Reasonable compensation has been a relatively hot topic this year. Charles Allen previously discussed the Blossom case in which the taxpayers were penalized for understating the compensation of the two owners/officers of an S corporation.[1] While Charles’s discussion focused on employment taxation, Josh Sage followed up with an article on the resulting income taxation consequences of the case.[2] In a similar vein, the Tax Court recently denied a Section 162 deduction for a closely held C corporation’s payment of unreasonable compensation to one of its shareholders/executives, finding that the corporation failed to establish that the compensation was reasonable and paid solely for services rendered.[3]
Facts
Clary Hood Inc. was founded by Clary L. Hood and his wife in 1980, and they were the sole shareholders and members of the board. Mr. Hood held ultimate decisional control over all the corporation’s operations from its founding through the years at issue. From its humble beginnings, the Hoods grew the corporation to a very successful construction company, along the way sacrificing Mr. Hood’s salary to make payroll during difficult times.
Despite numerous challenges, the corporation thrived, and in 2014, Mr. Hood and his advisors concluded that he had been undercompensated in prior years. In 2015, the board (consisting of Mr. Hood and his wife) set Mr. Hood’s salary at $168,559 and his bonus at $5 million, with similar compensation in 2016, “in grateful appreciation of the many years of sacrificial work done [by Mr. Hood] on the [corporation]’s behalf.” The corporation claimed a Section 162 deduction for the amounts paid to Mr. Hood as compensation. Importantly, the corporation never paid a cash dividend to its shareholders, the Hoods, during the relevant tax years.
The IRS examined the corporation’s 2015 and 2016 tax returns and, although they conceded that Mr. Hood was entitled to some degree of additional compensation for prior services rendered, determined that that Mr. Hood’s compensation for the years 2015 and 2016 was not reasonable. The IRS issued a notice of deficiency claiming that the corporation owed additional tax of $1,581,202 and $1,613,308 for 2015 and 2016, respectively, and accuracy related penalties of over $300,000 for both years.
Opinion
The Tax Court first made clear that the IRS’s determination of Mr. Hood’s salary being unreasonable is presumably correct, and the burden is on Mr. Hood to prove otherwise..[4] Next, the Court addressed that the determination of whether payments are reasonable and purely for services is a question of fact to be determined from all the facts and circumstances of each particular case.[5] The Court acknowledged that an employer may deduct compensation paid to an employee in the current year although the employee may have performed the services in a prior year, provided the employer can show the employee was not sufficiently compensated in the prior year and that the current year’s compensation was in fact to compensate for that underpayment.[6] However, it also noted that when officers or shareholders are in control of a closely held corporation and set their own compensation, additional scrutiny must be utilized to determine whether the alleged compensation is in fact a disguised dividend.[7]
Key to the opinion were the following eight factors from the Richlands case, which the Court used to determine whether the compensation was reasonable:[8]
- The employee’s qualifications;
- The nature, extent, and scope of the employee’s work;
- The size and complexities of the business;
- A comparison of salaries paid with gross income and net income;
- The prevailing general economic conditions;
- A comparison of salaries with distributions to stockholders;
- The prevailing rates of compensation for comparable positions in comparable concerns; and
- The salary policy of the corporation as to all employees.
The Court provided a varying amount of insight as to its analysis of the factors, but focused heavily on the last three factors, with experts from both sides providing evidence for factor seven. With respect to those three factors, the fact that the corporation had never paid any dividends, there was no written agreement regarding Mr. Hood’s compensation, and the degree of control Mr. Hood exercised over the business, especially with regard to determining his own compensation, were most persuasive. The Court found that Mr. Hood’s compensation far exceeded that of similarly situated individuals in the same industry, and was not persuaded by the testimony provided by the expert witnesses of the taxpayers which attempted to justify the discrepancy, instead finding the analysis of the IRS’s expert more persuasive.
Accordingly, the Tax Court held that the record supported reasonable compensation of $3,681,269 and $1,362,831 for 2015 and 2016, respectively, and the corporation was denied the Section 162 deduction for the excess in each year. The taxpayers were able to show sufficient evidence, consisting mostly of an executive compensation spreadsheet and accompanying research provided by the corporation’s CPAs, to rise to the standard of good faith reliance on the advice of experts so as to avoid accuracy related penalties in 2015. However, the taxpayers could provide almost no evidence with respect to the advice relied upon for 2016, especially since the corporation’s board minutes did not attempt to address why it felt the 2015 amount had been insufficient to cover the amount of backpay due to Mr. Hood. Having failed to provide the Court with sufficient evidence, the corporation was found liable for accuracy-related penalties for 2016.
Individual Concerns
The opinion was focused on the determination of reasonable compensation and the accompanying Section 162 deduction at the corporate level and made no mention of the potential consequences that the redetermination might have for the Hoods individually. Presumably, Mr. Hood would have originally claimed the full amount of compensation as ordinary income, which would have been subject to self-employment taxes. Ideally the Hoods would have been able to amend their return to reclassify the excess compensation (corresponding with the amount of the denied Section 162 deduction) to a qualified dividend, which is not only taxed at the more favorable capital gains rate but is also not subject to self-employment taxation.[9] Unfortunately for the Hoods, the window for amending the returns in question would have closed. As we have seen in other recent cases, the taxpayers were likely whipsawed out of their only real option to properly mitigate the denied deduction because the returns could no longer be amended by the time the case was resolved.[10]
Conclusion
Since the determination of what constitutes reasonable compensation is based on a facts and circumstances analysis, it is rarely a straightforward process. Closely held entities must be especially careful where the officers are also the holders of a majority of the equity interests, since they are typically the ones determining their own compensation. Prudent taxpayers will consider the factors the IRS and courts are likely to evaluate when setting such compensation amounts and properly document the non-tax business support for the level of compensation paid. Even though the taxpayers in this case apparently considered the factors, they took an overly aggressive approach. The most egregious fact, in my opinion, was that the corporation never paid any dividends. It seems mind boggling that the taxpayers were able to get anything to support such a position from a licensed CPA, since doing so seems almost like taunting the IRS. In the end the taxpayers, as they so often do, paid for their avarice.
[1] Charles J. Allen, “Corporation Liable for Employment Tax on Reasonable Compensation of Corporate Officers” (July 28, 2021), https://esapllc.com/blossom-941-2021/.
[2] Joshua W. Sage, “Blossom Day Care Centers – The Income Tax Side” (August 3, 2021), https://esapllc.com/blossom-income-tax21/.
[3] Clary Hood, Inc., TC Memo 2022-15.
[4] Welch v. Helvering, 290 U.S. 111, 115 (1933).
[5] Martens v. Commissioner, 934 F.2d 319 (4th Cir. 1991).
[6] Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 (1930) and Estate of Wallace v. Commissioner, 95 T.C. 525, 553-554 (1990).
[7] Richlands Med. Ass’n v. Commissioner, 953 F.2d 639, (4th Cir. 1992).
[8] Id.
[9] IRC § 1(h)(11)(B).
[10] See Hacker, TC Memo 2022-16, which was the individual side of the Blossom case.
