Determining the appropriate compensation for the shareholder/owners of a corporation often proves challenging, perhaps never more so than when the IRS is involved. If the agency deems a shareholder’s compensation is unreasonably high for the services rendered, for example, the excessive compensation could be treated as a constructive dividend and disallowed as a salary deduction. But as the Tax Court decision in Thousand Oaks Residential Care Home I v. Commissioner shows the “reasonable compensation” evaluation isn’t always as straightforward as it might seem.
In 1973, Dr. Robert Fletcher purchased a struggling corporation called Thousand Oaks Residential Care I (TORCH) for $25,000, assuming debt obligations of several hundreds of thousands of dollars. TORCH owned and operated an assisted living facility.
Dr. Fletcher oversaw TORCH’s general operations, handled its finances and supervised its maintenance workers. He also performed substantial maintenance work. His wife, a nurse, managed the health care and housekeeping personnel, worked with the facility’s residents (which included learning their diagnoses, handicaps and illnesses), handled family matters, and communicated with doctors, pharmacists and dietitians. From 1997 to 2001, the Fletchers took little compensation even though they paid their employees at market rates.
In 2002, TORCH sold the assisted living facility for $3.4 million. When the sale was imminent, Dr. Fletcher consulted an accountant about its tax implications. The accountant advised him that if he and his wife hadn’t been paid reasonable compensation in the past, they could make a “catch-up” adjustment to pay themselves more. As a result, TORCH provided Dr. Fletcher with a total compensation package of $880,939 for the years 2003 through 2005. His wife received a total compensation package of $820,348 for the same period.
The IRS determined that the compensation packages were unreasonable and disallowed deductions for all of the compensation paid for tax years 2003 through 2005. The Fletchers and TORCH appealed.
The Tax Court began its analysis by noting that catch-up compensation for prior years’ services is deductible in the current year if: 1) the employee was actually under-compensated in earlier years, and 2) current payments were intended as compensation for past services. Like any compensation, though, catch-up compensation is only deductible under IRC Section 162 if it’s reasonable.
According to the Tax Court, the reasonableness of compensation is based on five factors:
- The employee’s role in the company,
- A comparison of the employee’s salary with salaries paid by similar companies for similar services,
- The character and condition of the company,
- Potential conflicts of interest, and
- Internal consistency.
Because the Ninth Circuit Court of Appeals would hear a further appeal of the matter, the Tax Court also considered a sixth factor: whether an independent investor would be willing to compensate the employee as he or she was compensated.
FACTORS FAVOR TAXPAYER
The court found that the Fletchers’ roles as hands-on operators favored a finding of reasonableness. TORCH’s character and condition also slightly favored reasonableness. Although the corporation wasn’t profitable enough to pay the Fletchers during some years, they were able to pay down their long-term debt. And they managed to make TORCH profitable enough to pay its own bills and command a substantial sale price. The internal consistency treatment factor favored reasonableness because, while their compensation was inconsistent with payments to other employees, the Fletchers discriminated against themselves through underpayment.
The Tax Court considered a sixth factor: whether an independent investor would be willing to compensate the employee as he or she was compensated.
A comparison with salaries paid by a similar company for similar services weighed against reasonableness for 2003 through 2005. After deducting the amounts by which the Fletchers were underpaid in prior years, the court found that Dr. Fletcher’s compensation for 2003 through 2005 was $638,585 and Mrs. Fletcher’s was $264,410 — exceeding figures derived from the Bureau of Labor Statistics’ Occupational Employment Statistics program. And the Fletchers conceded that they had a conflict of interest, which also weighed against reasonableness.
Ultimately, the court seemed to focus most on the sixth factor. Taking into account the rate of return a reasonable investor would have expected, it found that the Fletchers were overpaid by a total of $282,615. (This number was calculated by assuming a 10% return on $25,000 of $503,300 compounded over 31.5 years, less TORCH’s retained earnings of $161,685 at the end of 2005, less a $59,000 disallowed salary for the Fletchers’ daughter.) In other words, the Fletchers’ compensation was unreasonable to the extent that it reduced the assets available to pay the investor’s expected return.
PROCEED WITH CAUTION
Clients can’t afford to take for granted that their compensation is reasonable. A CPA can help them determine if the IRS and the courts would agree, before it’s too late.
TAX COURT HANDS OUT A MIXED BAG
The Tax Court in Thousand Oaks Residential Care Home I v. Commissioner (see main article) also ruled on several other issues.
After the sale of Thousand Oaks Residential Care I (TORCH), the corporation established a defined benefit pension plan, effective Jan. 1, 2003. TORCH made large contributions for the Fletchers in 2003 and 2004. Their accountant advised them that the contributions were benefits and could be included as compensation not previously received.
When the Tax Court found their compensation unreasonable, it concluded that Dr. Fletcher therefore received a nondeductible pension contribution of about $75,000 and his wife a nondeductible contribution of about $65,000. Therefore, the Section 4975 10% Excise Tax on nondeductible contributions to qualified employer plans applied.
However, the court didn’t impose penalties for failure to file excise tax returns or failure to pay a penalty on the tax that would have been due on those returns. It found that the Fletchers had reasonably relied on the advice of their accountant.
This article was written and published by Dennis Frankeberger, CPA/CFF, CFE 909-597-1100.
The Partners of Frankeberger Vausher + Company, CPAs and Litigation Consultants, have in excess of 35 years professional litigation and expert witness experience. We consult with clients, their attorneys and or accountants on the matters listed above in support of confrontational issues requiring settlement and or potential equitable adjustments. We have the technical expertise to analyze complex situations, assist with discovery, and render independent, professional opinions.
Frankeberger Vausher + Company includes CPAs, Forensic Accountants, Certified Fraud Examiners, and includes an expert with a Master’s Degree in Taxation. Dennis Frankeberger – Managing Partner, is also the Chairman of the Board of Advisors to The Leventhal School of Accounting at the University of Southern California. He has lectured extensively regarding matters of Internal Control, Discovery, Fraud, Ethics and Taxation.
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