Key Factors in Determining Reasonable Compensation for C Corporations
The reasonableness of shareholder/employee compensation is an important – and often controversial – income tax consideration for closely held corporations. This is particularly true for the closely held corporation structured as either a C corporation or an S corporation.
For a C corporation, the IRS is typically concerned with an unreasonably high (or excessive) level of employee compensation. In such cases, the Service often claims that the excess employee compensation absorbs taxable income and represents a disguised dividend to the shareholder/employee.
When dealing with compensation, the rules allowed for a deduction in “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business include a reasonable allowance for salaries or other compensation for personal services actually rendered,” according to Code Section 162. The Service juxtaposes this by stating that “the test of deductibility in the case of compensation payments is as to whether they are in fact purely payments for services.”
Both the IRS and the courts tend to focus on whether the compensation of a closely held C corporation shareholder is ripe for the services the shareholder performs. This focus is driven because if the compensation paid to the shareholder is not reasonable, it generally would be presumed that a portion of the payments is not for services rendered.
In 2013, this issue peaked before the US Tax Court. In the 2013 case, Aries Communications Inc. & Subs v. Commissioner, the sole shareholder’s role was president, CFO, and general manager of a radio broadcasting business. The corporation paid the shareholder $6.9 million in compensation. Upon examination, the IRS disallowed a large portion of the deduction and stated that $800,000 was considered reasonable enough for compensation. The corporation went to the Tax Court and the court ruled that $2.7 million was deductible as reasonable compensation.
In another Tax Court case, Thousand Oaks Residential Care Home I Inc. v. Commissioner, a husband and wife were owners of an assisted living facility. They had been in business since the 1970s, and in 2002, they sold the main asset of the corporation, being the assisted living facility. After the sale, the corporation began compensating the husband and wife, who were the corporation’s sole shareholders, at a higher level than in the decades before the sale. The company stated that these large salaries were just “catch up” payments from decades of taking low salaries due to cash-flow restraints.
When making its decision, the Tax Court used the 9th Circuit’s “five broad factors” analysis, which are:
- The employee’s role in the company.
- An external comparison with other companies.
- The character and condition of the company.
- Potential conflicts of interest.
- Internal consistency of compensation.
When these factors were applied, the court determined that the large compensation paid by the corporation to the husband and wife was not reasonable, and lowered the salaries that were allowable.
The Mayson and Elliots Factors
When the IRS or the courts determine reasonable compensation to closely held C corporations, they generally take into account two cases: Mayson Manufacturing Co. v. Commissioner and Elliotts Inc. v. Commissioner. The Mayson case was brought before the 6th Circuit, and the Elliotts case was brought before the 9th Circuit.
The following are nine individual factors of the Mayson case:
- The employee’s qualifications.
- The nature, extent, and scope of the employee’s work.
- The size and complexity of the business.
- A comparison of salaries paid with the gross income and net income of the business.
- The prevailing general economic conditions.
- A comparison of salaries with distributions (or dividends) to stockholders.
- The prevailing rates of compensation for comparable positions.
- The salary policy of the taxpayer to all employees.
- The amount of compensation paid to a particular employee in previous years.
The following are five individual factors of the Elliotts case:
- The employee’s role in the company.
- An external comparison to other businesses.
- The character and condition of the business.
- Whether there is a conflict of interest regarding the negotiation of compensation.
- Whether there is internal consistency in a company’s treatment of payments to employees.
With the Mayson factors compared to the later Elliotts factors, you’ll notice the courts’ compression from nine factors down to five. More importantly, in Elliotts, you’ll also notice the introduction of the concept and relevance of an “independent investor” in determining whether compensation is reasonable.
The 9th Circuit’s introduction of an independent investor considered the perspective with the conflict of interest and internal consistency factors. In summation, the 9th Circuit’s view was broad of the multifactor approach, which considered the perspective of an independent investor as a useful tool in its analyzation of the various factors. Other circuit courts have taken this a step further.
The 7th Circuit made this notion of an independent investor simple. In Judge Richard Posner’s ruling in Exacto Spring Corp. v. Commissioner, he relied upon a measure of performance based on return on equity. Judge Posner stated in his ruling that return on equity should basically be viewed from the perspective of a “hypothetical investor.”
Instead of rejecting the notion of the multifactor approach, some other courts have taken a broader view of this approach. They reasoned that the independent investor test is the lens through which the various factors are viewed. However, the 7th Circuit considered that such a stance is a “formality” and that “the new test dissolves the old and returns the inquiry to basics.”
Know the Rules of a Particular Situation
In an S corporation, we are more concerned about not compensating the shareholder reasonably. In a C corporation, we are basically concerned about overcompensating a shareholder. In a closely held C corporation, the corporation pays income tax on its profits gained. If we are to pay the sole shareholder all of the profits as salary, the C corporation would not pay income taxes.
As the courts have demonstrated, reasonable compensation for C corporations has to be relative to the role that the shareholder plays in the corporation, the economics of what is surrounding the company, the conflict of interest of the shareholder in the business, and the normal compensation of the shareholder’s role. Reduction in the salary of a sole shareholder doesn’t necessarily mean that the corporation or the shareholder, for that matter, will pay astronomical amounts in taxes.
For example, if we have a C corporation that grosses $1 million and has expenses of $600,000 before shareholder compensation, we can pay the shareholder $250,000 in compensation, through fringe benefits pay them an additional $50,000 or so, and defer $54,000 into a deferred compensation plan for the shareholder, leaving $46,000 in the C corporation, which is taxed at 15 percent. The shareholder could even take a dividend from the corporation and pay 15 percent on his or her personal tax return.
With reasonable compensation, you are often wearing two different hats as an accountant. With one type of business, you are trying to get the salaries of the shareholders up, while in another type of business, you are trying to get the salaries down. One thing is certain: We need to know the rules of the particular situation that we are in, for the sake of our clients.
Over the years, the IRS and the federal courts have developed generally accepted factors and methods used to analyze the shareholder/employee reasonableness of compensation. These generally accepted methods were developed based on statutory authority, administrative rulings, and judicial precedent.
To ensure that reasonable compensation analyses can withstand the scrutiny of the Service and the federal courts, the analyst (and the taxpayer) should fully understand the generally accepted factors and methods that are considered when determining the shareholder/employee reasonableness of compensation.
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...