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June 24, 2014

2014-Issue 25—Frank Underwood likely would appreciate that as tax advisors, we are often called upon to fight chaos with chaos. Chaos, of course, describing the present state of our tax system. One particularly chaotic area is determining what constitutes “reasonable compensation” for U.S. federal income tax purposes, particularly with respect to closely-held corporations.

Generally, a closely-held corporation is a corporation owned primarily by a small number of individuals, often members of the same family, or sometimes even a single shareholder. These individuals generally hold dual roles in the corporation as shareholders and employees, and therefore, an overlapping identity exists between those who own the corporation and those who work for it. As a result, any transactions between the corporation and the shareholder-employees, such as compensation, are more likely to be viewed as related-party transactions rather than transactions between two parties with adverse interests.

Almost since the enactment of the federal income tax in 1913, closely-held corporations and the tax professionals that advise them have been bedeviled by the reasonable compensation rules of Internal Revenue Code (IRC) Section 162(a), which, as discussed further below, imposes a limitation on the amount of compensation paid that may be deducted for U.S. federal income tax purposes. The reason for the limitation under IRC Section 162(a) is straightforward: Dividends are not deductible for U.S. federal income tax purposes, while compensation usually is; therefore, shareholder-employees of closely-held corporations are generally incented to pay themselves dividends disguised as compensation in order to maximize their after-tax cash proceeds. Closely-held corporations that distribute most of their earnings to their shareholder-employees in the form of wages are at risk of attracting the discerning, inflamed eye of the IRS, which may assert that the compensation paid is unreasonably high and recharacterize deductible compensation payments as nondeductible dividend distributions. Also, note that with the imposition of the new 3.8 percent Medicare tax on net investment income, which generally includes dividends, the IRS is now further motivated to find and expose disguised dividends, wherever they may be hiding.

Note that with respect to S corporations, the incentive is for shareholder-employees to take most of their compensation in the form of distributions rather than wages, since distributions from S corporations are not subject to payroll taxes, while wages generally are. In that case, the IRS may assert that the shareholder-employees’ compensation is unreasonably low rather than unreasonably high as in the case of a corporation without an S corporation election in effect (referred to as a C corporation in U.S. federal income tax parlance). This article primarily focuses on reasonable compensation issues with respect to C corporations; however, courts use many of the factors and tests discussed below to analyze the reasonableness of compensation paid to S corporation shareholder-employees.

This edition of Tax Advisor Weekly surveys the historical development of the rules governing what constitutes reasonable compensation for U.S. federal income tax purposes and discusses various defensive measures taxpayers may use to mitigate the risk of a reasonable compensation audit by the IRS.

Must be Reasonable…

IRC Section 162(a) provides that a deduction will be allowed for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including “a reasonable allowance for salaries or other compensation for personal services actually rendered.” The statute has generally been interpreted as imposing the following conjunctive two-part test for compensation to be deductible for U.S. federal income tax purposes:

(i) The compensation must be reasonable; and

(ii) The compensation must be for personal services actually rendered.

Unsurprisingly, Congress has left the term “reasonable” undefined. The regulations that have been promulgated by the IRS are largely silent on this issue as well, only venturing so far as to opaquely state that “it is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”

Faced with a lack of meaningful guidance as to what constitutes “reasonable” in the context of reasonable compensation, the courts have crafted their own tests for use in evaluating shareholder-employee compensation, which are discussed further below.

Mayson — The Grandfather of Reasonable Compensation Case Law

One of the seminal cases in the area of reasonable compensation is Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949). Prior to its adjudication more than 60 years ago, there was little in the way of standard analyses with respect to reasonable compensation cases. Mayson is significant in that it appears to be one of the first cases in which an appellate court used a set of factors in analyzing the reasonableness of compensation paid to certain shareholder-employees. Since it was rendered, Mayson has been cited by numerous other courts, and arguably no other ruling has done more to advance reasonable compensation jurisprudence.

The Mayson court listed the following nine factors that should be evaluated in determining whether the compensation paid to a shareholder-employee is reasonable:

i. The employee’s qualifications;
ii. The nature, extent and scope of the employee’s work;
iii. The size and complexities of the business;
iv. A comparison of the salaries paid with gross income and the net income;
v. The prevailing general economic conditions;
vi. A comparison of salaries with distributions to stockholders;
vii. The prevailing rates of compensation for comparable positions in comparable concerns;
viii. The salary policy of the taxpayer as to all employees; and
ix. In the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.

The court stated that “the situation must be considered as a whole with no single factor decisive.”

As discussed further below, a frequent criticism of multifactor tests is that they are subjective, which necessarily leads to uncertainty in their application. In the time since the Mayson decision was rendered, the factors used in reasonable compensation analyses have waxed and waned. Some courts have chosen to use only a small number of factors, others more than twenty. It wasn’t until 1983 that the next significant development in the evolution of reasonable compensation jurisprudence occurred.

Elliotts Factors

In Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983), the United States Court of Appeals for the Ninth Circuit (9th Circuit) articulated the following five factors that should be evaluated in determining whether the compensation paid to a shareholder-employee is reasonable:

i. The employee’s role in the company;
ii. An external comparison of the employee’s compensation with that paid by similar companies for similar services;
iii. The character and condition of the company;
iv. Whether a conflict of interest exists between the employee and the company; and
v. Whether the company maintains internal consistency with respect to employee compensation.

Similar to the Mayson factors, none of the aforementioned Elliotts factors are decisive.

While at first blush it may appear that the Elliotts factors are just a condensed and restated version of Mayson, the Elliotts decision is notable in that it appears to be one of the first attempts by an appellate court to apply a more objective standard to the analysis of reasonable compensation. Specifically, with respect to the fourth factor concerning whether a conflict of interest exists between the shareholder-employee and the company, the court stated that “it is appropriate to evaluate the compensation payments from the perspective of a hypothetical independent investor. If the bulk of the corporation’s earnings are being paid out in the form of compensation, such that the corporate profits, after payment of the compensation, do not represent a reasonable return on the shareholder’s equity in the corporation, then an independent shareholder would probably not approve of the compensation arrangement. If, however, that is not the case and the company’s earnings on equity remain at a level that would satisfy an independent investor, there is a strong indication that management is providing compensable services and that profits are not being siphoned out of the company disguised as salary.”

Independent Investor Test

More recently, the United States Court of Appeals for the Seventh Circuit (7th Circuit) has, for the most part, eschewed multifactor tests when evaluating reasonable compensation with respect to shareholder-employees in favor of what it believes to be a more objective standard. In Exacto Spring Co. v. Commissioner, 196 F.3d 833 (7th Cir. 1999), the court dumped the seven-factor test it previously used, stating that multifactor tests in general are “redundant, incomplete and unclear.” 

In its place, the court applied an independent investor test to determine whether compensation paid to a shareholder-employee is reasonable. Under the independent investor test, the court specified that in the context of evaluating the reasonableness of compensation paid to shareholder-employees, when the company’s shareholders are receiving above-average returns on their investments, a rebuttable presumption is created that the shareholder-employees’ compensation is reasonable. While no formal guidance has been issued as to what rate of return is necessary to satisfy the independent investor test, in Thousand Oaks Residential Care Home I, Inc., et al. v. Commissioner, 105 T.C.M. (CCH) 1056 (2013), the court ruled that a rate of return that ranges between 10 and 20 percent tends to indicate that that the compensation paid to shareholder-employees is reasonable.

As noted above, under Exacto, when a company’s shareholders are receiving above-average returns on their investments, there is a rebuttable presumption that the compensation paid to shareholder-employees is reasonable. Therefore, the court left the door open to the possibility of considering other factors in cases where it may be warranted. But, while the door may have been left open, the court nonetheless intended for the independent investor test to be the primary tool of analysis in reasonable compensation cases. The United States Tax Court learned this lesson the hard way when it was reversed in Menard, Inc. v. Commissioner, 560 F.3d 620 (7th Cir. 2009). InMenard, the 7th Circuit utterly excoriated the Tax Court for applying a multifactor test to the reasonable compensation analysis, rather than the independent investor test, even though the taxpayer’s shareholders were receiving above-average returns on their investments.

…And for Personal Services Actually Rendered

The second test under IRC Section 162(a) for determining whether compensation is deductible for U.S. federal income tax purposes is that the compensation paid must be for personal services actually rendered (the “Services Rendered Test”). Although this test is just as important as the test for reasonableness discussed above (because both tests must be satisfied for a compensation deduction to be sustained), it is arguably the more mysterious of the two because there is substantially less guidance to be found concerning what constitutes personal services actually rendered. As the Elliotts court noted, “proof of the second prong, which requires a ‘compensatory purpose,’ can be difficult to establish because of its subjective nature…by and large, the inquiry under section 162(a) has turned on whether the amounts of the purported compensation payments were reasonable.” Indeed, the Elliotts court appeared to indicate that unless the government specifically asserts that compensation paid is not for personal services actually rendered (and assuming no other aggravating factors), the Services Rendered Test is assumed to have been satisfied by the taxpayer and the analysis will focus solely on whether the compensation at issue is reasonable.

The Services Rendered Test can be difficult to apply in practice, primarily because it seems fairly intuitive that reasonable compensation would necessarily be paid in exchange for personal services actually rendered.

Automatic Dividend Rule

In Charles McCandless Tile Service v. United States, 422 F.2d 1336 (Ct. Cl. 1970), the taxpayer at issue was a closely-held corporation that had never paid a dividend. The court ruled that although the compensation paid to the two main shareholder-employees was reasonable, the compensation was not solely for personal services actually rendered. At best, the court’s reasoning may be characterized as strange and went as follows: because the taxpayer had never paid a dividend, the compensation payments made to the two shareholder-employees necessarily contained a disguised dividend. Posterity has designated this as the automatic dividend rule (ADR).

Similar to King Joffrey, the first of his name, the ADR’s reign was short-lived.

It wasn’t long after the ADR was articulated that other courts began to distance themselves from it. In 1974, the 7th Circuit declined to follow the ADR, stating that “while the absence of dividends might be a red flag, it should not deprive compensation demonstrated to be reasonable under all of the circumstances of the status of reasonableness.” The Tax Court followed soon thereafter.

The ADR’s technical underpinnings were considered by some to be so poor that the IRS eventually issued Revenue Ruling 79-8 in which it, like the courts above, also declined to follow the ADR.

The death knell for the ADR may have come from Elliotts, where the 9th Circuit expressly rejected it for the following reasons: (i) there is no law requiring corporations to pay dividends; (ii) shareholders of profitable corporations do not always require dividends to be paid to them; and (iii) there may be a valid business reason for reinvesting corporate earnings rather than paying out dividends.

It’s clear now that the better analysis is that the ADR should not be followed. However, as a technical matter McCandless may still be law, as it does not appear to have been expressly overruled.

In the absence of a bright-line rule like the ADR, however flawed it may be, analyses of compensation under the Services Rendered Test often leave you with an “It’s a trap!” feeling and become intensive and exhaustive factual inquiries. Pediatric Surgical Associates, P.C. v. Commissioner, 81 T.C.M. (CCH) 1474 (2001), is typical of such. After a detailed analysis of the taxpayer’s financial records, the Tax Court ruled that part of the compensation paid to certain shareholder-employees was in fact a disguised dividend. The case stands for the proposition that litigation under the Services Rendered Test more often than not turns on highly subjective and factual analyses, and taxpayers should be aware that their compensation practices may, notwithstanding their intentions to the contrary, be challenged as a device to distribute disguised dividends at some future date.

Preparing for the Inevitable Audit

An important step closely-held corporations should consider in order to mitigate the risk of having compensation recharacterized into dividends by the IRS is to institute written corporate policies on matters relating to dividend payments and compensation, including bonuses. Even if the policies may not be applicable, such as with a closely-held corporation that chooses to reinvest corporate earnings rather than pay dividends, taxpayers should still consider having a dividend policy in place that specifies what the rationale is for reinvesting corporate earnings versus paying dividends.

The same goes for compensation. Closely-held corporations should consider instituting written policies that provide an objective basis for how compensation and bonuses are determined for both shareholder and non-shareholder employees. If feasible, taxpayers should also consider engaging third-party service providers to conduct compensation benchmarking studies, since an external comparison of the compensation paid by similar companies for similar services is one of the Elliotts factors.

With respect to bonuses paid to shareholder-employees, closely-held corporations should document why the particular shareholder-employee is receiving the bonus and should also consider tying bonus payments to the achievement of certain objective metrics. Bonuses awarded to shareholder-employees that track or mirror stock ownership should be avoided

A final note on policies is that they can only be an effective deterrent to potential reasonable compensation disputes if they are in fact followed. It is understandable that some closely-held corporations are run with varying degrees of formality, which may extend to setting compensation and determining bonuses paid to employees, including shareholder-employees. But as noted above, one of the Elliottsfactors is whether the company maintains internal consistency with respect to employee compensation. The court noted that “evidence of a reasonable, longstanding, consistently applied compensation plan is evidence that the compensation paid in the years in question was reasonable.” Although the preceding statement is somewhat circular in nature, it is clear that the court considers highly-structured and well-established compensation plans to be a positive factor in evaluating whether compensation paid to shareholder-employees is reasonable. One might even say that good intentions and byzantine legal guidance are no match for a well-written corporate compensation policy.

A common issue that is encountered by closely-held corporations is how to rectify undercompensation that occurred in prior years without running afoul of the reasonable compensation rules. Although the IRS has, on occasion, argued otherwise, taxpayers generally may currently deduct payments made to employees for services rendered in the past for which they were inadequately compensated. 

Alvarez & Marsal Taxand Says:

Reasonable compensation audits can be expensive to defend, time-consuming and distracting, and taxpayers would be well served to avoid them. Unfortunately, expect more of them as the IRS takes aim at what it perceives to be various schemes and devices that are used to extract corporate earnings under the guise of compensation. In addition, although not specifically addressed in this article, there has been increased speculation that the IRS may look at monitoring fees or management fees paid to private equity firms as another form of disguised dividends and apply a similar test to determine reasonable compensation. Therefore, it’s never too soon for taxpayers to begin implementing measures that may reduce the likelihood of reasonable compensation being raised as an issue in the event of an IRS audit.

Author

Leslie Nielson
Managing Director, New York
+1 212 763 9805

William B. Weatherford, Director, Simon Bernstein, Senior Associate, and Matthew Elijah, Associate, contributed to this article.

For More Information

Brian Cumberland
Managing Director, Dallas
+1 214 438 1013

J.D. Ivy
Managing Director, Dallas
+1 214 438 1028

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Disclaimer

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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