Company's Deduction for Shareholder-Executive's Pay Reduced

BY DAYNA E. ROANE, CPA, M.TAX.

The Tax Court reduced a corporation’s deduction for compensation to its CEO, but by much less than the IRS sought. Factors favoring the taxpayer were consistent compensation policies and that the owner was the driving force behind successful operations. Weighing against the taxpayer for one tax year was a negative return on equity to a hypothetical investor.

 

Randall Unthank had since 1972 performed all managerial tasks and made all major business decisions for Multi-Pak Corp., a California C corporation that had been founded by his father. As Multi-Pak’s CEO and COO, Unthank, who was also the company’s sole shareholder, was paid $2,020,000 and $2,058,000, respectively, in 2002 and 2003. The IRS determined that reasonable compensation for those years should have been $655,000 and $660,000. The IRS issued notices of deficiency and imposed a 20% accuracy-related penalty under section 6662(c).

 

The Tax Court allowed the taxpayer to deduct the full amount of compensation in 2002 but only $1,284,104 in 2003, and it declined to impose any accuracy-related penalties. The court noted that the Ninth Circuit, to which this case could be appealed, follows precedent established in Elliotts Inc. v. Commissioner (716 F.2d 1241 (9th Cir. 1983)) by using a five-factor test, with no single factor being determinative. The five factors are: (1) the employee’s role in the company, (2) comparison with other companies, (3) the character and condition of the company, (4) potential conflicts of interest and (5) internal consistency in compensation. (For more, see “Executive Compensation: What’s Reasonable?JofA, June 2009, page 56.)

 

Concerning the first factor, the court found in Multi-Pak’s favor that the petitioner’s critical decision-making role and dedication to the company directly contributed to the company’s excellent growth. For the second factor, the court rejected both Multi-Pak’s and the IRS’ experts’ analyses of other companies as not comparable to the taxpayer.

 

The third factor, “character and condition of the company,” was found to favor the petitioner, as Multi-Pak clearly was a successful competitor in its field. The fourth factor, “conflict of interest,” examines whether any relationship between a company and its employee would permit the company to disguise nondeductible corporate distributions as compensation. The court found that such a relationship did exist and that closer scrutiny of Unthank’s position as both employee and sole shareholder was merited. Using a return-on-equity (ROE) assessment, the court concluded that the compensation paid in 2002, when sales grew by about $3 million and ROE was 2.9%, was reasonable. However, the company’s negative 15.8% ROE in 2003 called into question Unthank’s compensation for that year.

 

Finally, the court considered “internal consistency of compensation” and found that Multi-Pak’s monthly review of bonuses indicated a consistent business policy.

 

The court noted that Unthank’s “dedication and hard work resulted in the company’s record sales for the years at issue.” However, it held that reasonable compensation in 2003 would have been $1,284,104, which was Unthank’s average compensation for 1999 to 2001 and would have resulted in a 10% ROE for 2003.

 

Multi-Pak also contested the IRS’ assessment of an accuracy-related penalty, arguing it had acted in good faith and had reasonable cause. The court agreed, holding that the taxpayer met the exception for reliance upon professional advice by conferring regularly with its CPA adviser and tax preparer.

 

  Multi-Pak Corp. v. Commissioner , TC Memo 2010-139

 

By Dayna E. Roane, CPA, M.Tax., Kingsbery Baris Vogel Nuttall, Boulder, Colo.

 

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