Own your own business, decide your own salary… right?
Wrong.
The Tax Court recently upheld corporate tax deficiencies and accuracy-related penalties assessed by the IRS after it disallowed as a business expense deduction half of $2 million in bonuses paid by an eye care center (the “Center”) to its sole shareholder. The sole shareholder, who also worked as a surgeon at the Center, served as the Center’s Medical Director, CEO, CFO, and COO (“Dr. A.”). For the two years at issue (“Year 1” and “Year 2”), Dr. A. received in compensation salaries of $780,000 and $690,000, respectively, and bonuses of $2 million and $1.1 million, respectively. 
The Center operated four different locations, and employed around fifty people during the years at issue, including surgeons, optometrists, and support staff. Dr. A. was responsible for about one-third of the Center’s billings in Year 1, and his surgical responsibilities during those years increased with the sudden departure of one fellow surgeon and the gradual departure of another to begin her own practice.
The IRS and the Center’s Tax Returns
On its return for Year 1, the Center claimed a compensation deduction for salary and bonus paid to Dr. A. for more than $2.7 million, but claimed a net operating loss. For Year 2, using a net operating loss carryforward, the Center did not report any taxable income. Additionally, despite the sizeable salary and bonus paid to Dr. A. that year, the Center reported gross operating receipts in excess of $6 million.
The IRS disallowed $1 million of the claimed bonus compensation deduction for Year 1, determining that this was a disguised dividend rather than bonus compensation. As a result of this disallowance, the IRS also disallowed certain deductions for claimed taxes and license expenses, as well as the net operating loss carryforward that was ultimately used in Year 2. The IRS also determined that the Center was liable for an accuracy-related penalty under Code section 6662.
Standard for Deducting Compensation Expenses
Generally, there is a presumption, rebuttable by the taxpayer, that determinations in a notice of deficiency are correct. Additionally, with respect to deductions, it is the taxpayer’s responsibility to maintain sufficient records to substantiate each claimed deduction so that the IRS can determine the correct tax liability.
Section 162(a)(1) of the Code allows taxpayers to deduct “ordinary and necessary expenses,” including a “reasonable allowance for salaries or other compensation for personal services actually rendered.” Therefore, compensation is deductible if it is (1) reasonable in amount, and (2) paid for services actually rendered.
The regulations under section 162 state that in order for compensation for personal services to be deductible, it “may not exceed what is reasonable under all the circumstances.” Thus, the Center was required to establish that the bonuses paid to Dr. A. were reasonable.
Reasonable compensation is generally “only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.” The Tax Court also cited the Court of Appeals for the Seventh Circuit, which has held that “other factors besides the percentage of return on equity have to be considered, in particular comparable salaries.” The Court highlighted, however, that evidence of comparable salaries is helpful only to the extent that such evidence accounts for the details of the compensation package for the compared executives, and not just the final number.
The Center’s Argument
Such detail turned out to be irrelevant, as the Center produced no evidence of comparable salaries, instead arguing that its enterprise was so unique that there were no “like enterprises” under “like circumstances” from which it might draw comparisons. The Center emphasized Dr. A.’s increased workload after the departure of his colleagues, as well as the various capacities in which Dr. A. served the Center. The Center did not, however, explain how it arrived at the specific amounts paid to Dr. A. as bonuses.
The Tax Court’s Holding
Because the Center did not “provide any methodology to show how [Dr. A.’s] bonus was determined in relation to his [managerial and medical] responsibilities,” the Court held that the Center had not shown that the compensation paid to Dr. A. was reasonable. As a result, it upheld the IRS’s deficiency determinations.
Furthermore, as a result of this holding, the Court also upheld the 20% accuracy-related penalty for Year 1, which was imposed as a result of the Center’s “substantial understatement” of income in that year. (That penalty can be challenged if a taxpayer can show that it had reasonable cause for, and acted in good faith regarding, the underpayment; however, the Center provided no such explanation.)
The Lesson: Your Corporation is Not Your Personal Piggy Bank
Dr. A. undoubtedly felt entitled to whatever salary he had decided to pay himself. After all, as the 100% owner of the Center, he was the person who would ultimately reap the benefits of the Center’s profits and losses. Moreover, the Center was not what one might call a capital-intensive business—it involved the provision of personal services, though not exclusively those of the sole shareholder. This case, however, highlights the inexactitude of this mindset. While Dr. A. was entitled, speaking broadly, to receive excess profits from the Center, he was not entitled to manipulate his receipt of those profits to result in the most tax economically tax advantageous position possible, Tax Code notwithstanding.