Taxing Lessons Case Summaries

Case — Reasonable Compensation

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TL Case Summ

THE QUESTION

What is reasonable compensation for the sole shareholder of a corporation who also holds the position of CEO?

THE DISPUTE

Taxpayer Says: The compensation paid to the shareholder/employee was reasonable and is fully deductible.

Internal Revenue Service Says: The compensation is excessive and is only partially deductible.

THE LAW

From Internal Revenue Code Section 162(a)(1): Permits a taxpayer to deduct ordinary and necessary business expenses, including “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 if the payments were reasonable in amount and in fact paid purely for services.

From Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1243-1245 (9th Cir. 1983), revg. T.C. Memo. 1980-282: The Court of Appeals 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 with other companies; (3) the character and condition of the company; (4) potential conflicts of interest; and (5) internal consistency in compensation.

From Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. 1142, 1156 (1980): When officers who control the corporation set their own compensation, careful scrutiny is necessary to determine whether the alleged compensation is in fact a distribution of profits and a constructive dividend.

THE CAUSE OF THE DISPUTE

Wages you pay yourself from a corporation in which you are the majority shareholder are deductible from the gross income of your corporation, as long as the amount paid is considered “reasonable.” Excessive wages–those deemed not “reasonable”–can be reclassified as dividends. Dividends are not a deductible corporate expense, but are income to the recipient.

Disputes arise over compensation because “reasonable” is not defined in the Internal Revenue code.

In this case, the corporation’s sole shareholder received compensation of $2,020,000 in 2002 and $2,058,000 in 2003. The corporation deducted these amounts on its tax returns.

The IRS said the compensation was excessive, and that the proper deduction should have been $655,000 for 2002 and $660,000 for 2003.

With the agreement of the taxpayer and the IRS, the court assessed the reasonableness of the compensation by evaluating five factors and determining whether each factor favored the taxpayer or the IRS.

1) Role in the company. The taxpayer was the sole shareholder, president, CEO, and COO. He performed services for the corporation, devoted time to the business and made all important decisions.

2) External comparison. The taxpayer’s expert witness determined the compensation was reasonable by comparing the taxpayer’s pay to other executives in similar companies and by assessing the pay against the services rendered. The compensation expert for the IRS determined the compensation was not reasonable by applying the “independent investor” test, which asks whether an investor would be satisfied with the return on investment in the company and assumes that if so, the investor would approve the compensation.

3) Character and condition of the company. The company provided contract packaging services and designed and manufactured packing equipment, and was a successful business.

4) Conflict of interest. The corporation was controlled by the taxpayer. Since this is a conflict of interest, the reasonableness of compensation should be evaluated from the perspective of a hypothetical independent investor. If the company’s earnings on equity after payment of the compensation at issue remain at a level that would satisfy a hypothetical independent investor, there is a strong indication that the employee is providing compensable services and that profits are not being siphoned out of the company disguised as salary. Return on equity was 2.9% in 2002 and -15.8% in 2003.

5) Internal Consistency of Compensation. The company had no established monthly amount for bonuses. The shareholder determined the amount received on the basis of performance, and this amount was paid each month.

WHAT WOULD YOU DECIDE?

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, 45KB)

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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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For the taxpayer. Factor 1. The taxpayer devoted all of his time to the businesses operations and directly contributed to its financial condition. This factor weighs in taxpayer’s favor. Factor 2. Neither expert was more convincing than the other. This factor is neutral. Factor 3. Complexity of the business and the success of the business weighs in taxpayer’s favor. Factor 4. An independent investor would have expected a higher rate of return in 2003. This factor weighs for taxpayer in 2002 and IRS in 2003. Factor 5. The bonus schedule was consistent. This factor weighs in taxpayer’s favor.
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