In the recent case Thousand Oaks Residential Care Home I, Inc. v. Commissioner, the Tax Court considered whether a corporation’s compensation packages for its owner-employees were unreasonable and thus disallowable as deductions.  The facts can be summarized as follows: in 1973, Petitioners “Mr. and Mrs. F.” purchased a struggling corporation called Thousand Oaks Residential Care I (“TORCH”).  Mr. and Mrs. F. both provided services to TORCH following the purchase.  However, because the corporation initially struggled financially, neither received compensation for these services between 1973 and 1983.  Additionally, Mr. F. received zero compensation in several of the years that followed, despite being a full-time employee.  All of the other employees were paid for their services at market rate.

Mr. and Mrs. F. sold TORCH in 2002.  Effective on January 1, 2003, TORCH created a defined benefit plan in which Mr. and Mrs. F. and their daughter were the only three participants.  Including the amounts they received from this plan, Mr. and Mrs. F’s total compensation for 2002 – 2005 was as follows:

Mr. F.              $880,939

Mrs. F.             $820,348

TORCH’s board minutes from November, 2003 state that compensation had been approved for “payment of back salaries that were not paid in prior years due to insufficient cash flow”; the minutes from 2004 and 2005 contain similar statements of approval.

It is not unusual for the founder of a closely-held business to forego the receipt of any compensation for services rendered to the business, at least until such time as the business can stand on its own.  At that point, however, can the founder seek to recover the value of these services for the preceding years?  Moreover, will the business be allowed to deduct currently the amount of compensation paid to these individuals in respect of their prior years of service?

As a general matter, 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.  When the compensation was actually for prior years of service, it need not be reasonable in the year it is paid; it does, however, have to be reasonable in light of the services provided.

Despite the fact that Mr. and Mrs. F. were not compensated for several years while they worked to overhaul TORCH, the Court found that the amounts paid to them in 2002 – 2005 were not reasonable.  The reasonableness of compensation, the Court said, is determined on a case-by-case basis, generally using a broad, five-factor test; no one factor is dispositive.  The factors are: (1) the employee’s role in the company; (2) comparison with salaries paid by similar companies; (3) character and condition of the company; (4) potential conflicts of interest; and (5) internal consistency.  The Court also considered an additional factor: (6) whether an independent investor would be willing to compensate the employee as he was so compensated.

1.  The Employee’s Role in the Company

The Court considered Mr. and Mrs. F’s overall significance to TORCH.  As they were “hands-on owner-operators,” and had turned the company around in 18 months from one that was losing money to one that was moderately profitable, the Court found that this factor weighed in Mr. and Mrs. F.’s favor.

2.  Comparison With Salaries Paid by Similar Companies

The Commissioner presented an expert witness to compare Mr. and Mrs. F.’s compensation with nationwide data from 1973 – 2002.  After adjusting for inflation there was a large difference between the actual compensation and the relevant numbers presented by the expert.  Thus, the Court found that this factor weighed against Mr. and Mrs. F.

3.  Character and Condition of the Company

This factor considers the character and condition of the company.  In its analysis, the Court highlighted that a company’s profitability is not the only indication of the character and condition of a company, and emphasized that Mr. and Mrs. F. made the decision to aggressively pay down TORCH’s loans in lieu of paying themselves compensation.  Had Mr. and Mrs. F. chosen to strike a balance between the two, the Court pointed out, they would have received a lower sale price when they sold the company.  However, because Mr. and Mrs. F. did improve the Company’s financial condition significantly, the Court found that this factor “slightly” favored Mr. and Mrs. F.

4.  Potential Conflicts of Interest

This factor focuses on whether there is a relationship between the employee and the company that may facilitate the concealment of nondeductible corporate distributions as compensation payments.  The Court quickly found that such a conflict of interest did exist, and that this factor weighed against Mr. and Mrs. F.

Internal Consistency

Though the compensation for Mr. and Mrs. F. was not consistent with that of other TORCH employees, this was not because Mr. and Mrs. F. received much more but, rather, much less than the other employees.  Therefore, the Court found that this factor weighed in favor of Mr. and Mrs. F.

6.  Additional Factor:  The Independent Investor

This factor considers whether, after compensation is paid, the remaining profits would still represent a reasonable return on an independent shareholder’s equity in the company.  The Court has found in the past that a return on investment of between 10% and 20% is reasonable.  After compensation was paid to Mr. and Mrs. F., there were insufficient assets for even a 10% return on a hypothetical investor’s investment in TORCH.  Thus, the Court found that this factor weighed against Mr. and Mrs. F.

 

Conclusion

 After reviewing the factors discussed above, the Court found that the compensation paid to Mr. and Mrs. F. between 2002 – 2005 was not reasonable.  In applying the holding of this case to an analysis of whether or not a compensation package would be considered reasonable by the IRS, it is worth noting that the Court seemed to weigh heavily the “additional” factor—the independent investor test.  Thus, when a closely-held business is determining compensation packages, in addition to taking into account the first five factors, it should also ensure that enough money will remain in the business following payment that an independent investor would realize a sufficient return on his investment.