Within Reason

Remember those postings about whether payments constitute compensation for services rendered, and thus subject to FICA, or whether they’re dividends and thus FICA-free. There is, of course, another facet of that question. In the context of C corporations, contrary to the situation in the S corporation setting, it is often the Service that argues that payments purportedly made to compensate officer/shareholders are unreasonably high. If such payments are not reasonable, they are deemed to be dividends. Thus, they are not deductible to the corporation and, effectively, subject to double taxation.

In Devine Brothers, Inc. v. Commissioner, a Tax Court memorandum decision just handed down, the Tax Court was faced with an attack on payments to an officer/shareholder deemed by the Service to be unreasonably high.

The corporation at issue was a family-owned mechanical contracting business. The senior family member ("Richard, Sr.") was the son and nephew of the two founders who started the business in 1918. However, beginning in the early 1970's, the business fell on hard times. For many years, Richard, Sr., took lower than deserved compensation from the company in order to allow it to maintain its bonding capacity. Beginning in 1986 and concluding in 1996, Richard, Sr., entered into a process of transferring all of the corporation’s stock to his son, Richard, Jr.

Through the fiscal year ending in February, 1994, the salaries paid to both Richard, Sr. and Richard, Jr. were quite modest. However, in that year, their salaries were dramatically increased, with Richard, Sr.'s moving from less than $52,000 to slightly less than $261,000. The Service contended that $65,000 of Richard, Sr.'s salary in that year was excessive and thus a disguised dividend. Oddly, however, the Service stipulated that: "Richard Sr.'s annual salary for the taxable year [in question] falls in the range of salaries paid to presidents/chief executive officers of comparable companies in the same industry during the taxable year."

The Tax Court first noted that there is a division among the circuits as to the appropriate test to be applied in determining whether a salary is reasonable. The traditional test applies a lengthy list of factors that are relevant in the determination of reasonableness, including (i) The employee's qualifications; (ii) the nature, extent, and scope of the employee's work; (iii) the size and complexities of the business; (iv) a comparison of salaries paid with gross income and net income; (v) the prevailing general economic conditions; (vi) comparison of salaries with distributions to stockholders; (vii) the prevailing rates of compensation for comparable positions in comparable concerns; (viii) the salary policy of the taxpayer as to all employees; and (ix) the amount of compensation paid to the particular employee in previous years. More recently, however, courts have substituted instead an independent investor test.

The Tax Court had no difficulty rejecting the Service's attack here. Not only was the compensation paid to Richard, Sr. in line with compensation paid to similarly situated executives, but he was also able to argue persuasively that he had been underpaid in many previous years and the payments in the year in question were made in part to make up for those underpayments.

Before chortling about the Service speaking with forked tongue in comparing cases such as Devine with Veterinary Surgical, it should be noted that the Service only attacked the reasonableness of the Richard, Sr.'s salary after it exceeded $195,000 a year. (And, Richard, Sr., enjoyed a fairly extensive and expensive panoply of non-taxable benefits.) This case gives no succor to those who attempt to recast salary as S corporation dividends, since, in order for that to succeed as a valuable tax planning tool, taxpayers generally have to reduce the officer's wage compensation dramatically.