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Tax

Reasonable Compensation

By William J. Cenker and Robert Bloom
November 2003
Determining what constitutes reasonable compensation is a long-standing issue for C corporations. IRC section 162(a)(1) allows a deduction for reasonable compensation for personal services actually rendered. The IRS views unreasonable salaries as disguised dividends, making them nondeductible by C corporations and taxable to the shareholder. This means employee shareholders are double-taxed on such amounts.

The courts and the IRS consider many factors in determining the reasonableness of compensation, including an individual’s qualifications, the work involved, the nature of the business, the relationship between gross and net income, business conditions, salaries in relation to dividends, comparable salaries in comparable companies, the salary policy of the company in question, salaries paid in prior years and pension or profit-sharing plans. They examine all of the facts and circumstances; no single factor is paramount. A recent Tax Court decision addressed this issue.

Brewer Quality Homes sells mobile homes and is owned 50/50 by husband and wife shareholders. After the IRS conceded the wife’s compensation was reasonable (the initial deficiency notice partially disallowed deductions for both spouses), the issue before the Tax Court centered on the reasonableness of the husband’s compensation for 1995 and 1996.

In this case the factors indicating a relatively high level of reasonable compensation include the husband’s involvement in all aspects of the company since its inception, the company’s rapid growth, his personal guarantee of the company’s debt, the fact the company did not furnish that individual with a defined benefit or profit-sharing plan and the company’s ability to survive several significant economic downturns in contrast to many of its competitors.

On the other hand the factors indicating a relatively low level of reasonable compensation include excessively high percentages of compensation to gross sales and taxable income; the company’s failure to maintain a compensation policy for the husband (who thus could set his own pay since he controlled the company); bonuses given to him on an ad hoc basis without any prescribed formula and many times his regular salary; the company’s omission of dividends in two recent years even though profits were higher than in two previous dividend-paying years; and the company’s average return on its equity being below that of comparable businesses.

The IRS contended that part of the husband’s compensation represented disguised dividends because

If the company had a good year, so did the husband.
The ad hoc bonus and absence of a compensation plan reflected an intent to pay dividends rather than salary.
In a C corporation, double taxation of retained earnings and dividends occurs, giving the company an incentive to pay higher compensation.

To evaluate the reasonableness of compensation, both the company and the IRS brought in expert witness testimony. The court was not persuaded by much of it. Nevertheless, in its deliberations the court used some of the data, particularly the Robert Morris Associates (RMA) statistics concerning executive compensation as a percentage of sales.

Result. Partially for the IRS. The court concluded that factors taken from the RMA 90th percentile were appropriate for determining reasonable compensation. By applying these factors and making other adjustments for nonsalary considerations, the court arrived at levels of reasonable compensation that exceeded those of the IRS but were less than the deductions the corporation took. Thus, the court deemed part of the payments to be noncompensation, resulting in tax deficiencies for the years in question.

This decision reinforces the need for proper planning to help ensure the deductibility of executive salaries in a closely held business. It also emphasizes the need for careful consideration of appropriate entity choice and possible alternatives to C corporation status.

Brewer Quality Homes Inc., TC Memo 2003-20, July 10, 2003.

Prepared by William J. Cenker, CPA, PhD, KPMG Professor of Accounting and Robert Bloom, PhD, professor of accounting, both at the Boler School of Business, John Carroll University, University Heights, Ohio.

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