Defending Owner's Compensation

IRS Battles Owner-Managed Business in Tax Court

In closely-held corporations where owner-employees determine their own compensation, the concept of “reasonable compensation” has never been clearly defined. Thus, the IRS will often challenge “high salaries” as being “unreasonable.” When the IRS is successful, the tax-deductible salary expense for the corporation becomes a non-deductible dividend... and the result can be a huge bill to the corporation for additional taxes, penalty and interest. This is a huge concern for closely-held businesses because the potential tax bill can be devastating to the corporation’s cash flow.

The Tax Court recently reviewed a contested IRS audit for tax years 2002 and 2003¹. In this case, the court challenged the IRS’s view of how “reasonable compensation” is determined, which led to some key victories for the corporation under audit. Let’s see what we can learn from this case.

The Case

The taxpayer was a closely-held corporation with:

$9 million in revenue, $3 million in assets, a single owner, who managed the business and employed his sons, owner-compensation of $2 million for each of the two years under audit.

The IRS’s Defense: Industry Comparison

The IRS came to court armed with salary figures of executives in other companies in the same industry as the taxpayer under audit. The salaries of other companies, as put forth by the IRS, were apparently significantly less than what this corporation was paying its owner-employee. The IRS thought they had an easy win...but the Tax Court rendered the executive compensation information provided by the IRS to be irrelevant. Why? The other companies were much larger than the taxpayer, and therefore, in the eyes of the Tax Court, they were not similar to the taxpayer, even though they were in the same industry. In other words, size does matter when looking for salaries of executives in “similar businesses”… and salary data for small and closely-held corporations is difficult, and sometimes even impossible, to obtain. This was a win for the taxpayer.

Alternate Method 1: The Hypothetical Investor

A better indicator of “reasonable salary,” the Tax Court decided, is whether or not the net profit (after paying the salary in question) would give an independent investor a reasonable return on its investment. In the first year under audit, the return on investment was 2.9%. As it was 2002, the court decided that 2.9% was, in fact, a reasonable return on investment. Therefore, the $2 million salary of the owner-executive was sustained by the court. A win for the taxpayer.

Conversely, in the subsequent year, the corporation had a net loss, and therefore, a negative return on investment. The court allowed only $1.2 million of the $2 million to be paid to the owner as salary expense. The court’s rationale was that a hypothetical investor would not get a reasonable return on investment until the salary expense was reduced to $1.2 million. Even though the salary expense was reduced by the court from $2 million to $1.2 million, the court-approved salary was double the amount that the IRS was willing to allow...so I would still call this one a win for the taxpayer.

Take-Away for Owner-Executives:

Calculate and document your company’s “return on investment” when determining owner-compensation. Ask yourself if you would you accept that rate of return when investing in someone else’s business. Ask your financial advisors if the rate of return is reasonable in today’s economic environment.

Alternate Method 2: A Measurable and Consistent Process

The court found that another persuasive factor that favored the taxpayer was the consistent application of a measurable internal process for determining the owner’s compensation. In this case, the owner-executive determined the salary for himself, as well as for his sons, based on their performance on a monthly basis. Monthly compensation for the owner ranged from less than $50,000 to a high of $375,000. The court looked favorably upon the fact that: the monthly salary was not guaranteed; it was based on performance and objective criteria; performance was reviewed and salary was determined on a consistent basis. This strengthened the taxpayer’s arguments that the salaries paid were reasonable. A win for the taxpayer.

Take-Away for Owner-Executives:

Establish a policy as to how salary and bonuses are determined and when they are paid. Compensation should be based on performance, with objective measurements. The compensation policy and process should be applied on a consistent basis.

Alternate Method 3: Role in the Company

The Tax Court also viewed the multiple roles played by the owner-executive as a significant factor in the taxpayer’s favor. In this case the sole shareholder performed no less than ten distinct and essential roles in the operation of the business: (1) engineering services; (2) designing machines; (3) negotiating contracts; (4) ordering equipment; (5) making financial arrangements to acquire products; (6) accounting & finance functions; (7) troubleshooter in the operation of the machines and equipment; (8) marketing & developing new business; (9) making policy decisions in all areas of operations and management; (10) decisions regarding insurance coverage and risk management; etc.

This is not unusual: in an owner-managed business, the owner will often have multiple roles and responsibilities which normally would be spread among several different employees in a larger business. The Tax Court found that in this case, the multiple roles held by the owner could support an argument for a higher salary than the IRS was willing to allow. Another win for the taxpayer.

Take-Away for Owner-Executives:

Describe your job description & duties in detail. Make this a permanent addition to your personnel records. Document how many hours you spend each week (or month) performing each function. Review and update this list on a regular basis. Determine how many people you would have to hire to replace yourself to fulfill all the duties you perform, and how much those salaries would cost the business.

Summary

Keep in mind that this was just one of many court cases on “reasonable compensation” for closely-held businesses… and the IRS has the right to appeal the case. But this case illustrates that owner-executives can strengthen their defense from IRS attack on “reasonable compensation” when they sufficiently address and document their compensation in three additional areas addressed by the court:

Allowing for a reasonable return on investment after owner-salaries are paid. Establishing criteria for performance-based salaries and bonuses. Documenting the multiple roles in the company the owner-executive performs.

When dealing with IRS audits, it is not just a question of doing the right thing: having the right process, procedure and documentation in place can save you a bundle in taxes, and provide a strong defense on your audit.

¹ Case: Multi-Pak Corp., TC Memo 2010-139