Definitions — Dealing with the unreasonable

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Image source: Public domain via Wikimedia commons

Image source: Public domain via Wikimedia commons

Unreasonably high compensation may seem like a problem you wish you had. But when a C corporation pays excessive or unreasonable wages to a shareholder/employee, part of those wages could be nondeductible. What do you call that nondeductible portion? Is it still wages? Or something else? The answer matters because when nondeductible compensation remains compensation, it’s taxable to the recipient and subject to payroll taxes.

Generally, when the IRS concludes compensation is unreasonable, the “unreasonable” portion is reclassified as dividends (Treasury regulation 1.162-8). While the reclassification eliminates payroll taxes, the double taxation continues to exist for a C corporation because dividends are nondeductible for the company and taxable income to the recipient.

Here are three cases where the courts considered taxpayer arguments for other classifications of excessive compensation.

1.

A company paid $25,000 to the taxpayer, who was the company’s secretary-manager. The company employed the taxpayer on a salary plus commission basis. When the company realized the payment would be considered unreasonable compensation, the board of directors voted that the taxpayer’s commission agreement be canceled for the past fiscal year and that the taxpayer be placed on a flat salary. The taxpayer relinquished his earned commissions and the contract entitling him to future commissions, and the cancellation was carried out on the books of the company.

The stockholders and directors of the company instructed and directed the board of directors “to pay or credit the account of the taxpayer, on the books of this corporation, with the sum of Twenty-five Thousand ($25,000) Dollars, as a gift in recognition of his able and successful direction of the affairs of this corporation during the past seven (7) years.”

The $25,000 was paid to the taxpayer. He used the money in the payment of his personal debt to the chief stockholder of the corporation.

The taxpayer filed a gift tax return reporting the $25,000 payment as a gift. The company charged the sum off to its surplus account and did not deduct the payment in its own income tax returns.

The IRS said the $25,000 was compensation for services rendered by the taxpayer to the company, and not a gift, and as such was taxable income. The tax court agreed with the IRS.

The taxpayer asked an appeals court to review the decision.

WHAT WOULD YOU DECIDE?

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Source: Thomas v. Commissioner of Internal Revenue, Circuit Court of Appeals, Fifth Circuit.•135 F.2d 378 (5th Circuit 1943)

2.

In this combined case, the taxpayers were sisters who were employed by their father in his business of manufacturing special machinery and precision tools. One sister served as engineer and production supervisor and the other served as secretary and office manager. Both received salaries, reported the salaries as income on their respective tax returns, and paid the tax due. Their father, on his income tax returns, treated the exact amounts as compensation paid for services rendered and deducted them as business expenses.

On audit of the father’s income tax returns, the IRS allowed part of the deductions as reasonable compensation for the daughters. The excess was disallowed as business deductions because the IRS concluded it was unreasonable compensation. The IRS assessed deficiencies in income taxes against the father.

The father argued that the entire amounts involved were paid to his daughters as salary and were reasonable compensation for services rendered in the course of employment.

The tax court disagreed and the father paid the additional taxes due. Afterward, the father filed gift tax returns reporting as gifts to his daughters the amounts which had been disallowed as income tax deductions. No gift tax was due because of the statutory exemptions.

The daughters filed claims for refund of income taxes asserting that the sums involved had been disallowed to their father as business deductions so consequently the sums were gifts and not taxable income to them.

The daughters’ claims for refund were rejected by the IRS. The daughters went to court. The court agreed that since the payments were disallowed as expenses to the father, by matter of law, the payments were gifts.

The IRS appealed the decision to the United States Court of Appeals Third Circuit.

 

WHAT WOULD YOU DECIDE?

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THE COURT’S DECISION

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Source: Smith v. Manning

3.

When a corporation’s executive vice-president, who was also a director and stockholder, died, the company bought back his stock, pursuant to an agreement made before his death. The executive left a will naming the founder of the company the principal beneficiary and co-executor of his estate. In the will, he directed that his wife and children receive nothing, and that the balance of his estate go to a woman with whom he had become personally involved.

The taxpayer, who was the founder of the company, had known the executive and his wife for years. He believed the executive was wrong to exclude his wife from receiving any benefit from the estate. He also felt it would set a good example for the company employees to take care of the executive’s widow. Though the company had no established plan for payment of benefits to partners of deceased employees, the taxpayer requested that the board adopt a resolution to authorize a payment of $50,000 to the widow, “in recognition of past services rendered to the company by the deceased executive.”

The corporation deducted the payment as a business expense. The IRS disagreed, saying the payment was not deductible on the corporate return because it had no business purpose. In addition, the IRS reclassified the payment as a dividend taxable to the company founder (the taxpayer). The court agreed.

The taxpayer paid the assessment, then appealed for a refund. The taxpayer said he did not benefit in any way from the payment and it should not be taxable to him.

WHAT WOULD YOU DECIDE?

Make your selection, then hover your mouse
over the link beneath “The Court’s Decision”

For the or for the

THE COURT’S DECISION

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Source: Montgomery Engineering Company

***

Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided to read the entire case.

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.

Although the parties themselves made every effort to have this payment take the form of a gift, we agree with the tax court opinion that the facts and circumstances surrounding the payment indicate the payment was in consideration of valuable services rendered by the employee to the corporation. The taxpayer, shortly before, had relinquished earned commissions in addition to his contract entitling him to future commissions. The background of this payment indicates the intention of the parties in making the payment was different from that which they outwardly manifested.

The company expressly described the payment as a gift “in recognition of able and successful direction of the affairs of this corporation during the past seven (7) years.” We feel this clearly indicated the true nature of the payment—additional compensation in the form of a bonus for past service rendered by the taxpayer.

The ultimate finding of fact that the $25,000 payment was compensation for services rendered and not a gift is supported by substantial evidence, and findings of fact will not be overturned unless they are clearly contrary to the weight of evidence.

We are not the triers of fact, but merely reviewers of the action, and in our investigation we are limited to an ascertainment of the existence of substantial evidence sufficient to support the findings. We have considered the evidence in the present case and find that there was substantial evidence to sustain the conclusion.

The decision is affirmed.

Sorry, wrong answer :(
Right answer!

For the IRS.

The basis of the taxpayers’ position, as well as of the holding of the previous court, is that since the IRS determined the sums disallowed as business expense deductions to the father were not compensation for services rendered, they must be gifts.

We cannot agree either with the premise or the conclusion.

The internal revenue code exerts the taxing power in broad language indicating “the purpose of congress to use the full measure of its taxing power within * * * definable categories.” But the allowance of tax benefits is a matter of legislative grace, in practice held closely confined. A determination of nondeductibility does not conclude the issue of gross income. We all know that we have items of expense which, when paid, are includible in the payee’s gross income, but which are not deductible to us.

In the instant case, the IRS may well have denied a deduction on the ground that the amounts paid to the daughters were something other than business expenses or that they were something other than compensation for services actually rendered.

The IRS did not do so. The IRS merely resolved the issue of reasonable compensation and disallowed the balance. It does not necessarily follow upon this determination that the excess was other than taxable income to the daughters.

Nor does it necessarily follow that the excess was not compensation for services. While amounts paid as compensation for services may be income in their entirety to the employee, they are not entirely deductible by the employer. We think it clear, therefore, that the disallowance of the deductions claimed by the father in the circumstances related did not, without more, convert to gifts the excess paid to the taxpayers.

The contention of the taxpayers is that the sums disallowed as deductions to their father are gifts to them. Although receipts cannot be both income and gifts, whether the receipts are gifts is primarily a question of fact to be resolved upon the peculiar circumstances of the case.

In the instant case, the evidence convinces us that the payments involved were made without a donative intent; it establishes that they were given and received as salaries. The taxpayers obviously considered the sums received as compensation, for they reported them as such on their income tax returns.

The taxpayers’ father, in his testimony, referred to the payments as salaries; he stated that at the time the payments were made he thought they were salaries, not gifts; he claimed their full deduction on his income tax returns as salaries paid in the course of business; he actively sought allowance of the full amount of the payments as reasonable salaries both with the IRS and the tax court.

He only came to consider the payments as gifts when he failed to convince the IRS that they were not excessive compensation. It was then that he filed gift tax returns, upon the specious assumption that since “the government said it wasn’t salary; it was something else. The next closest would be a gift.”

While it does not fully appear on what basis the taxpayers’ salaries were calculated, the father testified that he paid them a certain amount each week, and “a little more” toward the end of each year. But the mere fact that the payments were voluntary does not establish them as gifts.

The filial relationship is, of course, a fertile ground for the blossoming of the donative intent, and where it exists, the burden of proving a gift would seem to be easier. But viewing this record as a whole, it is clear to us that the father only intended to reward his daughters for the services they rendered to him. The evidence shows only a liberal return for valuable consideration, and an absence of circumstances establishing that gifts were made or intended on either side.

Accordingly, we conclude that the prior court was in error in holding that since the payments made to the taxpayers were disallowed to their father as deductions, such payments must have been gifts as a matter of law. We conclude also, that the determination of the district court, that the payments in excess of the deductions permitted to the taxpayers’ father were gifts, to the extent it is a finding of fact, is clearly erroneous.

For the reasons stated, the judgment of the district court will be reversed.

Sorry, wrong answer :(
Right answer!

For the IRS.

The claims for refund are based upon the contention that the payment of $50,000 to the widow of a deceased executive was, as recited in the resolution of the board of directors of the company, “in recognition of past services rendered to it by the executive.”

The taxpayer alleges that the payments made by the corporation to the widow “were made solely by, on behalf of, and for the benefit of the corporation in appreciation of the past services of her deceased husband to the corporation, and in order to encourage the loyalty of other executives. The said payments were not made for the benefit of the taxpayer.”

The evidence presented in the trial of this case failed to bring the payments made by the company within any of the categories mentioned in the language of the sections of the internal revenue code upon which the company relies. It is impossible to envision the $50,000 paid by the company to the widow as a necessary or proper subject of corporate expenditure, or as tending to stimulate employee loyalty or advance the financial interests of the corporation.

Not only did the corporation owe the deceased executive nothing, it was under no obligation whatsoever to extend charity to his surviving widow and children, especially in the face of the decedent’s mandatory testamentary direction that the widow and children should receive no benefit whatsoever from his estate. No reason appears, nor is any motive disclosed, for the application of corporate assets to the alleviation of the necessities of the widow and children of its deceased former officer. No corporate plan, scheme, or arrangement for the benefit of the families of deceased employees was shown.

The company had no established plan for the payment of benefits to the widows of deceased employees, nor was there any evidence that it had ever before adopted a resolution in any way like the one which authorized the payments to the executive’s widow. The company never informed its employees that, on their deaths, payments would be made to their widows. In the case of these particular payments, there was no evidence that the adoption of the resolution and the payments were ever made known to the other company employees.

The taxpayer’s altruism in operating his company has a double aspect; it represents both his general moral character and his application of that character in the conduct and for the purposes of his business. The company’s payment to the deceased executive’s widow however, cannot be said to have been made for any purpose related to the business of the company. It is difficult to see how a payment to a widow, whose deceased husband specifically directed that she was to receive nothing from his estate, could be regarded as any incentive to other employees to work harder for the company. Nor can the payment be regarded as having been made for a business purpose, insofar as it set an ethical example for the company’s employees, since, in this case, there was no set company policy of such payments to widows and the employees were not notified in any way of the resolution and payment to the widow.

The significant fact is that the taxpayer had known both the executive and his wife long before their separation and had regarded them as part of his corporate family. He continued his affectionate regard for both after the separation and he felt personally that the widow had been wronged by her husband’s will. He therefore had the company make the payment to her, to right the wrong her husband had done. Such a payment could in no way be construed as having been made for the purpose of “carrying on any trade or business” or as having been directly connected with the business of the company. The payment, therefore, was not properly deducted by the company as an expense.

For the same reasons, there is no evidence to support the claim of the taxpayer that the total payment to the widow was not a dividend to him. The company’s payment of $50,000 to the widow was made to satisfy the taxpayer’s personal desire to right the wrong he thought had been done to the widow. The payment was made by the company solely for the taxpayer’s benefit and personal gratification in correcting what he felt was an injustice, and it was therefore a constructive dividend to him and should have been included in his income tax return.

Because the taxpayer has failed to carry the burden of proof cast upon him to support his claims for refund, judgment of dismissal of the complaint with prejudice and costs will be entered.

Note: The above is from the appeal to the US District Court of New Jersey. The taxpayer next appealed to the US Court of Appeals, Third Circuit, which upheld the district court’s judgment.

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