The IRS salivates over the prospects of unreasonable compensation to the employee/shareholder--no deduction to the corporation; dividend to the employee/shareholder. For planning and defense purposes, the tax practitioner must know the extensive criteria established in Court decisions and the most relevant characteristics used in making settlements.

With the demise of the tax shelter and the redirecting of IRS attention, the practitioner is more likely to face the issue of reasonable compensation when providing services to a closely-held corporation. Any disallowed unreasonable portion of compensation paid to a stockholder will be deemed a dividend to the recipient and generate an addition to the corporation's taxable income. Disallowance of a portion of the compensation deduction may then result in adjustments to claimed qualified plan contributions, modification of withholding taxes, penalty and interest accruals, and the potential for an accumulated earnings tax issue. The aggregate effects of a disallowance can be devastating.

Recent judicial standards are reviewed in this article to provide the practitioner with a concise reference tool for use in justifying a compensation deduction.

THE STARTING POINT IS

QUITE SIMPLE

The concept of reasonable compensation finds its origin in Sec. 162(a)(1), which provides:

"...a taxpayer may deduct ordinary and necessary business expenses, including a reasonable allowance for salaries and other compensation for personal services actually rendered."

This definition was expanded by Reg. Secs. 1.162-7(a), (b)1 and (3) to require that the amount claimed be solely for services and that it be reasonable, i.e., limited to the amount that would ordinarily be paid by an enterprise under like circumstances.

Because the determination of reasonable compensation is purely subjective under the statute, taxpayers and the IRS locked horns at an early stage with respect to this issue. Numerous situations arose where taxpayers presented compelling evidence substantiating a claimed deduction, yet were unsuccessful throughout the IRS's administrative process. It became clear that taxpayers and practitioners faced ancillary issues such as personal opinion and bias at the administrative level. Generally, it was only through expensive and time consuming court proceedings that taxpayers could ultimately prevail. Case law quickly developed, establishing both qualitative and quantitative precedents to be considered.

CASE LAW DEVELOPMENT

Most areas of the tax law saddle the taxpayer with the burden of proof on a particular issue. However, in the area of reasonable compensation, this concept has been modified to the taxpayers' benefit by judicial precedent. Initially, there is a presumption that the IRS's determination concerning a compensation issue is correct. The taxpayer is then given the opportunity to present proof to substantiate the claimed deduction. When the taxpayer introduces uncontradicted, unimpeached testimony from well qualified, impartial witnesses sustaining its compensation deduction, the burden of proof shifts to the IRS. 1 Thus, the taxpayer has the ability to turn the tide in this highly subjective area.

Many tax court rulings have required that reasonable compensation paid to an employee be determined in accordance with the particular facts and circumstances of each case, 2 evaluated on a year-by-year basis. Therefore, an allowance or disallowance in any given year does not in itself provide precedent for other years. The courts have developed a litany of factors, through a variety of different cases, to be used by taxpayers and the IRS in the analysis of compensation issues. One of the first cases to provide comprehensive criteria was Mayson Mfg. Co. v. Commr., 49-2, USTC para. 9467, 178 F2d. 115 (6th Cir. 1949). The factors enumerated by the court for consideration included:

* Employee qualifications;

* Nature, extent, and scope of employee's work;

* Size and complexities of the business;

* Comparison of salaries paid with gross and net income of the business;

* Prevailing economic conditions;

* Comparison of salaries with distributions to stockholders;

* Prevailing rates of compensation for comparable positions in comparable concerns;

* Salary policy of taxpayer as compared to all employees; and

* In small corporations with limited officers, the amount paid to the particular employee in prior years.

Over the years, courts consistently made reference to many of these criteria when analyzing compensation issues, expanding, modifying, or eliminating some as years passed. In 1983, the tax court considered yet another case in this area--Elliotts Inc. v. Commr., 40 TC 80Z Dec 37,110(n), TC MEMO 1980-282. In Elliott, the Tax Court determined that a portion of the compensation paid the corporation's CEO and sole shareholder was a dividend distribution and not deductible under Sec. 162(a)(1). In remanding this case to the Tax Court, the Circuit Court of Appeals presented an in-depth analysis of five criteria it considered most relevant in its evaluation of Elliott's compensation (83-2 USTC para. 9610,715 2d. 1241 9th Cir. 1983). The 9th Circuit Court determined that the Tax Court erred in its approach by finding that a disguised dividend had been paid to the sole shareholder. However, upon rehearing, the Tax Court reached the same conclusion that it was unreasonable for the shareholder to retain 50% of the net profits and compensation. (48 TCM 1245 Dec 41,520(n), TC Memo 1984-516).

The taxpayer, an Idaho corporation, sold and serviced equipment made by John Deere and other manufacturers. The corporation operated in two locations and was one of three dealers that sold both agricultural and industrial equipment. There were only approximately 170 dealers of agricultural equipment at the time. The taxpayer began business in 1952, generating gross sales of approximately $500,000 and employing eight people during its initial year. By 1975, sales exceeded $5 million and the corporation employed 40 people. Edward G. Elliott, the sole shareholder and CEO from inception of the company, possessed total managerial responsibility. He established corporate policy and worked an average of 80 hours per week. The company established a recurring compensation policy calling for a fixed salary of $2,000 per month plus a year-end bonus. The bonus formula called for a lump-sum payment equal to 50% of the corporation's net profit before taxes and other management bonuses. Total compensation as paid to Elliott and claimed in the returns amounted to $181,074 and $191,663 during fiscal 1975 and 1976. No dividends were paid since the inception of the corporation. The Commissioner limited Elliott's compensation in each of the years in question to $65,000. The Tax Court, after review, allowed $120,000 and $125,000, respectively.

While these salary levels pale in comparison with today's experience, the following factors considered by the Circuit Court of Appeals are still relevant:

* Employee's role in the company;

* External comparisons;

* Character and condition of the company;

* Conflicts of interest; and

* Internal consistency.

These criteria have been used consistently by the courts in formulating an organizational framework. Because Elliott has become a dominant precedent in this area, a thorough discussion of each of the criteria is warranted.

Role in the Company

An employee's role in a company can be quite broad. Some considerations include: the position held by the employee, the number of hours worked, duties performed and the employee's relevant experience and education. Areas in which the practitioner may find arguments to fortify a compensation deduction include the following:

* Functions performed by the employee, including multiple roles within the company, e.g., sales, production, accounting;

* Number of hours worked;

* Special skills and/or education;

* Personal dedication and devotion to the job;

* Integration with the management team;

* Relationship with business clientele;

* Personal guarantees of loans advanced to the business, if any; and

* Acting in the capacity of trustee for any company sponsored qualified plans, if applicable.

Outside testimony in the form of letters and affidavits shoul be obtained where possible to corroborate each of the aforementioned.

External Comparison

The external comparison criterion attempts to establish a common ground from which compensation can be adjusted for factors unique to the closely held corporation. Making reference to facts and circumstances outside the company can either support or undermine a closely-held corporation's salary policy.

The most common external comparison is the salary survey. It is quite common for practitioners and the IRS to present surveys in developing their positions. Surveys must be relevant to the situation at hand. For example, a salary survey of Fortune 500 CFOs has little or no relevance to salaries paid to the president of a midwest manufacturing company grossing $4 million. In evaluating the relevance of a survey, the practitiooner should consider the size and location of the company and the industry in which it operates. In many circumstances, both the taxpayer and the IRS present survey information. It is quite possible that both surveys are credible, yet they paint two separate and distinct pictures. In such a situation, the courts have generally discounted the use of the surveys in making a final determination.

It may be possible to compare salaries of competitors within the same industry. This form of comparison is generally very difficult to make because this information is not readily available; many competitors are closely-held businesses themselves and are unwilling to provide information for fear of triggering an audit or providing their counterpart with confidential information. If relevant salary and financial information cannot be obtained, the practitioner should consider contacting trade associations or similar organizations within the taxpayer's industry. If the entity under examination is a franchise, the franchisor may be able to furnish the practitioner with useful data.

When analyzing external factors, the number of jobs that the individual is performing must be considered. It is quite common for the owner of a closely-held business to perform tasks that two or three individuals would generally handle in another company. In such a situation, the combined salaries of the comparison company would be used for analysis purposes.

Comparisons can also be made to precedent case law in limited circumstances. Where a case has similar facts and circumstances, its result can be applied to a current situation to support a compensation deduction. Compensation determined in the case can be adjusted upward or downward using published cost of living indices.

Character and Condition of

Company

This criterion examines the environment in which an entity operates. Approaches include establishing and documenting the size and reputation of a company, measured in terms of sales, net income and capital value. Also relevant are the complexities of the business and past and present economic conditions.

Comparison again plays an important role in establishing this factor. Items indicative of the company's condition include the following:

* Reputation in the industry;

* Nature of clientele or client list;

* Offers from potential acquirers; and

* The company's performance as measured against industry standards, for example, common size financial statements, published ratios, etc.

Conflicts of Interest

Relationships between a corporation and its controlling shareholders are considered potentially exploitable relationships. However, the mere existence of such a relationship does not in itself automatically taint a deduction for compensation. Other factors must be considered to fully evaluate the relationship. These factors include the following:

* Salary structure as compared to similar ompanies, taking into account multiple tasks and job responsibilities;

* Operating ratios of the entity as compared to industry norms;

* Dividend history of the company; and

* Hypothetical investor analysis.

Of these four factors, two warrant further discussion. The first is the company's dividend history. It should be pointed out that the absence of dividends does not automatically create a presumption of unreasonableness. The automatic dividend notion was eliminated by Rev. Rul. 79-8, 1979-1 C.B. 92. Lack of, or insubstantial, dividend payments could be the result of legitimate business decisions, such as restrictions mandated by loan agreements with banks, or the necessity to accumulate working capital to finance business operations. When making an argument for the accumulation of working capital, care should be exercised to avoid potential exposure to an accumulated earnings tax issue.

In applying the hypothetical investor factor, compensation paid to a shareholder or family member must be evaluated from the perspective of a hypothetical independent shareholder. If corporate earnings are being drained, leaving little or no residual profits, an investor would most likely disapprove the existing compensation arrangement. This premise assumes that an investor expects a reasonable return on investment, either in dividends or capital appreciation. Thus, if the corporation's residual profits are maintained at a level that would satisfy an independent investor, there is a compelling indication that management has received suitable remuneration and that profits are not being extracted under the guise of compensation.

In situations where the corporation has suffered losses or cannot provide a proper return on investment, a practitioner must exercise care in developing a strategy. It is possible that the IRS can use these facts against the taxpayer in situations where compensation deductions were in fact reasonable. A practitioner faced with this situation should consider using an independent expert to assist in an analysis of the company's operating history and related compensation and profit trends.

Internal Consistency

Inconsistency in the corporation's salary structure may indicate that a portion of such payments go beyond compensation and should be construed as distributions of corporate profits. Conversely, proof of a long established, consistently applied compensation arrangement provides evidence that compensation paid should be considered reasonable. Bonuses that have not been granted under a formalized, structured, and consistently applied program will be suspect. 3 Similarly, compensation arrangements that tie bonuses to a shareholder's percentage of stock holdings or to a specified tax benefit, e.g., available surtax exemption amounts, will also be looked at critically.

The consistency criterion assumes that a long standing compensation formula or arrangement applied consistently results in an averaging of compensation over a period of years. Formulas may overcompensate in good years and undercompensate in lean ones. In the case of undercompensation,

TABULAR DATA OMITTED

it has been long established that a taxpayer can pay and deduct compensation for services performed in prior years. 4 This analysis assumes that there are no material changes in the circumstances and conditions in which the entity operates. Formulas that were reasonable at the onset may prove unreasonable in later years due to a change in circumstances. Compensation arrangements must also be evaluated in concert with the return on investment tests previously discussed.

If a taxpayer has used a formula to calculate compensation deductions, the practitioner should attempt to establish that, over the long run, such a formula reasonably compensated for work done, the performance achieved, the responsibility assumed, and the experience and dedication of the employee. At the same time, the formula should not stand in the way of a satisfactory return on equity. 5

Tax Planning

As with most areas of the tax law, reasonable compensation issues can be avoided or minimized through proper planning at the time the compensation decisions are being made. Some pointers the practitioner should observe include the following:

Insure that compensation decisions are properly documented in written board of directors minutes. Comparisons to industry guidelines, operating ratios, salary surveys (where available), and a description of the individual's contribution to the company should be included. Formal employment agreements should be executed describing the duties, tasks and responsibilities of the individual, and how compensation will be determined and paid.

Fully document the company's dividend history and the manner in which dividends were determined. If the company has not paid dividends, include specific reasons for this fact, e.g., future expansion needs, bank restrictions, etc. This documentation will also help thwart any potential accumulated earnings tax issues.

Avoid, to the extent possible, lump sum bonus payments near year end when profit information is readily available. Compensation should be spread out ratably to the extent feasible.

Fully document contingent compensation arrangements. The compensation should not be in proportion to stock ownership and the policy should be applied to non-shareholders where at all possible.

Consider salary repayment/hedge agreements. Under this type of arrangement, an agreement is drafted between the shareholder/employee and the corporation requiring that any disallowed, previously deducted compensation be repaid to the corporation. The repayment generates a deduction to the employee/shareholder, thereby mitigating the double taxation effect of the original disallowance.

Many practitioners feel that this form of an agreement raises the probability of compensation being deemed unreasonable. The IRS is likely to argue that there was a pre-existing notion that the compensation claimed had exceeded the reasonable level. Repayment agreements entered into subsequent to the compensation arrangement further strengthen the IRS's position. 6 Where taxpayers have prevailed using repayment arrangements, the agreements were exercised contemporaneously with the compensation agreement before the corporation became actively engaged in business. 7 Careful planning before the fact is required with this form of an agreement.

Consider electing S status. S corporation status will generally eliminate any potential reasonable compensation issues. Salary payments to a shareholder/employee in excess of what is deemed reasonable would be considered a distribution taxed in accordance with the S corporation distribution rules. Pension, profit-sharing, and other benefits based on compensation may still be affected, however.

Some taxpayers have taken a reverse approach by taking little or no salary and treating all payments as distributions. The primary objectives of this tactic were to avoid payment of FICA and other payroll taxes and to defer the deposit of income taxes. The IRS and the courts have stated that, in most cases, a reasonable salary must be taken for services actually rendered by an employee. (See Rev. Rul. 74- 44, 1974-1 C.B. 287, and Radtke, S.C. Joseph 89-2, USTC para. 9466 aff'd CA-7, 2/23/90.)

The IRS also has the ability to reallocate income, including salaries, among family members involved in an S corporation. Many factors, both tax and non-tax, must be reviewed before an S election is made.

FACING THE MINEFIELD

After more than 40 years of case law development, the area of reasonable compensation remains a minefield. A thorough evaluation of judicial precedents indicates that the practitioner must possess a sound understanding of the criteria upon which reasonable compensation decisions are based. Proper planning before the fact, coupled with appropriate documentation along the way, will in many instances avert a reasonable compensation issue.

1 Roth Office Equipment Co. v. Gallagher, 49-1, USTC para. 9165, 172 F2d. 452 (CA-6) and Mills Supply Corp. v. Commr., 49-1, USTC para. 9193, 173 F2d. 572, (CA-6).

2 Pepsi cola Bottling Co. of Salina, Inc. v. Commr., 76-1, USTC para. 9107, aff'd 528 F2d. 176 (10th Cir. 1975).

3 Nor-Cal Adjuster v. Commr., 30 T.C.M. 837 (1971) aff'd, 503 F2d. 359 (9th cir. 1974).

4 Ox Fibre Brush Co. v. Lucas, 281 U.S. 115 (1930).

5 Elliot's Inc. v. Commr., 716 F2d. 1241, 1244 (9th Cir. 1983).

6 Footer Sczepanski, "Current Factors Being Used to Determine When Compensation Is Deductible As Reasonable," 32 Taxation for Accountants, p. 226.

7 Plastics Universal Corp. v. commr., 39 T.C.M. 32 (1979).

Charles A. Barragato, MS-Taxation, CPA, is an Assistant Professor of Accounting at the C.W. Post School of Professional Accountancy at Long Island University. He is Partner in the accounting firm of Kreitzman, Barragato & Kreitzman. Mr. Barragato has written and lectured extensively on taxation subjects.