How C Corporations Can Pass the Reasonable Compensation Test

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More Lessons from Tax Court:

When a C corporation’s shareholder-employees are given generous salaries and benefits, the corporation should be prepared to fight IRS claims that some of the compensation payments are actually disguised dividends, which were paid according to stock ownership. Specifically, the IRS will argue that the corporation can’t justify compensation amounts that exceed what’s ordinarily paid by similar companies to workers who supply similar services. This is referred to as the reasonable compensation test.

Two Tax Court Decisions

There are many court decisions involving reasonable compensation. Here are a taxpayer victory and a taxpayer loss.

1. Taxpayer Victory

In this case, a C corporation operated a concrete contracting business. It was 51% owned by the founder’s wife and 49% owned by her two sons. The company revenue grew rapidly after the sons took control of daily operations as co-vice presidents.

Together, they managed all aspects of the business. They each supervised over 100 employees and worked 10-12 hours a day, five to six days a week. They were known in local business circles for their responsive, hands-on management style. In addition, the sons personally guaranteed loans that the business took out to purchase materials and supplies.

Because the corporation had an excellent reputation, it was routinely awarded contracts even when it wasn’t the low bidder. During the two tax years in question, the business deducted approximately $4 million and $7.3 million paid to the sons as compensation. After an audit, the IRS denied $811,039 for one year and $768,916 for the other year on the grounds that the amounts exceeded reasonable compensation.

The Tax Court found the sons were integral to the company’s success and that an independent investor would have been satisfied with the company’s return on equity. Therefore, the compensation paid was reasonable and fully deductible. (H.W. Johnson, Inc., TC Memo 2016-95)

2. Taxpayer Loss

In this case, the Tax Court upheld the IRS’s imposition of penalties against an incorporated law firm for federal income tax underpayments resulting from mischaracterization of amounts paid to shareholder-attorneys as deductible compensation. The IRS and the court found the amounts to be disguised dividends.

For the two tax years in question, the firm employed about 150 attorneys, including 65 who were also shareholders. The firm also employed about 270 non-attorney staff members. Consistent with past practice, the firm’s board set annual compensation amounts to be paid to the shareholder-attorneys. Basically, it was calculated and paid so that shareholder-attorneys would receive a percentage of their expected compensation over the course of the year. Bonuses were paid at year end and were intended to reduce the firm’s book income to zero — which also reduced the firm’s taxable income to a relatively insubstantial amount.

The firm treated all amounts paid to the shareholder-attorneys, including bonuses, as deductible employee compensation on its federal income tax returns. After an audit for both years, the IRS disallowed various deductions, including those for the bonuses. After negotiations, the firm entered into a closing agreement with the IRS that resulted in tax underpayments of $1.1 million and $1 million for the two years, and penalty amounts of $222,000 and $203,000. Nevertheless, the case went to Tax Court for final resolution.

The IRS argued that amounts paid to shareholder-employees of a corporation don’t qualify as deductible compensation to the extent the amounts are attributable to services performed by non-shareholder employees or to the use of the corporation’s intangible assets or capital. According to the IRS, amounts attributable to these sources are dividends that can’t be deducted at the corporate level, and such amounts (the bonuses) were treated that way by the IRS. The court agreed and also found that the firm lacked substantial authority to deduct the bonuses. Therefore, the penalties imposed by the IRS were sustained.

The court stated the practice of zeroing out the corporation’s income resulted in failing the independent investor test, especially since the firm had millions of dollars in shareholder equity. Finally, the court rejected the firm’s argument that the independent investor test shouldn’t apply because the shareholder-attorneys were also the equity owners. Case closed in favor of the IRS. (Brinks Gilson & Lione a Professional Corporation, TC Memo 2016-20)

When allegedly excessive amounts of compensation and benefits are provided to an individual, the IRS will treat the excess as dividends. This can result in double taxation. Corporate taxable income is taxed once at the corporate level and again at the shareholder level when that income is paid out as dividends.

The right-hand box summarizes two U.S. Tax Court decisions involving reasonable compensation. But first, we’ll cover some necessary background information.

Avoiding Double Taxation

In general, the easiest, best way to avoid double taxed dividends is to make deductible compensation payments to shareholder-employees and deductible payments for fringe benefits for those individuals. As long as such payments pass the reasonable compensation test, they can be used to reduce the corporation’s annual taxable income to zero — or at least to $100,000 or less, where the corporation’s average federal income tax rate is far below the current 28%, 33%, 35% and 39.6% marginal federal rates that typically apply at the shareholder-employee level.

How Much Can Be Justified as Reasonable?

In the real world, the reasonable compensation test is often not easy to apply to closely held companies. Shareholder-employees are often business founders who made big personal sacrifices over the years, were grossly underpaid in some years, and have been the driving force behind their company’s growth and profitability.

Reasonable Compensation Checklist

The following checklist summarizes some relevant factors to consider when determining how much compensation can be paid to a shareholder-employee while still passing the reasonable test.

“Yes” answers suggest reasonable compensation. “No” answers indicate the opposite. However, that doesn’t mean you can’t have some “No” answers. Each factor’s importance depends on the facts of the particular case. In other words, assessing reasonable compensation is more of an art than a science. That’s why the issue is frequently litigated.

Tax Motivation Factors

1. Would a hypothetical outside investor conclude that return on shareholder equity hasn’t been reduced to unacceptably low levels because of excessive compensation to shareholder-employees? Based on trends in court decisions, this so-called hypothetical outside investor standard now appears to be the single most important factor in assessing compensation reasonableness.

2. Is it clear that compensation levels aren’t determined simply by percentage of stock ownership?

3. Does the company have a history of paying at least some dividends? However, the mere fact that no dividends have been paid doesn’t by itself prove that compensation is unreasonable.

Company-Specific Factors

1. Are sales and profits healthy and growing?

2. Are key financial ratios favorable?

3. Is the company performing above average for the industry?

4. Is the nature of the business unique, difficult or highly specialized?

Employee-Specific Factors

1. Has the shareholder-employee demonstrated commitment by length of service and making measurable contributions in the past?

2. Does the shareholder-employee handle multiple functions (marketing, personnel, financial management, etc.) for one salary?

3. Does the shareholder-employee have extensive experience in the company’s line of business?

4. Does the shareholder-employee possess unique skills or education, or possess a unique “package” of attributes?

5. Is the workload of the shareholder-employee exceptionally high?

6. Are the fringe benefits (retirement plan, medical insurance, and so forth) paid to or on behalf of the shareholder-employee relatively modest?

7. Has the shareholder-employee been underpaid in the past? It’s well-established that large compensation increases can be justified if they’re intended to make up for significant undercompensation in earlier years. In other words, reasonable compensation is measured over a period of years rather than just one year at a time.

Compensation Policy Factors

1. Can the corporation document that it has established compensation policies and that they’ve been followed? In particular, year-end bonuses should be paid pursuant to written plans, and such plans should be followed consistently over the years. Large year-end payments are generally okay if the preceding advice is followed.

2. Was an outside advisor (for example, a CPA or compensation planning professional) engaged to design and oversee the bonus plan?

3. Can the company show that compensation levels for at least some non-shareholder-employees have been set using similar guidelines to those used to determine salaries for shareholder-employees?

Comparability Factors

1. Is there evidence that the compensation paid to the shareholder-employee is comparable to that received by employees rendering similar services to similar businesses? If favorable comparable salary data is available, it’s helpful to include it in your corporate minutes.

2. Is the shareholder-employee’s role with the company unique (meaning it’s unrealistic to compare this person to employees at other similar businesses)?

The Lesson

If you operate a profitable C corporation, passing the reasonable compensation test may be the key to avoiding double taxation. Your tax advisor can help you to document that compensation amounts paid to shareholder-employees pass the test.