A Shareholder-employees’ Guide to Determining Their Worth

By Adam S. Minow, CPA
As long as there are double taxes, there will be hotly contested battles between the IRS and closely held corporation owners over the reasonable compensation owners deserve—and should report to the IRS—for the services they provide to and the value they create for their companies.

In the instance of C corporations, a double tax occurs when the IRS first taxes a C corp’s profit, and then taxes the distributions of profit from the company to its owners. But the issue is not simply isolated to C corps. The IRS is also cracking down on S corp owners who deploy strategies to avoid paying employment taxes. In either case, reasonable compensation of owners of closely held corporations has become a central focus of IRS audits.

A common strategy closely held C corp owners may adopt is to have their companies set the compensation of officers equal to the company’s profit, so there is no income left in the corporation for the IRS to tax. So, why not just declare bonuses to the owners at the end of the year, equal to the profits of the company, and avoid corporate income taxes altogether? If the IRS determines officers’ compensation is too high, it may unleash an attack and send the company a notice of tax deficiency whereby the IRS unilaterally reverses the portion of the salary deduction it deems excessive and imposes taxes, penalties and interest on the excess.

The IRS also will assert that excess compensation—the portion of compensation of shareholder-employees beyond what is reasonable compensation—is not deductible under Internal Revenue Code Sec. 162 because it is not an “ordinary and necessary” expense of the business. Ironically, the tax code does not define “ordinary and necessary” and the IRS does not provide a specific definition of “reasonable compensation.”

S corps owners also face reasonable compensation, but from a much different perspective than C corp owners. S corps are pass-through entities, whereby the IRS does not tax income at the corporate level, but allows income to flow through directly to S corp shareholders. The result is that income is only taxed once on shareholders’ personal tax returns, eliminating the double income tax issue. However, the IRS has taken aim at S corp shareholder-employees who report unreasonably low salaries (or even no salary) for the purpose of avoiding employment taxes (Social Security and Medicare). When S corp shareholder-employees adopt the strategy to take distributions from their companies in lieu of salaries, they avoid both income taxes on distributions and employment taxes on unreported compensation.

For example, in 2011, S corp shareholder-employees have an obligation to fund the entire 10.4 percent Social Security tax and 2.9 percent Medicare tax, totaling 13.3 percent of their salaries (subject to a wage ceiling of $106,800 on the Social Security tax).

Under the scenario that these shareholder-employees take $100,000 in distributions rather than a $100,000 salary, they would not pay taxes on distributions and avoid $13,300 of employment taxes.

The Tax Inspector General for Tax Administration and the U.S. Government Accountability Office believe unreported employment taxes of S corp owners can be in the billions of dollars [TIGTA, (2005-30-080) (May 2005) and U.S. GAO, (GAO-10-195) (December 2009)].

In August 2008, the IRS published Fact Sheet FS-2008-25, Wage Compensation for S Corporation Officers. The IRS takes a powerful stance as it writes: “The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes. S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.”

While the IRS stakes its claim on what it believes is reasonable compensation, the U.S. Supreme Court’s ruling in Botany Worsted Mills v. United States, 278 U.S. 282 (1929) provided taxpayers the opportunity to defend their claims and present the proof to justify that their compensation is in fact reasonable and that the IRS levy was illegally collected.

This seminal ruling shifted the burden of proof of reasonable compensation to taxpayers to justify their worth. In countless battles between the IRS and corporate shareholders, the various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.

In Fact Sheet FS-2008-25, the IRS lists some factors considered by the courts in determining reasonable compensation:

• Training and experience.
• Duties and responsibilities.
• Time and effort devoted to the business.
• Dividend history.
• Payments to non-shareholder employees.
• Timing and manner of paying bonuses to key people.
• What comparable businesses pay for similar services.
• Compensation agreements.
• The use of a formula to determine compensation.

Reasonable Compensation
While the IRS can dispute compensation of shareholder-employees of closely held corporations, the courts have routinely awarded higher compensation to those who justify their salaries based on the value they create for their companies, the number of hours they work, the number of roles they fulfill and the salaries paid to executives in comparable positions based on compensation market studies.

However, when a shareholder-employee’s talents are truly unique and fringe on being indispensable to the company (such as the owner who develops the patents, designs the manufacturing processes and obtains capital for the company), the challenges of establishing a reasonable compensation figure become much more difficult.

As a stopgap measure, the tax courts have placed outer limits on compensation, even for the indispensable employee [Owensby & Kritikos Inc. v. Commissioner; Dexsil Corp. v. Commissioner [98-1 USTC P50,471], 147 F. 3d 96, 102-03 (2d Cir. 1998)].

Multiple Hats Theory
The tax courts may also provide some flexibility when assessing reasonable compensation. There are numerous instances where tax courts have recognized the opportunity for companies to award higher compensation for greater duties performed. One commonly cited argument is the “multiple hats” theory.

This theory says that an employee who performs multiple roles deserves to earn higher compensation [RAPCO, Inc. v. Commissioner, U.S. Tax Court, 69 T.C.M. 2238, T.C. Memo. 1995-128, (March 27, 1995); [99-2 USTC P50,964], Exacto Spring Corporation, Petitioner-Appelant v. Commissioner of Internal Revenue, Respondent-Appellee, Deduction: Business expenses: Resonable Compensation: Closely held corporation: Office: Seven, (Nov. 16, 1999), U.S. Court of Appeals, Seventh Circuit, (Nov. 16, 1999)].

Case law exists to support the argument that CEO-owners who started the company, developed the technology, landed the most lucrative sales contracts and continue to be the key interface with customers can be rewarded with higher reasonable compensation due to the multiple hats they wear.

Market-based Compensation
The IRS and courts rely on third-party compensation studies to determine the reasonableness of shareholder-employee compensation. ERI Economic Resource Inc. is a leading compensation data provider that the IRS relies on to determine whether officers’ compensation is in line with compensation of executives at companies within the same industry, geographic region or size.

In fact, ERI’s Executive Compensation Assessor & Survey was initially created at the request of the IRS National Appeals & Appraisal Services Office for the purpose of assessing the reasonableness of executive compensation. ERI and its Executive Compensation Assessor & Survey have received positive treatment from various tax courts.

Incentive Pay Structure: Pay for Performance
Generally, employees with such broad-reaching and integral responsibilities are compensated with an incentive-based structure. Compensation may be driven by or based on one or any number of success factors—such as sales, net income, economic value added, return on equity and increase in stock price. Performance-based compensation has received favorable treatment in the tax courts.

Even if the information presented above supports shareholder-employee compensation and is justified through case law, there are additional measures the IRS and courts prefer shareholder-employees put in place before they are awarded their salaries. These next few topics may help shield corporations from IRS attacks on unreasonable compensation and are solid business practices.

Time of Decision, Documentation
The first step companies should take to justify officers’ compensation is to put it in writing before it is paid, preferably at the beginning of each year. Further, while employment contracts may speak for themselves, the tax courts have ruled favorably with taxpayers when compensation amounts were set by independent compensation committees (or minority shareholders), based on predetermined formulas that correlate to performance and are documented in employment agreements, board minutes and corporate resolutions.

The IRS more favorably views compensation packages to shareholder-employees when they are set at the beginning of the year before company performance is known.

Conversely, the IRS has presented arguments that bonuses and other compensation paid to shareholder-employees at the end of the year (after profits have been determined) are distributions of earnings to avoid double taxation.

Obtain an Expert Opinion of Reasonable Compensation
The courts rely on the expert opinions of CPAs and other compensation professionals, and reference the work of experts in published opinions. Using a CPA or other compensation expert to help define, evaluate and document a reasonable level of compensation is a recommended practice and can help bolster the defense in tax court.

Payments to Shareholders Based on Ownership Percentages
There have been instances where payments to shareholder-employees based on ownership percentages have been determined by the court to be distributions rather than salaries. Therefore, corporations should avoid paying compensation to shareholder-employees based on percentage ownership interests.

Independent Investor Test
One test the tax courts have relied on to determine the reasonableness of shareholder-employee compensation is the Independent Investor Test [Elliotts, Inc., Petitioner-Appellant v. Commissioner of Internal Revenue, Respondent-Appellee, Corporations: Deductions: Reasonable compensation v. dividends: Absence of declared dividends (Sep 26, 1983), US Court of Appeals, Ninth Circuit, (Sept. 26, 1983)]. The courts have ruled that compensation of shareholder-employees is an ordinary and necessary deduction (and not excessive) when companies can demonstrate that the returns made on equity are reasonable after deduction of shareholder-employee compensation.

If companies can generate sufficient equity returns to independent investors after the deduction of shareholder-employee compensation, then the courts have accepted the compensation as ordinary and necessary. Companies can provide returns to investors in the form of dividends or capital appreciation.
However, absent a conscious strategy for reinvesting earnings for capital growth, profitable companies are expected to pay dividends and distribute profits to their shareholders. In either case, the Independent Investor Test may be the litmus test for reasonable compensation.

Past Pay Inequity
In various circumstances, the IRS has also allowed companies to deduct higher than average levels of compensation when companies maintain records and effectively demonstrate that shareholder-employees were purposely awarded high levels of compensation to make up for past pay inequity [Elliotts, Inc. v. Commissioner of Internal Revenue, U.S. Tax Court, 48 T.C.M. 1245, T.C. Memo. 1984-516, (Sept. 27, 1984)].

In start-up or growth years, companies may not have the resources to pay shareholder-employees reasonable levels of compensation. During this period, companies may be generating lower margins or retaining capital for corporate investment. At the point these companies determine they can sustain more reasonable levels of compensation to shareholder-employees, they may award higher pay to retroactively remunerate shareholder-employees for the sacrifice of lower compensation during start-up or growth periods.

While there is substantial guidance regarding compensation of shareholder-employees, there is not a definitive set of rules or consistent application among the courts. The issues become more complex as compensation arrangements become increasingly sophisticated by including stock-based compensation that is difficult to measure and has less comparability to compensation packages at competitive companies.

To alleviate the complexities, the courts have routinely demonstrated a flexible approach by providing an extensive list of factors that can be used to justify reasonable compensation and have consistently embraced the unbiased doctrine of the unique facts and circumstances of each particular situation [Mayson Manufacturing Co. v. Commissioner [49-2 USTC P9467], 178 F.2d 115, 119 (6th Cir. 1949), affg. A Memorandum Opinion of this Court [Dec. 16,701(M)].

Still, supporting compensation arrangements with written documentation is an important first step. Benchmarking compensation against competitive market data bolsters the defense against an IRS attack, and evaluating compensation using the Independent Investor Test is gaining momentum as an indicator of reasonable compensation.
Adam S. Minow, CPA/CFF, MBA, CVA is senior manager of litigation support at Glenn M. Gelman & Associates.