Treated as Dividends: Pediatric Surgical Associates, P.C. v. Commissioner
Kevin G. Mosley
In Pediatric Surgical Associates, P.C. v. Commissioner, the Tax Court held that a portion of a personal service corporation’s payments to its shareholder employees was a dividend and not deductible compensation. The court reasoned, in effect, that where a personal service corporation employs both shareholders and non-shareholders, deductible compensation to the shareholders cannot include an amount in excess of the corporate net profit attributable to the shareholder employees. Before reaching that result, the court considered whether the Service’s seeming departure from the deficiency notice shifted the burden of proof from the taxpayer to the Service under Tax Court Rule 142(a) and an earlier opinion in Shea v. Commissioner. Concluding that it did not, the court approved the Service’s imposition of the section 6662(a) negligence penalty on the corporate taxpayer.Part I of this note provides the background of Pediatric Associates, including its facts and the relevant Code provisions, Regulations, and court decisions. Part II describes the Tax Court’s holding with respect to the burden of proof, the penalties assessed, and the deduction at issue. Part III analyzes the most difficult tax planning issues raised by the decision: the Rule 142(a) burden of proof issue and the section 6662(a) penalty issue. In addition, because the court focused on the section 162(a)(1) deduction, the analysis will briefly discuss the correctness of that holding and its ramifications for tax planning. Part IV summarizes the tax planning strategy suggested by the court’s decision.