Friday, September 30, 2022

THE IRS CONTINUES ATTACK ON "ZERO OUT" OF PROFITS BY CLOSELY-HELD C CORPORATIONS[1]

 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).

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