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Putting it to the Test:
Deducting Reasonable Compensation
By Melanie G. McCoskey, PhD,
CPA, University of Tennessee at Chattanooga
Now may be a good time to meet with clients or shareholder-employees to
review their compensation plans to ensure that amounts paid as deductible
compensation are not reclassified as nondeductible dividends by the
government. While the recent favorable tax rate on qualified dividends has
reduced the incentive to try to restructure nondeductible dividends as
deductible compensation, that incentive has not been fully eliminated. The
shareholder-employee of a closely held corporation still benefits when the
tax rate applied to corporate earnings is taxed once at the individual tax
rates as compensation to the shareholder, versus being taxed twice when
distributed as a dividend.
Per IRC Section 162(a)(1), the deduction for compensation is limited to “a
reasonable allowance for salaries or other compensation for personal
services actually rendered.” The reasonable compensation issue generally
arises in closely held corporations with amounts in excess of reasonable
compensation generally reclassified as dividends. In The John Harsch
Bronze & Foundry Co., TC Memo1958-125, the Tax Court describes the issue
perfectly:
“Where those whose compensation is at issue for tax purposes own the
controlling stock of the employer-corporation, it is necessary to examine
the facts carefully in order to determine whether dividends are in fact
being distributed under the guise of compensation for services.” Although the regulations list two tests that must be satisfied in order for
a business to deduct compensation expense, most of the authority on this
issue has been developed judicially. In Alpha Medical Inc. v Comm, 83 AFTR
2d 99-1922, the Appeals Court stated, “Inherently, there is a natural
tension between (1) shareholder/employees who feel that they are entitled to
be paid from a corporation’s profit an amount that reflects their skills and
efforts, and (2) a provision in the tax law that conditions the
deductibility of compensation on the concept of reasonableness. What is
reasonable to the entrepreneur/employee often may not be reasonable to the
tax collector. Accordingly, courts are asked to examine the relevant facts
and circumstances of the business and the underlying employment relationship
in order to render an opinion as to whether the compensation paid was
reasonable.”
The Sixth Circuit, which is comprised of Michigan, Kentucky, Ohio and
Tennessee, has been one of the most influential courts in developing the
judicial framework for determining deductible amounts of reasonable
compensation. Furthermore, the Sixth Circuit has been generous to taxpayers
in determining reasonable compensation.
Regulation 1.162-7(a) states that two tests must be satisfied in order for
compensation to be deductible by the corporation: the compensation must be
both intended as compensation and reasonable in amount. Per language in
Mayson Manufacturing Co. v Comm., 38 AFTR 1028, whether these two tests are
met is determined based upon the facts and circumstances of each individual
case.
Amount Test
Most reasonable compensation cases focus on the amount of the compensation
payment to determine if it is reasonable. Generally, all 12 circuits rely on
a multi-factor test to determine the amount of reasonable compensation.
Mayson, heard by the U.S. Court of Appeals for the Sixth Circuit in 1949, is
probably the most-used case in determining whether or not compensation is
reasonable. Of the 12 circuits, seven use the multiple factors identified in
Mayson. The Sixth Circuit Court of Appeals generated a list of nine criteria
in Mayson to be used in evaluating compensation and noted that no single
factor is decisive. See Exhibit 1 for a list of these factors. A
single-factor – independent investor standard test identified by the Seventh
Circuit in Exacto Springs Corp. v Comm, 84 AFTR 2d 99-6977 – has been
largely dismissed. Rather, Courts generally analyze the multi-factor tests
through the lens of an independent investor.
Intent Test
Regulation 1.162-7(b)(1) states that where a corporation has few
shareholders and those shareholders receive salaries “in excess of those
ordinarily paid for similar services and the excessive payments correspond
or bear a close relationship to the stockholdings of the officers or
employees, it would seem likely that the salaries are not paid wholly for
services rendered, but that the excessive payments are a distribution of
earnings upon the stock.” (Emphasis added). Accordingly, any payment can be
characterized as partly for services and partly as a dividend.
With the multi-factor test, courts have some basis on which to determine
reasonableness. Intent, on the other hand, is hard to quantify. Consistent
with this sentiment, courts rarely focus on the intent test, mentioning it
only as an aside. (See, for example, East Tenn. Motor Co. v US, 29 AFTR 2d
72-313.)
The exception is where it is obvious that the intent of the payment was to
pay out earnings. For example, in W.C. Hudlow, Jr. v Comm, TC Memo 1971-218,
the shareholders-employees would sit down at the end of the year, determine
how much profit they had made for that year, and then split those profits in
direct proportion to their stock ownership.
All transactions between the corporation and the employee-shareholder should
be documented so that intent for each payment is clear. For example, if the
shareholder-employee has loans to the corporation, those loans should pay
sufficient interest so that compensation payments will not be reclassified
as interest payments. Also, paying out more than a nominal amount of
dividends to shareholders will provide at least some indication that salary
payments should not be reclassified as disguised dividends.
Summarized Recommendations
If the government questions a client’s compensation deduction, it is
important to provide the courts with convincing evidence regarding the
reasonableness of the salary. There are several steps the taxpayer can take
to ensure that the compensation amount is upheld.
First, the taxpayer should create, document, and follow a compensation
formula. See Boca Construction, Inc. v Comm., TC Memo 1995-005. That
compensation formula should neither pay out all taxable income as
compensation nor pay bonuses only to shareholder-employees, at least not in
proportion to their stock ownership. The compensation policy should be
followed each year, even when it yields low compensation. It should not be
changed in a year when it would otherwise yield low compensation. Even if
the government has previously audited the business and found no faults with
the compensation plan, the compensation can still be questioned on the
reasonableness issue in a later year. See Alpha Medical Inc. v Comm.
When the salary increases dramatically from one year to the next without a
proportionate increase in duties, the increased salary may be denied. As
such, if compensation increases dramatically, document increased duties that
the shareholder-employee performs. However, this is one area in which the
Sixth Circuit is especially taxpayer-friendly, because in Alpha, the Court
allowed an increase in the president’s salary from $400,000 to $4.4 million.
See also Law Offices of Richard Ashare P.C. v Comm, TC Memo 1999-282, where
the Tax Court allowed $1,750,000 salary expense to sole shareholder based on
prior under-compensation, even though sole shareholder had to loan almost $1
million to company and the company had to liquidate assets in order for the
corporation to make the salary payment. Also note that this salary expense
Ashare generated an NOL of almost $2 million that the corporation was
allowed to carry back and use to recover previously paid taxes.
If the shareholder-employee has been paid a lower salary in earlier years,
make sure that previous under-compensation and the amount of current make-up
compensation has been documented. The Supreme Court has addressed payment of
prior under-compensation as the only issue regarding reasonable compensation
in Lucas v Ox Fibre Brush Co., 50 S. Ct. 273.
If a client owns more than one business and works for each of them, the
salary from each business should be adjusted annually in order to reflect
the amount of time the shareholder-employee worked for each. See Geraldine
C. Medina, TC Memo 1983-253.
It may be wise to consider paying some dividends if it seems like the
taxpayer’s compensation may be scrutinized. Almost all cases that examine
taxpayers that have not paid any dividends cite the lack of dividends as an
unfavorable factor to the taxpayer.
The courts can weigh the testimony of witnesses based upon their
credibility. However, courts often do not accept the testimony of experts.
There are, of course, exceptions where the Tax Court accepted the
petitioner’s expert witness calculation. However, when defending a
reasonable compensation case, consideration should be given to the cost of
the expert witness against the likelihood that the testimony will be
accepted.
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Lastly, in almost all of these reasonable compensation cases,
the government
argues that the deductible compensation expense is too high. However, if the
corporation happens to be an S-Corporation where the incentive is to pay
lower wages than average in order to minimize Social Security taxes, the
government can argue that salaries are too low. (See, for example, Joly v
Comr., 85 AFTR 2d 2000-1234.)
About the Author
Melanie McCoskey, PhD, CPA teaches tax classes at the University of
Tennessee at Chattanooga, where she is the Brice Holland Associate Professor
of Taxation. A licensed CPA in Georgia, McCoskey is a member of the American
Accounting Association and a past president of her local chapter of American
Society of Women Accountants. She can be contacted at
Melanie-McCoskey@utc.edu.
Exhibit 1 - Mayson Manufacturing Factors
In 1949, the Appeals Court for the Sixth Circuit listed the following
factors that are relevant in determining reasonable compensation:
- Employee’s qualifications
- Nature, extent, and scope of the employee’s work
- Size and complexity of the business
- Comparison of salaries paid with the gross income and net income
- Prevailing general economic conditions
- Comparison of salaries with distributions to stockholders
- Prevailing rates of compensation for comparable positions in comparable
concerns
- Salary policy of taxpayer as to all employees
- Amount of compensation paid to the employee in prior years (for small
corporations with a limited number of officers)
No single factor is decisive.
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November/December 2011
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