Friday, March 26, 2021
A “hot-button” audit issue for S corporations involves the issue of “reasonable compensation” for shareholders. Compensation is also an important issue in the C corporate context. While in the S corporate context the temptation is to set compensation too low, the concern is just the opposite when a C corporation is involved.
But, what is “reasonable compensation”? Why does it matter?
Compensation issues in the C corporation context – it’s the topic of today’s post.
The Basic Problem
A corporate-level deduction is allowed for “reasonable” salaries and compensation paid to employees for their personal services. Because of the dual-level taxation associated with C corporations (on corporate income when earned and again when paid as dividends) C corporations have an incentive to pay larger than normal salaries so as to reduce their taxable income and get corporate earnings to owners with only one level of tax. But, the IRS can challenge what it deems to be “excessive” salaries as disguised dividends resulting in a loss of a corporate deduction from taxable income and the addition of the “excessive” amount to the corporation’s net taxable income. Conversely, in certain situations, corporate employees may receive only a nominal salary in an attempt to minimize FICA and Medicare taxes. Upon audit, IRS may increase the salary with the result that FICA and Medicare tax will be due, plus interest and penalties. Another problem associated with setting salaries too low is that the corporation could be assessed for payroll taxes on the unreported compensation. The penalties and interest associated with unreported compensation are often greater than an income tax deficiency assessment. The quarterly payroll deposit rules will typically have been violated, resulting in cascading penalties that include the failure to timely deposit and failure to properly report.
What is a “Reasonable” Salary?
Corporate salaries must be “reasonable” in light of the personal services that are actually rendered. I.R.C. §162(a)(1). However, “reasonable” is not defined in the Code, and the Regulations provide only that “reasonable compensation is an amount paid for like service by like enterprises under like circumstances.” Treas. Regs. §§1.162-7(b)(3) and 1.1366-3(a). Thus, the facts and circumstances of each particular situation are determinative of the outcome. The courts, in numerous cases involving the issue, have set forth several factors to be used in determining the reasonableness of salaries, including. Likewise the IRS Audit Manual utilizes the same factors.
The factors are as follows:
- The level of the salary in light of the employee’s qualifications
- The compensation paid in light of the nature and extent of the employee’s work, with consideration paid to the role that the shareholder plays in the corporation (e.g., the employee’s position, number of hours worked and duties performed)
- How the compensation compares to compensation paid for similar services by similar entities
- Whether the compensation is reasonable in relation to the salary history of the corporation
- Whether the compensation is reasonable in light of the character and financial condition of the corporation
- Whether a hypothetical, independent investor would conclude that there is an adequate return on investment after considering the shareholder’s compensation
- The size and complexity of the business
- How the amount of salaries paid compares to corporate sales and net income
- General economic conditions
- How the amount of salaries compare to shareholder distributions and retained earnings
- The corporation’s dividend history
- Whether the employee and employer dealt at arm’s length
- Whether the employee guaranteed the employer’s debt
- Whether there has been a “catch-up” element involved where the corporation is making up for years when the employee was under paid
- Whether the corporation has developed compensation policy for employees allowing them to participate in the company’s success
The cases confirm that no single factor controls. Instead, a combination of the factors must be considered. In addition, the factors are not all inclusive and may not be given equal weight. Fewer or additional factors may be appropriate, depending on the surrounding facts and circumstances.
What’s “reasonable compensation” for an owner of a closely-held farming or ranching operation? The answer to that question depends on how the factors listed above apply to the facts and circumstances of the particular situation.
Tax Planning Strategy
As a tax planning strategy, before year-end, each shareholder/employee’s compensation should be reviewed for reasonableness and increased by payment of a year-end bonus if needed. While reasonableness is based on the facts and circumstances, compensation can often be set at the low end of a wide salary range that is both reasonable and supportable. The better the documentation explaining why wages and bonuses are appropriate, the more likely that the payments can withstand IRS attack.
Consider the following example:
Joe starts up an accounting practice, and employs Blake and Terry. Joe operates as a personal service corporation. The firm has a successful first year, generating an extra $300,000 in corporate net income. Joe declares a bonus for himself in the amount of $300,000, which eliminates the corporation’s taxable income. However, $200,000 of the $300,000 in additional income was generated by the efforts of Blake and Terry. Joe actually spent a couple of months of the year taking a sabbatical in the north woods of Minnesota playing his ukulele for the animals that would listen and giving a break to Blake and Terry from his dry humor. Joe claimed he continued to “manage’ the practice from his remote location.
The IRS would likely take the position that the extra time and effort expended by Joe in managing the accounting practice is, at best, a nominal factor to be taken into account when a large portion of the income is based on the services rendered by other employees. So, IRS would likely conclude that $200,000 of net income paid to Joe is actually a non-deductible dividend to Joe. The resulting additional corporate income is taxed at the 21 percent rate applicable to personal service corporations. The result would be an added tax liability of $42,000.
Joe could elect to have the company taxed as an S corporation. Joe would then refrain from declaring and paying the $300,000 bonus to himself, instead picking it up as an S corporation distribution which is taxed to the shareholders on a pro rata basis. But, if Joe does this, IRS could examine the $300,000 paid as an S corporation distribution to determine whether it actually should be treated as compensation to Joe. If all or a portion of the $300,000 is deemed to be compensation, Social Security and Medicare tax will be assessed on the amount deemed to be compensation. Also, with an S election, if Joe were to set his compensation at the amount of the maximum for qualified retirement plan funding, with the balance of corporate net income structured as an S corporation distribution, that would avoid Medicare tax on the amount of the S corporation distribution. IRS, however, would likely examine that scenario to determine whether the compensation amount is too low.
There have been numerous prominent cases on the issue of reasonable compensation. A particularly high-profile one involved the founder and CEO of Menards, a chain of “home improvement” stores located in the Midwest.
In Menard, Inc. v. Commissioner, 560 F.3d 620 (7th Cir. 2009), the IRS challenged the $20 million salary of a corporate CEO (who was also a shareholder/employee that worked full time and owned all of the voting stock and 56 percent of the non-voting stock) as unreasonable. The compensation plan for the CEO included a base salary, a profit-sharing plan and a bonus plan that had been in place since 1973. Over $17 million of the total amount was paid in accordance with a bonus plan that had been in place since 1973. The bonus was tied to 5 percent of the corporation’s net income before taxes. The Tax Court disallowed all but $7 million of the salary (after comparisons to CEO salaries of competing businesses – Home Depot and Lowe’s) determining it to be a disguised dividend. On further review, the appellate court reversed. The appellate court determined that, the under the CEO’s management, corporate revenues grew from $788 million in 1991 to $3.4 billion in 1998 (the year at issue) and the corporation’s taxable income grew from $59 million to $315 million during the same timeframe. The corporation’s rate of return on shareholder’s equity in 1998 was higher than that of either company the Tax Court used for comparison purposes. The appellate court noted that the CEO handled a large part of the duties which were normally delegated in other companies to subordinates. In addition, the fact that there was no independent Board of Directors for the corporation required the CEO to accept greater responsibility and duties that normally don’t apply to comparable CEOs. Thus, to the appellate court, the 5 percent of net corporate income did not look at all like a dividend and the appellate court held that the Tax Court committed clear error in holding that the salary was excessive. That was particularly the case, the court noted because the compensation that the Tax Court determined to be a disguised dividend was paid before a determination of the corporation’s net income for the year, and was paid on an annual basis. That meant that it was not a set dollar amount that constituted a dividend.
The appellate court was also highly skeptical of the Tax Court’s remark that the owner of a business has no need for incentive compensation because ownership is incentive enough. The appellate court reasoned that owners should not be treated differently from other managers and also stated that the Tax Court had established itself as the “super-personnel department for closely-held corporations.”
In Aspro, Inc. v. Comr., T.C. Memo. 2021-8, the petitioner was a C corporation in the asphalt paving business incorporated under Iowa law with its principal place of business in Iowa. The petitioner had three shareholders and did not declare or distribute any dividends to them during the tax years in issue (2012-2014) or in any prior year. This was despite the petitioner having significant profits before setting management fees. Thus, the shareholders didn’t receive any return on their equity investment. The petitioner did not enter into any written management or consulting services agreements with any of its shareholders. Also, there was no management fee rate or billing structure negotiated or agreed to between the shareholders and petitioner at the beginning of any of the years in issue. In addition, none of the shareholders invoiced or billed the petitioner for any services provided indirectly via other legal entities that the shareholders controlled. Instead, the petitioner’s board of directors would approve the management fees to be paid to the shareholders at a board meeting later in the tax year, when the board had a better idea how the company was going to perform and how much earnings the company should retain. But, the board minutes did not reflect how the determinations were made. The petitioner’s board did not attempt to value or quantify any of the services performed on its behalf and simply approved a lump-sum management fee for each shareholder for each year. The amounts were not determined after considering the services performed and their values. There was no correlation between management fees paid and services rendered. In total, the shareholders received management fees exceeding $1 million every year for the years in issue. The management fees were simply paid after-the-fact in an attempt to zero-out the petitioner’s taxable income.
The IRS completely denied the petitioner’s claimed deductions for management fees and amounts the petitioner claimed for the domestic production activities deduction for the years in issue. The Tax Court upheld the IRS position denying the deduction. The Tax Court determined that the petitioner failed to prove that the management fees were neither ordinary and necessary business expenses or reasonable in accordance with Treas. Reg. §1.162-7. Based on the facts and circumstances, the Tax Court concluded that the absence of the dividend payments where the petitioner had available profits created an inference that at least some of the compensation represented a distribution with respect to corporate stock. While the management fees loosely corresponded to each shareholder’s percentage interest, the Tax Court inferred that the shareholders were receiving disguised distributions based on each shareholder’s equity interest.
As for the services rendered to the petitioner via the shareholders’ controlled entities, the Tax Court noted that if the services were to be compensated, the petitioner should have invoiced directly for the services. The services, as a result, did not provide even indirect support for the management fees the petitioner paid to its shareholders. The Tax Court also noted that the management fees were not set in advance for services to be provided and there was no management agreement that supported any objective pricing that the parties bargained for. The shareholders also could not explain how the management fees were determined, and the corporate president (and one of petitioner’s board members) displayed a misunderstanding of the nature of deductible management fees and stock distributions. The Tax Court also noted that the effect of the deduction for management fees was to create little taxable income to the petitioner, indicating that the fees were disguised distributions. The Tax Court further determined that the petitioner’s president rendered no services to the petitioner other than being the president and, as such was already overcompensated by his base salary and annual bonus totaling approximately $500,000 annually. Thus, the additional management fee was completely unreasonable as to him.
Paying “reasonable compensation” in the context of closely-held corporations is critical.