Reasonable Compensation: Still Alive and Kicking

The reasonable compensation issue seems to be making a comeback. Although there have not been many cases over the past several years, recently, there have been more than a few. Several of these cases have espoused new criteria for determining if compensation paid to an executive is reasonable. The "independent investor test" involves considering whether an independent investor would approve the compensation package of an executive, given the return on his investment. A "return" involves several criteria, including dividends paid to shareholders and increases in the value of stock.

Normandie Metal Fabricators, Inc.

In Normandie Metal Fabricators, Inc., 5/30/01, aff'g TC Memo 2000-102, the Second Circuit affirmed the Tax Court's finding that compensation was not reasonable. This case points to the importance of documenting positions and criteria for determining compensation when paid. The Tax Court, applying the independent investor test, analyzed several criteria, including:

1. The employee's role in the company (e.g., position, hours, duties and special roles or duties);

2. Potential conflicts (i.e., ability to disguise dividends as salary—especially if there is one shareholder or a controlling shareholder, or when a large percentage of the compensation is a bonus);

3. Consistency in the compensation system;

4. Character and condition of the company (e.g., sales, net income, capital value and general economic fitness); and

5. Comparison with other companies (e.g., salaries paid to comparable employees in similar situations).

The court discovered that Normandie paid the founding shareholder an unreasonable amount, despite the argument that his compensation was low in earlier years. The facts showed that the founding shareholder had significantly cut back his activity in the company and did not earn the compensation the company paid him. On the other hand, his son, the CEO, was now running the company and took significant bonuses, even in years when the company was average at best. An expert testified, on behalf of the IRS, that an independent investor would not be happy with the CEO's results and the Tax Court agreed.

This case might have had a different outcome if Normandie had instituted a compensation plan with a formula containing specific measurable criteria with which it could determine remuneration. If the formula had been applied consistently from one year to the next, Normandie would have had a stronger position for claiming that the compensation was reasonable. The Service also challenged year-end bonuses. Because there was no apparent criteria for determining the amount of the bonuses, the court held they were, in part, disguised dividends. Again, criteria must exist for the calculation of bonuses, especially in closely held corporations.

Eberl's Claim Service, Inc.

Eberl's Claim Service, Inc., 10th Cir., 5/4/01, aff'g TC Memo 1999-211, involved compensation paid to the founder and sole shareholder of a corporation. The court held that he set his own salary and did not deal at arm's length with the company. The Tenth Circuit applied a more traditional analysis, using 12 factors to determine reasonableness of compensation:

1. Employee's qualifications;

2. Nature and scope of employee's work;

3. Size and complexity of business;

4. General economic conditions;

5. Business's financial condition;

6. Comparison of salaries paid with gross and net income;

7. Comparison of salaries paid with distributions to shareholders and retained earnings;

8. Whether employee and employer dealt at arm's length;

9. Compensation policy for all employees;

10. Prevailing rates of compensation for comparable positions in comparable companies;

11. Compensation paid in prior years; and

12. Employee guarantees of employer debt.

The sole shareholder modified an existing compensation agreement to obtain a higher salary. The court focused on two of the years in question and determined that despite the sole shareholder's efforts, long hours, etc., his compensation of $4.3 and $2 million in 1992 and 1993, respectively, was not reasonable. Eberl's reported taxable losses in 1992 and prior years. It reported a small profit in 1993. Retained deficits were reported in most of the years.

The court ultimately reasoned that the sole shareholder had left the company nothing to show for its significant growth in 1992 and 1993 by taking such large salaries. It agreed with the IRS that the company compensated the sole shareholder at a level which "depleted it of virtually all of its profits." It therefore agreed with the Tax Court that a large portion of the salary paid in two of the years was disguised dividends.

Eberl's points to the necessity for companies to significantly document and plan compensation of shareholders in closely held corporations. This is particularly true for highly successful companies.

Most of the recent cases deal with the early 1990s. There will likely be more cases in the near future. Practitioners should be aware that this issue is not typically settled at the examination level. Taxpayers should be advised that if the Service raises the issue, they must be prepared to move to the Appellate level (and beyond), if necessary.

From John W. Lindbloom, CPA, PFS, Huber, Ring, Helm & Co., P.C., St. Louis, MO