Taxing Lessons Case Summaries

Case — Reasonable Compensation

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TL Case Summ

THE QUESTION

Is salary paid to a company’s sole officer/shareholder actually a distribution of profits (a nondeductible dividend) instead of compensation?

THE DISPUTE

Taxpayer Says:  $509,000 paid to officer/shareholder ($500,000 bonus plus $9,000 executive salary) is reasonable compensation.

Internal Revenue Service Says: $100,000 of amount paid is reasonable compensation; the balance of $409,000 is a dividend.

THE LAW

From Internal Revenue Code Section 162(a)(1): A taxpayer can deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered”.

From Federal Tax Regulation 1.162-7(a): A taxpayer is entitled to a deduction for compensation only if the payments were reasonable in amount and in fact paid purely for services.

From Court Case: Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1983 U.S. App. LEXIS 16571. The Court of Appeals for the Ninth Circuit (where an appeal of this case would go) uses five factors to determine the reasonableness of compensation, with no single factor being determinative. The factors are: (1) The employee’s role in the company; (2) comparison of the compensation with that of similar companies; (3) the character and condition of the company; (4) potential conflicts of interest; and (5) internal consistency in compensation.

THE CAUSE OF THE DISPUTE

Both salaries and dividends are taxable to the person receiving them. Salaries are deductible at the corporate level. Dividends are not. In effect, profits distributed as dividends are taxed twice–once at the corporate level and once at the individual level. By paying out company profits as salary instead of dividends, this double taxation is avoided.

The Internal Revenue Service takes the position that corporations should pay employees a reasonable salary and distribute the remaining profits as dividends, but the Internal Revenue Code does not define “reasonable compensation.”

WHAT WOULD YOU DECIDE?

 Note: In applying the factors from the Elliott case, the court determined:

(1)   The employee’s role in the company – President, secretary, and treasurer, handling all managerial duties.

(2)   Comparison of the compensation with that of similar companies – No data provided by taxpayer. IRS provided data that was not comparable.

(3)   The character and condition of the company – Small company with total gross receipts of $1,055,433; net income of $38,886; wages of $31,757 paid to other employees.

(4)   Potential conflicts of interest – Company is controlled by compensated employee.

(5)   Internal consistency in compensation – Company had no formal compensation policy. The bonus was determined and paid at the end of the fiscal year based on available cash.

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 23KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. Taxpayer failed to prove the compensation was reasonable. $100,000 of compensation is deductible; $409,000 is not.
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