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IRS “unreasonable compensation” challenges likely to increase

By Ronald Levitt • Monday, April 22, 2013

judge“Unreasonable compensation” challenges by the IRS are generating steam. We anticipate that this trend will continue as a result of the tax rate increases and new taxes under the American Taxpayer Relief Act of 2012 (ATRA).

Under ATRA, the highest marginal tax rate applicable to C corporation earnings distributed to owners as dividends increased from 15% to 20% beginning in 2013. In addition, ATRA introduced a new 3.8% Medicare tax on C corporation dividends. In the S corporation realm, active shareholders do not pay Medicare tax on S corporation distributions. These differences in taxation of corporate distributions encourage C corporations to pay high compensation to their shareholder-employees and encourage S corporations to pay low compensation to their shareholder-employees.

The Service's recent efforts appear to be focused on closely-held C corporations with shareholder-employees, but with the enactment of ATRA, S corporations are surely susceptible to scrutiny. Three recent cases highlight the divergent theories that the courts may employ in analyzing the unreasonably high compensation issue. The cases also provide valuable lessons on steps that taxpayers may take to protect themselves in the event of an IRS audit of the corporation's compensation deductions. We will address unreasonably low compensation cases in the context of S Corporations in a later issue of The Defender.

Mulcahy, Pauritsch, Salvador & Co., Ltd. v. Commissioner, 680 F.3d 867 (7th Cir. 2012), aff'g, T.C. Memo. 2011-74 (2011)

In Mulcahy, Pauritsch, Salvador & Co., Ltd. v. Commissioner, 680 F.3d 867 (7th Cir. 2012), aff'g, T.C. Memo. 2011-74 (2011), the IRS challenged deductions taken by an accounting firm, organized as a C corporation, for “consulting fees” that it paid to entities owned by its founding shareholders, in addition to salaries that it paid directly to them. In the Tax Court, Judge Morrison applied the “independent investor test” to determine if the firm was entitled to a presumption that the salaries plus the “consulting fees” constituted reasonable compensation. As stated by the Tax Court, the “independent investor test” creates a presumption that an owner-employee's salary is reasonable if investors in the firm would obtain a higher return than they had reason to expect. Deducting the salaries and consulting fees reduced the firm's net income to zero or below in two of the three tax years at issue. Thus, the firm's rate of return on equity, in effect zero, would not have been acceptable to an independent investor. The Seventh Circuit affirmed the Tax Court's application of the independent investor test in denying the firm's deduction.

Having failed the “independent investor test,” the burden was then on the firm to establish the reasonableness of the consulting fees paid to the entities owned by the founding shareholders. Both the Tax Court and Seventh Circuit concluded that the neither the firm nor its expert presented any credible evidence that the “consulting fees” constituted reasonable compensation for services to the firm. Thus, each court held that the firm did not carry its burden of showing the reasonableness of the “compensation” for which it took a deduction.

The Seventh Circuit further noted that even if the firm could prove that the fees were reasonable compensation for something, it presented no evidence or documentation that the fees were compensation for services rendered or even treated as such by the firm. The entities to which the fees were paid had not performed any services for the firm, which also did not account for the fees as compensation in its internal records. In arguing that the fees were payment for services rendered by the founding shareholders, the firm asserted that it paid the fees indirectly through the related entities in order to conceal from the other employees and shareholders the amount of compensation being paid to the founding shareholders. It is unlikely that this argument sat well with the courts.

Mulcahy highlights the importance of documentation and expert testimony on the issue of reasonable compensation when a taxpayer flunks the independent investor test. The most critical takeaway, however, is the Tax Court's and Seventh Circuit's willingness to apply the independent investor test to a professional services firm (here, an accounting firm organized and taxed as a C corporation). Application of this test to a professional services firm is surprising because seldom does a professional services firm have an “independent” investor.

Thousand Oaks Residential Care Home I, Inc. v. Commissioner, T.C. Memo. 2013-10 (2013)

In Thousand Oaks Residential Care Home I, Inc. v. Commissioner, T.C. Memo. 2013-10 (2013), the Tax Court held that certain amounts of compensation paid to a C corporation's sole shareholder-employee and his wife were not reasonable. Following the sale of the corporation's sole asset, an assisted living facility, the corporation began compensating the husband and wife at much higher levels than in the decades preceding the sale. The Tax Court found that the corporation intended the additional compensation to constitute “catch up” payments for prior services actually rendered. From the early 1970s through the asset sale in 2002, the shareholder-employee and his wife received depressed salaries due to cash flow constraints. These constraints were eased upon the sale of the assisted living facility. The Tax Court next considered the reasonableness of the total amount of “catch-up” compensation.

The Tax Court applied the Ninth Circuit's “five broad factors” analysis, supplemented by the independent investor test as an additional factor, in holding that the total compensation was unreasonable. The five factors test embodies the same reasonableness and evidentiary considerations as in Mulcahy (e.g., industry comparisons and nature and extent of services performed). However, unlike Mulcahy, the Tax Court did not first apply the independent investor test to determine if the taxpayer was entitled to a presumption that the compensation was reasonable. Nevertheless, the Tax Court relied heavily on the independent investor test in finding that the compensation was unreasonable, even though it concluded that the five broad factors weighed slightly in favor of the taxpayer.

Thousand Oaks shows yet another approach the courts may take when analyzing the reasonableness of compensation. Though the Tax Court applied the Ninth Circuit's “five broad factors test,” it also relied heavily on the independent investor test. It appears that the Ninth Circuit approaches the unreasonable compensation analysis in almost reverse order of the Seventh Circuit's approach by applying a reasonableness analysis before turning to the independent investor test.

Importantly, Thousand Oaks is one of the first cases in which the court applied the “independent investor test” in a particular manner. In his Tax Court Memorandum, Judge Wherry looked to prior cases, the company's size and financial condition and historic interest rates, in determining a return on investment that a reasonable investor would expect. Judge Wherry's methods may prove to be a helpful, objective approach to unreasonable compensation challenges in jurisdictions that apply the “independent investor test.”

Hot off the press, Judge Wherry again applied the five broad factors test coupled with the independent investor test in Aries Communications Inc. & Subs. v. Commissioner, T.C. Memo. 2013-97 (2013). In Aries Communications, the Tax Court found the compensation paid to the sole shareholder of a radio broadcasting company, including “catch up” payments for undercompensation in prior years, unreasonably high. A significant portion of the compensation was found to be reasonable, however, and it appears that the independent investor test once again may have heavily influenced Judge Wherry's opinion.

Applying the independent investor test analysis, the Court found a 10–20% rate of return acceptable, which the taxpayer easily met with a 20% return on investment. This rate of return range appears to be a mainstay in the courts' analyses of unreasonable compensation cases. Therefore, it is wise for a taxpayer to gauge compensation levels by determining compensation amounts that would still produce a 10 – 20% annual return on investment.

K&K Veterinary Supply, Inc. v. Commissioner, T.C. Memo. 2013-84 (2013)

In K&K Veterinary Supply, Inc. v. Commissioner, T.C. Memo. 2013-84 (2013), the Tax Court applied a multi-factor analysis to address the reasonableness of compensation. Here, the corporate taxpayer, taxed as a C corporation, had one shareholder who was also an officer. The shareholder's wife, daughter and brother-in-law were also employed by the corporation. The employees performed substantial services for the corporation, which generated significant income for the tax years at issue.

Just as in Thousand Oaks, the Tax Court did not begin the reasonable compensation analysis with the independent investor test. Instead, the Tax Court utilized a nine-factor analysis, which included consideration of the size and complexity of the business, the nature and extent of each employee's work, and comparable salaries in the industry for similar job duties. Though addressing each of the nine factors, the Tax Court noted that the Eighth Circuit places the most importance on a comparison of the salaries at issue with those paid by like businesses, for like services. Both the taxpayer and IRS presented expert testimony on this issue. The Tax Court gave little weight to the taxpayer's expert because he failed to properly identify comparable companies. At the same time, the Tax Court adopted the compensation opinion presented by the Service's expert (without adjustment for any of those factors that the Court found weighed in favor of the taxpayer).

A critical takeaway from K&K Veterinary Supply is the Tax Court's holding that the taxpayer corporation was not entitled to offset its now higher corporate tax liability (resulting from the lower salary deduction) with the higher income tax already paid by the shareholder and his wife on the disallowed compensation. The taxpayer argued that the doctrine of equitable recoupment required such an offset. The Tax Court noted that the doctrine of equitable recoupment requires a sufficient identity of interest between the taxpayers subjected to the two taxes such that they should be treated as one. The Court, however, concluded that a sufficient identity of interest did not exist because the corporation and its shareholder were legally separate taxpayers. It does not appear that the shareholder-employee had filed timely “protective” claims for refund of the excess taxes. Since the statute of limitations for filing a refund claim had passed by the time of the Tax Court opinion, the shareholder-employee was “whipsawed,” by paying taxes at the higher ordinary rate (as if the payments were salary) while the corporation was denied the compensation deduction. Thus, K&K Veterinary Supply not only demonstrates an alternative method the courts may use to analyze the reasonableness of compensation, but it also underscores the importance of anticipating an unfavorable outcome and filing a protective claim for refund at the outset of an IRS examination in order to avoid this “whipsaw” effect.


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