Executive Compensation: What’s Reasonable?
Safe passage through the minefield of deductibility
When a corporate client seeks words of wisdom regarding tax planning, most CPAs go through the litany of suggestions related to acceleration of deductions and deferral of income. Yet one of the biggest and potentially most dangerous tax issues facing corporations is the compensation paid to the top executives and whether the IRS will allow the company to deduct the full compensation paid.
PUBLIC COMPANIES AND PERFORMANCE-BASED PAY
In the publicly traded company arena, the IRS has signaled it will follow a literal reading of the requirements for performance-based compensation deductible under IRC § 162(m) for amounts over $1 million. Private Letter Ruling 200804004 and Revenue Ruling 2008-13 interpreted IRC § 162(m) as disallowing a deduction even if the employee’s contract contains performance-based criteria if the employee can also receive the compensation for employment that is terminated without cause or for voluntary retirement. Contract provisions that allow compensation to be paid upon the employee’s death or disability or a change of control or ownership of the corporation will not cause performance-based compensation to cease to be regarded as such.
Otherwise, if the salary is based on objective performance criteria but ultimately could be paid via any other provision of the employment contract, the performance criteria is superfluous and the deduction is lost. It is irrelevant to the IRS whether in hindsight the payments were made because the objective performance criteria were met or whether termination without cause or a retirement led to the payment.
Let’s assume a CEO is making $1 million per year in base pay and has another $4 million in performance-based incentives. The incentives can be objectively analyzed and approved and can meet the criteria for deduction under IRC § 162(m)(4)(C). Again, as long as no part of the incentives may be paid for any reason besides meeting the performance measures, other than death, disability or change in control or ownership, the total salary of $5 million can be deducted.
LOWER SALARIES NOT IMMUNE FROM SCRUTINY
Trades or businesses must also show that their deductions for employee compensation, even for amounts less than $1 million, are reasonable. This issue arises most often in the context of private companies.
The author recently litigated a Tax Court case involving the deductibility of salary paid to a woman who was a principal owner, the chairwoman of the board and the CEO of such a company and appealed the finding to the Ninth Circuit Court of Appeals (E.J. Harrison & Sons Inc. v. Commissioner, TC memos 2003-239 and 2006-133 (aff’d in part and rev’d in part, 9th Cir., 2005 and 2008)). The Ninth Circuit affirmed the Tax Court in part but reversed and remanded for further proceedings to determine a more appropriate basis than the Tax Court had applied for determining reasonable compensation, to include her role in running the corporation.
The facts were fairly simple and typical. At the end of the year, the board of directors determined what the CEO’s bonuses should be and set her compensation for the following year. It was a family- owned and -run multimillion-dollar business. The board rewarded the CEO for the company’s ongoing profitability with a handsome salary, but it was less than $1 million for each year under audit. There was very little discussion about incentives or goals being reached in calculating her salary, certainly not in writing or reflected in any minutes. As in most small corporations, board members were basing their decisions on instincts and fairness.
The board had no idea that the IRS could, in essence, look over their shoulders and determine that their business judgment regarding her compensation was “unreasonable” and subject to second-guessing. Most directors of small companies may be unaware of this fact. Of course, if the IRS can recategorize the salary as a profit distribution, the deduction is lost and the CEO/owner is deemed to have received a dividend distribution. The deduction must reflect “a reasonable allowance for salaries or other compensation for personal services actually rendered” (IRC § 162(a)(1)). It may be paid in stock or other property or be made contingent on profits but should reflect what would “ordinarily be paid for like services by like enterprises under like circumstances” as they existed at the time the amount was set (Treas. Reg. § 1.162-7(b)(3)).
The provisions are intended to prevent corporate taxpayers from characterizing as salary amounts that are actually dividends. But just as determining the value of many things is often problematic, so is fixing and documenting reasonableness of compensation.
S corporations also face the reasonable compensation issue, but unlike owner/employees of C corporations, owner/employees of S corporations must make sure their salary is not unreasonably low compared with the S corporation’s distributions to them. If it is, the IRS may reclassify distributions as salary and assess liability and penalties for any unpaid payroll taxes.
INDEPENDENT INVESTOR APPROACH
The tests for what is reasonable compensation in the private company arena are literally all over the map, and the exact test used depends upon which federal circuit the company litigates in. In the author’s judgment, the most reasonable, well-thought-out opinion in this area was written by Judge Richard Posner of the Seventh Circuit Court of Appeals in Exacto Spring Corp. v. Commissioner (196 F.3d 833 (7th Cir. 1999)). Most other circuits use a plethora of tests, formulas and analyses that provide a tortuous trail of “guidance” to a small corporation much akin to a trail of breadcrumbs left for lost hikers (see sidebar, “In Search of a Standard”).
The Seventh Circuit, which covers Illinois, Indiana and Wisconsin, made the determination very simple in Exacto Spring. It relied upon a measure of performance based on a corporation’s return on equity (ROE). This measure is commonly referred to as the independent investor test, since
it views ROE from the perspective of a hypothetical independent investor. It has been widely acknowledged as important in determining reasonable compensation and has been used for at least 26 years by various courts, including the Tax Court. But usually, courts consider it along with other factors that Judge Posner criticized as vague, subjective and, in Exacto Spring, supporting a decision contrary to the one the Tax Court, applying them, had then made. (In March this year, the Seventh Circuit again ruled on the same issue in Menard Inc., No. 08-2125 (7th Cir. 3/10/09)).
Again, an opinion written by Judge Posner relied predominantly on an independent investor test in overruling the Tax Court. This time, the Seventh Circuit held that a $20 million bonus paid to the founder and CEO of a privately held chain of hardware stores was reasonable (see sidebar, “‘Workaholic’ CEO Worth $20 Million a Year,” below).
Several courts have applied the independent investor test to more than one employee at a time. However, the Tax Court has criticized the use of the test in this context because, by itself, it provides no guidelines for how reasonable compensation might be determined among several employees who might be considered responsible for a satisfactory ROE.
HELPING COMPANIES APPLY THE TEST
CPAs and other outside professionals advising the management and directors of privately held businesses can suggest that they prepare and review an analysis of reasonable compensation including an independent investor test and record it as an exhibit in the minutes of board meetings, along with their findings regarding it. The board of directors typically will then turn back to the CPA and request guidance on how to do the analysis.
The analysis boils down to this: Test the different rates of ROE at different salary levels and choose the salary level at which the hypothetical independent investor would be satisfied with his or her rate of return. If the company is providing a rate of return of 10% to this hypothetical investor in today’s economic climate, wouldn’t this hypothetical investor be happy? Ecstatic at 15%? Whatever the resulting salary figure, it then becomes a presumptively reasonable salary for the executive being measured. For companies in the Seventh Circuit, this analysis may be all that is needed. Those in other circuits may want to include analyses of other factors. Perhaps most important, the board should make sure the study is thoroughly documented.
When considering a low or negative ROE, courts may take unusual or one-time charges into consideration The company can document the cause of the expenditure, treat one year as an aberration and use a longer testing period (consistent with any known or likely tax audit period). For example, in E.J. Harrison & Sons, the taxpayer argued that a one-year negative ROE was attributable to a mandate by the California Legislature. Harrison was among contract waste haulers required to implement a state recycling initiative by providing individual customers new barrels for recyclables and yard waste in addition to their existing household waste bin. This requirement forced the company to make a large cash outlay in one year. A company’s board of directors in such a situation could choose a three- or four-year window to do an independent investor analysis, on the theory that a change in the law artificially affected the ROE. The key here is the discussion must be documented and the officer’s salary justified in the context of the events.
Additional factors companies might consider besides the independent investor test include some measure of the CEO’s effectiveness. “The nature and quality of the services should be considered, as well as the effect of those services on the return the investor is seeing on his investment,” wrote the Ninth Circuit in Elliotts Inc. v. Commissioner (716 F.2d 1241 (1983)). The nature and quality of the services performed by the employee is an overarching principle in a five-factor test the Ninth Circuit adopted in Elliotts and reaffirmed in Labelgraphics Inc. v. Commissioner (221 F.3d 1091 (2000)).
Although the Elliotts court merely called the independent investor test “helpful,” it remanded the case to the Tax Court to reconsider the independent investor test as a factor, and some other courts have accorded it a greater, if not commanding, role. Besides the Seventh Circuit’s giving the independent investor test primacy, the Second Circuit has stated that the five Elliotts factors should be viewed from the perspective of the independent investor. Other circuits that regard the test as important include the First, Fifth and Sixth. But most courts also employ some matrix of the other Elliotts factors, often along with still other criteria.
The problem that privately held corporations confront with this labyrinth of factsand- circumstances-based tests is that they are expensive to administer in practice. What small corporation wants to hire salary consultants to do comparisons to similarly situated companies? The independent investor test is a good starting point because it is factual and relatively easy to determine. It is a calculation that CPAs can easily perform and that corporate clients will easily understand.
CPAs who advise or represent privately held corporations can suggest directors do three things: One, use the performance-based compensation provisions applicable to publicly held corporations as a model and make sure that executives’ salaries are mostly performance- driven. Two, apply the independent investor test before setting the salaries. And last, document the resulting determinations in minutes of their meetings.
“Workaholic” CEO Worth $20 Million a Year
In March 2009, a decade after the Seventh Circuit Court of Appeals first declared its preference for a single factor rather than a matrix to determine reasonable employee compensation under IRC § 162(a), the court reasserted the primacy of that factor: return on equity (ROE) to a hypothetical investor in a closely held corporation. The opinions in both the earlier case, Exacto Spring (196 F.3d 833 (7th Cir. 1999)), and the one this year, Menard Inc. v. Commissioner (No. 08-2125, 7th Cir. 3/10/09) both overruled the Tax Court in favor of the taxpayers. Both were written by the same judge, Richard A. Posner.
The latter decision was notable chiefly for the amount of compensation deducted, $20,642,400 for 1998, the bulk of which ($17,467,800) was paid in the form of a bonus of 5% of the company’s before-tax profits. The Tax Court had ruled that the arrangement for John Menard, founder and CEO of a Midwestern chain of hardware stores, Menard Inc., looked more like a dividend than a salary. Although the 5% bonus had been in place since 1973, the Tax Court was troubled by a provision in Menard’s contract requiring him to pay back any deduction of it disallowed by the IRS. The Tax Court also applied Treas. Reg. § 1.162-7(b)(3), which states that compensation may be assumed reasonable where it is consistent with the pay of similar companies under similar circumstances for similar services. On that basis, it compared Menard’s pay with that of CEOs for Lowe’s Cos. Inc. and The Home Depot Inc. relative to those two public companies’ ROE and arrived at a figure for Menard of $7.1 million.
But, Judge Posner wrote, the Tax Court ignored dissimilarities between Menard Inc. and its much larger rivals, notably the level of service that Menard provided. He worked 12 to 16 hours a day, six or seven days a week and took only seven days of vacation a year. Under his leadership, company revenues grew in seven years from $788 million to $3.4 billion. And most tellingly, Judge Posner wrote, at the end of that period, the tax year in dispute, a hypothetical investor in Menard Inc. would have enjoyed an 18.8% ROE for the year. In contrast to the lack of any evidence presented regarding the individual contributions of the CEOs of the larger companies relative to those of their directors and senior management, there was ample evidence of Menard’s nearly single-handed “workaholic, micromanaging ways,” Judge Posner wrote.
The Seventh Circuit panel also said that reasonableness under the ROE factor may be rebutted where company success results more from external reasons than an employee’s exertions or where there is a conflict of interest. The compensation paid other executives within the company is considered relevant, as well.
—by Paul Bonner
EXECUTIVE SUMMARY
One factor in determining reasonable compensation that has gained prominence in some circuits, particularly the Seventh, is the value of the employee’s contributions as reflected in the return on equity (ROE) of a hypothetical independent investor in the corporation, and the effect of that compensation on ROE. These are calculations CPAs are well-equipped to assist companies in making.
Philip Garrett Panitz, Esq., LL.M., is the senior tax partner at the law firm Panitz & Kossoff LLP in Westlake Village, Calif. His e-mail address is pgp@pktaxlaw.com.
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The Tax Adviser article
“The Status of the ‘Independent Investor’ Test in Reasonable Compensation Determinations,” June 00, page 406
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