As we all know “C” corporation owners, because of the double tax regime, can be subject to claims by the IRS of excessive compensation. In two recent case the IRS attacked the use of the "zero out" technique. The IRS focused on how closely-held corporations taxed as "C" corporations compensate their shareholders. Under this approach, a "C" corporation compensates its shareholders by paying a portion of its anticipated pre-tax operating profits as compensation (salary) in regular increments during the tax year and then distributes the bulk of its profits in bonuses that are paid at year-end. Both the salary and year-end bonuses are deducted as compensation in order to reduce or even eliminate federal income taxes.
The potential tax risk of this method for compensation is that
even though the shareholders provided services to the corporation, the IRS
could disallow the compensation deduction for the "salary" and
bonuses paid and treat the payments as non-deductible dividends made by the
corporation to its shareholders on either or both of two grounds: (1) that the
payments made were unreasonably excessive based on the services provided, and/or
(2) that the payments made were not purely for services.
Two recent cases provide insight into how the zero out approach
to compensation can be properly structured to support the deductibility of
payments of salary and year-end bonuses made by closely-held "C"
corporations to their shareholders as compensation for services provided. In
one case, the Tax Court issued a lengthy opinion in support of its denial in
part of the deduction of compensation paid to the sole owner of a construction
business organized as a C corporation. In another case, the Eighth Circuit
Court of Appeals affirmed a 2021 Tax Court case that upheld the IRS's
characterization of payments made by an asphalt paving company to or for its
owners as non-deductible dividends rather than deductible compensation.
The Aspro Case
The Eighth Circuit Court of Appeals affirmed a Tax Court case
that had upheld the IRS's characterization of payments made by a "C"
corporation as non-deductible dividends rather than as deductible compensation
payments for management services.[2]
In Aspro, the taxpayer was a "C" corporation that
operated an asphalt paving business and obtained business by bidding on paving
contracts through the efforts of its owners. Even though the taxpayer generated
income throughout the year, it made no payments for services to or for the
benefit of its three shareholders until the end of the year, when it paid
"management fees" for assistance provided to the taxpayer on how to
bid for projects.
The Tax Court had found that the payments made during each of
three tax years by the corporate taxpayer to its three shareholders were
non-deductible dividends and could not be deducted as compensation for personal
services provided to the corporation. The Tax Court indicated that to be
deductible under the applicable regulation, compensation payments must be made
purely for services.[3]
This regulation states in part that "[a]ny amount paid in the form
of compensation, but not in fact as the purchase price of services, is not
deductible. An ostensible salary paid by a corporation may be a distribution of
a dividend on stock. This is likely to occur in the case of a corporation
having few shareholders, practically all of whom draw salaries... ."
The Tax Court noted that the corporation had never previously
paid any dividends to its shareholders, the payments made were in roughly the
same proportions as share ownership of the taxpayer, and that two recipients of
the payments were corporations that were shareholders of the taxpayer, both of
which were "paid" the same amounts each year for services ostensibly
performed by the individuals who owned these two shareholder-corporations.
The court also pointed out that the personal services for which
compensation was paid were performed throughout the entire year but the
payments were made annually at the end of each year and thus lacked a
compensatory purpose. Additionally the payments eliminated almost 90% of the
taxpayer's taxable income in two of the three years and just under 80% of its
taxable income in the third year. Because the corporation had never paid dividends
an inference could be made that the management fees paid were not compensation
for services but dividends.
The amounts paid had little relation to the value of the
services provided by the three shareholders (or their owners) to the
corporation.
The Tax Court[4]
noted Reg.
1.162-7(a) which provides that payments
made that "correspond or bear a close relationship to the stockholdings of
the officers or employees" are subject to recharacterization as dividends.
Since the Tax Court had identified "numerous indicia of disguised
distributions," the court found that the payments were not deductible, and
the taxpayer was liable for corporate income taxes based on its net income
determined without the denied compensation deductions.
The Court of Appeals then addressed each of the factors relied
upon by the Tax Court in making its decision and expanded on the Tax Court's
analysis. For example, the Court of Appeals noted that all compensation
arrangements within closely-held corporations should be closely scrutinized,
that the payments made by the taxpayer were made in a lump sum at the end of
the year (a true "zero out" approach), and that the corporation did
not pay and had never paid dividends to its owners.
As a result, the Court of Appeals upheld the Tax Court decision
that denied in their entirety the deductibility of the payments made to or for
the benefit of the taxpayer's three shareholders as compensation.
The Clary Hood case
In Clary Hood, Inc.,[5]
the Tax Court redetermined the deductible portion of the salary and the
substantial "one-time" bonuses in the amount of $5 million that the
taxpayer, a construction company owned by one shareholder, paid its CEO/founder
during each of two tax years. Based in part on testimony provided by the IRS
expert and applying the multifactor test utilized by the Tax Court in the Aspro
case as to whether or not the payments made were reasonable based on the
services provided, the Tax Court found that a significant portion but not all
of the salary and bonuses paid to the sole shareholder of the construction company
in each tax year could be deducted as reasonable compensation for services
provided to the corporation.
Even though the Board of Directors of the construction company
consisted only of the sole shareholder and his spouse, prior to Board approval
of payment of the two significant bonuses, the corporation had engaged its
accountants to determine the extent to which the corporation's owner had been
"undercompensated" during the tax years prior to the review of the
compensation paid and to obtain the accountants' recommendations as to how to
compensate the taxpayer's sole shareholder for services provided going forward.
Working with the corporation's accountants, an officer and the
corporation's shareholder reviewed the accountants' report and determined that
the owner had been undercompensated on an historical basis and that any
compensation paid to the shareholder going forward should also take into
account the ongoing financial risk incurred by the shareholder in personally
guaranteeing the performance bonds of the taxpayer corporation. This analysis
by the corporation's accountants used publicly available industry specific
compensation data in its findings and recommendations.
In support of its decision, the Tax Court cited several facts:
· prior to the payment of the first annual bonus, the taxpayer had
conducted a detailed study to confirm that its sole shareholder/founder had
been undercompensated during its startup years,
· that he personally agreed to guarantee claims of the companies
that provided performance bonds for construction contracts of the corporation,
and
· that the detailed analysis provided by an expert engaged by the
taxpayer's Board of Directors established a reasonable method to compensate the
owner for the ongoing financial risk he incurred in guaranteeing personally the
construction company's performance bonds and other significant factors.
The Tax Court also noted that the taxpayer had bonused out to
the founder during the two tax years in question a relatively small portion of
the business's pre-tax operating profits. Specifically, the Tax Court concluded
that "[w]hile such amounts are not insignificant, we do not necessarily
consider them telling of an egregious pattern of disguised dividends . . .
[since paid for prior services]. " The amounts found by the Tax Court to
be deductible were those determined as reasonable by the IRS's compensation
expert who testified at trial.
Even though the taxpayer corporation's Board of Directors (the
sole shareholder and his spouse) set annual compensation on a subjective basis
(i.e., not using an objective formula), the Board solicited and accepted input
and advice from the corporation's accountants for this purpose. In addition,
prior to the tax years in question, the corporation had not compensated the
shareholder for the financial risk he had personally incurred in annual
guarantees of the corporation's performance bonds.
Lessons from Aspro and Clary Hood
These two cases provide valuable lessons to closely-held
corporations organized as "C" corporations as they develop methods
for compensating employed shareholders for services rendered:
• Do not wait until the end of the year to pay bonuses to the
corporation's shareholders. Instead, make periodic payments of base
compensation as salary during the year, using an objective formula that takes
into account the value of the services provided by each shareholder.
• If the corporation is owned by more than one shareholder, do not
pay compensation to the corporation's shareholders in the same percentages as
their relative share ownership.
• The Board of Directors of the closely-held corporation should
engage competent accountants, tax preparers, or compensation consultants to
provide advice and counsel in structuring any compensation method, and the
Board of Directors should review and consider written guidance and reports from
these advisors prior to approval of any compensation method (or prior to
payment of any year-end bonuses based on that method). Make sure that these
compensation advisors rely upon available industry specific compensation
studies to support their analysis.
• Do not zero out all corporate pre-tax profits each year as
compensation, but declare and pay annual dividends of a portion of these
profits and pay federal income taxes on the remaining pre-tax profits of the
corporation.
• Enter into a written employment agreement with each individual
shareholder that contains an objective formula for determining at least the
contingent portion of compensation.
Further Lessons
Today many small businesses are operated as pass through entities
such as S corporations as there is largely no double taxation. Therefore, the
tax incentive is to pay as little compensation as possible and pass profits as
S corporation distributions. This is done to avoid FICA, Medicare taxes and
other taxes. These two cases illustrate that a corporation must pay reasonable
compensation to its owners lest it be subject to underpayment of compensation
with the S corporation distribution being converted to compensation.
Like many things in taxation adherence to guide lines established
by statutes, regulations, cases, rulings etc. provide a road map to be followed.
Its when the taxpayer “takes a wrong turn” that she finds herself facing
additional taxes and penalties.
[1]
This is an abstract of an article published in Corporate
Taxation (WG&L), Sep/Oct 2022 issue by Ralph Levy.
[2]
Aspro, Inc. v. Comm’r., 129 AFTR
2d 2022-1581, 32 F.4th 673 (8th Cir. 2022), 2022-1 USTC P 50,147 (8th Cir. 2022).
