It is no secret that corporations often try to reduce their tax liability by redirecting revenue taken in toward paying highly compensated employees. This allows the corporation to deduct the salaries as an expense and thus show less taxable net profit.  But how does this tax minimization strategy impact a corporation’s ability to later prove damages for lost profits in litigation?

In Illinois, in the case of a professional corporation formed under the Medical Corporation Act, a corporation that pays professional shareholders salaries that reduce the corporation’s net profit to zero is not barred from proving lost profits in litigation.  Instead, the corporation’s revenues before the payment of salary to the professional shareholder may be considered in establishing damages for lost profits.

The issue was analyzed by the Illinois Supreme Court in the recently filed opinion in Edward Atkins, M.D.S.C. v. Robbins, Salomon & Patt, LTD.  There, a medical corporation filed a malpractice lawsuit against its attorneys for failure to include non-compete clauses in the employment contracts of two anesthesiologists.  The anesthesiologists left their positions and started a competing business that won a contract from one of the corporation’s prior customers.  The corporation initially filed a lawsuit for tortious interference with prospective business advantage against the departed anesthesiologists, but then changed tack and pursued a malpractice lawsuit against its attorneys for failing to include non-competition clauses in the departing anesthesiologists’ contracts.

At trial, the evidence demonstrated that the corporation’s sole shareholder, an anesthesiologist, took home more than $1 million in compensation annually while the corporation showed a net profits of at least $0, and sometimes losses, year after year.  In pre-trial motions and at trial, the defendant attorneys argued that the corporation should be barred from recovering lost profits because the corporation’s tax returns painted the picture of an unprofitable business.  The corporation argued that it should not be punished for maximizing its tax savings.  Instead, the corporation argued that its lost profits should be discerned by focusing on the amount of money left in the corporation after its other expenses were deducted, but before the highly compensated shareholder’s salary was deducted out.  The trial court agreed with the defendant attorneys and barred the corporation’s claim for lost profits.

On appeal, the Illinois Supreme Court sided with the corporation.  The Court ultimately settled on the approach taken by the Fourth Circuit Court of Appeals in Bettius & Sanderson, P.C. v. National Union Fire Insurance Co.  In Bettius, the Fourth Circuit posited that traditional business corporations and professional corporations are dissimilar.  Specifically, the Fourth Circuit’s contended that traditional business corporations typically have shareholders that are not involved in running the business, while shareholders in professional corporations are involved in the day to day activities of the business.  Based, in part, on this stated difference between professional and traditional business corporations, the Illinois Supreme Court held that a professional corporation is not barred from proving damages in the form of lost profits even when the corporation shows net profit of $0 after paying compensation to shareholders.