Salary was partially reasonable

BY LAURA JEAN KREISSL, PH.D. AND DARLENE PULLIAM, CPA, PH.D.
July 1, 2013

Relying on standards set by the Ninth Circuit, the Tax Court found that a sole shareholder’s compensation from a wholly owned corporation for the year in question was partially deductible as reasonable compensation. The deductible compensation included catch-up payments for prior years’ services.

Arthur Astor was the president and CFO of his wholly owned corporation, Aries Communications Inc. Since the company’s formation in 1983, Astor was very involved in day-to-day operations and was a major factor in its success. In 2003 and 2004, Aries reported large sales of radio station assets through its subsidiaries, which resulted in large taxable income for those years. In the years before and after these sales, the company reported negative taxable income.

In 2004, Aries claimed a deduction of $6,896,974 for compensation to Astor. The IRS disallowed most of the 2004 deduction—$6,086,753—and determined a deficiency of $2,676,002 and an accuracy-related penalty under Sec. 6662(a).

The Tax Court relied on six factors to determine how much of the compensation was reasonable. The specific factors selected are those used by the Ninth Circuit, to which the case would be appealed (see Elliotts, Inc., 716 F.2d 1241 (9th Cir. 1983), and Metro Leasing & Dev. Corp., 376 F.3d 1015 (9th Cir. 2004)).

Three of the factors were not favorable for allowing the full compensation deduction claimed by Aries. After reviewing expert reports submitted by both Aries and the IRS that determined Astor’s reasonable compensation based on compensation information from similar companies, the court found that the amount claimed by Aries for fixed compensation for the current and prior years was less than that paid by similar companies. However, the court rejected both experts’ opinion on the reasonable part of Astor’s bonus compensation and independently determined that only $2 million of the nearly $6.7 million bonus payment for 2004 was reasonable. Second, the company’s character and condition indicated that Aries was thinly capitalized and in poor financial condition, supporting a much smaller deduction. Third, Astor had a potential conflict of interest in characterizing his economic reward for his work as salary rather than dividends, especially when he had been well-compensated for his efforts for the prior year’s asset sale.

The court determined the factor of internal consistency in the treatment of payments to employees was neutral. Astor’s compensation was not awarded under a structured, formal, consistently applied program; however, in 2004, it included amounts for prior years of hard work for which he had been undercompensated. Also, Astor’s compensation could not be compared with other nonowner Aries’ employees because the company had no employees with duties similar to Astor’s.

The court determined two factors were favorable: Astor’s role in the company was obviously significant. He was very involved and important in the company’s success and in the asset sales. Also, under the independent-investor standard (whether corporate profits, after paying the compensation, would provide a satisfactory return on equity for a hypothetical independent investor), the court found that Aries had sufficient net income and retained earnings to support Astor’s compensation.

The court concluded that Aries could deduct $2,660,899, which consisted of $461,625 for prior years’ underpayments, current annual salary of $199,274, and a $2 million bonus. The accuracy-related penalty was allowed.

Taxpayers should take steps to support the deduction of a large salary. The factors important to the appropriate court of appeals should be supported and documented. A record of dividends should be established, even if the amounts are relatively small.

  Aries Communications, Inc., T.C. Memo. 2013-97

By Laura Jean Kreissl, Ph.D., assistant professor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.

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