Case — Catch-up Compensation

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TL Case Summ

THE QUESTION

Is a taxpayer’s catch-up compensation reasonable?

THE DISPUTE

Taxpayer Says: The total compensation package included catch-up payments for prior years, and is reasonable. The deduction should be allowed.

Internal Revenue Service Says: The compensation package was not reasonable, and is not deductible.

THE LAW

From Internal Revenue Code Section 162(a)(1): Provides a deduction for 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: The deductibility of compensation is determined through a two-prong test: the amount of compensation must be reasonable, and the payment must be purely for services rendered.

From R.J. Nicoll Co. v. Commissioner, 59 T.C. 37, 50-51 (1972): Compensation for prior years’ services is deductible in the current year as long as the employee was actually under-compensated in prior years and the current payments are intended as compensation for past services.

From Devine Bros., Inc., v. Commissioner, T.C. Memo. 2003-15: When the compensation was actually for prior years of service, it need not be reasonable in the year it was paid.

From Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983), rev’g T.C. Memo. 1980-282: The reasonableness of the payments is considered with reference to five broad factors. No single factor is dispositive. The relevant factors are: (1) the employee’s role in the company; (2) a comparison of the employee’s salary with salaries paid by similar companies for similar services; (3) the character and condition of the company; (4) potential conflicts of interest; and (5) internal consistency.

From Metro Leasing & Dev. Corp. v. Commissioner, 376 F.3d 1015, 1019 (9th Cir. 2004), aff’g 119 T.C. 8 (2002): The Court of Appeals for the Ninth Circuit, to which an appeal in these cases would lie absent stipulation to the contrary, adds an additional factor: whether an independent investor would be willing to compensate the employee as he was so compensated. The Court of Appeals notes that “the perspective of an independent investor is but one of many factors that are to be considered when assessing the reasonableness of an executive officer’s compensation.”

THE CAUSE OF THE DISPUTE

You can deduct a reasonable amount of wages you pay yourself as the owner of a business for services you provide to your business. Wages you pay yourself in the current year for services rendered in prior years are also deductible (see Lucas v. Ox Fibre Brush Co. 281 U.S. 115 (1930)), as long as the wages meet the requirement of a reasonable wage paid for services rendered.

Disputes arise when wages are paid to related parties such as shareholders, because there’s generally a lack of independence in determining the amount paid.

Factors used to assess reasonability include: (1) the employee’s role in the company; (2) a comparison of the employee’s salary with salaries paid by similar companies for similar services; (3) the character and condition of the company; (4) potential conflicts of interest; and (5) internal consistency. In addition, when the case can be appealed to the Ninth Circuit (as in this case), an additional factor is considered: the perspective of an independent investor; that is, whether an independent investor would be willing to compensate the employee as she was compensated.

In this case, the taxpayer, a licensed chiropractor, and his wife, an RN, purchased an assisted living facility in 1973 for $25,000. The facility was the sole asset in the taxpayers’ corporation. Both taxpayers worked for the corporation as hands-on operators, though the husband was the sole shareholder. The corporation was profitable most years, and paid down long-term debt.

From 1973 through 2002, the taxpayers earned total compensation from the corporation of $828,684. During that time, they paid other employees market wages, and took no salaries for themselves during various years due to insufficient cash flow.

In 2002, the corporation sold the assisted living facility for $3.4 million. In January 2003, the corporation created a defined benefit pension plan for the benefit of the taxpayers, who continued to work at the facility for an additional nine months after the sale.

For the years at issue (2003, 2004, and 2005), the taxpayers received a total compensation package consisting of wages and pension plan contributions of $1,701,287. Those payments were approved in the corporate minutes, and included back salaries that had not been paid in prior years.

The corporation was advised by its tax preparer that the compensation was reasonable, and deducted the total amount on the corporate tax return.

The IRS says the compensation was not reasonable, and disallowed it entirely.

In reaching a decision, the tax court considered the six factors as follows:

1) Employee’s Role in the Company. The taxpayers were hands-on owner-operators of the company.

2) Comparison With Salaries Paid by Similar Companies. Labor rates data for 2003 through 2005 from the Bureau of Labor Statistics’ Occupational Employment Statistics program, as compiled by an expert, showed that a combined compensation inflated for California wages and assuming full-time employment would be $187,537.40 for the taxpayer and $195,785.60 for his wife.

3) Character and Condition of the Company. Although the corporation was not profitable enough to pay the taxpayers in some years, the taxpayers paid down long-term debt, and upon purchasing the business, managed to make it profitable enough to pay its own bills and to command a substantial price when it was sold.

4) Potential Conflicts of Interest. The relationship between the corporation and the taxpayer is indicative of a conflict of interest.

5) Internal Consistency. The payments to the taxpayers was inconsistent with payments to other employees–but not in the taxpayers’ favor.

6) The Independent Investor. The corporation had net assets of $186,685. Assuming a 10% rate of return, an independent investor would expect to have $503,300 left for distribution after payment of the salaries. Therefore, the compensation packages did not leave enough of the corporation’s assets to be paid back to the hypothetical investor as a return on investment.

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, 65KB)

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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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