The IRS and C corporations often disagree about the reasonableness of shareholder-employee compensation. C corporations usually prefer to classify payments as tax-deductible wages because it lowers corporate taxes. But, if the IRS believes that an owner’s compensation is excessive, it may claim that payments are disguised dividends, which aren’t tax deductible.
Reasonableness is decided on a case-by-case basis. In H.W. Johnson, Inc. v. Commissioner, the U.S. Tax Court found that a corporation was entitled to deduct more than $11 million paid to two shareholder-employees over two years.
A solid business
H.W. Johnson involved a successful Arizona concrete contractor owned 51% by the founder’s wife, and 24.5% each by her two sons, who served as co-vice presidents. H.W. Johnson didn’t produce its own concrete, so it was affected by a statewide concrete shortage starting in late 2002.
In 2003, the sons partnered with other investors to form a concrete supply business. The partnership helped ensure that H.W. Johnson would receive a steady supply of concrete, even when other contractors couldn’t procure what they needed.
During 2003 and 2004, H.W. Johnson paid the sons, combined, more than $11 million in salary, bonuses and directors’ fees. The company computed bonuses according to a formula adopted in 1991 and amended in 1999. The IRS determined that the sons had received more than $8 million in excessive compensation and argued that this amount should be reclassified as nondeductible dividend payments.
Factors to consider
The Tax Court, based on legal precedent set forth by the Ninth U.S. Circuit Court of Appeals, considered the following factors to estimate a reasonable level of compensation:
The employees’ role in the company. Given their expertise, management skills, relationships, reputations and personal guarantees of corporate indebtedness, the sons were integral to the company’s success.
Compensation paid by comparable companies for similar services. The company’s performance significantly surpassed that of any benchmark companies identified by the parties’ experts, making meaningful comparisons difficult.
The company’s character and condition. H.W. Johnson’s remarkable revenue, profits and asset growth during 2003 and 2004 warranted above-market compensation for the sons’ contributions to the company’s day-to-day operations.
Internal consistency of compensation arrangements. Bonuses were paid pursuant to a “structured, formal, and consistently applied program” that was applied equally to all of the company’s employees.
The IRS challenged another critical factor: potential conflicts of interest. It argued that family ownership of the company’s stock permitted the business to disguise nondeductible dividends as deductible compensation.
Independent investor test
In evaluating the reasonableness of owners’ compensation, the Ninth Circuit traditionally examines potential conflicts of interest from a hypothetical independent investor’s perspective. If such an investor would be satisfied by his or her return on equity (ROE), then arguably shareholder-employees “are providing compensable services and . . . profits are not being siphoned out of the company disguised as salary.”
H.W. Johnson provided investors with a pretax ROE of 10.2% in 2003 and 9% in 2004. The court found that these numbers aligned with industry averages for similar concrete contractors and, therefore, would satisfy an independent investor. In light of this test, the court decided that the amounts paid to the sons were reasonable and deductible as compensation expense.
Tests for evaluating what level of shareholder-employee compensation is reasonable vary depending on the case’s venue, as well as the facts and circumstances surrounding a company’s compensation. Be sure your financial expert understands the factors used in a case’s jurisdiction and incorporates them into his or her analysis.