The clash between the form in which a corporate taxpayer casts a payment to a shareholder-employee, and the substance of such a payment, has been played out in the courts for as long as there has been a corporate income tax. The stakes involved can be significant. (See, e.g., A Story of Law Firm Compensation, Part II)

Dividend

To the extent the payment is properly treated as a dividend (assuming the corporation has sufficient earnings and profits), the corporation is not permitted to reduce its taxable income by the amount of the payment. Thus, the corporation pays a corporate-level tax on the amount distributed, up to a maximum federal rate of 35%. [IRC Sec. 11]

As for the recipient shareholder, he or she will report the dividend as investment income, taxable up to a maximum federal rate of 20%. [IRC Sec. 1(h)] The dividend may also be subject to the 3.8% federal surtax on net investment income. [IRC Sec. 1411]

Compensation

To the extent the payment is properly treated as compensation, and is reasonable in amount for the services rendered, the corporation will be allowed to deduct the payment in determining its own taxable income. [IRC Sec. 162] Thus, the corporation will “save” corporate income tax up to an amount equal to 35% of the payment.

However, the corporation will also be obligated to withhold employment taxes in respect of the compensation paid. Both the corporate employer’s share of such taxes, and the employee’s share thereof, are determined at the rate of 7.65% each; the corporation may deduct its share (the amount it pays from its own funds) in determining its taxable income.

The employee-shareholder will report the compensation received as ordinary income, taxable up to a maximum federal rate of 39.6%; greater than the corporate rate at which it would have been taxed if it had not been paid as compensation to the employee-shareholder.

It Was A Very Good Year (or Two)

With this background, let’s turn to a recent Tax Court decision that considered the tax treatment of substantial compensation payments made by a corporation to two of its shareholders. [Johnson v. Commr., T.C. Memo. 2016-95]

Corporation was created in 1974 by Dad and Mom. Shortly after, Sons A and B began working for Corporation. A and B gradually assumed increasing responsibilities and took over Corporation’s daily operations in 1993. Mom and Dad gifted shares of stock to A and B and, by 1996, when Dad retired from the business, A and B had each acquired 24.5% of the shares, with Mom retaining the remaining 51%. The brothers became officers and members of the board of directors, along with Mom.

Corporation’s revenues grew rapidly after A and B assumed control of operations, tripling within three years. The revenues climbed steadily every year thereafter, then increased dramatically during the years at issue (the “Years”).

Corporation was profitable and experienced significant revenue and asset growth during the Years, with gross profit margins before payment of officer bonuses of over 38%.

During the Years, A and B personally guaranteed loans whose proceeds Corporation used to purchase materials and supplies.

Sons A and B together managed all operational aspects of petitioner’s business. Operations were split into two geographical divisions, eastern and western, with each brother managing a division’s operations, including contract bidding and negotiation, project scheduling and management, equipment purchase and modification, personnel management, and customer relations. They each supervised over 100 employees in their respective divisions, and worked 10 to 12 hours a day, five to six days a week. They were at the jobsites daily. They were readily available if problems at a jobsite arose and were known in the local industry for their responsive and hands-on management style.

Corporation earned an excellent reputation with its business partners, and was known for its timely performance and quality product. As a result, Corporation was routinely awarded contracts even where it was not the lowest bidder, and the company needed little marketing beyond its reputation in the industry.

During the Years, Corporation’s board held annual meetings to determine officer compensation, director’s fees, and dividends. Corporation compensated A and B for their services as officer-employees; they also received directors fees.

A bonus pool was calculated on a sliding scale in proportion to Corporation’s annual revenue. At year-end, and upon the advice of Corporation’s accountant, the board paid bonuses out of the bonus pool based on officer performance and the company’s ability to pay.

During the Years, Corporation also had a dividend plan that called for dividend distributions when the Corporation’s retained earnings exceeded $2 million. The board determined the amount of the dividend on the basis of Corporation’s financial position, profitability, and capitalization, based upon the advice of its accountant. Historically, Corporation paid modest dividends to its shareholders.

The Tax Dispute

On its corporate income tax returns for the Years, Corporation claimed deductions for the salaries and bonuses paid to A and B.

The IRS asserted that a portion of the amounts reported as officer compensation could not be deducted because it exceeded reasonable compensation.

The Code permits a taxpayer to deduct, as an ordinary and necessary business expense [IRC Sec. 162], compensation payments that are reasonable in amount and that are, in fact, paid purely for services rendered. The taxpayer has the burden of proving that the amounts paid to its employees were reasonable.

Among the factors that are often considered to determine the reasonableness of compensation, are the following: (1) the employee’s role in the company; (2) a comparison of compensation paid by similar companies for similar services; (3) the character and condition of the company; (4) potential conflicts of interest; and (5) the internal consistency of compensation arrangements. In analyzing the fourth factor, the courts often evaluate the reasonableness of compensation payments from the perspective of a hypothetical independent investor, focusing on whether the investor would receive a reasonable return on equity after payment of the compensation.

The Court’s Analysis
The Tax Court considered each of these factors, observing that no one factor is deemed dispositive.

Role in the Company
This factor focuses on the employee’s importance to the success of the business. Pertinent considerations include the employee’s position, duties performed, and hours worked.

After reviewing their activities, as described above, the Court noted that Sons A and B were integral to Corporation’s success during the Years. While some of Corporation’s growth was due to external factors, Corporation’s reputation for quality and timely performance under A’s and B’s management allowed it to secure contracts even when it was not the lowest bidder.

Moreover, A and B personally guaranteed indebtedness that Corporation incurred to purchase materials and supplies, adding to their role in ensuring its successful operations. This factor weighed in Corporation’s favor.

External comparison
This factor compares the employee’s compensation with that paid by similar companies for similar services.

The IRS conceded that Corporation’s performance so exceeded that of any of the companies identified by the parties’ experts as comparable that compensation comparisons were not meaningful. Corporation contended that its performance so exceeded the industry average that the divergence of its compensation from the average was justified. The Court decided that it lacked reliable benchmarks from which to assess Corporation’s claim and, therefore, concluding instead that this factor was neutral.

Character and Condition of the Company
This factor considers the company’s character and condition, focusing on size as measured by sales, net income, or capital value. The complexities of the business and general economic conditions are also relevant.

As reflected in the Court’s findings, Corporation experienced remarkable revenue, profit margins (before officer compensation), and asset growth during the Years. The IRS conceded Corporation’s “substantial success” during the Years. Thus, this factor weighed in Corporation’s favor.

Conflict of interest
The primary focus of this factor is whether a relationship exists between the company and the employee which may permit the company to disguise nondeductible corporate distributions (dividends) as deductible compensation payments.

A potentially exploitable relationship may exist where the employee is the company’s sole or controlling shareholder, or where a special family relationship indicates that the terms of a compensation arrangement may not be arm’s-length.

According to the Court, because Mom was Corporation’s majority shareholder during the Years at issue and, together with her Sons, owned all of Corporation’s stock, this factor warranted scrutiny.

The Court noted that Corporation paid minor dividends for the Years, notwithstanding gross profit margins (before officer compensation) for each year exceeded 38%.

The Court evaluated the compensation payments from the perspective of a hypothetical independent investor, focusing on the investor’s return on equity. If the company’s earnings on equity after payment of compensation remain at a level that would satisfy an independent investor, there is a strong indication that the employee is providing compensable services and that profits are not being siphoned out of the company disguised as salary.

The parties agreed that Corporation had average pretax returns on equity of 9.6% for the Years. They differed, however, on what an expected return on equity should have been for Corporation. The Court found that Corporation’s return on equity figures were derived from financial information of privately-held companies that were more comparable to Corporation for purposes of a return on equity analysis than those used by the IRS. Thus, they provided the best index of a reasonable return on equity.

The IRS claimed that an independent investor would have demanded a return more commensurate with Corporation’s superior performance. Corporation contended that its return on equity was in line with the industry average and therefore would have satisfied an independent investor.

The Court agreed with Corporation, noting that the IRS had cited no authority for the proposition that the required return on equity for purposes of the independent investor test must significantly exceed the industry average when the subject company has been especially successful. Rather, it is compensation that results in returns on equity of zero or less than zero, the Court noted in passing, that has been found to be unreasonable.

Consequently, the court found that Corporation’s returns on equity for the Years tended to show that the compensation paid to A and B was reasonable. Thus, this factor weighed in Corporation’s favor.

Internal consistency of compensation
This factor focuses on whether the compensation was paid pursuant to a structured, formal, and consistently applied program; bonuses not awarded under such plans are suspect.

Corporation consistently adhered to the officer bonus formula for many years, and the IRS conceded as much. The Court concluded that this factor weighed in Corporation’s favor.

Conclusion
As a whole, the factors supported the conclusion that the compensation Corporation paid to A and B in the Years was reasonable. The brothers were integral to Corporation’s successful performance, and its remarkable growth in revenues, assets, and gross profit margins during those years. The return on equity generated for the Years after payment of officer’s compensation was in line with the return generated by comparable companies; accordingly, an independent investor would have been satisfied with the return.

For these reasons, the Court held that the amounts paid by Corporation as officer compensation were reasonable and, therefore, deductible in determining its taxable income.

Takeaway
The taxpayer in the decision discussed above did many things right; for example, it consistently applied a formula in setting officer bonuses, and it followed a process for determining dividend payments.

Although it ultimately succeeded – on the strength of its economic performance – in defending the amount of compensation paid to its officers, query whether it could have avoided a drawn-out audit and a Tax Court proceeding if it had been aware of the factors generally employed by the courts in determining the reasonableness of compensation. It could then have tied the form of its payments to their substance.

If it had considered those factors in advance, it could have, presumably, contemporaneously gathered the necessary data and memorialized its compensation and dividend decisions, and presented them to the IRS during the examination of its tax returns.

Unfortunately, it has been my experience that most taxpayers are averse to spending a little more today in order to avoid spending what is likely to be much more later. Nonetheless, it remains the role of the tax adviser to encourage clients to do their homework before they act, and to document their actions. You can lead a horse to water, . . .