Physician Bonuses Can Create Tax Liability Issues

April 14, 2015

Done incorrectly, big year-end bonuses can result in big trouble, as seen in the case of one Illinois physician.

We've covered a number of income tax issues of concern to doctors in discussions ranging from tax fraud schemes that target doctors to how doctors may face liability for employee classification choices and their surrounding tax reporting and withholding obligations. Today, we examine how mistakes and lack of documentation in how doctors pay themselves can lead to very serious problems.

Physician's aggressive bonus creates issue with I.R.S.

An eye surgeon took seven figure bonuses (up to 300 percent of his salary) that were then expensed as compensation to the surgery practice that he owned. The result was it created deductible expenses to the business and removed a significant amount of income from what would other wise be taxable corporate income. According to the memo on the case from the U.S. Tax Court:

Year

2007

2008

Salary

$780,000

$690,000

Bonus

$2,000,000

$1,100,000

Total compensation

$2,780,000

$1,790,000

 Dr. Afzal Ahmad was the president, medical director, and 100 percent shareholder. Dr. Ahmad was also the CEO, chief operation officer, and chief financial officer. These positions required him to perform various managerial tasks. He was also an active surgeon in the practice. Dr. Ahmad received a salary of $30,000 every two-week pay period. He also received a substantial bonus at the end of each year. During the tax years at issue, his compensation was:

Ahmad's bonus for 2007 was paid out via four separate checks each $500,000, all taken between November 2007 and December of 2007. The tax code allows taxpayers to deduct "ordinary and necessary expenses," including a "reasonable allowance for salaries or other compensation for personal services actually rendered." Such compensation is deductible only if it is: reasonable in amount and paid or incurred for services actually rendered.

In this case, the tax court held that the compensation was not reasonable for the services performed, for a number of reasons including the fact that he failed two important tests used to determine the reasonableness of compensation and the accompanying deductions, which the court also determined he had the legal burden of proving.

Test one: The independent investor

Loosely re-stated, this test requires a finding that a "reasonable investor" would examine the amount of compensation for the work actually performed and find it objectively reasonable within some case-specific range under the totality of the circumstances. In this case, the bonus compensation paid actually resulted in a net operating loss of over $50,000 in one year, which clearly would have not satisfied a third-party investor in the practice. The result? He cannot raise this test as proving him a "presumption of reasonableness," leaving him only one other option.

Test two: The reasonableness test

When the presumption above does not apply, previous case law has held that factors other than the percentage of return on the investment or ownership have to be considered, including comparable salaries. This test examines the compensation for the work actually performed, compares it with similarly situated and experienced professionals in comparable businesses and would determine that the compensation paid was within a reasonable and standard industry range.

In this case, because Ahmad assumed some of the duties and caseloads of two other surgeons, (one who left and one who reduced her hours) as well as a number of executive functions, based on his ownership and the number of titles or "hats" he wore, there was no comparably situated business in the area to compare his practice to for this test. Finally, Ahmad further failed his legal burden to explain how the compensation was reasonably calculated or why it was taken as it was, when it was.

The results in this case were significant for the doctor; for one year alone, 2007, the court disallowed the deduction of over $1 million as compensation leaving Ahmed with the tax liability on that at his corporate rate (plus interest) and additional penalties of an additional 20 percent that the court also applied due to his substantial understatement of income and negligent disregard of the rules. Interestingly, Ahmad failed to raise any defense based on reliance on a tax preparer or even to have one testify on his behalf. This leads me to wonder if he did his taxes himself or was merely covering for a friend or family member that did an exceptionally sloppy job.