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Reasonable compensation: how much is too much?

REASONABLE COMPENSATION: How Much Is Too Much?

The issue of reasonable compensation has probably caused as much dispute with the IRS as any other issue, resulting in scores of court cases. The purpose of this article is to analyze judicial and administrative decisions with a view toward planning.

Section 162(a) merely contains a brief reference to the word "reasonable," stating that ... a reasonable allowance for salaries or other compensation for personal services actually rendered is allowed as a deduction. The regulations to Section 162 offer only a little more guidance, stating that: 1. An ostensible salary paid by a

corporation may be a distribution

of a dividend on stock (a

constructive dividend). 2. The form or method of fixing

compensation is not decisive as

to deductibility, although any

form of contingent compensation

invites scrutiny. 3. The allowance for compensation

paid may not in any event exceed

what is reasonable under all the

circumstances. Relevant circumstances

are those existing as of

the date when the contract for

services was made, not those existing

at the date the contract is

questioned.

For purposes of determining reasonable compensation, both current and deferred compensation must be taken into account, and fringe benefits must be included to determine the reasonableness issue. (1)

Factors to be considered by IRS auditors as listed in Internal Revenue Manual 4233 are as follows: nature of duties, background and experience, knowledge of the business, size of the business, individual's contribution to profit making, time devoted, economic conditions in general, local, character and amount of responsibility, time of year compensation is determined, relationship of stockholder-officer's compensation to stockholdings, whether alleged compensation, is, in reality, in whole or in part, payment for a business or assets acquired, the amount paid by similar size businesses in the same area to equally qualified employees for similar services, etc.

Judicial Decisions

The burden of proof is on the taxpayer to show that the compensation is reasonable. The taxpayer must show by a preponderance of the evidence that the assessment is not correct. (2)

Payments must be for services rendered, as well as being reasonable. (3) The court case most often cited for listing relevant factors is Mayson. In Mayson the Sixth Circuit Court said "Several basic factors should be considered. Such factors include the employee's qualifications; the nature, extent and scope and of the employee's work; the size and complexities of the business; a comparison of salaries paid with the gross income and the net income; the prevailing general economic conditions; comparison of salaries with distributions to shareholders; the prevailing rates of compensation for comparable positions in comparable concerns; the salary policy of the taxpayer to all employees; and in the case of small corporations with a limited number of officers the amount of compensation paid to the particular employee in previous year." (4)

In Kennedy (1982) (5), the sixth circuit added, "among other factors which courts have taken into account when considering this question are the success of the employee's efforts; profitability of the business; absence of the usual fringe benefits such as a pension or profit-sharing plan, stock options, etc., which are available to executives of other companies of comparable size; unusual capability of employees; and bonuses not paid in the same ratio as stock holdings."

Favorable Factors

The following is a list of factors which have been cited favorably by the courts.

Long hours. In Wag-Aero the court noted that "he {the president} devoted upwards of 70 hours per week. He has literally worked night and day for the company." (6) In Steel Constructors the Tax Court observed that the "payee worked extremely long hours and was primarily responsible for success of the business." (7) In Medina, the Tax Court said that the president "worked long hours and had a great deal of responsibility." (8)

Uniqueness of contribution. This factor has been given considerable weight by the courts. In Wag-Aero (1981) the court stated that the president "personally designed and developed products representing over 40% of sales." In Hanslik Cotton Co. (1978) the Tax Court said that "The company's success was almost surely attributable to the president's efforts and knowledge in a specialized field." In Walsh (1981), the Tax Court noted that "it would have been difficult to find a replacement with such a breadth of proven background." In Paramount Clothing Co. the Tax Court considered the ability of the president to stave off competition from off-shore and non-union manufacturers. (9)

Success in turning the company around. In Ocean Pool Supply the Tax Court noted that "the dramatic growth in sales through the efforts of E.L. Keuerlaber amply demonstrates his worth." (10) In Skyland Oldsmobile, Inc. the Tax Court said that {when the petitioner took over} it {the dealership} was producing a less than satisfactory return on investment, its profits were low and its penetration of its market class unsatisfactory. {He} turned Skyland away from the abyss of failure and singularly developed the dealership into one of the most successful in the country." (11)

Above average growth and/or profitability. In Skyland Oldsmobile, Inc. (1972) the Tax Court noted that "gross sales were doubled" {since the petitioner took over}. In Ocean Pool Supply (1974) the Tax Court was impressed with the "dramatic growth in sales through the efforts of the president." Growth in the business is a relevant factor even if the growth is in years prior to the year under consideration. In Drexel Park Pharmacy the Tax Court, in ruling on the reasonableness of compensation in for the years 1973 and 1974, considered the growth in corporate sales for the period 1959-1972. (12) In Ledford Construction (1977) the Tax Court cited as a factor that the president was responsible for the company's growth and success. Again, in Neils (1982) the Tax Court decided that the success and rapid growth of the corporation was due to the president's efforts and not due to fortuitous market events. On the other hand, in Southern Explosives Corp. (1979) and Ken Miller Supply. Inc. (1978), the Tax Court held that a large increase in sales that is primarily due to economic conditions will not necessarily help make a case for reasonable compensation.

Experience of employees. The courts generally tend to allow higher salaries for employees with many years of experience. In Multomah Plywood Corporation a district court cited as one of several favorable factors that the shareholder employees were more experienced than the union employees. (13) The many years of experience was noted approvingly by the Tax Court in Medina (1983) as well as in Plastics Universal Corporation. (14) In Shotmeyer Bros. Petroleum Corp. (1980) the Tax Court mentioned the value of the president's experience, business acumen and high esteem among his peers. On the other hand, in Drexel Park Pharmacy (1979) the Tax Court, in finding that compensation was unreasonable, noted that the president did not have experience in the field.

High productivity, efficiency. etc. of the company. In Multomah Plywood Corporation (1972) the court noted favorably that the company required fewer foremen than the average for the industry and that they achieved greater productivity than the average. In Ward Trucking (1965) the Tax Court gave great weight to a study showing that the company's operating ratios were superior to all but one of 47 comparable carriers.

Bonus arrangements entered into prior to becoming a stockholder. In Steel Constructors (1978) the employee's bonus increased dramatically as income increased sixfold. However, the Tax Court observed that the petitioner's bonus arrangement was established prior to the years in question and before the employee was a stockholder of petitioner, thus militating against the finding of a de facto dividend."

Employee offered a higher salary by outsiders. In Ledford Construction Co. (1977) the Tax Court gave great credence to the fact that the president was offered a higher salary by a company attempting to purchase the company.

Inability of the employee to control compensation levels and/or dividends. In D. Walsh (1981) the Tax Court said that "The officer did not control the corporation and the other officer-stockholders had approved of the compensation paid to him to their financial detriment either through lower salaries or dividends."

Salary compares favorably with that of other companies. The courts are more impressed with studies comparing direct competitors than with secondary data obtained from industry comparisons. In Suwannee Lumber (1979) the Tax Court gave some weight to a study done by the company of executive salaries in comparable jobs in related and other industries which was done before the company increased compensation. In Weaver Paper Co. (1980) the evidence presented (testimony of two other paper company executives) indicated that the employee would have earned a similar amount working for other employers. In Good Chevrolet (1977) the Tax Court noted that compensation paid was in line with that of other auto dealers even though those dealers were less successful. In Laure (1978) a retired bank president who was familiar with more than 50 closely-held corporations similar in size and growth testified that the compensation paid was reasonable. In William C. Neils (1982), in holding for the taxpayer, the Tax Court said that the comparison of salaries to competitors (as was done by the IRS) was less relevant than comparisons to other distributors of the same manufacturer.

A showing by the IRS that similar companies paid lower salaries is not necessarily fatal to the taxpayer's case. In Ledford Construction Co. (1977) the IRS showed that three similar companies paid much lower salaries than Ledford. However, the Tax Court observed that Ledford was much more successful and executives of two of the companies testified that they would have paid him more than he earned. A similar conclusion was reached by the Seventh Circuit in Edwin's, Inc. (1974).

As previously mentioned, the courts are often unimpressed with secondary data. In R.L. Towsend (1980) the Tax Court said that comparison of compensation with Dun & Bradstreet reports was flawed because, among other items, the data showed only averages. In Federal Lithograph Co. (1975) the Court of Claims said that neither the IRS Source Book nor printing industry ratio statistics furnished information sufficiently comparable, since they reflected only statistical averages and did not distinguish between good and bad executive performances. On the other hand, in Shotmeyer (1980), the Tax Court cited as evidence of compensation the Annual Statement Studies - 1975 Edition, by Robert Morris Associates which listed average salaries and salaries as a percent of net sales for petroleum products wholesalers approximating 10 million in sales.

Failure to show that salaries are reasonable compared to competitors or comparisons that lack comparability may be damaging to the taxpayer's case. In Castle Ford (1978) the Tax Court noted disapprovingly that the petitioner had failed to introduce any evidence (other than unsupported assertions) as to compensation paid by comparable business to executives with responsibilities comparable to Castle's.

Employee was undercompensated in previous years. In Nicoll Co. (1932) the Tax Court said that the payments were not unreasonable in light of services performed in previous years for which compensation was substantially less than the value of services then rendered. However, failure to designate part of the salaries as such may be damaging. In Pacific Grains (1968) the Ninth Circuit said that the taxpayer had the burden of showing that the salary was intended to compensate for prior periods and that the failure of the board to earmark the funds as being in part for prior services negated the claim that the compensation was for prior services.

Unfavorable Factors

The following are factors which have been cited unfavorably by the courts.

Compensation rate exceeds that of comparable companies. In Pepsi-Cola Bottling the Tax Court found that the compensation was considerably higher than that of comparable companies. (15) Although the testimony of outside experts is given considerable weight, the Eighth Circuit in Schneider accepted the testimony of an Internal Revenue Agent who had examined many corporate returns, testified that the compensation paid the executives involved was excessive and set out in detail his reasons for such a conclusion. (16) In News Publishing Co. (1981) the Court of Claims found that the compensation was unreasonable, based on evidence of average salaries paid in the industry and on a comparison to the salary paid by a similar publishing company.

Lack of dividend payments. The lack of dividend payments, even if salaries are in proportion to shareholdings, does not automatically mean that the compensation is unreasonable and a constructive dividend. Not only have the courts held otherwise, but the IRS in Rev. Rul. 79-8 ruled that insufficient dividends alone does not mean that compensation is unreasonable. Nonetheless, it is definitely an unfavorable factor.

In Schneider & Co. (1974) the Eight Circuit noted that an absence of profits paid back to the shareholders as dividends justified an inference that some of the purported compensation really represents a distribution of profit. In Lefkowitz (1983) the Tax Court held the failure to distribute any part of the progressively larger annual earnings as dividends to be particularly damaging.

Instrumental in a district court decision in Trinity Quarries was that the ratio of salaries to stock ratio of the officers was very similar and that the corporations had never paid dividends. (17)

In Kremer Co. the Tax Court felt that even though there was an apparent reason (a large variation among family members as to the amount of stock owned), the lack of dividend payments implied that some of the compensation was a distribution of profits rather than for services rendered. (18)

In a mixed decision in Drexel Park Pharmacy (1979) the Tax Court considered the low dividend payment record to be the most important negative factor. In a mixed decision in Rich Plain of Northern New England (1978) the Tax Court was very concerned with the lack of dividends despite a considerable accumulation of earnings and profits during the year in question. However, in some cases, e.g., Paramount Clothing (1979) and Plastics Universal Corporation (1979), the courts have disregarded the lack of a dividend payment record, while in Machinery Specialties & Engineering Co. (1982) the very low dividend rates were disregarded. If the lack of dividends is due to mitigating factors, the courts are likely to disregard such deficiency. In Steel Constructors (1978) the Tax Court stated, "The petitioner was clearly not in a position to pay dividends given the potential liability under the pending lawsuits, the payments to the former shareholders for their stock and the liquidity problems occasioned by the cyclical nature of petitioner's business."

Compensation formulas which are inappropriate. In Pepsi-Cola Bottling (1974) the Tax Court felt that the compensation formula was outmoded. In Schneider & Co. (1974) the Eighth Circuit noted that "a bonus-type contract which is reasonable with a non-stockholder employee may be unreasonable with a large stockholder since the incentive of the bonus would presumably not be needed to call for the stockholder's best efforts." In Kipnis (1982) the Tax Court was troubled by the fact that the bonus was not set by formula but by considering net profits. Bonuses which represent too high a portion of compensation may be viewed unfavorably by the courts. In Kremer Co. (1979) the Tax Court disapproved of the fact that almost all of the compensation was paid in year-end bonuses. In Trinity Quarries (1981) the Tax Court disapproved of the fact that the compensation was contingent, was determined at the end of the year and that bonuses were based on profits. Although compensation can be for past services, this should be made explicit. In A. Mennuto (1971) the Tax Court denied the assertion that part of the compensation was for past services, noting that the corporate minutes made no mention of that.

Taxpayer's expert witness outgunned. In Knodel-Tygrett Co. (1978) the testimony of the taxpayer's expert witness was refuted by comparative evidence showing that a comparable company paid only about one-third of the compensation of the employee's compensation in question.

Lack of uniqueness of employee's skills. Part of the compensation for a pharmacist was denied in Drexel Park Pharmacy (1979) on the grounds that there was "nothing particularly unique about petitioner's qualifications {as a pharmacist}."

Employee spends little time on the job or works less than in previous years. In Bev Anderson Chevrolet (1967) the Tax Court in ruling against the taxpayer observed the employee's services were minimal and required little time.

Board of directors not independent. In most cases the board of directors will in fact not be independent, that is, the board will be controlled by the employee. While not conclusive by any means, it is a negative factor. In H. Fox. Inc. (1978) the Tax Court cited the lack of independence in ruling against the taxpayer. In Kerrigan Iron Works (1951) not only was the board considered not independent, but because a minor was one of the directors, the court ruled that the board was not qualified under the laws of the state.

Increase in salary without increase in duties. This factor, or maintenance of salary with a decrease in hours worked or duties performed, is viewed very unfavorably by the courts. (19)

Planning Strategies

From the favorable and unfavorable factors cited by the courts, some planning strategies can be developed. In setting salaries, bonuses and other forms of compensation of employees/stockholders, the minutes should reflect consideration of the number of hours worked by the employee, the unique skills furnished, the experience of the employee and the operating results of the company in terms of reversal of negative trends, growth in sales and profits, and the relative efficiency and productivity of the firm. If industry data can be used to demonstrate the reasonableness of the salary, this could also be reflected in the minutes. Payment of at least some dividends would be helpful. If dividends are not paid, the corporate minutes should reflect valid reasons for accumulations of earnings and profits, e.g., reserves for legal damages or reserves to expand the plant. This could be done at the same time that retained earnings are formally appropriated.

Companies should avoid compensation to employee/shareholders that greatly exceeds that paid by comparable companies. Bonuses should ideally be based on factors other than net income. Employees should put in their time; the courts are not impressed with high compensation paid to part-time corporate officers. If the compensation is challenged by the IRS and the issue winds up in court, expert witnesses should be obtained. The most credible witnesses appear to be consultants who are experienced in that particular industry. If possible, the board of director's vote on compensation should reflect votes of independent members. If not possible to demonstrate some independence, it may be helpful to demonstrate that a member or member's vote for compensation or bonuses to a particular employee is detrimental to that board member's interest.

Employees of S corporations should be aware that under proposed regulations under Section 1361, a difference in the timing of distributions on stock as well as the amount of the distributions can create two classes of stock. Thus, a determination that compensation to an S corporation shareholder was unreasonable and was therefore a constructive dividend could result in the creation of two classes of stock and thus invalidate the election.

Conclusion

In summary, closely-held companies that substantiate the need to pay reasonable salaries to stockholder/employees may be able to head off the IRS auditors at the pass. However, those companies who pay excessive salaries without giving thought to justifying those salaries may find themselves in a box canyon.

Footnotes

(1) Rev. Rul. 67-341.

(2) Helvering v. Taylor, 293 US 507, 14 AFTR 1194 (1939).

(3) See Nor-Cal Adjusters, Inc. v. Comr., 74-2 USTC para. 9701, 503 F.2d 359, 34 AFTR 2d 74-5834 (9th Cir., 1974).

(4) Mayson Mfg. Co. v. Comr., 178 F.2d. 115, 49-3 USTC para. 9467 (6th Cir., 1949).

(5) For a detailed citation of this and other court cases not completely cited due to space considerations, write the author.

(6) Wag-Aero, Inc. v. U.S., 81-1 USTC para. 9183 (DC E. Wisc, 1980).

(7) Steel Constructors, Inc., 37 TCM 1851 (1978).

(8) Medina v. Comr., 46 TCM 76 (1983).

(9) Paramount Clothing Co., Inc. v. Comr., 38 TCM 261 (1979).

(10) Ocean Pool Supply Co., Inc. v. Comr., 33 TCM 784 (1974).

(11) Skyland Oldsmobile, Inc., v. Comr., 31 TCM 47 (1972).

(12) Drexel Park Pharmacy, Inc. v. Comr., 39 TCM 788 (1979).

(13) Multomah Plywood v. U.S., 72-2 USTC para. 9677, 30 AFTR 2d 72-5273 (DC, 1972).

(14) Plastics Universal Corporation v. Comr., 38 TCM 32 (1979).

(15) Pepsi-Cola Bottling Co. of Salina, Inc. v. Comr., 61 TC 564 (1974).

(16) C. Schneider & Co. Inc. v. U.S., 74-2 USTC para. 9563, 500 F.2d 148, 34 AFTR 2d 74-5422 (8th Cir., 1974).

(17) Trinity Quarries, Inc. v. U.S., 81-2 USTC para. 9527 (DC Ala., 1981).

(18) Kremer Co., Inc. v. Comr., 39 TCM 1212 (1979).

(19) See, for example Pacific Grains, Inc. v. Comr. 68-2 USTC para. 9536, 399 F.2d 603 (9th Cir. 1968); Huckins Tool and Die, Inc. v. Comr., 61-1 USTC para. 9399, 289 F.2d 549 (7th Cir. 1961); Rich Plains of Northern New England, Inc.,

v. Comr., 37 TCM 1853-8; R.J. Kremer v. Comr., 39 TCM 1212.

Gary L. Maydew, CPA, PhD, is an associate professor in the accounting department at Iowa State University. He has published articles in Taxes, Taxation for Accountants, The Practical Accountant, The CPA Journal and numerous other journals. He also is the author of the book, Agribusiness Accounting and Taxation, and has a book forthcoming, Tax Planning for Small Businesses. He regularly presents seminars on taxation and accounting in the small business and agribusiness areas.
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Title Annotation:accounting for employees' salaries
Author:Maydew, Gary L.
Publication:The National Public Accountant
Date:Aug 1, 1991
Words:3617
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