Second Circuit rejects Tax Court's analysis of reasonable compensation.

In Dexsil Corporation, 6/3/98, the Second Circuit vacated and remanded TC Memo 1995-135, which had partially disallowed Dexsil's compensation deduction for its chief executive officer (CEO) (who was also Dexsil's majority shareholder). The Court of Appeals ordered the Tax Court to reconsider the disallowance of the deduction in light of the factors that determine reasonable compensation for services performed. With the current booming economy, reasonable compensation is an important issue for closely held corporations whose employee-shareholders want to get more money out of the corporation and have it deduct the payments.

Sec. 162(a)(1) allows a deduction for "a reasonable allowance for salaries or other compensation for personal services actually rendered." The problem is distinguishing between reasonable compensation (which is deductible) and dividends (which are not), when an employee is also a shareholder and the corporation is closely held. The corporation and the employee-shareholder both want to characterize the corporation's payments as deductible compensation. Moreover, if the employee-shareholder is the majority or sole shareholder, he determines the payment amounts. Therefore, the IRS and the courts scrutinize such payments carefully and disallow any amounts disguised as dividends.

In Elliotts, Inc., 716 F2d 1241 (1983), the Ninth Circuit specified five factors that determine whether compensation is reasonable:

1. The employee's position, hours worked and duties performed;

2. A comparison of the employee's compensation with that paid by similar companies for similar services;

3. The financial condition of the company, as indicated by its sales and net income, and its complexity;

4. Potential conflicts of interest, such as majority shareholder-employees who disguise dividends as salary or receive unduly large bonuses, or both; and

5. Internal consistency in the company's compensation of employees, as evidenced by the use of a reasonable, long-standing, consistently applied contingent compensation formula. Also relevant is the compensation of nonshareholder employees.

No single factor determines if compensation is reasonable; the five factors must be assessed from the perspective of a hypothetical independent investor: Would an independent investor approve the compensation paid to the employee by the company in question, given the dividends received (if any) and the return on equity (ROE) enjoyed by the investor? The independent investor perspective provides an objective viewpoint. As the Court of Appeals in Dexsil! explained, the independent investor perspective is not a separate factor; rather, it is "a lens through which the entire analysis should be viewed"

Ted Lynn, an engineer, and John Churchill founded Dexsil Corporation in 1977. In 1981, Lynn bought out Churchill for $20,000 and became president. Under Lynn's leadership, Dexsil developed, manufactured and marketed field-test kits to detect hazardous contaminants. From 1983-1990, Lynn was its president, CEO, treasurer and chief financial officer, working 60-65 hours per week. Beginning in 1984, Dexsil's net income increased dramatically. For 1989, Dexsil had sales of $3,419,984 and net income of $413,935; for 1990, it had sales of $4,899,359 and net income of $521,160. The 1989 ROE was 26.3% and the 1990 ROE was 25.5%. Dexsil paid dividends of $16,090 in 1989 and $25,992 in 1990.

Lynn's annual salary and bonus increased as Dexsil's sales increased. Dexsil's accountant testified that, since 1982, there was an informal formula by which Lynn would be paid approximately 11% of Dexsil's yearly gross sales. For 1989, Lynn received total compensation of $382,540, consisting of $74,200 in salary, $302,340 in bonus and $6,000 in director's fees. For 1990, Lynn received total compensation of $510,000, consisting of $78,000 in salary, $410,000 in bonus and $22,000 in director's fees. For other employees, Dexsil had incentive stock option and restrictive stock plans. Also, Dexsil paid bonuses to all employees, but shareholder-employees received much larger bonuses than the other employees. During 1989-1990, Lynn owned 62% of the stock; other family members owned 29%. Other employees and investors owned 9%.

The Service disallowed $221,348 and allowed $161,192 of Lynn's total compensation for 1989, and disallowed $332,689 and allowed $177,311 of Lynn's total compensation for 1990. The Service argued that Lynn did not play an important role at Dexsil, because he did not possess current expertise in environmental science. The Tax Court rejected this contention, noting that hiring and managing individuals is among a CEO'S most valuable skills. The IRS's expert found that Dexsil's return on assets and on sales significantly exceeded industry norms and similar companies' returns, but that Lynn's compensation was two to four times higher than the industry norms and similar companies' CEO compensation. He recommended approximately $200,000 per year in compensation for Lynn. (The Tax Court ruled that Dexsil's expert was not qualified, and the expert's analysis of public companies' CEO compensation was irrelevant.)

Dexsil argued that Lynn's compensation was reasonable because of Lynn's multiple roles at Dexsil, Dexsil's extraordinary financial success, its high ROE and the use of a long-standing compensation formula. The Tax Court rejected the multiple roles argument and found no evidence of a compensation formula, but ruled that reasonable compensation was $300,000 for 1989 and $320,000 for 1990 (due to Dexsil's superior financial performance). The court noted that these amounts exceeded the compensation of 90% of the industry's CEOs.

Dexsil appealed on the independent investor, compensation formula and multiple roles issues. The Ninth Circuit agreed with Dexsil on all three issues. First, the court ruled that the Tax Court must use the independent investor perspective in applying the five factors to determine if Lynn's compensation was reasonable; the court cited a prior ruling that a 20% ROE would satisfy an independent investor. Next, the court ruled that the Tax Court must consider Dexsil's compensation formula; such formulas, typically based on sales or income, will generally be upheld if they are established early in the corporation's life and are consistently followed in both good and bad years. Also, the formula should not be so generous as to prevent a reasonable ROE to an independent investor. Finally, formulas can validly apply to only one or two employees. On multiple roles, the court ruled that performing many duties justifies additional compensation; if Lynn did the work of three people, he should be paid their combined salaries.

Dexsil is an important case. Although the Tax Court almost doubled the reasonable compensation allowed by the IRS, the Court of Appeals nevertheless ruled that the Tax Court must reconsider the case to determine if all the compensation claimed by Dexsil was reasonable and therefore deductible. In the reconsideration, the Tax Court must apply all five factors as seen from the independent investor's perspective. Despite this favorable ruling, CPAs should emphasize to closely held corporate clients the importance of adopting a compensation formula as soon as possible and following it consistently. The formula should allow for a reasonable ROE to an independent investor. In addition, a corporation's case is strengthened if dividends are paid. However, the compensation should reflect the employee's contributions to the corporation and the compensation of employees of comparable corporations.