## Facts

- Mulcahy, Pauritsch, Salvador & Co., Ltd. was a closely held CPA firm with roughly 40 employees and annual revenues of about $5–$7 million.
- Three founding shareholder-accountants owned more than 80% of the corporation during tax years 2001–2003 and were also employees who received salaries (which the IRS did not dispute as deductible).
- For each of 2001–2003, the corporation deducted more than $850,000 as “consulting fees” paid to three entities owned by the founding shareholders; the entities then paid the money through to their respective owner-shareholders.
- The corporation did not treat these “consulting” payments as wages subject to payroll withholding, did not report them as employee compensation, and did not reflect them as shareholder compensation on relevant schedules.
- Despite high revenues, the corporation reported minimal or negative taxable income during the years at issue, consistent with the large “consulting fee” deductions.
- The IRS reclassified the “consulting fees” as dividends, disallowed the deductions, and determined substantial corporate income tax deficiencies.
- The Tax Court sustained the reclassification and imposed a 20% accuracy-related penalty for substantial understatement under 26 U.S.C. § 6662.
- The corporation appealed to the Seventh Circuit.

## Issues

1. Whether the payments labeled “consulting fees” to shareholder-owned entities (and passed through to the shareholders) were deductible compensation for services actually rendered under 26 U.S.C. § 162(a)(1) or nondeductible dividends.
2. Whether the corporation was liable for the 20% accuracy-related penalty for substantial understatement under 26 U.S.C. § 6662(a), (b)(2).

## Decision

- The Seventh Circuit affirmed the Tax Court.
- The court held the Tax Court did not err in treating the “consulting fees” as dividends rather than deductible compensation.
- The court upheld the 20% accuracy-related penalty for substantial understatement.

## Legal Principles

- Under 26 U.S.C. § 162(a)(1), a corporation may deduct compensation only if it is (1) for services actually rendered and (2) reasonable in amount; distributions of corporate earnings to shareholders are dividends and are not deductible.
- Labels and payment routing do not control tax treatment; courts assess economic substance and evidence of actual services performed.
- Payments to shareholder-controlled entities that largely function to transfer corporate profits to shareholder-owners may be treated as disguised dividends.
- The “independent investor” approach supports finding compensation unreasonable when challenged payments leave the corporation with little or no return on equity, indicating the payments are profit distributions rather than arm’s-length compensation.
- An accuracy-related penalty for substantial understatement applies when the understatement exceeds statutory thresholds and the taxpayer lacks reasonable cause and good-faith support for the reporting position, particularly where the taxpayer has tax expertise and the position lacks factual support.

## Conclusion

The Seventh Circuit sustained the IRS’s reclassification of shareholder-directed “consulting fee” deductions as nondeductible dividends because the record did not show distinct compensable services and the payments eliminated corporate return in a manner inconsistent with arm’s-length compensation, and it also sustained the § 6662 accuracy-related penalty for substantial understatement.


Mulcahy, Pauritsch, Salvador & Co., Ltd. v. Commissioner, 680 F.3d 867 (7th Cir. 2012)