With this post, we continue to examine transactions between the closely-held business and its owners. As we saw last week, special scrutiny is given in situations where a business is controlled by the individual with whom it engages in a transaction because there is a lack of arm’s-length bargaining. That is certainly the case where a close corporation pays compensation to its controlling shareholder-employee for which it claims a deduction.
The Code allows as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business, including salaries or other compensation, if the payments were reasonable in amount and are, in fact, payments for services. Whether the compensation paid to a shareholder-employee was reasonable is a question of fact. In determining the reasonableness of compensation, courts have considered various factors, including:
– The employee’s qualifications;
-The nature and extent of the employee’s work;
-The size and complexity of the business;
-The employee’s compensation as a percentage of gross and net income;
-The employee-shareholder’s compensation compared with distributions to shareholders;
-The employee-shareholder’s compensation compared to that paid to non‑shareholder-employees; and
-The prevailing rate of compensation for comparable positions in comparable businesses.
All In The Family
In K&K Veterinary Supply Inc. v. Comr., the corporation’s sole shareholder was also its president, co‑CEO and co‑COO; his wife was vice‑president, secretary and assistant CFO; his brother was senior vice‑president, co‑CEO and co‑COO; and his daughter was CFO.
During each of the years at issue, the corporation paid a dividend to the sole shareholder. It also paid compensation to each of its officers. In addition, the corporation entered into a lease for real property owned by an LLC whose only members were the sole shareholder and his wife.
The IRS disallowed a portion of the deductions claimed for the compensation paid to the employee-shareholder and the related officers. It also disallowed a portion of the deduction claimed for the rent paid to the related LLC.
After considering the various factors described above, including the expert testimony of compensation consulting firms as to the prevailing rates of compensation paid to those in similar positions in comparable companies within the same industry, the Tax Court made a significant downward adjustment to the corporation’s compensation deduction, noting, among other things, that the aggregate amount of compensation paid and deducted by the corporation as to the officers was more than 100% of the corporation’s net income before taxes. As to one officer, the Court commented that her hours were “incongruous with her position titles in companies in which family relationships do not exist.”
The Court then considered the rent deduction, stating that in connection with a lease between related parties, the inquiry “requires a careful examination of the circumstances surrounding the rental of the property to determine the intentions of the parties in agreeing upon…the lease and in fixing the terms thereof.” Relying upon the report of the IRS’s expert, the Court disallowed a portion of the rental deduction.
The taxpayer then claimed that the disallowed portions of the compensation and rent should be treated as dividends paid by the corporation to is shareholder and, so, taxable at a lower rate than the ordinary income rate applicable to compensation and rent.
Again the Court disagreed with the taxpayer, finding that there was “no identity of interest” between the corporation and its sole shareholder and his family members. The corporation and the shareholder are separate entities, it said, and there is no necessary correlation between the corporation’s right to a deduction for a payment and the taxability of the payment to the shareholder-employee. According to the Court, the separate treatment of a payment’s deductibility and recognition as income obtains even where the payor and payee are a corporation and its sole shareholder.
Many a business owner will treat his or her business as their alter ego. While this may seem reasonable on some visceral level, it is not advisable from a tax perspective (not to mention the perspective of one who is seeking to defend against a “piercing” argument by a creditor). Rather, the owner’s guiding principles in evaluating any transaction with the business should be the following: would an unrelated third party have entered the transaction on comparable terms, and is the taxpayer’s behavior consistent with what one would expect from a third-party? To the extent these questions are answered in the negative, can the taxpayer distinguish or otherwise account for the difference on reasonable business-related grounds? If not, then the taxpayer has to be prepared to have the transactions re-characterized by the IRS and to accept the tax consequences, including penalties, that may follow.
[The next blog post will conclude this series on transactions between a business and its owners. Rest assured, there are bound to be many more judicial decisions involving such transactions that will be covered on this blog.]