Shareholder-Employee Compensation: Defending Reasonability in Closely Held C-Corporations

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The “reasonable compensation” issue is in the news again and has been mired in controversy since its origin as part of the Revenue Act of 1918!

Future planned economic tax stimulus and infrastructure spending may mean more C-corporation profits in your construction business along with increased owner compensation. In the recent tax case involving Johnson, Inc. two brothers and very active owners of a $24M in 2003 to $38M in 2004 contracting company received compensation of $2.0M and $3.6M each, respectively for 2003 and 2004. The owner’s bonuses were calculated under a prior plan adopted by the board of directors that also provided for dividends to be paid if excess earnings were retained in the business. The tax court ruled against the IRS which was limiting the compensation deductions and found that the brothers’ compensation to be reasonable under the circumstances.

Why all the controversy?

Well, we can simply search for the definition of “reasonable” in an online Webster’s dictionary for the answer. We’d find that included in the definition of “reasonable” are the words “not extreme or excessive” or “fair”. So there we have it; for all of us Parents out there, how many arguments have we endured when deciding whether something is “fair” or not?

Congress, in its infinite wisdom with no clear explanation why, set the stage for many years of costly litigation by injecting subjectivity in the tax code with this “reasonable compensation” clause. In its wake leaving the IRS, the tax court and appellate levels to argue with taxpayers in the quest of determining what is “reasonable or fair” compensation. The ultimate “Parent”, the US Supreme Court, has decided not to get involved in this mess Congress created.

What’s in it for the IRS in a Closely Held C-Corporation Context?

In the closely held C-corporation context, shareholder-employees generally prefer to receive deductible compensation instead of nondeductible dividends in order to mitigate the effect of double-taxation.

For example, a C-corporation is taxed once on its income and its shareholders are again taxed when its undistributed earnings are actually distributed as a taxable dividend; thus paying out most of the profits as a bonus results in less taxes in the long run if those profits are needed by the owners. As a result, compensation arrangements between shareholder-employees and their corporations often include significant salaries and substantial bonuses. In order for these salaries and bonuses (and whatever other “perks” the shareholder-employee is provided) to be deductible against the company’s taxable income, they must be considered reasonable in relation to the services being rendered by the shareholder-employee.

IRS and courts struggle with what’s reasonable

Since the statute and IRS regulations do not contain any “bright-line” test for determining whether compensation paid to a shareholder-employee of a closely held C-corporation is reasonable or fair, the IRS has been forced to make its determination based on an analysis of the taxpayer’s specific facts and circumstances in light of all the many, many years of relevant case law. A time-consuming and costly exercise for all parties involved!

The IRS and the courts generally have taken one of two approaches in determining whether compensation paid to a shareholder-employee of a closely held C-corporation is reasonable. The first approach is a multi-factor approach, derived mainly from Mayson Manufacturing Co. v. Commissioner, and Elliotts, Inc. v. Commissioner. The second approach is a single-factor approach, based on what is referred to as the “independent investor” test. This latter test is derived mainly from Exacto Spring Corp. v. Commissioner. The specific approach applied depends on the Circuit in which the taxpayer resides.

In Mayson, the Sixth Circuit identified the following nine different factors to consider in determining whether compensation is reasonable, with no single factor being determinative:

  • The employee’s qualifications.
  • The nature, extent, and scope of the employee’s work.
  • The size and complexity of the employer’s business.
  • A comparison of salaries paid with the employer’s gross income and net income.
  • Prevailing general economic conditions.
  • A comparison of salaries with distributions to stockholders
  • Prevailing rates of compensation for comparable positions in comparable businesses.
  • The employer’s salary policy as to all employees.
  • The amount of compensation paid to the employee in prior years (for small corporations with a limited number of officers).

In Elliotts, the Ninth Circuit listed the following five factors to consider when determining whether compensation in a closely held corporation is reasonable:

  1. The employee’s role in the company.
  2. External comparison with other companies.
  3. The character and condition of the company.
  4. Conflict of interest.
  5. Internal consistency.

In Exacto, the Seventh Circuit found the multi-factor test unacceptable and in its place adopted the “hypothetical independent investor” test, measured via return on equity, as the only criterion that should be considered in determining the amount of reasonable compensation. The court cited five reasons for shunning the use of the multi-factor approach:

  1. The multi-factor test provides no clear rule as to how the many factors should be weighted; citing many factors as being “vague”.
  2. The factors do not have a clear relationship to each other or to the primary purpose of the code, which is preventing dividends from being disguised as salary.
  3. The multi-factor test would require the court system to become a “super-personnel” department for closely held corporations, having to decide what employees should be paid on the basis of the judges’ own ideas of what jobs are comparable; a role that “[t]he judges of the Tax Court are not equipped by training or experience…”.
  4. The multi-factor test does not determine a numerical amount for reasonable compensation, allowing for arbitrary decisions as to what’s reasonable compensation.
  5. Since the courts can be unpredictable with respect to reasonable compensation cases, closely held corporations have no clear guidance on how to set compensation levels

Conclusion

Well, it appears that the IRS and the courts over the years have done the best they could with the cards Congress dealt them back in 1918. Until either the US Supreme Court decides to play referee or our friends in Congress decide to legislate some form of “bright line” test, there appears to be no end in sight for costly litigation around the “reasonableness” determination.

So what can your company do to increase the odds of sustaining its compensation arrangements?

1. No different than many other issues in the tax arena, robust documentation of your compensation arrangement can certainly help carry the day. It is highly recommended that closely held corporations have written policies in place that provide an objective basis for how compensation and bonuses are determined for both shareholder and non-shareholder employees (e.g., compensation formulas should be consistently used for all compensation decisions, bonuses should not be allocated in proportion to stock ownership, salary and bonus payments should not cause a loss or negative retained earnings.).
2. Engaging the services of a reputable accounting firm specializing in the construction industry that has the expertise and information available to assist with compensation planning, benchmarking, investor tests and dividend studies.
3. An appropriate level of transparency is recommended in communicating compensation decisions in annual board meetings. It would be advisable to record these conversations in board minutes and maintain a record of all compensation decisions for all employees. Additionally, the minutes should document the rationale for paying, or not paying, dividends.

For more information on the topics discussed or services we can provide to assist with documentation or recommended plan design, please contact:

Paul Helderman, CPA, MST, Partner Paul Helderman, CPA, MST, Tax Partner
T (973) 898 9494
phelderman@withum.com
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Paul Helderman

Louis Sandor III, CPA, CCIFP®, Partner Louis Sandor III, CPA, CCIFP®, Partner
Practice Leader, Construction Services
T (732) 842 3113
lsandor@withum.com
View Experience

Louis Sandor

To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

Shareholder-Employee Compensation

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