reasonable compensation

The Business-Charity Connection

As our readers know, this blog is dedicated to addressing the tax-related business and succession planning issues that are most often encountered by the owners of a closely held business. Occasionally, however, we have crossed over into the space occupied by tax-exempt charitable organizations inasmuch as such an exempt organization (“EO”) may be the object of a business owner’s philanthropy, either during the owner’s life or at their demise.


For example, we have considered grant-making private foundations (“PF”) that have been funded by the business owner and, thus, are not reliant upon the general public for their financial survival. In particular, we have reviewed a number of the penalty (“excise”) taxes applicable to PFs. These are rooted in the government’s tacit recognition that the activities of such a PF cannot be influenced by the withholding of public support from the foundation. Rather, the threatened imposition of these taxes is intended to encourage certain “good” behavior and to discourage certain “bad” behavior by a PF.[i]

Although PFs are important players in the charitable world, a business owner is far more likely to support charitable activities by making direct financial contributions to publicly-supported charities that operate within their community, rather than to create a PF through which to engage in such charitable giving.[ii]

Board Service

Where the business owner has a personal connection to an EO’s charitable mission, the owner may seek to become a member of the organization’s board of directors. In other cases, the EO itself may solicit the owner’s involvement, in part to help secure their financial support, not to mention the access they can provide to other potential donors from the business world.

Another reason that business owners may be attractive candidates for an EO’s board of directors is that they are experienced in . . . running a business.[iii] This skillset may be especially important in light of recent changes to the Code that reflect Congress’s heightened skepticism toward EOs, and that are aimed at limiting the amount of executive compensation payable by EOs.

Increased Public Scrutiny

Congress’s reaction to EO executive compensation is, in part, attributable to the public’s own changing perspective. As the charitably-inclined segment of the “public” has become more sophisticated, and better informed, it has demanded more accountability as to how its charitable contributions are being utilized, including what percentage of the contributions made to a charity is being used for executive compensation.[iv]

These “economic” concerns are magnified when viewed in light of the reality that the vast majority of charitable organizations are governed by self-perpetuating boards of directors,[v] which in turn hire the executive employees who operate these organizations on a day-to-day basis.

In response to these concerns, Congress has slowly been adding provisions to the Code that are intended (as in the case of the excise taxes applicable to PFs) to dissuade public charities and their boards from engaging in certain behavior.

Until the passage of the Tax Cuts and Jobs Act of 2017,[vi] the most notable of these provisions was that dealing with “excess benefit transactions.”[vii]

Blurring the Lines

As a result of these economic pressures, not to mention the attendant governmental scrutiny, most public charities have sought to fulfill their charitable missions on a more efficient basis. In other words, they have tried to become more “business-like” in performing their charitable functions. In furtherance of this goal, many EOs have tried to attract and retain the services of talented and experienced executives, while also inviting successful business owners onto their boards.

Notwithstanding these efforts, many EOs continue to be in the Congressional crosshairs. In particular, some larger EOs have been accused, in some circles, of taking advantage of their tax-preferred status to generate what critics have characterized as large profits, a not-insignificant portion of which find their way, or so these critics assert, into the hands of the organizations’ key executives in the form of generous compensation packages.

The Act represents the latest Congressional effort to rein in what its proponents perceived as abuses in the compensation of EOs’ top executives.

In order to stem these “abuses,” the Act draws liberally from the tax rules applicable to executive compensation paid or incurred by business organizations. Before delving into these provisions, it would be helpful to briefly review the “for-profit” rules from which they were derived.

For-Profit Compensation Limits

In determining its taxable income from the conduct of a trade or business, an employer may claim a deduction for reasonable compensation paid or incurred for services actually rendered to the trade or business.[viii] Whether compensation is reasonable depends upon all of the facts and circumstances. In general, compensation is reasonable if the amount thereof is equal to what would ordinarily be paid for “like services by like enterprises under like circumstances.”[ix]

However, Congress has determined – without stating that it is per se unreasonable – that compensation in excess of specified levels may not be deductible in certain situations.

Public Corporations

Prior to the Act, and in order to protect shareholders from grasping executives, a publicly-held corporation generally could not deduct more than $1 million of compensation in a taxable year for each “covered employee,”[x] unless the corporation could establish that the compensation was performance-based.[xi]

Golden Parachutes

In addition, a corporation generally cannot deduct that portion of the aggregate present value of a “parachute payment” – generally a payment of compensation that is contingent on a change in corporate ownership or control[xii] – which equals or exceeds three times the “base amount” of certain shareholders, officers and highly compensated individuals.[xiii] The nondeductible excess is an “excess parachute payment.”[xiv]

The purpose of the provision is to prevent executives of widely-held corporations from furthering their own interests, presumably at the expense of the shareholders, in the sale of the business.[xv]

Quite reasonably, certain payments are excluded from “parachute payment status” – in particular, the amount established as reasonable compensation for services to be rendered after the change in ownership or control is excluded.[xvi]

In addition, the amount treated as an excess parachute payment is reduced by the amount established as reasonable compensation for services actually rendered prior to the change in ownership or control.[xvii]

Finally, the individual who receives an excess parachute payment is subject to an excise tax of 20% of the amount of such payment.[xviii]

EO Compensation Limits

Prior to the Act, the foregoing deduction limits generally did not affect an EO.

That being said, there were other provisions in the Code that addressed the payment of unreasonable compensation by an EO to certain individuals.


PFs are prohibited from engaging in an act of “self-dealing,” which includes the payment of compensation by a PF to a disqualified person.[xix]

However, the payment of compensation to a disqualified person by a PF for the performance of personal services which are reasonable and necessary to carry out the PF’s exempt purpose will not constitute self-dealing if the compensation is not excessive.[xx]

In other words, the EO-PF may pay reasonable compensation to a disqualified person.[xxi]

Where it has paid excess compensation, the EO is expected to recover the excess from the disqualified person.[xxii]

Excess Benefit Transaction

A public charity is prohibited from engaging in an “excess benefit transaction,” meaning any transaction in which an economic benefit[xxiii] is provided by the organization to a disqualified person if the value of the economic benefit provided exceeds the value of the consideration, including the performance of services, received for providing such benefit.[xxiv]

To determine whether an excess benefit transaction has occurred, all consideration and benefits exchanged between the disqualified person and the EO, and all entities that the EO controls, are taken into account.[xxv]

In other words, the EO-public charity may pay reasonable compensation to a disqualified person without triggering the excess benefit rules.

As in the case of a PF, the public charity is expected to recover the amount of any excess payment made to the disqualified person.[xxvi]

Private Inurement

An organization is not operated exclusively for one or more exempt purposes if its net earnings inure, in whole or in part, to the benefit of private individuals.[xxvii]

Whether an impermissible benefit has been conferred on an individual is essentially a question of fact. A common factual thread running through the cases where inurement has been found is that the individual stands in a relationship with the organization which offers them the opportunity to make use of the organization’s income or assets for personal gain. This has led to the conclusion that a finding of inurement is usually limited to a transaction involving “insiders.”

Whereas the excise taxes on acts of self-dealing and on excess benefit transactions are intended to address situations that do not rise to the level at which the EO’s tax-favored status should be revoked, a finding that the organization’s net earnings have inured to the benefit of its “insiders” connotes a degree of impermissible benefit that justifies the revocation of its tax-exemption.

The Act

Congress must have believed that the foregoing limitations were not adequate to police or control the compensation practices of EOs. The committee reports to the Act, however, do not articulate the reason for the enactment of the provisions we are about to consider.

The only rationale that I can think of is that Congress was attempting to maintain some sort of “parity” between for-profits and EOs with respect to executive compensation.[xxviii]

Thus, the new provision draws heavily from the limitations applicable to business organizations, described above, and its purpose likewise may be deduced from the purposes of such limitations: to prevent certain individuals in the EO from paying themselves “excessive” salaries and other benefits, and thereby ensuring that those amounts are instead used in furtherance of the EO’s exempt purpose and for the benefit of its constituents.[xxix]

The Tax

Under the Act, effective for taxable years beginning after December 31, 2017, an employer (not the individual recipient of the payment) is liable for an excise tax equal to 21 percent[xxx] of the sum of:

(1) any “remuneration” in excess of $1 million paid to a covered employee by an EO for a taxable year, and

(2) any excess parachute payment paid by the EO to a covered employee.[xxxi]

Accordingly, the excise tax may apply as a result of an excess parachute payment, even if the covered employee’s remuneration[xxxii] does not exceed $1 million; in other words, there are two events that may trigger the imposition of the tax.

Where both provisions may apply, the remuneration that is treated as an excess parachute payment is not accounted for in determining if the $1 million limit is exceeded.

Covered Employee

For purposes of the provision, a covered employee is an employee (including any former employee) of an applicable tax-exempt organization if the employee

  • is one of the five highest compensated employees of the organization for the taxable year (the current year; there is no minimum dollar threshold for an employee to be a covered employee), or
  • was a covered employee of the organization (or of a predecessor organization) for any preceding taxable year beginning after December 31, 2016.[xxxiii] Thus, if the individual was a covered employee in a prior year (beginning with 2017), they continue to be treated as such for purposes of determining whether any payments made to them in subsequent years violate one of the two limitations described above.[xxxiv]

Related Persons

Remuneration of a covered employee also includes any remuneration paid with respect to employment of the covered employee by any person related to the EO.

A person is treated as related to an EO if the person:

(1) controls, or is controlled by, the organization,

(2) is controlled by one or more persons that control the organization,

(3) is a supported organization with respect to the organization, or

(4) is a supporting organization with respect to the organization.

Parachute Payments

Under the provision, an excess parachute payment is the amount by which any parachute payment exceeds the portion of the base amount allocated to the payment.

A parachute payment is a payment in the nature of compensation to a covered employee if:

  • the payment is contingent on the employee’s separation from employment and
  • the aggregate present value of all such payments equals or exceeds three times the base amount.[xxxv]

It should be noted that this definition differs from that applicable in the case of a business organization, where the disallowance of the employer’s deduction, and the imposition of the excise tax on the employee-recipient, are not contingent on the employee’s separation from employment.

It should also be noted that the Act did not provide an exception for a payment that represents reasonable compensation. Thus, even where the payment is reasonable in light of the services provided by the employee, and thus would not be trigger an excise tax for self-dealing or an excess benefit, the excise tax will nevertheless be applied.[xxxvi]


The employer of a covered employee – not the employee – is liable for the excise tax.

This is to be contrasted with the case of an employer that is a business organization. The employer is denied a deduction for the excess parachute payment, but an excise tax is also imposed upon the employee to whom the payment was made.

In addition, if the remuneration of a covered employee from more than one employer is taken into account in determining the excise tax, each employer is liable for the tax in an amount that bears the same ratio to the total tax as the remuneration paid by that employer bears to the remuneration paid by all employers to the covered employee.[xxxvii]

Parting Thoughts

The rules described above are complicated, and the IRS has yet to propose interpretive regulations, though it recently published interim guidance[xxxviii] to assist EOs with navigating the new rule, and on which they may rely, until regulations can be issued.

Of course, an EO will not be impacted by these provisions if it does not pay an employee enough remuneration to trigger the tax; there can be no excess remuneration if an EO (together with any related organization) pays remuneration of less than $1 million to each of its employees for a taxable year, and there can be no excess parachute payment if the EO does not have any “highly compensated” employees for the taxable year.[xxxix]

Does this mean that an EO should not pay any of its executives an amount that would trigger the imposition of the above tax? Should it walk away from candidates whom the EO can only hire by paying a larger amount? Or should it seek out the best people, pay them an amount that would trigger the tax but that the EO determines would be reasonable,[xl] and accept the resulting tax liability as a cost of doing business?[xli]

These are the kind of decisions that I have seen business owners make every day, and these are usually preceded by another set of inquiries: Will the return on our investment (in this case, in intellectual capital) justify the cost? Are we overpaying, or is the amount reasonable under the circumstances? Is there another way by which we can secure the same benefit – perhaps through a different mix of incentives, payable in varying amounts and at different times so as to skirt the literal terms of the Act, while also securing the services of a great executive?

The ability to bring this type of business analysis to an EO’s board discussion on executive compensation may be at least as valuable, in the current environment, as one’s willingness to open one’s wallet to the EO.


[i] See Subchapter A of Chapter 42 of the Code. Examples include the excise tax on a foundation that fails to pay out annually, to qualifying charities, an amount equal to at least five percent of the fair market value of its non-charitable assets, and the excise tax on certain “insiders” (with respect to the foundation) who engage in acts of self-dealing with the foundation (e.g., excessive compensation).

[ii] There are many reasons a business owner chooses to form a foundation; ego, tax planning, continued control, and family involvement are among these. There are also many reasons not to form one; the resulting administrative burden and the cost of tax compliance should not be underestimated.

[iii] Take a look at the board of any local charity. It is likely populated, in no small part, by the owners of businesses that operate within, or employ individuals from, the locality in which the EO is headquartered or that it services.

[iv] Instead of, say, furthering the charitable mission. It should be noted that these expenditures are not necessarily mutually exclusive.

[v] That’s right. The members of these boards elect themselves and their successors. It is rare for a larger charity to have “members” in a legal, “corporate law” sense– i.e., the counterparts to shareholders in a business organization – with voting rights, including the right to elect or remove directors. Rather, these charities depend upon honest, well-intentioned individuals to ensure that their charitable mission is carried out. Many of these individuals – the directors of the organization – are drawn from the business community. Of course, the Attorney General of the State in which a charity is organized also plays an important role in ensuring that the charity and those who operate it stay the course.

[vi] P.L. 115-97 (the “Act”).

[vii] IRC Sec. 4958; P.L. 104-168; enacted in 1996, it is generally applicable to public charities. More on this rule later.

[viii] IRC Sec. 162(a)(1).

[ix] Reg. Sec. 1.162-7.

[x] Specifically, its CEO, CFO, and the three other most highly compensated officers.

[xi] IRC Sec. 162(m); enacted in 1993 as part of the Omnibus Budget Reconciliation Act, P.L. 103-66. The Act eliminated the exception for performance-based pay.

[xii] IRC Sec. 280G(b)(2) and (c).

[xiii] An individual’s base amount is the average annualized compensation includible in the individual’s gross income for the five taxable years ending before the date on which the change in ownership or control occurs. IRC Sec. 280G(b)(3).

[xiv] IRC Sec. 280G(a) and (b)(1); enacted in 1984; P.L. 98-369.

[xv] The provision does not apply to “small business corporations” or to non-traded corporations that satisfy certain shareholder approval requirements. IRC Sec. 280G(b)(5).

[xvi] IRC Sec. 280G(b)(4)(A).

[xvii] IRC Sec. 280G(b)(4)(B).

[xviii] IRC Sec. 4999. Presumably because they would have been in a position to contractually obligate the corporation to make the payment.

[xix] IRC Sec. 4941. “Disqualified person” is defined in IRC Sec. 4946.

[xx] IRC Sec. 4941(d)(2)(E).

[xxi] The key, of course, is for the board to be able to demonstrate the basis for its determination of reasonableness.

[xxii] A “correction” under IRC Sec. 4941(e). The “obligation” to recover the excess portion is implicit in the calculation of the penalty.

[xxiii] For purposes of this rule, an economic benefit provided by an EO will not be treated as consideration for the performance of services rendered to the EO unless the EO clearly indicated its intent to treat such benefit as compensation.

[xxiv] IRC Sec. 4958(c)(1)(A).

[xxv] Reg. Sec. 53.4958-4. Congress foresaw that some individuals may try to circumvent the proscription by drawing down salaries from non-exempt organizations related to the EO.

[xxvi] IRC Sec. 4958(f)(6).

[xxvii] Reg. Sec. 1.501(a)-1.

[xxviii] Query whether EOs have been enticing executives away from business organizations in droves – I don’t think so.

[xxix] Interestingly, the Act made no distinction between public charities and PFs. In contrast, the comparable limitations for business organizations do not apply to “small business corporations” or certain non-publicly traded corporations.

[xxx] I.e., the newly established flat rate for C corporations – in order to mirror the amount of tax that such a corporation would have to pay in respect of the disallowed portion of the compensation paid to the individual service provider.

[xxxi] IRC Sec. 4960.

[xxxii] Remuneration includes amounts required to be included in the employee’s gross income under IRC Sec. 457(f).

Such amounts are treated as paid (and includible in gross income) when there is no substantial risk of forfeiture of the rights to such remuneration within the meaning of section 457(f). Sec. 4960(c)(3). For this purpose, a person’s rights to compensation are subject to a substantial risk of forfeiture if the rights are conditioned on the future performance of substantial services by any individual, or upon the achievement of certain organizational goals.

Up until now, the only cap on 457(f) arrangements was that the payment be reasonable for the services actually rendered.

In determining reasonableness, one looks to the totality of the recipient’s services to the EO, not only for the year paid; in other words, the payment may be “prorated” over many years for this purpose. Accordingly, the tax imposed by this provision can apply to the value of remuneration that is vested even if it is not yet received. Indeed, the excise tax can apply to amounts that are paid currently though they were earned in earlier years.

[xxxiii] Sec. 4960(c)(2).

[xxxiv] The list of covered employees may grow to include individuals who are no longer included in the five highest paid.

[xxxv] The base amount is the average annualized compensation includible in the covered employee’s gross income for the five taxable years ending before the date of the employee’s separation from employment.

[xxxvi] That being said, the Act does exempt compensation paid to employees who are not “highly compensated” employees from the definition of parachute payment.

Significantly for EO-hospitals, compensation attributable to medical services of certain qualified medical or veterinary professionals is exempted from the definitions of remuneration and parachute payment; remuneration paid to such a professional in any other capacity is taken into account.

Unfortunately, neither the Act nor the committee reports provide any guidance regarding the allocation of a medical professional’s remuneration between their medical services and, say, their administrative functions within the EO-employer.

[xxxvii] It should be noted that the Act authorizes the IRS to issue regulations to prevent the avoidance of the excise tax through the performance of services other than as an employee.

[xxxviii] Notice 2019-09, which consists of ninety pages of Q&A.

[xxxix] Within the meaning of IRC Sec. 414(q).

[xl] It should always be reasonable under the facts and circumstances.

[xli] Assuming the amount is reasonable within the meaning of the self-dealing and excess benefit rules, will there be any argument under state law that the imposition of the tax reflects a per se breach of the board’s fiduciary duty?

If the amount is not reasonable, such that the excise taxes on self-dealing and excess benefits become payable, what is purpose of the new tax?

How Does It Work?

Many employers struggle to hire and retain key employees. In addressing this challenge, employers will sometimes add unique benefits to the compensation package offered to such individuals. In fact, it is not unusual for the employer and the key employee to jointly structure the terms of such a benefit, often in response to a particular need of the employee.[i]

One of the more common benefits that a key employee may request to be included in such a compensation package is the provision of a “permanent” life insurance policy on the life of the employee; i.e., a policy that does not expire within a specified number of years, and which includes an investment component in addition to a death benefit.[ii] Of course, permanent insurance is more expensive than term life insurance, and may be too costly for the employee to acquire and carry alone.

Enter the split-dollar arrangement.

In general, a “split-dollar life insurance arrangement” entered into in connection with the performance of services is one between an employer (the “owner” of the policy) and a key employee (the “non-owner)”[iii] that satisfies the following criteria:

  • The employer pays the premiums on the policy, and
  • The employer is entitled to recover all, or a portion, of such premiums, and such recovery is to be made from, or is secured by, the life insurance proceeds.

The employee in this arrangement will typically designate the beneficiary of the death benefit,[iv] and may also have an interest in the cash value of the policy.

This arrangement is said to be compensatory, and certain economic benefits are treated as being provided by the employer-owner to the employee-non-owner.

Specifically, in determining gross income, the employee must take into account as compensation the value of the economic benefits provided to the employee under the arrangement.[v]

In general, the value of such benefits equals the cost of the current life insurance protection provided to the employee, plus the amount of the policy cash value to which the employee has “current access.”[vi]

But it’s Not Just for Employees

Although most split-dollar arrangements employed[vii] in the context of a business are compensatory in nature, it is possible for an arrangement to be entered into between a corporation and an individual in their capacity as a shareholder in the corporation.

In that case, the corporation would still pay all or a portion of the premiums, and the individual shareholder would designate the beneficiary of the death benefit, and may have an interest in the policy cash value.

However, the economic benefits provided by the corporation to the insured shareholder would constitute a distribution with respect to the shareholder’s stock in the corporation, which may represent a dividend to the shareholder,[viii] depending upon the corporation’s C corporation earnings and profits. In that case, the shareholder would be taxed at a much lower federal rate (23.8%), as compared to the rate applicable to compensation income (37%). If the corporation is an S corporation, it is possible that the distribution may not be taxable to the shareholder at all.[ix]

Thus, it is important, in determining the proper tax treatment of a split-dollar arrangement, that the parties thereto understand the capacity in which the benefit is being provided to the individual insured; i.e., as an employee or as a shareholder.

A recent decision by the Sixth Circuit Court of Appeals addressed this very issue.

Taxpayer as Employee or Shareholder?

Taxpayer was the sole shareholder of Corp, which was an S corporation. Taxpayer was also an employee of Corp.

Corp adopted a benefit plan in order to provide certain benefits to its employees. Pursuant to the plan, Corp provided Taxpayer a life insurance policy and paid a $100,000 annual premium in Tax Year. Because Corp was an S corporation, all of its income and deductions were “passed through” to Taxpayer for tax purposes.[x] On its Form 1120S return for Tax Year, Corp deducted the $100,000 premium as a business expense; thus, that amount of Corp’s income was not included in Taxpayer’s individual income as a pass-through item.[xi] However, Taxpayer also did not include as wages the economic benefits flowing from the life insurance policy.

The IRS challenged Taxpayer’s treatment of the split-dollar arrangement and issued a notice of deficiency, in response to which Taxpayer petitioned the Tax Court.

Tax Court

The Tax Court determined that Corp was not entitled to deduct the $100,000 premium payment.[xii] Because the $100,000 premium payment was not deductible, Corp underreported its income for that year and, due to its pass-through nature as an S corporation, the increased income was passed through to Taxpayer, who was then required to pay income tax on that amount. Taxpayer conceded that he had to report an amount equal to the premium payment as pass-through income.

The dispute before the Tax Court concerned whether Taxpayer was required to report as taxable wage income – in addition to the pass-through amount – the economic benefits flowing from the increase in the cash value of the life insurance policy caused by the payment of the premium.

The Tax Court ruled against Taxpayer, and found that he was required to account for the economic benefits in his individual income as wages:

[Corp’s] deduction, when disallowed . . . increased the S corporation’s gross income, which additional income was then passed on to [Taxpayer] as the shareholder of [Corp]. However, [Taxpayer], in addition to being a shareholder of the corporation, was also one of its employees. . . . , when the previously unreported and untaxed portion of the accumulation value of his policy was determined, the value of the $100,000 contribution by [Corp], was properly attributed to [Taxpayer] as an employee of the S corporation and a non-owner of the life insurance contract. While this result may seem aberrational in view of the pass-through treatment generally afforded to S corporations, it is a result mandated by the split-dollar life insurance regulations . . . . In instances other than those governed by the split-dollar life insurance regulations, the general rule of the non-taxability of previously taxed S corporation income is unperturbed. [Emph. added]

The Tax Court found that Taxpayer’s life insurance policy qualified as a compensatory arrangement. Moreover, the parties conceded that Taxpayer’s life insurance policy was not a shareholder arrangement.

Relying on the compensatory nature of the arrangement, the Tax Court rejected Taxpayer’s argument that the economic benefits (the “build-up” in cash value) should be treated as a shareholder distribution; instead, the Tax Court ruled that Taxpayer had to include as income the economic benefits resulting from Corp’s payment of a premium on Taxpayer’s life insurance policy.

Sixth Circuit

Taxpayer appealed the Tax Court’s decision to the Sixth Circuit, which considered the interplay of the split-dollar life insurance regulations and Subchapter S.

The Court explained that the split-dollar life insurance regulations apply “to any split-dollar life insurance arrangement,” whether the arrangement is a compensatory or a shareholder arrangement. When an arrangement is governed by the split-dollar life insurance regulations, the Court continued, the non-owner of the policy “must take into account the full value of all economic benefits” provided to them. “Depending on the relationship between the owner and the non-owner,” the Court stated, “the economic benefits may constitute a payment of compensation, a distribution in respect of stock, or a transfer having a different tax character.”

However, the Court also pointed out that another regulation (the “Regulation”) governs the tax treatment of the economic benefits flowing from a split-dollar arrangement to an individual insured who is a shareholder of the corporation paying the premiums. In particular, the Regulation states that “the provision by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement . . . of economic benefits . . . is treated as a distribution of property.” The Court noted that, by its terms, the Regulation applies to both compensatory and shareholder arrangements.[xiii]

The Court then observed that the split-dollar regulations make no specific reference to S corporations. It added that there was minimal case law concerning the interplay of Subchapter S and the split-dollar regulations, and that it was not aware of any case dealing with the application of the Regulation to the economic benefits provided to shareholder-employees pursuant to a compensatory arrangement.

Taxpayer’s Position

The thrust of Taxpayer’s argument was that the economic benefits provided under the split-dollar arrangement should be treated as a distribution of property by an S corporation to its shareholder, notwithstanding that they flowed from a compensatory arrangement.[xiv]

Taxpayer relied on the statement in the Regulation that the provision of economic benefits “by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement . . . is treated as a distribution of property.” Thus, Taxpayer argued, the economic benefits should be treated as a “distribution of property” from Corp to Taxpayer.[xv]

Taxpayer also relied on the statutory provisions governing the tax treatment of S corporations,[xvi] arguing that they “prevent double taxation otherwise imposed pursuant to an interpretative regulation addressing split dollar life insurance premiums that have been paid by S corporations.”

An S corporation’s income and deductions, Taxpayer asserted, are passed through to its shareholders, each shareholder is taxed on their allocable share thereof, and each shareholder’s stock basis is adjusted upward accordingly. In this case, $100,000 of Corp’s income – an amount equal to the nondeductible premium payment – was taxed to Taxpayer. How, then, Taxpayer argued, could he be taxed “again” as to the increase in the cash value of the policy attributable to premium?

IRS’s Position

The IRS argued[xvii] that the economic benefits should be treated as wage income – rather than as a shareholder distribution – because Taxpayer received the life insurance coverage as part of a compensatory split-dollar arrangement. The IRS noted that such treatment would be uncontroversial if the recipient of the economic benefits were an ordinary employee, rather than an S corporation’s shareholder-employee. The distinction between Taxpayer’s different roles – employee and shareholder – was, therefore, key to the IRS’s position.

The IRS pointed only to the distinction between compensatory and shareholder arrangements. The IRS recognized that the Regulation applies to both compensatory and shareholder arrangements but concluded that it “does not mean that in any situation where a compensatory arrangement covers a shareholder, the taxpayer’s status as a shareholder trumps his status as an employee, causing the economic benefit to be treated as a distribution to a shareholder,” because “[s]uch an interpretation of the regulation would make no sense, as it would defeat the reason for distinguishing between a compensatory arrangement and a shareholder arrangement.”

The Regulation is Dispositive

The Court rejected the IRS’s argument.

According to the Court, it was not clear that treating all economic benefits to shareholders as distributions – even to those who were also employed by the corporation –would undermine the purpose of the split-dollar regulations.

The Court noted that the Tax Court had not addressed the Regulation. However, the Court also added that if the economic benefits to Taxpayer were properly treated as a distribution of property to a shareholder – rather than as compensation to an employee – then the Tax Court had erred.

The Court decided that the Regulation was dispositive, and thereby rendered irrelevant whether Taxpayer received the economic benefits through a compensatory or shareholder split-dollar arrangement. The Regulation treats economic benefits provided to a shareholder pursuant to any split-dollar arrangement as a distribution of property with respect to the shareholder’s stock. The Court stated that the inclusion in the Regulation of all arrangements described in the split-dollar rules, which include compensatory arrangements – made clear that when a shareholder-employee receives economic benefits pursuant to a compensatory split-dollar arrangement, those benefits are treated as a distribution of property, and are thus deemed to have been paid to the shareholder in their capacity as a shareholder.

The Court stated that its interpretation was further supported by the fact that the split-dollar rules state that the tax treatment of the economic benefits depends on the “relationship between the owner and the non-owner.” The IRS argued that this language showed that the tax treatment depended on the nature of the split-dollar arrangement—compensatory or shareholder—but the Court pointed out that if this were the controlling factor, the Regulation could have said so (it does not).

Thus, the Court found that the Tax Court had erred by relying on the compensatory nature of Taxpayer’s split-dollar arrangement to conclude that the economic benefits were not distributions of property to a shareholder. Where a shareholder receives economic benefits from a split-dollar arrangement, the Regulation requires that those benefits be treated as a distribution of property to a shareholder.

The Court reversed the Tax Court’s decision with respect to the tax treatment of the economic benefits flowing to Taxpayer from Corp’s payment of the $100,000 premium on Taxpayer’s life insurance policy and held, pursuant to the Regulation, that those economic benefits had to be treated as distributions of property by Corp to its shareholder. Because Corp was an S corporation, that meant that the deemed distribution would be at least partially exempt from tax.[xviii]


Are you kidding? Compensation is compensation, isn’t it? It is paid for services rendered or to be rendered by the recipient to the payor. Except, at least according to the Sixth Circuit, when it is paid as part of a split-dollar life insurance arrangement to a shareholder of the payor who is also employed by the payor?

It is a basic principle of taxation that the capacity in which an owner of a business entity deals with the entity determines the appropriate tax treatment of the transaction. Salary paid by a corporation to a shareholder-employee for services actually rendered to the corporation is taxed as compensation.[xix] Where the amount paid is excessive for the services provided, the excess may be treated as a distribution to the shareholder in respect of their stock in the corporation (a dividend), the premise being that no one would pay more for the services than they were actually worth. Case closed, right?

What if the compensation paid to the shareholder-employee had been below market? Would the benefits provided under what was conceded to be a compensatory split-dollar arrangement still be treated as a distribution rather than as additional compensation?

What about the IRS’s historical concern over S corporations that pay less than reasonable compensation to their shareholder-employees in order to reduce their employment tax liability?

In holding as it did, has the Court created a second class of stock issue where none would otherwise have existed? The constructive distribution to a shareholder-employee of an S corporation sets that individual apart from other shareholders of the employer-corporation who are not employed in the business. Might it be easier to find that “a principal purpose” of the split-dollar arrangement (a “commercial contractual agreement”) is to circumvent the one class of stock requirement?[xx]

The Court should have upheld the Tax Court’s decision. It should have recognized that the literal wording of the Regulation needs to be revised to comport with the intention and language of the split-dollar rules.

[i] Actual equity, restricted equity, phantom equity, equity appreciation, change-in-control, and other equity-flavored or profits-based incentive bonus arrangements are also not uncommon.

[ii] For example, a whole life policy. A permanent policy will generally include an investment or savings component, reflected as the so-called “cash value” of the policy, against which the owner of the policy may borrow, or which may be withdrawn, during the life of the insured. Compare this to term insurance, which promises only a death benefit if the insured dies within a specified number of years.

[iii] The person named as the policy owner is generally treated as the “owner” of the policy for purposes of these rules. Thus, if the insured is named as the owner, they will be treated as the owner for purposes of these rules. However, if the only benefit accorded the insured is current life insurance protection (the death proceeds; they have no access to the cash value of the policy), then the non-owner is treated as the owner.

[iv] Often a trust for the benefit of the employee’s family.

[v] The employer will not be entitled to a deduction where it is a beneficiary of the policy.

[vi] To the extent it was not taken into account in a prior year. In general, the cash value builds up tax-free within the policy when the premium exceeds the cost of the insurance.

[vii] Yes, pun intended.

[viii] As in the case of compensatory split-dollar, the premium would not be deductible by the corporation.

[ix] Depending upon the shareholder’s stock basis and the corporation’s AAA; the deemed distribution would be treated as a return of already-taxed income or as a return of capital.

[x] IRC Sec. 1366.

[xi] The deduction claimed on the corporate return reduced, dollar-for-dollar, the amount of profit allocated to the shareholder on their Sch. K-1.

[xii] The corporation was a beneficiary of the policy (IRC Sec. 264); moreover, under Sec. 83, the employee had not included the premium in income.

[xiii] Reg. Sec. 1.301-1(q)(1)(i).

[xiv] Yep. You heard right.

[xv] Reg. Sec. 1.301-1(q)(1)(i).

[xvi] IRC Sec. 1366 (pass-through of corporate income), 1367 (upward basis adjustment for pass-through of income and downward for distribution thereof), and 1368 (treatment of S corporation distribution that would otherwise be treated as a dividend – return of already-taxed income and basis).

[xvii] And the Tax Court concluded.

[xviii] See IRC Sec. 1368.

[xix] And may be deducted to the extent it was reasonable.

[xx] Reg. Sec. 1.1361-1(l).

I had a call a couple of weeks ago from the owner of a business. His brother, who owned half of the business, owed some money to someone in connection with a venture that was unrelated to the business. The brother didn’t have the wherewithal to satisfy the debt and, to make matters worse, the person to whom the money was owed was a long-time customer of the business. The customer qua creditor had proposed and, under the circumstances, the brothers had agreed, that the business would satisfy the debt by significantly discounting its services to the customer over a period of time. The brothers wanted to know how they should paper this arrangement and that the resulting tax consequences would be.

We talked about bona fide loans, constructive distributions, disguised compensation, and indirect gifts. “What?” the one brother asked incredulously, “how can all that be implicated by this simple arrangement?” After I explained, he thanked me. “We’ll get back to you,” he said.

Last week, I came across this Tax Court decision.

A Bad Deal

Taxpayer and Spouse owned Corp 1, an S corporation. Taxpayer also owned Corp 2, a C corporation.

Things were going well for a while. Then Taxpayer bid and won a contract for a project overseas. Taxpayer formed LLC to engage in this project, and was its sole member. Unfortunately, the project required a bank guaranty. Taxpayer was unable to obtain such a guaranty, but he was able to obtain a line of credit, which required cash collateralization that he was only able to provide by causing each of his business entities to take out a series of small loans from other lenders.

The project did not go well, and was eventually shut down, leaving LLC with a lot of outstanding liabilities and not much money with which to pay them.

“Intercompany Transfers”

In order to avoid a default on the loans, Taxpayer tapped the assets of the other companies that he controlled. However, because Corp 1, Corp 2, and LLC were “related” to one another, he “didn’t see the merit” in creating any formal notes or other documentation when he began moving money among them.

Taxpayer caused Corp 2 to pay some of Corp 1’s and LLC’s debts. On its ledgers, Corp 2 listed these amounts as being owed to it, but on its tax returns, Corp 2 claimed them as costs of goods sold (COGS); because Corp 2 was profitable, there was enough income to make these claimed COGS valuable. That same year, Corp 2 issued Taxpayer a W-2 that was subsequently amended to reflect a much smaller amount.

In the following year, Corp 2 paid Taxpayer a large sum, which he used to pay a portion of LLC’s debts. Corp 2’s ledgers characterized these payments as “distributions”. Corp 2 also directly paid a significant portion of Corp 1’s and LLC’s expenses, which its ledger simply described as “[Affiliate] Payments.”

That same year, Corp 2 elected to be treated as an S corporation and filed its tax return accordingly, reporting substantial gross receipts and ordinary business income, which flowed through to Taxpayer. At the same time, Taxpayer and Spouse claimed a large flow-through loss from Corp 1 – a loss that was principally derived from Corp 1’s claimed deduction for “Loss on LLC Expenses Paid” and its claimed deduction for “Loss on LLC Bad Debt.” Taxpayer’s W-2 from Corp 2, however, reported a relatively small amount in wages.

The IRS Disagrees

The IRS issued notices of deficiency to: (i) Corp 2 for income taxes for the first year at issue (its last year as a C corporation), (ii) Taxpayer for income taxes for both years at issue, and (iii) Corp 2 for employment taxes for the second year at issue in respect of the amounts it “distributed” to Taxpayer and the amounts it used to pay Corp 1’s and LLC’s expenses. Taxpayer petitioned the Tax Court.

The Court considered whether:

  • Corp 2’s payment to creditors of Corp 1 and LLC were a loan between Corp 2 and those companies, or a capital contribution that was also a constructive dividend to Taxpayer;
  • Corp 1 was entitled to a bad-debt deduction for payments it made to LLC’s creditors prior to the years at issue, or for the payments Corp 2 made; and
  • Corp 2’s payments to Taxpayer and to creditors of Corp 1 and LLC should be taxed as wages to Taxpayer and, thus, also subject to employment taxes.

Loans or Constructive Dividends?

Corp 2 claimed a COGS adjustment for expenses of Corp 1 and LLC that it had paid. However, it changed its position before the Court, arguing that the payment was a loan.

The IRS countered that the payment was only “disguised” as a loan; it was not a bona fide debt. Rather, it was really a contribution of capital by Corp 2 to each of Corp 1 and LLC. According to the IRS, this made the payment a constructive dividend to Taxpayer, for which Corp 2 could not claim a deduction, thereby increasing its income.

A bona fide debt, the Court explained, “arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”

Whether a transfer creates a bona fide debt or, instead, makes an equity investment is a question of fact. To answer this question, the Court stated, one must ascertain whether there was “a genuine intention to create a debt, with a reasonable expectation of repayment, and did that intention comport with the economic reality of creating a debtor-creditor relationship?”

According to the Court, there are a number of factors to consider in the “debt vs equity” analysis, including the following:

  • names given to the certificates evidencing the indebtedness
  • presence or absence of a fixed maturity date
  • source of payments
  • right to enforce payments
  • participation in management as a result of the advances
  • status of the advances in relation to regular corporate creditors
  • intent of the parties
  • identity of interest between creditor and stockholder
  • “thinness” of capital structure in relation to debt
  • ability to obtain credit from outside sources
  • use to which the advances were put
  • failure of the debtor to repay
  • risk involved in making the advances.

Corp 2’s book entries showed a write-off for payments made to Corp 1 described as “Due from Related Parties” which made it seem as though Corp 2 intended the payments to be loans. But Corp 2 deducted the payments as “purchases,” thus belying the label used on its books. And when Corp 2 made the payments, it didn’t execute a note, set an interest rate, ask for security, or set a maturity date.

The lack of these basic indicia of debt and Corp 2’s inconsistent labeling weighed in favor of finding that Corp 2 intended the payments to be capital contributions, not loans.

The fact that Corp 1 and LLC were broke when Corp 2 made the payments also undermined Taxpayer’s position that the payments were loans. Taxpayer testified that LLC “had no funds” or “wasn’t capitalized,” and its only contract (for which it hadn’t been paid) had been canceled. Corp 1’s situation was similar; it had virtually no book of business, its liabilities exceeded its assets, and it was losing money.

So, Corp 2’s payments went to entities that were undercapitalized, had no earnings, and could not have obtained loans from outside lenders – all factors suggesting that the payments were capital contributions.

The Court observed that Taxpayer treated legally separate entities as one big wallet. “Taking money from one corporation and routing it to another will almost always trigger bad tax consequences unless done thoughtfully.” The Court stated that “Taxpayer did not approach LLC’s problems with any indication that he thought through these consequences or sought the advice of someone who could help him do so.”

The Court found that Corp 2’s payments were not loans to LLC and Corp 1, but were capital contributions; the entities didn’t intend to form a debtor-creditor relationship.

Constructive Dividend

The Court then considered whether Corp 2’s payments were constructive dividends to Taxpayer. A constructive dividend, the Court explained, occurs when “a corporation confers an economic benefit on a shareholder without the expectation of repayment.”

A transfer between related corporations, the Court continued, can be a constructive dividend to common shareholders even if those shareholders don’t personally receive the funds. That type of transfer is a constructive dividend if the common shareholder has direct or indirect control over the transferred property, and the transfer wasn’t made for a legitimate business purpose but, instead, primarily benefited the shareholder.

Taxpayer had complete control over the transferred funds – he was the sole shareholder of Corp 2, the sole member of LLC, and he owned 49% of Corp 1. Moreover, there was no discernible business reason for Corp 2 to make the transfers because there was no hope of repayment or contemplation of interest. The transfer was bad for Corp 2, but it was good for Taxpayer because it reduced his other entities’ liabilities.

Corp 2’s payment of LLC’s and Corp 1’s expenses, therefore, was a constructive dividend to Taxpayer.

Bad-Debt Deduction

On their tax return, Taxpayer and Spouse claimed a large flow-through loss derived from a bad-debt deduction that Corp 1 took for earlier payments it made on behalf of LLC, and a deduction that it took for “Loss on LLC Expenses Paid.” The IRS denied all of these deductions, increasing the Taxpayer’s flow-through income from Corp 1.

Before there can be a bad-debt deduction, there had to be a bona fide debt. Even when there was such a debt, the Court continued, a bad-debt deduction was available only for the year that the debt became worthless.

The Court recognized that “transactions between closely held corporations and their shareholders are often conducted in an informal manner.” However, given the significant amount of the purported debt, the Court noted that the absence of the standard indicia of debt – formal loan documentation, set maturity date, and interest payments – weighed against a finding of debt.

The only documents Taxpayer produced about the purported loans were its books.

The amount that Corp 2 paid and that Corp 1 deducted that same year as “Loss on LLC’s Expenses Paid” appeared as entries on those books. But, the Court stated, it is not enough to look at the label a corporation sticks on a transaction; one has to look for proof of its substance, which the Court found was lacking.

Based upon the “debt vs equity” factors described above, the absence of any formal signs that a debt existed, and the underlying economics of the situation, the Court found that Taxpayer was “once again just using one of his companies’ funds to pay another of the companies’ debts.” Therefore, Corp 1’s advances to LLC did not create bona fide debt for which a bad debt deduction could be claimed.


Taxpayer argued that the payments he received from Corp 2, and that he immediately used to pay other corporate debts, was either a distribution or a loan. He also claimed that Corp 2’s payments to Corp 1’s and LLC creditors were loans.

The IRS contended that these payments were wages to Taxpayer, and argued that Corp 2 “just called them something else” to avoid employment taxes.

The Court pointed out that these payments lacked formal loan documentation, had no set interest rate or maturity date, were made to companies with no capital, and could be repaid only if the companies generated earnings. For those reasons, the payments couldn’t have been loans.

But were the payments wages, as the IRS insisted?

Wages are payments for services performed. Whether payments to an employee-shareholder are wages paid for services performed or something else – such as dividends – is a question of fact. Again, the Court emphasized that all the evidence had to be considered; one had to look to the substance of the situation, not the name the parties gave a payment.

According to the Court, a significant part of this analysis was determining what “reasonable compensation” for the employee’s services would be. Among the factors to consider in making this determination were the following:

  • employee’s qualifications
  • nature, extent and scope of the employee’s work
  • size and complexities of the business
  • comparison of salaries paid with the gross income and the net income
  • prevailing general economic conditions
  • comparison of salaries with distributions to stockholders
  • prevailing rates of compensation for comparable positions in comparable concerns
  • salary policy of the employer as to all employees
  • in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.

The IRS estimated the salary for the CEO of a company comparable to Corp 2, and pointed out that while Taxpayer’s W-2 fell short of this salary, the amount paid to Taxpayer came fairly close to the IRS’s estimate when combined with the contested payments. There was no reason, the Court stated, “for us to think that the IRS’s estimate was unreasonable given Taxpayer’s decades” of business experience and the fact that he singlehandedly ran three companies, one of which was very profitable.

Be Aware

The overlapping, but not necessarily identical, ownership of closely held business entities, especially those that are controlled by the members of a single family, can breed all sorts of tax issues for the entities and for their owners.

Intercompany transactions, whether in the ordinary course of business or otherwise, have to be examined to ensure that they are being undertaken for valid business reasons. That is not to say that there cannot be other motivating factors, but it is imperative that the parties treat with one another as closely as possible on an arm’s-length basis.

To paraphrase the Court, above, related companies and their owners may avoid the sometimes surprising and bad tax consequences of dealing with one another – including the IRS’s re-characterization of their transactions – if they act thoughtfully, think through the tax consequences, and seek the advice of someone who can help them.

Our last three posts focused on those provisions of the Tax Cuts and Jobs Act[1] that apply specifically to pass-through entities, including partnerships and S corporations.

The 2017 Tax Act: Other “Pass-Through” Tax Provisions – Part II

The 2017 Tax Act: Other “Pass-Through” Tax Provisions – Part I 

The New Deduction for “Qualified Business Income”: Tax Simplification Gone Awry?

Today, we turn our attention to domestic C-corporations (“C-corp”) and to some of the ways in which the taxation of their U.S.-sourced income is impacted by the Act.[2]

Why a “C” Corp?

By far, most closely held U.S. businesses are formed as pass-through entities, including sole proprietorships, partnerships, limited liability companies (“LLC”), and S corporations (“S-corp”).


That being said, a number of closely held businesses are C-corps. Many of these would not qualify as S corps (for example, their capital structure may include preferred stock, or some of their shareholders may not be eligible to own stock of an S corp.). Others were formed before the advent of LLCs. Still others were formed as C-corps so as to avoid the pass-through of their taxable income to their shareholders (for example, where the owners were taxable at a higher individual income tax rate, or where the owners would be subject to self-employment tax on their share of the business income, or where the business did not plan to distribute its profits to its owners).

What is it?

A “corporation” is a business entity that is organized under a federal or state law that describes or refers to the entity as “incorporated” or as a “corporation.”

It also includes a business entity that was not formed under one of these laws but that elects to be treated as a corporation (an “association”) for tax purposes.[3]

In general, a C-corp is a corporation for which its shareholders cannot elect that it be treated as an S corporation (for example, because it is not a “small business corporation”), or have not so elected for whatever reason.

How is it Taxed?

A C-corp. is a taxable entity. It files an annual tax return on which it reports its gross income and its deductions and calculates its taxable income, on which it pays a corporate-level income tax.

When the C-corp. distributes its after-tax profits to its shareholders in the form of a dividend, the shareholders pay tax on the amount distributed to them.

Thus, the C-corp.’s taxable income is taxed twice: once to the corporation and, upon distribution, to its shareholders.

Prior to the Act, corporate taxable income was subject to tax under a graduated rate structure. The top corporate tax rate was 35% on taxable income in excess of $10 million.

As in the case of other taxpayers, certain items of revenue and certain items of expenditure are excluded in determining a C-corp.’s taxable income. Some of these items were modified by the Act.

For example:

  • the gross income of a corporation generally did not include any contribution to its capital;
  • a corporate employer generally could deduct reasonable compensation for personal services as an ordinary and necessary business expense – however, the Code limited the deductibility of compensation with respect to a “covered employee” of a publicly held corporation to no more than $1 million per year, subject to an exception for performance-based compensation (including, for example, stock options and SARs);
  • a C-corp. could reduce its dividends received from other taxable domestic corporations by 70%-to-100% of such dividends, depending upon its ownership interest in the distributing C-corp.;
  • Interest paid or accrued by a C-corp. generally was deductible in the computation of its taxable income, subject to various limitations;
    • for example, the Code limited the ability of a C-corp. to deduct its interest expense in certain situations where the corporation’s debt-to-equity ratio was “too high” and the deduction would not be “offset” by a matching inclusion in the gross income of the creditor (the “earnings stripping” rules);
  • if a C-corp. had a net operating loss (“NOL”) for a taxable year (the amount by which the C-corp.’s business deductions exceeded its gross income), the NOL could be carried back two years and carried forward 20 years to offset the C-corp.’s taxable income in such years.

In addition, a 20% alternative minimum tax (AMT) was imposed on a C-corp. if its AMT (based on its alternative minimum taxable income, which was calculated to negate the benefit of certain preferences and income deferrals that were allowed in determining its regular taxable income) exceeded its regular tax.

The Act

As a result of the Act:

  • the corporate tax rate is reduced to a flat 21%;[4]
  • the term “contribution to capital” does not include (a) any contribution in aid of construction or any other contribution as a customer or potential customer, and (b) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such) – thus, these contributions will now be taxable;
  • the performance-based exception to the limitation on the deductibility of certain compensation paid by a publicly traded corporation is eliminated, and the limitation is extended to include certain corporations the equity of which is not publicly traded, such as large private C- or S-corps with registered debt securities;[5]
  • the 70% and 80% dividends received deductions are reduced to 50 percent and to 65%, respectively;
  • the earnings stripping rules are expanded such that the deduction for business interest for any taxable year (including on debt owed to unrelated persons) is generally limited to the sum of (a) business interest income for such year, plus (b) 30% of the corporation’s adjusted taxable income for such year;[6]
    • “adjusted taxable income” means the taxable income of the corporation computed without regard to (1) any item of income, gain, deduction, or loss which is not properly allocable to a business; (2) any business interest or business interest income; (3) the amount of any NOL deduction; and (4) certain other business deductions;
    • “business interest” means any interest paid or accrued on indebtedness properly allocable to a business (it excludes investment interest);
    • “business interest income” means the amount of interest includible in the gross income of the corporation for the taxable year which is properly allocable to a business (and not investment);
    • the amount of any business interest not allowed as a deduction for any taxable year may be carried forward indefinitely;
    • significantly for smaller businesses, the limitation does not apply to a corporation if its average annual gross receipts for the three-taxable-year period ending with the prior taxable year does not exceed $25 million;
    • significantly for real estate businesses, at the corporation’s election, any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business, is not treated as a trade or business for purposes of the limitation – thus, the limitation does not apply to such an electing trade or businesses;
  • the carryover NOL deduction for a taxable year is limited to 80% of the corporation’s taxable income, the two-year carryback is repealed, and carryovers may be carried forward indefinitely;[7]
  • the corporate AMT is repealed.

These changes are effective for taxable years (and for losses arising in taxable years) beginning after December 31, 2017.[8]


The Act also made certain changes that may affect the “rank-and-file” employees of a corporation to whom the corporate employer may offer shares of its stock as compensation for their services.

“Property” for Services

In general, an employee to whom shares of employer stock are issued as compensation must recognize ordinary income in the taxable year in which the employee’s right to the stock is transferable or is not subject to a substantial risk of forfeiture, whichever occurs earlier (“vesting”).

Thus, if the employee’s right to the stock is vested when the stock is transferred to the employee, the employee recognizes income in the taxable year of such transfer, in an amount equal to the fair market value (“FMV”) of the stock as of the date of transfer (less any amount paid for the stock).

If, at the time the stock is transferred to the employee, the employee’s right to the stock is unvested – for example, the employee must render a specified number of years of service in order for the stock to vest – the employee does not recognize income attributable to the stock transfer until the taxable year in which the employee’s right becomes vested. In that case, the amount includible in the employee’s income is the FMV of the stock as of the date that the employee’s right to the stock becomes vested (less any amount paid for the stock).[9]

In general, these rules do not apply to the grant of a nonqualified option on employer stock. Instead, these rules apply to the transfer of employer stock by the employee on exercise of the option; specifically, if the right to the stock is substantially vested on transfer (the time of exercise), income recognition applies for the taxable year of transfer. If the right to the stock is unvested on transfer, the timing of income inclusion is determined under the rules applicable to the transfer of unvested stock. In either case, the amount includible in income by the employee is the FMV of the stock as of the time of income inclusion, less the exercise price paid by the employee.[10]

The Act

In the case of a closely held business, the grant of stock in the employer corporation has almost always been limited to a small number of executive, or “key,” employees of the corporation.

Over the years, many such employees have, for various reasons, sought ways to further defer the recognition of compensation income attributable to unvested stock (for example, by extending the required period of service).[11]

The Act actually provides a way to achieve such additional deferral, but in a way that does not benefit a corporation’s top executives, and that is not likely to be utilized by established closely held businesses, though it may help some start-up companies.[12]

Under the Act, a qualified employee may elect to defer the inclusion in income of the FMV of qualified stock transferred to the employee by the eligible employer in connection with the exercise of a stock option or the settlement of a restricted stock unit (“RSU”):

  • the election to defer income inclusion (“inclusion deferral election”) with respect to qualified stock must be made no later than 30 days after the time the employee’s right to the stock is vested;
    • A corporation is an eligible corporation if
      • no stock of the employer corporation was readily tradable on an established securities market during any preceding calendar year, and
      • the corporation has a written plan under which, in the calendar year, not less than 80% of all employees who provide services to the corporation in the U.S. are granted options, or RSUs, with the same rights and privileges to receive qualified stock;
  • If an inclusion deferral election is made, the income must be included in the employee’s income for the taxable year that includes the earliest of:
  • the first date the qualified stock becomes transferable;
    • the date the employee first becomes an excluded employee;
      • an excluded employee with respect to a corporation is any individual (1) who owned 1% of the corporation at any time during the calendar year, or who owned at least 1% of the corporation at any time during the 10 preceding calendar years, (2) who is, or has been at any prior time, the CEO or CFO of the corporation, (3) who is a family member of such individuals, or (4) who has been one of the four highest compensated officers of the corporation for the taxable year, or for any of the 10 preceding taxable years;[13]
    • the first date on which any stock of the employer becomes readily tradable on an established securities market;
    • the date five years after the first date the employee’s right to the stock becomes substantially vested; or
    • the date on which the employee revokes the inclusion deferral election.

Having Fun Yet?

The more I read and analyze the Act, the more I realize its potential implications for closely held businesses, and the more I recognize[14] that “only time will tell,” as the saying goes.

That being said, the C-corp-related changes under the Act, discussed briefly above, raise some interesting questions, among which are the following:

  • Will the reduced rated rate induce an S-corp or its shareholders to give up its “S” election, either by revoking it, or by admitting new investors or changing its capital structure?[15]
  • Will the reduced rate cause the shareholders of a target C-corp to abandon their attempts to by-pass the C-corp, to the extent possible, in connection with the sale of its business?[16]
  • Will the limitation on the deduction of interest cause a corporation to rethink its capital structure, causing it to rely less on borrowed funds?
  • Will the elimination of the two-year NOL carryback, plus the addition of the 80%-of-taxable income cap, have an adverse effect on the recovery of a distressed corporation?[17]

The answers to these, and other, questions will best be answered by considering the unique facts and circumstances of each closely held corporate taxpayer and of its shareholders.

Taxpayers will have to review the Act’s changes with their tax advisers, consider and map out the implications thereof as to their business, and then plan accordingly.

[1] Pub. L. 115-97; the “Act.”

[2] Please note that some of the items discussed herein are not unique to C-corps, but because C-corps are liable for tax (unlike their pass-through brethren – at least in most cases), I chose to discuss these items as they apply to C-corps. By the same token, other C-corp-related changes have been covered in other posts; for example, re the application of the cash method of accounting, see The 2017 Tax Act: Other “Pass-Through” Tax Provisions – Part I 

[3] For example, a single member LLC that would otherwise be disregarded for tax purposes, but for which “the box has been checked” to treat it as an association/corporation for tax purposes.

[4] This 21% rate will also be applied to situations that determine tax liability by reference to the corporate tax rate; for example, the calculation of the built-in gains tax on S-corps.

[5] For example, a private company that does not qualify for an exemption to the securities registration requirements may have to register an offering of debt or convertible debt.

[6] This limitation rule also applies to partnerships and S corps at the entity level; special rules are provided for passing through the consequences of the rule to partners and S-corp. shareholders.

[7] See the discussion of “excess business losses” for non-corporate taxpayers at The 2017 Tax Act: Other “Pass-Through” Tax Provisions – Part I 

[8] It should be noted that existing indebtedness is not grandfathered under the new limitation for deducting interest.

[9] If the employee’s right to the stock is unvested at the time the stock is transferred to the employee, the employee may elect, within 30 days of transfer, to recognize income in the taxable year of transfer (a “section 83(b)” election). If the election is made, the amount of compensatory income is capped at the amount equal to the FMV of the stock as of the date of transfer (less any amount paid for the stock).

[10] A section 83(b) election does not apply to the grant of options by a closely held corporation. Moreover, under Sec. 409A of the Code, the exercise price of a nonqualified option cannot be less than the FMV of the underlying stock at the time the option is granted; otherwise, any spread may be includible in the employee’s income.

[11] Though doing so also defers the start of their holding period for the stock.

[12] Query whether this adds anything to the benefit provided under Sec. 83(b) for a stock in a presumably little-to-no-value start-up corporation.

[13] Except for family, basically the employees to whom such stock or options have traditionally been granted.

[14] Like the tax pun there? “Realize” and “recognize.”

[15] Perhaps – at least where the S-corp is not planning a sale of its business or is not in the habit of making regular distributions to shareholders. Before the Act, a non-materially-participating shareholder of an S-corp faced a tax of 43.4% (39.6% + 3.8%) on his pro rata share of the corporation’s income vs. a maximum C-corp tax rate of 35%; after the Act, the comparison is between 40.8% (37% + 3.8%) and 21%.

[16] For example, by arguing for the presence and sale of personal goodwill.

[17] For example, by removing its ability to receive a refund from those earlier years.

This week, we return to two recurring themes of this blog: (I) related party transactions – specifically, transactions between a taxpayer and a corporation controlled by the taxpayer; and (II) what happens when a taxpayer does not conduct the appropriate due diligence before engaging in a transaction.

Management Agreements

Taxpayers owned two operating companies (the “OCs”) that were treated as S-corporations for tax purposes. Taxpayers were the sole officers and directors of the OCs. Taxpayer One (“TP-1”) was primarily responsible for all operations of the OCs. His principal duties included: negotiating contracts, overseeing advertising purchases and content, managing the OCs’ finances, selling the products to retailers, and overseeing other employees’ work. In short, he performed all managerial tasks for the OCs.

Taxpayers’ attorney advised them that they could reduce their income tax liabilities by way of a series of transactions that included the use of a new management corporation.

TP-1 directed the attorney to implement the transactions. Accordingly, Management Corp (“MC”) was incorporated, Taxpayers were appointed as its directors, and TP-1 was designated as its president. MC then issued shares of stock to the Taxpayers, who elected that MC be taxed as an S-corporation.

The OCs entered into management agreements with MC. The agreements did not specify the particular services that MC’s employees would provide. Under these agreements, the OCs agreed to purchase management services from MC for 20% of their respective gross receipts.

This management fee was determined by TP-1, with input from his legal and tax advisers. The OCs and MC did not retain a professional consultant to assist with setting the amount of the management fee or to advise with respect to reasonable compensation.

MC then hired TP-1 to “provide management services to the client companies of * * * [MC] so as to fulfill the obligations of * * * [MC] under its various management agreements”. The contract between MC and TP-1 did not specify the particular “management services” that TP-1 was to provide. However, TP-1 provided the same services to the OCs that he had provided to them before incorporating MC.

The OCs’ functions did not change after they had hired MC, except that the employees of the OCs began providing services via MC. Employees were not aware of this change until they began receiving their salaries from MC. For all practical purposes, the work of OCs’ employees did not change when they began working for MC.

The OCs and MC subsequently amended their respective management agreements to provide that the OCs would pay MC 10% of their respective gross receipts for MC’s services because the OCs’ revenues had declined. They later amended the agreements to provide for a 3% fee. Regardless of the size of the fee, MC purportedly provided the same services to the OCs for the years at issue.

Notice of Deficiency

The IRS issued a notice of deficiency to Taxpayers in which it disallowed the deductions claimed on their respective tax returns (on IRS Form 1120S) for the management fees that the OCs reported paying to MC.

The IRS contended that Taxpayers were entitled to deduct only the portions of the management fees that were considered reasonable.

The IRS also argued that, to the extent the management fees constituted unreasonable compensation, the transaction should be re-characterized as distributions by the OCs to the Taxpayers.

As an alternative position, the IRS stated that MC should be disregarded as a sham for tax purposes because it lacked a legitimate business purpose and had no economic substance, in which case no part of the management fees would be deductible.

The Taxpayers petitioned the U.S. Tax Court.

On brief, the IRS conceded that MC was not a sham entity and should not be disregarded.

The Court’s Analysis

Because the IRS conceded that MC was not a sham entity, the Court focused on determining what constituted an arm’s-length management fee, which it noted may be higher than the salaries MC paid (i.e., there would be a profit).

The Court began by reviewing those Code provisions that were enacted to prevent tax evasion and to ensure that taxpayers clearly reflected income relating to transactions between controlled entities. The IRS, it stated, had broad authority to allocate gross income, deductions, credits, or allowances between two related corporations if the allocations were necessary either to prevent evasion of tax or to clearly reflect the income of the corporations.

To determine “true” taxable income, the Court continued, the standard to be applied in every case was that of a taxpayer dealing at arm’s-length with an uncontrolled taxpayer. The arm’s-length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s-length result. In determining which of two or more available methods provides the most reliable measure of an arm’s-length result, the two primary factors to take into account are the degree of comparability between the controlled taxpayer and any uncontrolled comparable, and the quality of data and assumptions used in the analysis.

Arm’s-Length Fee?

The task before the Court was to determine the most reliable method for calculating an arm’s-length management fee. It began its analysis by reviewing the Taxpayers’ and the IRS’s expert reports.

The Court found that the methodology used by the Taxpayers’ expert was unreliable because the companies on which the expert relied were not comparable to the OCs.

It then turned to the IRS’s expert report.

The IRS’s expert determined that an appropriate method for calculating an arm’s-length management fee – what unrelated parties would have paid for similar services – was a markup of MC’s expenses. His method required that, after determining MC’s costs, he multiplied them by the median profit margin of a comparable group of companies for the particular year at issue.

The IRS’s expert researched companies comparable to MC in terms of revenue and services provided. He did this by first determining the operating profits earned by comparable companies as a percentage of their total costs.

Next, he determined the cost markups of these comparable companies for the years at issue. He then calculated MC’s costs by using MC’s reported expenses for the years at issue, but subtracting that portion of the expenses he considered to be unreasonable compensation to TP-1.

After allowing for a deduction of an arm’s-length management fee, the IRS’s expert calculated the OCs’ three-year average operating income margin. Because this margin was within the three-year average for the OCs’ peer group, he considered his results reasonable.

Reasonable Compensation

The Taxpayers contended that the IRS’s analysis was unreliable because it had determined that TP-1 was overcompensated.

The Court explained that a taxpayer is entitled to a deduction for compensation payments if the payments are reasonable in amount and are, in fact, paid purely for services. The question of whether amounts paid to employees represent reasonable compensation for services rendered is a question of fact that must be determined in the light of all the evidence.

Special scrutiny is given, the Court continued, in situations where a corporation is controlled by the employees to whom the compensation is paid because there is a lack of arm’s-length bargaining.

It also noted that contingent compensation agreements (like the fee paid to MC) generally invite scrutiny as a possible distribution of earnings, though the courts have upheld such agreements under appropriate circumstances. If a contingent compensation agreement generates payments greater than the amounts that would otherwise be reasonable, those payments are generally deductible only if: (1) they are paid pursuant to a free bargain between the employer and the individual; (2) the agreement is made before the services are rendered; and (3) the payments are not influenced by any consideration on the part of the employer other than that of securing the services of the individual on fair and advantageous terms.

Where there is no free bargain between the parties, the contingent compensation agreement is not dispositive as to what is deductible. Rather the Court is free to make its own determination of what is reasonable compensation.

The Court identified the following factors to determine the reasonableness of compensation, with no one factor being determinative: (1) the employee’s qualifications; (2) the nature, extent and scope of the employee’s work; (3) the size and complexities of the business; (4) a comparison of salaries paid with the gross income and net income; (5) the prevailing economic conditions; (6) a comparison of salaries with distributions to shareholders; (7) the prevailing rates of compensation for comparable positions in comparable concerns; (8) the salary policy of the taxpayer as to all employees; and (9) in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.

According to the Court, shareholder-executive compensation in a closely-held corporation that depletes most of a corporation’s value is generally unreasonable when the deductible salary expenses are a disguise for nondeductible profit distributions.

Taxpayers owned the OCs. In this case, the management fee depleted most, if not all, of the OCs’ profits. The management fee in turn was used primarily to pay TP-1. For example, approximately 87% of the management fee went to pay TP’s compensation in one of the years at issue.

In summary, the Court found that TP-1’s compensation was unreasonable, and that the IRS correctly adjusted his compensation before calculating an arm’s-length management fee. In calculating TP-1’s reasonable compensation, the IRS analyzed executive compensation of companies engaged in a comparable business and found that TP-1’s compensation was substantially more. Therefore, the Court found that the IRS’s conclusions regarding TP-1’s reasonable compensation were reliable.

The Court concluded that the IRS’s determination produced the most reliable measure of an arm’s-length result under the facts and circumstances. Accordingly, the Court reduced the amount that the OCs were entitled to deduct as management fees.

Lesson Learned?

You may be surprised at how frequently the IRS challenges the reasonableness, or even the nature, of the payments that are made between related taxpayers, and especially between related, closely-held businesses.

Over the years, the IRS, Congress, and the courts have developed a number of theories by which to force taxpayers to report the true income resulting from transactions with related persons, including the following: sham transaction, sham entity, substance over form, economic substance, assignment of income, “true earner,” reallocation of income, re-characterization of income, and others.

In almost every case, the best defense against an IRS challenge of the taxpayer’s treatment of a “related party transaction” is established in advance of the transaction.

The taxpayer should determine whether the transaction would be undertaken without regard to its tax consequences; whether there is an independent and bona fide business purpose for the transaction. If these inquiries cannot be answered in the affirmative, the taxpayer should avoid the transaction.

Assuming there is an independent business purpose for the related party transaction, the taxpayer may structure it in a tax-efficient manner. However, the taxpayer must also act to structure the transaction with the related party, as closely as reasonably possible, on an arm’s-length basis, and it should document its efforts and compile the data (such as comparables) and other evidence (for example, expert reports) on which it based its conclusions.


In the course of valuing a target business, a potential buyer will want to develop an accurate picture of the target’s earnings and cash flow. In doing so, the buyer will try to normalize those earnings by “adding back” various target expenses that the buyer is unlikely to incur in the ordinary course of operating the business after its acquisition. These may include certain one-time costs (for example, an “ordinary and necessary” litigation expense), but the most common add-backs involve payments made to or for the benefit of persons who are somehow related to the owners of the business. Among these related party payments, the compensation paid to family members is by far the most frequently recurring add-back.

“Why is that?” you may ask. Because family-owned and operated businesses are notorious for often paying unreasonable amounts of compensation to family members. These payments may exceed the fair market value of the services actually rendered by the family member – “reasonable compensation,” or the amount that would be paid for like services by like enterprises under like circumstances – or even may be made to a family member who does not actually work in the business. In the case of a family member who is employed by, and provides a valuable service to, the business – a service for which the buyer will have to pay after the acquisition – the add-back will be limited to the amount, if any, by which the payment exceeds reasonable compensation.

There are many reasons why family-owned businesses pay unreasonable compensation: to support a child or grandchild, to enable a family member to participate in retirement and health plans, to make “gifts” to them as part of the owner’s estate planning, and, of course, to zero-out the employer-payor’s taxable income.

Whatever the motivation, the payment violates one of the precepts often advanced by this blog: in a business setting, treat related parties on an arm’s-length basis as much as possible.

“Father Knows Best” (?)

A recent decision of the U.S. Tax Court described one taxpayer who ignored this precept at great cost.

Taxpayer was a C corporation engaged in a wholesale business. Its president and founder (“Dad”), along with his four sons (not My Three Sons; the “Boys”), were its only full-time employees and officers. Each of them performed various and overlapping tasks for the Taxpayer, including tasks that might have been performed by lower level employees. The Boys performed no supervisory functions.

Just before the tax years at issue (the “Period”), Dad owned 98% of Taxpayer’s stock; the other 2% was owned by an unrelated person. Dad then transferred all of his shares of nonvoting common stock to the Boys, after which Dad owned only shares of voting common stock.

Dad was familiar with the marginal income tax rates applicable to him and to his sons. Dad alone determined the compensation payable to the Boys; he did not consult his accountant or anyone else in determining compensation. The only apparent factors considered in determining annual compensation were reduction of Taxpayer’s reported taxable income, equal treatment of each son, and share ownership.

On its corporate income tax returns for the Period, Taxpayer deducted the compensation paid to the Boys.

During those same years, the Taxpayer paid only one insignificant dividend.

Interestingly, during one of the years at issue, Dad considered selling Taxpayer to an unrelated person. They entered into a nondisclosure agreement, and Dad provided the potential buyer with salary figures for the shareholders (his own and the Boys’), adjusted to a market rate that was significantly below what was actually being paid.

Disallowed Deductions

The IRS audited Taxpayer’s returns for the Period, and issued a notice of deficiency in which it disallowed Taxpayer’s deduction for much of the compensation paid to the Boys, claiming that it was unreasonable.

In general, a taxpayer must show that the determinations contained in a notice of deficiency are erroneous, and it specifically bears the burden of proof regarding deductions.

The Tax Court found that Taxpayer’s evidence with respect to the reasonableness of the compensation, as presented by its expert, was not credible.

In fact, the Court was quite critical of the Taxpayer’s “expert.” In most cases, it stated, there is no dispute about the qualifications of the experts. “The problem,” the Court continued, “is created by their willingness to use their résumés and their skills to advocate the position of the party who employs them without regard to objective and relevant facts, which is contrary to their professional obligations.”

The Court concluded that Taxpayer’s expert disregarded objective and relevant facts and did not reach an independent judgment.

“Reasonable” Compensation

The Code allows as a deduction all the ordinary and necessary expenses paid or incurred by a taxpayer during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered. A taxpayer is entitled to a deduction for compensation if the payments were reasonable in amount “under all the circumstances,” and were in fact payments purely for services.

Whether the compensation paid by a corporation to a shareholder-employee is reasonable depends on the particular facts and circumstances.

In making this factual determination, courts have considered various factors in assessing the reasonableness of compensation, including:

  • employee qualifications;
  • the nature, extent, and scope of the employee’s work;
  • the size and complexity of the business;
  • prevailing general economic conditions;
  • the employee’s compensation as a percentage of gross and net income;
  • the shareholder-employees’ compensation compared with distributions to shareholders;
  • the shareholder-employees’ compensation compared with that paid to non-shareholder-employees;
  • prevailing rates of compensation for comparable positions in comparable businesses; and
  • comparison of compensation paid to a particular shareholder-employee in previous years where the corporation has a limited number of officers.

No single factor is dispositive. However, special scrutiny is given in situations where a corporation is controlled by the employees to whom the compensation is paid, because there is usually a lack of arm’s-length bargaining.

The Court’s Analysis

The Court noted that while “the actual payment would ordinarily be a good expression of market value in a competitive economy, it does not decisively answer the question” of reasonableness “where the employee controls the company and can benefit by re-labeling as compensation what would otherwise accrue to him as dividends.”

According to the Court, Taxpayer acknowledged as much in the materials prepared in connection with the possible sale, in which the shareholder salaries were recast to a much lower “market rate.”

As in many family enterprises, the Boys were involved early on in the business and did whatever was needed to keep the business going. Compensation in closely-held businesses is subject to close scrutiny because of the family relationships, and it is determined by objective criteria and by comparisons with compensation in other businesses where compensation is determined by negotiation and arm’s-length dealing.

In their testimony, the Boys denied knowledge of principles basic to the performance of their respective functions on behalf of Taxpayer. Moreover, none of them had any special experience or educational background. Each of them testified that they had overlapping duties, but those duties included menial tasks as well as managerial ones because there were no other employees.

Dad testified that he intended to treat the Boys equally, that he alone determined their compensation, and that he was aware of their marginal tax rates, obviously intending to minimize Taxpayer’s, and the family’s overall, tax liability.

The amounts and equivalency of the Boys’ compensation – allegedly to avoid competition among them – the proportionality to their stock interests, the manner in which Dad alone dictated the amounts, the reduction of reported taxable income to minimal amounts, and the admissions in the sale materials relating to their compensation “all justified skepticism,” the Court stated, toward Taxpayer’s “assertions that the amounts claimed on the returns were reasonable.”

The Court was especially critical of Taxpayer’s compensation expert. The expert did not consider any of the foregoing factors. He disregarded sources and criteria that he used in other cases, and that would have resulted in lower indicated reasonable compensation amounts. He used only one source of data although, in his writings and lectures, he had urged others to use various sources. Although he testified that he was an expert in “normalizing owner compensation,” which is “adjusting the numbers to what they think a buyer might experience,” he did not attempt to do so in this case. In attempting to justify the compensation paid to the Boys in the absence of material reported earnings, he assumed that Taxpayer increased in value from year to year.

The expert placed Taxpayer’s officers in the 90th percentile of persons in allegedly comparable positions, which their own testimony showed that they were not. He determined aggregate compensation of the top five senior executives in companies included in his single database while acknowledging that the titles assigned and duties performed by Taxpayer’s officers were not typical of persons holding senior executive offices. He understood that the compensation was set solely by Dad and was not the result of negotiation or arm’s-length dealing, but he ignored that factor. He relied completely on the representations of Dad and the Boys and did not consult any third parties.

Although his report discussed officer retention as a reason for high compensation, he did not consider the likelihood – as confirmed by the Boys’ testimony – that any of them would ever leave Taxpayer’s employ, even if he were paid less.

The approach throughout the appraiser’s report indicated that it was result-oriented – to validate and confirm that the amounts reported on Taxpayer’s returns were reasonable – rather than an independent and objective analysis. The Court found that, overall, neither the expert’s analysis nor his opinion was reliable.

Because Taxpayer’s expert’s opinion disregarded the objective evidence and made unreasonable assumptions, the Court held that Taxpayer failed to satisfy its burden of proving the reasonableness of the amounts paid to the Boys in excess of those allowed in the notice of deficiency.

Apologies to Dad? Nope

Yesterday was Father’s Day, yet here I am, one day later, writing about a Dad who tried to do right by his Boys, but was punished with an increased tax bill. Unfortunately, he deserved it. The compensation paid to the Boys appeared solely related to their shareholdings, to Dad’s desire to transfer his wealth to them equally, and to his desire to reduce the Taxpayer’s corporate income tax liability.

This is what happens when you violate the precept recited above: in a business setting, treat related parties on as close to an arm’s-length basis as possible; stated differently, “you mess with the bull, you get the horns.”

This simple rule accomplishes a number of goals. It supports the separateness of the corporate entity and the protection it affords from personal liability. It rewards those who actually render services, and may incentivize others to follow suit. It may cause those who are not productive to leave the business. It may reduce the potential for intra-family squabbling based on accusations of favoritism. And let’s not forget that it helps to avoid surprises from the IRS.

Where estate and gift planning is a consideration, there are other means of shifting value to one’s beneficiaries. Combined with the appropriate shareholders’ agreement, these transfers may be effectuated without adversely affecting the business.

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)


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]


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.

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.

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, . . .

Don’t miss Part I, here!

“I appreciate your eagerness,” said the adviser. “You can just imagine how I feel every morning when I read through the latest tax news. It takes a Herculean effort to contain myself.”

“OMG,” he’s crazy, “what was my dad thinking when he retained this guy?!”

“I see the look in your eyes. Rest assured, your patience is about to be rewarded.

The “Independent Investor Test”

“I’m sure you are familiar with the basic economic principle that the owners of an enterprise with significant capital are entitled to a return on their investment. Thus, a corporation’s consistent payment of salaries to its shareholder-employees in amounts that leave insufficient funds available to provide an adequate return to the shareholders on their invested capital indicates that a portion of the amounts paid as salaries is actually a distribution of earnings.

“The ‘independent investor test,’ the Court noted, recognizes that shareholder-employees may be economically indifferent to whether payments they receive from their corporation are labeled as compensation or as dividends.

“From a tax standpoint, however, only compensation is deductible to the corporation; dividends are not. Therefore, the shareholder-employees and their corporations generally have a bias toward labeling payments as compensation rather than dividends, without the arm’s-length check that would be in place if nonemployees owned significant interests in the corporation.

“Thus, the courts consider whether ostensible salary payments to shareholder-employees meet the standards for deductibility by taking the perspective of a hypothetical ‘independent investor’ who is not also an employee.

“Ostensible compensation payments made to shareholder-employees by a corporation with significant capital that ‘zero out’ the corporation’s income, and leave no return on the shareholders’ investments, fail the independent investor test. An independent (non-employee) shareholder would probably not approve of a compensation arrangement pursuant to which the bulk of the corporation’s earnings are being paid out in the form of compensation, so that the corporate profits, after payment of the compensation, do not represent a reasonable return on the shareholder’s equity in the corporation.

“The record established that Taxpayer had substantial capital even without regard to any intangible assets, although Taxpayer’s expert witness admitted, at trial, that a firm’s reputation and customer list could be valuable entity-level assets.

“Invested capital of the magnitude described in the decision, the Court said, could not be disregarded in determining whether ostensible compensation paid to shareholder-employees was really a distribution of earnings. The Court did not believe that Taxpayer’s shareholder-attorneys, were they not also employees, would have forgone any return on this invested capital. Thus, Taxpayer’s practice of paying out year-end bonuses to its shareholder-attorneys that eliminated its book income failed the independent investor test.

Exemption From the Independent Investor Test?

“Taxpayer observed that its shareholder-attorneys held their stock in the corporation in connection with their employment, they acquired their stock at a price equal to its cash book value, and they had to sell their stock back to Taxpayer at a price determined under the same formula upon terminating their employment. Taxpayer suggested that, as a result of this arrangement, its shareholder-attorneys lacked the normal rights of equity owners.

“Contrary to Taxpayer’s argument, the Court noted, the use of book value as a proxy for market value for the issuance and redemption of shares in a closely-held corporation to avoid the practical difficulties of more precise valuation hardly meant that the shareholder-attorneys did not really own the corporation and were not entitled to a return on their invested capital. Any shareholders who were not also employees would generally demand such a return.

“More generally, Taxpayer’s argument that its shareholder-attorneys had no real equity interests in the corporation that would have justified a return on invested capital proved too much. If Taxpayer’s shareholder-attorneys were not its owners, who was? If the shareholder-attorneys did not bear the risk of loss from declines in the value of its assets, who did? The use of book value as a proxy for fair market value deprived the shareholder-attorneys of the right to share in unrealized appreciation upon selling their stock—although they were correspondingly not required to pay for unrealized appreciation upon buying the stock.

“But acceptance of these concessions to avoid difficult valuation issues did not compel the shareholder-attorneys to forgo, in addition, any current return on their investments based on the corporation’s profitable use of its assets in conducting its business.

“Taxpayer’s arrangement effectively provided its shareholder-attorneys with a return on their capital through amounts designated as compensation. The Court believed that, were this not the case, the shareholder-attorneys would not have been willing to forgo any return on their investment.

Court’s Conclusion

“The Court concluded that the independent investor test weighed strongly against the claimed deductions. The independent investor who had provided the capital demonstrated by the cash book value of petitioner’s shares—even leaving aside the possibility of valuable firm-owned intangible assets—would have demanded a return on that capital and would not have tolerated Taxpayer’s consistent practice of paying compensation that zeroed out its income.

“The classification of a law practice as a business in which capital is not a material income-producing factor, the Court said, did not mean that all of an attorney’s income from his or her practice was treated as earned income and that any return on invested capital was ignored.

“The Court did not doubt the critical value of the services provided by employees of a professional services firm. Indeed, the employees’ services may be far more important, as a factor of production, than the capital contributed by the firm’s owners. Recognition of these basic economic realities might justify the payment of compensation that constitutes the vast majority of the firm’s profits, after payment of other expenses—as long as the remaining net income still provides an adequate return on invested capital.

“But Taxpayer, the Court said, did not have substantial authority for the deduction of amounts paid as compensation that completely eliminated its income and left its shareholder-attorneys with no return on their invested capital.

“Because Taxpayer did not have substantial authority for its treatment of the year-end bonuses it paid during the years in issue, the disallowance of a portion of the deductions Taxpayer claimed for those payments represented a ‘substantial understatement’ for each year.”

Post Script

The tax adviser turned back from the window and looked at the client. The client’s head was resting against the back of the chair. Was that drool trickling from the side of her mouth?

He cleared his throat. Nothing. He cleared it again, this time more forcefully. Her head was now upright. He looked meaningfully into her eyes. “They were lifeless eyes,” he thought, “like a doll’s eyes.” He realized he was channeling Captain Quinn from “Jaws.”

Then she blinked, or tried to – she winced in pain, moved her hands to her face, seemed to fiddle with something, rubbed her eyes, then focused on the adviser. amazing-monkey-face

“You’ve always told me that clients, like me,” she said, base hiring decisions on the reputation of the individual lawyer rather than upon that of the firm at which the lawyer practices. If I heard you correctly just now, “ and she doubted anything she might have heard by that point, “the goodwill of a law firm may be an asset of the firm, rather than of its individual partners, is that right?”

“In the right circumstances, that’s correct. That’s one of many reasons why most firms operate as a pass-through entity, like a partnership, for tax purposes.” He went to the shelf behind his desk, and as he began to remove a volume on “choice of entity” issues, the door slammed. He turned, but the client was gone.

Who can blame her for wanting to avoid another long-winded lecture, but she should have stuck around a while longer. The message of the decision described above is not limited to the personal service business, though it is chock-full of guidance for such a business.

Taxpayers have long sought structures by which they could reduce the double tax hit that attends both the ordinary operation of a C corporation and the sale of its assets.

Many of you have come across the concept of “personal goodwill,” probably in the context of a sale by a corporation.  Some shareholders have argued that they own personal goodwill, as a business asset that is separate from the goodwill of their corporation.  They have then attempted to sell this “personal” asset to a buyer, hoping to realize capital gain in the process, and – more to the point of this post – also hoping to avoid corporate level tax on a sale of corporate goodwill.

Of course, the burden is on the taxpayer to substantiate the existence of this personal goodwill and its value, not only in the context of the sale of the corporate business, but also in the sale of his or her services to the corporate business.  The best chance of supporting its existence is in the circumstances of  a business where personal relationships are paramount, or where the shareholder has a reputation in the relevant industry or possesses a unique set of skills.

The right circumstances may support a significant compensation package for a particular shareholder-employee, either on an annual basis or in the context of an asset sale by his or her corporation.  In each case, a separate, corporate-level tax would not be imposed in respect of the portion of the payments made to the shareholder-employee.

However, before a taxpayer, hell-bent on avoiding corporate-level tax, causes his or her corporation to pay compensation in an amount that wipes out any corporate-level tax, he or she needs to be certain that the existence and value of the personal goodwill – the reasonableness of the compensation for the service rendered – can be substantiated.  The taxpayer needs to plan well in advance.

The employee-owner of a corporate business will sometimes ask his or her tax adviser, “How much can I pay myself out of my corporation?”

The astute tax adviser may respond, “First of all, you are not paying yourself. The corporation is a separate entity from you, its shareholder. That being said, the corporation can pay you as much as it can reasonably afford in light of its business needs and other relevant facts and circumstances, and subject to state corporate law requirements, depending on the nature of the payment. For example, . . .”

The client will then typically interrupt, “C’mon wise guy. You know what I mean.”

The offended tax adviser will then say, “From a tax perspective, the corporation can pay you – and deduct against its income – a reasonable amount of compensation for the personal services you have actually rendered to the corporation. Anything in excess of that amount will be treated as a dividend distribution, to the extent of the corporation’s earnings and profits. Of course, . . .”

“I know, I know,” says the client, “and a dividend is not deductible by the corporation in calculating its own taxes. Give me some credit here.”

“OK. Except in the case of a start-up, or any other situation in which the corporation cannot ‘afford’ to pay its shareholder-employees, the corporate employer will – in fact, should – pay an amount of compensation that is reasonable for the services rendered – an exchange of value-for-value, or cash for services. In the case of an S corporation –”

Another interruption.

“Does the amount depend on the nature of the business?” asks the client.

“In general, yes. In a capital-intensive business, it may be more difficult to justify a certain level of compensation than in a business that involves only personal services.

“But,” continues the adviser, let me tell you about a recent decision involving a professional corporation . . .”

And as the adviser began, the client sunk deeper into the chair, recognizing the didactic look on the adviser’s face (the one that would broach no further interruptions), wishing that she had never raised the subject, willing for her phone to ring with some emergency, to extract her from her predicament.

Oblivious to his client’s plight, the tax adviser went on, encouraged by the thought that this client really cared about what he had to share.

Once Upon A Time, . . .

“Taxpayer was a law firm organized as a corporation. During the years at issue, it employed about 150 attorneys, of whom about 65 were shareholders. It also employed a non-attorney staff of about 270. storybook

“Taxpayer’s shareholders held their shares in the corporation in connection with their employment by the corporation as attorneys. Each shareholder-attorney acquired her shares at a price equal to their book value and was required to sell her shares back to Taxpayer at a price determined under the same formula upon terminating her employment.

“Taxpayer’s shareholder attorneys were entitled to dividends as and when declared by the board. For at least 10 years before and including the years in issue, however, Taxpayer had not paid a dividend. Upon a liquidation of Taxpayer, its shareholder-attorneys would share in the proceeds.

“For the years in issue, the board met to set compensation and ownership-percentages in late November or early December of the year preceding the compensation year. Before those meetings, the board settled on a budget for the compensation year. On the basis of that budget, the board determined the amount available for all shareholder-attorney compensation for that year. With that amount in mind, it set each shareholder-attorney’s expected compensation using a number of criteria, then determined the adjustments in their ownership-percentages necessary to reflect changes in proportionate compensation. Adjustments in actual share ownership were made by share redemptions and reissuances.

“The board intended the sum of the shareholder-attorneys’ year-end bonuses to exhaust Taxpayer’s book income. Shareholder-attorneys shared in the bonus pool in proportion to their ownership-percentages. Specifically, Taxpayer calculated the year-end bonus pool to equal its book income for the year after subtracting all expenses other than the bonuses. Thus, Taxpayer’s book income was zero for each year: its income statements showed revenues exactly equal to expenses.”

The client carefully placed the second toothpick at the corner of her right eye. “Great,” she exhaled, “that should do it. Sure hope he’s near-sighted.”

At that point, the adviser glanced over at the client, who seemed to be listening intently, her eyes wide open. Pleased with himself, he continued.

Compensation, Or Something Else?

“Taxpayer treated as employee compensation the amounts it paid to its shareholder-attorneys, including the year-end bonuses.  In each of its tax returns for the years at issue, Taxpayer included the year-end bonuses it paid to its shareholder-attorneys in the amount it claimed as a deduction for officer compensation.

“Taxpayer’s returns reflected a relatively small amount of taxable income. Because Taxpayer’s book income was zero for each year, the taxable income Taxpayer reported was attributable entirely to items that were treated differently for book and tax purposes.”

The IRS Disagrees

“Now comes the good part,” said the adviser, his voice rising slightly.

The client hadn’t moved, yet her eyes were fixed on him, like some Byzantine icon.

“When the IRS examined Taxpayer’s returns, it disallowed the deductions for the year-end bonuses paid to Taxpayer’s shareholder-attorneys. After negotiations, the parties entered into a closing agreement that disallowed portions of Taxpayer’s officer compensation deductions for the years in issue, which portions it re-characterized as non-deductible dividends.”

The client bent forward slightly, then rocked back, as though nodding in agreement.

Encouraged by this sign of assent, the adviser continued.

“The sole issue remaining for the court was whether Taxpayer was liable for accuracy-related penalties on the underpayments of tax relating to its deduction of those portions of the year-end bonuses that it agreed were nondeductible dividends.

“The court began by stating the general rule that the Code allows a deduction for ordinary and necessary business expenses. However, in order for amounts paid as salary to be deductible, they must be paid for services actually rendered, and they must be reasonable. Ostensible salary payments to shareholder-employees that are actually dividends are thus nondeductible.

The Parties’ Arguments

“In support of its deduction of year-end bonuses paid to its shareholder-attorneys that eliminated its book income for the years in issue, Taxpayer cited a number of authorities that purportedly established that capital was not a material income-producing factor in a professional services business.

“The IRS claimed that amounts paid to shareholder-employees of a corporation did not qualify as deductible compensation to the extent that the payments were funded by earnings attributable to the services of non-shareholder-employees or to the use of the corporation’s intangible assets or other capital. The IRS said that amounts paid to shareholder-employees that are attributable to those sources must be nondeductible dividends.

“Taxpayer responded that any ‘profit’ made from the services of non-shareholder-attorneys could justifiably be paid to its shareholder-attorneys in consideration of their business generation and other non-billable services.”

The adviser turned toward the window. “I hope he jumps,” was the first thought that occurred to the client. No such luck – he only opened it a crack.

“It’s a bit stuffy in here,” he said, as if to himself, clearly not expecting a response.

“You have no idea,” she whispered under her breath.

“What’s that?”

“I said I have no idea where this is going.”

Stay tuned for Part II, tomorrow, to find out!

There is nothing like an old proverb to remind you of the obvious. Unfortunately, too many taxpayers need to be reminded all too often. It’s one thing when the reminder comes from the taxpayer’s own advisers – at that point, the taxpayer may still have an opportunity to “correct” his or her actions. It is a very different thing, however, when the reminder comes from the IRS or from a court.

Imagine being the taxpayer to whom the Tax Court directed the following statement:

There is no doubt [a taxpayer] is entitled to benefit from his hard work. However, there is also no doubt that it was [the taxpayer’s] choice to structure the payments in a certain manner. He now must face the tax consequences of his choice, whether contemplated or not.

Corp. was a closely-held C corporation, the issued and outstanding shares of which were owned 85% by Dad (together with Corp., the “Taxpayers”) and 5% each by Mom (together with Dad, the “Shareholders”) and their two daughters, all of whom sat on Corp.’s board of directors and served as corporate officers.

Dad was employed full time as the president and CEO of Corp. In that capacity he had final decision-making and supervisory power over all business matters, including compensation and tax return preparation and approval. As it often happens in small-to-medium size businesses, Dad had to be a jack of all trades and ended up performing the work of three to four individuals.

“It Was A Very Good Year”

Corp. never declared a dividend. The Taxpayers explained that, historically, they kept any excess cash in the business in order to fund its expansion, instead of paying it out as compensation or dividends.

During the tax years at issue, Corp’s business was more profitable than usual. As a result, Dad received not only his base salary, but Corp. also paid him a significant bonus. In fact, his total reported compensation for those years was more than three times his reported salary in prior years. These were also the first years that Corp. had paid bonuses.

 Also during these tax years, Corp. paid for materials and labor in connection with the construction of several structures on land owned by the Shareholders, including a new personal residence for the Shareholders and a barn (the “Barn”). amex corp

The Barn housed Dad’s office, which he used for both business and personal purposes. In addition, the Shareholders used a part of the building to store their personal vehicles and some Corp. vehicles. There was no lease or other written agreement for the use of the Barn between the Shareholders and Corp.

In addition, during the same tax years, Corp. paid and reported on its books as cost of goods sold personal credit card charges on the Shareholders’ behalf. Corp. never recorded these amounts as compensation for Dad and Mom on its books.

Finally, Corp. paid for the purchase of a sports car (“Car”) to which Dad took title in his individual capacity, explaining that this was because Corp.’s business insurance would not permit it to insure the Car. Corp. claimed depreciation deductions for the Car. The Taxpayers, however, did not produce any records or other evidence associated with the alleged business use of the Car. Corp. did not report the amount paid for the car as compensation to Dad.

IRS vs. Taxpayer

According to the IRS, the construction costs of the Shareholders’ house and the Barn, the personal credit card bills, and the purchase of the Car were personal expenses paid by Corp. The IRS argued that these amounts should be treated as a constructive dividend to the Shareholders and, thus, nondeductible to Corp. The IRS also argued that Corp. could not deduct depreciation for the car because it was Dad’s personal property.

The Taxpayers disagreed and petitioned the Tax Court for relief.

The Taxpayers admitted that they “mistakenly” reported the house construction expenses as cost of goods sold, and they conceded that the Corp.’s credit card payments were for personal expenses of the Shareholders.

They argued, however, that the Barn and the Car were capital assets owned by Corp. The Taxpayers contended that the Barn was a storage facility that belonged to Corp., and that any expenses related to that facility should be treated as business-related. They claimed that they used the facility to store Corp.’s vehicles.

However, the IRS pointed out that the Shareholders also used it to store their personal vehicles. Dad had one of his offices in the Barn, and he admitted to using it for both business and personal purposes. The title to the land on which the Barn was constructed belonged to the Shareholders, and the Taxpayers did not introduce any documents containing an agreement between the Shareholders and Corp. as to the use of the land or the ownership of any structures on that land. The only testimony Taxpayers introduced on the subject of the Barn’s ownership was Dad’s, and he did not shed any light on the title to the property or other arrangements with Corp. that would allow the Court to conclude that the Barn was used for legitimate business purposes. Thus, the Taxpayers failed to meet their burden of proof, and the Court concluded that the expenses paid by Corp. to construct the Barn were personal expenses of the Shareholders.

Next, the Taxpayers argued that the Car was an asset that belonged to Corp. and that was used for business purposes, namely, as a means of transportation for Dad between various Corp.   worksites. The IRS argued that because the title to the vehicle was in Dad’s name alone and Taxpayers did not introduce any evidence of the business use of the vehicle such as travel logs detailing date, mileage, and business purpose for the use of the Car, it must be a personal expense of the Shareholders. As a result, the Taxpayers failed to meet the burden of proof to show that Corp. purchased the Car for business purposes.

The Court’s Analysis

Gross income includes all income from whatever source derived unless otherwise specifically excluded. The definition of gross income broadly includes any instance of undeniable accession to wealth, clearly realized, and over which the taxpayer has complete dominion and control.

The IRS argued that the income the Shareholders received in the form of a “distribution” of corporate property was a constructive dividend. The Taxpayers, in turn, argued that the payments should be treated as compensation to Dad for the prior years of service when he was underpaid. Under both theories, the Shareholders would have been required to include the amounts received as ordinary income for the tax years at issue.

It should be noted, however, that if the Taxpayers prevailed, Corp. may have been able to deduct the amounts paid as an ordinary and necessary business expense, provided the amounts represented reasonable compensation. The Shareholders, however, could potentially have benefited from the lower tax rate on qualified dividend income.  Moreover, dividend treatment would have avoided the imposition of employment taxes.


The Code allows a taxpayer to deduct payments for reasonable compensation for services when incurred as ordinary or necessary business expenses during the taxable year.  Whether amounts are paid as compensation turns on the factual determination of whether the payor intends at the time that the payment is made to compensate the recipient for the services performed. Only if payment is made with the intent to compensate is it deductible as compensation. The relevant time for determining the intent is when the purported compensation payment is made, not when the IRS later challenges the payment’s characterization. The taxpayer bears the burden of proof as to intent to compensate.

According to the Court, the record did not support the Taxpayer’s assertion that Corp. intended the payments for the construction of the house, the Barn, credit card bills, and the Car to be compensation. The only evidence the Taxpayers introduced to prove compensatory intent was Dad’s “self-serving testimony,” as Corp.’s CEO and majority shareholder, that he always intended the payments as compensation for his services in prior years. The Taxpayers did not introduce into evidence any board resolutions that addressed the payment of compensation to Dad. Absent such evidence, the Court could not conclude that Corp. “intended an action not reflected in its corporate documents.”

The Court stated that it did not question Dad’s business decision to keep the money in the business instead of paying himself a higher salary. Because of his efforts, Corp’s business grew substantially—as did his compensation. However, on the record, the Court was convinced that the payments in question were not intended as compensation for services at the time they were made. Dad tacitly approved running the personal expenses at issue through the corporate accounts and recording them as cost of goods sold. Corp. did not report these expenses as compensation either on its books or on its tax return for the years at issue. Nor did Corp.  pay payroll taxes on these amounts. The Shareholders did not report these amounts on their tax return at all, and did not inform their tax preparer that they considered these payments compensation.

It seemed clear, the Court stated, that the Taxpayers played “tax audit roulette” by trying to hide the expense payments and pay as little tax as possible.

Under the circumstances, the Court concluded that Corp. did not intend to compensate Dad for his services at the time it paid the expenses in question. Thus, these amounts were not compensation for prior services that could be deducted by Corp. In addition, Corp. was not entitled to a depreciation deduction for the car because it was Dad’s personal property and the Taxpayers did not introduce any evidence of the business use of the car.


The Court then considered whether the payment by Corp. of the Shareholders’ personal expenses was a constructive dividend. If a distributing corporation has sufficient earnings and profits, the Court stated, the distribution is a dividend, and a shareholder must include it in gross income. [IRC Sec. 301 and 316]. A constructive dividend is a payment or economic benefit conferred by a corporation on one of its shareholders. A constructive dividend may arise through a diversion or conversion of corporate earnings and profits, or through corporate payments to third parties at the direction of shareholders. Whether corporate expenditures constitute a constructive dividend is a question of fact. The amount of the constructive dividend is equal to the fair market value of the benefits received.

In the years at issue, Corp. had sufficient earnings and profits to declare a dividend to its shareholders. Because Dad, as Corp.’s CEO and majority shareholder, had the ultimate control over Corp.’s dealings, he was able to divert corporate funds to pay his personal expenses. Moreover, he approved the payment of those expenses out of the corporate funds. These facts fit squarely into the definition of a constructive dividend.

When Will They Ever Learn?

Every tax adviser has encountered a situation like the one described above. That is because almost every business owner, to some degree, diverts business profits to the payment of a personal, non-business expense. Businesses sometimes pay for personal credit card expenses, residential property taxes, club dues, personal cars, trips, etc. They provide no-show, paying jobs for family members. They over- or under-pay related businesses for services or property.

It is also a fact that many business owners believe that their gambits will never be discovered, especially during a period that has seen Congress basically eviscerate the IRS’s enforcement budget.

Yet, as many tax advisers see every day, taxpayers do get “caught,” whether as a result of traditional IRS audit activity, the analysis of information collected through data mining using new technologies, increased state tax enforcement activity, whistleblowers, or other means.

The guiding principle, as always, should be the following: how would you conduct business with an unrelated third party? Would you charge a reasonable fee and expect to be paid only a reasonable fee? What would you do to determine the reasonableness of a payment? Would you insist that the arrangement between you be properly authorized and memorialized?

Within these parameters, there are many legitimate business and personal goals that a business owner can accomplish without necessarily weakening his or her position vis-à-vis the IRS. One need only ask how.