Reasonable compensation for closely held corporations.

Excess compensation was the issue in three recent court cases. The facts of the cases were similar; in each, the fact that the principal shareholder was clearly the driving force behind the decisions helps facilitate an understanding of the critical factors that made a difference.

In O.S. C. & Associates, Inc. (OSC), 9th Cir, 8/16/99, aff'g TC Memo 1997-300, the court determined that substantially all the compensation paid to each of two shareholders was a nondeductible, disguised dividend. In contrast, in Richard P. Ashare, TC Memo 1999-282, substantially all distributed earnings were considered deductible compensation. Finally, in Eberl's Claim Service, Inc., TC Memo 1999-211, the court took a middle ground and characterized a portion of the compensation as nondeductible dividends and a portion as deductible compensation.

OSC

In the OSC case, Allen Blazick and his spouse operated a silk screening business. Mr. Blazick, a 90% shareholder, was president and chief operating officer; Steve Richter was the vice president and held the remaining 10% of the shares.

OSC is a textbook example of how not to set up a bonus plan. The company adopted an incentive compensation plan that covered only its two shareholders. Under the plan, the two shareholders would be compensated in direct proportion to their stock ownership. The amount of compensation was determined based on the business exceeding certain hypothetical gross margins that had the effect of distributing virtually all of the company's net income.

The company never paid or declared dividends, even though the company's accountant advised it. Further, a written memorandum explained that the company did not want to pay dividends, because the shareholders did not want the earnings to be taxed twice.

The Ninth Circuit upheld the Tax Court's determination that the "bonuses" paid to the shareholders represented nondeductible disguised dividends. The court focused on a two-prong test referred to in Elliotts Inc., 716 F2d 1241 (9th Cir. 1983), in which the amount of compensation had to be reasonable and the payments had to have a compensatory intent. Under Elliott, it was suggested that reasonable compensation could not be deducted if there was no compensatory intent.

In OSC, the majority decided that the incentive bonus plan was primarily designed to avoid income taxes and, therefore, failed the compensatory intent test. The court based its decision on the fact that most of its net income was distributed to two shareholders, dividends were never declared and the incentive compensation plan improperly increased allocations to the shareholders.

The dissenting opinion argued that the bonus plan should be respected as compensation to the extent that, when added to the shareholders' base salaries, the total compensation was reasonable. The majority, however, found that, if the bonus plan did not have a compensatory intent, none of it would be compensation, not even the portion that would have been reasonable had it been part of the base compensation.

Ashare

Richard Ashare incorporated his law practice in 1974. Ashare was an expert in the area of employee pension plans and worked primarily on one class action suit. In the year in which his cash-method company collected a substantial contingent fee, it paid tax because it did not pay the full amount out to Ashare, its sole shareholder. In 1993, a year in which the company had no income, Ashare's tax adviser suggested that the company pay him $1.75 million, the amount necessary to create a loss sufficient to carry back and recover the tax paid previously. For the company to make this payment, it had to borrow a substantial portion of the payment. The company's board of directors approved the compensation plan and the loan needed to accomplish it.

The board of directors consisted of Ashare, his spouse and his tax adviser. In addition, employee compensation was discussed between the taxpayer's outside accountant and the tax adviser. Under the compensation plan, Ashare was entitled to receive all legal fees received by the business, less any corporate expenses, plus any funds retained for future operations.

The Tax Court determined that the compensation paid to Ashare was reasonable. It believed that Ashare's qualifications justified his high compensation. The taxpayer's business was complex and highly specialized; without Ashare, the business would not have been successful. In addition, the court looked at previous years when the taxpayer could have paid Ashare additional compensation, but the board chose not to do so. The compensation each year was based on the value of the services rendered, and the court found that Ashare had been compensated at fair value. The court said that the decision to borrow money to pay the compensation was a business decision it was reluctant to question.

Eberl

Kirk Eberl, the sole shareholder and president, incorporated his independent claims adjusting business in 1988. Eberl signed an employment agreement that provided him a base salary and bonus. The board of directors determined Eberl's annual salary and bonus at the end of each year.

Eberl made all of the business decisions and supervised or performed substantially all of the managerial functions. He marketed the business and negotiated all the contracts with the insurance companies.

In determining the level of compensation, Eberl had various advisers, including his attorney, accountant and financial adviser. The parties agreed that compensation levels equal to 20-25% of gross receipts would be reasonable.

The court determined that a portion of the payments made in 1992 and 1993 were unreasonable disguised dividends, not compensation for services to the company. The court looked at several factors, including the employee's qualifications, the scope of the employee's work, the size and complexity of the business, comparison of salaries paid to sales and net income, distributions to shareholders, comparable positions in comparable companies and compensation paid in prior years. Like OSC and Ashare, Eberl's compensation plan had the effect of drawing virtually all the net income out of the corporation; only a minimal amount of earnings were retained. By distributing substantially all the earnings, the business would not be able to provide for future growth and expansion.

The court was also persuaded by the fact that, like OSC, Eberl set his own compensation. There was not an "independent" board of directors as in Ashare.

Contusion

In OSC, the majority ruled that the incentive compensation payments were nondeductible disguised dividends, even though the IRS admitted that a significant amount of the "bonus" compensation was reasonable. In an important development, the court ruled that deductible compensation must be both reasonable and compensatory. In contrast, Ashare was allowed to deduct substantially all of its earnings as deductible compensation. The court seemed reluctant to "second guess" the board of directors' decisions in Ashare. In Eberl, although Eberl's personal qualifications and contributions were significant, the court was concerned with the company's lack of dividend payments and minimal accumulated earnings. Therefore, the court characterized the compensation as part deductible and part nondeductible dividends.

The lessons that can be learned from these three cases include:

1. Pay out some amount of dividends;

2. Do not establish a bonus or incentive plan that benefits only the shareholders (particularly if the bonus is proportional to the share holdings);

3. Name an independent board of directors to set compensation and document the company's working capital needs; and

4. Set the "base" compensation at a relatively high level.

FROM GARY GRUSH, CPA, LOS ANGELES, CA