United States: Renewed Perils From "Zeroing Out" A Corporation At Year-End

Last Updated: October 13 2016
Article by Ralph Levy, Jr. and Brian Fleetham

Physicians who are involved in the financial management of their practices are all too familiar with the year-end scramble to “zero out” the corporation’s profits. Under this technique, a physician practice that is structured as a “C” corporation will, after paying all of its year-end expenses, distribute its remaining profits to its shareholders as bonuses. A corporation that effectively uses this technique is left with little or no taxable profits at year-end and thus little or no federal tax liability.

A recent Tax Court case raises renewed concerns about this approach. That case, Brinks Gilson & Lione PC (TC Memo 2016-20), involved an intellectual property law firm structured as a professional corporation that was also taxed as a “C” corporation. Like most professional practices structured in that manner, it regularly issued year-end bonuses to its shareholders from its remaining year-end profits, thus minimizing both its year-end taxable income and any resulting federal tax liability. (While some physicians may delight to learn of attorneys facing scrutiny from the IRS and resulting penalties, the analysis of this case potentially applies to any professional corporation that is structured as a “C” corporation that issues its remaining year-end profit as bonuses to its shareholders regardless of the type of services provided.)

That case involved two particularly troubling aspects. As a result of an audit prior to the actual Tax Court case, the law firm ultimately acceded to the determination of the Internal Revenue Services that at least some portion of the year-end bonuses issued by the corporation to its shareholders should have been classified as dividends. A significant concern with this determination of the IRS is the prevalence of the use of the “zeroing out” technique by professional corporations and the tax effect of issuing dividends. Unlike a bonus or other form of compensation, a dividend is not a deductible expense. A corporation that issues dividends is thus usually left with some amount of year-end taxable income. And, unlike individual tax rates, which are graduated, a corporation’s federal tax rate is 35%, beginning with the first dollar of taxable income. Accordingly, if the IRS is now signaling that using the “zeroing out” technique to the exclusion of issuing dividends of some amount is disfavored or even impermissible, professional corporations may need to reconsider their approaches and structures or risk incurring tax liability and/or potential tax penalties.

The other problematic aspect of that case was the Tax Court’s conclusion that the law firm lacked “substantial authority” in support of its position. In other words, the Tax Court ruled that the law firm did not have a reasonable basis under the tax code for claiming a deduction for the year-end bonuses it issued to its shareholders. The Tax Court rejected the law firm’s defense that it acted reasonably and in good faith by relying on its accountants. As a result, the law firm had to pay penalties in addition to potential taxes resulting from the dividends it agreed to pay as a result of its audit.

This is not the first time the Tax Court has issued a ruling like this. In 2001, in Pediatric Surgical Associates, PC. v. Commissioner (TC Memo 2001-81), the Tax Court also ruled that a portion of year-end bonuses paid to that professional corporation’s shareholders had to be recharacterized as dividends. That case involved a professional corporation with four shareholder-physicians and two nonshareholder physicians. The Tax Court held that some portion of the profit generated by the nonshareholder physicians and distributed to the shareholders represented a return on the investment of the shareholders in the corporation and thus constituted a (nondeductible) dividend rather than some form of (deductible) compensation.

When the Pediatric Surgical Associates case was issued, some suggested that it was merely an aberration that did not necessarily reflect the IRS’s general position. The recent Brinks Gilson case, which specifically cited the prior Pediatric Surgical Associates case, seems to confirm the IRS’s prevailing view that a professional corporation should typically pay some “reasonable” amount of dividend to its shareholders and that “zeroing out” a professional corporation at year-end through bonus distributions without any associated dividend may involve at least some degree of tax-related risk. On the other hand, the IRS has not announced, at least publically, that it is making this matter a particular enforcement priority. At least for now, it seems that the IRS will challenge corporations that “zero out” in this manner when the opportunity arises but that it probably is not investigating corporations only for this.

The dilemma for professional corporations that regularly “zero out” at year-end without paying dividends is how to react to this latest ruling. Many professional corporations have done nothing differently since the 2001 Pediatric Surgical Associates case and have been fine from a tax standpoint. Again, however, the Brinks Gilson case may signal a reason for greater concern.

One option for professional corporations is to pay a “reasonable” dividend of some amount to its shareholders. If the shareholders’ paid in capital (i.e., their aggregate shareholder buy-in payments) is not too large, issuing dividends of between five and ten percent of that invested capital would probably not be large enough to result in either significant taxable income or federal income taxes. Under this approach, the corporation would use some of its year-end profits to pay a dividend and then distribute the rest as shareholder bonuses, just as before. This step alone would probably be sufficient to avoid the sorts of problems identified in the Brinks Gilson and Pediatric Surgical Associates cases. But this approach might not be financially viable for a corporation with significant shareholder equity or that already has some amount of federal income tax.

At a minimum, a professional corporation should have a specific, articulated shareholder compensation methodology, preferably one that is directly connected to each shareholder through appropriate provisions in each shareholder’s employment agreement. With that in place, if the IRS asserts that some portion of the corporation’s year-end bonuses to its shareholders should be recharacterized as dividends, the corporation has an argument that it would be in breach of its established contractual compensation obligations if it were required to pay some amount as a dividend that would reduce those payments. For this approach to have a chance of being effective, the compensation methodology would need to provide for a specific formula for allocation of profits, rather than merely stating that any year-end profits will be generally distributed as shareholder bonuses.

Especially in small or mid-sized professional practices, many different shareholders often perform some amount of the administrative services necessary to support the corporation’s operations. Another possible approach is to explicitly identify those services and specify that some amount of a shareholder’s total compensation is for performing those administrative services. That would involve appointing each shareholder as a particular officer of the corporation, developing at least minimal job descriptions for each of those positions, and formally designating, in either each shareholder’s employment agreement or the corporation’s compensation methodology, that some amount of a shareholder’s total compensation is for performing his or her designated administrative duties. Although probably not likely to be as effective as paying a dividend, this approach would provide a professional corporation with another potential argument against an attempt by the IRS to reclassify a portion of year-end bonuses as dividends.

In response to the Pediatric Surgical Associates case, some professional practices made “S” corporation elections or even converted into professional limited liability companies. While those approaches effectively eliminate the potential dividend issue identified in this article, they have other potential consequences. For example, converting a corporation into a professional limited liability company can result in one-time, immediate taxable consequences. In addition, the eligibility and tax treatment of certain employee benefits (such as health insurance and medical expense reimbursement plans) are handled differently for shareholders of a corporation that makes an “S” corporation election as compared to these tax consequences for the owners of a professional limited liability company, which may not be appealing to those shareholders or owners.

In light of this recent tax case regarding these matters, professional corporations that have historically “zeroed out” profits at the end of each year may want to take this opportunity to discuss this issue with their professional advisors and undertake some additional planning before another year-end approaches.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions