Reasonable shareholder-employee compensation.

IRC section 162(a)(1) allows companies to deduct from income a reasonable allowance for salaries or other compensation for services actually rendered. Determining whether the compensation paid to a shareholder-employee is reasonable is a factual question. In some cases high compensation is used to distribute profits and is not really related to the services provided. Shareholder-employee compensation agreements must be closely scrutinized to ensure that a company's deductions for compensation will not be recharacterized as disguised dividends.

The Tax Court has used both the "independent investor test" and the "multiple-factor approach" to evaluate whether compensation is reasonable. In general the independent investor test questions whether an inactive, independent investor would have been willing to pay the amount of the disputed compensation on the basis of the facts of each particular case. If the shareholder-employees would have received the same amount of compensation in an arm's-length negotiation, the corporation's shareholders received a fair return on their investments.

The majority of circuit courts use a multiple-factor approach to determine the reasonableness of the compensation; no single factor is controlling.

In Miller & Sons Drywall, Inc. v. Commissioner, TC Memo 2005-114, the sole issue before the court was whether the company's payments to its shareholder-employees were reasonable. The IRS argued the disallowed amounts for the years in question were disguised dividends. The company claimed that under IRC section 162(a) the total compensation was reasonable and, therefore, deductible. The Tax Court ruled the payments were reasonable for the years in issue.

In the mid-1970s Darle Miller and his father entered the drywall construction business. Darle acquired the business from his father and initially operated it as a sole proprietorship. The company is a subcontractor that is awarded jobs based on the lowest bid. In 1980 Darle and his brother Dean incorporated the business as Miller & Sons Drywall Inc. In 1982 another brother, Rocky, purchased an interest. Since its inception, the company's tax year has ended June 30. From July 1, 1982, until June 30, 2000, the brothers' ownership interest in the company was as follows: Darle Miller, 51.8%; Dean Miller, 24.1%; Rocky Miller, 24.1%.

As the company's CEO and president, Darle worked an average of 55 hours per week and regularly brought work home to estimate the cost of completing a job. Rocky was the company's vice president and job-site supervisor. Dean was the company's secretary/treasurer and also functioned as a job-site supervisor with the same duties as Rocky. On average Dean and Rocky each worked 55 to 60 hours per week.

For fiscal years ending June 30, Miller & Sons Drywall Inc. paid the following amounts in base salary and bonuses to Darle, Dean and Rocky: for 1998, $300,000, $150,000 and $150,000, respectively; for 1999, $282,501, $150,000 and $150,000; and for 2000, $440,000, $250,000 and $250,000.

In 2003 the IRS determined deficiencies for 1998 through 2000, based, in part, upon a partial disallowance of the company's deductions for compensation paid to Darle, Dean and Rocky in those three years. After concessions, the only remaining issue before the court was the reasonable compensation issue.

In determining the reasonableness of the company's shareholder-employee compensation in this case, the Tax Court based its analysis on an application of the independent investor test as a lens through which to view the reasonable compensation factors. It considered nine factors and found

* The brothers' knowledge and experience warranted their receiving high compensation.

* The nature, extent and scope of their work also justified high compensation.

* Given the size and complexity of Miller & Sons Drywall Inc.'s operations, the brothers' business methods and techniques directly influenced the company's success.

* The company's success was not due to favorable economic circumstances during the period.

* The company did not declare a dividend, and "the absence of dividends to stockholders out of available profits justified an inference that some of the purported compensation really represented a distribution of profits as dividends." The average return on equity of 15% for the three years, however, was close to the assumed rate of return, a factor favoring the company's position.

* Compensation was calculated as a percentage of gross and net income.

* No data were available to compare shareholder-employee salaries to salaries similar companies pay for similar employee services.

* The company's salary policy as to all employees was inconsistent.

* The company's exceptional pretax profit margin was an indication that these shareholder-employees deserved high compensation.

The court concluded a preponderance of the evidence showed the company's shareholder-employees were reasonably compensated for each year under review and, therefore, the brothers' compensation was deductible in full.

Observation. Because this case can be appealed to the Eighth Circuit Court of Appeals, the court followed the relevant decisions of that circuit, which has not applied the independent investor test. Taxpayers outside the Eighth Circuit should view the facts and circumstances surrounding shareholder-employee compensation in light of the applicable reasonableness factors and the independent investor test.

* Miller & Sons Drywall, Inc. v. Commissioner, TC Memo 2005-114.

Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting Christian Brothers University, Memphis, and Tina Quinn, CPA, PhD, associate professor of accounting, Arkansas State University, Jonesboro.

Tax Pros in Demand

Of those who planned to file their federal tax returns online, more than 42% intended to use a professional service to help them do it.

Source: The Conference Board, www.conference-board.org, survey of 10,000 households.

Most Returns, But Fewest Audits

Among corporations with assets of $250 million or more, the financial services industry filed the most returns (7,898) but had the lowest audit rate in fiscal year 2004--only 17% of returns filed.

Source: Transactional Records Access Clearinghouse, Syracuse University, Syracuse, N.Y., www.trac.syr.edu.