Tax Law for the Closely Held Business blog authors Lou Vlahos and Bernadette Kasnicki presented yesterday, January 17, on how the Tax Cuts and Jobs Act affects not-for-profit organizations. Their presentation–given at the 41st Annual New York State Society Certified Public Accountants (NYSSCPA) Not-for-Profit Conference in New York City–was summarized in article format for The Trusted Professional, the NYSSCPA’s newspaper.

Below is an excerpt from the article:

The Tax Cuts and Jobs Act has a number of provisions that both directly and indirectly affect not-for-profit organizations, but tax attorneys Bernadette Kasnicki and Louis Vlahos—speaking at the Foundation for Accounting Education’s 41st Annual Nonprofit Conference today—said that the targeted provisions seem to focus on narrowing the gap between rules that govern non-profit and for-profit organizations.

For example, Kasnicki, an associate with the firm Farrell Fritz P.C., said that the TCJA imposes a 21 percent excise tax on nonprofits that pay compensation of $1 million or more to any of their five highest-paid employees, which applies to all forms of remuneration of a covered employee. She noted that, in the for-profit world, compensation of top executives cannot be deducted beyond the point of $1 million. She said that, by subjecting nonprofits to a similar rule, the TCJA is attempting to bring exempt organizations into parity with taxable ones.

Vlahos, a partner at the same firm, said that it’s actually a little worse for nonprofits under the new rules. For-profit organizations have two carveouts for the deduction limit: one is if the pay is reasonable for services rendered previously, and the other is for parachute payments that represent payment for services going forward “because we’re not firing you but keeping you.” Not-for-profits, on the other hand, have no such carveouts.

Please click here to read the full article.

 In case you missed it, you may also be interested in reading Lou Vlahos’s latest post on the blog: It’s a Business . . . No, It’s a Charity . . . Wait – It’s a Charity That Is Treated Like a Business?

 

In today’s cautionary tale, we hear about a doctor, his self-directed simplified employee pension (“SEP”) individual retirement account (“IRA”), the investment of IRA funds in a business, and the consequences of crossing over the perilous line between “direction” and “control.”

The Facts

Dr. V., an anesthesiologist, ran a medical practice with three partners (the “Practice”). Prior to the time of this case, the Practice had adopted a self-directed SEP plan arrangement with Investment Firm, through which the Practice made deductible contributions to the Plan, and the contributions were then placed in self-directed IRAs set up for each partner through the SEP plan arrangement.  Investment Firm was the custodian of Dr. V.’s SEP-IRA. shutterstock_104120462

Historically, Dr. V. had instructed Investment Firm to invest the contents of his SEP-IRA in mutual funds and stocks. In 2011, however, upon hearing of an investment opportunity from a friend, Dr. V. decided to try a more adventurous vehicle for the contents of his SEP-IRA.

Dr. V.’s friend, Mr. C., was involved in a publicly-traded company, PubCo. PubCo was looking to raise capital in the short-term, as it expected to receive funding from a large company in the near future.  Trusting his friend’s business sense and descriptions of X’s potential, Dr. V. agreed to loan X $125,000 from his SEP-IRA, and a contract memorializing the same was prepared (the “Agreement”).

The Agreement

The Agreement, titled “Corporate Loan Agreement/Promissory Note,” was between “PubCo or Mr. C.” as the borrower, and “Dr. V., SEP-IRA” as the lender. It specified that it was for $125,000, but not how that sum would be advanced.  It did, however, provide specific details about the maturity date, interest payments, and late fees.  Significantly, as it turned out, the Agreement provided that the borrower would repay the loan to “Dr. V.” at his personal residence, and Dr. V. and Mr. C. each signed the Agreement in their respective personal capacities.  Dr. C. later testified that the Agreement was worded as such because he wanted Dr. V. to know that the funds were specifically for PubCo expenses, but that he, Mr. C., would be responsible for repayment.

Transfer of Funds

Dr. V. then signed a form titled “Retirement Distribution or Internal Transfer” requesting that Investment Firm distribute $125,000 from his SEP-IRA to his joint account with his wife at Investment Firm; wired that amount from the joint account to his personal account at Bank; and then wired the same amount from Bank to an account titled “Mr. C.” at a different bank.

Reporting the Distribution

Using the same accounting firm, M&M, that they had for over twenty years, Dr. V. and his wife (together, the “Taxpayers”) filed a joint Form 1040 for 2011. Dr. V. explained to the return preparer what had happened with the distribution from his SEP-IRA, and documentation reporting the sequence of events leading up to the loan.  On the advice of the M&M accountant, Dr. V. and his wife reported that they had received $125,000 in pensions and annuities, but characterized it as a nontaxable rollover.  They included with their return a copy of the Agreement, as well as a letter from M&M stating that the return preparer believed that the funds were directly rolled over from the SEP-IRA to either PubCo’s account or Mr. C.’s account.

Notice of Deficiency

Following examination of the return, the Commissioner issued a notice of deficiency determining a $52,682 deficiency in income tax, and determining an additional tax under section 72(t) of the Code and an accuracy-related penalty for a substantial understatement of income tax. The Taxpayers petitioned for a redetermination of the deficiency.

The Arguments

The Taxpayers argued that they did not receive a distribution from the SEP-IRA because the various transfers should be stepped together and treated as an investment by the SEP-IRA in PubCo. Alternatively, they contended that the withdrawal was a non-taxable rollover.

The Commissioner argued that the loan was a taxable distribution used to finance a loan from Dr. V. to Mr. C.

The Tax Court Weighs In

Under section 408(d)(1), any amount paid or distributed out of an IRA must be included in the gross income of the payee or distribute as provided in section 72. The Taxpayers argued that Dr. V. did not have a claim of right to the $125,000 withdrawn from the SEP-IRA because he was acting as a mere conduit in transmitting the funds to Mr. C.

Claim of Right

The Court stated that a taxpayer has a claim of right to income if the taxpayer:

  1. Receives the income;
  2. Controls the use and disposition of the income; and
  3. Asserts either a “claim or right” or entitlement to that income.

The Court found that Dr. V. met these requirements, as he had “unfettered control over the funds” at all times.

The Court rejected the Taxpayers’ reliance on two previous cases in which the Court had found taxpayers to be a “custodians” of funds coming out of their self-directed IRAs for various investments. In both of those cases, the taxpayers at issue were never the payees of the funds to be invested.  Rather, they merely assisted in having the funds transferred.  In the case at issue, the Court pointed out, at no time was the note held by Dr. V.’s IRA, and at all times it was payable to Dr. V. personally.

Rollover

Section 408(d)(3) of the Code provides an exception to the general rule that any amount paid or distributed out of an IRA must be included in gross income. It provides that the taxpayer does not have to include such an amount if the entire amount that he or she receives is paid into an IRA or other eligible retirement plan within 60 days of the distribution.

The Taxpayers argued that if the amount at issue was a distribution, it was reinvested in the SEP-IRA within the prescribed 60-day period. In this argument, the Taxpayer essentially asked the Court to disregard the various agreements executed in connection with the transaction, and to find that the distribution was made directly to Mr. C.

The Court also rejected this argument, applying a “strong proof” for the case when taxpayers attempt to disregard the form of their own transactions. The Court found that the substance of what had occurred was entirely consistent with the form.

Conclusion

Self-directed IRAs provide taxpayers with a great deal of freedom in choosing how their retirement funds are invested. Thus a taxpayer may, subject to certain limitations, direct that the IRA funds be invested in a business venture.  It is critical, however, that a taxpayer know where his or her personal involvement must cease.  As Dr. V. learned the hard way, sometimes (and, in the case of handling IRA funds, all the time), it is not enough for one’s transactions to have a permissible objective; that objective must also be reached through a permissible route, with no extra “assistance” to affect its path.

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. doc

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

 piggy bankDr. 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.

For the owner of a closely-held business, and especially one with a limited support staff, it can be easy to drift into carelessness or, worse, neglect, when it comes to maintaining detailed records of the business’s expenses.  However, as one taxpayer recently learned the hard way, such inattention to detail can come back to haunt you when it comes time to file your tax returns.

In Nguyen v. Commissioner, tax deficiencies were assessed upon the taxpayer, an owner of a hardwood floor installation business (the “Taxpayer”), for the years 2009 and 2010.  The IRS also determined accuracy-related penalties for the same period.  The crux of the case turned on the Taxpayer’s lack of substantiation for the amounts claimed for cost of goods sold as well as for supplies.

 Taxpayer’s Practice    

In conducting his business, Taxpayer generally purchased the flooring necessary for each job as he was hired, rather than maintaining an inventory of flooring materials.  At times, Taxpayer also installed flooring already purchased by his customers.  In addition to purchasing flooring materials, Taxpayer purchased supplies in connection with the business, including wood, paper, glue, and nails.  He made these purchases using his debit card, checks, and cash.

Taxpayer’s practice for both 2009 and 2010 was to keep business bank statements in the drawer of his desk, and receipts for business expenses in a bag in his basement.  However, due to a flood in Taxpayer’s home in 2009, some of the receipts for that year were destroyed.  (At least the dog didn’t chew his homework.)

The 2009 and 2010 Returns

Taxpayer’s returns for 2009 and 2010 were prepared by two different tax professionals.  The preparer for the 2009 return reviewed Taxpayer’s bank statements and the receipts that remained after the flood over the course of an hour-long meeting.  The IRS determined that about 40% of the cost of goods sold claimed on Taxpayer’s Schedule C had been substantiated, and asked for an explanation of the discrepancy.  A review of additional documents provided by the Taxpayer only substantiated a small portion for cost of goods sold.

Taxpayer’s 2010 return was prepared by a different tax professional, who was given the 2009 return as a guide but no other documentation.  On the 2010 return, $39,894 was claimed as a deduction for supplies, which the IRS determined had been about 60% substantiated.  A review of additional documents provided by the Taxpayer substantiated an additional $178.26.

Court’s Analysis

In its analysis, the Court highlighted the fact that “[d]eductions are a matter of legislative grace, and taxpayers bear the burden of establishing entitlement to any claimed deduction.”  In this instance, in addition to the limited documentation provided by the Taxpayer to substantiate the claimed deductions for cost of goods sold and supplies, Taxpayer failed to provide any testimony regarding specific expenditures related to flooring jobs for which deductions should be allowed but were denied, or for supply expenses in excess of the amount determined as allowable, in either 2009 or 2010.  As a result of his inability to back up the amounts on his returns, Taxpayer was not entitled to any more deductions, for either cost of goods sold or supplies, than the IRS had already determined as allowable.

The Court also found in favor of the IRS in upholding the accuracy-related penalty of 20% under Code § 6662, which penalty applies, among other things, to the portion of an underpayment attributable to negligence.  For purposes of this rule, negligence includes any failure to keep adequate books and records or to substantiate items properly.  The burden is on the IRS to produce evidence of such negligence, and was met in this case with the showing that the Taxpayer lacked adequate records to substantiate fully the amounts claimed.

Although there is a good faith exception to the § 6662 penalty under Code § 6664 if the Taxpayer can establish that there was reasonable cause for the underpayment and that the Taxpayer acted in good faith, the Taxpayer provided no evidence that he fell within this exception.  Therefore, the accuracy-related penalty was upheld.

 Conclusion

For all businesses, but especially for a business that routinely purchases goods and supplies, it is critical to keep meticulous records of purchases throughout the year.  While many of these purchases may seem insignificant at the time—in the instance of the Taxpayer here, for example, purchases of  glue and nails—in the aggregate, if documented correctly, they are likely to result in a significant tax benefit and thus be well worth the headache of cataloging them along the way.

Small, closely-held businesses must especially be diligent if they are to reduce their tax liability and avoid penalties.  The tax savings will warrant the cost of recordkeeping.

In several previous posts, we have emphasized the importance of educating oneself about the tax consequences of any given business transaction well before that transaction comes to life.  In many situations, such forethought gives a taxpayer the opportunity to weigh the costs and benefits of different courses of action and, as a result, to act thoughtfully in the events leading up to the transaction.  This will minimize any surprises resulting from a close look at the transaction by the IRS, and thus ensure that the taxpayer receives the economic result that he or she is expecting.

The Tax Court recently considered a case in which taxpayers apparently did not act pursuant to a carefully considered plan, and, as a result, were assessed a significant deficiency as well as an accuracy-related penalty.

 Boree v. Commissioner

 The Facts

In Boree v. Commissioner, husband and wife taxpayers (the “Taxpayers” or “Mr. and Mrs. B.”) and their partner, through an LLC, purchased almost two thousand acres of undeveloped land in Florida for approximately $3.2 million.  Between 2002 and 2006, the LLC sold several lots each year, representing over one-third of the property in the aggregate; most of the lots sold during that time comprised approximately ten acres, and were sold for between $3,000 and $6,000 each. 

In 2003 the LLC began building an unpaved road, and submitted to the county’s local board of commissioners (the “Board”) a conceptual map of a planned residential development consisting of one hundred lots.  It also applied for, and received, exemptions from certain county subdivision requirements that called for interior roads and the submission of plans to the Board prior to the sale of lots, and executed a declaration of covenants, conditions, and restrictions on the land that defined the LLC as the “developer.”

In 2004, the Board adopted one-year moratoriums relating to permits for the development of certain subdivisions and lots.

In 2005, the Taxpayers became the sole owners of the property when the LLC purchased their partner’s interest.  Also during that year, the LLC proposed to the Board that almost 1,000 acres of the property be rezoned as a planned development unit (“PUD”), and Mr. B. and his representative attended several Board meetings relating to that application.

In 2006, following the Board’s adoption of a requirement that developers pave certain public roads leading to subdivisions, the LLC entered into a purchase and sale agreement with Development Co., pursuant to which Development Co. obtained an option to purchase most of the remaining property.

In 2007, the LLC sold just over one thousand acres to Development Co. for $9.6 million.

 The Tax Returns    

On their Forms 1040, U.S. Individual Tax Return, relating to 2005, 2006, and 2007, the Taxpayers indicated on their Schedule C, Profit or Loss from Business, that Mr. B.’s principal business or profession was “Land Investor.”  For 2005 and 2006, the Taxpayers reported income from the LLC’s lot sales as ordinary income and deducted expenses relating to the property.

On their 2007 Form 1040, however, the Taxpayers listed Mr. B.’s occupation as “Real Estate Professional” and reported long-term capital gain relating to the transaction with Development Co.  Between 2005 and 2007, the LLC did not engage in any significant activity that was unrelated to the property.

 The IRS Disagrees

 In 2011, the Service sent Taxpayers a notice of deficiency relating to 2007, indicating that the gain relating to the transaction with Development Co. did not qualify for capital gains treatment.  In addition to finding a deficiency of $1,784,242, the Service determined that the Taxpayers were also liable for a section 6662(a) accuracy-related penalty.

The Tax Court Weighs In

 The Court stated that to determine whether or not an asset is “capital,” it considers, among other factors, “the number, extent, continuity and substantiality of sales… and the extent of subdividing, developing, and advertising.”  While no specific factor is controlling, the Court highlighted that the “frequency and substantiality of sales” is often the most important factor because “the presence of frequent sales ordinarily belies the contention that property is being held ‘for investment’ rather than ‘for sale.’”

The Court emphasized that the Taxpayers consistently treated the LLC as a real estate business, representing it as such to buyers of the property, the Board, and on their 2005, 2006, and 2007 returns, and spending significant time and money on zoning activities.  Additionally, the Court underscored the frequent and substantial sales of property between 2002 and 2006, and the fact that the Taxpayers deducted, rather than capitalized, expenses related to the real estate activities.  Each of these factors contributed to the Court’s conclusion that the transaction with Development Co. resulted in ordinary income to the Taxpayers.

Finally, the Court held that because the Taxpayers had understated their tax liability in 2007 by over $1,780,000—over 10% of the tax required to be shown on their return for that year—they were subject to the accuracy-related penalty under section 6662(a).

 Conclusion

 As Boree demonstrates, a taxpayer that wishes to be taxed on a sale of real property as an investor, thereby receiving capital gains treatment on the sale, must be careful to, in fact, hold that property as an investor.  If Mr. B. had determined at the outset that it was a priority for him to avoid recognizing ordinary income on an eventual sale of his property, then he could have structured his actions accordingly to ensure that he was holding the property only as an investor.  Bear in mind, however, that it is quite possible that it was Mr. B.’s regular participation in and dedication to his investment that made the transaction with Development Co. as profitable as it was; a taxpayer in the same situation should carefully consider and compute the economic benefits of such participation against that of capital gains treatment in determining how best to hold his or her investment.

We have previously looked at the recognition period for built-in gains of S corporations, and the effect of the expiration of the temporary reduction of this period, under the American Taxpayer Relief Act of 2012, to five years.  Earlier this week, however, the House Ways and Means Committee approved six “tax extender” bills to extend certain tax provisions that expired at the end of 2013.  Among these bills was H.R. 4453, which would make the five-year recognition period permanent.  As we have discussed, electing S corporation status is still a smart option for C corporations in several scenarios to consider, and, if this bill is ultimately passed, it will make such an election even more attractive.  Stay tuned for updates as this bill and the companion Senate bill, S. 1855, wind their way through the legislative process.

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.