Challenging Excess Compensation

A closely held corporation’s profitability often is due in large part to the knowledge, skills and entrepreneurship of shareholder-employees. A company’s attempts to compensate these employees adequately for their efforts often lead the IRS to challenge the compensation paid as excessive. In such situations, the IRS reclassifies part of the compensation as a dividend, which — unlike wages — is not deductible by the corporation.

With adequate documentation, it is possible for a closely held company to fully compensate shareholder-employees without having part of the payment reclassified as a disguised dividend. The company can apply a five-part test to evaluate the reasonableness of such compensation based on

1. The employee’s role in the company.
2. A comparison of the compensation paid with the payments of similar companies.
3. The character and financial condition of the company.
4. Potential conflicts of interest, such as the ability to “disguise” dividends as salary.
5. Internal consistency of compensation throughout the company’s ranks.

Dexsil Corp. was formed to manufacture and market a product used in gas chromatography. The number of employees expanded rapidly from 2 to 30. A single shareholder-employee functioned as president, CEO, treasurer and CFO, working between 60 and 65 hours a week. He increased his compensation as the company’s sales and profits grew. The IRS persuaded the Tax Court — which used the five factors listed above — that the total compensation paid to him was excessive and therefore a portion represented a dividend. Dexsil appealed.

Result: For the taxpayer. The case was remanded to the Tax Court for further proceedings consistent with the opinion. The taxpayer convinced the Second Circuit Court of Appeals that it should consider additional factors that were either omitted or incorrectly evaluated by the Tax Court. The taxpayer successfully asked the Second Circuit to consider

• A hypothetical or independent investor test. Would an independent investor pay the employee in question the reported salary based on the company’s dividend record and return on equity? To the extent an outsider would do so, the compensation is reasonable.
• The existence of a contingent compensation formula. To be valid, such a formula would have had to have been in existence for several years, preferably from the beginning of the employee’s term of employment, and result in reasonable compensation over a long period of time. Although the formula can be informal and oral, a fixed compensation policy is easier to prove.
• The many roles performed by the employee. To evaluate an individual’s compensation adequately, it is necessary to compare what he or she earns with the pay of individuals in other companies who perform all the jobs the employee in question performed. It is also important to select the right company and employees to serve as benchmarks in applying the five factors.

• Dexsil Corporation v. Commissioner, 98-1 USTC 50, 471; 81 AFTR 2d 2312 (CA-2).

Prepared by Edward Schnee, CPA, PhD,
Joe Lane Professor of Accounting and
director, MTA program, Culverhouse
School of Accountancy, University of
Alabama, Tuscaloosa.