Circuit courts debate reasonable compensation.

Circuit Courts Debate Reasonable Compensation

A quiet storm has been brewing among the U.S. circuit courts of appeal. In the past few years, the Second, Fifth, Sixth, Seventh and Ninth Circuits were asked to decide whether the compensation paid to certain corporate business owners was reasonable and, therefore, wholly deductible, or whether it should be considered a nondeductible dividend. Each of these circuit courts espoused slightly different tests for reasonableness, and reached different results. In some cases, the Tax Court's rationale was adopted; in others, it was harshly criticized. To ensure deductions for amounts paid to employee-shareholders will withstand scrutiny, practitioners need to be aware of the current thinking in the circuit court districts in which they have clients.

Background

IRC section 162(a)(1) permits a deduction for "a reasonable allowance for salaries or other compensation for personal services." Regulations section 1.162-7(a) and (b) add a test of deductibility: Is compensation reasonable, in an amount that would ordinarily be paid for like services by similar enterprises under the same circumstances and is payment purely for services?

The deductibility of compensation in large corporations is rarely questioned because employees are generally dealt with at arm's length. However, in many small businesses, the owner may be a sole shareholder, one of few employees and serving in several capacities (for example, CEO, CFO and primary salesperson). The IRS may view the compensation paid to that person (and deducted by the corporation) as excessive and as a "nondeductible disguised dividend." If the IRS reduces or denies the compensation deduction, the taxpayer may want to litigate the issue.

The Tax Court and circuit courts have devised different tests to determine the reasonableness of compensation paid in the small business setting. An examination of several recent cases offers guidance to practitioners on how to advise clients so the IRS will accept the compensation deduction taken on the return.

The Tax Court

Two recent Tax Court cases examined the reasonable compensation issue. In Ashare (TC Memo 1999-282), the Tax Court concluded that a $1.75 million compensation deduction was reasonable. Ashare, a pension attorney and sole shareholder, had won a large class-action suit. In a later year in which his company had no income, on the advice of his tax adviser, the company borrowed (from an outside source) and paid him $1.75 million, to create a loss that would be carried back to trigger a refund. The board of directors that approved the loan and compensation payment consisted of the taxpayer, his spouse and his tax adviser.

The Tax Court concluded that the compensation paid to Ashare was reasonable because his qualifications justified his compensation. Without Ashare, it stated, the business would not have succeeded.

In Eberl's Claim Service, Inc. (TC Memo 1999-211), Eberl was the president and sole shareholder of a claims adjusting business. His employment agreement provided him with a base salary and bonus, which the board of directors determined at the end of each year. Eberl made all business decisions, and performed or supervised most of the business's managerial, marketing and negotiation functions.

Although his attorney, accountant and financial adviser advised Eberl about compensation, which was set at 20-25% of the business's gross receipts, the Tax Court ultimately held that $2 million of Eberl's $4.34 million salary and bonus for 1992 and $1 million of his $2.08 million salary and bonus for 1993 were unreasonable disguised dividends.

The court examined Eberl's qualifications, the scope of his work, the size and complexity of his business, his salary in relation to sales and net income, distributions to shareholders, comparable positions in comparable companies and prior years' compensation. It found that the compensation plan drained the company of earnings and the business would not be able to grow. Furthermore, contrary to the employment agreement, Eberl, not the board of directors, had set his own compensation.

Two lessons can be gleaned from Ashare and Eberl: Make sure an "independent" board of directors is setting compensation, and do not drain all earnings from the company.

Second Circuit

In Dexsil Corp. (2d Cir., 6/3/98), the Second Circuit Court of Appeals vacated and remanded the Tax Court's decision partially disallowing Dexsil's compensation deduction for its CEO and majority shareholder. The Second Circuit ordered the Tax Court to reconsider the disallowance and make specific findings in light of the factors that determine reasonable compensation for services performed.

In 1981, Ted Lynn, an engineer, became Dexsil's president. Dexsil manufactured and marketed field-test kits to determine hazardous contaminants. From 1983 to 1990, Lynn was Dexsil's president, CEO, CFO and treasurer; he worked 60 to 65 hours a week. Lynn's income increased as Dexsil's income grew--an informal formula paid him each year about 11% of the company's annual gross sales.

For 1989 and 1990, the years at issue, Lynn owned 62% of Dexsil's stock. In 1989, Lynn received $382,540 in compensation--$74,200 in salary, a $302,340 bonus and $6,000 in director's fees. In 1990, he received a total of $510,000, consisting of a $78,000 salary, a $410,000 bonus and $22,000 in director's fees.

Dexsil paid dividends of $16,090 in 1989 and $25,992 in 1990. Dexsil's 1989 return on equity was 26.3%; in 1990, it was 25.5%. The company's gross sales were approximately $3.42 million in fiscal 1989 and $4.9 million in fiscal 1990.

The IRS allowed only $161,192 in total compensation for Lynn for 1989 and $177,311 for 1990, and Dexsil brought suit in Tax Court. There, the IRS argued Lynn was not crucial to Dexsil's success, because he was not an expert in environmental science. Dexsil countered that Lynn's multiple roles justified the compensation it paid him.

The Tax Court rejected Dexsil's argument. It found no evidence of a compensation formula, but concluded that reasonable compensation was $300,000 for 1989 and $320,000 for 1990, due to the company's superior financial performance. The court noted that these figures exceeded the compensation of 90% of the industry's CEOs. The court also rejected the taxpayer's argument that the company's return on equity was such that an independent investor would have approved the compensation.

Dexsil based its appeal on the independent investor, compensation formula and multiple role issues, and the Second Circuit agreed with the company's position on all of them. It ruled that the Tax Court had to use the independent investor perspective in determining whether Lynn's compensation was reasonable. According to the Second Circuit, the "independent investor" factor is a "lens through which the entire analysis should be viewed." The Tax Court also had to consider Dexsil's compensation formula and whether Lynn's performance of multiple duties justified additional compensation.

Fifth Circuit

In Donald Palmer Co., Inc. (5th Cir., 4/1/96), the company was engaged in buying and selling bags and packaging materials. The sole shareholder was also the corporation's president and sole officer. He worked 70 hours a week, generated most of the company's sales and managed its daily operations. In 1990, the company had gross receipts over $4 million; Palmer was paid a $441,446 salary and a $818,533 bonus. The company never paid dividends. The IRS disallowed the deduction for the bonus, but the Tax Court found that $220,723 of the bonus was reasonable compensation. On appeal, the Fifth Circuit agreed with the Tax Court ruling.

Sixth Circuit

In Alpha Medical, Inc. (6th Cir., 4/19/99), William Rogers, president, director and sole shareholder, worked at least 12 hours a day and was available at all times by telephone and pager. He made all strategic decisions and handled all client and employee problems. Alpha paid him $4.4 million in compensation for 1990, 44.9% of that year's gross receipts. The IRS concluded that the excess over $400,000 was nondeductible. The Tax Court held that $2.3 million of compensation was a reasonable figure (approximately halfway between $400,000 and $4.4 million).

The Sixth Circuit, however, reversed the Tax Court's decision. It noted that Rogers was well-qualified, an indispensable factor in the business's success, wore many hats and had been underpaid in previous years. Further, the business was complex and the return on equity was favorable. Thus, the 1990 compensation deduction was valid.

Seventh Circuit

In Exacto Spring Corp. (7th Cir., 11/16/99), William Heitz was the cofounder, CEO and principal owner of that corporation. The company paid him $1.3 million in 1993 and $1 million in 1994. The IRS found only $381,000 and $400,000 to be reasonable for those years. The Tax Court approved $900,000 and $700,000 in compensation payments as deductible.

On appeal, the Seventh Circuit concluded that, although the Tax Court had used a seven-factor test to determine reasonableness of compensation, that test did not provide adequate guidance for a rational decision. First, the test was nondirective; that is, there was no indication of how the factors were to be weighed in the event they did not all line up on one side. Further, some of the factors, such as the type and extent of services rendered, were vague. Moreover, some of the factors did not bear a clear relation to one another or to IRC section 162(a)(1). The test also invited the Tax Court to set itself up as a "superpersonnel department for closely held corporations."

The Seventh Circuit, using the independent investor test, concluded that the compensation paid Heitz was reasonable and deductible.

Ninth Circuit

In O.S.C. & Associates, Inc. (9th Cir., 8/16/99), the Ninth Circuit affirmed the Tax Court's determination that substantially all the compensation paid to each of two shareholders was a nondeductible disguised dividend. Allen Blazick operated a silk screening business. Blazick was the president, COO and a 90% shareholder. Steve Richter, his brother-in-law, was the vice-president and a 10% shareholder.

The company's incentive compensation plan covered only its two shareholders. They were compensated in direct proportion to their stock ownership. Compensation was based on the business's exceeding hypothetical gross margins--in effect, distributing between 82% and 94% of the company's net income to the two shareholders. The company never paid dividends.

For the years in issue, 1990 to 1992, O.S.C. paid the following totals in salary and bonus to the two shareholders: $802,059 in 1990, $2,075,068 in 1991 and $1,707,159 in 1992. The IRS disallowed $357,453, $1,580,631 and $1,198,677, respectively, for those years, and the Tax Court agreed compensation was excessive.

The Ninth Circuit, affirming the Tax Court, used the following test to determine reasonableness: Was the amount of compensation reasonable and did the payments have compensatory intent? The circuit court concluded that the incentive bonus plan existed mainly to avoid income taxes and failed the intent test. Therefore, it ruled no amount paid from the plan was compensation, not even the portion that would have been reasonable had it been part of the shareholders' base compensation.

Conclusion

What do these decisions mean for practitioners? If a practitioner has clients in one of the circuit court districts discussed, the decisions of that court should be scrutinized for clues as to what it looks for in determining whether compensation is reasonable. The existence of a compensation formula, regular payment of dividends, a board of directors that makes the compensation decisions, and a high return on equity may be the difference between a disallowed or reduced compensation deduction and an accepted one.

--Lesli S. Laffie, LLM, technical editor of The Tax Adviser.